Class : B.

Com(H) Semester-III

Paper Code : 203

Subject : MANAGEMENT ACCOUNTING

Unit 1- MANAGEMENT ACCOUNTING (Introduction)

Meaning:

Management Accounting is the presentation of accounting information in order to formulate the

policies to be adopted by the management and assist its day-to-day activities.

In other words, it helps the management to perform all its functions including planning, organising,
staffing, directing and controlling.

Management accounting, also called managerial accounting or cost accounting, is the process of
analyzing business costs and operations to prepare internal financial report, records, and account to
aid managers’ decision making process in achieving business goals. In other words, it is the act of
making sense of financial and costing data and translating that data into useful information for
management and officers within an organization.

In the words of J. Batty:

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

According to R. N. Anthony:

“Management Accounting is concerned with accounting information that is useful to management.”

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

Similarly, according to American Accounting Association:

“Management Accounting includes the methods and concepts necessary for effective planning for
choosing among alternative business actions and for control through the evaluation and interpretation
of performances.”

The Institute of Chartered Accountants of England and Wales defines Management

Accounting as:
“Any form of accounting, which enables a business to be conducted more efficiently, can be
regarded as Management Accounting.”

And in the opinion of Haynes and Massie:

“The application of appropriate techniques and concepts in processing the historical and projected
economic data of an entity to assist management in establishing a plan for reasonable economic
objectives and in making of rational decisions with a view towards achieving these objectives.”

From the above, it becomes crystal clear that Management Accounting presents to the management
the accounting information in the form of processed data which it collects from Financial
Accounting, Cost Accounting including Statistics—so that it will be very helpful on the part of the
management to take proper decisions in a scientific manner as and when necessary.

Functions and Objects of Management Accounting:

The primary object of Management Accounting is to present the accounting information to the
management.
The objects are:
1. To Assist in Planning:
Management Accounting assists the management in planning as well as to formulate policies by
making forecasts about the production, the selling, the inflow and outflow of cash etc., i.e., in
planning a very wide range of activities of the business.

Not only that, it may also forecast how much may be needed for alternative courses of action or the
expected rate of return therefrom and, at the same time, decide upon the programme of activities to
be undertaken.

2. To Assist in Organising:
By preparing budgets and ascertaining specific cost centre, it delivers the resources to each centre
and delegates the respective responsibilities to ensure their proper utilisation. As a result, an inter-
relationship grows among different parts of the enterprise.

3. To Assist in Motivating:
By setting goals, planning the best and economical courses of action and also by measuring the
performances of the employees, it tries to increase their efficiency and, ultimately, motivate the
organisation as a whole.

4. To Coordinate:
It helps the management in coordinating the activities of the enterprise, firstly, by preparing the
functional budgets, then coordinating the whole activity by integrating all functional budgets into one
which goes by the name of ‘Master Budget’. In this way it helps the management by coordinating the
different parts of the enterprise. Besides, overall coordination is not at all possible without
‘Budgetary Control’.

5. To Control:
The actual work done can be compared with ‘Standards’ to enable the management to control the
performances effectively.

6. To Communicate:
It helps the management in communicating the financial information about the enterprise. For taking
decisions as well as for evaluating business performances, management needs information. Now, this
information is available with the help of reports and statements which form an integral part of
Management Accounting.

7. To Interpret Financial Information:

It is not possible for all concerned to understand clearly the different treatments of accounting until
and unless the users have acquired a sufficient knowledge about the subject since accounting is a
highly technical subject.

And, for the same reason, management may not understand the implications of the accounting
information in its raw form. But this problem does not arise in the case of Management Accounting
as it presents the required information in an intelligible and non-technical way. This leads the
management to interpret financial data, evaluate alternative courses of action and to take correct
decisions.

8. Miscellaneous:
(a) To provide necessary help while evaluating the efficiency and effectiveness of different policies;

(b) To provide necessary help in locating uneconomic as well as inefficient place of business
activities;

(c) To provide necessary help in solving business problems, e.g., to expand the existing business unit
or not, etc.

Nature or Characteristics of Management Accounting:

The very purpose of Management Accounting is to serve the needs of the management by presenting
relevant information so that the business may be conducted in a better way. Here, information—both
economic and financial—is collected from internal as well as external sources.

The information so collected is analysed and processed accordingly in the prescribed manner. The
results thus obtained are presented to the management for taking decisions. It may also be called an
information system since it is concerned with the getting and giving of information.

Management Accounting deals with the forecasts about the future. It helps the management to take
decisions as well as to draw plans for future courses of action.

Secondly, it adopts a selective technique. Its technique is not in the nature of collecting and then
sorting the data.

Thirdly, it is analytical, i.e., it explains the reason why the profit or loss increases or decreases in
comparison with the past periods. Besides, it tries to examine and analyse the effect of different
variables on profit and profitability and thereby helps the management to adopt future plans of
action.

Fourthly, it does not provide information in a prescribed format like Financial Accounting. It
provides information to the management in such a way that it may be more useful to them.

Lastly, it does not take any decision but helps the management in taking decision by supplying
necessary data and information, i.e., it can recommend but cannot prescribe.

In other words, we can also define the nature or characteristics of Management Accounting as
follows:

The task of management accounting involves furnishing of accounting data to the management for
basing its decisions on it. It also helps, in improving efficiency and achieving organizational goals.
The following are the main characteristics of management accounting:
1. Providing Accounting Information: Management according is based on accounting
information. The collection and classification of data is the primary function of accounting
department. The information so collected is used by the management for taking policy
decisions. Management accounting involves the presentation of information in away it suits
managerial needs. The accounting data is used for reviewing various policy decisions.
Management accounting is a service function and it provides necessary information to
different levels of management.

2. Cause and effect Analysis: Financial accounting is limited to the preparation of profit and
loss account and finding out the ultimate result, i.e., profit or loss management accounting
goes a step further. The ‘cause and effect’ relationship is discussed in management
accounting. If there is a loss, the reasons for the loss are probed. If there is a profit, the factors
different expenditures, current assets, interest payables, share capital, etc. So the study of
cause and effect relationship is possible in management accounting.

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. The type of technique to be used will be determined
according to the situation and necessity.

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. The historical data is studied to see its possible impact on future decisions. The
implications of various alternative decisions are also taken into account while taking
important decisions.
 5. Achieving of Objectives: In management accounting, the accounting information is used in
such a way that it helps in achieving organizational objectives. Historical data is used for
formulating plans and setting up objectives. The recording of actual performance and
comparing it with targeted figures will give an idea to the management about the performance
of various departments. In case there are deviations between the standards set and actual
performance of various departments corrective measures can be taking at one. All this is
possible with the help of budgetary control and standard costing.

6. Increase in Efficiency: The purpose of using accounting information is to increase efficiency

of the concern. The efficiency can be achieved by setting up goals for each department. The
performance appraisal will enable the management to pin point efficient and inefficient spots.
An effort is made to take corrective measures so that efficiency is improved. The constant
review of working will make the staff cost – conscious. Everyone will try to control cost on
one’s own part.

7. Supplies Information and not decision: The management accountant supplies information
to the management. The decisions are to be taken by the top management. The information is
classified in the manner in which it is required by the management. Management Accountant
is only to guide and not to supply decisions. ‘How is the data to be utilized’ will depend upon
the caliber and efficiency of the management.

8. Concerned with forecasting: The management accounting is concerned with the future. It
helps the management in planning and forecasting. The historical information is used to plan
future course of action.

Scope of Management Accounting

The scope of Management Accounting can be described as under:
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. Though
planning is always for the future but still it has to be based on past and present data. The
control aspect too is based on financial data. The performance appraisal is based on recorded
facts and figures. So management accounting is closely related to financial accounting.

2. Cost Accounting: Cost Accounting provides various techniques for determining cost of
manufacturing products or cost of providing service. It uses financial data for finding out cost
of various jobs, products or processes. The systems of standard 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. It deals with raising of funds and their
effective utilization so to maximize earnings. Finance has become so important for every
business that all managerial activities are connected with it. Financial viability of various
propositions influences decisions on them. Therefore 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
enterprise for a definite period in future. The targets are set for different departments and
responsibility is fixed for achieving these targets. The comparison of actual performance with
budgeted figures will give an idea to the management about the performance of different
departments. 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.

5. Inventory Control: Inventory is used to denote stock of raw materials, goods in the process
of manufacture and finished products. Inventory has a special significance in accounting for
determining correct income for a given period. Inventory control is significant as it involves
 large sums. The management should determine different levels of stocks, ie. minimum level,
maximum level, re- ordering level for inventory control. The control of inventory will help in
controlling costs of 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 reports are presented in the form of graphs, diagrams, index numbers or other
statistical techniques so as to make them easily understandable. The management accountant
sends interim reports to the management and these reports may be monthly, quarterly, half –
yearly. The reports may cover profit and loss statement, cash and found flow statements,
stock reports, absentee reports and reports on orders in hand, etc. These reports are helpful in
giving a constant review of working of the business.

7. Interpretation of Data: The management accountant interprets various financial statements

to the management. These statements give an idea about the financial and earning position of
the concern. These statements may be studied in comparison to statements of earlier periods
or in comparison with the statements of similar other concerns. The significance of these
reports is explained to the management in a simple language. If the statements are not
properly interpreted then wrong conclusions may be drawn. So interpretation is also important
as compiling of financial statements.

8. Control procedures and Method: Control procedures and methods are needed to use various
factors of production in a most economical way. The studies about cost, relationship of cost
and profits are useful for using economic resources efficiently and economically.

9. Internal Audit: Internal audit system is necessary to judge the performance of every
department. The actual performance of every department and individual is compared with the
 pre-determined standards. Management is able to know deviations in performance. Internal
audit helps management in fixing responsibility of different individuals.

10. Tax Accounting: In the present complex tax systems, tax planning is an important part of
management accounting. Income statements are prepared and tax liabilities are calculated.
The management is informed about the tax burden from central government, state government
and local authorities. Various tax returns are to be filed with different departments and tax
payments are to be made in time. Tax accounting comes under the purview of management
accountants duties.

11. Office services: Management accountant may be required to control an office. He will be
expected to deal with data processing, filing, copying, duplicating, communicating etc. He
will also be reporting about the utility of different office machines.

Advantages of Management Accounting

1. It helps to increase the efficiency of all functions of management.

2. It helps in target-fixing, decision-making, price-fixing, selection of product-mix and so on.
3. Forecasting and Budgeting help the concern to plan the future and financial activities.
4. Various tools and techniques provide reliability and authenticity to carry out the business
functions.
5. It is useful in controlling wastage and defects.
6. It helps in complete communication between all levels of management.
7. It helps in controlling the cost of production thus increasing the profit percentage.
8. It is proactive-analyses the governmental policies and socio-economic scenario which helps to
assess the external environmental impacts on the organization.
Limitations of Management Accounting

1. It is concerned with financial and cost accounting. If these records are not reliable, it will
affect the effectiveness of management accounting.
2. Decisions taken by the management accountant may or may not be executed by the
management.
3. It is very expensive. Only big concerns can adopt this method of accounting.
4. New rules and regulations are to be framed; hence there is a possibility of opposition from the
employees.
5. It is only in the developing stage.
6. It provides only data and not decisions.
7. It is a tool to the management and not an alternative of management.

Relationship between Financial Accounting and Management Accounting

Financial accounting and management accounting are two major sub-systems of accounting
information system. Both are concerned with revenues and expenses, assets and liabilities and cash
flows. Both therefore involve financial statements. But the major differences between the two arise
because they serve different audiences. The main points of difference between the two are as follows:

Basis Financial Accounting Management Accounting

1. External Financial accounting information Management accounting information
and is mainly intended for external is mainly meant for internal user,
Internal users like investors, shareholder, i.e., management
users creditors, Govt. authorities etc.
2. Statutory Under company law and tax law, Management accounting is optional
requirements financial accounting is obligatory though its utility makes it highly
to satisfy various statutory desirable to adopt it.
provisions.
3. Analysis of Financial accounting shows the Management accounting provides
cost and profit / loss of the business as a detailed information about individual
profit whole. It does not show the cost products, plants, departments or any
and profit for individual products, other responsibility centre.
processes or departments, etc.
4.Past and It is concerned with recording It is future oriented and concentrates
future data transactions, which have already on what is likely to happen in future
taken place, i.e., it represents past though it may use past data for
or historical records. future projections.
5.Periodic and Financial reports, i.e., Profit and Management accounting reports are
continuous Loss account and Balance Sheet prepared frequently, i.e, these may
reporting are prepared usually on a year to be monthly, weekly or even daily
year basis. depending on managerial
requirements
6. Accounting Companies are required to prepare Management accounting is not
Standards financial accounts according to bound by accountings standards. It
accounting standards issued by the may use any practice which
Institute of chartered accountants generates useful information to
of India. management.
7.Types of Financial accounting prepares In Management accounting special
statements general purpose statements Profit purpose reports are prepared, eg,,
prepared & Loss account and Balance sheet performance report of sales manager
which are used by external users. or any other department manager
which are used by top level
Management.
8.Publication Financial statements, i.e., P&L Management accounting statements
and A/c and Balance sheet are are for internal use and thus neither
Audit published for general public use published for general public use nor
and also sent to share holders. these are required to be audited by
These are required to be audited chartered accountants.
by the chartered Accountants.
9.Monetary Financial accounting provides Management accounting may apply
and information in terms of money monetary or non monetary units of
non monetary only. measurements for example
measurements information may be expressed in
terms of Rs. or units of quantity,
machine hours, labour hours, etc.

Relationship between Cost Accounting and Management Accounting

The distinction between cost accounting and management accounting may be made on the following
points:

Basis Cost Accounting Management Accounting

1. Scope Scope of cost accounting is Scope of management accounting is
limited to providing cost broader than that of cost accounting
information for managerial uses. 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 – making to
ensure maximum profit. maximize profit.
3.Techniques Various techniques used by cost Management accounting also uses
employed accounting include standard all these techniques used in cost
costing and variance analysis, accounting but in addition it also
marginal costing and cost volume uses techniques like ratio analysis,
profit analysis, budgetary control, funds flow statement, statistical
uniform costing and inter-firm analysis operations research and
comparison, etc. certain techniques from various
branches of knowledge like
mathematics, economics, etc. which
so ever can help management in its
tasks
4. Evolution Evolution of cost accounting is Evolution management accounting is
mainly due to the limitations of due to the limitations of cost
financial accounting accounting. In fact, management
accounting is an extension of the
managerial aspects of cost
accounting.
5. Statutory Maintenance of cost records has Management accounting is purely
requirements been made compulsory in selected voluntary and its use depends upon
industries as notified by the Govt. its utility to management.
from time to time.
6.Data base It is based on data derived from It is based on data derived from cost
financial accounts accounting, financial accounting and
other sources.
7.Status in In the organizational set up, cost Management accounting is generally
organization accountant is placed at a lower placed at a higher level of hierarchy
 level in hierarchy than the than the cost accounting
management accounting
8.Installation Cost accounting system can be Management accounting cannot be
installed without management installed without a proper system of
accounting cost accounting.

The Management Accountant

Management accounting provides significant economic and financial data to the Management and the
Management Accountant is the channel through which this information efficiently and effectively
flows to the Management.

The Management Accountant has a very significant role to perform in the installation, development
and functioning of an efficient and effective management accounting system. He designs the frame
work of the financial and cost control reports that provide each managerial level with the most useful
data at the most appropriate time. He educates executives in the need from control information and
ways of using it. His position is unique with respect to information about the organization. Apart
from top management no one in the organization perhaps knows more about the various functions of
the organization than him. He is as the chief intelligence officer or financial advisor or financial
controller of the management. He gathers information, breaks it down, sifts it out and organizes it
into meaningful categories. He separates relevant and irrelevant information and then ranks relevant
information according to degree of importance to management. He reports relevant information in an
intelligible form to the management and sometimes also to those who are interested in the
information outside the company. He also compares the actual performance with the planned one and
reports and interprets the results of operations to all levels of management and to the owners of the
business.

Functions of the Management Accountant

It is the duty of the management accountant to keep all levels of management informed of their real
position. He has, therefore, varied functions to perform. His important functions can be summarized
as follows:

1. Planning: He has to establish, coordinate and administer as an integral part of management, an

adequate plan for the control of the operations. Such a plan would include profit planning,
programmes of capital investment and financing sales forecasts, expense budgets and cost
standards.
2. Controlling: he has to compare actual performance with operating plans and standards and to
report and interpret the results of operations to all levels of management and the owners of the
business. This is done through the compilation of appropriate accounting and statistical records
and reports.
3. Coordinating: He consults all segments of management responsible for policy or action. Such
consultation might concern any phases of the operation of the business having to do with
attainment of objectives and the effectiveness of the organization structures and policies.
4. Other Functions:
a. He administers tax policies and procedures.
b. He supervises and coordinates the preparation of reports to government agencies.
c. He ensures fiscal protection for the assets of the business through adequate internal
control and proper insurance coverage.
d. He carries out continuous appraisal of economic and social forces, and the government
influences, and interprets their effect on the business.
Unit 2- FINANCIAL ANALYSIS

Meaning:
Analysis and Interpretation of financial statements refers to the process of determining the significant
operating and financial characteristics from the accounting data with a view to getting an insight into
the activities of an enterprise.

Myers defines:

“Financial Statement analysis is largely a study of relationship among the various financial factors in
a business as disclosed by a single set of statements, and a study of the trend of these factors as
shown in a series of statements”.

Financial analysis is the examination of a business from a variety of perspectives in order to fully
understand the greater financial situation and determine how best to strengthen the business. A
financial analysis looks at many aspects of a business from its profitability and stability to its
solvency and liquidity. For example, these elements are typically reviewed in a financial analysis:
 Profitability: The business needs to review the levels of current and past profitability and decide
what they need to do to increase profitability in the future.
 Solvency: Businesses are also concerned with making sure that they do not fold because they are
in debt. A financial analysis will highlight the debts they owe, and help create a pay-off plan.
 Liquidity: A business needs to understand its cash position and make sure that it has the ability
to maintain a positive cash flow, while still being able to pay for what they need immediately.
 Stability: The business also wants to make sure that it is financially stable, and does not have
components that could cause it to fold. They are thinking long term about the future of the
company. They want to make sure they do not get into financial trouble.
By establishing a strategic relationship between the items of a balance sheet and income statement
and other operative data, the financial analysis [as -it is simply called] explains the meaning and
significance of such items.

The terms ‘analysis’ and ‘interpretation’ are complimentary to each other, though sometimes they are
used distinctively.

While analysis is used to mean the simplification of data by methodical classification of data given in
the financial statements, the term interpretation means explaining the meaning and significance of the
data so simplified. However, analysis is useless without interpretation, and interpretation becomes
difficult without analysis.

Hence, as the objective of analysis is to study the relationship among the various items of financial
statements by interpretation, many to cover both analysis and interpretation together use it.

Objective of Financial Analysis:

Different parties are interested in the financial statements for different purposes and look at them
from different angles. For example, the debenture-holders analyze the statements in order to ascertain
the ability of companies to make regular periodical interest payments and final payment of principal
amount on maturity.

The prospective shareholders would like to know whether the business is profitable and is
progressing on sound lines. Above all, the management is interested in the operational efficiency as
well as the financial position of the business.

Hence, the main objective of financial analysis is to make a detailed study about the cause and effect
of the profitability and financial condition of the firm.

Types of Financial Analysis:

Financial analysis may be classified into different categories depending upon:
(i) The materials used, and
(ii) The method of operation followed in the analysis.

(i) Based on the material used or people interested in the analysis, it may be classified as External vs.
Internal Analysis.

External Analysis:

People outside the firm do external analysis. In the matter of financial statement analysis, investors,
credit agencies, government agencies, shareholders, etc., are outsiders/external parties to the firm.

An external analyst usually has only the published information to rely upon. His position has been
improved in recent times due to increased governmental regulations requiring business concerns to
provide detailed information to the public through audited accounts.

Internal Analysis:
Analysis for management purposes is the internal type of analysis. It is done by the Company’s
finance and accounting departments and is more detailed than external analysis. Executives and
employees of the organization also conduct it.

Officers appointed by the governmental or court agencies under regulatory and other jurisdictional
powers vested in them over the business also conduct the analysis.

(ii) Based on the methods of analysis, it may be classified as horizontal vs. vertical analysis.

Horizontal Analysis:
It refers to the comparison of the trend of each item in the financial statement over a period of years,
or that of companies. The figures for this type of analysis are presented horizontally over a number of
columns.
Such a column represents a year or a company. This type of analysis is also called as Dynamic
Analysis as it is based on data from year to year, rather than on data of any one year.

Vertical Analysis:
It is also called as Static Analysis. In vertical analysis the figures relating to a financial statement are
presented vertically, i.e., a figure from a year’s statement is compared with a base selected from the
same statement.

This type of analysis is mainly used to study through ratios the quantitative relationship of various
items in the financial statement on a particular data, or for one accounting period.

It is useful to understand the performance of several companies in the same group, or many divisions
or departments in the same company.

However this type of analysis is not very conducive to a proper analysis of a company’s financial
position, for it depends on the data for one time period. In order to make it more effective, it could be
conducted both vertically as well as horizontally.

Meaning of Financial Statement Analysis:

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

According to Lev:

“Financial Statement Analysis is an information processing system designed to provide data for
decision-making models, such as the portfolio selection model, bank lending decision models, and
corporate financial management models.”
Objectives of Financial Statement Analysis:

The major objectives of financial statement analysis are to provide decision makers information
about a business enterprise for use in decision-making. Users of financial statement information are
the decision-makers concerned with evaluating the economic situation of the firm and predicting its
future course.

Financial statement analysis can be used by the different users and decision makers to achieve
the following objectives:
1. Assessment of Past Performance and Current Position:
Past performance is often a good indicator of future performance. Therefore, an investor or creditor is
interested in the trend of past sales, expenses, net income, cash flow and return on investment. These
trends offer a means for judging management’s past performance and are possible indicators of
future performance.

Similarly, the analysis of current position indicates where the business stands today. For instance, the
current position analysis will show the types of assets owned by a business enterprise and the
different liabilities due against the enterprise. It will tell what the cash position is, how much debt the
company has in relation to equity and how reasonable the inventories and receivables are.

2. Prediction of Net Income and Growth Prospects:

The financial statement analysis helps in predicting the earning prospects and growth rates in the
earnings which are used by investors while comparing investment alternatives and other users
interested in judging the earning potential of business enterprises. Investors also consider the risk or
uncertainty associated with the expected return.

The decision makers are futuristic and are always concerned with the future. Financial statements
which contain information on past performances are analysed and interpreted as a basis for
forecasting future rates of return and for assessing risk.

3. Prediction of Bankruptcy and Failure:

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability
of business enterprises. After being aware about probable failure, both managers and investors can
take preventive measures to avoid/minimize losses.

Corporate managements can effect changes in operating policy, reorganize financial structure or even
go for voluntary liquidation to shorten the length of time losses.

In accounting and finance area, empirical studies conducted have suggested a set of financial ratios
which can give early signal of corporate failure. Such a prediction model based on financial
statement analysis is useful to managers, investors and creditors. Managers may use the ratios
prediction model to assess the solvency position of their firms and thus can take appropriate
corrective actions.

Investors and shareholders can use the model to make the optimum portfolio selection and to bring
changes in the investment strategy in accordance with their investment goals. Similarly, creditors can
apply the prediction model while evaluating the creditworthiness of business enterprises.

4. Loan Decision by Financial Institutions and Banks:

Financial statement analysis is used by financial institutions, loaning agencies, banks and others to
make sound loan or credit decision. In this way, they can make proper allocation of credit among the
different borrowers. Financial statement analysis helps in determining credit risk, deciding terms and
conditions of loan if sanctioned, interest rate, maturity date etc.

TECHNIQUES/TOOLS OF THE FINANCIAL STATEMENT ANALYSIS

As already discussed, that the Financial Statement Analysis can be undertaken by different
persons and for different purposes, therefore, the methodology adopted for the Financial
Statement Analysis may be varying from the one situation to another. However, the
following are some of the common techniques of the Financial Statement Analysis: a)
Comparative Financial Statements, (b) Common-size financial statements, (c) Trend
percentages analysis, and (d) Ratio Analysis. The last techniques i.e. the Ratio Analysis is
the most common, comprehensive and powerful tool of the Financial Statement Analysis.
For the sake of proper understanding, all these techniques have been discussed in detail as
follows:
1. COMPARATIVE FINANCIAL STATEMENTS (CFS)
In Comparative Financial Statements, two or more Balance Sheets and/or the Income
Statement of a firm are presented simultaneously in columnar form. The financial data for
two or more years are placed and presented in adjacent columns and thereby the financial
data is provided a times perspective in order to facilitate periodic comparison. In
Comparative Financial Statements, the Balance Sheet and the Income Statement for
number of years are presented in condensed form for year-to- year comparison and to
exhibit the magnitude and direction of changes.

The preparation of the Comparative Financial Statements is based on the premise that a
statement covering a period of a number of years is more meaningful and significant than
for a single year only, and that the financial statements for one period represent only 1
phase of the long and continuous history of the firm. Nowadays, most of the published
Annual Reports of the companies provide important statistical information about the
company in condensed from for the last so many years. The presentation of such data
enhances the usefulness of these reports and brings out more clearly the nature and trends
of changes affecting the profitability and financial position of the firm.
So, the Comparative Financial Statements helps a financial analyst in horizontal analysis
of the firm and in establishing operating and positional trend of the firm. The
Comparative Financial Statements may be prepared to show the absolute amount of
different items in monetary terms, the amount of periodic changes in monetary terms and
the percentages of periodic changes to reveal the proportionate changes. The Comparative
Financial Statements can be prepared for both the Balance Sheet and Income Statement.
Comparative Income Statement (CIS): A CIS shows the figures of different items of the ISs
of the firm in absolute terms, the absolute changes from one period to another and if
desired, the changes in percentage form. The CIS is helpful in deriving meaningful
conclusions regarding changes in sales volume, cost of goods sold, different expense items
etc. From the CIS a financial analyst can quickly ascertain whether sales are increasing or
decreasing and by how much amount or by how much percentage. Similarly, analysis can
be made for other items also.
Comparative Balance Sheet (CBS): The CBS shows the different assets and liabilities of the firm
on different dates to make comparisons of absolute balances and also of changes if any, from one
date to another. The CBS may be helpful in analyzing and evaluating the financial position of the
firm over a period of number of years.

2. COMMON SIZE STATEMENT (CSS)

The CSS represents the relationship of different items of a financial statement with some Common
item by expressing each item as a percentage of the Common item. In Common size Balance Sheet,
each item of the Balance Sheet is stated as a percentage of the total of the Balance Sheet. Similarly
in Common size Income Statement, each item is stated as percentage of the Net Sales. The
percentages for different items are computed by dividing the absolute amount of that item by the
Common base (i.e. the Balance Sheet Total or the Net Sales as the case may be) and then
multiplying by 100. The percentage so calculated can be easily compared with the corresponding
percentages in some other period. Thus, the CSS is useful not only in intra-firm comparisons over a
series of different year but also in making inter-firm comparisons for the same year or for several
years.

3. TREND PERCENTAGE ANALYSIS (TPA)

The TPA is a technique of studying several financial statements over a series of

years. In TPA, the trend percentages are calculated for each item by taking the
figure of that item for some base year as 100. So, the trend percentage is the
percentage relationship, which each item of different years bears to the same
item in the base year. Any year may be taken as the base year. Any year may be
taken as the base year, but generally the starting/initial year is taken s the base
year. So, each item for base year is taken as 100 and then the same item for years
is expressed as a percentage of the base year. The TPA which can be used both
for the Balance Sheet as well as the Income Statement.
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RATIO ANALYSIS

Ratio analysis is the tool of Finance. With ratio analysis, we can check our
financial position and revenue position. It is very helpful to analyze financial
statement. It is also easy to understand and explain interpretations through these
ratios.

Before discussing different ratios, you should understand the meaning of Ratio.
Ratio is the relationship between two or more items of balance sheet or profit and
loss account or both statements. For knowing short term position’s strength or
liquidity, we can find current ratio, liquid ratio. These ratios tell us what is the
amount of current assets, which is in the business if we take the burden of current
liabilities. If amount of current assets will more the amount of current liabilities,
then our liquidity position will strong. We can also calculate mixed ratios like
Inventory Turnover Ratio, Debtor Turnover Ratio, and Creditor Turnover Ratio.

These ratios are very helpful to find following period

1. With inventory turnover ratio, we can calculate inventory conversion period. If

this period is very short then it means we have power to sell our product fastly.
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2. With debtor turnover ratio, we can calculate debtor conversion period, if this
period is short then it means that we can convert over credit sale fastly into cash.

3. With creditor turnover ratio, we can calculate creditor conversion period, if this
period is short, then it means we are ready fastly to reduce our current liabilities.
This is plus point if our debtor conversion period will also short. If debtor
conversion period is long, then shortness of creditor conversion period is our
negative point.

We can analyze of profitability by making gross profit ratio, operating ratio, net
profit ratio and ROI ratio. We can also check our long term financial position’s
strength or weakness by calculating debt-equity ratio, fixed asset and equity ratio,
current asset and capital employed ratio.

ADVANTAGES OF RATIO ANALYSIS:

Ratio analysis is very useful tool of management accounting. With this, we can
analyze business's financial position. We also check company's short term and long
term solvency with ratio analysis. Following are the main advantages of ratio
analysis.

1. Helpful in Decision Making

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All our financial statements are made for providing information. But this
information is not helpful for decision making because financial statements
provide only raw information. When we calculate different ratios in ratio analysis,
at that time, we get useful information. I can explain it with simple example.
Suppose, we calculate our interest coverage ratio which is 10times but our
competitor company's interest coverage ratio is 15 times. It means capacity of the
profit of our competitor company is more than us. By seeing this, we can take
decisions for increasing our profitability.

2. Helpful in Financial Forecasting and Planning

Every year we calculate lots of accounting ratios. When we make trend of all these
ratios, we can get useful information for our future forecasting and planning. For
example, we can tell five year collection period with following way

2007 = 90 days
2008 = 70 days
2009 = 60 days
2010 = 50 days
2011 = 30 days
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From this trend, we know that we are decreasing the days for collection money
from our debtors. With this information, we can make two plans. One is effective
use of money which we are getting from our debtors more fastly and second we
can also check the behavior of our debtors by comparing this with sales trend. Like
this, there are lots of ratios which are also useful for better planning.

3. Helpful in Communication

Ratio analysis are more important from communication point of view. Suppose, we
have to appoint new sales agents for our company. At that time, we can
communicate them by using our company's sales and profit related ratios. There is
no need of hi-tech for understanding the meaning of any specific ratio. For
example, our gross profit in 2010 is 26.6% and in 2011, it is 28.55%. By just
telling this ratio, we can understand whether our company is growing or falling.

4. Helpful in Co-ordination

No company has all the strength points. Company's financial results shows some
strength points and some weak points. Ratio analysis can create co-ordination
between strength points and weak points.

5. Helps in Control
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Ratio analysis can also use for controlling our business. We can easily create the
standard of each financial item of our balance sheet and profit and loss account. On
this basis, we can also calculate standard ratios. By comparing standard ratios with
actual accounting ratios, we can find variance. This variance may be favorable and
unfavorable. On this basis, we can control our business from financial point of
view.

6. Helpful for Shareholder's decisions

For example, I am a shareholder. I want to invest in any company's shares. Before

buying any company's shares, I will be interested to know company's long term
solvency. So, I have to calculate long term solvency ratios. In which, I have
to calculate fixed assets to net worth ratio, fixed assets to long term debt ratio. On
this basis, I can know the level of fixed assets and its main resource. After
checking my money's security, I will be interested to know my return on this
investment. ROI, EPS and DPS are most useful ratios which I can calculate for
knowing this.
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7. Helpful for Creditors' decisions

Creditors are those persons who provide goods on credit to company or provides
short period loan to company. All the creditors are interested to know whether
company will repay their debt or not. For this, they calculate current ratio and
quick liquid ratio and average payment period. On this basis, they take decisions.

8. Helpful for employees' decisions

Every employee wants to increase his salary. He also wants to get more and more
incentives from company. For this, he takes help from company's profitability
ratios. Profitability ratios will be helpful for employees to pressure on the company
for increasing their salary.

9. Helpful for Govt. decisions

Different companies analyze their accounting ratios and publish on the net and
print newspapers. Govt. collects all these information. On this basis, Govt. makes
policies. If ratios will wrong, Govt. policies will become wrong. For example,
Govt. collects income data of all companies in different industries
for calculation the national income.
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DISADVANTAGES OF RATIO ANALYSIS

Ratio analysis can be used to compare information taken from the financial
statements to gain a general understanding of the results, financial position,
and cash flows of a business. This analysis is a useful tool, especially for an
outsider such as a credit analyst, lender, or stock analyst. These people need to
create a picture of the financial results and position of a business just from its
financial statements. However, there are a number of limitations of ratio
analysis to be aware of. They are:

1) Historical. All of the information used in ratio analysis is derived from

actual historical results. This does not mean that the same results will carry
forward into the future. However, you can use ratio analysis on pro
forma information and compare it to historical results for consistency.

2) Historical versus current cost. The information on the income statement is

stated in current costs (or close to it), whereas some elements of the balance
sheet may be stated at historical cost (which could vary substantially from
current costs). This disparity can result in unusual ratio results.

3) Inflation. If the rate of inflation has changed in any of the periods under
review, this can mean that the numbers are not comparable across periods. For
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example, if the inflation rate was 100% in one year, sales would appear to have
doubled over the preceding year, when in fact sales did not change at all.

4) Aggregation. The information in a financial statement line item that you are
using for a ratio analysis may have been aggregated differently in the past, so
that running the ratio analysis on a trend line does not compare the same
information through the entire trend period.

5) Operational changes. A company may change its underlying operational

structure to such an extent that a ratio calculated several years ago and
compared to the same ratio today would yield a misleading conclusion. For
example, if you implemented a constraint analysis system, this might lead to a
reduced investment in fixed assets, whereas a ratio analysis might conclude that
the company is letting its fixed asset base become too old.

6) Accounting policies. Different companies may have different policies for

recording the same accounting transaction. This means that comparing the ratio
results of different companies may be like comparing apples and oranges. For
example, one company might use accelerated depreciation while another
company uses straight-line depreciation, or one company records a sale at gross
while the other company does so at net.

7) Business Conditions. You need to place ratio analysis in the context of the
general business environment. For example, 60 days of sales outstanding
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for receivables might be considered poor in a period of rapidly growing sales,

but might be excellent during an economic contraction when customers are in
severe financial condition and unable to pay their bills.

8) Interpretation. It can be quite difficult to ascertain the reason for the results
of a ratio. For example, a current ratio of 2:1 might appear to be excellent, until
you realize that the company just sold a large amount of its stock to bolster its
cash position. A more detailed analysis might reveal that the current ratio will
only temporarily be at that level, and will probably decline in the near future.

9) Company strategy. It can be dangerous to conduct a ratio analysis

comparison between two firms that are pursuing different strategies. For
example, one company may be following a low-cost strategy, and so is willing
to accept a lower gross margin in exchange for more market share. Conversely,
a company in the same industry is focusing on a high customer service strategy
where its prices are higher and gross margins are higher, but it will never attain
the revenue levels of the first company.

10) Point in time. Some ratios extract information from the balance sheet. Be
aware that the information on the balance sheet is only as of the last day of
the reporting period. If there was an unusual spike or decline in the account
balance on the last day of the reporting period, this can impact the outcome of
the ratio analysis.
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Types of Ratios
Financial ratios can be grouped into five types: liquidity, debt, profitability,
coverage, and market-value ratios. No one ratio gives us sufficient information
by which to judge the financial condition and performance of the firm. Only when
we analyze a group of ratios we are able to make reasonable judgments. We must
be sure to take into accountancy seasonal character of a business. Underlying
trends may be assessed only through a comparison of raw figures and ratios at the
same time of year. We would not compare a December 31 balance sheet with a
May 31 balance sheet, but we would compare December 31 with December 31.
Although the number of financial ratios that might be computed increases
geometrically with the amount of financial data, we concentrate only on the more
important ratios in this topic. Computing unneeded ratios adds both complexity
and confusion to the problem.

1) LIQUIDITY RATIOS
Liquidity ratios are used to judge a firm’s ability to meet short-term obligations.
From them, much insight can be obtained into the present cash solvency of a
company and its ability to remain solvent in the event of adversities. Essentially,
we wish to compare short-term obligations with the short-term resources available
to meet these obligations.
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a) Current Ratio
One of the most general and most frequently used liquidity ratios is the current
ratio: Current Assets
Current Liabilities

b) Quick Ratio
A somewhat more accurate guide to liquidity is the quick, or acid-test, ratio:
Current Assets less Inventories or Quick Assets
Current Liabilities

2) DEBT or LEVERAGE RATIOS

Extending our analysis to the long-term liquidity of the firm (that is, its ability to
meet long term obligations), we may use several debt ratios. The debt-to-equity
ratio is computed by simply dividing the total debt of the firm (including current
liabilities) by its shareholders’ equity:
Total Debt
Shareholders' Equity

3) COVERAGE RATIOS

Coverage ratios are designed to relate the financial charges of a firm to its ability to
service them. Bond-rating services, such as CRISIL, ICRA, Moody and Standard
and Poor’s, make extensive use of these ratios.
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a) Interest Coverage Ratio

Interest coverage ratio is one of the most traditional of the coverage ratios. The
ratio of earnings before interest and taxes for a particular reporting period to the
amount of interest charges for the period is known as interest coverage ratio. We
must differentiate which interest charges should be used in the denominator.

b) Cash Flow Coverage Ratios

This ratio involves the relation of earnings before interest, taxes, and depreciation
(EBITD) to interest and to interest plus principal payments. For the cash-flow
coverage of interest we have:
EBITD
Annual interest payments

4) PROFITABILITY RATIOS
There are two types of profitability ratios: (i) those showing profitability in relation
to sales, and (ii) those showing profitability in relation to investment. Together
these ratios indicate the firm’s efficiency of operation.
a) Profitability in relation to sales

Gross Profit Margin = Sales less Cost of Goods Sold

Sales
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Gross profit margin ratio tells us the profit of the firm relative to sales after we
deduct the cost of producing the goods sold.
It indicates the efficiency of operations as well as how products are priced. A more
specific ratio of profitability is the net profit margin: Net Profits after Taxes
Sales
This ratio tells us the relative efficiency of the firm after taking into account all
expenses and income taxes, but not extraordinary charges.
b) Profitability in relation to investment
The group of profitability ratios relates profits to investments. One of these
measures is the rate of return on equity, or the ROE:
Net Profits after Taxes – Preferred Stock Dividend
Shareholders' Equity

The rate of return on equity tells us the earning power on shareholders’ book
investment and is frequently used in comparing two or more firms in an industry.
The figure for shareholders’ equity used in the ratio may be expressed in terms of
market value instead of book value. When we use market value, we obtain the
earnings/price ratio of the stock.
A more general ratio used in the analysis of profitability is the return on assets, or
the ROA:
Net Profits after Taxes
Total Assets
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ROA ratio is somewhat inappropriate, inasmuch as profits are taken after interest is
paid to creditors. Because these creditors provide means by which part of the total
assets are supported, there is a fallacy of omission. When financial charges are
significant, it is preferable, for comparative purposes, to compute a net operating
profit rate of return instead of a return on assets ratio. The net operating profit rate
of return may be expressed as
Earnings Before Interest And Taxes
Total Assets

c) Assets Turnover Ratio

Generally, the financial analyst relates total assets to sales to obtain the asset
turnover ratio:
Sales
Total Assets

Assets turnover ratio tells us the relative efficiency with which the firm utilizes its
resources in order to generate output. It varies according to the type of company
being studied. A food chain has a considerably higher turnover, for example, than
does an electric utility. The turnover ratio is a function of the efficiency with which
the various asset components are managed: receivables as depicted by the average
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collection period, inventories as portrayed by the inventory turnover ratio, and

fixed assets as indicated by the plant or the sales to net fixed asset ratio.
d) Earning Power
When we multiply the asset turnover of the firm by the net profit margin, we
obtain the return on assets ratio, or earning power on total assets:

Earning Power = Sales X Net Profit after Taxes

Total Assets Sales

= Net Profit after Taxes

Total Assets

Another way to look at the Return on Equity (ROE) is

ROE = Earning Power X [1+ Debt\Equity]

5) MARKET VALUE RATIOS:

We do find several widely used ratios that relate the market value of a company’s
stock to profitability, to dividends, and to book equity.
a) Price/Earnings Ratio
The Price/Earnings Ratio of a company is simply
P/E Ratio = Share Price
Earnings per share
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b) Dividend Yield
The dividend yield for a stock relates the annual dividend to share price. Therefore,
Dividend Yield = Dividends per share
Share Price

c) Market to Book Ratio

The final market-value ratio we consider relates market value per share to book
value M/B Ratio = Share Price
Book Value per share
where M/B ratio is the market-to-book value ratio

FOR EXAMPLE:
The Total Sales (all credit) of a firm are Rs. 6, 40,000. It has a Gross Profit Margin
of 15 per cent and a Current Ratio of 2.5. The firm’s Current Liabilities are Rs.
96,000; Inventories Rs. 48,000 and Cash Rs. 16,000. (a) Determine the Average
Inventory to be carried by the firm, if an Inventory Turnover of 5 times is
expected? (Assume a 360-day year), (b) Determine the Average Collection Period
if the Opening Balance of Debtors is intended to be of Rs. 80,000? (Assume a 360-
day year).
Solution:
(a) Inventory turnover = Cost of goods sold
Average inventory
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Since gross profit margin is 15 per cent, the cost of goods sold should be 85 per
cent of the Sales.
Thus, Cost of goods sold = 0.85 × Rs. 640000 = Rs. 544000.
= Rs. 544000 =5
Av. inventory
Average Inventory = Rs. 544000\ 5 = Rs. 1, 08,800
(b) Average Collection Period: Average Debtors X 360
Credit sales
Average Debtors = (Op. Debtors + Cl. Debtors)/2
Closing balance of debtors is found as follows:
Current Assets (2.5 of Current Liabilities) Rs. 2, 40,000
Less: Inventories Rs. 48,000
Cash Rs.16, 000 64,000
∴ Debtors Rs. 1, 76,000
Average Debtors = (Rs. 1, 76,000 + Rs. 80,000)/2 = Rs. 1, 28,000
Average Collection Period = Rs. 128000\Rs. 640000 × 360 = 72 days
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FUNDS FLOW & CASH FLOWS STATEMENTS:

FUNDS FLOW STATEMENT:

The Funds Flow Statement is combination of three words Funds, Flow and
Statement. Funds mean working capital. There are mainly two concepts regarding
the meaning of the working capital. First, the broad concept according to which
working capital refers to the gross working capital and represents the amount of
funds invested in current assets. Thus, the gross working capital is the capital
investment in total current assets of the enterprise.
Current Assets are those assets, which in the ordinary course of business can be
converted onto cash within a short period of time normally one accounting year.
Second, the narrow sense, which termed Working Capital as the excess of current
asset over current liabilities or that part of the current asset, which is financed by
the long-term source of finance. In case of the Funds Flow Statement we will use
the narrow concept of the working capital.
Flow means movement. It we take the flow of funds it means changes in the
position of the funds due to any transaction. As a result of the transaction the funds
may increase or decrease. The increase in funds is called funds inflow and if funds
decrease, it is called funds outflow. The one important point to be noted here is that
the flow of funds only occurs when a transaction affects on the one hand a non
current account and on the other a current account and vice-versa. If a transaction
only two current account or only two non-current accounts then flow of funds does
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not take place because here funds means the difference of the current assets and
current liabilities.
Statement means the written description about something or a detail note, which
provide the information. The Funds Flow Statement means a summary of the
sources and uses of the working capital.
Definitions:
“A statement of sources and application of funds is a technical device designed to
analyze the changes in the financial condition of a business enterprise between two
dates.” Foulke
According to I.C.W.A. “Funds Flow Statement is a statement prospective or
retrospective, setting out the sources and applications of the fund of an enterprise.
The purpose of the statement is to indicate clearly the requirement of funds and
how they are proposed to be raised and the efficient utilization and application of
the same.”
Anthony defines the Funds Flow Statement as the sources from which additional
funds were derived and the use to which these sources were put.
Thus, Funds Flow Statement is a statement, which indicates various means by
which the funds have been obtained during a certain period and the ways to which
these funds have been used during that period.
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OBJECTIVES OF FUNDS FLOW STATEMENT

As it is clear from the above discussion the main objective of the Funds Flow
Statement is to know the sources and applications of the funds within a specific
time period. Some other questions are also there which can be sorted out by the
help of Funds Flow Statement. These questions are:
• What happened to the net profit? Where did they go?
• How the higher dividend can be paid in case of shortage of funds?
• What are causes of the shortage of fund in spite of higher profit?
• How the fixed assets have been financed?
• How the obligations are fulfilled?
• How was the increase in working capital financed and how it will be
financed in future?
IMPORTANCE OF FUNDS FLOW STATEMENT
Importance of funds flow statement is as follows:
1. Provide the information regarding changes in funds position
Funds Flow Statement provides the information’s regarding the funds, from where
they have procured and where they have invested meanwhile two specific dates.
2. It helps in the formation of future dividend policy
Sometimes a firm has sufficient profit available for distribution as dividend but yet
it may not be advisable to distribute dividend for lack of liquid or cash resources.
In such cases, funds flow statement helps in the formation of a realistic dividend
policy.
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3. It helps in proper allocation of resources

The resources of a concern are always limited and it wants to make the best use of
these resources. A projected funds flow statement constructed for the future helps
in making managerial decisions. The firm can plan the deployment of its resources
and allocate them among various applications.
4. It act as future guide
A projected funds flow statement also acts as a guide for future to the management.
The management can come to know the various problems it is going to face in near
future for want of funds. The firm’s future needs of funds can be projected well in
advance and also the timing of these needs. The form can arrange to finance these
needs more effectively and avoid future problems.
5. It helps in appraising the use of working capital
It helps to appraise the performance of a financial manager in utilization of the
working capital and also suggested the right way to use the working capital
efficiently.
6. It helps to the overall credit worthiness of a firm
The financial institutions and banks such as SFI, IDBI, IFCI etc. all ask for funds
flow statement constructed for a number of years before granting loans to know the
creditworthiness and paying capacity of the firm. Hence, a firm seeking financial
assistance firm these institutions has no alternative but to prepare funds flow
statements.
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7. It helps to know about the utilization of the sources

It also provides the information to the managers and the another interested parties
that the sources they have collected or provided where they have allocated.
4.4 LIMITATIONS
The funds flow statement also suffers from some of the limitations, which are as
follows:
1. Prepared from the final statements: The funds flow statement is prepared
with the help of final statements. So all the limitations of the final statements are
inherent in it.
2. Only rearrangement: The funds flow statement is only the rearrangement of
the data provided by the final statements so this is not providing the actual figure
and facts.
3. Past oriented: The funds flow statements provides only the historical
information. They are not guiding about the future.
4. Working capital oriented: It concentrates on the concept of the working capital
and show the position of the working capital in the concern while changes in cash
are more important and relevant for financial management than the working
capital.
5. Periodic in nature: It only reveals the changes in the working capital position
in the concern between to specific dates. It cannot reveal continuous changes.
6. Not a substitute: It is not a substitute of an income statement or a balance sheet,
it provide only some additional information as regards changes in working capital.
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Procedure for Preparing Funds Flow Statements:

Funds flow statement can be prepared by comparing two balance sheets and other
information derived from various accounts as may be needed. While preparing the
funds flow statement mainly two statements are prepared:
1) Schedule of Changes in Working Capital
2) Fund Flow Statement
1) Schedule of Changes in Working Capital
As earlier stated, here we are using the narrow concept of the working capital it
means working capital means the surplus of current assets over current liabilities.
This statement is made to recognize the changes in the amount of working capital
among the dates of two balance sheets. This statement is prepared by deriving the
values of current assets and current liabilities from the balance sheet. Current
assets are those assets, which can be converted into cash into a short time period in
the ordinary course of the business. Similarly current liability means those
obligations, which are to be fulfilled in a short time period, generally a financial
year.
The schedule of changes in working capital can be prepared by comparing the
balance sheets of two dates. Firstly we have to recognize the current assets and
current liabilities of the concern and then compare them between two dates if the
current assets of current year are more than the previous year that is recognized as
an increase in working capital or vice-versa. On the other hand if current liabilities
of current year is more than the previous year it will recognize as decrease in
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working capital or vice versa because Working Capital = Current Assets – Current
Liabilities.
2) Funds Flow Statement
Funds flow statement is a statement, which shows the sources and application of
the funds during a particular time period. This statement shows that during that
period from where the funds have been procured and where have been invested.
This statement can be prepared in two forms:
1) Report Form
2) T Form or Account Form
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*Note Payment of dividend and tax will appear as and application of the funds
only when these items are considered as non-current item. If nothing is specified in
question then that depends on the discretion of the student how to treat these items.
Specimen of Report Form of Funds Flow Statement
Sources of Funds Amount

Funds from operations

Issue of Share Capital

Raising of Long term Loans

Receipts from partly paid shares

Sales of non-current assets

Non-trading receipts

Sale of Investment

Decrease in working capital

Total

Applications of Funds

Funds Lost in Operations

Redemption of Preference Share

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Redemption of Debentures

Repayment of Long-term loan

Purchase of non-current assets

Non-trading payments

Payment of Dividend

Payment of Tax
Increase in working capital
Total

Sources of the Funds

Under this heading we will show all the sources of the funds from where the funds
are procured. These sources can be classified in two categories.
1) Internal Source
2) External Source
1. Internal Source: Funds from Operations is only single internal source of funds.
Funds from operations means the funds obtained by the general business of the
organization. It is equal to the difference of revenue obtained by the sale of goods
and the total cost of manufacturing them. As example if a businessman is selling
1000 units of a good @ Rs. 7 per unit and the direct and indirect expenses incurred
on the production of a unit is Rs. 5 per unit.
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Then funds from operations will be 1000 X 7 – 1000 X 5 = Rs. 2000. During the
calculation of funds from operations following things should be considered.
The profit or loss shown by the Profit & Loss a/c is not always equal to the funds
from operations because in the some non-cash items are included in the Profit &
Loss a/c, which does not affect the working capital such as Depreciation and
amortization or written off Preliminary Expenses, Discount on Debentures,
goodwill, Patent Rights, Advertisement Expenses, Underwriting Commission etc.
All the expenses, which do not affect the position of the funds, should be added
back in the profit. With the non cash expenses some exceptional items are also
there which are not concerning with the operations of the business such as profit or
loss arise from the sale of fixed assets and investment and non business incomes
such as dividend received, interest received, rent received, refund of income tax
and appreciation in the value of fixed assets etc. These items should be deducted
from the profit to calculate the funds from operations.
2. External Source: These sources include:
i) Issue of Share Capital: One of the source of collection of the funds is issuance
of the new share that may be preference share issue or equity share issue. Not only
the new issue but also the call made on the partly paid share is also considered as
the source of the funds because it generates inflow of funds. The premium charged
on the time of issue is also considered, as inflow of funds and similarly the
adjustment for the discount provided on the time of issue should be made. If the
shares are issued in respect of another consideration rather than cash then it will
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not be considered as a source of funds.

ii) Issue of Debenture and Raising of Loans: Just like the shares issue of
debenture and raising of loans are also a source of funds and the same adjustment
regarding the premium and discount should be made as in case of the issuance of
the share.
iii) Sale of the Fixed Assets and Long-term Investments: One can increase the
funds in the concern by selling their investment they have made in different
alternatives and in fixed assets just like plant, machinery, building etc. but one
thing that should be remembered that if the assets are exchanged with rather than
cash that will not a source of funds.
iv) Non-Trading Receipts: Any non-trading receipts just as rent received, interest
received, dividend received and refund of tax or any another non-operating
income generates the inflow of cash will be treated as source of funds.
v) Decrease in Working Capital: If the working capital decreases in comparison
of previous year in the release of funds from the working capital so that will be
termed as source of funds.
Application or Uses of Funds
The other side of the funds flow statement is application of funds that side shows
how the funds procured from different sources are allocated or used. There may be
following uses or applications of the funds:
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1) Funds lost in Operations: Sometimes the result of trading in a certain year is a

loss and some funds are lost during that trading period. Such loss of funds means
outflow of funds so that item if treated as an application of funds.
2) Redemption of the Preference Share Capital: A company can’t redeem its
equity share within its life time but can redeem their preference share as the result
of redemption of preference share an outflow of funds takes place. So the
redemption of the shares is written in the application side of the funds flow
statement. One thing should be remembered is that the premium provided on the
redemption will also considered as an application.
3) Repayment of Loans & Redemption of Debentures: As share the repayment
of loans and redemption of debenture also leads a outflow of cash so these items
are also treated as application of the funds.
4) Purchase of any Non-current or Fixed Asset: If the businessman purchases
any fixed asset or making investment for the long time period that will also
generate a outflow of funds and treated as an application of funds. But if the fixed
asset is purchased in exchange of any other consideration rather than cash that will
not treated as application of funds.
5) Payment of Dividend & Tax: Payment of dividend and tax are also
applications if funds. It is the actual payment of dividend and tax, which should be
taken as an outflow of funds and not the mere declaration of the dividend or
creation of a provision for taxation.
6) Any other Non-trading Payment: Any payment or expenses not related to the
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trading operations of the business amounts to outflow and is taken as an

application of funds. The examples could be drawing in case of sole trader or
partnership firm, loss of cash.

CASH FLOW STATEMENTS:

Cash Flow Statement is a statement that describes the inflow (sources) and outflow
(applications) of cash and cash equivalent in an enterprise during a specified period
of time. Such a statement enumerates net effect of the various business transactions
on cash and its equivalent and takes into account receipts and disbursement of
cash. Cash flow statement summaries the causes of changes in cash position of a
business enterprise between dates of two balance sheets. 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 term cash, cash
equivalent and cash flow are used in the statement with the following meanings:
Cash comprises cash on hand and demand deposit with bank.
Cash Equivalents are short term highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an insignificant
risk of changes in value. Cash equivalent are held for the purpose of meeting short
term cash commitments rather than for investment or other purposes. An
investment normally qualifies as a cash equivalent only when it has a short-
maturity, of say, three months or less from the date of acquisitions.
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Cash flow means movement of funds that may be toward outside called outflow of
cash and that may be from outside to inside business called inflow of cash. In
another words flow of cash is said to have taken place when any transaction makes
changes in the amount of cash and cash equivalent before happening of the
transaction.
Cash flows exclude movements between items that constitute cash or cash
equivalent because these components are part of the cash management of an
enterprise rather than part of its operating, investing and financing activities. Cash
management includes the investment of excess cash in cash equivalent.
PURPOSE AND USES OF CASH FLOW STATEMENT
The main purpose of the statement of cash flows is to provide relevant information
about the cash receipts and cash payments of an enterprise during a period. The
information will help users of financial statements to assess the amounts, timing
and uncertainty of prospective cash flows to the enterprise. The statement of the
cash flows is useful to them in assessing an enterprise’s liquidity, financial
flexibility, profitability and risk. It also provides a feedback about the previous
assessments of these factors. Investors, analyst, creditors, managers and others
will find the information in the statement of cash flows helpful in assessing the
following:
1. It is very useful in the evaluation of cash position of a firm.
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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 coordinates its
financial operations properly.

3. A comparison of historical and projected cash flow statement can be made so as

to find the variation and deficiency or otherwise in the performance so as to enable
the firm to take immediate and effective actions.
4. A series of intra firm and inter firm cash flow statement reveals whether the
firm’s liquidity 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.
6. Cash flow analysis is more useful and appropriate than funds flow analysis for
short-term financial analysis as in a very short period it is cash, which is more
relevant, then the working capital for forecasting the ability of the firm to meet its
immediate obligations.
7. Cash flow statement prepared according to AS-3 is more suitable for making
comparison than the funds flow statement, as there is no standards format used for
the same.
8. Cash flow statement provides information of all activities classified under
operating, investing and financing activities.
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STRUCTURE OF CASH FLOW STATEMENT

According to AS-3, the cash flow statement should report cash flows during the
period classified by operating, investment and financing activities as follows:
• Cash flow from Operating Activities
• Cash flow from Investing Activities
• Cash flow from Financing Activities
1. Cash flow from Operating Activities involves cash generated by producing
and delivering goods and providing services. Cash inflow includes receipts from
customers for sales of goods and services (including collection of debtors). Cash
outflow from operating activities include payments to suppliers for purchase of
material and for services, payment to employees for services and payment to
governments for taxes and duties. Then by comparing the inflow and outflow of
cash we can determine the net value of cash flows. If the inflows are more than
outflows then it is called cash generated from operating activities or if cash
outflows are more than cash inflows then it is called cash lost in operating
activities. This cash flow is a key indicator of the extent to which the operations of
the enterprise have generated sufficient cash flows to maintain the operating
capability of the enterprise, pay dividend, repay loans and make new investments
without recourse to external sources of financing.
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Information about the specific component of historical operating cash flows is

useful, in conjunction with other information, in forecasting future operating cash
inflows.
Examples of cash flows from operating activities are:
• Cash receipts from the sale of goods and rendering the services.
• Cash receipts from royalties, fees, commission and other revenue.
• Cash payment to suppliers of goods and services.
• Cash payment to and on behalf of employees.
• Cash receipts and cash payment of an insurance enterprise for premium and
claims, annuities and other policy benefits. Cash payment and refund of income tax
unless can be specifically identified with financing and investing activities.
• Cash receipts and payments relating to futures contract, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading
purpose.
Some transactions, such as the sale of an item of plant, may rise to a gain or loss
that is included in the determination of the net profit or loss. However, the cash
flow relating to such transactions are cash flows from investing activities.
2. Cash flow from Investing Activities involves the cash generated by making
and collecting loans and acquiring and disposing of debts and equity instruments
and fixed assets. Cash inflows from investing activities are receipts from collection
of loans, receipts from sales of shares, debts or similar instruments of other
enterprises, receipts from sale of fixed assets and interest and dividend received
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firm loans and investments. Cash outflows from investing activities are
disbursement of loans, payments to acquire share debts or similar instruments of
other enterprise and payment to acquire fixed assets.
Cash receipts and payments relating to futures contract, forward contracts, option
contracts and swap contracts except when the contracts are held for dealing or
trading purpose or the payments or receipts are classified as financing activities.
3. Cash flows from Financing Activities involves cash generated by obtaining
resources from owners and providing them with a return on their investment,
borrowing money and repaying amounts borrowed and obtaining and paying for
other resources obtained from creditors on long-term credit. Cash flows from
financing activities involve the proceeding from issuing share or other similar
instrument, debentures, mortgages, bonds and other short term or long-term
borrowings. Cash outflow from financing activities are payments of dividend,
payments to acquire or redeem shares to other similar instruments of the enterprise,
payment of amount borrowed, principal payment to creditors who have extended
long-term credit and interest paid.
It is important to note down that the classification of the cash flows into operating,
investing and financing categories will depend upon the nature of the business. For
example, for financial institutions like banks lending and borrowing are parts of
their business operations.
So the income and expenditure regarding the borrowing and lending will be
included in the cash flow from operating activities.
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TREATMENT OF SOME TYPICAL ITEMS

AS-3 (Revised) has also provided for the treatment of cash flow from some
peculiar items as discussed below:
1) Extraordinary items: The cash flow from extraordinary items just like winning
the lottery, loss by fire etc. either classified as arising from operating, investing or
financing activities as appropriate and separately disclosed in the cash flow
statement to enable users to understand their nature effect on the present and future
cash flows of the enterprise.
2) Interest and Dividend: A great care have to be taken regarding the interest and
dividend as receivable of the interest and dividend is a Receipts from sale of
investments and from collection of loans, Receipts from interest and dividend on
loan and investments, Investing Activities Receipts from issuance of shares,
Receipts from issuance of debentures, Receipts from other long-term borrowing,
Financing Activities: Payment for purchase of investments and for making of
loans, Payment for dividend on share capital, Payments for principal on
debentures and other borrowings, Payments for interest on debenture and other
borrowings result of investment so it is considered as cash inflow from investing
activities while payment of dividend and interest arise due to collection of finance
so it is termed as cash outflow from financing activities. But in case of a financial
institution payment and receipts of interest and dividend are related to their main
business so these items are treated under the head of cash flow from operating
activities.
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3) Taxes on Income: Taxes paid by the business should be treated as cash outflow
generated by operating activities if nothing is stated in the problem but if it is
specified in question that the tax arise due to financing and investing activities then
that tax should be treated under respective activities.
4) Acquisitions and Disposal of Subsidiaries and other Business
Units: The aggregate cash flows arising from acquisitions and from disposal
subsidiaries or other business units should be presented separately and classified as
investing activities. The separate presentation of the cash flow effects of
acquisitions and disposal of subsidiaries and other business units as single line
items helps to distinguish these cash flows from other cash flows. The cash flow
effects of disposal are not deducted from those of acquisitions.
5) Foreign Currency Cash Flow: Cash flows arising from transactions in a
foreign currency should be recorded in an enterprise’s reporting currency by
applying to the foreign currency amount the exchange rate between the reporting
currency and the foreign currency at the date of the cash flow. The effect of the
changes in exchange rates on cash and cash equivalents held in a foreign currency
should be reported as a separate part of the reconciliation of the changes in cash
and cash equivalents during the period.
Unrealized gains and loss arising from changes in foreign exchange rates are not
cash flows. However, the effect of exchange rate changes on cash and cash
equivalent held is reported in the cash flow statement in order to reconcile the
value of cash and cash equivalent at the beginning and the end of the period. This
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amount is presented separately from cash flows from operating, investing and
financing activities and includes the difference, if any.
6) Non-Cash Transactions: There are some transactions, which do not affect the
cash positions of the business directly but affect the capital and asset structure of
an enterprise. Such as the conversion of debts into equity, the acquisitions of an
enterprise by means of issue of shares etc. These transactions should not be
included in the cash flow statement but due to their importance these can be shown
as additional information under the statement.
FORMAT OF CASH FLOW STATEMENT
AS-3 (Revised) has not provided any specific format for preparing a cash flow
statement. The cash flow statement should report cash flows during the period
classified by operating, investing and financing activities. A widely used format of
cash flow statement is given below.
COMPANY’S NAME:…………………………
Cash Flow Statement
For the year ended…………..
Cash flow from Operating Activities
(List of the individual inflows and outflows) ………...
Net Cash Flow from Operating Activities ………
Cash Flows from Investing Activities
(List of individual inflows and outflows) ……….
Net Cash Flows from Investing Activities ……….
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Cash Flows from Financing Activities

(List of individual inflows and outflows) ……….
Net Cash Flows from Financing Activities ……….
Net increase (Decrease) in Cash and Cash Equivalents ……….
Cash and cash Equivalent at the Beginning of the period ……….
Cash and cash Equivalent at the End of the period ……….
LIMITATIONS OF CASH FLOW STATEMENT
Despite a numbers of uses, cash flow statement suffers from the following
limitations:
1. As cash flow statement is based on cash basis of accounting, it ignores the basic
accounting concepts of accrual basis.
2. Some people feel that as working capital is a wider concept of funds flow
statement provides a more complete picture than cash flow statement. So it is
based on narrow concept.
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.
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COMPARISON BETWEEN FUNDS FLOW AND CASH FLOW

STATEMENT
The term funds have a variety of meaning. In narrow sense it means cash and the
statement of changes in the financial position prepared on cash basis is called a
cash flow statement. In the most popular sense, the term funds refer to working
capital and a statement of changes in the financial position prepared on this basis is
called a funds flow statement. A cash flow statement is much similar to a funds
flow statement as both are prepared to summarize the causes of changes in the
financial position of a business. However the following are the main differences
between funds and a cash flow statement.
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UNIT III: BUDGETORY CONTROL AND STANDARD COSTING

BUDGETORY CONTROL
Meaning of Budgetary Control:
Management has in its armory a number of weapons which it uses according to its
efficacy and necessity to control the business, particularly as a device for financial
control. One of such weapons or tools—very effective as a controlling device — is
the budgetary control so far as financial aspect is concerned.

A budget is a detailed plan of operations for some specified future period. In the
words of Terry, budget is “an estimate of future needs arranged according to
an orderly basis, covering some or all of the activities of an enterprise for a
definite period of time” and budgetary control is “a process of finding out what is
being done and comparing actual result with the corresponding budget data in
order to approve accomplishments or to remedy differences by either adjusting the
budget estimates or correcting the cause of differences.”
Budgetary control has been defined as “the establishment of budgets relating the
responsibilities of executives to the requirements of a policy and the
continuous comparison of actual with budgeted results either to secure by
individual action the objective of that policy or provide a basis for its
revision.”
Budgetary control involves the use of budgets and budgeting reports throughout
the period to coordinate evaluate and control day-to-day operations in accordance
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with the goals specified in the budget. Budgets are prepared to control operations
so that established policies and objectives can be achieved. Budgeting serves to
clarify the programme, measure efficiency and provide definite plans to interested
parties.

There are various types of budgets — Fixed, Variable, Revenue, Capital, Material,
Cash, Labour, Sales, Production, Master budgets etc. to meet different objectives.

So, control through budgets should not be misconceived as a measure of control of

financial matters only, but all types of budgets, in the real sense, control finance by
eliminating the scope of wastage and securing efficiency through work according
to plans.

Advantages of Budgetary Control:

Sound planning, effective co-ordination and dynamic control are not possible to
the desirable extent without budgeting. A budget is a tool of planning as well as of
control.

A sound system of budgetary control ensures efficiency of an organisation in

the following ways:
(i) Budgeting tends to make planning definite and coordinated:
A budget is more than a financial instrument and serves as a complete programme
of business activities. A business with good budgetary control can anticipate and
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provide for contingencies rather than groping in the dark. Budgeting also helps in
selecting the most profitable course of action.

(ii) Budgetary control makes for unified action and co-ordination of

individual efforts:
Budgeting is an excellent means of communication and motivation. It stimulates
preventive action. Budgeting facilitates co-ordination by promoting team spirit. It
makes possible the selection of the most desirable course of action.

(iii) Budgetary control helps management in delegating authority more freely

over specified functions:
“Budgeting correlate planning and allow authority to be delegated without loss of
control.” Budgeting improves organizational efficiency as effective budgeting
requires sound organization structure.

(iv) Budgets are the most important means of management control:

A budget serves as a yardstick with which performance of employees can be
evaluated and costs can be controlled. Budgeting permits ‘control by exception’
thereby saving executive time and attention.

(v) Budgetary control promotes efficiency and minimizes waste:

Budgeting stimulates good management practices like proper planning, a sound
organisation structure, adequate reporting system etc. It helps in the optimisation of
resources.
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(vi) Budgeting helps in fixing responsibility for results and in taking corrective
actions in time. The budget provides guideposts to efficient working.

In the words of Blocker:

“Budgetary control is planned to assist management in the allocation of
responsibility and authority, to aid in making estimates and plans for the future, to
assist in the analysis of the variations between estimated and actual results and to
develop bases of measurement of standards with which to evaluate the efficiency
of operation.”

Disadvantages of Budgetary Control:

(i) Since budgets are based on estimates, they cannot be cent per cent correct and
accurate. They are as good as the data and forecasts on which they are based.
Inflation and rapid changes in business-environment tend to distort budget data
before they are put into operation.

(ii) An efficient system of budgeting can achieve little without effective planning
and control. Budget does not indicate the corrective action, neither is it a blueprint
to be adhered to at all costs. A sound budget system requires effective supervision
and administration.

(iii) People very often fail to adjust when required according to budget. Budgeting,
therefore, entails danger of inflexibility. “The budget is not a straight—jacket
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but a measure of performance and a guide which should be adjusted to meet

new situations.”Budgeting is a nuisance rather than an aid to management where
budgets are prepared mechanically without serious thought to the ways of
improving operation.
(iv) Rigid adherence to budgets discourages initiative and creativity. It may also
lead to internal frictions and pressures.

(v) Budgeting is a time-consuming process and involves expenses. There is a

tendency to go into excessive detail which restricts freedom of action.

(vi) Budgeting goals may lead people to supersede the enterprise goals. Budgets
may be used to hide inefficiencies as past precedents often become evidence for
the present.

(vii) Success of budgeting depends on the motivation of people who are to install
and use budgets. People cannot change their habits and attitudes overnight. To be
effective, budgeting should be a gradual and co-operative exercise.

(viii) Too much should not be expected of budgetary control within a short period
of time. Budgeting is not a cure to all nor is it a tool which provides rapid results
when first installed.
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Problems in Budgeting

Whilst budgets may be an essential part of any marketing activity they do have a
number of disadvantages, particularly in perception terms.

1) Budgets can be seen as pressure devices imposed by management, thus resulting

in:
a) bad labour relations
b) inaccurate record-keeping.

2) Departmental conflict arises due to:

a) disputes over resource allocation

b) departments blaming each other if targets are not attained.

3) It is difficult to reconcile personal/individual and corporate goals.

4) may arise as managers adopt the view, "we had better spend it or we will lose
it". This is often coupled with "empire building" in order to enhance the prestige of
a department.

Responsibility versus controlling, i.e. some costs are under the influence of more
than one person, e.g. power costs.

5) Managers may overestimate costs so that they will not be blamed in the future
should they overspend.

Characteristics of a Budget

A good budget is characterized by the following:

a) Participation: involve as many people as possible in drawing up a budget.

b) Comprehensiveness: embrace the whole organisation.
c) Standards: base it on established standards of performance.
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d) Flexibility: allow for changing circumstances.

e) Feedback: constantly monitor performance.
f) Analysis of costs and revenues: this can be done on the basis of product
lines, departments or cost centres.

Budget Organisation and Administration:

In organising and administering a budget system the following characteristics may

apply:

a) Budget centres: Units responsible for the preparation of budgets. A budget

centre may encompass several cost centres.

b) Budget committee: This may consist of senior members of the organisation, e.g.
departmental heads and executives (with the managing director as chairman).
Every part of the organisation should be represented on the committee, so there
should be a representative from sales, production, marketing and so on. Functions
of the budget committee include:

· Coordination of the preparation of budgets, including the issue of a manual

· Issuing of timetables for preparation of budgets
· Provision of information to assist budget preparations
· Comparison of actual results with budget and investigation of variances.

c) Budget Officer: Controls the budget administration. The job involves:

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· liaising between the budget committee and managers responsible for budget
preparation
· dealing with budgetary control problems
· ensuring that deadlines are met
· educating people about budgetary control.

d) Budget manual:

This document contains the charts of the organization, details of budget

procedures, contains account codes for items of expenditure and revenue,
timetables of the process and clearly defines the responsibility of persons involved
in the budgeting system.

TYPES OF BUDGETS:

The following points highlight the nine types of budget. The types are:

1. Plant Utilisation Budget

2. Production Cost Budget

3. Direct Material Budget

4. Capital Budgeting

5. Zero Base Budgeting

6. Performance Budget
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7. Sales Budget

8. Cash Budget

9. Flexible Budget

1. Plant Utilisation Budget:

Plant utilisation budget is prepared in terms of working hours, weight or other
convenient units of plant facilities required to carry out the programme laid down
in the production budget.

The objectives of Plant Utilisation Budget are:

(i) To determine the load on each process, cost or groups of machines for the
budget period;

(ii) To indicate the process or cost centers which are overloaded so that corrective
action can be taken;

(iii) To dovetail the sales, production budgets where it is not possible to increase
the capacity of any of the overloaded processes;

(iv) To make effort to boost sales to utilise the surplus capacity.

2. Production Cost Budget:

A product Cost Budget is the summary of material budget, labour budget, factory
overhead budget.
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A Production Cost Budget is also known as Manufacturing Budget that

consists of three budgets namely:
(i) Material budget,

(ii) Labour budget, and

(iii) Factory overhead budget.

3. Direct Material Budget:

Direct Material Budget indicates the cost of direct material purchased.

The direct material budget is useful for the following reasons:

1. It helps the purchase department to prepare a schedule to ensure supply of
material to the production departments as and when materials are required for
production.

2. It helps the store department in fixing maximum and minimum levels of

inventories.

3. It also helps the finance manager to ascertain the financial requirements to

finance production targets.

Direct Material Budget consists of:

1. Material Usage Budget,

2. Purchase Budget.
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The following example will clarify the matter.

4. Capital Budgeting:
Definition:
In the words of R.M. Lynch, “Capital budgeting consists in planning for
development of available capital for the purpose of maximizing the long-term
profitability of the firm”.

Charles T. Horngren defines Capital Budgeting as “A long-term planning for

making and financing proposed capital outlays”.

Gitman L.J. has put, “Capital Budgeting refers to the total process of generating,
evaluating, selecting and following up of capital expenditure alternatives”.
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The capital budgeting decision, therefore, involves a current outlay or series of

outlays of cash resources in return for anticipated flow of future benefits.

Importance:
Capital budgeting decision are of paramount importance in financial decision
making.

Firstly, capital budgeting decisions affect the profitability of the firm. They also
have a bearing on the competitive position of a firm.

Capital budgeting decisions determine the future destiny of a company. An

opportune investment decision can result in a spectacular returns while an
irrational investment decision can endanger the very survival of the firm.

Secondly, a capital expenditure decision has its effect over a long time span and
inevitably affects the company’s future cost structure.

Thirdly, capital expenditure decisions once made and implemented are not easily
reversible without much financial loss.

Finally, It involves costs. Since most of the firms have scarce capital resources
there is need for wise, thoughtful and correct investment decisions.
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Advantages of Capital Expenditure Budget:

Capital Expenditure Budget offer the following advantages:
(i) It highlights the capital development programmes and estimated capital
expenditure during the budget period.

(ii) It provides a tool for controlling capital expenditure.

(iii) It enables the company to establish system of priorities in expenditure.

(iv) It provides some of the fixed-asset figures that will be required for the forecast
Balance Sheet.

5. Zero Base Budgeting:

Definition:
Zero Base Budgeting is an operating planning and budgeting process which
requires each manager to justify his entire budget requests in detail from scratch.
Each manager has to justify why he should spend any money at all. This approach
requires that all activities be identified as decision on packages which would be
evaluated by a systematic analysis and ranked in order of importance.

Leonard Merewit has defined ZBB as a “technique which complements and links
the existing planning, budgeting and review process. It identifies alternatives and
efficient methods of utilizing limited resources in effective attainment of selected
benefits. It is a flexible management approach which provides a credible rationale
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for re-allocating resources by focusing on a systematic review and justification of

the funding and performance levels of current programmes or activities”.

Devid Heminger has also explained ZBB as “a management tool which provides
a systematic method for evaluating all operations and programme, current or
new, allows for budget reductions and expansions in a rational manner and
allows re-allocation of resources from low to high priority programmes”.
The above definition of ZBB suggests to examine a programme or function or
responsibility from ‘scratch’. The evaluator proceeds on the assumption that
nothing is to be allowed simply since it was being done previously. The manager
proposing the activity has to justify that the activity is essential and the outlay
proposed is reasonable and rational in the present circumstance.

The ZBB technique suggests that an organization should not only make decisions
about the proposed new programmes but it should also, from time to time, review
the ‘utility’ and appropriateness of the existing programmes.

Stages of Zero Base Budgeting:

1. Corporate objectives should be established and laid down in detail.

2. Each separate activity of the organization is identified and called decision

package. A decision package is a document that identifies each activity and
describes it in such a fashion so that management can (i) evaluate it and rank it
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against other activities competing for limited and scarce resources, and (ii) decide
to approve or disapprove it.

3. Budget staff will compile operating expenses for packages approved by the
departmental head.

Advantages of Zero Base Budgeting:

Zero Base Budgeting has some distinct advantages, some of them are outlined
below:
(i) The proposals for funds are strictly considered on merit basis and funds are
allocated on the basis of priority.

(ii) This technique motivates managers to evolve cost effective ways of performing
jobs. New ideas also emerge.

(iii) Obsolete operations and wastages are identified and eliminated.

(iv) Decision packages improve coordination within the firm and strengthen
communication between different departments.

(v) Managers become aware of the value of inputs helping them to identify
priorities.

(vi) Zero Base Budgeting is particularly useful in areas like service departments
where it is often difficult to identify and quantity output.
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(vii) ZBB aims at motivating the staff to take greater interest in the job because it
involves staff in decision taking process.

(viii) ZBB is useful especially for service departments where it may be difficult to
identify output.

Disadvantages of Zero Base Budgeting:

(i) It is very expensive because the costs involved in preparing a vast number of
decision packages in a large firm are very high.

(ii) Since more managers are involved in this process administration and
communication of ZBB process may turn complicated.

(iii) Managers develop fear and feel threatened by ZBB and, therefore, may oppose
new ideas and changes.

(iv) It involves a large amount of paper work and is very time consuming.

(v) The ranking of decision packages and allocation of resources is subjective to a

certain degree that may lead to departmental conflict.

6. Performance Budget:
Traditional budgeting does not provide a link between inputs in financial terms and
output in physical terms. The term ‘Performance Budget’ was originally used in
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U.S.A. by the first Hoover Commission in 1949 when it recommended the

adoption of a budget based on functions, programmes and activities.

Definition:
A performance budget is a work plan which expresses for achievement in respect
of various responsibility levels based on accepted norms and standards. The
National Institute of Bank Management, Mumbai has defined the performance
budgeting technique as “the process of analyzing identifying, simplifying and
crystallizing specific performance objectives of a job to be achieved over a period,
within the frame work of organizational objectives, the purposes and objectives of
the job. The technique is characterized by its specific direction towards the
business objectives of the organization”.

The above definition lays stress on the achievement of specific goals over a period
of time. The technique of performance budgeting calls for preparation of periodic
performance reports which compare budget and actual performance to locate
existing variances. Their preparation is greatly facilitated if the authority and
responsibility for the incurrence of each cost element is clearly defined within the
firm’s organizational structure.

7. Sales Budget:
Sales Budget is one of the functional budgets. Since sales forecast is the starting
point of budgeting, sales budget assumes primary importance. The sales budget
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represents the total sales in physical quantities and values for a future budget
period. Here the quantity that can be sold is the key factor for many business
undertakings.

The purpose of sales budget is not to estimate or guess what the actual sales will
be, but rather to develop a plan with clearly defined objectives towards which
operational efforts are directed.

Factors to be considered for preparing the Sales Budget:

The following factors are to be reckoned for preparing the sales budget:
(a) Reports of the salesmen who have the first hand information about the present
market conditions for the product.

(b) General economic and political conditions are to seriously studied.

(c) Relative product profitability.

(d) Pricing policies.

(e) Market Research studies providing information like changes in fashion, tastes,
consumers’ preference, purchasing power of the consumers, and competitions’
activities etc.

(f) Seasonal and cyclical variations.

(g) Advertising and sales promotion and their impact on the product market.

(h) Production capacity of the plant etc.

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The Sales Budget may be prepared under the following classification or

combination of classifications:
(a) Products or groups of products,
(b) Areas, Towns, Salesmen, and Agents,
(c) Types of customers like government, Export, Home Sales, Retail depots,
(d) Period: months weeks etc.

Production Budget:
A production budget incorporates the estimates of the total volume of production
with the scheduling of operations by days, weeks and months. The production
manager is responsible for the preparation of production budget. It is normally
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prepared in quantitative terms as units of output, tones of production. It is to be

noted that sales budget should be used as basis for production estimates and
forecasts.

8. Cash Budget:
The Cash Budget is one of the most important budgets to be prepared. It represents
the cash requirements of the business during the budget period.

It contains detailed estimates of cash receipts (cash inflows) and disbursements

(cash outflows) either for the budget period or some other specific period. It is a
useful tool in cash management of organisations as it reveals potential cash
shortages as well as potential excess cash.

Objectives of Cash Budget:

Cash budget is prepared with the following objectives:
(i) It indicates the cash availability for taking advantage of cash discount.

(ii) It indicates the cash requirement needed for capital expenditure for business
expansion.

(iii) It determines the amount of loan to be taken from banks to manage working
capital for a short period.
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(iv) It shows the availability of excess funds for short-term investments to increase
income of the organization.

(v) Cash Budget helps the management in planning the financial requirements of
bond redemption, payments to pension and retirement funds.

(vi) Efficient cash management is possible if cash budget is prepared.

Cash budgets help management to avoid having unnecessary idle cash on the one
hand, and unnecessary ‘nerve-racking’ cash deficiencies, on the other.

9. Flexible Budget:
Before discussing flexible budget it seems to be appropriate to highlight upon fixed
budget. According to ICMA, London, “a fixed budget is a budget designed to
remain unchanged irrespective of level of activity actually attained”. Thus, a
budget prepared for fixed level of activity is known as fixed budget.
In fixed budgetary control, the budgets prepared are based on one level of output, a
level which has been carefully planned. In fact, fixed budget presents expected
sales revenue, costs and profits or losses for a definite level of activity, a level
which has carefully been planned to equate sales and production at the most
profitable rate.
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Significantly, targets of fixed budget do not change with the changes of level of
activity. It is true; in some companies it becomes extremely difficult to forecast
sales with even a reasonable chance of success.

This situation may arise in case of following companies:

(i) Companies that are greatly affected by weather condition, e.g., the soft drink
industry;

(ii) Which frequently introduce new products, e.g. the food camping industry;

(iii) Companies in which production is carried out only when order is received, e.g.
shipbuilding industry;

(iv) Companies that are affected by changes in fashion; and

(v) Where large output is intended for export, e.g. production of consumers’ goods.

Definition of Flexible Budget:

The I.C.M.A. defines flexible budget as, “budget which is designed to change in
accordance with the level of activity actually attained”.

The flexible budget (also called variable budget) is based on knowledge of cost
behaviour pattern. It is prepared for a range, rather than a single level of activity. It
is essentially a set of budgets that can be tailored to any level of activity. Ideally,
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the flexible budget is compiled after obtaining a detailed analysis of how each cost
is affected by changes in activity.

In fixed budgetary control, the budget is prepared on the basis of one level of
output, a level which has been carefully planned to equate sales and production at
the most profitable rate. But if the level of output actually achieved differs
considerably from that budgeted, large variances will arise. In some companies it
seems extremely difficult to forecast sales with even a reasonable chance of
success.

This situation may arise in case of the following companies:

(i) Companies greatly affected by weather conditions, e.g. there is a great demand
of cold drinks while demand falls during winter;

(ii) Companies that introduce frequently new products, e.g. food canning industry;

(iii) In which production is carried on only after receiving order;

(iv) Companies affected by change of fashion, e.g. millinery trade; and

(v) Where a large part of the output is intended for export, e.g. air conditioning
equipment.
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Flexible budgetary control has been developed with the objectives of changing the
budget figures progressively to correspond with the actual output achieved. Some
companies operate flexible budgets in conjunction with a fixed budget.

The preparation of flexible budgets necessitates the analysis of all overheads into
fixed, variable and semi-variable costs. This analysis is very much significant in
preparing flexible budget because varying levels of output need to be considered
and they will have a different effect on each class of overhead.

Significance of Flexible Budgeting:

The following advantages can be derived from flexible budgeting:
(i) It presents a detailed picture of output, costs, sales and profit for varying levels
of business operations which makes the marginal analysis more practicable and
feasible;

(ii) Flexible budget is an indispensable tool for achieving cost reduction and cost
control;

(iii) Flexible budget is useful to forecast for varying level of operations;

(iv) It makes possible the comparison of actual performance and budgeted one for
actual level of operation in a very easy and understandable way.
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Operational Areas of Flexible Budget:

Preparation of flexible budget is needed in the following cases:
(i) Where the business is subject to the vagaries of nature like agro-based
industries, soft drinks, woolen industries etc.

(ii) Where the demand for the product depends upon customers’ tastes and fashion
like cotton textile and garment industries.

(iii) Where production is carried out only after receiving the customer’s orders.

(iv) Where business depends heavily on export markets.

(v) Where sales are unpredictable due to typical nature of business and influence of
external factors e.g. luxury goods.

(vi) Where customer’s reaction towards a new product is almost impossible to

foresee and predict.

Standard Costing
Cost control is a basic objective of cost accountancy. Standard costing is the most
powerful system ever invented for cost control. Historical costing or actual costing
is nothing but, a record of what happened in the past. It does not provide any
‘Norms’ or ‘Yardsticks’ for cost control. The actual costs lose their relevance after
that particular accounting period. But, it is necessary to plan the costs, to determine
what should be the cost of a product or service. It the actual costs do not conform
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to what the costs should be, the reasons for the change should be assessed and
appropriate action should be initiated to eliminate the causes.

Definitions:

• Standard: According to Prof. Eric L.Kohler, “Standard is a desired attainable

objective, a performance, a goal, a model”. Standard may be used to a
predetermined rate or a predetermined amount or a predetermined cost.

• Standard Cost: Standard cost is predetermined cost or forecast estimate of cost.

I.C.M.A. Terminology defines Standard Cost as, “a predetermined cost, which is
calculated from management standards of efficient operations and the relevant
necessary expenditure. It may be used as a basis for price-fixing and for cost
control through variance analysis”. The other names for standard costs are
predetermined costs, budgeted costs, projected costs, model costs, measured costs,
specifications costs etc. Standard cost is a predetermined estimate of cost to
manufacture a single unit or a number of units of a product during a future period.
Actual costs are compared with these standard costs.

• Standard Costing: Standard Costing is defined by I.C.M.A. Terminology as,

“The preparation and use of standard costs, their comparison with actual costs and
the analysis of variances to their causes and points of incidence”. Standard costing
is a method of ascertaining the costs whereby statistics are prepared to show:

i. The standard cost

ii. The actual cost
iii. The difference between these costs, which is termed the variance” says
Wheldon. Thus the technique of standard cost study comprises of:
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• Pre-determination of standard costs

• Use of standard costs
• Comparison of actual cost with the standard costs
• Find out and analyse reasons for variances
• Reporting to management for proper action to maximize efficiency

Advantages of Standard Costing:

1. Cost Control: Standard costing is universally recognised as a powerful cost

control system. Controlling and reducing costs becomes a systematic practice
under standard costing.

2. Elimination of Wastage and Inefficiency: Wastage and inefficiency in all

aspects of the manufacturing process are curtailed, reduced and eliminated over a
period of time if standard costing is in continuous operation.

3. Norms: Standard costing provides the norms and yard sticks with which the
actual performance can be measured and assessed.

4. Locates Sources of Inefficiency: It pin points the areas where operational

inefficiency exists. It also measures the extent of the inefficiency.

5. Fixing Responsibility: Variance analysis can determine the persons responsible

for each variance. Shifting or evading responsibility is not easy under this system.

6. Management by Exception: The principle of ‘management by exception can be

easily followed because problem areas are highlighted by negative variances.
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7. Improvement in Methods and Operations: Standards are set on the basis of

systematic study of the methods and operations. As a consequence, cost reduction
is possible through improved methods and operations.

8. Guidance for Production and Pricing Policies: Standards are valuable guides
to the management in the formulation of pricing policies and production decisions.

9. Planning and Budgeting: Budgetary control is far more effective in

conjunction with standard costing. Being predetermined costs on scientific basis,
standard costs are also useful in planning the operations.

10. Inventory Valuation: Valuation of stocks becomes a simple process by

valuing them at standard cost.

Limitations of Standard Costing:

1. Variation in Price: One of the chief problems faced in the operation of the
standard costing system is the precise estimation of likely prices or rate to be paid.

2. Varying Levels of Output: If the standard level of output set for pre-
determination of standard costs is not achieved, the standard costs are said to be
not realised.

3. Changing Standard of Technology: In case of industries that have frequent

technological changes affecting the conditions of production, standard costing may
not be suitable.
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4. Applicability: It cannot be used in those organizations where non-standard

products are produced. If the production is undertaken according to the customer
specifications, then each job will involve different amount of expenditures.

5. Difficult to set Standard: The process of setting standard is a difficult task, as it

requires technical skills. The time and motion study is required to be undertaken
for this purpose. These studies require a lot of time and money.

6. Problem in fixing Responsibility: The fixing of responsibility is not an easy

task. The variances are to be classified into controllable and uncontrollable
variances. Standard costing is applicable only for controllable variances.

VARIANCE ANALYSIS:

‘Variance’ is the difference between planned, budgeted or standard cost and actual
costs and similarly in respect of revenues. This should not be confused with the
statistical variance which measures the dispersion of a statistical population.

‘Variance Accounting’ is a technique whereby the planned activities of an

undertaking are quantified in budgets, standard costs, standard selling prices and
standard profit margins, and the differences between these and the actual results
are compared. The procedure is to collect, compare, comment and correct.

‘Variance Analysis’ is the analysis of variances arising in a standard costing

system into their constituent parts. It is the analysis and comparison of the factors
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which have caused the differences between predetermined standards and actual
results, with a view to eliminating inefficiencies.

Variance analysis highlights areas of strengths and weaknesses, but doesn’t

indicate what action, if any, should be taken. A manager must be able to correctly
interpret the significance of variances before he can initiate control action. All
planning is based on estimates (e.g., of prices, costs, volumes) and actual outcomes
will rarely be precisely in line with these estimates. Some variation is inevitable.

Variances obtained under standard costing system have to be reported to

management for taking remedial steps. Before taking any action, the management
must try to know the causes of such variances. In a business organization, control
is a relative rather than absolute concept.

Seldom, the management will attempt to maintain absolute control. Control is

justified only to the extent that it produces values and the excess control is not
suggested where the cost of control exceeds the values it produces. Thus in some
instances exercising little control may be the best policy.
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For understanding of the ‘variance analysis’ topic, variances are classified

into the following:
(i) Material variances,
(ii) Labour variances,
(iii) Variable overhead variances,
(iv) Fixed overhead variances,
(v) Sales variances, and
(vi) Profit variances
Each of these variances are discussed elaborately in the following paragraphs:
(i) Material Variances:
For the purpose of material variance analysis, the following two types of standards
need be fixed.

1. Material Price Standards:

Price factor is controlled by external factors. If the price changes during the period
due to inflation, raise in prices of controlled items like cement, steel, etc., there is
going to be wide variations.

Material prices are fixed keeping in mind the terms of contract of purchases, nature
of items and other relevant factors. Some organizations have regular system of
purchases (rate contract) for the whole period/year at predetermined price
irrespective of the prevalent market rates.
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2. Material Quantity Standards:

Quantity usage standards are set on the basis of various test runs and guidelines
provided by R&D department or Engineering department and specifications on the
basis of past experience. The standards should also take into consideration
allowances for acceptable level of waste, spoilage, shrinkage, seepage,
evaporation, leakage, etc.

3. Material Cost Variance:

The material cost variance is also called ‘material total variance’ is the difference
between standard direct material cost of actual production and the actual cost of
direct material.

(Standard units x Standard price) – (Actual units x Actual price)

or Standard cost of material – Actual cost of material used

4. Material Price Variance:

The material price variance is the difference between the standard price and the
actual purchase price for each unit of material multiplied by the actual quantity of
material purchased. It is preferable to base the price variance on the actual quantity
of material purchased and not on the actual quantity used in order that price
variances can be reported for control purposes.

Actual quantity (Standard price p.u. – Actual price p.u.)

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5. Material Usage Variance:

The material usage variance is the difference between the actual quantity of
material used and the standard quantity of material that should be used for actual
production, multiplied by the standard price per unit of material.

Standard price p.u. (Standard quantity – Actual quantity)

Material usage variance is further segregated into (a) Material mix variance, and
(b) Material yield variance.

6. Material Mix Variance:

If a process uses several different materials which could be combined in a standard
proportion, a mix variance can be calculated which shows the effect on cost of
variances from the standard proportion. There are two recognized ways of
calculating this mix variance.

Some authorities regard the variance as a subset of the usage variance but others
treat it as part of the price variance. If the mix variance is treated as a subset of the
usage variance, then the material mix variance is the difference between the total
quantity in standard proportion priced at the standard price and the actual quantity
of material used priced at the standard price.

Material Mix Variance

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Standard price (Revised standard quantity – Actual quantity)

Revised Standard Quantity

(Total quantity of actual mix/Total quantity of standard mix) x Standard quantity

7. Material Yield Variance:

Apart from operator or machine performance, output quantities produced are often
different to those planned, e.g., this arises in chemical plants where plant should
produce a given output over a period for a given input but the actual output differs
for a variety of reasons. Material yield variance is the difference between the
standard yield of the actual material input and the actual yield, both valued at the
standard material cost of the product.

Standard cost p.u. (Standard output for actual mix – Actual output)

(ii) Labour Variances:

Normally it is taken that labour is a variable cost but at times it becomes
fixed cost as it is not possible to remove or retrench in case of fall/stoppage
in production.

Labour Rate Standard and Grades of Labour:

This is basically dependent on the agreement with the labour unions or rate
prevalent in the particular area or industry.
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1. Labour Efficiency Standard:

The labour (quantities) efficiency means the number of hours that the appropriate
grade of worker will take to perform the necessary work. It is based on actual
performance of worker or group of workers possessing average skill and using
average effort while performing manual operations or working on machine under
normal conditions. The standard time is fixed keeping in mind the past
performance records or work study. This is on the basis that is acceptable to the
worker as well as the management.

2. Labour Cost Variance:

The labour cost variance is also called’ labour total variance’ is the difference
between the standard direct labour cost and the actual direct labour cost incurred
for the production achieved.

(Standard labour hours produced x Standard rate per hour) – (Actual direct labour
hours x Actual rate per hour)

or Standard cost for actual output – Actual cost

3. Labour Rate Variance:

The labour rate variance is the difference between the actual direct labour rate per
hour and the standard direct labour rate per hour, multiplied by the actual hours
paid, i.e., the rate per hour paid to the direct labour force more or less than standard
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use of higher/lower grade of skilled workers than planned or wage inflation causes
this variance.

Actual time (Standard rate – Actual rate)

4. Labour Efficiency Variance:

The labour efficiency variance is the difference between the actual hours taken to
produce the actual output and the standard hours that this output should have taken,
multiplied by the standard rate per hour. The possible cause for this variance is due
to use of higher/lower grade of skilled workers than planned or the quality of
material used, errors in allocating time to jobs.

Standard rate (Standard time for actual output – Actual time)

The labour efficiency variance can be segregated into the following:

5. Labour Mix Variance:
The labour mix variance arises due to change in composition of labour force.

Labour Mix Variance

Standard rate (Revised standard time – Actual time)

Revised Standard Time

Total actual time/Total standard time x Standard time

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6. Labour Yield Variance:

The labour yield variance arise due to the difference in the standard output
specified and the actual output obtained.

Standard cost p.u. (Standard output for actual time – Actual output)

7. Idle Time Variance:

The idle time variance represents the difference between hours paid and hours
worked, i.e., idle hours multiplied by the standard wage rate per hour. This
variance may arise due to illness, machine breakdown, holdups on the production
line because of lack of material.

Idle hours x Standard rate

8. Net Efficiency Variance:

This variance is calculated after deducting idle hours from actual hours. The
efficiency variance less idle time variance is called ‘net efficiency variance’.

Standard rate (Standard time for actual output – Actual time worked)

or Standard rate (Standard time – Actual hours paid – Idle time)

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Illustration 1:
100 skilled workmen, 40 semiskilled workmen and 60 unskilled workmen were to
work for 30 weeks to get a contract job completed. The standard weekly wages
were Rs. 60, Rs. 36 and Rs. 24 respectively. The job was actually completed in 32
weeks by 80 skilled, 50 semiskilled and 70 unskilled workmen who were paid Rs.
65, Rs. 40 and Rs. 20 respectively as weekly wages.

Find out the labour cost variance, labour rate variance, labour mix variance and
labour efficiency variance.

Solution:
Basic Data for Calculation of Labour Variances:
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Calculation of Labour Variances:

(1) Direct Labour Cost Variance

Std. cost for actual output – Actual cost

= 2,75,200- 2,66,400 = Rs. 8,800 (A)

(2) Direct Labour Rate Variance Actual time (Std. rate – Actual rate)

Skilled = 2,560(60- 65) = Rs. 12,800 (A)

Semiskilled = 1,600(36 – 40) = Rs. 6,400 (A)

Unskilled = 2,240 (24 – 20) = Rs. 8.960 (F) = Rs. 10,240 (A)

(3) Direct Labour Efficiency Variance

Std. rate (Std. time for actual output – Actual time)

Skilled = 60(3,000 – 2,560) = Rs. 26,400 (F)

Semiskilled = 36(1,200 – 1,600) = Rs. 14,400 (A)

Unskilled = 24 (1,800 – 2,240) = Rs. 10,560 (A) = Rs. 1,440 (F)

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Direct Labour Efficiency Variance can be further analyzed into:

(a) Direct Labour Mix Variance

Std. rate (Revised std. time – Actual time)

Skilled = 60 (3,200 – 2,560) = Rs. 38,400 (F)

Semiskilled = 36 (1,280 – 1,600) = Rs. 11,520 (A)

Unskilled = 24 (1,920 – 2,240) = Rs. 7.680 (A) = Rs. 19,200 (F)

Revised std. time

Skilled =6,400/6,000 x 3,000 = 3,200

Semi-Skilled = 6,400/6,000 x 1,200 = 1,280

Unskilled = 6,400/6,000 x 1,800 = 1,920

(b) Direct Labour Revised Efficiency Variance

Std. rate (Std. time for actual output – Revised std. time)

Skilled = 60(3,000 – 3,200) = Rs. 12,000 (A)

Semiskilled =36 (1,200 – 1,280) = Rs. 2,880 (A)

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Unskilled =24(1,800 – 1,920) = Rs. 2.880 (A) = Rs. 17,760 (A)

(iii) Variable Overhead Variances:

For fixation of costs for overheads, a survey of overheads will be necessary and
with the data available for budgetary control, the overheads will be charged to
various cost centres/products etc. on the basis of standard costs. For this, after
dividing the overheads into fixed and variable the calculation of standard overhead
rate for each cost centre/product is done.

The number of hours representing the capacity to manufacture is to be reduced by

various idle facilities, etc. The choice of method of absorption (direct wage rate or
machine hour) will depend upon the circumstances. The main object is to establish
a normal overhead rate based on total factory overhead at normal capacity volume.

1. Variable Overhead Cost Variance:

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The variable overhead cost variance represents the difference between the standard
cost of variable overhead allowed for actual output and the actual variable
overhead incurred during the period. The variance represents the under absorption
or over absorption of variable overheads.

(Actual output x Standard variable overhead rate p.u.) – Actual variable overhead
cost

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

2. Variable Overhead Expenditure Variance:

It is the difference between the actual variable overhead rate per hour and the
standard variable overhead rate per hour multiplied by the actual hours worked.
The actual hours worked must be used not the actual hours paid because the latter
may include idle time and it is usually assumed that variable overhead will not be
recovered in idle time.

(Standard variable overhead rate x Budgeted output) – Actual variable overheads

or (Standard hours for budgeted output x Standard variable overhead rate per hour)
– Actual variable overheads

or Budgeted variable overheads – Actual variable overheads

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3. Variable Overhead Efficiency Variance:

The variable overhead efficiency variance is calculated by taking the difference in
standard output and actual output multiplied by the standard variable overhead
rate.

Standard variable overhead rate (Standard output – Actual output)

Illustration 2:
The budgeted variable overheads for March are Rs. 3,840. Budgeted production for
the month is 38,400 units. The actual variable overheads incurred were Rs. 3,830
and actual production was 38,640 units. Calculate variable production overhead
variance.

Solution:
Working Notes:
Standard Variable Overhead p.u.

Budgeted variable overhead/Budgeted production = Rs. 3,840/38,400 =Re. 0.10

Budgeted production 38,400 units

Total Standard Variable Overhead

= Actual quantity x Std. variable overhead p.u.

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= 38,640 units x Re. 0.10 = Rs. 3,864

Variable Production Overhead

= Standard variable overhead – Actual variable overhead

= Rs. 3,864 – Rs. 3,830 = Rs. 34 (F)

(iv) Fixed Overhead Variances:

Fixed overhead represents all items of expenditure which are more or less remain
constant irrespective of the level of output or the number of hours worked.

The fixed overheads variances are classified as follows:

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1. Fixed Overhead Cost Variance:

The fixed overhead cost variance represents the under/over absorbed fixed
production overhead in the period. This under/over absorbed overhead may be due
to differences between actual and budgeted fixed overheads, i.e., expenditure
variances, and/or differences between the actual and budgeted levels of activity
i.e., volume variances.

(Actual output x Standard fixed overhead rate p.u.) – Actual fixed overheads

or (Standard hours for actual output x Standard fixed overhead rate per hour) –
Actual fixed overheads

or Recovered fixed overheads – Actual fixed overheads

2. Fixed Overhead Expenditure Variance:

This variance is also called ‘budget variance’, obtained by comparing the total
fixed overhead cost actually incurred against the budgeted fixed overhead cost.

Budgeted fixed overheads – Actual fixed overheads

Fixed Overhead Volume Variance:

The volume variance is computed by taking the difference between overhead

absorbed on actual output and those on budgeted output.
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(Actual output x Standard rate) – Budgeted fixed overheads

or Standard rate (Actual output – Budgeted output)

or Standard rate per hour (Standard hours produced – Budgeted hours)

3. Fixed Overhead Efficiency Variance:

The efficiency variance arise due to the difference between budgeted efficiency to
production and the actual efficiency is achieved.

Standard rate (Actual output in units – Standard output in units)

or Standard rate per hour (Actual hours worked – Standard hours for actual output)

4. Fixed Overhead Capacity Variance:

The capacity variance represents the part of volume variance which arise due to
working at higher or lower capacity than standard capacity.

Standard rate (Budgeted quantity – Standard quantity)

5. Revised Fixed Overhead Capacity Variance:

The revised capacity variance is calculated as follows:
Standard fixed overhead rate (Revised budgeted quantity – Standard quantity)

6. Fixed Overhead Calendar Variance:

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The calendar variance arise due to the volume variance which is due to the
difference between the number of working days anticipated in the budget period
and the actual working days in the period to which the budget is applied.

Standard fixed overhead rate (Budgeted quantity – Revised budgeted quantity)

(v) Sales Variances:

All of the variances discussed previously have been concerned with costs; the
effects on profits due to adverse or favourable variances affecting direct materials,
direct labour or overheads. Some companies calculate cost variances only, but to
obtain the full advantages of standard costing, it is required to calculate sales
variances.

Sales variances affect a business in terms of changes in revenue: changes which

have been caused either by a variation in sales quantities or in sales prices.

There are two distinctly separate systems of calculating sales variances, which
show the effect of a change in sales as regards:
(i) Sales margin variance (on the basis of profit), and

(ii) Sales value variance (on the basis of turnover).

1. Sales Variances Based on Profit:

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The sales variances based on profit are also called ‘sales margin variances’
which indicated the deviation between actual profit and standard or budgeted
profit:

2. Total Sales Margin Variance:

This variance takes into account the difference between actual profit and standard
or budgeted profit.

Actual profit – Budgeted profit

or (Actual quantity of sales x Actual profit p.u.) – (Budgeted quantity of sales x

Budgeted profit p.u.)

3. Sales Price Variance:

The price variance is the difference between standard price of the quantity of sales
effected and the actual price of those sales.
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Actual quantity of sales (Actual profit p.u. – Standard profit p.u.)

or (Actual quantity of sales x Standard price) – (Actual quantity of sales x Actual

price)

4. Sales Volume Variance:

It represents the difference between the actual units sold and the budgeted quantity
multiplied by either the standard profit per unit or the standard contribution per
unit. In absorption costing standard profit per unit is used, but in marginal costing,
standard contribution per unit must be used.

Standard profit p.u. (Actual quantity of sales – Standard quantity of sales)

or Standard profit on actual quantity of sales – Standard profit on standard quantity

of sales

Sales volume variance can be further segregated into (a) Sales mix variance
and (b) Sales quantity variance as given below:
5. Sales Mix Variance:
The sales mix variance arises when the company manufactures and sells more than
one type of product. This variance will be due to variation of actual mix and
budgeted mix of sales.
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Standard profit p.u. (Actual quantity of sales – Standard proportion for actual
sales)

Or Standard profit – Revised standard profit

6. Sales Quantity Variance:

The sales quantity is the difference between the budgeted profit on budgeted sales
and expected profit on actual sales.

Standard profit p.u. (Standard proportion for actual sales – Budgeted quantity of
sales)

or Revised Standard Profit – Budgeted Profit

or Budgeted margin p.u. on budgeted mix (Total actual quantity – Total budgeted
quantity)

7. Sales Variances Based on Turnover:

The sales variances based on turnover are classified as follows:

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Sales Value Variance:

(Actual quantity x Actual selling price) – (Standard quantity x Standard selling
price)

Sales Price Variance:

Actual quantity (Actual selling price – Standard selling price)

Sales Volume Variance:

Standard selling price (Actual quantity of sales – Standard quantity of sales)

Sales Mix Variance:

Standard value of actual mix – Standard value of revised standard mix

Sales Quantity Variance:

Standard selling price per unit (Standard proportion for actual sales quantity –
Budgeted quantity of sales)
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or Revised standard sales value – Budgeted sales value

Illustration 4:
(vi) Profit Variances:
The profit variances are classified as follows:

Formulas:
Profit Value Variance:
Budgeted profit – Actual profit

Profit Price Variance:

Actual quantity (Standard rate of profit – Actual rate of profit)

Profit Volume Variance:

Standard rate of profit (Budgeted quantity – Actual quantity)

Profit Mix Variance:

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Revised standard profit – Standard profit

Profit Quantity Variance:

Budgeted profit – Revised standard profit

Benefits and Problems of Variance Analysis:

The segregation of traditional variances into those which are due to planning
deficiencies and those which are due to controllable factors is probably not widely
used, but it does have the following benefits:
(a) It makes standard costing and variance analysis more realistic and meaningful
in volatile and changing conditions.

(b) Operational variances provide an up-to-date guide to current levels of operating

efficiency as the standards have been recalculated using up-to-date information.

(c) Having up-to-date standards and, therefore, more meaningful variances is likely
to make the standard costing system more acceptable and to have a positive effect
on motivation.

(d) It emphasizes the importance of the planning function in the preparation of

standards and helps to identify planning deficiencies.

(e) The calculation of such variances provides a systematic method of reviewing

standards and the assumptions contained within them.

The following are the problems in using such variances:

(a) There is an element of subjectivity in determining after the event (i.e., ex-post)
what is a realistic price. This makes the allocation between planning and
operational causes a subjective matter susceptible to political pressures.
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(b) There is undeniably more clerical and managerial time involved in continually
establishing up-to-date standards and calculating additional variances.

(c} Where the planning and operating functions are carried out in the same
responsibility centre there is likely to be pressure to put as much as possible of the
total variance down to outside, uncontrollable factors rather than internal,
controllable actions. However, these pressures exist in the interpretation of any
type of variance.

UNIT 4: MARGINAL COSTING

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

Thus, in this context, marginal costing is not a system of costing such as process
costing, job costing, operating costing, etc. but a technique which is concerned
with the changes in costs and profits resulting from changes in the volume of
output. Marginal costing is also known as ‘variable costing’.

2. Basic Characteristics of Marginal Costing:

The technique of marginal costing is based on the distinction between product
costs and period costs. Only the variable costs are regarded as the costs of the
products while the fixed costs are treated as period costs which will be incurred
during the period regardless of the volume of output.
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The main characteristics of marginal costing are as follows:

a. It is a technique of analysis and presentation of costs which help 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 costs are
analysed into fixed and variable.

c. The variable costs (marginal costs) are regarded as the costs of the products.

d. Fixed costs are treated as period costs and are charged to profit and loss account
for the period for which they are incurred.

e. The stocks of finished goods and work-in-process are valued at marginal costs
only.

f. Prices are determined on the basis of marginal cost by adding ‘contribution’

which is the excess of sales or selling price over marginal cost of sales.

3. Assumptions of Marginal Costing:

The technique of marginal costing is based upon the following assumptions:
a. All elements of cost—production, administration and selling and distribution—
can be segregated into fixed and variable components.

b. Variable cost remains constant per unit of output irrespective of the level of
output and thus fluctuates directly in proportion to changes in the volume of
output.

c. The selling price per unit remains unchanged or constant at all levels of activity.
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d. Fixed costs remain unchanged or constant for the entire volume of production.

e. The volume of production or output is the only factor which influences the costs.

4. Advantages of Marginal Costing:

The following are the important advantages of marginal costing:
a. The technique of marginal costing is very simple to operate and easy to
understand. Since, fixed costs are kept outside the unit cost; the cost statements
prepared on the basis of marginal cost are much less complicated.

b. It does away with the need for allocation, apportionment and absorption of fixed
overheads and hence removes the complexities of under-absorption of overheads.

c. Marginal cost remains the same per unit of output irrespective of the level of
activity. It is constant in nature and helps the management in production planning.

d. It prevents the carry forward of current year’s fixed overheads through valuation
of closing stocks. Since fixed costs are not considered in valuation of closing
stocks, there is no possibility of factitious profits by over-valuing stocks.
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e. It facilitates the calculation of various important factors, viz., break-even point,

expectations of profits at different levels of production, sales necessary to earn a
predetermined target of profit, effect on profit due to changes of raw materials
prices, increased wages, change in sales mixture, etc.

f. It is a valuable aid to management for decision-marking and fixation of selling

prices, selection of a profitable product/sales mix, make or buy decision, problem
of key or limiting factor, determination of the optimum level of activity, close or
shut down decisions, evaluation of performance and capital investment decisions,
etc.

g. It facilitates the study of relative profitability of different product lines,

departments, production facilities, sales divisions, etc.

h. It is complimentary to standard costing and budgetary control and can be used

along with them to yield better results.

i. Since fixed costs are not controllable and it is only variable or marginal cost that
is controllable, marginal costing, by dividing costs into controllable and non-
controllable, help in cost control.

j. It helps the management in profit planning by making a study of relationship

between cost, volume and profits. Further, break-even charts and profit graphs
make the whole problem easily understandable even to a layman.

k. It is very useful in management reporting, marginal costing facilitates

‘management by exception’ by focussing attention of the management towards
more important areas than to waste time on problems which do not require urgent
attention of the higher managements.
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5. Limitations of Marginal Costing:

In spite of so many advantages, the technique of marginal costing suffers from the
following limitations:
a. The technique of marginal costing is based upon a number of assumptions which
may not hold good under all circumstances.

b. All costs are not divisible into fixed and variable. There are certain costs which
are semi-variable in nature; it is very difficult and arbitrary to classify these costs
into fixed and variable elements.

c. Variable costs do not always remain constant and do not always vary in direct
proportion to volume of output because of the laws of diminishing and increasing
returns.

d. Selling prices do not remain constant forever and for all levels of output due to
competition, discounts for bulk orders, changes in the general price level, etc.

e. Fixed costs do not remain constant after a certain level of activity. Further,
marginal costing ignores the fact that fixed costs are also controllable.

f. The exclusion of fixed costs from the stocks of finished goods and work-in-
progress is illogical since fixed costs are also incurred on the manufacture of
products. Stocks valued on marginal costing are undervalued and the profit and
loss account cannot reveal true profits. Similarly, as the stock is undervalued, the
balance sheet does not give a true picture.

g. Although the technique of marginal costing overcomes the problem of under or

over-absorption of fixed overheads, the problem still exists in regard to under or
over-absorption of variable overheads.
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h. Marginal costing completely ignores the ‘time factor’. Thus, if two jobs give
equal contribution but one takes longer time to complete, the one which takes
longer time should be regarded as costlier than the other. But this fact is ignored
altogether under marginal costing.

i. The technique of marginal costing cannot be applied in contract or ship-building

industry because in such cases, normally the value of work-in-progress is very high
and the exclusion of fixed overheads may result into losses every year and huge
profit in the year of completion of the job.

j. Cost control can be better be achieved with the help of other techniques, viz.,
standard costing and budgetary control than by marginal costing technique.

k. Fixation of selling prices in the long run cannot be done without considering
fixed costs. Thus, pricing decisions cannot be based on marginal cost alone.

l. In the present days of automation, the proportion of fixed costs in relation to

variable costs is very high and hence managerial decisions based upon only the
marginal cost ignoring equally important element of fixed cost may not be correct.

Although, the technique of marginal costing suffers from the above mentioned
limitations, it is a very useful tool in the hands of the management and is
extensively used for cost control, decision-making and profit planning.
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MARGINAL COSTING FORMULAS:

Marginal Costing Equation, Profit Volume Ratio, Break-Even Point, Margin of

Safety, Cost Break-Even Point, finding the selling price, finding the profit,

SALES – VC = FC
1 MARGINAL COSTING EQUATION + PROFIT

2 Contribution Sales – VC

Profit + FC

3 Profit Volume Ratio Contribution / Sales

(In Marginal Costing,

Change in Profit /
Profit = Contribution) Change in Sales

Change in
Contribution /
(Profit = EBIT) Change in Sales

100% – VC Ratio
(PV % + VC % =
100% of Sales)
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School of Law
An ISO 9001:2008 Certified Quality Institute
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Total Revenue =
4 Break Even Point Total Cost

Break Even Point(In Rupees) FC / PV Ratio

Break Even Point *

Break Even Point(In Rupees) Selling Price

FC / Contribution
Break Even Point(Quantity) p.u

At BEP, Total
Contribution = Total
Fixed Cost

Total Sales – Break

5 Margin Of Safety even Sales

Margin Of Safety(In Rupees) Profit / PV Ratio

Profit / Contribution
Margin Of Safety(Quantity) p.u

Total Sales = Total

6 Indifference Point / Cost Break Even Point Profits

Difference in FC /
(In Rupees) Difference in VCR

Difference in FC /
(In Rupees) Difference in PVR
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&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

Difference in FC /
Difference in VC
(In Quantity) p.u

Difference in FC /
Difference in
(In Quantity) Contribution p.u

7 Shut Down Point

Avoidable FC / PV
(In Rupees) Ratio

Avoidable FC /
(In Quantity) Contribution p.u

Total FC – Min
8 Avoidable FC Unavoidable FC

Some Other Formulas:

1 CONTRIBUTION PROFIT + FC

2 Sales(In Rupees) Contribution / PV Ratio

3 Profit Contribution – FC

4 Contribution Sales * PVR

5 Finding the Selling Price Total VC / VCR

 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

6 Finding the Profit MOS * PVR

Always MOS + PVR = 100%

PROFIT PLANNING
Concept of Profit Planning:
Managerial efficiency in a profit seeking organization is generally gauzed in terms
of probability. The management, therefore, aims at maximizing profitability of the
enterprise. In furtherance of this objective profit planning technique is very
frequently employed.

Profit Planning is a systematic and formalized approach of determining the effect

of management’s plans upon the company’s profitability. In order to undertake
planning for profits finance manager makes projections of outflows and inflows of
the enterprise. The main inflows of an enterprise are people, capital and materials
and they are generally cost incurring factors.

On the other hand, the planned outflows are products, services and social
contributions that the enterprise generates. After projecting inflows and outflows,
the management manipulates combinations of inflows and planned outflows so that
the ultimate goal of the enterprise is achieved.
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

Profit planning as a decisional tool involves establishment of specific goods for the
enterprise, development of long range plans and short range annual profile plans
which are prepared after integrating sales plan, production plan, administration
expense budget, distribution expense budget, etc.

Profit planning, thus resembles comprehensive managerial budgeting. It focuses

directly an a rational approach to comprehensive planning that emphasizes
management by objectives. In profit planning exercises, prudent management
follows systems approach where all the functional and operational aspects of the
enterprises are integrated.

It is important to note that profit planning is an accounting technique as it is not

only related to accounting function but also to other functions of business which
can be thought and operated independently of the total management process.

On the other hand, the planned outflows are products, services and social
contributions that the enterprise generates. After projecting inflows and outflows,
the management manipulates combinations of inflows and planned outflows so that
the ultimate goal of the enterprise is achieved.

Profit planning as a decisional tool involves establishment of specific goods for the
enterprise, development of long range plans and short range annual profile plans
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

which are prepared after integrating sales plan, production plan, administration
expense budget, distribution expense budget, etc.

Profit planning, thus resembles comprehensive managerial budgeting. It focuses

directly an a rational approach to comprehensive planning that emphasizes
management by objectives. In profit planning exercises, prudent management
follows systems approach where all the functional and operational aspects of the
enterprises are integrated.

It is important to note that profit planning is an accounting technique as it is not

only related to accounting function but also to other functions of business which
can be thought and operated independently of the total management process.

Rather it is an integral aspect of the management process and is

basically management activity with critical behavioural
implications emerging out of the major decision-making role of
the total management team.
Fundamentals of Profit Planning:
With a view to laying down strong foundation of profit planning in a business
enterprise, the following fundamental principles must be kept in view:
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

1. Profit Planning is a decision making process entailing streams of managerial

decisions. Development of inflows and outflows and manipulation of these flows
implies a stream of well-conceived decisions. Fundamentally, management
decision making involves the task of manipulating the controlling variables and
taking advantage of the non-controlling variables that may influence revenues,
costs and investment.

2. Key to success of profit planning lies in the competence of the management to

plan activities of the enterprise. The management must have absolute confidence in
its ability to establish realistic objectives and to devise effective means to attain
these objectives for the enterprise.

3. Comprehensive profit planning programme calls for involvement of all levels of

management. With a view to competently engaging in profit planning,
management of all cadres, especially top management must have proper
understanding of the nature and characteristics of profit planning, be convinced
that this particular technique of management is preferable for their situation, be
willing to devote intense and concerted managerial efforts required to make it
operative and support the programme by all means. It must also have support of
each member of management.
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

The management must recognize that individuals having managerial

responsibilities will have to strive seriously and aggressively to carry out the tasks
assigned to them in every respect which include participation in developing sub-
unit plans and implementing these plans. Profit plans, if developed through full
participation and in harmony with assigned responsibilities, assure a degree of
understanding not otherwise possible.

4. Sound organizational structure and clear cut delineation of authorities and

responsibilities are pre-requisites to successful profile planning programme. This
implies that planned performance must be tailored to and be in harmony with
organizational responsibilities assigned to the various individual managers of the
enterprise. Profit plans should be classified on the basis of organizational sub-
divisions of the enter-price.

5. The management should refrain from being influenced by undue conservation

and irrational optimism. Profit plan should be based on realistic expectations so
that the management may feel motivated to achieve them.

It is, therefore, advisable that inflows and outflows of the enterprise be projected in
the light of conditions prevailing in the enterprise, viz., scale of operation and its
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)

nature, characteristics of managers, leadership qualities, maturity of the enterprise,

sophistication of management at all levels and various psychological forces.

6. Profit planning programme should be so prepared at to allow sufficient

flexibility in the plans. Flexible profit planning will enable the management to size
upon favourable opportunities even though they are not covered by the budget.