Financial Management NOTES

Course outline of Mgt A/cing- Lakshminarayana.
S
M.Com., MBA M.Phil.,
NATURE AND SCOPE OF MANAGEMENT ACCOUNTING The word Accounting can be classified into three categories: a) Financial Accounting b) Cost Accounting c) Management Accounting Meaning of Financial Accounting: The object of financial accounting is to find out the profitability and to provide information about the financial position of the concern. Two principal statements of financial accounting are Income and Expenditure Statement and Balance Sheet. Functions of Financial Accounting: 1. Recording of Information 2. Classification of Data 3. Making Summaries 4. Dealing with Financial Transactions 5. Interpreting Financial Information 6. Communicating Results 7. Making Information More Reliable Limitations of Financial Accounting: 1. Historical Nature 2. Provides Information about the Concern as a whole 3. Not helpful in Price Fixation 4. Cost Control Not Possible
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Course outline of Mgt A/cing- Lakshminarayana.S

5. Appraisal of Policies not Possible 6. Only Actual Costs Recorded 7. Not helpful in taking Strategic Decisions 8. Technical subject 9. Quantitative Information 10. Lack of Unanimity about Accounting Principles 11. Chances of Manipulation Accounting as an Information System Accounting provides information to vested interests in a business organization-managers, shareholders, employees, creditors, customers, etc. Various parties are interested to know about the activities of the business. 1. Information Needs of Management 2. Information Needs of Shareholders and Investors 3. Information Needs of Employees 4. Information Needs of Creditors 5. Information Needs of Government Cost Accounting The need for determination and control of costs necessitated new set of principles of accounting and thus emerged cost accounting as a specialized branch of accounting. The costing terminology of I.C.M.A. London defines cost accounting as the process of accounting for cost from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centers and cost units. In its widest usage, it embraces the
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preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of activities carried out or planned. Objects and Functions of Cost Accounting 1. Analysis and Ascertainment of Costs 2. Presentation of Costs for Cost Reduction and Cost Control 3. Planning and Decision making Importance and Advantages of Cost Accounting 1. Cost Accounting as an Aid to Management 2. Advantages to Employees 3. Advantages to the Creditors, Investors and Bankers 4. Advantages to the Government and the Society Limitations of Cost Accounting 1. It is not an independent system of accounts. 2. It is based largely on estimates like absorption of indirect expenses or apportionment of expenses on estimate basis. 3. There is scope for subjectivity on items like depreciation, valuation of closing stock, etc. 4. It does not take into consideration all items of expenses and incomes eg., items of purely financial nature such as interest, finance charges, discount and loss on issue of share and debentures etc.
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Management Accounting Management accounting provides all possible information required for managerial purposes. Meaning and Emergence of Management Accounting Management Accounting is comprised of two words Management and Accounting. It is the study of managerial aspect of accounting. The emphasis of management accounting is to redesign accounting in such a way that it is helpful to the management in formation of policy, control of execution and appreciation of effectiveness. It is that system of accounting which helps management in carrying out its functions more efficiently. Definitions of Management Accounting Robert N. Anthony: Management Accounting is concerned with accounting information that is useful to management. The Institute of Chartered Accountants of India : Such of its technique and procedures by which accounting mainly seeks to aid the management collectively have come to be know as management accounting. The Institute of Cost & Works Accountants of India defines Management Accounting as a system of collection and presentation of relevant economic information relating to an enterprise for planning, controlling and decision making. The American Accounting Association: Management Accounting includes the methods and concepts necessary
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for effective planning for choosing among alternative business actions and for control through the evaluation and interpretation of performances. Characteristics or nature of Management Accounting 1. Providing Accounting Information 2. Cause and effect analysis 3. Use of Special Techniques and Concepts 4. Taking Important Decisions 5. Achieving of Objectives 6. No fixed norms followed 7. Increase in efficiency 8. Supplies information and not decision 9. Concerned with forecasting Scope of Management Accounting 1. Financial Accounting 2. Cost Accounting 3. Financial Management 4. Budgeting and Forecasting 5. Inventory Control Scope of Management Accounting 1. Financial Accounting 2. Cost Accounting 3. Financial Management 4. Budgeting and Forecasting 5. Inventory Control 6. Reporting to Management 7. Interpretation of Data 8. Control Procedures and Methods
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9. Internal Audit 10. Tax Accounting 11. Office Services Objectives of Management Accounting 1. Planning and Policy Formulation 2. Helpful in Controlling Performance 3. Helpful in Organizing 4. Helpful in Interpreting Financial Statements 5. Motivating Employees 6. Helpful in Making Decisions 7. Reporting to Management 8. Helpful in Co-ordination 9. Tax Administration Functions of Management Accounting 1. Planning and Forecasting 2. Modification of Data 3. Financial Analysis and Interpretation 4. Facilities Managerial Control 5. Communication 6. Use of Qualitative Information 7. Co-ordinating 8. Helpful in taking Strategic Decision 9. Supplying Information to Various Management
Levels
of
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Relationship of Management Accounting with Financial Accounting The main points of distinction are discussed as below: 1. Object: The object of financial accounting is to record various transactions with the purpose of maintaining accounts and to know the financial position and to find out profit loss at the end of the financial year. These records are useful to shareholders, creditors, bankers, debentures holders, etc. On the other hand management accounting is essential to help management in formulating policies and plans. 2. Nature: Financial accounting is mainly concerned with the historical data. It records only those transactions which have already taken place. Management accounting deals with projection of data for the future. It uses historical data only for taking decisions for the future. In financial accounting actual figures are used whereas in management accounting projected or estimated figures are used. 3. Subject-matter: Financial accounting is concerned with assessing the results of the whole business while management accounting deals separately with different units, departments and cost centers. In financial accounting overall performances is judged, while in management accounting the results of different departments are evaluated separately to find out their performance differently. Financial accounts are concerned with details whereas management
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accounting is concerned in analyzing data from different angles. 4. Compulsion: The preparation of financial accounts is compulsory in certain undertakings while these are a necessary in others. Management accounting is not compulsory. It is only a service function and is helpful to the management in administration of the business. The management is free to use or not to use management whereas there are no such procedures in management accounting. It is the suitability of the management which is important while using management accounting. 5. Precision: In management accounting no emphasis is given to actual figures. The approximate figures are considered more useful than the exact figures. In financial accounting only actual figures are recorded and there is no room for using approximate figures. The transactions are recorded only when they have taken place so exact figures are used. 6. Reporting: Financial accounts are prepared to find out profitability and financial position of the concern. These reports are useful for outsiders like bankers, investors, shareholders, government agencies, etc. these reports are prepared not only for the benefit of the concern but also for outsiders. Management accounting reports are meant for internal use only. These are prepared for the benefit of different levels of management. Financial reports such as profit and loss account and balance sheet are prepared for a specific period and on a main idea for preparing these reports is to enable the management to have a view about the position of the concern and no consideration is given to the period.
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Management accounting reports are rather future projections of figures. 7. Description: Only those things are recorded in financial accounting which can be measured as monetary terms. Anything which cannot be recorded in figures is outside the scope of financial accounting. Management accounting uses both monetary and non-monetary events. The competition in the market, impact of political changes, a situation of trade cycles and such other factors are also considered in management accounting, though these cannot be measured in monetary terms. 8. Quickness: Reporting of management accounting is very quick. Management is fed with reports at regular intervals. Various figures are required to take managerial decisions at different levels of management. On the other hand, reporting of financial accounting is slow and time consuming. Profit and loss account and balance sheet are prepared at the end of the financial year. Management is able to know the profitability and financial position only after the preparation of final accounts. 9. Accounting Principles: Financial accounts are governed by the generally accepted principles and conventions. No set principles are followed in management accounting. Management accounting is used for taking policy decisions, so, form and method of presenting figures differs from concern to concern. The requirement and expediency of the situation determines the mode of information to be presented.
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10. Period: Financial accounts are prepared for a particular period. Profit and loss account is generally prepared for one year. All the items relating to that year are taken to P/L account. Balance sheet is prepared on a particular date. It reveals the financial position of the concern on that date. Management accounting supplies information from time to time during the whole year. There are no specific periods for which management accounts are prepared. 11. Publication: Financial accounts like profit and loss account and balance sheet are published for the benefit of the public. Under companies law every registered company is supposed to supply a copy of profit and loss account and balance sheet to the registrar of companies at the end of the financial year. Management accounting statements are prepared for the benefit of the management only and these are not published. 12. Audit: Financial accounts can be got audited. Company law, auditing of financial accounts is compulsory. Management accounts cannot be audited. They are not based on actual figures and projected data are also used in management accounting. So, it is not possible to get management accounts audited. It is clear from the earlier discussions that financial accounts are based on historical data and only actual facts and figures are recorded. Management accounting too uses historical data but the purpose is to use it for planning and forecasting. Both financial and management accounting are complementary and are necessary in running the concern efficiently.
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Relationship Accounting
between
Cost
and
Management
1. Object: The object of cost accounting is to record the cost of producing a product or providing a service. The cost is recorded product wise or unit wise. Besides recording, it deals with cost control, matching of costs with revenue and decision-making. The purpose of management accounting is to provide information to the management for planning and co-ordinating the activities of the business. 2. Scope: The scope of management accounting is very wide. It includes financial accounting, cost accounting, budgeting, tax planning, reporting to management and interpretation of financial data. On the other hand, cost accounting deals primarily with cost ascertainment. 3. Nature: Management accounting is generally concerned with the projection of figures for future. The policies and plans are prepared for providing future guidelines. Cost accounting uses both past and present figures. 4. Data used: In cost accounting only those transactions are taken which can be expressed in figures. Only quantitative information. 5. Development: The development of cost accounting is related to industrial revolution. Financial accounting could not satisfy information needs of management. Cost accounting was thus evolved as a supplementary accounting method. Cost accounting was able to provide information not only about cost structure but
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also for planning and decision-making. Management accounting has developed only in the last thirty years. Management accounting and cost accounting are both complementary subjects. 6. Principle followed: Certain principles and procedures are followed for recording costs of different products. The same rules are applicable at different times too. No specific rules and procedures are followed in reporting management accounting. The information is prepared and presented as is required by the management. Tools and Techniques of Management Accounting 1. Financial Policy and Accounting 2. Analysis of Financial Statements 3. Historical Cost Accounting 4. Budgetary Control 5. Standard Costing 6. Marginal Costing 7. Decision Accounting 8. Revaluation Accounting 9. Control Accounting 10. Management Information System Need and Importance of Management Accounting The following accounting: are the advantages of management
1. Increases Efficiency 2. Proper Planning 3. Measurements of Performance 4. Maximizing Profitability

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5. Improves Services to Customers 6. Effective Management Control Limitations of management accounting 1. Based on Accounting Information 2. Lack of Knowledge 3. Intuitive Decisions 4. Not an Alternative to Administration 5. Top Heavy Structure 6. Evolutionary Stage 7. Personal Bias 8. Psychological Resistance Installation of Management Accounting System 1. Organizational Manual 2. Preparing Forms and Returns 3. Requisite Staffing 4. Classifying Accounts and Integrating the System 5. Introducing Standard Costing Technique 6. Setting up Budgetary Control System 7. Setting up Operational Research Technique Management Accountant Any person responsible for the supply of accounting information to management is known by different names in different organizations, i.e. , Controller, Comptroller, Chief Accountant, Financial Adviser, Financial Controller, etc. It is essential to determine the status of management accountant in the organization. It is also necessary to determine his scope of work and responsibility.
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Functions of Management Accountant 1. Planning for Control 2. Reporting 3. Evaluating 4. Administration of Tax 5. Appraisal of External Effects 6. Protection of Assets Duties of Management Accountant 1. Collection of Information 2. Evaluation of Information 3. Interpretation of Information 4. Reporting of Information
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Module-2:-Funds flow Statement The funds flow statement which shows the movement of funds and is a report of the financial operations of the business undertaking. It indicates various means by which funds were obtained during a particular and the ways in which these funds were employed words, it is a statement of sources and application of funds. Meaning and Concepts of Funds In a narrow sense, it means cash only and a funds flow statement prepared on this basis is called a cash flow statement. Such a statement enumerates net effects of the various business transaction on cash and takes into account receipts and disbursements of cash. In a broader sense; the term funds refers to money values in whatever form it may exist. Here funds means all financial resources, used in business whether in the form of men, material, money, machinery and others. In a popular sense, the term funds, means working capital, i.e., the excess of current over current liabilities. The working capital concept of funds has emerged due to the fact that total resources of a business are invested partly in fixed assets in the form of fixed capital and partly kept in form of liquid or near liquid form as working capital. Meaning and Concept of Flow of Funds The term flow means movement and includes both inflow and outflow.
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Rule The flow of funds occurs when a transaction changes on the one hand a non-current account and on the other a current account and vice-versa. Current and Non-Current Accounts To understand flow of funds, it is essential to classify various accounts and balance sheet items into current and noncurrent categories. Current Accounts can either be current assets or current liabilities. Current assets are those assets which in the ordinary course of business can be or will be converted into cash within a short period of normally one accounting year. Current liabilities are those liabilities which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assets or the income of the business.
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Funds flow statement The following is the list of Current or Working Capital Accounts : List of Current or Working Capital Accounts Current Liabilities Current Assets 1. Bills payable 1. Cash in hand 2. Sundry Creditors or 2. Cash at bank Accounts payable 3. Accured or outstanding 3. Bills receivable expenses 4. Dividends payable 4. Sundry debtors or Accounts receivable 5. Bank overdraft 5. Short-term debtors or accounts receivable 6. Short-term loans 6. Temporary or marketable advances & deposits investments 7. Provision against current 7. Inventories or stocks such assets as (a) Raw materials (b) Work-in-process Stores and spares (d) Finished goods 8. Provision for taxation, if it 8. Prepaid expenses does not amount to appropriation of profits 9. Proposed dividend (May 9. Accured incomes be a current or a Noncurrent liability)
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List of Non-Current or working capital accounts Non-Current or permanent Non-current or permanent liabilities assets 1. Equity share capital 1. Goodwill 2. Preference share capital 2. Land 3. Redeemable preference 3. Building share capital 4. Debentures 4. Plant and machinery 5. Long-term loans 5. Furniture and fittings 6. Share Forfeited Account 6. Trade marks 7. Share forfeited account 7. Patent rights 8. Profit and loss account 8. Long-term investment (balance of profit, i.e., credit balance) 9. Capital reserve 9. Debit balance of profit and loss account 10. Capital redemption 10. Discount on issue of reserve shares 11. Provision for 11. Discount on issue of depreciation against fixed debentures assets 12. Appropriation of profits 12. Preliminary expenses a) General reserve 13. Other deferred expense b) Dividend equalization fund c) Insurance fund d) Compensation fund e) Sinking fund f) Investment fluctuation fund g) Provision for taxation
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h) Proposed dividend Meaning and definitions of funds flow statement Foulke defines this statement as : A statement of sources and application of funds is a technical device designed to analyze the changes in the financial condition of a business enterprise between two dates. Difference between funds flow statement and income statement Funds flow statement 1. It highlights the changes in the financial position of a business and indicates the various means by which funds were obtained during a particular period and the ways to which these funds were employed. 2. It is complementary to income statement. Income statement helps the preparation of funds flow statement. 3. While preparing funds flow statement both capital and revenue items are considered. 4. There is no prescribed format for preparing a funds flow statement. Income statement 1. It does not reveal the inflow and outflows of funds but depicts the item of expenses and income arrive at the figure of profit or loss. 2. Income statement is not prepared from funds flow statement. 3. Only revenue items are considered. 4. It is prepared prescribed format. in a
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Difference between funds flow statement and balance sheet Funds flow statement 1. It is a statement of changes in financial position and hence is dynamic in nature. 2. It shows the sources and uses of funds in a particular period of time. 3. It is a tool of management for financial analysis and helps in making decisions. 4. Usually, schedule of changes in working capital has to be prepared before preparing fund flow statement. Balance sheet 1. It is a statement of financial position on a particular date and hence is static in nature. 2. It depicts the assets and liabilities at a particular point of time. 3. It is not of much help to management in making decisions. 4. No such schedule of changes in working capital required. Rather profit and loss accounts is prepared
Limitations of funds flow statement The funds flow statement has a number of uses, however, it has certain limitations also, which are listed below : 1. It should be remembered that a funds flow statement is not a substitute of an income statement or a balance sheet. It provides only some additional information as regard changes in working capital. 2. It cannot reveal continuous changes. 3. It is not an original statement but simply arearrangement of data given in the financial statements.
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4. It is essentially historic in nature and projected funds flow statement cannot be prepared with much accuracy. 5. Changes in cash are more important and revelant for financial management than the working capital.
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Module:-3 Procedure for preparing a funds flow statement Cash flow statement Cash plays a very important role in the entire economic life of a business. A firm needs cash to make payments to its suppliers, to incur day-to-day expenses and to pay salaries, wages, interest and dividend, etc. In fact, what blood is to a human body, cash is to a business enterprise. It is very essential for a business to maintain an adequate balance of cash. But many a times, a concern operates profitably and yet it becomes very difficult to pay taxes and dividend. This may be because (i) although huge profits have been earned yet cash may not have been received or (ii) even if cash has been received, it may have drained out (used) for some other purposes. This movement of cash is of vital importance to the management. Although the funds flow statement provided useful information, it suffered from the following limitations: 1. The accounting standard (A S-3) allowed considered flexibility regarding the meaning of the term funds. As a result, some firms prepared this statement on working capital basis, whereas others prepared it on cash basis. However, in general, this statement was prepared on working capital basis. Working capital includes items, like inventories and prepaid expenses which are not easily convertible into cash within a short period and which do not contribute to the ability of a firm to pay its short term obligations as and when they become due.
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2. A S-3 did not provide any standard format for the preparation of funds flow statement. As such firms adopted different methods for preparing the statement making comparisons difficult. 3. The funds statement, even when prepared on cash basis did not disclose cash flows from operating investing and financing activities separately. It merely provided information regarding inflows and outflows of funds. In June 1995, the securities and exchange board of India (SEBI) amended clause 32 of the listing agreement requiring every listed company to give along with the balance sheet and profit and loss account, a cash flow statement prepared in the prescribed format, showing separately cash flows from operating activities investing activities and financing activities. Recognizing the importance of cash flow statements, the Institute of Chartered Accountants of India (ICAI) issued. A S-3 Revised: Cash flow statements in March, 1997. The revised accounting standard supersedes A S-3 changes in financial position, issued in June 1981. The objectives of the cash flow statement as given in A S-3 (Revised) are as under : Information about the cash flow of an enterprise is useful in providing users of financial statement with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprises to utilize those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an enterprise to
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generate cash and cash equivalents and the timing and certainty of their generations. The statement deals with the provision of information about the historical changes in cash and cash from operating, investing and financing activities. Meaning According to AS-3 (Revised), an enterprise should prepare a cash flow statement and should present it for each period for which financial statements are prepared. The term cash, cash equivalents and cash flows are used in this statement with the following meanings: 1. Cash comprises cash on hand and demand deposits with banks. 2. Cash equivalents are short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. Cash equivalent are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. 3. Cash flow are inflows and outflows of cash and cash equivalents. Flow of cash is said to have taken place when any transaction makes changes in the amount of cash and cash equivalents available before happening of the transaction, if the effect of transaction results in the increase of cash and its equivalents, it is called an inflow (source) and if it results in the decrease of total cash, it is known as outflow (use) of cash.
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Classification of cash flows 1. Cash flows from operating activities. 2. Cash flows from investing activities. 3. Cash flows from financing activities. Treatment of some Typical items A S-3 (Revised) has also provided for the treatment of cash flows from some peculiar items as discussed below: 1. Extraordinary Items: The cash flows associated with extraordinary items should be classified as arising from operating, investing or financing activities as appropriate and separately disclosed in the cash flow statement to enable users to understand their nature and effect on the present and future cash flow of the enterprise. 2. Interest and Dividends: Cash flows from interest and dividends received and paid should be disclosed separately. Further, the total amount of interest paid during the period should be disclosed in the cash flow statement whether it has been recognized as an expense in the statement of profit and loss or capitalized. The treatment of interest and dividends received and paid depends upon the nature of the enterprise. For this purpose, the enterprises are classified as (i) financial enterprises and (ii) other enterprises. i) Financial Enterprises. In the case of other enterprises, cash flows arising from interest paid and interest and dividend received should be classified as cash flows arising from operating activities.
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ii) Other Enterprises. In the case of other enterprises, cash flows arising from interest paid should be classified as cash flows from financing activities while interest and dividends received should be classified cash flows from investing activities. Dividends paid should be classified as cash flows from financing activities. 3. Taxes on Income: Cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. Taxes on income arise on transactions that give rise to cash flows that are classified as operating, investing or financing activities in a cash flow statement. While tax expense may be readily identifiable with investing or financing activities, the related tax cash flows are often impracticable to identify and may arise in a different period from the cash flows of the underlying transactions. Therefore, taxes paid are usually classified as cash flows from operating activities. However, when it is practicable to identify the tax cash flow with an individual transaction that gives rise to cash flows that are classified as investing or financing activities, the tax cash flow is classified as an investing or financing activity as appropriate. When tax cash flow are allocated over more than one class of activity, the total amount of taxes paid is disclosed. 4. Acquisitions and Disposal of Subsidiaries and other Business Units : The aggregate cash flows arising from acquisitions and from disposals of subsidiaries or other business units should be presented separately and classified
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as investing activities. An enterprise should disclose, in aggregate, in respect of both acquisition and disposal of subsidiaries or other business units during the period each of the following: a) The total purchase or disposal consideration; and b) The portion of the purchase or disposal consideration discharged by means of cash and cash equivalents. The separate presentation of the cash flow effects of acquisitions and disposals of subsidiaries and other business units as single line items helps to distinguish those cash flows from other cash flows. The cash flow effects of disposal are not deducted from those of acquisitions. 5. Foreign Currency Cash Flow: Cash flows arising from transactions in a Foreign currency should be recorded in an enterprises reporting currency by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the cash flow. A rate that approximates the actual rate may be used if the result is substantially the same as would arise if the rates at the dates of the cash flows were used. The effect of changes in exchange rates on cash and cash equivalents held in a foreign currency should be reported as a separate part of the reconciliation of the changes in cash and cash equivalents during the period. Unrealized gains and losses arising from changes in foreign exchange rates are not cash flows. However, the effect of exchange rate changes on cash and cash equivalents held or due in a foreign currency is reported in the cash flow statement in order to reconcile cash and cash equivalents at the beginning and the end of the period. This amount is
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presented separately from cash flows from operating, investing and financing activities and includes the difference, if any, had those cash flows been reported at the end of period exchange rates. 6. Non-Cash Transactions: Many investing and financing activities do not have a direct impact on current cash flows although they do affect the capital and asset structure of an enterprise. Examples of non-cash transactions are: a) The acquisitions of assets by assuming directly related activities. b) The acquisitions of an enterprise by means of issue of shares; and c) The conversation of debt to equity. Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a cash flow statements. Such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.
Format of cash flow statement A S-3 (Revised) has not provided any specific format for preparing a cash flow statement. However, an idea of the suggested format can be inferred from the illustrations appearing in the appendices to the accounting standard. The cash flow statement should report cash flows during the period classified by operating, investing and financing activities.
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Difference between Funds flow statement and Cash flow statement Basis of Funds flow Cash flow Difference statement statement 1. Basic of It is based on a It is based on a Concept wider concept of narrower concept of funds, i.e., working funds i.e., cash capital 2. Basic of It is based on It is based on cash Accounting accrual basis of basis of accounting accounting 3. Schedule of Schedule of No such schedule of changes in changes in working changes in working working capital capital is prepared capital is prepared to show the changes in current assets and current liabilities 4. Method of Fund flow It is prepared by preparing statement reveals classifying all cash the sources and inflows and outflows applications of in terms of funds. The net operating, investing difference between and financing sources and activities. The net applications of difference funds represents represents the net net increase or increase or decrease in decrease in cash working capital and cash equivalents. 5. Basis of It is useful in It is more useful for usefulness planning short-term analysis
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intermediate and and cash planning of long term financing the business
Uses and significance of cash flow statement Cash flow statement is of vital importance to the financial management. It is an essential tool of financial analysis for short-term planning. The chief advantages of cash flow statement are as follows: 1. Since a cash flow statement is based on the cash basis of accounting, it is very useful in the evaluation of cash position of a firm. 2. A project cash flow statement can be prepared in order to know the future cash position of a concern so as to enable a firm to plan and coordinate its financial operations properly. By preparing this statement, a firm can come to know as to how much cash will be generated into the firm and how much cash will be needed to make various payments and hence the firm can well plan to arrange for the future requirements of cash. 3. A comparison of the historical and projected cash flow statements can be made so as to find the variations and deficiency or otherwise in the performance so as to enable the firm to take immediate and effective action. 4. A series of intra-firm and inter-firm cash flow statements reveals whether the firms liquidity (short-term paying capacity) is improving or deteriorating over a period of
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time and in comparison to other firms over a given period of time. 5. Cash flow statement helps in planning the repayment of loans, replacement of fixed assets and other similar long-term planning of cash. It is also significant for capital budgeting decisions. 6. it better explains the causes for poor cash position in spite of substantial profits in a firm by throwing light on various applications of cash made by the firm. It further helps in answering some intricate questions like-what happened to the net profits? Where did the profits go? Why more dividends could not be paid in spite of sufficient available profit? 7. Cash flow analysis is more useful and appropriate than funds flow analysis for short-term financial analysis as in a very short period it is cash which is more relevant then the working capital for forecasting the ability of the firm to meet its immediate obligations. 8. Cash flow statement prepared according to AS-3 (Revised) is more suitable for making comparison than the funds flow statement as there is no standard format used for the same. 9. Cash flow statement provides information of all activities classified under operating, investing and financing activities. The funds statement even when prepared on cash basis, did not disclose cash flows from such activities separately. Thus, cash flow statement is more useful than the funds statement.
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Limitations of cash flow statement Despite a number of uses cash flow statements suffers from the following limitations: i) ii) iii) As cash flow statement is based on cash basis of accounting, it ignores the basic accounting concept of accrual basis. Some people feel that as working capital is a wider concept of funds, a funds flow statement provides a more complete picture than cash flow statement. Cash flow statement is not suitable for judging the profitability of a firm as non-cash charges are ignored while calculating cash flows from operating activities.
Procedure for preparing a cash flow statement (Modern approach) 1. Compute the net increase or decrease in cash and cash equivalents by making comparison of these accounts given in the comparative balance sheets. 2. Calculate the net cash flow provided (used in) operating activities by analyzing the profit and loss account, balance sheet and additional information. There are two methods of converting net income into net cash flows from operating activities : the direct method and the indirect method. These methods have been discussed separately in this chapter. 3. Calculate the net cash flow from investing activities. 4. Calculate the net cash flow from financing activities,
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5. Prepare a formal cash flow statement highlighting the net cash flow from (used in) operating investing and financing activities separately. 6. Make an aggregate of net cash flows from the three activities and ensure that the total net cash flow is equal to the net increase or decrease in cash and cash equivalent as calculated in Step 1. 7. Report significant non-cash transactions that did not involve cash or cash equivalents in a separate schedule to the cash flow statement e.g., purchase of machinery against issue of share capital redemption of debentures in exchange for share capital. Methods of calculating cash flows from (used in) operating activities The Direct Method : Under the direct method, cash receipts (inflows) from operating revenues and cash payments (outflows) for operating expenses are calculated to arrive at cash flows from operating activities. The difference between the cash receipts and cash payments is the net cash flow provided by (or used in) operating activities. The direct Method: Under the indirect method, the net cash flow from operating activities is determined by adjusting net profit or loss for the effect of : a) Non-cash items as depreciation, provisions, deferred taxes, and unrealized foreign exchange gains and losses and b) Changes during the period in inventories and operating receivables and payable.
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c) All other items for which the cash effects are investing or financing cash flows.
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Module:- 4 Ratio Analysis Meaning of Ratio A ratio is a simple arithmetical expression of the relationship of one another. It may be defined as the indicated quotient of two mathematical expressions. According to Accountants Handbook by Wixon, Kell and Bedford, a ratio is an expression of the quantitative relationship between two numbers. According to Kohler, a ratio is the relation, of the amount, a, to another b, expressed as the ratio of a to b: a : b (a is to b) : or as a simple fraction, integer, decimal fraction or percentage. In simple language ratio is one number expressed in terms of another and can be worked out by dividing one number into the other. For example, if the current assets of a firm on a given date are 5,00,000 and the current liabilities are Rs. 2,50,000, then the ratio of current assets of a firm on a given date are 5,00,000 and the current liabilities are Rs. 2,50,000, then the ratio of current assets to current liabilities will work out to be 5,00,000 or 2 ----------2,50,000 Thus the ratio of two figures 200 and 100 may be expressed in any of the following ways: a) 2:1 b) 2 C) 2/1 d) 2 to 1 e) 200%
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Nature of Ratio Analysis Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis not an end in itself. It is only a means of better understanding of financial strengths and weaknesses of a firm. Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are analysed and interpreted. There are number of ratios which can be calculated from the information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objective of analysis. The ratios may be used as a symptom like blood pressure the pulse rate or the body temperature and their interpretation depends upon the caliber and competence of the analyst. The following are the four steps involved in the ratio analysis : i) Selection of relevant data from the financial statements depending upon the objective of the analysis. ii) Calculation of appropriate ratios from the above data. iii) Comparison of the calculated ratios with the ratios of the same firm in the past, or the ratios developed from projected financial statements or the ratios of some other firms or the comparison with ratios of the industry to which the firm belongs. iv) Interpretation of the ratios.
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Interpretation of the ratios 1. Single absolute ratio 2. Group of ratios 3. Historical comparison 4. Projected ratios 5. Inter-firm comparison Guidelines or precautions for use of ratios 1. Accuracy of financial statements 2. Objective or purpose of analysis 3. Selection of ratios 4. Use of standards 5. Calibre of the analyst 6. Ratios provide only a base Use and significance of ratio analysis a) Managerial uses of ratio analysis b) Utility to shareholders/investors c) Utility to creditors d) Utility to employees e) Utility to government f) Tax audit requirements Limitations of ratio analysis 1. Limited use of a single ratio 2. Lack of adequate standards 3. Inherent limitations of accounting 4. Change of accounting procedure 5. Window dressing
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6. Personal bias 7. Uncomparable 8. Absolute figures distortive 9. Price level changes 10. Ratios no substitutes Classification of ratios Traditional classification or statement ratios Traditional classification or classification according to the statement from which these ratios are calculated is as follows: Functional classification or classification according to tests In view of the financial management or according to the tests satisfied, various ratios have been classified as below: a) Liquidity ratios: These are the ratios which measure the short-term solvency or financial position of a firm. These ratios are calculated to comment upon the short-term paying capacity of a concern or the firms ability to meet its current obligations. The various liquidity ratios are : current ratio, liquid ratio and absolute liquid ratio. Further to see the efficiency with which the liquid resources have been employed by a firm, debtors turnover and creditors turnover ratios are calculated. b) Long-term solvency and leverage ratios: Long term solvency ratios convey a firms ability to meet the interest costs and repayments schedules of its long-term obligations
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e.g. Debt Equity Ratio and Interest Coverage Ratio. Leverage Ratios. Du-point control chart A system of management control designed by an American company named Du-point company is popularly called Dupoint control chart. This system uses the ratio interrelationship to provide charts for managerial attention. The standard ratios of the company are compared to present ratios and changes in performance are judged. The chart is based on two elements i.e., Net profit and capital employed. Net profit is related to operating expenses. If the expenses are under control then profit margin will increase. The earnings as a percentage of sales from sales. Cost of sales includes cost of goods sold plus office and administrative expenses and selling and distributive expenses. Capital employed, on the other hand, consists of current assets and net fixed assets. Current assets include debtors, stock, bills receivables, cash etc. fixed assets are taken after deducting depreciation. So profit margin is divided by capital employed and is multiplied by 100. The ratio will be
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Module:-5 Meaning of a Budget A budget is the monetary or/and quantitative expressions of business plans and policies to be pursued in the future period of time. The term budgeting is used for preparing budgets and other procedures for planning co-ordination and control of business enterprise. According to CIMA, Official Terminology, A budget is a financial and/or quantitative statement prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. In the words of Crown and Howard, A budget is a pre-determined statement of management policy during a given period which provides a standard for comparison with the results actually achieved. Meaning and nature of budgetary control According to Brown and Howard, Budgetary control is a system of controlling costs which includes the preparation of budgets, co-ordinating the department and establishing responsibilities, comparing actual performance with the budgeted and acting upon results to achieve maximum profitability. Weldon characterizes budgetary control as planning in advance of the various functions of a business so that the business as a whole is controlled. Budget, Budgeting and Budgetary control A budget is a blue print of a plan expressed in quantitative terms. Budgeting is technique for formulating budgets. Budgetary control, on the other hand, refers to the principles,
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procedures and practices of achieving given objectives through budgets. Rowland and William have differentiated the three terms as: Budgets are the individual objectives of a department, etc., whereas Budgeting may be said to be the act of building budgets. Budgetary control embraces all and in addition includes the science of planning the budgets to effect an overall management tool for the business planning and control. Objectives of budgetary control Budgetary control is essential for policy planning and control. It also acts as an instrument of co-ordination. The main objectives of budgetary control are as follows : 1. To ensure planning for future by setting up various budgets. The requirements and expected performance of the enterprise are anticipated. 2. To co-ordinate the activities of different departments. 3. To operate various cost centers and departments with efficiency and economy. 4. Elimination of wastes and increase in profitability. 5. To anticipate capital expenditures for future. 6. To centralize the control system. 7. Correction of deviations from the established standards. 8. Fixation of responsibility of various individuals in the organization. Characteristics of good budgeting 1. A good budgeting system should involve persons at different levels while preparing the budgets. The subordinates should not feel any imposition on them.
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2. There should be a proper fixation of authority and responsibility. The delegation of authority should be done in a proper way. 3. The targets of the budget should be realistic, if the targets are difficult to be achieved then they will not enthuse the persons concerned. 4. A good system of accounting is also essential to make the budgeting successful. 5. The budgeting system should have a whole-hearted support of the top management. 6. The employees should be imparted budgeting education. There should be meetings and discussions and the targets should be explained to the employees concerned. 7. A proper reporting system should be introduced, the actual results should be promptly reported so that performance appraisal is undertaken. Requisites for successful budgetary control system For making a budgetary control system successful, following requisites are required: 1. Clarifying objectives: 2. Proper delegation of authority and responsibility: 3. Proper communication system: 4. Budget education: 5. Participation of all employees: 6. Flexibility: 7. Motivation: Essentials of budgetary control 1. 2.
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Organization of budgetary control Budget centers

3. 4. 5. 6. 7.
Budget officer Budget manual Budget committee Budget period Determination of key factor
Organization for budgetary control : Budgetary Vs. Forecasting Forecasting may be needed for future planning or budgeting but it cannot be confused with the later. Forecasts are only will-educated guesses or inferences as to what the future may be. The management has to make predictions while preparing plans for the future. According to Henry Fayol, father of modern management, the entire plan is made up of series of separate plans called forecasts. Forecasting provides a logical basis for preparing the plans/budgets. The actual performance of the past, the present situation and likely trends in the future are considered while preparing budgets. A budget is the monetary or/and quantitative expression of business plans and policies to be pursued in the future period of time. The difference between budgeting and forecasting can be summarized as below: 1. Forecasts are merely well-educated estimates or inferences about the future probable events whereas a budget relates to planned events and is the quantitative expression of business plans and policies to be pursued in the future. 2. Budgeting begins where forecasting ends. In fact, forecasting provides the logical basis for preparing the budgets.
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3. A budget provides a standard for comparison with the results actually achieved and thus is an important control device for the management, while a forecast represents merely a probable event over which no control can be exercised. Advantages of budgetary control 1. Maximization of profit 2. Co-ordination 3. Specific aims 4. Tool for measuring performance 5. Economy 6. Determining weakness 7. Corrective action 8. Consciousness 9. Reduces costs 10. Introduction of incentive schemes Budgetary control Advantages Limitations 1. Maximization of profits 1. Uncertain future 2. Proper co-ordination 2. Revision required 3. Provides specific aims 3. Discourages efficient persons 4. Tool for measuring 4. Problem of co-ordination performance 5. Economy 5. Conflict among different departments 6. Corrective action 6. Depends upon support of top management 7. Creates budget consciousness
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8. Reduced costs 9. Determine weakness 10. Introduction of incentive schemes Limitations of budgetary control 1. Uncertain future 2. Budgetary revisions required 3. Discourages efficient persons 4. Problem of co-ordination 5. Conflict among different departments 6. Depends upon support of top management Classification and types of budgets The budget are usually classified according to their nature. The following are the types of budgets which are commonly used : A) Classification according to time 1. Long-term budgets 2. Short-term budgets 3. Current budgets B) Classification on the basis of functions 1. Operating budgets 2. Financial budgets 3. Master budget C) Classification on the basis of flexibility 1. Fixed budget 2. Flexible budget Difference between a fixed and flexible budget 1. Rigidity A fixed budget remains A flexible budget is recast
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the same irrespective of changed situations. It remains inflexible even if volume of business is changed. 2. Conditions A fixed budget assumes the conditions will remain constant. 3. Cost In fixed budgets costs classification are not classified according to their nature. 4.Change in If the level of activity volume changes then budgeted and actual results cannot be compared because of change in basis. 5. Forecasting Forecasting of accurate results in difficult.
to suit the changed circumstances. Suitable adjustments are made if the situation so demands. This budget is changed if level of activity varies. The costs are studied as per the nature i.e., fixed variable semi-variable.
The budgets are redrafted as per the changed volume and a comparison between budgeted and actual figures will be possible. Flexible budgets clearly show the impact of expenses on operations and it helps in making accurate forecasts. 6. Cost Under changed The costs can be easily Ascertainment circumstances cost ascertained under cannot be ascertained. different levels of activity. This helps in fixing prices.
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Module:-6 costing
Definitions of marginal cost and marginal
According to the terminology of cost accountancy of the institute of cost and management accountants, London, Marginal Cost represents the amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit. In practice, this is measured by the total variable costs attributable to one unit. In this context, a unit may be a single article, a batch of articles, an order, a stage of production capacity, a manhour, a process or a department. It relates to the change in output in the particular circumstances under consideration. In the words of Blocker and Weltmore, Marginal cost is the increase or decrease in total cost which results from producing or selling additional or fewer units of a product or from a change in the method of production or distribution such as the use of improved machinery, addition or exclusion of a product or territory, or selection of an additional sales channel. Marginal costing The institute of cost and management accountants, London, has defined Marginal costing as the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. In this technique of costing only variable costs are charged to operations, processes or products, leaving all indirect costs to be written off against profits in the period in which they arise. Basic characteristics of marginal costing
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The technique of marginal costing is based on the distinction between product costs and period costs. Only the variable costs are regarded as the costs of the products while the fixed costs are treated as period costs which will be incurred during the period regardless of the volume of the output. The main characteristics of marginal costing are as follows : 1. It is a technique of analysis and presentation of costs which help management in taking many managerial decisions and is not an independent system of costing such as process costing or job costing. 2. All elements of cost-production, administration and selling and distribution are classified into variable and fixed components. Even semi-variable costs are analysed into fixed and variable. 3. The variable costs (marginal costs) are regulated as the cost of the products. 4. Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are incurred. 5. The stocks of finished goods and work-in-process are valued at marginal costs only. 6. Prices are determined on the basis of marginal cost by adding contribution which is the excess of sales or selling price over marginal cost of sales.
Assumption of marginal costing

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The technique of marginal costing is based upon the following assumptions: 1. All elements of cost-production, administration and selling and distribution-can be segregated into fixed and variable components. 2. Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly in proportion to changes in the volume of output. 3. The selling price per unit remains unchanged or constant at all levels of activity. 4. Fixed costs remain unchanged or constant for the entire volume of production. 5. The volume of production or output is the only factor which influence the costs. Marginal costing Vs. direct/differential/variable costing The term marginal costing is also referred to as variable costing, direct costing, differential costing or incremental costing. However, these items are not exactly the same in all respects. For example, the use of the term direct costing is not appropriate since the emphasis of marginal costing is on variable and fixed costs and not on direct and indirect costs as is the case in direct costing. Further more, all direct costs in place of marginal costing is inaccurate. Similarly marginal costing is not exactly the same as differential or incremental costing in spite of the fact that both are the techniques of cost analysis and cost presentation and both the techniques are used by management for decision making and policy formulation. Differential costs are the increase or decrease in total cost that result from producing additional or fewer units or from the adoption of an alternative course of action. Thus,
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differential costing takes into account changes in fixed cost also due to change in the output while fixed costs are excluded from marginal costs. In fact, differential cost and marginal cost are the same when fixed costs do not change with change in output. We have discussed differential costing in detail in the next chapter of this book. Thus, the use of the term variable costing seems to be more appropriate and acceptable. Marginal costing Vs. absorption costing or full costing The basic differences between Absorption costing and marginal costing are as follows: 1. Absorption costing is the total cost technique. According to the terminology of cost accountancy, absorption costing is the practice of charging all costs, both variable and fixed, to operations, processes, or products. Thus, under absorption costing all costs whether variable or fixed are treated as product costs even though fixed cost are period costs and have no relevance to current operations. In marginal costing technique only variable costs are treated as product cost, fixed cost is treated as period cost and is charged to profit and loss account for that period. 2. Absorption costing differs from marginal costing from the point of view of inventory valuation also. In absorption costing, the stock of finished goods and work-in-process is valued at marginal cost, includes both variable and fixed cost. In marginal costing, such stocks are valued at marginal cost, i.e., variable cost only. Hence, it results in higher valuation of inventories in absorption costing as compared to marginal costing.
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3. In absorption costing arbitrary appointment of fixed costs, over the products, results in under or over-absorption of such costs. While marginal costing excludes fixed costs and the question of under or over absorption of fixed costs does not arise. 4. In absorption costing, managerial decision-making is based upon profit which is the excess of sales value over the total cost. While in marginal costing, the managerial decisions are guided by contribution which is the excess of sales value over variable cost. Income determination under absorption and marginal costing Diagram 6.4 Contribution Contribution is the difference between sales and variable cost or marginal cost of sales. It may also be defined as the excess of selling price over variable cost per unit. Contribution is also known as contribution margin or gross margin. Contribution being the excess of sales over variable cost is the amount that is contributed towards fixed expenses and profit. Marginal cost equation For the sake of convenience, a marginal cost equation can be derived as follows: Sales variable cost = contribution Or, Sales = variable cost + contribution Or, Sales = variable cost + fixed cost + profit/loss
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Or, Sales variable cost = fixed cost + profit/loss Or, S-V=F+P Where, S stands for sales V stands for fixed cost F stands for fixed cost P stands for profit/loss the marginal cost equation is very useful in the sense that if any three factors out of the four are known, the fourth can easily be found out. Graphic method of break-even analysis or break-even chart The break-even point can also be computed graphically. A break-even chart is a graphical representation of marginal costing. The break-even chart Portrays a pictorial view of the relationships between costs, volume and profits. It shows the break-even point and also indicates the estimated profit or loss at various levels of output. The break-even point as indicated in the chart is the point at which the total cost line and the total sales line intersect. There are three methods of drawing a break-even chart. These methods of drawing break-even chart have been explained with the help to the following illustration. First method Under this method following steps are taken to draw the break-even chart: 1. Volume of production/output or sales is plotted on horizontal axis, i.e., X-axis. The volume of sales or production may be expressed in terms of rupees, units or as a percentage of capacity.
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2. Costs and sales revenue are represented on vertical axis, i.e., Y-axis. 3. Fixed cost line is drawn parallel to X-axis. The line indicates that fixed expenses remain constant at all levels of activity. 4. The variable costs for different levels of activity are plotted over-the fixed cost line. The variable cost line is joined to fixed cost line at zero level of activity. As the variable cost line is drawn above the fixed cost line, it represents the total cost at various levels of output/sales. 5. Sales values at various levels of output are plotted and a line is drawn joining these plotted points. This line is called the sales (revenue) line. 6. The point of intersection of total cost line and sales (revenue) line is called the break-even point. 7. The number of units to be produced at break-even point can be determined by drawing a perpendicular to the X-axis from the point of intersection of cost and sales line. 8. The sales revenue at break-even point can be determined by drawing a perpendicular to the X-axis from the point of inter-section of cost and sales line. 9. The area below the break-even point represents the loss area as the total sales and less than the total cost and the area above the break-even point indicates the area of profit as the sales revenue exceeds the total cost.
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Second method The break-even chart also be drawn by another method which is a variation of the first method. Under this method, the variable cost line is drawn first and then fixed cost line is drawn over and parallel to the variable cost line. The fixed cost line, so drawn, represents the total cost (variable+fixed) at various levels of output because it is drawn above the variable cost line. This method is useful to the management for decision making because it reveals additional information. a) The variable costs are shown directly for various levels of output/sales. b) Marginal contribution at various levels of sales is indicated clearly by the difference between sales line and variable cost line. c) It indicates the recovery of fixed costs at various levels of production. Diagram 6.21 A small variation of this method is that of showing the various elements of fixed and variable costs, for example, major cost elements such as direct material cost, labor cost, variable factory overhead cost, variable selling overhead and fixed costs. Third method contribution break-even chart This is a modified form of a simple break-even chart as shown in the first-two methods above. Under this method
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total cost line is not drawn, rather another line called contribution line is drawn from the origin and this line goes up with the increase in the level of output. The fixed cost line is drawn parallel to the X-axis as in the first method. The sales line is also drawn as usual. In this method, the question of intersection of sales line with the total cost line does not arise because there is no cost line. The break-even point is that point where the contribution line crosses the fixed cost line. At this point total contribution is equal to the total fixed cost and hence there is no profit or loss. As the contribution decreases from the fixed cost, there shall be loss to the organization. The contribution break-even chart shows clearly contribution at different levels of activity and indicates that all levels below the break-even point are unable to cover the fixed costs. In the above examples, at level of output/sales of 25,000 units, there is a profit of Rs. 50,000 as indicated by the break-even charts under the three methods. Assumptions underlying break-even charts There are a number of assumptions which are made while drawing a break-even chart, such as: i) All costs can be separated into fixed and variable costs. ii) Fixed costs remain constant at all levels of activity. iii) Variable cost fluctuates directly in proportion to changes in the volume of output. iv) Selling prices per unit remain constant at all levels of activity. v) There is no opening or closing stock. vi) There will be no change in operating efficiency.
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vii) Product mix remains unchanged or there is only one product. viii) The volume of output or production is the only factor which influences the cost. Advantages or uses of break-even charts Computation of break-even point or presentation of cost, volume and profit relationship by way of break-even charts has the following advantages : 1. Information provided by the break-even chart is in a simple form and is clearly understandable even to a layman. The whole idea of the problem is presented at a glance. 2. The break-even chart is very useful to the management for taking managerial decisions because the chart studies the relationship of cost, volume and profit at various levels of output. The effects of changes in fixed costs and variables costs at various levels of output and that of changes in the selling price on the profits can be depicted very clearly by way of break-even charts. 3. The break-even charts help in knowing and analyzing the profitability of different products under various circumstances. 4. A break-even chart is very useful for forecasting (the costs and profits) planning and growth. 5. The break-even chart is a managerial tool for control of costs as it shows the relative importance of fixed cost in the total cost of a product.
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6. Besides determining the break-even point, profits at various levels of output can also be determined with the help of break-even charts. 7. The break-even charts can also be used to study the comparative plant efficiencies of business. Limitations of break-even charts Despite many advantages, a break-even chart suffers from the following limitations: 1. A break-even chart is based upon a number of assumptions, discussed above, which may not hold good under all circumstances. For example, fixed costs do not remain constant after a certain level of activity; variable costs do not always vary in direct proportion to changes in the volume of output because of the laws of diminishing and increasing returns; selling prices do not remain the same for ever and for all levels of output due to competition and changes in the general price level; etc. 2. A break-even chart provides only a limited information. We have to draw a number of charts to study the effects of changes in the fixed costs, variable costs and selling prices on the profitability. In such cases, it becomes rather more complicated and difficult to understand. 3. Break-even charts present only cost-volume profit relationships but ignore other important considerations such as the amount of capital investment, marketing problems and government policies, etc.
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4. A break-even chart does not suggest any action or remedies to the management as a tool of management decisions. 5. More often a break-even chart presents only a static view of the problem under consideration. Marginal of safety The excess of actual or budgeted sales over the break-even sales is known as the margin of safety. It is the difference between actual sales minus the sales at break-even point. It represents the amount by which sales revenue can fall before a loss is incurred. As at break-even point there is no profit no loss, sales beyond the break-even point represent margin of safety because any sales above the break-even point will give some profit. Thus, margin of safety = total sales-sales at break-even point. Angle of incidence The angle of incidence is the angle between the sales line and total cost line formed at the break-even point where the sales line and the total cost line intersect each other. The angle of incidence indicates the profit earning capacity of a business. A large angle of incidence indicates a high rate of profit and on the other hand, a small angle of incidence indicates a low rate of profit. Usually, the angle of incidence and margin of safety are considered together to indicate the soundness of a business. A large angle of incidence with a high margin of safety indicates the most favorable position of a business.
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Profit-volume graph Profit-volume graph is a pictorial representation of the profitvolume relationship. This graph shows profit and loss at different volumes of sales. It is said to be a simplified form of break-even chart as it clearly represents the relationship of profit to volume of sales. A profit-volume graph also called the P/V graph or profit graph can be constructed from any data relating to a business from which a break-even chart can be drawn. The profit-volume graph may be preferred to a break-even chart because profits or losses can be directly read at different levels of activity. But the basic limitation of a P/V graph is that is does not show how costs vary with the change in the level of activity. For this reason, break-even chart and profit-volume graph should be both be drawn together to derive the maximum advantage of both. The construction of a profit-volume graph involves the following steps : 1. Sales line (in volume or value) is drawn on horizontal or Xaxis. 2. Profits and losses are given on vertical or Y-axis. 3. The area above the horizontal of X-axis is called the profit area and the area below the horizontal axis is the loss area. 4. Profits and losses at different levels of activity are plotted against corresponding sales and then these points are joined and extended. This line is called profit line. In case of more than one products, a separate profit line for each product should be drawn. 5. The point where profit line intersects with the sales line is the break-even point.
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Advantages of marginal costing The following are the important advantages of marginal costing: 1. The technique of marginal costing is very simple to operate and easy to understand. Since, fixed costs are kept outside the unit cost the cost statements prepared on the basis of marginal cost are much less complicated. 2. It does away with the need for allocation, apportionment and absorption of fixed overheads and hence removes the complexities of under-absorption of overheads. 3. Marginal cost remains the same per unit of output irrespective of the level of activity. It is constant in nature and helps the management in production planning. 4. It prevents the carry forward of current years fixed overheads through valuation of closing stocks. Since fixed costs are not considered in valuation of closing stocks, there is no possibility of factitious profits by over-valuing stocks. 5. It facilitates the calculation of various important factors, viz, break-even point, expectations of profits at different levels of production, sales necessary to earn a predetermined target of profit, effect on profit due to changes of raw materials prices, increased wages, changes in sales mixture, etc. Advantages of Marginal Costing 1. Simple to operate and easy to understand 2. Removes complexities of under-absorption of overheads.
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3. Helps management in production planning. 4. No possibility of fictitious profits by over-valuing stocks. 5. Facilities calculation of important factors like B.E.P. 6. Valuable aid to management for decision-making. 7. Facilities study of relative profitability. 8. Complimentary to standard costing and budgetary control. 9. Helps in cost control. 10. Profit planning. 11. Management reporting. Limitations or disadvantages of marginal costing In spite of so many advantages, the technique of marginal costing suffers from the following limitations: 1. The technique of marginal costing is based upon a number of assumptions which may not hold good under all circumstances. 2. All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature. It is very difficult and arbitrary to classify these costs into fixed and variable elements. 3. Variable costs do not always remain constant and do not always vary in direct proportion to volume of output because of the laws of diminishing and increasing returns. 4. Selling prices do not remain constant for ever and for all levels of output due to competition, discounts for bulk orders, changes in the general price level, etc.
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5. Fixed costs do not remain constant after a certain level of activity. Further, marginal costing ignores the fact that fixed costs are also controllable. 6. The exclusion of fixed costs from the stocks of finished goods and work-in-progress is illogical since fixed costs are also incurred on the manufacture of products. Stocks valued on marginal costing are undervalued and the profit and loss account cannot reveal true profits. Similarly, as the stock are undervalued, the balance sheet does not give a true picture. 7. Although the technique of marginal costing overcomes the problem of under or over-absorption of fixed overheads, the problem still exists in regard to under or over-absorption of variable overheads. 8. Marginal costing completely ignores the time factor. Thus, if two jobs give equal contribution but one takes longer time to complete, the one which takes longer time should be regarded as costlier than the other. But this fact is ignored altogether under marginal costing. 9. The technique of marginal costing be applied in contract or ship-building industry because in such cases, normally the value of work-in-progress is very high and the exclusion of fixed overheads may result into losses every year and huge profit in the year of completion of the job. 10. Cost control can be better be achieved with the help of other techniques, viz., standard costing and budgetary control than by marginal costing technique.
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11. Fixation of selling prices in the long run cannot be done without considering fixed costs. Thus, pricing decisions cannot be based on marginal cost alone. 12. In the present days of automation, the proportion of fixed costs in relation to variable costs is very high and hence managerial decisions based upon only the marginal cost ignoring equally important element of fixed cost may be correct. Although, the technique of marginal costing suffers from the above mentioned limitations, it is a very useful tool in the hands of the management and is extensively used for cost control, decision-making and profit-planning.
ALL THE BEST FOR YOUR EXAMINATION & FUTURE. ByLAKSHMINARAYana.s

Asst Prof.(accounting & finance)
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Course outline of Mgt A/cing- Lakshminarayana.

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

1. Increases Efficiency 2. Proper Planning 3. Measurements of Performance 4. Maximizing Profitability

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Organization of budgetary control Budget centers

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Definitions of marginal cost and marginal

Course outline of Mgt A/cing- Lakshminarayana.S

Assumption of marginal costing

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S

Course outline of Mgt A/cing- Lakshminarayana.S