B.

COM (H) – Core 10 - Semester IV

MANAGEMENT
ACCOUNTING
Author:
Dr.Biswo Ranjan Mishra

Edited By:
Dr.Sujit Kumar Acharya
Dr.Rashmi Ranjeeta Das

UTKAL UNIVERSITY
Directorate of Distance & Continuing Education
Bhubaneswar
 SYLLABUS
(Core-10)

MANAGEMENT ACCOUNTING

Objective: To acquaint the students with basic concepts of management accounting,

and basic understanding of tools and techniques used for managerial decision making.

CONTENTS: `

Unit – I:

Management Accounting: Meaning, nature, scope, and importance of management

accounting; Role of management accounting; management accounting vs. financial
accounting; Role of management accounting in modern business; Tools and techniques
of management accounting.

Unit – II: Ratio Analysis & Cash flow statement

Ratio Analysis:
Meaning and utility of ratios; significance of Ratio analysis; Classification of Ratios –
Profitability ratios, Efficiency Ratios, Liquidity Ratios, Solvency Ratios; Advantages and
limitations of Ratio Analysis.

Cash flow Statements:

Cash Flow Statements: Meaning and utility of Cash flow statements; Preparation of
Cash flow statements – Indirect method; Limitations of Cash flow statements; Cash flow
statements vs. Funds flow statements. (Reference to Revised AS-3 and Ind AS-7)

Unit – III:
Absorption & Marginal Costing: P/V Ratio, Break-even analysis, Margin of safety,
angle of incidence; Marginal and differential costing as a tool for decision making –
make or buy, change of product mix, exploring new markets, shut down decisions.

Unit – IV:

Budgeting & Standard Costing: Concept of budget and budgetary control; objectives,
merits and limitations of budgetary system; Master budget, Functional budget, Fixed
and Flexible budgets; Zero based budgeting. Standard Costing & Variance Analysis:
Meaning of standard cost and standard costing, Advantages and disadvantages of
standard costing and variance analysis: Material, Labour, & Overhead.

Learning Outcome: After the completion of this paper, the students will be able to have
Confidence in managing cost issues and also to keep a check on cost control and
taking managerial decisions.

Text Books Recommended

1. Management Accounting, S swain/ S.P. Gupta/ A Sharma, V.K. Global Pub. Pvt. Ltd.,
2. Horngreen, Charles T., Gary L. Sundem. Introduction to Management Accounting.
3. Prentice Hall.

Suggested Reading:
1. Jain & Narang, Management Accounting, Kalyani Publications
2. Management Accounting-M Wilson- Cost Accounting-Jena B,Bal S and Das
AHimalaya
Publishing House
3. Narasimhan M.S. , Management Accounting, Cengage Learning
4. Cost & Management Accouning, Taxmann Publications
5. Arora, M.N. Cost Accounting – Principles and Practice. Vikas Publishing House,
New Delhi.
6. Maheshwari, S.N. and S.N. Mittal. Cost Accounting: Theory and Problems. Shri
Mahabir Book Depot, New Delhi.
7. Lal, Jawahar. Advanced Management Accounting Text and Cases. S. Chand & Co.,
New Delhi.
8. Khan, M.Y. and P.K. Jain. Management Accounting. Tata McGraw Hill, Publishing
 UNIT-1
CONCEPTS OF MANAEMENT ACCOUNTING
LEARNING OBJECTIVES:

 To understand different branches of Accounting with their limitations

 To conceptualize the meaning, definition, nature, scope and objectives of Management

Accounting

 To analyze the importance/role of Management Accounting

 To differentiate between Management Accounting, Financial Accounting and Cost

Accounting

 To know the role of Management Accounting in modern business

 To acquaint with the tools and techniques of Management Accounting

CHAPTER PLAN:

1.1 Introduction
1.2 Definition of Management Accounting
1.3 Nature/Characteristics of Management Accounting
1.4 Scope of Management Accounting
1.5 Objectives of Management Accounting
1.6 Importance/Functions of Management Accounting
1.7 Role of Management Accounting
1.8 Role of Management Accountant
1.9 Distinction between Management Accounting, Financial Accounting & Cost Accounting
1.10 Role of Management Accounting in Modern Business
1.11 Tools and Techniques of Management Accounting
1.12 Limitations of Management Accounting
1.13 Glossary
1.14 Review Questions
1.1 INTRODUCTION:

Accounting is the process of recording, classifying, summarizing, analyzing and interpreting the
financial transactions of the business for the benefit of management and those parties who are
interested in business such as shareholders, creditors, bankers, customers, employees and
government. Thus, it is concerned with financial reporting and decision making aspects of the
business.

Branches of Accounting

Accounting can be groupedinto three categories:

1. Financial Accounting

2. Cost Accounting, and

3. Management Accounting

1.1.1 Financial Accounting

The term ‘Accounting’ unless otherwise specifically stated always refers to ‘Financial
Accounting’. Financial Accounting is commonly carried on in the general offices of a business.
It is concerned with revenues, expenses, assets and liabilities of a business house.

Financial Accounting has two-fold objectives, viz.

1. To ascertain the result of the business in terms of earning of profits or suffering of losses, and

2. To know the financial position of the concern.

The following are the functional aspects of financial accounting:

1.Dealing with Financial Transactions

2. Recording of information

3. Classification of Data

4. Summarizing Group of Information

5. Analyzing

6. Interpreting the Financial Information

7. Communicating the Results

Financial Accounting is like a post-mortem report. At the most it can reveal what has happened
so far, but it does not have any control over the past happenings.

The limitations of financial accounting are as follows:

1. It records only quantitative information.

2. It records only the historical cost. The impact of future uncertainties has no place in financial
accounting.

3. It does not take into account price level changes.

4. It provides information about the whole concern. Product-wise, process-wise, department-

wise or information of any other line of activity cannot be obtained separately from the financial
accounting.

5. Cost figures are not known in advance. Therefore, it is not possible to fix the price in advance.
It does not provide information to increase or reduce the selling price.

6. As there is no technique for comparing the actual performance with that of the budgeted
targets, it is not possible to evaluate performance of the business.

7. It does not tell about the optimum or otherwise of the quantum of profit made and does not
provide the ways and means to increase the profits.

8. In case of loss, whether loss can be reduced or converted into profit by means of cost control
and cost reduction? Financial Accounting does not answer such question.

9. It does not reveal which departments are performing well? Which ones are incurring losses
and how much is the loss in each case?

10. It does not provide the cost of products manufactured

11. There is no means provided by financial accounting to reduce the material losses, i.e.
wastage, scrap, spoilage and defectives.

12. Can the expenses be reduced which results in the reduction of product cost and if so, to what
extent and how? There is no answer to these questions in financial accounting.

13. It is not helpful to the management in taking strategic decisions like replacement of assets,
introduction of new products, discontinuation of an existing line, expansion of capacity, etc.

14. It provides ample scope for manipulation like overvaluation or undervaluation. This
possibility of manipulation reduces the reliability.
 15. It is technical in nature. A person not conversant with accounting has little utility of the
financial accounts.

1.1.2 Cost Accounting

The Institute of Cost and Works Accountants, India defines cost accounting as, “the technique
and process of ascertainment of costs. Cost Accounting is the process of accounting for costs,
which begins with recording of expenses or the bases on which they are calculated and ends with
preparation of statistical data”.

To put it simply, when the accounting process is applied for the elements of costs (i.e.,
Materials, Labour and Other expenses), it becomes Cost Accounting.

The main objectives of cost accounting are as follows:

1. Cost Ascertainment

2. Cost Control

3. Cost Reduction

4. Fixation of Selling Price

5. Providing information for framing Business policy.

Limitations of Cost Accounting

i)GroundedonEstimation: As cost accounting relies heavily on predetermined data, it is not

reliable.

ii)No StandardizedProcedure:As there is no uniform procedure, with the same information

different results may be arrived by different cost accountants.

iii)Conventions and Estimates: There are number of conventions and estimates in preparing
cost records such as materials are issued on an average (or) standard price, overheads are charged
on percentage basis, Therefore, the profits arrived from the cost records are not true.

iv) Formalities: Many formalities are to be observed to obtain the benefit of cost accounting.
Therefore, it is not applicable to small and medium firms.

v) Expensive: Cost accounting is expensive and requires reconciliation with financial records.

vi) AdditionalTool: Cost Accounting is an additional tool not an essential tool and an enterprise
can survive even without cost accounting.
vii) Secondary Data: Cost Accounting depends on financial statements for a lot of information.
The errors or short comings in that information creep into cost accounts also.

1.1.3 Management Accounting

Management Accounting is comprised of two words ‘Management’ and ‘Accounting’. It means

the study of managerial aspect of accounting. The emphasis of management accounting is to
redesign accounting in such a way that it is helpful to the management in formation of policy,
control of execution and appreciation of effectiveness.

Management Accounting can be viewed as Management-oriented Accounting. Basically it is

the study of managerial aspect of financial accounting,i.e.“accounting in relation to management
function". It is developed mainly to help the management in the discharge of its functions and for
taking various decisions. The primary task of management accounting is, therefore, to redesign
the entire accounting system so that it may serve the operational needs of the firm. It furnishes
definite accounting information-past, present or future, which may be used as a basis for
management action. The financial data are so devised and systematically developed that they
become a unique tool for management decision.Hence, Management Accounting involves the
study of accounting information and techniques that managers use in analyzing information.

Management Accounting is not a specific system of accounts, but could be any form of
accounting which enables a business to be conducted more effectively and efficiently.
Management Accounting, therefore, appears as the extension of the horizon of cost accounting
towards emerging areas of management. Management Accounting is largely concerned with
providing economic information to managers for achieving organizational goals.Managers use
management accounting information to choose strategy to communicate it and to determine how
best to implement it. They use management accounting information to coordinate their decisions
about designing, producing and marketing a product or service.

1.2 DEFINITION OF MANAGEMENT ACCOUNTING:

Anglo-American Council of Productivity: “ManagementAccounting is the presentation of

accounting information in such a way as to assist the management in creation of policy and the
day to day operation of an undertaking".

Institute of Chartered Accountants of England and Wales: “Any form of accounting which
enables a business to be conducted more efficiently can be regarded as Management
Accounting”.

American Accounting Association: “It includes the methods and concepts necessary for
effective planning for choosing among alternative business actions and for control through the
evaluation and interpretation of performances.”
Institute of Cost and Management Accountants, London: “Management Accounting is the
application of professional knowledge and skill in the preparation of accounting information in
such a way as to assist management in the formulation of policies and in the planning and control
of the operation of the undertakings”.

Institute of Management Accountants (IMA): "Management Accounting is a profession that

involves partnering in management decision making, devising planning and performance
management systems, and providing expertise in financial reporting and control to assist
management in the formulation and implementation of an organization's strategy"

J. Batty: “Management Accountancy is the term used to describe the accounting methods,
systems and techniques which, with special knowledge and ability, assist management in its task
of maximizing profit or minimizing losses.”

Brown and Howard: “Management Accounting is that aspect of accounting which is concerned
with the efficient management of a business through the presentation of management of such
information as will facilitate efficient and opportune planning and control.”

Robert Anthony: “Management Accounting is concerned with accounting information which is

useful to management”

CIMA, London: “Management Accounting is an integral part of management concerned with

identifying, presenting and interpreting information used for: (a) formulating strategy; (b)
planning and controlling activities; (c) decision taking; (d) optimizing the use of resources; (e)
disclosure to shareholders and others external to the entity; (f) disclosure to employees; (g)
safeguarding assets”.

1.3 NATURE /CHARACTERISTICS OF MANAGEMENT ACCOUNTING:

1. Grounded onAccounting Information

Management Accounting is based on accounting information. Management Accounting is a

service function and it provides necessary information to different levels of management.
Management Accounting involves the presentation of information in a way that suits the
managerial needs. The accounting data collected by accounting department is used for reviewing
various policy decisions.

2. Cause and Effect Analysis

The role of financial accounting is limited to find out the ultimate result, i.e., profit and loss,
whereas management accounting goes a step further. Management Accounting discusses the
cause and effect relationship. The reasons for the loss are probed and the factors directly
influencing the profitability are also analyzed. Profits are compared to sales, different
expenditures, current assets, interest payables, share capital, etc. to give meaningful
interpretation.

3. Use of Special Techniques and Concepts

Management Accounting uses special techniques and concepts according to necessity, to make
accounting data more useful. The techniques usually used include financial planning and
analyses, standard costing, budgetary control, marginal costing, project appraisal etc.

4. Aids in Taking Important Decisions

It supplies necessary information to the management which may be useful for its decisions. The
historical data is studied to see its possible impact on future decisions. The implications of
various decisions are also taken into account.

5. Aims at Achieving Objectives

Management Accounting uses the accounting information in such a way that it helps in
formatting plans and setting up objectives. Comparing actual performance with targeted figures
will give an idea to the management about the performance of various departments. When there
are deviations, corrective measures can be taken immediately with the help of budgetary control
and standard costing.

6. No Fixed Norms

No specific rules are followed in management accounting as that of financial accounting. Though
the tools are the same, their use differs from concern to concern. The deriving of conclusions
also depends upon the intelligence of the management accountant. The presentation will be in the
way which suits the concern most.

7. ImprovesEfficiency

The purpose of using accounting information is to increase efficiency of the concern. The
performance appraisal will enable the management to pin-point efficient and inefficient spots.
Efforts are made to take corrective measures so that efficiency can be improved. The constant
review will make the staff cost conscious.

8. DeliversInformation and not Decision

Management accountant is only to guide to take decisions. The data is to be used by the
management for taking various decisions. ‘How is the data to be utilized’ will depend upon the
caliber and efficiency of the management.
9. Involvedin Forecasting

The management accounting is concerned with the future. It helps the management in planning
and forecasting. The historical information is used to plan future course of action. The
information is supplied with the object to guide management for taking future decisions.

1.4 SCOPE OF MANAGEMENT ACCOUNTING

The advancement in information technology and the ever growing appetite of information
consumers in this information age has broadened the scope of management accounting to include
things that were not included in the discipline some ten years ago.Management Accounting has
moved from a mere information gathering and processing system to an all-encompassing
business solution box.

Management Accounting is concerned with presentation of accounting information in the most

useful way for the management. Its scope is, therefore, quite vast and includes within its fold
almost all aspects of business operations. However, the following areas can rightly be identified
to be within the ambit of management accounting:

(i) Financial Accounting: Management Accounting is mainly concerned with the

rearrangement of the information provided by financial accounting. Hence, management cannot
obtain full control and coordination of operations without a properly designed financial
accounting system.

(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential
costing and other cost techniques play a useful role in operation and control of the business
undertaking.

(iii) Revaluation Accounting: This is concerned with ensuring that capital is maintained intact
in real terms and profit is calculated with this fact in mind.

(iv) Budgetary Control: This includes framing of budgets, comparison of actual performance
with the budgeted performance, computation of variances, finding their causes, etc.

(v) Inventory Control: It includes control over inventory from the time it is acquired till its
final disposal.

(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other
statistical methods make the information more impressive and intelligible.

(vii) Interim Reporting: This includes preparation of monthly, quarterly, half yearly income
statements and the related reports, cash flow and funds flow statements, scrap reports, etc.

(viii) Taxation: This includes computation of income in accordance with the tax laws, filing of
returns and making tax payments.
(ix) Office Services: This includes maintenance of proper data processing and other office
management services, reporting on best use of mechanical and electronic devices.

(x) Internal Audit: Development of a suitable internal audit system for internal control.

(xi)Management Information System [MIS]: Management Accounting serves as a centre for

collection and dissemination of information.MIS is an essential part of Management Accounting.

1.5 OBJECTIVES OF MANAGEMENT ACCOUNTING

The fundamental objective of management accounting is to enable the management to maximize

profits or minimize losses. The evolution of management accounting has given a new approach
to the function of accounting. The main objectives of management accounting are as follows:

1. Planning and Policy Formulation

Planning involves forecasting on the basis of available information, setting goals, framing
polices, determining the alternative courses of action and deciding on the programme of
activities. Management accounting can help greatly in this direction. It facilitates the preparation
of statements in the light of past results and gives estimation for the future.

2. Interpretation Process

Management Accounting is to present financial information to the management. Financial

information is technical in nature.

Therefore, it must be presented in such a way that it is easily understood. It presents accounting
information with the help of statistical devices like charts, diagrams, graphs, etc.

3. Assists in Decision-Making Process

With the help of various modern techniques, management accounting makes decision-making
process more scientific. Data relating to cost, price, profit and savings for each of the available
alternatives are collected and analyzed and thus it provides a base for taking sound decisions.

4. Controlling

Management Accounting is a useful tool for managerial control. Management Accounting tools
like standard costing and budgetary control are helpful in controlling performance. Cost control
is affected through the use of standard costing and departmental control is made possible through
the use of budgets. Performance of each and every individual operation is controlled with the
help of management accounting.
5. Reporting

Management Accounting keeps the management fully informed about the latest position of the
concern through reporting. It helps management to take proper and quick decisions. The
performances of various departments are regularly monitored and reported to the top
management.

6. Facilitates Organizing

Since management accounting stresses more on Responsibility Centres with a view to control
costs and fixation of responsibilities, so it also facilitates decentralization to a greater
extent.Thus, it is helpful in setting up effective and efficient organization framework.

7. Facilitates Coordination of Operations

Management Accounting provides tools for overall control and coordination of business
operations. Budgets are important means of coordination.

1.6 IMPORTANCE/FUNCTIONS OF MANAGEMENT ACCOUNTING

The basic function of management accounting is to assist the management in performing its
functions effectively. The functions of the management are planning, organizing, directing and
controlling. Management Accounting helps in the performance of each of these functions in the
following ways:

(i) Provides Data: Management Accounting serves as a vital source of data for management
planning. The accounts and documents are a repository of a vast quantity of data about the past
progress of the enterprise which are a must for making forecasts for the future.

(ii) Modifies Data: The accounting data required for managerial decisions is properly compiled
and classified. For example, purchase figures for different months may be classified to know
total purchases made during each period product-wise, supplier-wise and territory-wise etc.

(iii) Analyses and Interprets Data: The accounting data is analyzed meaningfully for effective
planning and decision-making. For this purpose the data is presented in a comparative form.
Ratios are calculated and likely trends are projected.

(iv) Serves as a Means of Communicating: Management Accounting provides a means of

communicating management plans upward, downward and outward through the organization.
Initially, it is a means of identifying the feasibility and consistency of the various segments of the
plan. At later stages it keeps all parties informed about the plans that have been agreed upon and
their roles in these plans.

(v) Facilitates Control: Management Accounting helps in translatinggiven objectives and

strategy into specified goals for attainment by a specified time and secures effective
accomplishment of these goals in an efficient manner. All this is made possible through
budgetary control and standard costing which is an integral part of management accounting.

(vi) Uses also Qualitative Information: Management Accounting does not restrict itself to
financial data for helping the management in decision making but also uses such information
which may not be capable of being measured in monetary terms. Such information may be
collected form special surveys, statistical compilations, engineering records, etc.

1.7 ROLE OF MANAGEMENT ACCOUNTING

The role of management accounting can be summarized in following points:

1. Helping Forecast the Future:

Forecasting aids decision-making and answering questions, such as: Should the company invest
in more equipment? Should it diversify into different markets? Should it buy another company?
Management Accounting helps in answering these critical questions and forecasting the future
trends in business.

2. Helping in Make-or-Buy Decisions:

Is it cheaper to procure materials or a product from a third party or manufacture them in-house?
Cost and production availability are the deciding factors in this choice. Through management
accounting, insights will be developed which will enable decision-making at both operational
and strategic levels.

3. Forecasting Cash Flows:

Predicting cash flows and the impact of cash flow on the business is essential. How much cost
will the company incur in the future? Where will its revenues come from and will the revenues
increase or decrease in the future? Management Accounting involves designing of budgets and
trend charts, and managers use this information to decide how to allocate money and resources to
generate the projected revenue growth.

4. Helping Understand Performance Variances:

Business performance discrepancies are variances between what was predicted and what is
actually achieved. Management Accounting uses analytical techniques to help the management
build on positive variances and manage the negative ones.

5. Analysing the Rate of Return:

Before embarking on a project that requires heavy investments, the company would need to
analyse the expected rate of return (ROR). If given two or more investment opportunities, how
should the company choose the most profitable one? In how many years would the company
break-even on a project? What are the cash flows likely to be? These are all vital questions that
can be answered through management accounting.

1.8 ROLE OF MANAGEMENT ACCOUNTANT

The management accountant, often referred to as controller, is the managers of accounting

information used in planning, control and decision making areas. He is responsible for collecting,
processing and reporting information that well help managers in their planning, controlling and
decision making activities. He participates in all accounting activities within the organization.

The following are the Roles of Management Accountant:

1. Participating in Management Process: The management accountant occupies a pivotal

position in the organization. He performs a staff function and also has line authority over the
accountant and other employees in his office. He educates executives on the best use of
accounting information.

2. Maintaining optimum Capital Structure: Management accountant has a major role to play
in raising of funds and their application. He has to decide about maintaining a proper mix of debt
and equity. The raising of funds through debt is cheaper because of tax benefits and a proper
leverage leads to trading on equity.

3. InvestmentOpportunities: A management accountant can assist either person or a firm

regarding the investment in different ways. He can suggest how, when and where the investment
should be made so that an investor or the firm canearn maximum return.

4. Financial Investigations: A management accountant can assist the management about the
financial investigations which is extremely desired to determine the financial position for the
interested parties. Relating to issue of shares, amalgamation or mergers, or reconstructions etc to
ascertain the reason of decreasing profit or increasing costs, it so happened.

5. Long-term and Short –term Planning: Management accountant plays an important role in
forecasting future business and economic events for making future plans i.e., short term and
long-term plans, formulating corporate strategy, market study etc.

6. Participating in Management Process: The management accountant occupies a pivotal

position in the organization. He performs a staff function and also has line over the accountant
and other employees in his office. He educates executives on the need for collecting information
and on the ways of using it. He shifts relevant information from the irrelevant and reports the
same in a clear form to the management and sometimes to interested external parties.

7. Decision Making; Management accountant provides necessary information to management in

taking short-term decision e.g. optimum product mix, make or buy, lease or buy, pricing of
product, discontinuing a product etc. and long-term decisions e.g., capital budgeting,investment
appraisal, project financing. However, the job of management accountant is limited to the
adequacy of required information, both in a comprehensive as well as reliable form for decision
making purposes.

8. Control: The management accountant analyses accounts and prepares reports e.g., standard
costs, budgets, variance analysis and interpretation, cash and funds flow analysis, management of
liquidity, performance evaluation and responsibility accounting etc. for control.

9.Developing Management Information System: The routine reports as well as reports for long
term decision making are forwarded to managerial personnel at all levels to take corrective
action at the right time and also uses these reports for taking important decisions.

10. Stewardship Accounting: Management accountant designs the framework of cost and
financial accounts and prepares reports for routine financial and operational decision making.

11. CorporatePlanning: He can assist management for long-term planning and advise
management regarding amalgamation or mergers or reconstructions including financial planning
to see whether effective utilization of resources is made or not. Thus, the role of management
accountant cannot be ignored. As such, his services are primarily desired for the efficient
management of an undertaking.

1.9 DISTINCTION BETWEEN MANAGEMENT ACCOUNTING, FINANCIAL

ACCOUNTING, COST ACCOUNTING

1.9.1 DIFFERENCE BETWEEN COST ACCOUNTING AND FINANCIAL ACCOUNTING

Sl No Basis Cost Accounting Financial Accounting

1 Purpose: The main purpose of Cost The main purpose of Financial
Accounting is to analyze, Accounting is to record financial
ascertain and control costs transactions and prepare financial
statements.

2 Decision The Cost Accounts are basically Financial accounts are of limited
Making: designed to facilitate decision use in decision making.
making in the areas of
production, purchase, sales etc.
3 Analysis of The Cost Accounting shows the Financial Accounting shows the
Cost and detailed cost and profits for each overall profit/loss of the entire
Profit: product, process, job, contract organization.
etc.
4 Transactions Cost Accounting keeps records Financial Accounts keep records
Recorded: of both external and internal of only external transactions with
transactions. outsiders.

5 Access: In Cost Accounting the outsiders In Financial Accounting anybody

 generally have no access to cost can have access to Financial
records. Statements of Companies.

6 Control: Cost Accounting Control all Financial Accounting does not

elements of Costs. exercise adequate control over
material, labour and overhead
costs.

7 Profit or Loss Cost Accounting determines the Financial Accounting determines

profit or loss of each product, the profit or loss of the entire
process, job and department. business.

8 Units Cost Accounting records both Financial Accounting records only

monetary and physical units monetary units in the books of
such as labour hour, machine accounts.
hour etc.
9 Valuation of Closing Stock is valued at cost In Financial Accounting Closing
Closing price only in Cost Accounting. Stock is valued at cost or market
Stock price {Net Realizable value}
whichever is lower.

10 Audit Cost Accounting need not be Financial Accounting needs a

followed by a system of external system of independent audit of the
audit. financial records by an external
auditor.

11 Tax Cost Accounting does not form a Financial Accounting forms a

Assessment basis for tax assessment. basis for determination tax
liability of the business.

12 Parties Cost Accounting serves the Financial Accounting serves the

information needs of the information needs of owners,
management. creditors, employees and the
society at large.

13 Mandatory Installing a costing system is Maintaining Financial Accounting

purely optional. is mandatory.
14 Lack of There are no fixed rules and There are fixed rules and
Uniformity: regulations in Cost regulations in Financial
Accounting.Therefore different Accounting.
cost accounting system may be
followed by different firms in
the same industry which makes
comparison difficult.
1.9.2DIFFERENCE BETWEEN COST ACCOUNTING AND MANAGEMENT
ACCOUNTING

The important differences between Cost Accounting and Management Accounting are as
follows:

Sl No Basis Cost Accounting Management Accounting

1 Purpose: The purpose of Cost Accounting The purpose of Management
is the ascertainment of cost at Accounting is to provide
each stage of production. information to the management
for decision making.
2 Basis: Cost Accounting is prepared Management Accounting purely
mainly on the basis of past and aims at the future based on the
less emphasis is given for the past information.
future.
3 Preparation: Cost Accounting is prepared on Management Accounting is
the basis of some rules and prepared without adopting any
regulations prescribed by the specific and rigid rules. It may be
ICAI (Institute of Cost prepared according to the will of
Accountants of India). the managerial personnel.

4 Reports: The Reports of the Cost The reports of the Management

Accounting are subject to Accounting are not subject to
statutory audit. statutory audit.

5 Useful: The reports of the Cost The reports of the Management

Accounting are useful both to Accounting are useful only for the
the internal and external parties. internal parties.

6 Scope: Cost Accounting does not Management Accounting includes

include tax planning and tax tax planning and tax accounting.
accounting.

7 Evolution: Cost Accounting evolves due to Management Accounting evolves

the limitation of financial due to the limitations of cost
accounting, accounting. It is the managerial
aspects of financial accounting
and cost accounting.
8 Maintenance The maintenance of records is The maintenance of records is
of Records: compulsory for complying the purely voluntary and for internal
statutory requirements in use of management of the
selected industries as notified by Company.
Govt. from time to time.
9 Planning Cost Accounting is mainly Management Accounting is
Aspect: concerned with short-term concerned with short term as well
planning. as long term planning of the
 organization.

10 Installation Cost Accounting can be installed Management Accounting system

of System: without the help of the cannot be properly installed
Management Accounting in the without a proper cost accounting
organization. system.

11 Derivation of Cost Accounting data are Management Accounting data are

Data: derived basically from financial derived from both Cost Accounts
accounts. as well as from Financial
Accounts.

12 Status: The status of the Cost The status of the Management

accountant in the organization accountant is higher than Cost
comes after the management accountant in the organization due
accountant. to direct participation in decision
making process.

1.9.3DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

Sl No Basis Financial Accounting Management Accounting

1 Objective Financial Accounting aims at The aim of Management
recording business transaction Accounting is to prepare various
systematically to ascertain profit statements for managerial
or loss and financial position at planning, control and decision
the end of the financial year. making.

2 Time Period In Financial Accounting the InManagement Accounting the

accounts are prepared for a reports are prepared from time to
particular period. time to update with the changing
business environment.
3 Audit In Financial Accounting under InManagement Accounting audit
Company law Financial is optional..
accounts are subject to
compulsory Audit.
4 Principles Financial Accounting is In Management Accounting no set
prepared as per Generally of standing principles are
Accepted Accounting principles followed.
(GAAP).

5 Nature Financial Accounting is The Management Accounting is

concerned with historical data. It concerned with both historical
records only those transactions data and estimated data.
which have already taken place.
 Thus, the accounts prepared here
are like post-mortem report.
6 Publication In Financial Accounting, In Management Accounting the
Financial Statements are statements and reports are not
published annually for external published. They are meant for
parties interested in the internal use of the management.
accounting information.
7 Quickness In Financial Accounting, In Management Accounting,
reporting is slow and time reporting is very quick as it is
consuming. Hence, one has to meant for decision making.
wait till the end of the
accounting year to get the
financial statements.
8 Nature of Financial Accounting is Management Accounting is
Information concerned with quantitative concerned with both qualitative
information expressed in terms and quantitative information.
of money.
9 Reporting In Financial Accounting, InManagement Accounting, the
Financial reports are prepared reports are prepared for internal
not only for the organization but use only.
for others interested in the
accounting information of the
business.
10 Legal Preparation of financial accounts Management Accounting is not
Compulsion is mandatory to comply with compulsory.
statutory requirements.

1.10 ROLE OF MANAGEMENT ACCOUNTING IN MODERN BUSINESS:

Management Accounting is required to satisfy the demands of the current economic

environment. There is a need for more innovative and useful management accounting techniques
to improve productivity, to reduce costs, to improve quality, to determine accurate product costs
to satisfy managerial needs of planning, decision making and control.

1. Activity-Based Costing (ABC) and Management:

The demand for more accurate and relevant management accounting information has led to the
development of activity-based costing and activity-based management. Activity-based costing
improves the accuracy of assigning costs by first tracing costs to activities and then to products
or customers that consume these activities. Process value analysis, on the other hand, emphasizes
activity analysis— trying to determine why activities are performed and how well they are
performed.
The objective is to find ways to perform necessary activities more efficiently and to eliminate
those that do not create customer value. Activity-based management is a system- wide,
integrated approach that focuses management’s attention on activities with the objective of
improving customer value and the resulting profit. Activity-based management emphasizes
Activity- Based Costing (ABC) and process value analysis.

2. Increasing Customer Value:

Globalisation has brought a wave of change in the way business operates and creates value for
the customer. Now the market is not firm-centric but customer-centric. Customer value is a key
focus of every firm. Firms can establish a competitive advantage by creating better customer
value for the same by reducing cost than that of competitors with value addition to the product.

Customer value is the difference between what a customer receives (customer realization) and
what the customer gives up (customer sacrifice). Increasing customer value means increasing
customer realization or decreasing customer sacrifice, or both.

Increasing customer value to create a sustainable competitive advantage is achieved through

selection of strategies. Cost information plays a critical role in this process and does through a
process called as strategic cost management. Strategic cost management is the use of cost data to
develop and identify superior strategies that can produce a sustainable competitive advantage. A
focus on customer value ensures that the management accounting system should produce
information about both realization and sacrifice.

3. Cross-Functional Perspective:

Management Accounting has a cross-functional perspective and management accountant must

understand all functions of the business, from manufacturing to marketing and customer service.
When customer value is attempted to be increased, all the functions of a business become
interrelated; a decision affecting one, affects others as well.

A cross-functional perspective helps us to see the forest, not just one or two of the trees. This
broader vision allows managers to increase quality, reduce the time required to serve customers
and improve efficiency. In this perspective, management accounting helps other business
functions through providing useful information and analysis.

4. Total Quality Management (TQM):

Continuous improvement is fundamental for establishing a state of manufacturing excellence.

Manufacturing excellence is the key to survival in today’s world-class competitive environment.
A philosophy of total quality management, in which manufacturers strive to create an
environment that will enable workers to manufacture perfect (zero-defect) products, has replaced
the “acceptable quality” attitudes of the past.
Quality cost measurement and reporting are key features of a management accounting system for
both manufacturing and service industries. In both cases, the management accounting system
should be able to provide both operational and financial information about quality, including
information such as the number of defects, quality cost reports, quality cost trend reports and
quality cost performance reports.

5. Enhancing Efficiency and Reducing Time:

Improving efficiency in business activities is of vital concern in all business enterprises. Both
financial and non-financial measures of efficiency are needed. Cost is a critical measure of
efficiency. Trends in costs over time and measure of productivity changes can provide important
measures of the efficiency of continuous improvement decisions. (Output measured in relation to
the inputs).

Reducing time in all phases of production cycles, selling and distribution should be an important
target for all business houses. Firms should deliver products or services quickly by eliminating
non-value-added time and time of no-value to the customer. Decrease in non-value added time
has correspondence with increase in quality.

Now-a-days, the technological innovation has increased for many industries and the life of a
particular product can be quite short. Managers must be able to respond quickly and decisively to
changing market conditions. Information to allow them to accomplishthis must be available from
a management accounting information system.

6. Electronic Business (E-Business):

E-business is doing business transaction through information and communication technology. E-

commerce is buying and selling products using information and communication technology.
Business firms can expand sales and lower costs through e-business compared to paper-based
transactions. Management accounting plays significant role in e-business through providing
relevant cost information about its benefits, risks and opportunities. For example, business
managers need to know the cost per electronic transaction versus cost per paper transaction.

1.11TOOLS AND TECHNIQUES USED IN MANAGEMENT ACCOUNTING

Some of the important tools and techniques used in management accounting are briefly
explained below.

1. Financial Planning

The main objective of any business organization is maximization of profits. This objective is
achieved by making proper or sound financial planning. Hence, financial planning is considered
as best tool for achieving business objectives.
2. Financial Statement Analysis

Profit and Loss account and Balance Sheet are important financial statements. These statements
are analysed for different period. This type of analysis helps the management to know the rate of
growth of business concern. This analysis is done through comparative financial statements,
common size statements, ratio analysis and trend analysis.

3. Cost Accounting

Cost Accounting presents cost data in product wise, process wise, department wise, branch wise
and the like. These cost data are compared with predetermined one. This comparison of two
costs enables the management to decide the reasons responsible for the difference between these
costs.

4. Funds Flow Analysis

This analysis finds out the movement of fund from one period to another. Moreover, this analysis
is very useful to know whether the fund is properly used or not in a year when compared to the
previous year. The net working capital changes and funds lost from operation are also found out
through this analysis.

5. Cash Flow Analysis

The movement of cash from one period to another can be found out through this analysis.
Besides, the reasons for cash balance and changes between two periods are also found out. It
studies the cash from operation and the movement of cash in a period under the distinct heading
of operating activities, financing activities and investing activities.

6. Standard Costing

Standard cost is predetermined cost. It provides a yard stick for measuring actual performance. It
is used to find the reasons for the variances if any.

7. Marginal Costing

Marginal costing technique is used to fix the selling price, selection of best sales mix, best use of
scarce raw materials or resources, to take make or buy decision, acceptance or rejection of bulk
order and foreign order and the like. This is based on the fixed cost, variable cost and
contribution.

8. Budgetary Control

Under Budgetary control techniques, future financial needs are estimated and arranged according
to an orderly basis. It is used to control the financial performances of business concern. Business
operations are directed in a desired direction.
9. Revaluation Accounting

The fixed assets are revalued as per the revaluation accounting method so that the capital is
properly represented with the assets value. It helps to find out the fair return on capital employed.

10. Decision-Making Accounting

A business problem can be solved by choosing any one of the best and most profitable
alternatives. To select such alternative, the relevant costs are compared. Thus, accounting
informationare used to solve the business problem which are arising out of increasing complexity
of nature of business.

11. Management Information System (MIS)

Free flow of communication within the organization is essential for effective functioning of
business. Hence, the management can design the system through which every employee of an
organization can assess the information and used for discharging their duties and taking quality
decisions.

12. Statistical Techniques

There are a lot of statistical techniques used in removing management problems. Methods of
least square, Regression analysis, Correlation analysis, Time series analysis and Statistical
quality control etc. are some examples of statistical techniques.

13. Management Reporting

The management accountant is preparing the report on the basis of the contents of profit and loss
account and balance sheet and submit the same before the top management. Thus, management
reports disclose the strength and weakness indifferent areas of operating activities and financial
activities. These identifications are highly useful to management in exercising control and taking
appropriate decision.

14. Ratio Analysis

It is used by management in the discharge of its basic functions of forecasting, planning,

coordination, communication and control. It paves the way for effective control of business
operations by undertaking an appraisal of both the physical and monetary targets.

Summary of Tools and Techniques of Management Accounting:

1. Based on Financial Accounting Information

 Analysis of Financial Statements through Ratio Analysis.
 Analysis of Financial Statements through Comparative statements,Common size
statements, Trend, Graph and Diagram.
 Funds flow and Cash flow analysis.
  Return on Capital Employed Techniques.

2. Based on Cost Accounting Information

 Marginal costing (including cost-volume-profit analysis).
 Differential costing.
 Standard Costing.
 Analysis of Cost Variances.

3. Based on Mathematics
 Operation Research.
 Linear Programming.
 Network Analysis.
 Queuing theory and Game Theory.
 Simulation Theory.

4. Based on Future Information

 Budgetary Control.
 Business Forecasting.
 Project Appraisal or Evaluation.

5. Miscellaneous Tools
 Managerial Reporting.
 Integrated Auditing.
 Financial Planning.
 Revaluation Accounting.
 Decision Making Accounting.
 Management Information System.

1.12 LIMITATIONS OF MANAGEMENT ACCOUNTING

Management Accounting, being comparatively a new discipline, suffers from certain limitations
which limits its effectiveness. These limitations are as follows:

1. Limitations of Basic Records: Management Accounting derives its information from

financial accounting, cost accounting and other records. The strength and weakness of the
management accounting, therefore, depends upon the strength and weakness of these basic
records. In other words, their limitations are also the limitations of management accounting.

2. Persistent Efforts: The conclusions drawn by the management accountant are not executed
automatically. He has to convince people at all levels because people by nature are resistant to
change. In other words, he must be an efficient salesman in selling his ideas.

3. Management Accounting is only a Tool: Management Accounting cannot replace the

management. Management accountant is only an adviser to the management. The decision
regarding implementing his advice is to be taken by the management. There is always a
temptation to take an easy course of arriving at decision by intuition rather than going by the
advice of the management accountant.

4. Wide Scope: Management Accounting has a very wide scope incorporating many disciplines.
It considers both monetary as well as non-monetary factors. These factors bring inexactness and
subjectivity in the conclusions obtained through it.

5. Top-Heavy Structure: The installation of Management Accounting system requires heavy

costs on account of an elaborate organization and numerous rules and regulations. It can,
therefore, be adopted only by big concerns.

6. Opposition to Change: Management Accounting demands a break away from traditional

accounting practices. It calls for a rearrangement of the personnel and their activities which is
generally not liked by the people involved.

7. Evolutionary Stage: Management Accounting is in its evolution stage. It has, therefore, the
same impediments as a new discipline will have, e.g., fluidity of concepts, raw techniques and
imperfect analytical tools. This all creates doubt about the very utility of management
accounting. The rapid changes in the business scenario are big challenge before management
accounting.

1.13 REVIEW QUESTIONS:

1. Discuss in detail the functions of management accounting. Explain the nature and scope of
management accounting.

2. Explain the term ‘management accounting’ and state the objectives of management
accounting.

3. ‘Management Accounting is the presentation of accounting information in such a way as to

assist management in the creation of policy and in the day to day operations of the undertaking’.
Elucidate this statement.

4. ‘Management Accounting is nothing more than the use of financial information for
management purpose’. Explain this statement and clearly distinguish between financial
accounting & management accounting.

5. What do you understand by ‘Management Accounting’? How does it differ from Cost
Accounting?

6. How does management accounting differ from Financial Accounting? What are the limitations
of Management Accounting?
7. ‘Management Accounting aims at providing financial result of the business to the management
for taking decisions.’ Explain by bringing out advantages of Management Accounting.

8. Describe fully the limitations of Financial Accounting and point out how Management
Accounting helps in overcoming them.

10. “Management Accounting is Financial Accounting bend at its elastic point.” How far do-you
agree with this statement? Explain.

10. Explain the features of Management Accounting.

11. “There is an intimate relationship between Management Accounting and finance function.”
Elucidate.

12. “Management Accounting is concerned with information which is useful to management.”

Explain.

13. “A management accountant is both an information provider and a part of management”

Explain.

14. “Management Accounting is the best tool for management to achieve its objectives”.
Elucidate.

15. How does management accounting help planning and controlling the functions of an
organization?

16. Define “Management Accounting” and state its important tools and techniques.
 UNIT-2

CASH FLOW STATEMENT

LEARNING OBJECTIVES:

-To understand the meaning, nature, objective of Cash Flow Statement

-To learn the classification of activities under Cash Flow Statement

-To acquaint with the provisions of Indian Accounting Standard on Cash Flow Statement

-To know different steps of preparation of Cash Flow Statement

-To analyze the merits and demerits of Cash Flow Statement

-To differentiate between Cash Flow Statement, Income Statement and Funds Flow Statement

CHAPTER OUTLINE:

1.1: Introduction

1.2: Meaning of Cash Flow Statement

1.3 Objectives of Preparing Cash Flow Statement

1.4 Classification of Cash Flow Activities

1.5 Main Heads of Cash Flow Statement

1.6 Methods of Preparing Cash Flow Statement

1.7 Indian Accounting Standard (Ind AS-7) on Cash Flow Statement

1.8 Basic information for Preparation of Cash Flow Statement

1.9Stepby Step Procedure to Prepare Cash Flow Statement

1.10 Utility/Uses/Importance/Significance of Cash Flow Statement

1.11 Limitations/Disadvantages of Cash Flow Statement

1.12 Difference between Cash Flow Statement & Income Statement

1.13 Difference between Cash Flow Statement & Funds Flow Statement

1.14 Miscellaneous Examples

1.15 Glossary
1.16 Theoretical Questions

1.17 Practical Questions

1.1 INTRODUCTION

“Cash is King”; is a known fact, that it is the basis of any business. No bills, employee payment,
expenses payment would be made without cash. Expansions or addition to businesses can happen
only through cash. In financial terms, Cash FlowStatement is a statement (report) of flows (both
in and out of the business) of cash. Monitoring the cash situation of any business is the key. The
income statement would reflect the profits but does not give any indication of the cash
components. The important information of what the business has been doing with the cash is
provided mainly by the Cash FlowStatement. Like the other financial statements, the Cash
FlowStatement is also usually drawn up annually, but can be drawn up more often. It is
noteworthy that Cash FlowStatement covers the flows of cash over a period of time (unlike the
balance sheet that provides a snapshot of the business at a particular date). Also, the Cash
FlowStatement can be drawn up in a budget form and later compared to actual figures.

1.2 MEANING OF CASH FLOW STATEMENT

1. It is a summary of the actual or anticipated incomings and outgoings of cash in a firm over
an accounting period (month, quarter, and year). It answers the questions: Where the cash came
(will come) from? Where it went (will go)?

2. Cash Flow Statements assess the amount, timing, and predictability of cash-inflows and
cash-outflows, and are used as the basis for budgeting and business-planning.

3. A Cash FlowStatement provides information about the changes in cash and cash
equivalents of a business by classifying cash flows into operating, investing and financing
activities. It is a key report to be prepared for each accounting period for which financial
statements are presented by an enterprise.

NOTE: Cash and Cash Equivalents generally consist of the following: Cash in hand, Cash at
bank& Short term investments that are highly liquid.

1.3 OBJECTIVES OF PREPARING CASH FLOW STATEMENT

1. Cash Flow Statement shows inflow and outflow of cash and cash equivalents from various
activities of a company during a specific period under the main heads i.e., operating activities,
investing activities and financing activities.

2. Information through the Cash Flow Statement is useful in assessing the ability of any
enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize those
cash flows.
3. Taking economic decisions requires an evaluation of the ability of an enterprise to generate
cash and cash equivalents, which is provided by the Cash Flow Statement

4. Statement of cash flows provides important insights about the liquidity and solvency of a
company which are vital for survival and growth of any organization.

5. It enables analysts to use the information about historic cash flows for projections of future
cash flows of an entity on which to base their economic decisions.

6. By summarizing key changes in financial position during a period, Cash Flow Statement
serves to highlight priorities of management.

7. Comparison of cash flows of different entities helps to reveal the relative quality of their
earnings since cash flow information is more objective as opposed to the financial performance
reflected in income statement.

1.4 CLASSIFICATION OF CASH FLOW ACTIVITIES:

Cash flow activities are to be classified into three categories:

 Operating Activities
 Investing Activities
 Financing Activities

This is done to show separately the cash flows generated / used by these activities, thereby
helping to assess the impact of these activities on the financial position and cash and cash
equivalents of an enterprise.

1.4.1 Cash Flows from Operating Activities:

Operating activities are the activities that comprise of the primary / main activities of an
enterprise during an accounting period. For example, for a garment manufacturing company,
operating activities include procurement of raw material, sale of garments, incurrence of
manufacturing expenses, etc. These are the principal revenue generating activities of the
enterprise. Hence, Operating activities are the principal revenue-producing activities of the
enterprise. Operating activities include cash effects of those transactions and events that enter
into the determination of net profit or loss. Cash flows from operating activitiesinclude the
followings:

 Cash receipts from sale of goods and the rendering services;

 Cash receipts from royalties, fees, commissions and other revenue;
 Cash payments to suppliers for goods and services;
 Cash payments to and on behalf of employees;
  Cash receipts and payments of an insurance enterprise for premiums and claims annuities
and other policy benefits;
 Cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
 Cash receipts and payments relating to future contracts, forward contracts, option
contracts, and swap contracts when the contracts are held for dealing or trading purpose.

1.4.2 Cash Flows from Investing Activities:

Cash flow from investing activities includes the movement of cash flows owing to the purchase
and sale of assets. Investing activities are the acquisition and disposal of long term assets and
other investments not included in cash equivalent. In other words, investing activities include
transactions and events that involve the purchase and sale of long-term productive assets (e.g.,
land, building, plant and machinery, etc.) not held for resale and other investments. The
following are the examples of cash flows arising from investing activities:

(a) Cash payments to acquire fixed assets (including intangibles). These payments include those
relating to capitalized research and development costs and self-constructed fixed assets.

(b) Cash receipts from disposalof fixed assets (including intangibles).

(c) Cash payments to acquire shares, warrants, or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalent and those held for dealing or trading purposes).

(d) Cash receipt from disposal of shares, warrants, or debt instruments of other enterprises and
interest in joint ventures (other than receipts from those instruments considered to be cash
equivalents and those held for dealing or trading purposes).

(e) Cash advances and loans made to third parties (other than advances and loans made by a
financial enterprise).

(f) Cash receipts from repayment of advances and loans made to third parties (Other than
advances and loan of a financial enterprise).

(g) Cash receipts and payments relating to futurecontract, option contract, and swap contracts
except when the contracts are held for dealing or trading purposes.

1.4.3 Cash Flows from Financing Activities

It includes financing activities related to long-term funds or capital of an enterprise. Financing

activities are activities that result in changes in the size and composition of the owners’ capital
and borrowings of the enterprisee.g., cash proceeds from issue of equity shares, debentures,
raising long-term loans, repayment of bank loans, etc.
Financing activities are activities that result in changes in the size and composition of the
‘owners’ capital (including preference share capital in the case of a company) and borrowings of
the enterprise. The following are the examples of cash flows arising from financing activities:

(a) Cash proceeds from issuing shares or other similar instruments;

(b) Cash proceeds from issuing debentures, loans notes, bonds and other short term borrowing;

(c) Cash payments of amount borrowed;

(d) Payment of dividend.

Special Items: In addition to the general classification of three types cash flow, Ind AS-7
provides for the treatment of the cash flows of certain special items as under:

(a)Foreign Currency Cash Flows: Cash flow arising from transactions in a foreign currency
should be recorded in an enterprise’s reporting currency by applying to the foreign currency
amount the exchange rate between the reporting currency and foreign currency at the date of
cash flow. A rate that approximates actual rate may be used if the result is substantially the same
as would arise if the rates at the date of cash flows were used. Unrealised gains and losses arising
from changes in foreign exchange rate changes on cash and cash equivalent held or due in
foreign currency is reported in the Cash FlowStatement in order to reconcile cash and cash
equivalents at the beginning and end of the period.

(b) Extraordinary Items: The cash flows associated with extraordinary items such as bad debts
recovered, claims from insurance companies, winning of a law suit or lottery etc., are disclosed
separately as arising from operating, investing or financing activities in the Cash FlowStatement.

(c)Interest and Dividends: The treatment of interest and dividends, received and paid, depends
upon the nature of enterprise, that is, financial enterprises or other enterprises, as follows:

(i) In the case of financial enterprises, cash flows arising from interest paid and interest and
dividend received, should be classified as cash flows from operating activities.

(ii) In the case of other enterprises-(a) cash flows arising from interest paid should be classified
as cash flows from financing activities while interest and dividend received should be classified
as cash flows from investing activities; (b) dividends paid should be classified as cash flows
from financing activities.

(d)Taxes on Income: Cash flows arising from taxes on income should be separately disclosed
and should be classified as cash flows from operating activities unless they can be specifically
identified with financing and investing activities.
(e) Acquisition and Disposal of Subsidiaries and Other Business Units: The aggregate cash
flows arising from acquisitions and from disposals of subsidiaries or other business units should
be presented separately and classified as investing activities.

(f) Non-Cash Transaction: Investing and financing transactions that do not require the use of
cash or cash equivalents should be excluded from a Cash FlowStatement. Such transactions
should be disclosed elsewhere in the financial statements in a way that provides all the relevant
information about these investing and financing activities. The exclusion of non-cash
transactions from the Cash FlowStatement is consistent with the objective of a Cash
FlowStatement as these do not involve cash flows in the current period. Following are examples
of non-cash transactions:

(i) The acquisition of assets by assuming directly related liabilities;

(ii) The acquisition of an enterprise by means of issue of shares;

(iii) Conversion of debt into equity.

1.5 MAIN HEADS OF CASH FLOW STATEMENT:

Cash Flows from Operating Activities (A) xxx

Cash Flows from Investing Activities (B) xxx
Cash Flows from Financing Activities (C) xxx
Net Increase (Decrease) in Cash and Cash Equivalents (A + B + C) xxxxx
Add: Cashand Cash Equivalents at the Beginning xxx
Cash and Cash Equivalents at the End xxxxx

1.6 METHODS OF PREPARING THE CASH FLOW STATEMENTS

Operating activities are the main source of revenues and expenditures, thereby cash flow from
the same needs to be ascertained. The cash flow can be reported through two ways:

(a)Direct method that discloses the major classes of gross cash receipts and cash payments

(b)Indirect method that has the net profit or loss adjusted for effects of (1) transactions of a non-
cash nature, (2) any deferrals or accruals of past/future operating cash receipts and (3) items of
income or expenses associated with investing or financing cash flows.

DIRECT METHOD:

In the direct method, the major heads of cash inflows and outflows (such as cash received from
trade receivables, employee benefits, expenses paid, etc.) are to be considered.
As different lines of items are recorded on accrual basis in statement of profit and loss, certain
adjustments are to be made to convert them into cash basis such as the following:

1. Cash receipts from Customers = Revenue from operations + Trade Receivables at the
beginning – Trade Receivables at the end.

2. Cash payments to Suppliers = Purchases + Trade Payables atthe Beginning – Trade Payables
at the End.

3. Purchases = Cost of Revenue from Operations – Opening Inventory + Closing Inventory.

4. Cash Expenses = Expenses on accrual basis + Prepaid expenses in the Beginning and
Outstanding expenses in the End – Prepaid expenses in the End and Outstanding expenses in the
Beginning.

INDIRECT METHOD:

Indirect method of ascertaining cash flow from operating activities begins with the amount of net
profit/loss. This is so because statement of profit and loss incorporates the effects of all operating
activities of an enterprise. However, Statement of Profit and Loss is prepared on accrual basis
(and not on cash basis). Moreover, it also includes certain non-operating items such as interest
paid, profit/loss on sale of fixed assets, etc.) and non-cash items (such as depreciation, goodwill
written-off, etc). Therefore, it becomes necessary to adjust the amount of net profit/loss as shown
by Statement of Profit and Loss for arriving at cash flows from operating activities.

1.7 INDIAN ACCOUNTING STANDARD ON CASH FLOW STATEMENT

The Ind AS-7 “Statement of Cash Flows” deals with cash flow. It prescribes two formats for the
presentation of Cash Flow Statement. These formats are given in Tables 1 and 2

TABLE 1: CASH FLOW STATEMENT (DIRECT METHOD)

Cash FlowFrom Operating Activities
Cash receipts from customers xxx
Cash paid to suppliers and employees (xxx)
Cash generated from operation xxx
Income Tax Paid (xxx)
Cash Flow before extraordinary item xxx
± Extraordinary Items xxx
Net cash from Operating Activities (A) xxxx
Cash FlowFrom Investment Activities
Purchase of fixed assets (xxx)
Proceeds from sale of equipment xxx
Interest received xxx
Dividend received xxx
Net cash from Investing Activities (B) xxxx
Cash FlowFrom Financing Activities
Proceeds from issuance of share capital xxx
Proceeds from long-term borrowings xxx
Repayments of long-term borrowings (xxx)
Interest paid (xxx)
Dividend paid (xxx)
Net cash from Financing Activities (C) xxxx
Net Increase in Cash and Cash Equivalents (A+B+C) xxxxx
Add: Cash and cash equivalents at the beginning of the period xxx
Cash and Cash Equivalents at the End of the period xxxxx

TABLE 2: CASH FLOW STATEMENT (INDIRECT METHOD)

Cash Flow From Operating Activities
Net Profit before Taxation and Extraordinary item xxx
Adjustment for:
Depreciation xxx
Foreign exchange loss xxx
Interest income xxx
Dividend income xxx
Interest expense xxx
Operating profit before working capital changes xxx
Increase in current assets (xxx)
Decrease in current assets xxx
Decrease in current liabilities (xxx)
Increase in current liabilities xxx
Cash generated from operation xxx
Income tax paid (xxx)
Cash Flow before extraordinary item xxx
± Extraordinary Items xxx
Net cash from Operating Activities (A) xxxx
Cash FlowFrom Investment Activities
Purchase of fixed assets (xxx)
Proceeds from sale of equipment xxx
Interest received xxx
Dividend received xxx
Net cash from Investing Activities (B) xxxx
Cash FlowFrom Financing Activities
Proceeds from issuance of share capital xxx
Proceeds from long-term borrowings xxx
Repayments of long-term borrowings (xxx)
Interest paid (xxx)
Dividend paid (xxx)
Net cash from Financing Activities (C) xxxx
Net increase in Cash and Cash Equivalents(A+B+C) xxxxx
 Add: Cash and cash equivalents at the beginning of the period xxx
Cash and Cash Equivalents at the End of period xxxxx

1.8 BASIC INFORMATION FOR PREPARATION OF CASH FLOW STATEMENT

The following basic informationis required to prepare a Cash Flow Statement:

1. Comparative Balance Sheet: The first and the foremost requirement is the comparative
Balance Sheet in the beginning and end of the period to find out the changes taking place in
different items of the Balance Sheet.

2. Income Statement for the period under consideration: The Income Statement of the period
is also required to find out the cash generated or used in the operation of the firm.

3. Additional Information: Together with Balance Sheet and Income Statement other relevant
information is also required to identify the hidden information, if any.

1.9 STEP BY STEP PROCEDURE TO PREPARE CASH FLOW STATEMENT

1. Calculate the Net Increase or Decrease in Cash and Cash Equivalent. For this purpose the
opening balance of total cash and equivalents is compared with the closing balance of cash and
equivalents. The net increase/decrease as shown here is the figure to be explained by Cash Flow
Statement. Table 1.4 explains the procedure for this.

TABLE 1.4: INCREASE/DECREASE IN CASH AND CASH EQUIVALENT

Opening Bal. Closing Bal.
Cash in Hand xxx xxx
Cash at Bank xxx xxx
Short-term Investment xxx xxx
Total xxxxx xxxxx

The difference between the totals of opening and closing balances will be the increase or
decrease in cash and equivalents during the period. It may be noted that if there are only one or
two items of cash etc., then the table as above need not be prepared and the net increase or
decrease may be ascertained by simple observation only.

2. Net Cash Flow from Operating Activities: The term operating activities refers to the normal
business transactions relating to goods and services being traded by the firm e.g. sale and
purchase of goods and services. On the basis of the information contained in the Comparative
Balance Sheet and the Income Statement and the additional information, the net cash flow
generated or used by operating activities may be ascertained. The Income Statement prepared by
the firm gives the net profit figure earned by the firm, on an accrual basis i.e. all items in the
Income Statement are incorporated on the basis of earned/ accrued even if not resulting cash
movements. So, profit or loss as shown by the Income Statement may not result in
increase/decrease in cash balance by the same amount. In order to prepare the Cash Flow
Statement, what is required is the amount of cash generated or used by operating activities. For
this purpose, the non-cash and non-operating items are adjusted to the net profit figures as
reported in the Income Statement. In the Cash Flow from Operating Activities, the purpose is to
convert the net profit (accounting) which is based on accrual concept to the cash flow from
operations. Ind AS-7 has given two procedures to find out the net cash from operating activities
as follows:

(a) Direct Method: In Direct method, an attempt is made to convert the given Income Statement
into a cash basis Income Statement. All the sales, purchases, expenses etc. are analyzed to find
out the cash effect of all these items as follows:

(i) The Cash Realized from Sales may be ascertained as follows:

Cash Sales xxx
Credit Sales (as given in Income Statement) xxx
Less: Closing Balance of Debtors xxx
Closing Balance of Bills xxx
Add: Opening Balance of Debtors xxx
Opening Balance of Bills xxx
Cash generated from Credit sales xxx xxx
Total Cash Generated xxxxx
(ii) The Cash Paid for Purchases may be ascertained as follows:
Cost of goods sold (As given in Income xxx
Statement)
Less: Opening Stock xxx
Add: Closing Stock xxx
Total Purchases xxx
Add: Opening balance of Creditors xxx
Less: Closing balance of Creditors xxx
Cash paid for Purchases xxxxx
Similarly, Cash Paid for any Expense item may be ascertained as follows:
Expense (as given in Income Statement) xxx
Add: Outstanding in the beginning xxx
Less: Outstanding at the end xxx
Cash paid for Expenses xxxxx

Under Direct method, all non-cash expense items such as depreciation, writing off the fictitious
assets, amortization of intangible asset, etc. are ignored. Similarly, profit or loss on sale of
assets/investments is also not considered.
(b) Indirect Method: In the indirect method, the net profit (before tax and extraordinary items)
figure is the starting point. This profit figure is adjusted for non-cash and non-operating items to
find out the cash from operating activities. Generally, the adjustment is required for the
following items:

(i) Non-cash expenses such as depreciation, intangible and fictitious assets written off, loss on
sale of assets/investment, etc. are added back.

(ii) Non-cash and Non-operating incomes such as profit on sale of assets/investments, interest
income, dividend income, interest accrued but not received are deducted from the net profit to
arrive at the cash from operating activities.

(iii) Changes in current accounts and current liabilities during the year are also adjusted to find
out the cash from operating activities.

Under the Indirect method the cash from operating activities may be finally ascertained as shown
in Table 3.

TABLE 3: CASH FLOW FROM OPERATING ACTIVITIES

Amount
Net Profit Before Tax and Extraordinary Items xxx
+ Depreciation xxx
+ Provision for contingencies xxx
+ Provision for retirement benefits xxx
+ Loss on sale of fixed assets xxx
+ Loss/(Profit) on disposal of investments xxx
+ Interest paid xxx
- Dividend received (xxx)
- Interest received (xxx)
Operating Profit Before Working Capital Changes
Adjustment for:
+ Decrease/ (increase) in trade and other receivables xxx
+ Decrease/ (increase) in inventories xxx
+ Decrease/ (increase) in trade payables xxx
Cash Generated From Operations xxx
- Direct taxes paid (xxx)
Cash FlowBefore Extraordinary Items xxx
± Extraordinary item xxx
Net Cash Inflow/ (Outflow) From Operations xxxxx

3. Calculation of Cash provided by Financing and Investment Activities: All other items
(except current accounts already considered in step 2 above) are analysed in the light of
additional information to find out the resultant cash flow, if any. For this purpose, different items
and information are classified into financing activities and investing activities.
4. Preparation of Cash Flow Statement (CFS): On the basis of information collected and
calculations made in the above steps, now the Cash Flow Statement can be prepared as per any
of the formats given earlier (Table 1 and 2). The net cash flow provided by operating activities
plus financing activities plus investing activities is equal to the net change in cash and
equivalents (as calculated in step 1).

5.Other Items: If there is any other investment or financing transaction (not already covered in
step 3 above) that should be disclosed in the Cash Flow Statement e.g., there may be a purchase
of an asset by issue of capital or debenture. This transaction will not find place in the usual Cash
Flow Statement but must be disclosed to make the Cash Flow Statement a useful and a
meaningful document.

1.10UTILITY / USES, IMPORTANCE OR SIGNIFICANCE OF CASH FLOW

STATEMENT

The main uses and importance of Cash FlowStatement can be summarized as follows:

1.Evaluation of Liquidity Position : This statement helps to analyse whether short period
liabilities like creditors, bank overdrafts, bills payable, outstanding expenses can be paid easily
with the regular receipts (Inflow) of cash or not. There should be balance in inflow and outflow
to keep liquidity and smooth working conditions in business.

2. Comparison in Intra-firm and Inter-firm: With the help of Cash FlowStatement, intra firm
(within the firm) and inter firm (with other firms) can be carried out to know whether the
liquidity position is improving or deteriorating over the period of time.

3. Arrangement of Future Needs: The requirement of cash and availability of cash can be
calculated easily after a specified period regularly to know deficit or surplus of cash to make
timely arrangement.

4. Cash Generated by Various Activities Separately: Cash flow Statement is divided into
three separate activities. . These activities are (a) Operating (b) Investing (c) Financing. It shows
cash generated by each activity separately.There may be positive or negative generation of cash
by any of the activity but in the end total of all these three activities shows the ultimate cash
position.

5. Calculation of the Position of Repayments of Liabilities on Time: Cash FlowStatement

helps to find out whether the business has sufficient cash to pay or plan to pay its liabilities and
fulfil its other needs like (a) Repayment of loans (b) funds for replacement of plant, machinery,
vehicles or other fixed assets or not on time.

6.Useful to Outsiders : Cash Flow statement is very useful to outsiders like Bankers, Investors,
Lenders, Debenture- holders, Creditors to judge and analyse the long-term as well as short-term
liquidity and cash position of the business and taking decisions regarding financial position.
7. It Provides Test for Managerial Decision: For the long-term success of the business and
generating higher profits, the most important rule for the management should be "Maximum
Fixed Assets should be purchased from funds generated from long-term sources of funds like (a)
Shares (b) Debenture (c) Mortgages (d) Ploughing back of profits etc. and these liabilities should
be repaid out of cash generated from operating activities of the business.

8. Explains Causes of Change in Cash: Cash FlowStatement explains the reasons for change or
deviation in cash or cash equivalent between the two Balance Sheets which provides useful tips
and reasons for change in cash over the period.

9. Explanation Regarding Net Profit and Cash Balance: Sometimes a very funny position
arises in the organisation like profits are very high while cash balance is very low even there may
be situation that cash is not sufficient to pay salary bill, or power bill or for purchase of raw
material. On the other hand, sometimes profits are very low but large amount of cash balance
either in hand or in bank. The reason for this situation may be issuing shares, raising loans or
selling fixed assets etc.

10. Working Capital and Operating Activities Relation: The success of the business lies in
the fact that maximum needs of the working capital should be fulfilled through the cash flow
from operating activities. Funds from long period sources should be used for fixed assets and
other profit generating activities to provide strength/ stability, soundness and liquidity to
business.

11. Dividend Payment and Cash Resources: Regular payment of dividend is a positive sign of
growing and progressive business year by year. Payment of dividend increases Goodwill,
Credibility among investors and better public image of organisation as well as of management.
But these dividends should be paid out of the profits and reserves and not from borrowed funds
or funds raised on sale of fixed assets

12. Other Uses:

(i)Cash Flow Statements help in knowing the liquidity / actual cash position of the company
which funds flow and P&L are unable to specify.

(ii)As the liquidity position is known, any shortfalls can be arranged for or excess can be used for
the growth of the business

(iii)Any discrepancy in the financial reporting can be gauged through the Cash FlowStatement
by comparing the cash position of both.

(iv)Cash is the basis of all financial operations. Therefore, a projected Cash FlowStatement will
enable the management to plan and control the financial operations properly.
(v)Cash Flow analysis together with the ratio analysis helps measure the profitability and
financial position of business.

(vi)Cash FlowStatement helps in internal financial management as it is useful in formulation of

financial plans.

1.11LIMITATIONS/DIS-ADVANTAGES OF CASH FLOW STATEMENT

These can be summarized as follows:

1. It ignores Non-cash Transactions: While preparing Cash FlowStatement, non-cash

transactions are not included or are not considered. These transactions may be:

(a) Issue of Bonus Shares

(b) Conversion of Debentures into shares.

(c) Purchase of Fixed assets by issuing shares or consideration other than cash.

2. Closing Cash Balance can be manipulated or window dressed by Management: If

management wants, cash balance can be easily manipulated by:

(d) Postponing payments

(e) Postponing cash purchases

(f) Fast collection from debtors around closing dates of final accounts.

3. It is not a Substitute to an Income Statement (Profit and Loss Account/Statement of Profit

and Loss): In Profit and Loss Account, non-cash items like depreciation, writing off goodwill,
preliminary expenses etc. are included which reduces the profits while in Cash Flowstatement
these are ignored which results into difference in Net Income (profits) and cash flow during the
same period.

4. It ignores the Accrual Concept of Accounting: In the accounting system the accounts are
prepared on accrual basis. It means income earned whether received or not and expenditure
incurred whether paid or not are to be considered for true and fair calculation of the results of
business at the end of accounting year.But Cash FlowStatement is prepared on cash basis of
accounting. It is prepared on the basis of actual inflow and outflow of cash.

5. No True Judgment of Liquidity: Liquidity of a business cannot be judged solely upon cash
or bank balance but other current assets like debtors, stock, bills receivable etc. which can be
converted into cash easily in a short period. Thus, ability to pay current liabilities cannot be
judged by cash and bank balance alone.
6. It is a Historical Document: Cash FlowStatement is prepared on the basis of two consecutive
Balance Sheets taking into account the various information provided in those documents. So this
is related to past period and thus, a historical document. For expansion and growth future
planning is needed.

7. It is based on Secondary Data: This document is based on already prepared Income

Statement and Balance Sheet thus, for preparing Cash FlowStatement secondary data are used.

8. Other Limitations:

(i)Through the Cash FlowStatement alone, it is not possible to arrive at actual P&L of the
company as it shows only the cash position. It has limited usage and in isolation, it is of no use
and requires Balance sheet, Profit & Loss A/C for its projections. Cash FlowStatement does not
disclose net income from operations. Therefore, it cannot be a substitute for income statement

(ii) The cash balance as shown by the Cash FlowStatement may not represent the real liquidity
position of the business because it can be easily influenced by postponing the purchases and
other payments

(iii) Cash flow Statement cannot replace the funds flow statement. Each of the two has a
separate function to perform.

1.12DIFFERENCE BETWEEN CASH FLOW STATEMENT AND INCOME

STATEMENT

Sl No Basis Cash Flow Statement Income Statement

1 Disclosure It is a statement of inflows and It shows the net profit/net loss
outflows of cash from during the period.
operating, investing and
financing activities during a
period.
2 Scope Cash Flow Statement provides Income Statement focuses on
information about cash flows of the ascertainment of results of
an entity and its scope is limited the operations of the entity. It
only to the extent of cash flows requires the measurement of
from operating, investing and period’s income by revenue
financing activities. recognition and matching
expenses.
3 Activities Cash Flow Statement provides It focuses on the results of the
Covered information not only about operations of the business and
operating activities but also does not provide information
about investing and financing about investing and financing
activities. activities.
4 Earning Per Cash Flow Statement does not Schedule III of Companies
Share provide information about Act, 2013, requires the
 earning per share. statement of Profit and Loss to
state the basic and diluted
earnings per share also.
5 Revenue & Cash Flow Statement does not Income Statement shows the
Expenses show revenues recognized, or revenue recognized and
expenses incurred during the expenses incurred as per
period. relevant Accounting Standards.
6 Nature Items shown in Cash Flow Several items in Income
Statement are objective and Statement are based on
factual. judgement and subjectivity.
7 Preparation Cash Flow Statement can be Income Statement is to be
prepared only after Balance prepared before Balance Sheet
Sheet and Income Statement are and Cash Flow Statement.
prepared.

1.13DIFFERENCE BETWEEN CASH FLOW STATEMENT AND FUNDS FLOW

STATEMENT

Sl No Basis Cash Flow Statement Funds Flow Statement

1 Disclosure It discloses the It discloses the changes of net
inflowandoutflow ofcash and working capital.
cashequivalentsunder
theheading of
operating.Investingand
Financing activities.
2 BasisofAcco It is prepared It is prepared under
unting undercashbasis. accrualbasis.

3 Usefulness It is usedfor shortterm It is used for long term

financialplanning. financialplanning.
4 DistinctHead It shows inflows andoutflows It shows sources and
ing of cashunder threedistinct applicationsof funds without
headings-Operating, any heading.
Investing and
Financingactivities.
5 Prescribedfor It is prepared There is no
mat asperprescribedformat of suchprescribedformat.
IndAS-7.
6 Scope It's scope is narrow It's scope is wide as the
asonlycash and concept of fund is net working
cashequivalentsareconsidered capital i.e. total current assets
. minustotal current liabilities.
7 Changes of It shows the changes in It shows the changes in
Working working capital more working capital at a glance.
Capital clearly.
1.14 DIFFERENCE BETWEEN CASH FLOW STATEMENT AND BALANCE SHEET

Sl No Basis Cash Flow Statement Balance Sheet

1 Meaning A statement that shows the A statement that shows the
cash inflow and outflow of assets owned and the liabilities
the company. owed by the company.
2 Classified into Three parts Two parts
3 Importance Helpful in budgeting and Discloses financial position of
forecasting. the company.
4 Information Movement of cash and cash Assets, Equity and Liabilities.
Disclosed equivalent.
5 Basis It is prepared taking profit & It is prepared taking profit &
loss account and balance loss account into consideration.
sheet into consideration.

1.15 ILLUSTRATIONS:

Illustration 1:

The following are the list of Transactions for Ram Software Limited (RSL) for 2019

On March 1 Ram & others invest ₹50,000 in cash in RSL.

On March 2 Ram took a loan of ₹20,000 from Venugopal for RSL. Being a nice friend,
Venugopal does not demand any interest on the loan amount and asks it to be
repaid in six months’ time.
On March 3 RSL purchased for cash two computers, each costing ₹29,000
On March 4 RSL purchased supplies especially stationary for ₹6,000 on credit.
On March 19 RSL completes its maiden sale of software to a retail store and receives a
price of ₹12,000.
On March 21 RSL pays ₹2000 to its creditors for supplies.
On March 29 RSL pays salaries to its employees, amounting to ₹4,000 and office rent ₹
1,200.
On March 30 RSL delivers a software package for a shoe shop. The customer agrees to pay
the price of ₹8,000 a week later.
On March 31 Ram withdraws ₹3,500 for his personal use.

At the end of the month, you are required to prepare its statement of cash flow following

Direct Method.
Solution:

The first and second transactions of raising owner’s equity and taking a loan would be part of its
financing activities as cash inflows.

The third transaction involving RSL purchasing two computers would be a part of its investing
activities cash outflow.

The fourth transaction would not lead to any change in its cash position and hence would not be
part of its Cash FlowStatement.

The next transaction on March 19, wherein RSL completes its maiden sale of software to a retail
store and receives a price of ₹12,000 would be a part of its operating cash inflow. On March 21,
RSL pays ₹ 2,000 cash (Part of its payables) to its supplier resulting in an operating cash
outflow.

RSL pays salaries to its employees, amounting to ₹4,000 and office rent ₹1,200 resulting in an
operating cash outflow.

RSL delivers Software package for a shoe shop worth ₹ 8,000 and the customer agrees to pay
the price week later. This transaction would result in neither a cash inflow nor a cash outflow and
hence there would be no change in our statement of cash flow. On the other hand, accrual
principle would have taken this transaction as an increase in the revenue of the company by a
similar amount as part of its profit and loss account.

On March 31, the owner withdraws ₹3,500 from the profits of the company. We may consider
this outflow of the company’s profit as the dividend resulting in a cash outflow due to the firms
financing activities.

A summary of all the above transactions would be:

CASH FLOW STATEMENT OF RAM SOFTWARE LIMITED

(For the period 1 stMarch 2019 to 31st March 2019)

Particulars Details Amount

(₹) (₹)
Cash Flow From Operating Activities
Cash received from customers 12,000
Cash paid to suppliers, rent, and employees (7,200)
Net Cash Provided By Operating Activities (A) 4,800
Cash Flow from Investing Activities
Purchase of office equipment (58,000)
Net Cash Provided By Investing Activities (B) (58,000)
Cash Flow from Financing Activities
 Capital invested by owner, Equity 50,000
Withdrawal by owner (3,500)
Loan 20,000
Net Cash Provided By Financing activities(C) 66,500
Net Increase (Decrease) in Cash Position (A+B+C) 13,300
Add: Beginning Cash Balance 0
Cash Balance At The End 13,300

Note: The negative figures are presented in brackets.

Please note that the adjustment entries done, based on the matching principle (such as
depreciation on fixed assets and expiry of inventory), would result in no change in statement of
cash flow.
Illustration 2:
ShikariShambu was running an investigating agency,ShikariShambu Security Services Limited.
From the summary cash accountof the firm, prepare the Cash FlowStatement for the year ended
31st March, 2013 by using Direct Method.
SUMMARY CASH ACCOUNT
For the year ended 31st March, 2013
Receipts Amount Payments Amount
(₹) (₹)
Cash balance as on 1.04.12 10,000 Cash purchases during the 2,00,000
year
Issue of equity shares 15,000 Factory expenses incurred 25,000
Issue of preference shares 15,000 Wages & salary paid 15,000
Cash sales for the period 2,30,000 Income tax paid 5,000
Sale of fixed assets 60,000 Dividend paid 15,000
Repayment of loan 40,000
Balance on 31.03.13 30,000
Total 3,30,000 Total 3,30,000

Solution:

As we read in the chapter, preparation of the cash flow statement can be done using two
methods, viz, the direct method and the indirect method.
 Only the calculation of cash flow from operating activities is different under both the
methods, though the results are the same. We use the direct method here. The direct method
requires the gross receipts and payments to be disclosed. Accordingly, our cash flow statement
would be:

CASH FLOW STATEMENT

SHIKARI SHAMBU SECURITY SERVICES LIMITED

For the year ended 31st March 2013

Particulars Details Amount

(₹) (₹)
Cash Flow From Operating Activities(A)
Receipt from customers (cash sales) 2,30,000
Payment to suppliers (cash purchases) (2,00,000)
Payment for factory expenses (25,000)
Payment for salary & wages (15,000)
Income tax paid (5,000)
Net Cash Flow From Operating Activities (15,000)
Cash Flow From Investing Activities(B)
Sale of fixed asset 60,000
Net Cash Flow From Investing Activities 60,000
Cash Flow From Financing Activities(C)
Issue of equity shares 15,000
Issue of preference shares 15,000
Repayment of loan (40,000)
Dividend paid (15,000)
Net Cash Flow From Financing Activities (25,000)
Increase in Cash Balance (A) +(B) + (C ) 20,000
Add: Opening Cash Balance 10,000
Closing Cash Balance 30,000

Note: The negative figures are presented in brackets.

Interpretation:The Company has shown a very weak performance wherein the cash has been
generated through the sale of fixed assets and through issue of shares other than through
operations. The cash was basically utilized for repayment of loan and for paying the dividends.

Illustration 3:
From the following summary cash account of Bismaya Limited, Prepare Cash Flow Statement
for the year ending 31st March 2019 in accordance with Ind AS- 7 using Direct method.

SUMMARY OF CASH ACCOUNTOF BISMAYA LIMITED

FOR THE YEAR ENDING 31ST MARCH 2019

(Figures in Thousands)

Particulars Amount(₹)
Balance on 01.04.2018 50
Issue of equity share 300
Received from customers 2,800
Sale of fixed assets 100
Total 3,250
Payment to suppliers 2,000
Purchase of fixed assets 200
Overhead expenses 200
Wages and salaries 100
Taxation 250
Dividend 50
Repayment of bank loan 300
Balance on 31.03.2019 150
Total 3,250

Solution:

CASH FLOW STATEMENT OF BISMAYALIMITED

For the year ending 31.12.2019
(Figures in Thousands)

Particulars Details Amount

(₹) (₹)
Cash Flow from Operating Activities(A)
Cash received from customers 2,800
Cash paid to suppliers and employees (2,000+200+100) (2,300)
Cash Generated From Operation 500
Income tax paid (250)
Net Cash Flow From Operating Activities 250
Cash Flow from Investing activities(B)
Purchase of fixed assets (200)
Proceed from sale of fixed assets 100
Net Cash Flow From Investing Activities (100)
Cash Flow from Financing Activities(C)
Issue of equity share 300
Repayment of bank loan (300)
Dividend paid (50)
Net Cash Outflow in Financing Activities (50)
Net Increase in Cash and Cash Equivalent During The 100
Period(A+B+C)
Add: Cash and Cash Equivalent at the Beginning 50
Cash and Cash Equivalent At The End 150

1.16 SELF ASSESMENT QUESTIONS

1. What is meant by Cash Flow Statement? State its main objectives.

2. State the uses of Cash Flow Statement. What are the objectives of preparing it?

3. How are the various activities classified (as per Ind AS-7) while preparing the Cash Flow
Statement?

4. Describe ‘direct’ and ‘indirect’ methods of ascertaining cash flow from operating activities.

5. Enumerate the various steps involved in the preparation of Cash Flow Statement.

6. Prepare a format of cash flow from operating activities under direct and indirect methods.

7. What is a Cash Flow Statement? Write the differences between a funds flow statement and
cash flow statement.

8. What is meant by Cash Flow Statement? Explain briefly how the statement is prepared as per
Ind-AS 7.

9. Elaborate the importance and limitations of Cash Flow Statement?

10. What is the purpose of preparing Cash Flow Statement? How is it prepared? Explain and
illustrate.
 RATIO ANALYSIS
(Financial Ratios compare the results in different line items of the financial statements. The
analysis of these ratios is designed to draw conclusions regarding the financial
performance, liquidity, leverage and asset usage of a business.): Anonymous

Learning Objective:
To understand the meaning of Ratio and Ratio analysis

To know the uses/significance/importance/utility of Ratio Analysis

To identify various limitations of Ratio Analysis

To acquaint with different classification of Ratios

To comprehend the use of Ratio Analysis for studyingliquidity, solvency and profitability of a
business firm

To conceptualize the construction of financial statements from given ratios

Chapter Outline:
1.1 Meaning of Ratio

1.2 Meaning of Ratio Analysis

1.3 Uses/Significance/Importance/Utility of Ratio Analysis

1.4 Limitation of Ratio Analysis

1.5 Classification of Ratios

1.6 Liquidity Ratios

1.7 Efficiency/Activity/Turnover Ratios

1.8 Solvency Ratios

1.9 Capital Structure/Leverage Ratios

1.10 Profitability Ratios

1.11 Market Based Ratios/Ratio for prospective Investors

1.12 DuPont Analysis

1.13 Construction of Financial Statements from Ratios

1.14 Ratios at a Glance

1.15 Miscellaneous Illustrations

1.16 Glossary

1.17Review Questions
 UNIT-2

RATIO ANALYSIS

1.1 MEANING OF RATIO

A ratio is a simple arithmetical expression of the relationship of onenumber to another. It may be

defined as the indicated quotient of twomathematical expressions. In general words, a ratio is an
expression of relationship of one figure with another. It may be defined as the relationship or
proportion that one amount bears to another. It is found by dividing a figure with another. A ratio
may be expressed in percentage.

Accounting ratios express relationships worked out among various accounting data which are
mutually interdependent and which influence each other in significant manner. Financial ratios
express arithmetical relationship between two figures or two groups of figures of the financial
statements which are related to each other.

Expression of Ratios:

A ratio is an expression of the quantitative relationship between two numbers. In simple

language, ratio is one number expressed in terms of another and can be worked out by dividing
one number by the other. A ratio can be expressed in the form of a fraction, number of times,
percentage or in proportion. Hence, there are three ways of expressing ratios:

(a)Pure Ratio or Simple Ratio: In this form, the item of financial statements is expressed by
simple division of one number by another e.g., if current assets of a company are ₹20,000 and
current liabilities are ₹10,000, the ratio of current assets to current liabilities is shown as:

,
= = = :
,

(b) Rate or So many Times: In this form, it is calculated how many times an item is, in
comparison to other item. For example, Cost of goods sold of a company is ₹ 10,000 and
Average Inventory is ₹ 2,000, then stock turnover is:

Cost of goods sold÷ Average Inventory = 5times

(c) Percentage: Percentage is one kind of ratio in which the base is taken as equal to hundred
(100) and the quotient is expressed as per hundred of the base. For example, if an institution
earns a gross profit of ₹10,000 and sales is ₹50,000, the ratio of gross profit to sales, in terms
of percentageis :

. ,
= × = %
. ,
1.2 MEANING OF RATIO ANALYSIS

Ratio Analysis is a very important tool of financial analysis. It is the process of establishing a
significant relationship between the items of financial statements to provide a meaningful
understanding of the performance and financial position of a firm. So,ratio analysis is a
technique of analysis and interpretation of financial statements. It is the process of establishing
and interpreting various ratios for helping in making certain decisions. It is not an end in itself
and is only a means of better understanding of financial strengths and weaknesses of a firm. A
ratio will be meaningful only when it is analyzed and interpreted.

Steps in Ratio Analysis:

The Ratio Analysis requires four steps as follows:

1. Selection of relevant data from the financial statements depending upon the objective of the
analysis.

2. Computation of appropriate ratios from the above data.

3. Comparison of the calculated ratios with the ratios of the same firm in the past, or the ratios
developed from projected financial statements or the ratios of some other firms or the
comparison with ratios of the industry to which the firm belongs.

4. Interpretation of the ratios.

Approaches to Ratio Analysis:

There are three approaches or ways of comparing ratios:

(a) Cross-Section Analysis:

One way of comparing the ratio or ratios of a firmis to compare them with the ratio or ratios of
some other selected firm in thesame industry at the same point of time. So, it involves the
comparison of twoor more firm's financial ratios at the same point of time. The Cross-
SectionAnalysis helps the analyst to find out as to how a particular firm hasperformed in relation
to its competitors. The firm’s performance may becompared with the performance of the leader
in the industry in order touncover the major operational inefficiencies. In this type of an analysis,
thecomparison with a standard helps to find out the quantum as well as directionof deviation
from the standard. It is necessary to look for the large deviationson either side of the standard
could mean a major concern for attention. TheCross-Section Analysis is easy to be undertaken as
most of the data requiredfor this may be available in financial statements of the firm.
(b)Time-Series Analysis

The analysis is called Time-Series Analysis when the performance of a firm isevaluated over a
period of time. By comparing the present performance of afirm with the performance of the same
firm over last few years, anassessment can be made about the trend in progress of the firm, about
thedirection of progress of the fir. The information generated by the Time-SeriesAnalysis can
also help the firm to assess whether the firm is approaching longterm goals or not. The Time-
Series Analysis can be extended to coverprojected financial statements. In particular, the Time
Series Analysis looksfor (i) Important trends in financial performance, (ii) Shift in trend over
theyears, and (iii) Significant deviations if any, from other set of data. So in this case,ratio of 5 to
10 years is compared at a time to find out the trend.

(c)Combined Analysis:

If both the Cross-Section and Time Series Analyses are combined together to study the behavior
and pattern of ratios, then meaningful and comprehensive evaluation of the performance of the
firm can definitely be made. A trend of ratios of a firm compared with the trends of the ratios of
the standard firm can give good results. For example, the ratio of Operating Expenses to Net
Sales for a firm, may be higher than the industry average, however, over the years it has been
declining for the firm, whereas the industry average has not shown any significant changes.

Interpretation of Ratios:

Ratios are not in themselves an end. They are the means of financial analysis. To make them
useful, they have to be interpreted. Interpretation of ratio needs skill, intelligence and
foresightedness. The inherent limitations of ratio analysis should also be kept in mind while
interpreting ratios. The interpretation of ratios can be made in the following ways:

(a) Interpretation on the Basis of Single Ratio:Broadly, no meaningful conclusion can be

drawn by one single ratio. However, there are few ratios which can be considered in isolation.
For example, 2:1 is a well proven convention for current ratio. Hence, continuous fall in the ratio
is considered as a sign of weak liquidity position of the concern. Such ratios are very few where
rules of thumb may be applied and which alone are capable of some meaningful interpretation.

(b) Interpretation on the Basis of group of Related Ratios: There is large number of ratios
which are well interpreted when supported by certain other related ratios. For example, current
ratios may be supported by liquidity ratios to draw more dependable conclusions. Similarly,
ratios of profit of sales can be well interpreted when it is considered with reference to net worth
turnover ratio.

(c) Interpretation on the Basis of Historical Trends:In this method, a firm’s performance is
compared with its own past over a period of time and trend is noted on the basis of figures of the
same ratio of past few years. This is a most popular method of appraising the performance of the
firm. When financial ratios are compared over a period of time, it gives an indication of the
direction of change. But while interpreting ratios from comparison over time, the analyst must
pay attention to the changes in the firm’s policies, accounting procedures and also price level
changes. Sometimes, current performance is evaluated by comparing the ratios with its past
average.

(d) Interpretation on the Basis of Inter-Firm Comparison: Ratios of one firm can also be
compared with the ratios of other firms in the same industry or with the average of all firms in
the industry. But while making such comparison, the analyst has to be very careful regarding the
difference of accounting methods, policies and procedures adopted by different firms.

(e) Interpretation on the Basis of Projected Ratios (or Future Expectations): Ratios for the
future can be projected and these may be taken as standard for comparison with ratios calculated
on the basis of actual performance. This method is not used usually in practice.

(f) Interpretation on the Basis of Similar Firms:If we compare the firm with similar firms in
other industries, we often gain a better insight into the financial condition. For example, if we are
examining a growth of firm in a non-growth industry, it makes sense to compare it with other
growth firms in other industries.

(g) Interpretation on the Basis of Common Sense: The analyst may also use his subjective
judgment and reasons for the purpose. For example, a 20% return on investment may be
considered reasonable as a norm.

1.3USE/SIGNIFICANCE/IMPORTANCE /UTILITY OF RATIO ANALYSIS:-

Mainly the persons interested in the analysis of the financial statements can be grouped under
three heads (i) Owners or investors (ii) Creditors and (iii) Financial executives. The importance
of analysis varies materially with the purpose for which it is calculated. The primary information
which seeks to be obtained from these statements differs considerably reflecting the purpose that
the statement is to serve.

The significance of these ratios varies for these three groups as their purpose differs widely.
These investors are mainly concerned with the earning capacity of the company whereas the
creditors including bankers and financial institutions are interested in knowing the ability of
enterprise to meet its financial obligations timely. The financial executives are concerned with
evolving analytical tools that will measure and compare costs, efficiency, liquidity and
profitability with a view to make intelligent decisions. Hence, the use, significance, importance
of ratio analysis can be highlighted as below:

1.Helpful to Management: The ratio analysis proves to be of significant value to the

management in the process of the discharge of its elementary functions such as planning, co-
ordination, communication and control. In short, it paves the way for effective control of the
enterprise in the matter of achieving physical and monetary targets.

2. Helpful in Trend Analysis: The ratio analysis facilitates a firm to consider the time
dimension into account, i.e. whether the financial position of a firm is showing any improvement
or deterioration over years. This is affected through the use of trend analysis. With the help of
the financial analysis one can ascertain whether the trend is favourable or unfavourable.

3. Use in Comparative Study:Ratioanalysis also helps in comparative study. It helps to make an

inter-firm comparison either between different departments of a firm or between two firms
employed in the identical types of business or between the same firms on two different dates.

4.Helpful for Communication:With the help of ratio analysis, it is possible to know the changes
that had taken place in the business between two periods. In this way the weakness of business
concern can easily be found out. In brief, ratios are helpful in communication of information.

5.Helpful in Determining the Standards: Keeping in mind the old ratios and present operating
efficiency, the standard can be fixed. In this way ratio analysis is considered to be essential part
of budgetary control and standard costing.

6.Helpful in Effective Control: On the basis of ratios, by establishing standards the effective
control can be exercised upon the activities of the firm. On the comparison of standard ratios
with actual ratios, adverse financial position can be found out and accordingly corrective
measures can be taken.

7.Helpful in the Evaluation of Efficiency: With the help of ratio analysis, comparison of
current year figures can be made with those of previous years. Similarly, comparison of
profitability, effectiveness and financial soundness can be made between business concerns. In
this way, the use of ratio analysis can be made for measuring the effectiveness of business
concern.

8. Helpful in Evaluation of Financial Soundness: With the help of liquidity, solvency,

profitability and capital gearing ratios, detailed information can be gathered which are related to
financial soundness of any organization.

9.Helpful for Interested Parties in the Firm: Through ratio analysis the internal and external
parties interested in the firm also get benefited. The workers of the firm may use the information
presented in the financial statements as basis for requesting increase in wages and salaries. By
studying profitability ratios, investors can take decision for investment or not.
1.4 LIMITATION OF RATIO ANALYSIS

The ratio analysis is one of the most powerful tools of financial management. Though, ratios are
simple to calculate and easy to understand, they suffer from some serious limitationswhich are
summarized as below:

1. Limited use of Single Ratio: A single ratio in itself is meaningless; it does not furnish a
complete picture. In other words, one single ratio, used without reference to other ratios, may
produce misleading results. Hence, a number of related ratios are to be calculated for proper
analysis and interpretation of financial statements. For example, to test the liquidity wemake use
of all the liquidity ratios.

2. IgnoresQualitative Factors: The ratio facilitates quantitative analysis only. The qualitative
factors which are so important for the successful functioning of the organization are completely
ignored and hence, whatever conclusions drawn may be distorted.

3.Only a part of the information needed in the process of Decision Making: It should also be
remembered that ratio analysis helps in providing only a part of the information needed in the
process of decision making. Any information drawn from the ratios must be used with that
obtained from other sources so as to ensure a balanced approach in solving the ticklish issues.

4.Possibility of Window Dressing: Ratio depends on figures of the financial statements. But in
most cases, the figures are window dressed. As a result, the correct picture cannot be drawn up
by the ratio analysis.

5.Different meaning to Accounting Terms: Comparisons are also made difficult due to
difference in definitions of various terms used in computing ratios. For example, terms like
shareholders’ funds, capital employed, working capital etc. are used in different sense by
different people. Hence, unless the meanings of relevant terms are properly defined, the use of
ratios may lead to wrong comparisons and conclusions.

6. Variation in Accounting Policies: Comparison between two variables proves worth provided
their basis of evaluation is identical. But in reality, it is not possible, such as methods of
valuation of stock in trade or charging different methods of depreciation on fixed assets etc. That
is different methods are followed by different firms for their valuation, in that case, comparison
will practically be of no use.

7. Difficulty in evolving Standard Ratios:It is very difficult to ascertain the normal or standard
ratio in order to make a proper comparison.

8. Historical Analysis: Ratios are developed in the past as they are obtained from the financial
statements which are considered to be historical documents. A financial analyst is more
concerned with the probable happenings in the future rather than those in the past. These ratios
cannot be completely relied upon as reflecting current conditions.
9. Effect of Price Level Changes is not taken into account:A change in price level can
seriously affect the validity of comparisons of ratios computed for different time periods.

10. Personal Bias: Ratios are only means of financial analysis and not an end itself. They can be
affected with the personal ability and bias of the analyst. Generally, different analyst may
interpret the same ratio in different ways.

1.5 CLASSIFICATION OF RATIOS

Financial ratios are classified in to various groups. Their actual classification depends upon the
objects of analysis, nature of party interested in analysis and the source and quantity of data
available. The following four forms of ratio classification are more common in actual use.

Statement wise Classification by Classification Functional

Classification Users according to Classification
Importance
1.Balance sheet 1.Ratio for 1.Primary Ratio 1.Liquidity Ratio
Ratios Management 2.Secondary Ratio 2.Efficiency
2.Profit and Loss 2.Ratio for Ratios/Activity Ratios
account Ratio Shareholders 3.Solvency Ratios
3.Composite or Mixed 3.Ratio for Creditors 4.Leverage/Capital
Ratios Structure Ratios
5.Profitability Ratios(
Based on Sales &
Based on Capital)
6.Market Based
Ratios/Ratios for
Prospective Investors

1.Statement-wise Classification:
It is most traditional classification of financial ratios. This classification is based on accounting
statement providing information necessary for the calculation of various ratios. There are three
types of ratios on the basis of financial statements:-
(a)Balance sheet Ratios:When both figures for ratio computation are extracted from the balance
sheet of the business, the ratio is called balance sheet ratio. Such ratios are often called as
financial ratios also. e.g.,Current ratio, Liquidity ratio, Proprietary ratio, Fixed asset ratio, Capital
gearing ratio, Book value per share.
(b)Profit and Loss Account Ratio:When both figures for ratio computation are extracted from
the profit and loss account, the ratioiscalledprofit and loss account ratio.e.g. Operating ratio,
Expenses ratio, Net profit ratio, Gross profit ratio, Stock turnover ratio.
(c) Composite or Mixed Ratios:In such ratio, one items or a group of items is taken from
balance sheet and the other from profit and loss account.e.g, Return on capital employed, Return
on share holder’s fund, Current assets turnover ratio, Ratio of net sales to fixed assets.
2.Classification by Users:
(a) Ratio for Management: These ratios are used by managers for measuring the effectiveness
of management of the businesse.g,Operating Ratio, Return on capital employed, Stock turnover
Ratio, Debtors turnover Ratio, Solvency Ratio.
(b) Ratio forCreditors:These ratios are used by creditors for assessing the creditworthiness of
the businesse.g,Current Ratio, Solvency Ratio, Creditors turnover Ratio, Fixed asset Ratio, Asset
cover Ratio, Debt service Ratio.
(c) Ratio forShareholders: These ratios are used by the shareholders for assessing the return or
solvency of the businesse.g,Return on shareholders’ fund, Capital gearing Ratio, Dividend
coverRatio, Yield rate, Proprietary Ratio.

3.Classification According to Importance:

This classification is being adopted by the British Institute of Management for inter-firm
comparisons. In this classification, all the ratios are classified into two groups:
(a) Primary Ratio: This is one which is of prime importance to a concern e.g, return on capital
employed, asset turnover etc.
(b) Secondary Ratio:The ratios which support or explain the primary ratio is called secondary
ratio.

4.Functional Classification:
1 2 3 4 5 6
Liquidity Efficiency SolvencyRatios Leverage Profitability Market
Ratios Ratios Ratios Ratio Based
Ratios
1.Current 1. 1. Debt-Equity 1. Capital a)General 1. Earnings
Ratio, Stock/Inventory Ratio /Debt-Net gearing Ratio Profitability per Share
2.Liquidity turnover Ratio worth Ratio or Gear Ratio Ratios(Profit (EPS)
Ratio, 2. Debtors/ 2. Proprietary 2.Debt –Total in relation to 2. Dividend
3.Absolute Ratio/Equity Fund Ratio Sales) Payout
liquid Receivables
turnover Ratio Ratio 3. Ratio of 1.Gross Profit Ratio (D/P
Ratio Ratio Ratio)
3. 3. Solvency total
Creditors/Payab Ratio investments to 2.Operating 3. Dividend
les turnover 4. Fixed Assets Long-term Ratio Yield Ratio
Ratio to Net worth liabilities 3.Operating 4. Price
4. Current Ratio 4. Ratio of Profit Ratio Earnings
Assets 5. Funded Debt fixed asset to 4.Expenses Ratio (P/E
Turnover Ratio to Capitalization funded debt Ratio Ratio)
5. Working Ratio 5. Ratio of 5.Net Profit 5. Price to
reserve to Book
 Capital 6. Fixed Assets equity capital Ratio Value
Turnover Ratio to Total Long- 6. Ratio of (b)Overall Ratio (P/B
6. Fixed Assets term fund Ratio current Profitability Ratio)
Turnover Ratio or Fixed Assets liabilities to Ratios(Profit
Ratio proprietor’s in relation to
7. Total Assets
Turnover Ratio 7. Ratio of funds Investment)
tangible assets to 1.Return on
8. Net Tangible total debts
Assets Equity(ROE)
Turnover Ratio 8. Debt-Service 2.Return on
coverage Ratio/ Net
9. Capital/Net Interest coverage
worth Turnover worth(RONW
Ratio/ Fixed )
Ratio Charges
Coverage Ratio 3.Return on
Investment(R
9. Preference OI)
Dividend
Coverage Ratio 4.Return on
Assets(ROA)
10.Cash to debt
service Ratio or 5.Return on
Debt cash flow Capital
coverage Ratio Employed(RO
CE)

(a)LiquidityRatios:These ratios measure the short term debt repaying capacity of a businesse.g.,
Current Ratio, Liquidity Ratio, Absolute liquid Ratio or Cash Ratio.
(b)EfficiencyRatios:These ratios measure the efficiency with which assets are being used by the
businesse.g., Total asset turnover Ratio, Fixed asset turnover Ratio, Working capital turnover
Ratio, Inventory turnover Ratio, Debtor turnover Ratio, Creditors turnover Ratio.
(c)Solvency Ratios: These ratios measure the long term debt repaying capacity of the business.
e.g. Debt equity Ratio, Proprietary Ratio, Solvency Ratio or Debt to total assets Ratio, Fixed
assetRatio, Capital gearing Ratio, Debt-service Ratio or Interest coverage Ratio.
(d) Leverage Ratio: These ratios measure the relationship between finance provided to the firm
by the outsiders and the owners. They also indicate the risk of debt finance, e.g. Capital Gearing
Ratio, Ratio of Total Investment to long-term liability, Ratio of Fixed Assets to Funded Debt,
Ratio of Current liability to Proprietor’s funds.
(c)Profitability Ratios: These ratios measure the profit earning capacity of the business. These
ratios can be computed in relation to sales or in relation to capital.

(i)Ratio Based on Sales: e.g., Gross profitRatio, Operating profit Ratio, Expenses Ratio,
Operating profit Ratio, Net profit Ratio.
(ii)Ratio Based on Capital:e.g.,Return on shareholders’ fund, Return on capital employed,
Return on equity capital.

(f)Market Based Ratios:These ratios are used by prospective investor before investing in a
stock,.e.g. Earnings per share, Book value per share, Capitalization Ratio, Dividend Yield Ratio,
Dividend Payout Ratio, Dividend cover Ratio.

1.6 LIQUIDITY RATIOS

The short term creditors of a company, like suppliers of goods on credit andcommercial banks
providing short-term loans, are primarily interested in knowingthe company’s ability to meet its
current or short term obligations as and whenthese become due. The short term obligations of a
firm can be met only whenthere are sufficient liquid assets. Therefore, a firm must ensure that it
does notsuffer from lack of liquidity or the capacity to pay its current obligations. Even avery
high degree of liquidity is not good for the firm because such a situationrepresents unnecessarily
excessive funds of the firm being tied up in currentassets.
The importance of adequate liquidity is the sense of the ability of a firm to meet its current/
short-term obligation when they become due for payment. It reflects the short-term financial
strength of the firm. Liquidity is basic to continuous operations of the firm. In fact, it is pre-
requisite for the very survival of a firm.
The object of liquidity analysis is to examine the firm’s ability to meet its current obligation out
of short-term resources. However, a very high degree of liquidity is not desirable because it
implies that funds are idle as they earn very little. It is not good from profitability point of view.
Hence, a proper balance between the two contradictory requirements i.e. liquidity and
profitability is required for efficient financial management. It becomes, therefore, necessary to
determine the degree of liquidity of the firm.
The ratios which indicate the liquidity of a firm are known as Liquidity Ratio. The following are
ratios calculated to measure the liquidity of a firm:
1. Current Ratio
2. Quick Ratio
3. Absolute Liquid Ratio
1. CurrentRatio:
Current Ratio is the most common and widely used ratio for measuring liquidity. Being related to
working capital analysis, it is also called the Working Capital Ratio. This ratio indicates the
relationship between total current assets and total current liabilities of a firm. This is calculated
by dividing current assets by current liabilities.

Current assets(Will be converted in to cash Current liabilities (Payable within one year)
within one year)
Ex: Cash in hand, Cash at bank, Debtors, Ex: Bills payable, Income tax payable,
Prepaid expenses, Short term deposits, Short Creditors, Outstanding expenses, Bank
term investments, Bills receivable, Money at overdraft, Provision for taxation, Interest due
call and short notice, Stock of finished goods, on fixed liabilities, Reserve for unbilled
Stock of work in progress, Stock of raw expenses, Installment payable on long-term
materials loans.

Illustration 1:On December 31, 2010 Company B had total asset of ₹150,000,equity of
₹75,000, non-current assets of ₹50,000 and non-current liabilities of₹ 50,000. Calculate the
Current Ratio.
Solution
To calculate current ratio, we need to calculate current assets and currentliabilities first:
Current Assets = Total Asset − Non-Current Assets =₹150,000 −₹50,000 = ₹100,000
Total Liabilities = Total Assets − Total Equity = ₹150,000 − ₹75,000 =₹75,000
Current Liabilities = ₹75,000 − ₹50,000 =₹25,000
Current Ratio = ₹100,000 ÷ ₹25,000 = 4
Interpretation:
1. CurrentRatio is a good measure of liquidity. It indicates the rupees of current assets available
for each rupee of current liability.
2. Higher the current ratio, the larger the amount of rupees available per rupee of current
liability, the more the firm’s ability to meet current obligation and greater the safety of funds of
short-term creditors.
3. But too high current ratio may be good from creditors point of view, but it can never be good
from view of the owners. Too high current ratio shows weak investment policy, excessive stock
etc. Such a situation cannot be good for the profitability of the business.
4. On the other hand, low current ratio shows shortage of working capital in the business and it
may endanger the survival of the firm. Hence, the current ratio in business should be appropriate.
5.A ratio of 2:1 (two times current assets to current liabilities) is considered satisfactory as a
rule of thumb.
6. In inter-firm comparison, the firm with the higher current ratio has better liquidity or short
term solvency.
7. It is important to note that the norm of 2:1 should not be followed blindly. We should pay
attention to the quality and nature of current assets. If major portion of current assets consists of
debtors, prepaid expenses and slow moving obsolete stock, then even twice the current assets
may prove insufficient to pay the short-term liabilities when due for payment.
8.On the other hand, if the firm is capable of making immediate arrangement of cash easily in
case of emergency, then a lower than 2:1 ratio may be treated satisfactory.
9. Hence, it would be necessary to consider the following factors while deciding the standard of
current ratio:
  Nature of business: If the business is of speculative nature, then a higher current ratio is
necessary. Similarly, if the business is of seasonal nature, then it would be appropriate to
change current ratio according to fluctuation is output and sales.
 Plans to introduce by the firm in the near future and amount required for them.
 Credit period allowed and received.
 Nature of stock, if the major portion of inventory is of raw materials or it consists of slow
moving and obsolete stock, then a higher current ratio would be essential. On the other
hand, if inventory consists of fast moving finished goods, then possibility of their
conversion into cash would be higher and so even a lower current ratio may be good.
 In case of heavy fixed charges of long-term loans, a higher current ratio would be
appropriate and essential.
Limitations:
1. It is a crude measure of financial liquidity as it does not take into account the liquidity of the
individual component of current assets. Cash and bills receivable are more liquid in comparison
to inventories, prepaid expenses and sundry debtors. But in computing this ratio they all are
treated at par.
2. The greatest weakness of current ratio is the possibility of window dressing and manipulation.
The current ratio can be improved by making payment of current liability at the year-end or by
over valuing current assets and under valuing current liabilities.
3. The current ratio is largely affected by seasonal fluctuations.
4. Conclusions drawn on the basis of current ratio only may be misleading because in spite of
high current ratio, the firm may unable to pay its current liabilities,if major portion of current
asset consists of raw materials slow moving or obsolete finished goods or unrecoverable debtors.
Hence, it is not proper to rely upon this ratio only for analyzing liquidity of the firm.
2. Quick or Acid Test Ratio or LiquidRatio:
Quick Ratio, also known as Acid Test Ratio or Liquid Ratio, is a morerigorous test of liquidity
than the current ratio. The term liquidity refers to theability of a firm to pay its short term
obligations as and when they become due. Quick Ratio may be defined as the relationship
between quick/liquid assets andcurrent or liquid liabilities. An asset is said to be liquid if it can
be converted intocash within a short period without loss of value. In that sense cash in hand
andcash at bank are the most liquid assets. The other liquid assets include billsreceivable, sundry
debtors, marketable securities and short term or temporaryinvestments. Prepaid expenses and
Inventories cannot be termed as liquid assetbecause they cannot be converted into cash without
loss of value. A ratio of 1:1 is considered as satisfactory Quick Ratio.
The ratio is used as a compliment of current ratio. This ratio is calculated for assessing the
capacity of the firm to make immediate payment of its liabilities. This ratio discloses the
relationship between liquid assets and current liabilities.

=

Quick Assets/Liquid assets= Current assets-Stock-Prepaid expenses

Illustration 2
Calculate Quick Ratio from the information:
Stock₹60,000 ; Cash₹40,000; Debtors₹40,000; Creditors ₹50,000,Bills Receivable ₹20,000;
Bills Payable ₹30,000; Advance Tax₹ 4,000,Bank Overdraft₹ 4,000; Debentures ₹ 2,00,000;
Accrued interest ₹4,000.
Solution
Quick Assets = Current Assets – Stock – Advance Tax
Quick Assets = ₹1,68,000 – (₹60,000 + ₹4,000) = ₹1,04,000
Current Liabilities = ₹84,000
Quick Ratio = Quick Assets / Current Liabilities
= ₹1,04,000/₹84,000= 1.23:1
Illustration 3

X Ltd. has a current ratio of 3.5:1 and quick ratio of 2:1. If excess of current assets over quick
assets represented by stock is ₹1, 50,000, calculate current assets and current liabilities.

Solution

Let Current Liabilities = X

Current Assets = 3.5X

And Quick Assets = 2X

Stock = Current Assets – Quick Assets

1,50,000 = 3.5X – 2X

1,50,000 = 1.5X

X = ₹1,00,000

Current Assets = 3.5X = 3.5 × 1,00,000 = ₹3,50,000.

Illustration 4

Calculate the current ratio and quick ratio from the following information:

Working capital ₹9,60,000; Total debts ₹20,80,000; Long-term Liabilities₹16,00,000; Stock ₹

4,00,000; Prepaid expenses ₹80,000.
Solution

Current Liabilities = Total debt- Long term debt

= 20,80,000 – 16,00,000= 4,80,000

Working capital = Current Assets – Current liability

9,60,000 = Current Assets – 4,80,000

Current Assets = 14,40,000

Quick Assets = Current Assets – (stock + prepaid expenses)

= 14,40,000 – (4,00,000 + 80,000)= 9,60,000

Current Ratio = Current Assets / Current liabilities

= 14,40,000/4,80,000= 3:1

Quick Ratio = Quick Assets / Current liabilities

= 9,60,000/4,80,000= 2:1

3. AbsoluteLiquidity Ratio:
It is more rigorous test of liquidity of a firm. It is calculated by dividing cash and marketable
securities (termed as super-quick current assets) by quick or liquid liabilities. It is calculated as
follows:

=

Absolute liquid assets= Cash in hand, cash at bank and short term highly liquid marketable
securities.The acceptable norm for thisratio is 50% or 0.5:1.
Illustration 5
Calculate Absolute Liquid Ratio from the following information
Goodwill ₹50,000 ,Cash at Bank ₹30,000,Plant and machinery₹4,00,000 Inventories
₹75,000,Trade investments ₹2,00,000, Bank overdraft ₹70,000,Marketable securities
₹1,50,000, Sundry creditors ₹60,000,Bills receivable ₹40,000, Bills payable ₹90,000,Cash in
hand ₹45,000, Outstanding expenses ₹30,000.
Solution
Absolute Liquid Ratio = Absolute Liquid Assets/Current Liabilities
Absolute Liquid assets = Mark. Securities+ Cash in hand and at Bank
= ₹1,50,000+₹45,000+₹30,000 = ₹2,25,000
Current Liabilities = Bank overdraft + Creditors + Bills Payable+ Outstanding Expenses
= ₹70,000+₹60,000+₹90,000+₹30,000 = ₹2,50,000
Absolute Liquid Ratio = Absolute Liquid Assets/Current Liabilities
= ₹2,25,000/₹2,50,000= 0.9
Illustration6

From the following information regarding current assets and current liabilities of Sun Ltd,
Comment upon the liquidity of the concern:

Current Liabilities Amount (₹) Current Assets Amount (₹)

Creditors 27,000 Cash 42,000
Bills Payable 12,000 Debtors 20,000
Outstanding expenses 5,000 Bills receivable 15,000
Provision for tax 18,000 Stock 35,000
Bank overdraft 10,000 Investment in Government securities 24,000
Prepaid expenses 10,000
Interest receivable 1,000
Total 72,000 Total 1,47,000

Solution:

Current Assets 1,47,000

Current Ratio = = = 2.04:1
Current Liabilities 72,000

Quick Assets 1,02,000

Quick Ratio = = = 1.4:1
Current Liabilities 72,000

Absolute Liquid Assets 66,000

Absolute Liquid Ratio = = = 0.92:1
Current Liabilities 72,000

Working Note:

Quick Assets=Current Assets-Stock-Prepaid Expenses=1,47,000-35,000-10,000=1,02,000

Absolute Liquid Assets=Cash+Government Securities=42,000+24,000=66,000

Comment: All the three ratios show good liquidity position as all the three ratios are more than
rule of thumb. The rule of thumb for current ratio is 2:1, quick ratio is 1:1and absolute liquid
ratio is 0.5:1.
1.7 EFFICIENCY/ACTIVITY/TURNOVER RATIOS
Activity Ratios, sometimes referred to as Operating Ratios or Management Ratios, measure the
efficiency with which a business uses its assets, such asinventories, accounts receivable and
fixed (or capital) assets. The morecommonly used operating ratios are the average collection
period, the inventoryturnover, the fixed assets turnover, and the total assets turnover. These
ratios indicate the efficiency of management in the use of resources,both short term and long
term. The overall performance of a company isevaluated on the basis of its ability to make sales
using minimum resources.Turnover Ratios reflect the speed at which assets are utilized in
effecting sales. Ahigher turnover ratio means efficient use of funds by management in
generatingmore sales. The important turnover ratios are:

1. Stock/Inventory turnover Ratio

2. Debtors/Receivables turnover Ratio
3. Creditors/Payables turnover Ratio
4. Current Assets Turnover Ratio
5. Working Capital Turnover Ratio
6. Fixed Assets Turnover Ratio
7. Total Assets Turnover Ratio
8. Net Tangible Assets Turnover Ratio
9. Capital/Net worth Turnover Ratio

1. Stock Turnover Ratio/Inventory Turnover Ratio/Stock Velocity

This ratio is calculated to consider the justification of amount of capital employed in stock.
Under it, rate of conversion of stock into sales (i.e. stock velocity) is known by establishing
relationship between cost of goods sold and inventory. This ratio indicates the amount of sales
per rupee of investment in inventory. This is calculated by dividing cost of goods sold of a period
by the average stock of that period.

=
( )
Note:
1. Cost of goods sold = Opening stock +Net Purchases + Direct expenses – Closingstock
Or
Cost of goods sold = Net sales – Gross Profit
2. Average inventory = (Opening inventory +Closing inventory)/2
3.Inventory here will mean inventory of finished goods only.Because it only is capable of being
sold.
4.This ratio may be calculated on the basis of Net sales but in such situation average inventory
will be taken at sale price. In departmental stores, where inventory is usually valued at sale price,
this ratio is calculated on this basis (i.e. Net sales/ Average inventory at selling price).
5. If average stock cannot be known then this ratio may be calculated with the figure of closing
inventory (i.e. Net sales/ Closing stock).
6. In case of manufacturing concern inventory turnover ratio may be known separately for raw
material and finished goods both applying the following formulae:

=

7. Anotherapproach of this ratio is computation of stock velocity.Stock velocity can be measured

in months also by applying following formula.

= ×

This ratio indicates the period during which supply of goods may be maintained out of current
stock without its replenishment.

8. Some people calculate average age of inventory also together with inventory turnover.

Average age of Inventory: This represents the number of working days, on an average, an item
remains in the firm’s inventory. It is also called inventory conversion period. It is calculated as
follows:

=
( )

Note: The number of working days in a year differs from organisation to organization.It may be
taken as 365/360/300. The shorter the average age of firm’s inventory, the more liquid or active
it may be considered.

Interpretation:

1.Inventory Turnover Ratio (ITR) is an indicator of velocity of flow of inventory in business.

This shows the rate of conversion of stock into sales. In fact, inventory policy of management
and liquidity of firm both may be tested by this ratio. This is also a measure of marketing
capacity of the firm.

2. No standard rate or norm can be determined for this ratio.Because it based more on nature of
industry and sales policy of the firm. Hence, this ratio should be compared with the firm’s own
past ratios and ratios of other similar firms or with industry average.
3. Comparatively higher inventory turnover ratio is an indicator of expansion of business
(efficiency in sales increases) and efficient management of inventory because it shows higher
sales with lesser investments in inventory. Such firms may earn high profits even at low margin
of profit. On the contrary, a fall in this ratio is an indicator of dull business and over-investment
in inventories.

4. A too high inventory turnover ratio may not necessarily always imply a favourable situation. It
may be the result of very low level of inventory which results in shortage of goods or a position
of stock-out whenever demand increases. It may also be the result of firm’s policy to buy
frequently in small lots at some higher prices.

5. Similarly, low inventory turnover may not necessarily always imply an unfavourable situation.
It may be result of management policy of keeping high inventory when price rise is anticipated
or stock shortage in near future is anticipated, or when some sizeable order is anticipated, for
which immediate supply is required. Hence, for drawing correct conclusion, causes of changes in
this ratio should be examined precisely.

Illustration 7

Calculate Stock turnover Ratio from the following information of Sanjit Limited:

Opening Stock ₹20,000,Purchases ₹1,09,000, Direct Expenses ₹1,000,Closing Stock

₹40,000,Administration Expenses ₹5,275,Selling & Distribution Expenses ₹10,000,Sales
₹2,50,000.

Solution:

Cost of goods sold=Opening stock +Net Purchases + Direct expenses – Closing stock =
₹20,000+₹1.09,000+₹1,000 -₹40,000=₹90,000

Average Stock= (Opening inventory +Closing inventory)/2 =₹(20,000+40,000)/2 =₹30,000

Stock Turn Over Ratio = (Cost of Goods Sold/Average Inventory) =₹90,000/₹30,000=3 times

Illustration 8

Calculate Stock Turnover Ratio from the following information related to Swapna Limited:

Opening Stock₹46,400,Purchases₹3,87,200,Sales₹5,12,000,Gross Profit:25% on Sales.

Solution:

Cost of goods sold=Sales-Gross Profit=₹5,12,000-(25%on ₹5,12,000)=₹5,12,000-₹1,28,000

=₹3,84,000

Cost of goods sold=Opening stock +Net Purchases + Direct expenses – Closing stock
Or ₹3,84,000=₹46,400+₹3,87,200+0-Closing Stock

Or Closing Stock=₹46,400+₹387,200-₹3,84,000=₹49,600

Average Stock= (Opening inventory +Closing inventory)/2 =₹(46400+49600)/2=₹48,000

Stock Turn Over Ratio = (Cost of Goods Sold/Average Inventory) =₹3,84,000/₹48,000

=8Times

Illustration 9
Compute the merchandise turnover of Paswan Ltd for each of the following three years shown
below and give your interpretation of the result.
Particulars 2018 (In ₹) 2017 (In ₹) 2016 (In ₹)
Cost of goods sold 5,16,378 4,53,740 6,41,425
Average inventory 2,36,420 3,01,231 5,39,850
Solution:

Cost of goods sold

Stock Turnover Ratio (STR) =
Average inventory

₹5,16,378
2018 = = 2.19 times
₹2,36,420

₹4,53,740
2017 = = 1.51 times
₹3,01,231

₹6,48,425
2016 = = 1.20 times
₹5,39,850

Interpretation: As it is clear from the above calculations,stock turnover has shown an

increasing trend during the years under review. It implies that the sales level per rupee invested
in stock has been increasing continuously. An analysis of absolute amounts of stock shows that
the company is following the policy of reducing investments in stock each year. All this is an
indication of company’s efficient inventory control policy and sales capability.
2. Debtors Turnover Ratio or Receivable Turnover Ratio (DTR)
A concern may sell goods on cash as well as on credit. Credit is one of theimportant elements of
sales promotion. The volume of sales can be increased byfollowing a liberal credit policy. The
effect of a liberal credit policy may result in tying up substantial fundsof a firm in the form of
trade debtors (or receivables). Trade debtors are expectedto be converted into cash within a short
period of time and are included incurrent assets. Hence, the liquidity position of concern to pay
its short termobligations in time depends upon the quality of its trade debtors.
Debtors Turnover Ratio or Accounts Receivable Turnover Ratio indicates thevelocity of debt
collection of a firm. In simple words, it indicates the number oftimes average debtors
(receivable) are turned over during a year.This ratio is a qualitative analysis of a firm’s
marketing and credit policy and debtors realizations. It is calculated to know the uncollected
portion of credit sales in the form of debtors by establishing relationship between trade debtors
and net credit sales of the business. The following formula is applied for this purpose.

=

Note:
1. Trade Debtors means Debtors plus Bills Receivables.
2. Average Trade Debtors =(Opening Trade Debtors + Closing Trade Debtors)/2
3.It should be noted thatprovision for bad and doubtful debts should not be deducted since this
may givean impression that some amount of receivables has been collected.
4. Net credit sales consist of gross credit sales minus sales returns.
5. Debtors and bills receivable arising from irregular or non-trading activities (such as bills
receivables received on sale of a fixed assets) are not included in this calculation.
6. If cash sales are negligible, then calculation may be made from net total sales figure in place
of net credit sales.
7.When theinformation about opening and closing balances of trade debtors and credit salesis not
available, then the debtors turnover ratio can be calculated by dividing thetotal sales by the
balance of debtors (inclusive of bills receivables) given. Andformula can be written as follows:
Debtors Turnover Ratio = Total Sales / Debtors
Interpretation:
1.Accounts receivable turnover ratio or Debtors’ turnover Ratio indicates thenumber of times the
debtors are turned over a year.
2. The higher the value ofdebtors’ turnover the more efficient is the management of debtors or
more liquidthe debtors are. Aincrease in this ratio each year is an indicator of efficiency of
marketing and credit policy of the firm.
3. Similarly, low debtors turnover ratio implies inefficientmanagement of debtors or less liquid
debtors.
4. It is the reliable measure of thetime of cash flow from credit sales.
5. There is no rule of thumb which may be usedas a norm to interpret the ratio as it may be
different from firm to firm.Hence, this ratio should be compared with the firm’s own past ratios
and ratios of other similar firms or with industry average.
Average Collection Period:
In analyzing the debtors, usually average collection period is also calculated with debtors’
turnover ratio. The period indicates the period taken in the realization or collection of debtors. In
other words, it represents the average number of days for which a firm has to wait before its
receivables are converted into cash. The purpose of calculating this period is to find out the ratio
of cash flow from collection of debtors. There are three formula for computation of average
collection period:

=

×
=

=
( )
Notes:
1. Credit Sales Per Day = (Net Credit Sales/Number of working Days in a year)
2. Number of working days in a year differs from organization to organization. It may be taken
as 365/360/300.
Interpretation:
1.This ratio measures the quality of debtors. A short collection period impliesprompt payment by
debtors. It reduces the chances of bad debts. Similarly, alonger collection period implies too
liberal and inefficient credit collectionperformance. It is difficult to provide a standard collection
period of debtors.
2. The average collection period is compared with actual trade terms (i.e. credit period allowed in
sales terms) to examine the managerial efficiency in debt collection. In this respect, the general
rule is that average collection period should not exceed the stated credit period on trade terms
plus 1/3rd of such period. If average collection period exceeds 4/3 of stated credit period, it will
indicate either liberal credit policy or slackness of management in realizing debts. A higher
average collection period also implies that chances of bad debts are more.
3. The average collection period is affected by change in sales terms, change in policy in respect
of including or excluding cash and installment sales in the sales, special sales campaign at the
close of the accounting year, direct sales to consumers, price changes, effectiveness of credit
collection and sales department, strikes and luck-outs and nature of trade cycle.

Illustration 10
From the following information of Ezra Limited calculate Debtors Turnover Ratio
(DTR)and Average Collection Period(ACP)
Particulars Amount(₹)
Total Sales for the Year 2,62,000
Cash Sales 20%of Total Sales
Sales Return out of credit sales 15,000
Opening Balance of Sundry Debtors 10,000
Opening Balance of Bills Receivable 2,000
Closing Balance of Sundry Debtors 15,000
Closing Balance of Bills Receivable 3,000

Solution:
Net Credit Sales = Total Sales-Cash Sales-Sales Return out of Credit Sales = ₹2,62,000-(20%
of₹2,62,000)-₹15,000 =₹(2,62,000-52,500-15,000) = ₹1,95,000
Opening Trade Debtors =Opening Debtors+ Opening Bills Receivable =₹10,000+₹2,000
=₹12,000
Closing Trade Debtors =Closing Debtors+ Closing Bills Receivable =₹15,000+₹3,000
=₹18,000
Average Trade Debtors =(Opening Trade Debtors + Closing Trade Debtors)/2
=₹(12,000+18,000)/2=₹30,000/2 =₹15,000
Debtor Turnover Ratio = Net Credit Sales/Average Trade Debtors = ₹1,95,000/₹15,000 =13
Tmes.
Average Collection Period=(Number of working Days in a Year/Debtor Turnover Ratio)
=365Days/13=28.07 days or 28 Days(Approximately)

Illustration 11
A manufacture sells to retailer on terms 2.5% discount in 30 days, 60 days net. The debtors and
receivable at the end of March on past three years and net sales for all these three years as under:
Particulars 2018 (In ₹) 2017 (In ₹) 2016 (In ₹)
Debtor 85,582 33,932 54,845
Bills receivable 9,242 3,686 4,212
Net sales 4,43,126 3,37,392 2,68,466
Determine the average collection period for each of these three years and comment.
Solution:

Trade receivables
Average collection period or average age of receivables = × 365
Net credit sales

₹59,054
2016 = × 365 = 80 days
₹2,68,466

₹37,618
2017 = × 365 = 41 days
₹3,37,392
 ₹94,824
2018 = × 365 = 78 days
₹4,43,126

Comments:As stated, credit period is 60 days.Hence collection period should not exceed
60+1/3rd of 60= 80 days. It is a matter of satisfaction that all the three years, firm’s average
collection period has never crossed this limit. It may be taken as an indication of alertness of
sales manager towards credit collection.
Illustration 12
Jagannath Ltd sells goods on cash as well as on credit. The following particulars are taken from
their books of accounts for the year ending 31st March 2019:
Particulars Amount (₹)
Total sales 10,00,000
Cash sales 2,00,000
Sales return 70,000
Total debtors (31/3/2019) 90,000
Bills receivable (31/3/2019) 20,000
Provision for bad debts (31/3/2019) 10,000
Calculate the average collection period.

Solution:

Trade
Average collection receivables 1,10,000
= × 365 = × 365 = 55 days
period
Net credit sales 7,30,000

Whereas trade receivables= ₹.90,000 +₹. 20,000= ₹. 1,10,000

Net credit sales= ₹.10,00,000 – ₹.2,00,000 – ₹.70 000= ₹ 7,30 000

3. Creditors Turnover Ratio(CTR)/Payables Turnover Ratio:

LikeDebtorsturnoverRatio, Creditor’s turnover Ratio may also be calculated. The short-term

creditors (i.e. suppliers of goods) are very much interested in this ratio, as it shows the firm’s
trend of payment to its short-term creditors. This ratio shows the relationship of net credit
purchases and averagetrade creditors.

Note:

1. Trade Creditors means Creditors plus Bills Payables.

2. Average Trade Creditors = (Opening Trade Creditors + Closing Trade Creditors)/2

3. Net credit Purchaseconsist of gross credit purchases minus purchase returns.

4. Creditors and Bills Payable arising from irregular or non-trading activities (such as bills
payable on purchase of a fixed assets) are not included in this calculation.

5. If cash purchases are negligible, then calculation may be made from net total purchases figure
in place of net credit purchases.

6. When the information about opening and closing balances of trade creditors and credit
purchases is not available, then the creditors turnover ratio can be calculated by dividing the
total purchases by the balance of creditors (inclusive of bills Payables) given. And formula can
be written as follows: Creditors Turnover Ratio = Total Purchases / Creditors

Interpretation:

This ratio indicates the velocity with which the creditors are turned over in relation to purchases.
Higher the creditors velocity, better it is. A fall in the ratio shows delay in payment to creditors.

Average Payment Period

While analyzing creditors, usually average payment period is also calculated. This period
discloses the time taken by the firm in making payment to its trade creditors.Average payment
period ratio gives the average credit period enjoyed from the creditors. It can be calculated using
any one the following three formulae:

×
=

=
( )
Interpretation:

1. The average payment period ratio represents the number of days by thefirm to pay its
creditors.

2. A high Creditor’s turnover Ratio or a lower credit periodratio signifies that the creditors are
being paid promptly. This situation enhancesthe credit worthiness of the company.

3. However a very favorable ratio to this effectalso shows that the business is not taking the full
advantage of credit facilitiesallowed by the creditors.

4. Average disbursement period is compared with credit period allowed by suppliers of goods to
know promptness or delay in payment.

Illustration 13

From the following information of Aiswarya Limited calculate Creditors Turnover Ratio
and Average Payment Period:

Particulars Amount(₹)
Credit Purchases during the year 5,30,000
Purchase return(Out of credit purchase) 30,000
Opening Creditors 90,000
Closing Creditors 50,000
Opening Bills Payables 20,000
Closing Bills Payables 40,000
Solution:

Net Credit Purchase Credit Purchase-Purchase Return =₹.5,30,000-₹.30,000 =₹.5,00,000

Opening Trade Creditor =Opening Creditor+Opening Bills Payable =₹ .90,000+₹ .20,000=₹

.1,10,000

Closing Trade Creditor =Closing Creditor+Closing Bills Payable =₹ .50,000+₹ .40,000=₹

.90,000

Average Trade Creditor =(Opening Trade Creditor +Closing Trade Creditor)/2 = (₹

.1,10,000+₹.90,000)/2 =₹.2,00,000/2=₹.1,00,000

Creditor Turn Over Ratio =Net Credit Purchase/Average Trade Creditor=₹ .5,00,000/₹
.1,00,000 = 5 times

Average Payment Period = Number of Working Days in a year/Creditor Turnover Ratio =365
Days/5 =73 Days
Illustration 14
A trader purchases goods both on cash and credit terms. The following particulars are obtained
from the books:
Particulars Amount (₹)
Total purchases 2,00,000
Cash purchases 20,000
Purchase return 34,000
Creditors at the end 70,000
Bills payable at the end 40,000
Reserve for discount on creditors 5,000
Calculate the average payment period.

Solution:

Step-I: Net credit purchase= Total purchase - Cash purchase - Purchase return
= ₹.2,00,000 - ₹.20,000 - ₹.34,000 = ₹ 1,46,000
Step-II:
Creditors + Bills payable
Average payment period = × 365
Net credit purchase
70,000+40,000
= × 365 = 275 days
1,46,000
Illustration 16
The following ratios are taken from Jagannath Traders:
Particulars Details
Stock velocity 5 months
Debtors velocity 2.5 months
Creditors velocity 3 months
Gross profit Ratio 30%
Gross profit for the current year ended 31 March 2019 amounts to ₹ 9,00,000. Closing stock of
st

the year is ₹ 30,000 more than the opening stock. Bills receivable amounts to ₹ 50,000 and bills
payable to ₹ 30,000. Find out Amount of sales, sundry debtors, closing stock and sundry
creditors.

Solution:

Amount of Sales:

Gross profit×100
Gross profit Ratio =
Sales

9,00,000×100
30 = = ₹30,00,000
Sales
Sundry Debtors:

Debtors + BR
Debtors velocity = × 12 months
Net credit sales

Debtors + 50,000
2.5 = × 12
30,00,000

Therefore debtors = ₹.6,25,000- ₹.50,000 = ₹ 5,75,000

Closing Stock:

Cost of goods sold= Sales-gross profit= ₹.30,00,000 – (30% of ₹. 30,00,000) = ₹ 21,00,000

Average stock
Stock velocity (in months) = × 12 months
Cost of goods sold

Average stock
5 = × 12
21,00,000

Therefore average stock = ₹ 8,75,000

Opening stock + Closing stock
Average stock =
2

Opening stock + (30,000 + Opening stock)

= 8,75,000 =
2

Therefore average stock = ₹ 8,60,000

Closing stock = ₹ 8,60,000 +₹.30,000 = ₹ 8,90,000

Sundry Creditors:

Net credit purchases= Cost of goods sold + closing stock – opening stock=₹.( 21,00,000 +
8,90,000 – 8,60,000 ) = ₹ 21,30,000
Creditors + B/P
Creditors velocity = × 12 months
Net credit purchases
 Creditors + 30,000
3 = × 12
21,30,000

Therefore Creditors =₹. 5,32,500 –₹. 30,000 = ₹.5,02,500

4. CurrentAsset Turnover Ratio:

In order to examine truly the liquidity of a firm, it is essential to measure the effectiveness and
efficiency with which the firm is managing its current assets, specially debtors and stock.This
ratio measures the utilization and effectiveness of current assets by establishing relationship of
current assets with net sales. It is calculated as below.
( )
=

This ratio is useful for those concerns where use of fixed assets is negligible. Higher the ratio,
better it is.

5. Working Capital Turnover Ratio or Ratio of Sales to Working Capital:

Working capital turnover Ratio indicates the velocity of the utilization of networking capital.
This ratio is a measure of efficiency of working capital utilization.This ratio represents the
number of times the working capital is turned over inthe course of yearIt is calculated as follows:
( )
=

Note:Net Working Capital = Current Assets- Current Liabilities
Interpretation:
1. A high working capital turnover ratio shows the efficient utilization of working capital.
2. But too high or too low ratio indicates over-trading and under-trading respectively. Both these
situations are harmful for the smooth conduct of the business.
3. However, the ratio should be interpreted along with inventory turnover and debtor turnover
ratios.
Illustration 17
From the following particulars of Abhijit Limited, compute Current Assets Turnover Ratio and
Working capital Turnover Ratio:
Particulars Amount(₹)
Cash 10,000
Bills Receivable 5,000
Sundry Debtor 25,000
Stock 20,000
Sundry creditors 30,000
Cost of Sales 1,40,000
Solution:
Current Assets = Cash + Bills Receivable + Sundry Debtors +Stock =₹ .( 10,000+5,000
+25,000+30,000) =₹.70,000
Current Liabilities = Sundry Creditors =₹.30,000
Net Working Capital = Current Assets- Current Liabilities =₹.(70,000-30,000) = ₹.40,000
Current Asset Turnover Ratio = Cost of sales/Current Assets =₹.1,40,000/₹.70,000 =2 times.
Working Capital Turnover Ratio = Cost of Sales/Net Working Capital =₹.1,40,000/₹.40,000 =
3.5 times
6. FixedAsset Turnover Ratio or Ratio of Sales to Fixed AssetsRatio
This ratio measures management’s ability of efficient and profitable use of fixed assets. It
indicates the firm’s ability to generate sales per rupee of investments in net fixed assets. It is
calculated as follows:

( )
=

Interpretation:
1. This ratio assumes more significance in manufacturing concerns because of comparatively
higher investment in fixed assets in these concerns.
2. Higher the ratio, better it is. But this ratio varies from one industry to other. In labour intensive
industries, it is expected to be high and in capital intensive industries (where investment in fixed
assets is high), it is bound to be low.
3.Inmanufacturing industry5: 1 is considered to be satisfactory.
4.A high fixed asset turnover ratio indicates efficiency of management in utilizing the fixed
assets
5. But a very high fixed assets turnover is an indication of over trading on fixed assets.
6. On the other hand, a low fixed assets turnover ratio indicates under or inefficient utilization of
fixed assets or over-investment in fixed assets.
7.If a business shows a weakness in this ratio, its plant may be operating belowcapacity and the
management should be looking at the possibility of selling the lessproductive assets.
8. As there is no direct relationship between the sales and fixed assets, this ratio is of use only in
manufacturing concerns.
7. TotalAssets Turnover Ratio:
This ratio shows relationship between total assets of the company and its total sales or cost of
sales. This ratio takes into account both net fixed asset; and current assets. This ratio is a measure
of effectiveness of the use of total assets in the working of the concern. It is calculated as
follows:
( )
=

Interpretation:
1. It also gives an indication of the efficiency with which assets are used.
2.A low ratio means that excessive assets are employed to generate sales.
3. A ratio of 2:1 asset turnover is considered satisfactory.
4. If the ratio is very high, it may be considered that the concern is over trading on fixed assets
and if it is very low it indicates over-investments in assets and underutilization of total capacity.

8. Net Tangible Assets Turnover Ratio or Ratio of Sales to Net Tangible Assets:
It is calculated as follows:
( )
=

Note: Net tangible asset are calculated by taking sum of all assets excluding intangible assets
and deducting total liabilities from this sum.
Interpretation:
Higher the ratio, better it is but if this is too high, it implies over-utilization of firm’s goodwill.
This is called as over trading.

9. Capital or Net WorthTurnover Ratio or Ratio of Sales to Capital or Net Worth:

This ratio is a measure of efficiency of utilization of shareholders capital. Efficient use of capital
is an indicator of profitability of business and managerial efficiency. It is calculated as follows:

=

Some authors suggest that total capital employed should match with net sales and they can
calculate the ratio as follows:

=

Total capital implies shareholders fund plus long-term debt. Higher the ratio, better it is. A
higher ratio indicates more profits while low ratio would result low profits. A very high capital
turnover ratio would indicate over-trading and a very low capital turnover ratio leads to under-
trading.

1.8 Solvency Ratio:

The term solvency refers to the ability of the concern to meet its long-term commitments.
Solvency is examined with reference to the firm’s capacity to pay interest regularly and
eventually repay on maturity the sum borrowed. Long-term creditors as well as present and
prospective shareholders are interested in the analysis of solvency of a company. The following
ratios are calculated for examining long-term solvency of a concern:
1. Debt-Equity Ratio /Debt-Net worth Ratio
2. Proprietary Ratio/Equity Ratio
3. Solvency Ratio
4. Fixed Assets to Net worthRatio
5. Funded Debt to Capitalization Ratio
6.Fixed Assets to Total Long-term fund Ratio or Fixed Assets Ratio
7.Ratio of tangible assets to total debts
8. Debt-Service coverage Ratio/ Interest coverage Ratio/ Fixed Charges Coverage Ratio
9. Preference Dividend Coverage Ratio
10.Cash to debt service Ratio or Debt cash flow coverage Ratio
1. Debt-Equity Ratio or Debt-Net worthRatio:
A firm uses both equity and debt for financing its assets. The ratio of thesetwo sources of funds
is terned as Debt Equity Ratio. This ratio indicates the relationship between external equities and
internal equities. This is also known as External-Internal Equity Ratio. It is calculated as follows:
− ( )
− =
( )

Outsider's Long term Fund(Debt) Shareholder's Fund/Net-worth (Equity)

Debenture or Bond+ Long- Term loan from Preference share capital +Equity share capital,
Financial Institutions + Other long-term +Capital reserve, Retained earnings and any
Borrowings other reserves representing the accumulated
profit – Accumulated Losses (if any)

Note: Some authors consider the meaning of debt as Total Borrowed Funds. Hence they
calculate Debt equity ratio as (Total Borrowed funds/Shareholder’s Fund).Total Borrowed funds
include both long term and short term borrowings orcurrent liabilities. It is the aggregate of
bonds, debentures, bank loans and all thecurrent liabilities.
Interpretation
1. A low ratio signifies a smaller claim of debt- holders. More precisely, the greater the debt-
equity ratio, greater the risk to debt- holders.
2. This ratio indicates the extent of cushion available to the debt- holders on liquidation of the
borrower concern. Lower the ratio, greater security for the debt- holders. A high debt equity ratio
is a danger signal for the debt- holders because in case of fall in profits of the concern, it may not
be able to bear the heavy burden of interest and also not able to repay its debts on time.
3. But shareholders stand to gain from the high debt equity ratio because
 They can retain the control of the company with less contribution and thus bearing lesser
risks.
 In case of increase in the profitability of the company, their earning per share will
increase very fast. This is called trading on equity.
4. Low debt equity ratio provides sufficient safety margin to debt- holders but it indicates
company’s failure to use low-cost outsiders fund to magnify shareholders earnings.

5. The standard norm of Debt-Equity ratio is 2:1. It indicates that total borrowedfund can be two
times of equity or owned funds. The intention is to maximize thereturn of equity shareholders by
taking, advantage of cheap borrowed funds. However lending institutions prefer a debt equity
ratio of 1:1.
2. Proprietary Ratio/ Equity Ratio:
This ratio is also known as Equity Ratio orShareholders Equity to Total Equity Ratio or Net
Worth to Total Assets Ratio. It indicates the relationship of owner’s funds (shareholders equity)
to total assets or total equities.
′
=

Note: This ratio can be represented in percentage also which will indicate the percentage of
owner’s fund to total assets.

Interpretation:

1. The purpose of this ratio is to know the proportion of total assets financed by the owners.

2. There are no generally accepted norms for this ratio.

3.Higher the ratio lesser the dependence for capital on outside sources, better the long-term
solvency and greater the protection to the debt- holders of the firm.

4.In case of stability in earnings of the firm, comparatively a lower ratio can also be accepted.

3. Solvency Ratio or Debt to total asset Ratio:

It is also known as Debt Ratio.It is the ratio of total borrowed funds to total assets (also equal to
totalliabilities). It indicates the relative contribution of outsiders in financing theassets of the
firm. This ratio indicates the relationship of total liabilities of the firm to its total assets. This is
why it is also known as the ratio of total liabilities to total assets. It measures the proportion of
total assets financed by outside creditors. It is calculated by using any of the following two ratios

Solvency Ratio =100-Equity Ratio

Interpretation:

1. The higher this ratio, the greater is the dependence of the firm on outsiders for its financing.
The position of debt holder in this case is not safe in the event of winding up.
4. Proprietor’s Liability Ratio:

This ratio indicates the relationship between two main sources of financing i.e. proprietor’s fund
/shareholder’s fund and outsider’s loans (or liabilities). It is calculated as follows:

’
’ =

Interpretation:

Higher the ratio better is the security of debt holders.

5.Fixed Assets to Net worth Ratio or Ratio of Fixed Assets to Proprietor’s Fund
The ratio shows the relationship between net fixed assets and Net worth. An important aspect of
financial soundness is that all fixed assets of the business are financed out of shareholder’s funds.
If fixed assets are more than owner’s funds then it implies that fixed assets have been financed
with outside sources (i.e. borrowed money) also. In such a case, if the debt holders demand for
repayment of their loans, the firm may have to face serious financial problems because amount
invested in fixed assets cannot be taken back. Hence, if owner’s funds exceed the fixed assets, it
is treated as a good proof of firm’s long-term solvency.
This ratio is calculated by dividing the value of fixed assets after depreciation by proprietor’s
fund.

( − )
=

Interpretation:
1. This ratio should not exceed 1:1.
2.On the contrary, lesser the ratio, better the position because in such a case proprietor’s funds
will be available for working capital needs because in such case proprietor’s funds will be
available for working capital needs also.
3.Usually, a ratio of 0.67:1 (i.e. fixed assets are about two-third of the proprietor’s funds) is
considered satisfactory.

6. Fixed Assets to Total Long-term fund Ratio or Fixed Assets Ratio

This is an improvement over fixed assets to net worth ratio. The modern view of financial
experts is that fixed assets could be financed by long-term loans also together with proprietor’s
funds. Hence for long-term solvency analysis the relationship of fixed assets should be
established with total long term funds (proprietor’s funds plus long-term loans). Fixed assets
ratio is calculated for this purpose. It is calculated as follows:
 ( − )
=

Interpretation:
1. This ratio should not exceed 1:1. If it exceeds 1:1, it implies that short-term funds of the firm
have also been applied for acquiring fixed assets which in no way be considered appropriate.
2. The general rule is that fixed assets should not exceed 2/3 rd of total long-term funds so that
rest of the long-term funds could be utilized for meeting working capital requirement.

7. Ratio of tangible assets to total debts

This ratio indicates the relationship of tangible assets to total debts.

Interpretation:
This ratio measures the ability of the firm to pay its debt, as it shows the extent to which total
liabilities of the firm can be repaid its tangible assets. Higher the ratio greater is the security of
the creditors.

8. Debt Service Ratio (DSR) or Interest Coverage Ratio

This ratio relates the fixed interest charge to the income earned by the business. It indicates
whether the business has earned sufficient profits to pay periodicallythe interest charges. This
ratio is calculated to evaluate the debt-servicing capacity of the firm. It is calculated by dividing
the net profit before interest and taxes by fixed interest charges.

& ( )
=

Interpretation:
1. This ratio is very meaningful for the long-term creditors of the firm because it measures the
firm’s capacity to pay interest on its loans on due dates.
2. It also measures the margin of safety for the lenders. Higher the ratio, better is the position of
long-term creditors.
3.But a too high interest coverage ratio may mean that firm is not taking adequate advantage of
trading on equity to increase the earning per share.
4. Eight to nine times interest cover is considered as satisfactory for an industrial concern.
5. A sharp decline in this ratio may endanger payment of interest and the firm will find it
difficult to raise additional funds.
6. The interest coverage ratio does not take into account other fixed obligations like payment of
preference dividend and repayment of loan instilments.
Illustration 18
If the net profit (after taxes) of a firm is 75,000 and its fixed interest charges on Interest onLong-
term borrowings are 10,000. The rate of income tax is 50%.Calculate Debt service Ratio /
Interest coverage Ratio
Solution:
Particulars Amount(₹)
Net profit (after taxes) of a firm 75,000
Add: Taxes (50% of Profit Before Tax) 75,000
Net profit (before taxes) 1,50,000
Add: Interest on Long-term Borrowing 10,000
Earnings Before Interest & Taxes(EBIT) 1,60,000

Interest Coverage Ratio = EBIT/Interest Charges =₹.1,60,000 / ₹.10,000= 16 times

9. Preference Dividend Coverage Ratio:

It is calculated as follows:

( )
=

Interpretation:
1. This ratio is an index of the risk accruing to preference shareholders.
2. Coverage of at least 2 is considered standard.

10. Cash to Debt Service Ratio or Debt Cash Flow Coverage Ratio:
Some authors find Cash to debt service Ratio as a better measure to judge firm’s ability to meet
its long-term obligations. As the firm has to pay debt service charges in cash, so in order to
analyze firm’s long term liquidity, it is better to calculate this ratio on the basis of total cash
inflows instead of net income. If the firm has created sinking fund to repay the long-term loans,
then, annual contribution to sinking fund shall also be added to interest charges and the following
formulae shall be applied.

=
+ [( )/ ( − )]

Interpretation:
1. If it is not possible to calculate precisely the amount of annual cash inflows, then the amount
arrived at by adding depreciation and other non-cash expenses to the amount of net profit before
interest and tax may be used in place of annual cash inflows.
2. High coverage ratio would be required in firms whose incomes are very instable.The firms
whose incomes are stable; comparatively a low coverage ratio will be sufficient.
Illustration 19
From the following information calculate
1. Interest Coverage Ratio
2. Debt cash flow coverage Ratio
Particulars Amount
Net income after tax ₹1,56,370
Depreciation charged ₹20,000
Tax rate 50% of net income
5% mortgage Bonds ₹2,50,000
Fixed interest Charges ₹14,750
Sinking fund appropriation 5% of outstanding debentures

Solution:

Particulars Amount(₹)
Net income after tax 1,56,370
Add: Taxes(50% Tax on Profit before tax) 1,56,370
Net Income before tax 3,12,740
Add: Fixed Interest Charges 14,750
Net Profit Before Interest & Taxes(EBIT) 3,27,490
Add: Depreciation Charged 20,000
Annual Cash flow before interest and tax 3,47,490

Net profit before interest and income tax

Interest Coverage Ratio =
Fixed interest charges

3,27,490
= = 22 times approximately
14,750

Debt cash flow coverage Annual cash flow before interest and tax
= Interest + [( Sinking fund appropriation on debt)/ (1-Tax rate )]
Ratio

3,47,490
= = 8.7 times
14,750+[ (12,500)/(1-0.50)]
Illustration-20
From the following Balance Sheet of Deepak Ltd. compute:
a) Equity Ratio of Proprietory Ratio
b) Debt- Equity Ratio
c) Funded Debt to Capitalization Ratio
d) Fixed Assets to Net Worth Ratio
e) Solvency Ratio
f) Current Assets to Proprietory Fund Ratio
g) Fixed Asset Ratio

Balance Sheet of Deepak Limited

₹
Equity & Liabilities
Equity Share Capital 3,00,000
9% Preference Share Capital 1,50,000
Reserve Fund 50,000
Profit and Loss A/c 20,000
Share Premium 10,000
8% Debentures 2,00,000
6% Mortgage Loan 60,000
Sundry Creditors 80,000
Income Tax Provision 20,000
Depreciation Fund 50,000
Total 9,40,000
Assets 90,000
Goodwill 90,000
Land and Building 1,00,000
Plant & Machinery 2,50,000
Equipment 60,000
Furniture & Fittings 80,000
Sundry Debtors –Less Provision (₹92,000 – ₹2,000) 90,000
Bills Receivables 1,00,000
Stock-in hand 1,20,000
Cash Balance 45,500
Prepaid Insurance 1,500
Preliminary Expenses 2,000
Discount on Issue of Debentures 1,000
Total 9,40,000
Solution:

Shareholder’s Funds
a) Equity Ratio =
Total Assets
Shareholder’s Funds

= Equity Share Capital + Preference Share Capital + Reserve Funds + Profit and Loss A/c +
Share Premium – Preliminary Expenses – Discount on Issue of Debentures

= ₹3,00,000 + ₹1,50,000 + ₹50,000 + ₹20,000 + ₹10,000 – RS. 2,000 – ₹1,0000

= ₹5,27,000

Total Assets

= Total Assets – Preliminary Expenses – Discount on Issue of Debentures – Depreciation Fund

= ₹9,40,000 – ₹2,000 – ₹1,000 – ₹50,000

₹8,87,000

Note: Preliminary Expenses and Discount on Issue of Debentures are deferred expenses are not
assets.

₹5,27,000
Equity Ratio = = 0.59
₹8,87,000

Outsider’s Funds
b) Debt-Equity Ratio =
Shareholder’s Funds

Outsider’s Funds

= 8% Debentures + 6% Mortgage Loan + Sundry Creditors + Income Tax Provision

= ₹2,00,000 + ₹60,000 + ₹80,000+ ₹20,000

= ₹3,60,000

₹3,60,000
Debt Equity Ratio = = 0.68
₹5,27,000

Funded Debt
c) Funded Debt to Capitalization Ratio =
Total Capitalization
Funded Debt = Long-term loans

= 8% Debentures + 6% Mortgage Loan

= ₹2,00,000 + ₹60,000

= ₹2,60,000

Total Capitalization = Shareholders Funds + Long-term loans

= ₹5,27,000 + ₹2,60,000

= ₹7,87,000

₹2,60,000
Funded Debt to Total Capitalization Ratio = = 0.33
₹7,87,000

Net Fixed Assets

d) Fixed assets to Net Worth Ratio =
Net Worth

Net Fixed Assets

= Goodwill + Land and Building + Plant and Machinery + Equipments + Furniture & Fittings –
Depreciation Fund

=RS. 90,000 + ₹1,00,000 + ₹2,50,000 + ₹60,000 + ₹80,000 – ₹50,000

= ₹5,30,000

Net Worth = Net Worth is the same as Shareholders Funds

₹5,30,000
Fixed assets to Net Worth Ratio = = 1.01
₹5,27,000

Total Liabilities to Outsiders

e) Solvency Ratio =
Total assets

Total Liabilities to Outsiders

= 8% Debentures + 6% Mortgage Loan + Sundry Creditors + Income Tax Provision

= ₹2,00,000 + ₹60,000 + ₹80,000 + ₹20,000

= ₹3,60,000
 ₹3,60,000
Solvency Ratio = = 0.41
₹8,87,000

Current Assets
f) Current Assets to Proprietors’ Funds Ratio =
Proprietors’ Funds

Current Assets

= Sundry Debtors + B/R + Stock –in-trade + Cash Balance + Prepaid Insurance

= ₹90,000 + ₹1,00,000 + ₹1,20,000 + ₹45,500 + ₹1,500

₹3,57,000

Proprietors’ Funds = Shareholders Funds

₹3,57,000
Current Assets to Proprietors’ Funds Ratio = = 0.68
₹5,27,000

Net Fixed Assets

g) Fixed Assets Ratio =
Total Long-term Funds

Total Long-term Funds = Shareholders Funds + Long-term borrowings (Funded debt)

= ₹5,27,000 + ₹2,60,000

=₹7,87,000

₹5,30,000
Fixed Assets Ratio = = 0.67
₹7,87,000

Illustration:21

From the following Balance Sheet of Deepa Ltd. compute:

i) Funded Debts to Capitalization Ratio
ii) Total Liabilities to Total Assets Ratio
iii) Fixed Assets Ratio
iv) Total Fixed Assets to Proprietors’ Equity
v) Total Current Assets to Proprietory Equity Ratio
vi) Interest Coverage Ratio
 Balance Sheet of Deepa Ltd as at 31st Dec. 2017
₹
Equity & Liabilities
20,000 Equity Shares of ₹10 each fully paid 2,00,000
8% 10,000 Preference Share of ₹100 each, fully paid 1,00,000
General Reserve 50,000
Securities Premium 25,000
Profit and Loss A/c 1,00,000
10% Debentures 1,00,000
12% Mortgage Loan 50,000
Sundry Creditors 50,000
Bills Payable 10,000
Total 6,85,000
Assets
Plant & Machinery (Net) 2,00,000
Land and Building (Net) 1,00,000
Closing Stock 1,50,000
Debtors 80,000
Bills Receivables 60,000
Cash and Bank 95,000
Total 6,85,000
Net Profit before Interest and Taxes (EBIT) amounted to ₹40,000.

Solution:

Before calculating the actual ratios, the following components are computed:

Funded Debts

₹
10% Debentures 1,00,000
12% Mortgage Loan 50,000
1,50,000

Total Capitalization

₹
Equity Share Capital 2,00,000
Preference Share Capital 1,00,000
General Reserve 50,000
Securities Premium 25,000
Profit and Loss A/c 1,00,000
10% Debentures 1,00,000
12% Mortgage Loan 50,000
6,25,000
Total Liabilities to Outsiders

₹
10% Debentures 1,00,000
12% Mortgage Loan 50,000
Sundry Creditors 50,000
Bills Payable 10,000
2,10,000

Total Assets

₹
Fixed Assets 3,00,000
Current Assets 3,85,000
6,85,000

Total Long-Term Fund

₹
Shareholders’ Fund
Equity Share Capital 2,00,000
Preference Share Capital 1,00,000
General Reserve 50,000
Securities Premium 25,000
Profit and Loss A/c 1,00,000
4,75,000
Other Long-term Funds
10% Debentures 1,00,000
12% Mortgage Loan 50,000
6,25,000

Total Fixed Interest Charges

₹
Debenture Interest 10,000
Mortgage Loan 6,000
16,000

Funded Debts
(i) Funded Debts to Total Capitalization Ratio = × 100
Total Capitalization
 ₹1,50,000
= × 100 = 24%
₹6,25,000

Total Liabilities to Outsiders

(ii) Total Liabilities to Total Assets Ratio = × 100
Total Assets

₹2,10,000
= × 100 = 31%
₹6,85,000

Fixed Assets
(iii) Fixed Assets Ratio = × 100
Total Long-m Funds

₹3,00,000
= × 100 = 200%
₹1,50,000

Total Fixed Assets

(iv) Total Fixed Assets to Proprietors’ Fund Ratio = × 100
Proprietors’ Fund
₹3,00,000
= × 100 = 63%
₹4,75,000

Total Current Assets

(v) Total Current Assets to Proprietors’ Fund Ratio = × 100
Proprietors’ Fund

₹3,85,000
= × 100 = 81%
₹4,75,000

Net Profit before Interest & Tax (EBIT)

(vi) Interest Coverage Ratio =
Fixed Interest Charges

₹40,000
= = 2.5 times
₹16,000
1.9 CAPITAL STRUCTURE RATIOS OR LEVERAGE RATIOS
A firm’s capital structure is the relation of debt to equity as sources of a firm’s asset. Ratios used
for capital structure analysis are known as leverage ratios. These ratios measure the relationship
between finance provided to the firm by the outsiders and the owners. They also indicate the risk
of debt finance. Hence, both the owners and creditors of the firm are interested in the analysis of
capital structure. The long-term creditors of the firm are interested mainly evaluating firm’s
capacity of repayment the principal and amount on the maturity and timely payment of interest
on their loans. A finance manager can increase significantly rate of dividend and worth of
investments of equity shareholders by appropriate leverage.
Purpose of Leverage Ratios:
1. Identifying Sources of Funds: The firm finances all its resources from debt to equity sources.
The amount of resources from each source is shown by these ratios.
2. Measuring the Finance Risk: One measure of the degree of risk prevailing from debt
financing is provided by these ratios. If the firm has been increasing the percentage of debt in its
capital structure over a period of time, this may indicate an increase in risk for its shareholders.
3. Forecasting Future Borrowing Prospects: If the firm is considering expansion and needs to
raise additional money, the capital structure ratios offer an indication of whether debt funds will
be available. If the ratios are too high, the firm may not be able to borrow.
Types of Leverage Ratio:
Following ratios may be calculated for leverage analysis:
1. Capital gearing Ratio or Gear Ratio
2.Debt –Total Fund Ratio
3. Ratio of total investments to Long-term liabilities
4. Ratio of fixed asset to funded debt
5. Ratio of reserve to equity capital
6. Ratio of current liabilities to proprietor’s funds

1. CapitalGearing Ratio or Gear Ratio:

This is most important ratio for analyzing the capital structure of a concern. The term capital
gearing denotes the extent of reliance of a company on fixed cost bearing securities (preference
share capital and debt capital) as against equity funds (i.e. equity share capital and surplus). In
simple words, capital gearing implies financing of a business enterprise through fixed interest
and dividend carrying securities. Capital gearing Ratios express relationship between fixed cost
bearing capital and variable cost bearing capital.

=

If fixed cost bearing capital is greater proportion than variable cost bearing capital (i.e. the ratio
is more than 1) the business enterprise is said to be highly geared. The business enterprise is said
to be low geared when fixed cost capital is less than variable cost bearing capital (i.e. ratio is less
than 1).
Interpretation:
1. A company can increase the return on equity shareholders by adopting high gearing policy.
But this is possible only when the rate of interest/ dividend payable on fixed cost bearing capital
is less than the rate of earnings on total capital employed in the firm.
2. In the case of loan capital, there is also the benefit of tax shield because interest on loan capital
is a permissible deduction from profits for the purpose of ascertaining taxable income.
3. Hence, by adopting the policy of high gearing, return on equity shareholders exceed even the
return on capital employed. This is known as trading on equity. But this policy is profitable only
when the cost of capital is less than the additional earning from it. In case of reverse situation,
the equity shareholder may have not only to lose their dividend but sometimes their capital also
to meet out this loss. Hence, the policy of high gearing is very risky and speculative. The equity
share holders dwell upon feast and fast under such circumstances.
4. During boom, dividend on these shares and consequently their market value rise sharply and
on reverse circumstances (i.e. during depression) they fall sharply.
Illustration-22
Following is the capital structure of A Ltd and B Ltd. As on 31st March 2017:
Particulars A Ltd(₹) B Ltd(₹)
Equity share capital 5,00,000 1,00,000
10% Preference share capital 1,00,000 2,00,000
12% Debentures Nil 3,00,000
General reserve 2,50,000 2,50,000

During the year 2018, each company earned profit of RS. 2,00,000 before interest and taxes. The
rate of tax is 50%. Comment on the capital gearing of the two companies.

Solution:
Fixed cost bearing capital
CGR =
Variable cost bearing capital

1,00,000
A Ltd = = 0.13:1
7,50,000

5,00,000
B Ltd = = 1.43:1
37,50,000
2. Debt to Total Funds Ratio:
It is a modified version of Debt-Equity Ratio. It represents how much amount of outside long-
term liabilities are related to total capital structure of the firm. This ratio is computed by dividing
the long-term debts by the amount of Total funds. This is computed as below:

−
− =

3. Ratio of Total Investments to Long-term Liabilities:

It expresses relationship of total long-term funds to long-term liabilities:

−
( ′ + − )
=

Note: As a general rule, proportion of long-term liabilities should be very high.

4. Ratio of Fixed Asset to Funded Debt:

This ratio determines the margin of safety to funded debt, such as debentures. The debentures of
a company are usually issued by mortgaging the fixed assets. Hence, higher the ratio of fixed
asset to debentures, the greater will be the security of debenture holders. It is calculated as
follows:

=

5. Ratio of Reserve to Equity Capital:

It is calculated as follows:

= ×

This ratio throws light on dividend policy of the management. Higher the ratio, more
conservative is dividend policy of the management and better is the growth potentiality of the
company.

6. Ratio of current liabilities to proprietor’s funds:

This ratio is calculated by

’ =
’
This ratio measures short-term borrowings as compared to funds provided by the proprietors.
The norm is 35%.

1.10 PROFITABILITY RATIO

A business firm is basically a profit earning organization. The profitability is generally treated as
an indicator or efficiency of business activities. It depends upon the amount of sales, nature of
costs and efficiency of business activities. It depends upon the amount of sales, nature of costs
and efficient use of resources. Profitability is analysed by different parties according to their
interest.
 To the management, profits are the test of efficiency and a measure of control to owners,
a measure of worth of their investment,
 To the creditors, the margin of safety,
 To employees, a source of fringe benefits,
 To government, a measure of taxpaying capacity and the basis of legislation action,
 To customers a hint to demand for price cut’
 To an enterprise, less cumbersome source of finance for growth and existence and
 To the country, an index of economic progress.
For reliable and meaningful analysis of profitability, three of four ratios should be calculated. A
single ratio may lead to misleading conclusions. This analysis is of two kindsi.e. general
profitability analysis, overall profitability analysis.
General Profitability Ratios(Profit in Overall Profitability Ratios(Profit in
relation to Sales) relation to Investment)
1.Gross Profit Ratio 1.Return on Equity(ROE)
2.Operating Ratio 2.Return on Net worth(RONW)
3.Operating Profit Ratio 3.Return on Investment(ROI)
4.Expenses Ratio 4.Return on Assets(ROA)
5.Net Profit Ratio 5.Return on Capital Employed(ROCE)

General profitability analysis

In this type of analysis profit is related to the volume of operation or sales. The different types of
General Profitability Ratios are as under:
1. Gross profit Ratio:
This ratio establishes relationship between gross profit and net sales. This indicates gross profit
margin to net sales and usually expressed in percentage. The formula is as follows:

= ×

Notes:
1. The two main components of this ratio are gross profit and net sales.
2. Gross profit is the excess of net sales over the cost of goods sold.
3.Net sale is found out of deducting sales returns from gross or total sales.
Interpretations:
1. Gross profit Ratio is very important ratio of measuring profitability of an enterprise.
2. It indicates the management the margin of the profit left to cover indirect expenses.
3. In other words, it indicates the extent to which the selling price of goods may decline without
resulting in losses.
4. Higher the ratio, better it is.
5. But there is no rule of thumb for gross profit ratio. It may vary from business to business,
industry to industry and also for different units within the same industry.
6. Hence, a firm’s gross profit ratio should be compared with own past ratio or with ratio of the
competitive firms.
7. However, the gross profit should be adequate to cover administrative, selling and distribution
expenses and to provide for fixed charges, dividends and desired reserves.
8. A decrease in Gross profit Ratio may be due to any of the following causes:

 Reduction in selling price without corresponding decrease in cost.

 Increase in raw material prices without corresponding increase in sale price.
 Theft, damage or misappropriation of stock
 Under valuation of closing stock
 Increase in cost of production due to over investment in plant and machinery and their
unfavourable location
 Rise in wage rate and direct costs.
 Goods purchased for personal use wrongly included in the purchase of the business.

9.Increase in Gross profit Ratio may be due to

 Increase in sale price
 Decrease in raw material and other direct cost
 Under- valuation of opening stock and over- valuation of closing stock
 Inflating sales by including goods sent on consignment or goods sent on sale or approval
basis.
2. OperatingRatio:
This ratio is calculated by dividing the operating cost (i.e. cost of goods sold plus all operating
expenses) by net sales.
( + )
= ×

Notes:
1. Operating expenses means the sum of administrative, selling and distribution expenses.
2.100 minus operating ratio is operating profit ratio.
3. Operating profit ratio measures efficiency and general profitability of the business.
Interpretations:
1. Lower the ratio, higher the profit left for recouping the non-operating expenses and higher the
net profits.
2. There is no rule of thumb for this ratio as it may differ from firm to firm depending upon the
nature of the business.
3. However, 75 to 85 percent may be considered to be a satisfactory rate in case of
manufacturing concern.
4. Though operating ratio is good indicator of operating efficiency of the firm but it should be
used cautiously because it reflects a combined effect of number of factors.

3. Operating Profit Ratio or Operating Margin Ratio

The operating profit of a business is the profit after meeting all operating expenses incurred in
the regular course of operations. It is a measure of operating efficiency of a business. The ratio is
calculated by dividing operating profit or earnings before interest and taxes [EBIT] by Net Sales.

= ×

Notes:
1. Operating Profit =Net Sales-(Cost of Goods sold + Operating Expenses)
2. This ratio can also be computed as: Operating Profit Ratio=100-Operating Ratio

4. ExpensesRatio:
Expense Ratios indicate the relationship of various expenses to net sales. The operating ratio
reveals the average total variations in expenses. But some of the expenses may be increasing
while some may be falling. Hence, expense ratios are calculated by dividing each item of
expenses or group of expenses with the net sales. The ratio can be calculated for individual items
of expense or a group ofitems of a particular type of expense like cost of sales ratio,
administrative expense ratio, selling expense ratio, materials consumed ratio etc.
It is calculated to show the relationship of each item of manufacturing cost and operating
expenses to net sales. These ratios help in analyzing the causes of variation of operating ratio.
The following formula used for calculation of expenses ratio is as follows:

= ×

Note: It is to be remembered that these ratios should be calculated separately for each item of
fixed and variable expenses. The ratio of variable expenses should remain constant while the
ratio of fixed expenses should fall with the increase in sales.
Interpretations:
1. These ratios show how much part of net sales is involved in recouping various operating
expenses.
2. By comparing these ratios with respective past ratios or with the standards determined by
management or with ratios of similar firms in the industry, economy or diseconomy of each item
of expenses can be determined.
3. These ratios throw light on managerial efficiency and profitability of the firm.
4. The lower the operating ratio, the larger is the profitability and higher the operating ratio,
lower is the profitability.

5. Net Profit Ratio:

This ratio measures the rate of net profit on sales.Net profit Ratiois the ratio of net profit (after
taxes) to net sales. It is expressedas percentage. This is calculated as follows:

= ×

Note:Some authors calculate this ratio on the basis of net operating profit after tax in place of net
profit after tax. In calculating net operating profit, non operating incomes and expenses are
excluded.
Interpretations:
1.This ratio is the measure of overall profitability and efficiency of the firm.
2. The higher the ratio, the better is the profitability of the firm.
Illustration 23:
Following is the Income Statement of M/S Raman & Co. for the year ending 31st March 2018.
Particulars Amount(₹) Particulars Amount(₹)
To opening stock 45,750 By sales 3,00,000
To purchases 1,89,150 By closing stock 59,100
To carriage 1,200
To wages 3,000
To Gross Profit 1,20,000

3,59,100 3,59,100
To administrative expenses 60,600 By Gross Profit 1,20,000
To finance expenses By non-operating income
Interest 720 Interest 900
Discount 1,440 Dividend 2,250
Bad debts 2,040 By profit on sale of securities 450
To selling expenses 7,200
To non-operating expenses 1,200
To net profit 50,400
1,23,600 1,23,600

You are required to calculate

1. ExpensesRatio
2. Gross profit Ratio
3. Net profit Ratio
4. Operating Ratio
5. Operating profit Ratio
Solution:
1. ExpensesRatio
Administrative expenses
Administrative expenses Ratio = × 100
Verkauf
60,600
= × 100 = 20.2%
3,00,000

Finance expenses
Finance expenses Ratio = × 100
Sales

4,200
= × 100 = 1.4%
3,00,000
Selling and distribution expenses
Selling and distribution expenses Ratio = × 100
Sales
7,200
= × 100 = 2.4%
3,00,000

Non-operating expenses
Non-operating expenses Ratio = * 100
Sales
1,200
= × 100 = 0.4%
3,00,000

2. Gross Profit Ratio

Gross profit
Gross profit Ratio = × 100
Net sales
1,20,000
= × 100 = 40%
3,00,000

3. Net Profit Ratio

Net profit after tax
Net profit Ratio = × 100
Net sales
50,400
= × 100 = 16.8%
3,00,000

Alternatively,
Net operating profit
Net profit Ratio = × 100
Net sales
48,000
= × 100 = 16%
3,00,000
4. Operating Ratio

(Cost of goods sold+operating expenses)

Operating Ratio = × 100
Verkauf

(1,80,000+ 72,000)
= × 100 = 84.0%
3,00,000

5. Operating Profit Ratio

= 100- Operating Ratio= 100-84= 16%

Overall Profitability Ratios

It is the analysis of profitability in relation to the volume of capital employed or investment in
the business. Management and shareholders are interested in ascertaining the return on capital
employed, return on shareholders’ funds etc. The important tests applied to measure overall
profitability are:
1. Return on Equity Capital (ROEC)
2. Return on Net worth (RONW)
3. Return on Investment (ROI)
4. Return on Assets (ROA)
5. Return on Capital Employed (ROCE)
Note:While calculating all the above ratios the following Income statement must be used

INCOME STATEMENT FOR OVERALL PROFITABILITY RATIO COMPUTATION

Particulars Amount
Net Sales XXX
Less: Cost of Goods sold XXX
Gross Profit XXX
Less: Operating Expenses(Administrative & Selling & Distribution Expenses) XXX
Earnings Before Interest & Taxes(EBIT) XXX
Less: Interest XXX
Profit Before Tax(PBT) XXX
Less :Tax XXX
Profit After Tax(PAT) XXX
Less: Preference Dividend XXX
Earnings Available for Equity Shareholders(A) XXX
Number of Equity Share Holders(B) XXX
Earning per Share(EPS){A ÷ B} XXX
1. Return on Equity Capital (ROEC)

In real sense, ordinary shareholders are the real owners of the company. They assume the highest
risk in the company.Thus ordinary shareholdersare more interested in the profitability of a
company and the performance of acompany should be judged on the basis of return on equity
capital of thecompany. Return on equity capital shows the relationship between profits of a
company available for its equity share holders and its equity capital. This ratio is calculated with
the help of the following formulae:

= ×
( − )
Notes:
1. A small variation of this ratio is to calculate the return on shareholders total equity in the
company which is equal to the sum of paid up equity share capital, reserves, surplus and security
premium account.
2. If there is change in equity share capital during the year, then a simple average of opening and
closing capital would be taken to calculate this ratio.
Interpretations:
1. This ratio is more meaningful to the equity shareholders. It examines the earning capacity of
equity share capital.
2. In fact the ratio provides the real test of managerial efficiency in utilizing the equity
shareholders money.
3. There is no rule of thumb for this ratio. Hence, higher the ratio, better it is.
4. However, the ratio may be compared with other similar firms or with the firm’s own past.
Illustration : 24
Calculate return on equity share capital from the following information of Rajesh Limited:
Equity share capital: 10,00,000 ; 9% Preference share capital: 500,000;Taxation rate: 50% of net
profit; Net profit before tax: 400,000.
Solution:
Particulars Amount(₹)
Net Profit Before Tax 4,00,000
Less Tax ( 50%) 2,00,000
Profit After Tax 2,00,000
Less Preference Dividend(9% on ₹5,00,00) 45,000
Earning available for Equity Share Holders 1,55,000

Earning Available for Equity Shareholders

Return on Equity Capital = × 100
Equity Share Capital(Paid − up)

= (1,55,000/10,00,000) × 100 =15.5%

2. Return on Shareholder’s Fund or Proprietor’s Fund or Net worth:
This ratio measures the profitability of the concern in relation to total investments made by the
shareholders (or proprietors) in the business. It is calculated by dividing net profit after interest
and taxes by shareholder’s fund.

’ =

Notes:
1. The excess of total assets over total outsider’s liability of an enterprise is known as
shareholder’s fund or proprietor’s funds or net worth.
2. Alternatively, the sum of share capital (whether equity or preference) and accumulated profits
(capital reserves plus all revenue reserves plus undistributed profits) minus losses, if any, is also
known as shareholder’s investment.
3. Experts suggest that in calculating this ratio, average shareholder’s investment should be used
in place of shareholder’s investments.
4. Averageshareholder’s funds or average proprietor’s fund is the simple average of
shareholder’s investment (or proprietor’s funds) at the beginning and at the end of the year.
5. However, if fresh capital has been introduced in the business at the end of the year, such
capital should be excluded in this calculation.
6. This ratio reveals the efficiency of utilization of shareholder’s fund, higher the ratio better are
the results.
Significance:
1. This ratio provides a good basis of evaluating overall profitability and managerial ability of
financing the business. In fact, it is one of the most important relationships used in financial
statement analysis.
2. This ratio is of great importance to the present and prospective shareholders as well as the
management of the company. Some main uses of this ratio are as follows:

 This return determines the earning power of shareholder’s investments. As the primary
objective of business is to maximize its earnings, this ratio indicates the extent to which
this objective is being achieved.
 A comparison of this ratio of the firm with that of the other firms or with industry
average determines the adequacy of return.
 This ratio helps in forecasting future earning capacity of the business. For this purpose,
trend analysis is most helpful.

3. Return on Total Investment/Return on Investment (ROI):

This is measure of managerial efficiency of utilizing funds invested in the firm. This is calculated
as follows.
 & ( )
= ×

Note: Total investment implies shareholder’s funds plus long-term liabilities.
Interpretation: Higher the ratiobetter is the profitability of the company.

4. Return on Total Assets or Total Resources (ROA):

Profitability can be measures in terms of the relationship between net profits and total assets of
the firm. This ratio is also called as profit to asset ratio. This is calculated as follows:
& ( )
=

Interpretation: Higher the ratiobetter is the overall profitability position.

5. Return on Capital Employed (ROCE)

The prime objective of making investments in any business is to obtainsatisfactory return on
capital invested. Hence, the return on capital employed isused as a measure of success of a
business in realizing this objective.Return on capital employed establishes the relationship
between the profitand the capital employed. It indicates the percentage of return on
capitalemployed in the business and it can be used to show the overall profitability andefficiency
of the business. Hence, astudy of profit in relation to size of investment is known as return on
capital employed. In other words, return on capital employed implies finding out ratio of net
profit on capital employed in the firm. This is the only satisfactory measure of examining the
overall operating efficiency or profitability of a business entity. In fact, it is an evaluation of
efficiency in using funds entrusted to management.
Significance of ROCE:
1. Measure of overall efficiency: It is a suitable measure of overall efficiency or profitability of
the concern because it is calculated keeping in view profit, sales and capital employed. In fact, it
is good measure of efficiency in utilizing funds entrusted to the management.
2. Disclosure of Borrowing Policy: This clarifies borrowing policy of the firm. A firm should
not borrow normally at a rate of interest higher than return on capital employed.
3. Basis of inter-company comparisons: It provides a sound basis for inter-company
comparisons. If the magnitude of the profits of two companies is the same, it does not necessarily
mean that efficiency level of the two is equal. Its true examination is possible only by calculating
return on capital employed. Higher the return, more efficient is the firm.
4. Basis of inter-departmental comparison: This return can be used in appraising and
comparing divisional or departmental performances. Similarly, in a multiple product firm,
profitability of various products inter-departmentally can be examined by calculating their
returns separately.
5. Helpful in capital budgeting decisions: The technique is also used to examine the
profitability of a capital expenditure proposal or in the project evaluation. Projects providing a
return less than return on capital employed are normally not considered. Thus, return on capital
employed provides a yardstick for approving or disapproving a capital expenditure project.
6. Integral part of budgetary control system: Return on capital employed can become an
integral part of a budgetary control system. It can evaluate the progress of the business.
7. Helpful in projecting long-term pricing policy: The technique is also used both for tactical
and strategic decisions particularly in deciding long-term pricing policy. The price of the product
should be fixed in such a way that the price recovers not only the cost of product but ensures a
reasonable rate of return on capital employed.
8. Helpful in designing the capital structure: This ratio can also be usefully employed in
designing the overall capitalization and capital structure. It means that management should
borrow funds from the market only when the return on capital employed is more than the fixed
charges on such funds.

Computation of ROCE:
The term capital employed has been defined by various committees and experts in various firms.
The term is mainly used in the following four meanings: Gross Capital Employed, Net Capital
Employed, Proprietor’s Net Capital Employed and Average Capital Employed.

= ×

= ×

′

= ×
′

= ×

Meaning of CapitalEmployed: The term capital employed has been defined by various
committees and experts in the following forms:

Gross Capital Employed:

It implies the sum of all fixed and current assets of the firm. It is also sometimes called total
resources of the concern. Thus, return on gross capital employed is the same as return on total
resources (or assets) discussed earlier. However, the following concept may also be used for this
calculation.
Gross Capital Employed = Equity Share Capital + Preference Share Capital + Reserve and
Surplus + All Long term and Short term External Loans

Or

Gross Capital Employed = All Net Fixed Assets + Current Assets (includingGoodwill of the
firm but excludingFictitious Assets)

NetCapital Employed:

It is calculated by deducting the current liabilities from the sum of all fixed and current assets.
Alternatively, the sum of fixed assets and working capital is net capital employed. It is also
known as total investment i.e. shareholder’s fund plus assets (e.g investments made outside
business)

Net CapitalEmployed = Equity Share Capital + Preference Share Capital + Reserve and
Surplus + Long Term Loans

Proprietor’s Net capital employed: It is calculated by deducting all outside liabilities from the
sum of total fixed and current assets. Alternatively, it may be calculated by taking sum of paid up
share capital, reserves and undistributed profits and deducting losses and fictitious assets from
the sum. The return on proprietor’s net capital employed is the same as return on shareholder’s
investment.

Proprietor’s Net capital = Equity Share Capital + Preference Share Capital + Reserve and
Surplus – Accumulated Losses, if any

Average Capital Employed:

Capital employed should represent truly the capital invested in the business throughout the year.
For this purpose, it is better to calculate average capital employed in place of capital employed.
The logic is that profits are earned in the business throughout the year and they remain in use in
the business and dividend is distributed out of it only at the end of the year. Hence, for taking
into consideration the profit earned during the year average capital employed should be
calculated in the following two ways:

(a) By taking simple average of capital employed at the beginning and end of the year.

In other words, it may be found out by dividing the sum of opening and closing capital employed
by two.
(b)By adjusting half of the profits of the year in capital employed.
If net capital employed at the end of the year is known, then half of the profits (after deducting
interest and tax) should be deducted to calculate average net capital employed. On the contrary,
if the net capital employed in the beginning of the year is known then half of the profits earned
during the year would be added.

Choice of appropriate concept:

1. The choice of appropriate concept out of three mentioned above depends upon the purpose of
computation of return on capital employed.
2. If the purpose is to show proprietor’s (or the shareholders) profit earned, then the concept of
proprietor’s net capital employed should be used.
3. But if the purpose is to indicate the effectiveness of the business or to reflect the efficiency of
internal management, then the use of the concept of gross capital employed is most suitable.
4. However, of these two, the concept of net capital employed is preferred.

Adjustment made at the time of computing Capital Employed

The following adjustments are required in different assets and liabilities which are included in
calculation of capital employed.
(a) Fixed assets: All fixed assets are included in the calculation of capital employed. There are
three accepted alternatives of valuing fixed assets. Gross value, net value and replacement cost.
Out of these, net value basis is generally used but due to inflationary trend in the economy for
the last six decades, the accountants consider replacement cost as an appropriate basis for the
valuation of fixed assets but this would require recomputation of provision for depreciation.

If any fixed asset remains idle due to abnormal or unusual events, such as trade recession, fire or
obsolescence or under work, then it should not be included in capital employed. But idle
machines and tools required for normal operation of plant would be included in capital
employed.

(b)Intangible Assets:These assets such as goodwill, patent, trade mark, copy right etc. are not
considered in the computation of capital employed but when assets are taken at their historical
cost and payment has been made for acquiring goodwill etc. in that case such intangible assets
should be included in the computation of capital employed.

(c) Cash in hand and at Bank:Cash, by nature, is an idle asset. Hence, only so much amount of
cash should be included in capital employed which is essential for normal working of the
business. If there has been abnormal inflow of cash in to business (such as an issue of fresh issue
of shares or sale of fixed assets), then such cash should not be included in the cash computation
of capital employed. As cash requirements of a business vary from period to period, it would be
appropriate to treat average cash requirement as the normal amount of cash for the purpose of
computation of capital employed.

(d) Debtors: Tradedebtors are included in capital employed after deducting the bad debts and
provision to this effect.
(e) Stocks: All type of stocks excluding obsolete and useless stocks are included in capital
employed. Stock should be valued on proper basis and there must be consistency in respect of
method of valuation.

(f)Investments:Considerable difference is found in respect of investment s according to nature

and purpose of computation. If the purpose of computing return on capital employed is to assess
the effectiveness of the business and efficiency of the management, then all those investments
should be excluded which do not affect managerial efficiency, such as investments outside the
businessi.e. non-trading investments. In such case income from non-trading investments should
not be included in profit. On the contrary, internal investment and trade investments for
enhancing of the company should be included in capital employed. If the amount of outside
investment is substantial, return on capital employed may be calculated in two ways i.e. One by
including such investments and the other by excluding such investments.

(g) Fictitious Assets:Fictitiousassets such as preliminary expenses, deferred revenue

expenditures, discount on issue of shares or debentures etc. should always be excluded from
capital employed.

Meaning of Adjusted Profit

The meaning and definition of profit will differ according to the method of computation and
meaning of capital employed. Profit for this purpose should be determined taking into account
the following rules:

(a)Profit must match with the capital employed. Hence, if any asset is not included in capital
employed, income from that asset or loss from its write off should not be included for calculating
profit for this purpose. For example, if non-trading investments are not included in capital
employed, income from such investments should not be included in profits. Hence, income from
such investments should be deducted from given net profits.
Similarly, write off of fictitious assets and intangible assets should be added back to nullify their
effects.

(b)If long-term liabilities are a part of capital employed, interest paid on such loans should be
added back to the profits. Similarly, if return to be calculated on gross capital employed, interest
on short term loans should also be added back to the profits because these liabilities also form
part of gross capital employed.

(c)Abnormal and non-recurring losses or gains should not be included in the profits. Hence,
appropriate adjustment in net profit should be done to nullify their effect.

(d)If fixed assets are valued at replacement cost, then depreciation charged to profit and loss
account should be based on their replacement cost.
(e)Profit should match with capital employed with reference to period also. It means that income
of any previous year or subsequent year should not be included in current year’s profit.

(f)In determining profit, due consideration should be given to all accepted principles and
conventions of accounting.

(g)A clear distinction has to be made between revenue expenditure and capital expenditure in
calculating profit and a conservative approach should be adopted in the calculation of profit.

(h)Return on capital employed should be calculated on the basis of net profits before tax because
income tax is not a business expenses and it has no relationship with profit earning capacity of
the business and it is paid only after profit is earned.

Illustration 25:

Following are the summarized Profit and Loss Account and Balance Sheet of Lipun Ltd for the
year ended 31st December, 2017.

Profit and Loss Account

₹ ₹
To Opening Stock 1,00,000 By Sales 13,00,000
To Purchases 9,00,000 By Closing Stock 2,00,000
To Wages 60,000
To Freight and Carriage 10,000
To Gross Profit 4,30,000
15,00,000 15,00,000
To Office and Administrative expenses 1,00,000 By Gross Profit 4,30,000
To Selling and Distribution expenses 1,10,000 By Interest on Govt. 12,000
Securities
To Interest on debentures 10,000 By Profit on sale of 8,000
plant
To Interest on bank overdraft 5,000
To Depreciation 15,000
To Loss on sale of machine 10,000
To Provision for tax 1,00,000
To Net Profit 1,00,000
4,50,000 4,50,000

Balance Sheet as on 31st Dec. 2018

₹
Equity & Liabilities
Equity Share Capital 4,00,000
8% Preference Share Capital 2,00,000
Reserves 60,000
Profit & Loss A/c 40,000
10% Debentures 1,00,000
Bank Overdraft 50,000
Other Current Liabilities 1,50,000
Total 10,00,000
Assets
Land & Building (Net) 2,50,000
Plant & Machinery (Net) 3,00,000
Investment in Govt. Securities 1,00,000
Stocks 2,00,000
Sundry Debtors 1,00,000
Cash 40,000
Discount on Issue of Shares 10,000
Total 10,00,000
You are required to calculate:
(i) Return on Gross Capital Employed.
(ii) Return on Net Capital Employed.
Solution:
Calculation of Capital Employed
₹
Land and Building 2,50,000
Plant and Machinery 3,00,000
Stocks 2,00,000
Sundry Debtors 1,00,000
Cash 40,000
8,90,000

Net Capital Employed = Gross Capital Employed – Current Liabilities

= ₹8,90,000 – ( ₹50,000 + ₹1,50,000)
=₹6,90,000
Calculation of Adjusted Profits
₹
Net Profit as per P/L A/C 1,00,000
Add: Loss on sale of Machine 10,000
Interest on debentures 10,000
Provision for tax 1,00,000
2,20,000
Less : Interest on Govt. Securities 12,000
Less: Profit on sale of plant 8,000
Adjusted Profit for Return on Net Capital 2,00,000
Employed
Note:To find out adjusted profits for return on gross capital employed further ₹5,000 should be
added back to ₹2,00,000 for interest on bank overdraft as current liabilities are included in gross
capital employed.
Adjusted Net Profits
Return on Gross Capital Employed = × 100
Gross Capital Employed

₹2,05,000
= × 100 = 23.03%
₹8,90,000

Adjusted Net Profits

Return on Net Capital Employed = × 100
Net Capital Employed

₹2,00,000
= × 100 = 28.98%
₹6,90,000

(Note: Capital employed can also be found as average capital employed by deducting half of the
profits earned for the year.)

1.11 MARKET BASED RATIOS OR RATIOS FOR PROSPECTIVE INVESTORS

Market based Ratios are used by shareholders and investors to evaluate the performance of a
company in the market place. These ratios include:

1. Earnings per Share (EPS)

2. Dividend Payout Ratio (D/P Ratio)

3. Dividend Yield Ratio

4. PriceEarningsRatio (P/E Ratio)

5. Price to Book Value Ratio (P/B Ratio)

1. Earning PerShare (EPS):

The shareholders are interested mainly in capital appreciation of their investment and
higherdividend per share. Both the variables are affected mainly by earnings of the company and
the most suitable way of expressing these earnings is earning per share.It is small variation of
return on equity capital. Here, earnings are expressed per share instead of in percentage. Earning
per share is calculated by dividing net profits after tax and preference divided by total number of
equity shares.

=

Notes:
1. Earnings available for Equity Shareholders = Profit after tax-Preference Dividend
2. Here, the number of equity shares excludes the shares authorized but not issued, forfeited,
cancelled, surrendered or repurchased.
Interpretations:
1. Earnings per share are a good measure of profitability. Market value of a share is usually
determined on the basis of its EPS. Higher the EPS, better it is. EPS of a company may be
compared with that of similar companies or companies’ own past.
2. The increasing trend of earnings per share increases the possibility of higher cash dividend and
capital bonus and this affects favorably the market value of the share.
3. Although earnings per share are the most widely published and used data, it should not be
believed blindly because of the following reasons.. First, EPS cannot represent the various
financial operations of the business. Secondly, comparison of the EPS of different companies can
be distorted by the effect of different accounting procedure relating to stock in trade,
depreciation and the like. Therefore, EPS should be examined with other ratios.

2. Dividend Payout Ratio:

This is a ratio of dividend per share to earnings per share. It indicates the extent to which
earnings per share have been used for paying dividend and what portion of earnings has been
retained in the business for growth and future uncertainties.

= ×

Note: Sometimes we also calculate Retention Ratio =100-Dividend Pay outRatio. It represents
that percentage of earnings which is retained and ploughed back in business.

Interpretations:
1. Guidelines for this ratio vary widely. Companies often attempt to pay approximately 50% of
their earning as dividends.
2. If the firm is experiencing a need for funds to support its operation, it might allow the
dividends to decline in relation to earnings.
3. But if the firm lacks opportunities to use funds generated by retained earnings, it might allow
the dividends to increase in relation to earnings.
4. In either case, consistency of dividend payment would be important to investors, so changes
should be gradual
3. Dividend Yield Ratio:
Dividend is declared as percentage on paid-up capital. But the return, de facto is more or less,
depends upon lower or higher market price of a share respectively. It is this rate which is crucial
from the point of view of fresh investors in particular who desire dividends as a source of
income. This is calculated as follows:

=

Interpretation: The ratio compares the rate of dividend with the market price of the share. This
ratio is calculated to know the effective return for the owners.

4. Price-Earnings Ratio (P/E Ratio)

It is the ratio between market price per equityshare and earning per share. The ratio is calculated
to make an estimate of appreciation in the value of ashare of a company and is widely used by
investors to decide whether or not tobuy shares in a particular company. It is also called P/E
multiples. Following formula is used to calculate price earnings ratio:

=

Interpretation:
1. This is most widely used ratio in the stock exchange by the investors. This ratio indicates upto
how much the public is ready to pay for future earning prospects of the company.
2. A high price-earnings ratio indicates investor’s faith in stability and appreciation of company’s
earnings.
3. This ratio can be used in forecasting market value of the share on a certain future date.
Market price per share= PE Ratio × EPS
4. The market value of a share is affected by many market factors. Hence, this ratio is used by
knowing the position of over- valuation of share.
5. Sixteen times earnings multiple is considered appropriate. Hence, if price earning ratio is more
than 16 times, the share may be concluded as overvalued.
6. This ratio may also be used to determine capitalization of a share. As this ratio largely depends
upon market factors, it differs from company to company within the same industry and also for
the same company over a period.

5. Price to Book value Ratio (P/B Ratio):

The PBV Ratio is the market price per share divided by the book value per share. The market
price per share is simply the stock price. The book value per share is a firm's assets minus its
liabilities, divided by the total number of shares.

=

Notes:The market price per share is simply the stock price. The book value per share is a firm's
assets minus its liabilities, divided by the total number of shares.
Interpretation:
1. A higher P/B Ratio implies that investors expect management to create more value from a
given set of assets, or else equal (and/or that the market value of the firm's assets is significantly
higher than their accounting value).
2. P/B Ratios do not, however, directly provide any information on the ability of the firm to
generate profits or cash for shareholders.
3. This ratio also gives some idea of whether an investor is paying too much for what would be
left if the company went bankrupt immediately.

Illustration- 26
The information provided by Jagan Ltd is as follows:
Particulars Amount (₹)
9% Preference Shares of ₹ 10 each 3,00,000
Equity share ₹ 10 each 8,00,000
Profit after tax 60% 2,70,000
Depreciation 60,000
Equity dividend 20%
Market price per equity share ₹40
You are required to calculate the following.
1. The dividend yield on equity shares
2. The cover for preference and equity shares
3. The earning per share
4. The price earnings ratio
5. The net cash flow.
Solution:
Dividend per share
1. Dividend Yield =
Market price per share

2
= = 0.05 or 5%
40

Whereas Dividend per share = 20% of₹ 10 = ₹ 2

Profit after tax

2.Cover of Preference Dividend =
Preference Dividend
 2,70,000
= = 10 times
27,000

Earning after Preference Dividend

Cover of Equity Dividend =
Equity Dividend

2,70,000 - 27,000
= = 1.52 times
1 60,000

Net profit after preference dividend

3.Earning Per Share (EPS) =
Number of equity shares

2,70,000 - 27,000
= = ₹3.04
80,000

Market price per share

4.Price EarningsRatio =
earnings per share

40
= = 13.16 : 1
3.04

5.Total Cash Flow = N.P after tax + Non cash expenditure

= 2,70,000 + 60, 000 = ₹ 3,30,000

Net cash flow = Total cash flow – Dividend on shares

1.12 DU PONT ANALYSIS

DuPont Analysis is an extended examination of Return on Equity (ROE) of a company. This

analysis was developed by the DuPont Corporation in the year 1920. ROE is that it is an
important measure of profitability that only requires two numbers to compute: net income and
shareholders' equity. ROE is computed by dividing Net Income with shareholder’s equity
(ROE=Net Income/Shareholder’s equity). If this number goes up, it is generally a good sign for
the company as it is showing that the rate of return on the shareholders' equity is rising. The
problem is that this number can also increase simply when the company takes on more debt,
thereby decreasing shareholder equity. This would increase the company's leverage, which could
be a good thing, but it will also make the stock riskier. Hence, without a way of breaking down
ROE components, investors could be duped into believing a company is a good investment when
it's not. In this context, DuPont Analysis explains how to break apart ROE and gain a much
better understanding of where movements in ROE are coming from.

There are two variants of DuPont analysis: the original three-step equation, and an extended five-
step equation.

The Three-Step DuPont Calculation

Multiplying the equation by (Sales / Sales), we get:

= ×

Now by multiplying the above equation by (Assets / Assets), we end up with the three-step
DuPont identity

= × ×

Or ROE=Profit Margin× Total Assets Turnover× Equity Multiplier

Components of Three Step DuPont Analysis

This analysis has 3 components to consider;

1. Profit Margin– This is a very basic profitability ratio. This is calculated by dividing the net
profit by total revenues. This resembles the profit generated after deducting all the expenses. The
primary factor remains to maintain healthy profit margins and derive ways to keep growing it by
reducing expenses, increasing prices etc, which impacts ROE.

For example; Company X has Annual net profits of ₹ 1000 and Annual turnover of ₹ 10000.
Therefore the net profit margin is calculated as

Net Profit Margin= Net profit/ Total revenue= 1000/10000= 10%

2. Total Asset Turnover– This ratio depicts the efficiency of the company in using its assets.
This is calculated by dividing revenues by average assets. This ratio differs across industries but
is useful in comparing firms in the same industry. If the company’s asset turnover increases, this
positively impacts the ROE of the company.
For example; Company X has revenues of ₹10000 and average assets of ₹200. Hence the asset
turnover is as follows

Asset Turnover= Revenues/Average Assets = 1000/200 = 5

3. Equity Multiplier –It is a measure of how much the company is leveraged. This refers to the
debt usage to finance the assets. More the ratio higher is the leverage and vice versa. The
companies should strike a balance in the usage of debt. The debt should be used to finance the
operations and growth of the company. However usage of excess leverage to push up the ROE
can turn out to be detrimental for the health of the company.

Interpretation of the DuPont Analysis:

If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a
very positive sign for the company. However, if the equity multiplier is the source of the rise,
and the company was already appropriately leveraged, this is simply making things riskier. If the
company is getting over-leveraged, the stock might deserve more of a discount despite the rise in
ROE. The company could be under-leveraged as well. In this case, it could be positive and show
that the company is managing itself better.

Even if a company's ROE has remained unchanged, examination in this way can be very helpful.
Suppose a company releases numbers and ROE is unchanged. Examination with DuPont analysis
could show that both net profit margin and asset turnover decreased, two negative signs for the
company, and the only reason ROE stayed the same was a large increase in leverage. No matter
what the initial situation of the company, this would be a bad sign.

The Five-Step DuPont Calculation

The five-step, or extended, DuPont equation breaks down net profit margin further. From the
three-step equation we saw that, in general, rises in the net profit margin, asset turnover and
leverage will increase ROE. The five-step equation shows that increases in leverage don't always
indicate an increase in ROE.

The Five-Step Calculation

Since the numerator of the net profit margin is net income, this can be made into earnings before
taxes (EBT) by multiplying the three-step equation by 1 minus the company's tax rate:

= × × ×( − )
We can break this down one more time since earnings before taxes is simply earnings before
interest and taxes (EBIT) minus the company's interest expense. So, if there is a substitution for
the interest expense, we get:

= ( × − )× ×( − )

ROE= (OPM×AT−IER) × EM × TRR

Where: OPM=Operating profit margin

AT=Asset Turnover Ratio

IER=Interest Expense Rate

EM=Equity Multiplier

TRR=Tax Retention Rate

Interpretation

If the company has a high borrowing cost, its interest expenses on more debt could mute the
positive effects of the leverage. The five-step equation shows that increases in leverage don't
always indicate an increase in ROE.

1.13CONSTRUCTION OF FINANCIAL STATEMENTS FROM RATIOS

Ratios are worked out from financial statements ie, Profit and loss accountand Balance sheet. In
a reverse approach, one can prepare the financialstatements in a concise or summarized form
from the ratios and additionalinformation. In order to prepare Balance sheet or Profit and Loss
account, studentsmust have a clear idea regarding the contents of a typical balance sheet
andprofit and loss account. Using the given information and ratios students maywork out the
missing figures in a logical sequence.

Illustration 27:

From the following data relating to a firm, prepare Balance Sheet of the firm as at 31st Dec,
2018:

Particulars ₹
Annual Sales 36,00,000
Sales to Net Worth 4 times
Current Liabilities to Net Worth 50%
Total Debts to Net Worth 80%
Current Ratio 3:1
Sales to Inventory (ITR) 6 times
Average Collection Period 73 days
Fixed Assets to Net Worth 30%
Solution:

Net Worth:

Sales
Sales to Net Worth =
Net Worth

₹36,00,000
or, 4 =
Net Worth

or, Net Worth = ₹9,00,000

Current Liabilities:

Current Liabilities
Current Liabilities to Net Worth =
Net Worth

50 Current Liabilities
or, =
100 ₹9,00,000

or, Current Liabilities = ₹4,50,000

Long Term Debts:

Total Debts
Total Debts to Net Worth =
Net Worth

80 Total debts
or, =
100 ₹9,00,000

or, Total Debts = ₹7,20,000

Long Term Debt = Total Debts – Current Liabilities

= ₹7,20,000 - ₹4,50,000
= ₹2,70,000
Current Assets:

Current Assets
Current Ratio =
Current Liabilities

Current Assets
or, 3 =
₹4,50,000

or, Current Assets = ₹13,50,000

Inventory:

Sales
Sales to Inventory =
Inventory

₹36,00,000
or, 6 =
Inventory

or, Inventory = ₹6,00,000

Debtors:

Debtors
Debtors' Turnover Ratio = × 365
Sales

Debtors
or, 73 days = × 365
₹36,00 000

or, Debtors = ₹7,20,000

Cash and Bank Balance:

Current Assets= Stock + Debtors + Cash & Bank

Or, ₹13,50,000= ₹6,00,000+₹7,20,000 + Cash & Bank

Or, Cash & Bank= ₹30,000

Fixed Assets:

Fixed Assets
Fixed Assets to Net Worth =
Net Worth

Fixed Assets
or, 30 =
₹9,00,000

or, Fixed Assets = ₹2,70,000

Balance Sheet as on 31st Dec. 2018

Particulars ₹
Equity & Liabilities
Net worth 9,00,000
Long term Debts 2,70,000
Current Liabilities 4,50,000
Total 16,20,000
Assets
Fixed Assets 2,70,000
Current Assets:
Stock 6,00,000
Debtors 7,20,000
Cash at Bank 30,000
Total 16,20,000

1.14 RATIOS AT A GLANCE

Liquidity and SolvencyAnalysis

Ratio Formulae Comments/Remarks

Current Ratio Current assets/ Current liabilities A ratio of2: 1 (two times current assets
to current liabilities) is considered
satisfactory as a rule of thumb.

Quick or Acid Test Quick assets/ Current liabilities 1 : 1 is considered satisfactory

Ratio or Liquidity
Ratio

Absolute liquidity (Cash + marketable securities) / 0.5 : 1 is considered standard

(Liquid liabilities or Current
Ratio liabilities)

Stock turnover Cost of goods sold/ Average No standard rate or norm can be
Ratio stock [ cost of goods sold= (sales determined for this ratio because it is
–GP) or Opening stock+ based more on nature of industry and
purchases – closing stock) , sale policy of the firm.
Average stock = (Opening stock
+ closing stock)/2 ]

Stock velocity (in (Average stock/ Cost of goods

months) sold) × 365 days or 12 months or
52 weeks

Average age of 365/ Inventory turnover Ratio The shorter the average age of the
inventory (ITR) firm’s inventory, more liquid or active
it may be considered.

Debtors Turnover (Average trade receivables/ net Higher the value of debtors turnover,
Ratio (DTR) credit sales ) ×100 the more efficient is the management of
debtors.

Average collection No of working days / DTR It should not exceed the stated credit
period period on trade terms plus 1/3rd of such
period. At high average collection
period also implies that chances of bad
debts are larger.

Creditors Turnover Average accounts payable / Net Lower the ratio better is the liquidity
Ratio credit purchases position of the firm. Higher creditor’s
turnover ratio indicates weak
liquidation position.

Creditors Turnover Net credit purchases / Average Higher the creditors velocity, better it
or velocity accounts payables is. A fall in the ratio shows delay in
payment to creditors.

Debt-Equity Ratio External equity / Internal equity 1:1 debt equity is considered
or Debt-worth or Long-term fund / satisfactory. However, in case of a well
Ratio Shareholder's fund or net worth established concern 2: 1 debt equity
ratio even more may also be considered
satisfactory.
Proprietary Ratio Shareholder's fund / Total assets Higher the ratio lesser the dependence
or Shareholder's fund / Total for working capital on outside sources,
equity better the long-term solvency, stability
and greater the protection to the
creditors of the firm.

Solvency Ratio Total borrowed Fund / Total Higher the ratio, the greater is the
Assets or 100-Equity Ratio dependence of the firm on outsiders.

Fixed assets to net Fixed assets (after depreciation) / This ratio should not exceed 1:1. On
worth Ratio or Total long-term fund the contrary, lesser the ratio, better the
Fixed assets to position because in such a case
proprietary fund proprietors funds will be available for
working capital need also. Usually, a
ratio of 0.67: 1 is considered
satisfactory.

Fixed assets to Fixed assets (after depreciation) / This ratio should not exceed 1:1. If it
long-term fund or Total long-term fund exceeds 1:1, it implies that short-term
Fixed assets Ratio funds of the firm have also been
applied for acquiring fixed assets which
is in no way be considered appropriate.

Ratio of current Current assets/ Proprietor’s fund There is no rule of thumb for this ratio.
assets to
proprietor’s fund

Ratio of current Current assets/ Total liabilities There is no rule of thumb for this ratio.
assets to total
liabilities

Proprietor’s Proprietor’s fund / Total Higher the ratio better is the security of
liability Ratio liabilities the creditor.

Ratio of tangible Tangible assets / Total debt Higher the ratio greater is the security
assets to total debts of the creditor.

Debt service Ratio Net income (before charging Higher the ratio better is the position of
or Interest interest and income tax) / Fixed long-term creditors. But a too high
Coverage Ratio interest charges interest coverage ratio may mean that
the firm is not taking adequate
advantage of trading on equity to
increase the earning per share. Eight to
 nine times interest cover is considered
as satisfactory for an industrial concern.

Preference Net income after interest tax) / Coverage of 2 is considered as

dividend coverage Preference dividend standard.
Ratio

Cash to debt (Annual cash flow before High coverage would be required in
service Ratio or interest and tax ) / (Interest +SF firms whose incomes are very instable
Debt cash flow appropriation / 1 - T and the firms whose incomes are stable.
coverage Ratio

Profitability Analysis

General profitability Ratio

Ratio Formulae Comments/remarks

Gross profit Ratio (Gross profit / Net sales) × Higher the ratio better is. But
100 there is no rule of thumb for
gross profit ratio.

Operating Ratio (Operating cost / Net sales ) Lower the ratio, higher the
×100 [Operating cost = COGS profit left for recouping the
+ operating expenses] non-operating expenses and
higher the net profit. There is
no rule of thumb for this ratio
as it may differ from firm to
firm depending upon the
nature of its business.
However, 75 to 85 percent
may be considered to be a
satisfactory rate in case of
manufacturing concern.

Expenses Ratio (Particular expenses / Net The lower the ratio, the greater
sales) ×100 the profitability of the
business.

Net profit Ratio (Net profit / Net sales) ×100 Higher the ratio better is
profitability of the firm.
Overall profitability analysis

Ratio Formulae Comments/remarks

Return on equity share capital [Net profit (after tax and There is no rule of thumb for
preference dividend) / Paid up this ratio. Hence higher the
equity share capital] × 100 ratio better it is. However, this
ratio may be compared with
that of similar firms or with
the firm’s own past.

Earnings per share (EPS) [Net profit after tax and Higher the EPS better it is.
preference dividend / No. of
equity shares

Return on shareholder’s [Net profit (after interest and Higher the ratio better are the
investment (or Proprietor’s tax) / Shareholder's fund] × results.
fund or net worth) 100

Return on total investment (Net profit before interest and The higher the ratio, the
tax/ Total asset) × 100 greater the profitability of the
business.

Return on total assets or total (Profit before interest and tax/ Higher the ratio better it is.
resources Total asset) × 100

Return on capital employed (Profit before tax/ Capital Higher the ratio better it is.
employed) × 100

Activity Analysis- Sales Ratios

Ratio Formulae Comments/remarks

Stock turnover Ratio Explained in liquidity

analysis

Debtors Turnover Ratio(DTR) Explained in liquidity

analysis

Creditors Turnover Ratio Explained in liquidity

 analysis

Total assets turnover Ratio Net sales (or Cost of sales) / 2:1 assets turnover ratio is
Total assets considered satisfactory.

Fixed asset turnover Ratio or Cost of sales (or Net sales) / Higher the ratio better it is. In
Ratio of sales to fixed asset Fixed assets (net) manufacturing industry 5:1
ratio is considered
satisfactory.

Current asset turnover Ratio Net sales ( or cost of sales) / Higher the ratio better it is.
Current assets

Net tangible asset turnover Net sales / Net tangible asset Higher the ratio better it is.
Ratio But if it is too high it implies
over utilization of firm’s
goodwill. This is called over
trading.

Working capital turnover Net sales ( or Cost of sales) / A high working capital
Ratio Working capital turnover ratio shows the
efficient utilization of working
capital. But too high or low
ratio indicates over-trading
and under trading respectively.

Capital or Net worth turnover Net sales / Share capital or Net Higher the ratio better it is. A
Ratio worth higher ratio indicates more
profits while low ratio would
result low profits. A very high
capital turnover ratio would
indicate over-trading or under
capitalization.

Capital Structure Analysis or Leverage Ratios

Ratio Formulae Comments/remarks

Capital gearing Ratio or Gear (Fixed cost bearing capital/ Policy of high gearing is very
Ratio Variable cost bearing capital) risky. In other words, lower
or (Variable cost bearing the gearing, higher the gearing
 capital / Fixed cost bearing ratio and higher the gearing,
capital) or (Fixed cost bearing lower the gearing ratio.
capital / equity)

Debt equity Ratio It is already discussed in long-

term solvency.

Ratio of total investments to [Long term fund (Share As a general rule the
Long-term liabilities holder's fund + Long-term proportion of long-term
liabilities)] / Long term liabilities should not be very
liabilities high.

Ratio of fixed asset to funded Fixed asset / Fixed debt Higher the ratio of fixed assets
debt to debentures, the greater will
be the security of debenture
holders.

Ratio of reserve to equity (Revenue reserve / Equity Higher the ratio, more
capital capital) × 100 conservative is the dividend
policy of the management and
better is the growth
potentiality of the company.

Ratio of current liabilities to Current liabilities / The norm is 35%.

proprietor’s funds Proprietor’s funds

Ratios for prospective investors

Ratio Formulae Comments/remarks

Earning per share(EPS) Net profit after preference Higher the ratio, better the
dividend / Number of equity performance and higher the
shares future of the company

Book value per share Shareholders fund / Number Now this ratio has lost its
of shares importance

Price EarningsRatio (PER) Market price per share / A high price earnings ratio
Earning per share indicates investor’s faith in the
stability and appreciation of
company earnings.
Market price per share PER / EPS If price earnings ratio is more
than 16 times, the share may
be concluded as overvalued.

CapitalizationRatio Earning per share/ Market

price per share

Dividend yield Ratio Dividend per share / Market

price per share

Dividend payout Ratio (D/P (Dividend per share / Earning Guidelines for this ratio vary
Ratio) per share) × 100 widely. Companies often
attempt to pay approximately
50% of their earnings as
dividends.

Cover of Preference and (Earning after tax / Preference Higher the cover better it is.
Equity Dividends Dividend ) or (Earning after
Preference Dividend / Equity
Dividend)

1.15 SELF ASSESMENT QUESTIONS:

1. What do you mean by Ratio Analysis? Discuss the advantages and limitations of Ratio
Analysis.

2. “Ratio analysis is an important tool for judgment of the health of any organization.” Discuss.

3. What are the factors affecting the efficacy of ratios?

4. Who are the major users of ratio analysis? Explain in detail.

5. “Ratio are indicators-sometimes pointers but not in themselves powerful tools of the
management.” Explain.

6. What is liquidity ratio? Discuss its significance to a firm.

7. What are the important profitability ratios? How are they calculated?

8. Explain and illustrate any two of the followings:

(a) Debtors turnover Ratio (b) Creditors turnover Ratio (c ) Inventory turnover Ratio

9. Describe any five accounting ratios.

10. Explain which financial ratio will be useful to the following

(a) Potential investor of a company

(b) Company’s own management

11. What are the important Profitability Ratios? How are they worked out? Explain and
illustrate?

12. Define Return on capital employed(ROCE)? Discuss different methods of calculating the
same with example?

13. Examine the relationship between Liquidity, Solvency and profitability of a business in
context of ratio analysis?

14.”Ratio analysis is a tool to examine the health of a business with a view to make the financial
results more intelligible.”-Discuss.

15. By applying ratio analysis how would you find out the followings:

(i)Whether the company is able to pay off its maturing obligations?

(ii)Whether the collection system is effective?

(iii)Whether the company is accumulating excess stock?

(iv)Whether the company relies too much on loan?

(v)Whether the profit earning capacity is good?

 UNIT-3
ABSORPTION COSTING AND MARGINAL COSTING
Chapter Outlines
2.0 Learning Objectives
2.1 Introduction
2.2 Meaning of Marginal Cost
2.3 Marginal Costing
2.4 Absorption Costing
2.5 Special Terms for Marginal Cost
2.5.1 Contribution
2.5.2 Cost Volume Profit Analysis
2.5.3 Break-Even Point
2.5.4 Angle of Incidence
2.5.5 Margin of Safety
2.5.6 Key or Limiting factor
2.5.7 Assumptions underlying CVP Analysis / Break - Even Charts
2.6 Managerial Application of CVP Analysis.
2.7 Summary
2.8 Key Terms
2.9 Questions and Exercises
2.0 LEARNING OBJCTIVES
After studying this chapter, you should be able to understand:
 Explain concept of absorption and marginal costing.
 Distinguish between absorption costing and marginal costing.
 Explain the managerial application of CVP analysis.
 Explain the concept of angle of incidence.
2.1 INTRODUCTION
In cost accounting, cost of production per unit of the goods produced or services provided is
calculated with the help of the various methods such as Unit Costing Method, job costing, Batch Costing
contract Costing or Process Costing. Marginal costing is not a method of calculating the cost of
production as the above given methods are but it is a technique applicable to the existing methods to find
out the effect on profits if changes are made either in the volume of output or in the type of output. Thus
marginal costing is a technique which helps the management in taking various routine and special or
crucial decisions for running the organisational activities like (i) To continue with a product or not, (ii) To
change the selling price as per the market conditions, (iii) To change the method of production, (iv) To
make or buy decision, (v) To decide about sales mix.
2.2 MEANING OF MARGINAL COST
(i) According to I.C.M.A. London, marginal cost is defined as “The amount at any given volume of
output by which aggregate costs are changed if the volume of output is increased or decreased by
one unit. In practice this is measured by the total variable attributable to one unit.” In this context, a
‘Unit’ may be single article, a batch of articles, an order, a stage of production capactiy, a man-
hour, a process or a department.
(ii) According to Blocker and Weltmore, “Marginal cost is the increase or decrease in the total cost
which result from producing or selling additional unit of a commodity or from a change in the
method of production or distribution.”
Marginal cost is the aggregate of variable costs. It is the cost of producing one additional unit. The
marginal cost concept is based on the distinction between fixed and variable costs. Marginal cost is the
total of variable costs only and fixed costs only and fixed costs are ignored.
 So, after analysing the definition we can say that with the increase in one unit of output, the total
cost is increased and this increase in total cost from the existing to the new level is known as ‘Marginal
Cost’.
For example, for the production of 1,000 units of product, the variable costs per unit is `5 and fixed
costs are `5,000 per annum. If the production is increased by one unit, the marginal cost will be:
Total cost of 1, 000 units:
Fixed costs = ` 5,000
Variables costs (1, 000 units × 5) = ` 5,0000
Total cost = Fixed Costs + Variables Costs
= `5,000 + ` 5,000 = ` 10, 000
10, 000
Per unit costs = = `10/-
1, 000
Total cost of 1,001 units:
Fixed costs ` 5,000
Variable costs (1, 001 units × 5) `5,005
Total costs `10,005
Marginal cost = ` 10,005 – ` 10,000 = ` 5
Hence, marginal cost is `5. This is the change in total cost due to change in one unit of output.
2.3 MEANING OF MARGINAL COSTING
According to the Institute of cost and management accountants, London, Marginal costing is
defined as “The ascertainment of marginal cost and of the effect on profit of changes in volume or type of
output by differentiating between fixed costs and variable costs. In this technique of costing only variable
cost are charged to operations, processes or products, while the fixed costs are to be written off against
profits in the period in which they arise.”
Thus, in this context, we can say that marginal costing is a technique which is concerned with the
changes in costs and profits result from changes in volume of output. Marginal costing is also known as
‘Variable Costing’.
2.4 ABSORPTION COSTING / TOTAL COSTING
Absorption costing is the total cost technique. It is the practice of charging all costs, both variable
and fixed, to operations, processes or products. Under absorption costing all costs whether variable or
fixed are treated as product cost. Absorption costing is also known as full costing technique.
This method employs highly arbitrary way of apportionment of overheads which reduces the
practical utility of cost data for controlling purposes.
Illustration 2.1
The following information relates to a company:
Production 40, 000 units
Sales 40, 000 units
Selling Price ` 30 per unit
Direct Material ` 5 per unit
Direct Labour `4 per unit
Overheads :
Variables `3 per unit
Fixed ` 1,00, 000
Calculate net profit under :
(a) Absorption Costing Method : (b) Marginal Costing Method.
Solution:
Income Statement (Absorption Costing)
Sales Particulars ` `
Sale (40,000 units `30) 12,00,000
Less : Cost of goods sold :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Overheads :
Variable (40,000 × 3) 1,20,000
Fixed 1,00,000 5,80,000
Net Profit 6,20,000
Income Statement (Marginal Costing)
Particulars ` `
Sale (40,000 × `30) 12,00,000
Less : Variable Cost :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Variable Overheads (40,000 × 3) 1,20,000 4,80,000
Contribution 7,20,000
Less : Fixed Cost 1,00,000
Net Profit 6,20,000
Illustration 2.2
The following information relates to a company:
Production 40,000 units
Sales 30,000 units
Selling Price `30 per unit
Direct Materials ` 5 per unit
Direct Labour R
Factory Overheads:
Variable `3 per unit
Fixed `1, 00,000
Selling and Distribution overheads:
Variable `1 per unit
Fixed ` 45,000
Calculate:
(i) Net Profit under Absorption Costing Method.
(ii) Net Profit under Marginal Costing Method.
Solution:
Income Statement (Absorption Costing)
Sales Particulars ` `
Sale (30,000 × 30) 9,00,000
Less : Cost of Sales :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Factory overheads :
Fixed 1,00,000
Variable (40,000 × 3) 1,20,000
Less : Closing Stock  5,80, 000 10, 000 units  5,80,000
 40, 000 
 
 1,45,000
4,35,000
Add : Selling and Distribution Overheads :
Fixed 45,000
Variable (30,000 × 1) 30,000 5,10,000
Net Profit 3,90,000
Note : Closing stock value of Total Cost.
Income Statement (Marginal Costing Method)
Particulars ` `
Sale (30,000 × 30) 9,00,000
Less : Variable Cost :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Factory Overheads (40,000 × 3) 1,20,000
 4,80, 000 
Less: Closing Stock  10, 000 units  4,80,000
 40, 000 
1,20,000
3,60,000
Add: Selling and Distribution (30,000 × 1) : 30,000 3,90,000
Contribution 5,10,000
Less: Fixed Cost:
Factory Overheads 1,00,000
Selling and Distribution Overheads 45,000 1,45,000
Net Profit 3,65,000
Note: Closing stock value of Variable Cost.
2.5 SPECIAL TERMS FOR UNDERSTANDING MARGINAL COST
(i) Contribution
(ii) Profit Volume Ratio (P/V ratio)
(iii) Break Even Analysis
(iv) Break Even point (BEP)
(v) Break Even Graph
(vi) Angle of Incidence
(vii) Sales for Desired Profit
(viii)Margin of Safety (M/S)
2.5.1 Contribution
Contribution is the difference between Sales and Variable Cost or marginal cost. In other words,
contribution is defined as the excess of sales over variable cost. Contribution first contributes to fixed cost
and then to profit. Higher contribution means more profit and lower contribution means less profit. So the
management of an organisation tries to increase contribution for higher earning.
Contribution can be represented as :
1.Contribution  Sales  Variable Cost(Marginal Cost)
2. Contribution   per unit   Selling price per unit  Variable cost per unit
3. Contribution  Fixed Cost  Profit / Loss
or C  F  P / L
4. Contribution  Sales  P / V Ratio
For example, if the selling price of a product is R 100 per unit and its variable cost is R 60 per unit,
contribution per unit is `40 (`100 – ` 60).
2.5.2 Profit Volume Ratio
The profit/volume ratio, also called the ‘contribution ratio’ or ‘marginal ratio’, is defined as the
relationship between contribution and sales. In other words, profit/volume ratio is a ratio of contribution
to sales and it can be expressed as under:
Contribution per unit
P / V Ratio 
Sales per unit
Contribution C
(i) P / V Ratio  100 or  100
Sales S
Sales  Variable Cost
(ii) P / V Ratio   100
Verkauf
Fixed Cost+Profit F+P
(iii) P/V Ratio= ×100 or = ×100
Sales S
Change in profit contribution
(iv) P / V Ratio   100
Change in sales
(v) P / V Ratio  1  var iable Cost Ratio
Example: If selling price of product is ` 100 and the variable cost is `75 per unit, then P/V ratio is :
Marginal costing and Break Even Analysis
100  75 25
P / V Ratio  100  100  25%
100 100
2.5.3 Cost-Volume-Profit (CVP) Analysis or Break Even Analysis
CVP analysis is the relationship among cost, volume and profit. In CVP analysis, an attempt is
made to measure variations of costs and profit with volume of production. In other words, it is a technique
of management accounting which determines profit, cost and sale volume at different levels of
production. When volume of production increases, cost per unit decreases because fixed cost remains
constant. Again, with the increase in volume of output there are chances of decrease in cost per unit and
increase in profit per unit. Thus, cost–volume profit analysis helps the management in profit planning
because we can determine the amount of profits at different levels of activity and the volume of sales to
earn desire profit can also be determined. In this regard, Herman C.Heiser rightly said ‘the most
significant single factor in profit planning of the average business is the relationship between the volume
of business, costs and profits.”
The study of cost – volume – profit analysis is also known as break-even analysis because break-
even analysis refers to the study of relationship between costs, volume and profit at different levels of
production or sales.
2.5.4 Break-even Point:
Break-even point may be defined as the point of sales volume at which total revenue equals total
costs. It is the point of no profit, no loss. When the total sales of a business is equal to its total costs, it is
known to break-even point. At this point, contribution is equal to fixed costs. If a business is producing
more than the break-even point there shall be profit to the business organisation otherwise it would suffer
a loss. The detailed study of Break-even point is known as Break-even Analysis.
2.5.5 Break-even Chart: Graphic Method
Break-even chart is a tool of presentation of the information relating to production quantity, sales
and profits of a business organisation. With the help of this chart the break-even point can be known as
well as the amount of profit or loss at the various levels of output and margin of safety can be found out.
It also provides us the knowledge about the relationship between fixed and variable costs as well as the
contribution and profit-volume(P/V) relationship. Break-even chart shows the relationship between cost,
volume and profit. Break-even point is the most important information out of the all above information
and due to this reason, it is known as break-even chart.
Methods of Drawing a Break-even chart
For drawing a break-even chart, one should have information regarding production capacity,
variable costs and fixed costs of a business organisation.
Firstly, a table is prepared to know about the fixed cost, total costs and total sales at various levels
of output.
First Method (BEP Chart) :
(i) Volume of production/output or sales (in units/rupees) is plotted on X-axis (horizontal axis).
(ii) Cost and sales revenue are shown in Y-axis (vertically).
(iii) On Y-axis, fixed costs are shown first. A parallel line to X-axis
is drawn which means that fixed costs remain constant at each
level of input. Total cost line is drawn upward from the starting
point of fixed cost line. To draw total cost line, the total costs
points are plotted at various levels of output with the help of
table and a line is drawn thereafter joining all these points. This
line is called total cost line.
(iv) Sales values at various levels of output are plotted and a line is
drawn joining these points. This line is called total revenue line.
(v) The point at which total cost line and total revenue line
intersect each other is called break-even point.
(vi) A perpendicular is drawn, from this point, to X-axis to know the break-even point in units and sales
revenue at break-even point can be known by a perpendicular Y-axis from this point.
(vii) The area on the left of break-even point represent the loss area and on the right of BEP indicates the
profit area.
(viii) The angle between sales or total revenue line and total cost line in profit area is called ‘angle of
incidence’. The wider the angle the greater is the profit and vice-versa.
(ix) Difference between the present sales and Break-even sales on the graph shows the margin of safety.
Second Method (BEP Chart) :
In this method, variable costs are shown first and fixed cost line
is drawn parallel and upward to the variable cost line. The fixed cost
line drawn represents the total cost of various levels of output. With
the help of this chart, contribution can be known at various levels of
output by the differences between total sales (revenue) line and
variable cost line.
Third Method (Contribution Chart):
In this method, fixed cost line is drawn parallel to X-axis. The
contribution line is drawn from the origin point which increases with the increase in the output. The
contribution line and fixed cost line inter sects each other that points are called break-even point:
2.5.6 Angle of Incidence:
The angle formed at the intersection of the total sales curve
and the total cost curve is known as angle of incidence. Bigger the
angle of incidence higher will be the profits and smaller the angle of
incidence the lower will be the profits. To improve this angle
contribution should be increased either:
(i) By raising the selling price or
(ii) By reducing Variable cost or
(iii) By both the way.
Illustration 2.3
Plot the following data on a graph and determine break-even point: selling price = ` 20 per unit,
Variable Cost = ` 10 per unit, Fixed Cost ` 20,000.
 Output Variable Cost Fixed Expenses Total Cost Total Sales Contribution Pr ofits
 in units  10 per unit 
0 0 20, 000 20, 000 0 0 20, 000
1, 000 10, 000 20, 000 30, 000 20, 000 10, 000 10, 000
2, 000 20, 000 20, 000 40, 000 40, 000 20, 000 
3, 000 30, 000 20, 000 50, 000 60, 000 30, 000 10, 000
4, 000 40, 000 20, 000 60, 000 80, 000 40, 000 20, 000
5, 000 50, 000 20, 000 70, 000 1, 00, 000 50, 000 30, 000
First Method

B.E.P. = 2,000 units or `40,000

Second Method

B.E.P. = 2,000 units or `40,000

Third Method

B.E.P. = 2,000 units or `40,000

Calculation of Break-even point: Algebraic Method
1. Break-even Point in units : It can be calculated with the help of following formula:
Fixed Cost
Break  even po int (in units) 
Selling P r ice per unit  Variable Cost per unit
Fixed Cost
or B.E.P. 
Contribution per unit
or B.E.P.  F C / C

2.Break-even point in terms of money value :

Fixed Cost  Sales
Break  even po int (Rupees) 
Sales  Variable Cost
Fixed Cost  Sales
or B.E.P. 
Contribution
With the help of P / V ratio, B.E.P can be calculated as follows :
Fixed Cost
B.E.P. 
P / V Ratio
New Break-even Point :If the selling price of a product changes, contribution will be changed. As
a result, new Break-even point will be as follows:
Fixed Cost
(i) New B.E.P. (in units) 
New Selling Pr ice  Variable Cost
FC
or 
New Contribution
Fixed Cost
(ii) New B.E.P. (Rupees) 
New P / V Ratio
Calculation of selling price when Break-even point is shifted
When break-even point is shifted, selling price will be calculated in the following manner:
Fixed Cost
New Contribution=
New BEP (in units)
Sales=New Contribution+Variable cost
Illustration 2.4
From the following information, calculate:
(i) BEP (in units)
(ii) BEP (in `)
Sales of 50,000 units @ `6
Variable Costs @ ` 4
Total Fixed Costs ` 80,000
Solution:
Fixed Costs 80, 000
(i) B.E.P. (in units) =   40, 000 units
Contribution Per unit 2(6  4)
Contribution = selling price – Variable Cost
or C=S–V
C=`6–`4=`2
 (ii) B.E.P. (in Rs) = Fixed Cost  Sales
Sales  Variable Cost
80, 000  (50, 000  6) 80, 000  3, 00, 000
 
(50, 000  6)  (50, 000  4) 3, 00, 000  2, 00, 000
80, 000  3, 00, 000 = `2,40,000

1, 00, 00
or with the help of P/V ratio, BEP is :
Fixed Costs
BEP (in `) =
P / V Ratio
Contribution C
P / V Ratio   100   100 [C  S  V]
Sales S
Marginal Costing and Break Even Analysis
and C = Selling Price per unit – Variable Cost
= ` 6 – `4 = ` 2
2
 P/V Ratio =  100  33.33%
6
Fixed Costs 80, 000 100
BEP (in `) =   `2,40,000
P / V Ratio 33.33
2.5.7 Sales for Desired Profit
Marginal Costing technique can be applied for maintaining a desired level of profit. Due to
competition, the price of the products may have to be reduced. The change in sales price affects the
profitability of a concern. Marginal costing helps the management to know how many units have to be
sold to maintain the desired level of profits. In order to achieve the desired level of profit the required
sales can be calculated by the following formula:
(a) When total amount of desired profit is given :
Fixed Cost  Desired Pr ofit
(i) Required sales to earn desired profit (in units) 
Contribution per unit
Fixed Cost  Desired profit
(ii) Re quired sales to earn desired profit 
P / V Ratio
(b) When desired profit per unit is given :
Fixed Cost
(i) Sales (in units) 
Contribution per unit  profit per unit
Fixed Cost
(ii) Sales (in Rs)   Selling Pr ice Per unit
Contribution per unit  Pr ofit per unit
Illustration 2.5
Following data are collected from the record of a manufacturing unit of scooter :
Selling price of a scooter is ` 32,000
Fixed cost of a scooter is ` 2,000
Variable cost of a scooter is ` 23,000
In the given period 1000 scooters were sold.
Calculate break -even point of the company and how many scooters should be sold to earn the same
profit, if company reduces the selling price of scooter by ` 2000 per scooter?
Solution:
Total Fixed = ` 2000 × 1000 = ` 20,00,000
 Fixed Cost
Break  even po int 
Contribution per unit
20, 00, 000
  222.22 [C= SV=`32,00 `23,000 = `9,000 ] or = 222 Scooters.
9, 000
The present profit of the company is as follows:
Variable cost per scooter `23,000
Fixed cost per scooter `2,000
Total cost per scooter _________
`25,000
Selling price of a scooter is ` 32,000
Profit of the company per scooter is `32,000 – ` 25,000 = ` 7,000
Total profit is (`7,000 × 1,000) = ` 70,00,000
To earn the same profit with a reduced price by ` 2000, the number of scooters can be found out as
follows:
New Selling Price = `32,000 – ` 2,000 = ` 30,000
Fixed Cost = `20,00,000
Described profit = `70,00,000
New contribution per unit = `30,000 – ` 23,000
= `7, 000
FC  Desired profit 20, 00, 000  70, 00, 000
Sales  
Cost per unit 7, 000
= 1,285.71 or = 1,286 scooters.
2.5.8 Margin of Safety:
Margin of safety is the difference between actual sales and sales at break-even point. For example,
if actual sales of a company is `10,00,000 and the sales at break-even point is `4,00,000 the difference
between these two figures `6, 00, 000 (10,00,000 – 4,00,000) is margin of safety. Margin of safety can be
calculated by the following formulae:
(i) Margin of safety (in units)  Actual sales (in units)  sales at B.E.P.(in units)
(ii) Margin of sales(in Rupees)  Actual sales(in Rupees)  sales at B.E.P.(in Rupees)
Pr ofit
(iii) Margin of safety   100
P / V Ratio
Margin of Safety
(iv) Margin of safety(%)   100
Actual Sales
Illustration 2.6
The data below relate to a company:
Sales `1,50,000
Fixed Cost `45,000
Profit `15,000
Calculate:
(i) P/V ratio at present
(ii) P/V ratio, if selling price is increased by 10%.
(iii) P/V ratio, if selling price is decreased by 20%.
Solution:
Sales(S) = `1,50,000.
Fixed Cost(FC) = ` 45,000
Profit(P) = `15,000
S – V = FC + P
`1,50,000 – V = ` 45,000 + ` 15,000
 or V = `1,50,000 – `60,000 = ` 90,000
(i) P/V ratio at present is:
C 1, 50, 000  90, 000
Since P/V ratio =  100   100  C  S  V
S 1, 50, 000
60, 000
=  100  40%
1,50, 000
(ii) Calculation of P/V Ratio, if selling price is increased by 10%:
Sales Value = `1,50,000 + ` 1,50,000 × 10
100
= ` 1,50,000 + 15,000 = ` 1,65,000
SV 1, 65, 000  90, 000
P/V ratio =  100   100
S 1, 65, 000
75, 000
=  100  45.45%
1, 65, 000
(iii) Calculation of P/V ratio, if selling price is decreased by 20%:
In this case, sale value would be ` 1,50,000 – ` 30,000 = ` 1,20,000
SV
P/V Ratio =  100
S
1, 20, 000  90, 000 30, 000
=  100   100  25%
1, 20, 000 1, 20, 000
Illustration 2.7
Following information is available from the records of a company:

Year Sales (`) Profit/Loss (`)

I 5,00,000 2,000 (Loss)
II 7,00,000 2,000 (Profit)

Selling price is given ` 100 per unit

Calculate:
(i) Fixed Cost
(ii) Break-even point in units
(iii) Sale in units for desired profit of ` 28,000.
Solution:
Change in profit / Contribution 4000
P/V Ratio =  100   100  2%
Change in Sales 2, 00, 000
(i) Fixed Cost:
S × P/V Ratio = P + FC
2
I Year: ` 5, 00, 000   FC  ( 2, 000)
100
` 10,000 = Fc – 2,000
FC =` 10,000 + ` 2,000 = ` 12,000
2
II Year: 7, 00, 000   FC  2, 000
100
` 14,000 = FC + ` 2,000
FC = `14,000 – ` 2,000 = `12,000
 FC 12, 000
(ii) B.E.P. =   100  `6,00,000
P / V Ratio 2
6, 00, 000
B.E.P.(in units) =  6, 000 units
100
(iii) Sale of units for a profit of ` 28,000:
FC  DP 12, 000  28, 000
Sale =   100
P / V Ratio 2
40, 000
=  100  `20,00,000
2
20, 00, 000
Sales (in units) =  20, 000 units
100
2.6 MANAGERIAL APPLICATION OF CVP ANALYSIS
2.6.1 Fixation of Selling Price:
Fixation of selling price is an important function of management. Under normal circumstances, the
price is fixed to cover the fixed as well as variable cost and to earn the profit. But under other
circumstances, the product may be sold at a price below the total cost. These circumstances may arise due
to stiff competition, trade depression, for accepting additional orders, for exporting, etc. In such
circumstances, the price should be fixed on the basis of marginal cost in such a manner so as to cover the
marginal cost and contribute something towards the fixed costs. In the following circumstances
production may be continued even if the selling price is below the marginal cost:
(i) To dispose of surplus stocks.
(ii) To eliminate the competitor from the market.
(iii) To utilise idle capacity.
(iv) To explore new markets.
(v) To explore foreign markets in order to earn foreign exchange.
(vi) when company deals with perishable products.
(vii)when company wants to introduce a new product in the market.
(viii) when the labour cannot be retrenched.
(ix) when company wants to avoid extra losses by closing down the business.
Illustration 2.8
The P/V Ratio of a company is 75%. Marginal cost of the product is `50. Determine the selling
price of the product.
Solution:
If selling price is `100
Variable cost will be ` 25
and contribution is `75
Selling price of the product, when the marginal cost is `50, will be:
100
=  50  `200
25
Assumptions Underlying Break-Even Charts
There are a number of assumptions which are made while drawing a break-even chart, such as :
(i) All costs can be separated into fixed and variable costs.
(ii) Fixed costs remain constant at all levels of activity.
(iii) Variable cost fluctuates directly in proportion to changes in the volume of output.
(iv) Selling prices per unit remain constant at all levels of activity.
(v) There is no opening or closing stock.
(vi) There will be no change in opening efficiency.
 (vii) Product mix remains unchanged or there is only one product.
(viii) The volume of output or production is the only factor which influences the cost.
Advantages Or Uses of Break-Even Charts
Computation of break-even point or presentation of cost, volume and profit relationship by way of
break-even charts has the following advantages:
1. Information provided by the break-even chart is in a simple form and is clearly understandable
even to a layman. The whole idea of the problem is presented at a glance.
2. The break-even chart is very useful to management for taking managerial decisions because the
chart studies the relationship of cost, volume and profit at various levels of output. The effects of
changes in fixed costs and variables costs at various levels of output and that of changes in the
selling price on the profits can be depicted very clearly by way of break-even charts.
3. The break-even charts help in knowing and analysing the profitability of different products under
various circumstances.
4. A break-even chart is very useful for forecasting (the costs and profits), planning and growth.
5. The break-even chart is a managerial tool for control of costs as it shows the relative importance of
fixed cost in the total cost of a product.
6. Besides determining the break-even point, profits at various levels of output can also be determined
with the help of break-even charts.
7. The break-even charts can also be used to study the comparative plant efficiencies of business.
Limitations of Break–Even Charts
Despite many advantages, a break-even chart suffers from the following limitations:
1. A break-even chart is based upon a number of assumptions, discussed above, which may not hold
good under all circumstances. For example, fixed costs do not remain constant after a certain level
of activity; variable costs do not always vary in direct proportion to changes in the volume of
output because of the laws of diminishing and increasing returns; selling prices do not remain the
same forever and for all levels of output due to competition and changes in general price level; etc.
2. A break-even chart provides only a limited information. We have to draw a number of charts to
study the effects of changes in the fixed costs, variable costs and selling prices on the profitability.
In such cases, it becomes rather more complicated and difficult to understand.
3. Break-even charts present only cost-volume profit relationships but ignore other important
considerations such as the amount of capital investment, marketing problems and government
policies, etc.
4. A break-even chart does not suggest any action or remedies to the management as a tool of
management decisions.
5. More often, a break-even chart presents only a static view of the problem under consideration.
2.6.2 Maintaining a Desired Level of Profit
Marginal Costing techniques can be applied for maintaining a desired level of profit. Due to
competition, the price of the products may have to be reduced. The change in sales price, variable cost
and product mix affects the profitability of a concern. Marginal costing helps the management to know of
profit the sales can be ascertained by the following formula;
Fixed Cost  Desired Pr ofit
Sales =
P / V Ratio
Illustration 2.9
The price structure of a cycle made by a company is as follows:
Per Cycle `
Materials 600
Labour 200
Variable overheads 200
1000
Fixed overheads 500
 Profit 500
Selling price 2,000
This is based on the manufacture of one lakh cycles per annum. The company expects that due to
competition they will have to reduce selling prices, but they want to keep the total profit intact. How
many cycles will have to be made to get the same amount of profit if:
(a) the selling price is reduced by 10%.
(b) the selling price is reduced by 20%.
Solution:
Total Fixed Costs = 500 × 1 lakh = 500 lakhs
Total Present Profit = 500 lakhs
Fixed Cost  Desired Pr ofit
Sales =
Contribution per unit
(a) If selling price is reduced by 10%: Use
New selling price = (2,000 – 10 % of 2,000)
= 2,000 – 200 = ` 1,800
500  500
Sales =
1,800  1, 000
1000
=  1, 00, 000 = 1,25,000 Cycles
800
(b) If selling price is rescued by 20%:
New selling price = (2,000 – 20 % of 2,000)
= 2,000 – 400 = `1,600
500  500
Sales =
1, 600  1, 000
1000
=  1, 00, 000 = 1,66,667 Cycles
600
2.6.3 Key or Limiting Factor:
A key factor or limiting factor is a factor which limits or puts a restriction on production or sales
and restricts a company from making unlimited profits. Limiting factors may be availability of raw
material, labour, sales finance, plant capacity, etc. When contribution and key factors are known, the
profitability of a product can be measured as under:
Contribution
Profitability =
Key Factor
For example:
(i) When limiting factor is the availability of labour:
Contribution
Profitability =
Key Hours
(ii) When limiting factor is raw material:
Contribution
Profitability =
Materials in Kg
Illustration 2.10
A company is producing two products A and B. The particulars of the company are as follows:
Product A Product B
(`per unit) (` per unit)
Sales 75 80
Material Cost 15 20
Labour Cost 20 15
Direct Expense 10 12
Variable overheads 10 15
Machine Hours used 3 hrs 2 hrs
Consumption of material 2 kg 3 kg
Comment on profitability of each product, if both use the same raw material, when:
(i) Total sales potential in units is key factor.
(ii) Total sales potential in values is key factor.
(iii) Raw material is in short supply.
(iv) Production Capacity (in terms of machine hrs.) is the key factor.
Solution:
Product A Product B
(`per unit) (` per unit)
Sales 75 80
Marginal Cost
Materials 15 20
Wages 20 15
Direct expense 10 12
Variable overheads 10 15
Total Marginal Cost 55 62
Contribution (Sales – Total marginal cost) 20 18
Contribution (per ` of Sales) 20/75 18/80
(Contribution/Sales) = ` 0.266 =` 0.225
Material consumed contribution per kg of materials 20/2kg 18/3kg
= ` 10 `6
Contribution per hour 20/3 hrs 18/2 hrs
= `6.6 `9
Comments:
(i) When total sales potential in units is limited, product A is more profitable as its contribution per
unit is more than that of product B.
(ii) When total sales potential in value is limiting factor, product A is more profitable as it has more
contribution as per sales in rupees than that of product B.
(iii) Product A is more profitable than product B, when raw material is in short supply.
(iv) Product B is more profitable that product A, when production capacity in terms of machine hours is
the key factor.
2.7 SUMMARY
 Marginal cost is the aggregate of variable costs. It is the cost of producing one additional unit.
 Absorption costing is the total cost technique. It is the practice of charging all costs, both variable
and fixed, to operations, processes or products.
 Contribution is the difference between Sales and Variable Cost or marginal cost.
 Break-even chart is a tool of presentation of the information relating to production quantity, sales
and profits of a business organisation.
 The angle formed at the intersection of the total sales curve and the total cost curve is known as
angle of incidence.
  Marginal Costing techniques can be applied for maintaining a desired level of profit.
 Fixation of selling price is an important function of management. Under normal circumstances,
the price is fixed to cover the fixed as well as variable cost and to earn the profit.
2.8 KEY TERMS
Marginal cost -Marginal cost is the aggregate of variable costs.
Marginal costing- marginal costing is a technique which is concerned with the changes in costs and
profits result from changes in volume of output.
Absorption Costing- Absorption costing is the total cost technique. It is the practice of charging all
costs, both variable and fixed, to operations, processes or products.
Higher contribution- Higher contribution means more profit
Break-even Analysis- In CVP analysis, an attempt is made to measure variations of costs and profit
with volume of production.
Break-even point- Break-even point may be as the point of sales volume at which total revenue
equals total costs.
2.9 QUESTIONS AND EXERCISES
1. What is ‘cost and profit’? Bring out its importance.
2. ‘Profit-Volume analysis’ is a technique of analysing the costs and profits at various ‘level of
volume’. Explain how such analysis helps management.
3. (a) Your boss is looking over a Break-even Chart which you have constructed to portray the cost
volume profit relationship of proposed plan of operations. He comments ‘The chart only tells
me more we sell more profits we make’. What is your reply?
(b) What are the limitations of a break even chart.
4. Explain the technique of marginal costing and state its importance in decision-making.
5. (a) State distinction between Marginal Costing and Absorption Costing as regards valuation of
finished goods inventories.
(b) State the circumstances in which ‘contribution approach to price is most suitable’. If this
approach is adopted, what are the special items of cost or revenue that have to be considered
when quotation for an export order is made ?
6. (a) What benefits are gained from Marginal Costing ? Are there any pitfalls in the application of
Marginal Costing ? Discuss these matters critically.
(b) Give a brief account of practical application of marginal costing which you consider sound
from a policy point of view.
7. What is Break-even Analysis ? Discuss its assumptions and uses.
8. State the implications of selling the product of a multiple firm at a price less than the marginal cost.
When would you advocate selling below the marginal cost ?
9. ‘Cost-Volume-Profit’ relationship provides the management with a simplified framework for an
organization which is thinking on a number of its problems. Discuss.
10. ‘The proper treatment of fixed costs presents a problem in full cost pricing’. Explain this statement.
Give suitable illustrations.
11. Explain with suitable illustrations the following statements:
(a) ‘In the very long run all costs are differential’.
(b) ‘In the long run profit calculated under absorption costing will be the same as that under
variable costing’.
12. State four different methods of finding out the break-even point graphically.
13. Explain how semi-variable costs could be split into fixed and variable costs.
14. What is meant by differential cost? Explain the practical utility of differential cost analysis.
15. What is meant by break-even analysis? Explain the important assumptions and practical
significance of break-even analysis.
16. What are the uses of break-even analysis and direct costing?
17. Mention the types of problems which a Management Accountant can expect to solve with break-
even analysis.
18. ‘Marginal Costing is an administrative tool for the management to achieve higher profits and
efficient operation’. Discuss.
19. Explain under what circumstances marginal costing plays important role in price fixation ?
20. Explain how marginal costing technique is useful in day-to-day decision making.
21. What are the cheif advantages of break-even analysis ? Outline the assumptions behind this
analysis.
22. Write briefly about Cost-Volume-Profit Analysis’.
23. Examine the concept of ‘Margin of Safety’ and give its uses for decision-making.
24. Explain the concept of BEP and CVP. Explain as to how are they useful for the managers for their
decision-making.
25. What are the limitations of marginal costing? Explain.
26. Distinguish between Marginal Costing and Total Costing techniques of cost Analysis. How are the
Profit Statements under the two techniques Present ?
27. Mention any four important factors to be considered in Marginal Costing Decisions.
28. Discuss the relationship between Angle of Incidence, Break-even and Margin of Safety.
 UNIT 4
BUDGETARY CONTROL
Chapter Outlines

5.0 Learning Objectives

5.1 Introduction
5.2 Meaning of Budget
5.2.1 Meaning of Budgetary Control
5.2.2 Budgetary Control as a Management Tool
5.2.3 Limitations of Budgetary Control
5.2.4 Forecasts and Budgets.
5.3. Budgetary Control System
5.3.1 Installation of Budgetary Control System.
5.3.2 Kinds of Budgets.
5.3.3 Functional Budgets.
5.3.4 Flexibility Budgets
5.3.5 Period Budgets
5.3.6 Condition Budgets
5.4 Zero-Base Budgeting Strategy
5.5 Balanced Scorecard
5.6 Summary
5.7 Key Terms
5.8 Questions and Exercises
5.0. LEARNING OBJECTIVES
After studying this chapter, you should be able to understand:
 Explain Budget, Budgeting.
 Explain Budgetary control and distinguish between Budget and forecast.
 Explain precautions in Budgeting.
 Explain the advantages of Budgetary control.
 Explain kinds of Budgets.
 Explain the advantages and disadvantages of zero-Base Budgeting.
5.1 INTRODUCTION
Budgetary Control is an important tool for the management to make optimum use of limited business
resources and to maximize the profits of business. In order to maximize the profits of business effective
control on cost is must. In budgetary control, plans are made in advance for various business activities
like purchases, sales and productions, etc. These plans are termed as budget and the actual results are
compared with the budgets and the variance are discussed and analyzed.
5.2 MEANING OF BUDGET
“ Budget is a financial and/or quantitative statement, prepared prior to defined period of time , of the
policy to be pursued during that period for the propose of attaining a given objective . It may include
income, expenditure and the employment of capital.” -I.C.M.A London
5.2.1 Meaning of Budgetary Control:-
(i) “Budgetary control is the establishment of budgets relating to the responsibilities of
executives to the requirement of a policy and continuous comparison of actual with budget
results, either to secure by individual action of objectives of that policy to provide a solid
basis for its revision.”
(ii) “Budgetary control is the planning in advance of the various functions of a business so that
the business as a whole can be controlled.” -Wheldon
5.2.2 Budgetary Control as a Management Tool
• Advantages of Budgetary Control
(i) Definite Objectives: Under budgetary control, every department is given a target to be
achieved. The efforts are made to achieve the specific aims.
(ii) Reduction in Cost of Production: In budgetary control, the various departments prepare the
budgets and this results in reduction in cost of production. Moreover, every businessmen tries to
reduce the cost of production and opts for more profitable combinations of products.
(iii) Coordination: The working of different departments is properly coordinated and a 'Master
Budget is prepared for effective coordination and cooperation among various departments of the
organisation.
(iv) Maximum Profits: Under budgetary control, the resources are utilised efficiently in an
organisation as each person is aware of his task and the best way by which it is to be
performed,
(v) Reduces Uncertainty: Under budgetary control, the managers are forced to map out future
courses of action clearly. Thus, uncertainty is reduced to minimum.
(vi) Determining Weaknesses: The deviations in budgeted and actual performance will enable the
determination of weak spots. By pin-pointing responsibility for inefficient performance, budgetary
control helps managers trace weak spots early and take remedial steps.
(vii) Economy: The planning of expenditure will be systematic and there will be economy in
spending. The resources are used to the best advantage. The benefits derived for the enterprise will
ultimately extend to industry and then to national economy.
(viii) Adoption of Standard Costing: The use of performance standards in financial matters and
operational activities help the adoption of standard costing.
(ix) Optimum use of Resources: The resources of the organisation are used to the best
advantage as the objectives are clear and each level of management is aware of its task. It
directs enterprise activity towards maximisation of efficiency, productivity and profitability.
(x) Effective Control: It is a very important tool for effective control because under it the actual
performance is compared with the budgets and remedial steps are taken in case of deviation, if any.
(xi) Successful Planning: Budgets are based on plans and all the departmental managers are
informed about the expectations from them. The extent of expenditure that they can incur is [aid
down in the budget alongwith the expected profits of their department. The departmental managers
make their utmost effort to achieve the target and thus much help is obtained in the success of the
plans.
(xii) Inculcates the feeling cost consciousness: Budgetary control inculcates the feeling of cost
consciousness among workers. Thus, it increases productivity and operating economy.
(xiii) Introduction of Incentive schemes: Budgetary control system also enables the introduction of
incentives schemes of remuneration. The comparison of budgeted and actual performance will
enable the use of such schemes. Thus, efficient workers become more efficient and
inefficient workers start becoming efficient.
Thus it can be said that "Budgetary control improves planning, aids in coordination and helps in having
comprehensive control.
5.2.3 Limitations of Budgetary Control
To maximise the profit of the business and industry budgeting control is an important managerial technique but
the technique of the budgetary control has following limitations:
(i) Based on Estimates: Budgets are based on estimates regarding an event the success of
budget depends upon experience and estimates. Thus, these estimates cause the failure of
budgetary control system.
(ii) Co-operation: The success of the budgetary control system depends upon the co-operation
and co-ordination among the various levels of the management. The lack of co-ordination and
co-operation at the operating level results into failure of budgetary control.
 (iii) Time Effect: The world is changing everyday like change in price, change in demand, change
in government policies, create problems in achieving the budgetary targets. So, budget needs
revision for their success but this revision is a very costly affair.
(iv) Excessive Cost of Budgetary System: To apply and implement budgetary control system
successfully needs heavy expenditure, which may not be possible for small scale organisations.
(v) Internal Disputes: Each and every departmental head wants more and more financial outlay for
their respective departments which becomes a cause of contention (dispute) among the various
departments of the organisation.
(vi) Opposition of Budgets: Employees and Managerial personnel are of the view that budgetary
control will reveal their efficiency and inefficiency at the various levels and hence because of
fear of inefficiency they oppose the implementation of budgetary control system.
(vii) Pressure Devices: Budgets are perceived by the work force as pressure devices imposed by top
management. This can have an adverse effect on labour relations.
(viii) Success Depends Upon the Support of Top Management: If the top management is dynamic
and enthusiastic then it will bring success to the budgetary control. On the other hand, if the top
management is dull and lethargic then the system will collapse.
5.2.4 Difference between Budget and Forecast

Basis Budget Forecast

Concept It relates to planned events and is the It is the estimate or inference about
quantitative expression of business plans and the future probable events which
policies for the future. may or may not be accurate.
Control It is an important control device for the It represents a probable event over
management. which no control can be exercised.
device
Provision The difference between actual Here, there is no such provision-
performance and budgeted performance can be
for found out under budgetary control and necessary
correction steps taken to rectify the deficiencies, if any.
Period It is prepared separately for each It may covers a long period.
accounting period.
Sequence Budgeting begins where forecasting ends. Forecasting provides a logical basis
for preparing budgets.
Scope Budgets have limited scope. It can be made of Forecasts are wider in scope and it
phenomenon capable of being can be made in those spheres also
where budgets cannot interfere
expressed quantitatively.
5.3 BUDGETARY CONTROL SYSTEM
5.3.1 Precautions in Budgeting/Budget Administration/Essentials/Installation of Budgetary
Control system
For the successful implementation of the budgetary control system, the following steps should be
considered:
(i) Objectives and Policy of Business: The budget is prepared for the achievement of the business
objectives. Therefore, the objectives of the business should be clear. Business policy is made to attain
the business objectives.
(ii) Budget Period: Budget period refers to the period of time for which the budget is prepared. The
budget period depends on the various factors such as nature of business, timing of availability of
finance, period required for manufacturing the products, etc. Generally there are two types of budget -
short term and long term budgets, cash budget, sales budget, income and expenditure budget are short
term budgets whereas capital expenditure budget, research and development budget are long term
budget.
(iii) Budget Committee: Budget committee will have the managers of various departments like
production, marketing, sales, finance, etc. The managers of each department prepare budgets for their
own department and submit it to the committee. The main functions of this committee are as follows:
(a) To provide previous years data to departmental managers for making budgets,
 (b) To determine business policy regarding budgets.
(c) To prepare master budget.
(d) To review the departmental budgets and to establish coordination among them, etc.
(iv) Budget Centres: It is that part of the organisation which is selected for budgetary control such as sales
department, purchase department, production department, etc. Each budget centre prepares a
separate budget. A budget centre must be clearly demarcated to facilitate the formulation of various
budgets with the help of concerned departmental heads.
(v) Budget Manual: A budget manual helps in knowing in writing the role of every employees and the
ways of undertaking various tasks. It helps in avoiding ambiguity in time. Any problem arising from the
operation of a budgetary controls system can be settled through the budget manual. Thus, Budget
manual is a written document or booklets which covers the following matters:
(a) It states the functions of various officials connected with the formulation of budgets.
(b) Duties, responsibilities' of various officials connected with the preparation of budgets.
(c) Objectives and benefits of budgetary control system.
(d) Length of various budget periods.
(e) Specimen forms and number of copies for preparing budget report.
(vi) Budget Key Factor: A factor which sets a limit to the total activity is known as budget factor / key
factor / limiting factor. There may be a limitation on the quantity of goods a concern may sell. In
this case, sales will be a key factor and all other budgets will be prepared by keeping in view the
amount of goods the concern will be able to sell. The raw material supply may be limited; so,
production, sales and cash budgets will be decided according to raw materials budget. Similarly,
plant capacity may be a key factor if the supply of other factors is easily available. The key factors
may not necessarily remain the same. The sales may be increased by adding more salesmen and
advertisement. The raw material supply may be limited at one time and it may be easily
available at another time.
(vii) Organisation for Budgetary Control: For the successful preparation of budgets, a proper
organisation is a must. There must be cooperation among all the departments. Therefore,
keeping in mind the cooperation and coordination, an organisation chart is prepared
(viii) Budget Officer: The chief executive appoints some person as budget officer. The budget
officer works as a coordinator among different departments. He determines the deviations
between actual performance and budgeted and takes necessary step to rectify the deficiencies. He also
informs the top management about the performance of different departments.
5.3.2 Kinds of Budgets
(A) (B) (C) (D)
According to Functions According to Flexibility According to Period According to Condition

1. Sales Budget 1. Fixed Budget 1. Long Period Budget 1. Basic Budget

2. Production Budget 2. Flexible Budget 2. Short Period Budget 2. Current Budget
3. Materials Budget
4. Labour Budget
5. Plant Budget
6. Overhead Budget
7. Research & Development Budget
8. Cash Budget
9. Master Budget
5.3.3 Functional Budgets
According to Functions
(1) Sales Budget: A sales budget is an estimate of expected sales during a budget period. It is
the most important budget and it is called the backbone of the enterprise. A sales budget
is the starting point on which other budgets are based.
In sales, budget expected sales are expressed in quantity as well as in value. A sales
manger is made responsible for preparing sales budget. The following factors should be
taken into account while preparing a sales budget:
(i) Past sales figures and facts; (ii) Availability of raw materials; (iii) Seasonal
fluctuations; (iv) Plant capacity; (v) State of competition in the market; (vi) Availability of
finance; (vii) Government policy; (viii) Selling price and quality of the products of
competitors; (ix) Development of market.
The following informations can be obtained with the help of sales budget:
(i) Sales target; (ii)Possibility of sales in different areas; (iii) What efforts should be made for
increasing sales in new areas? (iv) How much amount is required to increase the sales?
Illustration 5.1
A company manufactures two types of products A and B and sells them in the markets of Ambala and
Panchkula. The following information is made available for the current year:
Market Budgeted Sales Actual Sales
Ambala :A 400 units at ` 9 each 500 units at ` 9 each
:B 300 units at`21 each 200 units at ` 21 each
Panchkula :A 600 units at ` 9 each 700 units at ` 9 each
:B 500 units at `21 each 400 units at ` 21 each
Market studies reveal that product A is popular as it is under priced. It is observed that if its price
is increased by 11 it will get a ready market. On the other hand, product B is overpriced and market could
absorb more sales if its selling price is reduced to `20. The management has agreed to give effect to the
above price changes.
On the above basis, the following estimates have been prepared by sales manager:
Percentage increase in Sales over Current Budget
Product Ambala Panchkula
A + 10% + 5%
B + 20% + 10%
With the help of an intensive advertisement campaign, the following additional sales above the
estimated sales:
Product Ambala Panchkula
A 60 units 70 units
B 40 units 50 units
You are required to prepare a budget for sales incorporating the above estimates.
Solution:
Sales Budget
Market Product Budget for Current Period Actual Sales Budget for Future
Qn. Price(`) Value (`) Qn. Price(`) Value(`) Qn. Price(`) Value(`)
Ambala A 400 9 3.600 500 9 4,500 50 10 5,000
B 300 21 6,300 200 21 4,200 0 20 8,000
Total 700 — 9,900 700 — 8,700 40
900 — 13.000
Panchkula AB 600 9 5,400 700 9 6,300 700 10 7,000
500 21 10,500 400 21 8,400 0 20 12,000
Total 1,100 15,900 — 60
14,700 1,300 19,000
0
 Budgeted Sales for the future has been calculated as under:
Ambala Panchkula
Product A Product B Product A Product B
400 600 500
(10% of 400) 40 (20% of 300) 60 (5% of 600) 30 (10% of 500) 50
440 360 630 550
60 40 70 50
500 400 700 600

(2) Production Budget: Production budget is a forecast of production and cost of production for a
budget period. A production manager is made responsible for preparing production budget. A
production budget is prepared on the basis of sales budget. The sales budget presents demand
while the production budget makes adequate arrangements for the fulfilment of this demand.
The object of this budget is to manufacture the product at the minimum cost. A proper production
planning is essential for preparing the production budget.
The following factors should be taken into account while preparing production budget:
(i) The optimum plant capacity utilization
(ii) Avoidance of bottlenecks due to shortage of materials and labour
(iii) Key factors
(iv) Quantity of different products
(v) Opening stock, closing stock and estimated sales
(vi) Availability of physical resources
Example of Production Budget is as follows:
Production Budget

Products
Stock on 31st Dec. 2014
A B C
Add: Budgeted Sales Units Units Units
5,000 10,000 15,000
50,000 60,000 70,000
Estimated Stock on 1st Jan., 55,000 70,000 85,000
2014 Production requirement 4,000 6,000 8,000
51,000 64,000 77,000
Illustration 5.2
From the following data, prepare a Production Budget for a company: Stocks for the budget period:
Product as on 1st January 2014 as on 30th June 2014
A 8000 10,000
B 9000 8,000
C 10,000 14,000
Requirement to fulfill sales programme:
A 60,000 units
B 50,000 units
C 80,000 units
Solution:
Production Budget

Products
A B C
Units Units Units
Sales 60,000 50,000 80,000
Add: Stock on 30th June, 2014 10,000 8,000 14,000
70,000 58,000 94,000
Less: Stock on 1st January, 2014 8,000 9,000 10,000
Production requirement 62,000 49,000 84,000
(3) Materials Budget: Material budget is prepared for determining the requirement of raw material
for production. This budget depends upon sales and production budget. The materials are
purchased as per the requirements of production department. The number of units to be produced
multiplied by the rate of consumption of raw materials will give the figure of materials required.
The units of materials required multiplied by the rate per unit of raw material will give a figure of
material cost.
Total material required = (Quantity of material required per unit)(Budgeted output)
Material cost = (Units of material required) (Rate per unit of Raw material)
The raw materials budget will enable the fixation of minimum stock level, maximum level and re-
ordering level.
(4) Labour Budget: The labour required for manufacturing the product is known as direct labour and
the labour which cannot be specified with production is called indirect labour. Labour budget is
prepared for making possible the continuous availability of labour for attaining the production
targets. This budget is useful for anticipating labour time required for production.
Labour Cost is determined as under:
Labour Cost = Labour hours  Rate of pay per hour
Labour budget provides the following information:
(i) Number and types of workers required,
(ii) Rate of remuneration payable to the workers of different categories and availability of them.
(iii) Time and cost of training to be provided to the labourers.
(iv) The number of workers to be required more in the year.
(5) Plant Budget: In big enterprises where plants are valuable and most of the production is carried
out with the help of machinery, preparation of plant budget becomes essential. Plant budget
provides the following informations:
(i) Department wise the number of machines.
(ii) Original cost, depreciation and current value of machineries.
(iii) Work for which each machine is to be used.
(iv) Need to purchase new machines and amount required thereof.
(v) Production capacity of machines.
(vi) Remaining life of machines, etc.
(6) Overheads Budget: Overheads budget is prepared for the estimation of indirect
expenses related to production, i.e., indirect material, indirect labour and other indirect expenses.
This budget is classified into following parts:
(i) Factory overheads Budget
(ii) Financial overheads Budget
(iii) Sales overheads Budget
(iv) Administrative Overheads Budget
(7) Research and Development Budget: It is a long term budget. It is prepared for the
expansion of business and to adopt new techniques of production. In this budget, the
 estimates are made for expenses on current research programmes. Development starts where
research ends and development ends where actual production commences. Thus, development
is the stage between research and actual production.
(8) Cash Budget: Cash budget is a statement of estimates of cash position for the budget period.
It is a plan of estimated receipts and payments of cash for the budget period. It can be
prepared for any time period. Normal time period of cash budget is half year which is
further sub-divided into the months. It helps in planning and control of the financial
requirements of the organisation. Cash budget ensures that cash is available in time for carrying
out business activities and meeting financial obligations. If there is any shortage of cash, then
time by arrangements can be profitability used in temporary investments. In cash budget,
estimate regarding each item of cash receipt and payment is made at the time of its preparation.
Cash-receipts items: Cash sales, credit sales having regard to credit collection policy, interest,
dividend, the amount received on shares and debentures, bank loan, the amount of tax
refund, rent receivable, etc.
Cash-payments items: Cash purchase of raw materials, payment made to suppliers of credit
purchases of raw materials, wages, salaries, manufacturing expenses, administrative
expenses, selling and distribution expenses, research and development expenses, repayment
of bank loans and public deposits, redemption of preference shares and debentures, payment
of taxes, interest and dividends.
•Importance of Cash Budget
The importance of preparing a cash-budget are as follows:
1. It serves as a device for planning and controlling of receipts and payments of cash to ensure
availability of cash in an adequate amount.
2. It enables the management to prepare borrowing and repayment schedule will in advance.
3. It enables the management to take advantages of cash discount.
4. It enables the management to plan for financing a new project and expansion modernization of
an existing project.
5. It enables the management to plan for dividend payment.
•Methods of Preparation of Cash Budget
(I) Receipt and Payment Method
(II) Adjusted Profit and Loss Account Method
(III) Projected Balance Sheet Method
(I) Receipt and Payment Method: In this method, estimated cash receipts and payments are taken into
consideration. Cash receipts and cash-payment items we have discussed earlier.
Illustration 5.3
Prepare a cash budget for the month of May, June and July 2014 on the basis of the following
information:
(1) Income and Expenditure Forecasts:
Months Credit Credit Wages Manufac- Office Selling
Sales Purchases (`) turing Expenses Expenses
(`) (`) Expenses (`) (`)
(`)
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
(2) Cash balance on 1st May, 2014 `8,000.
(3) Plant costing `16,000 is due for delivery in July and payable 10% on delivery and the
balance after 3 months.
 (4) Advance tax `8,000 each is payable in March and June.
(5) Period of credit allowed (i) by supplier - two months and (ii) to customers-one month.
(6) Lag in payment of manufacturing expenses – ½ month.
(7) Lag in payment of office and selling expenses - one month.
Solution:
Cash Budget
Particulars May 2014 June 2014 July 2014
(`) (`) (`)
Opening Balance 8,000 13,750 12,250
Add: Receipts
Credit Sales 62,000 64,000 58,000
70,000 77,750 70,250
Less: Payment
Credit Purchase 36,000 38,000 33,000
Wages 10,000 8,500 9,500
Manufacturing Expenses 3,750 4,000 3,750
Office Expenses 1,500 2,500 2,000
Selling Expenses 5,000 4,500 3,500
Plant - Payment on delivery — — 1,600
Advance Tax — 8,000
Total 56,250 65,500 53,350
Closing Balance 13,750 12,250 16,900
Working Notes:

(i) Since the period of credit allowed by suppliers is two months, the payment for credit
purchases in March will be made in May and so on.
(ii) Since the period of credit allowed to customers is one month, the receipt for credit sales in April
will be in May and so on.
(iii) One half of the manufacturing expenses of April and one half of May will be paid in May, i.e.,
(1/2 of ` 3,000) + (1/2 of `4,500) = `3,750 and so on.
(iv) Office and selling expenses of April shall be paid in May and so on.
(v) Opening balance of cash for the month of June has been ascertained after finding out closing
balance of May and for July after closing balance of June.
(ii) Adjusted Profit and Loss Method: In this method, the cash balance and net profit
disclosed by Profit and Loss Account and Balance Sheet does not represent the fair amount of
cash, since some such items take place in Profit and Loss Account which do not affect the outflow
and inflow of the cash. Therefore, all such non-cash items are to be adjusted just to get the correct
estimate of real cash. The formula for calculating closing cash balance is given below:
Opening Cash Balance + Net Profit + Non - Cash expenses + Decrease in Current Assets+
Increase in Current Liabilities + Sales of Fixed Assets of Issue of Shares and Debentures -
Increase in Current Assets - Decrease in Current Liabilities - Payment of Tax and Dividend-
Purchase of Fixed assets – Redemption of Shares and debentures etc. = Closing Cash Balance.
(iii) Balance Sheet Method: Under this method, a forecasted or budgeted balance sheet is prepared
at the end of the budget period. In this method, all assets and liabilities (except Cash and Bank
Balance) are shown. If the amount of budgeted liabilities exceeds the budgeted assets, the
difference will be cash or bank balance at the end of budget period. If the amount of budgeted
assets are in excess of liabilities, the difference will be bank overdraft.

Illustration 5.4
 From the following information prepare a Cash Budget by the Adjusted Profit and Loss Method,
for ABC Limited:
BALANCE SHEET
(as on 31st December, 2013)

Liabilities Amount Assets Amount

(`) (`)
Equity Share Capital 50,000 Cash 7,360
Debentures 29,400 Stock 24,760
Creditors 26,920 Debtors 19,600
ACC Depreciation 20,000 Investments 40,000
Profit & Loss A/c 53,400 Plant 88,000
1,79,720 1,79,720
Forecasted Profit and Loss Account

Particulars Amount Particulars Amount

(`) (`)
To ACC Depreciation A/c 8,800 By Gross Profit b/d 80,000
To Income Tax 2,000 By Profit on sale of Investment 800
To Interest 1,200 By Interest 4,000
To Admn. & Selling Exp. 4,000
To Loss on Sale of Plant 3,200
To Net Profit c/d 65,600
84.800 84,800
To Dividend 4,000 By Net Profit b/d 65,600
To Balance c/d 61 ,600
65,600 65,600

Additional Information:

(i) Investment Costing `4,000 were sold for ` 4,800.

(ii) New Plant Costing `32,000 was purchased during the year.
(iii) An old plant costing `24,000 and accumulated depreciation of `16,800 was sold for
`4,000.
Balance on 31st December, 2014:

Stock `37,000; Debtors ` 33,280;

Creditors v 40,000; Debentures `20,000;

Equity shares issued during the year`20,000

Solution:
 CASH BUDGET
(Adjusted Profit and Loss Method)
Particulars Amount(`) Amount (`)
Opening Cash Balance 7,360
Add: Budgeted Net Profit 65,600
Depreciation written off 8,800
Increase in Creditors 13,080
Loss on sale of Plant 3,200
Sale of Investment 4,800
Issue of Shares 20,000
Sale of old Plant 4,000 1,19,480
1,26,840
Less: Purchase of Plant 32,000
Redemption of Debentures 9,400
Payment of Dividend 4,000
Profit on sale of Investment 800
Increase in Debtors 13,680
Increase in Stock 12,240 72,120
Closing Balance of Cash 54 720

Illustration 5.5

By using the data of Illustration 5.4, prepare a Cash Budget showing Cash at Bank on 31st
December, 2014, under 'Balance Sheet Method'.
Solution:
Budgeted Balance Sheet
(On 31st December, 2014)

Liabilities Amount Assets Amount

(`) (`)
Equity Share Capital 70,000 Plant Investment Stock 96,000
Profit and Loss A/c (53,400 + 61 1,15,000 Debtors Cash at Bank (Bal. 36,000
,600) Debentures Ace. 20,000 Figure) 37,000
Depreciation (20,000 + 8,800 - 16,800) 12,000 33,280
Creditors 40,000 54,720
2,57,000 2,57,000
9. Master Budget: A master budget is prepared for the business as a whole, combining all the budgets
for a period into this budget. It is the summary of all subsidiary functional budgets, prepared by the
concern. Before preparing a master budget, it is necessary to prepare sales budget, purchase budget,
cash budget, production budget, overheads budget, etc. Thus, the master budget is a summary
budget which incorporates all functional budgets in a capsule form. It shows budgeted income
statement for the budget period and budgeted balance sheet at the end of the budget period. The
master budget requires the approval of the budget committee before it is put into action. The master
budget co-ordinates the budgets of all the departments.

5.3.4 Flexibility Budgets

On the basis of flexibility, budgets can be classified as follows:
 (1) Fixed Budget: According to I.C.M.A., London, "Fixed budget is a budget which is
designed to remain unchanged irrespective of the level of activity attained."
It does not change with the change in level of activity actually attained. It is prepared for a given level
of activity and does not take note of changes in the circumstances. Therefore, it becomes useless
for comparison with actual performance when level of activity changes.
(2) Flexible Budget; According to I.C.M.A., London, "A flexible budget is a budget
designed to change in accordance with the level of activity actually attained."
A flexible budget provides budgeted costs at different levels of activity. It varies with the level of
activity attained. Flexible budget is desirable in the following cases:-
(i) Where the business is new or estimation of demand is not possible.
(ii) Where the business is subject to the vagaries of nature such as soft drinks, etc.
(iii) Where sales are unpredictable.
(iv) Where the demands for the product keep changing due to change in fashion and tastes of
customers.
(v) Where production cannot be estimated due to irregular supply of necessary material and
labour.
Illustration 5.6
Prepare a Flexible Budget for the production at 80% and 100% activity on the basis of following
information:
Production at 50% capacity 5,000 units
Raw Material ` 80 per unit
Direct labour ` 50 per unit
Direct Expenses `15 per unit
Factory Overhead `50,000 (50% fixed)
Administration Overhead ` 60,000(60% variable)
Solution:
Flexible Budget
Particulars 50% 80% 100%
Capacity Capacity Capacity
5,000 units 8,000 units 10,000 units
(`) (`) (`)
Per unit Total Per unit Total Per unit Total
Raw Material 80 4,00,000 80 6.40.000 80 8,00,000
Direct Labour 50 2,50,000 50 4,00,000 50 5,00,000
Direct 15 75,000 15 1,20,000 15 1,50,000
Expenses 145 7,25,000 145 11,60,000 145 14.50,000
Prime Cost
Factory
Expenses: 5 25,000 3.125 25.000 2.50 25,000
(Fixed 50%) 5 25,000 5 40.000 5 50,000
(Variable 50%)
Works Cost 155 7,75,000 153.125 12,25,000 152.50 15,25,000
Administration Exps.
Fixed (40%) 4.80 24,000 3.00 24,000 2.40 24,000
Variable (60%) 7.20 36,000 7.20 57,600 7.20 72,000
Total Cost 167 8,35,000 163.325 13,06,600 162.10 16,21,000
Note: 1. Variable cost per unit and total fixed costs remain constant irrespective of changes on activity
levels.
2. Total variable cost and fixed cost per unit vary with the changes in the activity levels.
5.3.5 Period Budgets
 (i) Long Period Budgets: Long period budgets are those budgets which incorporate planning for
five to ten years and even more. Research and development budget is an example of long period
budget.
(ii) Short Period Budgets: Short period budgets are prepared for the period less than one year.
Material budget, Cash budget, etc. are the examples of short period budgets.
5.3.6Condition Budgets
(i) Basic Budget: A basic budget is one which is established for use unaltered over a long period of
time. Current circumstances are not considered while preparing this budget.
(ii) Current Budget: A current budget is one which is established for use over a short period of
time and it is related to current conditions. This budget is more useful than basic budget.
Illustration 5.7
ABC Ltd. prepared the budget for the production of one lakh unit of the one type of commodity
manufactured by them for a costing period as under:-
Raw Material Z 2.52 per unit
Direct Labour ? 0.75 per unit
Direct Expenses ? 0.10 per unit
Works overheads (60% Fixed) ? 2.50 per unit
Admn. overheads (80% Fixed) ? 0.40 per unit
Selling overheads (50% Fixed) ? 0.20 per unit
Actual production during the period was only 60,000 units. Calculate the budget cost per unit.
Solution:
Flexible Budget
1,00,000 Units 60,000 Units
Particulars Per unit Amount (`) Per unit Amount (`)
Raw Material 2.52 2,52.000 2.52 1,51,200
Direct Labour 0.75 75,000 0.75 45,000
Direct expenses 0.10 10,000 0,10 6,000
Prime Cost 3.37 3,37,000 3.37 2,02,200
Works Cost: (60% Fixed) 1.50 1,50,000 2.50 1,50,000
(40% Variable) 1.00 1 ,00,000 1.00 60,000
Admn. Overheads: (80% Fixed) 0.32 32,000 0.53 32,000
(20% Variable) 0.08 8,000 0.08 4,800
Cost of Production 6.27 6,27,000 7.48 4,49,000
Selling Overheads:
50% Fixed 0.10 10,000 0.17 10,000
50% Variable 0.10 10,000 0.10 6,000
Total Cost 6.47 6,47,000 7.75 4,65,000
•/ Programme Budgeting
Programme budgeting was firstly used by Department of Defence in U.S.A. in 1961. It focuses on
process of allocating funds.
5.4 ZERO-BASE BUDGETING STRATEGY (ZBB)
Zero-base budgeting is also known as "De nova budgeting", i.e., budgeting from beginning. In other
words, it is beginning from zero base, assuming that nothing is happened in the past. The concept of zero
base budgeting can be applied from a home budget to the national budget. In a home budget, a housewife
prepares the budget of next month after ignoring the current and past budget (expenditures) altogether.
1. According to Certified Institute of Management Accountants, London, "Zero
base budgeting is a method of budgeting whereby all activities are re-evaluated each time
a budget is set. Discrete levels of each activity are valued and a combination chosen to
match funds available."
2. According to Peter A Pyher, "A planning and budgeting process which requires each
manager to justify his entire budget request in detail from scratch (hence zero base) and
 shifts the burden of proof to each manager to justify why he should spend money at all. The
approach requires that all activities be analysed in decision packages which are evaluated by
systematic analysis and ranked in order of importance." Peter Pyher is known as the father of
Zero Base Budgeting as he introduced ZBB at Texas Instruments in USA in 1969.
Thus we can say that in zero base budgeting, every year is taken as a new year and previous year is not
taken as a base. It starts from a “Zero base” and every function within an organization is analysed for its
needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of
whether the budget is higher or lower than the previous one.
Steps Involved in the Process of Zero Base Budgeting
For implementing zero base budgeting, following necessary steps are taken
1. Determining the objectives of zero base budgeting.
2. Developing decision unit i.e., a department of an organization where decisions are taken.
Decision units are developed for cost benefit analysis.
3. Development decision packages: Decision package summaries the scope of work requirement,
anticipated benefits, time schedule etc.
4. Ranking of decision packages on the basis of benefits to the organization.
5. Allocation of resources on the basis of ranking of decision packages.
Advantages of Zero-Base Budgeting
1. Efficient allocation of resources, as it is based on needs and benefits rather than history.
2. It helps in identifying and eliminating wasteful and obsolete operations.
3. It helps in detecting inflated budgets.
4. It increases communication and coordination within the organization.
5. It enables the management to find cost effective ways to improve operations.
6. Responsibility and accountability are more specifically fixed under zero based budgeting as
compared to traditional budgeting.
7. It increases staff motivation by providing greater initiative and responsibility in decision making.
8. It is useful in Government department where all expenditure are incurred on the basis of budgets.
9. It focuses on cost benefit analysis to reach on maximization of profit of the company.
10. It can be used for implementation of “Management by objective’ (MBO). Thus it can be used not
only for fulfillment of the objective, but also for variety of the purpose.
11. It identifies activities involving wasteful expenditure.
12. It involves rational decision making.
13. It promotes operating efficiency.
Limitations of zero-Base Budgeting
1. It is more time consuming than traditional budgeting as every single item is paid attention to
afresh.
2. It requires specific training due to increased complexity as compared to traditional budgeting.
3. It increases paper work.
4. Cost of preparing the decision package may be very high.
5. There is a problem in defining decision units and decision packages.
6. Wrong cost-benefit analysis may hamper the future growth of the organization. For example,
cutting present advertisement cost may effect future sales. Similarly, cutting research and
development cost may effect the future growth and cost effectiveness of the organization.
7. The concept ZBB needs clarity at top management level otherwise conflict among departments
may affect the overall profitability of the organizations.
ZBB is highly relevant in ‘continuous improvement’ environment because of its nature of
continuous evaluation of costs and benefits. This technique is relevant for effective utilization of
 resources and increasing the profitability of the organizations. So ZBB can be implemented as a
planning device in the overall corporate strategy.

SELF-ASSESMENT QUESTION

1. What do you understand by “Budgeting” ? Mention the type of budget that the Management of a
big industrial concern would normally prepare.
2. What is budget ? What is sought to be achieved by Budgetary Control.
3. Has ‘Budgetary Control’ any significance with management accounting ?
4. Outline a plan for sales budget and purchases budget. What considerations are necessary in the
preparation of such budgets ?
5. Mr. Managing Director is surprised that his profit every year is quiet different from what be wants
or expects to achieve. Someone advised him to install a formal system of budgeting. He employs a
fresh accountant to do this. For two years, the accountant faithfully makes all budgets based on
previous year’s accounts. The problem remains unsolved. Advise Mr. Managing Director and the
Accountant on what steps they should take. Make assumption about what is lacking.
6. (a) What do you mean by budgetary control with reference to manufacturing-cum-selling
enterprise.
(b) What factors would influence the selection of budget period between two firms carrying on
diverse activities ?
(c) What do you mean by flexible budget allowance ? How is it ascertained ? Explain with a
cogent example.
7. (a) What do you mean by budgetary control ? Explain the objectives of budgetary control with
special reference to a large manufacturing concern.
(b) Explain what is meant by flexible budget and its utility. Prepare a proforma of flexible budget
of a manufacturing concern for their imaginary activity, levels in a suitable form.
8. (a) What do you understand by budget and budgetary control ? Give example of five budgets that
may be prepared and employed by a manufacturing concern.
(b) What is the principal budget factor ? Give a list of such factors and explain how you would
proceed to prepare budgets in the case of a manufacturing company.
9. Are you in agreement with the view that Budgeting should better be called profit planning and
control.
10. ‘Why do responsible people in an organization agree to accept budgetary control in theory but
resist in practice’ ? Explain.
11. ‘If the sales forecast is subject to error then there is no basis of budgeting’. Do you agree ? Also
explain how flexible budget can be used to help control cost.
12. Explain the procedure you would follow to prepare a projected Profit and Loss Account and
Projected Balance Sheet. Explain also use of these statements.
13. ‘Budgetary control improves planning, aids in coordination and helps in having comprehensive
control’. Elucidate this statement.
14. Describe in brief the modus operandi for the purpose of preparation of a production budget. What
are the principal considerations involved in budgeting production ?
15. What do you understand by budget and budgetary control ? How far is a budgetary control a tool in
the hands of management ?
16. What is ‘zero-base budgeting’ ?
17. What do you understand by the terms ‘Budget’ and ‘Budgetary Control’ ? What are the advantages
of ‘budgetary control’ ?
18. What is the mechanism of master budget ?
Discuss the difficulties which arise and how are they overcome in forecasting sales and preparing
sales budget in a jobbing concern.
19. (a) What is master budget ? How is it prepared ?
(b) Explain zero-based budgeting.
20. Write an essay on zero-based budgeting and highlight its procedure, norms and superiority over
functional budgeting.
21. What are different types of functional budgets which are prepared by a large scale manufacturing
concern ?
 UNIT-4

STANDARD COSTING

Standard Costing: Meaning

Standard costing is a system of accounting that uses predetermined standard costs for direct
material, direct labor, and factory overheads. Standard costing is the second cost control
technique, the first being budgetary control. It is also one of the most recently developed
refinements of cost accounting. The standard costing technique is used in many industries due to
the limitations of historical costing. Historical costing, which refers to the task of
determining costs after they have been incurred, provides management with a record of what has
happened. For this reason, historical costing is simply a post-mortem of a case and has its own
limitations. For managers within a company, exercising control through standards and standard
costs is a creative program aimed at determining whether the organization’s resources are being
used optimally.

Standard costs are typically determined during the budgetary control process because they are
useful for preparing flexible budgets and conducting performance evaluations. The use of
standard costs is also beneficial in setting realistic prices. Along with this, standard costs help to
identify any production costs that need to be controlled. Importantly, comparison of actual
cost with standard cost shows the variance. When correctly analyzed, this shows how to correct
adverse tendencies. The current category “Standard Costing and Variance Analysis” discusses
the technique of standard costing and variance analysis, which is aimed at profit improvement
mainly by reducing materials, labor, and overhead costs.

Standard Cost: Definition

There are different definitions of standard costing, all of which emphasize the use and
determination of standard cost. Hence, it is useful to understand the meaning of standard cost. A
standard cost is one that a company expects at the outset of a year under a normal level of
operational efficiency. Standard costs are used periodically as a basis for comparison with actual
costs. Standard costs may be termed commonsense costs. This reflects the view that a standard
cost represents the best judgment of management about what costs the business operations will
involve when undertaken efficiently. According to Brown & Howard, “standard cost is a pre-
determined cost which determines what each product or service should cost under given
circumstances.”

Blocker defined standard cost as follows:

A pre-determined cost based upon engineering specifications and representing highly efficient
production for quality standard with a fixed amount expressed in terms of dollars for materials,
labor, and overhead for any estimated quantity of production.
The Institute of Cost and Management Accountants (ICMA) defined standard cost in the
following way:

A pre-determined cost which is calculated from management’s standards of efficient operation

and the relevant necessary expenditure. It may be used as a basis for price fixation and for cost
control through variance analysis.

In ICMA’s definition of standard cost, the phrase “management’s standards of efficient

operation” is important. This is because standard cost is ascertained on this basis.

The standard of efficient operation is decided based on previous experience, research findings, or
experiments. The standard is generally defined as that which is attainable but only after
substantial effort. Standard cost serves as a measure against which actual cost is compared. If
actual cost does not exceed standard cost, performance is treated as fully efficient.

Standard cost also plays a role in evaluating staff performance. For example, by analyzing the
difference between actual costs and standard costs, management can identify the factors leading
these differences.Standard costs also assist the management team when making decisions about
long-term pricing.

Features of Standard Costing System

1. Standard cost is a predetermined cost. It is based on past experience and is referred to as

a common sense cost, reflecting the best judgment of management.

2. Standard cost relates to a product, service, process or an operation. It is also determined for a
normal level of efficiency of operation.

3. Standard cost is used to measure the efficiency of future production or future operations. For
this reason, it provides a useful basis for cost control.

4. Also, standard cost may be expressed in terms of money or other exact quantities.

Advantages of Standard Cost

This section highlights the most important advantages of standard cost.

1.First, standard costs serve as a yardstick against which actual costs can be compared.The
difference between standard cost and actual cost are called variances. For proper control and
performance measurement in an organization, variances should be measured and analyzed. This
also ensures that regular checks are made on expenditures.
2. The second advantage is that if immediate attention is taken, control over costs is greatly
facilitated. A proper standard costing system assists in achieving cost control and cost reduction.

3. Standard cost also helps to motivate employees. This is because the system can be used to
provide an incentive scheme wherein variance is minimized.

4. Production and pricing policies are formulated with certainty when standard cost systems are
in place. This helps to keep costs in check.

5. The last advantage of using standard cost is that even when other standards and guidelines are
constantly being revised, standard cost serves as a reliable basis for evaluating performance and
control costs.

Nature and Purpose of Standard Costing System

The main purpose of standard cost is to provide management with information on the day-to-day
control of operations.

1. Standard costs are predetermined costs that provide a basis for more effectively controlling
costs. Standard cost offers a criterion against which actual costs incurred by the business can be
measured and analyzed.

2. The difference between actual costs and standard costs is known as variance. Variance is
identified and carefully analyzed, and it is reported to managers to inform suitable corrective
actions.

Applicability of Standard Costing

Standard costing is applicable under diverse conditions. It requires the following:

 There should be an output or the production of a sufficient volume of a standard product

 The methods, operations, and processes of production should be capable of
standardization
 The costs should be controllable
Standard costing techniques have been applied successfully in all industries that produce
standardized products or follow process costing methods.

Examples of such industries include sugar, fertilizers, cement, footwear, breweries and
distilleries, and others.

Public utilities such as transport organizations, electricity supply companies, and waterworks can
also apply standard costing techniques to control costs and increase efficiency.
In jobbing industries, as well as industries that produce non-standardized products, it is not
possible to apply the technique advantageously.

Objectives of Using Standard Costing System

Within an organization, there are several objectives that a standard costing system may be
established to help achieve.

1. First, a standard costing system may be used to control costs, which is achieved mainly by
setting standards for each type of cost incurred: material, labor, and overhead.

2. This also helps to analyze variance and, hence, enables managers to be effective in controlling
the costs for which they are held responsible.

3. The second objective that a standard costing system may be used to achieve is to help in
setting budgets. Third, such a system may be used to provide useful and detailed information for
managerial planning and decision-making.

4. Fourthly, a standard costing system may be used to assess the performance and efficiency of
staff and management.

5. Finally, standard costing is a control technique that follows the feedback control cycle.
Therefore, the feedback system may help to eliminate unwanted costs in the future, leading to a
potential reduction in costs.

Preliminaries to Consider Before Using a Standard Costing System

When deciding whether to use standard costing in a business, several preliminaries have to be
considered. These preliminaries are:

1. Establishing cost centers

2. Classification and codification of accounts
3. Types of standards
4. Setting the standards

1. Establishing Cost Centers

A cost center is a location, person, or item of equipment (or a group of these) for which costs
may be ascertained and used for the purpose of cost control. Cost centers may be personal cost
centers or impersonal cost centers. Personal cost centers are related to a person, while impersonal
cost centers are related to a location or item of equipment. Establishing cost centers is needed to
allocate responsibilities and define lines of authority.
2.Classification and Codification of Accounts

Classification or grouping of accounts is essential for standard costing.

Accounts should be classified in such a way that the cost elements of every cost center are
clearly and precisely reflected. Codes and symbols are assigned to different accounts to make the
collection and analysis of costs more quick and convenient.

Types of Standards

A standard is a predetermined measure relating to materials, labor, or overheads. It is a reflection

of what is expected, under specific conditions, of plant and personnel.

A standard is essentially an expression of quantity, whereas a standard cost is its monetary

expression (i.e., quantity multiplied by price). It shows what the cost should be.

In setting standards, the key question is to decide on the type of standard to be used in fixing the
cost. The main types of standards are ideal, basic, and currently attainable standards.

1. Ideal Standards

Ideal standards, also called perfection standards, are established on a maximum efficiency level
with no unplanned work stoppages.

They are tight standards which in practice may never be obtained. They represent the level of
attainment that could be reached if all the conditions were perfect all of the time.

Ideal standards are effective only when the individuals are aware and are rewarded for achieving
a certain percentage (e.g., 90%) of the standard.

2. Basic Standards

Basic standards are long-term standards and they remain the same after being computed for the
first time. They are projections that are rarely revised or updated to reflect changes in products,
prices, and methods.

Basic standards provide the basis for comparing actual costs over time with a constant standard.
They are used primarily to measure trends in operating performance.
3. Currently Attainable Standards

A currently attainable standard is one that represents the best attainable performance. It can be
achieved with reasonable effort (i.e., if the company operates with a “high” degree of efficiency
and effectiveness).

These standards make proper allowances for normal recurring interferences such as machine
breakdown, delays, rest periods, unavoidable waste, and so on.

It is assumed that these are unavoidable interferences and are a fact of life. However, allowances
are not made for any avoidable interference with output.

The currently attainable standard is the most popular standard, and standards of this kind are
acceptable to employees because they provide a definite goal and challenge to them.

Setting the Standards or Establishing a Standard Costing System

Establishing a standard costing system for materials, labor, and overheads is a complex task,
requiring the collaboration of a number of executives.

For this purpose, a Standards Committee is established. The Standards Committee generally
consists of:

 Production Manager
 Purchase Manager
 Personnel Manager
 Production Engineer
 Sales Manager
 Cost Accountant
The Budget Committee and Standards Committee can be combined into one committee.

The Standards Committee is responsible for fixing standards. It also assists in the effective
application of standards, as well as making necessary changes as new circumstances render
previous standards obsolete. Before fixing standards, a detailed study of the functions involved
in the manufacturing of the product is necessary. While fixing standard costs, the fundamental
principle to be observed is that the set standards are attainable so that these are taken as
yardsticks for measuring the efficiency of actual performances. The setting up of standard costs
requires the consideration of quantities, price or rates, and qualities or grades for each element of
cost that enters a product (i.e., materials, labor, and overheads).

VARIANCE ANALYSIS

Variances may be classified into:

 (i) Favourable and Unfavourable Variances, and
(ii) Controllable and Uncontrollable Variances
(i) Favourable and Unfavourable Variances: When the actual cost incurred is less than the
standard cost, the deviation is known as 'favourable variance' whereas, when the actual cost
incurred is more than the standard cost, the variance is treated as 'unfavourable* or
'adverse*. A favourable variance reflects the efficiency while unfavourable variance indicates
inefficiency. Favourable variance is also known as positive ( + ) or credit variance and viewed
only as profits whereas adverse variance is known as negative (-) or debit variance and is
viewed as losses. In other words, any variance which increases the actual profit is favourable
variances and any variance which decreases the actual profit is unavoidable variable. Favourable
variance is designated by (F) and unfavourable or adverse by (A).
(ii) Controllable and Uncontrollable Variances: A variance is said to be controllable if primary
responsibility of a specified person or department can be identified. For example, excess
usage of materials by production department is controllable being the responsibility of the
foreman of the said department. On the other hand, when variance is due to the factors beyond
the control of the concerned person, it is said to be uncontrollable. For example, increase in
wage rate of workers on account of strike or government policy, etc. No individual person or
department can be held responsible for uncontrollable variances.
Variance analysis is a process of analysing variances by sub-dividing the total cost variance in such a way
that the management of the concern can assign the responsibility for off standard performance. It also leads to
ascertain the magnitude of each of the variances and reasons thereof. In variance analysis, the attention of the
management is drawn not only to the monetary value of unfavourable and favourable managerial performance
but also the responsibility and reasons for the same.
Material Variances
Material forms a very high percentage of the total cost. It is very important to study its cost variance. Material
variances consist of the following variances:
(1) Material Cost Variance (MCV)
(2) Material Price Variance (MPV)
(3) Material Usage/Quantity/Volume Variance (MQV)
(4) Material Mix Variance (MMV)
(5) Material sub-usage Variance/Revised Material Quantity Variance {RMQV}
(6) Material Yield Variance (MYV)
Classification of Cost Variances
(1) Material Cost Variance (MCV): "Material cost variance is the difference between the
standard cost of materials specified for the actual output and actual cost of materials
used." — I.C.M.A., London
It is expressed as:
MCV= Standard Cost of Material for Actual Output — Actual Cost of Material
or (SQ  SP) - (AQ AP)
SQ stands for Standard Quantity for Actual Output
SP stands for Standard Price
AQ stands for Actual Quantity
AP stands for Actual Price
Standard Quantity for Actual Output is computed as follows
Standard Quantity
 Acual output
Standard Output
(2) Material Price Variance (MPV): Material price variance is the portion of the Material Cost Variance
which arises due to the difference between the standard price specified and actual price paid. It can be
expressed as:
Material Price Variance - Actual Quantity (Standard Price - Actual Price) or MPV = AQ (SP - AP)
The reasons for the material price variance may be the following:
(i) Change in market price
(ii) Change in quantity of purchase
(iii) Change in quality of material purchased
(iv) Emergency purchases leading to higher prices
(v) Discounts not availed
(vi) Rush order to meet shortage of supply, etc.
(3) Material Usage/Quantity/Volume Variance: Material usage variance is the difference
between the standard quantity specified and the actual quantity used. This variance may arise due to the
following reasons:
(i) Use of inferior material
(ii) Poor inspection of material
(iii) Lack of due care in the handling of materials
(iv) Abnormal wastage, theft, pilferage of materials
(v) Setting of improper standards
(vi) Improper maintenance of machine, etc.
It may be expressed as:
Material Usage Variance = Standard Price (Standard Quantity for Actual Output- Actual Quantity)
or MUV = SP(SQ-AQ)
Relationship among MCV, MPV and MUV:
MCV = MPV + MUV
Illustration 4.1
The standard material required for production is 5,200 kg. A price of `2 per kg has been fixed for
the materials. The actual quantity of materials used for the product is 5,600 kg. A sum of ` 14,000 has
been paid for the materials.
Calculate: (a) Material Cost Variance; (b) Material Price Variance; (c) Material Usage Variance.
Solution:
Standard Quantity = 5,200 kg
Standard Price = ` 2 per kg
Actual Quantity = 5,600 kg
Actual Price = 14, 000 = ` 2.50 per kg
5, 600
(a) Material Cost Variance (MCV):
MCV = (SQ  SP)  (AQ  AP)
= (5,200 2)  (5,600  2.50)
= ` 10,400  `14,000 = `3,600 (Adverse)
(b) Material Price Variance (MPV):
MPV = AQ{SP - AP} = 5,600 {2-2.50}= 5600(-0.50) = `2,800 (Adverse)
(c) Material usage variance (MUV):
MUV =SP(SQ-AQ)
= 2(5,200-5,600)
= 2(-400) = `800 (Adverse)
Verification:
MCV =MPV + MUV = `3,600(Adv.) = 2,800 (Adv.) + 800 (Adv.)
Illustration 4.2
In a brass foundry, the standard mixture consists of 60% Copper and 40% Zinc. The standard loss
of production is10% on input. From the actual production in a month calculate the Material Cost
Variance and analyse it:
Copper 50kg@`30 per kg (standard 60kg)
Zinc 50 kg@`20per kg (Standard 40 kg)
 Actual Output: 86 kg
SP and AP are the same
Solution:
Standard Mix Actual Mix
SQ(kg) SP(`) Std. Cost(`) AQ(kg) AP(`) Actual Cost(`)
Copper 60 30 1800 50 30 1,500
Zinc 40 20 800 50 20 1,000
100 2,600 100 2,500
Less (10%) 10 14
(Loss) 90 86

Material Cost Variance (MCV) = (Std. Cost – Actual Cost)

Std. Cost – (SQ for Actual Output SP)
SQ for Actual Output will be computed as follows:
60
Copper   86  57.33
90
40
Zinc   86  38.22
90
Now, MCV for Copper =  57.33  30   50  30  ` 220 (Fav.)
MCV for =  38.22  20   50  20  ` 236 (Adv.)
= `16 (A|dv.)
This is explained by
(i) Material Price Variance = Nil
(ii) Material Mix Variance = (SQ-AQ)SP
Copper =  60  50  30 = `300 (Fav.)
Zinc =  40  50  20 = `200 (Fav.)
= `100 (Fav.)
(iii) Material Yield Variance = (AY -SY)SC per unit
 86  90  28.89*
= `116 (Adv.)
2600
*SC   `28.89
90
Verification
MCV = MPV + MMV + MYV
`16 (Adv.) = Nil + `100 (Fav.) + `116(Adv.)
`16 (Adv.) = `16(Adv.)
Note: Since SPO and AP are the same and Standard Total Quantity and actual Total Quantity are
the same, there will be no Material Price variance and Material Usage Variance.
Illustration 4.3
The standard material cost for a normal mix of one tonne of chemical Z is based on:
Chemical Usage (Kg) Price Per Kg. (`)
A 240 6
B 400 12
C 640 10
During a month, 12.5 tonnes of Z were produced from:
Chemical Consumption (Tonnes) Cost (`)
A 3.2 22,400
B 4.8 60,000
C 9.0 94,500

Analyse the Variances:

Solution:
(i) SQ for Actual output:
A = 24012.5 = 3,000 Kg
B = 400  12.5 = 5,000 Kg
C = 640  12.5 = 8,000 Kg
Total SQ = 16,000Kg
(ii) Total AQ = 3.200 + 4,800 + 9,000 = 17,000 Kg.
(iii) RSQ
3, 000
A  17, 000  3,187.5 Kg.
16, 000
5, 000
B  17, 000  5, 312.5 Kg.
16, 000
8, 000
C  17, 000  8, 500 Kg.
16, 000
Computation of Material Cost Variances
Material SQ for SP(`) SQ + AQ AP(`) AQ RSQ RSQSP(`)
AQ SP(`) AP(`)
A 3,000 6 18,000 3,200 7.0 22,400 3,187.5 19,125
B 5,000 12 60,000 4,800 12.5 60,000 5,312.5 63,750
C 8,000 10 80,000 9,000 10.5 94,500 8,500.00 85,000
16,000 17,000
Loss 3,500 4,500

12,500 1,58,000 12,500 1,76,900 1,67,875

(1) Material Cost Variance (MCV) = (SQ SP) – (AQAP)

= `1,58,000 – `1,76,000
= `18,000 (A)
(2) Material Price Variance (MPV) = AQ (SP – AP)
A = 3,200(6-7) = `3,200 (A)
B = 4,800 (12–12.5) = `2,400 (A)
C = 9,000 (10–10.5) = `4,500(A)
MPV = `10,100(A)
(3) Material Usage Variance (MUV) = SP (SQ- AQ)
A = 6 (3,000 – 3,200) = `1,200 (A)
B = 12 (5,000–4,800) = `2,400(F)
C = 10 (8,000 – 9,000) = `10,000(A)
MUV = 8,800(A)
(4) Material Mix Variance (MMV) = SP (RSQ-AQ)
A = 6(3,187.5 – 3,200) = `75(A)
B = 12(5,312.5 – 4,800) = `6,150 (A)
C = 10(8,500 – 9,000) = 5,000 (A)
MMV = `1,075(F)
(5) Material Yield Variance (MYV)
MYV = (Actual Yield – Std. Yield) SC per unit
Actual Yield = 12,500
Standard Yield = (12,500/16,000)17,000 = 13,281
Standard Cost = 1,58,000/12,500 = 12.64
MYV = (12,500 – 13.281)  12.64 = `9,875 (A)
Alternatively, MYV = SP(SQ – RSQ)
MYV = (SQSP) – (RSQSP)
= (1,58,000 – 1,67,875)
= `9,875 (A)
Verification:
1. MCV = MPV + MUV
18,900 (A) = 10,100(A) + 8,800 (A)
18,900(A) = 18,900 (A)
2. MUV = MMV + MYV
8,800(A) = 1,075(F) + 9,875 (A)
8,800 (A) = 8,800 (A)
Labour Variances
These may be two main reasons of the occurrence of deviations in cost of direct labour:
(i) Difference in actual rates and standard rates of labour and
(ii) The variation in the actual time taken by the workers and standard time allowed to them for
performing a job or an operation.
The various labour variances may be arranged as follows:

(1) Labour Cost Variance (LCV): It is the difference between the standard labour cost and
actual labour cost of the product.
LCV = (Standard Rate  Standard Time for Actual Output*)-(Actual Rate  Actual Time)
 Standard Time
*  Actual output
Standard Output
LCV  SR  ST    AR  AT 
Labour cost variance may be analysed further as (i) Labour rate variance, and (ii) Labour efficiency
variance.
(2) Labour Rate Variance (LRV): It is that portion of labour cost variance which is due to the
difference between the standard rate specified and the actual rate paid. It would occur due to the following
reasons:
(i) Employment of one or more workers of different grade than the standard grade,
(ii) Excessive overtime,
(iii) Overtime work in excess of that provided in the standard,
(iv) New workers not being allowed full wage rates, etc. The formula for calculating LRV is as
under: Labour Rate Variance (LRV) = Actual Time x {Standard Rate - Actual Rate)
or LRV=AT  SR-AR 
(3) Total Labour Time/Efficiency Variance (TLEV): It is that portion of labour cost
variance which arises due to the difference between the Standard Labour hours specified and
the actual labour hours spent. It may arise due to the following reasons:
(i) Wrong selection of workers,
(ii) Higher labour turnover,
(iii) Lack of supervision,
(iv) Poor working conditions,
(v) Defective machinery, tools and equipment,
(vi) Use of non-standardised materials,
(vii) Inefficiency of workers, etc.
TLEV = Standard Rate x {Standard Time for Actual Output* - Actual Time)
Standard Time
*  Actual output
Standard Output
TLEV = SR  (ST - AT) TLEV can be divided into three parts:
(i) Simple LEV = SR x (ST for Actual output - AT worked*)
* AT Allowed - Idle Time - Holiday Time
(ii) Idle Time Variance* = Idle Time x SR
Note: Idle time is always adverse,
(iii) Holiday/Calendar Variance - Holiday Time x SR
Note: Holiday/Calendar Variance is always adverse.
TLEV = SLEV + Idle Time Variance + Holiday Variance
Labour Idle Time Variance: It is that portion of labour efficiency variance which may arise due to
abnormal wastage of time on account of strikes, power out, non-availability of raw-material, breakdown
of machinery etc.
Idle Time Variance = Idle Time (Hours)  Standard Rate
(4) Labour Mix Variance (LMV): Where workers of two or more than two types are engaged in the
difference between the standard composition of workers and the actual gang (or group) of workers is
known as ‘Labour Mix Variance’. It is calculated as under:
LMV  Labour Mix Variance (LMV)= SR(RST-AT)
Standard Time
Revised Standard Time (RST) =  Total Actual Time
Total Standard Time
(5) Labour Yield Variance (LYV): It is that portion of labour efficiency variance which arises due to the
difference between actual output of worker and standard output of worker specified. It is calculated as
follows:
(LYV) = SC(Actual Yield – Revised Standard Yield*)
SC stands for standard cost of Labour per unit of standard output
SC is calculated as follows:
Standard Cost of Labour
SC 
Standard Output
*Revised Standard Yield = Standard Yield Actual mix of Labour before

Standard Mix of Labour Idle and Holiday Time
before Idle and Holiday Time
Illustration 4.4
From the following information, compute labour cost variance, labour efficiency variance and labour rate
variance.
Standard
Workers Hours Rate per hour (`) Total Amount (`)
A 10 3.00 30.00
B 15 4.00 60.00
Actual
A 20 3.00 60.00
B 5 4.50 22.50
Solution:
(a) Labour Cost Variance (LCV):
LCV = (STSR) – (ATAR)
Worker A = (10  3) – (20  3) = `30 (Adv.)
Worker B = (15  4) – (5  4.50) = `37.50 (Fav.)
= `7.50 (Fav.)
(b) Labour Efficiency Variance (LEV):
LEV = (ST - AT) SR
A = (10 - 20)  3 = `30 (Adv.)
B = (15 - 5)  4 = `40 (Fav.)
= `10 (Fav.)
(c) Labour Rate Variance (LRV)L
LRV = (SR – AR) AT
A = (3 - 3) 20 = 0
B = (4 – 4.50)  5 = `2.50 (Av.)
= `2.50 (Adv.)
Verification:
LRV = LEV + LRV
7.50 (Fav) = 10 (Fav.) + 2.50 (Adv.)
`7.50 (Fav.) = `7.50 (Fav.)
Illustration 4.5
Calculate Labour Variance from the following information:
Labour Rate = `1 per hour
Hours as Standard per unit = 12 Hours
Actual Date:
Units Produced = 1,000
Actual Labour Cost = `10,000
Hours Worked actually = 12,500 Hours
Solution:
Standard Time (ST) = 100012 = 12,000 Hours
Standard Cost = 12,0001 = `12,000
Labour Cost Variance (LCV) = (Standard Cost – Actual Cost)
= (12,000 – 10,000)
= `2,000 (Fav.)
Labour Rate Variance (LRV)= (SR – AR) AT
1.00  0.80   12, 500 = `2,500 (Fav)
10, 000
Actual Rate= = `0.80 per hour
12, 500
Labour Efficiency Variance (LEV): (ST – AT) AT
LEV = (12,000 – 12,500) 1
= `500 (Adv.)
Verification:
LCV = LRV + LEV
`2,000(Fav.) = `2,500 (Fav.) + `500 (adv.)
`2,000 (Fav.) = `2,000(Fav.)
Illustration 4.6
From the following information, calculate labour variance
Standard wages:
Grade X : 90 Labourers at `2 per hour
Grade Y: 60 Labourers at `3 per hour
Actual Wages:
X: 80 Labourers at `2.50 per hour
Y: 70 Labourers at `2.00 per hour
Budgeted Hours = 1,000
Actual Hours = 900
Budgeted Gross Production = 5,000 units
Standard Loss = 20%
Actual loss = 900 units
Solution:
Standard Actual
Grade Time (Hours) Rate (`) Amount(`) Time (Hours) Rate (`) Amount (`)
(80900)
X(901000) 90,000 2 1,80,000 72,000 2.50 1,80,000
Y(601,000) 60,000 3 1,80,000 63,000 2.00 1,26,000
(70900)
1,50,000 3,60,000 1,35,000 3,06,000

(i) Labour Cost Variance (LCV):

Standard Cost for actual production – actual Cost
Here actual production = 5,000 – 900 =4,100 units
So, Standard cost for actual Production:
3, 60, 000
 4,100  `3,69,000
4, 000
Standard Production (SP) = 5,000- 1,000 = 4,000 units
LCV = `3,69,000 - `3,06,000
= `63,000 (Fav.)
(ii) Labour Rate Variance (LRV): AT (SR – AR)
Grade X = 72,000 (2 – 2.50) = `36,000 (Adv.)
Grade Y = 63,000 (3 – 2.00) = `63,000 (Fav.)
= 27,000(Fav.)
(iii) Labour Efficiency Variance (LEV):
SR (ST for actual Output – Actual Time)
90, 000
ST for Grade X=  4,100  92, 250 hrs
4, 000
60, 000
ST for Grade Y =  4,100  61,500 hrs
4, 000
LEV:
Grade X = 2(92,250 – 72.000) = `40,500 (Fav.)
Grade Y = 3(61,500 – 63,000) = `4,500 (Adv.)
= 36,000 (Fav.)
Labour efficiency Variance can be further analysed as follows:
(iv) Labour Mix Variance (LMV): SR (RST – Actual Time)
Standard Time
RST =  Total Actual Time
Total Standard Time
90, 000
Grade X =  1, 35, 000  81, 000 hrs
1, 50, 000
60, 000
Grade Y =  1, 35, 000  54, 000 hrs
1, 50, 000
LMV:
Grade X = 2(81,000 – 72,000) = `18,000 (Fav.)
Grade Y = 3(54,000 – 63,000) = `27,000 (Adv.)
= `9,000 (Adv.)
(v) Revised Efficiency Variance (REV):
SR (ST for actual Output – RST)
Grade X = 2(92,250- 81,000) = `22,500 (Fav.)
Grade Y = 3(61,500 – 54,000) = `22,500 (Fav.)
= `45,000 (Fav.)
Verification:
1. LEV = LMV + REV
`36,000 (Fav.) = `9,000 (Adv.) + `45,000(Fav.)
`36,000 (Fav.) = `36,000 (Fav.)
2. LCV = LRV + LEV
`63,000 (Fav.) = `27,000 (Fav.) + `36,000 (Fav.)
`63,000 (Fav.) = `63,000 (fav.)
Note: Revised Efficiency Variance (REV) is equal to Labour Yield variance:
Labour Yield Variance = Standard Cost per unit  (Standard Output for Actual Mix – Actual Output)
3, 60, 000
Here, Standard Cost per unit =  `90
4, 000
standard Output
Standard Output for Actual Mix =  Acutal Mix
Standard Mix
4, 000
  1, 35, 000  3, 600
1, 50, 000
Labour Yield Variance = 90 (4,100 – 3,600) = `45,000 (Fav.)
Overhead Variances
Overhead variance is the difference between the standard overhead specified and actual overhead
incurred.
Overhead variance is divided into:
(A) Variable Overhead variance.
(B) Fixed Overhead Variance
(A) Variable Overhead Variance
Variable cost varies in proportion to the level of output, while cost is fixed per unit. As such the
standard cost per unit of these overheads remains the same irrespective of the level of output attend.
(1) Variable Overhead Cost Variances. The variable overhead cost variance represents the
difference between the standard cost of variable overhead for actual output and the actual
variable overhead incurred during the period.
Variable Overhead Cost Variance
= (Actual Output  St. Variable Overhead Rate per unit) - Actual Variable Overhead Cost
Or
= (St. Hours for Actual Output  St. Variable Overhead Rate per Hour)
Actual Variable Overhead Cost
(2) Variable Overhead Expenditure Variance. It is the difference between the actual
variable overhead rate per hour and standard variable overhead rate per hour multiplied
by the actual hours worked. It is also known as 'Budget Variance'.
Variable Overhead Expenditure Variance
= (St. Variable Overhead Rate x Actual Hours) - Actual Variable Overheads
Or
= Recovered Variable Overheads - Actual Variable Overheads
(3) Variable Overhead Efficiency Variance. The variable overhead efficiency variance is
calculated by taking the difference in standard output and actual output multiplied by the
standard variable overhead rate.
Variable Overhead Efficiency Variable = St.Variable Overhead Rate  (St. Quantity  Actual
Quantity) Or
= SVOR  (SHAO  AH)
Where SVOR = Standard Variable Overhead Rate per hour; SHAO = Standard Hours for
Actual Output;
AH = Actual Hours. Confirmation:
Variable Overhead Variance = V.O. Expenditure Variance + V.O. Efficiency Variance
Illustration 4.7
From the following information, calculate: (a) Variable Overhead Variance, (b) Variable Overhead
Expenditure Variance, and (c) Variable Overhead Efficiency Variance.
1. Standard hours per unit: 3; Variable Overhead per hour: `5
2. Actual Variable Overhead incurred: ` 4,20,000
3. Actual Output: 30,000 units
4. Actual Hours worked: 1,00,000 hours.
Solution:
(a) Variable Overhead Variance = Standard Variable Overhead - Actual Variable Overhead
= (3  ` 5  30,000 units) `4,20,000
= `4,50,000  ` 4,20,000 = ` 30,000 (F)
(b) Variable Overhead Expenditure Variance
= Standard Variable Overhead for Actual Time - Actual Variable Overhead = (Standard
Overhead Rate  Actual Hours) - A.V.O.
= (` 5  1,00,000 hours) - `4,20,000
= ` 5,00,000  ` 4,20,000 = `80,000 (F)
(c) Variable Overhead Efficiency Variance = Standard Variable Overhead on Actual Production
 Standard Variable Overhead for Actual Time
= (3  `5 30,000units)-( `51,00,000 hours)
= ` 4,50,000-`5,00,000 = ` 50,000 (A)
Confirmation:
Variable Overhead Variance = V.O. Expenditure Variance + V.O. Efficiency Variance.
` 30,000 (F) = ` 80,000 (F) + ` 50,000 (A)
` 30,000 (F) = ` 30,000 (F).
(B) Fixed Overhead Variance
Fixed overhead variance reveals all items of expenditure which are more or less remain constant
irrespective of level of output or number of hours worked. Fixed overhead variance depends upon
two factors, which are: (i) fixed expenses incurred and (ii) volume of production obtained.
The volume of production depends upon (a) capacity at which the factory works, (b) number of
days factory works, and (c) efficiency at which factory works.

Classification of Fixed Overhead Variances

(1) Fixed Overhead Cost Variance. It shows the difference between the standard cost of
fixed overheads recovered for actual output and actual cost of fixed overheads incurred.
Fixed Overhead Cost Variance = Standard Fixed Overheads - Actual Fixed Overheads
Or
= (Actual Output x Standard Fixed Overhead Rate)  Actual Fixed Overheads Fixed Overhead
Cost Variance may be classified as:
(a) Fixed Overhead Expenditure Variance;
(b) Fixed Overhead Volume Variance.
(2) Fixed Overhead Expenditure Variance. It is that part of fixed overhead cost variance
which arises due to the difference between budgeted fixed overhead expenditure and the
actual fixed overhead expenditure relating to a specified period.
Fixed Overhead Expenditure Variance = Budgeted Fixed Overheads - Actual Fixed Overheads
Or

= (Standard Overhead Rate x Budgeted Output) - Actual Overhead Rate x Actual Output)

(3) Fixed Overhead Volume Variance. This variance reveals the difference between fixed overhead
recovered on actual output and fixed overheads on budgeted output. It is the result of difference in
volume of production multiplied by the standard rate. Fixed Overhead Volume Variance =
Recovered Fixed Overheads - Budgeted Fixed Overheads
Or
 = (Actual Output x Standard Overhead Rate) - (Budgeted Output x Standard Overhead Rate) Fixed
overhead volume variance can further be analysed as (a) Fixed Overhead Efficiency Variance, (b)
Fixed Overhead Capacity Variance and (c) Fixed Overhead Calendar Variance
3 (a) Fixed Overhead Efficiency Variance. It is that part of fixed overhead volume variance which is
due to the difference between the budgeted efficiency of production and the actual efficiency
attained. The actual quantity produced and standard quantity fixed might be different because of
higher or lower efficiency of workers employed in manufacturing of goods. Fixed Overhead
Efficiency Variance = Recovered Fixed Overheads - Standard Overheads
Or
= Standard Overhead Rate (Actual Quantity - Standard Quantity)
3 (b) Fixed Overhead Capacity Variance. The variance which is related to the over or under
utilisation of plant capacity is known as fixed overhead capacity variance. Strikes, lock-out, idle
time, etc., lead to under-utilisation and overtime, extra shift, etc., lead to over-utilisation. Fixed
Overhead Capacity Variance = Standard Overhead Rate per unit (Revised Budgeted Output -
Budgeted Output)
Or
Hours = Standard Rate per hour (Revised Budgeted Hours - Budgeted Hours) Whereas, Revised
Budgeted Nos. = Actual Working days x Budgeted Hrs. per Day.
3 (c) Fixed Overhead Calendar Variance. It is that part of volume variance which arises due to the
difference between the number of working days anticipated in the budget period and the actual
working days in the budget period. The number of working days in the budget are arrived at by
dividing the number of annual days by twelve. But the actual days of a month may be more or less
than the standard days and with the result there may be calendar variance. Fixed Overhead
Calendar Variance = possible Fixed Overheads - Budgeted Fixed Overheads
Or
= (Standard Rate of Overhead per hour x Possible Hours)
(Standard Overhead Rate per hour x Budgeted Hours)
Possible Hours = Standard Working hours per day x Actual Number of Working days.
Or Fixed Overhead Calendar Revised Variance = (Standard Rate per hour/day)  (Excess or
Deficit Hours/Days Worked)
Fixed Overhead Capacity Revised Variance = Standard Overhead - Possible Overhead

Illustration 4.8
From the following data calculate Fixed Overhead Variances
Budgeted Actual
Output 20,000 units 18,000 units
Number of Working Days 25 28
Fixed Overheads `40,000 `41,000
There was an increase of 10% in capacity
Solution:
Standard Fixed Overheads
Standard Overhead Rate =
Standard Output
40,000
=  `2.00
20,000 Units
(a) Fixed Overhead Cost Variance
= Standard Fixed Overheads - Actual Fixed Overheads
= (Actual Output x Standard Fixed Overhead Rate)
- Actual Fixed Overheads
FOCV = (18,000 units  ` 2.00)  ` 41,000 = ` 36,000  ` 41,000
 = ` 5,000 (A)
(b) Fixed Overhead Expenditure Variance
= Budgeted Fixed Overheads - Actual Fixed Overheads
FOEV = ` 40,000  ` 41,000 = `1,000 (A)
(c) Fixed Overhead Volume Variance
= Recovered Fixed Overheads - Budgeted Fixed Overheads
= (Actual Output x Standard Overhead Rate)
- (Budget Output x Standard Overhead Rate)
= (18,000 units  ` 2.00) (20,000 units x `2.00)
FOW = ` 36,000  ` 40,000 = ` 4,000 (A)
(d) Fixed Overhead Efficiency Variance
= Standard Overhead Rate (Actual Quantity - Standard Quantity)
Standard Quantity (without increase) = Budgeted Quantity
=20,000 units
Increase in Capacity @ 10% = 2,000 units
 Standard Production = 22,000 units
(+) Standard Production for 3 days
 22, 000units 
i.e.,  28  25 days   3 days   2640 units
 25days 
Thus, Standard Quantity after Increase of Capacity = 24.640 units
. F.O.E.F.V = `3.00 (18,000 units  24,640 units) =` 13,280 (A)
(e) Fixed Overhead Capacity Variance
= Standard Overhead Rate (Standard Output for Actual Time  Budgeted Output)
= Standard Overhead Rate (Revised Budgeted units  Budgeted units)
10
= `2.00 [(20,000 + 20,000  ) = 20,000 units]
100
 F.O.C.V = `2.00 (22.000 units - 20,000 units) = ` 4,000
(F)
(f) Fixed Overhead Calendar Variance
= Increase or Decrease in production due to more or less working days
 Standard Overhead Rate per unit with the increase in capacity
 F.O.C.V = 2,640 units  ` 2 = ` 5,280 (F)
Confirmation:
Fixed Overhead Cost Variance = F.O. Expenditure Variance + F.O. Volume Variance
` 5,000 (A) = `1,000 (A) + ` 4,000 (A)
` 5,000 (A) = ` 5.000 (A)
Fixed Overhead Volume Variance
= F.O. Efficiency Variance + F.O. Capacity Variance +F.O. Calendar Variance
`4,000 (A) = `13,280(A) + ` 4,000 (F) + ` 5,280 (F)
` 4,000(A) = ` 13,280 (A) + `9,280 (F)
` 4,000 (A) = ` 4,000(A)

Illustration 4.9
Ankita Ltd. has furnished you the following data:
Budgeted Actual (July, 2014)
Number of Working Days 25 27
Production ( in units) 20,000 22,000
Fixed Overheads (in `) 30,000 31,000
Budgeted Fixed Overhead Rate is `1.00 per hour. In July, 2014, the actual hours worked were 31,500.
Calculate the following variances: (i) Efficiency Variance; (ii) capacity Variance; (iii) Calendar Variance;
(iv) Volume Variance; (v) Expenditure variance; (vi)Total Overheads Variance.
Solution:
Working Notes:
St. Hrs. for Actual Output =  22, 000  30, 000  = 33,000 hrs
 20, 000 
Budgeted Overheads = `30,000
Budgeted Overhead Rate per hour = `1.00
30, 000
Budgeted Hours =  30,000
1.00
Budgeted Output = 20,000 units
30, 000
St. Time per unit of Output =  1.5 hrs
20, 000
1.5Hours
St. Rate per unit of Output =  `1.50
1.0
Budgeted Days = 25
30, 000
Budgeted Hrs. Worked per day = =1200 Hrs
25
Calculation of First Overhead Variances:
(1) Efficiency Variance = St. Rate per hour (St. Hours – Actual Hours)
EV = `1.00 (33,000- 31,500) = `1,500 (F)
(2) Capacity Variance = St. Rate per hour (Actual Hours – Revised Budgeted Hours)
CV = `1.00 (31,500  27 1.200)= `900 (A)
Budgeted Overheads
(3) Calendar Variance =  (actual No. of Working Days
Budgeted Working Days
- Budgeted No. of Working Days)
30, 000
 CIV   27  25   `2,400 (F)
25
(4) Volume variance = Standard Rate per unit (Actual Output Budgeted Output)
VV = `1.50 (22,000 – 20,000) = `3,000
(5) Expenditure Variance = Budgeted Overheads Actual Overheads
Exp. V = ` 30,000 - `31,000 = ` 1,000 (A)
(6) Total Overhead Variance = (Actual Output x Standard Rate per unit) Actual Overheads
= (22,000 units x `1.50}` 31,000
TOV = `33,000  `31,000 - ` 2,000 (F)
Confirmation:
Total Overhead Variance = Expenditure Variance + Volume Variance
`2,000 (F) = `1,000 (A) + ` 3,000 (F)
`2,000 (F) = `2,000 (F)
Volume Variance = Efficiency Variance + Capacity Variance + Calendar Variance
`3,000 (F) - `1,500 (F) + ` 900 (A) + `2,400 (F)
`3,000 (F) = ` 3,000 (F)
Illustration 4.10
The following information is available from the cost records of a company for January, 2014:
(`)
Materials Purchased: 20,000 pieces 88,000
Materials Consumed: 19,000 pieces
 Actual Wages Paid: 4,950 Hours 24,750
Factory Overheads Incurred 44,000
Factory Overheads Budgeted 40,000
Units Produced: 1,800
Standard Rates and Prices are:
Direct Material Rate `4 per piece
Standard Input 10 pieces per unit
Direct Labour Rate `4 per hour
Standard Requirement 2.5 hours per unit
Overhead `8 per labour hour
Required:
(a) Show the Standard Cost Card.
(b) Compute all Material, Labour and Overhead Variances for January, 2014.
Solution:
(a) Standard Cost Card

Per Unit m
Direct — 10 pieces @ ` 4 per piece 40
Material — 2.5 hrs @ `4 per hour 10
Direct — 2.5 hrs @ ` 8 per hour 20
Labour Total Standard Cost 70
Overheads
(b) Computation of Variances:
I. Material Variances
(1) Total Material Cost Variance = Standard Cost of Material for Actual Output
- Actual Material Cost
 19, 000 
 1, 800  10 pieces ` 4    ` 88, 000  
 20, 000 
TMCV = `72,000` 83,600 =` 11600 (A)
(2) Material Price variance = Actual Qty. (St. Price - Actual Price)
 ` 88, 000 
MPV = 19,000 pieces  ` 4  
 20, 000 
= 19,000 pieces (`4 – `4.40) = `7,600 (A)
(3) Material Usage Variance = St. Price (St. Qty. – A. Qty.)
MUV = `4.00 (18,000  19,000) = ` 4,000 (A)
Confirmation:
TMCV = MPV + MUV
` 11,600 (A) = ` 7,600 (A) + ` 4,000 (A)
` 11,600 (A) = ` 11,600 (A)
II. Labour Variances
(1) Total Labour Cost Variance — St. Cost of Labour for Actual Output
- Actual Labour Cost
= (` 1,800  2.5 hrs x ` 4)  ` 24,750
LTV = ` 18,000  ` 24,750 = ` 6,750 (A)
(2) Labour Rate Variance = Actual hrs. (St. Rate per hour - Actual Rate per hour)
 ` 24, 750 
= 4,950 hrs.  ` 4  
 4, 950 
= 4,950 hrs. (`4 - `5)
LRV = ` 4,950 (A)
(3) Labour Efficiency Variance = St. Rate per hour (St. hrs. - A. hrs.)
= ` 4 [(1800 x 2.5 hrs) - 4,950 hrs.]
=` 4 (4,500 hrs. - 4,950 hrs.)
LEV = ` 1,800 (A)
Confirmation:
TLCV = LRV + LEV
`6,750 (A) = `4,950 (A) + `1,800 (A)
`6,750 (A) = `6,750 (A)
III. Fixed Overhead Variances
(1) Total fixed Overhead Cost variance = Overhead Recovered on Actual Output
- Actual Factory Overheads
= (1,800 units 2.5 hrs 8) – 44,000
 TFOC = ` 36,000 - `44,000 = ` 8,000 (A)
(2) Fixed Overhead Expenditure Variance
- Budgeted Fixed Overheads - Actual Fixed Overheads
 F.O. Exp. V. = ` 40,000 - ` 44,000 = `4,000 (A)
(3) Fixed Overhead Efficiency Variance = St. F.O. Rate per hour
(St. hrs, for Actual Output - Actual hrs.)
= ` 8 [(2.5 hrs.1,800)4,950 hrs.]
F.O. Eff. V. = ` 8 (4,500 hrs. 4,950 hrs.)
= ` 3,600 (A)
(4) Fixed Overhead Capacity Variance = St. F.O. Rate per hour (Actual Capacity hrs.
- Budgeted Capacity hrs.)
 Rs. 40, 000 
 Rs.8  4, 950hr  
 8 

= ` 8(4,950 hrs.  5,000 hrs.)

F.O.C.V = ` 400 (A)

Confirmation:

TFOCV = F.O. Exp. V. + F.O. Capacity V

` 8,000 = ` 4,000 (A) + ` 3,600 (A) + ` 400 (A)
`8.000(A) = ` 8,000 (A)
4.3.1 Evaluation of cost and sales variances
Sales Variances
Some companies are interested in calculating only cost variances relating to materials, labour and
overheads. These variances are of great significance to the business enterprises. But in order to obtain the
full advantages of standard costing system, many companies also calculate safe variances. Sales variances
affect a business in terms of changes in revenue.
Sales variances can be calculated by two methods:
(A) The Value or the Turnover Method, (B) The Profit or the Margin Method.
• (A) The Value or the Turnover Method
Under this method, variances are calculated with reference to their effect on sales or sales value.
 Classification of Sales Variances Based on Turnover

(1) Sales Value Variance (SVV): It shows the difference between the actual sales and the
budgeted sales. If the actual sales exceed the budgeted sales the variance is treated as
favourable and vice-versa.
Sales Value Variance (SVV) = Actual Value of Sales - Budgeted Value of Sales
or
SVV - (Actual Quantity  Actual Selling Price) 
(St. Quantity  St. Selling Price)
(2) Sales Price Variance (SPV): It is the that part of Sales Value Variance which arises due
to the difference between actual price and standard price of sales. If the actual price
attained is more than the standard price, the variance shall be favourable and vice-versa.
Sales Price Variance {SPV) = Actual Quantity (Actual Selling Price - St. Selling Price)
(3) Sales Volume Variance (S.Vlm. V): It is that part of Sales Value Variance which arises
due to the difference between the actual quantity sold and the standard quantity of sales.
Sales Volume Variance (S. Vim. V) = St. Selling Price (Actual Quantity of Sales
St. Quantity of Sales)
Sales Volume Variance can be further divided into:
3 (a) Sales Mix Variance (SMV): It is that part of Sales Volume Variance which arises due to the
difference between standard and actual composition of the sales mix. This variance arises only
when the business firm deals in more than one product. Sales Mix Variance (SMV) = St.
Value of Actual Mix - St. Value of Revised St. Mix
or
SMV = St. Selling Price (Actual Qty. - Revised St. Qty.)
3 (b) Sales Quantity Variance (SQV): It is that part of Sales Volume Variance which is due to the
difference between standard value of a actual sales at standard mix and the budgeted sales.
Sales Quantity Variance (SQV) = Revised Standard Sales Value - Budgeted Sales Value
or SQV — Standard Selling Price per unit (Standard Proportion for
Actual Sales Quantity - Budgeted Quantity of Sales)
or SQV — St. Selling Price per unit (Revised St. Mix - St. Mix)
Illustration 4.11

The budgeted sales for one month and the actual results achieved are as under :

Product Budget Actual

Quantity Rate (`) Amount (`) Quantity Rate (`) Amount (`)
(units) (units)
M 1,000 10.00 10,000 1,200 (`)
12.50 15,000
N 700 20.00 14,000 800 15.00 12,000
O 500 30.00 15,000 600 30.00 18,000
P 300 50.00 15,000 400 60.00 24,000
Total 2,500 54,000 69,000
You are required to calculate in respect of each product, the Sales Variances.

Solution:
(1) Sales Value Variance = Actual Value of Sales - Budgeted Value of Sales
 SVV = ` 69,000  ` 54,000 = ` 15,000 (F)
(2) Sales Price Variance = Actual Qty. (Actual Selling Price - St. Selling Price)
M = 1200 (` 12.50  ` 10.00) = ` 3,000 (F)
N = 800 (` 15.00  ` 20.00) = ` 4,000 (A)
O = 600 (` 30.00  ` 30.00) = Nil
P = 400 (` 60.00 ` 50.00) = ` 4000 (F)
 Total Sales Price Variance = ` 3.000 (F)
(3) Sales Volume Variance = St. Selling Price (Actual Qty. - St. Qty.)
M = ` 10.00 (1200 - 1000) = ` 2,000 (F)
N = ` 20.00 (800 - 700) = ` 2,000 (F)
O = ` 30.00 (600 - 500) = ` 3,000 (F)
P = ` 50.00 (400 - 300) = ` 5,000 (F)
 Total Sales Volume Variance = ` 12.000 (F)
3 (a) Sales Mix Variance = (St. Value of Actual Mix - St. Value of Revised St. Mix)
or SMV = St. Selling Price (Actual Qty.  Revised St. Qty.)

Total Actual Mix of Sales

Whereas, Revised St. Qty. =  St.Qty.
Total St. Mix of Sales
3, 000
Revised St. Qty. for product M =  1000 = 1,200 units
2, 500
3, 000
Revised St. Qty. for product N =  700  840 units
2,500
3, 000
Revised St. Qty. for product O =  500  600 units
2,500
3, 000
Revised St. Qty. for product P =  300 = 360 units
2,500
Sales Quantity Variance M = ` 10.00 (12001200) = Nil
N = ` 20.00 (800  840) = ` 800 (A)
O = ` 30.00 (600  600) = Nil
 P = ` 50.00 (400  360) = ` 2,000 (F)
Total Sales Mix Variance = ` 1,200 (F)
3 (b) Sales Quantity Variance - St. Selling Price (Revised St. Qty. - St. Qty.
M = ` 10.00 (1200  1000) = ` 2,000 (F)
N = ` 20.00 (840700) = ` 2,800 (F)
O = ` 30.00 (600 500) = ` 3.000 (F)
P = ` 50.00 (360 300) = ` 3,000 (F)

 Total Sales Quantity Variance = ` 10.800 (F)

Confirmation:

Sales Value Variance = Sales Price Variance + Sales Volume Variance

` 15,000 (F) = ` 3,000 (F) + ` 12.000 (F)

`15,000 (F) = `15,000 (F)

Sales Volume Variance = Sales Mix Variance + Sales Quantity Variance

` 12,000 (F) = ` 1200 (F) + ` 10,800 (F)

` 12,000(F) = ` 12,000(F)

• (B) The Profit or Margin Method

The sales variances based on profit are also known as Sales Margin Variances which indicates the
deviation or difference between actual profit and standard or budgeted profit.

(1) Total Sales Margin Variance: This sales variance reveals the difference between
actual profit and standard or budgeted profit.
Total Sales Margin Variance = Actual Profit - Budgeted Profit
or = (Actual Qty. of Sales  Actual Profit per unit)
- (Budgeted Qty. of Sales Budgeted Profit per unit)
(2) Sales Price Variance: It is that part of Total Sales Margin Variance per unit which
shows the difference between the standard price of the quantity of sales effected and the
actual price of those sales.
Sales Price Variance = Actual Qty. of Sales (Actual Profit per unit - Budgeted Profit per unit)
or = (Actual Qty. of Sales  St. Price) - (Actual Qty. of Sales  Actual Price)
(3) Sales Volume Variance: It shows the difference between the actual units sold and the
budgeted quantity multiplied by either the standard profit per unit or the standard
contribution per unit.
Note: In Absorption Costing, standard profit per unit is used, but in Marginal Costing, standard
contribution per unit must be used,
Sales Volume Variance = St. Profit per unit (Actual Qty. of Sales - St. Qty. of Sales)
or = (St. Profit on Actual Qty. of Sales) - (St. Profit on St. Qty. of Sales)
Sales Volume Variance can be further divided into:
3 (a) Sales Mix Variance: This variance arises only when the firm manufactures and sells more
than one type of product. This variance will be due to variation of actual mix and budgeted
mix of sales.
Sales Mix Variance - St. Profit per unit (Actual Qty. of Sales - Revised St. Qty. of Sales)
or = Standard Profit - Revised Standard Profit
3 (b) Sales Quantity Variance: It is that part of Sales Volume Variance which arises due to the
difference between the standard profit and revised standard profit. Sales Quantity
Variance = St. Profit per unit (St. Proportion for Actual Sales - Budgeted Qty. of
Sales)
or = Revised St. Profit - Budgeted Profit
or = Budgeted Margin per unit on budgeted Mix  (Total Actual Qty. - Total
Budgeted Qty.)
Illustration 4.12
Rama Ltd. is manufacturing and selling three products X, Y and Z. The company has a
standard costing system and analysis the variances between the budget and the actuals periodically.
The summarised working results for 2013-14 were as follows:
Product Budget Actual
Selling Price Cost per unit No. of Units Selling Price Cost per unit No. of Units
p. u.(`) (`) Sold p. u.(`) (`) Sold

X 50.00 16.00 20,000 48.00 15.00 24,000

Y 40.00 12.00 28,000 42.00 12.50 24,000
Z 30.00 9.00 32,000 31.00 10.00 30,000

(a) Calculate variances in profit during the period.

(b). Analyse the variance in profit into: (1) Sales Price Variance; (2) Sales Volume Variance; (3)
Total Sales Margin Variance; (4) Sales in Quantity Variance; and (5) Sales Margin Mix Variance.
Solution:
Working Notes:
1 (a). Actual Margin per unit = Actual Sales Price per unit - St. Cost per unit
X = ` (4816) = `32
Y = ` (4212) = `30
Z = ` {31  9} = ` 22
1 (b). Budgeted Margin per unit - Budgeted Selling Price per unit - St. Cost per unit
X = `(5016) = `34
Y = ` (40  12) =` 28
Z = ` (30  9) = ` 21
 2 (a). Actual Profit = Actual Quantity of Units Sold x Actual Margin per unit
X = 24,000 units  ` 32 = ` 7,68,000
Y = 24,000 units  ` 30 = ` 7,20,000
Z = 30.000 units  `22 = ` 6.60,000
Total = ` 21.48.000
2 (b). Budgeted Profit = Budgeted Quantity of Units Sold x Budgeted Profit per unit
X = 20,000 units  `34 =` 6,80,000
Y = 28.000 units  ` 28 = ` 7,84,000
Z = 32,000 units  `21 =` 6,72,000
Total = ` 21,36,000
3 (a). Budgeted Margin per unit on Actual Mix


 34  24, 000    28  24, 000    21 30, 000 
 24, 000  24, 000  30, 000  units

8,16, 000    6, 72, 000    6,30, 000 
78, 000 units
21,18, 000
 = `27.154
78, 000 units
3 (b). Budgeted Margin per unit on Budgeted Mix


 34  20, 000    28  28, 000    21 32, 000 
 20, 000  28, 000  32, 000  units

 6,80, 000    7,84, 000   6, 72, 000
80, 000 units
21,36, 000
 = `26.70
80, 000 units
Calculation of Sales Margin Variances:
(1) Sales Margin Price Variance = Actual Qty. {Actual Margin per unit
 Budgeted Margin per unit)
X = 24,000 units (` 32  ` 34) = ` 48,000 (A)
Y = 24.000 units (`30  ` 28) = ` 48,000 (F)
Z = 30,000 units (` 22  `21) = ` 30,000 (F)
Total Sales Margin Price Variance =` 30.000 (F)
(2) Sales Margin Volume Variance = Budgeted Margin per unit (Actual Qty. - Budgeted Qty.)
X = ` 34 {24,000 units  20,000 units =` 1.36,000 (F)
Y = ` 28 (24,000 units  28,000 units) = ` 1,12,000 (A)
Z = ` 21 {30,000 units  32,000 units) = ` 42,000 (A)
 Total Sales Margin Volume Variance =` 18,000 (A)
(3) Total Sales Margin Variance = Actual Profit - Budgeted Profit
= ` 21,48,000  ` 21,36,000 = `12,000 (F)
(4) Sales Margin Quantity Variance = Budgeted Margin per unit on Budgeted Mix
(Total Actual Qty.  Total Budgeted Qty.)
= ` 26,70 (78,000 units - 80,000 units)
Total Sales Margin Qty. Variance = ` 53,400 (A)
(5) Sales Margin Mix Variance = Total Actual Qty. (Budgeted Margin per unit on Actual Mix
 Budgeted Margin per unit on Budgeted Mix)
 = 78,000 units (` 27.154  ` 26.70)
 . Total Sales Margin Mix Variance = ` 35,412 or ` 35,400
Confirmation:
Total Sales Margin Variance = Sales Margin Price Variance + Sales Margin Volume Variance
` 12,000 (F) = ` 30,000 (F) + ` 18,000 (A)
` 12,000 (F) = ` 12,000 (F)
Sales Margin Volume Variance = Sales Margin Qty. Variance + Sales Margin Mix Variance
`18.000 (A) = ` 53.400 (A) + ` 35,400 (F)
`18,000 (A) = ` 18,000 (A)
• Disposition of Variances
When standard costs are used by a business enterprise only as a statistical data and are not entered
in the books of account, the disposition of variances is not needed since no adjustments are required for
variances in such a case. But when standard costs are incorporated into accounting system through
work-in-progress, finished goods and cost of goods sold accounts, the adjustment and disposition of
variances is required. There is no hard and fast rule regarding the disposition of variances nor there is any
single way of dealing with them. Hence, the method which will be adopted depends on the accountants
attitude and the practice that is followed by the business enterprise. However, the following methods may
be usually applied:
(1) Transfer to Costing Profit and Loss Account: According to this method, the
unfavourable variances are debited to Costing Profit and Loss Account whereas
favourable variances are credited to Costing Profit and Loss Account, at the end of
accounting period. Thus, work-in-progress, finished goods, and cost of goods sold
accounts are maintained at standard cost. This method has the significance of quick and
uniform valuation of stocks and shows the different variances separately to enable the
management to pay dual attention quickly and correctly.
(2) Allocation of Variances to Stocks and Cost of Sales: According to this method, cost
variances are allocated among finished goods, work-in-progress and cost of sales on the basis
of units or value. As a result, the stocks and cost of sales will appear in the books of actual
cost.
(3) Transfer of Variances to Reserve Account: The variances, whether favourable or
unfavourable are transferred to a Reserve Account to be carried forward to the next
accounting period as deferred 'debits' or 'credits'. If variances are favourable, they are
shown on liability side of Balance Sheet. On the other hand, if variances are
unfavourable, they are shown on asset side of Balance Sheet.
4.4 SUMMARY
 Variances may be classified into two categories, “Favourable and unfavourable, Controllable and
uncontrollable variances.
 Variance is the Difference between standard and Actual is known as variance.
 Favourable variance will be designated by (F) and Adverse variance by (A).
 Revision variance represents the difference between the original standard cost nad the revised
standard cost.
 Direct material mix variance is that portion of the material usage variance which is due to the
difference between standard and actual composition of materials.
4.5 KEY TERMS
 Actual production: is mean actual quantity produced during the actual hours worked.
 Standard Production: It means the quantity which have been produced during actual hours
worked.
 Budgeted cost: it means the budgeted quantity to be produced at the standard cost per unit.
 Standard cost: It means the actual quantity produced at the standard cost per unit.
 Material cost variance: Material cost variance is the difference between the standard cost of
materials specified for the actual output and actual cost of materials used.
  Material price variance: Material price variance is the portion of the material cost variance which
arises due to the difference between the standard price specified and actual price paid.
 Material usage variance: Material usage variance is the difference between the standard quantity
specified and the actual quantity used.
 Material mix variance: Material mix variance is that portion of material usage variance which is
due to the difference between the standard and actual composition of as mixture.
 Material yield variance: Material yield variance represents the portion of material usage variance
which is due to the difference between the standard yield specified and the actual yield obtained.
 Labour cost variance: it is the difference between the standard labour cost and actual labour cost
of the product.

4.6 SELF ASSESMENT QUESTIONS

1. What is standard costing? Explain its advantages and disadvantages.

2. What is standard costing? Explain the requisites of standard costing method.
3. Explain the procedure for determining standards.
4. Distinguish between the following:
5. Standard Cost and Estimated Cost, (b) Standard Costing and Budgetary Control.
6. What do you mean by variances? What are its different kinds and explain it?
7. What do you mean by 'Analysis of Variances'? Explain briefly the various types of
variances.
8. "Standard Costing is always accompanied by a system of budgeting, but budgetary
control may be operated in business where standard costing would be impracticable."
Comment.