MBA - I Semester Paper Code: MBAC 1003

Accounting For Managers

Objectives

Ֆ To acquaint the students with the fundamentals principles of financial,

cost and management accounting
Ֆ To enable the students to prepare, analyse and interpret financial
statements and
Ֆ To enable the students to take decisions using management accounting
tools.

Unit-I
Book-Keeping and Accounting – Financial Accounting – Concepts
and Conventions – Double Entry System – Preparation of Journal, Ledger
and Trial Balance – Preparation of Final Accounts –Trading, Profit and Loss
Account and Balance Sheet With Adjustment Entries, Simple Problems
Only - Capital and Revenue Expenditure and Receipts.

Unit-II
Depreciation – Causes – Methods of Calculating Depreciation –
Straight Line Method, Diminishing Balance Method and Annuity Method
- Ratio Analysis – Uses and Limitations – Classification of Ratios –
Liquidity, Profitability, Financial and Turnover Ratios – Simple Problems
Only.

Unit-III
Funds Flow Analysis – Funds From Operation, Sources and Uses of
Funds, Preparation of Schedule of Changes In Working Capital and Funds Flow
Statements – Uses And Limitations - Cash Flow Analysis – Cash From
Operation – Preparation of Cash Flow Statement – Uses and Limitations –
Distinction Between Funds Flow and Cash Flow – Only Simple Problems

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Unit-IV
Marginal Costing - Marginal Cost and Marginal Costing -
Importance - Break-Even Analysis - Cost Volume Profit Relationship –
Application of Marginal Costing Techniques, Fixing Selling Price, Make or
Buy, Accepting a Foreign Order, Deciding Sales Mix.

Unit-V
Cost Accounting - Elements of Cost - Types of Costs - Preparation
of Cost Sheet – Standard Costing – Variance Analysis – Material Variances
– Labour Variances – Simple Problems Related to Material And Labour
Variances Only.

[note: distribution of questions between problems and theory of this

paper must be 60:40 i.e., problem questions: 60 % & theory questions:
40 %]

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 UNIT – I: Basics of Accounting

Lesson – 1.1 Accounting – An Introduction

1.1.1 Introduction

Accounting is aptly called the language of business. This designation

is applied to accounting because it is the method of communicating business
information. The basic function of any language is to serve as a means of
communication. Accounting duly serves this function. The task of learning
accounting is essentially the same as the task of learning a new language.
But the acceleration of change in business organization has contributed to
increase the complexities in this language. Like other languages, it is
undergoing continuous change in an attempt to discover better means of
communications. To enable the accounting language to convey the same
meaning to all stakeholders, it should be made standard. To make it a
standard language certain accounting principles, concepts and standards
have been developed over a period of time. This lesson dwells upon the
different dimensions of accounting, accounting concepts, accounting
principles and the accounting standards.

1.1.2 Learning Objectives

After reading this lesson, the reader should be able to:

Ֆ Know the Evolution of Accounting

Ֆ Understand the Definition of Accounting
Ֆ Comprehend the Scope and Function of Accounting
Ֆ Ascertain the Users of Accounting Information
Ֆ Know the Specialized Accounting Fields
Ֆ Understand the Accounting Concepts and Conventions
Ֆ Realize the Need for Accounting Standards

1.1.3 Contents

1. Evolution of accounting
2. Book keeping and accounting

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 3. Definition of accounting
4. Scope and functions of accounting
5. Groups interested in accounting information
6. The profession of accounting
7. Specialized accounting fields
8. Nature and meaning of accounting principles
9. Accounting concepts
10. Accounting conventions
11. Summary
12. Key words
13. Self assessment questions

1.1.3.1 Evolution Of Accounting

Accounting is as old as money itself. It has evolved, as have

medicine, law and most other fields of human activity in response to the
social and economic needs of society. People in all civilizations have
maintained various types of records of business activities. The oldest known
are clay tablet records of the payment of wages in babylonia around 600 b.c.
accounting was practiced in india twenty-four centuries ago as is clear from
kautilya’s book ‘arthshastra’ which clearly indicates the existence and need
of proper accounting and audit.

For the most part, early accounting dealt only with limited aspects of
the financial operations of private or governmental enterprises. Complete
accounting system for an enterprise which came to be called as “double
entry system” was developed in italy in the 15th century. The first known
description of the system was published there in 1494 by a franciscan monk
by the name luca pacioli.

The expanded business operations initiated by the industrial

revolution required increasingly large amounts of money which in turn
resulted in the development of the corporation form of organizations. As
corporations became larger, an increasing number of individuals and
institutions looked to accountants to provide economic information about
these enterprises. For e.g. Prospective investors and creditors sought
information about a corporation’s financial status. Government agencies
required financial information for purposes of taxation and regulation. Thus
accounting began to expand its function of meeting the needs of

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relatively few owners to a public role of meeting the needs of a variety of
interested parties.

1.1.3.2 Book Keeping And Accounting

Book-keeping is that branch of knowledge which tells us how to

keep a record of business transactions. It is considered as an art of recording
systematically the various types of transactions that occur in a business
concern in the books of accounts. According to spicer and pegler, “book-
keeping is the art of recording all money transactions, so that the financial
position of an undertaking and its relationship to both its proprietors and to
outside persons can be readily ascertained”. Accounting is a term which
refers to a systematic study of the principles and methods of keeping
accounts. Accountancy and book-keeping are related terms; the former
relates to the theoretical study and the latter refers to the practical work.

1.1.3.3 Definition Of Accounting

Before attempting to define accounting, it may be made clear that

there is no unanimity among accountants as to its precise definition.
Anyhow let us examine three popular definitions on the subject:

Accounting has been defined by the american accounting association

committee as:
“the process of identifying, measuring and communicating economic
information to permit informed judgments and decisions by users of the
information”. This may be considered as a good definition because of its
focus on accounting as an aid to decision making.

The american institute of certified and public accountants committee on

terminology defined accounting as:

“accounting is the art of recording, classifying and summarizing, in a

significant manner and in terms of money, transactions and events which
are, in part at least, of a financial character and interpreting the results
thereof ”. of all definitions available, this is the most acceptable one
because it encompasses all the functions which the modern accounting
system performs.

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 Another popular definition on accounting was given by american
accounting principles board in 1970, which defined it as:

“accounting is a service society. Its function is to provide quantitative

information, primarily financial in nature, about economic entities that is
useful in making economic decision, in making reasoned choices among
alternative courses of action”.

This is a very relevant definition in a present context of business

units facing the situation of selecting the best among the various alternatives
available. The special feature of this definition is that it has designated
accounting as a service activity.

1.1.3.4 Scope And Functions Of Accounting

Individuals engaged in such areas of business as finance, production,

marketing, personnel and general management need not be expert
accountants but their effectiveness is no doubt increased if they have a good
understanding of accounting principles. Everyone engaged in business
activity, from the bottom level employee to the chief executive and owner,
comes into contact withaccounting. The higher the level of authority and
responsibility, the greater is the need for an understanding of accounting
concepts and terminology.

A study conducted in united states revealed that the most common

background of chief executive officers in united states corporations was
finance and accounting. Interviews with several corporate executives drew
the following comments:
“…… my training in accounting and auditing practice has been extremely
valuable to me throughout”. “a knowledge of accounting carried with it
understanding of the establishment and maintenance of sound financial
controls- is an area which is absolutely essential to a chief executive
officer”.

Though accounting is generally associated with business, it is not

only business people who make use of accounting but also many individuals
in non-business areas that make use of accounting data and need to
understand accounting principles and terminology. For e.g. An engineer
responsible for selecting the most desirable solution to a technical

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manufacturing problem may consider cost accounting data to be the decisive
factor. Lawyers want accounting data in tax cases and damages from breach
of contract. Governmental agencies rely on an accounting data in evaluating
the efficiency of government operations and for approving the feasibility of
proposed taxation and spending programs. Accounting thus plays an
important role in modern society and broadly speaking all citizens are
affected by accounting in some way or the other.

Accounting which is so important to all, discharges the following vital

functions:

Keeping Systematic Records:

This is the fundamental function of accounting. The transactions of

the business are properly recorded, classified and summarized into final
financial statements – income statement and the balance sheet.

Protecting The Business Properties:

The second function of accounting is to protect the properties of the

business by maintaining proper record of various assets and thus enabling
the management to exercise proper control over them.

Communicating The Results:

As accounting has been designated as the language of business, its

third function is to communicate financial information in respect of net
profits, assets, liabilities, etc., to the interested parties.

Meeting Legal Requirements:

The fourth and last function of accounting is to devise such a system

as will meet the legal requirements. The provisions of various laws such as
the companies act, income tax act, etc., require the submission of various
statements like income tax returns, annual accounts and so on. Accounting
system aims at fulfilling this requirement of law.

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It may be noted that the functions stated above are those of financial
accounting alone. The other branches of accounting, about which we are
going to see later in this lesson, have their special functions with the
common objective of assisting the management in its task of planning,
control and coordination of business activities. Of all the branches of
accounting, management accounting is the most important from the
management point of view.

As accounting is the language of business, the primary aim of

accounting, like any other language, is to serve as a means of
communication. Most of the world’s work is done through organizations –
groups of people who work together to accomplish one or more objectives.
In doing its work, an organization uses resources – men, material, money
and machine and various services. To work effectively, the people in an
organization need information about these sources and the results achieved
through using them. People outside the organization need similar
information to make judgments about the organization. Accounting is the
system that provides such information.

Any system has three features, viz., input, processes and output.
Accounting as a social science can be viewed as an information system,
since it has all the three features i.e., inputs (raw data), processes (men and
equipment) and outputs (reports and information). Accounting information
is composed principally of financial data about business transactions. The
mere records of transactions are of little use in making “informed judgments
and decisions”. The recorded data must be sorted and summarized before
significant analysis can be prepared. Some of the reports to the enterprise
manager and to others who need economic information may be made
frequently; other reports are issued only at longer intervals. The usefulness
of reports is often enhanced by various types of percentage and trend
analyses. The “basic raw materials” of accounting are composed of
business transactions data. Its “primary end products” are composed of
various summaries, analyses and reports.
The information needs of a business enterprise can be outlined and
illustrated with the help of the following chart:

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 Chart Showing Types Of Information

Information

Non-quantitative Quantitative
Information Information

Accounting Non- accounting

Information Information

Operating Financial Management Cost

Information Information Information Information

The chart clearly presents the different types of information that

might be useful to all sorts of individuals interested in the business
enterprise. As seen from the chart, accounting supplies the quantitative
information. The special feature of accounting as a kind of a quantitative
information and as distinguished from other types of quantitative
information is that it usually is expressed in monetary terms.

In this connection it is worthwhile to recall the definitions of

accounting as given by the american institute of certified and public
accountants and by the american accounting principles board.

The types of accounting information may be classified into four

categories: (1) operating information, (2) financial accounting information
(3) management accounting information and (4) cost accounting
information.

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Operating Information:

By operating information, we mean the information which is

required to conduct the day-to-day activities. Examples of operating
information are: amount of wages paid and payable to employees,
information about the stock of finished goods available for sale and each
one’s cost and selling price, information about amounts owed to and owing
by the business enterprise, information about stock of raw materials, spare
parts and accessories and so on. By far, the largest quantity of accounting
information provides the raw data (input) for financial accounting,
management accounting and cost accounting.

Financial Accounting:

Financial accounting information is intended both for owners and

managers and also for the use of individuals and agencies external to the
business. This accounting is concerned with the recording of transactions for
a business enterprise and the periodic preparation of various reports from
such records. The records may be for general purpose or for a special
purpose. A detailed account of the function of financial accounting has been
given earlier in this lesson.

Management Accounting:

Management accounting employs both historical and estimated data

in assisting management in daily operations and in planning for future
operations. It deals with specific problems that confront enterprise managers
at various organizational levels. The management accountant is frequently
concerned with identifying alternative courses of action and then helping to
select the best one. For e.g. The accountant may help the finance manager in
preparing plans for future financing or may help the sales manager in
determining the selling price to be fixed on a new product by providing
suitable data. Generally management accounting information is used in
three important management functions: (1) control
(2) co-ordination and (3) planning. Marginal costing is an important
technique of management accounting which provides multi dimensional
information that facilitates decision making.

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Cost Accounting:

The industrial revolution in england posed a challenge to the

development of accounting as a tool of industrial management. This
necessitated the development of costing techniques as guides to
management action. Cost accounting emphasizes the determination and the
control of costs. It is concerned primarily with the cost of manufacturing
processes. In addition, one of the principal functions of cost accounting is to
assemble and interpret cost data, both actual and prospective, for the use of
management in controlling current operations and in planning for the future.

All of the activities described above are related to accounting and in

all of them the focus is on providing accounting information to enable
decisions to be made. More about cost accounting can be gained in unit v.

1.1.3.5 Groups Interested In Accounting Information

There are several groups of people who are interested in the

accounting information relating to the business enterprise. Following are
some of them:

Shareholders:

Shareholders as owners are interested in knowing the profitability of

the business transactions and the distribution of capital in the form of assets
and liabilities. In fact, accounting developed several centuries ago to supply
information to those who had invested their funds in business enterprise.

Management:

With the advent of joint stock company form of organization the gap
between ownership and management widened. In most cases the
shareholders act merely as renders of capital and the management of the
company passes into the hands of professional managers. The accounting
disclosures greatly help them in knowing about what has happened and
what should be done to improve the profitability and financial position of
the enterprise.

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Potential Investors:

An individual who is planning to make an investment in a business

would like to know about its profitability and financial position. An analysis
of the financial statements would help him in this respect.

Creditors:

As creditors have extended credit to the company, they are much

worried about the repaying capacity of the company. For this purpose they
require its financial statements, an analysis of which will tell about the
solvency position of the company.

Government:

Any popular government has to keep a watch on big businesses

regarding the manner in which they build business empires without regard
to the interests of the community. Restricting monopolies is something that
is common even in capitalist countries. For this, it is necessary that proper
accounts are made available to the government. Also, accounting data are
required for collection of sale-tax, income-tax, excise duty etc.

Employees:

Like creditors, employees are interested in the financial statements

in view of various profit sharing and bonus schemes. Their interest may
further increase when they hold shares of the companies in which they are
employed.

Researchers:

Researchers are interested in interpreting the financial statements of

the concern for a given objective.

Citizens:

Any citizen may be interested in the accounting records of business

enterprises including public utilities and government companies as a voter
and tax payer.

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1.1.3.6 The Profession Of Accounting

Accountancy can very well be viewed as a profession with stature

comparable to that of law or medicine or engineering. The rapid
development of accounting theory and techniques especially after the late
thirties of 20th century has been accompanied by an expansion of the career
opportunities in accounting and an increasing number of professionally
trained accountants. Among the factors contributing to this growth has been
the increase in number, size and complexity of business enterprises, the
imposition of new and increasingly complex taxes and other governmental
restrictions on business operations.

Coming to the nature of accounting function, it is no doubt a service

function. The chief of accounting department holds a staff position which is
quite in contra - distinction to the roles played by production or marketing
executives who hold line authority. The role of the accountant is advisory in
character. Although accounting is a staff function performed by
professionals within an organization, the ultimate responsibility for the
generation of accounting information, whether financial or managerial, rests
with management. That is why one of the top officers of many businesses is
the financial controller. The controller is the person responsible for
satisfying other managers’ demands for management accounting
information and for complying with the regulatory demands of financial
reporting. With these ends in view, the controller employs accounting
professionals in both management and financial accounting. These
accounting professionals employed in a particular business firm are said to
be engaged in private accounting. Besides these, there are also accountants
who render accounting services on a fee basis through staff accountants
employed by them. These accountants are said to be engaged in public
accounting.

1.1.3.7 Specialised Accounting Fields

As in many other areas of human activity, a number of specialized

fields in accounting also have evolved besides financial accounting.
Management accounting and cost accounting are the result of rapid
technological advances and accelerated economic growth. The most
important among them are explained below:

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Tax Accounting:

Tax accounting covers the preparation of tax returns and the

consideration of the tax implications of proposed business transactions or
alternative courses of action. Accountants specializing in this branch of
accounting are familiar with the tax laws affecting their employer or clients
and are up to date on administrative regulations and court decisions on tax
cases.

International Accounting:

This accounting is concerned with the special problems associated

with the international trade of multinational business organizations.
Accountants specializing in this area must be familiar with the influences
that custom, law and taxation of various countries bring to bear on
international operations and accounting principles.

Social Responsibility Accounting:

This branch is the newest field of accounting and is the most

difficult to describe concisely. It owes its birth to increasing social
awareness which has been particularly noticeable over the last three decades
or so. Social responsibility accounting is so called because it not only
measures the economic effects of business decisions but also their social
effects, which have previously been considered to be immeasurable. Social
responsibilities of business can no longer remain as a passive chapter in the
text books of commerce but are increasingly coming under greater scrutiny.
Social workers and people’s welfare organizations are drawing the attention
of all concerned towards the social effects of business decisions. The
management is being held responsible not only for the efficient conduct of
business as reflected by increased profitability but also for what it
contributes to social well-being and progress.

Inflation Accounting:

Inflation has now become a world-wide phenomenon. The

consequences of inflation are dire in case of developing and underdeveloped
countries. At this juncture when financial statements or reports are based on
historical costs, they would fail to reflect the effect of changes in

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purchasing power or the financial position and profitability of the firm.
Thus, the utility of the accounting records, not taking care of price level
changes is seriously lost. This imposes a demand on the accountants for
adjusting financial accounting for inflation to know the real financial
position and profitability of a concern. Thus emerged a future branch of
accounting called inflation accounting or accounting for price level changes.
It is a system of accounting which regularly records all items in financial
statements at their current values.

Human Resources Accounting:

Human resources accounting is yet another new field of accounting

which seeks to report and emphasize the importance of human resources in
a company’s earning process and total assets. It is based on the general
agreement that the only real long lasting asset which an organization
possesses is the quality and caliber of the people working in it. This system
of accounting is concerned with, “the process of identifying and
measuring
data about human resources and communicating this information to
interested parties”.

1.1.3.8 Nature And Meaning Of Accounting Principles

What is an accounting principle or concept or convention or

standard? Do they mean the same thing? Or does each one has its own
meaning? These are all questions for which there is no definite answer
because there is ample confusion and controversy as to the meaning and
nature of accounting principles. We do not want to enter into this
controversial discussion because the reader may fall a prey to the
controversies and confusions and lose the spirit of the subject.

The rules and conventions of accounting are commonly referred to

as principles. The american institute of certified public accountants has
defined the accounting principle as, “a general law or rule adopted or
professed as a guide to action; a settled ground or basis of conduct or
practice”. It may be noted that the definition describes the accounting
principle as a general law or rule that is to be used as a guide to action. The
canadian institute of chartered accountants has defined accounting
principles as, “the body of doctrines commonly associated with the theory
and procedure of accounting, serving as explanation of current practices

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and as a guide for the selection of conventions or procedures where
alternatives exist”. This definition also makes it clear that accounting
principles serve as a guide to action.

The peculiar nature of accounting principles is that they are

manmade. Unlike the principles of physics, chemistry etc. They were not
deducted from basic axiom. Instead they have evolved. This has been
clearly brought out by the canadian institute of chartered accountants in the
second part of their definition on accounting principles: “rules governing
the foundation of accounting actions and the principles derived from
them have arisen from common experiences, historical precedent,
statements by individuals and professional bodies and regulation of
governmental agencies”. Since the accounting principles are man made
they cannot be static and are bound to change in response to the changing
needs of the society. It may be stated that accounting principles are
changing but the change in them is permanent.

Accounting principles are judged on their general acceptability to

the makers and users of financial statements and reports. They present a
generally accepted and uniform view of the accounting profession in
relation to good accounting practice and procedures. Hence the name
generally accepted accounting principles.

Accounting principles, rules of conduct and action are described by

various terms such as concepts, conventions, doctrines, tenets, assumptions,
axioms, postulates, etc. But for our purpose we shall use all these terms
synonymously except for a little difference between the two terms –
concepts and conventions. The term “concept” is used to connote
accounting postulates i.e. Necessary assumptions or conditions upon which
accounting is based. The term convention is used to signify customs or
traditions as a guide to the preparation of accounting statements.

1.1.3.9 Accounting Concepts

The important accounting concepts are discussed hereunder:

Business Entity Concept:

It is generally accepted that the moment a business enterprise is

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started it attains a separate entity as distinct from the persons who own it.
In recording the transactions of a business, the important question is:

How do these transactions affect the business enterprise? The

question as to how these transactions affect the proprietors is quite
irrelevant. This concept is extremely useful in keeping business affairs
strictly free from the effect of private affairs of the proprietors. In the
absence of this concept the private affairs and business affairs are mingled
together in such a way that the true profit or loss of the business enterprise
cannot be ascertained nor its financial position. To quote an example, if a
proprietor has taken rs.5000/- from the business for paying house tax for his
residence, the amount should be deducted from the capital contributed by
him. Instead if it is added to the other business expenses then the profit will
be reduced by rs.5000/- and also his capital more by the same amount. This
affects the results of the business and also its financial position. Not only
this, since the profit is lowered, the consequential tax payment also will be
less which is against the provisions of the income-tax act.

Going Concern Concept:

This concept assumes that the business enterprise will continue to

operate for a fairly long period in the future. The significance of this
concept is that the accountant while valuing the assets of the enterprise does
not take into account their current resale values as there is no immediate
expectation of selling it. Moreover, depreciation on fixed assets is charged
on the basis of their expected life rather than on their market values. When
there is conclusive evidence that the business enterprise has a limited life,
the accounting procedures should be appropriate to the expected terminal
date of the enterprise. In such cases, the financial statements could clearly
disclose the limited life of the enterprise and should be prepared from the
‘quitting concern’ point of view rather than from a ‘going concern’ point of
view.

Money Measurement Concept:

Accounting records only those transactions which can be

expressed in monetary terms. This feature is well emphasized in the two
definitions on accounting as given by the american institute of certified
public accountants and the american accounting principles board. The

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importance of this concept is that money provides a common denomination
by means of which heterogeneous facts about a business enterprise can be
expressed and measured in a much better way. For e.g. When it is stated that
a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery
items, 3000 square meters of land and building etc., these amounts cannot
be added together to produce a meaningful total of what the business owns.
However, by expressing these items in monetary terms such as rs.1,00,000
cash, rs.5,00,000 worth raw materials, rs,10,00,000 worth machinery items
and rs.30,00,000 worth land and building – such an addition is possible.

A serious limitation of this concept is that accounting does not take

into account pertinent non-monetary items which may significantly affect
the enterprise. For instance, accounting does not give information about the
poor health of the chairman, serious misunderstanding between the
production and sales manager etc., which have serious bearing on the
prospects of the enterprise. Another limitation of this concept is that money
is expressed in terms of its value at the time a transaction is recorded in the
accounts. Subsequent changes in the purchasing power of money are not
taken into account.

Cost Concept:

This concept is yet another fundamental concept of accounting

which is closely related to the going-concern concept. As per this concept:
(i) an asset is ordinarily entered in the accounting records at the price paid
to acquire it i.e., at its cost and (ii) this cost is the basis for all subsequent
accounting for the asset.

The implication of this concept is that the purchase of an asset is

recorded in the books at the price actually paid for it irrespective of its
market value. For e.g. If a business buys a building for rs.3,00,000, the asset
would be recorded in the books as rs.3,00,000 even if its market value at
that time happens to be rs.4,00,000. However, this concept does not mean
that the asset will always be shown at cost. This cost becomes the basis for
all future accounting of the asset. It means that the asset may systematically
be reduced in its value by changing depreciation. The significant advantage
of this concept is that it brings in objectivity in the preparations and
presentation of financial statements. But like the money measurement
concept, this concept also does not take into account subsequent changes

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in the purchasing power of money due to inflationary pressures. This is the
reason for the growing importance of inflation accounting.

Dual Aspect Concept (Double Entry System):

This concept is the core of accounting. According to this concept

every business transaction has a dual aspect. This concept is explained in
detail below:

The properties owned by a business enterprise are referred to as

assets and the rights or claims to the various parties against the assets are
referred to as equities. The relationship between the two may be expressed
in the form of an equation as follows:

Equities = Assets

Equities may be subdivided into two principal types: the rights of

creditors and the rights of owners. The rights of creditors represent debts of
the business and are called liabilities. The rights of the owners are called
capital.

Expansion of the equation to give recognition to the two types of

equities results in the following which is known as the accounting equation:

Liabilities + Capital = Assets

It is customary to place ‘liabilities’ before ‘capital’ because creditors

have priority in the repayment of their claims as compared to that of owners.
Sometimes greater emphasis is given to the residual claim of the owners by
transferring liabilities to the other side of the equation as:

Capital = Assets – Liabilities

All business transactions, however simple or complex they are,

result in a change in the three basic elements of the equation. This is well
explained with the help of the following series of examples:

(i) Mr. Prasad commenced business with a capital of rs.3,000: the

result of this transaction is that the business, being a separate entity, gets

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cash-asset of rs.30,000 and has to pay to mr. Prasad rs.30,000, his capital.
This transaction can be expressed in the form of the equation as follows:
Capital = Assets
Prasad Cash
30,000 30,000
(ii) purchased furniture for rs.5,000: the effect of this transaction is
that cash is reduced by rs.5,000 and a new asset viz. Furniture worth
rs.5,000 comes in, thereby, rendering no change in the total assets of the
business. The equation after this transaction will be:
Capital=Assets
Prasad Cash + Furniture
30,000 25,000 + 5,000
(iii) borrowed rs.20,000 from mr. Gopal: as a result of this
transaction both the sides of the equation increase by rs.20,000; cash
balance is increased and a liability to mr. Gopal is created. The equation will
appear as follows:
Liabilities + Capital = Assets
Creditors + Prasad Cash + Furniture
20,000 30,000 45,000 5,000
(iv) purchased goods for cash rs.30,000: this transaction does not
affect the liabilities side total nor the asset side total. Only the composition
of the total assets changes i.e. Cash is reduced by rs.30,000 and a new asset
viz. Stock worth rs.30,000 comes in. The equation after this transaction will
be as follows:
Liabilities + Capital =Asset
Creditors Prasad Cash + Stock + Furniture
20,000 30,000 15,000 30,000 5,000
(v) goods worth rs.10,000 are sold on credit to ganesh for rs.12,000. The
result is that stock is reduced by rs.10,000 a new asset namely debtor (mr.
ganesh) for rs.12,000 comes into picture and the capital of mr. Prasad
increases by rs.2,000 as the profit on the sale of goods belongs to the owner.
Now the accounting equation will look as under:

Liabilities + Capital = Asset

Creditors Prasad Cash + Debtors + Stock + Furniture
20,000 32,000 15,000 12,000 20,000 5,000
(vi) paid electricity charges rs.300: this transaction reduces both the cash
balance and mr. Prasad’s capital by rs.300. This is so because the
expenditure reduces the business profit which in turn reduces the equity.

20
The equation after this will be:
Liabilities + Capital =Assets
Creditors + Prasad Cash + Debtors + Stock + Furniture
20,000 31,700 14,700 12,000 20,000 5,000
Thus it may be seen that whatever is the nature of transaction, the
accounting equation always tallies and should tally. The system of recording
transactions based on this concept is called double entry system.

Accounting Period Concept:

In accordance with the going concern concept it is usually assumed

that the life of a business is indefinitely long. But owners and other
interested parties cannot wait until the business has been wound up for
obtaining information about its results and financial position. For e.g. If for
ten years no accounts have been prepared and if the business has been
consistently incurring losses, there may not be any capital at all at the end of
the tenth year which will be known only at that time. This would result in
the compulsory winding up of the business. But, if at frequent intervals
information are made available as to how things are going, then corrective
measures may be suggested and remedial action may be taken. That is why,
pacioli wrote as early as in 1494: ‘frequent accounting makes for only
friendship’. This need leads to the accounting period concept.

According to this concept accounting measures activities for a

specified interval of time called the accounting period. For the purpose of
reporting to various interested parties one year is the usual accounting
period. Though pacioli wrote that books should be closed each year
especially in a partnership, it applies to all types of business organizations.

Periodic Matching Of Costs And Revenues:

This concept is based on the accounting period concept. It is widely

accepted that desire of making profit is the most important motivation to
keep the proprietors engaged in business activities. Hence a major share of
attention of the accountant is being devoted towards evolving appropriate
techniques of measuring profits. One such technique is periodic matching of
costs and revenues.

21
 In order to ascertain the profits made by the business during a
period, the accountant should match the revenues of the period with the
costs of that period. By ‘matching’ we mean appropriate association of
related revenues and expenses pertaining to a particular accounting period.
To put it in other words, profits made by a business in a particular
accounting period can be ascertained only when the revenues earned during
that period are compared with the expenses incurred for earning that
revenue. The question as to when the payment was actually received or
made is irrelevant. For e.g. In a business enterprise which adopts calendar
year as accounting year, if rent for december 1989 was paid in january 1990,
the rent so paid should be taken as the expenditure of the year 1989,
revenues of that year should be matched with the costs incurred for earning
that revenue including the rent for december 1989, though paid in january
1990. It is on account of this concept that adjustments are made for
outstanding expenses, accrued incomes, prepaid expenses etc. While
preparing financial statements at the end of the accounting period.

The system of accounting which follows this concept is called as

mercantile system. In contrast to this there is another system of accounting
called as cash system of accounting where entries are made only when cash
is received or paid, no entry being made when a payment or receipt is
merely due.

Realization Concept:

Realization refers to inflows of cash or claims to cash like bills

receivables, debtors etc. Arising from the sale of assets or rendering of
services. According to realization concept, revenues are usually recognized
in the period in which goods were sold to customers or in which services
were rendered. Sale is considered to be made at the point when the property
in goods passes to the buyer and he becomes legally liable to pay. To
illustrate this point, let us consider the case of a, a manufacturer who
produces goods on receipt of orders. When an order is received from b, a
starts the process of production and delivers the goods to b when the
production is complete. B makes payment on receipt of goods. In this
example, the sale will be presumed to have been made not at the time when
goods are delivered to b. A second aspect of the realization concept is that
the amount recognized as revenue is the amount that is reasonably certain to
be realized. However, lot of reasoning has to be applied to ascertain

22
as to how certain ‘reasonably certain’ is … yet, one thing is clear, that is, the
amount of revenue to be recorded may be less than the sales value of the
goods sold and services rendered. For e.g. When goods are sold at a
discount, revenue is recorded not at the list price but at the amount at which
sale is made. Similarly, it is on account of this aspect of the concept that
when sales are made on credit, though entry is made for the full amount of
sales, the estimated amount of bad debts is treated as an expense and the
effect on net income is the same as if the revenue were reported as the
amount of sales minus the estimated amount of bad debts.

1.1.3.10 Accounting Conventions

Convention Of Conservatism:

It is a world of uncertainty. So it is always better to pursue the policy

of playing safe. This is the principle behind the convention of conservatism.
According to this convention the accountant must be very careful while
recognizing increases in an enterprise’s profits rather than recognizing
decreases in profits. For this the accountants have to follow the rule,
anticipate no profit, provide for all possible losses, while recording business
transactions. It is on account of this convention that the inventory is valued
at cost or market price whichever is less, i.e. When the market price of the
inventories has fallen below its cost price it is shown at market price i.e. The
possible loss is provided and when it is above the cost price it is shown at
cost price i.e. The anticipated profit is not recorded. It is for the same reason
that provision for bad and doubtful debts, provision for fluctuation in
investments, etc., are created. This concept affects principally the current
assets.

Convention Of Full Disclosure:

the emergence of joint stock company form of business organization

resulted in the divorce between ownership and management. This
necessitated the full disclosure of accounting information about the
enterprise to the owners and various other interested parties. Thus the
convention of full disclosure became important. By this convention it is
implied that accounts must be honestly prepared and all material
information must be adequately disclosed therein. But it does not mean that
all information that someone desires are to be disclosed in

23
the financial statements. It only implies that there should be adequate
disclosure of information which is of considerable value to owners,
investors, creditors, government, etc. In sachar committee report (1978), it
has been emphasized that openness in company affairs is the best way to
secure responsible behaviour. It is in accordance with this convention that
companies act, banking companies regulation act, insurance act etc., have
prescribed proforma of financial statements to enable the concerned
companies to disclose sufficient information. The practice of appending
notes relating to various facts on items which do not find place in financial
statements is also in pursuance to this convention. The following are some
examples:

(a) contingent liabilities appearing as a note

(b) market value of investments appearing as a note
(c) schedule of advances in case of banking companies

Convention Of Consistency:

According to this concept it is essential that accounting procedures,

practices and method should remain unchanged from one accounting period
to another. This enables comparison of performance in one accounting
period with that in the past. For e.g. If material issues are priced on the basis
of fifo method the same basis should be followed year after year. Similarly,
if depreciation is charged on fixed assets according to diminishing balance
method it should be done in subsequent year also. But consistency never
implies inflexibility as not to permit the introduction of improved
techniques of accounting. However if introduction of a new technique
results in inflating or deflating the figures of profit as compared to the
previous methods, the fact should be well disclosed in the financial
statement.

Convention Of Materiality:

The implication of this convention is that accountant should attach

importance to material details and ignore insignificant ones. In the absence
of this distinction, accounting will unnecessarily be overburdened with
minute details. The question as to what is a material detail and what is not is
left to the discretion of the individual accountant. Further, an item should be
regarded as material if there is reason to believe that

24
knowledge of it would influence the decision of informed investor. Some
examples of material financial information are: fall in the value of stock,
loss of markets due to competition, change in the demand pattern due to
change in government regulations, etc. Examples of insignificant financial
information are: rounding of income to nearest ten for tax purposes etc.
Sometimes if it is felt that an immaterial item must be disclosed, the same
may be shown as footnote or in parenthesis according to its relative
importance.

1.1.3.11 Summary

Accounting is rightly called the language of business. It is as old as

money itself. It is concerned with the collecting, recording, evaluating and
communicating the results of business transactions. Initially meant to meet
the needs of a relatively few owners, it gradually expanded its functions to a
public role of meeting the needs of a variety of interested parties. Broadly
speaking all citizens are affected by accounting in some way. Accounting as
an information system possesses with accountants engaged in private and
public accounting. As in many other areas of human activity a number of
specialized fields in accounting also have evolved as a result of rapid
changes in business and social needs.

Accounting information should be made standard to convey the

same meaning to all interested parties. To make it standard, certain
accounting principles, concepts, conventions and standards have been
developed over a period of time. These accounting principles, by whatever
name they are called, serve as a general law or rule that is to be used as a
guide to action. Without accounting principles, accounting information
becomes incomparable, inconsistent and unreliable. An accounting principle
to become generally accepted should satisfy the criteria of relevance,
objectivity and feasibility. The fasb (financial accounting standards board) is
currently the dominant body in the development of accounting principles.
The iasc is another professional body which is engaged in the development
of the accounting standards. The icai is an associate member of the iasc and
the asb started by the icai is formulating accounting standards in our
country. Both the iasc and icai consider going concern, accrual and
consistency as fundamental accounting assumptions.

25
1.1.3.12 Key Words

Ֆ Accounting: language of business.

Ֆ Financial Accounting: concerned with the recording of transactions for a
business enterprise and the periodic preparation of various reports from
such records
Ֆ Management Accounting: accounting for internal management needs.

Ֆ Cost Accounting: accounting for determination and control of costs.

Ֆ Accounting Principle: the body of doctrines commonly associated with

the theory and procedure of accounting.
Ֆ Accounting Concept: accounting postulates i.e. Necessary assumptions
or conditions upon which accounting is based.
Ֆ Accounting Conventions: convention signifies the customs or traditions
which serve as a guide to the preparation of accounting statements.

Ֆ Accounting Standard: standards to be observed in the presentation of

financial statements.

1.1.3.13 Self Assessment Questions

1. Why is accounting called the language of business?
2. What are the functions of accounting?
3. Accounting as a social science can be viewed as an information
system. examine.
4. Is accounting a staff function or line function? Explain the reasons.
5. Give an account of the various branches of accounting.
6. ‘accounting is a service function’. Discuss the statement in the
context of a modern manufacturing business.
7. Distinguish between financial accounting and management
accounting.
8. What are accounting concepts and conventions? Is there any
difference between them?
9. What is the significance of dual aspect concept?
10. Write a short note on accounting standards.
11. What is the position in india regarding the formulation and
enforcement of accounting standards?

*****

26
 Lesson – 1.2 The Accounting Process

1.2.1 Introduction

During the accounting period the accountant records transactions as

and when they occur. At the end of each accounting period the accountant
summarizes the information recorded and prepares the trial balance to
ensure that the double entry system has been maintained. This is often
followed by certain adjusting entries which are to be made to account the
changes that have taken place since the transactions were recorded. When
the recording aspect has been made as complete and upto-date as possible
the accountant prepares financial statements reflecting the financial position
and the results of business operations. Thus the accounting process consists
of three major parts:

i.The recording of business transactions during that period; ii.The

summarizing of information at the end of the period and iii.The
reporting and interpreting of the summary information.

The success of the accounting process can be judged from the

responsiveness of financial reports to the needs of the users of accounting
information. This lesson takes the readers into the accounting process.

1.2.2 Learning Objectives

After reading this lesson the reader should be able to:

Ֆ Understand the Rules of Debit and Credit

Ֆ Pass Journal Entries
Ֆ Prepare Ledger Accounts
Ֆ Prepare a Trial Balance
Ֆ Make Adjustment and Closing Entries
Ֆ Get Introduced to Tally Package

27
1.2.3 Contents

1.2.3.1 the account

1.2.3.2 debit and credit
1.2.3.3 the ledger
1.2.3.4 journal
1.2.3.5 the trial balance
1.2.3.6 closing entries
1.2.3.7 adjustment entries
1.2.3.8 preparation of financial statements
1.2.3.9 introduction to tally package
1.2.3.10 summary
1.2.3.11 key words
1.2.3.12 self assessment questions

1.2.3.1 The Account

The transactions that take place in a business enterprise during a

specific period may effect increases and decreases in assets, liabilities,
capital, revenue and expense items. To make up to-date information
available when needed and to be able to prepare timely periodic financial
statements, it is necessary to maintain a separate record for each item. For
e.g. It is necessary to have a separate record devoted exclusively to record
increases and decreases in cash, another one to record increases and
decreases in supplies, a third one on machinery, etc. The type of record that
is traditionally used for this purpose is called an account. Thus an account is
a statement wherein information relating to an item or a group of similar
items are accumulated. The simplest form of an account has three parts:

i. A title which gives the name of the item recorded in the account
ii. A space for recording increases in the amount of the item, and
iii. A space for recording decreases in the amount of the item. This form
of an account is known as a ‘t’ account because of its similarity to
the letter ‘t’ as illustrated below:
Title
Left side Right side
(debit side) (credit side)

28
1.2.3.2 Debit And Credit

The left-hand side of any account is called the debit side and the
right-hand side is called the credit side. Amounts entered on the left hand
side of an account, regardless of the tile of the account are called debits and
the amounts entered on the right hand side of an account are called credits.
To debit (dr) an account means to make an entry on the left-hand side of an
account and to credit (cr) an account means to make an entry on the right-
hand side. The words debit and credit have no other meaning in accounting,
though in common parlance; debit has a negative connotation, while credit
has a positive connotation.

Double entry system of recording business transactions is

universally followed. In this system for each transaction the debit amount
must equal the credit amount. If not, the recording of transactions is
incorrect. The equality of debits and credits is maintained in accounting
simply by specifying that the left side of asset accounts is to be used for
recording increases and the right side to be used for recording decreases; the
right side of a liability and capital accounts is to be used to record increases
and the left side to be used for recording decreases. The account balances
when they are totaled, will then conform to the two equations:

1. Assets = liabilities + owners’ equity

2. Debits = credits

From the above arrangement we can state that the rules of debits and
credits are as follows:

Debit Signifies Credit Signifies

1. Increase in asset accounts 1. Decrease in asset accounts
2. Decrease in liability accounts 2. increase in liability accounts
3. Decrease in owners’ equity accounts 3.increase in owners’ equity
accounts

From the rule that credit signifies increase in owners’ equity and
debit signifies decrease in it, the rules of revenue accounts and expense
accounts can be derived. While explaining the dual aspect of the concept in
the preceding lesson, we have seen that revenues increase the owners’
equity as they belong to the owners. Since owners’ equity accounts increase

29
on the credit side, revenue must be credits. So, if the revenue accounts are to
be increased they must be credited and if they are to be decreased they must
be debited. Similarly we have seen that expenses decrease the owners’
equity. As owners’ equity account decreases on the debit side expenses must
be debits. Hence to increase the expense accounts, they must be debited and
to decrease it, they must be credited. From the above we can arrive at the
rules for revenues and expenses as follows:

Debit Signifies Credit Signifies

Increase in expenses Increase in revenues
Decrease in revenues Decrease in expenses

1.2.3.3 The Ledger

A ledger is a set of accounts. It contains all the accounts of a specific

business enterprise. It may be kept in any of the following two forms:

(i) bound ledger and

(ii) loose leaf ledger

A bound ledger is kept in the form of book which contains all the
accounts. These days it is common to keep the ledger in the form of loose-
leaf cards. This helps in posting transactions particularly when mechanized
system of accounting is used.

1.2.3.4 Journal

When a business transaction takes place, the first record of it is done

in a book called journal. The journal records all the transactions of a
business in the order in which they occur. The journal may therefore be
defined as a chronological record of accounting transactions. It shows
names of accounts that are to be debited or credited, the amounts of the
debits and credits and any other additional but useful information about the
transaction. A journal does not replace but precedes the ledger. A proforma
of a journal is given in illustration 1.

30
Illustration 1:
Journal

Date Particulars L.F. Debit Credit

2005 Cash a/c dr. 3
30,000 30,000
August 3 To sales a/c 9

In illustration 1 the debit entry is listed first and the debit amount
appears in the left-hand amount column; the account to be credited appears
below the debit entry and the credit amount appears in the right hand
amount column. The data in the journal entry are transferred to the
appropriate accounts in the ledger by a process known as posting. Any entry
in any account can be made only on the basis of a journal entry. The column
l.f. which stands for ledger folio gives the page number of accounts in the
ledger wherein posting for the journal entry has been made. After all the
journal entries are posted in the respective ledger accounts, each ledger
account is balanced by subtracting the smaller total from the bigger total.
The resultant figure may be either debit or credit balance and vice-versa.

Thus the transactions are recorded first of all in the journal and then
they are posted to the ledger. Hence the journal is called the book of original
or prime entry and the ledger is the book of second entry. While the journal
records transactions in a chronological order, the ledger records transactions
in an analytical order.

1.2.3.5 The Trial Balance

The trial balance is simply a list of the account names and their
balance as of a given moment of time with debit balances in one column and
credit balances in another column. It is prepared to ensure that the
mechanics of the recording and posting of the transaction have been carried
out accurately. If the recording and posting have been accurate then the
debit total and credit total in the trial balance must tally thereby evidencing
that an equality of debits and credits has been maintained. In this connection
it is but proper to caution that mere agreement of the debt and credit total in
the trial balance is not conclusive proof of correct recording and posting.
There are many errors which may not affect the agreement of trial balance
like total omission of a transaction, posting the

31
 right amount on the right side but of a wrong account etc.

The points which we have discussed so far can very well be

explained with the help of the following simple illustration.

Illustration 2:

January 1 - started business with rs.3,000

January 2 - bought goods worth rs.2,000
January 9 - received order for half of the goods from ‘g’
January 12 - delivered the goods, g invoiced rs.1,300
January 15 - received order for remaining half of the total goods purchased
January 21 - delivered goods and received cash rs.1,200
January 30 - g makes payment
January 31 - paid salaries rs.210
- received interest rs.50
Let us now analyze the transactions one by one.

January 1 – Started Business With Rs.3,000:

The two accounts involved are cash and owners’ equity. Cash, an asset
increases and hence it has to be debited. Owners’ equity, a liability also
increases and hence it has to be credited.

January 2 – Bought Goods Worth Rs.2,000:

The two accounts affected by this transaction are cash and goods
(purchases). Cash balance decreases and hence it is credited and goods on
hand, an asset, increases and hence it is to be debited.

January 9 – Received Order For Half Of The Goods From ‘G’:

No entry is required as realization of revenue will take place only

when goods are delivered (realization concept).

January 12 – Delivered The Goods, `G’ Invoiced Rs.1,300:

This transaction affects two accounts – goods (sales) a/c and

receivables a/c. Since it is a credit transaction, receivables increase

32
(asset) and hence it is to be debited. Sales decreases goods on hand and
hence goods (sales) a/c is to be credited. Since the term ‘goods’ is used to
mean purchase of goods and sale of goods, to avoid confusion, purchase of
goods is simply shown as purchases a/c and sale of goods as sales a/c.

January 15 – Received Order For Remaining Half Of Goods:

No entry.

January 21 – Delivered Goods And Received Cash Rs.1,200:

This transaction affects cash a/c. Since cash is realized, the cash
balance will increase and hence cash account is to be debited. Since the
stock of goods becomes nil due to sale, sales a/c is to be credited (as asset in
the form of goods on hand has reduced due to sales).

January 30 - `G’ Makes Payment:

Both the accounts affected by this transaction are asset accounts –

cash and receivables. Cash balance increases and hence it is to be debited.
Receivables balance decreases and hence it is to be credited.

January 31 – Paid Salaries Rs.210:

Because of payment of salaries cash balance decreases and hence

cash account is to be credited. Salary is an expense and since expense has
the effect of reducing owners’ equity and as owners’ equity account
decreases on the debit side, expenses account is to be debited.

January 31 – Received Interest Rs.50:

The receipt of interest increases cash balance and hence cash a/c is
to be debited. Interest being revenue which has the effect of increasing the
owners’ equity, it has to be credited as owners’ equity account increases on
the credit side.

When journal entries for the above transactions are passed, they
would be as follows:

33
 Journal
Date Particulars L.F. Debit Credit
Cash A/C Dr. To
Jan. 1 Capital A/C (Being 3,000 3,000
Business Started)
Purchases A/C Dr.
Jan. 2 To Cash (Being Goods 2,000 2,000
Purchased)
Receivables A/C Dr.
Jan. 12 To Sales A/C (Being 1,300 1,300
Goods Sold On Credit)
Cash A/C Dr.
To Sales A/C
Jan. 21 1,200 1,200
(Being Goods Sold For
Cash)
Cash A/C Dr.
To Receivables A/C
Jan. 30 1,300 1,300
(Being Cash Received
For Sale Of Goods)
Salaries A/C Dr.
Jan. 31 To Cash A/C 210 210
(Being Salaries Paid)
Cash A/C Dr.
To Interest A/C
Jan. 31 50 50
(Being Interest
Received)
Now the above journal entries are posted into respective ledger accounts
which in turn are balanced.

Cash Account
Debit Rs. Credit Rs.
To Capital A/C 3,000 By PurchasesA/C 2,000
To Sales A/C 1,200 By Salaries A/C 210
To Receivables 1,300
A/C By Balance C/D 3,340
To Interest A/C 50
5,550 5,550

34
 Capital Account
Debit Rs. Credit Rs.
3,000 3,000
To Balance C/D By Cash A/C
3,000 3,000

Purchases Account
Debit Rs. Credit Rs.
2,000 2,000
To Cash A/C By Balance C/D
2,000 2,000

Receivables Account
Debit Rs. Credit Rs.
1,300 1,300
To Balance C/D By Cash A/C
1,300 1,300

Sales Account
Debit Rs. Credit Rs.
1,300
By Receivables
2,500
To Balance C/D A/C
1,200
By Cash A/C
2,500 2,500

Salaries Account
Debit Rs. Credit Rs.
210 210
To Cash A/C By Balance C/D
210 210

Interest Account
Debit Rs. Credit Rs.
To Balance C/D 50 50
By Cash A/C
50 50

Now A Trial Balance Can Be Prepared And When Prepared It Would Appear
As Follows:
Trial Balance
Debit Rs. Credit Rs.
Cash 3,340 Capital 3,000
Purchases 2,000 Sales 2,500
Salaries 210 Interest 50
5,550 5,550

35
1.2.3.6 Closing Entries

Periodically, usually at the end of the accounting period, all revenue

and expense account balances are transferred to an account called income
summary or profit and loss account and are then said to be closed. (a
detailed discussion on profit and loss account can be had in a subsequent
lesson). The balance in the profit and loss account, which is the net income
or net loss for the period, is then transferred to the capital account and thus
the profit and loss account is also closed. In the case of corporation the net
income or net loss is transferred to retained earnings account which is a part
of owners’ equity. The entries which are passed for transferring these
accounts are called as closing entries. Because of this periodic closing of
revenue and expense accounts, they are called as temporary or nominal
accounts. On the other hand, the assets, liabilities and owners’ equity
accounts, the balances of which are shown on the balance sheet and are
carried forward from year to year are called as permanent or real accounts.

The principle of framing a closing entry is very simple. If an account is

having a debit balance, then it is credited and the profit and loss account is
debited. Similarly if a particular account is having a credit balance, it is closed
by debiting it and crediting the profit and loss account. In our example sales
account and interest account are revenues, and purchases account and salaries
account are expenses. Purchases account is an expense because the entire goods
have been sold out in the accounting period itself and hence they become cost
of goods sold out. This aspect would become more clear when the reader
proceeds to the lessons on profit and loss account. The closing entries
would appear as follows:
Journal
P articulars L.F. Debit Credit
Profit And Loss a/c
Dr. 210
1 2,210
To Salaries A/C 2,000
To Salaries A/C
Sales A/C Dr.
2
To Profit And Loss 2,500 2,500
A/C
Interest A/C
Dr.
3 50 50
To Profit And Loss
A/C

Now profit and loss a/c, retained earnings a/c and balance sheet can be
prepared
which would appear as follows:

36
 Profit And Loss Account
Debit Rs. Credit Rs.
Purchases A/C
Salaries A/C 2,000
Retained 210 Sales 2,500
Interest 50
Earnings A/C
340

2,550 5,550

Retained Earnings Account

Debit Rs. Credit Rs.
Profit And Loss
Balance 340 340
A/C
340 340

Balance Sheet
Liabilities Rs. Assets Rs.
Capital 3,000
3,340
Retained Earn- Cash
ings 340
3,340 3,340

1.2.3.7 Adjustment Entries

Because of the adopting of accrual accounting, after the preparation

of trial balance, adjustments relating to the accounting period have to be
made in order to make the financial statements complete. These adjustments
are needed for transactions which have not been recorded but which affect
the financial position and operating results of the business. They may be
divided into four kinds: two in relation to revenues and the other two in
relation to expenses. The two in relation to revenues are:

(i) Unrecorded Revenues:

Income earned for the period but not received in cash. For e.g.
Interest for the last quarter of the accounting period is yet to be received
though fallen due. The adjustment entry to be passed is:

37
 Accrued interest a/c (Dr)
Interest a/c (Cr)

(ii) Revenues Received In Advance:

i.e. Income relating to the next period received in the current

accounting period: e.g. Rent received in advance. The adjustment entry is:

Rent a/c (dr)

Rent received in advance a/c (cr)

The two relating to expenses are:

(i) Unrecorded Expenses:

i.e. Expenses were incurred during the period but no record of them
as yet has been made: e.g. Rs.500 wages earned by an employee during the
period remaining to be paid. The adjustment entry would be:

Wages a/c (Dr)

Accrued wages a/c (Cr)

(ii) Prepaid Expenses:

i.e., expenses relating to the subsequent period paid in advance in the

current accounting period. An example which is frequently cited for this is
insurance paid in advance. The adjustment entry would be:

Prepaid insurance a/c (Dr)

Insurance a/c (Cr)

In the above four cases unrecorded revenues and prepaid expenses

are assets and hence debited (as debit may signify increase in assets) and
revenues received in advance and unrecorded expenses are liabilities and
hence credited (as credit may signify increase in liabilities).
Besides the above mentioned four adjustments, some more are to be done
before preparing the financial statements. They are:

38
 1. Inventory at the end
2. Provision of depreciation
3. Provision for bad debts
4. Provision for discount on receivables and payables
5. Interest on capital and drawings

1.2.3.8 Preparation Of Financial Statements

Now everything is set ready for the preparation of financial

statements for the accounting period and as of the last day of the accounting
period. Generally agreed accounting principles (gaap) require that three
such reports be prepared:

(i) a balance sheet

(ii) a profit and loss account (or) income statement
(iii) a fund flow statement

A detailed discussion on these three financial statements follows in the

succeeding lessons.

1.2.3.9 Introduction To Tally Package

Today an increasingly large number of companies have adopted

mechanized accounting. The main reasons for this development are that:

(i) the size of firms have become very large resulting in manifold increase
in accounting data to be collected and processed.

(ii) the requirements of modern management which want detailed analysis

in many ways, of the accounting and statistical information for the efficient
discharge of their duties.

(iii) collection of statistics not only for the firm’s own use but also for
submission to various official authorities.

In this context, the use of computers in accounting is worth

mentioning. Late 80’s and early 90’s was an era of financial accounting
software. Many software developers offered separate financial and

39
inventory software to take care of the needs of the concerns but users
wanted a single software that will take care of production and inventory
management i.e. They wanted a single software where, if an invoice is
entered, that will update accounts as well as inventory information. Here
tally comes in handy.

Tally is one of the acclaimed accounting software with large user

base in india and abroad, which is continuously growing. There is good
potential for tally professionals even in small towns. Tally which is a vast
software covers a lot of areas for various types of industries and is loaded
with options. So, every organization needs a hardcore tally professional to
exploit its full capabilities and functionality to implement tally. Tally which
is a financial and inventory management system is developed in india using
tally development language. Tally has been created by pentronics (p)
limited, bangalore.

Features Of Tally:

1. Accounts without any account codes.

2. Maintains complete range of books of accounts, final accounts like
balance sheets, profit and loss statements, cash and fund flows, trial
balance and others.
3. Provides option to post stock value from inventory directly to balance
sheet and profit and loss a/c as per the valuation method specified by
user. This greatly simplifies the procedure and one gets the final
accounts which is in tune with the stock statements of the inventory
system.
4. Provides multiple reports in diverse formats.
5. Various options for interest calculation.
6. Allows accounts of multiple companies simultaneously.
7. Multiple currencies in the same transactions and viewing all reports in
one or more currency.
8. Unlimited budgets and periods, user definable security levels for
access control and audit capabilities to track malafide changes.
9. Allows import and export of data from or to other systems.
10. Online help.
11. Backup and restore of data.
12. Facilitates printing of cheques etc.

40
1.2.3.10 Summary

The following steps are involved in the accounting process:

1. The first and the most important part of the accounting process is the
analysis of the transactions to decide which account is to be debited
and which account is to be credited.
2. Next comes journalising the transactions i.e. Recording the
transactions in the journal.
3. The journal entries are posted into respective accounts in the ledger
and the ledger accounts are balanced.
4. At the end of the accounting period, a trial balance is prepared to
ensure quality of debits and credits.
5. Adjustment and closing entries are made to enable the preparation of
financial statements.
6. As a last step financial statements are prepared.

These six steps taken sequentially complete the accounting process

during an accounting period and are repeated in each subsequent period.

1.2.3.11 Key Words

Account: a statement wherein information relating to all items are

accumulated.

Debit: signifies increase in asset accounts, decrease in liability

accounts and decrease in owners’ equity accounts.

Credit: signifies decrease in asset accounts, increase in liability

accounts and increase in owners’ equity accounts.

Ledger: a set of accounts of a specific business enterprise.

Journal: a book of prime entry.

Trial Balance: a list of balances of accounts to ensure arithmetical

accuracy.

Closing Entries: entries passed to transfer the revenue accounts to profit

and loss a/c.

41
Adjustment Entries: entries passed for transactions which are not recorded
but which affect the financial position and operating results of the business.

1.2.3.12 Self Assessment Questions

1. Explain the following:

(a) a journal
(b) an account
(c) a ledger
2. Bring out the relationship between a journal and a ledger.
3. Explain the significance of trial balance.
4. Why are adjustment entries necessary?
5. Narrate the rules of debit and credit.
6. Distinguish nominal accounts from real accounts.
7. Explain the mechanism of balancing an account.
8. How and why closing entries are made?
9. The following transactions relate to a business concern for the
month of december 2005. Journalise them, post into ledger accounts,
balance and prepare the trial balance.

March 1 - started business with a capital of rs.9,000

March 2 - purchased furniture for rs.300
March 3 - purchased goods for rs.6,000
March 11 - received order for half-of the goods from `c’
March 15 - delivered goods, `c’ invoiced rs.4,000
March 17 - received order for the remaining half of the goods
March 21 - delivered goods, cash received rs.3,800
March 31 - paid wages of rs.300

1.2.3.13 Books For Further Reading

1. M.A.Arulanandam & K.S.Raman: Advanced Accounts, Himalaya

Publishing House.
2. R.L.Gupta And M.Radhaswamy: Advanced Accounts, Vol.I, Sultan
Chand, New Delhi.
3. M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand & Co. New
Delhi.

*****

42
 Lesson 1.3 - Preparation of Final Accounts

1.3.1 Introduction

The primary objective of any business concern is to earn income.

Ascertainment of the periodic income of a business enterprise is perhaps the
important objective of the accounting process. This objective is achieved by
the preparation of profit and loss account or the income statement. Profit
and loss account is generally considered to be of greatest interest and
importance to end users of accounting information. The profit and loss
account enables all concerned to find out whether the business operations
have been profitable or not during a particular period. Usually the profit and
loss account is accompanied by the balance sheet as on the last date of the
accounting period for which the profit and loss account is prepared. A
balance sheet shows the financial position of a business enterprise as of a
specified moment of time. It contains a list of the assets, the liabilities and
the capital of a business entity as of a specified date, usually at the close of
the last day of a month or a year. While the profit and loss account is
categorized as a flow report (for a particular period), the balance sheet is
categorized as a status report (as on a particular date).

1.3.2 Learning Objectives

After reading this lesson the reader should be able to:

Ֆ Understand the Basic Ideas of Income and Expense

Ֆ Prepare a Profit and Loss Account/Income Statement in the Proper
Format
Ֆ Understand the Basic Ideas About a Balance Sheet
Ֆ Classify the Different Assets and Liabilities
Ֆ Prepare a Balance Sheet in the Proper Format

1.3.3 Contents

1.3.3.1 basic ideas about income and expense

1.3.3.2 form and presentation of profit and loss account /

43
 Income statement
1.3.3.3 explanation of items on the income statement
1.3.3.4 statement of retained earnings
1.3.3.5 balance sheet
1.3.3.6 form and presentation of balance sheet
1.3.3.7 listing of items in the balance sheet
1.3.3.8 classification of items in the balance sheet
1.3.3.9 summary
1.3.3.10 key words
1.3.3.11 self assessment questions
1.3.3.12 key to self assessment questions
1.3.3.13 case analysis
1.3.3.14 book for further reading

1.3.3.1 Basic Ideas About Income And Expense

Profit and loss account consists of two elements: one element is the
inflows that result from the sale of goods and services to customers which
are called as revenues. The other element reports the outflows that were
made in order to generate those revenues; these are called as expenses.
Income is the amount by which revenues exceed expenses. The term ‘net
income’ is used to indicate the excess of all the revenues over all the
expenses. The basic equation is:

Revenue – Expenses = Net Income

This is in accordance with the matching concept.

Income And Owner’s Equity:

The net income of an accounting period increases owner’s equity

because it belongs to the owner. To quote an example, goods costing
rs.20,000 are sold on credit for rs.28,000. The result is that stock is reduced
by rs.20,000 and a new asset namely debtor for rs.28,000 is created and the
total assets increase by the difference of rs.8,000. Because of the dual aspect
concept, we know that the equity side of the balance sheet would also
increase by rs.8,000 and the increase would be in owner’s equity. This is
because the profit on sale of goods belongs to the owner. It is clear from the
above example that income increases the owner’s equity.

44
Income Vs. Receipts:

Income of a period increases the owner’s equity but it need not result
in increase in cash balance. Loss of a period decreases owner’s equity but it
need not result in decrease in cash balance. Similarly, increase in cash
balance need not result in increased income and owner’s equity and
decrease in cash balance need not denote loss and decrease in owner’s
equity. All these are due to the fact that income is not the same as cash
receipt. The following examples make clear the above point:
I) when goods costing rs.20,000 are sold on credit for rs.28,000 it results in
an income of rs.8,000 but the cash balance does not increase.
Ii) when goods costing rs.18,000 are sold on credit for rs.15,000 there is a
loss of rs.3,000 but there is no corresponding decrease in cash.
Iii) when a loan of rs.5,000 is borrowed the cash balance increases but there
is no impact on income.
Iv) when a loan of rs.8,000 is repaid it decreases only the cash balance and
not the income.

Expenses:

An expense is an item of cost applicable to an accounting period. It

represents economic resources consumed during the current period. When
expenditure is incurred the cost involved is either an asset or an expense. If
the benefits of the expenditure relate to further periods, it is an asset. If not,
it is an expense of the current period. Over the entire life of an enterprise,
most expenditure becomes expenses. But according to accounting period
concept, accounts are prepared for each accounting period. Hence, we get
the following four types of transactions relating to expenditure and
expenses:

Expenditures That Are Also Expenses:

This is the simplest and most common type of transaction to account

for. If an item is acquired during the year, it is expenditure. If the item is
consumed in the same year, then the expenditure becomes expense. E.g.
Raw materials purchased are converted into saleable goods and are sold in
the same year.

45
Assets That Become Expenses:

when expenditures incurred result in benefits for the future period

they become assets. When such assets are used in subsequent years they
become expenses of the year in which they are used. For e.g. Inventory of
finished goods are assets at the end of a particular accounting year. When
they are sold in the next accounting year they become expenses.

Expenditures That Are Not Expenses:

As already pointed, out when the benefits of the expenditure relate

to future periods they become assets and not expenses. This applies not only
to fixed assets but also to inventories which remain unsold at the end of the
accounting year. For e.g. The expenditure incurred on inventory remaining
unsold is asset until it is sold out.

Expenses Not Yet Paid:

Some expenses would have been incurred in the accounting year but
payment for the same would not have been made within the accounting
year. These are called accrued expenses and are shown as liabilities at the
year end.

1.3.3.2 Form And Presentation Of Profit And Loss Account /

Income Statement

In practice there is considerable variety in the format and degree of

detail used in income statements. The profit and loss account is usually
prepared in “t” shape. The following (illustration-a) is the summarized profit
and loss account of ali akbar ltd.

46
Illustration – A:
Ali Akbar Ltd
Profit And Loss Account For The Year Ended 31st March 2005
(rs. In `000)

Particulars Rs. Particulars Rs.

Cost Of Goods Sold 78.680 Sales(Less Dis count) 89,740
Expenses (Schedule17) 33,804 Other Income (Sched- 39,947
Interest (Schedule 18) 2,902 ule 13)
Director’s Fees 11
Depreciation 20,94
Provision For Taxation 6,565
Net Profit 5,,625

1,29,687 1,29,687

In the “t” shaped profit and loss account, expenses are shown on the
left hand side i.e., the debit side and revenues are shown on the right hand
side i.e., the credit side. Net profit or loss is the balancing figure.

The profit and loss account can also be presented in the form of a
statement when it is called as income statement. There are two widely used
forms of income statement: single step form and multiple-step form. The
single-step form of income statement derives its name from the fact that the
total of all expenses is deducted from the total of all revenues.

Illustration – a can be presented in the single-step form as given in

illustration – b.

Illustration – B:
Ali Akbar Ltd
Income Statement For The Year Ended 31st March 2005
(Rs. In `000)
Revenues
Sales (Less Discount) 89,740
Other Income (Sched-
ule 13) 39,947 1,29,687

47
Expenses
Cost Of Goods Sold 78.680
Expenses (Schedule 17) 33,804
Interest (Schedule 18) 2,902
Director’s Fees 11
Depreciation 20,94
Provision For Taxation 6,565 1,24,062

5,625

The single-step form has the advantage of simplicity but it is

inadequate for analytical purpose.
The multi-step form income statement is so called because of its
numerous sections, sub-sections and intermediate balances. Illustration – c
is a typical proforma of multiple-step income statement.

Illustration – C:

Proforma Of A Multiple-Step Income Statement

Gross Sales Xxx

Less: Sales Returns Xxx
Net Sales Xxx
Less: Cost Of Goods Sold
Raw Materials Cost
Opening Stock Of Raw Material Xxx
Add Purchase Of Raw Material Xxx
Freight Xxx
Raw Materials Available Xxx
Less Closing Stock Of Raw Material Xxx
Raw Materials Consumed Xxx
Direct Labour Cost Xxx
Manufacturing Expenses Xxx
Total Production Cost Xxx
Add Opening Work-In-Progress Xxx
Total Xxx
Less Closing Work-In-Progress Xxx

48
Cost Of Goods Manufactured Xxx
Add Opening Finished Goods Xxx
Cost Of Goods Available For Sale Xxx
Less Closing Finished Goods Xxx
Xxx
Cost Of Goods Sold
Gross Profit Xxx
Less Operating Expenses Xxx
Administrative Expenses
Selling And Distribution Expenses Xxx
Operating Profit Xxx Xxx
Add Non-Operating Income Xxx
(Such As Dividend Received
Profit On Sale Of Assets Etc.)
Xxx Xxx
Less Non-Operating Expenses
(Such As Discount On Issue Of Shares
Written Off, Loss On Sale Of Assets, Etc.) Xxx Xxx
Profit (Or) Earnings Before Interest & Tax (Ebit) Xxx
Less Interest Xxx Xxx
Profit (Or) Earnings Before Tax (Ebt) Xxx
Less Provision For Income-Tax Xxx Xxx
Net Profit (Or) Earnings After Tax (Eat) Xxx
Earnings Per Share Of Common Stock Xxx Xxx

The Multiple-Step Form Of Illustration `C’ Would Be As Given Under

Illustration `D’.

49
Illustration – D

Ali Akbar Ltd

Income Statement For The Year Ended 31st March 2005
(rs. In `000)

Net Sales 98,740

Less: Cost Of Goods Sold 78,686
Gross Profit 11,054
Less Operating Expenses
Expenses (Schedule 17)
33,804
Director’s Fee
11
Depreciation
2,094 35,909
Operating Loss
(-) 24,855
Add Non-Operating Income
Other Income (Schedule 13) 39,947
Profit (Or) Earnings Before Interest & Tax(Ebit) 15,092
Less Interest (Schedule 18) 2,902
Profit (Or) Earnings Before Tax (Ebt) 12,190
Less Provision For Income-Tax 6,565
Net Profit (Or) Earnings After Tax (Eat) 5,625

The advantage of multiple-step form of income statement over

single step form and the “t” shaped profit and loss account is that there are a
number of significant sub totals on the road to net income which lend
themselves for significant analysis.
Income statements prepared for use by the managers of an enterprise
Usually contain more detailed information than that shown in the above
illustrations.

1.3.3.3 Explanation Of Items On The Income Stataement

The heading of the income statement must show:

I) the business enterprise to which it relates (ali akbar ltd.)

Ii) the name of the statement (income statement)
Iii) the time period covered (year ended 31st march of the relevant
year)

50
The income statement is generally followed by various schedules that give
detailed account of the items, listed on them. Information about these
schedules are given against each item in the financial statements.

One important objective in reporting revenue on an income

statement is to disclose the major source of revenue and to separate it from
miscellaneous sources. For most companies the major source of revenue is
the sale of goods and services.

Sales Revenue:

An income statement often reports several separate items in the sales

revenue section, the net of which is the net sales figure. Gross sales is the
total invoice price of the goods sold or services rendered during the period.
It should not include sales taxes or excise duties that may be charged to the
customers. Such taxes are not revenues but rather represent collections that
the business makes on behalf of the government and are liabilities to the
government until paid. Similarly, postage, freight or other items billed to the
customers at cost are not revenues. These items do not appear in the sales
figure but instead are an offset to the costs the company incurs for them.
Sales returns and allowances represent the sales values of goods that were
returned by customers or allowance made to customers because the goods
were defective. The amount can be subtracted from the sales figure directly
without showing it as a separate item on the income statement. But it is
always better to show them separately.

Sometimes called as cash discounts, sales discounts are the amount

of discounts allowed to customers for prompt payment. For e.g. If a
business offers a 3% discount to customers who pay within 7 days from the
date of the invoice and it sells rs.30,000 of goods to a customer who takes
advantage of this discount, the business receives only rs.29,100 in cash and
records the balance rs.900 as sales discount. There is another kind of
discount called as trade discount which is given by the wholesaler or
manufacturer to the retailers to enable them to sell at catalogue price and
make a profit: e.g. List less 30 percent. Trade discount does not appear in
the accounting records at all.

51
Miscellaneous Or Secondary Sources Of Revenues:

These are revenues earned from activities not associated with the
sale of the enterprise’s goods and services. Interest or dividends earned on
marketable securities, royalties, rents and gains on disposal of assets are
examples of this type of revenues. For e.g. In the case of ali akbar ltd., its
operating loss has been converted into net profit only because of other
income, other than sales revenue. Schedule 13 gives details of other income
earned by ali akbar ltd.

Schedule 13 – Other Income

(rs.`000)
Income From Trade Investments 825
Interest On Bank Deposits & Others 1,042
Profit On Sale Of Investments 456
Profit On Sale Of Inventories 813
Miscellaneous Income 2,394
Factory Charges Recovered 9,081
Bottle Deposits Forfeited 25,336

39,947

Cost Of Goods Sold:

when income is increased by the sale value of goods or services

sold, it is also decreased by the cost of these goods or services. The cost of
goods or services sold is called the cost of sales. In manufacturing firms and
retailing business it is often called the cost of goods sold. The complexity of
calculation of cost of goods sold varies depending upon the nature of the
business. In the case of a trading concern which deals in commodities it is
very simple to calculate the most of goods sold and it is done as follows:

Opening stock xxx

Add: purchase xxx
Freight xxx

Goods available for sale xxx

Less: closing stock xxx
Cost of goods sold xxx

52
 The calculation becomes a complicated process in the case of
manufacturing concern, especially when a number of products are
manufactured because it involves the calculation of the work in progress
and valuation of inventory. The cost of goods sold in the case of ali akbar
ltd., would have been calculated as given in illustration `e’.

Illustration E:

Cost Of Goods Sold

(rs.`000)
Opening Stock 4,436
Raw Materials Consumed 22,151
Packing Materials Consumed 48,536
Excise Duty 7,805
82,928
Less: Closing Stock 4,242

Cost Of Goods Sold 78,686

Gross Profit:

The excess of sales revenue over cost of goods sold is gross margin
or gross profit. In the case of multiple-step income statement it is shown as
a separate item. Significant managerial decisions can be taken by
calculating the percentage of gross profit on sale. This percentage indicates
the average mark up obtained on products sold. The percentage varies
widely among industries, but healthy companies in the same industry tend to
have similar gross profit percentages.

Operating Expenses:

Expenses which are incurred for running the business and which are
not directly related to the company’s production or trading are collectively
called as operating expenses. Usually operating expenses include
administration expenses, finance expenses, depreciation and selling and
distribution expenses. Administration expenses generally include personnel
expenses also. However sometimes personnel expenses may be shown
separately under the heading establishment expenses.
Until recently most companies included expenses on research and
development as part of general and administrative expenses. But now-

53
a-days the financial accounting standards board (fasb) requires that this
amount should be shown separately. This is so because the expenditure on
research and development could provide an important clue as to how
cautious the company is in keeping its products and services up to date.
Operating Profit: operating profit is obtained when operating expenses are
deducted from gross profit.

Non-Operating Expenses:

These are expenses which are not related to the activities of the
business e.g. Loss on sale of asset, discount on shares written off etc. These
expenses are deducted from the income obtained after adding other incomes
to the operating profit. Other incomes or miscellaneous receipts have
already been explained. The resultant profit is called as profit (or) earning
before interest and tax (ebit).

Interest Expenses:

Interest expense arises when part of the expenses are met from
borrowed funds. The fasb requires separate disclosure of interest expense.
This item of expense is deducted from income or earnings before interest
and tax. The resultant figure is profit (or) earnings before tax (ebt).
Income Tax: the provision for tax is estimated based on the quantum of
profit before tax. As per the corporate tax laws, the amount of tax payable is
determined not on the basis of reported net profit but the net profit arrived at
has to be recomputed and adjusted for determining the tax liability. That is
why the liability is always shown as a provision.

Net Profit:

This is the amount of profit finally available to the enterprise for

Appropriation. Net profits is reported not only in total but also per share of
stock. This per share amount is obtained by dividing the total amount of net
profit by the number of shares outstanding. The net profit is usually referred
to as profit or earnings after tax. This profit could either be distributed as
dividends to shareholders or retained in the business. Just like gross profit
percentage, net profit percentage on sales can also be calculated which will
be of great use for managerial analysis.

54
1.3.3.4 Statement Of Retained Earnings

The term retained earnings means the accumulated excess of

earnings over losses and dividends. The statement of retained earnings is
generally included with almost any set of financial statements although it is
not considered to be one of the major financial statements. A typical
statement of retained earnings starts with the opening balance of retained
earnings, the net income for the period as an addition, the dividends as a
deduction, and ends with the closing balance of retained earnings. The
statement may be prepared and shown on a separate sheet or included at the
bottom of the income statement. The balance shown by the income
statement is transferred to the balance sheet through the statement of
retained earnings after making necessary appropriations. This statement thus
links the income statement to the retained earning item on the balance sheet.
This statement can be prepared in `t’ shape also when it is called as profit
and loss appropriation account. Illustration `f ’ gives the statement of
retained earning of ali akbar ltd.

Illustration – F Ali Akbar Ltd.

For The Year Ended 31st March 2012

(Rs.`000)
Retained Earnings At The Beginning Of 700
The Year 5,625
Add: Net Income 6,325

Less: Dividends 5,600

General Reserve 625 6,225

Retained Earnings At The End Of The Year 100

1.3.3.5 Balance Sheet

The balance sheet is basically a historical report showing the

cumulative effect of past transactions. It is often described as a detailed
expression of the following fundamental accounting equation:
Assets = Liabilities + Owners’ Equity (Capital)
Assets are costs which represent expected future economic benefits to the
business enterprise. However, the rights to assets have been acquired by the
Enterprise as a result of past transactions.

55
 Liabilities also result from past transactions. They represent
obligations which require settlement in the future either by conveying assets
or by performing services. Implicit in these concepts of the nature of assets
and liabilities is the meaning of owners’ equity as the residual interest in the
assets of the enterprise.

1.3.3.6 Form And Presentation Of A Balance Sheet

Two objectives are dominant in presenting information in a balance

sheet. One is clarity and readability; the other is disclosure of significant
facts within the framework of the basic assumptions of accounting. Balance
sheet classification, terminology and the general form of presentation should
be studied with these objectives in mind.
It is proposed to explain the various aspects of the balance sheet with the
help of the following typical summarized balance sheet of an imaginary
Partnership firm:

56
Illustration A:

Sundaram & Sons

Balance Sheet As At 31st December 2011

Liabilities & Rs Rs Assets Rs Rs

Capital
Current Liabilities Current Assets
Bills Payable 7,000 Cash 1.000
Creditors 7,000 Bank 2,000
Outstanding Marketable
Expenses Securities 3,000
Income Received 7,000 Bills Receivables 3,000
In Advance Debtors 10,000
Provision For 1,000 Less Provision
Income 32,000 For Doubtful
Tax 10,000 Debts 1,000 9,000
Total Current Inventory 12,000
Liabilities Prepaid 3,000
Long Term Expenses 33,000
Liabilities Total Current
Mortgage Loan 20,000 Assets
Owners’ Equity Investments:
S’s Capital 10,000 Long Term
A’s Capital 15,000 Securities
U’s Capital 20,000 AtCosts 3,000
General Reserve 10,000 Fixed Assets:
Furniture &
Fixtures Less:
Accumulated
Dep. Plant &
Machinery 900
Less:
Accumulated
Dep. 1,000 8,000
Land 100 20,000
Buildings
Intangible Assets 10,000
Patents 2,100
Trade Marks 2,000 11,000
Goodwill 9,000
Total Assets 1,07,000 Total Liabilities 1,07.000
& Owners’
Equity

57
Conventions Of Preparing The Balance Sheet:

There are two conventions of preparing the balance sheet, the

american and the english. According to the american convention, assets are
shown on the left hand side and the liabilities and the owners’ equity on the
right hand side. Under the english convention just the opposite is followed
i.e. Assets are shown on the right hand side and the liabilities and owners’
equity are shown on the left hand side. In the illustration `a’, the american
convention has been followed.

Forms Of Presenting The Balance Sheet:

There are two forms of presenting the balance sheet – account form
and report form. When the assets are listed on the left hand side and
liabilities and owners’ equity on the right hand side, we get the account form
of balance sheet. It is so called because it is similar to an account. An
alternative practice is the report form of balance sheet where the assets are
listed at the top of the page and the liabilities and owners’ equity are listed
beneath them. In illustration `a’ we have followed the account form of
balance sheet. Now-a-days joint stock companies present balance sheet in
the form of a statement in the annual reports. To illustrate, the balance sheet
of ali akbar ltd. Pondicherry as on 31-3-2012 is given below:

58
Illustration `b’:
Ali akbar ltd.Balance sheet as on 31-3-2012
2004-05 2005-06
Rs. ‘000 Rs. ‘000
Sche-
dule
I. Sources of Funds
1. Shareholders’ Funds
Capital 1 1,40,00 1,40,00
Reserves And Surplus 2 12,11,94 12,73,93
2. Loan Funds
Secured Loans 3 2,45,15 2,67,62
Unsecured Loans 4 24
15,97,09 16,81,79
Ii. Application of
Funds
1. Fixed Assets
5 14,19,93 13,73,59
Gross Block
4,64,56 3,81,38
Less: Depreciation
9,55,37 9,92,21
Net Block
16,27
Capital Work-In-
Progress
2. Investments
6 9,55,37 10,08,48
3. Current Assets
76,39 63,07
Loans And Advances
Inventories
2,37,55
Sundry Debtors
1,55,71 3,16,52
Cash And Bank
7 3,59,65 74,55
Balances
8 69,52 2,11,60
Loans And Advances
9 2,22,03 8,40,22
Less: Current
10 8,06,91
Liabilities &
Provisions
1,74,77
Liabilities
1,85,58 55,21
Provisions
11 56,00
12 2,29,98
Net Current Assets 2,41,58

5,65,33 6,10,24
15,97,09 16,81,79
59
Notes On The Accounts:

Schedules 1 to 12 and 19 referred to above, form an integral part of

the balance sheet.

From the above balance sheet it would have been found that previous
years figures are also given. As per the companies act, 1956 it is mandatory for
the companies to give figures for the previous year also. Further one would
have noticed the “schedule” column in the above balance sheet. The schedules
attached to the balance sheet give details of the respective items. For e.g.
Schedule 3 gives details of the secured loan as given below:

Schedule 3 – Secured Loans Rs. ‘000

From banker 2004-05 2003-04

Term loan (secured by charge on certain 17,00 28,00
Plant & machinery)
Cash credit-account (secured by hypothecation 2,28,15 2,39,62
Of raw materials, stock-in-progress, finished
Goods, stocks and other current assets) 2,45,15 2,67,62

1.3.3.7 Listing Of Items On The Balance Sheet

Assets in balance sheet are generally listed in two ways – i) in the

order of liquidity or according to time i.e. In the order of the degree of ease
with which they can be converted into cash or ii) in the order of permanence
or according to purpose i.e., in the order of the desire to keep them in use.
Some assets cannot be easily classified. For e.g. Investments can be easily
sold but the desire may be to keep them. Investments may therefore be both
liquid and semi-permanent that is why they are shown as a separate item in
the balance sheet. Liabilities can also be grouped in two ways; either in the
order of urgency of payment or in the reverse order. The various assets and
liabilities grouped in the two orders will appear as follows:

60
 Order Of Liquidity

Liabilities Assets
Bank Overdraft Cash
Bills Payable Bank
Creditors Marketable Securities
Outstanding Expenses Debtors
Income Received In Advance Inventory
Provision For Income-Tax Bills Receivable
Mortgage Loan Prepaid Expenses
Debentures Investments
Owners’ Equity Furniture And Fixtures
Plant And Machinery
Land And Buildings
Patents
Trade Marks
Goodwill
Preliminary Expenses

Order Of Permanence

Liabilities Assets
Owners’ Equity Goodwill
Debentures Trade Marks
Mortgage Loan Patents
Provision For Income-Tax Land And Buildings
Income Received In Advance Plant And Machinery
Outstanding Expenses Furniture And Fixtures
Creditors Investments
Bills Payable Prepaid Expenses
Inventory
Debtors
Marketable Securities
Bank
Cash
Bills Receivables

Whatever is the order, it is always better to follow the same order for
both assets and liabilities. In the illustration `a’ the order of liquidity has
been followed.

61
 1.3.3.8 Classification Of Items In The Balance Sheet

Although each individual asset or liability can be listed separately on

the balance sheet, it is more practicable and more informative to summarize
and group related items into categories called as account classifications. The
classifications or group headings will vary considerably depending on the
size of the business, the form of ownership, the nature of its operations and
the users of the financial statements. For e.g. While listing assets, the order
of liquidity is generally used by sole traders, partnership firms and banks,
whereas joint stock companies by law follow the order of permanence. As a
generalization which is subject to many exceptions, the following
classification of balance sheet items is suggested as representative:

Assets
Current assets
Investments
Fixed assets
Intangible assets
Other assets

Liabilities
Current liabilities
Long term liabilities

Owners’ Equity
Capital
Retained earnings

Classification Of Assets

Consumed Current Assets:

Current assets are those which are reasonably expected to be realized

in cash or sold or consumed during the normal operating cycle of the
business enterprise or within one year, whichever is longer. By operating
cycle we mean the average period of time between the purchase of goods or
raw materials and the realisation of cash from the sale of goods or the sale
of products produced with the help of raw materials. Current

62
assets generally consist of cash, marketable securities, bills receivables,
debtors, inventory and prepaid expenses.

Cash:

Cash consists of funds that are readily available for

disbursement. It includes cash kept in the cash chest of the enterprise as also
cash deposited on call or current accounts with banks.

Marketable Securities:

These consist of investments that are both readily marketable

and are expected to be converted into cash within a year. These investments
are made with a view to earn some return on cash that otherwise would be
temporarily idle.

Accounts Receivable:

Accounts receivable consist of amounts owed to the

enterprise by its consumers. This represents amounts usually arising out of
normal commercial transactions. These amounts are listed in the balance
sheet at the amount due less a provision for portion that may not be
collected. This provision is called as provision for doubtful debts. Amounts
due to the enterprise by someone other than a consumer would appear under
the heading `other receivables’ rather than `accounts receivables’. If the
amounts due are evidenced by written promises to pay, they are listed as
bills receivables. Accounts receivables are expected to be realised in cash.

Inventory:

Inventory consists of i) goods that are held in stock for sale in

the ordinary course of business, ii) work-in-progress that are to be currently
consumed in the production of goods or services to be available for sale.
Inventory is expected to be sold either for cash or on credit to customers to be
converted into cash. It may be noted in this connection that inventory relates to
goods that will be sold in the ordinary course of business. A van offered for sale
by a van dealer is inventory. A van used by the dealer to make service calls is
not inventory but an item of equipment which is a fixed asset.

63
Prepaid Expenses:

These items represent expenses which are usually paid in

advance such as rent, taxes, subscriptions and insurance. For e.g. If rent for
three months for the building is paid in advance then the business acquires a
right to occupy the building for three months. This right to occupy is an
asset. Since this right will expire within a fairly short period of time it is a
current asset.

Long Term Investments:

The distinction between a marketable security shown under

current asset and as an investment is entirely based on time factor. Those
investments like investments in shares, debentures, bonds etc. That will be
retained for more than one year or one operating cycle will appear under
this classification.

Fixed Assets:

Tangible assets used in the business that are of a permanent

or relatively fixed nature are called plant assets or fixed assets. Fixed assets
include furniture, equipment, machinery, building and land. Although there
is no standard criterion as to the minimum length of life necessary for
classification as fixed assets, they must be capable of repeated use and are
ordinarily expected to last more than a year. However the asset need not
actually be used continuously or even frequently. Items of spare equipments
held for use in the event of breakdown of regular equipment or for use only
during peak periods of activity are also included in fixed assets.

With the passage of time, all fixed assets with the exception of land
lose their capacity to render services. Accordingly the cost of such assets
should be transferred to the related expense amounts in a systematic manner
during their expected useful life. This periodic cost expiration is called
depreciation. While showing the fixed assets in the balance sheet the
accumulated depreciation as on the date of balance sheet, is deducted from
the respective assets.

64
Intangible Assets:

While tangible assets are concrete items which have

physical existence such as buildings, machinery etc., intangible assets are
those which have no physical existence. They cannot be touched and felt.
They derive their value from the right conferred upon their owner by
possession. Examples are: goodwill, patents, copyrights and trademarks.

Fictitious Assets:

These items are not assets. Yet they appear in the asset side
simply because of a debit balance in a particular account not yet written off
– e.g. Debit balance in current account of partners, profit and loss account,
etc.

Classification Of Liabilities

Current Liabilities:

When the liabilities of a business enterprise are due within an

accounting period or the operating cycle of the business, they are classified
as current liabilities. Most of the current liabilities are incurred in the
acquisition of materials or services forming part of the current assets. These
liabilities are expected to be satisfied either by the use of current assets or
by the creation of other current liabilities. The one year time interval or
current operating cycle criterion applies to classifying current liabilities
also. Current liabilities generally consists of bills payable, creditors,
outstanding expenses, income received in advance, provision for income-tax
etc.

Accounts Payable:

These amounts represent the claims of suppliers related to

goods supplied or services rendered by them to the business enterprise for
which they have not yet been paid. Usually these claims are unsecured and
are not evidenced by any formal written acceptance or promise to pay.
When the enterprise gives a written promise to pay money to a creditor for
the purchase of goods or services used in the business or the money
borrowed, then the written promise is called as bills payable or

65
notes payable. Amounts due to financial institutions which are suppliers of
funds, rather than of goods or services are termed as short-term loans or by
some other name that describes the nature of the debt instrument, rather than
accounts payable.

Outstanding Expenses:

These are expenses or obligations incurred in the previous

accounting period but the payment for which will be made in the next
accounting period. A typical example is wages or rent for the last month of
the accounting period remaining unpaid. It is usually paid in the first month
of the next accounting period and hence it is an outstanding expense.

Income Received In Advance:

These amounts relate to the next accounting period but

received in the previous accounting period. This item of liability is
frequently found in the balance sheet of enterprises dealing in the
publication of newspapers and magazines.

Provision For Taxes:

This is the amount owed by the business enterprise to the

government for taxes. It is shown separately from other current liabilities
both because of the size and because the amount owed may not be known
exactly as on the date of balance sheet. The only thing known is the
existence of liability and not the amount.

Long Term Liabilities:

All liabilities which do not become due for payment in one

year and which do not require current assets for their payment are classified
as long-term liabilities or fixed liabilities. Long term liabilities may be
classified as secured loans or unsecured loans. When the long-term loans are
obtained against the security of fixed assets owned by the enterprise, they
are called as secured or mortgaged loans. When any asset is not attached to
these loans they are called as unsecured loans. Usually long-term liabilities
include debentures and bonds, borrowings from

66
financial institutions and banks, public debts, etc. Interest accrued on a
particular secured long term loan, should be shown under the appropriate
sub-heading.

Contingent Liabilities:

Contingent liabilities are those liabilities which may or may

not result in liability. They become liabilities only on the happening of a
certain event. Until then both the amount and the liability are uncertain. If
the event happens there is a liability; otherwise there is no liability at all. A
very good example for contingent liability is a legal suit pending against the
business enterprise for compensation. If the case is decided against the
enterprise the liability arises and in the case of favourable decision there is
no liability at all. Contingent liabilities are not taken into account for the
purpose of totaling of balance sheet.

Capital Or Owners’ Equity:

As mentioned earlier, owners’ equity is the residual interest

in the assets of the enterprise. Therefore the owners’ equity section of the
balance sheet shows the amount the owners have invested in the entity.
However, the terminology `owners’ equity, varies with different forms of
organisations depending upon whether the enterprise is a joint stock
company or sole proprietorship / partnership concern.

Sole Proprietorship / Partnership Concern:

The ownership equity in a sole

Proprietorship or partnership is usually reported in the balance sheet as a
single amount for each owner rather than distinction between the owners
initial investment and the accumulated earnings retained in the business. For
e.g. In a sole-proprietor’s balance sheet for the year 2011, the capital
account of the owner may appear as follows:

Rs.
Owner’s capital as on 1-1-2011 2,50,00
Add: 2011 – profit 30,000

67
 Less: 2011 – drawings 2,80,00
15,000
Owner’s capital as on 31-12-2011 2,65,000

Joint Stock Companies:

In the case of joint stock companies, according to the legal

requirements, owners’ equity is divided into two main categories. The first
category called share capital or contributed capital is the amount the owners
have invested directly in the business. The second category of owners’
equity is called retained earnings.

Share capital is the capital stock pre-determined by the company by

the time of registration. It may consist of ordinary share capital or
preference share capital or both. The capital stock is divided into units
called as shares and that is why the capital is called as share capital. The
entire predetermined share capital called as authorised capital need not be
raised at a time. That portion of authorised capital which has been issued for
subscription as on a date is referred to as issued capital.

Retained earnings is the difference between the total earning to date

and the amount of dividends paid out to the shareholders to date. That is, the
difference represents that part of the total earnings that have been retained
for use in the business. It may be noted that the amount of retained earnings
on a given date is the accumulated amount that has been retained in the
business from the beginning of the company’s existence up to that date. The
owners’ equity increases through retained earnings and decreases when
retained earnings are paid out in the form of dividends.

1.3.3.9 Summary

The profit and loss account or income statement summarizes the

revenues and expenses of a business enterprise for an accounting period.
The information on the income statement is regarded by many to be more
important than information on the balance sheet because the income
statement reports the results of operations and enables to analyze the
reasons for the enterprises’ profitability or loss thereof. A close relationship

68
exists between income statement and balance sheet; the statement of
retained earnings which is a concomitant of income statement explains the
change in retained earnings between the balance sheets prepared at the
beginning and the end of the period.

Balance sheet is one of the most important financial statements

which shows the financial position of a business enterprise as on a particular
date. It lists as on a particular date, usually at the close of the accounting
period, the assets, liabilities and capital of the enterprise. An analysis of
balance sheet together with profit and loss account will give vital
information about the financial position and operations of the enterprise.
The analysis becomes all the more useful and effective when a series of
balance sheets and profit and loss accounts are studied.

1.3.3.10 Key Words

Income: Revenues – expenses.

Expense: Item of cost applicable to an accounting period.
Cost Of Goods Sold: Opening stock + purchase + freight – closing stock.
Gross Profit: Excess of sales revenue over cost of goods sold.

Operating Expenses: Expenses incurred for running the business.

Operating Profit: Gross profit – operating expenses.

Non Operating Expenses: Expenses which are not related to the activities
of the business.
Net Profit: Amount of profit finally available to the enterprise for
appropriation.

Retained Earnings:
The term retained earnings means the accumulated excess of
earnings over losses and dividends.
Status Report: Financial position on a particular date.

Flow Report:
Financial position for a particular period.
Assets: costs which represent expected future economic benefits to the
business enterprise.

69
Liabilities:
Represent obligations which require settlement in the future.

Current Assets:
Assets which are reasonably expected to be realized in cash or sold
or consumed during the normal operating cycle of the business enterprise or
within one year, whichever is longer.

Operating Cycle:
The average period of time between the purchase of goods or raw
materials and the realization of cash from the sale of goods.
Fixed Assets: tangible assets used in the business that are of a permanent or
relatively fixed nature.

Intangible Assets:
Those assets which have no physical existence.

Fictitious Assets:
They are not assets but appear in the asset side simply because of a
debit balance in a particular account not yet written off.

Current Liabilities:
Liabilities due within an accounting period or the operating cycle of
the business.

Long Term Liabilities:

Liabilities that become due for payment after one year.

Contingent Liabilities:
Items which become a liability only on the happening of a certain
event.
Capital Or Owner’s Equity:
Tthis is the residual interest in the assets of the Enterprise.

70
1.3.3.11 Self Assessment Questions

1. What is an expenditure? When does it become an expense?

2. What is income? How is it different from receipt?
3. Explain the following:
(a) gross profit
(b) operating profit
(c) earnings before interest and tax
(d) earnings after tax
4. What is meant by statement of retained earnings?
5. The following are the balances taken from the books of meena
ltd. On 31st december 2011:

Stock on 1-1-2011 15,000 Salaries 800

Debtors 5,000 Bank account 3,400
Wages 8,000 Rent 2,000
Creditors 6,000 Bad debts reserve 175
Sales 40,000 Discount allowed 250
P&l a/c 3,500 Bad debts 150
Returns inward 500 General expenses 1,300
Purchases 6,000 Insurance 300
Plant 18,000 Dividend (interim) 575
Discounts earned 200 Capital 12,000
Cash in hand 600

Closing stock was valued at rs.9,000. Rs.500 still due to labourers.

Insurance unexpired rs.50. Provide for a bad debts reserve of 5% and a
reserve for discount at 1%. Prepare trading and profit and loss account as at
31st december 2011.

6. From the following figures relating to a leading software producing

company, prepare the income statement for the year ended 30th june 2012.

1. Sales 20,17,69,212
2. Dividend received 1,06,755
3. Costs of goods sold 5,86,88,675
4. Interest received 18,76,661
5. Manufacturing expenses 5,38,56,719
6. Selling expenses 81,81,822

71
7. Administration expenses 2,99,32,794
8. Managerial remuneration 1,78,200
9. Excise duty 48,94,360
10. Bad debts 16,48,157
11. Overseas project expenses 58,35,260
12. Interest paid 5,69,16,495
13. Depreciation 2,33,40,163
14. Auditor’s remuneration 71,488
15. Increase in stocks 9,16,30,652
16. Other income 94,13,004
17. Balance of profit brought forward from previous year 3,51,87,048
18. Proposed dividend 4,64,19,410
19. Transfer to general reserve 30,62,608

Also Prepare the Statement of Retained Earnings.

7. Explain the following:

(a) assets
(b) liabilities
(c) fictitious assets
(d) income received in advance
(e) investments
8. What are the two forms of presenting a balance sheet?
9. Explain owner’s equity. How is it to be presented in the balance sheet?
10. From the following trail balance extracted from the books of the general
traders limited as on 31st december 2005, you are required to prepare
trading and profit and loss account and balance sheet:

Rs Rs

Share capital 20,000 shares of rs.10 each 2,00,000

Stock on 1st january 2005 36,000
Sales 58,000
Salaries 5,250
Purchases 44,000
Sundry debtors 23,000
Wages 3,000
Calls in arrears 21,500
Sundry creditors 7,200

72
Postage and telegrams 470
Advertisement 960
Preliminary expenses 7,500
Printing and stationery 640
Land and buildings 65,000
General expenses 2,200
Furniture 1,200
Repairs 650
Bad debts 910
Rent received 2,700
Machinery 30,000
Cash with bank 24,100
Cash in hand 1,520
2,67,900 2,67,900

The stock on 31st december 2011 was rs.49,000. Write off rs.2,500 out of
preliminary expenses. Depreciate machinery by 10 percent and furniture by
6 percent.

11. The books of aranarasu show the following balances as on 31st

december 2011. You are required to prepare a trading and profit and loss
account and balance sheet.

Rs. Rs.

Stock on 1st january 2011 67,000

Sales 5,24,600
Bills payable 1,500
Purchases 4,88,000
Salaries and wages 9,800
Rent 1,100
Travelling expenses 2,600
Sundry creditors 57,000
Postage and telegrams 620
General charges 2,250
Printing and stationery 350
Capital account 75,000
Interest and commission 2,200
Lighting charges 175

73
Repairs 35
Sundry receipts 175
Furniture 3,000
Bills receivable 4,000
Bad debts 475
Sundry debtors 85,000
Aranarasu’s current account 17,000
Cash with bank 6,500
Cash in hand 2,170

6,75,275 6,75,275

Depreciate furniture by 6 percent. Outstanding salaries and rent were

rs.1,100 and rs.100 respectively. Stock at 31st december 2011 was valued at
rs.70,350.

12. From the following balances relating to software india ltd. Prepare the
Balance sheet as at 31st december 2011.

Rs.

(a) equity capital 36,42,58,510

(b) reserves and surplus 23,58,26,861
(c ) debentures 1,03,36,000
(d) secured loans 21,27,57,441
(e) fixed assets 37,07,93,048
(f) investments 5,94,80,459
(g) inventories 20,78,28,095
(h) sundry debtors 10,21,66,468
(i) cash and bank balances 1,49,87,264
(j) other current assets 57,75,568
(k) loans and advances 12,49,59,370
(l) current liabilities 4,71,71,358
(m) provisions 4,64,19,410
(n) miscellaneous expenditure 3,07,79,308

The balance sheet may be prepared in account form and report form.

74
1.3.3.12 Key To Self Assessment Questions (For Problems Only)

Q.no.5: gross profit: rs.19,000; net profit: rs.14,327; profit carried to

Balance sheet: rs.17,252.
Q.no.6: net profit: rs.6,12,52,151; retained earnings balance:
Rs.4,69,57,182.
Q.no.10: gross profit: rs.24,000; net profit: rs.10,048; balance sheet
Total: rs.1,95,748.
Q.no.11: gross profit: rs.39,950; net profit: rs.19,140; balance sheet
Total: rs.1,70,840.

1.3.3.13 Case Analysis

To give a practical insight to the students about the various aspects

of profit and loss account and of a balance sheet we give the financial
statements as on 31st march 2012 of tt limited a yarn manufacturing
company:

75
Tt Limited

Balance Sheet As At 31st March, 2005

I. Sources Of

Funds 1 107490250.00 107490250.00

1. Share Capital 2 202213218.39 190240718.95

Reserve & Surplus

2. Loan Funds 3 447855991.83 423528431.00

Secured Loans 4 69532615.80 56901290.19

Unsecured Loans

3. Deferred Tax 42276806.36 43673781.36

Liability 869368882.38 821834471.50

Ii. Application

of Funds

1. Fixed Assets

Gross Block 5 734104404.86 700390441.72

Less: Depreciation 217233181.41 184869109.73
Net Block 516871223.45 515521331.99
Capt. Work In 4305600.00 521176823.45 515521331.99
0.00
Progress/ Advances

2. Investments 6 1591141.57 1591642.57

3. I.Current Assets, 510807958.00 457861043.73

Loans & Advances

Ii. Less: Current

Liabilities & 164207040.63 153139546.79

Provisions 7

Net Current 346600917.37 304721496.94

Assets (I-Ii) 869368882.38 821834471.50

76
Tt Limited

Profit & Loss Account For The Year Ended 31st March, 2012

Particulars Schedule Current year Previous year

Rs. Rs.
INCOME
Sales 1656633139.30 1470167645.65
Less: Excise 9164920.45 59656449.44
Duty ------------------ ------------------
8 1649235545.85
Net Sales 9 3194055.78 1410511196.21
Other Income 10 23509662.45 9178442.33
Increase 22572632.64
(Decrease) ------------------ ------------------
In Stock 1675939264.08 1442262271.18
11 ------------------ ------------------
Expenditure
Material
Manufactu- 1262208246.11 1107760578.66
ring, 12
Personnel, 13
Admin. & 308899137.99 254353516.32
Selling 47902372.00 30855197.88
Expenses etc.
Financial
expenses 34107486.97
Depre. on
Fixed 33127938.23
Assets 2906557.05
Less: ------------
Transferred
from 31200929.92 3657679.05 29470259.18
Revaluation ----------------- ------------- -----------------
Reserve 1650210686.02 1422439552.04
------------------ -----------------

PROFIT
2000000.00
Profit Before
- 396975.00 25728578.06 19822719.14
Tax
-------------
Less:Provision
for Taxation
- for The Year
400000.00 5150084.00
- Deferred Tax
603025.00 4750084.00
Add: Taxation
------------- 2154911.83
Adjustment
0.00

77
Of Previous
Years (Net)
Profit After 25125553.06 16827546.97
Taxation 33458012.39 28831460.48
Add: Balance --------------- ---------------
B/F From 58583565.45 45659007.45
Previous Year --------------- ---------------

8599220.00 8599220.00
1123810.56 1101775.06

10000000.00 2500000.00

38860534.88 33458012.19
--------------- ---------------
58583565.45 45659007.45
--------------- ---------------

Appropriation
Dividend 1.57
Dividend
Distribution Tax
Trf. To General 2.34
Reserve
Balance Carried
Forward

Earning Per
Share (Equity
Shares, Par
Value
Rs.10 Each)
Basic & Diluted

78
1.3.3.14 Books For Further Reading

1. M.A.Arulanandam And K.S.Raman: Advanced Accounts,

Himalaya Publishing House.
2. R.L.Gupta And M.Radhaswamy: Advanced Accounts, Vol.I,
Sultan Chand & Sons, New Delhi.
3. S.P.Jain And K.L.Narang: Advanced Accounts, Kalyani Publishers.
4. M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand & Co.
New Delhi.
5. Tulsian: Financial Accounting, Pearson Education.

*****

79
80
 Revenue Recognition
Lesson 1.4: Capital and Revenue Expenditure and Receipts

1.4.1 Introduction

In the previous lessons pertaining to the preparation of profit and

loss account, the reader would have had an exposure to the concepts relating
to expenses, expenditure and incomes. The term expenditure is a broad term
and it is classified into capital expenditure, revenue expenditure and
deferred revenue expenditure. All incomes are not receipts and all receipts
are not incomes. For example, under accrual or mercantile system of
accounting even income earned but not received is treated as income.
Similarly all receipts are not recognised as incomes. This lesson deals with
the classification of capital and revenue expenditure and receipts.

1.4.2 Learning Objectives

After reading this lesson the reader should be able to:

Ֆ Understand capital expenditure

Ֆ Distinguish capital expenditure from revenue expenditure
Ֆ Identify capital receipts and revenue receipts

1.4.3 Contents

1.4.3.1. Capital Expenditure

1.4.3.2. Revenue Expenditure
1.4.3.3. Distinction Between Capital And Revenue Expenditure
1.4.3.4. Deferred Revenue Expenditure
1.4.3.5. Capital And Revenue Profits, Receipts And Losses
1.4.3.6. Illustrations
1.4.3.7. Summary
1.4.3.8. Key Words
1.4.3.9. Self Assessment Questions
1.4.3.10. Key To Self Assessment Questions
1.4.3.11. Case Analysis
1.4.3.12. Books For Further Reading

81
1.4..3.1 Capital Expenditure:

Capital expenditure is that expenditure, the benefit of which is not

fully consumed in one period but spread over periods i.e. The benefits are
expected to accrue for a long time. Any expenditure which gives the
following outcomes is a capital expenditure:

(i) increases the capacity of an existing asset.

(ii) increases the life of an existing asset.
(iii) increases the earning capacity of the concern.
(iv) results in the acquisition of a new asset.
(v) decreases the cost of production.

Following are the examples of capital expenditure:

(i) expenditure resulting in the acquisition of fixed assets e.g. Land,
building, machines, etc.
(ii) expenditure resulting in extension or improvement of fixed
assets e.g. Amount spent on increasing the seating accommodation in the
picture hall.
(iii) expenditure in connection with installation of a fixed asset.
(iv) expenditure incurred for acquiring the right to carry on a
business e.g. Patents, copyright, etc.
(v) major repairs and replacements of parts resulting in increased
efficiency of a fixed asset.
An expenditure cannot be said to be a capital expenditure only because:
(i) the amount is large.
(ii) the amount is paid in lump sum.
(iii) the amount is paid out of that fund which has been received out
of the sale of fixed asset.
(iv) the receiver of the amount is going to treat it for the purchase of
fixed asset.

1.4.3.2 Revenue Expenditure:

An expenditure which is consumed during the current period and

which affects the income of the current period is called revenue expenditure.
Also an expenditure which merely seeks to maintain the business of high
assets in good working conditions is revenue expenditure.

82
Following are the examples of revenue expenditure:
(i) Expenses of administration, expenses incurred in manufacturing
and selling products.

(ii) Replacements for maintaining the existing permanent assets.

(iii) Costs of goods purchased for resale.

(iv) Depreciation on fixed assets, interest on loans for business, etc.

1.4.3.3 Distinction Between Capital And Revenue Expenditure:

The proper distinction between capital and revenue as regard to

expenditure, payments, profits, receipts and losses is one of the fundamental
principles of correct accounting. It is very essential that in all cases this
distinction should be rigidly observed and amounts rightly allocated
between capital and revenue. Failure or neglect to discriminate between the
two will falsify the whole of the results of accounting. However, the
distinction is not always easy. In actual practice there is a good deal of
difference of opinion as to whether a particular item is capital or revenue
expenditure. However, the rules mentioned above may serve as a guide for
making distinction between capital and revenue expenditure.

1.4.3.4 Deferred Revenue Expenditure:

A heavy expenditure of revenue nature incurred for getting benefit

over a number of years is classified as deferred revenue expenditure. In
some cases the benefit of revenue expenditure may be available for a period
of two or three or even more years. Such expenditure is to be written off
over a period of two or three years and not wholly in the year in which it is
incurred. For example a new firm may advertise very heavily in the
beginning to capture a position in the market. The benefit of this
advertisement campaign will last quite a few years. It will be better to write
off the expenditure in three or four years and not only in the first year. Some
other examples of deferred revenue expenditure are preliminary expenses,
brokerage on issue of shares and debentures, exceptional repairs, discount
on issue of shares or debentures, expenses incurred in removing the business
to more convenient premises and so on.

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1.4.3.5 Capital And Revenue Profits, Receipts And Losses:

Capital and revenue profits:

Capital profit is a profit made on the sale of a fixed asset or a profit

earned on getting capital for the business. For example, if the original cost
of a fixed asset is rs.50,00,000 and if it is sold for rs.60,00,000 then
rs.10,00,000 is capital profit. Similarly if the shares having an original cost
of rs.4,000 are sold for rs.5,000, the profit of rs.1,000 thus made is capital
profit. Capital profits should not be transferred to the profit and loss account
but should be transferred to capital reserve which would appear as a liability
in the balance sheet. Revenue profit, on the other hand, is a profit by
trading, e.g. Profit on sale of goods, income from investments, discount
received, commission earned, rent received, interest earned etc. Such profits
are taken to profit and loss account.

Capital And Revenue Receipts:

The distinction between capital receipts and revenue receipts is also

important. Money obtained from the sale of fixed assets of investments,
issue of shares, debentures, money obtained by way of loans are examples
of capital receipts. On the other hand, revenue receipts are cash from sales,
commission received, interest on investments, transfer fees, etc. Capital
receipts are shown in the balance sheet and revenue receipts in the profit
and loss account.

Capital And Revenue Losses:

Capital losses are those losses which occur at selling fixed assets or
raising share capital. For e.g., if investments having an original cost of
rs.20,000 are sold for rs.16,000, there will be a capital loss of rs.4,000.
Similarly when the shares of the face value of rs.100 are issued for rs.90, the
amount of discount i.e. Rs.10 per share will be a capital loss. Capital losses
should not be debited to profit and loss account but may be shown on the
asset side of balance sheet. As and when capital profits arise, losses are met
against them. Revenue losses are those losses which arise during the normal
course of business i.e. In trading operations such as losses on the sale of
goods. Such losses are debited to profit and loss account.

84
1.4.3.6 Illustrations

Illustration 1:
State which of the following expenditures are capital in nature and
which are revenue in nature:
Ֆ Freight and cartage on the new machine rs.150; erection
charges Rs.200.
Ֆ A sum of rs.10,000 on painting the new factory.
Ֆ Fixtures of the book value of rs.1,500 was sold off at rs.600 and new
fixtures of the value of rs.1,000 were acquired, cartage on purchase rs.50.

Ֆ Rs.1,000 spent on repairs before using a second hand car purchased

recently.

Solution:

Ֆ Capital expenditure to be debited to machinery account.

Ֆ Painting charges of new or old factory are maintenance charges and be
charged to revenue. However, if felt proper, painting charges of new
factory may be treated as deferred revenue expenditure. However, some
say painting of new factory is capital expenditure.
Ֆ Loss of rs.900 on the sale of fixtures be treated as revenue expense
but the cost of new fixture rs.1,000 together with cartage rs.50 be
debited to fixture account as these are capital expenditure.
Ֆ Rs.1,000 being expense to bring the asset in usable condition is a
capital expenditure.

Illustration 2:

Ֆ The sum of rs.30,000 has been spent on a machine as follows:

Ֆ Rs.20,000 for additions to increase the output; rs.12,000 for repairs
necessitated by negligence and rs.8,000 for replacement of worn-out
parts.
Ֆ The sum of rs.17,200 was spent on dismantling, removing and
reinstalling in order to remove their works to more suitable premises.
Classify these expenses into capital and revenue.

85
Solution:

Ֆ Rs.20,000 spent on additions is to be capitalized but rs.12,000 and

rs.8,000 spent on repairs and replacement of worn-out parts respectively
are to be charged to revenue.
Ֆ Rs.17,200 spent for removing to a more suitable premises is to be
charged to revenue as it does not increase efficiency and income. It, may,
however be treated as deferred revenue at the most.

1.4.3.7 Summary

Final accounts are prepared from the balances appearing in the trial
balance. All accounts appearing in the trial balance are taken to either
trading and profit and loss account or balance sheet. All revenue
expenditures and receipts are taken to trading and profit and loss account
and all capital expenditures and receipts are taken to balance sheet. It is
therefore necessary to realise the importance of distinction between capital
and revenue items.

1.4.3.8 Key Words

Capital Expenditure:

It is that expenditure, the benefit of which is expected to accrue for a

number of years.

Revenue Expenditure:

It is that expenditure, the benefit of which is consumed during the

current year.

Capital Receipt:

Moneys obtained from sale of fixed assets, issue of capital,

borrowing of loans, etc.
Revenue Receipt: cash from sales, commission received, etc. Are examples
of revenue receipts.

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1.4.3.9 Self Assessment Questions

State which of the following items should be charged to capital and

which to revenue:
(i) Rs.6,000 paid for removal of stock to new site.
(ii) Rs.2,000 paid for the erection of a new machine.
(iii)Rs.2,500 paid on the repairing of new factory.
(iv) A car engine’s rings and pistons were changed at a cost of
rs.15,000; this resulted in improvement of petrol consumption to 12 km per
litre; earlier it had fallen from 15 km to 8 km.

1.4.3.10 Key To Self Assessment Questions

(i) Deferred revenue expenditure.
(ii) Capital expenditure.
(iii) Capital expenditure.
(iv) Revenue expenditure.

1.4.3.11 Case Analysis

Raja ram ltd., for which you are the accounts manager, has removed
the works factory to a more suitable site. During the removal process the
following stream of expenditure were incurred:
a)A sum of rs.47,500 was spent on dismantling, removing and
reinstalling plant, machinery and fixtures.
b)The removal of stock from old works to new works cost rs.5,000. c)Plant
and machinery which stood in books at rs.7,50,000 included a machine at a
book value of rs.15,000. This being obsolete was sold off for
rs.5,000 and was replaced by a new machine which costs rs.24,000. d)The
fixtures and furniture appeared in the books at rs.75,000. Of
these, some portion of the book value of rs.15,000 was discarded and sold
off for rs.16,000 and new furniture of the value of rs.12,000 was acquired.
e)A sum of rs.11,000 was spent on painting the new factory.

Your accounts clerk has come to you seeking your help to classify the above
expenditure as to capital expenditure and revenue expenditure. Advise him.

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Solution:

a)Rs.47,500 will have to be treated as revenue expenditure. It may

be treated as deferred revenue expenditure item and spread over a term of
say four to five years.
b)The cost of removal of stock from the old works to the new works
does not either add to the value of the profit earning capacity of the asset
and as such it should be treated as an item of revenue expenditure.
c)Rs.10,000, the difference between the book value of the machine
sold and the amount realized on sale, will have to be charged off to revenue
as depreciation. Rs.24,000, the cost of new machine, will have to be
capitalized.
d)Rs.1,000, the difference between the book value of the fixtures and
fittings discarded and the amount realized from there will be treated as
capital profit and therefore be credited to capital revenue account.
Rs.12,000, the cost of new furniture, will be capitalized.
e)A sum of rs.11,000 spent on painting a new factory is capital
expenditure and will be added to the cost of factory building as it is all to
the new factory.

1.4.3.12 Books For Further Reading

a) R.L.Gupta And M.Radhaswamy: Advanced Accounts,

Sultan Chand & Sons, New Delhi.
b) S.P.Jain And K.L.Narang: Advanced Accountancy, Kalyani
Publishers, New Delhi.
c) M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand
& Co., New Delhi.
d) Tulsian: Financial Accounting,, Pearson Education (P) Ltd.,
Delhi.
e) Warren Reeve Fess: Financial Accounting, Thomson, South
Westem.

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 Unit-II

Lesson 2.1: Depreciation

2.1.1 Introduction

With the passage of time, all fixed assets lose their capacity to render
services, the exceptions being land and antics. Accordingly, a fraction of the
cost of the asset is chargeable as an expense in each of the accounting
periods in which the asset renders services. The accounting process for this
gradual conversion of capitalised cost of fixed assets into expense is called
depreciation. This lesson explains the different aspects of depreciation.

2.1.2 Learning Objectives

After reading this lesson, the reader should be able to:

Ֆ Understand the meaning of depreciation.

Ֆ Know the causes of depreciation.
Ֆ Appreciate the need for depreciation accounting.
Ֆ Evaluate the methods of depreciation.

2.1.3 Contents

2.1.3.1 Meaning Of Depreciation

2.1.3.2 Causes Of Depreciation
2.1.3.3 Need For Depreciation Accounting
2.1.3.4 Methods Of Depreciation
2.1.3.5 Straight Line Method Of Depreciations
2.1.3.6 Diminishing Balance Method
2.1.3.7 Annuity Method Of Depreciation
2.1.3.8 Summary
2.1.3.9 Key Words
2.1.3.10 Self Assessment Questions
2.1.3.11 Key To Self Assessment Questions

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 2.1.3.12 Case Analysis
2.1.3.13 Books For Further Reading

2.1.3.1 Meaning Of Depreciation

In common parlance depreciation means a fall in the quality or value

of an asset. But in accounting terminology, the concept of depreciation
refers to the process of allocating the initial or restated input valuation of
fixed assets to the several periods expected to benefit from their acquisitions
and use. Depreciation accounting is a system of accounting which aims to
distribute the cost or other basic value of tangible capital assets, less salvage
(if any), over the estimated useful life of the unit (which may be a group of
assets) in a systematic and rational manner. It is a process of allocation and
not of valuation.

The international accounting standards committee (iasc) (now

international accounting standards board) defines depreciation as follows:
depreciation is the allocation of the depreciable amount of an asset over the
estimated useful life. The useful life is in turn defined as the period over
which a depreciable asset is expected to be used by the enterprise. The
depreciable amount of a depreciable asset is its historical cost in the
financial statements, less the estimated residual value. Residual value or
salvage value is the expected recovery or sales value of the asset at the end
of its useful life.

2.1.3.2 Causes Of Depreciation

Among other factors, the two main factors that contribute to the
decline in the usefulness of fixed assets are deterioration and obsolescence.
Deterioration is the physical process wearing out whereas obsolescence
refers to loss of usefulness due to the development of improved equipment
or processes, changes in style or other causes not related to the physical
conditions of the asset. The other causes of depreciation are:

1. Efflux of time – mere passage of time will cause a fall in the

value of an asset even if it is not used.
2. Accidents – an asset may reduce in value because of meeting
with an accident.
3. Fall in market price – a sudden fall in the market price of

90
the asset reduces its value even if it remains brand new.

2.1.3.3 Need For Depreciation Accounting

The need for depreciation accounting arises on three grounds:

(i) To calculate proper profit: according to matching concept of
accounting, profit of any year can be calculated only when all costs of
earning revenues have been properly charged against them. Asset is an
important tool in earning revenues. The fall in the book value of assets
reflects the cost of earning revenues from the use of assets in the current
year and hence like other costs like wages, salary, etc., it must also be
provided for proper matching of revenues with expenses.

(ii) To show true financial position: the second ground for

providing depreciation is that it should result in carrying forward only that
part of asset which represents the unexpired cost of expected future service.
If the depreciation is not provided then the asset will appear in the balance
sheet at the overstated value.

(iii) To make provision for replacement of assets: if no changes

were made for depreciation, profits of the concern would be more to that
extent. By making an annual charge for depreciation, a concern would be
accumulating resources enough to enable it to replace an asset when
necessary. Replacement, thus, does not disturb the financial position of the
concern.

2.1.3.4 Methods Of Depreciation

The amount of depreciation of a fixed asset is determined taking into

account the following three factors: its original cost, its recoverable cost at
the time it is retired from service and the length of its life. Out of these three
factors the only factor which is accurately known is the original cost of the
asset. The other two factors cannot be accurately determined until the asset
is retired. They must be estimated at the time the asset is placed in service.
The excess of cost over the estimated residual value is the amount that is to
be recorded as depreciation expense during the assets’ life-time. There are
no hard and fast rules for estimating either the period of usefulness of an
asset or its residual value at the end of such period. Hence these two factors,
which are inter-related are affected to a

91
considerable extent by management policies.

Let the reader consider the following example: a machine is

purchased for rs.1,00,000 with an estimated life of five years and estimated
residual value of rs.10,000. The objective of depreciation accounting is to
charge this net cost of rs.90,000 (original cost – residual value) as an
expense over the 5 year period. How much should be charged as an expense
each year? To give an answer to this question a 100 number of methods of
depreciation are available. In this lesson three such methods viz.

1.Straight line method,

2.Diminishing balance method and
3.Annuity method are discussed.

2.1.3.5 Straight Line Method Of Depreciation

This method which is also known as ‘fixed installment system’,

provides for equal amount of depreciation every year. Under this method,
the cost of acquisition plus the installation charges, minus the scrap value, is
spread over the estimated life of the asset to arrive at the annual charge. In
other words, this method writes off a fixed percentage, say 20%, of the
original cost of the asset every year in such a way that the asset is reduced to
nil or scrap value at the end of its life.

Evaluation:

The chief merit of this method is that it is easy to calculate

depreciation, and hence, it is simple. Depreciation charge is constant from
year to year, regardless of the extent of use of the asset. This method can be
employed in the case of assets like furniture and fixtures, short leases, etc.,
which involve little capital outlay, or which have no residual value. This
method is criticized on the ground that the depreciation charge remaining
the same every year, cost of repairs and maintenance would be increasing as
the asset becomes older. With the efficiency of the asset declining, it is
unfair to charge the same amount of depreciation every year.

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2.1.3.6 Diminishing Balance Method

This method which is also known as the, `reducing installment

system’, or `written down value method’, applies depreciation as a fixed
percentage to the balance of the net cost of the asset not yet allocated at the
end of the previous accounting period. The percentage of depreciation is so
fixed that, theoretically, the balance of the unallocated cost at the end of the
estimated useful life of the asset should be equal to the estimated residual
value.

Evaluation:

Unlike the fixed installment system, depreciation under this

method is not fixed, but gradually decreasing. As such, in the initial periods,
the amount will be much higher, but negligible in the later period of the
asset. Thus, this method tends to offset the amount of depreciation on the
one hand and repairs and maintenance on the other. This method is also
simple, although the calculation of depreciation is a bit complicated.
Further, as and when additions are made to the asset, fresh calculations do
not become necessary. This method is best suited to assets such as plant and
machinery which have a long life.

Entries Required:

The entry to be made on writing off depreciation under any method

is:
Depreciation a/c ….. Dr
To asset a/c
The depreciation account goes to the debit of the profit and loss account.
The entry for this is:
Profit and loss a/c … dr
To depreciation a/c

The asset appears at its reduced value in the balance sheet.

93
Illustration 1:

On 1-1-2003, machinery was purchased for rs.3,00,000.

Depreciation at the rate of 10% has to be written off. Write up the
machinery account for three years under:
1. Straight line method (SLM) and
2. Written down value method (WDV)

Solution:

Machinery Account
Date Particulars SLM WDV Date Particulars SLM WDV
1-1- To Bank 3,00,000 3,00,000 31-12- By 30,000 30,000
2003 A/C 2003 Depreciation 2,70,000 2,70,000
---------- ---------- 31-12- By Balance --------- ----------
3,00,000 3,00,000 2003 C/D 3,00,000 3,00,000
---------- ---------- --------- ----------

1-1- To Balance 2,70,000 2,70,000 30,000 27,000

2004 B/D 31-12- By 2,40,000 2,43,000
---------- ---------- 2004 Depreciation --------- ----------
2,70,000 2,70,000 31-12- By Balance 2,70,000 2,70,000
---------- ---------- 2004 C/D --------- ----------

1-1- To Balance 2,40,000 2,43,000 30,000 24,300

2005 B/D 2,10,000 2,18,700
---------- ---------- 31-12- By --------- ----------
2,40,000 2,43,000 2005 Depreciation 2,40,000 2,43,000
---------- ---------- 31-12- By Balance --------- ----------
2005 C/D
1-1- To Balance 2,10,000 2,18,700
2006 B/D

From the above illustration it can be seen that under SLM method
each year depreciation is calculated at 10% on original cost of asset i.e. On
rs.3,00,000, while under WDV method each year depreciation is calculated
at 10% on the written down value i.e. For e.g. In the 2nd year depreciation
is calculated at 10% on rs.2,70,000 and so on.

94
Illustration 2:

On 1-1-2002, machinery was purchased for rs.30,000. Depreciation

at the rate of 10% on original cost was written off during the first two years.
For the next two years 15% was written off the diminishing balance of the
amount. The machinery was sold for rs.15,000. Write up the machinery
account for four years and close the same.

Machinery Account
Date Particulars SLM Date Particulars SLM
1-1-2002 To Bank 30,000 31-12- By 3,000
A/C 2002 Depreciation 27,000
---------- 31-12- By Balance ----------
30,000 2002 C/D 30,000
---------- ----------

1-1-2003 To Balance 27,000 3,000

B/D 31-12- By 24,000
---------- 2003 Depreciation ----------
27,000 31-12- By Balance 27,000
---------- 2003 C/D ----------
1-1-2004
To Balance 24,000 3,600
B/D
31-12- By 2,0,400
---------- 2004 Depreciation ----------
2,40,000 31-12- (15% On 24,000
---------- 2004 24,000) ----------
20,400 By Balance 3,060
1-1-2005 To Balance C/D
B/D 15,000

31.122005 2,340
20,400------- By ---------
31.12.2005 Depreciation 20,400
31.12.2005 (15% On
20,400)
By Bank
(Sale)
By Profit &
Loss A/C
(Loss On
Sale)

95
Illustration 3:

A company, whose accounting year is the calendar year, purchased

a machinery on 1-1-2003 for rs.40,000. It purchased further machinery on
1-10-2003 for rs.20,000 and on 1st july 2005 for rs.10,000. On 1-7-2006,
one-fourth of the machinery installed on 1-1-2003 became obsolete and was
sold for rs.6,800. Show the machinery account for all the 3 years under
fixed installment system. Depreciation is to be provided at 10%p.a.

Machinery Account
Date Particulars Rupees Date Particulars Rupees
2003 2003
Jan 1 To Bank- 40,000 Dec 31 By Depreciation
Oct 10 Purchase 20,000 -On Rs.40000 For 1 4,000
To Bank- Year 500
Purchase Dec 31 -On Rs.20000 For 3 55,500
-------- Month --------
60,000 60,000
-------- By Balance C/D --------
2004 2004
Jan 1 To Balance 55,500 Dec 31
B/D 4,000
July 1 To Bank- 2,000
Purchase 10,000 By Depreciation 500
Dec 31 -On Rs.40000 For 1 59,000
-------- Year --------
65,500 -On Rs.20000 For 1 65,500
-------- Year --------
-On Rs.10000 For 6
Month
2005 By Balance C/D
59,000 July 1 500
July 1 6,800
July 1 700
2005 To Balance
Jan 1 B/D Dec 31
By Depreciation 3,000
On Machine Sold 2,000
By Bank-Sale 1,000
By P&L A/C (Loss On 45,000
-------- Sale) --------
59,000 By Depreciation 59,000

96
 -On Rs.30000 For 1 Year
-On Rs.20000 For 1 Year
-On Rs.10000 For 1 Year
By Balance C/D

Working Notes – Loss On Sale Of Machinery

Original cost of machinery on 1-1-2003: = 10,000

Less depreciation for 2003 at 10% 1,000 (4000 x ¼) = 1,000
--------
Book value on 1-1-2004 9,000
Less depreciation for 2004 at 10% on 10,000 1,000
--------
Book value on 1-1-2005 8,000
Less depreciation upto 1-7-2005 at 10% on 10000 500
--------
Book value on date of sale 7,500
Less sale proceeds 6,800
--------
Loss on sale 700
--------

2.1.3.7 Annuity Method Of Depreciation

Under the first two methods of depreciation the interest aspect has
been ignored. Under this method, the amount spent on the acquisition of an
asset is regarded as investment which is assumed to earn interest at a certain
rate. Every year the asset is debited with the amount of interest and credited
with the amount of depreciation. This interest is calculated on the debit
balance of the asset account at the beginning of the year. The amount to be
written off as depreciation is calculated from the annuity table an extract of
which is given below:
Years 3% 3.5% 4% 4.5% 5%
3 0.353530 0.359634 0.360349 0.363773 0.367209
4 0.269027 0.272251 0.275490 0.278744 0.282012
5 0.218355 0.221481 0.224627 0.227792 0.230975

The amount to be written off as depreciation is ascertained from

97
the annuity table and the same depends upon the rate of interest and the
period over which the asset is to be written off. The rate of interest and the
amount of depreciation would be adjusted in such a way that at the end of
its working life, the value of the asset would be reduced to nil or its scrap
value.

Evaluation:

This method has the merit of treating purchase of an asset as an

investment within the business, and the same is supposed to earn interest.
However, calculations become difficult when additions are made to the
asset. The method is suitable only for long leases and other assets to which
additions are not usually made and as such in case of machinery, this
method is not found suitable.

Illustration 4:

A lease is purchased for a term of 4 years by payment of rs.1,00,000.

It is proposed to depreciate the lease by annuity method charging 4%
interest. If annuity of re.1 for 4 years at 4% is 0.275490, show the lease
account for the full period.

Amount of annual depreciation =rs.1,00,000 x re.0.275490

= rs.27,549
Lease Account
Date Particulars Rupees Date Particulars Rupees
1st To Bank 100000.00 1st By Depreciation 27549.00
Year To Interest At 4% 4000.00 Year By Balance C/D 76451.00
------------ ------------
104000.00 104000.00
------------ ------------
2nd To Balance B/D 76451.00 2nd By Depreciation 27549.00
Year To Interest At 4% 3058.04 Year By Balance C/D 51960.04
------------ ------------
79509.04 79509.04
------------ ------------
3 r d To Balance B/D 51960.04 3rd By Depreciation 27549.00
Year To Interest At 4% 2078.40 Year By Balance C/D 26489.44
------------ ------------
54038.44 54038.44
------------ ------------

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 4th To Balance B/D 26489.44 4th By Depreciation 27549.00
Year To Interest At 4% 1059.56 Year
(Adjusted) ----------- -----------
27549.00 27549.00
----------- -----------

2.1.3.8 Summary

Though depreciation to a common man means a fall in the value of

an asset, actually it is not a process of valuation. It is a process of cost
allocation. Through depreciation accounting the cost of a tangible asset less
salvage value, if any, is distributed over the estimated useful life of the
asset. Depreciation is to be accounted to know the true profit earned by the
concern, to exhibit a true and fair view of the state of assets of the concern
and to provide funds for replacement of the asset when it is worn out.
Among the number of methods of depreciation available three methods, viz.
Straight line method, diminishing balance method and annuity method are
discussed.

2.1.3.9 Key Words

Depreciable Asset: It is that asset on which depreciation is written off.

Depreciation: It is the allocation of the depreciable amount of an asset

over estimated useful life.

Useful Life: It is the period over which a depreciable asset is expected to

be used by the enterprise.

Depreciable Amount: The depreciable amount of a depreciable asset is

its historical cost less estimated residual value.

Residual Value: It is the expected recovery or sales value of an asset at

the end of its useful life.

2.1.3.10 Self Assessment Questions

Question 1:
A manufacturing concern, whose books are closed on 31st

99
march, purchased machinery for rs.1,50,000 on 1st april 2002. Additional
machinery was acquired for rs.40,000 on 30th september 2003 and for
rs.25,000 on 1st april 2005. Certain machinery which was purchased for
rs.40,000 on 30th september 2003 was sold for rs.34,000 on 30th september
2005. Give the machinery account for the year ending 31st march 2006
taking into account depreciation at 10% p.a. On the written down value.

Question 2:
A seven years lease has been purchased for a sum of rs.60,000
and it is proposed to depreciate it under the annuity method charging 4%
interest. Reference to the annuity table indicates that the required result will be
brought about by charging annually rs.9996.55 to depreciation account. Show
how the lease account will appear in each of the seven years.
Question 3:
Examine the need for providing depreciation.

2.1.3.11 Key To Self Assessment Questions

Question 1: Machinery Account
2005 2005
April 1 to balance b/d 1,43,550 Sep 30 by depreciation 1,710
Sep 30 to bank 25,000 by bank 34,000
to p&l a/c 1,510 2006 by depreciation 13,435
(profit on sale) mar 31 by balance c/d 1,20,915

1,70,060 1,70,060

Question 2:
Interest for seven years:
1st year: rs.2,400; 2nd year: rs.2,096.14; 3rd year: rs.1,780.12; 4th year:
Rs.1,451.46; 5th year: rs.1,109.66; 6th year: rs.754.19; 7th year: rs.384.28.

2.1.3.12 Case Analysis

Pondicherry roadways ltd. Which depreciates its machinery at 10%

p.a. On written down value desires to change the basis to straight line
method, the rate remaining the same. The decision is taken on 31st
december 2005 to be effective from 1st january 2003.
On 1st january 2005, the balance in the machinery account is rs.29,16,000.
On 1st july 2005, a part of machinery purchased on 1st january 2003 for

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rs.2,40,000 was sold for rs.1,35,000. On the same day a new machine is
purchased for rs.4,50,000 and installed at a cost of rs.24,000. Analyze the
above case and answer the following questions:
(i) What was the loss incurred on the machine sold?
(ii) What was the book value of unsold machinery on 1-1-2003.
(iii) What would be the additional depreciation due to change in
method?
(iv) What should be the depreciation to be charged for 2005?
Answers:
(i) Rs.49,680
(ii) Rs.33,60,000
(iii)Rs.33,600
(iv)Rs.3,59,700

2.1.3.13 Books For Further Reading

1. R.L.Gupta And M.Radhaswamy: ADVANCED ACCOUNTS, Sultan

Chand & Sons, New Delhi.
2. S.P.Jain And K.L.Narang: ADVANCED ACCOUNTANCY, Kalyani
Publishers, New Delhi.
3. M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand & Co.,
New Delhi.
4. Tulsian: Financial Accounting, Pearson Education (P) Ltd., Delhi.
5. Warren Reeve Fess: Financial Accounting, Thomson, South Westam.

*****

101
102
 UNIT-II

Lesson 2.2: Ratio Analysis

2.2..1 Introduction

Financial statements by themselves do not give the required

information both for internal management and for outsiders. They are
passive statements showing the results of the business i.e. Profit or loss and
the financial position of the business. They will not disclose any reasons for
dismal performance of the business if it is so. What is wrong with the
business, where it went wrong, why it went wrong, etc. Are some of the
questions for which no answers will be available in the financial statements.
Similarly, no information will be available in the financial statements about
the financial strengths and weaknesses of the concern. Hence, to get
meaningful information from the financial statements which would facilitate
vital decisions to be taken, financial statements must be analysed and
interpreted. Through the analysis and interpretation of financial statements
full diagnosis of the profitability and financial soundness of the business is
made possible. The term `analysis of financial statements’ means
methodical classification of the data given in the financial statements. The
term `interpretation of financial statements’ means explaining the meaning
and significance of the data so classified. A number of tools are available for
the purpose of analysing and interpreting the financial statements. This
lesson discusses in brief tools like common size statement, trend analysis,
etc., and gives a detailed discussion on ratio analysis.

2.2.2 Learning Objectives

Ֆ After reading this lesson the reader should be able to:

Ֆ understand the nature and types of financial analysis
Ֆ know the various tools of financial analysis
Ֆ understand the meaning of ratio analysis
Ֆ ppreciate the significance of ratio analysis
Ֆ understand the calculation of various kinds of ratios
Ֆ calculate the different ratios from the given financial statements
Ֆ interpret the calculated ratios

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2.2.3 Contents

2.2.3.1 Nature Of Financial Analysis

2.2.3.2 Types Of Financial Analysis
2.2.3.3 Tools Of Financial Analysis
2.2.3.4 Meaning And Nature Of Ratio Analysis
2.2.3.5 Classification Of Ratios
2.2.3.6 Capital Structure Or Leverage Ratios
2.2.3.7 Fixed Assets Analysis
2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency
2.2.3.9 Analysis Of Liquidity Position
2.2.3.10 Analysis Of Profitability
2.2.3.11 Analysis Of Operational Efficiency
2.2.3.12 Ratios From Share Holders’ Point Of View
2.2.3.13 Illustrations
2.2.3.14 Summary
2.2.3.15 Key Words
2.2.3.16 Self Assessment Questions
2.2.3.17 Key To Self Assessment Questions
2.2.3.18 Case Analysis
2.2.3.19 Books For Further Reading

2.2.3.1 Nature Of Financial Analysis

The focus of financial analysis is on the key figures contained

in the financial statements and the significant relationship that exists between
them. “analyzing financial statements is a process of evaluating the relationship
between the component parts of the financial statements to obtain a better
understanding of a firm’s position and performance”.
The type of relationship to be investigated depends upon the objective and
purpose of evaluation. The purpose of evaluation of financial statements
differs among various groups: creditors, shareholders, potential investors,
management and so on. For example, short-term creditors are primarily
interested in judging the firm’s ability to pay its currently-maturing
obligations. The relevant information for them is the composition of the
short-term (current) liabilities. The debenture-holders or financial
institutions granting long-term loans would be concerned with examining
the capital structures, past and projected earnings and changes in the
financial position. The shareholders as well as potential investors would

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naturally be interested in the earnings per share and dividends per share as
these factors are likely to have a significant bearing on the market price of
shares. The management of the firms, in contrast, analyses the financial
statements for self-evaluation and decision making.

The first task of the financial analyst is to select the information

relevant to the decision under consideration from the total information
contained in the financial statements. The second step involved in financial
analysis is to arrange the information in such a way as to highlight
significant relationships. The final step is the interpretation and drawing of
inferences and conclusions. In brief, financial analysis is the process of
selection, relation and evaluation.

2.1.3.2 Types Of Financial Analysis

Financial analysis may be classified on the basis of parties who are

undertaking the analysis and on the basis of methodology of analysis. On
the basis of the parties who are doing the analysis, financial analysis is
classified into external analysis and internal analysis.

External Analysis:

When the parties external to the business like creditors, investors,

etc. Do the analysis, the analysis is known as external analysis. This analysis
is done by them to know the credit-worthiness of the concern, its financial
viability, its profitability, etc.

Internal Analysis:

This analysis is done by persons who have control over the books of
accounts and other information of the concern. Normally this analysis is
done by management people to enable them to get relevant information to
take vital business decision.
On the basis of methodology adopted for analysis, financial analysis may be
either horizontal analysis or vertical analysis.

105
Horizontal Analysis:

When financial statements of a number of years are analysed, then

the analysis is known as horizontal analysis. In this type of analysis, figures
of the current year are compared with the standard or base year. This type of
analysis will give an insight into the concern’s performance over a period of
years. This analysis is otherwise called as dynamic analysis as it extends
over a number of years.

Vertical Analysis:

This type of analysis establishes a quantitative relationship of the

various items in the financial statements on a particular date. For e.g. The
ratios of various expenditure items in terms of sales for a particular year can
be calculated. The other name for this analysis is `static analysis’ as it relies
upon one year figures only.

2.1.3.3 Tools Of Financial Analysis

The following are the important tools of financial analysis which can
be appropriately used by the financial analysts:
1. Common-size financial statements
2. Comparative financial statements
3. Trend percentages
4. Ratio analysis
5. Funds flow analysis
6. Cash flow analysis

Common-Size Financial Statements:

In this type of statements, figures in the original financial statements

are converted into percentages in relation to a common base. The common base
may be sales in the case of income statements (profit and loss account) and
total of assets or liabilities in the case of balance sheet. For e.g. In the case of
common-size income statement, sales of the traditional financial statement are
taken as 100 and every other item in the income statement is converted into
percentages with reference to sales. Similarly, in the case of common-size
balance sheet, the total of asset/liability side will be taken as 100 and each
individual asset/liability is converted into relevant percentages.

106
Comparative Financial Statements:

This type of financial statements are ideal for carrying out horizontal
analysis. Comparative financial statements are so designed to give them
perspective to the review and analysis of the various elements of
profitability and financial position displayed in such statements. In these
statements, figures for two or more periods are compared to find out the
changes both in absolute figures and in percentages that have taken place in
the latest year as compared to the previous year(s). Comparative financial
statements can be prepared both for income statement and balance sheet.

Trend Percentages:

Analysis of one year figures or analysis of even two years figures

will not reveal the real trend of profitability or financial stability or
otherwise of any concern. To get an idea about how consistent is the
performance of a concern, figures of a number of years must be analysed
and compared. Here comes the role of trend percentages and the analysis
which is done with the help of these percentages is called as trend analysis.

Trend analysis:

Is a useful tool for the management since it reduces the large amount
of absolute data into a simple and easily readable form. The trend analysis is
studied by various methods. The most popular forms of trend analysis are
year to year trend change percentage and index-number trend series. The
year to year trend change percentage would be meaningful and manageable
where the trend for a few years, say a five year or six year period is to be
analysed.

Generally trend percentage are calculated only for some important

items which can be logically related with each other. For e.g. Trend ratio for
sales, though shows a clear-cut increasing tendency, becomes meaningful in
the real sense when it is compared with cost of goods sold which might have
increased at a lower level.

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Ratio Analysis:

Of all the tools of financial analysis available with a financial

analyst the most important and the most widely used tool is ratio analysis.
Simply stated ratio analysis is an analysis of financial statements done with
the help of ratios. A ratio expresses the relationship that exists between two
numbers and in financial statement analysis a ratio shows the relationship
between two interrelated accounting figures. Both the accounting figures
may be taken from the balance sheet and the resulting ratio is called a
balance sheet ratio. But if both the figures are taken from profit and loss
account then the resulting ratio is called as profit and loss account ratio.
Composite ratio is that ratio which is calculated by taking one figure from
profit and loss account and the other figure from balance sheet. A detailed
discussion on ratio analysis is made available in the pages to come.

Funds Flow Analysis:

The purpose of this analysis is to go beyond and behind the

information contained in the financial statements. Income statement tells the
quantum of profit earned or loss suffered for a particular accounting year.
Balance sheet gives the assets and liabilities position as on a particular date.
But in an accounting year a number of financial transactions take place
which have a bearing on the performance of the concern but which are not
revealed by the financial statements. For e.g. A concern collects finance
through various sources and uses them for various purposes. But these
details could not be known from the traditional financial statements. Funds
flow analysis gives an opening in this respect. All the more, funds flow
analysis reveals the changes in working capital position. If there is an
increase in working capital what resulted in the increase and if there is a
decrease in working capital what caused the decrease, etc. Will be made
available through funds flow analysis.

Cash Flow Analysis:

While funds flow analysis studies the reasons for the changes in
working capital by analysing the sources and application of funds, cash flow
analysis pays attention to the changes in cash position that has taken place
between two accounting periods. These reasons are not available in the
traditional financial statements. Changes in the cash position can

108
be analysed with the help of a statement known as cash flow statement. A
cash flow statement summarises the change in cash position of the concern.
Transactions which increase the cash position of the concern are labelled as
`inflows’ of cash and those which decrease the cash position as `outflows’ of
cash.

2.2.3.4 Meaning And Nature of Ratio Analysis

Ratio expresses numerical relationship between two numbers. In the

words of kennedy and mcmullen, “the relationship of one item to another
expressed in simple mathematical form is known as a ratio”. Thus, the ratio
is a measuring device to judge the growth, development and present
condition of a concern. It plays an important role in measuring the
comparative significance of the income and position statement. Accounting
ratios are expressed in the form of time, proportion, percentage, or per one
rupee. Ratio analysis is not only a technique to point out relationship
between two figures but also points out the devices to measure the
fundamental strengths or weaknesses of a concern. As james c.van horne
observes: “to evaluate the financial condition and performance of a firm, the
financial analyst needs certain yardsticks. One of the yardsticks frequently
used is a ratio. The main purpose of ratio analysis is to measure past
performance and project future trends. It is also used for inter-firm and
intra-firm comparison as a measure of comparative productivity. The
significance of the various components of financial statements can be
judged only by ratio analysis. The financial analyst x-rays the financial
conditions of a concern by the use of various ratios and if the conditions are
not found to be favourable, suitable steps can be taken to overcome the
limitations. The main objectives of ratio analysis are:

Ֆ To simplify the comparative picture of financial statements.

Ֆ To assist the management in decision making.
Ֆ To guage the profitability, solvency and efficiency of an enterprise, and

Ֆ To ascertain the rate and direction of change and future potentiality.

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2.2.3.5 Classification of Ratios

Financial ratios may be categorised in various ways. Van horne has

divided financial ratios into four categories, viz., liquidity, debt, profitability
and coverage ratios. The first two types of ratios are computed from the
balance sheet. The last two are computed from the income statement and
sometimes, from both the statements. For the purpose of analysis, the
present lesson gives a detailed description of ratios, the formula used for
their computation and their significance. The ratios have been categorised
under the following headings:-
(i) ratios for analysis of capital structure or leverage.
(ii) ratios for fixed assets analysis.
(iii) ratios for analysis of turnover.
(iv) ratios for analysis of liquidity position.
(v) ratios for analysis of profitability.
(vi) ratios for analysis of operational efficiency.

2.2.3.6 Capital Structure or Leverage Ratios

Financial strength indicates the soundness of the financial resources

of an organisation to perform its operations in the long run. The parties
associated with the organisation are interested in knowing the financial
strength of the organisation. Financial strength is directly associated with
the operational ability of the organisation and its efficient management of
resources. The financial strength analysis can be made with the help of the
following ratios:
(1) Debt-equity ratio
(2) Capital gearing ratio
(3) Financial leverage
(4) Proprietary ratio and
(5) Interest coverage.

Debt-Equity Ratio:

The debt-equity ratio is determined to ascertain the soundness of the

long-term financial policies of the company. This ratio indicates the
proportion between the shareholders’ funds (i.e. Tangible net worth) and the
total borrowed funds. Ideal ratio is 1. In other words, the investor may take
debt equity ratio as quite satisfactory if shareholders’ funds are equal

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to borrowed funds. However, creditors would prefer a low debt-equity ratio
as they are much concerned about the security of their investment. This ratio
can be calculated by dividing the total debt by shareholders’ equity. For the
purpose of calculation of this ratio, the term shareholders’ equity includes
share capital, reserves and surplus and borrowed funds which includes both
long-term funds and short-term funds.
Debt
Debt-equity ratio = -----------
Equity

A high ratio indicates that the claims of creditors are higher as compared to
owners’ funds and a low debt-equity ratio may result in a higher claim of
equity.

Capital Gearing Ratio: This ratio establishes the relationship

between the fixed interest-bearing securities and equity shares of a
company. It is calculated as follows:
Fixed interest-bearing securities
Capital gearing ratio = -------------------------------------
Equity shareholders’ funds
Fixed-interest bearing securities carry with them the fixed rate of dividend
or interest and include preference share capital and debentures. A firm is
said to be highly geared if the lion’s share of the total capital is in the form
of fixed interest-bearing securities or this ratio is more than one. If this ratio
is less than one, it is said to be low geared. If it is exactly one, it is evenly
geared. This ratio must be carefully planned as it affects the firm’s capacity
to maintain a uniform dividend policy during difficult trading periods that
may occur. Too much capital should not be raised by way of debentures,
because debentures do not share in business losses.

Financial Leverage Ratio:

Financial leverage results from the presence of fixed financial

charges in the firm’s income stream. These fixed charges do not vary with
the earnings before interest and tax (ebit) or operating profits. They have to
be paid regardless of the amount of earnings before interest and taxes
available to pay them. After paying them, the operating profits (ebit) belong
to the ordinary shareholders. Financial leverage is concerned with the
effects of changes in earnings before interest and taxes on the

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earnings available to equity holders. It is defined as the ability of a firm to
use fixed financial charges to magnify the effects of changes in ebit on the
firm’s earning per share. Financial leverage and trading on equity are
synonymous terms. The ebit is calculated by adding back the interest
(interest on loan capital + interest on long term loans + interest on other
loans) and taxes to the amount of net profit. Financial leverage ratio is
calculated by dividing ebit by ebt (earnings before tax). Neither a very high
leverage nor a very low leverage represents a sound picture. (ebit ÷ ebt).

Proprietary Ratio:

This ratio establishes the relationship between the proprietors’ funds

and the total tangible assets. The general financial strength of a firm can be
understood from this ratio. The ratio is of particular importance to the
creditors who can find out the proportion of shareholders’ funds in the
capital assets employed in the business. A high ratio shows that a concern is
less dependent on outside funds for capital. A high ratio suggests sound
financial strength of a firm due to greater margin of owners’ funds against
outside sources of finance and a greater margin of safety for the creditors. A
low ratio indicates a small amount of owners’ funds to finance total assets
and more dependence on outside funds for working capital. In the form of
formula this ratio can be expressed as:-
Net Worth
Proprietary Ratio = --------------
Total Assets

Interest Coverage:

This ratio measures the debt servicing capacity of a firm in so far as

fixed interest on long-term loan is concerned. It is determined by dividing
the operating profits or earnings before interest and taxes (ebit) by the fixed
interest charges on loans. Thus,
EBIT
Interest Coverage = ----------
Interest

It should be noted that this ratio uses the concept of net profits

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before taxes because interest is tax-deductible so that tax is calculated after
paying interest on long-term loans. This ratio, as the name suggests, shows
how many times the interest charges are covered by the ebit out of which
they will be paid. In other words, it indicates the extent to which a fall in
ebit is tolerable in the sense that the ability of the firm to service its debts
would not be adversely affected. From the point of view of creditors, the
larger the coverage, the greater the ability of the firm to handle fixed-charge
liabilities and the more assured the payment of interest to the creditors.
However, too high a ratio may imply unused debt capacity. In contrast, a
low ratio is danger signal that the firm is using excessive debt and does not
have the ability to offer assured payment of interest to the creditors.

2.2.3.7 Fixed Assets Analysis

The successful operation of a business generally requires some

assets of fixed character. These assets are used primarily in producing goods
and in operating the business. With the help of these, raw materials are
converted into finished products. Fixed assets are not meant for sale and are
kept as a rule permanently in the business in order to carry on day-to-day
operations.

Analysis of fixed assets is very important from investors’ point of

view because investors are more concerned with long term assets. Fixed
assets are properties of non-current nature which are acquired to provide
facilities to carry on business. They include land, building, equipment,
furniture, etc. They are generally shown in balance sheet by aggregating
them into groups of gross block as reduced by the accumulated amount of
depreciation till date. Investment in fixed assets is of a permanent nature
and therefore should be financed by owners’ funds (permanent sources of
funds). The owners’ funds should be sufficient to provide for fixed assets.
Fixed assets are generally financed by owners’ equity and long-term
borrowings. The long-term borrowings are in the form of long-term loans
and of almost permanent nature. Under such a situation it becomes more or
less irrelevant to relate the fixed assets with only the owners’ equity.
Therefore, the analysis of the source of financing of fixed assets has been
done with the help of the following ratios:-
(a) Fixed Assets To Net Worth
(b) Fixed Assets To Long-Term Funds

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Fixed Assets To Net Worth: in the words of anil b.roy choudhary, “this ratio
indicates the relationship between net worth (i.e. Shareholders’ funds) and
investments in net fixed assets (i.e. Gross block minus depreciation)”.

The higher the ratio the lesser would be the protection to creditors. If the
ratio is less than 1, it indicates that the net worth exceeds fixed assets. It will
further indicate that the working capital is partly financed by shareholders’
funds. If the ratio exceeds 1, it would mean that part of the fixed assets has
been provided by creditors. The formula for derivation of this ratio is:-
Net Fixed Assets
Fixed Assets To Net Worth Ratio = ------------------
Net Worth

Fixed Assets To Long-Term Funds: this ratio establishes the

relationship
Between the fixed assets and long-term funds and it is obtained by the
formula:
Fixed Assets
FIXED ASSET RATIO = --------------------
Long-Term Funds

The ratio should be less than one. If it is less than one, it shows that
a part of the working capital has been financed through long-term funds.
This is desirable because a part of working capital termed as “core working
capital” is more or less of a fixed nature. The ideal ratio is 0.67.

If this ratio is more than one, it indicates that a part of current

liability is invested in long-term assets. This is a dangerous position. Fixed
assets include “net fixed assets” i.e. Original cost less depreciation to date
and trade investments including shares in subsidiaries. Long-term funds
include share capital, reserves and long-term borrowings.

2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency

Turnover ratios also referred to as activity ratios are concerned with

measuring the efficiency in asset management. Sometimes, these ratios are
also called as efficiency ratios or asset utilisation ratios. The efficiency with
which the assets are used would be reflected in the speed and rapidity with
which assets are converted into sales. The greater the rate

114
of turnover or conversion, the more efficient the utilisation/management,
other things being equal. For this reason such ratios are also designated as
turnover ratios. Turnover is the primary mode for measuring the extent of
efficient employment of assets by relating the assets to sales. An activity
ratio may, therefore, be defined as a test of the relationship between sales
(more appropriately with cost of sales) and the various assets of a firm.
Depending upon the various types of assets, there are various types of
activity ratios. Some of the more widely used turnover ratios are:-
Ֆ Fixed Assets Turnover Ratio
Ֆ Current Assets Turnover Ratio
Ֆ Working Assets Turnover Ratio
Ֆ Inventory (Or Stock) Turnover Ratio
Ֆ Debtors Turnover Ratio
Ֆ Creditors Turnover Ratio

Fixed Assets Turnover Ratio:

The fixed assets turnover ratio measures the efficiency with which
the firm is utilising its investment in fixed assets, such as land, building,
plant and machinery, furniture, etc. It also indicates the adequacy of sales in
relation to investment in fixed assets. The fixed assets turnover ratio is sales
divided by the net fixed assets (i.e., the depreciated value of fixed assets).

Sales
Fixed Assets Turnover Ratio = ----------------
Net Fixed Assets
The turnover of fixed assets can provide a good indicator for judging the
efficiency with which fixed assets are utilised in the firm. A high fixed
assets turnover ratio indicates efficient utilisation of fixed assets in
generating operating revenue. A low ratio signifies idle capacity, inefficient
utilisation and management of fixed assets.

Current Assets Turnover Ratio:

The current assets turnover ratio ascertains the efficiency with which
current assets are used in a business. Professor guthmann observes that
“current assets turnover is to give an overall impression of how rapidly the
total investment in current assets is being turned”. This ratio is strongly
associated with efficient utilisation of costs, receivables and inventory. A

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higher value of this ratio indicates greater circulation of current assets while
a low ratio indicates a stagnation of the flow of current assets. The formula
for the computation of current assets turnover ratio is:
Sales
Current Assets Turnover Ratio = -----------------
Current Assets

Working Capital Turnover Ratio: this ratio shows the number of

times working capital is turned-over in a stated period. Working capital
turnover ratio reflects the extent to which a business is operating on a small
amount of working capital in relation to sales. The ratio is calculated by the
following formula:-

Sales
Working Capital Turnover Ratio = ----------------------
Net Working Capital

The higher the ratio, the lower is the investment in working capital
and greater are the profits. However, a very high turnover of working capital
is a sign of over trading and may put the firm into financial difficulties. On
the other hand, a low working capital turnover ratio indicates that working
capital is not efficiently utilised.

Inventory Turnover Ratio:

The inventory turnover ratio, also known as stock turnover ratio

normally establishes the relationship between cost of goods sold and
average inventory. This ratio indicates whether investment in inventory is
within proper limit or not. In the words of S.C.Kuchal, “this relationship
expresses the frequency with which average level of inventory investment is
turned over through operations”. The formula for the computation of this
ratio may be expressed thus:
Cost Of Goods Sold
Inventory Turnover Ratio = -------------------------
Average Inventory

In general, a high inventory turnover ratio is better than a low ratio.

A high ratio implies good inventory management. A very high

116
ratio indicates under-investment in, or very low level of inventory which
results in the firm being out of stock and incurring high stock-out cost. A
very low inventory turnover ratio is dangerous. It signifies excessive
inventory or over-investment in inventory. A very low ratio may be the
results of inferior quality goods, over-valuation of closing inventory, stock
of unsaleable/obsolete goods.

Debtors Turnover Ratio And Collection Period:

One of the major activity ratios is the receivables or debtors turnover

ratio. Allied and closely related to this is the average collection period. It
shows how quickly receivables or debtors are converted into cash. In other
words, the debtors turnover ratio is a test of the liquidity of the debtors of a
firm. The liquidity of a firm’s receivables can be examined in two ways:
(i) debtors/receivables turnover and (ii) average collection period. The
debtors turnover shows the relationship between credit sales and debtors of
a firm. Thus,
Net Credit Sales
Debtors Turnover Ratio = ---------------------
Average Debtors

Net credit sales consists of gross credit sales minus returns if any,
from the customers. Average debtors is the simple average of debtors at the
beginning and at the end of the year.

The second type of ratio measuring the liquidity of a firm’s debtors

is the average collection period. This ratio is, in fact, interrelated with and
dependent upon, the receivables turnover ratio. It is calculated by dividing
the days in a year by the debtors turnover. Thus,

Days In Year
Average Collection Period = --------------------
Debtors Turnover

This ratio indicates the speed with which debtors/accounts

receivables are being collected. The higher the turnover ratio and shorter the
average collection period, the better the trade credit management and better
the liquidity of debtors. On the other hand, low turnover ratio and

117
long collection period reflects that payments by debtors are delayed. In
general, short collection period (high turnover ratio) is preferable.

Creditors’ Turnover Ratio And Debt Payment Period:

Creditors’ turnover ratio indicates the speed with which the

payments for credit purchases are made to the creditors. This ratio can be
computed as follows:-
Average Accounts Payable
Creditors’ Turnover Ratio = -----------------------------
Net Credit Purchases
The term accounts payable include trade creditors and bills payable.
A high ratio indicates that creditors are not paid in time while a low ratio
gives an idea that the business is not taking full advantage of credit period
allowed by the creditors.

Sometimes, it is also required to calculate the average payment period or

average age of payables or debt period enjoyed to indicate the speed with
which payments for credit purchases are made to creditors. It is calculated
as:
Days In A Year
Average Age Of Payables = --------------------------
Creditors’ Turnover Ratio

Both the creditors’ turnover ratio and the debt payment period
enjoyed ratio indicate about the promptness or otherwise in making payment
for credit purchases. A higher creditors’ turnover ratio or lower credit period
enjoyed ratio signifies that the creditors are being paid promptly.

2.2.3.9 Analysis Of Liquidity Position

The liquidity ratios measure the ability of a firm to meet its short-
term obligations and reflect the short-term financial strength/solvency of a
firm. The term liquidity is described as convertibility of assets ultimately
into cash in the course of normal business operations and the maintenance
of a regular cash flow. A sound liquid position is of primary concern to
management from the point of view of meeting current liabilities as and
when they mature as well as for assuring continuity of operations. Liquidity

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position of a firm depends upon the amount invested in current assets and
the nature of current assets. The under mentioned ratios are used to measure
the liquidity position:-
Ֆ current ratio
Ֆ liquid (or) quick ratio
Ֆ cash to current assets ratio
Ֆ cash to working capital ratio

Current Ratio:

The most widely used measure of liquid position of an enterprise is

the current ratio, i.e., the ratio of the firm’s current assets to current
liabilities. It is calculated by dividing current assets by current liabilities:
Current Assets
Current Ratio = -------------------
Current Liabilities
The current assets of a firm represent those assets which can be in
the ordinary course of business, converted into cash within a short period of
time, normally not exceeding one year and include cash and bank balance,
marketable securities, inventory of raw materials, semi-finished (work-in-
progress) and finished goods, debtors net of provision for bad and doubtful
debts, bills receivable and pre-paid expenses. The current liabilities defined
as liabilities which are short-term maturing obligations to be met, as
originally contemplated, within a year, consist of trade creditors, bills
payable, bank credit, provision for taxation, dividends payable and
outstanding expenses. N.l.hingorani and others observe:
“current ratio is a tool for measuring the short-term stability or ability of
the company to carry on its day-to-day work and meet the short-term
commitments earlier”. Generally 2:1 is considered ideal for a concern i.e.,
current assets should be twice of the current liabilities. If the current assets
are two times of the current liabilities, there will be no adverse effect on
business operations when the payment of current liabilities is made. If the
ratio is less than 2, difficulty may be experienced in the payment of current
liabilities and day-to-day operations of the business may suffer. If the ratio
is higher than 2, it is very comfortable for the creditors but, for the concern,
it indicates idle funds and lack of enthusiasm for work.

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Liquid (Or) Quick Ratio: liquid (or) quick ratio is a measurement of a
firm’s ability to convert its current assets quickly into cash in order to meet
its current liabilities. It is a measure of judging the immediate ability of the
firm to pay-off its current obligations. It is calculated by dividing the quick
assets by current liabilities:
Quick Assets
Liquid Ratio = ---------------------
Current Liabilities

The term quick assets refers to current assets which can be converted
into cash immediately or at a short notice without diminution of value. Thus
quick assets consists of cash, marketable securities and accounts receivable.
Inventories are excluded from quick assets because they are slower to
convert into cash and generally exhibit more uncertainty as to the
conversion price.

This ratio provides a more stringent test of solvency. 1:1 ratio is

considered ideal ratio for a firm because it is wise to keep the liquid assets
atleast equal to the current liabilities at all times.

Cash To Current Assets Ratio:

Efficient management of the inflow and outflow of cash plays a

crucial role in the overall performance of a business. Cash is the most liquid
form of assets which safeguards the security interest of a business. Cash
including bank balances plays a vital role in the total net working capital.
The ratio of cash to working capital signifies the proportion of cash to the
total net working capital and can be calculated by dividing the cash
including bank balance by the working capital. Thus,
Cash
Cash To Working Capital Ratio = --------------------
Working Capital

Cash is not an end in itself, it is a means to achieve the end.

Therefore, only a required amount of cash is necessary to meet day-to-day
operations. A higher proportion of cash may lead to shrinkage of profits due
to idleness of resources of a firm.

120
2.2.3.10 Analysis Of Profitability

Profitability is a measure of efficiency and control. It indicates the

efficiency or effectiveness with which the operations of the business are
carried on. Poor operational performance may result in poor sales and
therefore low profits. Low profitability may be due to lack of control over
expenses resulting in low profits. Profitability ratios are employed by
management in order to assess how efficiently they carry on business
operations. Profitability is the main base for liquidity as well as solvency.
Creditors, banks and financial institutions are interested in profitability
ratios since they indicate liquidity or capacity of the business to meet
interest obligations and regular and improved profits enhance the long term
solvency position of the business. Owners are interested in profitability for
they indicate the growth and also the rate of return on their investments. The
importance of measuring profitability has been stressed by Hingorani,
Ramanathan And Grewal in these words: “a measure of profitability is the
overall measure of efficiency”.

An appraisal of the financial position of any enterprise is incomplete

unless its overall profitability is measured in relation to the sales, assets,
capital employed, net worth and earnings per share. The following ratios are
used to measure the profitability position from various angles:
Ֆ Gross Profit Ratio
Ֆ Net Profit Ratio
Ֆ Return On Capital Employed
Ֆ Operating Ratio
Ֆ Operating Profit Ratio
Ֆ Return On Owners’ Equity
Ֆ Earnings Per Share
Ֆ Dividend Pay Out Ratio

Gross Profit Ratio:

The gross profit ratio or gross profit margin ratio expresses the
relationship of gross profit on sales / net sales. B.r.rao opines that “gross
profit margin ratio indicates the gross margin of profits on the net sales
and from this margin only, all expenses are met and finally net income
emerges”. The basic components for the computation of this ratio are gross
profits and net sales. `net sales’ means total sales minus sales returns

121
and `gross profit’ means the difference between net sales and cost of goods
sold. The formula used to compute gross profit ratio is:
Gross Profit
Gross Profit Ratio = ------------------ X 100
Sales

Gross profit ratio indicates to what extent the selling prices of goods
per unit may be reduced without incurring losses on operations. A low gross
profit ratio will suggest decline in business which may be due to insufficient
sales, higher cost of production with the existing or reduced selling price or
the all-round inefficient management. A high gross profit ratio is a sign of
good and effective management.

Net Profit Ratio:

Net profit is a good indicator of the efficiency of a firm. Net profit

ratio or net profit margin ratio is determined by relating net income after
taxes to net sales. Net profit here is the balance of profit and loss account
which is arrived at after considering all non-operating incomes such as
interest on investments, dividends received, etc. And non-operating
expenses like loss on sale of investments, provisions for contingent
liabilities, etc. This ratio indicates net margin earned on a sale of rs.100. The
formula for calculating the ratio is:

Net Profit
Net Profit Ratio = ---------------- X 100
Sales

This ratio is widely used as a measure of overall profitability and is

very useful for proprietors. A higher ratio indicates better position.

Return On Capital Employed:

The prime objective of making investments in any business is to

obtain satisfactory return on capital invested. Hence, the return on capital
employed is used as a measure of success of a business in realising this
objective. Otherwise known as return on investments, this is the overall
profitability ratio. It indicates the percentage of return on capital employed
in the business and it can be used to show the efficiency of the business as

122
a whole. The formula for calculating the ratio is:

Operating Profit
Return On Capital Employed = --------------------- X 100
Capital Employed
The term “capital employed” means [share capital + reserves and
surplus + long term loans] minus [non-business assets + fictitious assets]
and the term “operating profit” means profit before interest and tax. The
term `interest’ means interest on long-term borrowings. Non-trading income
should be excluded for the above purpose. A higher ratio indicates that the
funds are invested profitably.

Operating Ratio:

This ratio establishes the relationship between total operating

expenses and sales. Total operating expenses includes cost of goods sold
plus other operating expenses. A higher ratio indicates that operating
expenses are high and the profit margin is less and therefore lower the ratio,
better is the position. The operating ratio is an index of the efficiency of the
conduct of business operations. An ideal norm for this ratio is between 75%
to 85% in a manufacturing concern. The formula for calculating the
operating ratio is thus:

Cost Of Goods Sold + Operating Experience

Operating Ratio = ----------------------------------------------------- X 100
Sales

Operating Profit Ratio: this ratio indicates net-margin earned on a sale of

rs.100. It is calculated as follows:
Net Operating Profit
Operating Profit Ratio = ------------------------- X 100
Sales

The operating profit ratio helps in determining the efficiency with

which affairs of the business are being managed. An increase in the ratio
over the previous period indicates improvement in the operational efficiency
of the business provided the gross profit ratio is constant. Operating profit is
estimated without considering non-operating income such as profit on sale
of fixed assets, interest on investments and non-

123
operating expenses such as loss on sale of fixed assets. This is thus, an
effective tool to measure the profitability of a business concern.

Return On Owners’ Equity (Or) Shareholders’ Fund (Or) The Net Worth:

The ratio of return on owners’ equity is a valuable measure for

judging the profitability of an organisation. This ratio helps the shareholders
of a firm to know the return on investment in terms of profits. Shareholders
are always interested in knowing as to what return they earned on their
invested capital since they bear all the risk, participate in management and
are entitled to all the profits remaining after all outside claims including
preference dividend are met in full. This ratio is computed as a percentage
by using the formula:

Net Profit After Interest And Tax

Return On Owners’ Equity = ------------------------------------------ X 100
Owners’ Equity (Net Worth)

This is the single most important ratio to judge whether the firm has
earned a satisfactory return for its equity-shareholders or not. A higher ratio
indicates the better utilisation of owners’ fund and higher productivity. A
low ratio may indicate that the business is not very successful because of
inefficient and ineffective management and over investment in assets.

Earnings Per Share (EPS):

The profitability of a firm from the point of view of the ordinary

shareholders is analysed through the ratio `EPS’. It measures the profit
available to the equity shareholders on a per share basis, i.e. The amount
that they can get on every share held. It is calculated by dividing the profits
available to the shareholders by the number of the outstanding shares. The
profits available to the ordinary shareholders are represented by net profit
after taxes and preference dividend.
Net Profit After Tax – Preference Dividend
Earnings Per Share = ----------------------------------------------------
Number Of Equity Shares

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 This ratio is an important index because it indicates whether the
wealth of each shareholder on a per-share basis has changed over the period.
The performance and prospects of the firm are affected by eps. If eps
increases, there is a possibility that the company may pay more dividend or
issue bonus shares. In short, the market price of the share of a firm will be
affected by all these factors.

Dividend Pay Out Ratio:

This ratio measures the relationship between the earnings belonging

to the ordinary shareholders and the dividend paid to them. In other words,
the dividend pay out ratio shows what percentage share of the net profits
after taxes and preference dividend is paid out as dividend to the equity
shareholders. It can be calculated by dividing the total dividend paid to the
owners by the earnings available to them. The formula for computing this
ratio is:
Dividend Per Equity Share
Dividend Payout Ratio = -------------------------------
Earnings Per Share
This ratio is very important from shareholder’s point of view as its tells him
that if a firm has used whole, or substantially the whole of its earnings for
paying dividend and retained nothing for future growth and expansion
purposes, then there will be very dim chances of capital appreciation in the
price of shares of such firms. In other words, an investor who is more
interested in capital appreciation must look for a firm having low payout
ratio.

2.2.3.11 Analysis Of Operational Efficiency

The operational efficiency of an organisation is its ability to utilise

the available resources to the maximum extent. Success or failure of a
business in the economic sense is judged in relation to expectations, returns
on invested capital and objectives of the business concern. There are many
techniques available for evaluating financial as well as operational
performance of a firm. The two important techniques adopted in this study
are:
1. Turnover to capital employed or return on investment (ROI)
2. Financial operations ratio

125
Turnover To Capital Employed:

This is the ratio of operating revenue to capital employed. This is

one of the important ratios to find out the efficiency with which the firms
are utilising their capital. It signifies the number of times the total capital
employed was turned into sales volumes. The term capital employed
includes total assets minus current liabilities. The ratio for calculating
turnover to capital employed (in percentage) is:
Operating Revenue
Turnover To Capital Employed = --------------------------- X 100
Capital Employed
The higher the ratio, the better is the position.

Financial Operations Ratio:

The efficiency of the financial management of a firm is calculated

through financial operations ratio. This ratio is a calculating device of the
cost and the return of financial charges. This ratio signifies a relationship
between net profit after tax and operating profit. The formula for the
computation of this ratio is:

Net Profit After Tax

Financial Operations Ratio = --------------------------- X 100
Operating Profit
Here, the term “operating profit” means sales minus operating expenses. A
higher ratio indicates the better financial performance of the firm.

2.2.3.12 Ratios From Shareholders’ Point Of View

1. Preference dividend cover: this ratio expresses net profit after tax as so
many times of preference dividend payable. This is calculated as:
Net Profit After Tax
-------------------------
Preference Dividend

2. Equity Dividend Cover: this ratio gives information about net profit
available to equity shareholders. This ratio expresses profit as number of
times of equity dividend payable. This ratio is calculated using

126
the following formula:
Net Profit After Tax – Preference Dividend
-------------------------------------------------
Equity Dividend
3. Dividend Yield On Equity Shares Or Yield Ratio: this ratio interprets
dividend as a percentage of market price per share. It is calculated as:
Dividend Per Share
--------------------------- X 100
Market Price Per Share
4. Price Earning Ratio: this ratio tells how many times of earnings per
share is the market price of the share of a company. The formula to calculate
this ratio is:
Market Price Per Share
---------------------------
Earnings Per Share

2.2.3.13 Illustrations
Illustration 4: the following are the financial statements of yesye limited for
the year 2005.

Balance Sheet As At 31-12-2005

Rs. Rs.
Equity Share Capital 1,00,000 Fixed Assets 1,50,000
General Reserve 90,000 Stock 42,500
Profit & Loss Balance 7,500 debtors 19,000
Sundry Creditors 35,000 Cash 61,000
6% Debentures 30,000 Proposed
Dividends 10,000
2,72,500 2,72,500
---------------------------------------------------------------------------------
Trading And Profit And Loss Account
For The Year Ended 31-12-2005
Rs. Rs.
To Cost Of Goods Sold 1,80,000 By Sales 3 ,00,000
To Gross Profit C/D 1,20,000

3,00,000 3,00,000

127
To Expenses 1,00,000 By Gross Profit B/D 1,20,000
To Net Profit 20,000

1,20,000 1,20,000

You are required to compute the following:

1) Current Ratio
2) Acid Test Ratio
3) Gross Profit Ratio
4) Debtors’ Turnover Ratio
5) Fixed Assets To Net Tangible Worth
6) Turnover To Fixed Assets
Solution:
Current Assets
1) Current Ratio = ---------------------
Current Liabilities

1,22,500
= ----------- = 2.7:1.
45,000

Quick Assets
2) Acid Test Ratio = -------------------
Quick Liabilities

80,000
= ----------- = 1.8:1.
45,000

Gross Profit
3) Gross Profit Ratio = ---------------------- X 100
Sales

1,20,000
= ------------- X 100 = 40%
3,00,000
Net Sales
4) Debtors’ Turnover Ratio = ---------------------
Average Debtors

128
 3,00,000
= ------------- = 15.78 Times.
19,000

No. Of Days In The Year

Collection Period = -----------------------------
Debtors’ Turnover

365
= ----------- = 23 Days
15.78

5) Fixed Asset To Fixed Assets

Net Tangible Worth = ----------------------- X 100
Proprietor’s Fund

1,50,000
= ------------- X 100 = 76%
1,97,500

Net Sales
6) Turnover To Fixed Assets = ------------------
Fixed Assets

3,00,000
= ----------- = 2 Times
1,50,000

Illustration 5: from the following details prepare a statement of proprietary

fund with as many details as possible.
1) Stock Velocity 6
2) Capital Turnover Ratio 2
3) Fixed Assets Turnover Ratio 4
4) Gross Profit Turnover Ratio 20%
5) Debtors’ Velocity 2 Months
6) creditors’ velocity 73 days
Gross profit was rs.60,000. Reserves and surplus amount to 20,000. Closing
stock was rs.5,000 in excess of opening stock.

129
Solution:
1. Calculation Of Sales
Gross Profit
Gross Profit Ratio = --------------- X 100 = 20%
Sales

Rs.60,000 20
= --------------- = --------
Sales 100

1
= ---
5
Sales: Rs.3,00,000

2. Calculation Of Sundry Debtors

Debtors
Debtors’ Velocity = ------------ X 12 Months
Sales
Let Debtors Be X
X
2 = ----------- X 12
3,00,000

X 1
------------- = ---
3,00,000 6

X = Rs.50,000

Debtors: Rs.50,000
It Is Assumed That All Sales Are Credit Sales.

3. Calculation Of Stock
Cost Of Goods Sold
Stock Turnover Ratio = --------------------------- =6
= Average Stock
Cost Of Goods Sold = Sales – Gross Profit
= Rs.3,00,000 – Rs.60,000

130
 = Rs.2,40,000

Rs.2,40,000
------------------ =6
Average Stock

Rs.2,40,000
Average Stock = --------------- = Rs.40,000
6
Opening Stock + Closing Stock
Average Stock = --------------------------------------
2
Let Opening Stock Be Rs.X.
Then Closing Stock Will Be X + 5,000
X + X + 5,000
---------------- = 40,000
2
2X + 5,000
-------------- = 40,000
2
Cross Multiplying
2X + 5,000 = 80,000
2X = 80,000 – 5,000
= 75,000
X = 37,500

4. Calculation Of Creditors
Total Creditors
Creditors’ Velocity = ------------------------------ X 365
Days Credit Purchases
= 73 Days
Purchase = Cost Of Goods + Closing Stock – Opening Stock
= Rs.2,40,000 + 42,500 – 37,500
= Rs.2,45,000

Let The Creditors Be X

X
-------------- X 365 = 73
2,45,000

131
365 X = 2,45,000 X 73

2,45,000 X 73
X = ----------------
365

Creditors = Rs.49,000

5. Calculation Of Fixed Assets

Costs Of Goods Sold
Fixed Assets Turnover Ratio = ----------------------------- =4
Fixed Assets
Let Fixed Assets Be X
2,40,000
---------- = 4
X
X = 60,000
Fixed Assets = Rs.60,000

6. Shareholders’ Fund
Cost Of Goods Sold
Capital Turnover Ratio = ----------------------- =2
Proprietary Fund

2,40,000
--------------------- =2
Proprietary Fund

Proprietary Fund = Rs.1,20,000

Shareholders’ Fund Includes Share Capital, Profit & Reserve.
Share Capital = Shareholders’ Fund – (Profit + Reserve)
= Rs.1,20,000 – Rs.80,000
= Rs.40,000

7. Calculation Of Bank Balance

Shareholders’ Fund + Current Liabilities = Fixed Assets + Current Assets
Rs.1,20,000 + 49,000 = Rs.60,000 + Current Assets
Current Assets = Rs.1,09,000

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Current Assets = Stock + Debtors + Bank
Bank Balance = Current Assets – (Stock +
Debtors)
= Rs.1,09,000– (42,500 + 50,000)
= Rs.1,09,000 – 92,500
= Rs.16,500

Balance Sheet As On …
---------------------------------------------------------------------------------
Liabilities Rs. Assets Rs.
---------------------------------------------------------------------------------
Share Capital 40,000 Fixed Assets 60,000
Reserves & Surplus 20,000 Current Assets:
Profit 60,000 Stock 42,500
Current Liabilities 49,000 Debtors 50,000
Bank 16,500
---------- ------------
1,69,000 1,69,000
---------------------------------------------------------------------------------

Illustration 6: The Following Data Is Furnished:

A) Working Capital Rs.45,000
B) Current Ratio 2.5
C) Liquidity Ratio 1.5
D) Proprietary Ratio – (Fixed Assets To Proprietary Funds) 0.75
E) Overdraft Rs.10,000
F) Retained Earnings Rs.30,000
There Are No Long Term Loans And Fictitious Assets.
Find Out:
1) Current Assets
2) Current Liabilities
3) Fixed Assets
4) Quick Assets
5) Quick Liabilities
6) Stock
7) Equity
Solution:
Current Assets
Current Assets 2.5

133
Current Liability 1.0
---
Working Capital 1.5
If Working Capital Is 1.5, Current Asset Will Be 2.5.
If Working Capital Is Rs.45,000, Current Assets Will Be Rs.75,000
Current Assets = Rs.75,000

Current Liability

Current Liability = Current Assets – Working Capital

= Rs.75,000 – Rs.45,000
= Rs.30,000
Fixed Assets

Shareholders’ Fund+ Current Liabilities = Fixed Assets + Current Assets

Shareholders’ Fund=Fixed Assets + Current Assets – Current Liabilities
= Fixed Assets + Rs.75,000 – Rs.30,000
= Fixed Assets + Rs.45,000
Let The Shareholders’ Fund Be X, Fixed Assets Will Be ¾ X
X = Rs. ¾ X + Rs.45,000
¼X = Rs.45,000
X = Rs.1,80,000
¾X = Rs.1,35,000
Fixed Assets = Rs.1,35,000
Shareholders Funds = Rs.1,35,000 + Rs.45,000
= Rs.1,80,000
Stock

Quick Assets
Liquid Ratio = -------------------
Quick Liabilities
Quick Assets = Current Assets – Stock
Quick Liabilities = Current Liabilities – Bank Overdraft
Let The Value Of Stock Be X.
Quick Assets Rs.75,000 – X
-------------------- = ---------------------
Quick Liabilities 30,000 – 10,000

134
 75,000 - X
= ------------- = 1.5
20,000
Cross Multiplying
75,000 – X = 20,000 X 1.5
75,000 – X = 30,000
X = 45,000
Stock = Rs.45,000
Quick Assets = Rs.75,000 – Rs.45,000
= Rs.30,000
Quick Liabilities = Rs.20,000

Equity

Shareholders’ Fund = Equity + Retained Earnings

Shareholders’ Fund = Rs.1,80,000 (As Calculated)
Retained Earnings = Rs.30,000 (As Given)
Equity = Rs.1,50,000

Illustration 7:

From the following balance sheet of dinesh limited calculate (i)

current ratio (ii) liquid ratio (iii) debt-equity ratio (iv) proprietary ratio, and
(v) capital gearing ratio.
Balance Sheet Of Dinesh Limited As On 31-12-2005
---------------------------------------------------------------------------------
Liabilities Rs. Assets Rs.
---------------------------------------------------------------------------------
Equity share capital 10,00,000 goodwill 5,00,000
6% preference capita l 5,00,000 plant & machinery 6,00,000
Reserves 1,00,000 land & buildings 7,00,000
Profit & loss a/c 4,00,000 furniture 1,00,000
Tax provision 1,76,000 stock 6,00,000
Bills payable 1,24,000 bills receivables 30,000
Bank overdraft 20,000 sundry debtors 1,50,000
Sundry creditors 80,000 bank account 2,00,000
12% debentures 5,00,000 short term investment 20,000
------------ ---------
29,00,000 29,00,000
---------------------------------------------------------------------------------

135
 Current Assets
(I) Current = ------------------------
Ratio Current Liabilities

Stock + Bills Receivables + Debtors + Bank + S.T. Investments

= ----------------------------------------------------------------
S.Creditors + Bills Payable + Bank O.D. + Tax Provision

10,00,000
= ------------ = 2.5 : 1.
4,00,000

Interpretation:

The current ratio in the said firm is 2.5:1 against a standard ratio of
2:1. It is a good sign of liquidity. However, the stock is found occupying 60
percent of current assets which may not be easily realisable.
Current Assets – Stocks
(II) Liquid Ratio = --------------------------------
Current Liabilities
Liquid Assets
= ------------------------
Current Liabilities

4,00,000
= ----------
4,00,000
= 1:1.
Interpretation:

The standard for quick ratio is 1:1. The calculated ratio in case of
dinesh limited is also 1:1. The above two ratios show the safety in respect of
liquidity in the said firm.

Long Term Debt

(III) Debt Equity Ratio = -------------------------------------
Equity Shareholders’ Fund

136
 Debentures
= ---------------------------------------------------------------------------
Equity Capital + Preference Capital + Reserves + Profit & Loss A/C

5,00,000
= -------------------------------------------------------
10,00,000 + 5,00,000 + 1,00,000 + 4,00,000
= 1:4.

Interpretation:

Debt-equity ratio indicates the firm’s long term solvency. It can be

observed that the firm’s long term loans are constituting 25 percent to that
of the owners’ fund. Although such a low ratio indicates better long term
solvency, the less use of debt in capital structure may not enable the firm to
gain from the full stream of leverage effects.
Proprietors’ Funds
(IV) Proprietary Ratio = ---------------------------
Total Assets

20,00,000
= ------------= 20:29
29,00,000

Interpretation:

Out of total assets, seven-tenths are found financed by owners’

funds. In other words a large majority of long term funds are well invested
in various long term assets in the firm.
Owners’ Resources
(V) Capital Gearing Ratio = -------------------------------------------
Fixed-Interest Bearing Resources
Equity Share Capital + Reserves + P&L A/C
= -----------------------------------------------
Preference Capital + Debentures
10,00,000 + 1,00,000 + 4,00,000
= --------------------------------------------
5,00,000 + 5,00,000

137
 15,00,000
= ---------------= 1.5:1.
10,00,000

Interpretation:

Keeping rs.15 lakhs of equity funds as security, the firm is found to

have mobilised rs.10 lakhs from fixed interest bearing sources. It indicates
that the capital structure is low geared.

Illustration 8:

The following are the balance sheet and profit and loss account of
sundara products limited as on 31st december 2005.
Profit And Loss Account
To Opening Stock 1,00,000 By Sales 8,50,000
Purchases 5,50,000 Closing Stock 1,50,000
Direct Expenses 15,000
Gross Profit 3,35,000
------------ ------------
10,00,000 10,00,000
------------ ------------
To Admn. Expenses 50,000 By Gross Profit 3,35,000
Office Establishment 1,50,000 Non-Operating
Income 15,000
Financial Expenses 50,000
Non-Operating
Expenses/Losses 50,000
Net Profit 50,000
----------- -----------
3,50,000 3,50,000
---------------------------------------------------------------------------------

Balance Sheet
Liabilities Rs. Assets Rs.
Equity Share Capital Land & Buildings 1,50,000
(2000 @ 100) 2,00,000 Plant & Machinery 1,00,000
Reserves 1,50,000 Stock In Trade 1,50,000

138
Current Liabilities 1,50,000 Sundry Debtors 1,00,000
P&L A/C Balance 50,000 Cash & Bank 50,000
---------- ----------
5,50,000 5,50,000
---------------------------------------------------------------------------------

Calculate Turnover Ratios.

Solution:

(I) Share Capital To Turnover Ratio

Sales
= ----------------------------------
Total Capital Employed

Sales
= ------------------------------------------------
Equity + Reserve + P & L A/C Balance

8,50,000
= ----------
4,00,000

= 2.13 Times.

Interpretation:

This turnover ratio indicates that the firm has actually converted its
share capital into sales for about 2.13 times. This ratio indicates the
efficiency in use of capital resources and a high turnover ratio ensures good
profitability on operations on an enterprise.
(ii) fixed asset’s turnover ratio
Sales
= ---------------------------
Total fixed assets

139
 Sales
= ------------------------------------
Land + Plant & Machinery

8,50,000
= ------------
2,50,000

= 3.4 times.

Interpretation:

Although fixed assets are not directly involved in the process of

generating sales, these are said to back up the production process. A ratio of
3.4 times indicates the efficient utilisation of various fixed assets in this
organisation.
(iii) Net working capital turnover:
Sales
= ----------------------------
Net Working Capital

Sales
= --------------------------------------------
Current Assets – Current Liabilities

8,50,000
= -----------------------
3,00,000 – 1,50,000

= 5.67 Times.

Interpretation:

Net working capital indicates the excess of current assets financed

by permanent sources of capital. An efficient utilisation of such funds is of
prime importance to ensure sufficient profitability along with greater
liquidity. A turnover ratio of 5.7 times is really appreciable.
(iv) Average Collection Period:

140
 Credit Sales
Debtor’s Turnover = -----------------------
Average Debtors
Assuming that 80% of the sales of 8,50,000 as credit sales:
6,80,000
= ------------
1,00,000

= 6.8 times

Average collection period

360 Days
= -------------------------
Debtors’ Turnover

360
= -------
6.8

= 53 Days

Interpretation:

Average collection period indicates the time taken by a firm in

collecting its debts. The calculated ratio shows that the realisation of cash on
credit sales is taking an average period of 53 days. A period of roughly two
months indicate that the credit policy is liberal and needs a correction.

(v) Stock Turnover Ratio

Cost Of Goods Sold
= ---------------------------
Average Stock
Sales – Gross Profit
= ------------------------------------------------
(Opening Stock + Closing Stock) + 2

5,15,000
= ----------
1,25,000

141
 = 4.12 times.

Interpretation:

Stock velocity indicates the firm’s efficiency and profitability. The

stock turnover ratio shows that on an average inventory balances are cleared
once in 3 months. Since there is no standard for this ratio, the period of
operating cycle of this firm is to be compared with the industry average for
better interpretation.

Illustration 9:

Comment on the performance of arasu limited from the ratios given

below:
Industry average Ratios of
Ratios Arasu ltd.
1. Current ratio 2:1 2.5:1
2. Debt-equity ratio 2:1 1:1
3. Stock turnover ratio 9.5 3.5
4. Net profit margin ratio 23.5% 15.1%

Solution:

(i) Current Ratio:

This ratio indicates the liquidity position of a firm. The ability of a

firm in meeting its current liabilities could be understood by this ratio. The
calculated results show that the liquidity in arasu limited is even greater than
industry average, showing the safety. However, excess liquidity locks up the
capital in unnecessary current assets.
(ii) Debt-Equity Ratio:

It is an indicator of a firm’s solvency in terms of its ability to repay

long term loans in time. The calculated ratio shows better solvency of 1:1
indicating that for every one rupee of debt capital, to repay one rupee of
equity base exists in arasu ltd. However, this ratio is not likely to ensure the
leverage benefits that a firm gains by using higher dose of debt.

142
(iii) Stock Turnover Ratio:

Stock velocity is an indicator of a firm’s activeness. It directly

influences the profitability of a firm. The calculated ratio for arasu ltd. Is
very poor when compared to industry average. This poor ratio indicates the
inefficient use of capacities, consequently, the likely low profitability.

(iv) Net Profit Margin Ratio:

Although the firms in a particular industry could sell the product

more or less at same price, the net profits differ among firms due to their
cost of production, excessive administrative and establishment expenses etc.
This picture is found true in case of arasu ltd. A poor profitability of 15.1%
compared to an industry average of 23.5% may be due to low stock
turnover, inefficiency in management, excess overhead cost and excessive
interest burdens.

2.2.3.14 Summary

Financial statements by themselves do not give the required

information both for internal management and for outsiders. They must be
analysed and interpreted to get meaningful information about the various
aspects of the concern. Analysing financial statements is a process of
evaluating the relationship between the component parts of the financial
statements to obtain a proper understanding of a firm’s performance.
Financial analysis may be external or internal analysis or horizontal or
vertical analysis. Financial analysis can be carried out through a number of
tools like ratio analysis, funds flow analysis, cash flow analysis etc. Among
the various tools available for their analysis, ratio analysis is the most
popularly used tool. The main purpose of ratio analysis is to measure past
performance and project future trends. It is also used for inter-firm and
intra-firm comparison as a measure of comparative productivity. The
financial analyst x-rays the financial conditions of a concern by the use of
various ratios and if the conditions are not found to be favourable, suitable
steps can be taken to overcome the limitations.

2.2.3.15 Key Words

Analysis: analysis means methodical classification of the data given

143
in the financial statements.

Interpretation: interpretation means explaining the meaning and

significance of the data so classified.

Financial Statements: income statement and balance sheet.

Ratio: the relationship of one item to another expressed in simple
mathematical form is known as a ratio.

Ratio Analysis: the process of computing, determining and presenting the

relationship of items and groups of items in financial statements.

Financial Leverage: the ability of a firm to use fixed financial charges to

magnify the effects of changes in ebit on the firm’s earnings per share.

Net Worth: proprietors’ funds – intangible assets – fictitious assets.

Debt: both long term and short term liabilities.

Operating Profit: gross profit – operating expenses.

Equity: proprietors’ fund.

Capital Employed: net worth + long term liabilities.

2.2.3.16 Self Assessment Questions

1. Explain the meaning of the term `financial statements’. State their nature
and limitations.
2. Explain the different types of financial analysis.
3. Explain the various tools of financial analysis.
4. Justify the need for analysis and interpretation of financial statements.
5. Collect the annual reports of any public limited company for a period of
5 years. Calculate the trend percentages and prepare a report.
6. What is meant by ratio analysis? Explain its significance in the analysis
and interpretation of financial statements.
7. Explain the importance of ratio analysis in making comparisons between
firms.
8. How are the ratios broadly classified? Explain how ratios are calculated
under each classification.
9. What are the limitations of ratio analysis?

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10. From the below given summary balance sheet, calculate current ratio
and long term solvency ratio.

Balance Sheet As On 31st December 2005

Liabilities Rs. Assets Rs.
Share Capital 4,00,000 Fixed Assets 4,00,000
Long Term Loans 2,00,000 Current Assets 4,00,000
Current Liabilities 2,00,000
---------- -----------
8,00,000 8,00,000
---------------------------------------------------------------------------------
11. From the following trading and profit and loss account and balance
sheet calculate (i) stock turnover ratio (ii) debtors’ velocity (iii) sales to
working capital (iv) sales to total capital employed (v) return on investment
(vi) current ratio (vii) net profit ratio and (viii) operating ratios.

Trading And Profit And Loss Account

Rs. Rs.
To Opening Stock 1,00,000 By Sales 10,00,000
To Purchase 5,50,000 By Closing Stock 1,50,000
To Gross Profit 5,00,000
----------- ------------
11,50,000 11,50,000
By Gross Profit 5,00,000
Admn. Expenses 1,50,000
Interest 30,000
Selling Expenses 1,20,000
Net Profit 2,00,000
5,00,000 5,00,000
---------------------------------------------------------------------------------

Balance Sheet
Share capital 10,00,000 Land & Building 5,00,000
Profit & loss a/c 2,00,000 Plant & Machinery 3,00,000
S.creditors 2,50,000 Stock 1,50,000
Bills payable 1,50,000 Debtors’ 1,50,000
Bills receivable 1,25,000
Cash in hand 1,75,000
Furniture 2,00,000

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 16,00,000 16,00,000
--------------------------------------------------------------------------------- 12.
Triveni engineering limited has the following capital structure:
9% preference shares of rs.100 each 10,00,000
Equity shares of rs.10 each 40,00,000
-----------
50,00,000
-----------
The following information relates to the financial year just ended:
Profit after taxation 22,00,000
Equity dividend paid 20%
Market price of equity shares rs.20 each
You are required to find
(A) Dividend Yield On Equity Shares
(B) The Cover For Preference And Equity Dividend
(C) Earnings Per Share
(D) P/E Ratio

2.2.3.17 Key To Self Assessment Questions (For Problems Only)

Q.no.10: current ratio: 2:1; debt equity ratio: 1:2 or 1:1.

Q.no.11: (i) 4 times; (ii) 100 days; (iii) 5 times; (iv) 0.83 times; (v)
19.17%; (vi) 1.5:1; (vii) 20%; (viii) 77%.
Q.no.12: (a) 10%; (b) 24.4 times and 2.6 times (c) rs.5.275; (d) 3.8
times.

2.2.3.18 Case Analysis

The following figures are extracted from the balance sheets of a

Company:

2002-03 2003-04 2004-05

Rs. Rs. Rs.
Assets

Buildings 12,000 10,000 20,000

Plant And Equipment 10,000 15,000 10,000
Stock 50,000 50,000 70,000

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Debtors 30,000 50,000 60,000
-----------------------------------------------
1,02,000 1,25,000 1,60,000
-----------------------------------------------
Liabilities

Paid up capital (rs.10 shares – 56,000 56,000 56,000

Rs.7-50 paid up)
Profit & loss a/c 10,000 13,000 15,000
Trade creditors 11,000 26,000 39,000
Bank 25,000 30,000 50,000
1,02,000 1,25,000 1,60,000

Sales 1,00,000 1,50,000 1,50,000

Gross profit 25,000 30,000 25,000
Net profit 5,000 7,000 5,000
Dividend paid 4,000 4,000 3,000

The opening stock at the beginning of the year 2002-03 was

rs.4,000. As a financial analyst comment on the comparative short-term,
activity, solvency, profitability and financial position of the company during
the three year period.

Solution:

To test the short-term solvency the following ratios are calculated for
three years:
I. Current ratio and
Ii. Quick ratio

(i) Current Ratio:

2002-03 2003-04 2004-05
Current assets 80,000 1,00,000 1,30,000
------------------------ -------- ----------- ---------
Current liabilities 36,000 56,000 89,000
2.22:1 1.80:1 1.46:1
(ii) Quick Ratio:
2002-03 2003-04 2004-05

147
Quick assets (debtors) 30,000 50,000 60,000
------------------------------- ------- -------- --------
Quick liabilities (creditors) 11,000 26,000 39,000
2.7:1 1.9:1 1.5:1

As the standard for current ratio is 2:1 the working capital position
of the company has weakened in the 2nd year and 3rd year. However the
quick ratio for all the three years is well above the standard of 1:1. Thus it
can be said that the short term solvency position of the company shows a
mixed trend.

Activity Ratios:

To test the operational efficiency of the company the following

ratios are calculated. Debtors turnover ratio and inventory turnover ratio.

Debtors Turnover Ratio:

2002-03 2003-04 2004-05
Sales 1,00,000 1,50,000 1,50,000
-------------------- ---------- ---------- ---------
Average Debtors 30,000 40,000 55,000
3.33 Times 3.75 Times 2.73 Times
The sales as a number of times of debtors has improved in the year 2003-04
but has deteriorated in the year 2004-05.

Inventory Turnover Ratio:

2002-03 2003-04 2004-05
Cost Of Goods Sold (Sales – G.P.) 75,000 1,20,000 1,25,000
------------------------------------- --------- ---------- ---------
O.S + C.S 27,000 50,000 60,000
Average Stock (-------------- )
2 2.78 Times 2.40 Times 2.08 Times

Though there is no standard for inventory turnover ratio, higher the ratio,
better is the activity level of the concern. From this angle the ratio has come
down gradually during the three year period indicating slow moving of
stock.

148
Profitability Ratios:
To analyse the profitability position of the company, gross profit
ratio and net profit ratio are calculated.

Gross Profit Ratio:

2002-03 2003-04 2004-05

Gross Profit 25,000 30,000 25,000
-------------- X 100 ----------- ---------- ----------
Sales 1,00,000 1,50,000 1,50,000
25% 20% 16.7%

Net Profit Ratio:

2002-03 2003-04 2004-05
Net Profit 5,000 7,000 5,000
------------ X 100 ---------- ---------- ---------
Sales 1,00,000 1,50,000 1,50,000
5% 4.7% 3.3%

The profitability ratios show that there is steady decline in the profitability
of the concern during the period. One reason for this declining profitability
among others, is the low and decreasing inventory turnover ratio.

Financial Position: here the long term solvency position of the concern is
analysed by calculating debt/equity ratio and debt/asset ratio.

Debt/Equity Ratio:
2002-03 2003-04 2004-05
Debt 36,000 56,000 89,000
--------- -------- -------- --------
Equity 66,000 69,000 71,000
0.545:1 0.812:1 1.254:1
Debt/Asset Ratio:
2002-03 2003-04 2004-05
Debt 36,000 56,000 89,000
--------- --------- ----------- ---------
Assets 1,02,000 1,25,000 1,61,000
0.35:1 0.448:1 0.556:1

149
 Debt equity ratio expresses the existence of debt for every re.1 of
equity. From this standpoint the share of debt in comparison to equity is
increasing year after year and in the last year the debt is even more than
equity. Debt asset ratio gives how much of assets have been acquired using
debt funds. The calculation of this ratio reveals that in the 1st year 35% of
assets were purchased using debt funds which has increased to 44.8% in the
2nd year and 55.6% in the 3rd year. Thus both the ratios reveal that the debt
component in the capital structure is increasing which has far reaching
consequences.

2.2.3.19 Books For Further Reading

1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.

2. Khan & Jain: Management Accounting, Tata Mcgraw Hill Publishing
Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
6. S.Chand & Co. New Delhi.

*****

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 Unit-III

Lesson 3.1: Funds Flow Analysis And Cash Flow Analysis

3.1.1 Introduction

At the end of each accounting period, preparation and presentation

of financial statements are undertaken with an objective of providing as
much information as possible for the public. The balance sheet presents a
snapshot picture of the financial position at a given point of time and the
income statement shows a summary of revenues and expenses during the
accounting period. Though these are significant statements especially in
terms of the principal goals of the enterprise, yet there is a need for one
more statement which will indicate the changes and movement of funds
between two balance sheet dates which are not clearly mirrored in the
balance sheet and income statement. That statement is called as funds flow
statement. The analysis which studies the flow and movement of funds is
called as funds flow analysis. Similarly one more statement has to be
prepared known as cash flow statement. This requires the doing of cash flow
analysis. The focus of cash flow analysis is to study the movement and flow
of cash during the accounting period. This lesson deals at length both the
analyses.

3.1.2 Objectives

Ֆ After reading this lesson, the reader should be able to

Ֆ understand the concept of funds and flow.
Ֆ evaluate the changes in working capital in an organization.
Ֆ ascertain the sources and uses of funds from a given financial
Ֆ statement.
Ֆ prepare fund flow statement.
Ֆ understand the concepts of cash and cash flow.
Ֆ understand the cash flow analysis.
Ֆ prepare cash flow statement.

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3.1.3 Contents
3.3.3.1 Concept Of Funds
3.3.3.2. Flow Of Funds
3.3.3.3 Importance And Utility Of Funds Flow Analysis
3.3.3.4 Preparation Of Funds Flow Statement
3.3.3.5 Illustrations
3.3.3.6 Meaning Of Concepts Of Cash, Cash Flow And Cash Flow
Analysis
3.3.3.7 Cash Flow Statement
3.3.3.8 Calculation Of Cash From Operations
3.3.3.9 Utility Of Cash Flow Analysis
3.3.3.10 Cash Flow Analysis Vs. Funds Flow Analysis
3.3.3.11 Illustrations
3.3.3.12 Summary
3.3.3.13 Key Words
3.3.3.14 Self Assessment Questions
3.3.3.15 Key To Self Assessment Questions
3.3.3.16 Case Analysis
3.3.3.17 Books For Further Reading

3.1.3.1 Concept Of Funds

How are funds defined? Perhaps the most ambiguous aspect of funds
flow statement is understanding what is meant by funds. Unfortunately
there is no general agreement as to precisely how funds should be defined.
To a lay man the concept of funds means `cash’. According to a few, `funds’
means `net current monetary assets’ arrived at by considering current
assets (cash + marketable securities + short term receivables) minus short
term obligations. A third view, which is the most acceptable one, is that
concept of funds means `working capital’ and in this lesson the term
`funds’ is used in the sense of
Working capital.

Working Capital Concept Of Funds

The excess of an enterprise’s total current assets over its total current
liabilities at some point of time may be termed as its net current assets or
working capital. To illustrate this, let us assume that on the balance sheet
date the total current assets of an enterprise are rs.3,00,000 and its total

152
current liabilities are rs.2,00,000. Its working capital on that date will be
rs.3,00,000 – rs.2,00,000 = rs.1,00,000. It follows from the above, that any
increase in total current assets or any decrease in total current liabilities will
result in a change in working capital.

3.1.3.2 Flow Of Funds

The term `flow’ means change and therefore, the term `flow of
funds’ means `change in funds’ or `change in working capital’. According to
manmohan and goyal, “the flow of funds” refers to movement of funds
described in terms of the flow in and out of the working capital area. In
short, any increase or decrease in working capital means `flow of funds’.
Many transactions which take place in a business enterprise may increase its
working capital, may decrease it or may not effect any change in it. Let us
consider the following examples.

(i) Purchased Machinery For Rs.3,00,000:

The effect of this transaction is that working capital decreases by

3,00,000 as cash balance is reduced. This change (decrease) in working
capital is called as application of funds. Here the accounts involved are
current assets (cash a/c) and fixed asset (machinery a/c).

(ii) Issue Of Share Capital Of Rs.10,00,000:

This transaction will increase the working capital as cash balance

increases. This change (increase) in working capital is called as source of
funds. Here the two accounts involved are current assets (cash a/c) and
long-term liability (share capital a/c).

(iii) Sold Plant For Rs.3,00,000:

This transaction will have the effect of increasing the working

capital by rs.3,00,000 as the cash balance increases by rs.3,00,000. It is a
source of funds. Here the accounts involved are current assets (cash a/c) and
fixed assets (plant a/c).

153
(iv) Redeemed Debentures Worth Rs.1,00,000:

This transaction has the effect of reducing the working capital, as the
redemption of debentures results in reduction in cash balance. Hence this is
an example of application of funds. The two accounts affected by this
transaction are current assets (cash a/c) and long-term liability (debenture
a/c).

(v) Purchased Inventory Worth Rs.10,000:

This transaction results in decrease in cash by rs.10,000 and increase

in stock by rs.10,000 thereby keeping the total current assets at the same
figure. Hence there will be no change in the working capital (there is no
flow of funds in this transaction). Both the accounts affected are current
assets.

(vi) Notes Payable Drawn By Creditors Accepted For Rs.30,000:

The effect of this transaction on working capital is nil as it results in

increase in notes payable (a current liability) and decreases the creditors
(another current liability). Since there is no change in total current liabilities
there is no flow of funds.

(vii) Building Purchased For Rs.30,00,000 And Payment Is Made

By Shares:

This transaction will not have any impact on working capital as it

does not result in any change either in the current asset or in the current
liability. Hence there is no flow of funds. The two accounts affected are
fixed assets (building a/c) and long term liabilities (capital a/c).
From the above series of examples, we arrive at the following rules on flow
of funds:

I. There Will Be Flow Of Funds Only When There Is A Cross-Transaction

I.E., Only When The Transaction Involves:

Ֆ Current Assets And Fixed Assets E.G., Purchase Of Machinery For Cash
(Application Of Funds) Or Sale Of Plant For A Cash (Source Of Funds).

154
 Ֆ Current Assets And Capital, E.G., Issue Of Shares (Source Of Funds).

Ֆ Current Assets And Long Term Liabilities, E.G., Redemption Of

Debentures In Cash (Application Of Funds).
Ֆ Current Liabilities And Long-Term Liabilities, E.G., Creditors Paid Off
In Debentures Or Shares (Source Of Funds).
Ֆ Current Liabilities And Fixed Assets, E.G., Building Transferred To
Creditors In Satisfaction Of Their Claims (Source Of Funds).

Ii. There Will Be No Flow Of Funds When There Is No Cross

Transaction I.E., When The Transaction Involves:

Ֆ Current Assets And Current Assets, E.G., Inventory Purchased For Cash.

Ֆ Current Liabilities And Current Liabilities, E.G., Notes Payable Issued To

Creditors.
Ֆ Current Assets And Current Liabilities, E.G., Payments Made To
Creditors.
Ֆ Fixed Assets And Long Term Liabilities, E.G., Building Purchased And
Payment Made In Shares Or Debentures.

(a) Sources And Application Of Funds: the following are the main sources
of funds:
(i) Funds From Operations: the operations of the business generate
revenue and entail expenses. Revenues augment working capital and
expenses other than depreciation and other amortizations. The following
adjustments will be required in the figures of net profit for finding out the
real funds from operations:

Funds From Operations

Net profit for the year x x x
Add*: depreciation of fixed assets x x x
Preliminary expenses, goodwill, etc.
Written off x x x
Loss on sale of fixed assets x x x
Transfers to reserve x x x
Less: profit on sale or revaluation x x x
Dividends received, etc. X x x
Funds from operations x x x

155
* these items are added as they do not result in outflow of funds. In case of
`net loss’ for the year these items will be deducted.
(ii) Issue Of Share Capital: an issue of share capital results in an
inflow of funds.

(iii) Long-Term Borrowings: when a long-term loan is taken, there

is an increase in working capital because of cash inflow. A short term loan,
however, does not increase the working capital because a short-term loan
increases the current assets (cash) and the current liability (short term loan)
by the same amount, leaving the size of working capital unchanged.

(iv) Sale Of Non-Current Assets: when a fixed asset or a long-term

investment or any other non-current asset is sold, there will be inflow
represented by cash or short-term receivables.

(b) Uses Of Funds: the following are the main uses of funds:
(i) Payment Of Dividend: the transaction results in decrease in
working capital owing to outflow of cash.

(ii) Repayment Of Long-Term Liability:

The repayment of long-term loan involves cash outflow and
hence it is used for working capital. The repayment of a current liability
does not affect the amount of working capital because it entails an equal
reduction in current liabilities and current assets.

(iii) Purchase Of Non-Current Assets:

when a firm purchases fixed assets or other non-current assets, and

if it pays cash or incurs a short-term debt, its working capital decreases.
Hence it is a use of funds.

3.1.3.3 Importance And Utility Of Funds Flow Analysis

Funds flow analysis provides an insight into the movement of funds and
helps in understanding the change in the structure of assets, liabilities and
owners’ equity. This analysis helps financial managers to find answers to
questions like:
(i) how far capital investment has been supported by long term
financing?

156
 (ii) how far short-term sources of financing have been used to
support capital investment?
(iii) how much funds have been generated from the operations of a
business?
(iv) to what extent the enterprise has relied on external sources of
financing?
(v) what major commitments of funds have been made during the
year?
(vi) where did profits go?
(vii) why were dividends not larger?
(viii) how was it possible to distribute dividends in excess of current
earnings or in the presence of a net loss during the current period?
(ix) why are the current assets down although the income is up?
(x) has the liquidity position of the firm improved?
(xi) what accounted for an increase in net current assets despite a net
loss for the period?
(xii) how was the increase in working capital financed?

3.1.3.4 Preparation Of Funds Flow Statement

Two statements are involved in funds flow analysis.

(I) Statement Or Schedule Of Changes In Working Capital
(II) Statement Of Funds Flow
(a) Statement Of Changes In Working Capital:

This statement when prepared shows whether the working capital

has increased or decreased during two balance sheet dates. But this does not
give the reasons for increase or decrease in working capital. This statement
is prepared by comparing the current assets and the current liabilities of two
periods. It may be shown in the following form:

Schedule Of Changes In Working Capital (Proforma)

Items As on As on Change
Current Assets Increase Decrease
Cash Balances
Bank Balances
Marketable Securities
Stock In Trade
Pre-Paid Expenses

157
Current Liabilities
Bank Overdraft
Outstanding Expenses
Accounts Payable
Provision For Tax
Dividend
Increase / Decrease In
Working Capital

Any increase in current assets will result in increase in working

capital and any decrease in current assets will result in decrease in working
capital. Any increase in current liability will result in decrease in working
capital and any decrease in current liability will result in increase in working
capital.

(b) Funds Flow Statement:

Funds flow statement is also called as statement of changes in

financial position or statement of sources and applications of funds or where
got, where gone statement. The purpose of the funds flow statement is to
provide information about the enterprise’s investing and financing activities.
The activities that the funds flow statement describes can be classified into
two categories:

(i) activities that generate funds, called sources, and

(ii) activities that involve spending of funds, called uses.
When the funds generated are more than funds used, we get an
increase in working capital and when funds generated are lesser than the
funds used, we get decrease in working capital. The increase or decrease in
working capital disclosed by the schedule of changes in working capital
should tally with the increase or decrease disclosed by the funds flow
statement.

The funds flow statement may be prepared either in the form of a

statement or in `t’ shape form. When prepared in the form of statement it
would appear as follows:

158
 Funds Flow Statement
Sources Of Funds
Issues of shares x x x
Issue of debentures x x x
Long term borrowings x x x
Sale of fixed assets x x x
*operating profit
(funds from operations) x x x
Total sources x x x

Application Of Funds

Redemption of redeemable
Preference shares x x x
Redemption of debentures x x x
Payments for other long-term loans x x x
Purchase of fixed assets x x x
* operation loss (funds lost from x x x
Operations) -------------------------
Total uses x x x
--------------------------
Net increase / decrease in working capital
(total sources – total uses)
When prepared in `t’ shape form, the funds flow statement would
Appear as follows:
Funds Flow Statement
Sources Of Funds Application Of Funds
* Funds From Operation x x x *Funds Lost In Operations xx x
Issue Of Shares x x x Redemption Of
Preference Shares xxx
Issue Of Debentures x x x Redemption Of Debentures xxx
Long-Term Borrowings x x x Payment Of Other Long-Term
Loans xxx
Sale Of Fixed Assets x x x Purchase Of Fixed Assets xxx
* Decrease In Working Payment Of Dividend, Tax,
Capital x x x Etc. xxx
Increase In Working Capital xxx
--------------------------------------------------------------------------------- *Only
One Figure Will Be There.

159
 It may be seen from the proforma that in the funds flow statement
preparation, current assets and current liabilities are ignored. Attention is
given only to change in fixed assets and fixed liabilities.

In this connection an important point about provision for

taxation and proposed dividend is worth mentioning. These two may
either be treated as current liability or long-term liability. When treated as
current liabilities they will be taken to `schedule of changes in working
capital’ and thereafter no adjustment is required anywhere. If they are
treated as long-term liabilities there is no place for them in the schedule of
changes in working capital. The amount of tax provided and dividend
proposed during the current year will be added to net profits to find the
funds from operations. The amount of actual tax and dividend paid will be
shown as application of funds in the funds flow statement. In this lesson, we
have taken them as current liabilities.

3.1.3.5 Illustrations

Illustration 1: the mechanism of preparation of funds flow statement is

proposed to be explained with the help of annual reports for the years 2010-
11 and 2011-12 pertaining to arasu limited.

160
 Arasu limited
Balance sheet as at 31st march
Rs.2000
2011-12 2010-11
Source of
funds
1. Share capital 1,40,00 1,40,00
2. Reserves and
surplus 2,77,84 2,30,62
--------- - --------
4,17,84 3,70,62
---------- ---------
Ii. Application
of funds
1. Fixed assets 4,83,15 4,61,23
Less: dep.
Provision

2. Investments

2,57,85 2,25,30 2,27,36 2,33,87

--------- ---------
20,25 20,30
3. Current Assets,
Loans And Advances
Inventories 1,52,83 1,92,54
Debtors 51,41 64,29
Cash And Bank 1,40,80 18,46
Loans & Advances 17,82 14,73
--------- ---------
3,62,86 2,90,02
--------- ---------
Less: Current Liabilities
& Provisions
Liabilities 89,81 76,70
Provisions 100,76 96,87
--------- ---------
1,90,57 1,73,57
--------- ---------

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182
Net Current Assets 1,72,29 1,16,45
--------- ---------
(Working Capital) 4,17,84 3,70,62

---------------------------------------------------------------------------------

Profit And Loss Account

For The Year Ended 31St March
Rs.`000
---------------------------------------------------------------------------------
2011-12 2010-11
---------------------------------------------------------------------------------
Income
Sales 4,94,19 5,36,63
Other Income 2,35,73 2,57,64
------------------------------------
7,29,92 7,94,27
------------------------------------
Expenditure
Opening Stock 20,45 25,59
Raw Materials Consumed 87,35 95,67
Packing Materials Consumed 2,87,78 3,29,04
Excise Duty 23,90 27,26
Expenses 1,65,38 1,29,94
Directors’ Fees 11 10
Interest 94 5,69
Depreciation 30,49 39,98
-------------------------------------
6,16,40 6,53,27
Less: Closing Stock 19,06 20,45
------------------------------------
5,97,34 6,32,82
------------------------------------
Profit Before Taxation 1,32,58 1,61,45
Provision For Income-Tax (64,36) (82,40)
------------------------------------
68,22 79,05
Profit Brought Forward From

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Previous year 12 1
------------------------------------
Balance 68,34 79,06
183
Provision for taxation
Relating to earlier year ---- (46,27)
Miscellaneous expenditure
Written off ---- (15,67)
---------------------------------
Balance available for
Appropriation 68,34 17,12
---------------------------------
Appropriations
General reserve 47,25 3,00
Proposed reserve for appropriation 21,00 14,00
---------------------------------
68,25 17,00
---------------------------------
Balance carried over to next year 9 12
---------------------------------------------------------------------------------
----------------
For the above financial statements, funds flow statement is prepared as
Follows with necessary workings:

I. Calculation Of Funds From Operations For The Year 2011-12

(Rs.`000)
Balance of profit carried over to next year 9
Add: provision for depreciation 30,49
Transfer to general reserves 47,25
-------
77,83
Less: balance of profit brought forward from previous year 12
-------
Funds from operations 77,71
-------
Note: provision for income-tax and proposed dividend are taken as current
liabilities. Hence they are not added here. They will be taken to schedule of
Changes in working capital.

163
Ii. Fixed Assets: from a perusal of schedule relating to `fixed assets’ in the
annual report, it is ascertained that there was a sale of fixed assets
amounting to rs.16,62,000 and purchase of fixed assets to the tune of
rs.38,54,000. These will be shown as source and application of funds
respectively. (in examination problems information about, sale and purchase
of assets can be ascertained by preparing respective asset accounts).

Iii. Investments:

A similar perusal of schedule relating to `investments’ gives information

that there was a redemption of investment amounting to rs.5,000 which is a
source of fund.

Now the schedule of changes in working capital and funds flow

Statement are prepared.

Arasu Limited
Schedule Of Changes In Working Capital 2011-12
(Rs.`000)
2010-11 2011-12 Increase Decrease
Current Assets
Inventories 1,92,54 1,52,83 --- 39,71
Debtors 64,29 51,41 --- 12,88
Cash and
Bank 18,46 1,40,80 1,22,34 ---
Loans and
Advances 14,73 17,82 3,09 ---

(A) Total Of -------------------------

Current Assets 2,90,02 3,62,86
-------------------------
Current Liabilities
Creditors 75,43 88,81 --- 13,38
Unpaid
Dividend 1,27 1,00 27 ---
Provision for
Tax 82,87 79,76 3,11 ---
Proposed
Dividend 14,00 21,00 --- 7,00

164
 -------------------------
(b) Total Of Current 1,73,57 1,90,57
liabilities -------------------------
Working
Capital (a)-(b) 1,16,45 1,72,29 --- ---
Increase in working
Capital 55,84 --- --- 55,84
--------------------------------------------------------------------------
1,72,29 1,72,29 1,28,81 1,28,81
--------------------------------------------------------------------------

Arasu Limited
Funds Flow Statement 2011-12
Sources Applications
Rs. Rs.
Funds from operations 77,71 purchase of fixed assets 38,54
Sale of fixed assets 16,62 increase in working
capital 55,84
Redemption of investment 5
------- -------
94,38 94,38
---------------------------------------------------------------------------------
It may be seen from the above statement that sources amount to
rs.94,38,000 and applications amount to rs.38,54,000, thereby resulting in
an increase in working capital amounting to rs.55,84,000. This figure tallies
with the increase in working capital as shown by the schedule of changes in
working capital.

Illustration 2:

The balance sheet of mathi limited for two years was as follows:
Liabilities Assets
---------------------------------------------------------------------------------
2010 2011 2010 2011
---------------------------------------------------------------------------------
Share Capital 40,000 60,000 Land & 27,700 56,600
Buildings
Share Premium 4,000 6,000 Plant & 17,800 25,650
Machinery

165
General Reserve 3,000 4,500 Furniture 1,200 750
Profit & Loss A/C 9,750 10,400 Stock 11,050 13,000
5% Debentures --- 13,000 Debtors 18,250 19,550
Creditors 16,750 18,200 Bank 2,400 2,000
Provision For 4,900 5,450
Taxation --------------------- -----------------------------
78,400 1,17,550 78,400 1,17,550
---------------------------------------------------------------------------------

Additional Information

Depreciation written off during the year was:

Plant and machinery rs.6,400
Furniture rs. 200
Prepare: a schedule of changes in working capital and a statement of sources
and application of funds.

Schedule Of Changes In Working Capital

Working Capital
2010 2011 Increase Decrease
Rs. Rs. Rs. Rs.
---------------------------------------------------------------------------------

Current Assets
Stock 11,050 13,000 1,950
Debtors 18,250 19,550 1,300
Bank 2,400 2,000 400
---------------------------------------------------------
(a) 31,700 34,550
---------------------------------------------------------
Current Liabilities
Creditors 16,750 18,200 1,450
Provision for
Taxation 4,900 5,450 550
------------------------
(b) 21,650 23,650
------------------------
Working capital
(a) – (b) 10,050 10,900

166
Increase in working
Capital 850 850
---------------------------------------------------------------------------------
10,900 10,900 3,250 3,250
---------------------------------------------------------------------------------
Calculation Of Funds From Operations

Profit And Loss A/C As On 31-12-2011 10,400

Add: Transfer To Reserve 1,500
Depreciation – Plant & Machinery
6,400 Furniture 200
18,500
Less: P&L A/C As On 1-1-2011 9,750
---------
Funds From Operations 8,750
---------
Land & Building A/C
To Balance B/D 27,700 By Balance C/D 56,600
To Bank Purchase 28,900
(Balancing Figure) -------- --------
56,600 56,600
-------- --------
Plant & Machinery A/C
To Balance B/D 17,800 By Depreciation 6,400
To Bank Purchase 14,250 By Balance C/D 25,650
(Balancing Figure) -------- --------
32,050 32,050
-------- --------
---------------------------------------------------------------------------------
Furniture A/C
To Balance B/D 1,200 By Depreciation 200
By Bank – Sale 250
(Balancing Figure)
By Balance C/D 750
------- -------
1,200 1,200
---------------------------------------------------------------------------------

167
Statement of Sources And Application of Funds
Sources Rs. Applications Rs.
Funds From Operations 8,750 Purchase Of Land & 28,900
Share Capital 20,000 Buildings
Share Premium 2,000 Purchase Of Plant & 14,250
Debentures 13,000 Increase In Working 850
Sale Of Furniture 250 Capital
--------- --------
44,000 44,000
-------- --------
---------------------------------------------------------------------------------

3.1.3.6 Meaning of Concepts of Cash, Cash Flow And Cash Flow

Analysis

While explaining the concept of `fund’ it was mentioned that in a

narrower sense the term `fund’ is also used to denote cash. The term `cash’
in the context of cash flow analysis stands for cash and bank balances. Cash
flow refers to the actual movement of cash in and out of an organisation.
When cash flows into the organisation it is called cash inflow or positive
cash flow. In the same way when cash flows out of the organisation, it is
called cash outflow or negative cash flows. Cash flow analysis is an analysis
based on the movement of cash and bank balances. Under cash flow
analysis, all movements of cash would be considered.

3.1.3.7 Cash Flow Statement

A cash flow statement is a statement depicting changes in cash

position from one period to another i.e. The result of cash flow analysis is
given in the cash flow statement. For example if the cash balance of a
concern as per its balance sheet as on 31st march 2004 is rs.90,000 and the
cash balance as per its balance sheet as on 31st march 2005 is rs.1,20,000,
there has been an inflow of cash of rs.30,000 in the year 2004-05 as
compared to the year 2003-04. The cash flow statement explains the reasons
for such inflows or outflows of cash as the case may be. Normally the
following are principal sources of inflows of cash:
Ֆ Issue Of Shares And Debentures For Cash
Ֆ Sale Of Fixed Assets And Investments For Cash
Ֆ Borrowings From Banks And Other Financial Institution

168
 Ֆ Cash From Operations
Outflows of cash generally include:
Ֆ Redemption Of Shares And Debentures By Cash
Ֆ Purchase Of Fixed Assets And Investments By Cash
Ֆ Repayment Of Loans
Ֆ Cash Lost In Operations
The following is the format of a cash flow statement:

Cash Flow Statement For The Year Ending Say 31st March 2012
Balance as on 1-4-2011 balance as on 1-4-2011
Cash in hand xxx bank overdraft (if any) xx x
Cash at bank xxx
Add: cash inflows: cash outflows:
Here the items mentioned here the items mentioned
As sources of cash inflows as outflows of cash above
Above will be recorded will be recorded
Balance as on 31-3-2012 balance as on 31-3-2012
Bank overdraft (if any) xxx cash in hand xx x
Cash at bank xxx
------ ------
xxx xxx
------ ------
--------------------------------------------------------------------------------- The
accounting standard 3 issued by the institute of chartered accountants of
india requires the companies to prepare cash flow statement and present
them as part of their annual reports.

3.1.3.8 Calculation of Cash From Operations

The important step in the preparation of cash flow statement is the

calculation of cash from operations. It is calculated as follows:
The first step in the calculation of cash from operations is the calculation of
funds from operations (which is already explained in the lesson on funds
flow analysis). To the funds from operations the decrease in current assets
and increase in current liabilities will be added (except cash, bank and bank
o.d.). From the added total, increase in current assets and decrease in current
liabilities will be deducted (except cash, bank and bank o.d.). The resultant
figure is cash from operations (refer illustration 3).

169
Proforma Of Cash From Operations Statement
Funds from operations or funds lost from operations xxxx
Add: Decrease in current assets xxxx
Increase in current liabilities xxxx
--------
xxxx
--------
Less: Inecrease in current assets xxx
Decrease in current liabilities xxx
xxxx

Cash from operations or cash lost from operations

As in the case of fund flow analysis here also we assume provision for
taxation and proposed dividend as current liabilities.

3.1.3.9 Utility of Cash Flow Analysis

Cash flow analysis yields the following advantages:

Ֆ It is very helpful in understanding the cash position of the firm. This
would enable the management to plan and coordinate the financial
operations properly.
Ֆ Since it provides information about cash which would be available from
operations the management would be in a position to plan repayment of
loans, replacement of assets, etc.
Ֆ It throws light on the factors contributing to the reduction of cash balance
inspite of increase in income and vice versa.
Ֆ A comparison of the cash flow statement with the cash budget for the
same period helps in comparing and controlling cash inflows and cash
outflows.

However cash flow analysis is not without limitations. The cash

balance as disclosed by the cash flow statement may not represent the real
liquid position of the business since it can be easily influenced by
postponing purchases and other payments. Further cash flow statement
cannot replace the income statement or funds flow statement. Each of them
has a separate function to perform.

170
3.1.3.10 Cash Flow Analysis Vs. Funds Flow Analysis

Ֆ A cash flow statement is concerned only with the changes in cash

position while funds flow analysis is concerned with changes in working
capital position between two balance sheet dates.
Ֆ Cash flow analysis is a tool of short-term financial analysis while the
funds flow analysis is comparatively a long-term one.
Ֆ Cash is part of working capital and therefore an improvement in cash

position results in improvement in the funds position but not vice versa.

In other words “inflow of cash” results in “inflow of funds” but inflow of

funds may not necessarily result in “inflow of cash”.

Ֆ In funds flow analysis, the changes in various current assets and current
liabilities are shown in a separate statement called schedule of changes in
working capital in order to ascertain the net increase or decrease in
working capital. But in cash flow analysis, such changes are adjusted to
funds from operations in order to ascertain cash from operations.

3.1.3.11 illustrations

Illustration 3:
From the following balances calculate cash from operations:
December 31
2010 2011
Profit and loss a/c balance 75,000 1,55,000
Debtors 45,000 42,000
Creditors 20,000 26,000
Bills receivable 12,000 15,000
Cash in hand 2,500 3,000
Prepaid expenses 1,600 1,400
Bills payable 18,000 16,000
Cash at bank 8,000 10,000
Outstanding expenses 1,200 1,600
Income received in advance 250 300
Outstanding income 800 900
Additional Information:
(i) depreciation written off during the year rs.10,000
(ii) transfer to general reserve rs.10,000

171
Calculation Of Funds From Operations
Rs.
Profit & Loss A/C As On 31St December 2011 1,55,000
Add: Depreciation 10,000
Transfer To General Reserve 10,000
-----------
1,75,000
Less: P & L A/C As On 1St January 2011 75,000
-----------
Funds From Operations 1,00,000
-----------
Calculation Of Cash From Operations
Funds from operations 1,00,000
Add: Decrease In Current Assets
Decrease in debtors 3,000
Decrease in prepaid expenses 200
Increase In Current Liabilities
Increase in creditors 6,000
Increase in outstanding expenses 400
Increase in income received in advance 50
---------
1,09,650
Less: Increase In Current Assets
Increase in bills receivables 3,000
Increase in outstanding income 100
Decrease In Current Liabilities
Decrease in bills payable 2,000
5,100
-----------
Cash from operations 1.04,550
-----------
Note: decrease in current assets means current assets are converted into cash
and increase in current liabilities results in further generation of cash. Hence
they are added. Increase in current assets and decrease in current liabilities
result in outflow of cash. Hence they are deducted.

Illustration 4: balance sheets of somy thomas as on 1-1-2011 and 31-12-

2011 were as follows:

172
Liabilities 2010 2011 Assets 2010 2011
Rs. Rs. Rs. Rs.

Credits 40,000 44,000 Cash 10,000 7,000

Bills Payable 25,000 --- Debtors 30,000 50,000
Loans From
Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
-------------------------------------------------------------------------
2,30,000 2,47,000 2,30,000 2,47,000
-------------------------------------------------------------------------
---------------------------------------------------------------------------------

During the year, a machine costing rs.10,000 (accumulated

depreciation rs.3,000) was sold for rs.5,000. The provision for depreciation
against machinery as on 1-1-2011 was rs.25,000 and on 31-12-2011 it was
rs.40,000. Net profit for the year 2011 amounted to rs.45,000. Prepare cash
flow statement.

Calculation of Cash From Operations

Rs.
Net Profit For The Year 2011 45,000
Add: Addition To Provision For Depreciation 18,000
Loss Of Sale Of Machinery 2,000
---------
Funds From Operations 65,000

Add: Decrease In Stock 10,000

Increase In Creditors 4,000
--------
79,000
Less: Increase In Debtors 20,000
Decrease In Bills Payable 25,000
-------- 45,000
--------
Cash From Operations 34,000

173
 Capital A/C
To Drawings 17,000 By Balance B/D 1,25,000
(Balancing Figure)
To Balance C/D 1,53,000 By Net Profit For
The Year 45,000

1,70,000 1,70,000

Machinery A/C
To Balance B/D 1,05,000 By Bank Sale 5,000
(80000 + 25000) By Provision For Dep. 3,000
By P&L A/C – Loss 2,000
By Balance C/D 95,000
(55000 + 40000)
1,05,000 1,05,000

Provision For Depreciation A/C

To Machinery A/C 3,000 By Balance B/D 25,000

(Dep. On Machinery
Sold) By P&L A/C
To Balance C/D 40,000 Dep. For The Current
Year 18,000
43,000 43,000

Cash Flow Statement

Cash As On 1-1-2011 10,000

Add: Inflows Cash Outflows:
Cash From
Operations 34,000 Drawings 17,000
Loan From Bank 10,000 Purchase Of Land 10,000
Sale Of Machinery 5,000 Purchase Of Building 25,000
Cash As On
31-12-2011 7,000
59,000 59,000

174
3.1.3.12 Summary

A funds flow statement officially called as statement of changes in

financial position, provides information about an enterprise’s investing and
financing activities during the accounting period. Though there are many
concepts of funds, the working capital concept of funds has been used in
this lesson. Flow of funds results only when there is a cross transaction i.e.
Only when a transaction involves a fixed asset or liability and a current
asset or liability. The main sources of funds are: funds from operations,
issue of shares and debentures and sale of non-current assets. The main uses
of funds are repayment of long-term liabilities including redemption of
preference shares and debentures, purchase of non-current assets and
payment of dividends. Funds flow statement helps the financial analyst in
having a more detailed analysis and understanding of changes in the
distribution of sources between two balance sheet dates. In addition to funds
flow statement concerns are also preparing cash flow statement which is the
outcome of cash flow analysis. Cash flow analysis is based on the
movement of cash and bank balances and the cash flow statement is a
statement depicting changes in cash position from one period to another
period.

3.1.3.13 Key Words

Working Capital: working capital is that part of capital used for the
purposes of day-to-day operations of a business.

Fund: fund refers to the long term capital used for financing current assets.
It can be ascertained by finding the difference between current assets and
current liabilities.

Flow of funds: flow refers to transactions which change the size of fund in
an organisation. The flow transactions are divided into uses and sources.
While the former refers to those transactions which reduce the funds, the
latter increases the size of fund.

Cash: cash refers to cash and bank balances.

Cash Flow: cash flow refers to the actual movement of cash in and out of an
organisation.

175
3.1.3.14 Self Assessment Questions
1. What do you mean by working capital concept of funds?
2. Explain the significance of funds flow analysis and cash flow
analysis.
3. Distinguish between schedule of changes in working capital and
funds flow statement.
4. Distinguish between cash flow analysis and funds flow analysis.
5. Shyam and company has the following information for the year
ending
31st march 2012:sales rs.5,000, depreciation rs. 450, other operating
expenses rs.4,100
You are required to:
Ֆ Estimate The Amount Of Funds Generated During The Year.
Ֆ If The Amount Of Depreciation Increases To Rs.9,000 What Would Be Its
Effect On Funds Generated During The Year.
Ֆ Under What Circumstances Can The Funds From Operation Be Zero?

6. From the following balance sheets of damodar ltd. As on 31st december

2010 and 2011 you are required to prepare:
Ֆ A Schedule Of Changes In Working Capital
Ֆ A Funds Flow Statement

Assets 2010 2011

Goodwill 12,000 12,000
Building 40,000 36,000
Plant 37,000 36,000
Investments 10,000 11,000
Stock 30,000 23,400
Bills receivable 2,000 3,200
Debtors 18,000 19,000
Cash at bank 6,600 15,200

1,55,600 1,55,800

Liabilities 2010 2011

Share capital 1,00,000 1,00,000
General reserve 14,000 18,000
Creditors 8,000 5,400
Bills payable 1,200 800

176
Provision for taxation 16,000 18,000
Provision for doubtful debts 400 600
Profit & loss a/c 16,000 13,000
1,55,600 1,55,800

Additional information:
Ֆ Depreciation charged on plant was rs.4,000 And on building Rs.4,000.

Ֆ Provision for taxation rs.19,000.

Ֆ Interim dividend of rs.8,000 Was paid during the year 2011.
7. The financial position of subhulakshmi ltd. On 1-1-2011 and 31-122011
Was as follows:

Liabilities 2010 2011 Assets 2010 2011

Rs. Rs. Rs. Rs.
Current Liabilities 72,000 82,000 Cash 8,000 7,200
Loan From Rosary 40,000 Debtors 70,000 76,800
Ltd. Stock 50,000 44,000
Loan From Gayatri 60,000 50,000 Land 40,000 60,000
Ltd. Buildings 1,00,00 1,10,000
Capital & Reserves 2,96,000 2,98,000 Machinery 1,60,00 1,72,000

4,28,000 4,70,000 4,28,000 4,70,000

During the year rs.52,000 were paid as dividends. The provision for
Depreciation against machinery as on 1-1-2011 was rs.54,000 and on 31-12-
2011 was rs.72,000. Prepare a cash flow statement.

3.1.3.15 Key To Self Assessment Questions (For Problems Only)

Q.No.5: (I) Rs.900; (Ii) Rs.900; (Iii) When Other Operating Expenses Are
Increased To Rs.5,000 Or Sales Decreased To Rs.4,100 Without Any
Decrease In Other Operating Expenses.
Q.No.6: Increase In Working Capital Rs.5,000; Funds From Operations
Rs.17,000.
Q.No.7: Funds From Operations Rs.72,000; Cash From Operations
Rs.81,200.

177
3.1.3.16 Case Analysis

Given below are the balance sheets of bharathy ltd. For a period of three
years as at 31st march each.
Rs. In lakhs
2010 2011 2012
Liabilities
Share capital in equity shares of rs.10
Each 30 35 35
General reserve 10 15 18
Surplus 5 8 9
13% debentures 10 5 10
Bank credit 5 10 15
Trade creditors 10 12 15
Income tax provision 8 11 14
Proposed dividend 6 10.5 14

84 106.5 130

Assets
Plant and machinery 45 55 70
Investments 10 15 20
Stock 12 15 15
Debtors 14 15 12
Cash and bank 3 6.5 13

84 106.5 130

Other Details:
Ֆ Depreciation provided in the books:
Ֆ 2009-10: Rs.6 Lakhs; 2010-11: rs.8 Lakhs; 2011-12: rs.10 Lakhs
Ֆ A part of the debentures was converted into equity at par in september
2010.
Ֆ There was no sale of fixed assets during the period.

As you are the management accountant of the concern, the management

seeks your advice on the liquidity position of the company. Analyse the case
and advice the management using funds flow analysis.

178
Hint:
Ֆ Calculate funds from operations.
Ֆ Prepare schedule of changes in working capital.
Ֆ Prepare funds flow statement.
Ֆ Calculate current ratio and liquidity ratio.
Based on the above workings suitable advice may be given to the
management.

3.1.3.17 Books For Further Reading

1. James Jimbalvo: Management Accounting, John Wiley & Sons.

2.Khan & Jain: Management Accounting, Tata Mcgraw Hill Publishing
Co., New Delhi.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House,
Delhi.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons, New
Delhi.
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
S.Chand & Co., New Delhi.

*****

179
180
 Unit – IV: Management Accounting

Lesson 4.1: Marginal Costing

4.1.1 Introduction

Marginal costing is a technique of costing. This technique of costing

uses the concept `marginal cost’. Marginal cost is the change in the total
cost of production as a result of change in the production by one unit. Thus
marginal cost is nothing but variable cost. In marginal costing technique
only variable costs are considered while calculating the cost of the product,
while fixed costs are charged against the revenue of the period. The revenue
arising from the excess of sales over variable costs is known as
`contribution’. Using contribution as a vital tool, marginal costing helps to a
great extent in the managerial decision making process. This unit deals with
the various aspects of marginal costing.

4.1.2 Learning Objectives

Ֆ After reading this lesson, the reader should be able to:

Ֆ know the meaning of marginal cost.
Ֆ understand the various elements of marginal costing technique.
Ֆ appreciate the importance of marginal costing as a decision
Ֆ making tool.
Ֆ realise the advantages and disadvantages of marginal costing.
Ֆ apply marginal costing technique under appropriate situations.

4.1.3 Contents

4.1.3.1 Various Elements Of Marginal Costing

4.1.3.2 Benefits Of Marginal Costing
4.1.3.3 Application Of Marginal Costing
4.1.3.4 Limitations Of Marginal Costing
4.1.3.5 Additional Illustrations
4.1.3.6 Summary
4.1.3.7 Key Words
4.1.3.8 Self Assessment Questions
4.1.3.9 Key To Self Assessment Questions

181
 4.1.3.10 Case Analysis
4.1.3.11 Books For Further Reading

4.1.3.1 Various Elements Of Marginal Costing

According to the institute of cost and management accountants

(icma), london, marginal cost is `the amount at any given volume of output
by which aggregate costs are changed if the volume of output is increased or
decreased by one unit’. Thus marginal cost is the added cost of an extra unit
of output.
Mc = Direct Material + Direct Labour + Other Variable Costs =
Total Cost – Fixed Cost.

Contribution

The difference between selling price and variable cost (or marginal
cost) is known as `contribution’ or `gross margin’. It may be considered as
some sort of fund from out of which all fixed costs are met. The difference
between contribution and fixed cost represents either profit or loss, as the
case may be. Contribution is calculated thus:
Contribution = Selling Price – Variable Cost
= Fixed Cost + Profit Or – Loss
It is clear from the above equation that profit arises only when contribution
exceeds fixed costs. In other terms, the point of ‘no profit no loss’ will be at
a level where contribution is equal to fixed costs.

Marginal cost equation

The algebraic expression of contribution is known as marginal cost

equation. It can be expressed thus:

S–V = F+P
S–V = C
C = F + P And In Case Of Loss
C = F–L
Where: S = Sales
V = Variable Cost
C = Contribution
F = Fixed Cost

182
 P = Profit
L = Loss

Profit Volume Ratio (P/V Ratio)

The profitability of business operations can be found out by

calculating the p/v ratio. It shows the relationship between contribution and
sales and is usually expressed in percentage. It is also known as `marginal-
income ratio’, `contribution-sales ratio’ or `variable-profit ratio’. P/v ratio
thus is the ratio of contribution to sales, and is calculated thus:
Contribution
P/V Ratio = ----------------- X 100
Sales
C S–V F+P
= --- or --------- or --------
S S S
Variable Costs
= 1 - ---------------------
Sales
The ratio can also be shown by comparing the change in contribution to
change in sales, or change in profit to change in sales. Any increase in
contribution, obviously, would mean increase in profit, as fixed expenses
are assumed to be constant at all levels of production.

Change In Contribution
P/V Ratio = -------------------------------
Change In Sales

Change In Profit
= ------------------------
Change In Sales

The importance of p/v ratio lies in its use for evaluating the
profitability of alternative products, proposals or schemes. A higher ratio
shows greater profitability. Management should, therefore, try to increase
p/v ratio by widening the gap between the selling price and the variable
costs. This can be achieved by increasing sale price, reducing variable costs
or switching over to more profitable products.

183
Break-Even or Cost-Volume-Profit Analysis

Break-even analysis is a specific method of presenting and studying

the inner relationship between costs, volume and profits. (hence, the name
c-v-p analysis). It is an important tool of financial analysis whereby the
impact on profit of the changes in volume, price, costs and mix can be found
out with a certain amount of accuracy. A business is said to break even when
its total sales are equal to its total costs. It is a point of no profit or no loss.
At this point contribution is equal to fixed costs. Break-even point, can be
calculated thus:

Fixed Cost
B.E.P. (In Units) = --------------------------
Contribution Per Unit

Fixed Cost
= ---------------------------------------------
Selling Price/Unit – Marginal Cost/Unit

Fixed Cost
B.E.P. (Sales) = --------------------------- X Selling Price/Unit
Contribution Per Unit
Fixed Cost
= ------------------------- X Total Sales
Total Contribution
FXS
or = ------------
S–V
Fixed Cost
or = -----------------------------------
Variable Cost Per Unit
1 - ----------------------------------
Selling Price Per Unit

Fixed Cost
or = ------------------
P/V Ratio

184
At break-even point the desired profit is zero. Where the volume of output
or sales is to be calculated so as to earn a desired amount of profit, the
amount of desired profits has to be added to the fixed cost given in the
above formula.
Fixed Cost + Desired Profit
Units To Earn A Desired Profit = -------------------------------------
Contribution Per Unit
Fixed Cost + Desired Profit
Sales To Earn A Desired Profit = ------------------------------------
P/V Ratio
Cash Break-Even Point

It is the level of output or sales where the cash inflow will be

equivalent to cash needed to meet immediate cash liabilities. To this end,
fixed costs have to be divided into two parts (i) fixed cost which do not need
immediate cash outlay (depreciation etc.) And (ii) fixed cost which need
immediate cash outlay (rent etc.). Cash break-even point can be calculated
thus:
Cash Fixed Costs
Cash Break-Even Point (Of Output) = -----------------------------------
Cash Contribution Per Unit

Composite Break-Even Point

Where a firm is dealing with several products, a composite

breakeven point can be calculated using the following formula:
Cash Fixed Costs
Composite Break-Even Point (Sales) = ----------------------------------
Composite P/V Ratio

Total Fixed Costs X Total Sales

or = --------------------------------------
Total Contribution

Total Contribution
or = ---------------------------- X 100
Total Sales

185
Margin of Safety

Total sales minus the sales at break-even point is known as the margin of
safety. Lower break-even point means a higher margin of safety. Margin of
safety can also be expressed as a percentage of total sales. The formula is:
Margin Of Safety = Total Sales – Sales At B.E.P.
Profit
or = ------------------
P/V Ratio

Margin Of Safety
Margin Of Safety = ----------------------- X 100
(As A Percentage) Total Sales

Higher margin of safety shows that the business is sound and when
sales substantially come down, (but not below break even sales) profit might
be earned by the business. Lower margin of safety, as pointed out earlier,
means that when sales come down slightly profit position might be affected
adversely. Thus, margin of safety can be used to test the soundness of a
business. In order to improve the margin of safety a business can increase
selling prices (without affecting demand, of course) reducing fixed or
variable costs and replacing unprofitable products with profitable one.

Illustration 1: beta manufacturers ltd. Has supplied you the following

information in respect of one of its products:

Total Fixed Costs 18,000

Total Variable Costs 30,000
Total Sales 60,000
Units Sold 20,000

Find out (a) contribution per unit, (b) break-even point, (c) margin of safety,
(d) profit, and (e) volume of sales to earn a profit of rs.24,000.

186
Solution:
60,000
Selling Price Per Unit = -------- = Rs.3
20,000

30,000
Variable Cost Per Unit = -------- = Rs.1.50
20,000

(A) Contribution Per Unit = Selling Price Per Unit – Variable Cost Per Unit

= Rs.3 – Rs.1.50
= Rs.1.50
Total Fixed Cost
(B) Break-Even Point = -------------------------------
Contribution Per Unit

Rs.18,000
= -------------
Rs.1.50

= 12,000 Units

(C) Margin Of Safety = Units Sold – Break-Even Point

= 20,000 – 12,000
= 8,000 Units (Or) Rs.24,000

(D) Profit = (Units Sold X Contribution Per Unit) -

Fixed Cost
= (20,000 X Rs.1.50) - Rs.18,000
= Rs.12,000

(E) Volume Of Sales To Earn A Profit Of Rs.24,000

Fixed Cost + Desired Profit
= --------------------------------------
Contribution Per Unit
18,000 + 24,000
= ---------------------- = 28,000 units
1.50

187
Illustration 2: Calculate `Margin Of Safety’ from the following data:
---------------------------------------------------------------------------------
Particulars Mary & Co. Geetha& Co.
---------------------------------------------------------------------------------

Sales 1,00,000 1,00,000

Cost 80,000 80,000
Fixed – Mary & Co. 30,000
Geetha & Co. 50,000

Variable – Mary & Co. 50,000

Geetha & Co. 30,000
---------- ---------- ----------
Profit 20,000 20,000
---------- ---------- ----------

Solution:

Particulars Mary& Co. Geetha& Co.

Actual Sales 1,00,000 1,00,000

Less: Sales At Break-Even Point 60,000 71,429
Marginal Of Safety 40,000 28,571

Fixed Cost
Break-Even Sales = ----------------
P/V Ratio
Sales – Variable Cost
P/V Ratio = ----------------------------
Sales
Therefore;
P/V Ratio 1,00,000 1,00,000
- 50,000 - 30,000
50,000 70,000

50% 70%

188
 30,000 50,000
Break-Even Sales = ---------- --------
50% 70%
Rs.60,000 Rs.71,429

Illustration 3:

From the following particulars, find out the selling price per unit if
b.E.P. Is to be brought down to 9,000 units.
Variable Cost Per Unit Rs.75
Fixed Expenses Rs.2,70,000
Selling Price Per Unit Rs.100

Solution:

Let us assume that the contribution per unit at B.E.P. Sales of 9,000
is X.
Fixed Cost
B.E.P. = ------------------------------
Contribution Per Unit
Contribution per unit is not known. Therefore,
2,70,000
9,000 Units = -------------
X
9,000 X = 2,70,000
X = 30
Contribution Is Rs.30 Per Unit, In Place Of Rs.25. So, The Selling Price
Should Be Rs.105, I.E. Rs.75 + Rs.30.

4.1.3.2 Benefits Of Marginal Costing

The technique of marginal costing is of immense use to the

management in taking various decisions, as explained below:

1. How Much To Produce?

Marginal costing helps in finding out the level of output which is

most profitable for running a concern. This, in turn, helps in utilising plant
capacity in full, and realise maximum profits. By determining the most

189
profitable relationships between cost, price and volume, marginal costing
helps a business determine most competitive prices for its products.

2. What To Produce?

By applying marginal costing techniques, the most suitable

production line could be determined. The profitability of various products
can be compared and those products which languish behind and which do
not seem to be feasible (in view of their inability to recover marginal costs),
may be eliminated from the production line by using marginal costing. It,
thus, helps in selecting an optimum mix of products, keeping the capacity
and resource constraints in mind. It will also serve as a guide in arriving at
the price for new products.

3. Whether To Produce Or Procure?

The marginal cost of producing an article inside the factory serves as

a useful guide while arriving at make or buy decisions. The costs of
manufacturing can be compared with the costs of buying outside and a
suitable decision can be arrived at easily.

4. How To Produce?

In case a particular product can be produced by two or more

methods, ascertaining the marginal cost of producing the product by each
method will help in deciding as to which method should be allowed. The
same is true in case of decisions to use machine power in place of manual
labour.

5. When To Produce?

In periods of trade depression, marginal costing helps in deciding

whether production in the plants should be suspended temporarily or
continued in spite of low demand for the firm’s products.

6. At What Cost To Produce?

Marginal costing helps in determining the no profit- no-loss point.

The efficiency and economy of various products, plants, departments can

190
also be determined. This helps in profit planning as well as cost control.

4.1.3.3 Application Of Marginal Costing

Marginal costing technique helps management in several ways.

These are discussed below:

1. Profit Planning

There are four important ways of improving the profit performance

of a business: (i) increasing the volume, (ii) increasing the selling price, (iii)
Decreasing variable cost, and (iv) decreasing fixed costs. Profit planning is
the planning of future operations so as to attain maximum profit. The
contribution ratio shows the relative profitability of various sectors of
business whenever there is a change in the selling price, variable cost etc.

Illustration 4:

Two businesses, p ltd. And q ltd. Sell the same type of product in the
same type of market. Their budgeted profit and loss accounts for the coming
year are as under:
P Ltd. Q Ltd.
Sales 1,50,000 1,50,000
Less: Variable Costs 1,20,000 1,00,000
Fixed Costs 15,000 1,35,000 35,000 1,35,000

Budget Net Profit 15,000 15,000

You are required to:

Ֆ Calculate the break-even point for each business
Ֆ Calculate the sales volume at which each business will earn rs.5,000
Profit.
Ֆ State which business is likely to earn greater profit in conditions of:

1. Heavy demand for the product

2. Low demand for the product, and, briefly give your argument
also.

191
Solution:

(I) For Calculating The Break-Even Points, P/V Ratio Of P Ltd. And Q
Ltd.,
Should Be Calculated:
P/V Ratio = Contribution / Sales
Fixed Expenses + Profit
= ------------------------------
Sales
15,000 + 15,000 1
P/V Ratio Of P = ------------------------- = --- = 20%
1,50,000 5

35,000 + 15,000 1
P/V Ratio Of Q = ------------------------ = --- = 3 1/3%
1,50,000 3

Fixed Expenses
Break-Even Point = -------------------------
P/V Ratio

15,000
P Ltd. = ----------- = Rs.75,000
1/5

35,000
Q Ltd. = ------------ = Rs.1,05,000
1/3

(II) Sales Volume To Earn A Desired Profit (Rs.5000):

Fixed Expenses + Desired Profit

Formula = ----------------------------------------
P/V Ratio

15,000 + 5,000
P Ltd. = -------------------= Rs.1,00,000
1/5

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 35,000 + 5,000
Q Ltd. = -------------------= Rs.1,20,000
1/3
Ֆ In conditions of heavy demand, a concern with larger p/v ratio can earn
greater profits because of greater contribution. Thus, q ltd. Is likely to
earn greater profit.
Ֆ In conditions of low demand, a concern with lower break-even point is
likely to earn more profits because it will start earning profits at a lower
level of sales. In this case, p ltd. Will start earning profits when its sales
reach a level of rs.75,000, Whereas q ltd. Will start earning profits when
its sales reach rs.1,05,000. Therefore, in case of low demand, break-even
point should be reached as early as possible so that the concern may start
earning profits.

2. Introduction Of A New Product

Sometimes, a product may be added to the existing lines of products

with a view to utilise idle facilities, to capture a new market or for any other
purpose. The profitability of this new product has to be found out initially.
Usually, the new product will be manufactured if it is capable of
contributing something toward fixed costs and profit after meeting its
variable costs.

Illustration 5:

A concern manufacturing product x has provided the following

information:
Rs.
Sales 75,000
Direct materials 30,000
Direct labour 10,000
Variable overhead 10,000
Fixed overhead 15,000
In order to increase its sales by rs.25,000, the concern wants to introduce the
product y, and estimates the costs in connection therewith as under:

Direct materials 10,000

Direct labour 8,000
Variable overhead 5,000

193
Fixed overhead Nil Advise whether the product Y will be
profitable or not.

Solution:

Marginal Cost Statement

(in Rupees)
X Y Total

Sales 75,000 25,000 1,00,000

Less: marginal costs:
Direct materials 30,000 10,000 40,000
Direct labour 10,000 8,000 18,000
Variable overhead 10,000 5,000 15,000

50,000 23,000 73,000

Contribution 25,000 2,000 27,000

Fixed cost 15,000

Profit 12,000

Commentary: if product Y is introduced, the profitability of product X is

not affected in any manner. On the other hand, product Y provides a
contribution of Rs.2,000 Towards fixed cost and profit. Therefore, Y should
be introduced.

3. Level Of Activity Planning

Marginal costing is of great help while planning the level of activity.

Maximum contribution at a particular level of activity will show the
position of maximum profitability.

Illustration 6:

Following is the cost structure of sundaram corporation,

pondicherry, manufacturers of colour tvs.

194
 Level of activity
50% 70% 90%
Output (in units ) 200 280 360
Cost (in rs.)
Materials 10,00,000 14,00,000 18,00,000
Labour 3,00,000 4,20,000 5,40,000
Factory overhead 5,00,000 6,00,000 7,00,000

Factory Cost 18,00,000 24,20,000 30,40,000

In view of the fact that there will be no increase in fixed costs and
import license for the picture tubes required in the manufacture of its tvs has
been obtained, the corporation is considering an increase in production to its
full installed capacity.
The management requires a statement showing all details of
production costs at 100% level of activity.

Solution:
Marginal Cost Statement
(At 100% Level Of Activity Total Cost Cost Per Unit
With 400 Units) Rs. Rs.
Materials 20,00,000 5,000
Labour 6,00,000 1,500
Variable Factory Overhead 5,00,000 1,250

Marginal Factory Cost 31,00,000 7,750

Fixed Factory Overhead 2,50,000 625

Total factory cost 33,50,000 8,375

Thus, the marginal factory cost per unit is rs.7,750 and the total
production cost per unit is rs.8,375.

Commentary:
(i) Calculation Of Variable Factory Overheads Per Unit:
Rs.6,00,000 – Rs.5,00,000
= --------------------------------- = Rs.1,250 80
Units

195
(II) Calculation Of Fixed Factory Overheads:
Factory Overheads – (No. Of Units At Certain Level Of Activity X Variable
Factory Overheads Per Unit).
Therefore Rs.5,00,000 – (200 Units X 1,250)
Therefore Rs.5,00,000 – Rs.2,50,000 = Rs.2,50,000
The Amount Can Be Verified By Making Calculation At Any Other Level
Of Activity.
(III) Variable Factory Overheads At 100% Level Of Activity:
400 Units X 1,250 = Rs.5,00,000

4. Key Factor

A concern would produce and sell only those products which offer
maximum profit. This is based on the assumption that it is possible to
produce any quantity without any difficulty and sell likewise. However, in
actual practice, this seems to be unrealistic as several constraints come in
the way of manufacturing as well as selling. Such constraints that come in
the way of management’s efforts to produce and sell in unlimited quantities
are called `key factors’ or `limiting factors’. The limiting factors may be
materials, labour, plant capacity, or demand. Management must ascertain the
extent of the influence of the key factor for ensuring maximisation of profit.
Normally, when contribution and key factors are known, the relative
profitability of different products or processes can be measured with the
help of the following formula:

Contribution
Profitability = -----------------------
Key Factor

Illustration 7: from the following data, which product would you

recommend to be manufactured in a factory, time, being the key factor?
Per Unit of Per Unit of
Product X Product Y

Direct Material 24 14
Direct Labour At Re.1 Per Hour 2 3
Variable Overhead At Rs.2 Per Hour 4 6
Selling Price 100 110
Standard Time To Produce 2 Hours 3 Hours

196
Solution:
Per Unit of Per Unit of
Product X Product Y

Selling Price 100 110

Less: Marginal Cost:
Direct Materials 24 14
Direct Labour 2 3
Variable Overhead 4 30 6 23
-- --- -- ---
Contribution 70 87
Standard Time To Produce 2 Hours 3 Hours
Contribution Per Hour 70/2 87/3
= Rs.35 = Rs.29
Contribution per hour of product x is more than that of product y by rs.6.
Therefore, product x is more profitable and is recommended to be
manufactured.

5. Make Or Buy Decisions

A company might be having unused capacity which may be utilized

for making component parts or similar items instead of buying them from
the market. In arriving at such a `make or buy’ decision, the cost of
manufacturing component parts should be compared with price quoted in
the market. If the variable costs are lower than the purchase price, the
component parts should be manufactured in the factory itself. Fixed costs
are excluded on the assumption that they have been already incurred, and
the manufacturing of components involves only variable cost. However, if
there is an increase in fixed costs and any limiting factor is operating while
producing components etc. That should also be taken into account. Consider
the following illustration, throwing light on these aspects.

Illustrations 8:

You are the management accountant of XYZ CO. Ltd. The

Managing director of the company seeks your advice on the following
problem: the company produces a variety of products each having a number
of computer parts. Product “B” takes 5 hours to produce on machine no.99

197
working at full capacity. “bB” has a selling price of rs.50 and a marginal
cost, Rs.30 per unit. “A-10” a component part could be made on the same
machine in 2 hours for marginal cost of Rs.5 per unit. The supplier’s price is
Rs.12.50 per unit. Should the company make or buy “A10”? Assume that
machine hour is the limiting factor.

Solution:

In this problem the cost of new product plus contribution lost during
the time for manufacturing “A-10” should be compared with the supplier’s
price to arrive at a decision.
Rs.
“B” – Selling Price 50.00
Marginal Cost 30.00
-------
20.00
-------
It takes 5 hours to produce one unit of “B.
Therefore, contribution earned per hour on machine no.99 is Rs.20/5 = Rs.4.
“A-10” takes two hours to be manufactured on machine which is producing
“B”. Real cost of “A-10” to the company = marginal cost of “aA-10” plus
contribution lost for using the machine for “A-10”.

Rs.5 + Rs.8 = Rs.13

This is more than the seller’s price of rs.12.50 and so it is advisable for the
company to buy the product from outside.

Illustration 9:

A t.V. Manufacturing company finds that while it costs Rs.6.25 To

make each component X, the same is available in the market at Rs.4.85
Each, with an assurance of continued supply. The break down of cost is:

Rs.
Materials 2.75 Each
Labour 1.75 Each
Other Variables 0.50 Each
Depreciation And Other Fixed Costs 1.25 Each
6.25

198
Should you make or buy?

Solution:

Variable cost of manufacturing is Rs.5; (Rs.6.25 – Rs.1.25) but the

market price is Rs.4.85. If the fixed cost of Rs.1.25 is also added, it is not
profitable to make the component. Because there is a saving of Rs.0.15 even
in variable cost, it is profitable to procure from outside.

6. Suitable Product Mix/Sales Mix

Normally, a business concern will select the product mix which

gives the maximum profit. Product mix is the ratio in which various
products are produced and sold. The marginal costing technique helps
management in taking appropriate decisions regarding the product mix, i.e.,
in changing the ratio of product mix so as to maximise profits. The
technique not only helps in dropping unprofitable products from the mix but
also helps in dropping unprofitable departments, activities etc. Consider the
following illustrations:

Illustration 10: (Product Mix)

The following figures are obtained from the accounts of a

departmental store having four departments.

Departments
(Figures In Rs.)
Particulars A B C D Total
Sales 5,000 8,000 6,000 7,000 26,000

Marginal Cost 5,500 6,000 2,000 2,000 15,500

Fixed Cost 500 4,000 1,000 1,000 6,500
(Apportioned)
Total Cost 6,000 10,000 3,000 3,000 22,000
Profit/Loss(-) 1,000 (-) 2,000 3,000 4,000 4,000

On the above basis, it is decided to close down dept. B immediately, as the

loss shown is the maximum. After that dept. A will be discarded. What is
your advice to the management?

199
 Statement Of Comparative Profitability
Departments
Particulars A B C D Total
Sales 5,000 8,000 6,000 7,000 26,000
Less:
Marginal Cost 5,500 6,000 2,000 2,000 15,500

Contribution (-) 500 2,000 4,000 5,000 10,500

Fixed Cost 6,500

--------
Profit 4,000
--------

Commentary:

From the above, it is clear that the contribution of dept. A is negative

and should be discarded immediately. As dept. B provides rs.2,000 towards
fixed costs and profits, it should not be discarded.

Illustration 11 (Sales Mix):

Present the following information to show to the management:

(a) the marginal product cost and the contribution per unit; (b) the total
contribution and profits resulting from each of the following mixtures:

Product Per Unit (Rs.)

Direct Materials A 10
B 9
Direct Wages A 3
B 2
Fixed Expenses Rs.800
Variable Expenses Are Allocated To Products As 100% Of Direct Wages.
Rs.
Sales Price A 20
B 15

200
Sales Mixtures:
Ֆ 1000 Units Of Product A And 2000 Units Of B
Ֆ 1500 Units Of Product A And 1500 Units Of B
Ֆ 2000 Units Of Product A And 1000 Units Of B

Solution:

(A) Marginal Cost Statement A B

Direct Materials 10 9
Direct Wages 3 2
Variable Overheads (100%) 3 2
--- ---
Marginal Cost 16 13
Sales Price 20 15

Contribution 4 2

1000 A+ 1500 A+ 2000 A+

(B) Sales Mix 2000 B 1500 B 1000B
Choice (I) (II) (III)
(Rs.) (Rs.) (Rs.)

Total Sales (1000 X 20 + (1500 X 20 + (2000 X 20 +

2000 X 15) = 1500 X 15) = 1000 X 15) =
50,000 52,500 55,000

(1000 X 16 + (1500 X 16 + (2000 X 16 +

2000 X 13) = 1500 X 13) = 1000 X 13) =
Less: Marginal Cost 42,000 43,500 45,000
------------------------------------------------------------
Contribution 8,000 9,000 10,000
Less: fixed costs 800 800 800
------------------------------------------------------------
Profit 7,200 8,200 9,200

Therefore sales mixture (iii) will give the highest profit; and as such,
mixture (iii) can be adopted.

201
7. Pricing Decisions

Marginal costing techniques help a firm to decide about the prices of

various products in a fairly easy manner. Let’s examine the following cases:

(I) Fixation of Selling

Price Illustration 12:

P/V Ratio Is 60% and the marginal cost of the product is Rs.50.
What will be the selling price?

Solution:
S–V V C
P/V Ratio = ---------- = 1- ----- = -----
S S S
Variable Cost 40
---------------- = 40% or ------
Sales 100
50 50 X 100
Selling Price = ------- = -------------- = Rs.125
40% 40

(ii) Reducing Selling

Price Illustration 13:

The Price Structure Of A Cycle Made By The Visu Cycle Co. Ltd. Is
As Follows: Per Cycle
Materials 60
Labour 20
Variable Overheads 20
-----
Fixed Overheads 100
Profit 50
Selling Price 50
-----
200

202
 This is based on the manufacture of one lakh cycles per annum. The
company expects that due to competition they will have to reduce selling
prices, but they want to keep the total profits intact. What level of
production will have to be reached, i.e., how many cycles will have to be
made to get the same amount of profits, if:
(a) the selling price is reduced by 10%?
(b) the selling price is reduced by 20%?

Solution:
(Rs.) (Rs.)
Existing profit = 1,00,000 x 50 = 50,00,000
Total fixed overheads = 1,00,000 x 50 = 50,00,000
(a) Selling price is reduced by 10% and to get the existing profit of rs.50
lakhs.
New Selling Price = 200 – 10% Of Rs.200
= 200 – 20 =Rs.180
New Contribution = 180 – 100 =Rs.80 Per Unit
Total Sales (Units) = F + P/Contribution Per Unit
5,00,000 + 5,00,000
= ---------------------------
80
= 1,25,000 Cycles
Are to be obtained and sold to earn the existing profit of rs.5,00,000.
(b) Selling price reduced by 20% and to get the existing profit of rs.5,00,000.
New Selling Price = 200 – 20% Of Rs.200
= 200 – 40 = Rs.160
New Contribution = S–V
= 160 – 100 = Rs.80 Per Unit
Total Sales (Units) = F + P/Contribution Per Unit
5,00,000 + 5,00,000
= ---------------------------
60
= 1,66,667 cycles are to be produced
and sold to earn the existing profit of rs.50 Lakhs.

203
(iii) Pricing During

Recession: Illustration 14:

SSA company is working well below normal capacity due to

recession. The directors of the company have been approached with an
enquiry for special job. The costing department estimated the following in
respect of the job.

Direct Materials Rs.10,000

Direct Labour 500 Hours @ Rs.2 Per Hour
Overhead Costs: Normal Recovery Rates
Variable Re.0.50 Per Hour
Fixed Re.1.00 Per Hour
The directors ask you to advise them on the minimum price to be charged.
Assume that there are no production difficulties regarding the job.

Solution:

Calculation Of Marginal Cost:

(Rs.)
Direct Materials 10,000
Direct Labour 1,000
Variable Overhead @ Re.0.50 Per Hour 250
---------
Marginal Cost 11,250
---------
Commentary:

Here the minimum price to be quoted is Rs.11,250 which is the

marginal cost. By quoting so, the company is sacrificing the recovery of the
profit and the fixed-costs. The fixed costs will continue to be incurred even
if the company does not accept the offer. So any price above Rs.11,250 is
welcome.

7. Accepting Foreign Order

Marginal costing technique can also be used to take a

decision as to whether to accept a foreign offer or not. The speciality of

204
this situation is that normally foreign order is requiring the manufacturer to
supply the product at a price lower than the inland selling price. Here the
decision is taken by comparing the marginal cost of the product with the
foreign price offered. If the foreign order offers a price higher than the
marginal cost then the offer can be accepted subject to availability of
sufficient installed production capacity. The following illustration highlights
this decision:

Illustration 15:

Due to industrial depression, a plant is running at present at

50% of the capacity. The following details are available:
Cost Of Production Per Unit (Rs.)
Direct Materials 2
Direct Labour 1
Variable Overhead 3
Fixed Overhead 2
---
8
---
Production Per Month 20,000 Units
Total Cost Of Production Rs.1,60,000
Sale Price Rs.1,40,000
--------------
Loss Rs.20,000
--------------

An exporter offers to buy 5000 units per month at the rate of rs.6.50 per unit
and the company is hesitant to accept the order for fear of increasing its
already large operating losses. Advise whether the company should accept
or decline this offer.

Solution:

At present the selling price per unit is Rs.7/- and the marginal cost
per unit is Rs.6/- (Material Rs.2 + Labour Re.1 + Variable Overhead Rs.3).
The foreign order offers a price of Rs.6.50 and there is ample production
capacity (50%) available. Since the foreign offer is at a price higher than
marginal cost the offer can be accepted. This is proved hereunder:

205
 (Rs.)
Marginal Cost Of 5000 Units = 5000 X 6 = 30,000
Sale Price Of 5000 Units = 5000 X 6.50 =32,500
--------
Profit 2,500
--------
Thus by accepting the foreign order the present loss of Rs.20,000 would be
reduced to Rs.17,500 I.E., Rs.20000 Loss – Rs.2,500 Profit.

4.1.3.4 Limitations Of Marginal Costing

Marginal costing has the following limitations:

1.difficulty in classification:

In marginal costing, costs are segregated into

Fixed and variable. In actual practice, this classification scheme proves to
be
Superfluous in that, certain costs may be partly fixed and partly variable and

Certain other costs may have no relation to volume of output or even with
the time. In short, the categorisation of costs into fixed and variable
elements is a difficult and tedious job.

2.Difficulty In Application:

the marginal costing technique cannot be applied in industries where

large stocks in the form of work-in-progress (job and contracting firms) are
maintained.

3.Defective Inventory Valuation:

under marginal costing, fixed costs are not included in the value of
finished goods and work in progress. As fixed costs are also incurred, these
should form part of the cost of the product. By eliminating fixed costs from
finished stock and work-in-progress, marginal costing techniques present
stocks at less than their true value. Valuing stocks at marginal cost is
objectionable because of other reasons also:

1. In case of loss by fire, full loss cannot be recovered from the

206
 insurance company.
2. Profits will be lower than that shown under absorption costing
andhence may be objected to by tax authorities.
3. Circulating assets will be understated in the balance sheet.

4.Wrong Basis For Pricing:

In marginal costing, sales prices are arrived at on the basis of

contribution alone. This is an objectionable practice. For example, in the
long run, the selling price should not be fixed on the basis of contribution
alone as it may result in losses or low profits. Other important factors such
as fixed costs, capital employed should also be taken into account while
fixing selling prices. Further, it is also not correct to lay more stress on
selling function, as is done in marginal costing, and relegate production
function to the backgroud.

5.Limited Scope:

The utility of marginal costing is limited to short-run profit

planning and decision-making. For decisions of far-reaching importance,
one is interested in special purpose cost rather than variable cost. Important
decisions on several occasions, depend on non-cost considerations also,
which are thoroughly discounted in marginal costing.
In view of these limitations, marginal costing needs to be applied with
necessary care and caution. Fruitful results will emerge only when
management tries to apply the technique in combination with other useful
techniques such as budgetary control and standard costing.

4.1.3.5 Additional Illustrations

Illustration 16:

from the following information, find out the amount of profit earned during
the year, using marginal cost equation:
Fixed Cost Rs.5,00,000
Variable Cost Rs.10 Per Unit
Selling Price Rs.15 Per Unit
Output Level 1,50,000 Units

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Solution:

Contribution = Selling Price – Variable Cost

=(1,50,000 X 15) – (1,50,000 X 10)
= Rs.22,50,000 – Rs.15,00,000
= Rs.7,50,000
Contribution = Fixed Cost + Profit
Rs.7,50,000 = 5,00,000 + Profit
Profit = 7,50,000 – 5,00,000
= (C – F)
Profit = Rs.2,50,000

Illustration 17:

Determine the amount of fixed costs from the following details,

using the marginal cost equation.

Sales Rs.2,40,000
Direct Materials Rs. 80,000
Direct Labour Rs. 50,000
Variable Overheads Rs. 20,000
Profit Rs. 50,000

Solution:

Marginal Costing Equation = S – V = F + P

= 2,40,000 – 1,50,000
=F+P
= 90,000
= F + 50,000
F = 90,000 – 50,000
F = Rs.40,000

Illustration 18:

Sales 10,000 Units @ Rs.25 Per Unit

Variable Cost Rs.15 Per Unit
Fixed Costs Rs.1,00,000
Find Out The Sales For Earning A Profit Of Rs.50,000

208
Solution:

Sales To Earn A Profit Of Rs.50,000

(Fixed Cost + Profit) Sales
= ----------------------------------
Sales – Variable Cost
1,00,000 + 50,000 X 2,50,000
= -------------------------------------
2,50,000 – 1,50,000
1,50,000 X 2,50,000
= ---------------------------
1,00,000
= Rs.3,75,000

Illustration 19:

The records of ram ltd., Which has three departments give the following
figures:
Dept. A Dept. B Dept. C Total
(Rs.) (Rs.) (Rs.) (Rs.)
Sales 12,000 18,000 20,000 50,000
-------------------------------------------------------------
Marginal Cost 13,000 6,000 15,000 34,000
Fixed Cost 1,000 4,000 10,000 15,000
-------------------------------------------------------------
Total Cost 14,000 10,000 25,000 49,000
Profit/Loss -2,000 +8,000 -5,000 1,000
The management wants to discontinue product c immediately as it gives the
maximum loss. How would you advise the management?

Solution:

Marginal Cost Statement

Particulars A B C Total
(Rs.) (Rs.) (Rs.) (Rs.)
---------------------------------------------------------------------------------
Sales 12,000 18,000 20,000 50,000
Less: Marginal Cost 13,000 6,000 15,000 34,000
-------------------------------------------------------------

209
Contribution -1,000 12,000 5,000 16,000
Fixed Cost 15,000
---------
Profit 1,000

Here department A gives negative contribution, and as such it can be given

up. Department C gives a contribution of Rs.5,000. If department C is
closed, then it may lead to further loss. Therefore, C should be continued.

Summary

Marginal costing is an important technique of costing where only

variable costs are considered while calculating the cost of the product. It is a
technique of presenting cost information and can be used with other
methods of costing (such as job costing, contract costing, etc). This
technique can be applied while taking decisions relating to profit planning,
introducing a new product, level of activity planning, allocating scarce
factors to profitable channels, make or buy decisions, suitable production/
sales mix, fixing prices for products, etc. However this technique is not
without limitations.

4.1.3.7 Key Words

Marginal costing: the change in total cost because of change in total output
by one unit which is otherwise called as variable cost.

Contribution: the excess of selling price over variable cost.

Profit volume ratio: it shows the relationship between contribution and
sales.

Break even point: it is that point of sales at which there is no profit or no

loss i.e. Where total revenues and total costs are equal.

Margin of safety: excess of actual sales over break-even sales.

Marginal cost equation:
S–V=C
C=F+P

210
4.1.3.8 Self Assessment Questions

1. Define marginal cost.

2. What is meant by contribution? Explain its significance.
3. Explain the following:
Ֆ Profit Volume Ratio
Ֆ Break Even Point
Ֆ Margin Of Safety
4. Explain how marginal costing technique is useful as a decision making
tool.
5. Critically evaluate marginal costing technique.
6. Break-down of cost per unit at an activity level of 10,000 units of a
company is as follows:
Rs.
Raw materials 10
Direct expenses 8
Chargeable expenses 2
Variable overheads 4
Fixed overheads 6
---
Total cost per unit 30
Selling price 32
---
Profit per unit 2
---

How many units must be sold to break-even?

7. Tamarai ltd., gives you the following information:
Sales Profit
Rs. Rs.
Period I 1,50,000 20,000
Period II 1,70,000 25,000
Calculate:
(a) the p/v ratio.
(b) the profit when sales are rs.2,50,000
(c) the sales required to earn a profit of rs.40,000
(d) the break-even point.
8. Production costs of selvi enterprises limited are as follows:

211
 Level of Activity

Output (In %Ge) 60% 70% 80%

Output (In Units) 1,200 1,400 1,600
------------------------------------------------
Direct Materials 24,000 28,000 32,000
Direct Labour 7,200 8,400 9,600
Factory Overheads 12,800 13,600 14,400
------------------------------------------------
Works Cost 44,000 50,000 56,000
------------------------------------------------

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

consideration of the management. The proposal is not expected to involve
any increase in fixed factory overheads.
[Hint: fixed factory overheads rs.8,000]

9. The following expenses are incurred in the manufacture of 1,000 units of

a product in the manufacture of which a factory specialises:
Raw materials 2,800
Wages 1,900
Overhead charges (rs.4,000 fixed) 4,200
10,000 units of the product can be absorbed by the home market where
the selling price is rs.9 per unit. There is a demand for 50,000 units of the
product in a foreign market if it can be offered at rs.8.20 per unit. If
This is done, what will be the total profit or loss made by the manufacturer?

10. The following data are obtained from the records of a factory:
Rs.Rs.
Sales 4000 units @ rs.25 Each 1,00,000
Less: marginal cost
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
--------
72,000
Fixed cost 18,000 90,000
--------- ----------
Profit 10,000
----------

212
 It is proposed to reduce the selling price by 20%. What extra units
should be sold to obtain the same amount of profit as above?

4.1.3.9 Key To Self Assessment

Questions (for problems only)

Q.No.6: 7500 Units.

Q.No.7: (A) 25%; (B) Rs.45,000; (C) Rs.2,30,000; (D) Rs.70,000.
Q.No.8: Prime Cost Rs.46,800; Marginal Cost Rs.54,000; Works Cost
Rs.62,000.
Q.No.9: Profit Rs.2,02,000.
Q.No.10: 10,000 Units.

4.1.3.10 Case Analysis

The cost per unit of the three products x, y and z of a concern is

As follows:

X Y Z
(Rs.) (Rs.) (Rs.)
Direct Material 6 7 6
Direct Labour 10 8 9
Variable Expenses 4 5 3
Fixed Expenses 3 3 2
--------------------------------------------
23 23 20
Profit 9 7 6
--------------------------------------------
Selling Price 32 30 26
--------------------------------------------
No. Of Units Produced 10,000 5,000 8,000

Production arrangements are such that if one product is given up, the
production of the others can be raised by 50%. The directors propose that z
should be given up because the contribution in that case is the lowest.
Analyse the case and give your opinion.

213
Solution:

Statement of projected profitability with products x and y

X Y

Production (In Units) 10000 5000

Add 50% Increase (Proposed) 5000 2500
15000 7500
Selling Price Per Unit 32 30
--------------------------
Less: variable cost per unit
Materials 6 7
Labour 10 8
Variable expenses 4 5
20 20
Contribution per unit 12 10

Total contribution
X 15000 Units X Rs.12 = Rs.1,80,000
Y 7500 Units X Rs.10 = Rs. 75,000
Rs.2,55,000
Less: Fixed Cost
X 10000 X 3 = 30000
Y 5000 X 3 = 15000
Z 8000 X 2 = 16000 Rs. 61,000
------- --------------
Projected Profit = Rs.1,94,000
--------------
Statement Of Present Profit With Products X, Y And Z
Rs.
Product X = 10000 Units X Rs.9 = 90,000
Product Y = 5000 Units X Rs.7 = 35,000
Product Z = 8000 Units X Rs.6 = 48,000
------------
1,73,000
----------
Since by discontinuing product z and increasing the production of products
X andY the profit increases from Rs.1,73,000 to Rs.1,94,000. The directors
proposal may be implemented.

214
4.1.3.11 Books For Further Reading

1. P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons, New
Delhi.
2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4. S.N.Maheswari: Management Accounting And Financial Control,
Sultan
5. Chand & Sons.
6. V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.

*****

215
216
 Lesson 4.2 - Cost Volume Profit Analysis

4.2.1 Introduction

The cost of a product consists of two items: fixed cost and variable
cost. Fixed costs are those which remain the same in total amount regardless
of changes in volume. Variable costs are those which vary in total amount as
the volume of production increases or decreases. As a result, at different
levels of activity, the cost structure of a firm changes. The effect on profit on
account of such variations is studied through break even analysis or cost-
volume-profit analysis. This lesson deals with the various concepts, tools
and techniques of cost-volume profit analysis.

4.2.2 Learning Objectives

After reading this lesson, the reader should be able to:

Ֆ understand the meaning of cost-volume-profit analysis.

Ֆ apply cost-volume-profit analysis while taking decisions.
Ֆ construct the break-even chart.
Ֆ evaluate the advantages and limitations of break-even analysis.

4.2.3 Contents

4.2.3.1 Meaning Of Cost-Volume-Profit Analysis

4.2.3.2 Application Of Cost-Volume-Profit Analysis
4.2.3.3 Break Even Chart
4.2.3.4 Consultation Of Break Even Chart
4.2.3.5 Profit Volume Graph
4.2.3.6 Advantages And Limitations Of Break Even Analysis
4.2.3.7 Summary
4.2.3.8 Key Words
4.2.3.9 Self Assessment Questions
4.2.3.10 Key To Self Assessment Questions
4.2.3.11 Case Analysis
4.2.3.12 Books For Further Reading

217
4.2.3.1 Meaning of Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis focuses on the way cost and

profit change when volume changes. It is, broadly speaking, that system of
analysis which determines the probable profit at any level of activity. This
technique is generally used to analyse the incremental effect of volume on
costs, revenues and profits. At what volume of operations are costs and
revenues equal? What volume of output or sales would be necessary to earn
a profit of say rs.2 lakhs? How much profit will be earned at a volume of,
say 10,000 units? What will happen if there is a reduction of 10 percent in
the selling price? Questions like these are sought to be answered through
cvp analysis. This detailed analysis will help the management to know the
profit levels at different activity levels of production and sales and various
types of costs involved in it.

4.2.3.2 Application Of Cost-Volume-Profit Analysis

CPV analysis helps in:

Ֆ Forecasting the profit in an accurate manner
Ֆ Preparing the flexible budgets at different levels of activity
Ֆ Fixing prices for products

Illustration 1:

(Profit Planning) based on the following information, find out the break
even point, the sales needed for a profit of rs.6,00,000 and the profit if
4,00,000 units are sold at rs.6 per unit.

Units Of Output 5,00,000

Fixed Costs Rs.7,50,000
Variable Cost Per Unit Rs. 2
Selling Price Per Unit Rs. 5

Solution:
(1)Break-Even Point (Of Sales)
Fixed Costs
= -------------------------- X Selling Price Per Unit
Contribution Per Unit

218
 7,50,000
= ------------- x 5 = Rs.12,50,000
3
(2) Sales Needed For A Profit Of Rs.6,00,000
Fc + Desired Profit
Sales = --------------------------
P/V Ratio
7,50,000 + 6,00,000
= ---------------------------
3/5

5
= 13,50,000 X -----
3
= Rs.22,50,000 [or]
22,50,000
= ---------------
(SP) 5
= 4,50,000 Units
(3) Profit On Sale Of 4,00,000 Units At Rs.6 Per Unit
Sales = 4,00,000 Units
= 4,00,000 X Rs.6
= Rs.24,00,000

Sales – V. Cost = Contribution

24 Lakhs – (4 Lakhs X 2 Per Unit) = 16,00,000
C – Fc = Profit
16,00,000 – 7,50,000 = Rs.8,50,000 [Or]
Unit Sales X Contribution Per Unit – Fc
4 Lakhs X Rs.4 = 16 Lakhs – 7,50,000 = 8,50,000

Illustration 2: (Pricing)

A company is considering a reduction in the price of its product by

10% because it is felt that such a step may lead to a greater volume of sales.
It is anticipated that there will be no change in total fixed costs or variable
costs per unit. The directors wish to maintain profit at the present level.

219
You are given the following information:
Sales (15,000 Units) Rs.3,00,000
Variable Cost Rs.13 Per Unit
Fixed Cost Rs.60,000
From the above information, calculate P/V ratio and the amount of sales
required to maintain profit at the present level after reduction of selling
price by 10%.

Solution:
S–V 3,00,000 – (15,000 X 13)
P/V Ratio = ---------- = -------------------------------
S 3,00,000
= 0.35 Or 35%
After reduction of price by 10% it will be Rs.18 (original price per unit
Rs.20).
Present profit level = (35% of 3,00,000) – 60,000
= Rs.45,000
P/v ratio after price reduction
S–V 18 – 13 5
= -------- = ---------- = ---- %
S 18 18
To earn the same profit level
F + Desired Profit
= ------------------------
P/V Ratio
18
= 1,05,000 X ------
5
= Rs.3,78,000

Illustration 3:

From the following data, calculate the break-even point.

First year Second Year
Sales 80,000 90,000
Profit Rs.10,000 Rs.14,000

220
Solution:
Fixed Costs
Bep Sales = ----------------
P/V Ratio
Change In Profit
P/V Ratio = -------------------- X 100
Change In Sales

4,000
= --------- X 100 = 40%
10,000

Fixed Cost = Contribution – Profit

40
= 80,000 X ------ − Rs.10,000
100
= 32,000 – 10,000
= 22,000

22,000 X 100
Bep Sales = ---------------- = Rs.55,000
40
Illustration 4:

A company is considering expansion. Fixed costs amount to

rs.4,20,000 and are expected to increase by rs.1,25,000 when plant
expansion is completed. The present plant capacity is 80,000 units a year.
Capacity will increase by 50 percent with the expansion. Variable costs are
currently rs.6.80 per unit and are expected to go down by re.0.40 per unit
with the expansion. The current selling price is rs.16 per unit and is
expected to remain the same under either alternative. What are the break-
even points under either alternatives? Which alternative is better and why?

221
Solution:

Computation of BEP Under Two Alternatives

Items Currently Afterthexpansion
Rs. Rs.
---------------------------------------------------------------------------------
Fixed Costs 4,20,000 5,45,000
Capacity 80,000 Units 1,20,000Units
Variable Cost Per Unit 6.80 6.40
Contribution Margin Per Unit 9.20 9.60
Selling Price Per Unit 16 16

4,20,000 5,45,000
BEP = ------------ -----------
9.20 9.60
= 45,652 Units = 56,771 Units
---------------------------------------------------------------------------------

Assuming that the whole production can be sold, the profit under
The two alternatives will be:

Items Currently After The Expansion

Sales 12,80,000 19,20,000
- Variable Cost 5,44,000 7,68,000
------------ ------------
Contribution 7,36,000 11,52,000
- Fixed Cost 4,20,000 5,45,000
------------ ------------
3,16,000 6,07,000
------------ ------------
---------------------------------------------------------------------------------

It is obvious from the above calculations that the profits will be almost
double after the expansion. Hence, the alternative of expansion is to be
preferred.

222
Illustration 5:

A factory engaged in manufacturing plastic buckets is working at

40% capacity and produces 10,000 buckets per annum:
Rs.
Material 10
Labour cost 3
Overheads 5 (60% fixed)
The selling price is rs.20 per bucket.
If it is decided to work the factory at 50% capacity, the selling price falls by
3%. At 90% capacity the selling price falls by 5%, accompanied by a similar
fall in the prices of material.
You are required to calculate the profit at 50% and 90% capacities and also
the break-even points for the same capacity productions.

Solution:

Statement showing profit and break-even point at different capacity levels:

Capacity Level 50% 90%
Production (Units) 12,500 22,500
Per Unit Total Per Unit Total
Rs. Rs. Rs. Rs.
---------------------------------------------------------------------------------

(A) Sales 19.40 2,42,500 19.00 4,27,500

Variable Cost
Materials 10.00 1,25,000 9.50 2,13,750
Wages 3.00 37,500 3.00 67,500
Variable
Overhead 2.00 25,000 2.00 45,000
---------------------------------------------------------------------------------
(B)Total Variable Cost 15.00 1,87,500 14.50 3,26,250
---------------------------------------------------------------------------------
(C) Contribution
(S-V) 4.40 55,000 4.50 1,01,250
Or (a-b)
Less Fixed Cost 30,000 30,000
---------- ----------
25,000 71,250
---------- --------

223
Break-even points at 50% at 90%
Fixed Costs
Units = ---------------------------
Contribution Per Unit
30,000 30,000
= ---------- = 6818 ---------- = 6667
4.40 4.50
Sales Value = Rs.1,32,269 = Rs.1,26,667

Illustration 6:

Calculate:
Ֆ The amount of fixed expenses
Ֆ The number of units to break-even
Ֆ The number of units to earn a profit of rs.40,000 The
selling price can be assumed as rs.10.
The company sold in two successive periods 9,000 units and 7,000
units and has incurred a loss of rs.10,000 and earned rs.10,000 as profit
respectively.

Solution:

Year Sales Profit/Loss

I 7,000 Units Rs. (- )10,000
II 9,000 Units Rs. (+)10,000
------- ----------
2,000 20,000 (Change)
------- ----------

Year I Year II
(I) Contribution = 9,000Units X Rs.10 7,000Units Xrs.10
= Rs. 90,000 = Rs. 70,000
Less: Profit/Loss = Rs. -10,000 = Rs.+10,000
----------- --------------
Fixed Cost = Rs. 80,000 = Rs. 80,000
(Contribution = Fixed Cost + Profit)

224
 Rs.20,000
(Ii) Contribution = --------------- = Rs.10 Per Unit
2,000 Units

FC Rs.80,000
BEP = --------- = ------------- = 8,000 Units
C Rs.10
(Iii) The No. Of Units To Earn A Profit Of Rs.40,000
F + Desired Profit
= -----------------------
C Per Unit
80,000 + 40,000
= --------------------- = 12,000 Units
10
Illustration 7:

From The Following Data Calculate:

Ֆ P/V Ratio
Ֆ Profit When Sales Are Rs.20,000
Ֆ Net Break-Even If Selling Price Is Reduced By 20% Fixed
Expenses Rs.4,000
Break-Even Point 10,000

Solution:
Fixed Expenses
(I) Break-Even Sales = --------------------
P/V Ratio
Fixed Expenses
or P/V Ratio = ----------------------
Break-Even Sales
4,000
= -------- = 40%
10,000

(II) Profit When Sales Are Rs.20,000

Profit = Sales X P/V Ratio – Fixed Expenses
= Rs.20,000 X 40% − Rs.4,000
= Rs. 8,000 – Rs.4,000
= Rs. 4,000

225
(III) New Break-Even Point If Selling Price Is Reduced By 20%
If Selling Price Is Rs.100, Now It Will Be Rs.80
V. Cost Per Unit = Rs.60 (I.E., 100 – 40% Old P/V Ratio)

80 – 60
New P/V Ratio = ---------- = 25%
80

4,000
Break-Even Point = ------- = Rs.16,000
25%

Illustration 8:

From the following data calculate:

Ֆ Break-even point in amount of sales in rupees.
Ֆ Number of units that must be sold to earn a profit of Rs.60,000 Per year.

Ֆ How many units must be sold to earn a net profit of 15% of sales?

Sales Price Rs.20 Per Unit

Variable manufacturing costs Rs.11 per unit
Variable selling costs Rs. 3 per unit
Fixed factory overheads Rs.5,40,000
Fixed selling costs Rs.2,52,000

Solution:
---------------------------------------------------------------------------------
(I) Items Per Unit Total Fixed Cost
Rs. Rs.
---------------------------------------------------------------------------------
Sales Price 20 Factory Overheads 5,40,000
Variable Costs Selling Costs 2,52,000

Manufacturing 11 7,92,000
Selling 3 14
-- ---
Contribution Per Unit 6

226
 Fixed Costs 7,92,000
BEP = ------------------------- = ------------
Contribution Per Unit 6
= 1,32,000 Units
Total Sales = 1,32,000 X Rs.20 = 26,40,000

Fixed Cost + Desired Profit 7,92,000 + 60,000

(II) ----------------------------------- = -----------------------
Contribution per unit 6

8,52,000
= -----------
6
= 1,42,000 units

(III) Let The No. Of Units Sold Be X.

Marginal Cost Equation:
=S–V =F+P
= 20X – 14X = F + 15% Of Sales
= 20 X – 14 X = 7,92,000 + 15% Of 20X
=6X = 7,92,000 + 3 X
=6X–3X = 7,92,000
=3X = 7,92,000

7,92,000
X= No. Of Units = ------------
3
= 2,64,000
2,64,000 X Rs.20 X 15
Profit = --------------------------- = Rs.7,92,000
100

4.2.3.3 Break-Even Chart

The break-even point can also be shown graphically through the

break-even chart. The break-even chart `shows the profitability or otherwise
of an undertaking at various levels of activity and as a result indicates the
point at which neither profit nor loss is made’. It shows the relationship,
through a graph, between cost, volume and profit. The break-

227
even point lies at the point of intersection between the total cost line and the
total sales line in the chart. In order to construct the breakeven chart, the
following assumptions are made:

Assumptions Of Break-Even Chart

1. Fixed costs will remain constant and do not change with the level
of activity.
2. Costs are bifurcated into fixed and variable costs. Variable costs
change according to the volume of production.
3. Prices of variable cost factors (wage rates, price of materials,
suppliers etc.) Will remain unchanged so that variable costs are
truly variable.
4. Product specifications and methods of manufacturing and selling
will not undergo a change.
5. Operating efficiency will not increase or decrease.
6. Selling price remains the same at different levels of activity.
7. Product mix will remain unchanged.
8. The number of units of sales will coincide with the units produced,
and hence, there is no closing or opening stock.

4.2.3.4 Construction Of Break-Even Chart

The following steps are required to be taken while constructing the

Break-even chart:

1. Sales volume is plotted on the x-axis. Sales volume can be shown

in the form of rupees, units or as a percentage of capacity. A
horizontal line is drawn spacing equal distances showing sales at
various activity levels.
2. Y axis represents revenues, fixed and variable costs. A vertical line
is also spaced in equal parts.
3. Draw the sales line from point o onwards. Cost lines may be drawn
in two ways (i) fixed cost line is drawn parallel to x axis and above
it variable cost line is drawn from zero point of fixed cost line. This
line is called the total cost line (fig.1) (ii) in the second method the
variable cost line is drawn from point o and above this, fixed cost
line is depicted running parallel to the variable cost line. This line
may be called total cost line. (fig.2)

228
 4. The point at which the total cost cuts across the sales line is the
break-even point and volume at this point is break-even volume.
5. The angle of incidence is the angle between sales and the total cost
line. It is formed at the intersection of the sales and the total cost
line, indicating the profit earning capacity of a firm. The wider the
angle the greater is the profit and vice versa. Usually, the angle of
incidence and the margin of safety are considered together to show
that a wider angle of incidence coupled with a high margin of
safety would indicate the most suitable conditions.

Illustration 9:

from the following information, prepare a break-even chart

Showing the break-even point.
Budget output …. 80,000 units
Fixed expenses …. Rs.4,00,000
Selling price per unit .…. Rs. 20
Variable cost per unit …. Rs. 10

Solution:

Total costs and sales at varying levels of output:

Output Variable Fixed Total Sales
(Units) Cost Rs. Cost Rs. Cost Rs. Cost Rs.
---------------------------------------------------------------------------------
@ 10 p.u. @ 20 p.u.
20,000 2,00,000 4,00,000 6,00,000 4,00,000
40,000 4,00,000 4,00,000 8,00,000 8,00,000
60,000 6,00,000 4,00,000 10,00,000 12,00,000
80,000 8,00,000 4,00,000 12,00,000 16,00,000

229
Fig. 1

fig. 2

230
First Method (Fig.1)
Fixed cost line runs parallel to x-axis. Total cost line is drawn at rs.4 lakhs
on y-axis and runs upward. Sales line drawn from point o.
B.E.P. is at 40,000 units, i.e., rs.8,00,000

M/S = Sales – B.E. Volume

= 80,000 – 40,000
= 40,000 Units (I.E. Rs.8,00,000)

Alternative Method (Fig.2)

Variable cost line starts from point o and runs upward. Total cost
Line is drawn parallel to v.c.line from rs.4 lakhs point on y-axis. Total Cost
and sales line cut each other at 40,000 units (i.e., rs.8,00,000 sales). This is
the break-even point.

Cash Break-Even Chart

This chart is prepared to show the cash need of a concern. Fixed

expenses are to be classified as those involving cash payments and those not
involving cash payments like depreciation. As the cash break-even chart is
designed to include only actual payments and not expenses incurred, any
time lag in the payment of items included under variable costs must be
taken into account. Equal care must be shown on the period of credit
allowed to the debtors for the purpose of calculating the amount of cash to
be received from them, during a particular period.

Illustration 10:

The following information is available in respect of graphics ltd.,

ghaziabad, for the budget period.
Sales 10,000 units at rs.10 per unit.
Variable costs rs.4 per unit.
Fixed costs rs.25,000 including depreciation of rs.5,000
Preference dividend to be paid rs.5,000
Taxes to be paid rs.5,000
It may be assumed that there are no lags in payment. Prepare a cash
break-even chart.

231
Fig.3.
4.2.3.5 Profit Volume Graph

This graph (called profit graph) gives a pictorial representation of

cost-volume profit relationship. In this graph x axis represents sales.
However, the sales line bisects the graph horizontally to form two areas. The
ordinate above the zero sales line, shows the profit area, and the ordinate
below the zero sales line indicates the loss or the fixed cost area. The profit-
volume-ratio line is drawn from the fixed cost point through the break-even
point to the point of maximum profit. In order to construct this graph,
therefore, data on profit at a given level of activity, the break-even point and
the fixed costs are required.

Illustration 11:

Draw the profit volume graph and find out p/v ratio with the
following information:
Output 3,000 units
Volume of sales rs.7,500
Variable cost rs.1,500
Fixed cost rs.1,500

Solution:

In the above graph, the profit is rs.1,500. The fixed cost is rs.1,500. Pq
represents sales line at point positive, which is the break even point i.e.,
rs.3,750. The p/v ratio can easily be found out with the help of this graph as
follows:
FXS 1,500X 7,500
Sales At B.E.P. = --------- = ----------------- Rs.3,750
S–V 7,500– 4,500
Margin Of Safety = 7,500 – 3,750 = 3,750

S–V 7,500 – 4,500

P/V Ratio = --------- = -----------------
S 7,500
2
= --- or 0.4 or 40%
5

232
 ( use fig.4)
4.2.3.6 Advantages And Limitations Of Break-Even Analysis

The break-even analysis is a simple tool employed to graphically

represent accounting data. The data revealed by financial statements and
reports are difficult to understand and interpret. But when the same are
presented through break-even charts, it becomes easy to understand them.
Break-even charts help in:

1. Determining total cost, variable cost and fixed cost at a given level
of activity.
2. Finding out break-even output or sales.
3. Understanding the cost, volume, profit relationship.
4. Making inter-firm comparisons.
5. Forecasting profits.
6. Selecting the best product mix.
7. Enforcing cost control.
On the negative side, break-even analysis suffers from the following
limitations:

1.It is very difficult if not impossible to segregate costs into fixed

and variable components. Further, fixed costs do not always remain
constant. They have a tendency to rise to some extent after production
reaches a certain level. Likewise, variable costs do not always vary
proportionately. Another false assumption is regarding the sales revenue,
which does not always change proportionately. As we all know selling
prices are often lowered down with increased production in an attempt to
boost up sales revenue. The break even analysis also does not take into
account the changes in the stock position (it is assumed, erroneously though,
that stock changes do not affect the income) and the conditions of growth
and expansion in an organisation.

2.The application of break-even analysis to a multiproduct firm is

very difficult. A lot of complicated calculations are involved.

3.The break-even point has only limited importance. At best it would

help management to indulge in cost reduction in times of dull business.
Normally, it is not the objective of business to break-even, because no
business is carried on in order to break-even. Further the term

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bep indicates precision or mathematical accuracy of the point. However, in
actual practice, the precise break-even volume cannot be determined and it
can only be in the nature of a rough estimate. Therefore, critics have pointed
out that the term `break-even area’ should be used in place of bep.

4.Break-even analysis is a short-run concept, and it has a limited

application in the long range planning.

Despite these limitations, break-even analysis has some practical utility in

that it helps management in profit planning. According to wheldon, `if the
limitations are accepted, and the chart is considered as being an
instantaneous photograph of the present position and possible trends, there
are some very important conclusions to be drawn from such a chart’.

Summary

Cost-volume-profit analysis is a technique of analysis to study the

effects of cost and volume variations on profit. It determines the probable
profit at any level of activity. It helps in profit planning, preparation of
flexible budgets, fixation of selling prices for products, etc.

The break-even point is generally depicted through the break-even

chart. The chart shows the profitability of an undertaking at various levels of
activity. It brings out the relationship between cost, volume and profit
clearly. On the negative side, the limitations of break-even analysis are:
difficulty in segregating costs into fixed and variable components, difficulty
in applying the technique to multi-product firms, short-term orientation of
the concept etc.

Key Words

Cost-volume-profit analysis: it is that system of analysis which determines

the probable profit at any level of activity.
Profit planning: estimating the profit as accurately as possible.
Pricing: fixing prices for products.
Break-even chart: it is that chart which shows the bep graphically.
Cash break-even chart: this chart shows the cash need of a concern. Profit-
volume graph: this chart gives a pictorial representation of cost volume-
profit analysis.

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4.2.3.9 Self Assessment Questions

1. What is meant by cost-volume-profit analysis? Explain its

application in managerial decision making.
2. How would you construct a break-even chart?
3. Make an evaluation of break-even analysis.
4. You are given the following data for the year 1989 of x company.

Rs. %
Variable costs 6,00,000 60
Fixed costs 3,00,000 30
Net profit 1,00,000 10
----------- -----
Total sales 10,00,000 100
----------- -----
Find out (A) Break-Even Point
(A) P/V Ratio, And
(B) Margin Of Safety Ratio
Also draw a break-even chart indicating contribution.
A firm is selling x product, whose variable cost per unit is
rs.10 and fixed cost is rs.6,000. It has sold 1,000 articles during one month
at rs.20 per unit. Market research shows that there would be a great demand
for the product if the price can be reduced. If the price can be reduced to
rs.12.50 per unit, it is expected that 5,000 articles can be sold in the
expanded market. The firm has to take a decision whether to produce and
sell 1,000 units at the rate of rs.20 or to produce and sell for the growing
demand of 5,000 units at the rate of rs.12.50. Give your advice to the
management in taking decision.

A publishing firm sells a popular novel at rs.15 each. At current sales

of 20,000 books, the firm breaks even. It is estimated that if the author’s
royalties were reduced, the variable cost would drop by rs.1.00 to rs.7.00
per book. Assume that the royalties were reduced by rs.1.00, that the price
of the book is reduced to rs.12 and that this price reduction increases sales
from 20,000 to 30,000 books. What are the publisher’s profits, assuming
that fixed costs do not change?

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An analysis of a manufacturing co. Led to the following information:
Variable Cost Fixed Cost
Cost Element (% Of Sales) Rs.
Direct Material 32.8
Direct Labour 28.4
Factory Overheads 12.6 1,89,900
Distribution Overheads 4.1 58,400
General Administration Overheads 1.1 66,700
Budgeted Sales Rs.18,50,000
You are required to determine:
(a) the break-even sales volume
(b) the profit at the budgeted sales volume
(c) the profit if actual sales
(i) drop by 80%
(ii) increase by 5% from budgeted sales.

4.2.3.10 Key To Self Assessment

Questions (for problems only)
Q.No.4: (A) Rs.7,50,000; (B) 40%; (C) 25%
Q.No.5: The Proposal Is Profitable
Q.No.6: Rs.10,000
Q.No.7: (A) Rs.15,000; (B) Rs.73,000; (C) (I) Rs.34,650; (Ii) Rs.9,925

4.2.3.11 Case Analysis

The directors of anandam ltd. Provide you the following data relating to the
cylce chain manufactured by them:
Rs.
Sales 4,000 units @rs.50 each 2,00,000
Production cost details: Rs.
Materials consumed 80,000
Labour cost 40,000
Variable overheads 20,000
Fixed overheads 30,000 1,70,000
---------- ----------
Profit 30,000
----------

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They require you to answer their following queries:
(i) the number of units by selling which the company will be
At break-even.
(ii) the sales needed to earn a profit of 20% on sales.
(iii) the extra units which would be sold to obtain the present
Profit if it is proposed to reduce the selling price by 20%

Solution:

(i) Break Even Units:

Fixed Cost Rs.30,000
-------------------------- = -------------- = 2000 Units
Contribution Per Unit Rs.15
(Ii) Sales To Earn 20% On Sales
Let the units to be sold to earn 20% be x. Therefore sales will be 50x and
profit is 20% of 50x i.e. 10x.
Now The Total Sales Should Be Fixed Cost + Variable Cost + Profit
Is
50x = 30000 + 35x + 10x
5x = 30000
x = 6000 units
Therefore sales required is 6000 units x Rs.50 = Rs.3,00,000
(iii) extra units to be sold if selling price is reduced by 20%.
Present Selling Price Rs.50
Less 20% Rs.10
-------
New Selling Price Rs.40
Less Variable Cost Rs.35
-------
Contribution Rs. 5
-------

Fixed Cost + Target Profit

Units To Be Sold = -------------------------------
Contribution
30,000 + 30,000
= -------------------- = 12000 Units
5
Extra Units To Be Sold =12000 – 4000 = 800 Units

237
4.2.3.12 Books For Further Reading

1.P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons,

New Delhi.
2.Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3.Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4.S.N.Maheswari: Management Accounting And Financial
Control, Sultan Chand & Sons.
5.V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.

*****

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 UNIT V: Cost Estimation And Control

Lesson – 5.1 Cost Accounting

5.1.1 Introduction

Accounting can no longer be considered a mere language of

business. The need for maintaining the financial chastity of business
operations, ensuring the reliability of recorded experience resulting from
these operations and conducting a frank appraisal of such experiences has
made accounting a prime activity along with such other activities as
marketing, production and finance. Accounting may be broadly classified
into two categories – accounting which is meant to serve all parties external
to the operating responsibility of the firms and the accounting, which is
designed to serve internal parties to take care of the operational needs of the
firm. The first category, which is conventionally referred to as “financial
accounting”, looks to the interest of those who have primarily a financial
stake in the organisation’s affairs – creditors, investors, employees etc. On
the other hand, the second category of accounting is primarily concerned
with providing information relating to the conduct of the various aspects of
a business like cost or profit associated with some portions of business
operations to the internal parties viz., management. This category of
accounting is divided into “management accounting” and “cost accounting”.
This section deals with cost accounting.

5.1.2 Learning Objectives

After reading this lesson, the reader should be able to:

Ֆ understand the different dimensions of cost accounting.

Ֆ distinguish cost accounting from financial accounting.
Ֆ appreciate the utility of cost accounting.
Ֆ apply the various bases of classification of costs.
Ֆ prepare a cost sheet or tender or quotations.

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5.1.3 Contents

5.1.3.1 Meaning Of Cost Accounting

5.1.3.2 Distinction Between Financial Accounting And Cost
Accounting
5.1.3.3 Utility Of Cost Accounting
5.1.3.4 Distinction Between Costing And Cost Accounting
5.1.3.5 Classification Of Cost
5.1.3.6 Cost Sheet
5.1.3.7 Illustrations
5.1.3.8 Summary
5.1.3.9 Key Words
5.1.3.10 Self Assessment Questions
5.1.3.11 Key To Self Assessment Questions
5.1.3.12 Case Analysis
5.1.3.13 Books For Further Reading

5.1.3.1 Meaning Of Cost Accounting

Cost accounting developed as an advanced phase of accounting

science and is trying to make up the deficiencies of financial accounts. It is
essentially a creation of the twentieth century. Cost accounting accounts for
the costs of a product, a service or an operation. It is concerned with actual
costs incurred and the estimation of future costs. Cost accounting is a
conscious and rational procedure used by accountants for accumulating
costs and relating such costs to specific products or departments for
effective management action. Cost accounting through its marginal costing
technique helps the management in profit planning and through its another
technique i.e. Standard costing facilitates cost control. In short, cost
accounting is a management information system which analyses past,
present and future data to provide the basis for managerial decision making.

5.1.3.2 Distinction Between Financial Accounting

And Cost Accounting

Though there is much common ground between financial accounting

and cost accounting and though in fact cost accounting is an outgrowth of
financial accounting yet the emphasis differs. Firstly financial accounting

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is more attached with reporting the results of business to persons other than
internal management – government, creditors, investors, researchers, etc.
Cost accounting is an internal reporting system for an organisation’s own
management for decision making. Secondly financial accounting data is
historical in nature and its periodicity of reporting is much wider. Cost
accounting is more concerned with short-term planning and its reporting
period much lesser than financial accounting. It not only deals with historic
data but also is futuristic in approach. Thirdly, in financial accounting the
major emphasis in cost classification is based on the type of transaction e.g.
Salaries, repairs, insurance, stores, etc. But in cost accounting the major
emphasis is on functions, activities, products, processes and on internal
planning and control and information needs of the organisation.

5.1.3.3 Utility Of Cost Accounting

A properly installed cost accounting system will help the

management in the following ways:
- the analysis of profitability of individual products, services or jobs.
- the analysis of profitability of different departments or operations.
- it locates differences between actual results and expected results.
- it will assist in setting the prices so as to cover costs and generate an
acceptable level of profit.
- cost accounting data generally serves as a base to which the tools and
techniques of management accounting can be applied to make it more
purposeful and management oriented.
- the effect on profits of increase or decrease in output or shutdown of a
product line or department can be analysed by adoption of efficient cost
accounting system.

5.1.3.4 Distinction Between Costing And Cost Accounting

Costing is the technique and process of ascertaining costs. It tries to

find out the cost of doing something, i.e., the cost of manufacturing an
article, rendering a service, or performing a function. Cost accounting is
a broader term, in that it tries to determine the costs through a formal system
of accounting (unlike costing which can be performed even through
informal means). Stated precisely, cost accounting is a formal mechanism
by means of which costs of products and services are ascertained and
controlled. The institute of cost and management accountants, u.k. define

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cost accounting as: the application of accounting and costing principles,
methods and techniques in the ascertainment of costs and the analysis of
savings and/or excesses as compared with previous experience or with
standards. It, thus, includes three things:
Ֆ Cost Ascertainment: finding out the specific and precise total and unit costs
of products and services.
Ֆ Cost Presentation: reporting cost data to various levels of management with
a view to facilitate decision making.
Ֆ Cost Control: this consists of estimating costs for production and activities
for the future, and keeping them within proper limits. Budgets and standards
are employed for this purpose.
Cost accounting also aims at cost reduction, i.e., achieving a
permanent and real reduction in cost by improving the standards. Cost
accountancy is a comprehensive term that implies the `application of costing
and cost accounting principles, methods and techniques to the science, art
and practice of cost control’. It seeks to control costs and ascertain the
profitability of business operations.

5.1.3.5 Classification Of Cost

In the process of cost accounting, costs are arranged and rearranged

in various classifications. The term `classification’ refers to the process of
Grouping costs according to their common characteristics. The different
bases of cost classification are:
1. By nature or elements (materials, labour and overheads)
2. By time (historical, pre-determined)
3. By traceability to the product (direct, indirect)
4. By association with the product (product, period)
5. By changes in activity or volume (fixed, variable, semi-variable)
6. By function (manufacturing, administrative, selling, research
and development, pre-production)
7. By relationship with the accounting period (capital, revenue)
8. By controllability (controllable, non-controllable)
9. By analytical/decision-making purpose (opportunity, sunk,
differential, joint, common, imputed, out-of-pocket, marginal,
uniform, replacement)
10. By other reasons (conversion, traceable, normal, avoidable,
unavoidable, total)

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1. Elements Of Cost

The elements of costs are the essential part of the cost. There are
broadly three elements of cost, as explained below:

(A) Material

The substance from which the produce is made is called material.

It can be direct as well as indirect.
I) Direct Material: it refers to those materials which become an integral
part of the final product and can be easily traceable to specific physical
units. Direct materials, thus, include:
1. All materials specifically purchased for a particular job or process.
2. Components purchased or produced.
3. Primary packing materials (e.g., carton, wrapping, card-board
boxes etc.).
4. Material passing from one process to another.

Ii) Indirect Material: all materials which are used for purpose ancillary to
the business and which cannot conveniently be assigned to specific physical
units are known as `indirect materials’. Oil, grease, consumable stores,
printing and stationery material etc. Are a few examples of indirect
materials.

(b) Labour
In order to convert materials into finished products, human effort is
required. Such human effort is known as labour. Labour can be direct as
well as indirect.

I) Direct Labour:

It is defined as the wages paid to workers who are engaged in the

production process and whose time can be conveniently and economically
traceable to specific physical units. When a concern does not produce but
instead renders a service, the term direct labour or wages refers to the cost
of wages paid to those who directly carry out the service, e.g., wages paid to
driver, conductor etc. Of a bus in transport service.

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Ii) Indirect Labour:

Labour employed for the purpose of carrying out tasks

Incidental to goods produced or services provided is called indirect labour
or indirect wages. In short, wages which cannot be directly identified with a
job, process or operation, are generally treated as indirect wages. Examples
of indirect labour are: wages of store-keepers, foremen, supervisors,
inspectors, internal transport men etc.

(C) Expenses
Expenses may be direct or indirect.

I) Direct Expenses:

These are expenses which can be directly, conveniently and wholly

identifiable with a job, process or operation. Direct expenses are also known
as chargeable expenses or productive expenses. Examples of such expenses
are: cost of special layout, design or drawings, hire of special machinery
required for a particular contract, maintenance cost of special tools needed
for a contract job, etc.

Ii) Indirect Expenses:

Expenses which cannot be charged to production directly and which

are neither indirect materials nor indirect wages are known as indirect
expenses. Examples are rent, rates and taxes, insurance, depreciation,
repairs and maintenance, power, lighting and heating etc.

The above elements of cost may be shown by means of a chart:

Element of cost
materials labour expenses
Direct indirect direct indirect direct indirect

1. Overheads

The term overheads includes, indirect material, indirect labour and

indirect expenses, explained in the preceding paragraphs. Overheads may be
incurred in the factory, office or selling and distribution departments/
divisions in an undertaking. Thus overheads may be of three types: factory

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overheads, office and administrative overheads and selling and distribution
overheads. This classification of overheads may be shown thus:

Classification Of Overheads

Overheads
Factory office selling and distribution
Indirect indirect indirect indirect indirect indirect indirect indirect indir
Material labour exp mat lab. Exp. Mat. Lab exp

2. Cost Classification By Time

On the basis of the time of computing costs, they can be classified

Into historical and pre-determined costs.

I) Historical Costs:

These costs are computed after they are incurred. Such costs are
available only after the production of a particular thing is over.

Ii) Pre-Determined Costs:

These costs are computed in advance of production on the basis of a

specification of all factors influencing cost. Such costs may be:

1. Estimated costs: estimated costs are based on a lot of guess

work. They try to ascertain what the costs will be based on certain factors.
They are less accurate as only past experience is taken into account
primarily, while computing them.

2. Standard costs: standard costs is a pre-determined cost based

on a technical estimate for material, labour and other expenses for a selected
period of time and for a prescribed set of working conditions. It is more
scientific in nature and the object is to find out what the costs should be.

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3. Cost Classification By Traceability

As explained previously, costs which can be easily traceable

to a product are called direct costs. Indirect costs cannot be traced to a
product or activity. They are common to several products (e.g., salary of a
factory manager, supervisor etc.) And they have to be apportioned to
different products on some suitable basis. Indirect costs are also called
`overheads’.

4. Cost Classification By Association With Product

Costs can also be classified (on the basis of their association with
products) as product costs and period costs.
1.Product Costs: product costs are traceable to the product and
include direct material, direct labour and manufacturing overheads. In other
words, product cost is equivalent to factory cost.
2.Period Costs: period costs are charged to the period in which they
are incurred and are treated as expenses. They are incurred on the basis of
time, e.g., rent, salaries, insurance etc. They cannot be directly assigned to a
product, as they are incurred for several products at a time (generally).

5. Cost Classification By Activity/Volume

Costs are also classified into fixed, variable and semi-variable on the
basis of variability of cost in the volume of production.

1.Fixed Cost:

Fixed cost is a cost which tends to be unaffected by variations in

volume of output. Fixed cost mainly depends on the passage of time and
does not vary directly with the volume of output. It is also called period
cost, e.g., rent, insurance, depreciation of buildings etc. It must be noted
here that fixed costs remain fixed upto a certain level only. These costs may
also vary after a certain production level.

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 2.Semi-Variable Cost:

These costs are partly fixed and partly variable. Because of the
variable element, they fluctuate with volume and because of the fixed
element, they do not change in direct proportion to output. Semi-variable or
semi-fixed costs change in the same direction as that of the output but not in
the same proportion. For example, the expenditure on maintenance is to a
great extent fixed if the output does not change significantly. Where,
however, the production rises beyond a certain limit, further expenditure on
maintenance will be necessary although the increase in the expenditure will
not be in proportion to the rise in output. Other examples in this regard are:
depreciation, telephone rent, repairs etc.

3.Variable Cost:

Cost which tends to vary directly with volume of outputs is called

`variable cost’. It is a direct cost. It includes direct material, direct labour,
direct expenses etc. It should be noted here that the variable cost per unit is
constant but the total cost changes corresponding to the levels of output. It is
always expressed in terms of units, not in terms of time.

6. Cost Classification By Function

On the basis of the functions carried out in a manufacturing concern,

Costs can be classified into four categories:
1.Manufacturing/Production Cost: it is the cost of operating the
manufacturing division of an enterprise. It is defined as the cost of the
sequence of operations which begin with supplying materials, services and
ends with the primary packing of the product.

2Administrative/Office Cost: it is the cost of formulating the policy,

directing the organisation and controlling the operations of an undertaking,
which is not directly related to production, selling, distribution, research or
development. Administration cost, thus, includes all office expenses:
remuneration paid to managers, directors, legal expenses, depreciation of
office premises etc.

3.Selling Cost: selling cost is the cost of seeking to create and

stimulate demand e.g., advertisements, show room expenses, sales

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promotion expenses, discounts to distributors, free repair and servicing
expenses, etc.

4.Distribution Cost: it is the cost of the sequence of operations which

begins with making the packed product, available for despatch and ends
with making the reconditioned returned empty package, if any, available for
re-use. Thus, distribution cost includes all those expenses concerned with
despatching and delivering finished products to customers, e.g., warehouse
rent, depreciation of delivery vehicles, special packing, loading expenses,
carriage outward, salaries of despatch clerks, repairing of empties for re-use,
etc.

5. Research And Development Cost: it is the cost of discovering new

ideas, processes, products by experiment and implementing such results on
a commercial basis.

6.Pre-Production Cost: expenses incurred before a factory is started

and expenses involved in introducing a new product are preproduction
costs. They are treated as deferred revenue expenditure and charged to the
cost of future production on some suitable basis.

7. Cost Classification By Relationship With Accounting Period

On the basis of controllability, costs can be classified as controllable or

uncontrollable.
1.Controllable Cost: a cost which can be influenced by the action of
a specified member of an undertaking is a controllable cost, e.g., direct
materials, direct labour etc.

2.Uncontrollable Cost: a cost which cannot be influenced by the

action of a specified member of an undertaking is an uncontrollable cost,
e.g., rent, rates, taxes, salary, insurance etc.

The term controllable cost is often used in relation to variable cost

and the term uncontrollable cost in relation to fixed cost. It should be noted
here that a controllable cost can be controlled by a person at a given
organisation level only. Sometimes two or more individuals may be
involved in controlling such a cost.

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8. Cost Classification By Decision-Making Purpose

Costs may be classified on the basis of decision-making purposes for

which they are put to use, in the following ways:
1.Opportunity Cost: it is the value of the benefit sacrificed in favour
of choosing a particular alternative or action. It is the cost of the best
alternative foregone. If an owned building, for example, is proposed to be
used for a new project, the likely revenue which the building could fetch,
when rented out, is the opportunity cost which should be considered while
evaluating the profitability of the project.

2.Sunk Cost: a cost which was incurred or sunk in the past and is not
relevant for decision-making is a sunk cost. It is only historical in nature and
is irrelevant for decision-making. It may also be defined as the difference
between the purchase price of an asset and its salvage value.

3.Differential Cost: the difference in total costs between two

alternatives is called as differential cost. In case the choice of an alternative
results in increase in total cost, such increase in costs is called `incremental
cost’. If the choice results in decrease in total costs, the resulting decrease is
known as decremental cost.

4.Joint Cost: whenever two or more products are produced out of

one and the same raw material or process, the cost of material purchased
and the processing are called joint costs. Technically speaking, joint cost is
that cost which is common to the processing of joint products or by-
products upto the point of split-off or separation.

5.Common Cost: common cost is a cost which is incurred for more

than one product, job territory or any other specific costing object. It cannot
be treated to individual products and, hence, apportioned on some suitable
basis.

6.Imputed Cost: this type of cost is neither spent nor recorded in the
books of account. These costs are not actually incurred (hence known as
hypothetical or notional costs) but are considered while making a decision.
For example, in accounting, interest and rent are recognized only as
expenditure when they are actually paid. But in costing, they are charged on
a notional basis while ascertaining the cost of a product.

249
 7.Out-Of-Pocket Cost: it is the cost which involves current or future
expenditure outlay, based on managerial decisions. For example a company
has its own trucks for transporting goods from one place to another. It seeks
to replace these by employing public carriers of goods. While making this
decision, management can ignore depreciation, but not the out-of-pocket
costs in the present situation, i.e., fuel, salary to drivers and maintenance
paid in cash.

8.Marginal Cost: it is the aggregate of variable costs, i.e., prime cost

plus variable overheads.

9.Replacement Cost: it is the cost of replacing a material or asset in

the current market.

5.1.3.6 Cost Sheet

Cost sheet is a statement presenting the items entering into cost of

products or services. It shows the total cost components by stages and cost
per unit of output during a period. It is usually prepared to meet three
objectives: to provide the classification of costs in a summarised form, to
prepare estimates of costs for future use and to facilitate a comparative
study of costs with previous cost sheets to know the cost trends.

250
The layout of a typical cost sheet is provided below:
Specimen cost sheet

Particulars Total cost Cost per Unit

Direct materials
opening stock of materials
add purchases of materials
less closing stock of materials
(a) materials consumed

Direct wages

Direct expenses

Prime cost

Add Factory Overheads

Factory Rent, Rates, Taxes
Fuel-Power And Water
Lighting And Heating
Indirect Wages
Salaries Of Works Manager Etc.
Indirect Materials
Drawing Office And Works Office Expenses
Depreciation On Factory Land And
Building
Less Scrap Value
Defective Work
Add Work In Progress (Opening)
Less Work In Progress (Closing)
Works cost
Add Office/Administration Overheads
Office Rent, Insurance, Lighting, Cleaning
Office Salaries, Telephone, Law And
Audit Expenses
General Manager’s Salary
Printing And Stationery
Maintenance, Repairs, Upkeep Of Office
bldg
bank charges and miscellaneous expenses

251
Cost Of Production
Add opening stock of finished goods
Less closing stock of finished goods
Cost of goods sold
Add selling and distribution overheads
showroom expenses, salesmen’s salaries
& commission, bad debts, discounts,
warehouse rent, carriage outwards,
advertising, delivery expenses, samples and
free gifts etc.
ost of sales
add net profit or deduct net loss:
Sales

Treatment of certain items in the cost sheet:

(a) Computation Of Profit: profit may be calculated either as a
Percentage of cost or selling price.
Example: profit as a percentage of cost:
Factory cost 5,700
Administration overhead 600
-------
Total cost 6,300
-------
Profit 10% on cost 630
-------
Selling price 6,930
-------
percent
So profit = cost -------------
100
Example: Profit as a percentage of selling price. Here the percentage is on
Selling price. Selling price includes Cost + Profit.
Sales price = 100
Less profit = 10
----
Cost price = 90
----

252
This profit of rs.10 is on rs.90 which is the cost price. So it is 1/9th of cost
price. In the above example,
Total cost = 6,300
Profit on 10% on SP = 700
-------
Selling price 7,000
-------
Cost x percent
So sale price = -------------------
100 – percent
6,300 x 100
= -----------------
100 - 10
= 7,000
(b) Treatment Of Stock: the term `stock’ includes three items: raw materials,
work in progress and finished goods. The value of raw materials is arrived
at in the following manner:

Opening stock of raw material

Add purchases
Add expenses involved in the purchases of raw material
Less closing stock of raw materials
Work-in-progress represents the quantity of semi-finished goods at
the time of the preparation of the cost sheet. It represents cost of materials,
labour and manufacturing expenses to-date. Work-in-progress may be
shown in the cost sheet either immediately after the prime cost or after the
calculation of the factory overheads, as shown in the specimen cost sheet.
Finally, in respect of stock of finished goods, adjustments have to be made
where opening and closing stock of finished goods are given. This is done,
as shown in the specimen cost sheet, by adding opening stock of finished
goods to the cost of production arrived at on the basis of current figures and
reducing the closing stock of finished goods from this total. Let’s explore
these aspects more clearly through the following illustrations:

Tenders And Quotations:

While preparing tenders or quotations, manufacturers or contractors

have to look into the figures pertaining to the previous year as shown in the
cost sheet for that period. These figures have to be suitably

253
modified in the light of changes expected in the prices of materials, labour,
etc., and submit the tender or quotation accordingly.

5.3.6 Illustrations

Illustration 1:

Prepare the cost sheet to show the total cost of production and cost
per unit of goods manufactured by a company for the month of july 2012.
Also find out the cost of sales.

Stock of raw materials 1-7-2012 3,000

Raw materials purchased 28,000
Stock of raw materials 31-7-2012 4,500
Manufacturing wages 7,000
Depreciation of plant 1,500
Loss o n sale of a part of plant 300
Factory rent and rates 3,000
Office rent 500
General expenses 400
Discount on sales 300
Advertisement expenses to be fully charged 600
Income-tax paid 2,000
The number of units produced during july, 2012 was 3,000.
The stock of finished goods was 200 and 400 units on 1-7-2012 and
31-7-202 respectively. The total cost of units on hand on 1-7-2012 was
Rs.2,800. All these have been sold during the month.

Output 3,000 units.

Cost sheet for the year ended 31-7-2012
Particulars Total Cost Per Unitcost
Rs. Rs.
Raw materials consumed
Opening stock 3,000
Add purchases 28,000
---------
31,000
Less closing stock 4,500 26,500 8.83
--------

254
Direct wages 7,000 2.33
------- --------
Prime cost 33,500 11.16
Factory overheads:
Depreciation 1,500
Factory rent 3,000 4,500 1.50

Factory cost 38,000 12.66

Office and administrative
Overheads:
Office rent 500
General expenses 400 900 0.30

Cost of production 38,900 12.96

Statement of cost of sales

Cost of production 38,900
Add: opening stock of
Finished goods 2,800
---------
41,700
Less: closing stock of finished
Goods (400 x rs.12.96) 5,184
--------
Cost of production of goods sold 36,516
Add: selling and distribution overhead:
Discount on sales 300
Advertisement expenses 600 900

Cost of sales 37,416

Illustration 2:

From the following particulars, prepare a cost sheet for the year
ending 31-12-2011.

Opening stock of raw materials (1-1-2011) 50,000

Purchases of raw materials 1,60,000
Closing stock of raw materials (31-12-2011) 80,000

255
Wages – productive 1,50,000
general 20,000
Chargeable expenses 40,000
Rent, rates and taxes – factory 10,000
Rent, rates and taxes – office 1,000
Depreciation on plant and machinery 3,000
Salary – office 5,000
Salary – travellers 4,000
Printing and stationery 1,000
Office cleaning and lighting 800
Repairs and renewals (factory) 6,400
Other factory expenses 5,000
Management expenses (including managing
Director’s fees) 24,000
Travelling expenses of salesmen 2,200
Showroom expenses and samples 2,000
Carriage and freight – outwards 2,000
Carriage and freight – inwards 9,000
Octroi on purchases 1,000
Advertisement 30,000
Sales 4,60,000
Management expenses should be allocated in the ratio of 2:1:3 on factory,
office and sales departments.
Solution:
Statement of cost and profit for 2011
Rupees Rupees
Materials consumed
Opening stock 50,000
Add purchases 1,60,000
Add carriages freight inwards 9,000
Add octroi on purchases 1,000
-----------
2,20,000
Less closing stock 80,000
-----------
Cost of materials used 1,40,000
Productive wages 1,50,000
Chargeable expenses 40,000
Prime cost 3,30,000

256
Factory expenses
General wages 20,000
Rent, rates and taxes 10,000
Depreciation on plant and
Machinery 3,000
Repairs and renewals 6,400
Other factory expenses 5,000
Management expenses: 1/6 of Rs.24,000 8,000 52,400
-------- ---------
Factory cost 3,82,400
Administrative expenses
Rent, rates and taxes 1,000
Salary 5,000
Printing and stationery 1,000
Cleaning and lighting 800
Management expenses:1/6
of Rs.24,000 4,000 11,800
----------
Cost of production 3,94,200

Selling and distribution expenses

Advertising 4,000
Show-room expenses and samples 2,000
Traveller’s salary 4,000
Salesmen’s travelling expense 2,200
Carriage outwards and freight 2,000
Management expenses: 3/6 of
Rs.24,000 12,000 26,200

Cost of sales 4,20,400

Sales 4,60,000
---------
Profit 39,600
---------
---------------------------------------------------------------------------------

257
Illustration 3:

the following particulars relate to a company for a period of

Three months:
Raw materials (1-1-2012) 55,000
Raw materials (31-3-2012) 35,000
Factory wages 80,000
Materials purchased 60,000
Sales 1,54,000
Indirect expenses 10,000
Stock of finished goods (1-1-2012) NIL
Stock of finished goods (31-3-2012) 30,000
No. Of units produced during the period was 2,000.
Prepare a statement of cost for the period and compute the price to be
quoted for 500 units in order to realise the same profit as for the period
under review, assuming no alternation in wages and cost of materials.

Solution:

Statement of cost for the period ending 31-3-2012

Output 2,000 Units
Particulars Amount
Rs. Rs.
---------------------------------------------------------------------------------
Opening stock of raw materials 55,000
Add: purchases 60,000
---------
1,15,000
Less: closing stock of raw materials 35,000
---------
Raw materials consumed 80,000
Factory wages
80,000
---------
Prime cost 1,60,000
Indirect expenses 10,000
----------
Cost of production 1,70,000
Less: closing stock of finished goods 30,000
----------

258
Cost of goods sold
1,40,000
14,000 x 100
Profit ( -------------------- ) = 10% of cost
1,40,000
14,000
----------
Sales 1,54,000
---------
Tender statement showing quotations for 500 units
Particulars Amount
Rupees
---------------------------------------------------------------------------------

80,000 x 500
Materials consumed ( ---------------- )
2,000 20,000
80,000 x 500
Wages ( ----------------- ) 20,000
2,000 ---------
Prime cost 40,000
10,000 x 500
Add: indirect expenses ( ----------------- ) 2,500
2,000 --------
Cost of production 42,500
Add: profit (10% of cost of production) 4,250
----------
Price to be quoted 46,750
---------

Illustration 4: The following information has been taken from a factory:

Rupees
Materials 50,000
Direct wages 40,000
Factory overheads 30,000
Administration overheads 20,000
You are required to fix the selling price of a machine costing rs.4,200 in
materials and rs.3,000 in wages so that it yields a profit of 25% on selling
price.

259
Solution:
Statement of cost Rupees
Materials 50,000
Direct wages 40,000
---------
Prime cost 90,000
Factory overheads 30,000
----------
Works cost 1,20,000
Administration overheads 20,000
----------
Cost of production 1,40,000
----------
Percentage of factory overheads to direct wages:
30,000
------------ x 100 = 75%
40,000
Percentage of office overheads to works cost:
20,000
-------------- x 100 = 16.67%
1,20,000

Tender or quotation
Rupees
Materials 4,200
Wages 3,000
-------
Prime cost 7,200
Factory overheads - 75% of wages 2,250
-------
Works cost 9,450
Administration overheads – 16.67% on
Works cost 1,575
--------
Cost of production 11,025
Profit 25% on selling price or
33 1/3
33 1/3% on cost 11,025 x ----------- 3,675
100

260
 --------
Estimated selling price 14,700
-------
5.1.3.8 Summary

Traditional accounting or financial accounting can no longer serve

the purposes of all concerned. Especially the internal organs of the business
concerns, namely managements, want a lot of analytical information which
could not be provided by the financial accounting. Hence to serve the needs
of management two more kinds of accounts – management accounting and
cost accounting have evolved. Simply stated, management accounting
serves the needs of management and cost accounting tries to determine the
costs through a formal system of accounting. Costs can be classified on
various bases and cost sheet is a statement presenting the items entering into
cost of products or services.

5.1.3.9 Key Words

Direct Expenses: expenses that can easily be identified with a particular

product.
Indirect Expenses: expenses which cannot be easily identified with a
particular product.
Overheads: total of all indirect expenses.
Works Cost: prime cost + factory overheads.
Cost Of Production: works cost + administration overheads.
Cost Of Sales: cost of production + selling and distribution overheads.
Cost Sheet: a statement which is prepared to ascertain the cost of sales.
Tenders: a statement which quotes the price for a particular job or level of
production activity.

5.3.10 Self Assessment Questions

1.What are the limitations of financial accounting?

2.Justify the need for cost accounting.
3.Explain the various bases for classification of costs.
4.What are the differences between a `cost sheet’ and `tender’.
5.Prepare a cost sheet for the production of 100 units of an article
using imaginary figures.
6.Prepare a statement of cost showing:

261
 (a) value of materials consumed
(b) total cost of production
(c) cost of goods sold and
(d) the amount of profit
From the following details relating to a toy manufacturing concern:
Rupees
Opening stock: raw materials 25,000
finished goods 20,000
Raw materials purchased 2,50,000
Wages paid to labourers 1,00,000
Closing stock: raw materials 20,000
finished goods 25,000
Chargeable expenses 10,000
Rent, rates and taxes (factory) 25,000
Motive power 10,000
Factory heating and lighting 10,000
Factory insurance 5,000
Experimental expenses 2,500
Waste materials in factory 1,000
Office salaries 20,000
Printing and stationery 1,000
Salesmen’s salary 10,000
Commission to travelling agents 5,000
Sales 5,00,000

7.Kolam products ltd., produces a stabilizer that sells for rs.300. An

increase of 15% in the cost of materials and 10% in the cost of labour is
anticipated. If the only figures available are those given below, what must
be the selling price to give the same percentage of gross profit as before?
Ֆ Material costs have been 45% of cost of sales
Ֆ Labour costs have been 40% of cost of sales
Ֆ Overhead costs have been 15% of the sales
Ֆ The anticipated increased costs in relation to the present sale
Ֆ Price would cause a 35% decrease in the amount of present gross Profit.

262
5.1.3.11 Key To Self Assessment Questions (For
Problems Only)

6. Materials used rs.2,55,000; prime cost rs.3,65,000; works cost

Rs.4,18,500; cost of production rs.4,39,500; cost of sales rs.4,49,500 and
profit rs,50,500.
7. Selling price: rs.332.25.

5.1.3.12 Case Analysis

A small scale manufacturer produces an article at the operated

capacity of 10,000 units while the normal capacity of his plant is 14,000
units. Working at a profit margin of 20% on sales realisation, he has
formulated his budget as under:
10,000 units 14,000 units
Rs. Rs.
Sales realisation 2,00,000 2,80,000
Variable overheads 50,000 70,000
Semi-variable overheads 20,000 22,000
Fixed overheads 40,000 40,000

He gets an order for a quantity equivalent to 20% of the operated

Capacity and even on this additional production profit margin is desired At
the same percentage on sales realisation as for production to operated
Capacity. As you are a cost manager, he approached you to advise him as
To what should be the minimum price to realise this objective.

Solution:
Computation of prime cost
Profit margin is 20% on sale
Therefore cost of sale, 80% of rs.2,00,000 i.e. 1,60,000
Variable overheads 50,000
Semi-variable overheads 20,000
Fixed overhead 40,000 1,10,000
Prime cost 50,000

Since an additional production of 4000 units requires an increase of

rs.2000 in semi-variable expenses, an additional production of 2000 units
will require an increase of rs.1000 in semi-variable expenses:

263
 Differential cost of production of 2000 extra units
10000 12000 Differential Cost
Units Units For 2000 Units
Rs. Rs. Rs.
---------------------------------------------------------------------------------
Prime cost 50,000 60,000 10,000
Variable overheads 50,000 60,000 10,000
Semi-variable overheads 20,000 21,000 1,000
Fixed overheads 40,000 40,000 ---
-------------------------------------------------
1,60,000 1,81,000 21,000
-------------------------------------------------
The different cost for 1 unit is rs.21000 ÷ 2000 units i.e. Rs.10-50. Profit
margin required is 20% on sale or 25% on cost. Hence the minimum selling
price = rs.10.50 + rs.2.625 = rs.13.125.

5.1.3.13 Books For Further Reading

1.P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons, New
2.Delhi.
3.Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
4.Jawaharlal: Advanced Management Accounting, S.Chand & Co.,
New Delhi.
5.Lall Nigam & Sharma: Advanced Cost Accounting, Himalaya
Publishing
6.House.
7.Vashist & Saxena: AdvancedCostAccounting, Sultan Chand & Sons.

*****

264
 Lesson 5.2
Standard Costing And Variance Analysis

5.2.1 Introduction

During the evolutionary stage of costing, the focus was only on the
determination of actual cost i.e. The main activity of the cost accountants
was determining the actual cost of production. This resulted in the non-
availability of cost control measures to the management. Standard costing
was developed by cost accountants to meet these contingencies.

5.2.2 Learning Objectives

After reading this lesson the reader should be able to;

Ֆ Know the meaning of standard costing

Ֆ Understand the advantages of standard costing system
Ֆ Understand the different kinds of variances with special reference to
material variance and labour variance
Ֆ Understand the reasons for these variances
Ֆ Realize the importance of variance analysis

5.2.3 Contents

5.2.3.1 Meaning Of Standard Costing

5.2.3.2 Objectives Of Standard Costing
5.2.3.3 Advantages Of Standard Costing
5.2.3.4 Limitations Of Standard Costing
5.2.3.5 Standard Costing And Budgetary Control
5.2.3.6 Variance Analysis
5.2.3.7 Cost Variances
5.2.3.8 Direct Material Cost Variance
5.2.3.9 Direct Labour Cost Variance
5.2.3.10 Summary
5.2.3.11 Keywords
5.2.3.12 Self Assessment Questions

265
 5.2.3.13 Key To Self Assessment Questions
5.2.3.14 Books For Further Reading

5.2.3.1 Meaning Of Standard Costing

Standard costing is a technique which uses standards for costs and

revenues for the purpose of control through variance analysis. Standard
costing involves the setting of predetermined cost estimates in order to
provide a basis for comparison with actual costs. Standard costing is
universally accepted as an effective instrument for cost control in industries.

A standard cost is a planned cost for a unit of product or service

rendered. According to h.j. wheldon, “standard costs are pre-determined or
forecast estimates of cost to manufacture a single unit or a number of units
of product during a specific immediate future period”. Standard cost is
defined in the cima official terminology as: “a predetermined calculation of
how much costs should be under specified working conditions. It is built up
from an assessment of the value of cost elements and correlates technical
specifications and the qualification of materials, labour and other costs to
the prices and/or usage rates expected to apply during the period in which
the standard cost is intended to be used. Its main purpose is to provide basis
for control through variance accounting for the valuation of stock and work-
in-progress and in some cases, for fixing selling prices”.

5.2.3.2 Objectives Of Standard Costing

Ֆ The objectives of standard costing technique are as follows:

Ֆ To provide a formal basis for assessing performance and efficiency.
Ֆ To control costs by establishing standards and analyzing of variances.

Ֆ To enable the principle of ‘management by exception’ to be practiced at

the detailed operational level.
Ֆ To assist in setting budgets

To achieve the above objectives the following steps are adopted in standard
costing:

ՖՖ Determining the standard for direct material, direct labour and

266
 different overheads
Ֆ Ascertaining the actual cost of production
Ֆ Ascertaining the variances by comparing actual costs with standard costs

Ֆ Analyse the variances to know the reason for variances.

Ֆ Adopting corrective measures to control the variances in futures.

5.2.3.3 Advantages Of Standard Costing

A good standard costing system results in the following advantages:

Ֆ The setting of standards should result in the best resources and methods
being used and thereby increase efficiency.
Ֆ Budgets are compiled from standards.
Ֆ Actual costs can be compared with standard costs in order to evaluate
performance
Ֆ Areas of strengths and weakness are highlighted
Ֆ It acts as a form of feed forward control that allows an organization to

plan the manufacturing inputs required for different levels of output.

Ֆ It acts as a form of feedback control by highlighting performance that did

not achieve the standard set.
Ֆ It operates via the management by exception principle where only those

variances (i.e. Differences between actual and expected results) which are

outside certain tolerance limits are investigated, thereby saving

managerial time and maximizing managerial efficiency.

Ֆ The process of setting, revising and monitoring standards encourages

reappraised of methods, materials and techniques thus leading to cost
control as an immediate effect and to cost reduction as a long term effect.

5.2.3.4 Limitations Of Standard Costing

Standard costing suffers from the following limitations:

Ֆ A lot of input data is required which can be expensive

Ֆ Unless standards are accurately set any performance evaluation will be
meaningless.
Ֆ Uncertainty in standard costing can be caused by inflation,

267
 technological change, economic and political factors, etc.
Standards therefore need to be continually updated and revised.
Ֆ The maintenance of the cost data base is expensive.
Ֆ Setting of standards involves forecasting and subjective judgments with
inherent possibilities of error and ambiguity.
Ֆ Standard costing cannot be adopted in the firms which do not have
uniform and standard production programme.
Ֆ It is very difficult to predict controllable and uncontrollable variances.

5.2.3.5 Standard Costing Vs. Budgetary Control

Standard costing and budgetary control are control techniques

adopted in a firm with specific objectives. Following points of differences
between the two can be observed:

1. Standard costing is a long range control activity developed and

adopted with focus on production. Budgetary control is an activity
concerned with every functional area of the firms and functional
budgets are prepared to control that function in a shorter term.
2. Standard costs are scientifically predetermined. Budgetary control
is concerned with the overall profitability and financial position of
the concern.
3. Standard costing is concerned with ascertainment and control of
costs. Budgetary control is concerned with the overall profitability
and financial position of the concern.
4. The emphasis of standard costing is on what should be the cost
whereas in budgetary control the emphasis is on the level of costs
not to be exceeded.
5. Standards are determined for each element of cost. Budgets are
determined for a specified period.
6. Standard cost is a projection of cost accounts. Budget is a
production of financial accounts.
7. Standard costing is concerned with the control of costs and is more
intensive in scope. Budgetary control is concerned with the
operation of business as a whole and is more extensive.

268
5.2.3.6 Variance Analysis

The difference between the standard cost and the actual cost is
known as ‘cost variance’. If actual cost is less than the standard cost, the
variance is favorable. If the actual cost is more than the standard cost, the
variance is unfavorable. A favorable variance indicates efficiency, while an
unfavorable one denotes inefficiency. However, mere knowledge of these
variances would not be useful for ensuring cost control. These have to be
thoroughly analyzed so as to find out the contributory factors. It would then
be possible to find out whether the variances are amenable to control or not.
The term ‘variance analysis’, thus, may be defined as ‘the resolution into
constituent parts and the explanation of variances’.

Variances are of two types: cost variances and sales variances. In this
lesson cost variances relating to material and labour are explained.

5.2.3.7 Cost Variances

As noted previously, the difference between the standard cost and

the actual cost is known as ‘cost variance’. The total cost variance should be
split into its constituent parts, in order to analyze the cost variances in
greater detail. The following figure reveals the picture clearly:

Total cost variance

Direct Material Direct Labour Overhead

Cost Variance Cost Variance Cost Variance
(DMCV) (DLCV) (OCV)

Price Usage Rate Efficiency Variable Fixed

Variance Variance Variance Variance Overhead Overhead
(DMPV) (DMUV) (DLRV) (DLEV)

269
 Cost Cost
Variance Variance
(VOVC) (FOCV)

Expenditure Volume
Variance Variance
(FOEXPV) (FOVV)

5.2.3.8 Direct Material Cost Variance

It is the difference between the standard cost of material specified

for the output achieved and the actual cost of materials used. The standard
cost materials is computed by multiplying the standard price with the
standard quantity for actual output and the actual cost is obtained by
multiplying the actual price with actual quantity. The formula is:
= Standard Cost For Actual Output – Actual Cost
or
DMCV = (Standard Price × Standard Quantity For Actual Output)
– (Actual Price × Actual Quantity)
= (SP × SQ) – (AP × AQ).

Example 1.

The standard cost of material for manufacturing a unit of a particular

product is estimated as under :

16 kg of raw materials @ rs. 1 per kg. On completion of the unit it

was found that 20 kg. Of raw material costing rs. 1.50 per kg. Have been
consumed. Compute material cost variance:

DMCV= (SP × SQ) – (AP × AQ)

= (16 × 1) – (20 × 1.50)
= Rs. 14 (Adverse)

270
Direct Material Price Variance (DMPV)

It is that portion of material cost variance which is due to the

difference between the standard prices specified and the actual price paid.
This variance may be due to a number of reasons: change in price,
inefficient buying, standard quality of materials not purchased, favorable
discounts not obtained etc. The formula is:

Dmpv = actual quantity (standard price – actual price)

If the actual price is more than the standard price, the variance
would be adverse and in case the standard price is more than the actual
price, it would result in a favourable variance.

Example 2.

Use the information given in example 1 and compute the material

price variance.

DMPV = AQ (SP – AP)

= 20 (1 – 1.50)
= Rs. (10) Adverse.

Direct Material Usage Or Quantity Variance (DMUV)

It is the difference between the standard quantity specified and the

actual quantity used. This variance may arise because of: careless handling
of materials, wastage, spoilage, theft, pilferage, changes in product design,
use of inferior materials, defective tools and equipment etc. The formula is:

DMUV = Standard Price (Standard Quantity For Actual Output – Actual

Quantity)

= SP (SQ – AQ).

271
Example 3.

Use the information given in example 1 and compute the material

usage variance.

DMUV = SP (SQ – AQ)

= 1 (16 – 20)
= Rs. 4 (Adverse)

Note. The total of material price and usage variances is equal to

material cost variance. Thus,

DMCV = DMPV + DMUV

in the example that has been used so far, let us verify this:

DMCV = DMPV + DMUV

Rs. 14 (A) = Rs. 10 (A) + Rs. 4 (A)

Illustration 1.

A manufacturing concern which had adopted standard costing

furnishes the following information.

Standard :
Material for 70 kgs. Finished products
100 kgs.
Price Of Material Rs. 1 Per Kg.

Actual :
Output 2,10,000 kgs.
Materials used 2,80,000 kgs.
Cost of materials Rs.2,52,000

Calculate :
a)Material usage variance
b)Material price variance
c)Material cost variance

272
Solution:

For an output of Rs.70 kgs. Of finished products, standard quantity

of material output is 100 kgs.

Therefore for the output of 2,10,000 kgs., standard quantity of

material input should be = {100/70 × 2,10,000}= 3,00,000 kgs. Actual price
per kg. = 2,52,000 / 2,80,000 = .90 paise

(a) Material usage variance :

= Standard Price (Standard Quantity – Actual Quantity)
= Rs.1 (3,00,000 – 2,80,000) = Rs. 20,000 (Favorable)

(b) Material price variance :

= Actual Quantity (Standard Price – Actual Price)
= 2,80,000 (1- .90) = Rs. 28,000 (Favorable)

(c) Material cost variance :

= Standard Quantity × Standard Price – Actual Quantity ×
Actual Price
= (3,00,000 × 1) – (2,52,000)
= Rs. 48,000 (Favorable)

Verification:

Material cost variance = material price variance + material usage

variance.
Rs.48,000 (Favorable) = Rs.28,000 (Favorable) + Rs.20,000
(Favorable).

Illustration 2.

From the following particulars calculate :

Ֆ Total materials cost variance;
Ֆ Material price variance; and
Ֆ Material usage variance.

273
 Standard
Actual
Materials Units Price (Rs.) Units
Price (Rs.)
1.2 A 1,010 1.0 1,080
1.8 B 410 1.5 380
1.9 C 350 2.0 380

Solution:

(i) Material Cost Variance = (SQ × SP) – (AQ × AP)

Standard Cost Materials Actualcost Materials

Rs. Rs. Rs. Rs.
Material A 1,010 Units @ 1.0 = 1,010 1080Units@1.20 =1,296
Material B 410 Units @ 1.5 = 615 380Units@1.80 =684
Material C 350 Units @ 2.0 = 700 380Units@1.90 =722
Total Standard Cost 2,325 Totalactualcost2,702

. . . Materials Cost Variance = Rs. 2,325 – Rs. 2,702

= Rs. 377 Adverse.

(ii) Material Price Variance = Actual Quantity (St. Price – Actual Price)

Material A : 1,080 Units (1 – 1.20) = 216 Adverse

Material B : 380 Units (1.5 – 1.80) = 114 Adverse
Material C : 380 Units (2.0 – 1.90) = 38 Favourable
-------------
Total Material Price Variance = 292 Adverse
--------------
(iii) Material Usage Variance = St. Price (St. Quantity – Actual Quantity)

Material A : Rs. 1 (1,010 Units – 1,080 Units) = Rs. 70 Adverse

Material B : Rs. 1.5 (410 Units – 380 Units) = Rs. 45 Favourable
Material C : Rs. 2 (350 Units – 380 Units) = Rs. 60 Adverse

Total Material Usage Variance = Rs. 85 Adverse

274
Verification

Materials Cost Variance = Materials Price Variance + Material

Usage Variance
Rs. 377 (A) = Rs. 292 (A) + Rs. 85 (A)
= Rs. 377 Adverse

Illustration 3.

From the following particulars compute material cost variance,

price variance and usage variance.

Quantity Of Materials Purchased 3000Unit

Value Of Materials Purchased Rs. 9,000
Standard Quantity Of Materials Required
Per Tonne Of Output 30 Units
Standard Price Of Material Rs.2.50Per Unit
Opening Stock Of Material Nil
Closing Stock Of Material 500Units
Output During The Period 80Tonnes.

Solution.

Material Consumed = 3,000 – 500 = 2,500 Units

Actual Price Of Material = Rs. 9,000/3,000 = Rs. 3 Per Unit
Standard Quantity For Actual
Output = 30 × 80 = 2,400 Units
Material Cost Variance (DMCV)= (St. Price × Std. Qty) – (Actual Price
× Actual Quantity)
= (2.50 × 2,400) – (3 × 2,500)
= 6,000 – 7,500 = Rs. 1,500 (Adverse)
Material Price Variance (DMPV)= Actual Quantity (Sp – Ap)
= 2,500 (2.50 – 3) = 2,500(.50)
= Rs. 1,250 (Adverse)
Material Usage Variance
(DMUV) = Std. Price (Sq - Aq)
= 2.50(2,400 – 2,500)
= Rs. 250 (Adverse)

275
Verification :

DMCV = DMPV + DMUV

1,500 (A) = 1,250 (A) + 250 (A)

Illustration 4.

Given that the cost standards for material consumption are 40 kgs.
At rs. 10 per kg., compute the variances when actuals are :

(a) 48 kgs. At rs. 10 per kg.

(b) 40 kgs. At rs. 12 per kg.
(c) 48 kgs. At rs. 12 per kg.
(d) 36 kgs. At rs. 10 per kg.

Solution :

Material Cost Variance = (SQ × SP) – (AQ × AP)

(a) 40 kgs. @ rs. 10 – 48 kgs. @ rs. 10 = rs. 80 adverse

(b) 40 kgs. @ rs. 10 – 40 kgs. @ rs. 12 = rs. 80 adverse
(c) 40 kgs. @ rs. 10 – 48 kgs. @ rs. 12 = rs. 176 adverse
(d) 40 kgs. @ rs. 10 – 36 kgs. @ rs. 10 = rs. 40 favourable

Material Usage Variance = Standard Price (Standard Qty. –

Actual Qty.)

(a) Rs. 10 [40 kgs. – 48 kgs.] = rs. 80 adverse

(b) Rs. 10 [40 kgs. – 40 kgs.] = nil
(c) Rs. 10 [40 kgs. – 48 kgs.] = rs. 80 adverse
(d) Rs. 10 [40 kgs. – 36 kgs.] = rs. 40 favourable

Material Price Variance = AQ(SP – AP)

(a) 48 kgs. [rs. 10 – rs. 10] = nil

(b) 40 kgs. [rs. 10 – rs. 12] = 80 adverse
(c) 48 kgs. [rs. 10 – rs. 12] = 96 adverse
(d) 36 kgs. [rs. 10 – rs. 10] = nil

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5.2.3.9 Direct Labour Cost Variance (DLCV)

Labour variances are calculated like material variances. The direct

labour cost variance is the difference between the standard direct wages
specified for the activity achieved and the actual direct wages paid. The
formula is :

DLCV = Standard Cost For Actual Output – Actual Cost

or
= (Standard Rate × Standard Time For Actual Output) –
(Actual Rate × Actual Time)
= (SR × ST) – (AR × AT)

Example 4 :

Standard Hours 5,000

Standard Wage Rate Rs.4 Per Unit
Actual Hours 6,000
Actual Wage Rate Rs.3.50 Per Unit
calculate labour cost variance.

Solution :

DLCV = (SR × ST) – (AR × AT)

= (4 × 5,000) – (3.50 × 6,000)
= 20,000 – 21,000
= Rs. 1,000 (Adverse)

The labour cost variance may arise on account of difference in either

rates of wage or time. Thus, it may be analysed further as (i) labour rate
variance, and (ii) labour time or efficiency variance.

Direct Labour Rate Variance (DLRV)

It is the difference between the standard rate specified and the actual
rate paid. It is also called ‘rate of pay variance or wage rate variance’. This
would arise, usually, because of : (i) excessive overtime, (ii) employment of
wrong type of labour (employing skilled person in place of an unskilled
one), (iii) overtime workers engaged more or less than the standard, (iv)

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employment of labour at higher rates due to shortage of workers etc. The
formula for calculating labour rate variance is as under :

Direct Labour Rate Variance = Actual Time (Standard Rate – Actual Rate)
DLRV = AT (SR – AR)

Direct Labour Time Or Efficiency Variance (DLEV)

It is the difference between the standard labour hours specified and

the actual hours spent on the works. This variance is primarily concerned
with the standard wage rate. As such, where piece wage payment is in force,
there will be no labour efficiency variance. Labour efficiency variance
arises on account of any one or combination of factors such as : (i) lack of
supervision, (ii) poor working conditions in the factory, (iii) use of sub-
standard or higher standard materials, (iv) inefficiency of workers due to
inadequate training, (v) lack of proper tools, equipment and machinery, (vi)
higher labour turnover etc. Symbolically,
Labour Time Or Efficiency Variance = Standard Rate (Standard Time For
Actual Output – Actual Time)
DLEV = SR (ST – AT)

IIlustration 5.

Data Relating To A Job Are As Thus:

Standard Rate Of Wages Per Hour Rs. 10
Standard Hours 300
Actual Rate Of Wages Per Hour Rs. 12
Actual Hours 200
You are required to calculate –
(i) labour cost variance, (ii) labour rate variance and (iii) labour efficiency
variance.

Solution.

(i) Labour Cost Variance = Standard Cost – Actual Cost

= Std. Rate × Std. Time) – (Actual
Rate × Actual Time)
= (300 × 10) – (200 × 12)
= 3,000 – 2,400 = 600 (Favourable)

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 (ii) Labour Rate Variance = Actual Time (Std. Rate – Actual Rate)
= 200 (10 – 12) = 400 (Adverse)

(iii) Labour Efficiency

Variance = Std. Rate (Std. Time – Actual Time)
= 10 (300 – 200) = 1,000 (Favourable).

Verification :
DLCV = DLRV + DLEV
600 (F) = 400 (A) + 1000 (F)

Illustration 6.

Standard hours for manufacturing two products m and n are 15

hours per unit and 20 hours per unit respectively. Both products require
identical kind of labour and the standard wage rate per hour is rs. 5. In the
year 2011, 10,000 units of m and 15,000 units of n were manufactured. The
total of labour hours actually worked were 4,50,500 and the actual wage bill
came to rs. 23,00,000. This included 12,000 hours paid for @ rs. 7 per hour
and 9,400 hours paid for @ rs. 7.50 per hour, the balance having been paid
at rs. 5 per hour. You are required to compute the labour variances.

Solution :

LabourCostVariance=StandardCostForActualOutput–ActualCost

Standard cost :

Standard Time : M = 10,000 × 15 = 1,50,000

N = 15,000 × 20 = 3,00,000
- ---- - - - - - - -
4,50,000 Hours
--- - - - - - - - - -

Rs.
For Product M = 10,000 × 15 × 5 = 7,50,000
For Product N = 15,000 × 20 × 5 = 15,00,000

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 - - - - - --
Total Standard Cost 22,50,000
------

Rs. Rs.
Total Actual Cost = 23,00,000
Labour Cost Variance = 22,50,000 – 23,00,000
= 50,000 (A)

Labour Rate Variance = Actual Hours × (Std. Rate – Actual Rate)

Rs. Rs.
= 12,000(5 – 7) = 24,000 (A)
= 9,400(5 – 7.50) = 23,500 (A)
= 4,29,100(5 – 5) = –
----------
Total 47,500 (A)
-----------

Labour Rate Variance = Std. Rate × (Std. Time – Actual Time)

= Rs. 5 × (4,50,000 – 4,50,500)
= Rs.2,500 (A)

Verification:

labour Cost Variance = Labour Rate Variance + Labour Efficiency

Variance
50,000 (A) = Rs. 47,500 (A) + Rs. 2,500 (A)
= Rs. 50,000 (A)

Idle Time Variance (ITV)

Idle time variance, a component of labour efficiency variance, is

represented by the standard cost of the actual hours for which the workers
remain idle due to abnormal circumstances, like non-availability of raw
materials, power cut, breakdown of machinery etc. Symbolically :

Idle Time Variance = Standard Hourly Rate × Idle Time Or Hours

= SR × IT

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 This variance is always adverse. The total of labour rate, idle time
and efficiency variances would be equal to labour cost variance, as shown
below:

Illustration 7.

100 workers are working in a factory at a standard wage of rs. 4.80

per hour. During a month there are four weeks of 40 hours each. The
standard performance is set at 360 units per hour. The following is the
summary of the wages paid during the month:
91 workers were paid @ rs. 4.80 per hour
5 workers were paid @ rs. 5.00 per hour
The remaining were paid @ rs. 4.60 per hour
Power failure stopped production for 2 hours actual
production 57,960 units. Calculate labour variances.

Solution.

1. Labour Cost Variance

= Standard Cost – Actual Cost
= Rs. 77,280 – Rs. 76,832 = Rs. 448 (Fav.)

(I) Standard Cost

= Std. Rate Per Hour × 100 × Units Produced / Std.
Production per hour
= 4.80 × 100 × 57,960 / 360 = Rs. 77,280
(Ii) Actual Cost For The Month (For 40 × 4 = 160 Hrs.)
No. Of Workers × Hrs. During The Month × Rate Paid.
Rs.
91 × 160 × 4.80 = 69,888
5 × 160 × 4.80 = 4,000
4 × 160 × 4.60 = 2,944
------
76,832
------

2. Labour rate variance

= Actual Hours (Std. Rate – Actual Rate)
(A) (5 × 160) (Rs. 4.80 – Rs. 5.00) = Rs. – 160 (Adv.)

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 (B) (4 × 160) (Rs. 4.80 – Rs. 4.60) = Rs. + 128 (Fav.)
--------
Rs. – 32 (Adv.)

Note. For 91 workers rate variance is not calculated because they are paid
at std. Rate.

3. Labour efficiency variance

= Std. Rate (Standard Time – Actual Time)
= Rs. 4.80 (16,100 Hours – 15,800 Hours)
= Rs. 1,440 (Fav.)

Notes. (I) Standard Time

= No. Of Employees × Quantity Produced / Std. Quantity
Per Hour
= 100 × 57,960 / 360 = 16,100 Hours.

(Ii) Actual Time

= Possible Hours – Idle Time
= 100 × 160 Hours – 100 × 2 Hours
= 15,800 Hours
4. Idle Time Variance
= Std. Rate × Idle Time
= Rs. 4.80 × 200 Hours = 960 (A)

Verification :
LCV = LRV + LEV + ITV
448 (F) = Rs. 32 (A) + Rs. 1,440 (F) + 960 (A)
= Rs. 448 (F).

5.2.3.10 Summary

Cost control is a concrete step towards profit maximization and

standard costing with the aid of variance analysis ensures this. Cost control
is achieved by adopting the following steps: pre – determination of standard
costs, consumption of actual costs, comparison of actual costs with standard
costs and recording of the variances if any and analyzing and reporting on
these variances to the management so that suitable action may be taken
whenever necessary in order to control the costs in future.

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5.2.3.11 Key Words

Standard costing: this is a technique of cost accounting employed for

cost control.

Variances: Differences between the standards and the actual results

Favorable variances: Actual cost is lower than the standard cost.
Unfavorable variance: Actual cost is higher than the standard cost

5.2.3.12 Self Assessment Questions

1. The following are the particulars regarding the standard and the
actual production of the product x:

Standard quantity of material per unit – 5 kgs

Standard price – Rs.5Per kg
Actual number of units produced – 400 units.
Actual quantity of material used 2,200 kgs
Actual price of material – Rs. 4.80 Per kg
Calculate : (i) material price and (ii) material usage variances.

2. A furniture manufacturer makes sun mica tops for tables. From

the following information, find out price variance, usage variance and
material cost variance.

Standard quantity of sun mica per table 4 sq. Ft.

Standard price per sq. Ft. Of sun mica Rs. 5.00
Actual production of tables 1,000
Sun mica actually used 4,300sqft.
Actual purchase price of sun mica per sq. Ft. Rs. 5.50
Who is the responsible for these variances?

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 3. From the data given below compute price and usage variances:
Standard Actual

Quantity Unit Total Quantity Units

Total
Kg. Price Kg. Price
Rs Rs. Rs. Rs. Rs.
Material A 4 1.00 4.00 2 3.50
7.00
Material B 2 2.00 4.00 1 2.00
2.00
Material C 2 4.00 8.00 3 3.00
9.00

Total 8 16.00 6
18.00

4. The standard cost card for a product shows:

Per unit
Rs.
Material cost – 2 kg. @ 2.50 Each 5.00
Wages – 2 hours @ 50 p. Each 1.00
The actual which have emerged from business operations are as
follows:
Production 8,000units
Material consumed:
16,500 Kgs. @ Rs.2.40 Each Rs. 39,600
Wages paid:
18,000 Hours @ 40 p. Each Rs. 7,200
Calculate appropriate material and labour variances.

5. The standard cost for a product is:

Time 10 hours per unit, cost rs. 5 Per hour.
The actual performance was:
Production 1,000 units
Hours taken:
Production 10,400 hours

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 Idle time 400 hours
----------------
Total time 10,800 hours
----------------
Payment mode, rs. 56,160 @ Rs. 5.20 Per hour
Calculate (a) labour rate variance, (b) labour efficiency variance,
(C) idle time variance, (d) labour cost variance.

5.2.3.13 Key To Self Assessment Questions

Q.No 1: (I) Material Price Variance Rs 440 (F)

(II) Material Usage Variance Rs. 1000 (A)
Q.No 2: (I) Price Variance Rs. 2150 (A)
(II) Usage Variance Rs. 1500 (A)
(III) Cost Variance Rs. 3650 (A)
Q.No 3: (I) Material Cost Variance Rs. 2 (A)
(II) Material Price Variance Rs. 2 (A)
(III) Material Usage Variance – Nil
Q.No 4: (I) Material Cost Variance Rs. 400 (F)
(II) Material Price Variance Rs. 1650 (F)
(III) Material Usage Variance Rs. 1250 (A)
(IV) Lcv: Rs. 800 (F)
(V) Lev: Rs. 1000 (A)
(VI) Lrv: Rs.1800 (F)
Q.No 5: (I) Lcv: Rs.6160 (A)
(II) Lrv: Rs. 2160 (A)
(III) Lev: Rs. 2000 (A)
(IV) Itv: Rs. 2000 (A)

*****

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