MANAGEMENT

ACCOUNTING
Semester – VI

Student Workbook

Edition: 2018
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Edition: 2018

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 INDEX

Sl. No. Module Page No.

1 Syllabus 01-02

2 Books for Reference 03

3 Module - 1 04-24

4 Module - 2 25-54

5 Module - 3 55-75

6 Module - 4 76-103

7 Module - 5 104-124

8 Model Question Paper 125-129

 SYLLABUS
Subject: Management Accounting

Total Lecture Hours: 60 Credits: 04

Objective
To familiarize the students with various principles of Management Accounting and to
enable them acquire skills needed to understand, analyze, Interpret and present accounting
information to Management for decision-making.

Module I: Introduction to Management Accounting and Analysis and Interpretation

of Financial Statements 8 hours
Introduction, Meaning & Nature of Management Accounting, Scope, Objectives, Functions of
Management Accounting, Relationship between Financial Accounting, Management
Accounting & Cost Accounting, Tools & Techniques of Management Accounting, Limitations
of Management Accounting, Techniques of Financial Analysis, Comparative Financial
Statements - Comparative Balance Sheets - Comparative Income Statements - Common size
statements - Common size Balance Sheets - Common size Income statements - Trend
percentages

Module II: Ratio Analysis 12hour s

Introduction, Meaning of Ratio, Nature of Ratio analysis, Interpretation of the Ratios,
Guidelines for use of Ratios, Significance of Ratio analysis, Limitations of Ratio analysis,
Classification of Ratios, Calculation and interpretation of short term and long term financial
position ratios, Profitability ratios and capital structure leverage ratios. Activity & turn over
ratios, Preparation of financial statements using ratios, DuPont control chart

Module III: Cash Flow Analysis 11 hours

Introduction, Meaning of Cash Flow statement, Classification of Cash Flows, Uses and
significance of cash flow statement, Limitations of cash flow statement, Preparation of cash
flow statement in accordance with Accounting standard 3 (Revised) issued By ICAI (only
indirect method)

Module IV: Marginal Costing & Standard Costing 20 hours

Introduction, Meaning, Features of Marginal Costing , Advantages and Disadvantages,
Marginal Cost Equation, CVP Analysis and Break Even Analysis, PV Ratio and Marginal
Safety, Introduction & Meaning of Standard Costing, Standard Cost and Estimated Cost
Comparison, Advantages & Disadvantages of Standard Costing, Variance Analysis,
Favorable and Unfavorable Variances, Classification of Variances - Material Variance-
Labour Variance - Overhead Variance - Variable overhead Variance - Fixed overhead
Variance

1
Module V: Budgetary Control & Reporting 9 hours
Meaning, Objectives & Essentials of Budgeting, Advantages and Limitations of Budgetary
Control, Classification of Budgets, On the basis of Time - On the basis of Function - On the
basis of Flexibility, Cash Budget
Introduction, Meaning of Report, Reporting to different levels, Methods of Reporting, Kinds
of Reports, Principles of good Reporting System, Process of Report writing (Specimens)

2
 BOOKS FOR REFERENCE

Reference books
 Management Accounting- Shashi K Gupta; Kalyani Publishers; 2 edition (2015)
 Management Accounting- Khan & Jain; Mcgraw Higher Ed 7th Edn, 2017
 Management Accounting- M N Arora; Himalaya Publishing House

3
 Module – 1
Introduction to Management Accounting and Analysis and
Interpretation of Financial Statements

Structure:
1.1 Introduction
1.2 Meaning and Emergence of Management Accounting
1.3 Scope of Management Accounting
1.4 Objectives of Management Accounting
1.5 Functions of Management Accounting
1.6 Relationship of Management Accounting with Financial Accounting
1.7 Relationship between Cost and Management Accounting
1.8 Tools and Techniques used in Management Accounting
1.9 Limitations of Management Accounting
1.10 Meaning of Financial Analysis
1.11 Comparative Financial Statements
1.12 Comparative Income Statement
1.13 Common-size Financial Statements
1.14 Common-size Balance Sheet
1.15 Common-size Income Statement
1.16 Trend Analysis, Trend Percentage or Trend Ratio Analysis
1.17 Terminal Questions

Learning Objectives
 To learn how Management accounting as a discipline emerged.
 To understand the nature, scope, purpose and limitations of Management accounting.
 To learn how Management Accounting is different from Financial Accounting and cost
Accounting.
 To know the convention established in Management Accounting.
 To learn the tools of Management Accounting.

1.1 Introduction:

The term “management accounting” is the modern concept of accounts as a tool of

management. It is broad term and is concerned with all such accounting information that is
useful to the management. In simple words, the term management accounting is applied to
the provision of accounting information for management activities such as planning,
controlling, decision making, etc.

1.2 Meaning and Emergence of Management Accounting:

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

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
4
policy, control of execution and appreciation of effectiveness. It is that system of accounting
which helps management in carrying out its functions more efficiently.

Definitions of Management Accounting

“Management Accounting is the presentation of accounting information in such a ways as
to assist management in the creation of policy and the day-to-day operation of an
undertaking.” – Anglo-American Council on Productivity

Nature of Management Accounting:

1. Providing Accounting Information: Management accounting involves the presentation
of information in such a way to suit the managerial needs. The accounting data is used for
reviewing various policy decisions.
2. Cause and Effect Analysis: The ‘cause and effect’ relationship is discussed in
management accounting. If there is loss, the reasons for the loss are probed. If there is a
profit, the factors directly influencing the profitability are also studied.
3. Use of Special Techniques and Concepts: Management accounting uses special
techniques and concepts to make accounting data more useful. The techniques usually used
include financial planning and analysis, standard costing, budgetary control, marginal
costing, project appraisal, control accounting, etc.
4. Taking Important Decisions: Management accounting helps in taking various
important decisions. It supplies necessary information to the management which may base
its decisions on it.
5. Achieving of Objectives: In management accounting, the accounting information is used
in such a way that it helps in achieving organizational objectives.
6. No Fixed Norms Followed: No specific rules are followed in management accounting.
Though the tools of management accounting are the same, but their use differs from
concern to concern.

1.3 Scope of Management Accounting:

1. Financial Accounting: Financial accounting deals with the historical data. The recorded
facts about an organization are useful for planning the future course of action. So
management accounting is closely related to financial accounting.
2. Cost Accounting: Cost Accounting uses financial data for finding out cost of various jobs,
products or processes. The system of standards costing, marginal costing, differential
costing and opportunity costing are all helpful to the management for planning various
business activities.
3. Financial management: Financial management is concerned with the planning and
controlling of the financial resources of the firm. Although, financial management has
emerged as a separate subject, management accounting includes and extends to the
operation of financial management also.
4. Budgeting and Forecasting: Budgeting means expressing the plans, policies and goals
of the enterprises for a definite period in future. Forecasting, on the other hand, is a
prediction of what will happen as a result of a given set of circumstances. Both budgeting
and forecasting are useful for management accountant in planning various activities.
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5. Inventory Control: Inventory is used to denote stock of raw materials, goods in the
process of manufacture and finished products. Management accountant will guide
management as to when and from where to purchase and how much to purchase. So the
study of inventory control will be helpful for taking managerial decisions.
6. Reporting to Management: one of the functions of management accountant is to keep
the management informed of various activities of the concern so as to assist it in
controlling the enterprise. The management accountant sends interim reports to the
management and these reports may be monthly, quarterly, half-yearly. The reports may
cover profits and loss statements, cash and fund flow statements etc.

1.4 Objectives of Management Accounting:

1. Planning and Policy Formulation: The object of management accounting is to supply

necessary data to the management for formulation plans. Management accountant
prepares statements of past results and gives estimations for the future. The figures
supplied and opinion given by the management accountant help management in planning
and policy formation.
2. Helpful in Controlling Performance: Management accounting devices like standard
costing and budgeting control is helpful in controlling performance. The management is
able to control performance of each and every individual with the help of management
accounting devices.
3. Helpful in Organizing: Management accounting is connected with the establishment of
cost centers, preparation of budgets, preparation of cost control accounts and fixing of
responsibility for different functions. All these aspects are helpful in setting up an effective
and efficient organizational framework.
4. Helpful in Interpreting Financial Information: The main object of management
accounting is to present financial information to the management in such a way that it is
easily understood.
5. Motivating Employees: Targets are laid down for the employees. They feel motivated in
achieving their targets and further incentives may be given for improving their
performance.
6. Helpful in Making Decisions: Management accountant prepares a report on the
feasibility of various alternatives and makes an assessment of their financial implications.
The information provided by the accountant helps management in selecting a suitable
alternative and taking correct decisions.

1.5 Functions of Management Accounting:

1. Planning and Forecasting: Management accounting use various techniques such as

budgeting, standard costing, marginal costing, fund flow statements, probability and trend
ratios, etc., for fixing targets. These techniques are useful in planning various activities. So
management accounting tools are useful in planning and forecasting.
2. Modification of Data: Management accounting helps in modifying accounting data. The
information is modified in such a way that it becomes useful for the management.

6
 3. Financial Analysis and Interpretation: Management accountant analyses and
interprets financial data in a simple way and presents it in a non-technical language. He
gives his opinion about various alternative courses of action so that it becomes easy for the
management to take a decision.
4. Facilities Managerial Control: Management accounting is very useful in controlling
performance. Performance evaluation is possible through standard costing and budgetary
control which are an integral part of management accounting.
5. Communication: The management accountant prepares reports for the benefit of
different levels of management and employees. The activities of the concern are
communicated to outsiders such as bankers, investors, creditors, government agencies, etc.
6. Use of Qualitative information: The field of management accounting is not restricted to
the use of monetary data only. It collects and uses qualitative information also.

1.6 Relationship of Management Accounting with Financial Accounting:

Sl.
Basis Financial Accounting Management Accounting
No
1. External and Financial accounting information Management accounting
internal users is mainly intended for external information is mainly meant
users - investors, shareholders, for internal user, i.e.,
creditors, Govt. authorities, etc. management.
2. Accounting It is based on double entry It is not based on double entry
method system for recording business system
transactions.
3. Statutory Under company law and tax laws, Management accounting is
requirements financial accounting is obligatory optional though its utility
to satisfy various statutory makes it highly desirable to
provisions. adopt it
4. Analysis of cost Financial accounting shows the Management accounting
and profit profit/loss of the business as a provides detailed information
whole. It does not show the cost about individual products.
and profit for individual Plants, departments or any
products, processes or other responsibility centre.
departments etc.
5. Past and future It is concerned with recording It is future oriented and
data transactions which have already concentrates on what is likely
taken place, i.e., it represents past
to happen in future through it
or historical records. may use past data for future
projections.
6. Periodic and Financial reports, i.e., Profit and Management accounting
continuous Loss Account and Balance Sheet reports are prepared
reporting are prepared usually on a year to frequently, i.e., these may be
year basis. monthly, weekly or even daily
depending on managerial
7
 requirements.
7. Accounting Companies are required to Management accounting is not
standards prepare financial accounts to bound by accounting
Accounting Standards issued by standards. It may use any
the Institute of Chartered practice which generates
Accountants of India. useful information to
management.
8. Types of Financial accounting prepares In management accounting
statements general purpose statements - special purpose reports are
prepared Profits and Loss Account and prepared, e.g, performance
Balance Sheet which are used by report of sales manager or any
external users. other department manager
which are used by top level
management.
9. Publication and Financial statements, i.e., P&L A/c Management accounting
audit and Balance Sheet are published statements are for internal use
for general public use and also and thus neither published for
sent to shareholders. These are general public use nor are
required to be audited by the these required to be audited by
Chartered Accountants. Chartered Accountants.
10. Monetary and Financial accounting provides Management accounting may
non-monetary information in terms of money apply monetary or non-
measurements only. monetary units of
measurements. For example
information may be expressed
in terms of Rs. or units of
quantity, machine hours,
labour hours, etc.

1.7 Relationship between Cost and Management Accounting:

Sl. Basis Cost Accounting Management Accounting

No
1. Scope Scope of cost accounting is Scope of management
limited to providing cost accounting is broader than that
information for managerial uses. of cost accounting as it
provides all types of
information, i.e., cost
accounting as well as financial
accounting information for
managerial uses.
2. Emphasis Main emphasis is on cost Main emphasis is on planning,
ascertainment and cost control to controlling and decision-
ensure maximum profit. making to maximize profit.
8
3. Techniques Various techniques used by cost Management accounting also
accounting include standard uses all these techniques used
costing and variance analysis, in cost accounting but in
marginal costing and cost volume addition it also uses techniques
profit analysis, budgetary control, like ratio analysis, fund flow
uniform costing and inter-firm statements, statistical analysis,
comparison, etc. operations research and
certain techniques from
various branches of knowledge
like mathematics, economics,
etc., whatsoever can help
management in its tasks.
4. Evolution Evolution of cost accounting is Evolution of management
mainly due to the limitations of accounting is due to the
financial accounting limitations of cost accounting.
In fact, management is an
extension of the managerial
aspects of cost accounting.
5. Statutory Maintenance of cost records has Management accounting is
requirements been made compulsory in purely voluntary and its use
selected industries as notified by depends upon its utility to
the Govt. from time to time. management.
6. Data base It is based on data derived from It is based on data derived
financial accounts. from cost accounting, financial
accounting and other sources.
7. Status in In the organizational set up, cost Management accountant is
organization accountant is placed at a lower generally placed at a higher
level in hierarchy than the level of hierarchy that the cost
management accountant. accountant.
8. Installation Cost accounting system can be Management accounting
installed without management cannot be installed without a
accounting. proper system of cost
accounting

1.8 Tools and Techniques used in Management Accounting:

Management accounting uses a number of tools and techniques to help management in

achieving business goals.

Some of the important tools and techniques are as follows:

1. Budgeting
2. Standard costing and variance analysis.
3. Marginal costing and cost volume profit analysis.
4. Ratio analysis
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5. Comparative financial statements.
6. Differential cost analysis.
7. Funds flow statements.
8. Cash flow statement.
9. Responsibility accounting.
10. Accounting for price level changes.
11. Statistical and graphical techniques.
12. Discounted cash flow. Etc.

1.9 Limitations of Management Accounting:

1. Based on Accounting Information: Management accounting is based on data supplied

by financial and cost accounting. The correctness and effectiveness of managerial decisions
will depend upon the quality of data on which these decisions are based.
2. Lack of Knowledge: Management should be conversant with accounting principles,
statistics, economics, principles of management, etc., and only then management
accounting can be effectively utilized. Deficiency in knowledge of any of these subjects
limits the use of management accounting.
3. Intuitive Decisions: Though management accounting provides scientific analysis of
various situations and enables decision making based on facts and figures, there is a
tendency to make decisions intuitively. Intuitive decisions limit the usefulness of
management accounting.
4. Not an Alternative to Administration: Management accounting does not provide an
alternative to administration. The tools and techniques of management accounting provide
only information and not decisions.
5. Top Heavy Structure: Introduction of management accounting system is a costly affair
and can be used by big concerns only, smaller units cannot afford to use this system
because of heavy cost.
6. Evolutionary Stage: Management accounting is only in a developmental stage. It will
take some time before management accounting takes a final shape.

1.10 Meaning of Financial Analysis:

In the words of Myers, “Financial statement analysis is largely a study of relationship

among the various financial factors in a business as disclosed by a single set-of statement,
and a study of the trend of these factors as shown in a series of statements.”

Techniques/Types of Financial Analysis:

We can classify various types of financial analysis into different categories depending upon
(i) The material used and
(ii) The method of operation followed in the analysis or the modus operandi of analysis.

10
 TYPES OF FINANCIAL ANALYSIS

ON THE BASIS OF MATERIAL USED ON THE BASIS OF MODUS OPSRAND

EXTERNAL INTERNAL HORIZONATAL VERTICAL

ANALYSIS ANALYSIS ANALYSIS ANALYSIS

(i) On the basis of material used.

According to the material used, financial analysis can be of two types:

a. External Analysis: This analysis is done by outsiders who do not have access to the
detailed internal accounting records of the business firm. These outsiders include
investors, potential investors, creditors, potential creditors, government agencies credit
agencies, and the general public. For financial analysis, these external parties to the firm
depend almost entirely on the published financial statements.

b. Internal Analysis: The analysis conducted by persons who have access to the internal
accounting records of a business firm is known as internal analysis. Such an analysis can,
therefore, be performed by executives and employees of the organization as well as
government agencies which have statutory powers vested in them.

(ii) On the basis of modus operandi:

According to the method of operation followed in the analysis, financial analysis can also be
of two types:
a. Horizontal Analysis: Horizontal analysis refers to the comparison of financial data of a
company for several years. The figures for this type of analysis are presented horizontally
over a number of columns. The figures of the various years are compared with standard or
base year. Comparative statements and Trend percentages are two tools employed in
Horizontal analysis.

b. Vertical Analysis: Vertical analysis refers to the study of relationship of the various
items in the financial statements of one accounting period. In this type of analysis the
figures from financial statement of a year are compared with a base selected from the same
year’s statement. Common-size financial statements and financial ratios are the two tools
employed in vertical analysis.

11
1.11 Comparative Financial Statements:

The comparative financial statements are statements of the financial position at different
periods; of time. The elements of financial position are shown in a comparative form so as
to give an idea of financial position at two or more periods.

The two comparative statements are:

(i) Balance sheet
(ii) Income statement.

Comparative Balance Sheet:

The comparative balance sheet analysis is the study of the trend of the same items, group of
items and computed items in two or more balance sheets of the same business enterprise
on different dates. The changes in periodic balance sheet items reflect the conduct of a
business.

Illustration 1:
1. The balance sheet of Shrived ltd. for the years 2017 and 2018 are given below:
Balance Sheets 31-12-2017 (Rs) 31-12-2018(Rs)
LIABILITIES 6,00,000 12,00,000
Equity share capital 5,00,000 9,00,000
10% preference share 4,00,000 5,00,000
capital 2,00,000 3,00,000
Reserve fund 2,00,000 5,00,000
Profit and loss a/c 1,00,000 3,00,000
Long term loans
Creditors
Total 20,00,000 37,00,000
ASSETS
Fixed assets (gross block) 15,00,000 28,00,000
Less: depreciation 5,00,000 8,00,000
10,00,000 20,00,000
Investments 4,00,000 5,00,000
Inventories 4,50,000 6,50,000
Account receivables 1,00,000 4,00,000
cash 50,000 1,50,000
Total 20,00,000 37,00,000
You are required to comment on the financial position of the business with the help of
comparative balance sheet technique.

Solution:

12
Comparative Balance Sheet as on 31-12-2017 and 31-12-2018.
Absolute Percentage
As on As on
Increase of increase
Particulars 31-12- 31-12-
or decrease or decrease
2017 2018
in 2018 in 2018
Rs. Rs. Rs.
Capital and Liabilities:
Equity share capital 6,00,000 12,00,000 + 6,00,000 + 100%
10% Preference Share Capital 5,00,000 9,00,000 + 4,00,000 + 80%
Reserve fund 4,00,000 5,00,000 + 1,00,000 + 5%
Profit and Loss Account 2,00,000 3,00,000 + 1,00,000 + 50%
Owner’s Funds 17,00,000 29,00,000 + + 71%
Long-term Liabilities 12,00,000
Long-terms loans
Current Liabilities 2,00,000 5,00,000 + 3,00,000 + 150%
Creditors
1,00,000 3,00,000 + 2,00,000 + 20%
Assets: 20,00,000 37,00,000 + 17,00,000
Fixed Assets (Gross block less
depreciation, i.e., net):
Investments 10,00,000 20,00,000 + 10,00,000 + 100%
Current Assets: 4,00,000 5,00,000 + 1,00,000 + 25%
Inventories
Accounts Receivable 4,50,000 6,50,000 + 2,00,000 + 44.4%
Cash 1,00,000 4,00,000 + 3,00,000 + 30%
50,000 1,50,000 + 1,00,000 + 200%
20,00,000 37,00,000 +1700000

Conclusion drawn from the comparative balance sheet analysis on financial position of the
company:
a) There has been an increase of Rs.10,00,000 in fixed assets. The increase in fixed assets
has been financed through additional equity share capital of Rs.6,00,000 and additional
preference share capital of Rs.4,00,000. Financing the increase in fixed assets through
additional equity share capital and preference share capital is a sound financial policy.
b) There has been a substantial in long-term loans. It has to be seen whether the long-term
loans have been used productively or not.
c) Investments are treated as long-term investments. There has been an increase of Rs.1,
00,000 in investments. The increase in investments in appreciable.
d) There is an increase of 44.4% in inventories. This increase in not very high. That means,
much working capital is not locked up in inventories.
e) There is a very high increase of 300% in accounts receivables. That means, steps taken
for the collection of debts require scrutiny.

13
f) There has been an increase of 200% in cash. Cash is an idle asset. That means, a huge
cash balance is kept idle.
g) There is an overall increase of Rs.6,00,000 in current assets. There is also an overall
increase of Rs.2,00,000 in current liabilities. The percentage of increase in current
assets, viz., and 100% is less than the percentage of increase in current liabilities, viz.,
200%. That means, there is a slight decrease in the current ratio. But the current ratio
of the concern is quite good.
h) There is an increase of Rs.1,00,000 in reserve fund and Rs1,00,000 in profit and loss
account balance. This suggests that the profitability of the concern is good.
To conclude, the overall financial position of the concern seems to be good.

1.12 Comparative Income Statement:

A comparative income statement is a statement prepared to compare the various items of

the income statements of the different periods and to ascertain the changes (i.e., the
increases or decrease) that have taken place in the items of income statements from one
period to another. As such, a mere reading of the comparative Income statement helps one
to derive a meaningful conclusion about the performance and efficiency of the business
from year to year.

Illustration 2:
1. From the following data, prepare comparative profit and loss A/c showing increase or
decrease in individual incomes and expenses together with percentage of such increase or
decrease.
PARTICULARS 31st Dec 2017 31st Dec 2018
Sales 60,00,000 80,00,000
Cost of goods sold 50,00,000 60,00,000
Gross profits 10,00,000 20,00,000
Operating expenses:
Office expenses 2,50,000 3,50,000
Selling expenses 1,00,000 1,20,000
Distribution expenses 50,000 30,000
Net operating profit 6,00,000 15,00,000
Financial expenses 2,00,000 3,00,000
Net profit before tax 4,00,000 12,00,000
Income tax 2,00,000 6,00,000
Net profit after tax 2,00,000 6,00,000

14
 Solution:

Comparative Profit and Loss Account for the years ended

31-12-2017 and 31-12-218.
Prozentualer Anteil
Absolute
As on As on of increase
Increase
Particulars 31-12- 31-12- or
or decrease
2017 2018 decrease
in 2018
in 2018
Rs. Rs. Rs.

Sales 60,00,000 80,00,000 +20,00,000

Less Cost of goods sold

Gross Profit 50,00,000 60,00,000 +10,00,000 +20
Less Operating Expenses: 10,00,000 20,00,000 +10,00,000 +100
2,50,000
Office Expenses 1,00,000 3,50,000 1,00,000 +40
Selling Expenses 50,000 1,20,000 +20,000 +20
Distribution expenses 30,000 -20,000 -40
6,00,000 15,00,000 +9,00,000 +150
Net operating profit 2,00,000 3,00,000 +1,00,000 +50
Less Financial expenses 4,00,000 12,00,000 +8,00,000 +200
Net profit before tax 2,00,000 6,00,000 +4,00,000 +200
Less Income-tax 2,00,000 6,00,000 +4,00,000 +200
Net profit after tax
Conclusions drawn from the comparative profit and loss account:
The following conclusions can be drawn from the comparative profit and loss account
analysis:
1. While there is an increase of Rs.20,00,000 in sales, there is an increase of only
Rs.10,00,000 in the cost goods sold. The increase in the cost of goods sold is less than, in
proportion, as compared to the increase in sales. The result is the increase in gross
profit by Rs.10,00,000.
2. In opening expenses, there is an increase of only Rs.1,00,000. The increase in operating
expenses is less than, in proportion, as compared to increase in sales. The result is
increase in operating profits.
3. There is an increase of Rs.1,00,000 in financial expenses. This indicates additional
borrowing.
To conclude, the operating efficiency of the business is quite satisfactory.

1.13 Common-size Financial Statements:

Common-Size financial statements are those statements in which the data or figure
reported in the financial statements are converted into percentages of a common base

15
amount. Generally, in the common-size income statement, the net sales figure is taken as
100%, and all other items of the income statement are expressed as a percentage of net
sales. Similarly, in the common-size balance sheet, the total of assets, or the total of
liabilities and capital is taken as 100% and all the items in the balance sheet are expressed
as a percentage of this total.

Common-size financial statements are known as component percentage statements or

100 percent statements, because each statement is reduced to the total of 100% and each
individual item is expressed as a percentage of the total of 100.

Common-size financial statements mainly include

(1) Common-size balance sheet.
(2) Common size income statement and

1.14 Common-size Balance Sheet:

A common-size balance sheet is a statement in which the total of the assets or the total of
liabilities and capital is taken as 100%, and all the items of the balance sheet (i.e., each of
the assets and each of the liabilities) are expressed as a percentage of the total assets, or
the total of liabilities and capital.

Illustration 3:
1. Prepare Common Size Balance Sheets of A Ltd, and B Ltd, as on 31st March 2018 from the
following balance sheets of the two companies.
Liabilities A Ltd. B Ltd.
Rs Rs
Equity Share 4,80,0002 7,20,000
Capital ,60,000 1,20,000
Pref Share Capital 48,000 72,000
General Reserve - 64,800
Profit and Loss A/c

Current Liabilities: 67,200 93,600

Proposed dividend 70,000 1,00,000
Sundry creditors 17,200 27,200
Bills payable 39,200 14,400
Outstanding salary 67,200 76,800
Provision for 10,48,800 12,88,800
taxation
Assets A Ltd. B Ltd.
Rs Rs
Investments 43,200 -
Discount on 1,20,000 96,000
issue of shares

16
 Factory Building 2,00,000 1,20,000
Machinery 2,16,000 4,58,400
Fixed Deposits 24,000 84,000
Preliminary 24,000 16,8000
expenses
Current assets: 1,80,000 2,59,200
Sundry debtors 2,04,000 1,87,200
Stock 30,600 50,000
Bank 7,000 17,200
Cash
10,48,800 12,88,800

Solution:

Common Size Balance Sheets

For the year ending 313-2018
A. Ltd. B Ltd.
% of
Rs. Rs. % of total
total
Fixed Assets;
Investments 43,200 4.12 - -
Discount on issue of shares 1,20,000 11.44 96,000 7.45
Building 2,00,000 19.07 1,20,000 9.31
Machinery 2,16,000 20.59 4,58,400 35.37
Fixed deposits 24,000 2.29 84,000 6.52
Preliminary expenses 24,000 2.29 16,800 1.30
Total Fixed Assets 6,27,200 59.80 7,75,200 60.15
Current Assets:
Sundry debtors 1,80,000 17.16 2,59,200 20.11
Stocks 2,04,000 19.45 1,87,200 14.53
Bank 30,600 2.92 50,000 3.88
Cash 7,000 0.67 17,200 1.33
Total current Assets 4,21,600 40.20 5,13,600 39.85
Total Assets (Fixed + Current) 10,48,800 100.00 12,88,800 100.00
Capital and Reserves:
Equity capital 4,80,000 45.77 7,20,000 55.86
Preference shares capital 2,60,000 24.79 1,20,000 9.31
General reserves 48,000 4.57 72,000 5.59
Profit and loss account - - 64,800 5.03
Total capital and reserves 7,88,000 75.13 9,76,800 75.79
Current Liabilities:
Proposed dividend 67,200 6.41 93,600 7.26
Sundry creditors 70,000 6.67 1,00,000 7.76
Bills payable 17,200 1.64 27,200 2.11
17
 Outstanding salaries 39,200 3.74 14,400 1.12
Provision for taxation 67,200 6.41 76,800 5.96
Total current Liabilities 2,60,800 24.87 3,12,000 24.21
Total Capital and Liabilities 10,48,800 100 12,88,800 100

1.15 Common-size Income Statement:

A common-size income statement is a statement in which the net sales is taken as 100%,
and all the other items of the income statement are expressed as a percentage of net sales.

Illustration 4:
1. The Profit and Loss Account of a company is given below:
Profit and Loss Account
2017 2018 2017 2018
Rs. Rs. Rs. Rs.
To Cost of goods sold 600 750 By Net sales 800 1,000
To operating By non-operating 50 100
expenses: 30 40 income
Administrative 40 50
Expenses 30 40
Selling expenses 150 220
To Non-operating exp
To Net profit 850 1,100 850 1,100

You are required to prepare a common-size income statement and interpret the changes.

Solution:

Common-size Profit and Loss Account for the

Years ended 31st December, 2017 and 2018.
(Rs. In lakhs)
2017 2018
Particulars
Amount % Amount %
Rs. Rs.
Net sales 800 100 1,000 100
Less: Cost of goods sold 600 75 750 75
Gross profit 200 25 250 25
Less: operating Expenses:
Administrative expenses 30 3.75 40 4
Selling expenses 40 5.00 50 5
Operating Profit 130 16.25 160 16
50 6.67 100 10
Add: Non-operating income 180 22.92 260 26

18
Less Non-operating expenses 30 3.75 40 4
Net Profit 150 19.17 220 22
Conclusion from Common Size Income Statement

The following conclusions can be drawn from the common-size statement:

1. The percentage of cost of goods sold has remained the same in both the years, i.e., in
2017 and 2018. As a result, the percentage of gross profit also has remained the same in
both the years, i.e., 2017 and 2018.
2. The percentage of operating expenses has increased from 8.75% in 2017 to 9% in 2018.
As a result, the percentage of operating profit has decreased slightly from 16.25% in
2017 to 16% in 2018.
3. The percentage of non-operating income has increased considerably from 6.67% in
2017 to 10% in 2018. But the percentage of non-operating expenses has increased
slightly from 3.75% in 2017 to 4% in 2018. As a result, the percentage of net profit has
increased from 19.7% in 2017 to 22% in 2018.
To conclude, there is improvement in the operating results in 2018 as compared to 2017.

1.16 Trend Analysis, Trend Percentage or Trend Ratio Analysis:

Trend analysis or trend percentage or trend ratio analysis is a method of analysis under
which the percentage relationship that each financial statement item of each year bears to
the same item in the base year is calculated.

Illustration 5:
From the following balance sheets of the Hindustan Industries Ltd., compute the trend
percentages using 31st December, 2016as the base year.

2016 2017 2018

Share Capital 2,00,000 2,50,000 3,00,000
Reserves 1,00,000 1,50,000 1,50,000
Loans 2,00,000 1,00,000 50,000
Sundry Creditors 3,00,000 4,00,000 2,00,000
Buildings 2,00,000 2,50,000 3,00,000
Plant 2,00,000 2,50,000 1,00,000
Stock 2,50,000 2,50,000 1,50,000
Debtors 1,00,000 1,00,000 1,00,000
Cash at Bank 50,000 50,000 50,000

Solution:

Comparative Balance Sheets as on 31st December , 2016 to 2018

Trend Percentage
31st December
100
19
 Base year 2016
2016 2017 2018 2016 2017 2018
Rs. Rs. Rs.
Capital and Liabilities
Share Capital 2,00,000 2,50,000 3,00,000 100 125 150
Reserves 1,00,000 1,50,000 1,50,000 100 150 150
Long-term Loans:
Loans 2,00,000 1,00,000 50,000 100 50 25
Current Liabilities:
Sundry Creditors 3,00,000 4,00,000 2,00,000 100
Rs. 8,00,000 9,00,000 7,00,000
Assets:
Fixed Assets:
Buildings 100 125 150
2,00,000 2,50,000 3,00,000
Plant 100 125 150
2,00,000 2,50,000 1,00,000
Current Asset:
Stock 100 100 60
2,50,000 2,50,000 1,50,000
Debtors 100 100 100
1,00,000 1,00,000 1,00,000
Cash at Bank 100 100 100
50,000 50,000 50,000
Rs. 8,00,000 9,00,000 7,00,000

The following conclusions can be drawn from the trend analysis of balance sheet:
1. The capital of the concern has been increasing over the years. It is a healthy trend.
2. The reserves of the concern have increased in the second year, and remained intact in
the third year. This also indicates the improved financial position of the concern.
3. The debt or the long-term liability (i.e., loan) of the concern has been decreasing over
the years. As a result, the debt-equity ratio of the concern has improved over the years.
4. The fixed assets have increased in the second year, but decreased in the third year.
This can be taken to mean that there is gradual replacement and extension of fixed
assets.
5. The current ratio has decreased in the second year, but increased in the third year. The
increase in current ratio is a healthy trend.

1.17 Terminal Questions:

Section – A (2 Marks Questions)

1. State the principal tools of analysis of financial statements.
2. What is a comparative financial statement?
3. What do you mean by trend percentage analysis?
4. What is financial statement analysis?
5. Define Management accounting.
6. State the objectives of management accounting.
7. State the functions of management accounting.
8. Who is a management accountant?
20
9. State the tools of Management Accounting.
10. Give three points of comparison between financial and management accounting
11. State any two limitations of management accounting.

Section – B (4 Marks Questions)

1. What is the difference comparative statement and common size financial statement?
2. What is meant by internal analysis and external analysis?
3. Write a note on Common – size financial statements.
4. Compare Horizontal and vertical analysis.
5. State the nature of management accounting.
6. Distinguish between financial accounting and management accounting.
7. Distinguish between cost accounting and management accounting.
8. State the limitations of management accounting.

Section – C (10 Marks Questions)

1. What are the different methods used for the analysis and interpretation of financial
statements.
2. “Analysis without interpretation is meaningless and interpretation without analysis is
impossible.” Discuss.
3. The following are the balance sheets of a concern for the years 2009 and 2010. Prepare a
comparative balance sheet and study the financial position of the concern.

Balance Sheet As on 31st December

Liabilities 2017 2018
Rs Rs
Equity share capital 6,00,000 8,00,000
Reserves & Surplus 3,30,000 2,22,000
Debentures 2,00,000 3,00,000
Long-term loans on 1,50,000 2,00,000
mortgage
Bills payable 50,000 45,000
Sundry creditors 1,00,000 1,20,000
Other current 5,000 10,000
liabilities
Total 14,35,000 16,97,000
Assets 2017 2018
Rs Rs
Land & Buildings 3,70,000 2,70,000
Plant & Machinery 4,00,000 6,00,000
Furniture& Fixtures 20,000 25,000

21
 Other fixed assets 25,000 30,000
Cash in hand & 20,000 80,000
bank
Bills receivables 1,50,000 90,000
Sundry debtors 2,00,000 2,50,000
Stock 2,50,000 3,50,000
Prepaid Expenses _ 2,000
14,35,000 16,97,000

4. Prepare comparative statements from the following data:

Income Statements 2017 (Rs. In lakhs) 2018 (Rs. In
lakhs)
Net sales 600 750
Cost of goods sold 400 600
Admn. Expenses 20 20
Selling Expenses 10 10
Net profit 170 120

Balance sheets
Liabilities 2017(Rs. In lakhs) 2018(Rs. In lakhs)
Equity capital 400 400
6% Pref share capital 300 300
Reserves 200 245
6% Debentures 100 150
Bills payable 50 75
Creditors 150 200
Tax payable 100 150
Total 1300 1520
Assets 2017(Rs. In lakhs) 2018(Rs. In lakhs)
Land 100 100
Buildings 300 270
Plant 300 270
Furniture 100 140
Stock 200 300
Cash ? ?
Total 1300 1520

5. The balance sheets of S& CO. and K&CO. are given as follows:
Balance sheets as on Dec.31, 2018

22
Liabilities S&CO. K&CO.
Rs Rs
Preference share capital 1,20,000 1,60,000
Equity share capital 1,50,000 4,00,000
Reserve & surpluses 14,000 18,000
Long-term loans 1,15,000 1,30,000
Bills payable 2,000 -
Sundry creditors 12,000 4,000
Outstanding Expenses 15,000 6,000
Proposed Dividend 10,000 90,000
Total 4,38,000 8,08,000
Assets
Land and buildings 80,000 1,23,000
Plant and machinery 3,34,000 6,00,000
Temporary investment 1,000 40,000
Inventories 10,000 25,000
Book-debts 4,000 8,000
Prepaid Expenses 1,000 2,000
Cash and bank balances 8,000 10,000
Total 4,38,000 8,08,000
Compare the financial position of two companies with the help of common size balance
sheet.

6. Prepare a common size income statement from the following profit and loss account of
Rithvik Pvt. Ltd. for the three consecutive years and offer your comments.
15-16 16-17 17-18
To opening stock 1,30,000 1,50,000 1,80,000
To purchases 13,70,000 17,02,000 20,32,000
To administrative expenses 1,80,000 2,31,000 2,86,000
To selling expenses 90,000 1,21,000 1,56,000
To debenture interest 18,000 18,000 18,000
To depreciation 15,000 20,000 25,000
To provision for tax 73,500 69,000 56,500
To net profit c/d. 73,500 69,000 56,500

19,50,000 23,80,000 28,10,000

By sales:
Cash 4,50,000 4,48,000 5,20,000
Credit 13,50,000 17,52,000 20,80,000

18,00,000 22,00,000 26,00,000

By closing stock 1,50,000 1,80,000 2,10,000
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 19,,50,000 23,80,000 28,10,000

7. Calculate the trend percentages from the following figures of X ltd. taking 2018 as the
base and interpret them
(Rs in lakhs)
YEAR SALES STOCK PBT(profit before tax)
2001 1881 709 321
2002 2340 781 435
2003 2655 816 458
2004 3021 944 527
2005 3768 1154 672

8. Distinguish between financial accounting, cost accounting and management accounting.

9. State the nature, scope and functions of management accounting.

10. Management Accounting is the presentation of accounting information in such a ways

as to assist management in the creation of policy and the day-to-day operation of an
undertaking.” – Elucidate this statement.

24
 Module – 2
Ratio Analysis
Structure:
2.1 Introduction
2.2 Meaning of Ratio
2.3 Nature of Ratio Analysis
2.4 Interpretation of the Ratios
2.5 Guidelines for use of Ratios
2.6 Significance of Ratio Analysis
2.7 Limitations of Ratio Analysis
2.8 Classification of Ratios
2.9 Du Pont control chart
2.10 Terminal questions

Learning Objectives
 To understand the meaning of ratio and the concept of ratio analysis.
 To learn how to interpret and use the ratios.
 To know the importance of the analysis of ratios.
 To understand the limitations of ratio analysis.
 To learn about the functional classification of ratios, their calculation and
interpretation.
 To learn the preparation of financial statements using ratios.
 To know about the DuPont control chart

2.1 Introduction:

The ratio analysis is one of the most powerful tools of financial analysis. It is the process of
establishing and interpreting various ratios (quantitative relationship between figures and
groups of figures). It is with the help of ratios that the financial statements can be analyzed
more clearly and decisions made from such analysis.

2.2 Meaning of Ratio:

A ratio is a simple arithmetical expression of the relationship of one number to another. It

is an expression of the quantitative relationship between two numbers.

2.3 Nature of Ratio Analysis:

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. However, ratio analysis is not an end in itself. It is only a means of better
understanding of financial strengths and weaknesses of a firm. Calculation of mere ratios
does not serve any purpose, unless several appropriate ratios are analyzed and interpreted.
The following are the four steps involved in the ratio analysis:
25
(i) Selection of relevant data from the financial statements depending upon the objective of
the analysis.
(ii) Calculation of the appropriate ratios from the above data.
(iii) 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.
(iv) Interpretation of the ratios.

2.4 Interpretation of the Ratios:

The interpretation of the ratio can made in the following ways

1. Single Absolute Ratio: Generally speaking one cannot draw any meaningful conclusion
when a single ratio is considered in isolation. But single ratios may be studied in relation to
certain rules of thumb which are based upon well proven conventions as for example 2:1 is
considered to be a good ratio for current assets to current liabilities.
2. Group of Ratios: A single ratio supported by other related additional rules becomes
more understandable and meaningful.
3. Historical Comparison: One of the easiest and most popular ways of evaluating the
performance of the firm is to compare its present ratios with the past ratios called
comparison overtime.
4. Projected Ratios: Ratios can also be calculated for future standards based upon the
projected or proforma financial statements. These future ratios may be taken as standard
for comparison and the ratios calculated on actual financial statements can be compared
with the standard ratios to find out variances, if any.
5. Inter-firm Comparison: Ratios of one firm can also be compared with the ratios of
some other selected firms in the same industry at the same point of time. This kind of
comparison helps in evaluating relative financial position and performance of the firm.

2.5 Guidelines for use of Ratios:

1. Accuracy of Financial Statements: The ratios are calculated from the data available in
financial statements. The reliability of ratios is linked to the accuracy of information in
these statements.
2. Objective or Purpose of Analysis: The purpose or object for which ratios are required
to be studied should always be kept in mind for studying various ratios. Different objects
may require the study of different ratios.
3. Selection of Ratios: Another precaution in ratio analysis is the proper selection
appropriate ratios. The ratios should match the purpose for which these are required.
4. Use of Standards: the ratios will give an indication of financial position only when
discussed with reference to certain standards. Unless otherwise these ratios are compared
with certain standards one will not be able to reach at conclusions.
5. Caliber of the Analysis: the ratios are only the tools of analysis and their interpretation
will depend upon the calibre and competence of the analyst. A wrong interpretation may
create havoc for the concern since wrong conclusions may lead to wrong decisions.

26
6. Ratios Provide Only a Base: The ratios are only guidelines for the analyst, he should
not base his decisions entirely on them. He should study any other relevant information,
situation in the concern, general economic environment, etc. before rea ching final
conclusions.

2.6 Significance of Ratio Analysis:

(a) Managerial Uses of Ratio Analysis

1. Helps in decision-making: Financial statements are prepared primarily for decision-
making. Ratio analysis helps in making decisions from the information provided in these
financial statements.
2. Helps in financial forecasting and planning: Planning is looking ahead and the ratios
calculated for a number of years work as a guide for the future.
3. Helps in communicating: The financial strength and weakness of a firm are
communicated in a more easy and understandable manner by the use of ratios.
4. Helps in co-ordination: Better communication of efficiency and weakness of an
enterprise results in better co-ordination in the enterprise.
5. Helps in Control: Standards ratios can be based upon Proforma financial statements
and variances or deviations, if any, can be found by comparing the actual with the
standards so as to take a corrective action at the right time.

(b) Utility of Shareholders/Investors

An investor in the company will like to assess the financial position of the concern where
he is going to invest. His first interest will be the security of his investment and then a
return in the form of dividend or interest. Long-term solvency ratios will help him in
assessing financial position of the concern. Profitability ratios, on the other hand, will be
useful to determine profitability position.

(c)Utility to Creditors:
The creditors or suppliers extend short-term credit to the concern. They are interested to
know whether financial position of the concern warrants their payments at a specified time
or not. Current and acid-test ratios will give an idea about the current financial position of
the concern.

(d) Utility to Employees:

The employees are also interested in the financial position of the concern especially
profitability. Various profitability ratios relating to gross profit, operating profit, net profit,
etc. enable employees to put forward their viewpoint for the increase of wages and other
benefits.

(e) Utility to Government:

Government is interested to know the overall strength of the industry. Various financial
statements published by industrial units are used to calculate ratios for determining short-
term, long-term and overall financial position of the concerns. Government may base its
future policies on the basis of this information.
27
(f) Tax Audit Requirements:
Clause 32 of the Income Tax Act requires that the following accounting ratios should be
given:
(i) Gross Profit/Turnover
(ii) Net Profit/Turnover
(iii) Stock-in-trade/turnover
(iv) Material Consumed/Finished Goods Produced.
Further, it is advisable to compare the accounting ratios for the year under consideration
with the accounting ratios for the earlier two years so that the auditor can make necessary
enquires, if there any major variation in the accounting ratios.

2.7 Limitations of Ratio Analysis:

1. Limited Use of a Single Ratio: A single ratio, usually, does not convey much of a sense.
To make a better interpretation a number of ratios have to be calculated which is likely to
confuse the analyst than help him in making any meaningful conclusion.
2. Lack of Adequate Standards: There are no well accepted standards or rules of thumb
for all ratios which can be accepted as norms.
3. Inherent Limitations of Accounting: Like financial statements, ratios also suffer from
the inherent weakness of accounting records. Ratios of the past are not necessarily true
indicators of the future.
4. Change of Accounting Procedure: Change in accounting procedure by a firm often
makes ratio analysis misleading.
5. Window Dressing: Financial statements can easily be window dressed to present a
better picture of its financial and profitability position to outsiders. Hence, one has to be
very careful in making a decision from ratios calculated from such financial statements.
6. Personal Bias: Ratios have to be interpreted and different people may interpret the
same ratio in different ways.
7. Incomparable: Not only industries differ in their nature but also the firms of similar
businesses widely differ in their size and accounting procedures etc,. It makes comparison
of ratios difficult and misleading.
8. Absolute Figures Distortive: Ratios devoid of absolute figures may prove distortive, as
ratio analysis is primarily a quantitative analysis and not a qualitative analysis.
9. Price Level Changes: While making ratio analysis, no consideration is made to the
changes in price levels and this makes the interpretation of ratios invalid.
10. Ratios no Substitutes: Ratio analysis is merely a tool of financial statements. Hence,
ratios become useless if separated from the statements from which they are computed.

28
2.8 Classification of Ratios:

Functional Classification of Ratios

Functional Classification in View of Financial Management or Classification
According to Tests

Liquidity Ratios Long-term Solvency and Profitability Ratios

Activity Ratios
Leverage Ratios

(A) 1. Current Ratio Financial Operation, 1. Inventory Turnover (A) In relation to Sales
2. Liquid Ratio (Acid) Composite Ratio 1. Gross Profit Ratio
Test or Quick Ratio) 2. Debtors Turnover 2. Operating Ratio
3. Absolute Liquid 1. Debit Equity Ratio 3. Fixed Assets Turnover 3. Operating Profit Ratio
or Cash Ratio 2. Debt to total capital Ratio 4. Net Profit Ratio
4. Internal M easure Ratio 4. Total Asset Turnover 5. Expense Ratio
3. Interest Coverage Ratio (B) In relation to investments
(B) 1. Debtors Turnover 4. Cash Flow/Debt 5. Working Capital 1. Return on Investments
Ratio 5. Capital Gearing. Turnover Ratio 2. Return on Capital
2. Creditors Turnover 6. Payables Turnover 3. Return on Equity Capital
Ratio Ratio 4. Return on Total
3. Inventory Turnover 7. Capital Employed Resources
Ratio Turnover 5. Earnings per share
6. Price-Earning Ratio

1. Liquidity Ratios
Liquidity refers to the ability of a concern to meet its current obligations as and when these
become due. The short term obligations are met by realizing amounts from current assets.
The sufficiency or insufficiency of current assets should be assessed by comparing them
with current liabilities.
To measure the liquidity of a firm, the following ratios can be calculated:
(i) Current Ratio
(ii) Quick or Acid Test or Liquid Ratio
(iii) Absolute Liquid Ratio or Cash Position Ratio
(i) Current Ratio
Current ratio may be defined as the relationship between current assets and current
liabilities. This ratio, also known as working capital ratio, is a measure of general liquidity
and is most widely used to make the analysis of a short-term financial position or liquidity
of a firm.
Current Assets
Current Ratio =
Current Liabilities
Or Current Assets : Current Liabilities
Where bank overdraft is permanent or long-term arrangement with the bank, it should be
excluded.

Meaning of Current Assets:

Cash in hand and at bank, readily marketable securities, bills receivable. Debtors less
provision for bad and doubtful debts, stock in trade, prepaid expenses, any other asset
which, in the normal course of business will be converted in cash in a year’s time.

29
Meaning of Current Liabilities:
These include obligations maturing within a year such as, Sundry Creditors, bills payable,
bank overdraft, income tax payable, dividends payable, outstanding expenses, provision for
taxation, unclaimed dividend.

Interpretation of Current ratio:

A relatively high current ratio is an indication that the firm is liquid and has the ability to
pay its current obligations in time as and when they become due and a low current ratio
represents that the liquidity position is not good.
A ratio equal or near to the rule of thumb of 2:1 i.e., current assets double the current
liabilities is considered to be satisfactory.

(ii) Quick Ratio

Quick ratio is a more rigorous test of liquidity than the current ratio. Current assets include
inventories and prepaid expenses which are not easily convertible into cash within a short
period. Quick ratio may be defined as the relationship between quick/liquid assets and
current or liquid liabilities.
Inventories cannot be termed to be liquid asset because they cannot be covered into cash
immediately without a sufficient loss of value. In the same manner, prepaid expenses are
also excluded from the list of quick/liquid assets because they are not expected to be
converted into cash.
Quick or Liquid Assets
Quick/Liquid or Acid Test Ratio = Current Liabilities

Quick assets can be calculated as:

Current Assets – (Inventories + Prepaid Expenses)

Interpretation of Quick ratio:

A high acid test ratio is an indication that the firm is liquid and has the ability to meet its
current liabilities in time and a low quick ratio represents that the firm’s liquidity position
is not good.
As a rule of thumb or as a convention quick ratio 1:1 is considered satisfactory. It is
generally thought that if quick assets are equal to current liabilities then the concern may
be able to meet its short-term obligations.
(iii) Absolute Liquid Ratio or Cash ratio
Although receivables, debtors and bills receivable are generally more liquid than
inventories, yet there may be doubts regarding their realization into cash immediately or in
time. Hence absolute liquid ratio is calculated.

30
 Absolute Liquid Assets
Absolute Liquid Ratio =
Current Liabilities
Or
Cash & Bank + Short - term Securities
Cash Ratio = Current Liabilities

Interpretation of Absolute quick ratio:

The acceptable norm for this ratio is 50% or 0.5: 1 or 1 : 2 i.e. Re.1 worth absolute liquid
assets are considered adequate to pay Rs.2 worth current liabilities in time as all the
creditors are not expected to demand cash at the same time and then cash may also be
realized from debtors and inventories .

Illustration 1:
The following is the Balance sheet of Karuna Electric Company as on 30.6.2018
Liabilities Rs.
Equity capital 3,00,000
Sundry creditors 48,000
Bills payable 10,000
Bank overdraft 5,000
Outstanding expenses 2,000
3,65,000
Assets Rs.
Land and buildings 1,50,000
Plant and machinery 85,000
Short term investments 16,000
Stock in trade 50,000
Debtors 59,000
Prepaid expenses 1,000
Cash in hand 4,000
3,65,000
Calculate the following ratios:
(i) Current ratio
(ii) Absolute liquidity ratio
What conclusions do you draw about the company on the basis of these ratios?
Current ratio= current assets
Current liabilities
= 16,000+50,000+59,000+1,000+4,000
48,000+2,000+10,000+5,000
=2:1
Comments: the current ratio of 2:1 as calculated above shows that short term liquidity
position of the company is quite satisfactory

31
 Quick assets
Liquid ratio=. Quick assets
Quick liabilities
Quick liabilities
= 16,000+50,000+59,000+4,000
48,000+2,000+10,000
=1.32:1
Comments: the liquid or quick ratio is 1.32:1 is more satisfactory. It may, therefore, be said
that short term liquidity of the company is very sound.
Absolute liquidity ratio: Cash + marketable investments
Current liabilities

= 4,000+16,000
65,000
=0.31:1

Illustration 2:
A firm has a current ratio of 3:1. Its net working capital is Rs.2, 00,000. You are required to
determine (1) current assets (2) liquid assets assuming inventory of Rs.2, 20,000.
Working capital= current assets-current liabilities
2, 00, 000=3-1
2, 00,000=2
Current assets=2, 00,000/2*3=Rs.3, 00,000
Current liabilities=2, 00,000/2*1=Rs.1, 00,000
Liquid assets=current assets-stock
=3, 00,000-2, 20,000=Rs.80,000

2. Current Assets Movement or Efficiency/Activity Ratios:

Activity ratios measure the efficiency or effectiveness with which a firm manages its
resources or assets. These ratios are called turnover ratios because they indicate the speed
with which assets are converted or turned over into sales. The various activity ratios are:
(i) Inventory Turnover or Stock Turnover Ratio
Inventory Turnover Ratio (I.T.R) indicates the number of times the stock has been turned
over during the period and evaluates the efficiency with which a firm is able to manage its
inventory.
Cost of Goods Sold or Net Sales
Inventory Turnover Ratio =
Average Inventory at Cost
Inventory conversion period
It may also be of interest to average time taken for clearing the stocks. This can be possible
by calculating inventory conversion period.
Days in a year
Inventory Conversion Ratio =
Inventory Turnover Ratio

32
Interpretation of Inventory Turnover Ratio:
A high inventory turnover/Stock velocity indicates efficient management of inventory
because more frequently the stocks are sold; the lesser amount of money is required to
finance the inventory. A low inventory turnover implies over-investment in management of
inventory.
(ii) Debtors/Receivable Turnover or Debtors Velocity
Debtors turnover ratio indicates the velocity of debt collection of firm. In simple words, it
indicates the number of times average debtors (Receivables) are turned over during a year,
thus:
Net Credit Annual Sales
Debtorss (Receivables) Turnover/Velocity = Average Trade Debtors
= No. of Times

Trade Debtors = Sundry Debtors + Bills Receivable and Accounts Receivables.

Opening Trade Debtors + Closing Trade Debtors
Average Trade Debtors =
2
Note: Debtors should always be taken at gross value. No provision for bad and doubtful
debts is deducted from them.
If credit sales information is not available, then it can be calculated as:
Debtors turnover ratio = Total sales / Debtors

Interpretation of Debtors Turnover/Velocity

Generally, the higher the value of debtor’s turnover the more efficient is the management of
debtors/sales or more liquid are the debtors.
Average Collection Period Ratio
The average collection period represents the average number of days for which a firm has
to wait before its receivables are converted into cash.

Average collection period = Average Trade debtors / Sales per day

Net Sales
Sales per day =
No. of Working Day

Interpretation of Average Collection Period Ratio

Generally, the shorter the average collection period the better is the quality of debtors as a
short collection period implies quick payment by debtors. A higher collection period
implies an inefficient collection performance which adversely affects the liquidity of the
firm.
(iii) Creditors / Payable Turnover Ratio
The analysis for creditor’s turnover is basically the same as of debtor’s turnover ratio
except that in place of trade debtors, the trade creditors are taken as one of the

33
components in the ratio and in place of average daily sales, average daily purchases are
taken as the other component of the ratio.

(a) Creditors/Payable Turnover Ratio =

Interpretation of Creditors Turnover/Velocity

Generally, higher the creditors’ velocity better it is or otherwise lower the creditors’
velocity, less favorable are the results.
Average Payment Period Ratio
The average payment period ratio represents the average number of days taken by the firm
to pay its creditors.

(b) Average Payment Period Ratio =

Average daily purchases = Annual purchases / No. of working days in a year

Interpretation of Average Payment Period Ratio

Generally, lower the ratio, the better is the liquidity position of the firm and higher the
ratio, less liquid is the position of the firm.
(iv) Working capital turnover ratio:
Working Capital = Current Assets – Current Liabilities
Working Capital turnover ratio indicates the velocity of the utilization of net working
capital. This ratio indicates the number of times the working capital is turned over in the
course of a year. This ratio measures the efficiency with which the working capital is being
used by a firm. This ratio can be calculated as:

Working Capital turnover Ratio =

Average Working Capita l=

Interpretation of Working Capital Ratio

A higher ratio indicates efficient utilization of working capital and a low ratio indicates
otherwise. But a very high working capital turnover ratio is not a good situation for any
firm and hence care must be taken while interpreting the ratio.

2. Analysis of Long-Term Financial Position or Tests of Solvency

The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The
long-term creditors of a firm are primarily interested in knowing the firm’s ability to pay
regularly interest on long-term borrowings, repayment of the principal amount at the
maturity and the security of their loans. Accordingly, long-term solvency ratios indicate a
34
firm’s ability to meet the fixed interest and costs and repayment schedules associated with
its long-term borrowings.

(i) Debt-equity Ratio

Debt-Equity Ratio, also known as External – Internal Equity Ratio is calculated to measure
the relative claims of outsiders and the owners (i.e., shareholders) against the firm’s assets.

Debt-Equity Ratio =
The outsiders’ funds include all debts / liabilities to outsiders, whether long-term or short-
term or whether in the form of debentures, bonds, mortgages or bills. The shareholders’
funds consist of equity share capital, Preference share capital, capital reserves, revenue
reserves and reserves representing accumulated profits and surpluses like reserves for
contingencies, sinking funds, etc. The accumulated losses and deferred expenses, if any,
should be deducted from the total to find out shareholders’ funds. When the accumulated
losses and deferred expenses are deducted from the shareholders’ funds, it is called net
worth and the ratio may be termed as debt to net worth ratio.

Interpretation of Debt-Equity Ratio

A ratio of 1:1 may be usually considered to be a satisfactory ratio although there cannot be
any ‘rule of thumb’ or standard norm for all types of businesses. In some business a high
ratio 2 : 1 or even more may even be considered satisfactory, say, for example in the case of
contractor’s business.
(ii) Funded Debt to Total Capitalization Ratio
The ratio establishes a link between the long-term funds raised from outsiders and total
long-term funds available in the business.
Funded debt = Debentures + Mortgage loans + Bonds + Other long-term loans.
Total Capitalization = Equity Share Capital + Preference Share Capital + Reserves and
Surplus + Other Undistributed Reserves + Debentures + Mortgage
Loans + Bonds + Other long-term loans.

Funded Debt to Total Capitalization Ratio = × 100

Interpretation of Funded Debt to Total Capitalization Ratio

Through there is no ‘rule of thumb’ but still the lesser the reliance on outsiders the better it
will be. If this ratio is smaller, better it will be, up to 50% or 55% this ratio may be tolerable
and not beyond.
(iii) Proprietary Ratio OR Equity Ratio
This ratio establishes the relationship between shareholders’ funds to total assets of the
firm.
The shareholders’ funds are Equity Share Capital, Preference Share Capital, undistributed
profits, reserves and surpluses. Out of this amount, accumulated losses should be deducted.

35
 Proprietary Ratio or Equity Ratio =

Interpretation of Equity Ratio

As equity ratio represents the relationships of owner’s funds to total assets, higher the ratio
or the share of the shareholders in the total capital of the company better is the long-term
solvency position of the company.
(iv) Solvency Ratio OR The Ratio of Total Liabilities to Total Assets
This ratio is small variant of equity ratio and can be simply calculated as 100 - equity ratio.
The ratio indicates the relationship between the total liabilities to outsiders to total assets
of a firm and can be calculated as follows:

Solvency Ratio =

Interpretation of Solvency Ratio

Generally, lower the ratio of total liabilities to total assets, more satisfactory or stable is the
long-term solvency position of a firm.
(v) Fixed Assets to Net worth Ratio or Fixed Assets to Proprietor’s Funds
The ratio establishes the relationship between fixed assets and shareholder’s funds, i.e.,
share capital plus reserves, surplus and retained earnings.

Fixed Assets to Net worth Ratio =

Interpretation of Fixed Assets to Net worth Ratio

If the ratio is less than 100%, it implies that owner’s funds are more than total fixed assets
and a part of the working capital is provided by the shareholders. When the ratio is more
than 100%, it implies that owner’s funds are not sufficient to finance the fixed assets and
the firm has to depend upon outsiders to finance the fixed assets. There is no ‘rule of
thumb’ to interpret this ratio but 60 to 65% is considered to be satisfactory ratio in case of
industrial undertakings.
(vi) Fixed Assets to Total Long-term Funds or Fixed Assets Ratio
A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to total long-
term funds which is calculated as:

Fixed Assets Ratio =

36
Interpretation of Fixed Assets Ratio
The ratio indicates the extent to which the total of fixed assets is financed by long term
funds of the firm. Generally, the total of the fixed assets should be equal to the total of the
long-term funds or, say, the ratio should be 100%. But in case the fixed assets exceed the
total of the long-term funds it implies that the firm has financed a part of the fixed assets
out of current funds of the working capital which is not a good financial policy. And if the
total long-term funds are more than total fixed assets, it means that a part of the working
capital requirements is met out of the long-term funds of the firms.
(vii) Ratio of Current Assets to Proprietors’ Funds
The ratio is calculated by dividing the total of current assets by the amount of shareholders’
funds

Ratio of Current Assets to Proprietors’ Funds = × 100

Interpretation of Ratio of Current Assets to Proprietors’ Funds

The ratio indicates the extent to which proprietors’ funds are invested in current assets.
There is no ‘rule of thumb’ for this ratio and depending upon the nature of the business
there may be different ratios for different firms.
(viii) Debt Service Ratio OR Interest Coverage Ratio
This ratio is calculated by dividing the net profit before interest and taxes by fixed interest
charges:

Debt-Service Ratio or Interest Coverage =

Interpretation of Interest Coverage (IC) Ratio

Interest coverage ratio indicates the number of times interest is covered by the profits
available to pay interest charges. Generally, higher the ratio, safer are the long-term
creditors because even if earnings of the firm fall, the firm shall be able to meet its
commitment of fixed interest charges. But a too high interest coverage ratio may not be
good for the firm because it may imply that firm is not using debt as source of finance so as
to increase the earnings per share.
(ix)Cash to Debt Service Ratio
It is an improvement over the Interest coverage ratio. The logic of the ratio is that interest
payments are to be made out of cash inflow of the business and not profits and apart from
interest expenses sinking fund appropriation on debt should be considered to find out debt
cash flow coverage as a measure of long-term solvency of a firm.

37
 Cash to Debt Service Ratio =

Interpretation of Cash to Debt Service Ratio

Generally, higher the coverage better it is, as far as, long-term solvency of the firm is
concerned.
3. Analysis of Profitability or Profitability Ratios
In the words of Lord Keynes, “Profit is the engine that drives the business enterprises”. A
business needs profits not only for its existence but also for expansion and diversification.
The investors want an adequate return on their investments, workers want wages,
creditors want higher security for their interest and loan and so on. Profits are, thus, a
useful measure of overall efficiency of a business. Profitability ratios are calculated to
measure the overall efficiency of the business.
The various profitability ratios are discussed below:
(A) General Profitability ratios
(i) Gross Profit Ratio
Gross profit ratio measures the relationship of gross profit to net sales and is usually
represented as a percentage. Thus, it is calculated by dividing the gross profit by sales:

Gross Profit Ratio = × 100

Gross Profit Ratio = × 100

Interpretation of Gross Profit Ratio

Higher the gross ratio (Gross Profit Ratio) better the result. A low gross profit ratio,
generally indicates high cost of goods sold due to unfavorable purchasing policies, lesser
sales, lower selling prices, excessive competition, over-investment in plant and machinery,
etc.
(ii) Operating Ratio
Operating ratio establishes the relationship between cost of goods sold and other operating
expenses on the one hand and the sales on the other.

Operating Ratio = × 100

Operating Ratio = × 100

38
 Operating expenses consist of:
a) Administrative and office expenses like rent, salaries to staff, insurance,
directors’ fees. etc.
b) Selling and distribution expenses like advertisement, salaries of salesman, etc.

Interpretation of Operating Ratio

Higher the operating ratio, the less favorable it is, because, it would have a small margin
(operating profit) to cover interest, income-tax, dividend and reserves.
(ii) Operating Profit Ratio

Operating Profit Ratio = × 100

This ratio can also be calculated as:

Operating Profit Ratio = 100 – Operating Ratio.

(iv) Expenses Ratios

Expenses ratios indicate the relationship of various expenses to net sales.

Particulars Expense Ratio = × 100

Administrative & Office Expenses Ratio = × 100

Interpretation of Expense Ratios

The lower the ratio, the greater is the profitability and higher the ratio, lower is the
profitability.
(v) Net Profit Ratio
Net Profit ratio establishes a relationship between net profit (after taxes) and sales, and
indicates the efficiency of the management in manufacturing, selling, administrative and
other activities of the firm.

Net Profit Ratio = × 100

Interpretation of Net Profit Ratio
Obviously, higher the ratio, the better is the profitability.
(vi) Cash Profit Ratio
This ratio measures the relationship between cash generated from operations and the net
sales. Thus,

39
 Cash Profit Ratio = × 100

Where, Cash Profit = Net Profit + Depreciation.

(B) Overall Profitability Ratios
Profits are the measure of overall efficiency of a business. The higher the profit, the more
efficient is the business considered. Thus, overall profitability or efficiency of a business
can be measured in terms of profits related to investments made in the business.

(i) Return on Shareholder’s Investment or Net Worth

Return on shareholders’ investment, popularly known as ROI or return on shareholder /
Proprietors’ funds is the relationships between net profits (after interest & tax) and the
proprietors’ funds. Thus,

Return on Shareholder’s Investment =

The ratio is generally calculated as a percentage by multiplying the above with 100.
Shareholders’ funds include equity share capital, preference share capital, and free
reserves such as share premium, revenue reserve, capital reserve, retained earnings and
surplus, less accumulated losses, if any.
To sum up:
Shareholders’ investment = Equity Share Capital + Preference Share Capital + Reserve &
Surplus – (accumulated losses, if any)

Interpretation of ROI
This ratio is one of the most important ratios used for measuring the overall efficiency of a
firm. As this ratio reveals how well the resources of a firm are being used, higher the ratio,
better are the results.
(ii) Return on Equity Capital
Return on equity capital, which is the relationship between profits of a company and its
equity capital, can be calculated as:

Return on Equity Capital =

Interpretation of Return on Equity Capital

Interpretation of the ratio is similar to the interpretation of return on shareholder’s
investments and higher the ratio, better it is.
(iii) Earnings Per Share (E.P.S)
Earnings per share are a small variation of return on equity capital and are calculated by
dividing the net profit after taxes and preference dividend by the total number of equity
shares. Thus,

40
 E.P.S. =

Interpretation of E.P.S
The earnings per share is a good measure of profitability and when compared with E.P.S. of
similar other companies, it gives a view of the comparative earnings or earnings power of a
firm.
(iv) Capital Turnover Ratio
Capital turnover ratio is the relationship between cost of goods sold (or sales when
information about cost of goods sold is not available from the financial statements) and the
capital employed.

Capital Turnover Ratio =

Capital turnover ratio can be classified as:

1. Fixed Assets Turnover, and
2. Working Capital Turnover.

Fixed Assets Turnover Ratio =

Working Capital Turnover Ratio =

(c) Market Test or Valuation Ratios

(i) Dividend Yield Ratio
Dividend yield ratio is calculated to evaluate the relationship between dividend per share
paid and the market value of the share.

Dividend Yield Ratio =

Dividend per Share =

(ii) Dividend Pay-out Ratio or Pay-out Ratio

Dividend pay-out ratio is calculated to find the extent to which earnings per share have
been retained in the business. It is an important ratio because ploughing back of profits
enables a company to grow and pay more dividends in future.

41
 Dividend Pay-out Ratio =

(iii) Price-Earnings Ratio of P/E Ratio (Earnings Yield Ratio)

Price earnings ratio is the ratio between market price per equity share and earnings per
share.

Price earnings ratio =

Interpretation of P/E Ratio

Generally, higher the price-earnings ratio, the better it is. If the P/E ratio falls, the
management should look into the causes that have resulted into the fall of this ratio.
(iv) Earnings Yield Ratio
This ratio also shows a relationship between earnings per share and market value of
shares. It is calculated as follows:

Earnings Yield Ratio = × 100

(v) Market Value to Book Value Ratio

Market Value to book value ratio is the relationship between market value per share of a
firm and its book value per share. Thus,

Market Value to Book Value Ratio =

Book Value per share

Book Value per share indicates the net worth per equity share and the ratio of market value
to book value may be used to analyze its stock market position.

Illustrations
1. From the following ascertain liquid assets and current liabilities: current ratio 3:1,
Quick ratio 1:1, current assets Rs.1,80,000
Solution:
CR = CA/CL 3 : 1 = 180000 : CL
CL = 60000
QR = QA/CL 1 : 1 = QA : 60000
QA = 60,000
42
2. Average stock of a firm is Rs.40,000. Its opening stock is Rs.5,000 less than the closing
stock. Find out the opening stock.
Solution:
Let the closing stock = X
Opening stock = X - 5000
Average stock = opening stock + closing stock / 2
40,000 = (X - 5000) + X / 2
X = 42,500
Closing stock = 42,500
Opening stock = 37,500

3. The following information is obtained from the books of E for the year ended 31-12-
2017 and 2018.
Liabilities 2017 2018
Creditors 20,000 16,000
B/P 12,750 6,500
Debentures 1,00,000 1,00,000
Reserves 67,250 84,500
Share Capital 1,00,000 1,00,000
3,00,000 3,07,000
Assets 2017 2018
Cash at bank 15,380 26,02,
Trade debtors 11,260 11,710
Stock on hand 26,160 49,460
Fixed assets 2,17,200 2,19,810
3,00,000 3,07,000

2017 2018
Sales 1,80,000 1,95,000
Net profit 16,000 17,250
Gross profit 40,000 65,000
You are required to rearrange the above balance sheet figures to form suitable for analysis
and show separately the following ratios:
i) Gross profit ratio
ii) Operating ratio
iii) Proprietary ratio
iv) Current ratio
v) Debtor’s turnover ratio.
Solution:
As on 31st December 2017 As on 31st December 2018
Capital employed:
Shareholder’s funds
Share capital 1,00,000 1,00,000
Reserves 67,250 84,500
43
Shareholder’s funds 1,67,250 1,84,500
Long term Borrowed
Funds: 1,00,000 1,00,000
Debentures
Employment of Capital 15,380 26,020
Cash at Bank 11,260 11,710
Trade Debtors 26,640 37,730
Liquid Assets 56,160 49,460
Stock on hand 82,800 87,190
Current Assets
Current Liabilities: 20,000 16,000
Creditors 12,750 6,500
Bills payable 32,750 22,500
Current Liabilities
Working Capital: 82,800 87,190
Current Assets 32,750 22,500
Less Current Liabilities 50,050 64,690
Working Capital 2,17,200 2,19,810
Fixed Assets 2,67,250 2,84,500
Employment of Capital 2004 2005
Computation of Ratios:
Gross Profit Ratio 40,000 / 1,80,000 X 100 65,000 / 1,95,000 X 100
Gross Profit / Sales X 100 = 22.22% = 33.33%

Operating Ratio (1,80,000 – 40,000) (1,95,000 – 65,000)

COGS = Sales – GP = 1,40,000 = 1,30,000

Operating Expenses: 40,000 – 16,000 65,000 – 17,250

GP – NP = 24,000 = 47,750
1,40,000 + 24,000 1,30,000 + 47,750
Operating cost = COGS + = 1,64,000 = 177,750
operating expenses
Operating ratio = 1,64,000 / 1,80,000 X 100 1,77,750 / 1,95,000 X 100
Op.Cost/Sales X 100 = 91.11% = 91.15%

Proprietary Ratio 1,67,250 / 3,00,000 1,84,500 / 3,07,000

Share holders’ funds/Total = 0.56 = 0.60
Assets
Current Ratio 82,800/ 32,750 87,190 / 22,500
CA / CL = 2.53 : 1 = 3.88 : 1

Debtors Turnover ratio 6,80,000 / 12,650 1,95,000 / 11,710

Sales / Debtors = 16 times = 16.7

44
 Preparation of financial statements using ratios:
Illustrations
1. Complete the Balance Sheet items for a firm having a sale of Rs.36 lakhs, from the
following information:

Sales/Total assets 3 Sales/Fixed assets 5

Sales/Current assets 7.5 Sales/Inventories 20
Sales/Debtors 15 Current ratio 2
Total assets NW 2.5 Debt/Equity 1

Balance Sheet
Liabilities Rs. Assets Rs.
Net worth …… Fixed Assets
Long term Debt Current Assets:
…… Stock
Current Liabilities Debtors ……
…… Liquid assets ……

…… ……
Solution:
(i)Sales / Total assets = 3
Total Assets = 36,00,00 / 3 = 12,00,000
(ii)Sales / Fixed assets = 5
Fixed Assets = 36,00,000 / 5 = 7,20,000
(iii)Sales / current Assets = 7.5
Current Assets = 36,00,000 / 7.5 = 4,80,000
(iv)Sales / Inventory = 20
Inventory = 36,00,000 / 20 = 1,80,000
(v)Sales / Debtors = 15
Debtors = 36,00,000 /15 = 2,40,000
(vi)Current Ratio = CA / CL = 2
Current liabilities = 4,80,000 / 2 = 2,40,000
(vii)Total Assets / Net worth = 2.5
Net worth = 12,00,000 / 2.5 = 4,80,000
(viii)Debt / equity = 1
Debt = 4,80,000
(ix)Liquid Assets = CA – Stock – Debtors
= 4,80,000 – 1,80,000 – 2,40,000
= 60,000

Balance Sheet
Liabilities Rs. Assets Rs.
Net worth 4,80,000 Fixed Assets 7,20,000
Long term Debt 4,80,000 Current Assets:
45
 Stock 1,80,000
Current Liabilities 2,40,000 Debtors 2,40,000
Liquid assets 60,000

12,00,000 12,00,000

2. With the following ratios and further information given below, complete the Trading
Account, Profit and Loss Account and Balance Sheet of Mr.X:
Gross Profit Ratio = 25%
Net Profit Ratio = 20%
Sales / Inventory Ratio = 8
Fixed Assets / Total Current Assets = 3/4
Fixed Assets / Total Capital = 3/2
Capital / Total Outside Liabilities = 2/5
Fixed Assets = Rs.15,00,000
Closing Stock = Rs.2,00,000
Proforma Trading and Profit & Loss Account
Rs. Rs.
To Cost of Sales ……. By Sales ……
To Gross profit (25% in Sale) …….
……. ……
To Expenses ……. By Gross Profit ……
To Net Profit (20% in Sales) …….
……. ……
Proforma Balance Sheet
Liabilities Rs. Assets Rs.
Capital balance …… Fixed Assets

Add Net Profit …… Current Assets:

Stock ……
Total Liabilities …… Other Current Assets ……

…… ……

Solution:-
(a) Sales / Inventory =8

Sales = 2,00,000 × 8 = Rs.16,00,000

(b) Gross Profit Ratio = 25% (given)

Gross Profit = × 16,00,000 = Rs.4,00,000

Cost of Sales = Sales – Gross Profit = 16,00,000 – 4,00,000 = 12,00,000

46
(c) Net Profit Ratio = 20% (given)

Net Profit = × 16,00,000 = Rs.3,20,000

(d) Fixed Assets / Total Current Assets = (given)

Total Current Assets = 15,00,000 × = Rs.20,00,000

(e) Fixed Assets / Capital = (given)

Capital = 15,00,000 × = Rs.10,00,000

(f) Capital/Total Outside Liabilities = (given)

Total Outside Liabilities = 15,00,000 × = Rs.10,00,000

Trading and Profit & Loss Account
Rs. Rs.
To Cost of Sales 12,00,000 By Sales 16,00,000
To Gross profit (25% in Sale) 4,00,000
16,00,000 16,00,000
To Expenses (bal fig) 80,000 By Gross Profit 4,00,000
To Net Profit (20% in Sales) 3,20,000
4,00,000 4,00,000
Balance Sheet
Liabilities Rs. Rs. Assets Rs. Rs.
Capital Fixed Assets 15,00,000
Balance 6,80,000 Current Assets:
Add Net Profit 3,20,000 Stock
10,00,000 2,00,000 20,00,000
Total Liabilities 25,00,000 Other Current Assets
18,00,000
35,00,000 35,00,000

2.9 Du Pont control chart:

A system of management control designed by an American company named Du-Pont

Company is popularly called Du-Pont Control Chart. This system uses the ratio inter-
relationships to provide charts for managerial attention. The standard ratios of the
company are compared to present ratios and changes in performance are judged.

47
The chart is based on two elements i.e., Net profit and capital employed. Net profit is
related to operating expenses. If the expenses are under control then profit margin will
increase. The earnings as a percentage of sales or earnings divided by sales give us
percentage of profitability. Earnings can be calculated by deducting cost of sales from sales.
Cost of sales includes cost of goods sold plus office and administrative expenses and selling
and distributive expenses.

Capital employed, on the other hand, consists of current assets and net fixed assets. Current
assets include debtors, stock, bills receivables, cash, etc. Fixed assets are taken after
deducting depreciation. So profit margin is divided by capital employed and is multiplied
by 100.
Du-Pont Chart is presented as under:
DU-PONT CHART
Return on Investment

NET PROFIT x 100

CAPITAL EMPLOYED

PROFIT INVESTMENT TURNOVER

OPERATING PROFIT + SALES SALES INVESTMENT

[SALES - OPERATING EXPENSES]

COST OF GOODS SOLD +OFFICE AND SELLING + DISTRIBUTIVE

ADMINISTRATIVE EXPENSES EXPENSES

FIXED ASSETS + WORKING CAPITAL

CURRENT ASSETS (-) CURRENT LIABILITIES

The management is able to pinpoint weak spots and take corrective measures. The
performance can be better judged by having inter-firm comparison. The ratios of return on
investment, assets turnover and profit margins of comparable companies can be calculated
and these can be used as standards of performance.

2.10 Terminal questions:

Section – A (2marks questions)

1. What do you understand by ratio analysis?
2. Which ratios are used to test the short term liquidity of a company?
3. What do you mean be acid test ratio?
4. What is current ratio?
5. What is price earnings ratio?
6. What is the difference between current ratio and liquid ratio?
7. What does net profit ratio indicate?

48
8. How do you compute stock turnover ratio?
9. What are the profitability ratios? Name any three.
10. What is the debt equity ratio indicate?
11. What is debtor’s equity ratio?
12. What is ROI?
13. What is the difference between operating ratio and operating profit ratio?
14. What is proprietary ratio?
15. Which are the capital structure ratios?
16. What is the significance of capital turnover ratio?
17. Give any two limitations of ratio analysis?
18. Point out two advantages of ratio analysis?
19. What is meant by shareholders’ funds?
20. How is net working capital calculated?
21. X ltd has a current ratio of 4:5:1 and a quick ratio 3:1. If its inventory is Rs.60,000,
Find out its total current assets and total current liabilities.
(Ans: current assets = 1, 80,000, current liabilities = 40,000)

22. A firm has a current ratio of 3:1. Its net working capital is Rs.2,00,000. Calculate (i)
current assets (ii) current liabilities and (iii) liquid assets assuming inventory of
Rs.2,20,000.
(Ans: current assets = 3, 00,000, current liabilities = 1,00,000, Liquid assets =
80,000)

23. Gross profit ratio 20% on sales. Total gross profit Rs.1,00,000. Cash sales
Rs.1,20,000. Average debtors Rs.95,000. Calculate debtor’s turnover ratio.
[Ans: 4 times]

24. Current ratio is 2:5 liquid ratio is 1.5. Working capital is Rs.50,000. Ascertain
current assets and inventory.
[Ans: CA=83,333 and Inventory=33,333]

25. Turnover to fixed assets ratio is 1:1.5. Value of goods sold is Rs.5,00,000. Compute
the value of fixed assets.
[Ans: Fixed assets=3, 33,333]

26. Usha ltd has a current ratio of 3:1 and quick ratio of 1:1. Its current liabilities are
Rs.1, 50,000. Find out the value of stock in trade.
[Ans: stock=Rs.3,00,000]

Section – B (4 marks questions)

1. Briefly explain the meaning and significance of the following ratios:
(i) Operating ratio; (ii) Liquidity ratio; (iii) stock turnover ratio.

2. Assuming the current ratio of a company is 2, state in each of the following cases
whether the current ratio will improve or decline or will have no change:
49
 i) Purchase of a fixed asset on 3 months credit
ii) Purchase of a fixed asset on a long term deferred payment scheme.
iii) Sale of goods at a profit for cash.
iv) Sale of goods at a loss on credit.
v) Sale of goods at cost on credit.
vi) Bills receivable endorsed to creditors.
vii) Issue of new shares for cash.
viii) Issue of shares to vendors against the purchase of building.
ix) Issue of bonus shares.
x) Conversion of debentures into equity shares.
xi) Final dividend proposed.
[Ans: (i) decline (ii) no change (iii) improve (iv) decline (v) no change (vi) improve
(vii) improve (viii) no change (ix) no change (x) no change (xi) decline.]

3. Vasu& co. sells goods on cash and on credit. The following particulars are extracted from
their books of accounts for the calendar year 2018:
Total gross sales 1,00,000
Cash sales (included in the above) 20,000
Sales returns 7,000
Total debtors for sales as on 31-12- 9,000
2005
B/R as on 31-12-2005 2,000
Provision for doubtful debts as on 500
31-12-2005
Total creditors as on 31-12-2005 3,000
B/P as on 31-12-2005 1,000
Calculate the average collection period.
[Ans: Avg coll period=55 days.]

4. From the following information, calculate creditor’s turnover ratio and average payment
period.

Total Purchases 4,00,000

Cash Purchases (included in the 50,000
above)
Purchases returns 20,000
Creditors art end 60,000
B/P at end 20,000
Reserve for discount on Creditors 5,000
Take 365 days in year
[Ans: creditor’s turnover ratio=4.13times and average payment period. =88days]

Section – C (10 marks questions)

1. What do you mean by ratio analysis? Discuss its advantages and limitations.
50
2. Briefly explain the various profitability ratios.
3. Discuss the accounting ratios to judge the liquidity position of a business.
4. “Ratio analysis is only a technique for making judgment and not a substitute for
judgment” Examine.
5. Discuss the computation and significance of the following financial ratios:
(i) Current ratios; (ii) Quick ratio; (iii) Earnings per share; (iv) Return on capital
employed; (v) Inventory turnover; (vi) Interest coverage ratio.
6. The following are the P/L account and balance sheet of a company in a summarized
from:
Profit and Loss A/c
To opening stock 76,250 By sales 5,00,000
To purchases 3,22,250 By closing stock 98,500
To gross profit c/d 2,00,000
5,98,500 5,98,500
To selling and distribution 22,000 By gross profit b/d 2,00,000
expenses
To admn. Expenses 98,000 By dividend on 9,000
shares
To loss on sale of assets 2,000 By profit on sale of 3,000
shares
To net profit 90,000
2,12,000 2,12,000

Liabilities Amount
Share capital
2,600 equity shares of 2,60,000
Rs.100 each
Reserves 70,000
P/L a/c 20,000
Current liabilities 1,30,000
4,80,000
Assets Amount
Land and Building 1,50,000
Plant & Machinery 80,000
Stock 98,500
Debtors 61,500
B/R 60,000
Bank 30,000
4,80,000

Calculate the following ratios:

(i) Gross profit ratio
(ii) Net profit ratio
(iii) Operating ratio
51
(iv) Operating profit ratio
(v) Stock turnover ratio
(vi) Turnover of fixed assets
(vii) Return on total resources.
[Ans: (i) 40% (ii) 18% (iii) 84% (iv) 16% (v) 3.4 times (vi) 2.2 times (vii) 18.75%]

7. The following information is given:

Current ratio: 2.5
Liquidity ratio: 1.5
Net working capital Rs.3,00,000
Stock t/o ratio: 6 times [cost of sales/closing stock]
Fixed assets to net worth 0.80
Gross profit ratio 20%
Fixed assets t/o ratio: 2 times
Average debt collection period: 2 months
Reserves: Share capital 0.5:1
Draw up a Balance Sheet for the above information.
[Ans: capital=6,25,000, Reserves=3,12,500, long term liabilities=1,12,500, current
liabilities=2,00,000, Fixed assets=7,50,000, stock=2,00,000, debtors=2,50,000,
bank=50,000]

8. The gross profit of X ltd., for the year 2018 is Rs.80,000. This is one fourth of the year’s
sales. Out of total sales, ¾ is on credit. The stock turnover is 10 times and average
collection period is 15 days (assume 360 days). Total assets turnover is 4 times and the
long term debt to equity is 50%. Shareholders equity is Rs.40,000. The current ratio 2:1.
Calculate: i) Creditors ii) long term debt iii) cash in hand iv) debtors v) closing stock
vi) fixed assets.
Prepare the balance sheet of X ltd., for the year 2018
[Ans: i) Creditors=20,000 ii) long term debt=20,000 iii) cash in hand=6,000 iv)
debtors=10,000 v) closing stock=24,000 vi) fixed assets=40,000]

9. Using the following data, prepare a statement of P/L A/c and the Balance sheet:
Current ratio 1.75:1 Liquid ratio 1.27:1
Working capital Rs.33,000 Fixed assets to shareholders funds 0:625:1
Stock turnover ratio 4 items Gross profit ratio 40%
(On closing stock) Earnings per share Rs.0.5
Average debt collection period 73 days Number of shares issued 20000
Earnings for the year on share capital 25%

10. Prepare P\L A/c and Balance Sheet from the following information:
Capital 4,00,000 Working capital 1,80,000 Bank O/D 30,000
There is no fictitious asset. In current assets there is no asset other than stock, debtors and
cash.
Closing stock is 20% higher than opening stock.
Current ratio 2.5 Quick ratio 2
52
Gross profit ratio 20% (to sales) stock velocity 5
Proprietary ratio 0.6 (fixed assets: proprietary fund)
Debtor’s velocity 73 days
Net profit ratio (to average capital employed) 10%

[Ans: Op.stock=1,00,000, Cl.stock=1,20,000, sales=6,87,500, purchases=5,70,000,

GP=1,37,500, expenses=95,000, NP=42,500
CL=1,20,000, proprietary fund=4,50,000, CA=3,00,000, FA=2,70,000]

11. From the following information for AB ltd., given at the end of 2018 determine balances
for the income statement and balance sheet.
Net sales Rs. 1,00,000
Debtors turnover ratio based on net sales 2
Inventory turnover ratio 1.25
Fixed assets turnover ratio 0.8
Debts-assets ratio 0.6
Net profit margin 5%
Gross profit 25%
Return on investment 2%

Income statement for the year ending 31st December 2018

Sales Rs.1,00,000
Rs. 1,00,000
Cost of goods sold
Gross profit
Other expenses
Earnings before tax
Taxes at 50%
Earnings after tax

Balance sheet as on 31st December 2018

Liabilities Rs.
Equity
Long term debt
Short term debt 50,000
Assets Rs.
Net fixed assets
Inventory
Debtors
Cash

[Ans: Cost of goods sold=75,000, Gross profit=25,000, Other expenses=15,000,

Earnings before tax=10,000, Taxes at 50%=5,000, Earnings after tax=5,000.
Equity=1,00,000, Long term debt=1,00,000, Net fixed assets=93,750,
Inventory=60,000, Debtors=50,000, Cash=46,250]
53
12. The Capital of Star Co., Ltd. is as follows:

80,000 Equity shares of Rs. 10 each 8,00,000

9% 30,000 preference shares of Rs. 10 3,00,000
each
11,00,000

The following information has been obtained from the books of the company:
Profit after tax at 60% Rs.2,70,000
Depreciation Rs.60,000
Equity Dividend paid 20%
Market price of Equity share Rs. 40

You are required to calculate:

(a) Dividend yield on equity share
(b) Cover for the preference dividend
(c) Cover for the equity dividend
(d) Earnings per share
(e) The price earnings ratio
(f) Net cash flow
[Ans: (a) 5% (b) 10 times (c) 1.52 times (d) Rs.3.04 (e) 13.1: 1 (f) Rs.1, 43,000]

13. From the following prepare the Balance Sheet of R.K. Motors ltd.
Current ratio 2
Working capital Rs.4,00,000
Capital block to current assets 3:2
Fixed assets to turnover 1:3
Sales cash / credit 1:2
Stock velocity 2 months
Creditor’s velocity 2 months
Debtor’s velocity 3 Months
Share capital Rs.6,00,000
Debenture share capital 1:2
Net profit 10% of sales
Gross profit 25% of sales
Reserves 2.5% of sales
[Ans: CL=4,00,000, CA=8,00,000, FA=8,00,000, Reserves=60,000, NP=2,40,000,
Debentures=3,00,000]

54
 Module – 3
Cash Flow Analysis

Structure
3.1 Introduction
3.2 Meaning of Cash flow statement
3.3 Classification of Cash Flows
3.4 Uses and Significance of Cash Flow Statement
3.5 Limitations of Cash Statement
3.6 Preparation of cash flow statement in accordance with Accounting standard 3 (Revised)
issued by ICAI (only indirect method)
3.7 Treatment of Other Items
3.8 Non-Cash Transactions
3.9 Terminal questions

Learning Objectives
 To learn the concept of cash flows.
 To learn the cash flows from operating, investing and financing activities.
 To learn the procedure and Preparation of cash flow statement in accordance with
accounting standard 3 (Revised) issued by ICAI (only indirect method).
 To understand the significance and limitations of Cash flow statement.

3.1 Introduction:

Cash flow statement shows the various sources from which cash was received and the
various applications of cash, i.e., the various purposes for which the cash was utilized
during an accounting period and also the resulting cash balance at the end of the
accounting period. This statement helps the Management to understand the past behavior
of the cash cycle, and to control the uses of cash in future. Cash flow analysis is an
appropriate measure for short term financial analysis.

3.2 Meaning of Cash flow statement:

Cash flow statement is a statement which describes the inflows (sources) and outflows
(uses) of cash and cash equivalents in an enterprise during a specified period of time.
According to AS-3 (revised), an enterprise should prepare a cash flow Statement and
should present it for each period for which financial statements are prepared.

The Terms cash, cash equivalents and cash flows are used in this statement with the
following meanings:
1. Cash comprises cash on hand and demand deposits with banks.
2. Cash equivalents are short term, highly liquid investments that are readily
convertible into known amounts of cash.
3. Cash flows are inflows and outflows of cash and cash equivalents.
55
3.3 Classification of Cash Flows:

According to AS-3 (Revised), the cash flow statement should report cash flows during the
period classified by operating, investing and financing activities.
1. Cash Flows from Operating Activities: Operating activities are the principal
revenue-producing activities of the enterprise.
Examples of cash flows from operating activities are:-
a) Cash receipts from the sale of goods and rendering of services.
b) Cash receipts from royalties, fees, commissions, and other revenue.
c) Cash payments to suppliers of goods and services, etc.

2. Cash Flows from Investing Activities: Investing activities are the acquisition and
disposal of long-term assets and other investments not included in cash equivalents.
Examples of cash flows arising from investing activities are:-
a) Cash payments to acquire fixed assets (including intangibles).
b) Cash receipts from disposal of 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 equivalents and those held for trading
purposes) etc.

3. Cash Flows from Financing Activities: Financing activities are activities that result
in changes in the size and composition of the owners’ capital (including preference
share capital in the case of a company) and borrowings of the enterprise.
Examples of cash flows arising from financing activities are:-
a) Cash proceeds from issuing shares or other similar instruments..
b) Cash proceeds from issuing debentures, loans, notes, bonds, and other short-or
long-term borrowings.
c) Cash repayments of amounts borrowed such as redemption of debentures,
bonds, preference shares, etc.

3.4 Uses and Significance of Cash Flow Statement:

1. Cash flow statement is useful in the evaluation of cash position of a firm.

2. A projected cash flow statement can be prepared in order to know the future cash
position of a concern so as to enable a firm to plan and co-ordinate its financial
operations properly.
3. A comparison of the historical and projected cash flow statements can be made so as to
find the variations and deficiency.
4. A series of intra-firm and inter-firm cash flow statements reveal whether the firm’s
liquidity (short-term paying capacity) is improving or deteriorating over a period of
time.
5. Cash flow statement helps in planning the repayment of loans, replacement of fixed
assets and other similar long-term planning of cash.

56
3.5 Limitations of Cash Statement:

1. As cash flow statement is based on cash basis of accounting, it ignores the basic
accounting concept of accrual basis.
2. Some people feel that as working capital is a wider concept of funds, a funds flow
statement provides a more complete picture than cash flow statement.
3. Cash flow statement is not suitable for judging the profitability of a firm as non-cash
charges are ignored while calculating cash flows from operating activities.

3.6 Preparation of cash flow statement in accordance with Accounting standard 3

(Revised) issued by ICAI (only indirect method):

Cash flow statement

(For the year ended ……………)
Particulars Amount Amount
A. Cash Flows From Operating Activities
Net Profit/loss Before Tax and extraordinary Items x xx
Add: Non-cash and non-operating items which have already been
debited to P/L A/c: x xx
(a) Depreciation x xx
(b) Transfer to Reserves and Provisions x xx
(c) Goodwill written off x xx
(d) Preliminary expenses written off
(e) Other intangible asserts written off such as discount or loss on x xx
issue of shares/debentures, underwriting commission etc. x xx
(f) Loss on sale or disposal of fixed assets. x xx
(g) Loss on sale of investments. x xx x xx
(h) Foreign exchange loss. x xx

Less: Non-cash and non-operating items which have already been x xx

credited to P/L A/c: x xx
(a) Gain on sale of fixed assets x xx
(b) Profit on sale of investments x xx
(c) Income from interest or dividends on investments x xx
(d) Appreciation x xx x xx
(e) Reserve written back
(f) Foreign exchange gain x xxx

Operating Profit Before Working Capital Changes

Adjustments for changes in Current operating Assets and
Liabilities: x xx
Add: Decrease in Accounts of Current Operating Assets (except cash x xx
and cash equivalents) such as: x xx
Decrease in Trade Debtors x xx

57
 Decrease in Bills Receivables
Decrease in Inventories/Stock-in-trade x xx
Decrease in Prepaid Expenses etc. x xx
Add : Increase in Accounts of Current Operating Liabilities (except x xx x xx
Bank Overdraft) such as: x xx
Increase in Creditors x xx
Increase in Bills Payable x xx x xx
Increase in Outstanding Expenses x xx
x xx
Less: Increase in Accounts of Current operating Assets (As stated x x x xx
above) x xx

x xx
Less: Decrease in Accounts of Current operating Liabilities (As stated x xx
above) x xx
x xx

Cash generated from (used in) operations before tax

Less: Income tax paid x xx
cash flow before extra-ordinary items x xx
Add/Less : Extraordinary items if any x xx
Net Cash Flow From (Used In) Operating Activities x xx
x xx
B. Cash flows from Investing activities x xx x xx
Purchase of Fixed assets x xx
Sale of Fixed assets
Purchase of Investments
Sale of Investments x xx
Interest received x xx
Dividend received x xx
Net cash from/ used in investing activities x xx x xx
x xx
C. Cash flows from financing activities
Proceeds from issue of share capital x xx
Proceeds from long term borrowings/banks x xx
Payment of Long term borrowings x xx
Dividend paid
Net cash from/used in Financing activities

Net Increase/Decrease in cash and cash equivalents

Cash and cash equivalents as at ………………(opening balance)
Cash and cash equivalents as at ………………(closing balance)

58
3.7 Treatment of Other Items:

1. Interest and Dividends:

i. In case of a financing enterprise, cash flow from interest paid and interest and
dividend received should be treated as cash flows from operating activities.
Dividends paid should be classified as cash flows from financing activities.
ii. In the case of other enterprises, cash flow arising from interest and dividend paid
should be classified as cash flows from financing activities while interest and
dividend received should be classified as cash flows from investing activities.
Net profit is adjusted for non0oprating expenses and incomes for calculating
operating profits as shown below:
Net profit ….
Add : Non-operating expenses ….
Less : Non-operating incomes ….
Net operating profit ….

2. Income Tax: Cash flows arising from income tax should be classified as flow from
operating activities unless they can be specifically identified with financing and
investing activities. For example, capital gain tax on sale of land can be identified with
investing activity and therefore in the cash flow statement, it should be shown as
outflow from investing activities.

3. Extra ordinary items: The cash flows associated with extra ordinary items should be
classified as arising from operating, investing or financing activities as appropriate and
separately disclosed. For example, legal claim, cost of winning a law suit or lottery,
receipt of claim from an insurance company etc., are extra ordinary items.

3.8 Non-Cash Transactions:

Many investing and financing activities do not have a direct impact on current cash flows
although they do affect the capital and asset structure of an enterprise.

Examples of non-cash transactions are:

a) The acquisition of assets by assuming directly related activities;
b) The acquisition of an enterprise by means of issue of shares; and
c) The conversion of debt to equity.
Investing and financing transactions that do not require the use of cash or cash equivalents
should be excluded from a cash flow statement. Such transactions should be disclosed
elsewhere in the financial statements in way that provides all the relevant information
about these investing and financing activities.

Illustrations:
1. From the following information you are required to prepare a Cash Flow Statement of
C.P. Ltd. For the year ended 31st December, 2017 using the indirect method.

59
 2017 2018
Liabilities
Rs. Rs.
Share Capital 70,000 70,000
Secured Loans(Repayable - 40,000
in 2007) 14,000 39,000
Creditors 1,000 3,000
Tax Payable 7,000 10,000
P & L A/c
92,000 1,62,000
2017 2018
Assets
Rs. Rs.
Plant & Machinery 50,000 91,000
Inventory 15,000 40,000
Debtors 5,000 20,000
Cash 20,000 7,000
Prepaid Expenses 2,000 4,000
92,000 1,62,000

Profit and Loss Account

(for the ended 31st December 2017)
Rs. Rs.
To opening Inventory 15,000 By Closing Stock 40,000
To Purchases 98,000 By sales 1,00,000
To Gross Profit c/d 27,000
1,40,000 1,40,000
To General Expenses 11,000 By Gross Profit b/d 27,000
To Depreciation 8,000
To Taxes 4,000
To Net Profit c/d 4,000
27,000 27,000
To Dividend 1,000 By Balance b/f 7,000
To Balance c/f 10,000 By Net Profit b/d 4,000
11,000 11,000

Solution:
Cash flow statement
(for the year ended 31.12.2017)
Particulars Amount Amount
A. Cash Flows From Operating Activities
Net Profit Before Tax and extraordinary Items 8,000
Adjustments for non-cash and non-operating items:
Add: Non-cash and non-operating items which have already been
debited to P/L A/c. 8,000 16,000
Depreciation ______
60
Less: Non-cash and non-operating items credited to P/L A/c; 16,000
Operating Profit Before Working Capital Changes
Adjustments for changes in Current operating Assets and 25,000 25,000
Liabilities: 41,000
Add: Increase in Creditors 25,000
15,000
Less : Increase in Inventory 2,000 (42,000)
Increase in debtors (1,000)
Increase in Prepaid Expenses 2,000 (2,000)
Cash used in operations before tax (3,000)
Less: Income tax Paid (1)
Net Cash used in operating Activities (49,000)
B. Cash Flows From Investing Activities (49,000)
Purchase of Plant and Machinery (2)
Net Cash used in Investing Activities 40,000
C. Cash Flows From Financing Activities (1,000)
Proceeds from raising of secured loans 39,000
Dividend paid (13,000)
Net Cash Provided by financing Activities 20,000
Net Decrease in Cash and Cash Equivalents 7,000
Cash and cash equivalent at the beginning of the period
Cash and cash equivalents at the end of the period

Working Notes:
(1) Calculation of Income-tax paid (Rs. )
Opening Balance of Tax Payable 1,000
Add: Tax provided/charged during the year 4,000
5,000
Less: Closing Balance of Tax Payable 3,000
Tax paid during the year 2,000
(2) Calculation of Purchase of Plant & Machinery
Opening Balance of Plant & Machinery 50,000
Less: Depreciation charged during the year 8,000
42,000
Closing Balance of Plant & Machinery 91,000
Plant & Machinery Purchases during the year 49,000
Alternatively
(1) Tax Payable A/c
Rs. (Rs. )
To cash-tax paid (balancing figure) 2,000 By Balance b/d 1,000
To Balance c/d 3,000 By P/L A/c 4,000
5,000 5,000
(2) Plant and Machinery A/c
61
 Rs.
Rs.
To Balance b/d By Depreciation 8,000
50,000
To Cash-purchased (balancing By Balance c/d 91,000
49,000
figure)
99,000 99,000

2. Given below are the balance sheets of Glow Ltd. As on 31st March 2003 and 31st March
2004.
2017 2018
Rs. Rs.
Equity Share capital 2,00,000 3,00,000
Long-term Loan 1,00,000 1,00,000
Creditors 1,50,000 2,00,000
Bills payable 2,00,000 3,00,000
Retained earnings 1,80,000 2,00,000
8,30,000 11,00,000
Cash 60,000 30,000
Stock 1,20,000 1,90,000
Debtors 80,000 1,20,000
Good will 2,00,000 1,50,000
Plant & Machinery 1,00,000 2,00,000
Land and Building 2,00,000 4,00,000
Furniture 70,000 10,000
8,30,000 11,00,000

Additional information:
a) Operating expenses include depreciation Rs. 80,000 and amortization of goodwill Rs.
50,000.
b) A machine has been sold for Rs. 15,000. The written down value of the machine was Rs.
40,000 and Rs. 20,000 depreciation is charged on the same in 2018.
c) Plant and machinery was purchased for cash Rs. 1,40,000 and Land and Buildings for
Rs. 2,60,000
d) Furniture was sold for cash Rs. 60,000
e) Equity shares were issued for cash Rs. 1,00,000
f) Rs. 80,000 dividend was paid in cash.
g) Net profit for the year ending 31-3-2018 was Rs. 1,00,000

Prepare a Statement of Cash Flow for the year ending 31-3-2018.

Solution:

62
Cash Flow Statement for the year ending 31-3-2018
Rs. Rs.
(i) Cash flow from operating activities
Net profit for the year 1,00,000
Add: Depreciation (plant + building) 80,000
Loss on sale of plant 5,000
Goodwill written off 50,000
Increase in creditors 50,000
Increase in bills payable 1,00,000

2,85,000
Less: Increase stock (-) 70,000
Increase in debtors (-) 40,000 1,75,000
Net cash inflow from operating activities 2,75,000
(ii) Cash flow from investing activities:
Purchase of plant and machinery (-) 1,40,000
Purchase of land and building (-) 2,60,000
Sale of machinery 15,000
Sale of furniture 60,000
Net cash outflow from investing activities (-) 3,25,000
(iii) Cash flow from financing activities:
Issue of equity capital 1,00,000
Dividend payment (-) 80,000
Net cash inflow from financing activities 20,000
Net Decrease in cash (-) 30,000
Cash balance at the beginning 60,000
Cash balance at the end 30,000
Working Notes:
Plant Machinery Account
Rs. Rs.
To Balance b/d 1,00,000 By Cash (sale) 15,000
To Purchase 1,40,000 By Loss on sale 5,000
By Depreciation 20,000
By Balance c/d 2,00,000
2,40,000 2,40,000
Land and Building Account
Rs. Rs.
To Balance b/d 2,00,000 By Depreciation 60,000
To Purchase 2,60,000 By Balance c/d 4,00,000
4,60,000 4,60,000

3. The balance sheet of Western Manufacturers Ltd. As on 1st April 2017 and 31st march
2018 are as follows:

63
 Liabilities 1st April 31st March
2017 2018
Share capital 250000 250000
5% debentures 100000 80000
Sundry creditors 115000 108000
Profit & loss a/c 20000 27000
Depreciation fund 40000 44000
Reserve for contingencies 70000 55000
Outstanding expenses 15000 24000
610000 588000
Assets 1st April 31st March
2017 2018
Land and building 150000 150000
Machinery 82000 90000
Stock in trade 100000 114000
Sundry debtors 85000 81000
Cash and bank balance 60000 55000
Temporary investments 131000 95000
Prepaid expenses 2000 3000
610000 588000

The following additional information is available:

1. New machinery was purchased for Rs. 30000 but old machinery costing Rs. 15000
was sold for Rs. 5000 accumulated depreciation was Rs. 8000
2. Rs. 20000, 5% debentures were redeemed by purchase from open market @ Rs. 96.
3. Rs. 36000 investments were sold at book value.
4. 12% dividends were paid in cash.
5. Rs. 15000 was debited to contingency reserve for settlement of previous tax liability.

Solution:
A: cashflow from operating activities:
Net profit before tax and extraordinary items 45200
Adjustment for depreciation 12000
Operating profit before working capital changes 57200
Increase in outstanding expenses 9000
Decrease in sundry debtors 4000
Decrease in temp. investments 36000
Decrease in sundry creditors (7000)
Increase in stock in trade (14000)
Increase in prepaid expenses (1000)
Tax paid (15000)

Cash flow from operating activities 69200

B. cash flow from investing activities:
64
Sale of machinery 5000
Purchase of machinery (30000)

Net cash flow from investing activities (25000)

C. cash flow from financing activities:
Redemption of debentures (19200)
Payment of dividend (30000)

Net cash flow from financing activities (49200)

Net decrease in cash and cash equivalents (5000)

Cash and cash equivalents at beginning of period 60000

Cash and cash equivalents at end of period 55000

Working notes:
Adjusted profit and loss account
To profit & loss a/c(27000- 7000 By profit on redemption of 800
20000) debentures
To loss on sale of machinery 2000 By net profit &extra ordinary 45200
item
To machinery written off 7000
To dividend paid 30000
46000 46000

Depreciation fund account

To machinery a/c 8000 By bal b/d 40000
To bal c/d 44000 By profit & loss(current year 12000
depreciation)
52000 52000

Machinery account
To bal b/d 82000 By depreciation fund 8000
To bank a/c 30000 By bank 5000
By adjut. P/L a/c(loss) 2000
By adjut. P/L a/c(obsolete 7000
machinery written off)
By bal c/d 90000
112000 112000

4. From the following financial statements of AXE Ltd. As on 31st march 2017 and 31st
march 2018prepare cash flow statements:

65
Capital & liabilities As on 31-3- As on 31-
2017 3-2018
10% redeemable 100000 500000
preference share
capital
Equity share capital of 3000000 3200000
Rs. 10 each
Securities premium 300000 270000
Capital redemption ------- 300000
reserve
General reserve 500000 300000
Profit & loss a/c 320000 430000
Secured loan 880000 970000
Proposed dividend 400000 530000
Sundry creditors 1600000 2500000
8000000 9000000
Assets As on 31-3- As on 31-
2017 3-2018
Land at cost 200000 200000
Building at cost less 300000 275000
depreciation
Plant& machinery at 2700000 3000000
cost less depreciation
Investment at cost 800000 850000
Stock in trade 1600000 2600000
Book debts 2000000 1875000
Loans and advances 350000 175000
Cash and bank 50000 25000
balances
8000000 9000000

i. During the year 5000 redeemable preference shares of Rs. 100 were redeemed at a
premium of 10%. The premium was paid out of securities premium account. For this
purpose 20000 equity shares were issued fully paid for cash at a premium of 10%. The
capital redemption reserve was credited out of transfer from general reserve.
ii. Depreciation provided during the year was on building Rs. 25000; on plant and
machinery Rs. 300000.
iii. A plant original cost of Rs. 95000 depreciation provided till 31-3-2018 Rs. 78000
was sold for Rs. 35000 and profit was transferred to profit and loss a/c.
iv. Dividend proposed for 2017 was fully paid in 2018.

Solution:
Cash flow statement
66
A. Cash from operating activities:
Net profit before tax and extraordinary items 722000
Adjustment for depreciation(300000+25000) 325000
Operating profit before working capital changes 1047000
Increase in creditors 900000
Decrease in loans and advances 175000
Decrease in debtors 125000
Increase in stock in trade (1000000)
Net cash from operating activities 1247000
B. Cash flow from investing activities:
Sale of plant 35000
Purchase of plant & machinery (617000)
Purchase of investments (50000)
Net cash from investing activities (632000)
C. Cash flow from financing activities:
Issue of equity shares 200000
Securities premium 20000
Secured loan 90000
Payment of dividend (400000)
Redemption of preference shares (550000)
Net cash used in financing activities (640000)
Net decrease in cash and cash equivalents (25000)
Cash and cash equivalents at the beginning of period 50000
Cash and cash equivalents at the end of period 250000

Working notes:
Adjusted profit and loss a/c
To proposed dividend 530000 By bal b/d 320000
To general reserve 100000 By profit on sale of plant 18000
To profit and loss a/c 430000 By net profit before tax & 722000
extraordinary items
1060000 1060000

Plant and machinery a/c

To bal b/d 2700000 By depreciation a/c 300000
To adj. profit & loss a/c 18000 By bank a/c 35000
To bank a/c(bal fig) 617000 By bal c/c 3000000
3335000 3335000

Redeemable preference share capital a/c

To pref. shareholders a/c 500000 By bal b/d 1000000
To bal c/d 500000 `
1000000 1000000

67
 Share premium account
To pref. shareholders a/c 50000 By bal b/d 300000
To bal c/d 270000 By bank 20000
320000 320000

5. From the following balance sheet of PQR ltd. As on 31st march 2017 and 2018 and
income statement for the year ended 31st march 2018 prepare cash flow statement.
Liabilities 31-3-17 31-3-18
Equity share capital 1250 1500
Reserves 1380 3330
Debentures 1040 1110
Creditors 1890 150
Interest payable 100 230
Provision for tax 1000 400
6660 6720
Assets 31-3-17 31-3-18
Fixed assets: 1910 2180
Less: depreciation 1060 1450
850 730
Long term investments 2500 2500
Inventories 1950 900
Trade debtors 1200 1700
Cash and bank 160 790
Interest receivables ------ 100
6660 6720

Income Statement for the year 2017—2018

Sales 30650
Less: cost of goods sold 26000
Gross profit 4650
Less: depreciation 450
Interest 400
Advertisement 950
1800
2850

68
Add: interest income 300
Dividend 200 500

3350
Add: insurance claim for earthquake loss 180
3530
Less: income tax provisions 260
Net profit 3270

Additional information:
i. Plant having cost of Rs. 80000 and accumulated depreciation of Rs. 60000 were
sold for Rs. 20000.
ii. Debentures of Rs. 180000 were redeemed during the year.
iii. Out of the interest expenses of Rs. 400000 and 270000 were paid during the year.
iv. Dividend including corporate dividend tax Rs. 1320000 were paid during the year.

Solution:
Cash Flow Statement
Cashflow from operating activities:
Net profit for taxation & extraordinary items 3350
Adjustments for:
Depreciation 450
Interest 400
Interest income (300)
Dividend income (200)
Operating profit before working capital changes 3700
Decrease in inventories 1050
Increase in debtors (500)
Decrease in creditors (1740)
Income tax paid(1000+260-400) (860)
Insurance claim received for earthquake loss 180
Cashflow from operating activities 1830
Cash flow from investing activities:
Purchase of plant (2180+80-1910) (350)
Sale of plant 20
Interest received(300-100) 200
Dividend received 200
Cash flow from investing activities 70
Cash flow from financing activities
Issue of equity shares 250
Issue of debentures (1110+180-1040) 250
Dividend paid(including CDT) (1320)
Redemption of debentures (180)
Interest paid (270)
69
Cash used in financing activities (1270)
Net increase in cash and cash equivalents 630
Cash and cash equivalents at the beginning 160
Cash and cash equivalents at the end 790

3.9 Terminal questions:

Section – A (2marks questions)

1. Give the meaning of cash flow statements?
2. Give any two limitations of cash flow statement?
3. What are the sources of cash inflow?
4. What are cash equivalents?
5. Give two examples of operating activities.
6. Give two examples of financing activities.
7. Give two examples of investing activities.
8. State the objectives of preparing cash flow statement.

Section – B (4marks questions)

1. Discuss the utility of a cash flow analysis?
2. Explain the limitations of cash flow statement.
3. How do you ascertain the cash flow from operations?

Section – C (10marks questions)

1. Define cash flow statement. Explain in detail the classification of cash flows as per AS –
3(revised) with examples.

2. The following schedule shows the balance sheet in condensed form of sanjeev ltd. at the
end of the year 2017.
1-1-2017 31-12-2018
Assets:

Cash and bank balances

Sundry and debtors 45000 45000
Temporary investments 33500 21500
Prepaid expenses 55000 37000
Stock in trade 500 1000
Land and building 41000 53000
machinery 75000 75000
26000 35000

Liabilities and capital: 276000 267500

70
 Sundry creditors
Outstanding expenses
8% debentures 51500 48000
Depreciation fund 6500 6000
Reserve for contingencies 45000 35000
Profit and loss a/c 20000 22000
Capital 30000 30000
8000 11500
115000 115000

276000 267500

The following information is also available:

a.10% dividend was paid in cash.
b. New machinery for Rs. 15000 was purchased but old machinery costing Rs. 6000 was
Sold for Rs. 2000, accumulated depreciation was Rs. 3000.
c. Rs 10000 8% debenture were redeemed by purchase from open market @ Rs 96 for a
debenture of Rs. 100.
d. Rs. 18000 investments were sold at a book value.
You are required to prepare cash flow statement.
[Ans: Net cash flows from operating activities = 18,900, Net cash flows used in
investing activities = (13,000), Net cash used in financing activities = (23,900), Net
decrease in cash/ cash equivalents = (18,000)].

3. Following are the summarized balance sheet of ESS GEE ltd. as on 31st December 2017 and
2018.

LIABILITIES 2017 2018

Share capital 100000 130000

General reserve 25000 30000
Profit and loss 15200 15400
a/c 35000 -
Bank loan(long-
term) 75000 67500
Sundry creditors 15000 17500
Provision for tax
265200 260400
ASSETS 2017 2018

71
 Land & building 100000 95000
Machinery 75000 84500
Stock 50000 37000
Sundry debtors 40000 32100
Cash 200 300
Bank - 4000
Goodwill - 7500

265200 260400

Additional information:
a) Dividend of Rs 11,500 was paid.
b) Assets of another company were purchased for a consideration of Rs 30000 payable
in shares. The following assets were purchased: stock 10000, machinery Rs 12500.
c) Machinery was further purchased for Rs 4000.
d) Depreciation written off machinery Rs 6000.
e) Income tax provided during the year Rs 16500.
f) Loss on sale of machine Rs 100 was written off general reserve.
You are required to prepare a cash flow statement for the year ended 31st December 2007.
[Ans: Net cash flows from operating activities = 53,700, Net cash used in investing
activities = (3,100), Net cash used in financing activities = () 46,500, Net increase in
cash/ cash equivalents = 4,100].

4. The financial position of Mohan brothers on 1st Jan, and 31st December ,2018 was as
follows:

LIABILITIES 1stJan 31stDec

Sundry creditors 18000 20500

Mrs. Mohan loan - 10000
Loan from bank 15000 12500
Hire purchase - 10000
vendor
Capital 74000 77000

107000 130000
ASSETS 1stJan 31stDec

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 Cash 2000 1800
Sundry debtors 17500 19200
Stock 12500 11000
Land 10000 15000
Building 25000 27500
Machinery less 40000 43000
depreciation
Delivery van - 12500

107000 130000

The delivery van was purchased in December 2018 on hire purchase basis; a payment of Rs
2500 was made immediately and the balance of the amount is to be paid in 10 monthly
installments of Rs 1000 each; together with the interest at 12% per annum. During the
year,
The partners withdrew Rs 13000 for domestic expenditures. The provision for
depreciation against machinery as on 1-1-2018 was Rs 13500 and on 31-12-2018 was Rs
18000.
Prepare the cash flow statement for the year ended 31st December 2018 as per the revised
Accounting standard -3
[Ans: Net cash flows from operating activities = 22,800, Net cash used in investing
activities = (17,500), Net cash used in financing activities = (5,500), Net decrease in
cash/ cash equivalents = 200].

5. Balance sheet of Anita ltd.as on 31-12-2017 and 31-12-2018:

LIABILITES 2017 2018

Share capital 200000 300000

Share premium - 10000
8% debenture 100000 50000
General reserve 50000 80000
Profit & loss A/c 50000 70000
Provision for 30000 40000
taxation
Proposed 20000 30000
dividend 50000 70000
Sundry creditors 500000 650000
ASSETS 2017 2018

73
 Plant & 200000 300000
machinery 50000 110000
Land & building 10000 50000
Investment 80000 60000
Stock 90000 80000
Debtors 70000 50000
Cash & bank
500000 650000

Additional information:
a) Investment costing Rs 8000 was sold for Rs 15000 the profit being credited to profit
and loss a/c.
b) The interim dividend of Rs 20000 was paid during the year.
c) Accumulated depreciation:

2017 2018
Land and building 30000 40000
Plant and machinery 40000 60000

d) Depreciation charged during the year :

Land and building Rs 10000
Plant and machinery Rs 20000
e) Debentures were redeemed at par.
f)Profit and loss a/c balances of 2017 - 50000
Add- profit for 2018 - 40000
90000
Less- interim dividend - 20000
70000

Prepare cash flow statement.

[Ans: Net cash flows from operating activities = 1,83,000, Net cash used in investing
activities = (2,23,000), Net cash flows from financing activities = 20,000, Net
decrease in cash/ cash equivalents = 20,000].

6. From the following balance sheets of X company ltd. for the year ending 31st December
2017 and 31st December 2018, prepare a cash flow statement.

74
LIABILITIES 2017 2018
Equity share capital 200000 250000
9% pref. share capital 60000 40000
Capital reserve - 10000
General reserve 15000 20000
Profit & loss a/c 25000 40000
Sundry creditors 28000 52000
Bills payable 8000 10000
Outstanding expenses 4000 3000
Proposed dividend 18000 25000
Provision for taxation 20000 24000
378000 474000
ASSETS 2017 2018
Goodwill 50000 45000
Land & building 80000 55000
Plant & machinery 90000 160000
Furniture 12000 10000
Trade investments 10000 45000
Sundry debtors 32000 25000
Stock 64000 45000
Bills receivable 10000 35000
Cash in hand 10000 25000
Cash at bank 15000 26000
Preliminary expenses 5000 3000
378000 474000

Additional information:
1. An interim dividend of Rs. 10000 has been paid in 2018.
2. Rs 2000 has been received as dividend on trade investments.
3. A piece of land has been sold out in 2018 and the remaining has been revalued, the
profit on sale and revaluation being transferred to capital reserve.
4. Depreciation on plant and machinery has been written off Rs. 15000 in 2018 and no
depreciation has been charged on land and building.
5. A machinery was sold for Rs. 18000(W.D.V being Rs. 20000) and no furniture has
been sold during the year.
[Ans: Net cash flows from operating activities = 1, 09,000, Net cash used in investing
activities = (87,000), Net cash flows from financing activities = 4,000, Net increase in
cash/ cash equivalents = 26,000].

75
 Module 4
Marginal Costing and standard costing

Structure:
4.1 Introduction
4.2 Definitions of marginal cost and marginal costing
4.3 Marginal Costing
4.4 Features of marginal costing
4.5 Advantages of Marginal costing
4.6 Disadvantages of marginal costing
4.7 Marginal cost equation
4.8 Contribution
4.9 Cost-volume profit analysis: (CVP ANALYSIS)
4.10 Break-Even Analysis
4.11 Profit/Volume ratio (P/V ratio)
4.12 Breakeven point
4.13 Introduction to standard costing
4.14 Standard costs and estimated costs – comparison
4.15 Advantages and disadvantages of standard costing
4.16 Variance Analysis
4.17 Terminal questions

Learning Objectives:
 To know the technique of ascertaining cost used in any particular method of costing by
differentiating between fixed and variable costs.
 To analyze and present the cost which helps management in taking many managerial
decisions.
 To know the various ratios which would help in finding out the marginal costs?
 To understand the CVP analysis.
 To understand the meaning, advantages and limitations of Standard costing
 To learn the preliminaries for establishing a system of Standard costing
 To understand the application of Analysis of Variance, Computation of material, labour,
overhead and sales variance

4.1 Introduction:

Marginal costing is a technique of ascertaining cost used in any particular method of

costing by differentiating between fixed and variable costs. Marginal costing is the cost of a
“marginal unit”, a unit may be an article or a batch of articles. The techniques of marginal
costing system can be applied under any costing system with the only modification that
fixed and variable cost must be kept separate at every stage and that fixed costs must be
excluded from the cost rate. It is a valuable aid for control purposes. It may be said that
marginal costing goes further than ascertainment of cost. In addition to the ascertainment

76
of cost it provides a means of calculating how profit will be affected by change in volume in
cost in selling price in product mix or in mixture of sales.

4.2 Definitions of marginal cost and marginal costing:

According to Institute Of Cost and Management Accounts, London marginal cost

represents” the amount of any given volume of output by which aggregate costs are
changed if the volume of output is increased by one unit”. In practice this is measured by
total variable costs attributable to one unit. In this context a unit may be a single article, a
batch of articles, an order, a stage of production capacity, a man hour, a process or a
department.

G.H. Lawson defines marginal costing as” the cost of any unit of production is the increase
in the total cost to which the firm becomes committed by the production of that unit. But if
one part of the total cost is fixed, this part will remain unchanged as output expands- only
the variable costs will increase.
For example, the cost of production of 1000 units of radios is rs. 200000 and that of 1001
units are 200150 the marginal cost is rs. 150, i.e. (200150-200000)

4.3 Marginal Costing:

The Institute Of Cost and Management Accounts, London has defined marginal costing as
“The ascertainment of marginal cost and of the effect on profit of changes in volume or type
of output by differentiating between fixed cost and variable cost”. In this technique of
costing only variable cost are charged to operations, processes, or products leaving all
indirect costs to be written off against profits in the period in which they arise.
Marginal costing is also known as variable costing.

4.4 Features of marginal costing:

a. It is a technique of analysis and presentation of cost which helps management in taking

many managerial decisions and is not an independent system of costing such as process
costing or job costing.
b. All elements of cost- production, administration and selling and distribution are
classified into variable and fixed components. Even semi-variable cost are analysed into
fixed and variable.
c. The variable costs are regarded as the costs of the products.
d. Fixed costs are treated as period cost and are charged to profit/loss account for the
period for which they are incurred.

4.5 Advantages of Marginal costing:

i) It helps to understand relationship between cost, selling price and volume of output.
ii) It brings out clearly the contribution of each product to profit and which in turn helps
better decision making.
77
iii) It gives a clear idea how maximum overall profits can be earned.
iv) It helps in taking managerial decisions like make or buy decisions.
v) It is better and more accurate technique for determining income than absorption
costing.
vi) It is valuable aid for control due to clear distinction between fixed and variable cost
which enables the application of flexible budget as control technique.

4.6 Disadvantages of marginal costing:

i) This technique is useful only for short term analysis.

ii) It is very difficult to analyse overheads into fixed and variable elements.
iii) It is not suitable for capital intensive industries as fixed cost are much more than
variable cost.
iv) It creates unnecessary worries for the management when the recession set in because
it unduly magnifies the problem of decreasing profits or increasing losses.
v) Marginal costing is not suitable for pricing decision. It ignores fixed cost which is an
important element of the total cost.

4.7 Marginal cost equation:

For the sake of convenience a marginal cost equation can be derived as follows:
Sales- variable cost = contribution
Or Sales= variable cost + contribution
Or Sales = variable cost+ fixed cost±profit/loss
Or Sales- variable cost= fixed cost ±profit/loss
Or S – V = F ± P
Where: S stands for sales
V stands for variable cost
F stands for fixed cost
P stands for profit/loss

4.8 Contribution:

Contribution is the difference between sales and variable cost or marginal cost of sales. It
may be also defined as the excess of selling price over variable cost per unit. Contribution
being the excess of sales over variable cost is the amount that is contributed towards fixed
expenses and profit.

If the selling price of a product is Rs.20 per unit and its variable cost is Rs.15 per unit
contribution per unit is Rs. 5.

4.9 Cost-volume profit analysis: (CVP ANALYSIS):

Cost volume profit analysis is a technique for studying the relationship between cost,
volume and profit. Profits of an undertaking depend upon a large number of factors. But the
78
most important of these factors are the cost of manufacture, volume of sales, and selling
price of the products. The CVP relationship is an important tool used for profit planning of
a business.

The three factors of CVP analysis are interconnected and dependent on one another. For
example profits depends on sales, selling price to a large extent depends on cost and cost
depends on volume of production as it is only the variable cost that varies directly with
production whereas fixed cost remains fixed regardless of volume produced. In cost
volume profits analysis is an attempt is made to analyse the relationship between
variations in cost with variations in volume.

CIMA London has defined CVP analysis as, “The study of the effects on future profits of
changes in fixed cost, variable cost, sales price, quantity and mix.”

An understanding of CVP analysis is extremely useful to management in budgeting and

profit planning. It explains the impact of the following on the net profit:
a. Changes in selling prices,
b. Changes in volume of sales,
c. Changes in variable cost,
d. Changes in fixed cost.
In fact, CVP analysis helps in determining the probable effect of change in any one of these
factors on the remaining factors.

4.10 Break-Even Analysis:

Break-even analysis is a widely used technique to study the CVP relationship. It is

interpreted in narrow as well as broad sense. In its narrow sense, break-even analysis in
concerned with determining break-even point i.e., that level of production and sales where
there is no profit and no loss. At this point total cost is equal to total sales revenue.
When used in broad sense, break-even analysis is used determine probable profit/loss at
any given of production/ sales.

Assumptions underlying Break-even Analysis

The break-even analysis is based on the following assumptions:

1. All costs can be separated into fixed and variable components.
2. Variable cost per unit remains constant and total variable cost varies in direct
proportion to the volume of production.
3. Total fixed cost remains constant.
4. Selling price per unit does not change as volume changes.
5. There is only one product or in the case of multiple products, the sales mix does not
change. In other words, when several products are being sold, the sale of various
products will always be in some predetermined proportion.
6. There is synchronization between production and sales. In other words, volume of
production equals volume of sales.
79
7. Productivity per worker does not change.
8. There will be no change in the general price level.

4.11 Profit/Volume ratio (P/V ratio:

This shows the relationship between contribution and sales for studying profitability.
Contribution
P/V ratio= (or)
Sales
Fixed Assets  Profit
(or)
Sales
Sales  variable costs
(or)
Sales
Change in profits or contribution
Change in Sales

Uses of P/V ratio

P/V ratio is one of the most important ratios to watch in business. It is an indicator of the
rate at which profit is being earned. A high P/V ratio indicates high profitability and a low
ratio indicates low profitability in the business.

4.12 Breakeven point:

This is a point of no profit no loss where total costs=total cost. After breakeven point the
units sold will contribute towards profit.
Total fixed Expenses
BEP (units) =
Selling price per unit - Marginal cost per unit

(or)
Total fixed Expenses
=
Contribution per unit

Fixed Cost
BEP (in value) =
P/V Ratio

Margin of safety
It is the difference b/w actual sales & break even sales. It is based on the assumptions of
marginal costing that output will coincide sales. So margin of safety is excess production or
sales over BEP.

MOS = Actual Sales- Break even Sales

(or)
80
 Profit
MOS =
P/VRatio
Profit
Margin of safety (in units) =
Contribution per unit
Sales for desired profit (Rs) = Fixed cost + Desired profit / PV ratio
(or)
Sales for desired profit (Rs) = Fixed cost + Desired profit / Contribution per unit

Break even chart:

A break even chart is a graphical representation of marginal costing. It is considered as the
most useful graphic representation of accounting data. The chart shows the relationship
between cost volume and profit. It shows the breakeven point and estimated profit or loss
at various volumes of activities.

Angle of incidence:
This is the angle formed at breakeven point at which sales line cuts the total cost line .This
angle indicates the rate at which profits are made. Large angle of incidence means high
profits and a small angle means less profits. A large angle with high margin of safety
indicates most favorable position for any business.

Assumptions of break-even chart:

1. Cost is separated as fixed and variable.
2. Fixed cost remains constant at any level of production.
3. Selling price will remain constant irrespective of change in demand or production.
4. Operating efficiency will not change.
5. Product specifications and methods of manufacture will not change
6. The number of units produced and sold will be the same.

Limiting or Key Factor

A limiting or key factor may thus be defined as the factor in the activities of an undertaking,
which at a particular point in time or over a period will limit the volume of output.
Examples of limiting factors are:
(i) Sales
(ii) Materials
(iii) Labor of particular skill
(iv) Production capacity or machine hours
(v) Financial resources.

Illustration on utility of CVP analysis

1. Following data is given:

Total fixed cost= 12000, Selling price =12, Variable cost =9
Calculate contribution, p/v ratio, BEP in units, BEP in Rs.
Calculate profit when sales are 60000 & 100000.
81
Calculate sales when profit is 6000
Calculate variable cost when BEP is 30000, profit is 1500 & fixed cost is 6000.
Solution:
Contribution = SP per unit – VC per unit
= 12 – 9 = 3
PV ratio = (C/S) 100
= (3/12) 100 = 25%
BEP (in units) = FC/ C in units
= 12,000 / 3 = 4,000 units
BEP (in Rs) = FC/ PV ratio
= 12,000 / 25% = Rs.48,000
Profit when sales are 60000 Profit when sales are 100000.
PV ratio = 25% PV ratio = 25%
C = PV ratio x sales C = Pv ratio x sales
= 0.25 x 60,000 = 0.25 x 1,00,000
= 15,000 = 25,000
Profit = C – FC Profit = C – FC
= 15,000 – 12,000 = 25,000 – 12,000
= 3,000 = 13,000

Sales when profit is Rs.6000

Sales = FC + Desired profit / Pv ratio
= 12,000 + 6,000 / 0.25
= Rs.72,000

Calculate variable cost when BEP is 30000, profit is 1500 & fixed cost is 6000.
C = FC + Profit
= 6,000 + 1,500
= 7,500
BEP = (FC / C) Sales
30,000 = (6,000 / 7,500) sales
Sales = 37,500
C = S – VC
VC = 37,500 – 7,500
= 30,000

2. From the following information calculate breakeven point in units and in sales value:
Output 3000 units
Selling price per unit Rs.30
Variable cost per unit Rs.20
Total fixed cost Rs.20000

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Solution:
FixedCost
BEP (in units) =
Selling Price per unit  Vaariable cost
20,000 20,000
  2000 Units
30  20 10

Fixed Cost  Sales

Break-even point in sales value =
Sales  Variable Cost
Fixed cost = 20000 (given)
Sales = 3000x 30=Rs. 9000
Variable cost = 3000x20= Rs. 60000
20,000  90,000
Hence B.E.P (in sales value) =
90,000  60,000
20,000  90,000
= Rs. 60000
30,000
Otherwise as the B.E.P is 2000 units break even sales would be: 2000 x 30= Rs. 60000

3. The following information is related to sales of consumer goods for March 2009 and
2010.

Sales Profit
I 120000 9000
II 140000 13000

Calculate: i. P/V ratio

ii. Fixed cost
iii. Break-even point for sales
iv. Profit when sales are rs. 150000
v. sales require profit of rs. 50000
vi. Margin of safety as a profit rs. 80000
Solution:
Change in Profit
i. P/V ratio =  100
Change in sales
13000 - 9000
  100
14000 - 12000
4000
  100  20%
20000

ii. Fixed cost = sales x P/V ratio – profit

= 120000 x 20% - 9000= 24000-9000=15000 rs

83
 fixed cost
iii. Break – even point (for sales) =
PV Ratio
15000
=
20%
= Rs. 75000
iv. Profit when sales are Rs. 150000
Profit = PV Ratio × Sales – Fixed cost
= 20% × 150000 – 15000
= 150000 – 15000
= 30000 – 15000
= Rs. 15000
v. Sales when requires profit Rs. 50000
15000  50000
Sales = = 3,25000
20%
vi. Margin of safety as a profit of rs. 80000
Profit
Margin of safety =
PV Ratio
80000
=
20%
80000
=  100
20
= Rs. 400000

4.13 Introduction to standard costing:

One of the fundamental functions of management accounting is facilitating managerial

control. Management control is the process of evaluating performance and if necessary
applying corrected measures. The major aspect of managerial control is to control cost.
Standard costing is a technique which helps management to control costs and business
operations. It aims in eliminating wastes and increasing efficiency in performance through
setting up standards or formulating cost plans.

Meaning of Standard cost and standard costing:

The word ‘standard’ means a bench-mark or yardstick. The standard cost is a
predetermined cost which determines in advance what each product or service should cost
under the given circumstances. It is a planned cost for a unit of product or service
rendered.
According to Chartered Institute of Management Accountants, London, standard cost is “a
predetermined cost which is calculated from Management’s standards of efficient
operation and the relevant necessary expenditure. They are the predetermined costs based
on technical estimate of material, labour and overhead for a selected period of time and for
a prescribed set of working conditions”

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Standard Costing is a system of cost accounting which is designed to find out how much
should be the cost of a product under the existing conditions. The actual cost can be
ascertained only when the production is undertaken. The pre-determined cost is compared
to the actual cost and a variance between the two enables the management to take
necessary corrective measures.
According to Institute of Costs and Works Accountants, London, standard costing is “an
estimate cost, prepared in advance of production or supply correlating a technical
specification of material, and labour to the price and wage rates estimated for a selected
period of time, with an addition of the apportionment of overheads expenses estimated for
the same period within a prescribed set of working conditions.”
In the words of Brown and Howard, Standard costing is “a technique of cost accounting
which compares the standard cost of each product or service with actual cost to determine
the efficiency of the operation sot that any remedial action may be taken immediately.”

Steps Involved In Standard Costing

Standard costing involves the following steps:
1. The determination of standard cost.
2. The recording of actual cost.
3. The comparison between standard cost and actual cost.
4. The finding out of variance
5. The reporting of variance so as to find out inefficiency and take necessary corrective
measures.

4.14 Standard costs and estimated costs – comparison:

Both the standard costs and estimates costs are used to determine price in advance. The
purpose of both the systems is to control cost. The same accounting principles are used in
standard cost and estimated cost. Despite similarities, standard cost and estimated cost
differ in their objects and purpose.
The points of difference between standard cost and estimated cost are as below:
a. Estimated costs are based on historical accounting. It is an estimate of what the cost
will be. It is a cost of guess work or reasonable estimate for the costs in future. On
the other hand standard costs are based on scientific analysis and engineering
studies. It determines what the cost should be.
b. Estimated costs cannot be used to determine efficiency. It only determines the
expected costs. On the other hand standard costs are used as a device for measuring
efficiency. The standards are predetermined and a comparison of standards with
actual costs enables to determine the efficiency of the concern.
c. The purpose of determining estimated costs is to find out selling price in advance to
take a decision whether to produce or to make and also to prepare financial budgets.
Estimated costs do not serve the purpose of cost control. On the other hand
standard costs are helpful in cost control. The analysis of variance enables to take
corrective measures, if necessary.
d. Estimated costs are revised with the change in conditions. They are made more
realistic by incorporating changes in prices. Standard costs are not easily changed.
85
 They are static. The standards are set in such a way that small changes in conditions
do not require a change in standards.
e. Estimated costs are used by the concern using historical costing. Standard costing is
used by those concerns which use standard costing system. It is a part of cost
accounting process while estimated costs are statistical in nature and as such they
may not become a part of accounting.

4.15 Advantages and disadvantages of standard costing:

Advantages:
1. Standard costing system establishes yard-sticks against which the efficiency or
inefficiency of actual performances are measured.
2. Standard costing facilitates control and infuses cost consciousness among the
executives.
3. It also promotes co-operation and co-ordination amongst the various functions and
departments of the concern.
4. The standards provide incentive and motivation to work with greater effort and
vigilance for achieving the standard. This increases efficiency and productivity.
Disadvantages:
1. Establishment of standard costs is difficult in practice.
2. In course of time-sometimes even in a short period- the standards set becomes rigid
and it is not always possible to change the standards.
3. Inaccurate, unreliable, and out of date standards do more harm than benefits.
4. Sometimes, standards create adverse psychological effects. If the standard is set at a
high level, its non-achievement results in frustration and a build-up of resistance.

4.16 Variance Analysis:

Variance analysis is the process of analyzing variances by sub-dividing the total variance in
such a way that management can assign responsibility for any off standard performance.
According to C.I.M.A. London, Terminology, variance analysis is “the resolution into
constituent parts and the explanation of variances.”

Favorable and Unfavorable Variances:

The deviation of actual cost from the budgeted cost is known as a variance. When actual
cost is less than standard cost or actual profit is more than standard profit then it is a
favorable variance or when actual is more than budgeted cost it is called as unfavorable
variance. Analysis of variances may be done in respect of each element of cost such as.
1. Materials variance
2. Labor variance
3. Overhead variances

Classification of Variances:
The variances may be classified into following categories:

86
 Material Cost Variance

Material Price Variance Material Usage Variance

Material Mix Variance Material Yield Variance

The following equations may be used for verification of material cost variances:
1. Material Cost Variance = Material Price Variance + Material Usage Variance
2. Material Usage Variance = Material mix variance + Material yield variance
3. Material cost variance= Material price variance + Material mix variance + Material yield
variance.

Materials variances:
1. Material cost variance
It is the difference between the standard cost of materials and actual cost of materials. It is
expressed as
MCV = Standard cost of materials for actual output – Actual cost of materials used
(or)
Material price variance + Material usage or quantity variance
(or)
Material mix variance + Material mix variance + Material yield variance.
1. Material usage variance or quantity variance
It is that portion of cost variance which is due to the difference between the standard
quantity of materials specified for the actual output and the actual quantity of materials
used. It is expressed as:
MUV = Standard price (Standard usage - Actual usage
2. Material price variance
It is that portion of the materials cost variance which is due to the difference between
the standard cost of materials used for the output achieved and the actual cost of
materials used.
MPV=Actual usage (Standard price - Actual unit price)
3. Material mix variance
It is that portion of the material usage variance which is due to the difference between
standard and actual composition of a mixture. It is calculated as
Standard Unit Cost (Standard Quantity - Actual Quantity)

87
 (or)
Standard Cost of Standard Mix – Standard Cost of Actual Mix.
4. Material yield variance.
It is that portion of material usage variance which is due to the difference between the
standard yield and actual yield .This variance measures the abnormal loss or savings of
materials.
Yield Variance = Standard Rate (Actual Yield - Standard yield)
Standard Cost of Standard Mix
Where, Standard Rate =
Net Standard Output
This is used when actual and std. mix is the same. If the standard and actual mix differs,
the formula for calculation of yield variance is the same but standard rate is calculated
as:
Standard Cost of Revised Standard Mix
Standard Rate =
Net Standard Output
Labour Variance:
1. Labour Cost Variance:
It is the difference between the standard cost of labour allowed for actual output achieved
and actual cost of labour employed. It is calculated as
Labour Cost Variance = Standard Cost of Labour - Actual Cost of Labour.
2. Labour Rate Variance:
It is that portion of labour cost variance which arises due to the difference between
standard rate and actual rate paid. It is calculated as
Labour Rate Variance = Actual Time Taken (Standard Rate – Actual Rate)
3. Labour Efficiency Variance:
It arises due to the standard labour hours specified for the output achieved and the actual
hours. It is calculated as
Labour Efficiency Variance = Standard Rate (Standard Time for Actual Output – Actual
Time Worked)
4. Labour Idle Time Variance:
It is that portion of labour cost variance which arises due to abnormal idle time. It is
calculated as
Idle Time Variance = Abnormal Idle Time × Standard Rate
(or)
Idle Time Variance = Standard Rate (Actual Hours Spent – Actual Hours Paid)
5. Labour Mix Variance:
This variance shows the mgt. as to how much of the labour cost variance is changed due to
change in labour force. It is expressed as
Labour Mix Variance = Standard Cost of Standard Composition – Standard Cost of Actual
Composition
(or)
Labour Mix Variance = Total Actual Hours (Standard Rate per Hour of Standard Mix –
Standard Rate per Hour of Actual Mix)

If the actual time differs from Standard time the formula is

88
Total Time of Actual Labour Composition /Total time of Standard Labour Composition
(Standard Cost of Standard Labour Composition – Standard Cost of Actual Labour
Composition)
6. Labour yield variance:
Due to the difference between std yield and actual yield. It is calculated as
Labour Yield Variance = Std Labour Cost Per Unit (Std Yield – Actual Yield)

Overheads variances:
Overheads cost variance can be defined as the differences between the standard cost of
variance allowed for the actual output achieved and the actual overhead cost incurred. In
other words overhead cost variance is under or over absorption of overheads. The formula
is:
Overhead Cost Variance = Actual Output × Standard Overhead Rate Per Unit – Actual
Overhead cost
or
= Standard hours for actual output x standard rate per hour -
actual overhead cost

i. Variable overhead variance

ii. Fixed overheads variance
i. Variable Overhead Variance:
Variable Overhead Variance = (Actual Output × Standard Variable Overheads Rate Per Unit)
– Actual Variable Overheads
Or
= (Standard Hours for Actual Output × Standard Variable
Overhead Rate per Hour) – Actual Variable Overheads

a.
Variable Overhead Expenditure Variance = (Actual hours × Standard Variable Overheads
Rate per Hour) – Actual Variable Overheads
Or
= Actual Hours (Standard Variable Overheads
Rate – Actual Variable Overheads Rate)

b.
Variable Overheads Efficiency Variance = Standard Variable Overhead Rate (Standard
hours) – Actual hours for actual output

ii. Fixed Overheads Variance:

Actual Output × Standard Fixed Overheads Rate – Actual Fixed Overheads
a.
Expenditure variance = Budgeted Fixed Overheads – Actual Fixed Overheads

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b.
Volume variance = Actual Output X Standard Rate – Budgeted Fixed Overheads

(i)
Capacity variance = standard rate (revised budgeted units – budgeted units)
Or
Standard rate (revised budgeted hours – budgeted hours)

(ii)
Calendar variance = Decrease or Increase in number of units produced to the difference
of budgeted and actual days × standard rate per unit

(iii)
Efficiency variance = Standard Rate (Actual Quantity – Standard Quantity)
Or
= Standard rate per hour (standard hours produced – actual hours)

Total
overheads
cost variance

Variable Fixed
OverheadVar Overhead
iance Variance

Expenditure Efficiency Expenditure Volume

Variance Variance Variance Variance

Capacity Calender Efficiency

Variance Variance Variance

Illustrations on Material & Labour variances and overheads variance:

Illustration 1: From the following particulars, compute:

(a) Material cost variance,
(b) Material price variance, and
(c) Material usage variance.
Quantity of materials purchased 3.000 units
Value of materials purchased Rs.9,000

90
Standard quantity of materials required 0.30 units
per ton of output
Standard rate of material Rs.2.50 per
unit
Opening stock of materials Nil
Closing stock of materials 500 units
Output during the period 80 tons

Solution:
Basic Calculations
Actual quantity of material purchased = 3,000 units
Value of material purchased = Rs.9,000
Rs.9,000
Actual price per unit = = Rs.3 per unit
3,000 units
Standard price = 2.50 per unit
Standard quantity = 80 tons ×30 units = 2,400 units
Actual quantity = Opening stock + Purchase – Closing stock
= Nil + 3,000 – 500 = 2,500 units

Calculation of variances
(a) Material Cost Variance = SC – AC
= (SQ × SP) – (AQ × AP)
= (2,400 × 2.50) – (2,500 × 3.00)
MCV = Rs.1,500 (A)
(b) Material Price Variance = (SP – AP) × AQ
= (2.50 – 3.00) × 2,500
MPV = Rs. 1,250 (A)
(c) Material Usage Variance = (SQ – AQ) × SP
= (2,400 – 2,500) × 2.50
MUV = Rs.250 (A)
Check
MCV = MPV + MUV
Rs.1,500 (A) = Rs.1,250 (A) + Rs.250 (A)
Rs.1,500 (A) = Rs.1,500 (A)

Illustration 2: Following is the data of a manufacturing concern. From the following

figures given below calculate (i) material cost variance (ii) material price variance (iii)
material usage variance.
The standard quantity of materials required for producing one ton of output is 40 units.
The standard price per unit of materials is rs. 3. During a period 90 tons of output was
undertaken. The materials required for actual production were 4000 units. An amount of
Rs. 14000 was spent on purchasing the materials.

91
Solution:
Standard quantity of material = 90 × 40 = 3600 units
Standard price per unit = Rs. 3
Actual price per unit = 14,000/4,000 = Rs. 3.50
(i) Material cost variance = Standard Material Cost – Actual Material cost
Standard material cost= Standard quantity x Standard price
= 3600 × 3
= Rs. 10,800
Material cost variance = 10,800-14,000
= Rs. 3,200(unfavorable)

(ii) Material price variance = actual quantity (Standard price per unit – Actual price
per unit)
= 4,000(3.00 – 3.50)
= Rs. 2,000 (unfavorable)
(iii) Material usage variance = Standard price per unit (Standard quantity – Actual
quantity)
= 3(3,600 -4,000)
= Rs. 1,200(unfavorable)

Illustration 3: The standard mix of a product is as under

A 60 units at Rs. 15 per unit Rs. 9
B 80 units at Rs. 20 per unit Rs. 16
C 100 units at Rs. 25 per unit Rs. 25
Total 240 units Rs. 50

10 units of finished product should be obtained from the above mentioned mix. During the
month of January, 2000 ten mixes were completed and the consumption was as follows.

A 640 units at rs. 20 per unit Rs. 128

B 960units at rs. 15 per unit Rs. 144
C 840 units at rs. 30 per unit Rs. 252
Total 2440 units Rs. 524

The actual output was 90 units. Calculate various variances.

Solution:

(i) Material Cost Variance:

The standard has been given for 10 units in one mix. Ten mixes have been completed, so
standard production will be 100 units.
Standard cost for 100 units = 50 × 10= Rs. 500
Actual yield is 90 units so standard cost will be adjusted accordingly.
Standard cost for actual yield = 500/100 x 90= Rs. 450
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Material cost variance = Standard Cost – Actual Cost
= Rs. 450 -524 = Rs. 74 unfavorable

(ii) Material Price Variance = Actual quantity (Standard price – Actual price)
Material A = 640(0.15 – 0.20)
=640(-0.05) = Rs. 32 unfavourable
Material B =960(0.20-0.15)
=960(0.05)
= Rs. 48 favourable
Material C = 840(0.25-0.30)
=840(-0.05)
= Rs. 42 unfavourable
Material price variance (A+B+C) = Rs. 26 unfavourable

(iii) Material Usage Variance:

The standard quantity will be revised in proportion to actual production. Revised quantity
will be:
A= 600/100 x 90= Rs. 540
B= 800/100 x 90= Rs. 720
C= 1000/100 x 90= Rs. 900
Material usage variance = Standard Price (Standard Quantity – Actual Quantity)
Material A: 15(540 – 640)
15(-100) = Rs. 15 unfavourable
Material B: 20 (720- 960)
20(-240) = Rs. 48 unfavourable
Material C: 25(900- 840)
25(60) = Rs. 15 favourable
Material usage variance = Rs. 48 unfavourable.

There is a difference between standard quantity (240x10=2400) and actual quantity

(2440), so the standard will be revised first.
Revised standard quantity will be:
A = 60/100 x 2440 = 610
B = 80/240 x 2440 = 813(approx.)
C = 100/240 x 2440 = 1017(approx.)

(iv)Material Mix Variance = Standard price (Revised Standard Quantity – Actual

Quantity)
Material A: 15P (610-640)
15(-30) = Rs 4.50 unfavourable
Material B: 20P (813 – 960)
20 (-147) = Rs. 29.40 unfavourable
Material C: 25P (1017 – 840)
25P (177) = Rs. 44.25 favourable
Material Mix Variance = Rs. 10.35 favourable
93
(v) Material Yield Variance = Standard Rate (Actual Yield – Standard Yield)
Standard Cost of Standard Mix
Standard Rate =
Standard Output
= 50/10 = Rs. 5
Standard yield = 10/240 × 2440 = 101.67 units
Yield variance = 5 (90 – 101.67) = Rs. 58.35 unfavourable

Illustration 4: The following information is given:

Standards hours per unit 15
Standard rate Rs.4 per hour
Actual Data:
Actual production 1,000 units
Actual hours 15,300 hours
Actual rate Rs.3.90 per hour
Calculate labour cost variance.

Solution:
Labour Cost Variance = (SH for actual output × SR) – (AH × AR)
= (1,000 × 15 × 4) – (15,300 × 3.900
LCV = Rs.330 (Favourable).

Illustration 5: In a manufacturing firm, the standard time fixed for a month is 8000 hours.
A standard wage rate of Rs. 2.25 per hour has been fixed. During one month, 50 workers
were employed and average working days in a month are 25. A worker works for 7 hours
in a day. Total wage bill of the factory for the month amounts to Rs. 21875. There was a
stoppage of work due to power failure (idle time) for 100 hours. Calculate various labour
variances
Solution:
Standard Time = 8,000 hours
Standard wage rate = Rs. 2.25 per hours
Actual time = (50 × 25 × 7) = 8,750 hours
Actual wage rate = (21,875/8,750) = Rs. 2.50 per hour
(i) Labour Cost Variance = Standard Labour Cost – Actual Labour cost
= (Standard Time × Standard Rate) – (Actual Time × Actual Rate)
= (8,000 × 2.2.5) – (8750 × 2.50)
18,000 – 21,875 = Rs. 3,875 (Adverse)

(ii) Rate Of Pay Variance = Actual Time (Standard Labour Rate – Actual Labour Rate)
= 8,750 (2.2.5 – 2.50)
= 8,750 (-0.25) = Rs. 2,187.50 (Adverse)

(iii) Labour Efficiency Variance = Standard Labour Rate (Standard Rate – Actual Time)
= 2.25 (8,000 – 8,650)
= 2.25 (650)
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 = Rs. 1,462.50 (Adverse)
In this variance actual time will be = Actual time paid – Idle time
Actual Time = 8,750 – 200
= 8,650 hours
Illustration 6: Calculate labour variance from the following data:
Standard Actual
Output in units 2,000 2,500
Number of workers employed 50 60
Number of working days in a month 20 22
Average wage per man per month (Rs) 280 330

Solution:
Standard wage rate per day = 280/20 = Rs. 14
Actual wage per day = 330/22 = Rs. 15
Standard man days for an output of 2,000 units = 50 x 20 = Rs. 1,000
Since actual output is more than standard output standard time will be adjusted.
Standard man days for actual output = 1,000/2,000 x 2,500 = Rs. 1,250
(i) Labour rate variance = actual time (standard arte – actual rate)
= 1,320(14-15)
= 1,320(-1)
=Rs. 1,320 Adverse
(ii) Labour Efficiency Variance = Standard Rate (Standard time- Actual time)
= 14(1250-1320)
= Rs. 980 adverse
(iii) Labour cost variance = Labour rate variance + Labour efficiency variance
= (-1,320) + (-980)
= Rs. 2300 adverse

Illustration 7: From the following information compute:

(i) Fixed overheads variance.
(ii) Expenditure variance.
(iii) Volume variance.
(iv) Capacity variance.
(v) Efficiency variance
Budget Actual
Fixed overheads for November Rs. 20000 Rs. 20400
Units of production in November 10000 10400
Standard time for 1 unit 2 hours
Actual hours worked 20100

Solution:
Standard time = 10,000 × 2= 20,000 hrs
Fixed overheads rate = 20,000/20,000 = Rs. 1

95
(i) Fixed overheads variance= actual hours × Fixed Overhead Rate – Actual Fixed overheads
= 20,100 × 1 – 20, 400
= 20,100 – 20,400
= Rs. 300 unfavourable
(ii) Expenditure variance =Budgeted fixed Overheads – Actual fixed Overheads
=20,000 – 20,400
= Rs. 400 unfavourable
(iii) Volume variance =Actual hours Worked × Fixed overheads Rate – Budgeted Fixed
overheads
= 20,100 x 1 – 20,000
= Rs. 100 favourable
(iv) Capacity variance = Fixed overheads Rate (Revised budgeted hours – budgeted hours)
Revised Budgeted hours = 20,000/10,000 × 10400 = Rs. 20,800 hours
Capacity variance = 1 (20,800 -20,000)
= Rs. 800 favourable.

(v) Efficiency variance = Fixed overheads rate (Actual hours – Revised standard hours)
= 1(20,100 – 20,800)
=Rs. 700 unfavourable.

Illustration 8: From the following information calculate overheads varainces:

Budget Actual
Output in units 12,000 14,000
Number of working days 20 22
Fixed overheads 36,000 49,000
Variable overheads 24,000 35,000
There was an increase of 5% capacity.

Solution:
Standard Fixed overhead Rate = 36,000/12,000 = Rs. 3
Standard Variable overhead Rate = 24,000/12,000 = Rs. 2

(i) Total overhead cost variance = Actual output × Standard rate – Actual overheads
= 14,000 × (3+2) – (49,000 + 35,000)
= 70,000 – 84,000
= Rs. 14,000 adverse

(ii) Variable overheads variance = Actual output × Standard variable overheads rate
– Actual variable overheads
= 14,000 × 2 – 35,000
= 28,000 – 35,000
= Rs. 7,000 adverse

(iii) Fixed overheads variance = Actual output × Standard fixed Overheads rates
96
 – Actual overheads
= 14,000 x 3 – 49,000
= 42,000 – 49,000
= Rs. 7,000 adverse

(iv) Expenditure Variance = Budgeted fixed Overheads – Actual fixed Overheads

= 36,000 – 49,000
=Rs. 13,000 adverse

(v) Volume variance = Actual output × Standard rate – Budgeted fixed Overheads
= 14,000 × 3 – 36,000
= 42,000 – 36,000
= Rs. 6,000 favourable

(vi) Capacity variance = standard rate (Revised budgeted units – Budgeted units)
Budgeted units for 20 days = 12,000
Budgeted units for 22 days = 12,000 x 22/20 = Rs. 13,200
Revised budgeted units = 13200 + 5/100 x 13200(After 5% increase in capacity)
= 13,200 + 660 = 13,860
Capacity variance = 3(13,860 – 13,200)
= Rs. 1980 favourable.

Change in number of units by change

(vii) Calendar variance = × Standard Rate
in actual and standard number of days
There is an increase of 2 working days than budgeted
Increase in units in 2 days = 12,000/20 x 2 = 1,200 units
Calendar variance = 1,200 x 3
= Rs. 3,600 favourable.

(viii) Efficiency variance = Standard rate (actual quantity – standard quantity)

Standard quantity 12,000
Increase in production due to change in capacity 660
Increase in production due to increase in working days 1,200
13,860
Efficiency variance = 3 (14,000 – 13,860)
= Rs.420 favourable

4.17 Terminal questions:

Section – A (2marks questions)

1. What do you understand by marginal cost equation?
2. What is P/V ratio? Explain its ratio.
3. What do you understand by contribution? How is it related to profit?
4. What is breakeven point?
97
5. What do you mean by angle of incidence?
6. What is a break even chart?
7. Define absorption costing.
8. Define Marginal costing.
9. What is meant by standard costing?
10. What do you mean by variance analysis?
11. What is meant by material cost variance?
12. Give the meaning of overhead variances?

Section – B (4 marks questions)

1. What are the uses of CVP analysis? Discuss the various ways of presenting CVP
relationship.
2. What do you understand by (a) Break-even point, and (b) Break-even chart?
3. What do you understand by break-even analysis? Explain its uses
4. Explain the advantages and disadvantages of Marginal costing.
5. Analyze the characteristic features of Marginal costing.
6. Differentiate between Marginal costing and Absorption costing.
7. What is meant by break-even analysis? Discuss (a) assumption of the technique, and (b)
its managerial uses?

8. The following information is obtained from A ltd for the yr 2004

Sales 6000 Variable cost 3000 Fixed cost 15000
You are required to calculate:
P/v ratio, BEP & margin of safety at this level
Calculate the effect of 10% increase in sale price
Calculate the effect of 10% decrease in sale price

(Answer: PV ratio = 50%, BEP = Rs.30,000 MOS = Rs.30,000

10%increase in sale price = PV ratio = 54%, BEP = Rs.27,500
MOS=Rs.38,500
10%decrease in sale price = PV ratio = 44%, BEP = Rs.33,750
MOS = Rs.20,25

9. M Ltd manufactures & sells three products A, B, C with a sales mix of 33 1/3%, 16
2/3% & 50% respectively. The total budgeted sales during the month Dec 99 is
200000(2000 units). The following are the operating costs:
Variable cost: A - 70% of sales
B- 60% of sales
C- 65% of sales
Fixed cost Rs.50000. Calculate BEP for the products on an overall basis
What will be the BEP if sales mix ix changed as follows (with the total sales
remaining at 200000): A- 33 1/3%, B- 33 1/3%, C-33 1/3%.

Ans: BEP = Rs.1,46,342, Revised BEP = Rs.1,42,857

98
10. The sales & profit figures of two yrs are given below:
Yr sales profit
31/3/2000 150000 20000
31/3/2001 170000 25000
Calculate:
P/v ratio, BEP
Sales required to earn a profit of Rs.40000
The margin of safety at a profit of Rs. 50000
The profit made when sales are 250000

Ans: PV ratio = 25% BEP = Rs.70,000

Sales required to earn a profit of Rs.40000 = Rs.2,30,000
MOS = Rs.2,00,000
The profit made when sales are 250000 = Rs.45,000

11. A Co. has fixed expenses of 90000 with sales at 3000000 & a profit of 60000 during the
first half year. If in the next half yr, the Co. suffered a loss of 30000, calculate (a) p/v
ratio, (b) BEP, (c) margin of safety for the first half yr, (d) Expected sales volume for
next half yr assuming that selling price & fixed expenses remain unchanged, (e) The
BEP & margin of safety for the whole yr.
Ans: (a) 50% (b) Rs.1,80,000 (c) MOS = Rs.1,20,000 (d) Rs.1,20,000
(e) BEP = Rs.3,60,000 & MOS = Rs.60,000

12. The following information is given

Sales = 2,00,000 Variable cost = 1,20,000 Fixed cost = 30,000
Calculate
a) BEP
b) New BEP if selling price is reduced by 10%.
c) New BEP if variable cost increases by 10%
d) New BEP if fixed price increases by 10%.
Ans: (a) BEP = Rs.75,000 (b) Rs.90,009 (c) Rs.88,235 (d)
Rs.82,500

13. What are the steps involved in standard costing?

14. Distinguish between standard costs and estimated costs
15. What are the advantages and disadvantages of standard costing?
16. Write notes on:
a. Material cost variance
b. Idle time variance
c. Calendar Variance
d. Sales Mix Variance
e. Material Yield Variance

99
Section – C (10mks questions)

1. (a) What is meant by C.V.P. (Cost-Volume-Profit) Analysis?

(b) Explain the usefulness of CVP analysis to the management of a company.

2. The following figures relate to one yr. work in a manufacturing org:

Fixed OH 12000 Variable OH 20000
Direct wages 15000 Direct material 41000 Sales 100000
Prepare a break even chart on the basis of above information & verify your result by
actual calculations.
Ans: BEP Rs.50,000

3. An analysis of cost of Suman Mfg Co. led to the following info:

Cost elements Variable cost (% of sales) Fixed cost
Direct materials 32.8
Direct labour 28.4
Factory OH 12.6 189900
Distribution expenses 4.1 58400
General & Admn expenses 1.1 66700
Budgeted sales for the next yr are 1850000
You are required to
(a) Break even sales volume
(b) The profit at the budged sales volume
(c) The profit if actual sales drop by 10%
(d) The profit if actual sales increase by 5% from budged sales
Ans: (a) Rs.15,00,000 (b) Rs.73,500 (c) Rs.34,650 (d) Rs.92,925

4. The standard materials required for producing 100 units is 120 kgs. A standard price of
0.50 paise per kg is fixed and 2,40,000 units were produced during the period. Actual
materials purchased were 3,00,000 kgs. At a cost of Rs.1,65,000.
Calculate Material Variance.
Ans: Material Cost Variance – Rs.21,000 favourable
Material Price Variance – Rs.15,000 unfavourable
Material Usage Variance – Rs.6,000 favourable

5. From the data given below, calculate:

(i) Material Cost Variance
(ii) Material Price Variance
(iii) Material Usage Variance
Standard Quantity Standard Price Actual Quantity Actual Price
Produkte
(Units) (Rs.) (Units) (Rs.)
A 1,050 2.00 1,100 2.25
B 1,500 3.25 1,400 3.50
C 2,100 3.50 2,000 3.75
100
Ans: Material Cost Variance – Rs.550 unfavourable
Material Price Variance – Rs.1,125 unfavourable
Material Usage Variance – Rs.575 favourable

6. The standard cost of a chemical mixture is:

40% Material A at Rs.20 per kg.
60% Material B at Rs.30 per kg.
A standard loss of 10% is expected in production. During a period, there is used:
90 kgs Material A at a cost of Rs.18 per kg.
110 kgs material B at a cost of Rs.34 per kg.
The weight produced is 182 kgs of good product. Calculate
(a) Material Price Variance
(b) Material mix variance
(c) Material yield variance
(d) Material cost variance
Ans: Material Price Variance – Rs.260 Adverse
Material Mix Variance – Rs.100 favourable
Material yield Variance – Rs.52 favourable
Material Cost Variance – Rs.108 Adverse

7. From the following information, compute (a) Mix (b) Price and (c) Usage variance:
Standard Actual
Qty Unit Price Total Qty Unit Value
Materials
(kg) (Rs.) (Rs.) (kg.) Price (Rs.)
(Rs.)
A 10 2.00 20.00 5 3.00 15.00
B 20 3.00 60.00 10 6.00 60.00
C 20 6.00 120.00 15 5.00 75.00
50 4.00 200.00 30 5.00 150.00

8. The information regarding the composition and the weekly wage rates of labour force
engaged on a job scheduled to be completed in 30 weeks are as follows:
Standard Actual
Category of
No. of Weekly wage No. of Weekly wage
workers
Workers rate per hour Workers rate per hour
Skilled 75 60 70 70
Semi – Skilled 45 40 30 50
Unskilled 60 30 80 20
The work has completed in 32 weeks. Calculate various labour variances.
Ans: i. Labour cost variance – Rs.13,000 Adverse
ii. Labour rate variance – Rs.6,400 Adverse
iii. Labour efficiency variance – Rs.6,600 Adverse

101
9. The following data is taken out from the books of a manufacturing concern:
Budgeted labour composition for producing 100 articles
20 Men @ Rs.1.25 per hour for 25 hours
30 women Q 1.10 per hour for 30 hours
Actual labour composition for producing 100 articles
25 Men @ Rs.1.50 per hour for 24 hours.
25 Women @ Re.1.20 per hour for 25 hours
Calculate: (i) Labour Cost Variance (ii) Labour Rate Variance (iii) Labour Efficiency
Variance (iv) Labour Mix Variance.
Ans: (i) Rs.35 Adverse, (ii) Rs.212.50 Adverse, (iii) Rs.177.50 Favourable, (iv)
Rs.24.38 unfavourable.

10. Find out the Labour Mix Variance from the data given as under:
100 men @ Rs.1.50 per hour for 20 hours
200 women @ Rs.1.25 per hour for 15 hours
Actual labour consumption for producing 500 articles
120 men @ Rs.1.75 per hour for 15 hours
200 women @ rs.1.25 per hour for 20 hours
Ans: Labour mix variance – Rs.130 favourable.

11. Calculate labour variances from the following information:

Standard time – 3,900 hours
Standard Wages – Rs.7,800
Actual time taken – 4,025 hours
Actual wages paid – Rs.8,050
Ans: (a) LCV – Rs.250 Adverse, (b) LRV – Nil, (c) LEV – Rs.250 Adverse

12. From the following data, calculate material and labour variances:
1 tonne of material input yields a standard output of 1 lakh units.
Number of employees is 200.
The standard wage rate per employee per day is Rs.6.
Standard price for material is Rs.20 per kg.
Actual quantity of material issued by production department is 10 tonnes.
Actual price of material is Rs,21 per kg.
Actual output is 9 lakh units.
Actual wage rate per day is Rs.6.50
Standard daily output per employee is 100 units.
Total no. of days worked is 50
Idle time paid for and included above is ½ day.
Ans: (i) MCV – Rs.30,000 Adverse; (ii) MPV – Rs.10,000 Adverse; (iii) MUV – Rs.20,000
Adverse; (iv) LCV – Rs.11,000 Adverse (v) LRV – Rs.5,000 Adverse; (vi) LEV – Rs.5,400
Adverse; (v) Idle Time variance – Rs.600 Adverse.

13. Calculate variable overhead variances from the following data:

Budgeted Production for January, 2014 3000 units
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Budgeted variable overhead Rs.15,000
Standard time for one unit 2 hours
Actual production for January, 2014 2,500 units
Actual hours worked 4,500 hours
Actual variable overhead Rs.13,500
Ans: Variable overhead cost variance – Rs.1,000 adverse
Variable overhead expenditure – Rs.2,250 Adverse
Variable overhead efficiency variance – Rs.1,250 favourable.

14. Following figures are taken out form the records of a factory:
Budgeted Actual
Number of working days 22 25
Main Hours per day 4,000 4,500
Output per Man per hour in units 2.5 3
Overheads (Rs.) 55,000 65,000
Calculate overhead variances.
Ans: Overheads Cost Variances – Rs.19,375 Favourable
Expenditure Variance – Rs.10,000 Adverse
Volume Variance – Rs.29,375 Favourable
Capacity Variance – Rs.6,875 Favourable
Calendar Variance – Rs.8,437.50 Favourable
Efficiency Variance – Rs.14,062.50 Favourable

15. PVR Ltd. Has furnished you the following data:

Budgeted Actual
Number of working days 25 27
Production in units 20,000 22,000
Fixed Overheads (Rs.) 30,000 31,000
Budgeted fixed overhead rate is Re.1.00 per hour. In July 2013, 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 overhead variance
Ans: (i) Rs.1,500 Favourable (ii) Rs.900 adverse (iii) Rs.2,400 Favourable (iv)
Rs.3,000 Favourable (v) Rs.1,000 Adverse (vi) Rs.2,000 Favourable.

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 Module - 5
Budgetary control and Reporting
Structure:
5.1 Meaning of budget
5.2 Advantages and limitations of Budgetary Control
5.3 Essentials of effective budgeting
5.4 Classification of budgets
5.5 Cash budget
5.6 Introduction to Reporting
5.7 Reporting to different levels of management
5.8 Methods of Reporting
5.9 Kinds of Reports
5.10 Principles of a Good Reporting System
5.11 Process of Reporting Writing
5.12 Specimens of Management reports
5.13 Terminal questions

Learning Objectives
 To understand the meaning, objectives and importance of budgetary control.
 To study the classification of budgets,
 The preparation of cash budget, fixed and flexible budgets.
 To learn the meaning of report.
 To understand the meaning of Management reporting
 To learn the various kinds of reports and methods of report writing
 To understand the process and principles of good reporting system.

5.1 Meaning of budget:

A budget is a comprehensive and coordinated plan, expressed in financial terms, for the
operation and resources of an enterprise for some specific period. It is a formal statement
of policy, plan, objective and goal established by the top management in respect of some
future period. It acts as a business barometer as it is complete programme of activities of
the business for the period covered.
The basic elements of a budget are:
1. It is a comprehensive and coordinated plan.
2. It is expressed in financial terms.
3. It is a plan for the firm’s operations and resources.
4. It is a future plan for a specified period.

According to Gordon and Shilling law, a budget is “a predetermined detailed plan of

action developed and distributed as a guide to current operations and as a partial basis for
the subsequent evaluation of performance.”

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Budgetary Control: is also termed as a control system. Thus, budgetary control is a system
under which budget is used as a means for planning and controlling all aspects pertaining
to business operations.
Objectives:
1. To control departmental activities.
2. To help in systematic planning of production and in formulation of policies.
3. To determine from time to time, the money needed for the production.
4. To control direct and indirect expenses by limiting the chances of wastages and by
limiting the allowable expenses for different departmental heads.
5. To compare the pre-planned targets with the amount of actual expenses.

5.2 Advantages and limitations of Budgetary Control:

Advantages of budgetary control:

1. It signifies a systematic effort which helps the management to know whether the actual
performance is in line with the predetermined goal, plan and policy or not.
2. It co-ordinates with the various department of the organizations and establishes
responsibilities to them.
3. It provides for a yardstick or standard, which helps in the comparison of the actual
results with the budgeted one.
4. It analyses the variances between the actual and the standard and locates the factors
responsible for such variances.
Limitations of Budgeting:
The management must consider the following limitations in using the budgeting system as
a device to solve managerial problems.
1. Management Judgement: Budgeting is not an exact science, its success hinges upon the
precision of estimates. Managerial judgement can suffer from subjectivism and personal
biases. The adequacy of budgeting, thus, depends upon the adequacy of managerial
judgement.
2. Continuous adaptation: The installation of a perfect system of budgeting is not possible
in a short period. Management should go on trying various techniques and procedures in
developing and using the budgeting system. Ultimately, they will achieve success and reap
the benefits of budgeting.
3. Implementation: A skillfully prepared budgetary programme will not itself improve the
management of an enterprise unless it is properly implemented. All managers and
subordinates in the enterprise must have full involvement in the preparation and execution
of budgets, otherwise budgeting will not be effective.
4. Management complascency: The presence of a budgetary system should not make
management complascent. To get the best results of managing, management should use
budgeting with intelligence and foresight, along with other managerial techniques.

5.3 Essentials of effective budgeting:

An effective budgeting system should have some essentials or requisites just to ensure best
results. The following are the some characteristics of an effective budgeting:
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1. Sound forecasting: Business forecasts are the foundation of budgets, the more sound
are the forecasts, the better results would come out of the budgeting system.
2. An adequate and planned Accounting system: there should be proper flow of accurate
and timely information in the business which is ‘must’ for the preparation of budgets.
3. Efficient organization with definite lines of responsibility: An efficient, adequate and
best organization is imperative for budget preparation and its operation. Thus, a budgeting
system should always be supported by a sound organizational structure demarcating
clearly the lines of authority and responsibility.
4. Formation of Budget committee: In order to make a budgeting system more and more
effective, a budget committee should always be set up. This committee receives the
forecasts and targets of each department as well as periodic reports and finalizes the final
acceptable targets in form of Master Budget and also approves the departmental budgets.

5.4 Classification of budgets:

Budgets may be classified from various viewpoints depending upon the various bases
adopted for such classification.
However, general bases adopted for budget classification are:

Budgets

d. On the basis
a. On the basis b. On the basis c. On the basis of nature of
of Time of Function of Flexibility Business
Activity

On the basis of time

According to time, budgets may be classified into three categories.
i) Long-Term Budgets: These budgets are prepared on the basis of long-term forecasts ad
portray a long-range planning. These budgets normally cover such plans which extend to 5
to 10 years.
ii) Short-Term Budgets: these budgets are generally for one or two years and are in the
form of monetary terms. The consumers’ goods industries like sugar, cotton, textile etc., use
short-term budgets
iii) Current Budgets: The period of current budgets is generally of months and weeks.
These budgets relate to the current activities of the business. According to I.C.W.A London,
“current budgets is a budget which is established for use over a short period of time and is
related to current conditions.”

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On the basis of function
i) Operating Budgets: These budgets relate to the different activities or operations of a
firm. The number of such budgets depends upon the size and the nature of the business.
The commonly used operating budgets are sales budget, production budget, purchase
budget, etc.
The operating budget for a business firm may construct in terms of programmes or
responsibility areas, and hence may consist of:
a) Programme Budget: consists of expected revenues and costs of various
products/projects that are termed as the major programmes of the firm. Such a budget can
be prepared for each product line or project showing revenues, costs and the relative
profitability of the various programmes.
b) Responsibility Budget: when the operating budget of a firm is constructed in terms of
responsibility areas it is called the responsibility budget. Such a budget shows the plan in
terms of persons responsible for achieving them. It is used by the management as a control
device to evaluate the performance of executives who are incharge of various cost centres.
ii) Financial Budgets: these are concerned with cash receipts and disbursements,
working capital, capital expenditure, financial position and results of business operations.
The commonly used financial budgets are: cash budget, working capital budget, income
statement budget etc.
iii) Master Budgets: the various financial budgets are integrated into master budget. This
budget is prepared by the ultimate integration of separate functional budgets.
According to I.C.W.A London, “The Master Budget is the summary budget incorporating its
functional budgets.”

Classification on the Basis of Flexibility:

1. Fixed Budget: The fixed budgets are prepared for a given level of activity; the budget is
prepared before the beginning of the financial year. Fixed budgets are suitable under static
conditions. If sales, expenses and costs can be forecasted with greater accuracy, then this
budget can be advantageously used.
According to I.C.W.A London, “Fixed budget is a budget which is designed to remain
unchanged irrespective of the level of activity actually attained.”
2. Flexible Budgets: A flexible budget consists of a series of budgets for different level of
activity. It, therefore, varies with the level of activity attained. A flexible budget is prepared
after taking into consideration unforeseen changes in the conditions of the business. The
flexible budgets will be useful where level of activity changes from time to time.

Illustrations
Illustration 1:
The expenses for the production of 5,000 units in a factory are given as follows:
Particulars Per unit
(Rs)
Materials 70
Labour 25
Variable overheads 20

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Fixed overheads (Rs. 1,00,000) 10
Administrative expenses (5% variable) 10
Selling expenses (20% fixed) 6
Distribution expenses (10% fixed) 5
Total cost of sales per unit 146
You are required to prepare a budget for the production of 7,000 units.

Solution:
Flexible Budget
Particulars Output 5,000 units Output 7,000 units
Amount
Per Unit (Rs.) Amount (Rs.) Per Unit (Rs.)
(Rs.)
Materials 50.00 2,50,000 50.00 3,50,000
Labour 20.00 1,00,000 20.00 1,40,000
Prime Cost 70.00 3,50,000 70.00 4,90,000
Factory O/Hs:
Variable Overheads 15.00 75,000 15.00 1,05,000
Fixed Overheads 10.00 50,000 7.14 50,000
WORKS COST 95.00 4,75,000 92.14 6,45,000
Administrative 10.00 50,000 7.28 51,000
Expenses
Cost Of Production 105.00 5,25,000 99.42 6,96,000
Selling and
Distribution Expenses:
Selling Expenses 6.00 30,000 5.66 39,600
Distribution expenses 5.00 25,000 4.86 34,000
Total Cost of sales 116.00 5,80,000 109.94 7,69,600

Illustration 2:
The following information at 50% capacity is given. Prepare a flexible budget and forecast
the profit or loss at 60%, 70% and 90% capacity.
Particulars Amount (Rs)
Expenses at
50% capacity
Fixed Expenses:
Salaries 50,000
Rent and Taxes 40,000
Depreciation 60,000
Administration Expenses 70,000
Variable Expenses:
Materials 2,00,000
Labour 2,50,000
Others 40,000

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 Semi-Variable Expenses:
Repairs 1,00,000
Indirect Labour 1,50,000
Others 90,000

It is estimated that fixed expenses will remain constant at all capacities. Semi-Variable
expenses will not change between 45% and 60% capacity, will rise by 10% between 60%
and 75% capacity, a further increase of 5% when capacity crosses 75%.
The estimated sales at various levels of capacity are:
Capacity Sales (Rs.)
60% 11,00,000
70% 13,00,000
90% 15,00,000

Solution: Flexible Budget

Particulars Capacities
50% (Rs.) 60% (Rs.) 70% (Rs.) 90% (Rs.)
Fixed Expenses:
Salaries 50,000 50,000 50,000 50,000
Rent & taxes 40,000 40,000 40,000 40,000
Depreciation 60,000 60,000 60,000 60,000
Administrative expenses 70,000 70,000 70,000 70,000
Variable Expenses:
Materials 2,00,000 2,40,000 2,80,000 3,60,000
Labour 2,50,000 3,00,000 3,50,000 4,50,000
Others 40,000 48,000 56,000 72,000
Semi-Variable Expenses:
Repairs 1,00,000 1,00,000 1,00,000 1,15,000
Indirect Labour 1,50,000 1,50,000 1,65,000 1,72,500
Others 90,000 90,000 99,000 1,03,500
Total cost 10,50,000 11,48,000 12,80,000 14,93,000
Profit/loss - 48,000 + 20,000 + 7,000
Estimated Sales 11,00,000 13,00,000 15,00,000

5.5 Cash budget:

It is an estimate of cash receipts and disbursements during a future period of time. It

proceeds various other budgets like materials budgets and research and development
budget.

The cash budget “is an analysis of flow of cash in a business over a future, short or long
period of time. It is a forecast of expected cash intake and outlay.” The cash budget should
be co-ordinated with other activities of the business. The functional budgets may be
adjusted according to the cash budget.
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Illustration1:
ABC co. wished to arrange overdraft facilities with its bankers, during the period from
April, 2018 to June 2018 when it will be manufacturing mostly for stock.
Sales Purchases Wages
Month
(Rs.) (Rs.) (Rs.)
February 18,000 12,480 1,200
March 19,200 14,400 1,400
April 10,800 24,300 1,100
May 17,400 24,600 1,000
June 12,600 26,800 1,500
a. Prepare a cash budget for the above period from the following data, indicating the extent
of the bank facilities the company will require at the end of each month.
b. 50% of the credit sales are realised in the month following the sales and the remaining
50% in the second month following.
c. Creditors are paid in the month following the month of purchase.
d. Cash at Bank on 1.4.2018 is estimated at Rs. 2,500.

Solution:
ABC Co.
Cash Budget for the month of April to June, 2018
April May June
Rs. Rs. Rs.
Opening Balance 2,500 5,600 (-) 4,700
Receipts:
Collection from Debtors 18,600 15,000 14,100
21,100 20,600 9,400
Payments:
To Creditors 14,400 24,300 24,600
For Wages 1,100 1,000 1,500
15,500 25,300 26,100
Closing Balance 5,600 (-)4,700 (-) 16,700
21,100 20,600 9,400

The overdraft facility will be required in the month of May 2007 for Rs. 4,700 and in June
2018 for Rs. 16,700

Illustration 2:
From the following forecasts of income and expenditure, prepare a cash budget for the
months January to April 2018:
Sales
Months Purchases Manufacturing Administrative Selling
(Credit) Wages
(Credit) Expenses Expenses Expenses
Rs. Rs. Rs. Rs. Rs. Rs.
1995
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Nov. 30,000 15,000 3,000 1,150 1,060 500
Dec. 35,000 20,000 3200 1225 1040 550
1996
Jan. 25,000 15,000 2,500 990 1,100 600

Feb. 30,000 20,000 3,000 1,050 1,150 620

Mar. 35,000 22,500 2,400 1,100 1,220 570

April 40,000 25,000 2,600 1,200 1,180 710

Additional information is as follows:

a. The customers are allowed a credit period of 2 months.
b. A dividend of Rs. 10,000 is payable in April.
c. Capital expenditure to be incurred: Plant and Machinery on 15th Jan for Rs. 5,000; a
Building has been purchased on 1st March and the payments are to be made in monthly
instalments of Rs. 2,000 each.
d. The creditors are allowing a credit of 2 months.
e. Wages are paid on the 1st of the next month.
f. Lag in payment of other expenses is one month.
g. Balance of cash in hand on 1st Jan, 2018 is Rs. 15,000

5.6 Introduction to Reporting:

Reporting to Management is a part of an overall management information and control

system. It is a formal system whereby relevant information is continuously fed to the
management through reports. The purpose of reporting is to provide the necessary
information to the management through various levels to help them efficiently discharge
their functions of planning, organizing, controlling and decision making.

Meaning and definition of Report:

“A written statement based on a collection of facts, events and opinions and usually
expresses a summarized and interpretative value of this information. It may deal with past
accomplishments, present conditions or probable future developments” – G.R.Terry
Terry talks about report as a written communication prepared on the basis of collected
information related to present, past and future.

Management Reporting:
The process of providing information to the management is known as ‘Management
Reporting’. The reports are regularly sent to various levels of management so as to enable
in judging the effectiveness of their responsibility centre’s.

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5.7 Reporting to different levels of management:

The various levels of management and their reporting need are discussed as follows:
(A)Top management level:
The top level management comprises board of directors, Managing director or general
manager, assistant general management or any other chief executive by whatever name
called. These mangers at the top level are concerned more with the formulation of business
policies and evolving plans than in the day to day functioning of the business. Reports for
the top management include the following:
(i) Periodical profit and loss account and balance sheet.
(ii) Master budget
(iii) Capital budget
(iv) Reports on research and development activities
(v) Management ratio- showing overall financial position e.g. return on capital
employed, gross profit ratio and liquidity ratio
(vi) Summaries of cost of production in various departments, showing element wise
classification
(vii) Plant utilization reports

(B) Middle management level:

This comprise the heads of various departments such as sales manager, production
manage, etc. Reports for middle or coordinating level include the following:
(i) Reports on material price and usage variances.
(ii) Reports on labour rate and efficiency variances.
(iii) Overhead variance reports
(iv) Idle time report
(v) Report on wastage of materials
(vi) Report on production
(vii) Idle capacity report.

(C) Junior or Operating management level:

This comprises supervisors, foreman, section chiefs etc. they are concerned with the day to
day operations of the various sections of the business. Reports to operating management
are detailed and specific restricted only to the activity with which they are concerned.

Examples of such reports are:

(i) Material usage variance report
(ii) Labour efficiency variance report
(iii) Reports on overtime work
(iv) Labour productivity report
(v) Material spoilage report
(vi) Idle time report

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5.8 Methods of Reporting:

1. Written Reporting
A number of written reports may be sent to different levels of management. These reports
may be:
a) Formal Financial Statements
b) Tabulated Information
c) Accounting Ratios

2. Graphic Reporting
The reports may be presented in the form of charts, diagrams and pictures. These reports
have the advantages of quick grasp of trends of information presented.
3. Oral Reporting
Oral reporting may be in the following forms:
a) Group meetings
b) Conversation with individuals.
A combination of written, graphic and oral reporting may be useful for the concern.

5.9 Kinds of Reports:

The reports may be classified into the following categories

1. Classification According to Object or Purpose
a) External Reports: The reports meant for persons outside the business are known as
external reports. Outsiders interested in company reports may be shareholders,
creditors or bankers. The company publishes Income Statement and Balance Sheet at
the end of every financial year and these statements are filed with the Registrar of
Companies and Stock Exchanges.
b) Internal Reports: Internal reports refer to those reports which are meant for different
levels of management. Internal reports are not public documents and they are not
expected to conform to any standards. Some of the internal reports that are commonly
used are: Period report about profit or loss and financial position, statement of cash
flow and changes in working capital.

2. Classification According to Nature

a) Enterprise Reports: These reports are prepared for the concern as a whole. Enterprise
reports may include balance sheet, income statements, income tax returns, employment
reports, chairman’s report etc. These reports contain standardized information and are
beneficial to outsiders.
b) Control Reports: Control reports deal with two aspects. One aspect relates to the
personal performance and the second aspect deals with the economic performance. The
first types of reports are reported to judge the performance of managers and heads of
responsibility centre’s. The second type show how well the responsibility centre has
fared as an economic entity.

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c) Investigative Reports: These reports are linked with control reports. In case, some
serious problem arises then the cause of this situation are studied and analyzed. These
reports are intermittent and are prepared only when a situation arises.

3. Classification According to Period

a) Routine Reports: These reports are prepared about day-to-day working of the
concern. So far as the timing is concerned they may be sent daily, weekly, monthly, or
quarterly. Routine reports may relate to sales information, production figures etc.
b) Special Reports: These reports are prepared according to the need of the situation.
Available accounting information may not be sufficient, so data may have to be
especially collected. It may also involve co-ordination of different departments and
different levels of management.

4. Classification of Reports According to Function

a) Operating Reports: These reports provide information about operations of the
concern. The operating reports may consists of the following:
i) Control Reports: These reports are used for managerial control. They are
intended to spot deviations from budgeted performance without loss of time so
that corrective action can be taken.
ii) Information Reports: These reports are prepared to provide useful information
which will enable planning and policy formation for future.
b) Financial Reports: These reports provide information about the financial position of
the concern on specific dates or movement of finances during a specific period.

5.10 Principles of a Good Reporting System:

1. Proper flow of Information: A good reporting system should have a proper flow of
information. The information should flow from the proper place to the right levels of
management. The information should be sent in the right form and at a proper time so
that it helps in planning and co-ordination.
2. Proper Timing: Since reports are used as a controlling device, they should be
presented at the earliest or immediately after the happenings of an event.
3. Accurate Information: The information should be as accurate as possible. It the
information supplied is inaccurate it may result in making wrong decisions.
4. Basic of comparison: The information supplied through reports will be more useful
when it is supplied in comparison with past figures, standards set or objectives laid
down. The decision taking authority will able to make use of comparative figures while
taking a decision.
5. Reports should be clear and simple: The purpose of preparing reports is to help
management in planning, co-ordinating and controlling, this can be achieved only when
the reports are easily understood by the readers.
6. Cost: The benefits derived from reporting system must be commensurate with the cost
involved in it.

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7. Evaluation of Responsibility: The reporting system should enable the evaluation of
managerial responsibility. Management reporting should be devised in a way that it
helps in evaluating the work assigned to various persons.

5.11 Process of Reporting Writing:

The process of writing and designing a report consists of three stages. These stages are:
1. Deciding the nature and purpose of the report.
2. Structure of the report.
3. Drafting of a report.

Structure of the report

(i) Heading
(ii) Address
(iii) List of contents
Deciding Nature (iv) Terms of reference Drafting of
of the Report (v) Body of the report Report
(vi) Recommendation
(vii) Reference and appendices
(viii) Signature
(Process of Report Writing)

5.12 Specimens of Management reports:

Specimen 1:
The profits of Harsha Ltd., is declining year by year. You, as a management accountant of
that company, draft a report to the management explaining the reasons for declining
profits and suggest the corrective measures.
Harsha Ltd.
10, J.C. Road,
Bangalore – 560052.
20th August, 2010
The Managing Director,
Harsha Ltd.,
10, J.C. Road,
Bangalore – 560052

Dear Sir,

Sub: Report of declining profits.

In pursuance of your instructions for ascertaining the reasons for declining profits of our
company year by year, I submit hereunder the reasons for declining profits, and my
suggestions for arresting the decline.
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Reasons for declining profits:
In my view, the reasons for declining profits are:
(a) Lower Sales:
The sales of our company have been constantly declining by more than 20% over the past
three years. The fall in sales is due to higher prices of our products, severe competition in
the market, faulty product mix and poor sales promotion measures.
(b) Higher costs:
Higher prices and the consequent decline in sales are due to higher costs of our products.
Higher costs of our products are partly due to underutilization of our plant capacity,
inadequate control over wastage of material, labour and overheads, and partly due to
general rise in costs of materials, labour and overheads.
(c) Faulty product-mix:
The present product mix of our company is faulty. Of our five products, A, B, C, D and E,
only products A and B give sufficient contributions. The contribution of Product C is just
sufficient to cover its costs. Products D and E have huge negative contributions or losses.
(d) Inadequacy of funds:
Our company has been facing inadequacy of funds required for the smooth working. The
inadequacy of funds has forced the company to borrow at higher cost. The higher cost of
borrowing is also one of the reasons for declining profits.

Suggestions:
The following are my suggestions for arresting the declining trend in profits:
(i) Improving sales:
Sincere efforts must be made by our company to increase the volume of sales. The volume
of sales can be improved through proper control of product prices and effective sales
promotion measures.
(ii) Full utilization of plant capacity and effective control over costs:
Costs and prices of our products can be reduced considerably through full utilization of our
plant capacity and effective control over waste of all kinds. Reduction in cost and price of
our products, full utilization of plant capacity and control of costs will certainly contribute
to increase in sales.
(iii) Change in product mix:
As stated earlier, defective mix is one of the reasons for declining profits. As product D and
E have negative contributions and the contribution of product C is not adequate, it is better
that products C, D and E can be dropped, and efforts may be made for the expansion of
production and sale of products A and B.
(iv) Proper sales promotion measures:
One of the reasons for declining profits is severe competition faced by our products in the
market. This situation can be corrected only through effective sales promotion measures
like effective advertising and salesmanship techniques and liberal credit policies.

Yours faithfully,
Raghavendra.R
Management Accountant.

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Specimen 2:

The Directors of Ramya Steels Ltd., are facing the problem of working capital. They are not
in a position to co-ordinate the inflow and outflow of cash. Examine the existing
management of working capital and submit a report to the management on your findings
and recommendations to correct the situation.

Ramya Steels Ltd.,

150, M.G. Road,
Bangalore – 560004
1st November, 2010
The Board of Directors,
Ramya Steels Ltd.,
150, M.G. Road,
Bangalore – 560004.

Dear Sir,

Sub: Report on problem of working capital management.

As per your letter dated 15-10-2010, assigning to me the task of studying the problem of
working capital management and suggesting measures to improve it, I would like to report
as under:

Reasons:
The reasons for the inadequacy of working capital in the company are as follows:
(i) The chief reason for the inadequacy of working capital is the absence of sound liquidity
management. The absence of sound liquidity management has contributed to lack of
co-ordination between inflows and outflows of cash and the consequent shortage of
working capital.
(ii) The management of inventory in the company is also unsound. The unsound inventory
management has resulted in huge investment in closing inventories of poor selling
lines, and consequent locking up of funds and shortage of working capital.
(iii) The credit management has also been ineffective in the company. The liberal credit
policy and the inefficient recovery process have resulted in considerable increase in
sundry debtors.
(iv) The company has not been able to obtain sufficient period of credit from its suppliers.
While the average period of credit allowed by the company to its debtors is about 75
days, the period of credit obtained by the company from suppliers is just 30 days. This
is also responsible for the shortage of working capital.

Suggestions:
In my opinion, the following measures would go a long way to correct the situation:
(i) There should be much improvement in the cash management of the company. This
would help to co-ordinate the inflows and outflows of cash and overcome the problem
of shortage of working capital.
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(ii) Improvement should be made in the inventory management. There should be proper
purchase policy which would ensure the purchases of only good selling lines and only
in required quantities. Further, special efforts must be made by the company to
dispose of the existing poor selling items of goods.
(iii) The credit policy of the company requires considerable improvement. The credit policy
of our concern should be made stricter. The average of credit allowed to debtors
should be reduced from the present 75 days to at least 45 days. The collection
department should make vigorous efforts to collect the outstanding debts in time.
(iv) More emphasis should also be laid on cash sales. This would improve the working
capital and cash position of the company.
(v) Efforts should also be made to obtain sufficient period of credit from our suppliers. The
period of credit obtained from our suppliers should be increased from the present
level of 30 days to 45 days. This would contribute to proper co-ordination between the
inflow of cash from debtors and the outflows of cash to creditors.

Yours faithfully,
Avinash.M.P
Management Accountant.

Specimen 3
Tanmay & Co., are having shortage of cash, despite of increasing profits for the last three
years, due to which, the dividends cannot be paid. Draft a report to management
diagnosing and suggesting the appropriate action to remedy the situation.

Tanmay & Co.

Landsdown Road,
Mysore – 2
1st May, 2011

The Managing Director,

Tanmay& Co.,
Landsdown Road,
Mysore – 2
Dear Sir,

Sub: Shortage of cash

It is a matter of deep concern that, in spite of increasing profits for the last three years, the
company cannot pay dividend due to shortage of cash.

Reasons:
As requested by you, I have assessed the whole situation carefully, and in my opinion, the
following are the causes responsible for the situation:

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a) Though the company has had increasing profits during the last three years, it did not
conserve profits by creating sufficient reserves. This is partly responsible for shortage
of cash faced by the concern.
b) During the last three years, there has been deterioration in the liquidity position of the
company. During the last three years, the increase in current liabilities has been more
than the increase in the current assets. This has led to decrease in the working capital
and shortage of cash for the payment of dividend.
c) An examination of the total sales, net tangible worth and net working capital of the
company shows symptoms of over-trading resorted to by the company. This factor is
also responsible for shortage of cash.
d) A scrutiny of the structure of current assets clearly shows that a huge amount has been
locked up in closing inventories, leading to shortage of cash.
e) A study of the sales and debtors figures clearly reveal that the credit sales have been
expanding at a very high rate because of liberal credit policy, and the amount of sundry
debtors has been showing an increasing trend because of poor recovery of debts. This
factor is also responsible for shortage of cash.

Suggestions:
I strongly feel that the following corrective measures would certainly help to remedy the
situation to improve the cash position of the company:
a) The company should conserve sufficient profits by creating reserves. This would
improve the cash position of the company.
b) The company should stop the practice of over-trading.
c) Greater emphasis should be laid on cash sales. This would considerably improve the
cash position of the company.
d) The amount locked up in closing the inventories must be reduced by disposing of the
obsolete and slow moving items of goods. Further, a proper purchase policy, under
which only fast selling items of goods must be purchased only in required quantities,
must be purchased.
e) Special efforts must be made by the collection department to recover the debts in time.
This would go a long way in improving the cash position of the company.

Yours faithfully,
BrijeshRao,
Management Accountant

Specimen 4
The production manager of Prakash Co. Ltd. is experiencing difficulties like power
shortage, higher labour absenteeism and non-availability of raw materials on time. These
have caused the decline in production. You, as a management consultant of the company,
make an in-depth study of these problems and report to the management suggesting
suitable solutions.

Mangalore – 575002,
1st July, 2012
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The Managing Director,
Prakash Co. Ltd.
12, Nithya Industrial Estate,
Mangalore – 575002,

Dear Sir,
Sub: Report on problems of power shortage, high labour absenteeism and
non-availability of raw materials on time.

As requested by you, I have made a thorough study of the company’s problems of power
shortage, high absenteeism of the labour and non-availability of raw materials on time, and
I would like to report as follows:

Reasons:
a) The main reason for the shortage of power supply is the short supply of hydro-
electric power by the Bangalore Electricity Supply Company (BESCOM). The
BESCOM has not been able to generate enough hydro-electric dams in the State.

Another reason for the shortage of power supply is the inadequate production and
supply of thermal power in the State. The inadequate production of thermal power
in the State is mainly due to shortage of coal for thermal power generation.

Yet another reason for the shortage of power supply is the growing demand for
power not only from industries and commercial establishments but also from
farmers and domestic consumers.

b) The high labour absenteeism in the company is mainly due to the bad working
conditions and the inadequate rewards for the labour force in the company.

c) The main reason for the non-availability of the raw materials on time is the general
scarcity of the raw materials which is demanded by many competing firms.

Another reason for the non-availability of the raw materials on time is the
company’s dependence on just one supplier for the supply of raw materials in
question.

Yet another reason for the non-availability of the raw materials on time is the non-
placement of purchase orders by the Company with the supplier well in advance due
to lack of co-ordination between the production department, the stores department
and purchase department.

Suggestions:
In my opinion, the following measures would go a long way in overcoming the problems of
shortage of power supply, high labour absenteeism and non-availability of raw materials
on time:
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a) As there may not be uninterrupted supply of hydro-electric power and improvement in
the supply of thermal power in the State in the present circumstances, the company
should have an additional source of power to supplement the present hydro-electric
power supply. The additional source of power supply can take the form of power
generated through the installment of generators working on diesel.
b) The high labour absenteeism can be tackled by providing better working conditions in
the factory and providing higher emoluments and non-monetary incentives to the
labourers. The incentives, both monetary and non-monetary, offered to the workers
must be attractive enough to make the workers regular in attendance.

Again, the high labour absenteeism should also be tackled to a certain extent through
proper labour disciplinary measures.

c) The problem non-availability of the raw materials on time can be overcome by having
more than one supplier for the supply of raw materials, placing purchase orders well in
advance, which can be ensured through proper co-ordination between the production
department, stores department and the purchase department, installment of effective
inventory control measures like the perpetual inventory system, ABC Analysis of
control, etc. and also by finding out suitable substitutes for the material in question.

Yours faithfully,
Deepan Gupta
Management Consultant

5.13 Terminal questions:

Section – A (2marks questions)

1. What is meant by Budget?
2. Write down the definition of the term budget:
3. What do you mean by budgetary control?
4. What is meant by operating budget? Mention its two types.
5. Give the meaning of financial budgets.
6. What is meant by master budgets?
7. What is meant by cash budget
8. What is a report?
9. What do you mean by Management reporting?
10. State the different methods of reporting to Management.
11. What is the purpose of Management reporting?
12. What do you mean by control reports?
13. Name any four management reports for middle level managers.
14. What are specific reports?)
15. Name at least five reports meant for production manager.
16. What do you mean by internal and external reports?
17. What are the types of reports?

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Section – B (4marks questions)
1. Give some definitions for budget and budgetary control.
2. What are the objectives of budgetary control?
3. Mention some of the advantages and disadvantages of budgetary control.
4. What are the characteristic features of effective budgeting?
5. Explain the various types of budgets which is classified on the basis of time.
6. Explain various types of budgets which is classified on the basis of flexibility.
7. Explain the following:
(a) External reports.
(b) Control reports.
(c) Special reports.
(d) Financial reports.
(e) Investigative reports.
8. Explain in brief the general principles of a good reporting system.

Section C (10 marks)

1. The following information relates to a flexible budget at 60% capacity. Find out the
overhead costs at 50% and 70% capacity and also determine the overhead rates:
Particulars Amount (Rs)
Expenses at 60%
capacity
Variable Overheads:
Indirect Labour 10,500
Indirect Materials 8,400
Semi-Variable Overheads:
Repairs and Maintenance 7,000
(70% fixed, 30% variable)
Electricity 25,200
(50% fixed, 50% variable)
Fixed Overheads:
Office expenses including salaries 70,000
Insurance 4,000
Depreciation 20,000
Estimated direct labour hours 1,20,000

2. With the following data for a 60% activity, prepare a budget for production at 80% and
100% capacity
Production at 60% activity 600 units
Materials Rs. 100 per unit
Labour Rs. 40 per unit
Direct Expenses Rs. 10 per unit
Factory overheads Rs. 40,000 (40% fixed)
Administration Expenses Rs. 30,000 (60% fixed)

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 3. Production costs of Oriential Enterprises Limited are as follows:
Particulars Level of Activity
Out put (in units) 1,200 1,400 1,600
60% (Rs) 70% (Rs) 80% (Rs)
Cost (Rs)
Direct Materials 24,000 28,000 32,000
Direct Labour 7,200 8,400 9,600
Factory Overheads 12,800 13,600 14,400
Works Cost 44,000 50,000 56,000

A proposal to increase production to 90% level of activity is under the consideration of

management. The proposal is not expected to involve any increase in fixed factory
overheads. Prepare a statement showing the prime cost, total marginal cost and total
factory cost at 90% level activity.
4. The following data are available in a manufacturing company for a yearly period:
Particulars (Rs. Lakhs)
Fixed expenses:
Wages and Salaries 9.50
Rent, rates and taxes 6.60
Depreciation 7.40
Sundry administrative expenses 6.50
Semi-Variable Expenses:
(at 50% of capacity)
Maintenance and repairs 3.50
Indirect Labour 7.90
Sales department salaries 3.80
Sundry administrative expenses 2.80
Variable Expenses:
(at 50% of capacity)
Materials 21.70
Labour 20. 40
Other expenses 7.90
98.00

Assume that the fixed expenses remain constant for all levels of production, semi-variable
expenses remain constant between 45% and 65% of capacity, increasing by 10% between
65% and 80% capacity and by 20% between 80% and 100% capacity. Sales at various
levels are:
(Rs. Lakhs)
50% capacity 100
60% capacity 120
75% capacity 150
90% capacity 180

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 100% capacity 200
Prepare a flexible budget, for the year and forecast the profits at 60%, 75% and 100%
capacity.
1. Discuss various kinds of reports prepared by the Management accountant for different
levels of Management.
2. ABC Company is facing Raw material shortage. As a management accountant of the
company, draft a report to the management exploring the reasons for shortage of raw
material and suggest corrective measures.
3. The profits of “XL” Co. are declining year by year. As a Management accountant of the
company, draft a report to the management exploring the reasons for declining profit and
suggest the corrective measures.
4. What are the objectives of reporting to the Management? Suggest general principles to
be borne in mind when designing reports.
5. SMY ltd is facing the problem of working capital. Cash inflows are not matching with the
cash outflows. After examining the existing situation, submit a report to the management
on your findings and suggestions.

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 MANAGEMENT ACCOUNTING
MODEL QUESTION PAPER
3 HOURS 70 MARKS

SECTION A
ATTEMPT ANY EIGHT OUT OF ELEVEN
1. Define Management accounting.
2. Give three points of comparison between financial and management accounting
3. What do you mean be acid test ratio?
4. What is current ratio?
5. What are the sources of cash inflow?
6. What are cash equivalents?
7. What do you mean by variance analysis?
8. What is a break even chart?
9. What is P/V ratio? Explain its ratio.
10. What is meant by cash budget
11. What is a report?

SECTION B
ATTEMPT ANY SIX OUT OF EIGHT
1. Compare Horizontal and vertical analysis.
2. Vasu& co. sells goods on cash and on credit. The following particulars are extracted from
their books of accounts for the calendar year 2018:
Total gross sales 1,00,000
Cash sales (included in the above) 20,000
Sales returns 7,000
Total debtors for sales as on 31-12- 9,000
2005
B/R as on 31-12-2005 2,000
Provision for doubtful debts as on 500
31-12-2005
Total creditors as on 31-12-2005 3,000
B/P as on 31-12-2005 1,000
3. Calculate the average collection period. Assuming the current ratio of a company is 2,
state in each of the following cases whether the current ratio will improve or decline or
will have no change:
Purchase of a fixed asset on 3 months credit
Purchase of a fixed asset on a long term deferred payment scheme.
Sale of goods at a profit for cash.
Sale of goods at a loss on credit.
4. Explain the limitations of cash flow statement
5. What is meant by break-even analysis? Discuss (a) assumption of the technique, and (b)
its managerial uses?

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 6. The following information is obtained from A ltd for the yr 2004
Sales 6000 Variable cost 3000 Fixed cost 15000
You are required to calculate:
P/v ratio, BEP & margin of safety at this level
Calculate the effect of 10% increase in sale price
Calculate the effect of 10% decrease in sale price

7. Explain in brief the general principles of a good reporting system.

8. Explain the various types of budgets which is classified on the basis of time

SECTION C
ATTEMPT ANY THREE OUT OF FIVE
1. Prepare comparative statements from the following data:
Income Statements 2017 (Rs. In lakhs) 2018 (Rs. In
lakhs)
Net sales 600 750
Cost of goods sold 400 600
Admn. Expenses 20 20
Selling Expenses 10 10
Net profit 170 120

Balance sheets
Liabilities 2017(Rs. In lakhs) 2018(Rs. In lakhs)
Equity capital 400 400
6% Pref share capital 300 300
Reserves 200 245
6% Debentures 100 150
Bills payable 50 75
Creditors 150 200
Tax payable 100 150
Total 1300 1520
Assets 2017(Rs. In lakhs) 2018(Rs. In lakhs)
Land 100 100
Buildings 300 270
Plant 300 270
Furniture 100 140
Stock 200 300
Cash ? ?
Total 1300 1520

2. From the following prepare the Balance Sheet of R.K. Motors ltd.
Current ratio 2
Working capital Rs.4,00,000
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Capital block to current assets 3:2
Fixed assets to turnover 1:3
Sales cash / credit 1:2
Stock velocity 2 months
Creditor’s velocity 2 months
Debtor’s velocity 3 Months
Share capital Rs.6,00,000
Debenture share capital 1:2
Net profit 10% of sales
Gross profit 25% of sales
Reserves 2.5% of sales

3. Following are the summarized balance sheet of ESS GEE ltd. as on 31st December 2017
and 2018.

LIABILITIES 2017 2018

Share capital 100000 130000

General reserve 25000 30000
Profit and loss 15200 15400
a/c 35000 -
Bank loan(long-
term) 75000 67500
Sundry creditors 15000 17500
Provision for tax
265200 260400
ASSETS 2017 2018

Land & building 100000 95000

Machinery 75000 84500
Stock 50000 37000
Sundry debtors 40000 32100
Cash 200 300
Bank - 4000
Goodwill - 7500

265200 260400

Additional information:
a. Dividend of Rs 11,500 was paid.

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b. Assets of another company were purchased for a consideration of Rs 30000 payable in
shares. The following assets were purchased: stock 10000, machinery Rs 12500.
c. Machinery was further purchased for Rs 4000.
d. Depreciation written off machinery Rs 6000.
e. Income tax provided during the year Rs 16500.
f. Loss on sale of machine Rs 100 was written off general reserve.
You are required to prepare a cash flow statement for the year ended 31st December 2018.

4. From the following information, compute (a) Mix (b) Price and (c) Usage variance:
Standard Actual
Qty Unit Price Total Qty Unit Value
Materials
(kg) (Rs.) (Rs.) (kg.) Price (Rs.)
(Rs.)
A 10 2.00 20.00 5 3.00 15.00
B 20 3.00 60.00 10 6.00 60.00
C 20 6.00 120.00 15 5.00 75.00
50 4.00 200.00 30 5.00 150.00

5. The following data are available in a manufacturing company for a yearly period:
Particulars (Rs. Lakhs)
Fixed expenses:
Wages and Salaries 9.50
Rent, rates and taxes 6.60
Depreciation 7.40
Sundry administrative expenses 6.50
Semi-Variable Expenses:
(at 50% of capacity)
Maintenance and repairs 3.50
Indirect Labour 7.90
Sales department salaries 3.80
Sundry administrative expenses 2.80
Variable Expenses:
(at 50% of capacity)
Materials 21.70
Labour 20. 40
Other expenses 7.90
98.00

Assume that the fixed expenses remain constant for all levels of production, semi-variable
expenses remain constant between 45% and 65% of capacity, increasing by 10% between
65% and 80% capacity and by 20% between 80% and 100% capacity. Sales at various
levels are:
(Rs. Lakhs)
50% capacity 100
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60% capacity 120
75% capacity 150
90% capacity 180

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