MB0025-Unit-01-Financial Accounting – An Introduction Accounting is a branch of knowledge, concerned with recording classifying, analyzing and reporting financial information to owners, bankers, creditors, government and host of stakeholders regarding the financial performance of organizations – business or non-business entities. Over a period of time, accounting has assumed a status of a science and an art. In order to achieve uniformity globally, international standards have also emerged in accounting. In this Unit, the historical perspective of Accounting, its meaning, functions and basic terms used in the subject are discussed.

1.2 Evolution of Financial Accounting

Any branch of knowledge does not emerge all of a sudden. Knowledge is a product of continuous intellectual exercise and the changes in the environmental and social demands. Accounting is an ancient art. Michael Russel in his article ‘Evolution of Accounting’ points out that as early as 8500 B.C, accounting was existing. Archeologists have found clay tokens as old as 8500 BC in Mesopotamia which were usually cones, disks, spheres and pellets. These tokens correspond to such commodities like sheep, clothing or bread. They were used in the Middle West in keeping records. Similarly in ancient civilizations like China, Babylonia, Greece and Egypt, record keeping was in practice in the same manner as stated above. During 3600 BC in Babylonia payment of salaries was recorded in clay tablets. The rulers of these civilizations kept track of labour and material costs by using accounting methods.

· Private property: The power to change ownership, because book keeping is concerned with recording the facts about property and property rights

· Capital: Wealth productively employed, because otherwise commerce would be trivial and credit would not exist

· Commerce: The interchange of goods on a widespread level, because purely local trading in small volume would not create the sort of press of business needed to spur the creation of an organized system to replace the existing hodgepodge of record keeping

· Credit: The present use of future goods, because there would have been little impetus to record transactions completed on the spot.

· Writing: A mechanism for making a permanent record in a common language given the limits of human memory.

· Money: The common denominator for exchange, since there is no need for book keeping except as it reduces transactions to a set of monetary values.

· Arithmetic: A means of computing the monetary details of the deal.

Double entry records first came out during 1340 A.D. in Genoa. In 1494, the first systematic record keeping was formulated by Fra Luca Pacioli a Franciscan monk and one of the most celebrated mathematicians to this day. Pacioli is considered as the father of accounting.

Michael Russel, in his article states that industrial revolution, which brought paradigm changes in the working and business transactions paved way to the specialized field of accounting called ‘cost accounting’ in order to meet the need for the analysis of various costs. Welsch and Anthony, in their book’ Fundamentals of Financial Accounting’, comment that the growth of business organizations in size, particularly publicly held corporations, has brought pressure from stock holders, potential investors, creditors, government agencies, and the public at large, for increased financial disclosure.

1.4 Meaning of Accountancy, Book-keeping and Accounting

Book-keeping, accounting and accountancy are the terms used in the science of financial accounting. Book-keeping means recording of business transactions in the books of accounts in accordance with the principles of accounting. Book keeping is an adjunct for accounting. Day to day transactions are entered in a systematic manner to facilitate the preparation of profit and loss account, balance sheet and other statements containing information about debtors, creditors, tax payment etc., For the purpose of recording the financial data, debit and credit principles are adopted so that cross checking is made possible, summary of each account is known at the end of an accounting period.

Accounting on the other hand is the discipline of measuring, communicating and interpreting financial activities and it is widely referred to as language of business.

Way back in 1941, the definition for the word Accounting was given by the Committee on Terminology of the American Institute of Chartered Public Accountants, (AICPA)thus, ‘accounting is an art of recording, classifying and summarizing in a significant manner and terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.’

The American Accounting Association (AAA) in 1966 provided the following definition: “Accounting is the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information”

In 1970, the AICPA emphasized accounting with reference to the concept of information.. Accounting is treated as a service activity. The function of accounting is to provide quantitative information, primarily financial in nature, and about economic activities, that is intended to be useful in making economic decisions.

1.5 Characteristics of Accounting

From the above definitions of Accounting, one can list out the characteristics of accounting:

1. Accounting is an art and science: Recording and maintenance of accounts of various transactions needs special skill and knowledge. Reading and interpreting the results, obtained by the accounting system requires experience. From this angle, accounting is an art.

2. Accounting involves a process of identifying, classifying and recording financial information, expressed in terms of money. All financial transactions are expressed in terms of money. Incomes, expenses, acquisition of assets, payment of liabilities, capital of shareholders etc., are stated in money terms and all transactions are broadly classified as related to definite heads of account, namely – personal, real and nominal. After classification, they are recorded in the books of original entry as per the accounting principles. The book of original entry is called Journal. From Journal, the transactions are summarized under each head of relevant account and posting takes place to a book called ledger. At the end of a particular accounting period, the gist or the net balance of all ledger accounts is aggregated to prepare a trail balance. From trial balance, it is possible to prepare trading, profit and loss accounts and balance sheet.

3. Events of non financial nature can not be recorded, even though such events may have an impact on the operational results of the enterprise. For instance financial manager and production manager of a concern do not have good relationship and owing to this the production process is affected and subsequently the profitability. This event of non financial nature can not be reflected in accounts.

4. Accounting is an information system. The results of analysis and interpretation are communicated to the management and other interested parties. Internal control is effectively exercised and accountability is ensured through accounting information.

5. It helps in taking managerial decisions.

1.6 Functions and Objectives of Accounting

From the above paragraphs, it can be concluded that accounting involves the following functions and objectives.

a) Systematic recording of all business events or transactions and subsequent posting to ledger to finally prepare financial statements – profit and loss account and balance sheet.

b) Reporting the results to management, shareholders, creditors, bankers, investors, stock brokers, stock exchanges, employees, governments etc.,

c) Satisfying the statutory requirements, especially of Registrar of Companies, SEBI (Securities Exchange Board of India) in case the company is listed, tax authorities (sales

tax, excise, customs, income tax) and government in order to protect the interest of general public.

d) Protecting the properties of business by recording them on the date of acquisition and showing their accounts in the balance sheet.

e) It helps for internal control by holding the concerned persons responsible for any errors, lapses or under performance. Equally it helps to identify the strong areas of excellent performance and subsequently pin point the individuals or departments to be rewarded or appreciated.

f) Accounting is a tool for effective planning. Current year’s financial performance becomes the basis for future predictions and estimations. Since it is tool for planning, it also acts as tool for controlling. Preparation of budgets, cost analysis, tax planning, auditing are some of the functions of accounting.

The differences between book keeping and accounting are as under:

1.8 Financial Accounting and Management Accounting

Financial accounting is the preparation and communication of financial information to outsiders such as creditors, bankers, government, customers and so on. Another objective of financial accounting is to give complete picture of the enterprise to shareholders. Management accounting on the other hand aims at preparing and reporting the financial data to the management on regular basis. Management is entrusted with the responsibility of taking appropriate decisions, planning, performance evaluation, control, management of costs, cost determination etc., For both financial accounting and management accounting the financial data is the same and the reports prepared in financial accounting are also used in management accounting But the following are major differences between Financial accounting and Management accounting.

1.9 Basic Terms

To understand the subject, proper understanding of the following terms is essential.

1. Transaction: It is transfer of money or goods or service from one person or account to another person or account.

2. Capital: Funds brought in to start business, by the owner/s. In the case of a company, capital is collected by issue of shares. Capital used to purchase fixed assets is called fixed capital and that capital used for day to day affairs of business is known as working capital. From business point of view, Capital is a liability.

3. Assets: Every enterprise has assets. Land and buildings, plant and machinery, furniture and fixtures, cash in hand and at bank, debtors and stock etc., are regarded as assets, by the use of which business is carried on. Assets may be fixed, current, liquid or fictitious. Fixed assets are those which are held for use in the production or supply of goods and services. Ex: plant and machinery, which is used fairly for long period. Current assets are those which are held or receivable within a year or within the operating cycle of the business. They are intended to be converted into cash within a short period of time. Ex: Stock in trade, debtors, bills receivable, cash at bank etc., Liquid assets are those which can be easily converted into cash and for instance, cash in hand, cash at bank, marketable investments etc., Fictitious assets are in the form of such expenses which could not be written off during the period of their incidence. For example, promotional expenses of a company which could not be treated as expenditure in the year of incidence are shown as fictitious asset.

4. Liability: Obligation to be fulfilled in future with respect to payment towards acquisition of an asset or performance of a service. Current liability is that obligation which has to be satisfied within a year. For example, payment to be made sundry creditors for the goods supplied by them on credit; bills payable accepted by the businessman; overdraft raised by the businessman in a bank etc.

5. Goods: Commodities or articles purchased for resale are called goods. Furniture items dealt by a furniture dealer constitute goods for that business. If rice dealer purchases

furniture, not for resale but for use, it is called purchase of asset and the same furniture becomes asset. Rice for rice dealer is goods, because he purchases only for resale.

6. Trade: Purchase and sale of goods is called trade.

7. Purchases: It refers to goods bought in exchange for cash or credit. In case of credit purchase, goods are received against a promise to pay the price for the same at a future date.

8. Sales: Goods sold to customers either for cash or for credit are regarded as sales. In case of cash sales, cash is received immediately and in case of credit sales, cash will be received at a future date.

9. Sole trader: A single individual carrying on business with or without the help of his kith and kin is called sole trader.

10. Partnership: It is a relationship between partners to contribute capital to start business, agree to distribute profits and losses in an agreed proportion and the business being carried on by all or any one acting for all. Partnership firm refers to business where as the partnership refers to relationship caused by agreement.

11. Joint Stock Company: It is an organization, for which the capital is contributed by shareholders to carry on business and it is registered under Companies Act and it has a legal entity, having perpetual existence and a common seal.

12. Debtor: Debtor is a person who owes some thing to business. A person to whom goods are sold on credit becomes a trade debtor to the business.

13. Creditor: A creditor is a person to whom the business owes some thing. For example, a person from whom goods are purchased on credit and amount is yet to be paid is called a trade creditor.

14. Stock: Total goods kept on hand by a trader or industrial enterprise on a given date. It represents unsold part of goods.

MB0025-Unit-02-Accounting Concepts, Principles, Unit-02-Accounting Concepts, Principles,

2.3 Types of Accounting concepts

As said earlier, concepts are the basic assumptions or conditions upon which the science of accounting is based. There are five basic concepts of accounting, namely – business entity concept, which is also termed as separate entity concept, going concern concept, money measurement concept, periodicity concept and accrual concept. Each concept is discussed below.

2.3.1 Business Separate Entity Concept

The essence of this concept is that business is a separate entity and it is different from the owner or the proprietor.

2.3.2 Going concern concept

The fundamental assumption is that the business entity will continue fairly for a long time to come. There is no reason why an enterprise should be promoted for a short period only to liquidate the business in the foreseeable future. This assumption is called “going concern concept”. For this reason accountants value fixed assets on historical cost method. Had the business been set up to last for a short period, fixed assets should have been valued at a market price. Besides, going concern concept provides for amortization of the cost of fixed assets over the life time of the assets.

2.3.3 Money Measurement Concept

All transactions of a business are recorded in terms of money. An event or a transaction that can not be expressed in money terms, can not find place in the books of account. The honesty of the employees, dynamism of the selling agents, promptness and integrity of the cashier, even though influence the business results, can not be brought to the books of accounts.

2.3.4 Periodicity Concept

The time interval for which accounts are prepared is an important factor, even though we assume long life for a business. The time interval is usually one year and this period is called accounting year. Often the accounting period could be half year or even a quarter. The financial statements should be prepared at the end of each accounting period so that income statement shows profit or loss for the accounting period. So also a balance sheet is prepared to depict the financial position of the business.

2.3.5 Accrual Concept

Profit earned or loss suffered for an accounting period is the result of both cash and credit transactions. It is possible that certain incomes are earned but not received and similarly expenses incurred but not yet paid during an accounting period. But it is relevant to consider them while computing the financial results just because they are related to the specific accounting period. For example, interest receivable on Fixed deposit for the year ending 31-12-2006 is Rs. 12000 but it is actually credited to the bank account only in

February 2007. For calculating the income from interest, the amount Rs.12000 is considered even though it is not received before 31-12-2006. This amount is called accrued interest. Similarly the expenses which are incurred for the accounting period, might be paid only after the accounting period. Such accrued expenses are deducted while calculating the profit for the accounting period. This is the accrual concept.

2.4 Basic principles

2.4.1 Principle of Income Recognition

According to this concept, revenue is considered as being earned on the date on which it is realized., i.e., the date on which goods and services are transferred to customers for cash or for promise.

2.4.2 Principle of Expense

Expenses are different from payments. A payment becomes expenditure or an expense only when such payment is revenue in nature and made for consideration. Salaries are paid for having received the services of the employees and so it is an expense.

2.4.3 Principle of Matching Cost and Revenue

Revenue earned during a period is compared with the expenditure incurred to earn that income, whether the expenditure is paid during that period or not. This is matching cost and revenue principle, which is important to find out the profit earned for that period. Here costs are reported as expenses in the accounting period in which the revenue associated with those costs is reported.

2.4.4 Principle of Historical Costs

This is called ‘cost’ principle. All assets are recoded at the cost of acquisition and this cost is the basis for all subsequent accounting for the assets. The expenses and the goods purchased are all shown at the value at which they are incurred. The assets are constantly reduced in their value by charging depreciation against their cost to present their book value in the balance sheet. For example, land bought for Rs.5,00,000 will be shown at that price only and market value will not be considered. In financial statements, historical cost is considered but not market value for the purpose of consistency. However, on account of inflationary situations, this cost concept does not portray correct picture of the business and so inflation accounting has emerged.

2.4.5 Principle of Full Disclosure

The business enterprise should disclose relevant information to all the parties concerned with the organization. It means that any information of substance or of interest to the average investors will have to be disclosed in the financial statements.

2.4.6 Double Aspect Principle

This concept is the most fundamental one for accounting. A business entity is an independent unit and it receives benefits from some and gives benefits to some other. Benefit received and benefit given should always match and balance. For instance capital, say Rs.20000 provided by the proprietor is a liability to the business and it is used for purchasing goods Rs.10000, kept in bank account of the business Rs.8000 and the balance held in cash.Rs.2000. The goods, cash at bank and cash in hand (10000 + 8000 + 2000) are regarded as assets. The total liabilities balance with total of assets. This is dual aspect of accounting. The established principle of accounting is that for every debit there is an equivalent credit and this is called double entry principle of accounting.

2.4.7 Modifying Principle

The modifying principle states that the cost of applying a principle should not be more than the benefit derived from. If the cost is more than the benefit, then that principle should be modified. This is called cost-benefit principle. There should be flexibility in adopting a principle and the advantage out of the principle should over weigh the cost of implementing the principle.

2.4.8 Principle of Materiality

While important details of financial status must be informed to all relevant parties, insignificant facts, which do not influence any decisions of the investors or any interested group, need not be communicated. Such less significant facts are not regarded as material facts. What is material and what is not material depends upon the nature of information and the party to whom the information is provided. While income has to be shown for income tax purposes, the amount can be rounded off to the nearest ten. And fraction does not matter. When we send statement to a debtor, all details have to be presented. The same information about the debtors need not be given in great detail, while sending the information to the Registrar of companies.

2.4.9 Principle of Consistency

Consistency is required to help comparison of financial data from one period to another. Once a method of accounting is adopted, it should not be changed. For instance, stock is valued under FIFO method in an year and it should not be valued under LIFO method in another year. If assets are depreciated under diminishing balance method, it should be continued for ever. It should not be changed.

2.4.10 Principle of Conservatism or Prudence

Accountant follow the rule “anticipate no profit but provide for all anticipated losses “Whenever risk is expected, provision should be made. The value of investments is normally taken at cost, even if the market value is higher than the cost. If the market value expected is lower than the cost, then provision should be made by charging profit

and creating investment fluctuation fund. This is the principle of conservatism and it does not mean that the income or the value of assets should be intentionally under stated.

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MB0025-Unit-03-Double Entry Accounting 3.3 Cash and mercantile system of double entry system

There are two systems of double entry book keeping namely cash system and mercantile system. In case of cash system, transactions are recorded only if cash is received or paid. Government accounting is done basing on this system. On the other hand, mercantile system is one where both cash and credit transactions are recorded. Besides, outstanding expenses or incomes also find place in the mercantile system.

3.4 Accounting Trail

Accounting trail is the process of identifying the transactions or events, preparation of vouchers, recording them as journal entries, preparation of ledger accounts, balancing the ledger accounts, incorporating all adjustments, preparation of a trail balance and finally preparing the financial statements and balance sheet.

Real accounts are those which may be tangible real accounts and intangible real accounts. Tangible real accounts relate to things that can be touched, felt, physically measurable. Building account, furniture account, stock account, cash account etc are tangible real accounts. Intangible real accounts are such that they can not be seen or touched. They can be measured in terms of money such as goodwill, patent rights etc.

Nominal accounts are also known as impersonal accounts. They are in the form of expenses or losses, incomes or gains. They do not really exist in physical form, but behind every nominal account cash is involved. For example, salary account is a nominal account and when salary is paid, the reality is the cash goes out and there is nothing salary in physical form. Therefore salary account is regarded as nominal account. Similarly all expenses and losses and all incomes and gains accounts are regarded as nominal accounts.

3.5 Transactions and Events

A transaction is a business activity involving transfer of money or money’s worth. It may be cash transaction or credit transaction.

3.6 Preparation of Vouchers

A voucher is a document in support of a business transaction. It may be a receipt, a counterfoil of a receipt, an invoice or even correspondence with the concerned parties. The system has the following advantages:

1. It safeguards all cash disbursements

2. Total amount payable to creditors can be found out with the help of unpaid

3. vouchers.

4. Internal check is ensured

5. Information about future cash requirements can be found out.

However, the system is not suitable for small organizations because it involves personnel and the cost of maintenance.

3.7 Financial statements and their nature

The purpose of preparing trading account is to find out the gross profit / loss. Similarly, profit and loss account is prepared to find out net profit / loss. Both these accounts are revenue accounts. In other words, all revenue receipts and revenue payments are considered. Revenue expenses are those which are incurred in day to day business activities. Examples may include wages, carriage expenses, insurance premium paid on stocks, salaries, printing, stationary, administrative expenses, selling expenses and so on. Revenue receipts are called incomes and the examples include rent received, sales made, interest received, dividend received, discount received, royalty received, compensation received etc. More details about trading and profit and loss account are given in Unit 7.

After preparing final accounts, a balance sheet is prepared containing capital and liabilities on one side and assets on the other side of a statement. Balance sheet is a statement of affairs and not an account. Liabilities of a business include trade creditors, bills payable, bank over draft, loans payable, outstanding expenses, pre-received incomes etc. Capital of the owner, which is called equity, is added with liabilities on the left side of the balance sheet. Assets of a business include fixed assets like buildings, plant, machinery, furniture etc; current assets like sundry debtors, bills receivable, closing stock of materials, outstanding incomes, prepaid expenses, cash in hand, cash at bank etc., Trading account or profit and loss account and balance sheet are prepared at the end of a particular accounting period, say one year. In Unit 7, details about balance sheet preparation are given.

3.8 Accounting equation

The preparation of balance sheet is the final step in accounting process. The accounting equation indicates that the sources of funds should be equal to uses of funds. In other words, proprietor’s equity and liabilities to outsiders should be equal to assets.

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MB0025-Unit-04-Primary Books 4.2 Introduction to Primary Books

Journal is a book of original entry. In French, ‘jour’ means ‘a day’. Therefore journal is basically a day book in which transactions are first entered in a systematic manner adopting the principles of debit and credit. If a business organization is very small and the number of transactions taking place each day are limited, then all the transactions can easily be recorded in the journal. But it is not so, in case of organizations of large scale, where hundreds of transactions take place. To facilitate convenient way of entering transactions, journal is subdivided into several books of original entry, namely purchases, sales, cash, bills receivable, bills payable, returns inwards, returns outwards books. They are also regarded as primary books or subsidiary books. When once the transactions are recorded in the journal or other subsidiary books, posting is made to ledger. It is also possible that entries are made directly to ledger accounts without bringing them to journal at all. However, to help in cross checking, both journal and ledger accounts are prepared.

4.3 Journal

It is a book containing systematic recording of transactions. The entry made is known as journal entry and the process of writing the journal entry is called journalizing. Each page of the journal is numbered and it is called journal folio (JF). Entries are made date wise and they reflect what account is debited and what account is credited. The form of a journal is given below.

4.4 Ground rules of journal entry

As discussed earlier, a transaction affects at least two accounts and the accounts may be personal or real or nominal. For each class of accounts, the rules of debit and credit are also discussed. ‘Debit the receiver and credit the giver’ is the principle for personal accounts; ‘debit what comes in and credit what goes out’ is the rule for real accounts and ‘debit all expenses and losses and credit all incomes and gains’ is the rule for nominal accounts.

4.5 Types of Journal

Journal is a book of original entry and only one journal is maintained if the business is very small in size and the transactions are limited. However, if the transactions are multifarious, then subsidiary books which are known as books of original entry are prepared. The types of journal include purchases book, sales book, purchase returns book, sales returns book, bills receivable book, bills payable book, cash book and journal proper. The entries are made in these books straight without recording in usual journal. From the respective books, posting is made to ledger. In fact, from the entries made in the

subsidiary books, journalizing can be done. A detailed note is given in the following paragraphs on each of the subsidiary books.

4.6 Purchases Book/purchases day book

Purchases book is also called purchases journal. Only credit purchases of goods are recorded in this journal. ‘Goods’ mean items or commodities procured for resale. Cash purchases are recorded in cash book and credit purchases are recorded in purchases book.

4.7 Sales book or Sales Day book

Sales book or sales day book contains the details of credit sales of goods made during a particular period. The total of the sales book is transferred to ledger to an account called sales account. The parties to whom credit sales are made are known as trade debtors. All debtors are classified as personal accounts and for each party, ledger account is prepared in the ledger. Sales account shows credit balance and debtor’s account shows debit balance.

4.8 Purchase Returns Book

When the businessman purchases the goods and finds that the goods are not as per the specifications or the goods are damaged or for any other valid reason, he may decide to return the goods to the supplier from whom the goods were purchased. All such purchase returns are recorded in a journal called purchase returns book.

4.9 Sales Returns Book

Just as goods which do not conform with specifications are sent back to suppliers, our customers may also send the goods sold to them back to us owing to similar reasons. Then a credit note is prepared to show that the customer’s/debtor’s account is credited to the extent of the value of the goods returned by them to us. Goods are received from the customers and a credit note is sent to them.

4.10 Bills Receivable Book

When a businessman sells goods on credit, he does not receive cash immediately. But the businessman requires cash for which he draws a bill of exchange against the customer and the customer accepts it. Such a bill of exchange can be discounted with a banker for commission. The businessman who draws the bill is called drawer and the customer on whom it is drawn is drawee or acceptor. So bill of exchange is a document in writing, promising to pay a certain sum of money or money’s worth to the drawer at a certain date for value received. The businessman maintains a journal/ subsidiary book containing the details of the bills receivable. The bills receivable account shows debit balance and the amount receivable against them is an asset.

4.11 Bills Payable Book

What is bills receivable for a drawer, is bills payable to the drawee. In a business concern, proprietor draws bills on debtors and accepts bills drawn by trade creditors. All such bills accepted by the proprietor are recorded in a separate book called bills payable book. The sum of the value of bills payable for a period ending will be transferred to the ledger. Usually bills payable account shows credit balance and hence is a liability. The form of bills payable book is given here under.

4.12 Cash Book

Cash book is an important subsidiary book and a book of original entry. It is a record of cash receipts and cash payments made during a particular period. On the right hand side, receipts are recorded and on the left hand side, payments are recorded. A simple cash book has two sides, receipts side and payment side. The receipts are on debit side and the payments are on credit side. Just as a ledger account, the words ‘To’ and ‘By’ are used. Cash book may also contain cash column and bank column. Cash column represents cash in the business and bank column represents cash kept in the bank. Bank column of cash book is a reflection of bank pass book.

4.12 (a) Petty Cash Book

In large organizations, petty expenses like stationery, postage, stamps, refreshments, carriage, cartage, daily wages etc are incurred day in and day out. All these expenses are more in number and very insignificant in value. To look after payment of such expenses, a separate petty cashier is appointed, who obtains a definite sum of money at the beginning of a month and gives a statement of account at the end of the period to the chief cashier. To record such payments, a separate book, known as petty cash book is maintained.

There is a distinct method, namely imprest system which is adopted in maintaining such petty cash book. Under this system, at the beginning of a month, a definite sum of money is given by chief cashier to petty cashier for petty expenses. At the commencement of the next period, the petty cashier receives money equal to what is spent during the earlier period. For instance, in the beginning of January, 2004, a sum of Rs.10000 is given to petty cashier assuming that such miscellaneous expenses may be to the order of Rs.10000. By the end of January, it may be found that the actual expenses are only Rs.9000. Then the chief cashier will reimburse Rs.9000 so that the opening balance for the month of February will be Rs.10000. This is also called analytical petty cash book.

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MB0025-Unit-05-Secondary Books Journal is the book of original entry and all transactions are recorded first in that book. We have also learnt that there are subsidiary books, which are different types of journal and in large organizations, these subsidiary books are maintained as books of original

entry. However there is a book called Journal Proper, which is also a type of journal in which transactions which can not be entered in any other subsidiary books, shall be recorded. For instance, a loan is declared as bad and it should be written off.

5.2 Types

There are three types of ledger, namely debtor’s ledger, creditor’s ledger and general ledger. Debtor’s ledger contains accounts of debtors to whom goods are sold on credit. Creditor’s ledger contains accounts of creditors from whom goods are purchased on credit. General ledger contains real accounts, nominal accounts and all personal accounts, other than debtor’s and creditor’s accounts.

5.2 b. Closing entries

Closing entries are drawn at the end of accounting period and the purpose is to close down several account balances for the current period. The accounts of assets and liabilities will not be closed because they continue to exist further. All expenses and income accounts are closed by transferring them to the respective revenue accounts such as Trading account and Profit and Loss account. For example, salaries paid during the year are closed by transferring to P & L account, debiting P & L account and crediting Salaries account, so that the salaries account of the current year does not again appear in the next year. More details about closing entries will be dealt with in Unit 7.

5.2 c. Adjusting entries

After the closure of accounting year, there might be a few more transactions left over and which are not incorporated into journal or ledger, owing to omission and practical difficulties. For example, closing stock should be valued on the last day of the accounting period. If the stock is so large containing several items, it is possible that the calculation is not made along with physical verification. In such a case, an adjusting entry is made to bring that item into account. Similarly, with regard to rent paid in advance, expenses outstanding, incomes received in advance etc adjusting entries are made in Journal proper. If they are not considered, the profit or loss reflected by the final accounts will not give the correct picture for the accounting period. More details about adjusting entries will be discussed in Unit 7.

5.2 d. Rectification entries

Errors are natural and rectification is a must to arrive at exact position of profit or loss and balance sheet. These errors may or may not be disclosed by trail balance. Casting errors, omissions, commissions, principle errors, compensatory errors etc can occur in the process of accounting. They have to be identified and rectification entries have to be recorded. For example, wages which are paid for construction of a building are wrongly debited to wages account. By doing so, the expenses are increased and the resultant profit is reduced. Really speaking, the wages paid for construction, being a part and parcel of building account, should have been debited to building account. Therefore to rectify this

error, building account should be debited and wages account should be credited so that building account gets enhanced and wages account gets reduced. Such rectification entries are drawn in Journal proper. More details are available in Unit 6.

MB0025-Unit-06-Trial Balance 6.2 Meaning

Trial Balance is a statement containing the various ledger balances on a particular date. It is used to verify the equality of debits and credits in the ledger. When the total of debit balances equals the total of credit balances, the ledger is said to be in balance.

6.3 Objectives

There are three objectives of preparing a trial balance.

a) To check the arithmetic accuracy of entries made. In double entry, every debit has an equivalent credit. Even in General Journal, we have seen that the total of debits equals the total of credits. Similarly, if the debits and credits tally in a trial balance, it indicates that the books of account are arithmetically accurate. If the two sides do not tally, it is sure that errors have crept in.

b) Basis for financial statements. As stated earlier, trial balance is a bridge between ledger and final statements. It is only through trial balance, trading account, profit and loss account and balance sheet are prepared. If trial balance tallies, it means that the final statements should invariably tally.

c) It is a summarised ledger. The position of a ledger account be judged simply by looking at the trial balance. It is because, all ledger accounts, after being balanced, are grouped as those showing debit and those showing credit balances. They must be equal in value.

6.4 Methods of preparing Trial Balance

Totals method and Balance method are the two techniques of preparing trial balance. In the second method, instead of transferring the totals of both debit and credit, the net balance Rs.10000 (45000 – 35000) is shown on the debit side of trial balance. Same principle is adopted for all other accounts. The trial balance tallies. In the former method, more details can be understood but it is cumbersome. The second method gives the gist of the account and second method is popular.

6.7 Errors disclosed by Trial Balance

Those errors that can be disclosed by trial balance can easily be located. As soon as the trial balance does not tally, the accountant can proceed to find out the spots where the

errors might have been committed. The total amount of difference in the trial balance is temporarily transferred to a ‘Suspense Account’ so that it can be mitigated as and when the errors get rectified. T

6.8 Errors not disclosed by Trial Balance

There are four errors regarded as those which do not affect trial balance and it is difficult to locate them. A brief description of the four errors is offered in the following paragraphs:

a) Error of omission: Error of omission occurs when a transaction is completely omitted from the books of accounts.

b) Error of commission: If the error of wrong posting, wrong casting, wrong calculation etc., committed in the books of original entry or ledger, it is said to be error commission. c) Error of principle: While drawing journal entries, often error of principle is committed and this goes un noticed because it does not affect the total of trial balance. d) Compensating errors: It is also called off-setting error. Compensating error is one which is counter balanced by another error. If the account of Mr. X is to be debited for Rs1000, but it is debited for Rs100 while the account of Mrs X account is to be debited Rs.100 but it is debited by Rs.1000, the first error is compensated by the second error and therefore the trial balance is not affected. This comes to light only at a later stage. To rectify the error, Mr. X account should be debited by Rs.900 where as Mrs. X account should be credited by Rs.900.

MB0025-Unit-07-Final Accounts 7.1 Final Accounts – Introduction

The last step of accounting process is preparation of final accounts. Final accounts are Trading account and Profit and Loss Account with respect to any trading organization. If it is non trading organization like a club or an Educational Institution, Receipt and Payment Account and Income and Expenditure Account are the final accounts. In case of a manufacturing unit, a Manufacturing account is prepared in addition to Trading Account. Profit and Loss Account is prepared by all trading and manufacturing units. Balance Sheet is closely associated with these final accounts. But Balance Sheet is not an account. It is a statement of assets and liabilities of business organization prepared at the final stage of the accounting process. Therefore balance sheet is regarded as a part of final accounts. The purpose of preparing final accounts is to find out the end result of business at the end of an accounting period, may it be profit or loss.

7.2 Adjustments before preparing final accounts

The Generally Accepted Accounting Principles (GAAP) supports the accrual basis of accounting, according to which revenue is recognized when it is earned and expenses are recognized when they are incurred, irrespective of their actual receipt or actual payment.

If the accrual basis of accounting is used, adjusting entries are required at the end of the period to record any changes in assets, liabilities, revenue incomes, revenue expenses, previously unrecognized. Adjusting entries are regarded as internal transactions.

7.2.1 Outstanding expenses

Expenses due but not yet paid are known as outstanding expenses. To record that aspect, the journal entry drawn in the Journal proper is:

Concerned Expenses account Dr

To outstanding Expenses account.

Outstanding expenses account indicates liability for the current year and it will appear in the balance sheet.

7.2.2 Prepaid Expenses

Expenses paid in advance are regarded as prepaid expenses. Prepaid expenses form an asset and therefore prepaid expenses account is debited. To record this internal adjustment, the entry is

Prepaid Expenses account Dr 900

To Insurance account 900

Note that outstanding or prepaid expenses accounts are regarded as personal accounts.

7.2.3 Accrued Income

Accrued income is also called outstanding income. Outstanding income account is a personal account and it represents an asset. This account is credited and the concerned income account is debited in the journal proper as an adjusting entry. The entry is

Outstanding incomes account Dr

To Concerned income account

7.2.4 Income received in advance

Just as income is accrued, there are instances where income is received in advance. The amount is shown as liability in the balance sheet and it shows a credit balance. The adjusting entry to record the income received in advance is

Concerned item of income account Dr

To Income received in advance account

7.2.5 Depreciation

Depreciation is reduction in the value of an asset due to constant use of the same, which is called wear and tear. Fixed assets like, buildings, plant, machinery, furniture etc., are subject to depreciation.

There are two popular methods of depreciation, namely fixed installment method and reducing balance method. In fixed installment method, depreciation is calculated on cost of the asset. In case of reducing balance method (Diminishing balance method), the depreciation is charged on the reducing balance of the book value of the asset. Reducing balance method is more popular and well recognized.

7.2.6 Bad Debts

Bad debts are those debts which are not recovered. Bad debts form loss to the business and reduce the amount of debtors. Since bad debts are losses, they are debited and the debtor’s account is credited because the outstanding amount of debtors comes down.

If bad debts are identified well before preparing trial balance, then bad debts appear in the trial balance and they should be taken to the debit side of profit and loss account. Since debtors account is already reduced by the amount of bad debts, it does not require any further adjustment in the balance sheet.

If bad debts are shown outside the trial balance, which means that they are identified after the preparation of Trial Balance, then two adjustments should be incorporated. One – bad debts should be charged against profits in P & L A/C and the second – the debtor’s account should be reduced by the amount of bad debts in the balance sheet on the asset side.

7.2.7 Provision for Doubtful Debts

Debts that can not be recovered are called bad debts but debts, the recovery of which is doubtful, are called doubtful debts. From the past experience of the business proprietor, what percentage of good debts may become bad in future, can be estimated and in the current year itself an equal amount of profit be set aside. This provision is known as Reserve for Bad Debts or Provision for Doubtful Debts or Reserve for Doubtful Debts.

Since the provision for bad debts is a charge against current year profit, the adjusting entry is to debit P & L A/C and credit Provision for Bad Debts Account.

Profit and Loss Account Dr

To Provision for bad debts account

Provision for bad debts is a liability to be incurred in future and so it should appear on the liability side of balance sheet. However, the convention is – RBD (Reserve for Bad and Doubtful Debts) is deducted from the amount of good debtors. The important note here is that RBD is computed as a percentage of good debts, which means total debtors minus bad debts unadjusted.

7.2.9 Reserve for discount on creditors

Just as reserve is for discount on debtors is created, reserve for discount on creditors is also created. Businessman expects that he would receive discounts from suppliers (creditors), when the businessman remits cash to them. Anticipating some percentage of creditors being received as discount in the coming year, the business proprietor makes a provision for the expected income in the current year itself. Discount on creditors is an income and therefore reserve for discount on creditors is debited and profit and loss account is credited to show it as anticipated profit. In the subsequent year, when discount on creditors is actually received, it is first set of against provision for discount on creditors and the difference between the new provision for discount on creditors and the balance of old provision left over is carried to P&L Account.

Discount on creditors is income and to that extent the creditors due is reduced. So the journal entry to record them is

Creditor’s account Dr

To discount on creditors account

Later if the discount received is adjusted against reserve for discount on creditors, the entry will be

Discount on creditor’s account Dr

To Reserve for discount on creditors

When provision for discount on creditors is made in P&L Account, the entry will be

Reserve for discount on creditors account Dr

To Profit and loss account

The amount of provision for discount on creditors is calculated at a percentage on creditors. In the balance sheet, creditors are shown after deducting reserve for discount on creditors.

7.2.10 Closing stock

Stock of goods – raw materials, semi finished goods, finished goods – at the end of the accounting year should be considered for preparing trading account and balance sheet. It is an internal adjustment. Closing stock is normally valued at cost or market price which ever is lower, even though there are several other methods to value stock. Closing stock does not appear in the trial balance because the value of it is ascertained only after the preparation of trial balance. To bring to the records, a journal entry is passed in journal proper by debiting closing stock account and crediting trading account. In the balance sheet, closing stock appears as an asset.

7.3 Trading Account

Trading account shows gross profit or gross loss arising out of trading activities. 7.5 Profit and Loss Account

Profit and los account is an important final account in the sense that the net result of the business in the form of net profit or net loss is disclosed by preparing the same. All business expenses like administrative expenses, office expenses, selling and distribution expenses are shown on the debit side of the account. Besides, all provisions made for different purposes such as reserve for bad debts, reserve for discount on debtors, reserve for repairs, depreciation etc., also picture on the debit side of the account. On the credit side of the account, all incomes of revenue in nature, reserve for discount on creditors and gross profit carried from trading account are mentioned.

7.7 Balance Sheet

Balance Sheet is the sum and substance of financial performance a business undertaking. It shows the assets and liabilities of business on a particular day. It is not an account but is a statement of affairs. The statement of assets and liabilities is prepared, having two sides, left side containing capital and liabilities and on the right side, containing assets and properties. Often the statement is prepared vertically, mentioning sources of funds first and later application of funds. Sources of funds indicate capital and liabilities and application of funds indicate assets.

Balance Sheet is prepared from Trial Balance. In case of sole trader organization and Partnership organization, the format of preparing Balance Sheet is arranged basing on liquidity of the assets. In case of Companies, the Companies Act, 1956 has specified a definite pattern of preparing Balance Sheet. Both the models of preparing Balance Sheet are stated here under.

.

MB0025-Unit-08-Introduction to Management Accounting 8.1 Introduction

Management accounting is an accounting service to the management. It assists the managers in the formulation of policy, taking a decision, control of execution. It focuses in increasing the managerial efficiency. Hence management accounting is also called as “Accounting for Management”.

8.3 Meaning And Scope

Management accounting is an accounting service to the management. It covers all those services by which the accounting department can assist the managers in the formulation of policy, taking a decision, the control of its execution and the appreciation of effectiveness.

As regards the scope of management accounting, it is very wide. It is based on historical financial data. It is concerned with future. It uses the information available from different walks of life like Political Science, Statistics, Mathematics, Economics, Cost Accounting and Financial Accounting. The main purpose of management accounting is to utilize information in solving the business problems and taking scientific decisions. Hence, it is difficult to pinpoint the exact scope. The Management Accountant seek to support management decision making by the provision of information and the analysis of financial performance. As the data is required for internal purposes, the management accountant is not constrained by the need to comply with regulations of the format for presentations. The main scope is :

1. To identify and calculate costs of production. This is known as Cost Accounting

2. To provide estimates for future expenses and revenues. This is known as Budgeting

3. To identify inefficiencies within the organization

4. To control costs and manage the flow of cash

5. To seek opportunities e.g. to identify “tax breaks”, possible cost savings and movements in foreign exchange rates which could be exploited by the organization.

The main management accounting techniques are:

1. Break-even analysis

2. Costing

3. Budgeting

4. Ratio Analysis

5. Variance analysis

8.5 Budgetary Control

Budgeting is the most common and powerful standard device of planing and control.

Budgetary control is a technique of managerial control through budgets.. A budget is a quantitative expression of plan of action. . It is a pre-determined detailed plan of action developed as a guide for future operation. According to Wheldon “Budgetary control is the planning in advance of the various functions of business so that the business as a whole can be controlled”. Budgetary controls deals with planning, coordination, recording appraisal and follow-up of actions.

8.7 Financial Analysis

It is the process of determining the significant operating and financial characteristics of a firm from accounting data. An organization has to deal with three areas viz. financial records and external reports, accounting for management decisions and internal reports and finally financial assessment and analysis. Financial statement analysis is therefore largely a study of relationship among the various financial factors in a business . It is the process of selection, relation and evaluation. The technique of financial analysis is typically devoted to evaluate the past, present and projected performance of a business firm. Financial analysis is commonly called “the analysis and interpretation of financial statements”.

8.8 Relevant Cost

Management decision is based on relevant costs. Costs incurred in the past is sunk cost. Whether to replace a machine or a not is a decision not based on how much was invested to buy that machine. This is based on comparative cash inflows from replacements and additional investments necessary net of realization of the old asset. Thus, sunk costs are not relevant costs.

8.10 Functions of Management Accounting

Management Accounting functions nay be said to include all activities with collecting, processing, interpreting and presenting information to management. More specifically, the functions are as follows:

Forecasting and Planning: Short and long term forecasts are very essential. Planning the future operations of a business is crucial. Necessary information and data for

forecasting should be provided from time to time. Various tools and techniques should be made use of.

Organizing: Organizing of finance and accounting functions is an important function of management accounting.

Coordinating: Coordination increases the efficiency of an organization and maximizes its profits.

Controlling performance: The management accounting is very helpful in controlling the financial performance of the organization through financial reporting, budgeting, financial analysis.

Communication: It is an important medium of communication. The management reporting mechanism is a typical example of communicating the results to the superiors.

Other functions: Management accounting serves in a number of other ways. It supplies useful information to different functional authorities. It provides accounting information and advice for price determination and pricing decisions. It also helps in making certain strategic decisions, decisions regarding seasonal or temporary suspension of production, make or buy decisions, replacement decisions.

8.11 Special Features Of Management Accounting

Accounting principles are man-made. Unlike the principle of natural science, accounting principles were not deducted from axioms, nor is their validity verifiable by observation and experiment. They have been evolved as “ necessity is the mother of invention” Based on this the special features are:

1. Selective in Nature : It is technique of selective nature. It picks up only those data which are relevant for decision making.

2. Provides Data : The function is to provide data and not the decision. It can inform but it cannot prescribe.

3. Future oriented: It helps in planning for the future decision and hence future oriented.

4. Cause and effect relationship : M.A studies the causes of profits or losses since the profit and loss account does not tell the reasons for profit or losses. M.A analyses the results of different variables on the profits and the profitability.

5. Non-Adherence of rules : M.A does not follows set rules and formats like financial accounting. The basic task is to motivate management action. Hence M.A is on the utility of information and not on formats and legal presentation.

6. Economic Reality : Accounting data and information represents the economic activities but M.A is used to guide future planning and decision making thereby representing the underling economic realities in a clear and unambiguous manner.

7. Goal congruence : M.A normally encourages all employees to act in a fashion which contributes to the overall objectives.

8. Information system : An organization comprises a number of information system or networks. In other accounting system the information system are rarely integrated. But in M.A these are designed in accordance with the principle of system theory to make it more efficient.

9. Quantitative Techniques : Certain aspects of management accounting particularly in the area of planning and decision making, statistical and operational research techniques are used extensively, By use of it, a particular solution is being refined for cost effectiveness.

10. Uncertainty : Conditions of certainty are said to exist when a single point estimate can be made which will be exactly archived. Conversely, Uncertainty exists where there are various possible outcomes or results or values.

8.12 Merits and Demerits of Management Accounting

Merits

1. Efficient palling and effective organization which are the end product of the system of management accounting bring systematic regularity in the business activities.

2. Maximum return on capital employed is ensured by the use of management accounting because it helps in the functions of planning, coordination and control

3. Better and improved services by management to customers are assured by this system.

4. Management accounting removes unacceptable standards or sub-standards.

5. Industrial relations may be improved by adoption of management accounting principles.

6. Eliminations of various types of wastages, production defectives and other related work deficiencies are removed with the help of management accounting.

7. Economic uplift of community and development of nation’s economy can be achieved by the use of management accounting.

Demerits

1. Most of the information used in Management accounting are derived from financial accounting records or cost accounting records other records. As such fairness and accuracy of decisions deduced depends to a greater extent upon fairness and accuracy of these original records.

2. Decisions or conclusions derived are insignificant unless properly executed at all levels of business operations.

3. Management accounting is a mere tool for management. It cannot substitute for management.

4. The evolution has been on account of inter-alia development of new theories in other sciences. Hence there is a need to have a comprehensive knowledge and understanding of all these related disciplines to derive the full advantage.

5. Management accounting is still in its evolutionary stage. Hence, there is an uncertainty in its use.

6. The installation of management accounting is a costly affair and as such it has very limited scope for its use.

8.13 Distinction Between Management Accounting And Financial Accounting

Management accounting initially is said to emanate from financial accounting in the sense that financial accounting in the beginning designed to supply information in the form of statements for management use. In fact, both management accounting and financial accounting are complementary in nature to each other. But they are distinguished in terms of kind and relative importance of the problems involved

Area Financial Accounting Management Accounting

Objective Limited to the preparation for external use

Information is collected for internal communication and use.

Process Recoding of financial transactions

Data is collected for internal use

Nature It is objective It is Subjective

Flexibility It is rigid It is flexible

Data Emphasis on Past data It lays stress on future

Precision It is precise It is approximation

Legality It is a legal Document It is voluntary

Unitization It covers entire organization It is based on activity, Department, Division

Audit Compulsory Voluntary

Publication Mandatory Voluntary.

MB0025-Unit-09-Financial Statement Analysis “Every fact that is learned becomes a key to other facts” – E.Y. Youmans. Based on this, this Unit deals with analysis of financial statements, the functions of which is to identify and highlight the firm’s strengths and weaknesses. The objective of ratio analysis is to provide with the financial information necessary to make financial decisions.

Ratio analysis can provide you with this information in three steps:

1. Calculate the firm’s ratios for the current or recent period . Ratios are calculated from the firm’s income statement or balance sheet It is helpful and sometimes necessary to have the financial statement independently audited.

2. Compare these ratios to those calculated in past records. The purpose of this comparison is to identify tendencies in the firm’s ratios. This is known as trend analysis.

3. Compare the ratios to industry averages to show how the company compares to firms of the same size in its industry. This process is known as Cross- sectional analysis.

After completing the analysis, one can have a great deal of information on how the company is doing both over a period of time and compared to other firms in its industry.

9.2 Meaning of Ratio

Ratios are useful in two ways:

1. To make inter-business comparisons

2. To make comparisons across financial periods

A ratio is simply one number expressed in terms of another. It is a means of highlighting in arithmetical terms the relationship between figures drawn from various financial statements. Therefore, it refers to the numerical or quantitative relationship between two variables or items. A ratio expresses simply in one number the result of comparison between two figures. It is calculated by dividing one figure by the other. The quotient so obtained is the ratio of the figures.

Ratio can be expressed in the following three forms:

1. As proportion

2. As percentage

3. As turnover or rate

The Dictionary meaning of Analysis is “separation or breaking up of anything into its elements or component parts”. Ratio Analysis is, therefore, a technique of analysis and interpretation of financial statements. Ratio analysis is the process of establishing and interpreting various ratios for helping in making certain decisions. It involves the methods of calculating and interpreting financial ratios to assess the firm’s performance and status.

9.3 Meaning Of Ratio Analysis

The Dictionary meaning of Analysis is “ separation or breaking up of anything into its elements or component parts”. Ratio analysis is therefore a technique of analysis and interpreting various ratios for helping in making certain decisions. It involves the methods of calculating and interpreting financial ratios to assess the firm’s performance and status

9.4 Scope

The ratio analysis is one of the most powerful tools of financial analysis. The firm is answerable to the owners, the creditors and employees. The firm can reach a number of parties. On the other hand, parties interested in the business can compute ratios based on the financial statements of the firm. The analysis is not restricted to any one aspect but takes into account all aspects such as earning capacity of the firm, financial obligation, liquidity and solvency aspects, liquidity and profitability concepts.

9.5 Advantages

The various advantages of ratio analysis are as follows:

a) Financial Forecasting and Planning

Ratio analysis helps in the financial forecasting and planning activities. Ratios based on the past sales are useful in planning the financial position . Based on this, future trends are set.

b) Decision Making

Ratio analysis throws light on the degree of efficiency. It is also concerned with the management and utilization of the assets. Thus, it enables for making strategic decisions.

c) Comparison

With the help of ratio analysis, ideal ratios can be composed. These can be used for comparison in respect of the firm’s progress and performance, inter-firm comparison with industry average.

d) Financial Solvency

Ratios are useful tools. It indicates the trends in the financial solvency of the firm. Long term solvency refers to the financial liability of a firm. It can also evaluate the short term liquidity position of the firm. .

e) Communication

The financial strength and weaknesses of a firm are communicated in a more easy and understandable manner by the use of ratios. The information contained in the financial statements is conveyed in a meaningful manner. It, thus, helps in the communication and enhance the value of the financial statements.

f) Efficiency Evaluation

It evaluates the overall efficiency of the business entity. Ratio analysis is an effective instrument which, when properly used, is useful to assess important characteristics of business liquidity, solvency, profitability. A critical study of these aspects may enable conclusions relating to capabilities of business.

g) Control

It helps in making effective control of the business. Actual results can be compared with the established standard and to take corrective action at the right time.

h) Other uses

Financial ratios are very helpful in the early and proper diagnosis and financial health of the firm.

9.7 Liquidity Ratio

It means the liquidity of the firm. Liquidity is the ability of the firm to meet its current liabilities as they fall due. Since the liquidity is basic to continuous operations of the firm, it is necessary to determine the degree of liquidity of the firm. These are important because liquidity is close to the heart of the firm. A firm may have a high level of long term assets and substantial net income, but if they do not have enough cash on hand or assets that can be turned into cash fairly quickly, they will not be able to operate day to day. The liquidity ratios examine the current portion of the balance sheet : current assets and current liabilities. The implicit assumption is that current assets will be used to pay off current liabilities. This makes sense due to the matching principle (match the maturity of the debt with the duration of the need) e.g. one would not take a five year bank loan to pay off an account payable due in thirty days.

There are two ratios that determine how liquid a firm is : the current ratio and quick ratio.

Current Ratio

It is one of the popular financial ratios. It measures the firm’s ability to meet its short term obligations. This is achieved by comparing the current assets of a business with its current liabilities.. The formula for current ratio is :

Current Ratio = Current Assets / Current Liabilities

It is important to identify the specific types of current assets that are excessive such as

1. Excessive stock levels, indicating poor stock control or a decline in sales volume

2. Excessive debtors, indicating poor credit control and an increasing risk of bad debts

3. Excessive cash or near cash equivalents, indicating a lack of suitable investment opportunities in capital projects.

A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current liabilities) is acceptable. However, the current ratio may vary from less than one in such industries as fast foods to more than two in the telephone apparatus manufacturing industry. Consequently, it is important too utilize the industry averages.

A ratio that is much higher than the industry average indicates that the firm may have excessive current assets. Further investigation may demonstrate the cause of the excess. One reason may be that the firm is having trouble in the collection of its debtors or has high inventory, both of which will be identified through the use of other ratios. Another reason may be that the firm is holding too much cash or short term investments which could be earning more money if they were invested in long term instruments. Still another reason for a high ratio is that the firm may be at a specific point in its business cycle. The company that sells woolen goods in winter is expected to have high inventory in November, December, January and high debtors in February.

A ratio which is much lower than the industry average indicates that the firm is having liquidity problems, meaning that it may not be able to meet its short term obligations. Accordingly, an extremely low current ratio should be a red flag to the company being analyzed.

The components of current assets and current liabilities are:

Current Assets: Cash in hand, cash at bank, trade debtors, bills receivable, stock, prepaid expenses, trade investments, marketable securities

Current Liabilities: Trade creditors, bills payable, bank overdraft, outstanding or accrued expenses, tax payable, provision for tax, dividends payable.

Example: Given: Current Ratio is 2.5 and working capital is Rs.1,80,000. Calculate the Current Assets and current liabilities.

Solution: Given data is working capital, hence :

Working capital = Current assets minus current liabilities

Current Ratio = CA / CL

In the absence of any value, the current liability is always taken as 1 unit

2.5 = CA / 1 and cross multiplying , CA is 2.5

Working capital ratio is 2.5, then substituting the values,

2.5 = 2.5 minus 1 or WC = 1.5

For 1.5 WCR = Working capital value is Rs1,80,000

For 2.5 CAR, the current asset is Rs.1,80,000 x 2.5 / 1.5 = Rs.3,00,000

For 1 CLR, the current liability is 1,80,000 x 2.5 / 1 = Rs.1,20,000

Liquid Ratio

It is also known as Quick Ratio or Acid test Ratio. It is similar to current ratio except that it excludes inventory which is generally the least liquid current asset. The reason for eliminating inventory may be due to two primary factors

a. Many types of inventory cannot be easily sold because they are partially completed items, obsolete items, special purpose items.

b. The items are typically sold on credit. This results in the creation of

trade debtors or bills receivables before being converted into cash.

Citing the example, in the case of company B, the only current asset that it carries is stock. The question must be asked : is this level of stock too high or might it be essential to this type of business ?

As stock is the least liquid of the current assets, prudence requires that liquidity be looked at in another way. If current assets excluding stock are compared with current liabilities, a more cautious assessment of the liquidity of the two companies is given.. This ratio is calculated as follows:

Acid Test Ratio = Current assets less Stock / current liabilities

The quick ratios for companies A and B are as follows :

A = 24,000 – 3,000 / 24,000 = 0.875

B = 50,000 – 50,000 / 10,000 = 0

This time the quick ratio indicates that company A has a considerably better liquidity from this point of view and company B is dangerously insolvent.

Illustration:

Given that Current ratio is 3.5, acid test ratio is 1.5 and working capital is Rs.6,50,000. Compute current assets, current liabilities, liquid assets

Solution:

Given data, Working capital = Current Assets minus current liabilities

Where current liability is taken as 1

CR = CA /.CL = 3.5 = CA / CL

Cross-multiply = 3.5 x 1 = Current Assets

Working Capital Ratio is therefore : CAR – CLR or 3.5 minus 1 or 2.5

For 2.5 WCR, the amount is Rs.6,50,000

For 3.5, CAR, the current asset is 6,50,000 x 3.5 / 2.5 or Rs.9,10,000

For 1, CLR, the current liability is 6,50,000 x 1 /2.5 or Rs.2,60,000

Liquid asset is based on Acid Test Ratio where, 1.5 = LA / CL

Liquid asset, therefore, are = 2,60,000 x 1.5 or Rs.3,90,000

Problem: Given Current ratio 1.5 :1; Quick ratio 1 : 1 and Current liabilities Rs.50,000. Calculate current assets, quick assets and inventory.

Solution: Given Current ratio : 1. 5 : 1 and value of current liabilities Rs.50,000

Current assets : CR = CA /e 1.5 = CA / 50,000 or CA = Rs.75,000

Quick Asset : QR = QA / 1 or 1 = QA / 50,000 or Rs.50,000

Inventory = CA – QA or 75,000 – 50,000 or Rs.25,000

Problem: Assuming the Current ratio of DR Ltd is 2, state in each of the following cases whether the ratio will improve or decline or will have no change.

(a) payment of current liability

(b) purchase of fixed assets

(c) cash collected from customers

(d) Bills receivable dishonored and

(e) issue of new shares.

Solution: CR = CA / CL where 2 = CA / 1 or CA = 2 and CL = 1

a) Payment of current liability : Current ratio will not change. The reason is that when current ratio is 2:1, payment of current liability will reduce the same amount in the numerator and denominator. Hence, the ratio will not change.

b) Purchase of fixed assets : here, the current ratio will decline.

c) Cash collection : Current ratio will not be changed because cash will increase and debtors will decrease

d) BR dishonored : Current ratio will not change. Reason is that BR will decrease and debtors will increase

e) Issue of new shares : Current ratio will improve because cash balance will increase.

9.8 Solvency Ratios

The ratios are analyzed on the basis of long term financial position of a firm. It is also known as test of solvency or analyzing the debt. Many financial analysts are interested in

the relative use of debt and equity in the firm. Debt refers to outside borrowings by the firm.

Since the creditor’s claims must be satisfied before the distribution of earnings to shareholders, present and prospective shareholders pay close attention to the degree of indebtedness and ability to repay the debts. Lenders are also equally concerned about the indebtedness and the repayment modes. Hence, the solvency of the firm in particular needs consideration.

Debt Ratio

Debt ratios are important because debt is widely considered to be a measure of the health of the firm and the risk associated with it. If a firm has high debt, they have fixed payments which must be made. This means that limited funds may be directed to debt payment (either principal or interest or both) instead of investments. .

Total Liabilities / total assets

This ratio tells you how much of the firm’s assets are financed with debt. A high debt ratio indicates that the firm may be carrying too much debt. This is of concern to the firm because it may not be able to repay the debt nor to borrow additional funds they are needed. Accordingly, a firm in this situation is considered risky because short term financing is limited and may not be available in an emergency.

A low debt means that the firm has a low level of liabilities compared to its total assets. Such a ratio indicates that the firm is not risky because it has plenty of financing available when compared to its need. However, a low ratio may also indicate that the firm should take on more debt. The reason for this is that the ability to borrow is considered a resource and a firm with low debt may not be taking advantage of this resource.

Debt : Equity Ratio

The debt : equity ratio is : debt/equity

Long term Debt / Shareholder’s equity

The debt-equity ratio deals with the long term liabilities and equity portion of the balance sheet. Note that shareholders’ equity includes retained earning (Equity may also be known as net worth). The debt-equity ratio provides information on the capital structure (relationship between debt and equity) of the firm. Such information is important because it affects the value of the firm. The value of the firm is important because it has an impact on the ability to raise funds., either through increased borrowing or the sale of shares or both.

A high debt-equity ratio indicates a poor capital structure because it signifies that the firm has high debt in comparison to its level of shareholders’ equity. This means that the

firm’s creditors may be concerned about the repayment of debt, which in turn leads to high interest rates, which in turn leads to higher required returns on the firm’s potential investments..

A low debt equity ratio is an indication that the firm is in sound financial position and therefore is not considered risky. Normally, the debt equity ratio vary tremendously from industry to industry.

Problem: The Balance Sheet of DR Ltd is as follows :

Assets: Fixed Assets 10,00,000

Current Assets 5,00,000

Represented by:

Current Liabilities 1,00,000

Reserves and surplus 1,00,000

10 % Debentures 2,00,000

6 % Preference Share capital 3,00,000

Equity Share capital 8,00,000

Calculate the Debt Ratio and Debt-equity ratio.

Solution: Debt Ratio : Total Liabilities to outsiders / total assets

: Debentures + Trade creditors / Fixed + current assets

3,00,000 / 15,00,000 or 1 : 5

Debt – equity ratio : Outsiders’ funds / shareholders’ equity

Outsiders’ funds 10 % Debentures only + Sundry Creditors

Shareholders’ funds Equity Share capital + Preference share capital + Reserves

3,00,000 / 12,00,000 or 1 : 4

9.9 Profitability Ratios

A firm’s profitability can be assessed relative to sales, assets, equity or share value. The profitability ratios are important because they indicate whether the firm is doing what it set out to do : make a profit and provide a return to its investors. There are many measures of profitability. Each relates the returns of the firm with regard to the sales, assets, equity or share value. As a group, these measures enable to evaluate the firm’s earnings. The criteria for earnings can be related to a given level of sales,. A certain level of assets, the owner’s investment or share value. Earnings result in profits. Without profits, a firm may be handicapped to attract outside capital. The income statement of the firm shows the total profits earned by the firm during the preceding fiscal period. The important ratios which highlight the profitability of a firm would be as follows:

Gross Profit Ratio

It measures the percentage of each sales value remaining after the firm has paid for its goods. The higher the gross profit margin, the better and lower the relative cost of merchandise sold. Thus, it serves an important tool in shaping the pricing policy of the firm. The formula is :

Gross Profit = (Gross Profit / Sales) x 100

Where Gross profit = Sales minus Cost of goods sold (COGS)

Net Sales = Cash Sales + Credit Sales minus Sales Returns

It is normally expressed as a percentage. If we deduct gross profit ratio from 100, the ratio of COGS is obtained..

Problem

DR Ltd provides the following information.

Cash Sales Rs.8,00,000; Credit Sales Rs.10,000; COGS Rs.15,80,000 and Return Inwards Rs.20,000. Calculate Gross Profit Ratio and ratio of COGS.

Solution

GPR: GP / Net Sales x 100 : Gross Profit : Net Sales minus COGS

Net Sales: Gross Sales minus Return Inwards

Gross Sales : Cash + Credit Sales

8,00,000+10,00,000 minus 20,000 or Rs.17,80,000

Gross Profit : 17,80,000 minus 15,80,000 or Rs.2,00,000

GPR 2,00,000 /17,80,000 x 100 or 11.2 %

Ratio of COGS : 100 – GP Ratio or 100 – 11.2 or 88.76 %

Expenses Ratio

These ratios indicate the relationship of various expenses to net sales. Individual expenses are calculated based on the net sales and indicated as a percentage to net sales.

Net Profit Ratio

It is also known as Net Profit Margin. It measures the percentage of each sales in rupee after all expenses including taxes have been deducted This ratio provides considerable insight into the overall efficiency of the business. A higher ratio speaks about the overall efficiency of the business. It also focuses the attention of the better utilization of total resources. A lower ratio would mean a poor financial planning and low efficiency. A net profit margin of 1 percent or less would be unusual for a grocery store which a net profit margin of 10 percent would be low for a retail stores. It is divided by net income by net sales. The formula is :

Net Profit Ratio = (Net Profit after taxes / Net Sales ) x 100

The net profits are calculated after excluding the income tax, the non-operating incomes and non-operating expenses. It is expressed as a percentage on net sales..

Example: The income statement of DR Ltd is as follows:

To Opening Stock 2,00,000 By Sales 12,00,000

Purchases 8,00,000 Closing Stock 1,00,000

Direct Expenses 1,00,000   

Gross Profit 2,00,000   

 13,00,000

 13,00,000

To Admn Expenses 1,00,000 By Gross Profit 2,00,000

Selling Expenses 80,000 Profit on sale of Investments 60,000

Non-Operating exp 40,000 Dividends received 40,000

Net Profit 80,000   

 3,00,000

 3,00,000

Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Operating Profit Ratio and Expense Ratio.

Solution

Gross Profit Ratio = GP / New Sales x 100 or 2,00,000 / 12,00,000 x 100 or 16.61 %

Net Profit ratio = NP after tax / Net Sales x 100 or 80,000 / 12,00,000 x 100 or 6.67 %

Operating Ratio = COGS + operating expenses / Net Sales x 100

Sales minus Gross profit = COGS

10,00,000+1,00,000+80,000 / 12,00,000 x 100 or 98.33 %

Operating Profit = 100 – 98.33 or 16.67 % Ratio

Admn Expenses Ratio = Admn Expenses/Net sales x 100 or 1,00,000/ 12,00,000 x 100 8.33 %

Selling Expense Ratio = Selling Expenses/Net Sales x 100 or 80,000/12,00,000 x 100 or 6.67 %

9.10 Activity Ratios

These are used to measure the speed with which various accounts are converted into sales or cash. Measures of liquidity are generally inadequate due to the composition of the firm’s current assets and current liabilities. The activity ratios are also known as turnover ratios. Some of the turnover ratios are as follows :

Stock Turnover Ratio : STO

Debtors Turnover Ratio : DTO

Creditors Turnover Ratio : CTO

Stock Turnover Ratio

It commonly measures the activity or liquidity of the firm’s stock.. The STO is also known as stock velocity. Velocity refers to “speed” with which an object travel. Here, it is the speed on converting the stock into sales then to cash. It indicates the number of

times the stock has been turned over as cash during a given period of time. It evaluates the efficiency with which a firm is able to manage its stock.

If the cost of goods sold )COGS) is known, the STO can be calculated as follows:

STO = COGS / Average stock at cost

Where COGS = Net Sales – Gross Profit

Average Stock = Opening + Closing Stock / 2

If COGS is not known, it can be computed as follows:

STO = Net Sales / Stock

Example: DR Ltd provides the following

Stock: Opening Rs.75,000; Closing Rs.1,00,000. Credit Sales Rs.2,00,000. Cash sales

Rs. 50,000. Gross Profit 25 %. Calculate the Stock Turnover Ratio

Solution:

STO = COGS / Average stock

COGS = Net Sales – Gross Profit

Net Sales = Cash Sales + Credit Sales or 2,00,000 + 50,000 or 2,50,000

Average stock = Opening + closing stock / 2 or 75,000 + 1,00,000 / 2 or 87,500

Gross Profit = 25 % on Rs.2,50,000 or 62,500

COGS = 2,50,000 – 62,500 or 1,87,500

STO = 187,500 / 87,500 or 2.14 times.

Debtors Turnover Ratio : DTO

It is also known as Debtors velocity. The birth of debtor comes from credit sales. Total debtors include the Bills Receivable also. The Bills receivables are written promise of trade debtors. Trade debtors are normally provided with 3 months credit time. After the expiry, they will pay cash. Thus, debtors are expected to be converted into cash within a short period. Therefore, it is included in the current assets. It is calculated as follows :

DTO = ( Debtors + BR / Net credit sales) x Number of working days

DTO indicates the velocity of debt collection of firm. It indicates the number of times average debtors convert themselves over into cash during a year. Debtors care should always be taken on gross value/ Do not deduct the bad debts or provision for doubtful debts. It is expressed as the number of times.

If DTO is given in months, convert it into a common base period. If it is given as a number of times, do not reduce it to a base period.

Example: Total sales of a firm Rs.5,00,000, of which the credit sales are Rs.3,65,000.Sundry Debtors and Bills receivable are Rs.50,000 and Rs.2,000 respectively

Calculate the DTO.

Solution: DTO = Debtors + BR / Net credit sales x 365

50,000 + 2,000 / 3,65,000 x 365 or 52 days

Creditors Turnover Ratio : CTO

Creditors come into being out of credit purchases. Creditors include both trade creditors and bills payables. It is included in the current liability since the payment has to be made within three months normally. The formula is as follows :

CTO = ( Creditors + Bills Payable / Credit purchases ) x 100

Where credit purchases = Total purchases minus cash purchases

Example: Total purchases Rs.1,00,000. Cash purchases Rs.20,000. Discount Provision on creditors Rs.1,000. Purchase returns Rs.2,000. Creditors at close Rs.30,000. Bills payable at close Rs.25,000. Calculate CTO.

Solution: Credit purchases = Total purchase – cash purchase – purchase return

1,00,000 – 20,000 – 2,000 or Rs.78,000

CTO = 30,000 + 25,000 / 78,000 x 365 or 257 days

The Reserve for discount on creditors should not be considered for calculating the net credit sales.

9.11 Leverage Ratio

A firm’s capital structure is the relation of debt to equity as sources of the firm’s assets.. Normally both the owners and the creditors of the business will be interested in analyzing its capital structure. The ratios that deal with the leverage are as follows :

Capital Gearing Ratio:

It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the preference share capital and the debentures as against the equity funds provided by the equity shareholders. The ratio is calculated as:

Capital Gearing Ratio : Fixed cost bearing capital / variable cost bearing capital

Where fixed cost bearing capital = preference share capital, debentures , long term bank borrowings.

Variable cost bearing capital = equity share capital, reserves and surplus.

If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more than 1, the firm is said to be highly geared. On the reverse, it is low geared.

Example: The capital structure of two companies, Never-do-well and Good-for-nothing Ltd are as follows:

The capital of NDW is low geared when compared to GDF.

Debt-equity Ratio:

The ratio compares the debt with equity. Debt refers to long term loans and liabilities.

Redeemable Preference shares are also considered as debt. This measure is helpful to assess the soundness of the long-term financial policies. It determines the relative stake of outsiders and shareholders in the company Lower the ratio, it is considered more comfortable for the creditors financial position. 2 : 1 is taken as a satisfactory debt – equity ratio. However, it is not a very satisfactory measure. since the nominal values may bear very little relationship to their current market values. The calculation is as follows:

Debt – equity Ratio = Long term debts / Shareholders’ funds + Long term debts

Example: The capital structure of DR Ltd is as follows :

Equity Share Capital 10,00,000

Redeemable Preference Capital 5,00,000

6 % Debentures 3,00,000

Long term liabilities 2,00,000

Reserves and surplus 2,00,000

Calculate the Capital Gearing Ratio and Ratio of Total Investment to Long-term liabilities

Solution:

CGR : Fixed Cost bearing capital / variable cost bearing capital

10,00,000 / 12,00,000 or 0.83 : 1

TI to LTL : Equity Share capital + Reserves and surplus + Long term

Liabilities / Long term liabilities

22,00,000 / 10,00,000 or 2.2 : 1

9.12 Limitations Of Ratio Analysis

Undoubtedly, ratios are precious tools in the hands of the analyst. But its significance comes from proper use of these ratios. Misuse or mishandling of these ratios and using them without proper context may lead the analyst or management to a wrong direction. The person who uses these ratios should be well versed and should possess expertise knowledge about making proper use of these ratios. Like all tools, ratios also suffer from several ‘ifs’ and ‘buts’ and for a thorough understanding of proper use of these ratios. There are certain limiting factors in the case of ratio analysis. These limiting factors are :

1. The user should possess the practical knowledge about the concerns and the industry in general.

2. Ratios are not an end. They are only means to an end.

3. A single ratio in itself is not important. The trend is more significant in the analysis. Comparison of ratios should be made.

4. For comparative purposes, there should be a standard ratio. There is no such standards prescribed for the ratios.

5. The accuracy and correctness of ratios are totally dependent upon the reliability of the data contained in the financial statement on the basis of which ratios are calculated.

6. To use ratios, first of all there should be uniformity in the accounting plan used by both the firms. In addition. There must be consistency in the preparation of financial statement and recording the transactions from year to year within that concern.

7. Ratios become meaningless if detached from the details from which they are derived. The should be used as supplementary and not substitution of the original absolute figures.

8. Time lag in calculation and communicating the same should not be unnecessarily too much.

9. The method of presentation should be precise and without any ambiguity.

10. Price level changes make the ratio analysis meaningless.

11. Inter-firm comparison should never be undertaken iin the case of concerns which are not associated or comparable.

12. All techniques concerning the ratio analysis should be taken into account.

9.13 Computation of Ratios

Problem 1:

Extracts from financial account of DR ltd are given below:

 Year 2006 Year 2007

Assets   

Stock 10,000 20,000

Debtors 30,000 30,000

Payment in advance 2,000 –

Cash in hand 20,000 15,000     

Liabilities   

Sundry creditors 25,000 30,000

Bills payable 15,000 12,000

Bank Overdraft – 5,000

Sales amounted to Rs.3,50,000 2006 an Rs.3,00,000 in 2008. Compute the solvency position of DR.

Solution: Short-term solvency analysis

Current Ratio : CA / CL or Year 2006 : 62,000 / 40,000 or 1.55 : 1

2007 : 65,000 / 47,000 or 1.38 : 1

Liquid Ratio : LA / Liquid liabilities

For 2006 : 52,000 / 40,000 or 1.30 : 1

2007 : 45,000 / 42,000 or 1.07 : 1

Bank overdraft is not included in liquid liabilities as it tends to become some sort of a permanent mode of financing.

Inventory turnover ratio : Net sales / average inventory

For 2006 : 3,50,000 / 10,000 or 35 : 1

2007 : 3,00,000 / 15,000 or 20 : 1

The liquid position is not sound. The current ratio I the year 2006 does not appear to be good enough as it is below the rule of thumb i.e. 2 : 1 . In the year 20-07, the position has further deteriorated to 1.38: 1. The later ratio shows a definite weakening in the solvency position of the company. As regards the acid test ratio, it is satisfactory in the year 2006 and not alarming in the year 2007. However, the fall in the cash balance and appearance of bank overdraft in the year shows a definite deterioration in the financial position. Moreover, because of factors concerning sales, stock and debtors, the quick ratio is likely to soon deteriorate.

As regards inventory turnover ratio, it indicates an alarming deterioration in the year 2007. The disproportionate rise in the percentage of stock to total current assets from 16% in the year 2006 to 31 % in the year 2007 is also a matter of concern. This shows over purchase of materials which needs through investigation.

A comparison of debtors turnover ratios of the two years indicates worsening of the company’s liquid position. There will be much cause of worry if the sales is only to a few customers.

LONG TERM RATIOS

Debt to equity ratio : External equities / Internal equities

For 2006 : 40,000 / 22,000 or 1.82 : 1

2007 : 47,000 / 18,000 or 2.61 : 1

Proprietary Ratio : Shareholders’ Equities / Total Equities

For 2006 : 22,000 / 62,000 or 0.35 : 1

2007 : 18,000 / 65,000 or 0.28 : 1

From the long term point of view, the financial position of DR is very unsatisfactory as the debt to equity ratio and proprietary ratio are far off the norm in both years. The situation has worsened in the year 2007 resulting in a serious decline in the shareholders’ equity. The company seems to be heavily banking upon the creditors’ funds.

The overall conclusion of the above analysis is that the solvency position of DR is not satisfactory and needs careful planning.

Problem 1

A manufacturer of stoves sells to retailers on terms 2 .5 % discount in 30 days, 60 days net. The debtors and receivables at the end of December of past three years and net sales for all these three years are as under.

Year

2005 2006 2007

Debtors 54,842 33,932 85,582

Bills Receivable 4,212 3,686 9,242

Net Sales 2 ,68,466 3,47,392 4,43,126

Determine the average collection period for each of these three years and comment.

Solution:

Collection period : Trade receivables / Net credit sales x Number of working

days

Year 2005 : 59,054 / 2,68,466 x 365 = 80 days

2006 : 37,618 / 3,37,392 x 365 = 41 days

2007 : 94,824 / 4,43,126 x 365 = 78 days

The average collection period in all the three years has been within standard period 80 days, i.e. 60 + 1/3 of 60 days . Hence, it is good.

Problem 2: DR purchases goods both on cash and credit terms. The following particulars are obtained from the books:

Total purchases Rs.2,00,000. Cash purchases Rs.20,000. Purchase returns Rs.34,000. Creditors at the end Rs.70,000. Bills payable at the end Rs.40,000. Reserve for discount on creditors Rs.5,000. Calculate average payment period.

Solution:

Calculation of net credit purchases : Total purchases minus cash purchases minus purchase returns or Rs.3,00,000 – 20,000 – 34,000 or Rs.1,46,000.

Average payment period : Creditors + Bills payable / Net credit purchases x 365 days

70,000 + 40,000 / 1,46,000 x 365 days or 275 days.

Problem 3 : From the following Balance sheet , compute the Balance Sheet ratios

Assets: Plant and Machinery Rs.2,00,000. Land and Building Rs.2,00,000. Stock Rs.1,50,000. Debtors Rs.50,000 and Cash balances Rs.1,00,000 = Rs.7,00,000

Liabilities: Equity Share capital Rs.2,00,000. 6 % Preference Share capital Rs.1,00,000. 8 % Debentures Rs.1,00,000. Reserves and surplus Rs.1,00,000. Long term loan Rs.50,000. Creditors Rs.1,00,000. Bank overdraft Rs.50,000 = Rs.7,00,000.

Solution:

Current Ratio: CA / CL or 3,00,000 / 1,50,000 or 2: 1

Liquid Ratio: LA / CL or 1,50,000 / 150,000 or 1 : 1

Absolute Liquid Ratio: Absolute liquid assets / current liabilities or 1,00,000 / 1,50,000

Or 1 ; 0.67

Proprietary Ratio: Proprietors’ equity /current liabilities or 4,00,000 / 7,00,000 or 0.57 : 1

Assets Proprietary Ratio: Fixed assets / Proprietors’ equity or 4,00,000 / 4,00,000 or 1:1

Current assets to proprietors’ equity: Current assets/ Proprietors’ equity or 4,00,000 / 4,00,000 or 1 : 1

Debt Equity Ratio: Total debts / Proprietors’ equity or 3,00,000 / 4,00,000 or 0.75 : 1

Stock to Current asset Ratio: Stock / Current assets or 1,50,000 / 3,00,000 or 0.50:1

Stock to working capital ratio: Stock/working capital or 1,50,000 / 1,50,000 or 1:1

Current assets to working capital ratio: CA / WC or 3,00,000 / 1,50,000 or 2:1

Current assets to Liquid assets ratio: CA / LA or 3,00,000 / 1,50,000 or 2:1

Long term funds to working capital ratio: All long term funds / working capital or 2,50,000 / 1,50,000 or 1.67 : 1

Tangible assets to working capital ratio: Tangible assets / current liabilities or 4,00,000 / 1,50,000 or 2.67 : 1

Tangible assets to current liabilities ratio: Tangible assets / current liabilitieisi or 4,00,000 / 1,50,000 or 2.67 : 1

Capital Gearing Ratio: Equity share capital / Preference shares + Debentures or 2,00,000 / 2,00,000 or 1:1

Problem 4: A factory engaged in an industry which is capital intensive has been in operation for ten years. The capital employed is Rs.17,00,000, out of which Rs.10,00,000 represent equity capital and reserves, Rs.5,00,,, long term borrowings on Debentures and Rs.2,00,000 cash credit from banks. The working capital of the company is Rs.8,50,000 made up of stocks Rs.3,00,000, Stores Rs.1,40,000, Debtors Rs.3,50,000, Advances and deposits Rs.60,000. Annual Sales Rs.8,00,000. Calculate current ratio, liquidity ratio, debt equity ratio, proprietary ratio, Fixed assets to proprietors’ funds, Fixed asset ratio.

Solution: Current Ratio : 8,50,000 / 2,00,000 or 4.25 : 1

Liquidity Ratio = 4,10,000 / 2,00,000 or 2.05 : 1

Debt equity ratio : 7,00,000 / 10,00,000 or 0.7 : 1

Proprietary ratio : 10,00,000 / 17,00,000 or 0.59 : 1

FA to Proprietors’ fund or 8,50,000 / 10,000 or 0.85 : 1

Fixed assets ratio or 8,50,000 / 15,00,000 or 0.57 : 1

Problem 5: The ratios relating to DR Ltd are given below

Gross profit ratio 15 %. Stock velocity : 6 months. Debtors velocity 3 months. Creditors velocity 3 months. The gross profit for the year amounts Rs.60,000. Closing stock is equal to opening stock. Find sales, closing stock, sundry debtors and sundry creditors.

Solution:

Gross Profit Ratio = Gross Profit / sales and 100 or 15 % = 60,000 / sales x 100 or Sales is Rs. 4,00,000.

Closing stock = Basis stock velocity or Cost of goods sold / average stock where COGS = Sales – Gross profit or Rs.4,00,000 – Rs.60,000 or Rs.3,40,000

6 months = 3,40,000 / Average stock of Average stock is Rs.6,80,000.

Since opening and closing stocks are the same, the closing stock is Rs.6,80,000

Sundry Debtors : Basis Debtors velocity = Total debtors / sales x Number of months

Total Debtors is 4,00,000 x 3 /12 or Rs.1,00,000

Sundry Creditors : Total creditors / purchases x Number of months

Where Purchases = Opening stock + purchases – closing stock or Rs.3,40,000

Creditors = 3,40,000 x 3/12 or Rs.85,000

Problem 6: Prepare a Balance sheet from the following

Current Ratio 1.4. Liquid Ratio 1. Stock turnover Ratio 8. GP Ratio 20 %. Debt collection period 1.5 months. Reserves and surplus to capital 0.6. Turnover to fixed assets 1.6. Capital Gearing Ratio 0.5. Fixed assets to net worth 1.25. Sales Rs.10,00,000.

Solution: Calculation of cost of Sales : Sales – Gross profit 10,00,000 minus 2,00,000 (20 % of 10,00,000) Rs. 8,00,000.

Closing Stock: Cost of sales / Stock Turn over Ratio or 8,00,000 / 8 or Rs.1,00,000

Fixed Assets: Cost Sales / FA turnover or 8,00,000 / 1.6 or Rs.5,00,000

Debtors: Total sales x Debt collection period of 10,00,000 x 1.5 / 12 or Rs.1,25,000

Current assets based on liquid ratio: Current Ratio is 1.4. Therefore Stock is Current Ratio minus Liquid Ratio of 1.4 minus 1.0 or o.4 or Value of stock x current ratio / stock ratio o 1,00,000 x 1.4 /.4 or Rs.3,50,000

Liquid assets = Current assets minus stock or 2,50,000 minus 1.25,000 or Rs.1,25,000

Cash balances : Liquid assets minus Debtors or 2,50,000 minus 1,25,000 or Rs.1,25,000

Current Liabilities : Current Ratio is 1.4

Therefore, current liabilities is Current assets / current ratio or 3,50,000 / 1.4 or Rs.2,50,000

Net Worth : Fixed Assets / FA to net worth or 5,00,000 / 1.25 or Rs.4,00,000

Reserves and Surplus : Ratio 0.6

Let the Capital be 1

Add: Reserves and surplus which is 0.6, hence it is 1.6

Reserves and surplus will be : Shareholders funds x Reserves / Total ratio or 4,000 x 0.6 / 1.6 or Rs. 1,50,000

Share Capital : Shareholders funds minus Reserves or 4,00,000 minus 1,50,000 or Rs.2,50,000

Long term Liabilities : Capital Gearing ratio is 0.5

Share capital x Gearing ratio or 4,00,000 x 0.5 or Rs.2,00,000

Terminal Questions:

Problem 1:

Calculate Current ratio, acid test ratio.: Cash in hand Rs.3,000. Cash at Bank Rs.65,000. Bills receivable Rs.10,000. Stock Rs.1,20,000, Debtors Rs.80,000. Prepaid expenses Rs.2,000. Creditors Rs.1,20,000. Bills payable Rs.20,000.

Problem 2:

Calculate : Debts to equity Ratio and Proprietary ratio : Equity share capital Rs.5,00,000. Preference share capital Rs.3,00,000. Reserves Rs.2,00,000. Current liabilities Rs.1,00,000. 8 % Debentures Rs.3,00,000. Fixed assets Rs.10,00,000. Current assets Rs.4,00,000

Problem 3:

The current assets and current liabilities were Rs.16,00,000 and Rs.8,00,000 respectively. What is the effect of each of the following transactions individually and totally on the current ratio :

1. Purchase of new machinery for Rs.5,00,000

2. Purchase of new machinery for Rs.10,00,000 on a medium term loan from a bank with 20 % margin.

3. Payment of a dividend of Rs.2,00,000 of which Rs.0.47 lakh was tax deducted at source.

4. Materials purchased costing Rs.5,00,000 in respect of which bank financed Rs.3,00,000.

Problem 4:

The current ratio is 2 : 1. Which of the following suggestions would improve the ratio, which would reduce it and which would not change it.

a) to pay a current liability

b) to sell a motor car for cash at a slight loss

c) to borrow money for short time on an interest bearing ;promissory note

d) to purchase stock for cash

e) to give an interest bearing promissory note to a creditor to whom money was to be paid.

MB0025-Unit-10-Funds Flow Analysis 10.1 Introduction

The usefulness of developing certain financial statements as an aid to evaluate past and / or present performance of a business concern is unquestionable and beyond any dispute. The Income Statement reports the revenues earned and expenses incurred or outstanding. The Balance Sheet conveys about the deployment of funds in various assets and equities The Fund Flow analysis is a modern technique of analyzing the movement of “funds” of a concern. The Fund Flow statement shows the movement of funds between two balance sheet dates. As per Robert N. Anthony “the Funds Flow statement describes the sources from which additional funds were derived and the use to which these funds were put”.

Such a statement is becoming more and more popular and is being increasingly published as part of the annual accounts. Para 20 of International Accounting Standards 7 reads as follows :

“A statement of changes in financial position should be included as an integral part of financial statements. The statement of changes in financial position should be presented for each period for which the income statement is prepared”.

The inclusion of such a statement, therefore, is very helpful to improve the understanding of the operations and activities of an enterprise for the reporting period.

Objectives:

1. Understand the meaning and the concepts of funds flow statement.

2. Familiar with techniques of fund flow statement.

3. Preparation of fund flow statement.

10.2 Meaning of Fund Flow Statement

Statement of Sources and Uses of Funds is a statement which depicts the sources from which funds are obtained and the uses to which they are being put. It is essentially derived from the analysis of changes which have occurred in assets and equities between two Balance Sheets periods. It is not the end-product of accounting records. The statement speaks about the changes in financial items of Balance Sheets prepared at two different dates. Therefore, the funds flow indicates the inflows and outflows of funds during a particular accounting period generally a year. The flow exhibits the movements of funds in both the directions – inside and outside the business. As such, the term ‘flow’ in the context of funds indicates the transfer of cash or cash equivalent from asset to equity or one equity to another equity or from one asset to another asset.

10.3 Concept of Fund

The term “funds” has been defined in a number of ways in financial circles. The three common usages of the term are cash, working capita and total financial resources.

Cash: Under this concept, the term “funds” is used only in the sense of cash. Here, only the changes in cash are considered. Hence, the statement is called “Cash Flow statement. This statement aims at listing the various items which bring about changes in the cash balance between two balance sheet dates. Cash planning becomes useful for control purposes.

Using this method has certain disadvantages. Since cash is considered as short term assets, they are subjected to short term fluctuations. A delay in making payment to suppliers and a provision of one month’s credit for making a payment of land purchases

may show sufficient cash flow . They may reflect a satisfactory position. But it is not a reality. Therefore, cash equivalent concept of fund is useful only for short term financial planning and not for long term or general financial position assessment.

Working Capital: Working capital is Current asserts minus current liabilities. It is an alternative measure of the changes in the financial position. All those transactions which increase or decrease working capital are included in this statement. It excludes all such items which do not affect the working capital. The working capital concept of funds is in conformity with normal accounting procedures. Hence, a funds flow statement based on this concept fits well with the other statements. Moreover, working capital is also a measure of short term liquidity of the firm. Therefore, an analysis of factors bringing about a change in the amount of net working capital is useful for decision making by shareholders, creditors and management. Due to these reasons, the working capital approach to funds is more useful than the cash approach.

Total Financial Resources : The term “funds” is very often used in the sense of useful financial resources also. Cash approach and working capital approach both are incomplete and inadequate to the extent that they omit a few major financial and investment transactions. Such items do not affect net working capital. But, if they are included, they would certainly provide qualitative information for the decision making.,

For example issuing equity shares and debentures for purchase of buildings or assets shall not have any effect on the working capital. But it is a significant financial transaction that should be disclosed. Therefore, this concept seems to be the best approach to disclose the changes in the financial position as compared to other concepts. It is in conformity with the statutory regulations and legal requirements.

Objectives:

The main objectives of the funds flow statement is normally based on the purpose its going to be served. These are :

a) to help in understanding the changes that are likely to take place in the assets and liabilities portfolio. These may not be readily available from the income statement.

b) To inform the stakeholders as to how a firm can use the funds which are available at its disposal.

c) To bring out the financial strengths and weaknesses of the business.

10.4 Techniques Of Preparing A Funds Flow Statement

Like other accounting statements, the structure of Fund Flow Statement is based on the equality of financial assets and liabilities including capital. The basic understanding is that the funds are obtained through profit, external borrowings or by issue of shares. If funds are not available readily from these sources, the other alternative available is to sell

the fixed assets and investments. The preparation of Funds Flow Statement is normally based on the following to bring to scientific method of preparation.

a) Schedule of working capital changes

b) Statement of Sources and Uses of Fund.

Schedule of Working Capital Changes : It is also known as “Comparative change in Working Capital Statement” or “Working Capital Variation Statement”. The net change in working capital is projected here in the place of individual changes in all the current assets and current liabilities in the Funds Flow Statement. The statement indicates the amount of working capital at the end of two years. It shows the increase or decrease in the individual items of current assets and current liabilities. The effect of the changes in the individual items of the current assets and current liabilities on working capital is also presented clearly and precisely. The difference in the amount of working capital at the end of two years will depict either the increase or decease in working capital. While ascertaining the increase or decrease in individual items of current assets and current liabilities and its impact on working capital, the following Rules should be taken into account.

i) increase in Current Assets will increase the Working Capital

ii) Decrease in Current Assets will decrease the Working Capital

iii) Increase of Current Liabilities will decrease the Working Capital

iv) Decrease in Current Liabilities will increase the Working Capital

It is, therefore, noted that the changes in the items of current assets are positively correlated to the changes in the working capital. On the other hand, changes in current liabilities are inversely related to the changes in the working capital

10.5 Sources of Funds

The transactions that increase the working capital are sources of funds. Following may the sources of funds in a concern.

Funds from operations : Profit earned by the concern during the current year is deemed to be the source of funds. It is very important source of funds inflow. Net profit is arrived at by deducting cost of goods sold and other expenses from total sales revenue. However, the profit so calculated is seldom equal to the funds from operations because there are many items which are debited or credited in the Profit and Loss Account which do not affect working capital. Therefore, in calculating the funds from operations, the following adjustments must be kept in mind:

Items to be added back to net profit :

a. Non-fund revenue deductions: These are items which are debited to Profit and Loss account. These do not cause outflow of funds such as depreciation and depletion on non-current assets, amortization of fictitious and intangible assets, preliminary expenses, redemption of preference shares or debentures, deferred charges, advertising suspense account written off. If non fund expenditures does not affect the current assets such as unexpired insurance, do not add back. So also, all allowances for income tax payable in future years are excluded.

b. Non-trading charges or losses : These items which were debited to Profit and Loss account reduce the profits but they do not cause any outflow of funds. Hence, profit should be corrected by adding back all such charges and losses. These include appropriation of retained earnings such as general reserve, dividend equalization fund, reserve for contingencies, sinking fund. In addition the dividend on shares must be added back since it is an appropriation and not trading charge. The losses arising out of sale of land, buildings, machinery, long term investments which were written off to the profit and loss account must be added back. Do not add the loss arising out of sale of a current asset such short term investments. It is a trading loss and hence it will not require any adjustment. The amount set aside as provision for current taxation will also be added back. This will be considered only when the provision for taxation is treated as a charge on profits.

Items to be deducted from Net Profit.

The non fund and non trading revenue receipts or incomes must be deducted

Net profit in order to compute funds from operations. The items are:

(a) Dividend received or receivable: Although this transaction increases the current assets such as cash and debtors, it is not a trading income. Hence, it should be deducted from the net profits to determine the funds from operations.

(b) Retransfer of excess provisions: Where the provisions made for taxation, depreciation, doubtful debts exceed the genuine requirements, the excess amount is transferred back to the Profit and loss account. It does not create any inflow of funds since it is an accounting entry. Hence, deduct it.

(c) Profit on sale of non current assets: It is a non trading income. Hence it must be eliminated from the amount of profit.

(d) Appreciation in fixed assets: The amount of appreciation on revaluation of fixed assets is normally credited to the profit and loss account. If it is so, deduct it from the profit to compute the funds from operations.

10.6 Increse in Funds

In a nutshell, the sources of funds can be observed as follows :

a) increase of fresh shares derived from increase in share capital.

b) Issue of debentures derived from increase in debentures.

c) Raising of new loan derived from increase in long term loans

d) Sale of fixed assets for cash or for other current assets derived from decrease in fixed assets and additional information.

e) Non trading income

f) Profit from operations before deducting non cash items of expenses and losses and before additional non cash, non trading incomes.

g) Decrease in working capital derived from the Schedule of Working capital changes.

10.7 Decrease in Assets

Decrease in assets is always a source of funds for the business. Decrease may be in many ways: such as cash received from debtors, sale of goods for cash, Bills realized, sale of assets, fixed assets through provision for depreciation or amortization of fictitious assets. Decrease in an item of assets results in either a parallel decrease in some other liabilities or a parallel increase in some other item of assets example repayment of bank loan.. It should be remembered at the very outset that the decrease is ascertained by comparing the cost of fixed assets and not by comparing the written down value i.e cost less depreciation. If fixed assets have been shown not at cost but at written down value, then cost may be ascertained by adding total depreciation written off to-date (generally known as accumulated depreciation) to the written down value The decrease in fixed assets results in sale of fixed assets. Specific information is generally given in the problem about this. The decrease in fixed assets not on account of depreciation or writing off is known as sale of fixed assets. It must be noticed that the total sale proceeds and not the cost of fixed assets sold are shown as source of fund. If the information in respect of sale of fixed assets is not clearly given, the following steps should be taken to find out the value of sale proceeds.

The amount of profit or loss on sale of fixed assets for the above purpose derived from profit and loss account or from capital reserve or from any specific reserve. This is based on the fact that such profit or loss are credited or debited or transferred to these accounts in accordance with the accounting principles. It must be remembered that profit or loss on

sale of fixed assets are not included in profit from operation for the purpose of this Fund Flow Statement.

If such profit or loss has been included in Profit and Loss Account, adjustment has to be made. If there is profit on sale of assets, the net profit disclosed by Profit and Loss Account is reduced by the amount of profit earned on the sale of fixed assets. On the other hand, the net profit shown by Profit and Loss Account is increased by the amount of loss incurred on the sale of fixed assets.

Example:

The land and buildings account had a balance of Rs.5,00,000 on Jan 2007. A piece of land has been sold. There is no purchase. Rs. 30,000 depreciation has been charged in 2007. The profit on sale has been credited to Capital Reserve Account. The balance stood on January 1, 2007 was Rs. 20,000 and Rs .50,000 on December 31. The balance of land and building account as on December 31 is Rs. 4,50,000. Find the sale proceeds.

Solution

10.8 Increase In Liabilities

The increase in liabilities is always a source of funds for the business. It may occur as a result of many transactions such as equity share capital or / and debentures to the public., purchase of goods on credit. Outstanding expenses are also considered as source of funds since payments are postponed and cash saved is parked in the business. A comparison of the amount of the items of long term liabilities i.e debentures and mortgage and other loans for the current year and previous year will disclose the increase or decrease in the long term liabilities. Additional information should also be taken into account for determining the correct amount of increase or decrease for the purpose of this statement.

Any increase on account of the issue of debentures for consideration other than cash or current assets for the purchase of fixed assets or redeeming other debentures or preference shares would not at all be shown in the statement because in such a case there is no flow of fund.

10.9 Increase In Net-Worth

There can be only two main channels of increase in net-worth or equity :

a) procurement of more funds by issue of additional shares

b) through accumulation of retained earnings or profits in business

As the increased in owned funds is concerned, it happens only when the business has plans for expansion, diversification, modernization. The increase in paid-up equity

Share capital is not a regular feature. Its occurrence is only sporadic. But profit generated from operations is a normal feature and is virtually a continuous process from year to year. Profit earned during an operating period increases the new worth of the business and hence it is always considered as a source of funds. Sometimes, the premium received on sale of equity shares and credited to share premium account is also a source of funds as it adds to the size of net worth .

Share capital consists of equity share capital and preference share capital. The change in equity share capital is always in the form of increase; it can never be in the form of decrease. The increase in equity share capital as per Balance Sheet values must be adjusted in terms of additional information. If the increase has taken place on account of the issue of fresh shares, only that portion of increase should be treated as sources which is due to the issue of fresh shares for cash and other current assets. Increase on account of share issues for consideration involving the purchase of fixed assets or redemption of preference shares or debentures shall not partake the character of inflow of funds and hence should not be shown in the statement. If fresh shares have been issued at premium, the amount of premium must be added to the increase in share capital for the purpose of showing it as source of fund. If the fresh shares have been issued at discount, the amount of discount must be deducted from the increase in share capital because it does not involve inflow of fund.

Example:

The opening and closing balance of Share capital are Rs.6,00,000 and Rs.9,50,000 respectively. The Preference Share capital included in opening balance is Rs.1,00,000. During the year, Rs.75,000 worth of Preference shares were redeemed at 8 % premium. Bonus shares of one for every five equity shares held were issued. In addition, a business was purchased by issue of Rs.90,000 shares at a premium of 10 %. The opening and closing balance in the Premium Account is Rs.8,00,000 and Rs.14,00,000 respectively. Calculate the further fresh issue.

Solution:

10.10 Sources of Funds

The use of funds results in cash outflows. The outflows are known as: application” of funds. The uses of funds are mainly concerned with.

a) Redemption of Preference shares in cash derived from decrease in share capital.

b) Redemption of debentures in cash derived from decrease in debentures

c) Repayment of loan derived from decrease in long term loans

d) Purchase of fixed assets for consideration other than shares, debentures or long term debt derived from increase in fixed assets and additional information.

e) Loss from operations

f) Payment of dividend in cash

10.11 Increase In Assets

The increase in fixed assets is known in the accounting language as “Purchase of fixed assets”. In order to find out the increase in fixed assets, cost of fixed assets of previous year as reduced by the cost of fixed assets sold during the current year is deducted from the cost of fixed assets of the current year. In other words, the increase in fixed assets is calculated as under :

Example: The opening and closing written down balances of an asset are Rs.5,00,000 and Rs.5,50,000. The accumulated depreciation has been Rs.1,50,000 at the beginning and Rs.1,90,000 at the close. A machine costing Rs.30,000 (accumulated depreciation Rs.18,000) was sold during the year for Rs.9,500. Calculate the purchase price of the fixed assets.

Solution

Sometimes, it may happen that the cost figures cannot be ascertained on the basis of information available. Increase in fixed assets, in this case, has to be found out with reference to the written down value along with annual depreciation. If no purchase of fixed assets were made during the current year, then the value of fixed assets shown in the Balance Sheet of the current year should be equal to the values of the previous year minus annual depreciation for current year. The excess of current year’s value over previous year’s value minus annual depreciation will be treated as increase. This will represent the purchase of fixed assets.

Example: The written down value of a Machinery at the beginning and at close were Rs.2,00,000 and 1,75,000. An old machine whose written down value was Rs.12,000 was sold for Rs.6,500. Rs.32,000 depreciation was charged during the current year. Calculate the purchase price.

Solution:

10.12 Decrease In Liabilities

It implies application which is the flow of funds out of business. Decrease in liability may be done due increase in one or more liability items or due to decrease in one or more asset items. It may also be partly due to increase in liability and partly due to decrease in assets. Any amount of premium on the redemption of debentures should be adjusted as deduction. Any decrease on account of redemption of debentures through the issue of another debentures or preference shares should also not be shown in the statement.

Example:

On January 1, 2007, the balance of 8 % Debentures Account stood at Rs.5,00,000. Rs.60,000 debentures were repaid at 5 percent premium. Rs.75,000 debentures were purchased at Rs.95 from the market and cancelled. The closing balance of debentures was Rs. 2,00,000. Calculate the outflow of funds.

Solution:

10.13 Net Worth

It may be used due to (a) loss from operations (b) payment of cash dividend out of accumulated reserves and (c) return of a part of paid up share capital to shareholders implying reduction of share capital – a rare occurrence. If there is decrease in preference share capital and this decrease is on account of redemption of these shares in cash or other current assets, such decrease should be shown as use of fund. But the decrease on account of redemption by the issue of another preference shares or equity shares or debentures, shall never be shown in the statement because it will not involve outflow of fund. If the preference shares have been redeemed at a premium, necessary adjustments should be made

10.14 Flow of Funds

It refers to change in fund. Increase of funds of any transaction is a source and decrease of funds in any transaction is application or uses of funds. But the transactions which do not result in any change in the funds is called “Non-fund”. Flow of fund takes place when a business transaction brings a change in the working capital. Such change may be increase or decrease. The increase is a positive change and the decrease being the negative. These directions in change are known as fund elements or fund factors. They are commonly known as “inflows” and “outflows”. The basic rule is :

Flow of fund if a transaction involves :

a) Current assets and fixed assets that is machine sold for cash

b) Current assets and fixed liabilities that is issue of debentures to the public

c) Current assets and owner equity that is issue of shares for cash

d) Current liabilities and fixed assets that is transfer of assets to discharge a claim

e) Current liabilities and fixed liabilities that is conversion of creditors due by issue of debentures.

f) Current liabilities and capital that is conversion of creditors into owner’s equity by issue of equity shares.

10.15 Transactions that do not affect the flow of Funds

a) Current assets and current liabilities creditors paid

b) Fixed assets and fixed liabilities purchase of assets for debentures

c) Fixed assets and capital purchase of assets by issue of equity shares.

10.16 Steps In Preparation Of Funds Flow Statement

There are three steps involved in the preparation of a Fund Flow Statement (FFS). They are as follows:

a) a)Preparation of Statement of changes in working capital or Schedule of changes in working capital.

b) b)Preparation of Adjusted Profit and Loss Account (APL)

c) c)Statement of changes in Financial position as per AS – 7

10.17 Computation of Changes in Working Capital and Funds from Operations

It is a customary practice that only the net changes in working capital should be shown in the Fund Flow Statement instead of individual changes. Here, the current assets and current liabilities are considered. For this purpose, a separate statement or schedule is being prepared. Individual items are entered here. The opening and closing balances are entered one after the other. The corresponding increase or decrease are entered based on the following rules :

a) Increase in a current asset item increases working capital.

b) Decrease in a current asset item decreases working capital.

c) Increase in a current liability item decreases working capital.

d) Decrease in a current liability item increases working capital .

Insert the total of current asset and current liabilities of both opening and closing periods. Say, the total of current assets as A and that of total of current liabilities as B. Deduct A minus B. The answer is known as net Working capital. If the working capital at the end

of the current year is more than the working capital at the end of previous year, the excess is called as “increase in working capital”. Otherwise, if previous year’s working capital is more than the current year’s working capital, the difference is called as “Decrease in working capital”. Increase in working capital is shown as application of funds and decrease in working capital as source of funds in the Funds Flow Statement.

The funds from operation can be found with the help of preparing an Adjusted Profit and Loss Account.

10.18 Layout

The layout for schedule of changes in Working Capital is as follows

Example: DR Ltd provides the following information

Prepare a schedule of changes in working capital

Solution

Schedule of changes in Working Capital

Example :

Prepare a statement of changes in working capital from the following information.

Prepare Statement of Changes in Working Capital

Solution

Statement of changes in working capital during the year

Adjusted Profit and Loss Account

The Layout is as follows:

NOTE : If debit total of APL is more than the credit total, the difference is Funds generated from Operation : Record on the credit side of Adjusted Profit and Loss Account.

If credit total of APL is more than the debit total, the difference is funds lost in operations. Record on the debit side of Adjusted Profit and Loss Account

The balancing figures should be transferred in opposite direction to Funds Flow statement..

Example 3: Calculate funds from operations from the following Profit and Loss Account

Solution:

Example 4: Following are the extracts from the Balance sheets of DR Ltd

During the year, the company sold land whose book value was Rs.50,000 for Rs.54,000 and paid an interim dividend of Rs.2,000

Calculate funds from operations.

Solution

NOTES:

1. There is an increase in the balance in General Reserve. It implies that some amount has been transferred to the account from the Profit and Loss account. This is an appropriation of profit which does not result in any outflow of funds.

2. The balance in Goodwill Account and preliminary expenses account has come down which indicates that the difference has been written off. This also does not result in an outflow of funds.

3. The increase in provision for depreciation is on account of current year’s depreciation which does not result in any outflow of funds.

4. Profit on sale of land and interim dividend being non-operating items are to be separately shown as source and application of funds in the Funds Flow Statement.

Example 5: The following information is provided :

Opening balance of Plant Rs.1,32,500. Closing balance of Plant Rs.1,97,500. Provision for Depreciation in Plant at the beginning 45,000; and at close Rs.61,000. During the year Rs.65,000 worth of Plant was purchased in exchange for fully paid debentures and old Plant costing Rs.40,000 was sold for Rs.34,000. Depreciation provided Rs.18,000. Calculate the flow of funds.

Solution:

Calculation of Profit on sale : 34,000 minus (40,000 – 18,000) = 12,000

Note: For all Asset Account, record the opening balance on the debit side and closing balance on the credit side of the concerned Asset Account. For all liabilities , record the opening balance on the credit side and the closing balance on the debit side.

10.19 Treatment of Certain Items

There are certain items whose treatment is not uniform. Different authors differ differently. But, in this study material, an uniformity is maintained. The likely arguments have been provided for treating items on a particular principle. The items are :

Provision for Bad Debts

Sometimes, it is shown as reserve for bad / doubtful debts. Actually, this item is shown as deduction from total book debts to the asset side of the Balance Sheet. Therefore, this item should be deducted from the amount of debtors shown in the schedule of working capital changes. Since such treatment may complicate the calculation work, it is suggested that it should be shown along with current liabilities, although, it does not belong to that category.

Provision for Tax:

Do not treat this item as a current liability. The Provision has to be made to meet the tax liability of current year. If there is a Provision for last year, it has to be paid this year. Hence, the last year Provision actually becomes the current year cash outflow. Hence record it in the Funds flow statement.

Proposed Dividend

Normally, the proposed dividends are given as Balance Sheet item on the liability side. The Directors propose the final dividend which needs to be approved by the General Meeting. Hence, it is fair to assume that the proposed dividend is not a current liability. Do not show in the schedule of working capital changes. The last year proposed dividend should be paid during the current year, hence a cash outflow

Investments

It poses problems in its treatment. The Rule is :

a) if the investments are in the form of Government or other marketable securities, treat it as current assets.

b) If it is mentioned as trade investments, that is investments in shares and debentures of another companies, treat it as fixed assets.

c) If nothing is mentioned specifically, the treatment is :

: if investments have been sold simultaneously, treat it as current assets

: in other cases, treat it as Fixed Assets.

Depreciation

Normally, the value of deprecation will be provided in the problem as an adjustment items. Depreciation is a non cash item. It is, therefore, charged to Profit and Loss and recorded in the concerned Fixed Assets Account. If the depreciation is given as a

percentage, calculate the value on the opening balance of the concerned account.. If the value of depreciation is not given, it has to be found out as follows :

If a concern intends to show its fixed assets at its cost price, the periodic annual depreciation is shown under “liabilities” side as Provision for Depreciation commonly known as Accumulated Depreciation Fund Account. If there were to be an Accumulated Depreciation Fund Account already in operation, the current year depreciation is charged against this Provision for accumulated Depreciation Account and not recorded directly into Adjusted Profit and Loss Account . In other words, the current year depreciation is routed through the Provision Account.

Increase / Decrease in Fixed Assets

The increase or decrease by means of cash is recorded in the FFS. Increase or decrease due to purchase consideration through shares and debentures are not recorded.

Increase / Decrease in long-term liabilities

Compare debentures and mortgages as per the Balance Sheet figures. Only consider if cash is the main striker to cause the increase or decrease. If the changes were to be due to consideration other than cash or current assets, do not record it in the FFS..

Hidden Items

Prepare the necessary ledger accounts concerned in the fixed assets, fixed liabilities and share capital and carry out all the necessary adjustments. The balancing figure, if any, would be the cash transactions. For all non, cash transactions, concentrate on the Adjusted Profit and Loss Account.

Problem 6: The Balance Sheets are given below :

Year (Rs.in lakhs)

2006 2007

Fixed Assets 50 60

Investments 10 20

Current Assets 140 150

Share Capital 100 160

Profit and Loss Account 30 30

Debentures 10 –

Current Liabilities 60 40

Depreciation charges was Rs.6 lakhs. Prepare Fund Flow statement

Solution:

Schedule of changes in working capital

 2006 2007

Current Assets

LESS: Current liabilities

Working Capital : CA minus CL

Net Increase in working capital transferred to

FFS (application)

140

(60)

80

30

110

150

(40)

110

–

110

Problem 7 : From the following extracts, calculate funds from operations

Additional information: Tax paid Rs.2,500. Dividends paid Rs.1,000.. Calculate funds from operation taking provision for tax and provision for tax and proposed dividend as (a) non current liabilities and (b) current liabilities.

Solution:

Provision for tax and proposed dividend are taken as non-current liabilities

If Provision of tax and proposed dividend are taken as a current liability, funds from operations will be the difference in Profit and Loss account at the beginning and the end of the year.

NOTES

1. In case a) Income tax paid Rs.2,500 and Dividend paid Rs.1,000 are shown as application of funds in the FFS.

2. In case (b), there is no need to prepare proposed dividend account and provision for tax account. However, the opening and closing balances of the two accounts are shown as current liabilities in the statement of changes in working capital.

Problem 8: The book value of trade investments of DR Ltd as on March 1, 2006 and March 31, 2007 was Rs.50,000 and Rs.70,000 respectively. During the year, Rs.5,000 was received as dividends, of which Rs.2,000 pertained to pre-acquisition profits which have been credited to Investments Account. Investments costing Rs.10,000 have been sold during the year for Rs.10,000. Find the flow of funds on account of investments.

Solution:

Note:

The investments sold has been at the book value. There is no profit or loss on account of the transactions. If the transaction had resulted in profit, it will have to be deducted from net profit to calculate funds from operations. In case of loss, it would be added to net profit to calculate funds from operations.

Problem 9: Prepare a fund flow statement of DR Ltd.

Year

2007 2008

Equity share capital 10,00,000 15,00,000

10 % Preference Share Capital 3,00,000 –

11 % debentures 8,00,000 6,00,000

Share Premium Account 1,00,000 95,000

Additional information (a) 10 % Preference shares have been redeemed at a premium of 10%, the premium amount was charged to the share premium account (b) There has been a profit of Rs.1,000 on the redemption of debentures.

Solution:

Problem 10: The following are the summarized Balance Sheets of DR Ltd.

Prepare a Funds Flow statement

Solution:

Notes:

1) The increase in General Reserve is due to transfer a part of profit of the current year and hence the difference is transferred to Adjusted Profit and Loss account since it’s a non-cash item

2) The difference in depreciation is charged to Adjusted P&L, since it’s a non-cash item.

3) Increase in Equity Share capital is assumed to be the fresh issue which is a cash item. It is recorded in Funds Flow Statement.

4) The difference is debenture is the redemption. It’s a cash item. Hence taken to Funds Flow Statement

5) Purchase of fixed asset is difference between the opening and closing balance of fixed assets. It’s a cash item. Hence taken to Funds Flow Statement.

Problem 11

Prepare a Fund Flow Statement

Depreciation provided is Rs.1,750. Write off goodwill. Dividend paid Rs.3,500.

Solution:

Problem 12

The Balance Sheets of DR Ltd

A business was purchased during the year by the issue of 25,000 shares and 25,000 debentures. Depreciation Rs.6,000 has been provided in the year. A machine has been sold for Rs.1,50,000, the written down value being Rs.1,000. The business purchased had the following assets and liabilities : Machine Rs.20,000, Stock Rs.5,000, Debtors Rs.15,000, Creditors Rs.5,000. Prepare the Funds Flow Statement.

Solution

In this problem, another business concern was purchased whereby the assets and liabilities come into business. For this purchase, the payment is through the issue of shares and debentures. If the payment were to be in excess of assets and liabilities taken over, the excess payment is known as “Goodwill”.

Statement showing changes in working capital:

Terminal Question

Problem 1: The balance in the Provision for taxation : opening Rs. 30,000 and closing Rs. 40,000. Taxes paid during the year was Rs. 25,000. Calculate Funds from operation. (b) What is the provision made during the year?

Problem 2: Extracts of Balance Sheets are given below :

Calculate funds from operation

Problem 3: Calculate funds from operations:

Problem 4: Calculate funds from sale of Plant

Plant (gross) 1,00,000 1,25,000

Additional information:

a) Loss on sale – 1,000

b) Depreciation charged – 14,000

c) Purchase of Plant – 35,000

Problem: 5. The Balance Sheets are as follows

Prepare a statement of Sources and uses of funds.

.

MB0025-Unit-11-Cash Flow Analysis 11.1 Introduction

The funds flow analysis deal with the flow of funds within and outside the organization. The main focus of funds flow statement is to explain the changes which have taken place in net working capital during the period under consideration. Funds flow statement normally fails to explain the changes in cash balance. The movement of cash is of vital importance to the management. The organization may become directionless if the cash inflows are not sufficient to meet the cash outflows. Many a time, a management is posed with the paradox of huge profits and yet impossible to pay dividends or even taxes. This is due to the ground realities that cash is either not received or the cash received is drained out in other items. Hence, it has become a necessity to have a cash flow analysis on a day to day basis. The statement shows the items resulting in cash inflows and cash outflows.

11.2 Meaning of Cash Flow Statement

Cash flow statement, also known as “Statement Accounting for variations in cash” shows the movement of cash and their causes during the period under consideration. The statement is mainly prepared to show the impact of financial policies and procedures on the cash position. It takes into account all the transactions that have a direct impact upon cash.

11.3 Objectives

The main objective of cash flow analysis is to show the causes of changes in cash balances during the period under consideration.

11.4 Uses of Cash Flow Statement

The cash flow statement, being one of the important financial documents a firm has to possess , reveals the effective uses. First of all, it explains in depth the reasons for the low cash balance available at a particular time. Based on this, it is possible to find the reasons for such a situation. It also shows the major sources and uses of cash. By effectively maintaining the cash and controlling the outflow of cash, it is possible to set in motion the smooth functioning of the organization. It helps the financial decisions more effectively with regard to short term liquidity position of an organization. Projections of cash inflows and outflows can be regulated based on the records available in the past. Proper projections can be made once the reasons are analyzed. Based on this, it is possible to liquidate the short term obligations without much fun-fare. Short term obligations need to be serviced so that the credit worthiness of an organization can be carried on unabated.

11.6 Difference Between Cash Flow And Funds Flow Statement

The major differences between the two are :

1. FFS is related with accrual basis whereas CFS is on cash basis. For this the, it is necessary to convert the accrual to cash basis.

2. In FFS, a Schedule of changes in working capital de-linking the current assets and current liabilities are made. But in CFS, no schedule is prepared.

3. FFS shows the causes of the changes in net working capital. CFS shows the causes for the change in cash

4. In FFS, no opening or closing balances are recorded. But in CFS both are incorporated

5. FFS is not based on the Ledger mode. But CFS is prepared on the basis of Ledger principles.

6. In FFS, “To” and “By” are indicated. In CFS, these are not indicated.

7. In FFS, net effect of receipts and disbursements are recorded. In CFS only cash receipts and payments are recorded.

8. FFS is concerned with the total provision of funds. CFS is concerned with only cash.

9. FFS is flexible but CFS is rigid

10. FFS is more relevant for long range financial strategy. CFS concentrates on short term aspects mostly affecting the liquidity of the business.

11.7 Computation of Cash From Operations

The Cash Flow Statement should be prepared as per the revised Accounting Standard issued by the ICAI . Accounting Standards 3 specifies : “The cash flow statement should report cash flows during the period classified by operating, investing and financing activities”. As per the revised standard, there are two methods of preparing cash flow statement namely Direct method and Indirect method. In this Study material, indirect method is adopted throughout.

Format

CASH FLOWS FROM OPERATING ACTIVITIES

Meaning : Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities.,. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss.

Object : The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, pay dividends, repay loans and make new investments without recourse to external source of financing. Information about the specific components of future operating cash flows is useful in conjunction with other information in forecasting future operating cash flows.

Problem 1: Compute the cash flow from operating activities

Position of current assets and current liabilities are as follows :

                                                                                MARCH 31

2006 2007

Stock 30,000 28,000

Debtors 15,000 12,000

Bills Receivable 6,000 8,000

Creditors 10,000 12,000

Bills Payable 8,000 5,000

Outstanding expenses 4,000 5,000

Solution

Problem 2 : Calculate cash flow from operating activities

Solution

Problem 3: The following is the position of current assets and current liabilities

Solution

Problem 4:

Following extracts are in respect of a company.

Solution :

11.8 Terminal Questions

1. What are the objectives of cash flow statements?

2. Mention the steps involved in the preparation of CFS?

3. Distinguish between cash flow and fund flow statements.

4. Compute cash flows from operating activities

5. Cash transactions in respect of DR Ltd are as follows :

Prepare a cash flow statement

.

MB0025-Unit-12-Understanding Cost 12.1 Introduction

The need for accounting arose because of limitations of human memory. To preserve the knowledge, various steps are taken both in the past and in future. It is necessary to record all the business purposes. Accounting is a science as well ass an art of recording the business transactions in the books of accounts systematically and scientifically.

Until the1980s, the Cost Accounting was in the domain of the Engineer. Its integration with financial accounting started when Accountants started to audit the cost records. The costing technique play a vital role in gathering and analyzing revenue and cost data to assist management in decision making. The point of emphasis has logically shifted from cost accumulation to cost analysis, a change from a limited cost finding function on to a broader managerial function.

12.2 Meaning of Cost

Cost is the amount of resources given up in exchange of some goods and services. The resources are expressed in money or money’s equivalent. CIMA defines the term Cost as “ the amount of expenditure (actual or notional) incurred on or attributable to a given

thing.”. The given thing may be taken as a product, service or any other activity. While the actual expenditure refers to the amount spent , the notional expenditure does not involve in any cash outlay. It does not reflect itself in the accounting records. But, it is important for the purpose of comparison of cost and in decision making.

12.3 Cost Concepts

Cost represents expenses. It is a sacrifice in advance. It concerns with a release of something of value. The cost is used :

The expected cost of a particular action. It is what the cost is expected to be in choosing a course of action.

The cost of something purchase i.e. the price actually paid for it. It is the price paid or payable, time of purchase of goods or services. The price paid is the amount of money, the holding of which is foregone.

The cost of attaining some end – the sacrifices actually made to attain it – experienced costs.

12.4 Component or Element of Cost

Following are the three broad elements of cost

Materials

Labor

Expenses

Materials: The term materials may be defined as the substances from which products are manufactured. These materials may be in a raw or a manufactured state. Materials may be direct or indirect.

Indirect materials: These are materials which do ot become part of the product. These materials are consumed in the course of production. These materials cannot be conveniently assigned to specific physical units. Some of the indirect materials are consumable stores, oil, lubricants, cotton wastes, printing and stationers. Indirect materials may relate to the factory, the office and administration and the selling and distribution divisions.

Direct Labor: It represents wages payable / paid to those employees who directly engaged in the conversion of raw materials into final product. They operate in the manufacturing machinery and equipment. They directly handle the raw materials, work in process and the finished goods on the production line. They account is to see whether the work done on a particular product or a specific group of products.

Examples: In a furniture mart, the carpenters engaged in conversion of raw wood with sofa set, computer tables, windows, doors , benches are said to be the direct workers. In an engineering workshop, the wages paid to the operators working with laths, drilling, cutting, shaping machines can be specifically assigned to the products concerned. Therefore, the direct labor costs can be traceable to individual products.

Indirect Labor: Indirect labor is the labor which is not directly engaged in the production operations. They are, however, engage themselves to help in the production operations. Such labor does not alter the construction, composition or conditions of the product. Example foreman’s salary, storekeepers salary, Factory manager’s salary etc. The indirect labor may relate to the factory, office and administration and selling and distribution divisions.

Chargeable Expenses : The items are of expenses which may be allocated to a specific job, process or operation. The utility of expenses is exhausted on completion of the job concerned. Therefore, logically, they are treated as direct expenses. The chargeable expenses are usually incurred when the business concern undertakes some outside constructional work far away from the principal premises, example widening of road by L & T construction company for the new International Airport. The popular items fall under this category are:

a) cost of pattern, designs, drawings specifically prepared for a particular job

b) hire charges of special machinery, plant or equipment

c) architects and surveyors fees in connection with particular job or contracts.

d) Cost of any experimental work carried out for a particular job

Indirect expenses: These are those expenses which cannot be directly and conveniently allocated to specific cost units / cost centers.. They are apportioned. Examples are rent, rates and insurance. They may relate to the factory, the office and administration and selling and distribution divisions. These are now popularly known as “overheads”. These costs arise as a result of overall operations of a business. These costs are shared by all the products. It includes all manufacturing and non-manufacturing suppliers and services. These costs cannot be associated withy a particular product or unit. Overheads remain relatively constant from period to period. At- least they do not fluctuate in amount in relations to changing levels of factor production. Overhead costs are classified by functions of an organization into :

Factory, works or manufacturing overheads

Administration, office, establishment or general overheads

Selling and distribution overheads.

12.5 Components of Total Cost

The components of total costs are based on functional classification. The various stages through which the costs flow are:

Prime cost : It is the total of direct materials cost, direct labor cost and chargeable expenses/

Factory Cost : It consists of prime cost and factory overheads/

Office cost or Cost of Production: It comprises of factory cost and office and administration overheads.

Total Cost : By adding selling and distribution expenses to cost of production, one can get the total cost or cost of sales.

12.6 Statement of Cost Sheet

Cost sheet is a statement prepared to show the different components of the total cost. It generally shows the total cost and sales as well as cost and selling price per unit. It is generally presented in a tabular form.

12.7 Format

Specimen of Cost Sheet

Name of Company _______________________________

Cost sheet for the product __________________________

For the year ending ______________________________

Example:

Prepare a cost sheet Raw materials consumed Rs.1,60,000. Direct wages Rs.80,000. Factory overheads Rs.16,000. Office overheads 10% of factory cost. Selling overheads Rs.12,000. Units produced 4,000.Selling price per unit Rs.100.The closing stock is 10% of units produced.

Solution:

*Closing stock in units : Units produced minus units sold

**Denominator should be the current year production in units.

Items not included in Cost Sheet:

a) Income tax

b) Dividends to shareholders

c) Commission to managing directors

d) Capital losses i.e. loss out of sales

e) Interest on loan or debentures or bank interest

f) Donations

g) Capital expenditure

h) Discounts on shares and debentures

i) Premium on redemption of shares and debentures

j) Underwriting commission

k) Writing of goodwill, preliminary expenses

l) Reserve for bad debts

m) Transfer to all reserves or appropriation of profits

n) Share premium

o) Interest on capital

p) Drawing of proprietors

q) All personal expenses of owner

12.8 Valuation Of Work-in-Progress

In a manufacturing enterprise, there may be certain amount of goods in a partly manufactured state at the end of a particular period. These are called as “semi manufactured goods” or “work in progress”. The WIP is valued according to the value of raw material, labor and expenses which has so far incurred to the date of closing of financial period. The work in progress has usually three components:

Material work in progress cost to date

Labor to date

Manufacturing expenses incurred to date

The treatment of work in progress is to add the opening work in progress to the concerned cost and deduct the closing work in progress against it.

Example:

DR Ltd manufactures Electronic components. The following figures are supplied Rs.

Purchase of Raw Material 2,00,000. Direct labor 1,20,000. Carriage inwards 20,000 Manufacturing expenses 10,000. Stock of raw materials : opening 25,000, closing 75,000. Work in progress on 1:4:2006 : Materials 2,000 Labor 5,000 Expenses 1,000. Calculate the Factory cost..

Solution:

Problem 1:

Calculate the cost of raw materials purchased: Opening stock of raw materials Rs.10,000. Closing stock of raw materials Rs.15,000. Expenses on purchases Rs.5,000. Direct wages Rs.50,000 Prime cost s Rs.1,00,000.

Solution:

Prime cost given in the problem is Rs.1,00,000

Hence substituting , 1,00,000 = 50,000 + X; Therefore X = Rs.50,000

Cost of Raw Materials purchased is Rs.50,000

Problem 2:

Prepare a cost sheet:

Direct materials Rs.2,00,000. Factory expenses Rs.1,20,000. Office expenses Rs.90,000

Total sales Rs.6,50,000. Prime cost Rs.4,10,000 . 10 % of the output is in stock.

Solution

Problem 3 :

The following information is obtained:

Stock on Jan 1, 2007 : Raw materials 40,000; Finished goods 30, 000. Purchases of Raw materials 2,40,000. Direct wages 1,36,000. Works expenses 70,400. Dividends paid 40,000. Office expenses 24,000. Depreciation 10,000. Selling and Distribution expenses 32,000. Work in progress : 1.1.2007 64,000. 31:.12.:2007 72,000. Goodwill written off 40,000. Stock on 31.12.2007 Raw materials 42,000 Finished goods 32,000. Sale of finished goods 5,50,000. Payment of sales tax 16,000. Prepare a cost sheet.

Solution

Problem 4:

Prepare a cost sheet

Raw materials Rs.33,000. Unproductive wages Rs.10,500. Factory lighting Rs.2,200. Motive power Rs.4,400. Director’s fees (Works) Rs.1,000. Factory cleaning Rs.500. Factory stationery Rs.750. Loose tools written off Rs.600. Water supply Rs.1,200. Office insurance Rs.500. Chargeable expenses Rs.3,000. Depreciation: Plant and machinery Rs.2,000. Office Building Rs.1,000. Delivery vans Rs.200. Upkeep of Delivery van Rs.700. Commission on sales Rs.1,500. Productive wages Rs.35,000. Factory rent and

taxes Rs.7,500. Factory heating Rs.1,500. Haulage Rs.3,000. Director’s fees (office) Rs.2,000. Sundry office expenses Rs.200. Office stationery Rs.900. Rent and taxes (office) Rs.500. Factory insurance Rs.1,100. Legal expenses Rs.400. rent of warehouse Rs.300. Bad debts Rs.100. Advertising Rs.300. Sales Department salaries Rs.1,500. Bank charges Rs.50, Reserve for Doubtful debts Rs.100..Debenture interest Rs.20,000. Income tax Rs.22,500. Total output 20,000 tons.

Solution

Cost Per unit : Total Cost / No of Units produced : 117400 / 20,000 Rs.5.87

Note: Ignore reserve for doubtful debts.

Ignore Income tax

Ignore Debenture interest

Problem 5:

The following extract refers to a commodity for the half year ending 31st March 2008. Prepare a cost statement.

Purchase of raw materials Rs.1,20,000. Rent, rate, insurance and works expenses Rs.40,000. Direct wages Rs.1,00,000. Carriage inwards Rs.1,440. Opening stock Raw materials Rs.20,000, Finished goods (1000 units) Rs.16,000. Closi9ng stock : raw material Rs.22,240 Finished Goods (2,000 tons). Work in progress : opening Rs.4,800 and closing Rs.16,000. Sale of finished goods Rs.3,00,000. Cost of factory Rs.8,000.

Advertising, discounts allowed and selling costs Re.1 per ton sold. Production during the year is 16,000 tons. Prepare a cost sheet.

Solution

*To be valued only at number of units sold. Opening stock of finished goods + production minus closing stock = Number of units sold.

** Always to be valued at number of units sold. Number of units sold x Selling price per unit.

Problem 6:

The cost data is as follows:

Raw materials consumed Rs.1,82,000. Direct wages Rs.40,000. Chargeable expenses Rs.20,000. Opening stock of finished goods (1,000 units) Rs.32,000. Closing stock 2,000 units. Factory overheads 100 % of direct labor. Office overheads 10% of works cost. Selling of Distribution expenses Rs.4 per unit sold. Units produced 10,000. Profit mark-up 20% on selling price. Prepare a cost sheet.

Solution

MB0025-Unit-13-Marginal Costing and Break Even Analysis 13.2. Concept of Marginal Cost

According to C.I.M.A. London, “Marginal Cost means 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 amount by which total cost changes when there is a change in output by one unit. Marginal cost per unit remains unchanged irrespective of the level of activity or output. It is also known as Variable Cost. Marginal cost is the sum total of direct material cost, direct labor cost, variable direct expenses and all variable overheads. The marginal cost is the same as the variable cost.

13.3 Fixed Cost

It involves the way a cost changes in relation to changes in the activity of an organization. The activity refers to a measure of the organization’s output of products and services example number of contact classes conducted, number of students passed in MBA, number of cars manufactured by an Automobile industry, number of meals served by a hotel. The activities that cause costs to be incurred are called “Cost Drivers”. A fixed cost remains unchanged in total as the level of activity (cost drivers) varies. If activity increases or decreases say by 20 %, the total fixed costs remain the same e.g. depreciation, property tax, rent to landlord. But fixed costs per unit will change.

13.4 Variable Cost

A variable cost changes in total in direct proportion to a change in the level of activity or cost driver. If activity increases, say by 20%, total variable cost also increases by 20 %. The total variable cost increases proportionately with activity. Variable cost fixed per unit but varies in total.

13.5 Marginal Cost

It is extra cost incurrent when one more unit is produced. It typically differs across different ranges of production quantities because the efficiency of the production process changes. The marginal cost of producing a unit declines as output increases. It is much more efficient to produce more than to make only one.

13.6 Cost Volume Profit (CVP) Analysis

This technique summarizes the effects of changes in an organization’s volume of activity on its costs, revenue and profit. CVP analysis can be extended to cover the effects on profit of changes in selling prices, service fees, costs, income-tax rates and the organization’s mix of products or services. It provides management with a

comprehensive over view of the effects on revenue and costs of all kinds of short run financial changes

Although, the word “profit” appears in the term, CVP analysis is not confined to profit seeking enterprises. Managers in non profit organizations also routinely use CVP analysis to examine the effects of activity and other short run changes on revenue and costs. It is being used as a regular organizational tool. . In CVP analysis, it is necessary that expenses should be categorized according to their cost behavior that is fixed or variable.

13.7 Break Even Chart

It is a graphic or visual presentation of the relationship between costs, volume and profit. It indicates the point of production at which there is neither profit nor loss. It also indicates the estimated profit or loss at different levels of production. While constructing the chart, the following assumption is normally considered.

a) Costs are classified into fixed and variable costs

b) Fixed costs shall remain fixed during the relevant volume range of graph.

c) Variable cost per unit will remain constant during the relevant volume range of graph

d) Selling price per unit will remain constant

e) Sales mix remains constant.

f) Production and sales volume are equal

g) There exists a linear relationship between costs and revenue.

h) Linear relationship is indicated by way of straight line.

13.8 Break Even Analysis

It is an extension of or even part of marginal costing. It is a technique of studying cost volume profit relationship. Basically, the break even analysis is aimed at measuring the variations of cost with volume. It is a simple method of presenting the effect of changes in volume on profits. It is also known as CVP analysis. The various assumptions are:

a) All costs can be classified into fixed and variable

b) Sales mix will remain constant.

c) There will be no change in general price level

d) The state of technology, Methods of production and efficiency remain unchanged.

e) Costs and revenues are influenced only by volume

f) Cost and revenues are linear.

g) Stocks are valued at marginal cost

h) Unit produced and sold are same.

13.9 Break Even Point

BEP is the volume of activity where the organization’s revenues and expenses are equal. At a particular amount of sales, the organizations have no profit or loss: it normally breaks even.

Example

DR sells 8,000 pens at Rs.16 per pen. The variable expenses amount to Rs.10 per pen. The total fixed expenses are Rs.48, 000. Prepare an Income statement.

Solution

Note that the income statement highlights the distinction between variable and fixed expenses.

13.10 Contribution Margin Approach

The contribution margin approach refers to the total sales revenue minus the total variable expenses. This is the amount of revenue that is available to contribute to covering fixed expenses after all variable expenses have been covered or recovered.

DR’s firm will break even when the organization’s revenue from pen sales is equal to its expenses. How many pens must be sold during one month for DR to break-even?

Each pen sells for Rs.16, but Rs.10 of this is used to cover the variable expense per pen. This leave Rs…6 per pen to contribute to covering the fixed expenses of Rs.48, 000. When enough pens have been sold in one month so that these Rs.6 contributions per pen add up to Rs.48, 000, the organization will break even for the month. The break even can be computed as follows:

The Rs.6 amount that remains of each pen’s price after the variable expenses are covered is called the “Unit contribution margin”. The general formula for computing the break even sales volume in units is:

BEP (in units) : Fixed expenses / unit contribution margin

Sometimes, the management prefers that the BEP be expressed in sales rupees rather than unit. The formula is:

BEP in Rupees: Fixed expenses / Contribution sales ratio

The Contribution Sales Ratio is popularly known as “Marginal Contribution Sales Ratio – MCSR “. Its traditional name is: ‘P/V Ratio. ’

Note: Kindly avoid using the term P / V Ratio and only use the modern concept “MCSR”

MCSR = Contribution / Sales x 100

Where Contribution = Sales value minus variable expenses

13.11 Equation Approach

This approach is based on the profit equation. Income or profit is equal to sales revenue minus expenses. If expenses are separated into variable and fixed expenses, the essence of income or profit statement is captured by the following equation:

Sales minus Variable Cost = Fixed Cost + Profit

S – V = F + P

The contribution margin and equation approaches are two equivalent techniques are two equivalent techniques for finding g the BEP. Both the methods reach the same conclusion, hence personal preference dictates which approach should be used.

13.12 Target Profit

Based on the experiences gained, an organization may intend to increase the production and sales. When an organization was to be on its optimum level, a direction will be provided to achieve the maximum level. In this connection, if one intends to increase the current year production to higher levels, no variable expenses would be incurred. A target net profit or income may be decided in advance. To achieve this profit, efforts will be made to effect sales. The problem of computing the volume of sales required to earn a particular target net profit is very similar to the problem of finding the break even point.

After all, the break even point is the number of unit sales required to earn a target net profit of zero. The target net profit is known as “desired profit”. The formula is:

Number of units to be sold: Fixed expenses + Desired or Target profit / Contribution per unit

Example: Calculate sales in units and in rupees: Units produced 60,000. Selling price per unit Rs.15. Profits to be earned is Rs.87, 500.

Solution: Sales required in units : Fixed expenses + target profit / contribution per unit or 1,50,000 + 87,500 / 15 – 10 or 47,500 units or Rs.47,500 x Rs.15 or Rs.7,12,500.

13.13 Margin of Safety

The safety margin of an enterprise is the /difference between the budgeted sales revenue and the break even sales revenue. The safety margin gives management a feel for how close projected operations are to the organization’s break even point. The formula is:

MOS = Profit / MCSR

Example: Calculate BEP and MOS:

Sales at present 50,000 units per annum. Selling price Rs.6 per unit, Prime cost Rs.3 per unit. Variable overheads Re.1 per unit. Fixed cost Rs.75, 000 per annum.

Solution:

BEP = Fixed cost / (SP – VC) per unit or 75,000 / 6 – 4 or 75,000 / 2 or 37,500 units.

BEP in rupees: BEP in units x selling price per unit or 37,500 x Rs.6 or Rs.2, 25,000

MOS: Actual Sales – BEP Sales or (50,000 x 6) – 2, 25,000 or Rs.75, 000

13.14 Applications Of Marginal Costs

The marginal costing helps the management in taking many policy decisions. The vital areas where these concepts are applied directly are as follows:

Level of activity planning: Normally, the managements will consider different levels of production or selling activities to decide optimum level of activity. Such periodic exercise shall put the organization in the right tract to achieve its goal. Since the optimum level of activity results in the maximum contribution per unit, the planning can become a perfect execution tool.

Alternative methods of production: With the help of marginal costing techniques, it’s possible to undertake decision about the alternate methods of production. All the

decisions should be focused at the greater contribution so that profit can be maintained at a balanced level.

Make or buy decision: Depending upon the situational ambience, the management can have a blue print on a vital decision. Management can think of outsourcing the production activities or to undertake it within its purview. Based on the comparative statement of cost of manufacture with the purchase price, decisions can be taken.

Fixation of Selling Price: While pricing a product, the marginal costing techniques can come handy. While fixing a price for a product, it is prudent to take into account the recovery of marginal cost in addition to get a reasonable contribution to cover fixed overheads. Pricing will be at ease once the marginal cost and overall profitability of the concern are known.

Selection of optimum sales mix: The product mix plays an important role when a firm produces more than one product. The main focus will on profit maximization. With the help of marginal costing techniques, it is possible to decide the best product mix which will result in maximum profits to the firm.

New Product introduction: When a firm intends to diversify its activities or to expand its existing markets, with the help of marginal costing techniques. By fixing the time horizon to recover the fixed costs and profit, decisions can be taken for the introduction of new products.

Balancing of profits: As the economic trends gets changed on account of government fiscal policies and regulations, competition at the regional, national, and international levels, marginal costing techniques can aid to bring out facts with regard to maintaining a desired level of profits.

Final balancing decisions: If the sales of the product were not encouraging to cover the fixed costs, it is quite natural that the firm may decide about its continuance. This may lead to dovetailing or completely closing down the operations. Marginal costing helps the management to take a sound decision.

Self Assessment Questions 12:

1. The application is as _______________.

13.15 Limitations of Marginal Costing

There are certain limitations which can be described as follows:

Suitability: The techniques of marginal costing cannot be applied to all the concerns. When a concern needs to carry large stocks by way of work-in-progress, the technique becomes redundant In addition; the marginal costing techniques are not suitable to industries working on contract basis.

Inventory valuation difficulties: Since the work in progress and the closing inventories are valued at marginal cost basis, it will not be a sound decision from the Balance Sheet point of view. The main focus on the ‘true and fair value’ concept gets diluted and the very purpose of exhibiting the financial position will get defeated.

Segregation of costs: Though the marginal costing principles call for the differentiation of costs into fixed and variable, in actual practice it becomes difficult to classify them precisely. Many overheads which are appear to be fixed and variable may not exactly align at various levels of production. There is no logical method to segregate semi-variable expenses into fixed and variable.

Time factor: The marginal costing ignores the time factor which is very important for any costing purposes. Ignoring the time would naturally relate to unreliable and incomplete basis for comparing two alternative jobs.

Sales emphasis: Marginal costing principles are basically a sales-oriented concept. While the selling function gets the prominence, other functions are not given equal weight age. This would be a major set back.

Self Assessment Questions 13:

1. Limitation include ________________.

13.16 Useful Equations of Marginal Costing

Some of the useful equation of marginal costing are as follows :

Basic equation : Sales Revenue – Variable Expenses = Fixed Expenses + Profit

Other derivations are as follows

Sales Revenue – Variable Expenses – Fixed Expenses = Profit

Sales – Variable cost s = Contribution

Contribution – Fixed costs = Profit

Sales – Contribution = Variable costs

Marginal Contribution Sales Ratio (MCSR) = Contribution / Sales x 100

MCSR also can be found out : Change in profit / change in sales x 100

MCSR x Sales = Contribution

Sales = Contribution / MCSR

Number of units to be sold = Fixed expenses + Desired Profit / Contribution per unit

Sales required to earn

target net profit in Rupees : Fixed expenses + Profit / Marginal contribution

BEP in units = Fixed expenses / MCSR contribution per unit

BEP in Rupees : BEP in units x Selling price per unit or

Fixed costs x Total sales / Total Sales – Variable costs

Margin of Safety : Total Sales – Break Even sales OR

Profit / MCSR where Profit = Sales – Total Costs

Problem 1: Find the contribution and profit earned. Selling price per unit Rs.25. Variable cost per unit Rs.20. Fixed Cost Rs.3,,05,000. Output 80,000 units.

Solution: Contribution = Sales – variable cost . Rs.25 – Rs.20 or Rs.5 or 80,000 x 5 = Rs.4,00,000

Profit = Contribution – Fixed Cost or 4,00,000 – 3,05,000 = Rs.95,000

Problem 2: Calculate the profit earned. Fixed cost Rs.5,00,000. Variable cost R.10 per unit. Selling price Rs.15 per unit. Output 150,000 units

Solution : S – V = F + P or ( 1,50,000 x 15) – (1,50,000 x 20 ) = 5,00,000 + Profit

Profit = 22,50,000 – 15,00,000 – 5,00,000 = Rs.2,50,000

Problem 3: Find the fixed costs : Sales Rs.2,00,000. Variable Cost Rs. 40,000. Profit Rs. 30,000

Solution : S – V = F + P or 2,00,000 – 40,000 = Fixed Cost + 30,000

Fixed Cost = 2,00,000 – 40,000 – 30,000 = Rs.1,30,000

Problem 4: Calculate the variable cost : Sales Rs.1,50,000. Profit Rs.40,000. Fixed cost Rs.30,000. Find the amount of variable cost.

Solution : S – V = F + P or 1,50,000 – V = 30,000 + 40,000 or 1,50,000 – 30,000 – 40,000 = Rs. 80,000

Problem 5: Calculate MCSR or P / V Ratio : Marginal cost Rs.24,000. Sales Rs. 60,000

Solution: Contribution : Sales – Marginal Cost or 60,000 – 24,000 or 36,000

MCSR = Contribution / Sales x 100 or 36,000 / 60,000 x 100 or 60 %

Problem 6: The sales turn over and profit during two periods are as under:

Period 1 Period 2

Sales Rs. 20,000 Rs. 30,000

Profit Rs. 2,000 Rs. 4,000

Calculate the MCSR.

Solution : MCSR = Change in Profit / Change in Sales x 100 or 4,000 – 2,00,000 / 30,000 – 20,000 x 100

2,000 / 4,000 x 100 or 20%

Problem 7 : Calculate : MCSR. Total Sales Total Costs

Year ending 31st December 2006 22,23,000 19,83,600

Year ending 31st December 2007 24,51,000 21,43,200

Solution: Profit = Total Sales – Total Costs or For the year 2006 = 22,23,000 – 19,83,600 = 2,39,400

For the year 2007 = 24,51,000 – 21,43,200 = 3,07,800

MCSR = Change in profit / change in sales x 100 or 68,400 / 2,28,000 x 100 or 30 %

Problem: 8 : Calculate the selling price if marginal cost is Rs.2,400 and MCSR is 20 %.

Solution: MCSR = 20%, therefore the variable cost is 100 – 20 = 80 %

Variable cost given is Rs.2,400 : Therefore, Selling price is 24000 / 80 %

Or Rs.3,000.

Problem 9 : Find, Contribution and MCSR. Variable cost per unit Rs.40. Selling price per unit Rs.80. Fixed expenses Rs.2,00,000. Output 10,000 units.

Solution: Contribution : Sales – variable costs or (10,000 x Rs.80) – (10,000 x Rs. 40)

8,00,000 – 4,00,000 or Rs.4,00,000.

MCSR = Contribution / MCSR or 4,00,000 / 8,00,000 x 100 or 50 %

Problem 10. Calculate Break even point. Fixed costs Rs.80,000. Variable cost per unit Rs.4. Sales Rs.2,00,000. The number of units involved coincides with expected volume of output. Each unit sells at Rs.20.

Solution: BEP in units : Fixed expenses / contribution per unit

Contribution = S – V or Rs.20 – Rs.4 or Rs.16

Rs.80,000 / Rs.16 or 5,000 units.

Problem 11: Calculate the Break even point : Sales Rs.2,00,000. Fixed expenses Rs.50,000. Variable expenses.Rs.1,00,000.

Solution: Since no information about the number of units produced and costs per unit is given, only Break even point in value can be ascertained.

BEP in Rs. = Fixed costs x Total sales / Total Sales – Variable costs

50,000 x 2,00,000 / 2,00,000 – 1,00,000 or Rs.1,00,000

Problem 12: Calculate MCSR and Break Even Point : Sales Rs.5,00,000. Fixed Costs Rs.1,00,000. Profit Rs.1,50,000.

Solution:

MCSR = Contribution / Sales

Contribution = Fixed Costs + Profit or Rs.1,00,000 + Rs.1,50,000 = Rs.2,50,000

MCSR = 2,50,000 / 5,00,000 = 50%

BEP in Rs. = Fixed Costs / MCSR or 1,00,000 / 50 % or Rs.2,00,000.

Problem 13: Find BEP. Variable cost per unit Rs.12. Selling price per unit Rs.20. Fixed expenses Rs.60,000. What will be the selling price per unit if the BEP is brought down to 6000 units?

Solution: BEP in units : FC / CPU where CPU S – V 20 – 12 or Rs.8, 60,000 / 8 or 7,500 units

7,500 units x Rs.20 = Rs.1,50,000.

Selling price if BEP is 6000 units : FC / CPU or FC / (SP – VP) per unit or 60,000 / (x – 12)

Let selling price be Rs .x 6,000 = 60,000 / x – 12 or 6000 (x – 12) =

60,000 or x = Rs.22 on simplification.

Problem 14: Calculate MCSR. (2) Profit when sales are Rs.20,000 (3) New BEP if selling price is reduced by 20 %. Given Fixed expenses Rs.4,000 and Break even point Rs.10,000.

Solution:

Basis BEP sales : BEP in volume : FC / MCSR

Cross multiplying, MCSR = FC / BEP Sales or 40,000 / 10,000 x 100 or 40 %.

Profit Calculate the contribution first; where MCSR = C/Sales

40 % x 20,000 = Contribution or Rs8,000

C = F + P or 8,000 = 4,000 + P or Profit = Rs.4,000.

New BEP is SP is reduced by 20 % : Let the original SP be Rs.x. Therefore, at 20 % reduction, the Revised SP would become 20 % of x or .2x. Hence the revised SP would be x – 0.2x or 0.8x

New contribution is S – V or x – (60 % of x ) = C or 0.8x – 0.6x = 0.2x. SR = 0.2x / 0.8x or 0.25

BEP in volume = 4,000 / o.25 or Rs.16,000

Problem 15: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP sales Rs.40,000. Find the actual sales.

Solution: MCSR is based on BEP sales : BEP sales = FC / MCSR = FC / BEP sales or 8,000 / 40,000 = 0.2

Actual sales = FC + desired profit / MCSR or 8,000 + 2,000 /0.2 or Rs. 50,000

Terminal Questions:

1. A factory is manufacturing sewing machines. The variable cost of each machine is Rs.200 and each machine is sold for Rs.250. Fixed costs are Rs.12,000. Calculate the BEP for output.

2. Calculate break even point and margin of safety. Fixed cost Rs.1,60,000. Variable cost per unit Rs.2 and Selling price per unit Rs.18. Also compute the margin of safety if the company is earning a profit of Rs.36,000.

3. Calculate the break-even point and turnover required to earn a profit of Rs.3,600. Fixed overheads Rs.1,80,000. Variable cost per unit Rs. Selling price Rs.20. If the company is earning a profit of Rs.36,000, express the margin of safety available to it.

4. Given variable cost Rs.6,00,000. Fixed cost Rs.3,00,000. Net profit Rs.1,00,000. Sales Rs.10,00,000. Find (a) MCSR (b) BEP (c) Profit when sales amounted Rs.12,00,000 (d) sales required to earn a profit of Rs.2,00,000.

5. Given: Fixed costs Rs.4,000. Break even sales Rs.20,000. Profit Rs.1,000. Selling price per unit Rs.20. Calculate (a) sales and marginal cost of sales (b) new break even point if selling price is reduced by 10 %.

6. Find the margin of safety if profit is Rs.20,000 and MCSR is 40 %.

7. Calculate Break even sales and margin of safety. Given Sales Rs.10,00,000.Fixed costs Rs.3,00,000 and Profit Rs.2,00,000.

8. Given Sales Rs.20,000. Total Costs Rs.16,000 and Variable Costs Rs.12,000. Compute Break even sales, Margin of safety and sales to earn a profit of Rs.4,000.

MB0025-Unit-14-Budgetary Control 14.2 Meaning of A Budget

It is a numerical statement expressing the plans, policies and goals of an enterprise for a definite period in the future. Budgets are not actual but are estimated. It is therefore a financial and / or quantitative statement prepared and approved prior to a definite period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. (Definition by Cost and Management Accountants, England).

14.3 Budgetary Control

It is applied to a system of management accounting control by which all operations and output are forecasted far ahead as possible and actual results when known are compared with the budget estimates.

14.4 Objectives

Budgeting is a forward planning. It basically serves as a tool for management control. The objectives of budgeting may be taken as:

· To forecast and plan for future to avoid losses and to maximize profits.

· To help the concern in planning the activities both physical and financial.

· To bring about coordination between different functions of the enterprise.

· To control; actual actions by ensuring that actual are in tune with targets.

Therefore, the objectives can be summarized as follows:

· To conform with good business practice by planning for the future.

· To coordinate the various divisions of a business.

· To establish divisional and departmental responsibilities.

· To forecast operating activities and financial position.

· To operate most efficiently the divisions, departments and cost center.

· To avoid waste, to reduce expenses and to obtain the income desired.

· To obtain more economical use of capital available for the efficient operation.

· To provide more definite assurance of earning the proper return on capital employed.

· To centralize management control.

· To show the management where action is needed to remedy a situation.

· To help in controlling cash.

· To help in obtaining better inventory control and turnover.

14.5 Merits

In order to help in planning, coordinating and control, budgets need to be prepared for every organization to get the maximum benefit. Broadly, the merits are as follows:

1. It forces basic policies to initiatives

2. The budgetary control aims at the maximization of profits

3. Budgets fix the goals and targets without which operations lack direction

4. Reduction in cost and elimination of inefficiencies

5. Budgetary control facilitates to make ordered effort and brings about overall efficiency in results.

6. Budgetary control ensures that the capital employed at a particular level is kept at a minimum level

7. Budgetary control enables the management to decentralize responsibility without losing control

8. It is a good guide to the management for making future plans. Based on budgetary control realistic budgets can be drawn.

9. Budgetary control facilitates an intelligent and planned forecast of the future

10. Budgetary control acts as a safety signal for the management. It prevents wastages of all types.

11. Budgetary control brings to light the inefficiencies and weakness on comparing actual performance with budget. Management can take timely remedial measures.

12. Financial crisis can be avoided since budget provides advance information.

13. It is a guide to the management in the field of research and development in future.

14.6 Essential Features Of Budgetary Control

An effective budgeting system should have essential features to get best results. In this direction, the following may be considered as essential features of an effective budgeting.

Business Policies defined: The top management of an organization strives to have an action plan for every activity and for each department. Every budget should reflect the business policies formulated from time to time. The policies should be precise and the same must be clearly defined. No ambiguity should enter the document. Clear knowledge should be provided to all the personnel concerned who are going to execute the policies. Periodic suggestions should be called for.

Forecasting: Business forecasts are the foundation of budgets. Time and again discussions should be arranged to derive the most profitable combinations of forecasts. Better results can be anticipated based on the sound forecasts. As far as possible, quantitative techniques should be made use of while forecasting

Formation of Budget Committee: A budget committee is a group of representatives of various important departments in an organization. The functions of committee should be specified clearly. The committee plays a vital role in the preparation and execution of budget estimated. It brings coordination among other departments. It aids in the finalization of policies and programs. Non-financial activities are also considered to make it a wholesome affair.

Accounting System: To make the budget a successful document, there should be proper flow of accurate and timely information. The accounting adopted by the organization should be proper and must be fine-tuned from time to time

Organizational efficiency: To make the budget preparation and its subsequent implementation a success, an efficient, adequate and best organization is necessary a budgeting system should always be supported by a sound organizational structure. There must be a clear cut demarcation of lines of authority and responsibility. There must also be a delegation of authority from top to bottom line. .

Management Philosophy: Every management should set a healthy philosophy while opting for the budget. Management must wholehear4tedly support the activities which developing a budget. Encouragement should flow from top management. All the members must be involved to make it a workable preposition and a dream-driven document.

Reporting system: Proper feed back system should be established. Provision should be made for corrective measures whenever comparative measures are proposed.

Availability of statistical information: Since budgets are always prepared and expressed in quantitative terms, it is essential that sufficient and accurate relevant data should be made available to each department.

Motivation: Since budget acts as a mirror, the entire organization should become smart in its approach. Every employees both executive and non-executives should be made part of the overall exercise. Employees should be persuaded than pressurized to appreciate the benefits of the budgets so that the fruits can be shared by all the members of the organization.

14.7 Steps In Budgetary Control

The procedure to be followed in the preparation and control of budget may differ from business to business. But, a general pattern of outline of budget preparation and control may go a long way to achieve the end results. The steps are as follows:

Formulation of policies: The business policies are the foundation stone of budget construction. Function policies should be formulated in advance. Long-range policies with short term projections should be made for the functional areas such as sales, production, inventory, cash management, capital expenditure.

Preparation of forecasts: Based on the formulated policies, forecast should be made in respect of each function. Activity based concepts should be introduced at the micro level for each function Forecasts should not be considered as a mere estimates. Scientific methods should be adopted for forecasting. Analysis of various factors based on past, and present, future forecast should be made.

Preparation of budgets: Forecasts are converted into written codified document. Such written documents can be used for coordination purposes. Function budgets will act as guidelines for implementation.

Forecast combinations: While developing the budgets, through a Master Budget various permutations and combination processes are considered and developed. Based on this, establishment of the most preferred one which will yield optimum benefits should be considered. All the factor components should be identified which are likely to cause disturbances while implementing the budgets

14.8 Types of Budgets

The budgets are normally classified according to their nature. They are: (a) fixed budget. (b) Flexible Budget. (c) Functional Budget

Fixed Budget: It is also known as static budgets. It is prepared for a fixed or standard volume of activity. They do not change with change in the volume of activity. They are prepared well in advance Due to this, there are bound to be variances at the time of comparison. Hence, the budget targets become unsuitable for the purpose of comparison. Wide deviations are noticed due to changes in the volume of activity.

Flexible Budget: It is prepared with a view to take into account the periodic changes in the level of activity attained. In this case, the revenues and costs targets are set in respect of different levels of activity even from zero to 100 % of product ion volume. Such mechanism helps to change revenues and cost targets for the actual level of activity and thus makes the comparison more logical and scientific.

Functional Budget: These are also known as subsidiary budgets. These are prepared on the basis of approved forecasts for individual department. Since departments are created based on the functions, they are known as functional budgets. The functional budgets may vary in number from business to business. The functional budgets include sales budget. Production budget, selling and distribution overhead budget, plant budget, research and development budget, overheads budget, financial budget such as cash budget and capital expenditure budget.

14.9 Cash Budget

Cash budgeting is the process of forecasting the expected receipts known as cash inflows, and expected payments known as cash outflows to meet the future obligations. The written statement of receipts and payments form the cash budget.

Problem 1: A large retail stores makes 25% of its sales for cash and the remainder on 30 days net. Due to faulty collection practice, there have been losses from bad debts to the extent of 1 % of credit sales on average in the past. The experience of the store tells that normally 60 % of credit sales are collected in the month following the sale, 25% in the second following month and 14 % in the third following month. Sales in the proceeding

three months have been January 2007 Rs.80,000, February Rs.1,00,000 and March Rs.1,40,000. Sales for the next three months are estimated as April Rs.1,50,000, May Rs.1,10,000 and June Rs.1,00,000. Prepare a schedule of projected cash collection .

Solution:

Assume that the credit policy is enforced strictly ,what would be the cash receipts.

Forecasts of cash payments: The items of expenditures differ from business to business. The normal items which come under the lists are :

1. Cash purchases

2. Payment to creditors or suppliers

3. Payments to Bills payable

4. Payment to employees in the nature of wages, salaries

5. Manufacturing, selling and distribution and administration expenses

6. Repayments of bank load and special obligations such as bonus, donations, advances

7. Interest and dividend payments

8. Capital expenditures for acquiring assets of enduring benefit

9. payment of tax liability

10. other expenses of periodic nature

The quantum of amount likely to be spend on the above each item is generally determined with reference to functional budgets of the concerns. The policy of the management will also play a crucial role. It is the policy which determines the ratio of

cash purchases and credit purchases. In many cases, the time lag affects the amount of expenditures to be incurred in a particular period. The formula adopted for the expenses payable in next month is : month’s amount x time lag

Problem 2:

The following are the forecasts relating to wages and factory expenses.

The lag in payment of wages is 1/8 month and that in case of factory expenses 1/2 month. Estimate the amounts of wages and factory expenses payable in each month of September to November.

Solution

Problem 3:

The following information is provided in respect o DR Ltd. Prepare a Cash Budget for April, May and June 2007.

Additional information:

a. 10 % of the purchases and 20 % of sales are for cash

b. The average collection period of the company is 1 / 2 month and the credit purchases are paid regularly after one month.

c. Wages are paid half monthly and the rent of Rs.500 included in expenses is paid monthly. Other expenses are paid after one mo nth lag.

d. Cash balance on April 1, 2007 may be assumed to be Rs.15,000.

Solution:

DR Limited

Problem 4:

DR is to start production on January 1, 2008. The prime cost of an unit is expected to be Rs.40 (Rs.16 per material and Rs.24 for labor). In addition, variable expenses per unit are expected to be Rs.8 and fixed expenses per month Rs.30,000. Payment for materials is to be made in the month following the purchases. One-third of sales will be for cash and the rest on credit for settlement in the following month. Expenses are payable in the month in which they are incurred. The selling price is fixed at Rs.80 per unit. The number of units to be produced and sold are expected to be : January 900, February 1,200./ March 1,800. April 2,000. May 2,100. June 2,400. Draw a cash budget indicating cash requirements.

Solution

Problem 5:

DR wish to approach his Bankers for temporary overdraft facility for the period from June 1 to August 30th, 2007. During the period of these three months, DR will be manufacturing mostly for stock. Prepare a cash budget for the above period.

(a) 50 % of credit sales are realized inn the month following the sales and remaining in the second following month.

(b) Creditors are paid in the month following the month of purchase

(c) Estimated cash as on June 1 is Rs.50,000

Solution

Problem 6:

Prepare a cash budget from January to April

Wages to be paid to workers will be Rs.5,000 per month. Cash balance on January 1 may be assumed to be Rs.8,000. Management decides that :

a) in case of deficit within the3 limit of Rs.10,000 arrangement can be made with the bank

b) in the case of deficit exceeding Rs.10,000 but within a the limit of Rs.42,000 issue of debentures is to be preferred.

c) In the case of deficit exceeding Rs.42,000 the issue of equity shares is to be preferred. Assume that this will be within the Authorized Capital.

Solution

The total deficit of Rs,1,26,000 should be raised from the issue of Equity Shares.

14.10 Flexible Budget

According to I.C.M.A, London, a flexible budget is “a budget which is designed to change in accordance with the level of activity actually attained”. The basic idea of a flexible budget is that there shall be some standard of cost and expenditures. Thus, a budget prepared in a manner to give budgeted costs for any level of activity is, known as flexible budget. Such budget is prepared after considering the variable and fixed elements of costs and the changes which may be expected for each item at various levels of operations. .The main focus of flexible budget is to re cognize the difference in behavior pattern of fixed and variable costs in relation to fluctuations in production and sales. The flexible budget is, hence, designed to change appropriately with such fluctuations. In

flexible budget, data relating to costs and expenses may progressively be changed in any month in accordance with actual output achieved. Costs and estimates are made in advance based on standards. A maximum and a minimum levels of operation is made. Comparison of budgeted with actual are made. Budgeted activities are taken as basis. The principles of flexible budgeting concepts are applied to functional budget, master budgets. Popularly, the flexible budget is adopted for production cost budget. In this area., the costs are classified. A detailed classification is adopted such as variable, fixed and semi-variables.. Adopting micro-level classifications, it is intended to pin-point the various effects on each class of overheads.

14.11 Limitations Of Budgeting

The main limitations of budgeting are as under :

Budget plan : Since budget plans are based on estimates, the success or otherwise depends on the accuracy of basic estimates or forecasts. Due to this while making estimates, judgmental decision may accrue. The results need to be interpreted very cautiously.

Rigidity: Since the estimates are quantitative expression of all relevant data, there is likely that finality attachment may become very clear. Such consideration may result in rigidity. Rigidity may become a set back for the changing business conditions.

Replacement: Budgeting is not a substitute for management. It is essentially a tool of management. Under no circumstances, it should be concluded that the budgeting is alone sufficient to ensure success and to guarantee future profits.

Costly: The installation of budgeting system to an organization involve too much of costs. Its scientific approach will definitely call for huge cost allocation. Small concerns cannot afford to take over huge costs for the establishment of business systems. Since the costs and revenues and operational activities do not match in many occasions, the entire exercise will become costly. The system should be adopted only when benefits exceed the costs.

MB0025-Unit-15-Standard Costing 15.1 Introduction

Through planned accounting procedures, the difference between the actual and pre-determined costs are analyzed and then promptly reported upon to managers. Based on this, it is possible to take corrective and preventive action as well as employ the data for planning, coordination and control.

15.2 Definition of Standard Costing

Standard costing may be defined as a technique of cost accounting which compares the standard cost of each product or service with the actual cost to determine the efficiency of the operation so that any remedial action may be taken immediately: Brown and Howard. According to J. Batty “standard costing is a system of cost accounting which is designed to show in detail how much each product should cost to produce and sell when a business is operating at a stated level of efficiency and for a given volume of output”.

15.3 Meaning

The meaning of standard costing is focused on the method of financial control. It compares the predetermined and actual costs. It is normally associated closely with budgetary control; Many organizations use both the systems although one can be used without the other. Standard costing is mainly applied to products and processes. Therefore, it is a technique that is more commonly used in manufacturing organization, though it may also be useful in service industries. As in budgetary control, it allows the comparison of pre-determined costs and income with the actual costs and income achieved. Any difference can then be investigated.

15.4 Standard Cost and Budgetary Control

Both are closely interrelated. They both aim at the improvement of the system of managerial control. They both achieve the same objective of maximum efficiency and cost control; by establishing pre-determined standards. They compare actual performance with the predetermined standard. They take necessary steps to improve the situation wherever necessary. Both techniques are forward looking. However, the following are some of the differences identified.

1. The scope of budgetary control is wider. It is integrated plan of action, a coordinated plan in respect of all functions of an enterprise The scope of standard costing, on the other hand, is limited to the operating level. Here too, it is further linked to costs. Budgetary control is extensive whereas standard costing is intensive in its application

2. Budgetary control deals with costs and revenues. But standard costing restricts only with costs.

3. Budgetary control takes into account all activities such as production, sales, purchases, finance, capital expenditure, personnel whereas standard costing is restricted to deal with only costs.

4. Budgetary control targets are based on past actual adjusted to future trends. In Standard costing, standards are based on technical assessment.

5. At the approach level, budgeted targets work as the maximum limit of expenses above which the actual expenditure should not normally exceed. Under standard costing, standards are attainable level of performance.

6. Budget are projection of final accounts. Standard costs are projection of only cost accounts.

7. Budgetary control emphasizes the forecasting aspect of the future operations. Standard

8. Costing scope and utility is limited to only operating level of the concern.

9. In budgetary control, the degree of variance analysis tends to be much less and variances are not revealed through the accounts but are revealed in total. But in standard costing, variances are analyzed in details according to their originating causes and ar3e revealed through different accounts.

10. Budgetary control is possible even in parts of expenses according to the attitude of management. A standard costing system can not be operated in parts. All items of expenditure included in cost units are to be accounted for.

15.5 Establishment Of Standards

Standards should be fixed for each of them separately.

Direct Material : Standard material cost for each product should be pre-determined. This will require the determination of material quantity standard and material price standard. The standard quantity of each type of materials is determined by the engineering department on the basis of past records, experience and chemical and engineering tests. While setting such standards, an allowance should be made for the normal wastage of materials. The standard price for each item of material is established after carefully studying the market conditions and forecasting the trend of prices for a future period. This is done by cost accountant with the help of purchase officer.

Direct labor : The standard labor time and standard labor rate should be established. Standard time for each grade of labor is fixed by the production engineering department on the basis of time and motion study. In fixing the standard time due allowance should be made for fatigue, tool setting, receiving instructions and normal idle time. The standard rates of pay for each category of labor are fixed by the cost accountant with the help of personnel department.

Overheads : These are aggregate of indirect materials, indirect labor and indirect expenses/Separate standards must be established for variable and fixed overheads. As variable overheads per unit or per hour remain constant at each level of output / sales but total amount of variable overheads tend to vary directly with volume of output / sales. Therefore, it is sufficient to calculate only a standard variable overhead rate per unit or per hour. This is done by dividing the total variable overheads for the budget period by the budgeted output. In respect of fixed overheads standards are set for total fixed overheads for the budget period and the budgeted output and standard fixed overhead rate is computed by dividing the budgeted fixed overheads with budgeted output.

15.6 Cost Variance Analysis

The distinctive feature of standard costing system is variance analysis. By definition, the term “variance” means the variation or deviation of the actual from the standard. In standard costing, it implies the difference between the actual cost and standard cost. Variances indicate the extent to which standards set have been achieved. If properly recorded and analyzed, these variances become very important and useful tool for managerial control.

Variances by themselves are not the end. They are computed to know the reasons and fix the responsibility for any deviations of actual performances from pre determined targets. Based on this corrective measures are proposed for adoption in future. Therefore, variance analysis is the process of analyzing variances by sub-dividing the total variance in such a way that management can assign responsibility for off standard performance It is hence a very useful means for interpreting operating results and spotting situations calling for correction.

Variances are interpreted as favorable and unfavorable variances. Each variance is interpreted. Interpretation helps in deciding whether a variance is favorable or unfavorable. When the actual cost is less than the standard cost, the difference is termed as “favorable” or “credit” variance. On the other hand, when actual cost exceeds the standard cost, the difference is termed as “unfavorable”, “adverse” or “debit” variance. Ordinarily, a favorable variance is a sign of efficiency of the organization whereas an unfavorable variance a sign of inefficiency. But in variance analysis, this general logic may prove to be untrue. Therefore, all variances should be interpreted in relation to each other and only the net result be reported to the management for corrective action.

Controllable and Uncontrollable variances: The controllable variance can be identified as the primary responsibility of a specified person or a department. F a variance is due to the factors beyond the control of the concerned person or department, it is said to be uncontrollable. No person or department can be held responsible for uncontrollable variances. Actually revision of standards is required to remove such variances in future.

15.7 Material Variance

It refers to material cost variance. It is the difference between the standard cost of materials allowed for the actual output and the actual cost of materials used. It may be expressed as :

Material Cost Variance = Standard Cost – Actual Cost

Where standard cost = actual output x standard rate per unit of output

Or standard quantity of material for actual output x standard price per unit of material

Actual cost = actual quantity consumed x actual price per unit of

material.

A favorable variance would result if actual cost is less than the standard cost and vice versa.

The material cost variance is the sum total of material price variance and material usage variance.

Self Assessment Questions 6:

1. Material variance is ______________.

Example: DR Ltd. has decided to extend its range to include Denim Jackets. One jacket requires a standard usage of 3 meters of direct material which has been set at a standard price of Rs.2.20 per meter. In the period, 80 jackets were made and 260 meters of material consumed at a cost of Rs.1.95 per meter. Calculate the direct materials total variance.

Solution: Calculate the standard quantity of materials for the actual level of production

For 1 jacket = standard usage is 3 meters

Therefore for 80 jackets, it is 80 x 3 meters / 1 or 240 meters

Consider the formula, (SQ x SP) – (AQ x AP)

= (240 x Rs. 20) = (260 x Rs.1.90 ) or Rs. 528 – Rs. 507

= Rs. 21 (Favorable) variance.

The difference indicates that them company has spent less on materials than planned for the level of production.

15.8 Material Price Variance

Under Material price variance , the price paid for materials is different from the pre-determined price. It is calculated by multiplying the actual quantity of materials used with the difference between standard and actual prices. The formula is :

Material Price Variance = (Standard Price – Actual Price ) x Actual quantity used.

Shorten = (SP – AP) AQ

A favorable variance would result if the actual price is less than the standard price and vice versa.

Self Assessment Questions 7:

1. Material price variance is __________.

Example : Calculate the direct material price variance from the data of DR Ltd above.

Solution : Formula : (SP – AP ) AQ or (Rs.2.20 – Rs.1.90) x 260 meters or Rs.78 FAV

It is favorable because the company has paid less for the materials than planned for that level of production

15.9 Material Usage Variance

It is also known as material quantity variance or efficiency variance. It is that portion of material cost variance which measures the difference in material cost arising from higher or lessa consumption of materials than the standard material consumption for the actual output. It is calculated by multiplying the standard price with the difference between the standard and actual quantitities of materials :

Material Usage Variance = (Standard Quantity – Actual Quantity) Standard Price Shorten = (SQ – AQ) SP

A favorable variance would result if the actual quantity is less than the standard quantity and vice versa.

Self Assessment Questions 8:

1. Material usage is _______.

Example 1: Citing DR’s example : the direct material usage variance is :

(SQ – AQ ) SP or (240 – 260 meters) x Rs. 2.20 per unit or Rs. 44 (ADV)

It is adverse because the company has used more materials than planned for that level of production.

Example 2: It is observed that one unit of product X requires 3 kgs of material M at Rs.2 per kg. During January 2008, 200 units of product X were produced consuming 620 kgs of material M, all of which was purchased at Rs.1.80 per kg. Compute material cost variances.

Solution: Material Price Variance: (SP – AP) AQ or (2.00 – 1.80) x 620 o Rs. 124 F.

Material Usage variance : (SQ – AQ ) SP where SQ for actual consumption is 200 x 3 kg / 1 kg 0r 600 kgs

(600 – 620_ Rs.2 or Rs.40 A

Material Cost Variance : Material Price Variance + Material Usage variance

124 (F) + 40 )A) or Rs.84 (FAV)

Example 3: For producing a commodity, the standard quantity of material was fixed 10 kgs and standard price was fixed at Rs.2 per kg. The actual quantity was consumed 12 kgs and the actual price was Rs.1.90 per kg. Calculate the material variances.

Solution: MUV = (SQ – AQ) SP or (10 – 12) 2 or -2 x 2 or 4 ADV

MPV = (SP – AP ) SQ or (2 – 1.90 ) 12 or 1.20 FAV

MCV = (SQ x SR) – (AQ x AP) = (10 x 2 ) – (12 x 1.90) = 2.80 ADV

Example 4: Calculate the material variance.

Solution: Calculation of standard quantity

For 80 kgs, finished products needs 100 kgs material

Therefore, for 1,65,000 kgs, it is 1,65,000 x 100 / 80

or 2,06,250 kgs.

MUV = (SQ – AQ ) SP or (2,06,250 – 2,00,000) Rs.0.80

= Rs.5,000 FAV

MPV = (SP – AP ) AQ or (0.80 – 0.85 ) 2,00,000 or Rs.10,000, ADV

Cost of 2,00,000 kgs is Rs. 1,70,000

Therefore, cost of one kg is 0.85

MCV = (SQ x SR) – (AQ x AP )

(2,06,250 x 0.80) – (2,00,000 x 0.85)

= Rs. 5,000 ADV.

Example 5: It is estimated that in the manufacture of a product, for each ton of materials consumed 100 units should be produced. The standard price per ton of materials is Rs. 10. During the first week of January, 100 tons of materials were issued to the Production Department. The purchase price of which was Rs. 10.50 per ton. The actual output for the period was 10,250 units. Calculate the cost variances.

Solution: Standard rate of material: Standard cost per ton / standard output per ton or 10,250 units / 100 tons or 102.5 per ton

Material usage (SQ – AQ) Sp where SQ = Actual output / standard quantity or 10,250 / 100 tons = 102.5 ton (one ton for 100 units Rs. 10,250, the standard quantity is 102.5 tons. (102.5 – 100 tons) x Rs.10 or Rs. 25 FAV

MPV = (SP – AP) AQ (10 – 10.50 ) x 100 = Rs. 50 ADV

MCV = (SQ x SP) – (AQ x AP) or 102.5 x 10 – 100 x 10.50 or Rs. 25 ADV

Example 6: A factory works on standard costing system. The standard estimates of material for the manufacture of 1000 units of a commodity is 400 kg at Rs. 2.50 per kg. When 2000 units of a commodity are manufactured, it is found that 820 kgs of material is consumed at Rs. 2.60 per kg. Calculate the material variance

Solution : First calculate the standard quantity and standard cost.

Standard quantity : For manufacture of 1000 units, the standard estimates = 400 kgs. Therefore, for actual manufactured quantity, the standard is 2000 x 400 / 1000 or 800 kgs.

Standard cost = Standard quantity x Standard rate or 800 x Rs.25 or Rs.2,000

Actual Cost = 820 x Rs. 2.60 or Rs. 2,132

Material cost variance = Standard cost – Actual cost or 2000 – 21312 or 132 ADV.

Material price variance = (SR – AR ) AQ or 2.5-0 – 2.60 x 820 or Rs.82 ADV

Material usage variance = 800 – 820 x 2.50 or Rs.50 ADV

15.10 Material Mix Variance

This variance arises only when more than one type of materials are used in manufacturing the product and the quantities of materials issued to production are not in proportion of standard mix. It is defined as that portion of the direct materials usage variance which is due to difference between the standard and actual, composition of a mixture. For calculating the mix variance, first calculate the quantities of revised standard mix. This is calculated by dividing the total quantities of actual mix in standard mix proportion. In the

terminology of standard costing, quantities of revised standard mix are referred to as “revised standard quantity”. Mix variance is obtained by multiplying the standard price of materials with the difference between revised standard quantity and actual quantity for each material. It may be expressed as follows:

Material Mix Variance = Revised standard quantity for each material – actual MMV Quantity for each material) x standard price.

Where RSQ = standard quantity for each material / total of standard quantity of all types of materials x actual mix total

RSQ = Total weight of actual mix / total weight of standard mix

X standard quantity.

A favorable variance would result if actual quantity is less than revised standard quantity and vice versa.

Self Assessment Questions 9:

1. Material mix variance to __________.

Example : The following extracts are extracted from the books of DR Ltd.

Calculate the material mix variance

Solution :

Revised standard quantity = Total weight of actual mix / total weight of standard mix x standard quantity

15.11 Material Yield Variance

This variance arises only when the rate of output is known. It is that portion of the direct material usage variance which is due to the difference between standard yield specified and actual yield obtained. It measures the loss or saving due to wastage of materials. This variance is calculated as follows :

MYV = (Standard yield – Actual Yield ) x standard rate per unit of output or

(Standard Loss – Actual Loss ) x standard rate per unit of output

where standard rate = standard cost of standard mix / standard output from standard mix standard yield = standard output from standard mix / standard mix total x actual mix total MYV is an output variance and hence a favorable variance would result if actual yield is more than standard yield and vice versa.

Self Assessment Questions 10:

1. Material yield variance is __________.

Example 1: The following extracts refer to DR Ltd.

Calculate the material yield variance.

Solution:

Material Yield Variance : (Standard yield – Actual yield) Standard rate

Where standard rate = Total cost of standard mix / net standard output or 700 / 70 = Rs. 70

MYV = (70 – 75) 10 or Rs. 50 ADV.

Example 2: DR manufactures a product X. It is estimated that for each ton of material consumed, 100 articles should be produced. The standard price per ton of material is Rs. 10. During the first week of January 2008, 100 tons were issued to production, the price of which was Rs.10.50 per ton. Production during the week was 10,200 articles. Compute the variances

Solution:

Cost variance: Standard cost – Actual Cost or Rs.1,020 – Rs.1,050 = Rs.30 ADV

Working : Actual output x standard rate per unit of output or 10200 x 0.10 or Rs.1,020

SR = Actual output / standard output per ton or 10,200 / 1`00 or 102 tons

Price variance : Actual quantity of input (Standard price – Actual Price) or (10 – 10.50) x 100 = Rs.50 ADV

Usage Variance : (Standard quantity – Actual quantity) standard price or (102 – 100) x 10 or Rs.20 FAV

Yield variance = (Standard yield – Actual yield ) standard rate per unit of output or (10,000 – 10,200 ) 0.10 or Rs.20 FAV

Working : Standard yield = Actual quantity of material x standard rate per ton of output or 100 x 100 = 10,000 articles.

Example 3 : The standard mix of product MS is as follows

The standard loss in production is 10 % of input. There is no scrap value. Actual production for a month was 7,240 kgs of MS from 80 mixes. Actual purchases and consumption of materials are :

Solution

Less Std. Loss 800

Final output 7200 50,400

SC per kg of finished product = 50,400 / 7200 kg = Rs.7 per kg

Cost variance : SC – AC or 7 x 7240 -53500 or Rs.2,820 ADV

Price Variance : (SR – AR ) x A Q

A = Rs. 2,080 ADV

B = Rs. 420 FAV

C = Rs. 1,280 FAV

Mix Variance = (RSQ – AQ ) SR

A = (8400 x 50 /100) Rs. 5 = 200 FAV

B = 8400 x 20 / 100 x Rs. 4 Nil

C = 8400 x 30 / 100 x Rs. 10 = 400 ADV

Total : 200 ADV

Yield variance = (SY – AY ) SR per kg

Standard yield = 8400 kg x 9 / 10 or 7560 kg

(7,560 – 7,240) Rs. 7 or Rs. 2,240 ADV

15.12 Direct Labour Variances

The same principles apply to the calculation of Direct Labor variances as for the direct material variances. Standards are established for the rate of pay to be paid for the production of particular products and labor time taken for their production. The standard time taken is expressed in standard hours or minutes and become the measure of output. By comparing the standard hours allowed and the actual time taken, labor efficiency can be assessed. In practice, standard times are established by work, time and method study techniques.

Direct Labor variance : It is the difference between actual labor cost and the standard labor cost of production achieved. It is calculated as :

Total Labor Cost = Hours worked x Rate per hour

Labor Cost Variance = Standard Cost – Actual Cost

Shorten = SC – AC or (Standard labor hours x standard rate per hour) – (Actual labor hours x Actual rate per hour)

Self Assessment Questions 11:

1. Direct labor variance is ___________.

Example: The management of DR Ltd decides that it takes 6 standard hours to make one Denim jacket and the standard rate paid to labor is Rs. 8 per hour. The actual production is 900 units and this took 5,100 hours at a rate of Rs.8.30 per hour. Calculate the direct labor total variance.

Solution : Calculate the standard labor hour for 900 jackets.

For one Jacket production, the standard hour is 6.

Therefore, for producing 900 units, the standard hour is 900 x 6/1 = 5,400 hours.

DLV = (5,400 x – (5,100 x 8.30) = Rs. 870 favorable.

A favorable variance would result when actual cost is less than standard cost and vice versa.

Labor cost variance is the sum total of labor rate variance, labor efficiency variance, rate variance, idle time and labor calendar variance

15.13 Labour Efficiency Variance

It is that portion of labor cost variance which is due to the difference between the standard lab or hours specified for the activity i.e. output achieved and the actual labor hours worked. It is calculated by multiplying standard rate of wages with the difference between standard hours and actual hours worked.

LEV = Standard hours – actual hours worked) x standard rate

Shorten = (SH – AH ) SR

A favorable variance would result when actual hours worked are less than standard hours and vice versa.

Example : From the data above, calculate the labor efficiency variance;

Solution : (5400 standard hours – 5100 actual hours) x Rs. 8 standard rate

Rs. 2,400 FAV

15.14 Labor Rate Variance

It is that portion of labor cost variance which is due to the difference between the standard rate specified and actual rate paid. It is calculated by multiplying the actual hours paid with the difference between standard rate specified and actual rate paid.

Labor Rate variance = (Standard Rate – Actual Rate) x actual hours paid.

Shorten = (SR – AR) AH

Self Assessment Questions 13:

1. Labor rate variance is __________.

Example 1: Citing DR example, calculate the direct labor rate variance

Solution : (Rs.8 – 8.30 ) x 5,100 hours or Rs.1,530 ADV

Example 2: The production of a certain unit is assumed to require 18 hours labor at a rate of Rs. 1.25 per hour. On completion of a unit, it was found that the time taken was 16 hours, the wage rate being Rs. 1.50 per hour. Calculate labor variances.

Solution : Cost variance = Standard cost – actual cost

Rs. 22.50 – Rs. 24 or Rs. 1.50 ADV

Working : SC = Standard hours x standard rate per hour = 18 x Rs.1.25 = Rs. 22.50

OR

LCV = LEV + LRV

2.5 FAV + 4 ADV = 1.5 ADV

Efficiency variance = (Standard hours – actual hours worked)standard rate

(18 – 16) x 1.25 or Rs. 2..50 FAV

Rate variance = (Standard rate – actual rate) actual hours paid

(1.25 – 1.50) 16 or Rs. 4 ADV

Labor Idle Time variance : It is that portion of labor cost variance which is due to abnormal idle time of workers. This variance is calculated to show separately the effect

of abnormal causes affecting production such as failure of power supplies, machine break down, waiting for materials, waiting for instructions, strike, lock-outs. It is calculated as:

Labor idle time variance = Idle hours x standard hourly rate

This variance is always an adverse one.

Example 3: In the ma manufacture of a product, 200 employees are engaged at a rate of 50 paise per hour. A five day week of 40 hours is worked and the standard performance is set at 250 units per hour. During the first week in January, six employee were paid at 45 paise an hour and four at 56 paise an hour, the remaining employees were paid at standard rates. The factory stopped production for one hour due to power failure. Calculate variances.

Solution : Efficiency variance = (Std hours – actual hours worked ) x std rate (8000 – 7800) 0.50 or Rs.100 FAV

Rate variance = (SR – AR ) AH

(0.50 – 190 employees x 40 hours = Nil

(0.50 – 0.40 ) x 6 x 40 12 FAV

(0.50 – -.56 ) 4 x 40 9.60 ADV

Total 2.40 FAV

Idle time variance = Idle hours x std rate per hour

200 hrs and 0.50 or Rs.100 ADV

Labor cost variance = LEV +_ LRV + Idle time variance

100 FAV + 2.40 FAV + 100 ADV = Rs. 2.40

15.15 Labour Mix Variance

This variance arises only when different types of workers (women and men workers, trained, semi-trained and untrained workers, are employed in manufacturing. If actual working force of different grades of workers is not in the pre-determined ratio, then the mix variance will occur. The variance shows to the management as to how much of the labor cost variance is due to the changes in the composition of labor force. It is calculated as follows :

LMV = (Revised standard hours – actual hours worked) x standard hourly rate Shorten (RSLH – ALH) x SR

Where revised standard hour = total time of actual worker / total time of standard workers x standard labor rate.

Example 1: The labor budget for a week is as follows :

40 skilled men at Rs.1.50 per hour for 80 hours

80 unskilled men at Re.1 per hour for 80 hours

Actual labor force was used are given below;

60 skilled men at Rs.1.50 per hour for 80 hours

60 unskilled men at Re.1 per hour for 80 hours

Calculate labor mix variance.

Solution : Revised standard labor hours = total time of actual workers / total time of standard workers x standard labor hours

Skilled worker = 80 / 80 x 80 = 80 hours

Unskilled = 80 / 80 x 80 = 80 hours

LMV = Skilled = (3,200 – 4,800) 1.50 = Rs. 2,400 ADV

Unskilled = (6,400 – 4,800) Re.1 = Rs.1,600 FAV

Total labor mix variance Rs. 800 ADV.

15.16 Labor Yied Variance.

This is due to the difference in the standard output specified and the actual output obtained. The formula is as follows :

LYV : (Actual output – Standard output ) x standard cost per unit

Example 1: Actual output 460 units. Standard output 500 units. Standard rate of wages Rs.9 per hour. A Standard time 2 hour per unit.

Solution : Standard cost per unit = Rs.9 x 2 hours = Rs.18

LYV = (AO – SO) SC or (460 – 500 units) x Rs.18 or Rs.720 ADV

Example 2: Calculate (a) Labor rate variance (b) labor efficiency variance (c) labor cost variance

Standard : Labor rate 0.24 paise per hour. Labor hours 3 per unit.

Actual: Units produced 250. Labor rate 0.25 paise per hour. Hours worked 800.

Solution: LRV : (SR =- AR) AH or Rs.8 ADV

LEV = (SH – AH ) SR or Rs.12 ADV

LCV = (SLC – ALC) or (SH x SR) – (AH x AR) = Rs.20 ADV

Example 3 : The standard labor force of DR Ltd is as follows :

20 skilled men at Re. 0.50 per hour for 40 hrs

40 semi skilled men at 0.35 per hour for 40 hrs.

During a certain week, the actual ,labor force was :

30 skilled men at Rs.0.50 per hour for 40 hours

30 semi skilled men at 0.40 per hour

Analyze labor variance for 40 hours.

Solution : Calculation of standard hours

Since standard hours and actual hours are the same in total there would be no labor efficiency variance.

Labor cost variance : SLC – ALC or Rs.120 ADV

Labor rate variance : Skilled : (SR – AR) AH or Nil

Semi skilled (0.35-0.40) 1,200 or 60 ADV

Labor mix variance = ( SH – AH ) SR

Skilled (800 – 1200) x 0.50 or 200 ADV

Semi skilled (1,600 – 1,200) Rs. 0.35 or 140 FAV

Example 4: A contract job is scheduled to be completed in 20 weeks with a labor force of 10 skilled workers, 4 semi skilled workers and 6 unskilled workers. The standard weekly wages of each type of workers are: Skilled Rs.50, semi skilled Rs.40 and unskilled Rs. 30. The work is actually completed in 25 weeks with a labor force of 8 skilled, 5 semi-skilled and 7 unskilled workers and the actual weekly wage rates average Rs. 55 for skilled, Rs. 45 for semi skilled and Rs.25 for unskilled workers. Analyze the variance.

Solution:

Labor cost variance : LRV + LEV = 750 + 3450 = 4200 ADV

Labor yield variance = (Actual weeks – standard weeks ) Standard rate per hour

(500 – 400) Rs. 42 = Rs. 4,200 ADV (16800 / (20 Nos x 20 weeks)

RSLH: Total time of actual workers / total time of standard workers x Standard labor hours

500 / 400 x 200 = 250 = (250 – 200 ) 50 = Rs. 2,500 FAV

500 / 400 x 80 = 100 = (100 – 125) 40 = Rs.1,000 ADV

500 / 400 x 120 = 150 = (150 – 175) x 30 = Rs. 750 ADV