UNIT 1

ACCOUNTING: AN OVERVIEW

Accounting:
An Overview

Structure
1.0
1.1
1.2
1.3
1.4
1.5
1.6

Objectives
Introduction
Need for Accounting
Definition of Accounting
Objectives of Accounting
Accounting as Part of the Information System
Branches of Accounting
1.6.1
1.6.2
1.6.3

1.7
1.8
1.9
1.10

Role of Management Accountant

Financial Accounting Process
Accounting Equation
Accounting Concepts
1.10.1
1.10.2

1.11
1.12
1.13
1.14
1.15
1.16
1.17

1.0

Financial Accounting
Cost Accounting
Management Accounting

Concepts to be Observed at the Recording Stage

Concepts to be Observed at the Reporting Stage

Accounting Standards
Accounting Assumptions and Policies as per Accounting Standards of India
Let Us Sum Up
Key Words
Answers to Check Your Progress
Terminal Questions
Some Useful Books

OBJECTIVES

After studying this unit you should be able to appreciate:

l

the need for accounting;

definition of accounting and its objectives;

describe the advantages and limitations of branches of accounting;

identify the parties interested in accounting information;

activities of a management accountant;

identify the stages involved in accounting process;

explain the accounting concepts to be observed at the recording and reporting

stages; and

understand and appreciate the Generally Accepted Accounting Principles.

1.1

INTRODUCTION

In business numerous transactions take place every day. It is humanly impossible to

remember all of them. With the help of accounting records the businessman is able to
ascertain the profit or loss and the financial position of the business at a given period

Fundamentals of
Accounting

and communicate such information to all interested parties. In this unit you will learn
about an overview of accounting and the basic concepts which are to be observed at
the recording and reporting stage. You will also learn different stages involved in
accounting process and importance of accounting standards to maintain uniformity in
the practice of accounting.

1.2

NEED FOR ACCOUNTING

In early days the business organisations and transactions were small and easily
manageable by the owners of the business themselves. The businessmen used to
remember the transactions by memorizing them. In those days accounting developed
as a result of the needs of the business to keep relationship with the outsiders, listing
of their assets and liabilities. The advent of industrial revoluation and technological
changes have widened the market opportunities. Most of the business concerns in
these days are run by company type of organisation. The business concern has
constantly enter into transactions with outsiders. A transaction involves transfer of
money or moneys worth (goods or services) from one person to another. In addition
to the transactions with outsiders, there are also events requiring monetary record.
It is not possible for a human being to keep in memory all the transactions. Therefore,
it is necessary to record all these transactions properly to get required financial
information. With the help of accounting records the businessman would be able to
ascertain the profit or loss and the financial position of his business at the end of a
given period and would be able to communicate the results of business operations to
various interested parties. It is, therefore, necessary to record all the transactions
systematically from time to time irrespective of the form of business organisation.
The accounting information is useful both for the management and the outside
agencies. The management needs it for the purpose of planning , controlling and
decision making. The outsiders like banks, creditors etc. also require it for assessing
the financial solvency of the business and the tax authorities use it for determining the
amount of tax liability. Infact accounting is necessary not only for business
organisations but also for non-business organisations like schools, colleges, hospitals,
clubs etc.

1.3

DEFINITION OF ACCOUNTING

Accounting as said earlier, involves the collection, recording, classification and

presentation of financial data for the benefit of management and outside agencies such
as shareholder, creditors, investors, government and other interested parties.
Accounting has been defined in different ways by different authorities on the subject.
The following are some of the important definitions of accounting:
According to the Committee on Terminology of American Institute of Certified Public
Accountants (AICPA), Accounting is the art of recording, classifying and
summarizing in a significant manner and in terms of money, transactions and events
which are in part at least, of a financial character, and interpreting the results thereof.
Eric L. Kohlen (A Dictionary for Accountants) defines accounting as the procedure
of analysing, classifying and recording transactions in accordance with a preconceived plan for the benefit of : (a) providing a means by which an enterprise can be
conducted in orderly fashion, and (b) establishing a basis for reporting the financial
condition of enterprise and the results of its operations.

The former definition denotes that accounting is concerned with the recording of
transactions which are measurable in monetary terms in such a way that analysis and
interpretation of business activities is possible. According to the latter definition

accounting is concerned with the recording of business transactions for better

management of the concern and also reporting the true financial position of the
concern.

Accounting:
An Overview

The American Accounting Association (AAA) defines accounting as the process of

identifying, measuring and communicating economic information to permit informed
judgements and decisions by users of information.
Smith and Ashburne define accounting as the science of recording and classifying
business transactions and events, primarily of a financial character, and the art of
making significant summaries, analysis and interpretations of those transactions and
events and communicating the results to persons who must make decisions or form
judgments. Thus this definition emphasises financial reporting and decision making
aspects of accounting.
From the above definitions it is clear that accounting is a science of recording
transactions of economic nature in a systematic manner and also an art of analysing
and interpreting the same.
Based on the above definitions, we can summarise the functions of accounting as:
i)

Identifying financial transactions,

ii)

Recording of transactions which are financial in character,

iii) Classification of transactions,

iv) Summarising the transactions which also includes preparation of trail balance,
income statements and balance sheet,
v)

Interpretation of financial results, and

vi) Communicating the interpreted financial results in a proper form and manner to
the proper person.
Look at the following figure and note the functions of accounting which starts from
identifying financial transactions to be recorded in the books and ends with
communicating to the interested parties who use them for decision making.
Functions of Accounting
Recording of
Financial Transaction

Identifying financial
Transaction

Classifying the
Transaction

Interpretation of
Results

Communication
Owner or
Management

Make a Decision

Summarising
the Transactions

Interested Parties
s

Make Decision

Fundamentals of
Accounting

1.4

OBJECTIVES OF ACCOUNTING

The basic objectives of accounting is to provide necessary information to the persons

interested who will make relevant decisions and form judgement. The persons
interested in the business are classified into two types : i) Internal users, and
ii) External users. Internal users are those who manage the business. External users
are those other than the internal users such as investors, creditors, Government, etc.
Information required by the external users are provided through Profit and Loss
account and Balance sheet whereas the internal users get required information from
the records of the business. Thus the main objectives of accounting are as follows:
1) To keep systematic records of the business : Accounting keeps a systematic
record of all financial transactions like purchase and sale of goods, cash receipts
and cash payments etc. It is also used for recording all assets and liabilities of
the business. In the absence of accounting it is impossible to a human being to
keep in memory all business transactions.
2) To ascertain profit or loss of the business : By keeping a proper record of
revenues and expenses of business for a particular period, accounting helps in
ascertaining the profit or loss of the business through the preparation of profit
and loss account. Profit and Loss account helps the interested parties in
assessing the profit or loss made by the business during a particular period. It
also helps the management to take remedial action in case the business has not
proved remunerative or profitable. A proper record of all incomes and expenses
helps in preparing a profit and loss account and in ascertaining net operating
results of a business during a particular period.
3) To ascertain the financial position of business : The business man is also
interested to know the financial position of his business apart from operating
results of the business during a particular period. In other words, he wants to
know how much he owns and how much owes to others. He would also like to
know what happened to his capital, whether it has increased or decreased or
remained constant. A systematic record of assets and liabilities facilitates the
preparation of a position statement called Balance Sheet which provides
necessary information to the above questions. Balance Sheet serves as barometer
for ascertaining the financial solvency of the business.
4) To provide accounting information to interested parties : Apart from owners
there are various parties who are interested in the accounting information. These
are bankers, creditors, tax authorities, prospective investors etc. They need such
information to assess the profitability and the financial soundness of the
business. The accounting information is communicated to them in the form of an
annual report.

Parties Interested in Accounting Information

Many people are interested in examining the financial information provided in the
financial statements besides a owner or management of the concern. These financial
statements help them to know the following :
i) To study the present financial position of business,
ii) To compare its present performance with that of past years, and
iii) To compare its performance with similar enterprises.

The following are the various parties interested in the financial statements:
i) Owners/Shareholders : Shareholders are the real owners of the company
because they contribute the required capital and take the risk of business.
Obviously they are interested to know the result of operations and financial
position of the company. The shareholders are also interested to use the
accounting information to evaluate the performance of the managers because in
company type of organisation management of business is vested in the hands of
paid managers.

ii)

Prospective Investors : The persons who are interested in buying shares of a

company or who want to advance money to the company, would like to know
how safe and rewarding the investments already made or proposed investments
would be.

Accounting:
An Overview

iii) Lenders : Initially the required funds of the business are provided by the owners.
When business is going on, it requires more funds. These funds are usually
provided by banks and other money lenders. Before lending money they would
like to know about the solvency of the enterprise so as to satisfy themselves that
their money will be safe and repayments will be made on time.
iv) Creditors : The creditors are those who supply goods and services on credit.
These creditors like other money lenders are also interested to know the credit
worthiness of the business. The accounting information greatly helps them in
assessing the ability of the enterprise to what extent credit can be granted.
v)

Managers : Accounting information is very much useful to managers. It helps

them to plan, control and evaluate all business activities. They also need such
information for making various decisions relating to the business.

vi) Government : The Government may be interested in accounting information of a

business on account of taxation, labour and corporate laws. The financial
statements are of great importance for assessing the tax liability of the enterprise.
vii) Employees : The employees of the enterprise are also interested in knowing the
state of affairs of the organisation in which they are working, so as to know how
safe their interests are in the organisation. The knowledge of accounting
information helps them in conducting negotiations with the management.
viii) Researchers : The accounting information is of immense value to the
researchers undertaking research in accounting theory and practices.
ix) Citizen : An ordinary citizen as a voter and tax payer may be interested to know
the accounting information to measure the performance of Government Company
or a public utility concern like banks, gas, transport, electricity companies etc.

1.5

ACCOUNTING AS PART OF THE INFORMATION

SYSTEM

Accounting is part of an organisations information system, which includes both

financial and non-financial data. Accounting is the process of identifying, measuring
and communicating economic information to permit judgment and decisions by users
of the information. The main objective of accounting is to provide information to the
users. Accounting is also required to serve some broad social obligations since the
accounting information is used by a large body of people such as customers,
employees, investors, creditors and government.
Accounting is commonly divided into (1) Financial Accounting, and (2) Managerial
Accounting. Financial accounting refers to the preparation of general purpose reports
for use by persons outside an organisation. Such users include shareholders,
creditors, financial analysts, labour unions, government regulations etc. External
users are interested primarily in reviewing and evaluating the operations and financial
status of the business as a whole.
Managerial accounting, on the other hand, refers to providing of information to
managers inside the organisation. For example a production manager may want a
report on the number of units of product manufactured by various workers in order to
evaluate their performance. A sales manager might want a report showing the
relative profitability of two products in order to pinpoint selling efforts. The financial
reports are available from the libraries or companies themselves where as managerial

Fundamentals of
Accounting

accounting reports are not widely distributed outside because they often contain
confidential information. The following figure shows that accounting is part of an
organisation system which includes both Financial and non financial data :
Accounting as part of the information system
Accounting and Non-accounting Information

Financial Accounting

Creditors

Shareholders

Tax
Authorities

Managerial Accounting

Other
External
Users

Managerial
Decision making

Managerial Planning
Performance Evaluation

Uses of Accounting Information

Accounting provides information for the following three general uses :1)

Managerial decision making : Management is continuously confronted with the

need to make decisions. Some of these decisions may have immediate effect
while the others have in the long run. Decisions regarding the price of the
product, make or buy the product or to dropt it, to expand its area of operations
etc., are some of the examples of decisions that face management and
accounting provides necessary information to arrive at right conclusions.

2)

Managerial planning, control and internal performance evaluation :

Managerial accounting plays an important role in the planning and control. By
assisting management in the decision making process, information is provided for
establishing the standard. Accounting also provides actual results to compare
with projections.
Planning can be defined as the process of deciding how to use available
resources. The key word in this definition is deciding, because planning is
essentially a matter of choosing the set of alternatives which seem most likely to
enable the organisation to meet its objectives. Several different kinds of planning
processes can be identified, but most important is periodic planning for the
activities of the organisation as a whole.
Control is the complement of planning. It consists of managements efforts to
prevent undesirable departures from planned results and to take corrective action
in response to it.
The planning and control process consist of the following steps :
i) Setting standards as to what actual performance should be.
ii) Measuring the actual performance.
iii) Evaluating actual performance by comparing actual performance with the
standards. This evaluation aids management in assessing actions already
taken and in deciding which course of action should be taken in future.
The main relationship between planning and control is the planning produces a
plan. This becomes a set of instructions to be executed. The results of the action
taken on the basis of the plan are then compared with the planned results. The
difference of the plan are interpreted to determine what kind of response is
appropriate. A corrective response requires a change in the way of plan is
carried out, while adaptive response requires replanning. Each of these leads
back to an earlier phase of the process and the loop is completed.

1 0

For example where a marketing manger is given a target of sales revenues of

Rs. 10 crores, the amount of Rs. 10 crores will serve as a standard for evaluating

the performance of the marketing manager. If annual sales revenues vary

significantly from Rs. 10 crores, steps will be taken to ascertain the causes for
the difference. When the factors leading to the variance are not under the control
of the marketing manager, then the marketing manager would not be held
responsible for it. On the other hand the cause for variance is under the control
of marketing manager then he will be held responsible in evaluating the
performance of marketing manager.
3)

1.6

Accounting:
An Overview

External Financial reporting and performance evaluation : Accounting has

always been used to supply information to those who are interested in the affairs
of the company. Various laws have been passed under which financial
statements should be prepared in such way that required information is supplied
to shareholders, creditors, government etc. For example, the investors may be
interested in the financial strength of the business, creditors may require
information about the liquidity position, government may be interested to collect
details about sales, profit, investment, liquidity, dividend policy, prices etc. in
deciding social and economic policies. Information is required in accordance
with generally accepted accounting principles so that it is useful in taking
important decisions.

BRANCHES OF ACCOUNTING

To meet the requirements of different people interested in accounting information,

accounting can be broadly classified into three categories :
1)
2)
3)

Financial Accounting,
Cost Accounting, and
Management Accounting

1.6.1 Financial Accounting

The American Institute of Certified Public Accountants has defined Financial
Accounting as the art of recording, classifying and summarizing in a significant
manner in terms of money transactions and events which are in part at least of a
financial character, and interpreting the results thereof. Accounting is the language
effectively employed to communicate the financial information of a business unit of
various parities interested in its progress.
The object of financial accounting is to find out the profitability and to provide
information about the financial position of the concern. Two important statements of
financial accounting are Income and Expenditure Statement and Balance Sheet.
All revenue transactions relating to a particular period are recorded in this statement
to decide the profitability of the concern. The balance sheet is prepared at a particular
date to determine the financial position of the concern.

Functions of Financial Accounting

Financial accounting provides information regarding the status of the business and
results of its operations to management as well as to external parties. The following
are some of the important functions of financial accounting :
a)

Recording of Information
In business, it is not possible to keep in memory all the transactions. These
transactions need to be systematically recorded and pass through the journals,
ledgers and worksheets before they could take the form of final accounts. Only
those transactions are recorded which are measurable in terms of money. The
transactions which cannot be expressed in monetary terms does not form part of
financial accounting even though such transactions have a significant bearing on
the working of a business.

1 1

Fundamentals of
Accounting

b)

Managerial Decision Making

Financial accounting is greatly helpful for managers in taking decisions.
Without accounting, the managerial functions and decision making programmes
may mislead. The performance of daily activities are to be compared with the
predetermined standards. The variations of actual operations and their analysis
are possible only with the help of financial accounting.

c)

Interpreting Financial Information

Interpretation of financial information is very important for decision making.
The recorded financial data is interpreted in such a manner that the end users
such as creditors, investors, bankers etc., can make a meaningful judgment about
the financial position and profitability of the business operations.

d)

Communicating Results
Financial accounting is not only concerned with the recording of facts and
figures but it is also connected with the communication of results. In fact
accounting is the source of business operation. Therefore, the information
accumulated and measured should be periodically communicated to the users.
The information is communicated through statements and reports. The financial
statements and reports should be reliable and accurate. A variety of reports are
needed for internal management depending upon its requirement. In
communicating reports to outsiders, standard criteria of full disclosure,
materiality, consistency and fairness should be adhered to.

Limitations of Financial Accounting

Financial accounting was able to cope up with the needs of business in the initial
stages when business was not so complex. This is because financial accounting is
mainly concerned with the preparation of final accounts, i.e., profit and loss account
and balance sheet. But the growth and complexities of modern business have made
financial accounting highly inadequate. The management needs information for
planning, controlling and coordinating business activities.
The limitations of financial accounting are as follows :

1 2

1)

Historic nature : Financial accounting is the record of all those transactions

which have taken place in the business during a particular period. As
managements decisions relates to future course of action, they are made on the
basis of estimates and projections. Financial accounting provides information
about the past data and not about the future. It does not suggest the measures
about what should be done to improve efficiency of the business. Past data are
needed for making future decisions but that does not alone sufficient.

2)

It records only actual costs : Financial accounting has always been concerned
with figures treating them as single, simple and silent items because it records
only actual cost figures. The price of goods and assets changes frequently. The
current prices may be different from recorded costs. Financial accounts do not
record these price fluctuations. Therefore, the recorded information may not give
correct information.

3)

It provides quantitative information : Financial accounting considers only

those factors which are quantitatively expressed. Anything which cannot be
measured quantitatively will not constitute a part of financial accounting. Today
business decisions are influenced by a number of social considerations.
Governments polices have a direct bearing on the working of business.
Therefore, in addition to social consideration the management has also to take
into account, the impact of government policies on the business. But these
factors cannot be measured quantitatively so their impact will not reflect in
financial statement.

4)

It provides information about the whole concern : Financial accounting

provides information about the concern as a whole. It discloses only net results
of the collective activities of a business. Detailed information regarding productwise, process-wise, department wise, etc. is not recorded in financial accounts.
Thus, product wise or job wise cost of production cannot be determined. It is
essential to record the transactions activity wise for cost determination and cost
control purpose.

5)

Difficulty in price fixation : The cost of the product can be obtained only when
all expenses have been incurred. It is not possible to determine the prices in
advance. Price fixation requires detailed information about variable and fixed
costs, direct and indirect costs. Financial accounting cannot supply such
information and therefore, it is difficult to quote the prices during the periods of
inflation or depression in trade.

6)

Appraisal of policies is not possible : Financial accounting do not provide data

for evaluation of business policies and plans. There is no technique for
comparing actual performance with the budgeted targets. Financial accounting
do not provide any measure to judge the efficiency of a business. The only
criteria for determining efficiency is the profit at the end of financial period.
Therefore, the only yardstick for measuring the managerial performance is profit
and loss account which is not a reliable test for ascertaining efficiency of the
management.

7)

It is not helpful in Decision Making : Financial accounting do not help the

management in taking strategic decisions because they do not provide adequate
information to compare the probable effect of alternative courses of action such
as replacement of labour by machinery, introduction of new product line,
expansion of capacity etc. The impact of these decisions and cost involved is to
be ascertained in advance. Due to historic nature of accounting data available
from financial accounts, it is not of much helpful to the management.

8)

Lack of uniformity in accounting principles : Accounting policies differ on

the use of accounting principles. There is lack of unanimity on the use of
accounting principles and procedures. The financial statements prepared by two
different persons of the same concern gives different results due to varying
personal judgment in applying a particular convention. The methods of valuing
inventory, methods of depreciation, allocation of expenses between revenue and
capital etc. are the most controversial issues on which unanimity is not possible.
The use of different accounting methods reduces the usefulness and reliability of
financial accounting.

9)

It is not possible to control costs : Another limitation of financial accounting is

that the cost figures are known only at the end of financial period. When the cost
has already been incurred then nothing can be done to control the cost. A
constant review of actual costs from time to time is required for cost control and
this is not possible in financial accounting.

Accounting:
An Overview

10) Possibility of manipulation of accounts : The over and under valuation of

inventory may affect the profit figures. The profit may be shown more or less to
get more remuneration, to pay more dividend or to raise the share prices, or to
save taxes or not to pay bonus to workers, etc. The possibility of manipulating
financial accounts reduces their reliability.
11) Technological revolution : With the advancement in science and technology very
minute and detailed break-up of all types of data relating to various parts of a
business unit have become a must for the management of its day to day
functioning. It is clear that financial accounting with its simple structure is not
in a position to cater the needs of the management because it supplies only
elementary information.

1 3

Fundamentals of
Accounting

The limitations of financial accounting have given scope for the development of
Costing and Management accounting.

1.6.2 Cost Accounting

Cost accounting is one of the important elements of accounting information about the
problems of internal managerial control. Financial accounts are unable to meet
information needs about the cost structure of a product. The need for cost
determination and controls necessitated new set of principles of accounting and thus
emerged Cost accounting as a specialised branch of accounting. Cost accounting is
the process of accounting for costs. It includes the accounting procedures relating to
recording of all income and expenditure and preparation of periodical statements and
report with the object of ascertaining and controlling costs. Such cost accounting is a
good technique for ascertaining profitability and for decision making. The Institute of
Cost and Management, London defines cost accounting as the application of costing
and costing principles, methods and techniques to the science, art and practice of cost
control and ascertainment of profitability. It includes presentation of information
derived therefrom for the purpose of managerial decision making.

Functions of Cost Accounting

The main functions of cost accounting can be briefed as follows :
a)

Cost accounting enables the management to ascertain the cost of product, job,
contract, service or unit of production.

b)

It helps in price fixation or quotation.

c)

It provides information for the preparation of estimates and tenders.

d)

It helps in minimizing the cost of manufacture.

e)

It helps in determining profitability of each product, process, department etc.

f)

It is a useful tool for managerial control and helps in cost reduction and cost
control.

g)

It increases efficiency and reduces wastages and costs.

h)

It provides cost data for comparison in different periods.

Limitations of Cost Accounting

Cost accounting lacks a uniform procedure. It is developed through theories and
accounting practices based on reasoning and common sense. There is no common
system of cost accounting applicable to all industries. A limitation of cost accounting
is its emphasis on cost data and largely based on estimates. Hence, it is considered
very narrow in its perspective as it fails to consider the revenue aspect in detail.
Moreover, cost accounting can be used only in big organisations.

1.6.3 Management Accounting

Cost accounting helps the internal management by directing their attention on
inefficient operations and assisting in a day-to-day control of business activities.
The costing data needs to be arranged, re-analysed and processed further for effective
role in managerial process. In addition to costing and accounting data, managerial
functions need the use of socio-economic and statistical data (e.g., population
break-ups, income structure, etc.). Cost and financial accounting do not provide such
information and this limitation pave the way for the emergence of management
accounting. Management accounting is a systematic approach to planning and control
functions of management. It generates information for establishing plans and
1 4

controls. It provides for a system of setting standards, plans, or targets and reporting
variances between planned and actual performances for corrective actions. Thus,
Management accounting consists of cost accounting, budgetory control, inventory
control, statistical methods, internal auditing and reporting. It also covers financial
accounting.

Accounting:
An Overview

Management accounting is the process of identification, measurement, accumulation,

analysis, preparation, interpretation and accumulation of financial information used
by management to plan, evaluate, and control within an organisation and to assure
appropriate use of and accountability for its resources. Management accounting also
comprises the preparation of financial reports for management groups such as
shareholders, creditors, regulator agencies and tax authorities.Thus it is the
application of professional information to assist the management in the formation of
policies and in planning and control of the operations of the business enterprise.
Thus Management accounting helps an organisation to accomplish its goals in the
following ways :
1)

It provides a way to communicate expectations to managers throughout the

organisation.

2)

It provides feedback which enables a manager to monitor the day to day

operations of the company for which he is responsible. If actuals differ
significantly from targeted results, the manager is alerted, can look for causes for
deviation and can take corrective actions.

3)

It provides a set of prescribed tools and techniques for use in decision making.

Limitations of Management Accounting

Though Management Accounting is a useful tool for planning, directing and
controlling functions still it suffers from the following limitations :
1)

Based on Cost and Financial Information: Management accounting derives

information from financial and cost accounting and other records. The
accounting statements and records suffer from certain limitations as they are
prepared on the basis of certain accounting concepts and conventions. The
correctness and effectiveness of managerial decisions will depend upon the
quality of data on which these decisions are based. If financial data is not
reliable then management accounting will not provide correct analysis. The
limitations of financial statements and records may be transmitted to the
management accounting system. This may limit its effectiveness and make the
information a substandard one.

2)

Persistence of Intuitive Decision Making: Management accounting provides

facts and figures of various situations and assists management in taking
decisions scientifically. It includes decision tools such as marginal costing,
differential costing and OR techniques like linear programming, decision theory,
etc. Despite the facilities provided, the management mostly resorts to simple
methods of decision making by intuition. Intuitive decisions limit the usefulness
of management accounting.

3)

It has a very Wide Scope: For taking decision, management requires

information from both accounting as well as non-accounting sources and also
quantitative as well as qualitative information. This creates many problems and
brings a degree of inexactness and subjectivity in the conclusions obtained
through it .

4)

Lack of Knowledge: The use of Management accounting requires the

knowledge of a number of related subjects. Lack of knowledge in the related
subjects limits the use of management accounting

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Fundamentals of
Accounting

5)

It is very Costly System: The installation of Management accounting system

needs a very elaborate organisational system. A large number of rules and
regulations are also required to make this system workable and effective. This
results in heavy investment which only big concerns can afford.

6)

Scope for Personal Bias: The interpretation of financial information depends

upon the capability of interpreter as one has to make a personal judgment. There
is every possibility of personal bias in analysis and interpretation. Personal bias
will affect the quality of decision making.

7)

It invites Resistance within the Organisation: The installation of management

accounting needs a radical change in the accounting organisation. New rules and
regulations are also to be framed. It demands rearrangement of personnel and
their activities. This will affect a number of personnel and therefore, there is a
possibility of resistance by some of the people of the organisation concerned.

Check Your Progress A

1.

What is Accounting ?
...................
...................
...................

2.

List out various Accounting activities in an organisation.

...................
...................
...................

3.

What are the limitations of Accounting ?

...................
...................
...................

4.

Name the parties interested in accounting information.

...................
...................
...................

5.

What is the main purpose of Financial Accounting and Management Accounting ?

...................
...................
...................

6.

State whether each of the following statements is True or False :

i)
ii)
iii)
iv)
v)
vi)

1 6

Accounting is concerned only with the recording of transactions.

Accounting is the language of the business.
Accounting records both financial and non financial transactions.
Management accounting provide necessary information to outsiders only.
Cost accounting helps in ascertaining and controlling costs.
The main objective of financial accounting is to ascertain the operating
results and financial position of a concern.
vii) Management accounting provides decision to the management.

1.7

ROLE OF MANAGEMENT ACCOUNTANT

Accounting:
An Overview

The term Management Accountant has been applied to any one who performs
accounting work within a firm and it encompasses persons performing activities which
range from :
i)

Posting customers receivable accounts,

ii)

Doing financial analysis for decision making, and

iii) Making high-level decisions in a large scale organisation.

There is no particular academic or professional accomplishments have been associated
with the term. He plays a significant role in the decision making process of an
organisation. The positional status of management accountant in an organisation
varies from concern to concern depending upon the pattern of management system in
the concern. He plays a significant role in the decision making process of the
organisation heading the accounting department. In large organizations he is known
as Financial Controller, Financial Advisor, Chief Accounts officer etc. He is
responsible for installation, development and efficient functioning of the management
accounting system. He plays an important role in collecting, compiling, reporting and
interpreting internal accounting information. He prepares the financial and cost
control reports to satisfy the requirements of different levels of management. He
computes variances by comparing the actuals with the standards and interprets the
results of operations to different levels of the organisation and to the owners of the
business.
Thus, the management accountant occupies an important position in the organization.
He performs a staff function and also has line authority over the accountants. If he
participates in planning and execution of policies, he is equal to other functional
managers. In most of the organisations, management accountant performs staff
functions. He supplies information and gives his views about the data and leaves the
final decision making to functional heads. If management accountant provides the
facts accurately and are presented in a manner which allows proper analysis and
interpretation then he cannot be held responsible for any wrong judgment by the
management. On the other hand, if the information provided by the management
accountant is biased, inaccurate and is not presented properly then he is responsible to
the management for wrong decision making.

Functions of Management Accountant

The functions of the Management Accountant depends upon the position he occupies
in the organisation and requirements of the organisation. The functions of the
controller, by whatever name he is called, have been laid down by the controllers
Institute of America which are as follows :
1)

Planning and Control : Management accountant establishes, coordinates and

maintains an integrated plan for the control of operations. Such a plan would
provide, to the extent required in the business cost standards, profit planning,
programmes for capital investing and for financing, sales forecast and the
expense budgets, together with necessary procedures to effectuate the plan.

2)

Reporting and Interpreting : Management accountant measures the

performance against given plans and standards. The results of the operations are
interpreted to all levels of management and to the owners of the business. This
also includes installation of accounting and costing system and recording of
actual performance to find out deviation, if any.

3)

Evaluation of Policies and Programmes : He is responsible to evaluate various

policies and programmes. The effectiveness of policies, programmes and

1 7

Fundamentals of
Accounting

organisation structure to attain the objectives of the organisation to a large extent

depends upon the caliber of the management accountant.
4)

Tax administration : It is also the function of management accountant to report

to the government as required under different laws in force and to establish and
administer tax policies and procedures. He has also to supervise and coordinate
preparation of reports to government agencies.

5)

Protection of assets : The management accountant has to assure fiscal

protection for the assets of the business through adequate internal control and
proper insurance coverage.

6)

Appraisal of External Effects : He has to assess continuously the effect of

various economic and social forces and government policies and interpret their
effect upon the business towards the attainment of common goals.
The functions as stated above can also prove to be useful under the Indian
context. Some of the above functions, in India are performed by Company
Secretary, top level management, statistical department etc.

1.8

FINANCIAL ACCOUNTING PROCESS

Accounting may be defined as the process of recording, classifying, summarizing,

analysing, and interpreting the financial transactions and communicating the results
thereof to the persons interested in such information.
Thus the accounting process consists of the following five stages :
1)

Recording the Transactions,

2)

Classifying the Transactions,

3)

Summarizing the Transactions, and

4)

Interpreting the Tesults.

Let us discuss briefly these stages:

1 8

1)

Recording the Transactions : The accounting process begins with the basic
function of recording all the transactions in the book of original entry. This book
is called Journal. The journal is a daily record of business transactions. All
business transactions of financial character are recorded in the journal in a
chronological order (date wise) with the help of various vouchers such as cash
memos, cash receipts, invoices, etc. The process of recording a transaction in
the journal is called journalising. The journal may be further sub-divided into
various subsidiary books such as cash journal for recording cash transactions,
Purchase Journal for recording purchase of goods, Sales Journal for recoding
sale of goods, etc. The number of subsidiary books to be maintained will depend
upon the nature and size of the business.

2)

Classifying the Transactions : The journal is just a chronological record of all

business transactions and it does not provide all information regarding a
particular item at one place. To overcome this difficulty we maintain another
book called Ledger. It consists of systematic analysis of the recorded data with
a view to group the transactions of similar nature and posting them to the
concerned accounts. It contains different pages of individual account heads
under which all financial transactions of similar nature are collected. For
example, all transactions related to cash are posted to cash account and
transactions related to different persons are entered separately in the account of
each person. The objective of classifying the transaction in this manner is to
ascertain the combined effect of all transactions of a given period in respect of
each account. For this purpose all accounts are balanced periodically.

3)

Summarising the Transactions : The third step is presenting the classified data
in a manner which is understandable and useful to the internal as well as external
end users of accounting information. This can be done through the preparation
of a year end summary known as Final Accounts. Before proceeding to final
accounts one has to prepare a statement called Trial Balance in order to check
the arithmetical accuracy of the books of accounts. If the Trial Balance tallies,
more or less it means that the transactions have been accurately recorded and
posted into the ledgers. Then with the help of the Trial Balance and some other
additional information, final accounts are prepared. The objective of preparing
final accounts are :
i)
To know the net operating results of the business, and
ii) To ascertain the financial position of the business at a particular date.

Accounting:
An Overview

The operating results of the business can be ascertained by preparing an income

statement called Trading and Profit and Loss Account and financial position of
the business can be known by preparing a position statement called Balance
Sheet. The Trading and Profit and Loss account gives information about the
profit or loss made during the year and the Balance Sheet shows the position of
assets and liabilities of the business at a particular time.
4) Interpreting the Results : The final stage of accounting is analysing and
interpreting the results shown by the final accounts. The recorded financial data
is analysed and interpreted in a manner that the end users can make a
meaningful judgement about the financial position and profitability of the
business operations. This involves computation of various accounting ratios to
assess the liquidity, solvency and profitability of the business. The balance on
various accounts appearing in the Balance Sheet will then be transferred to the
new books of account for the next year. Thereafter the process of recording
transactions for the next year starts again.
The accounting information after being meaningfully analysed and interpreted has to
be communicated in the proper form and manner to the proper person. This is done
through preparation and distribution of accounting reports which includes besides the
final accounts, in the form of ratios, graphs, diagrams, funds flow statements, etc.

1.9

ACCOUNTING EQUATION

The recording of transactions in the books of accounts is based on accounting

equation. Each transaction has double effect on the financial profit of a concern.
Accounting equation is a formula expressing equivalence of the two expressions of
assets and liabilities. Thus, the total claims will equal to the total assets of the firm.
The total claims may be to outsiders and the proprietor. In the beginning the owner of
the firm provides funds to the business in the form of capital which is also known as
owners equity. Initially the capital contributed by the owner to the business will be
in the form of cash and this cash is treated as an asset of the firm. At the same time a
liability will be created in the form of owners equity according to business entity
concept (i.e., business and the owner are two separate entities). Thus, the asset is
(cash) balanced against liability (capital).
The accounting equation can thus be expressed as follows :
Cash (Asset) = Capital (Liabilities)
Total Assets = Total Liabilities (Capital + Liabilities)
OR
Fixed Assets + Current Assets = Internal Liabilities + External Liabilities
Capital = Assets Liabilities
OR
Liabilities = Assets Capital

1 9

Fundamentals of
Accounting

Thus the above relationship is known as accounting equation and it is also called as
Balance Sheet equation. Each transaction will affect the above equation but the
relationship will remain the same on account of dual aspect of the transaction. An
increase in asset side leads to increase in the liabilities side and vice versa. Thus dual
effect will take place either on the same side or on both the sides of accounting
equation. Let us take a few transactions and see how accounting equation is always
maintained.
1.

Mr. X started business with Rs. 1,00,000 cash : The business received a cash of
Rs. 1,00,000 which is an asset to business. The capital contributed by Mr. X is
a liability to the business because from the business point of view owner and
business are separate legal entity.
The equation now stands as follows:
Equation : Assets

= Capital

+ Liabilities

Rs. 1,00,000 (Cash) = Rs. 1,00,000 + Nil

2.

The business purchased furniture worth Rs. 15000 and paid cash : The effect of
this transaction is that on one hand it increases one asset (furniture) and on other
hand it decreases another asset (cash). The equation now will appear as follows;
Assets
Cash

Old equation

1,00,000

New Transaction

15,000

85,000

New Equation

3.

Furniture =

Capital

Liabilities

1,00,000

15,000

15,000

1,00,000

The business purchased goods on credit from Mr. Z for Rs. 10,000: The effect of
this transaction is that it increases an asset (stock of good) and creates a liability
(creditor). The equation now will be as follows :
Assets
Cash +
Old equation

85,000 +

New Transaction
(Creditor)
New Equation

4.

Furniture +
15,000

85,000 +

Stock

= Capital

+ Liabilities

= 1,00,000 +

+ 10,000

+ 10,000

15000

+ 10,000

= 1,00,000 + 10,000

The business sold goods for Rs. 7,000 on credit : In this transaction, assets will
be decreased by Rs. 7,000 in the form of stock and assets will be increased by
Rs. 7,000 in the form of sundry debtors.
Assets
Cash + Furniture +

Liabilities
Stock + Sundry Debtors = Capital

+ 10,000 +

New
Transaction

+ (7000) + 7,000

= 1,00,000 + 10,000

85,000 + 15000

3000 + 7000

+ Creditors

Old equation 85,000 + 15,000

New
Equation
2 0

= 1,00,000 + 10,000

5.

Mr. X withdrew Rs. 10,000 for his private expenses : Withdrawing of cash from
the business for private expenses, reduces business assets in the form of cash as
well as his capital by Rs. 10,000.
Assets

Accounting:
An Overview

Liabilities

Cash + Furniture + Stock + Sundry = Capital + Creditors

Debtors
Old
equation

85,000 + 15000

New
10,000 +
Transaction
New
Equation

75,000 + 15000

+ 3000 + 7000

= 1,00,000 + 10,000

= 10,000 +

+ 3000 + 7000

= 90,000

+ 10,000

Thus, the sum of assets will be equal to the sum of Capital and Liabilities irrespective
of the number of transactions. The equation can also be presented in the form of
statement of assets and liabilities called Balance Sheet which is always prepared at a
particular date. The last equation stated above if presented in the form of Balance
Sheet, it will be as follows :
Balance Sheet of Mr. X as at .
Capital and Liabilities
Capital
Creditors

Rs.
90,000
10,000

Assets
Cash
Stock
Sundry debtors
Furniture

1,00,000

Rs.
75,000
3,000
7,000
15,000
1,00,000

It should be noted that the total of both the sides of Balance Sheet should be equal
irrespective of the number of transactions and the items affected thereby. It is due to
the dual effect of business transactions on the assets and liabilities of the business.

1.10

ACCOUNTING CONCEPTS

Accounting is the language of business. Business firms communicate their affairs and
financial position to the outsiders through accounting in the form of financial
statements. To make the language to convey the same meaning to all interested parties
it is necessary that it should be based on certain uniform scientifically laid down
standards. The accountants in general, have agreed on certain principles to be
followed strictly by them to maintain uniformity and also for comparison purpose.
These principles are termed as Generally Accepted Accounting Principles.
Accounting principles may be defined as those rules of action or conduct which are
adopted by the accountants universally while recording accounting transactions. They
are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practice and as a guide for selection
of conventions or procedures where alternatives exist. To explain these principles,
the writers have used a variety of terms such as concepts, postulates, conventions,
underlying principles, basic assumptions, etc. The same rule may be described by one
author as a concept, by another as a postulate and still by another as convention.
Hence, it is better to call all rules and conventions which guide accounting activity and
practice as Basic Accounting Concepts. These are the fundamental ideas or basic
assumptions underlying the theory and practice of financial accounting and are broad

2 1

Fundamentals of
Accounting

working rules for all accounting activities developed and accepted by the accounting
profession. It brings about uniformity in the practice of accounting.
These concepts can be classified into two broad groups which are as follows :
1)

Concepts to be observed at the recording stage i.e., while recording the

transactions, and

2)

Concepts to be observed at the reporting stage i.e., at the time of preparing final
accounts.

It must however be remembered that some of them are overlapping and even
contradictory.

1.10.1 Concepts to be Observed at the Recording Stage

The concept which guide us in identifying, measuring and recording the transactions
are :
1)
2)
3)
4)
5)
6)

Business Entity Concept

Money Measurement Concept
Objective Evidence Concept
Historical Record Concept
Cost Concept
Dual Aspect Concept

Let us explain them one by one and learn the accounting implications of each
concept.
1) Business Entity Concept
According to this concept business is treated as a separate entity from its owners. All
transactions of the business are recorded in the books of the firm. Business
transactions and business property are different from personal transactions and
personal property. If business affairs are mixed with private affairs, the true picture
of the business is not available. The owner of the firm is treated as a creditor to the
extent of his capital. From the accounting point of view the owner is different and the
business is different. Therefore, under this concept the capital contributed by the
owner of the firm is the liability to the firm and the owner is regarded as the creditor
of the firm. However, personal expenditure of the owner is met from business funds it
shall be recorded in the business books as drawings by the owner and not as business
expenditure.
The business entity concept is applicable to all form of business organisation. This
distinction can be easily maintained in the case of a limited company because the
company has a separate legal entity of its own. But such distinction becomes difficult
in case of a sole proprietorship or partnership, because in the eyes of law sole
proprietor or partners are not considered separate entities. They are personally liable
for all business transactions. But for accounting purpose they are treated as separate
entities. This enables them to ascertain the profit or loss of the business more
conveniently and accurately.
2) Money Measurement Concept

2 2

Usually business deals in a variety of items having different physical units such as
kilograms, quintals, tons, metres, liters, etc. If the sales and purchase of different
items are recorded in the physical terms, it will pose problems. But if these are
recorded in common denomination their total become homogeneous and meaningful.
Therefore, we need a common unit of measurement. Money does this function. It is
adopted a common measuring unit for the purpose of accounting. All recording,

therefore, is done in terms of the standard currency of the country where business is
set up. For example, in India, it is done in terms of Rupees. In USA it is done in
terms of US dollars and so on.

Accounting:
An Overview

Another implication of money measurement concept is that only those transactions

and events are recorded in the books of accounts which can be expressed in terms of
money such as purchases, sales, salaries etc. Other happenings (non-monetary) like
labour management relations, sales policy, labour unrest, effectiveness of competition,
a team of dedicated and trusted employees etc., which are vital importance to the
business concern do not find place in accounting. This is because their effect is not
measurable and quantifiable in terms of money.
Another limitation of this concept is that it is based on the assumption that the money
value is constant which is not true. The value of money changes over a period of
time. The value of rupee today is much less than what it was in 1971. This is due to
a fall in money value. Thus this concept ignores the qualitative aspect of things and
the impact of inflationary changes is not adjustable in this principle. That is why
accounting data does not reflect the true and fair view of the affairs of business.
Now-a-days it is considered desirable to provide additional data showing the effect of
changes in the price level on the reported income and the assets and liabilities of the
business.
3) Objective Evidence Concept
The term objectivity refers to being free from bias or free from subjectivity.
Accounting measurements are to be unbiased and verifiable independently. For this
purpose all accounting transactions should be evidenced and supported by documents
such as invoices, receipts, cash memos etc. These supporting documents (Vouchers)
form the basis for making entries in the books of account and for their verification by
auditors. As per the items like depreciation and the provision for doubtful debts
where no documentary evidence is available, the policy statements made by the
management are treated as the necessary evidence.
4) Historical Record Concept
Recording the transactions in the books of account will be done only after identifying
the transactions and measuring them in terms of money. According to the historic
record concept we record only those transactions which have actually taken place in
the business during a particular period of time and not those transactions which may
take place in future. It is because accounting record presupposes that the transactions
are to be identified and objectively evidenced. This is possible only in the case of past
(actually happened) transactions. The future transactions can hardly be identified and
measured accurately. You also know that all transactions are to be recorded in
chronological (date wise) order. This leads to the preparation of a historical record of
all transactions. It also implies that we simply record the facts and nothing else.
One limitation of this concept is that the impact of future uncertainties has no place in
accounting. Management needs information for future planning not only of the past
but also for future. You know that we will also make a provision for some expected
losses such as doubtful debts at the time of ascertaining profit or loss of the business
which is contrary to the historic record concept. But it is not a routine item. This is
done in accordance with another concept called conservation concept which you will
study later.
5) Cost Concept
The price paid (or agreed to be paid in case of a credit transaction) at the time of
purchase is called cost. Under this concept fixed assets are recorded in the books of

2 3

Fundamentals of
Accounting

account at the price at which they are acquired. This cost is the basis for all
subsequent accounting for the asset. For example, when an asset is acquired for
Rs. 1,00,000, it is recorded in the books of account at Rs. 1,00,000 even though the
market value may be different later. But the asset is shown in the books at cost price.
You know that with passage of time the value of an asset decreases. Hence, it may
systematically be reduced from year to year by charging depreciation and the assets be
shown in the balance sheet at the depreciated value. The depreciation is usually
charged at a fixed percentage on cost. It bears no relationship with the changes in its
market value. This makes it difficult to assess the true financial position of the
concern and it is, therefore, considered an important limitation of the cost concept.
Another limitation of the cost concept is that if the business pays nothing for an item it
acquired, then this will not appear in the accounting records as an asset. Thus, all
such events are ignored which affect the business but have no cost. Examples are : a
favourable location, a good reputation with its customers, market standing etc. The
value of an asset may change but the cost remains the same in the books of account.
As such the book value of an asset as recorded do not reflect their real value.
It should, however, be noted that the cost concept is applicable to the fixed assets and
not to the current assets.
In spite of the above limitations the cost concept is preferred because firstly, it is
difficult and time consuming to ascertain the market values and secondly, there will be
too much of subjectivity in assessing current values. However, this limitation can be
overcome with the help of inflation accounting.
6) Dual Aspect Concept
This is a basic concept of accounting. According to this concept every business
transaction has a two-fold effect. In commercial context it is a famous dictum that
every receiver is also a giver and every giver is also a receiver. For example, if you
purchase a machine for Rs. 8,000, you receive machine on the one hand and give
Rs. 8,000 on the other. Thus, this transaction has a two-fold effect i.e.,(i) increase in
one asset, and (ii) decrease in another asset. Similarly, if you buy goods worth
Rs. 500 on credit, it will increase an asset (stock of goods) on the one hand and
increase a liability(creditors) on the other. Thus, every business transaction involves
two aspects (i) the receiving aspect, and (ii) the giving aspect. In case of the first
example you find that the receiving aspect is machinery and the giving aspect is cash.
In the second example the receiving aspect is goods and the giving aspect is the
creditor. If complete record of transactions is to be made, it would be necessary to
record both the aspects in books of account. This principle is the core of double entry
book-keeping and if this is strictly followed, it is called Double Entry System of
Book-keeping.
Let us understand another accounting implication of the dual aspect concept. To start
with, the initial funds (capital) required by the business are contributed by the owner.
If necessary, additional funds are provided by the outsiders (creditors). As per the
dual aspect concept all these receipts create corresponding obligations for their
repayment, In other words, a contribution to the business, either in cash or kind, not
only increases its resources (assets), but also its obligations (liabilities/equities)
correspondingly. Thus, at any given point of time, the total assets and the total
liabilities must be equal.
This equality is called balance sheet equation or accounting equation. It is stated
as under :

2 4

Liabilities (Equities) = Assets

Capital +Outside Liabilities = Assets

The term assets denotes the resources (property) owned by the business while the
term equities denotes the claims of various parties against the business assets.
Equities are of two types : (i) Owners equity, and (ii) outsiders equity. Owners
equity called capital is the claim of owners against the assets of the business
outsiders equity called liabilities is the claim of outside parties like creditors, bank,
etc. against the assets of the business. Thus, all assets of the business are claimed
either by the owners or by the outsiders. Hence, the total assets of a business will
always be equal to its liabilities.

Accounting:
An Overview

When various business transactions take place, they effect the assets and liabilities in
such a way that this equity is maintained. You will study later in detail under 1.9
Accounting Equation of this unit how the equity is maintained.

1.10.2 Concept to be Observed at the Reporting Stage

The following concepts have to be kept in mind while preparing the final accounts:
1.

Going concern concept

2.

Accounting period concept

3.

Matching concept

4.

Conservatism concept

5.

Consistency concept

6.

Full disclosure concept

7.

Materiality concept

Let us discuss the above concepts one by one.

1) Going Concern Concept
According to this concept it is assumed that every business would continue for a long
period. Keeping this in view, the investors lend money and the creditors supply goods
and services to the concern. For all practical purpose the business is normally treated
as a going concern unless there is a strong evidence to the contrary. The current
disposal value is irrelevant for a continuing business. Recording of transactions in
accounting is judged whether the benefits from expenses are immediate (short period,
say less than one year) or a long term. If the benefits from expenses are immediate it
is treated as a revenue or if the benefits are for long term, it is to be treated as capital
depending upon the nature of expenses. Short term benefits expenses like rent, repairs
etc. are limited to one year therefore such expenses are fully debited to profit and loss
account of that year. On the other hand, if the benefit of expenditure is available for a
longer period, it must be spread over a number of years. Therefore, only a portion of
such expenditure will be debited to profit and loss account. The balance of
expenditure is shown as an asset in the Balance Sheet. Similarly fixed assets are
recorded at original cost and are depreciated in a proper manner and while preparing
the balance sheet, market price of fixed asset are not considered. For example, a firm
purchased a delivery van for Rs. 1,00,000 and its expected life is 10 years. The
accountant has to spread the cost of the van for 10 years and charges Rs. 10,000
being 1/10th of its cost to the profit and loss account every year in the form of
depreciation and show the balance in the balance sheet as an asset. While preparing
final accounts, a record will also be made for outstanding expenses and prepaid
expenses on the assumption that the business will continue for an indefinite period and
the assets will be used for its expected life.
This concept will not apply in case of a concern when it has gone into liquidation or it
has become insolvent. In such as case the assets are valued at their current values and
the liabilities at the value at which they are to be met.

2 5

Fundamentals of
Accounting

2) Accounting Period Concept

You know that the going concern concept assumes that life of the business is indefinite
and the preparation of income and positional statements after a long period would not
be helpful in taking appropriate steps at the right time. Therefore, it is necessary to
prepare the financial statements periodically to find out the profit or loss and financial
position of the business. It also helps the interested parties to make periodical
assessment of its performance. Therefore, accountants choose some shorter period to
measure the results and one year has been generally accepted as the accounting period.
However, accounts can also be prepared even for a shorter period for internal
management purposes. But one year accounting period is recognised by law and
taxation is assessed annually. Acconting period may be a calender year i.e., January 1
to December 31 or any other period of twelve months, say April 1 to March 31 or
Diwali to Diwali or Dasara to Dasara. The final accounts are prepared at the end of
each accounting period and the financial reports thus, prepared facilitate to make good
decision, corrective measures, business expansion etc. and also enable the end users to
make an assessment of the progress of the enterprise.
3) Matching Concept
Matching concept is based on the accounting period concept. The matching concept is
also called Matching of costs against revenue concepts. To ascertain the profit made
by the business during a particular period, the expenses incurred in an accounting year
should be matched with the revenue earned during that year. The term matching
means appropriate association of related revenues and expenses. For this purpose,
first we have to recognize the revenues during an accounting period and the costs
incurred in securing those revenues. Then the sum of costs should be deducted from
the sum of revenues to get the net result of that period. The question when the
payment was received or made is irrelevant. In other words, all revenues earned
during an accounting period, whether received or not and all costs incurred, whether
paid or not have to be taken into account while preparing the final accounts.
Similarly, any amount received or paid during the accounting period which actually
relates to the previous accounting period or the following accounting period must be
eliminated from the current accounting periods revenues and costs. Therefore,
adjustments are to be made for all outstanding expenses, accrued incomes, prepared
expenses and unearned incomes, etc., while preparing the final accounts at the end of
the accounting period. By application of this concept, the owner of the business easily
know about the operating results of his business and can make effort to increase
earning capacity.
4) Conservation Concept

2 6

This concept is also known as Prudent Concept. It ensures that uncertainties and risks
inherent in business transactions should be given a proper consideration.
Conservatism refers to the policy of choosing the procedure that leads to
understatement of assets or revenues, and over statement of liabilities or costs. The
consequence of an error of understatement is likely to be less serious than that of an
error of over statement. On account of this reason, accountants generally follow the
rule anticipate no profit but provide for all possible losses. In other words, profits
are taken into account only when they are actually realized but in case of losses, even
the losses which may arise due to a remote possibility should also be taken into
account. That is the reason why the closing stock is valued at cost price or market
price whichever is less. Similarly, provision for doubtful debts and provision for
discounts on debtors are also made. This reflects a generally pessimistic attitude of
the accountant, but it is regarded as the best way of dealing with uncertainty and
protecting creditors against an unwarranted distribution of the firms assets as
dividends.

This concept is subject to criticism that it is against the convention of full disclosure.
It encourages creation of secret reserves and financial statements do not reflect a true
and fair view of the affairs of the business.

Accounting:
An Overview

5) Consistency Concept
The principle of consistency means that the same accounting principles should be used
for preparing financial statement for different periods. It means that there should not
be a change in accounting methods from year to year. Comparisons are possible only
when a consistent policy of accounting is followed. If there are frequent changes in
the accounting treatment there is little scope for reliability. For example, if stock is
valued at cost or market price whichever is less, this principle should be followed
year to year. Similarly if deprecation on fixed assets is provided on straight line basis,
it should be followed consistently year after year. Consistency eliminates personal
bias and helps in achieving comparable results. If this principle of consisting is not
followed, the accounting information about an enterprise cannot be usefully compared
with similar information about other enterprises and so also within the same enterprise
for some other period. Consistency principle enhances the utility of the financial
statements.
However, consistency does not prohibit change. When a change is desirable, the
change and its affect should be clearly stated in financial accounts.
6) Full Disclosure Concept
This concept states that the financial statements are to be prepared honestly and all
significant information should be incorporated there in because these statements are
the basic means of communicating financial information to all interested parties.
Therefore, these statements should be prepared in such a way that all material
information is clearly disclosed to the persons interested in its affairs . The purpose of
this concept is that any body who wants to study the financial statements should not
be prejudiced by concealing any facts. It is, therefore, necessary that the disclosure
should be fair and adequate to make impartial judgement.
This concept assumes greater importance in respect of Joint Stock Company type of
organisations where ownership is divorced from management. The Joint Stock
Companies Act, 1956 requires that Profit and Loss Account and Balance Sheet of a
company must give a true and fair view of the state of affairs of the company and also
provided prescribed form in which these statements are to be prepared so that
significant information may not be left out.
7) Materiality Concept
This concept is closely related to the full disclosure concept. Full disclosure does not
mean that everything should be disclosed. It only means that relevant and material
information must be disclosed. American Accounting Association defines the term
materiality as An item should be regarded as material if there is reason to believe that
knowledge of it would influence the decisions of informed investor. Materiality
primarily relates to the relevance and reliability of information. All material
information should be disclosed through the financial statements accompanied by
necessary notes. For example commission paid to sole selling agents, and a change in
the method of rate of depreciation, if any, must be duly reported in the financial
statements.
Further strict adherence to accounting principles is not required for items of little
importance or non-material nature. For example, erasers, pencils, stapler, pins, scales
etc., are used for a long period, but they are not treated as assets. They are treated as
expenses. This does not affect the amounts of profit or loss materially. Similarly,
while showing the amounts of various items in financial statements, they can be

2 7

Fundamentals of
Accounting

rounded off to the nearest rupee or hundreds. There may not be any material effect.
For example if an amount of Rs. 145,923.28 is shown as Rs. 1,45,923 or
Rs. 1,45,900 it does not make much difference for assessment of the performance of
the enterprise.
The materiality and immateriality convention varies according to the company, the
circumstances of the transaction and economic significance. An item considered to be
material for one business, may be immaterial for another. Similarly, an item of
material in one year may not be material in the subsequent years. However, there are
no specific rules for ascertaining material or non-material items. They are rather in
the category of conventions or rules developed from experience to fulfil the essential
and useful needs and purposes in establishing reliable financial and operating
information control for business entities. What is required is just a matter of personal
judgment.

Check Your Progress B

1)

What do you understand by money measurement concept ?

...................
...................
...................
...................

2)

Explain dual aspect concept.

...................
...................
...................
...................

3)

List the concepts to be observed at the reporting stage.

...................
...................
...................
...................

4)

What are the stages in accounting process ?

...................
...................
...................
...................

6)

State whether each of the following statements is True or False :

i)

2 8

In accounting all business transactions are recorded which are having a

dual effect.
ii) It is the basis of a going concern concept that the assets are always valued
at cost price.
iii) Accounting principles are the rules which are adopted by accountants
universally while recording transactions.
iv) A controller is entrusted with the responsibilities of raising funds.
v) Money measurement concept ignores qualitative aspect of things.

1.11

ACCOUNTING STANDARDS

Accounting:
An Overview

Accounting standards are generally accepted accounting principles which provides the
basis for accounting policies and for preparation of financial statements.
The object of these standards is to provide a uniformity in financial reporting and to
ensure consistency and comparability of the information provided by the business
firms. Therefore, the standards set for must be easily understandable as well as
acceptable by all and significantly reduce manipulation of information in the
books of accounts.
Thus, accounting standards provide useful information to the users to interpret
published reports. It provides information about the basis on which accounts have
been provided and the rules followed while preparing financial statements.
Importance of Accounting Standards
1)

It helps the investors in assessing the return and possible risk involved in
evaluating the various investment proposals in different enterprises.

2)

It raises the standards of audit while reporting the financial statements to the
management.

3)

It helps the government and other interested parties in formulating economic

policies, tax planning, market analysis, investment decisions etc.

4)

It helps the Chartered Accountants to deal with their client, in preparing financial
statements on a true and fair basis. They can refuse the reports of their clients
which are found to be incorrect or misleading.

5)

It helps the interested parities to understand the information properly and make
meaningful comparisons and interpretations for decision-making purposes.

6)

It facilitates inter firm comparison of the financial position and operating results
of similar enterprises.

7)

It will reduce the scope of manipulation of accounts to suit the requirement of

management.

8)

It would facilitate the development of international trade and commerce as

financial statements are clearly understandable.

Compliance with the accounting standards has been made mandatory. Section 211(3A)
of the Companies Act, 1956 requires that every financial statement i.e., profit and loss
account and balance sheet shall comply with the accounting standards. For the
purpose of this section the accounting standards issued by the Institute of Chartered
Accountants of India (ICAI) shall be deemed to be the accounting standards.
According section 211 (2B), If the financial statements of any company do not
comply with requirements of the accounting standards, it should state the reasons for
such deviations from the accounting standards together its financial effect, if any,
arising due to such deviation. Therefore, it is advisable for the companies as far as
possible to comply with the accounting standards in view of its mandatory nature. In
case the mandatory accounting standards are not complied with, it is in contravention
of provisions of the Companies Act and the financial statements prepared and
presented will not reflect a true and fair view of the state of affairs of the company.
These accounting standards also apply in respect of financial statements audited for
tax purpose under section 44 AB of Income Tax Act 1961.
These accounting standards are applicable to all commercial, industrial or business
activities of any enterprise but not to those enterprises which are not commercial,
industrial or business in nature.
2 9

Fundamentals of
Accounting

1.12 ACCOUNTING ASSUMPTIONS AND POLICIES AS

PER ACCOUNTING STANDARDS OF INDIA
Accounting measurements are not always uniform. Some financial quantities can be
measured in two or more different ways. The management with the help of companys
accountant decides which measurement alternatives are to be used. These choices are
known as accounting policies. These accounting polices differ from company to
company. Therefore, it is advisable to each company to state in the notes of its
financial statements which accounting policy it has followed. The company should
not change its policy frequently and when there is a change in the policy, the
company should justify the reason for such a change.
The management is not completely free in choosing any accounting policies because
selection of policy must fit within the limits set by the measurement guidelines known
as generally accepted accounting principles as well as to comply statutory
requirements. For example, The Central Board of Direct Taxes requires the following
information to be disclosed in respect of change in accounting polices :
1)

2)

A change in accounting policy shall be made only if the adoption of different

accounting policy is required by statute or if it is considered that the change
would result in more appropriate in preparation or presentation of the financial
statements of an assessee.
Any change in accounting policy which has material effect shall be disclosed in
the financial statements of the period in which such change is made. Where the
effect of such change is not ascertainable or such change has no material effect
on the financial statements for the previous year but has material effect in years
subsequent to the previous year, the fact shall be stated in the previous year in
which such change is adopted.

Materiality of an item depends on its amount and nature. An item should also be
considered material if the knowledge of it would influence the decisions of the
investors. Materiality varies from one business to another business. Similarly, an item
which is material in one year may not be material in the next year. While preparing
financial statements it is, therefore, necessary to give emphasis only on those matters
which are significant and thereby ignoring insignificant matters.
In order to bring uniformity for the presentation of accounting results, the Institute of
Chartered Accountants of India, established an Accounting Standard Board (ASB) in
April, 1977. The Board consists of representatives from industry and government.
The main function of ASB is to formulate accounting standards to be followed while
preparing and interpreting the financial results. While framing the accounting
standards, the ASB will pay due attention to the International Accounting Standards
and try to integrate them to the possible extent. It also takes into account the
prevailing laws, customs and business environment prevailing in India. To improve
quality and bring parity with the presentation of financial statements in India, the
ASB has formulated the following accounting standards:
No.

3 0

AS 1
AS 2
AS 3
AS 4
AS 5
AS 6
AS 7

Title
Disclosure of Accounting Policies
Valuation of Inventories
Cash Flow Statements
Contingencies and Events occurring after Balance Sheet Date
Net Profit or Loss, Prior Period Items and Changes in Accounting Policies
Depreciation Accounting
Accounting for Construction Contracts

AS 8
AS 9
AS 10
AS 11
AS 12
AS 13
AS 14
AS 15
AS 16
AS 17
AS 18
AS 19
AS 20
AS 21
AS 22
AS 23
AS 24
AS 25
AS 26
AS 27

Accounting for Research and Development

Revenue Recognition
Accounting for Fixed Assets
Accounting for the Effect of Changes in Foreign Exchange Rates
Accounting for Government Grants
Accounting for Investments
Accounting for Amalgamations
Accounting for Retirements Benefits in the Financial Statements of Employers
Borrowing Costs
Segment Reporting
Related Party Disclosures
Leases
Consolidated Financial Statement
Earnings per Share
Accounting for Taxes on Income
Accounting for Investments in Consolidated Financial Statements
Discounting Operations
Interim Financial Reporting
Intangible Assets
Financial Reporting of Interest in Joint Ventures

Accounting:
An Overview

Check Your Progress C

1)

Why accounting practices should be standardised ?

...................
...................
...................
...................

2)

State whether each of the following statements is True or False:

i)

A management accountant is not the custodian of properties and financial

interests of a business enterprise.
ii) Statement of Standard Accounting Practice were formulated by an
Accounting Standard Board in India.
iii) The generally accepted accounting principles prescribe a uniform
accounting practice.
iv) The materiality concept refers to the state of ignoring small items and
values from accounts.
vi) The avoidance of insignificant things will not affect accounting results.

1.13

LET US SUM UP

In business a number of transactions take place every day. It is not possible to

remember all of them. Hence there is a need to record them. The recording of
business transactions in a systematic manner is the main function of accounting. It
enables to ascertain the profit and loss and the financial position of the business. It
also provides necessary financial information to all interested parties.

3 1

Fundamentals of
Accounting

Accounting is the process of identifying, measuring, recording, classifying and

summarizing the transactions and analysing, interpreting and communicating the
results thereof. Accounting provides information for three general uses such as
i) managerial decision-making, ii) managerial planning control, and internal
performance evaluation, and iii) financial reporting and external performance
evaluation. To meet the requirements of different people interested in accounting
information, accounting is classified as financial accounting, cost accounting and
management accounting. Financial accounting refers to the preparation of reports for
general purpose whereas management accounting provides information to inside the
organisation. Cost accounting provides information about the problems of internal
managerial control.
Management accountant plays a significant role in the decision making process and it
depends upon his position and requirements of the organisation. The accounting
process is divided into four stages: (i) recording the transactions, (ii) classifying the
transactions, (iii) summarizing the transactions, and (iv) interpreting the results. The
recording of transactions in the books of accounts is based on accounting equation.
Accounting equation is a formula expressing equivalence of the two expressions of
assets and liabilities. The relationship will remain the same on account of dual aspect
of the transaction.
The accountants over a period of time, have developed certain guidelines for all
accounting work. These are called basic concepts of accounting. Certain concepts
are to be observed at the time of recording the transactions, while others are relevant
at the summarizing and reporting stages. The concepts to be observed at the recording
stage are : business entity, money measurement, objective evidence, historical record,
cost and the dual aspect concept. Concepts to be observed at the reporting stage are :
going concern concept, accounting period concept, matching concept, conservatism
concept, consistency concept, full disclosure concept and materiality concept. Lack of
uniformity in accounting practice makes it difficult to compare the financial reports of
different companies. The multiplicity of accounting practices makes it possible for
management to conceal material information. To avoid this problem accounting
standards are developed by various professional bodies. The object of accounting
standards is to provide uniformity in financial reporting and to ensure consistency and
comparability of the information provided by the business firms. The management is
not absolutely free in choosing any accounting policy. The accounting policy selected
must fit within the limits set by generally accepted accounting principles and also
comply to the statutory requirements. The Accounting Standard Board (ASB) of
India, has developed so far 27 standards to improve quality and parity with the
preparation of financial statements.

1.14

KEY WORDS

Accounting Period : A period of twelve months for which the accounts are usually
kept.
Balance Sheet : A statement of assets and liabilities as at the end of an accounting
period.
Books of Accounts : Books in the form of bound registers or loose sheets wherein
transactions are recorded.
Business Unit : A unit formed for the purpose of carrying on some kind of business
activity.

3 2

Financial Position : Position of assets and liabilities of a business at a given point of

time.

Financial Statement : Summary of accounting information such as profit and loss

account and Balance Sheet prepared at the end of accounting period.

Accounting:
An Overview

Profit and Loss Account: An account showing profit or loss of the business during
an accounting period.
Transaction : Transfer of money or moneys worth between the two business units.
Management Accountant : A staff-functionary who uses accounting information for
management planning and control.
Staff Function : It is performed in an advisory capacity without line or decisionmaking.
Accounting Conventions : Methods or procedures used in accounting
Accounting Equation : Assets = Owners equity + Liabilities
Accounting Principles : The methods or procedures used in accounting for events
reported in the financial statements.
Accounting Standards : Accounting Principles.
Cost Accounting : Classifying, Summarizing, recording, reporting and allocating
current or predicted costs.
Double Entry : The system of recording transactions that maintains the equality of
the accounting equation.
Generally Accepted Accounting Principles (GAAP) : The conventions, rules and
procedures necessary to define accepted accounting practice at a particular time;
includes both broad guidelines and relatively detailed practices and procedures.
Internal Reporting : Reporting for managements use in planning and control.
Materiality : The concept that accounting should disclose separately only
those events that are relatively important for the business or for understanding its
statement.
External Reporting : Production of financial statements for the use of external
interest groups like shareholders, investors, creditors, government etc.

1.15

ANSWERS TO CHECK YOUR PROGRESS

A)

(i) False (ii) True (iii) False (iv) False (v) True (vi) True (vii) True

B)

(i) True (ii) True (iii) True (iv) False (v) True

C)

(i) False (ii) True (iii) True (iv) False (v) True

1.16

TERMINAL QUESTIONS

1)

What are the objectives of Accounting ? Name the different parties interested in
accounting information and state why they want it.

2)

Briefly explain the accounting concepts which guide the accountant at the
recording stage.

3)

What do you understand by Dual Aspect Concept ? Explain the accounting

implications.

4)

Explain the role of Management Accountant in a modern business organisation.

5)

What are the accounting concepts to be observed at the reporting stage ?

Explain any two in detail.

3 3

Fundamentals of
Accounting

6)

Discuss in brief the basic accounting concepts and fundamental accounting

assumptions.

7)

Why do accounting practices be standardized ? What progress has been made in

India regarding standardization of accounting ?

8)

Is it possible to give a true and fair view of a companys position using accounting information ? Explain.

9)

Explain the following :

i)
ii)
iii)
iv)
v)
vi)

1.17

Accounting equation
Convention of materiality
Accounting standards
Accounting process
Branches of accounting
Accounting a source of financial information.

SOME USEFUL BOOKS

Harold Bierman Jr. and Allan R. Drebin, 1978. Financial Accounting : An

Introduction, W. B. Sounders Company, Philadelphion, London (Chapter 1-3).
Maheswari, S. N., 2002, An Introduction to Accounting, Vikas Publishing House :
New Delhi (Chapter 1 and 2)
Patil, V.A.,and J. S. Korlahalli, 1986. Principles and Practice of Accounting,
R. Chand and Co., New Delhi (Chapter 1-3)
Gupta, R. L. and M. Radhaswamy, 1986. Advanced Accountancy, Sultan Chand and
Sons : New Delhi (Chapter I and II)
Anthony, Robert, N. and James Reece, 1987. Accounting Principles, All India
Traveler Book Seller, New Delhi (Chapter 1-3)
Meigs, Walter, B. and Robert F. Meirgs, 1987. Accounting : The Basis for Business
Decisions, MC Graw Hill : New York (Chapter I)
Sidney Davidson, Michael W. Maher, Clyde P. Stickney, Roman L Weil, 1985.
Managerial Accounting, An Introduction to Concepts, Methods, and Uses, HoltSaunders International Editors, Japan. (Chapter I)

3 4

UNIT 2 BASIC COST CONCEPTS

Basic Cost Concepts

Structure
2.0

Objectives

2.1

Introduction

2.2

Need for Cost Data

2.3

Cost Concept

2.4

Classification of Costs
2.4.1
2.4.2
2.4.3
2.4.4
2.4.5
2.4.6

2.5

Concepts of Cost Unit and Cost Centre

2.5.1
2.5.2

2.6

Functional Classification
On the Basis of Identifiability with Products
On the Basis of Variability
On the Basis of Product or Period
On the Basis of Controllable and Non-Controllable Costs
On the Basis of Relevance to Decision-Making

Cost Unit
Cost Centre

Elements of Cost
2.6.1
2.6.2
2.6.3

Materials
Labour
Expenses

2.7

Total Cost Build-Up

2.8

Cost Sheet

2.9

Calculation of Recovery Rates

2.10

Statement of Quotation

2.11

Methods of Costing
2.11.1
2.11.2
2.11.3
2.11.4
2.11.5
2.11.6
2.11.7
2.11.8

2.12

Job Costing
Contract Costing
Batch Costing
Unit Costing
Bocess Costing
Operating Costing
Multiple Costing
Uniform Costing

Types of Costing
2.12.1 Marginal Costing
2.12.2 Absorption Costing
2.12.3 Historical Costing
2.12.4 Standard Costing

2.13

Let Us Sum Up

2.14

Key Words

2.15

Answers to Check Your Progress

2.16

Terminal Questions

2.17

Some Useful Books

3 5

Fundamentals of
Accounting

2.0

OBJECTIVES

After studying this unit, you should be able to :

l
l
l
l
l
l
l

2.1

describe the need for cost data;

meaning and classification of costs;
explain the concept of cost unit and cost centre;
describe the elements of cost;
prepare a Proforma of Cost Sheet and identify the components of total cost;
prepare a statement of quotation and ascertain the price of a tender; and
describe different methods of costing and identify the industries to which each
method is applicable.

INTRODUCTION

In this unit you will learn about certain basic cost concepts like cost, cost unit, cost
centre, classification of costs, elements of costs and components of total cost.
Apart from these aspects, the unit also covers preparation of cost sheet showing
details of various components of total cost. You will also study about the
preparation of statement of quotation. The unit also discusses various methods and
types of costing.

2.2

NEED FOR COST DATA

Enterprises may be either profit making or non-profit making organisations. If they

are profit making organisations, one of their primary objectives is to operate at a
profit. Non profit organisations are generally providers of service. Cost data is
required to know how much profit the enterprise is earned. To properly set their
prices at a level to ensure a profit for the entity as a whole, the enterprise must know
what their costs are. Similarly, decisions regarding adding new products or dropping
old products, etc., knowledge of cost data is essential to know how profit changes with
various alternatives. In case of non-profit institution, cost data helps to know what
level of funding is needed to provide the services. It also helps the management to
decide what kind of activities can engage in most efficiently. Thus the management
of an organisation requires cost data for the following purposes :
1)

To ascertain profit or loss periodically,

2)

To plan the operations and performance evaluation,

3)

For cost control,

4)

To price the products or services,

5)

To value inventory and measure the expenses in external financial reports, and

6)

In day to day operations of plans and policies,

2.3

3 6

COST CONCEPT

In principle, a cost is a sacrifice of resources. According to the terminology of British

Institute of Cost and Works Accountants, Cost is the amount of expenditure (actual
or notional) incurred on or attributable to a given thing. In other words, cost
indicates, (i) an actual or estimated expenditure (ii) a direct or indirect expenditure,
and (iii) it relates to a job, process, product or service. Examples of such costs are :
Material, labour, factory overheads, administrative overheads, selling and distribution
overheads.

Cost is a very broad and flexible term. It does not give an exact meaning unless it is
used in some particular context. It varies with time, volume, firm, method or purpose.
The meaning of cost may change according to its interpretation and the manner in
which it is ascertained. It does not mean the same thing under all circumstances.
Therefore, cost must indicate its purpose and the conditions under which it is
computed.

Basic Cost Concepts

Costs and Expenses

Cost information is necessary both for managerial accounting and financial
accounting. When costs are used inside the organisation to evaluate its performance
we say that costs are used for managerial accounting purposes. On the other hand
when costs are used by outsiders (interested parties) to evaluate the performance of
management and make investment decisions in the organisation, then costs are used
for financial accounting purpose.
It is also important to distinguish between cost as used in managerial accounting, from
expense, as used in financial accounting. A cost is a sacrifice of resource to achieve
specific objective which has been deferred or not yet utilized for the realisation of
revenues. The price paid for the acquisition of fixed assets, materials, etc. are the
examples of such deferred costs.
An expense is a cost that is charged against revenue in an accounting period
and hence expenses are deduced from revenue in that accounting period.
Examples are : Salaries, rent rates, etc. Generally Accepted Accounting
Principles and Regulations specify when costs are treated as expenses to be
charged to revenues.
In accounting for managerial decisions the focus is on costs, and not on expenses. For
external reporting, the term expense is used as defined by Generally Accepted
Accounting Principles. But in practice, the terms cost and expenses are sometimes
used synonymously.
Cost and Loss : There is difference between cost and loss. You know that cost
signifies an expenditure incurred for recurring some benefit to the enterprise. If no
benefit is derived from a particular expenditure, it is treated as a loss. Cost of
material destroyed by fire, salary paid to a foreman during the period of strike etc.,
are the examples of loss to the business.

2.4

CLASSIFICATION OF COSTS

Costs may be classified into different categories depending upon the purpose.
The following are the various bases according to which costs have been classified :
1)

According to functions to which they relate,

2)

According to their identifiability with jobs, products, or services,

3)

According to their variability with changes in output,

4)

According to the association with product or period,

5)

According to their controllability, and

6)

According to their relevance to decision-making

Let us discuss all the above in detail.

3 7

Fundamentals of
Accounting

2.4.1 Functional Classification

The most common classification of costs in a manufacturing establishment is on the
basis of functions to which they relate because costs have to be ascertained for each of
these functions. On the basis of functions, costs are classified into four categories.
They are :
i)
ii)
iii)
iv)

Manufacturing Costs
Administrative Costs
Selling Costs
Distribution Costs

Manufacturing Costs : Manufacturing costs are those costs related to factory

operations which are essential to the completion of the product. It includes direct
material costs, direct labour costs and manufacturing overheads. Direct materials are
the major components of the finished product and can be easily identified with the
product. Direct labour is the labour which is used in actually producing the product.
Manufacturing overheads consist of all other costs related to the manufacturing
process. These are also termed as production costs.
Administrative Costs: Administrative costs includes all those costs incurred on the
general administration and control of the firm. Examples of such costs are : salaries
of the office staff, rent of the office building, depreciation and repairs of the office
furniture etc. Infact any expenditure which is not related directly to production,
selling, distribution, research and development forms part of the administrative costs.
Selling Costs: Selling costs are those costs which are incurred in connection with the
sale of goods. Some examples of such costs are : Cost of warehousing, advertising,
salesmen salaries etc.
Distribution Costs: Distribution costs are those costs which are incurred on despatch
of finished products to customer including transportation. Examples of such costs are:
packing, carriage, insurance, freight outwards, etc.

2.4.2 On the Basis of Identifiability with Products

On this basis costs are divided into (i) Direct Costs, and (ii) Indirect Costs:
Direct Costs : Direct costs are those costs which are the major components of the
finished products and can be clearly identified with the product being produced. The
examples of direct costs are : raw materials, labour and other direct expenses which
are exclusively incurred for a particular job, product or process.
Indirect Costs : indirect costs are those costs which cannot be assigned to any
particular product, job or process. These costs are usually incurred for the business as
a whole and therefore, are to be allocated to various products manufactured in the
factory on some reasonable basis. Examples of indirect costs are : factory lighting,
rent of factory building, salaries of foreman, etc, Indirect costs are also called as
overheads or on costs. These overheads can be further subdivided into factory
overheads, administrative overheads, selling and distribution overheads.

2.4.3 On the Basis of Variability

Another classification is based on the cost behaviour. On this basis costs are
classified into (i) Fixed Costs, (ii) Variable Costs, and (iii) Semi-variable
(or semi-fixed) Costs, (iv) Step Costs.

3 8

Fixed Costs: These costs remain fixed irrespective of a change in the volume of
output. But fixed cost varies when it is expressed on per unit basis. In other words
fixed cost per unit decreases when the volume of production increases and vice versa.

Rent and lease, salary of production manager, salaries of staff, etc., are the examples
of fixed cost. It should also be noted that fixed costs do not remain fixed always.
They remain fixed only upto a certain level of production activity. If there is a change
in the production capacity which require additional building and equipment, staff, etc.,
such cost will also change. Therefore, fixed costs are fixed within a relevant range of
production. For example, if we produce 1000 units or 10,000 units of a particular
product during a particular period, the rent of the factory building or the salary of the
production manager will remain the same.

Basic Cost Concepts

Variable Costs: Variable costs are those costs which vary directly or almost
proportionately with the level of output. When volume of output increases, total
variable cost also increases and when volume of output decreases the variable cost
also decreases. But the variable cost per unit will remain unaffected. The examples
of variable costs are : direct material, direct wages, power, commission of salesmen
etc. Let us see the following example how the variable cost varies with the change in
the level of output.
Variable Cost

Unit Costs:
Direct Material
(Rs. 1 per unit)
Direct Labour
(Rs. 2 per unit)
Direct Expenses
(Rs. 1 per unit)
Total Variable Cost
Cost per unit
(Total VC No. of Units)

3,000

Level of Output (Units)

4,000

5,000

Rs.
3,000

Rs.
4,000

Rs.
5,000

6,000

8,000

10,000

3,000

4,000

5,000

12,000
Rs. 4

16,000
Rs. 4

20,000
Rs. 4

In the above example the variable cost varies in direct proportion to the activity level
but the variable cost per unit is fixed.
The following are the characteristics of variable costs :
i)

The variable cost varies direct proportion to the volume of output.

ii)

The cost per unit will remain the same irrespective of level of activity.

iii) It is easy to accurate allocation and apportionment to different cost centres.

iv) Variable costs can be controlled by functional managers as they incur only when
production takes place.
Semi-variable Costs (or semi-fixed costs): These costs are partly fixed and partly
variable. These are the costs which do vary but not in direct proportion to output.
A part of semi variable costs comprising of fixed cost component , is not expected to
change in response to the changes in the level of activity. Thus, semi-variable
costs vary in the same direction but not direct proportion to the changes in the
volume of output. Telephone bills, power consumption, depreciation, repairs, etc.,
are the examples of semi-variable costs. In case of telephone bills, there is a
minimum rent and after specified number of calls, the charges are according to the
number of calls made. Similarly, power costs include a fixed portion of
minimum charge will be charged even if the power is not consumed and
variable charge is based on the consumption of power. Thus, telephone
and power charges increase with an increase in the usage level but not in the same
direction.

3 9

Fundamentals of
Accounting

Step Costs: Fixed cost in general remain fixed over a range of activity and then jump
to a new level as activity changes. For example, a foreman can supervise a given
number of workers in a particular shift. The introduction of anther shift will require
additional foreman and certain costs will increase in lumps. Such costs are known as
step costs or stair step costs.
The graphical representation of fixed costs, variable costs semi-variable costs and
step costs is shown below:
Fixed Cost-Behaviour

Variable Cost-Behaviour

3
s

Fixed Cost Line

Fixed Cost Line

0
300
100
200
Production (Units)

300
100
200
Production (Units)

400

Semi-Variable Cost Behaviour

Fixed Costs Rising in Steps

4
3

400

4
Semi-variable cost line

0
300
100
200
Production (Units)

400

Fixed cost rising line

0
300
100
200
Production (Units)

400

Identification of costs according to their behaviour into fixed and variable elements is
essential for profit planning, cost control, fixation of prices, preparation of budgets
and also in various managerial decisions like make or buy or drop out decisions,
selection of a product mix, level of activity decisions, etc.

2.4.4 On the Basis of Product or Period

Product costs are those costs which are easily attributable to products. These costs
are necessary for the production and will not be incurred if there is no production.
Product costs consist of direct material, direct labour and a reasonable share of
factory overhead. These costs are also called inventoriable costs because these are
included the cost of product as work-in-progress, finished goods or cost of sales.
Generally all manufacturing costs are treated as product costs.
Costs which are easily attributable to time interval are known as period costs. These
costs do not attach to products. These costs incurred for a time period and generally
non-manufacturing costs are treated as period costs. These costs are charged to profit
and loss account. The examples of period costs are rent of office building, salary of
company executives, etc.

4 0

Period costs affect profit as they are charged to profit and loss account after they are
incurred whereas product costs will affect profit only when they goods are realized.
Thus, classification of costs on the basis of product and period is significant from
profit determination point of view.

Basic Cost Concepts

2.4.5 On the Basis of Controllable and Non-Controllable Costs

Controllable costs are those costs which can be controlled by a specified person or a
level of management. Variable costs are generally controllable by the lower level of
management like departmental heads. For example cost of raw materials can be
controlled by purchasing them in bulk quantities. Uncontrollable costs are those costs
which cannot be controlled or influenced by a specified person of an enterprise. For
example costs like factory rent, managerial salaries etc. It should be noted that the
costs which are not controllable in the short run likely to become controllable in the
long run at some level in the organisation. Similarly, when one moves to the higher
levels of management in the organisation more and more costs become controllable.
Sometimes classification of costs as controllable or non controllable will be a
discretionary matter of the management. The classification of costs on the basis of
controllability is important for the evaluation of performance of the executives and
assigning the responsibility in the organisation.

2.4.6 On the Basis of Relevance to Decision-Making

The following are some important cost concepts which help the management in
decision making process.
Differential Costs: The difference in total costs among the various alternatives is
termed as differential cost. In other words, differential cost is the result of change in
the total cost from an alternative course of action. If the change increases the cost it is
called incremental cost and the change decreases the cost it is called decrimental cost.
The difference in the total cost may be due to change in the methods of production,
change in sales volume, product mix, make or buy or drop out decisions, etc. While
assessing the profitability of a proposed change, the incremental costs should be
matched with the incremental revenues. Look at the following example :
A company is selling 1500 units @ Rs. 15 per unit. The variable cost per unit is
Rs. 7 and the total fixed costs is Rs. 6000. The company receives an export order for
the supply of 300 units @ Rs. 12 per unit. If this order is accepted, fixed cost will be
increased by Rs. 300.
Solution
The cost and sales before and after accepting the export order is worked out as follows:
Particulars

Before the Export

Order
Cost
Revenue
Rs.
Rs.

Sales
Less Variable Costs
Fixed Costs
Profit

After the Export

Order
Cost
Revenue
Rs.
Rs.

22,500
10,500
6,000

Incremental
Cost
Rs.

26,100

Revenue
Rs.
3,600

12,000
16,500
6,000

6,300

18,900
7,200

2,400
1,200

The proposed export order will result a profit of Rs. 1200. If the proposal is
implemented it results an incremental revenue of Rs. 3600 against the incremental cost
of Rs. 2400. Thus the differential concept is important for managerial decision making.
Sunk Costs: Sunk costs results from past expenditure. Sunk costs cannot be changed
now and management has no control over such costs. The examples of Sunk costs are :
past cost of inventory, past costs of long term assets etc. It should be noted that past
information is totally irrelevant but can be used to predict differential costs in future
course of actions. Further the management uses the past expenditure information in
performance evaluation.

4 1

Fundamentals of
Accounting

Imputed Costs : These costs are also called hypothetical costs or notional costs.
These costs are included in cost accounts only for the purpose of taking managerial
decisions. For example, interest on capital, rent of own building should be taken into
account while evaluating the relative profitability of the projects.
Opportunity Costs : Opportunity cost refers to the benefit foregone as a result of
accepting one course of action. The manager, while taking a decision should not only
take into account the costs and benefits of the proposed alternative but also the profit
scarified by making the decision. For example, if an owned building is proposed to be
utilized for housing a new project plant, the likely revenue which the building could
fetch, if it is let out, is the opportunity cost which should be taken into account while
evaluating the profitability of the project.

2.5

CONCEPTS OF COST UNIT AND COST CENTRE

2.5.1 Cost Unit

The main function of costing is to ascertain cost per unit of output. Each economic
activity has to be measured in identifiable units which may serve as the basis of
accounting. Such units for the purpose of costing may be as follows :
1)

Unit of product, or a group of products (e.g., pair of shoes or one batch of shoes
say one dozen)

2)

Unit of operating service (e.g., cost of running a bus per one kilometer)

3)

Unit of time (e.g., cost of generating electricity per hour)

4)

Unit of weight (e.g., cost per one tonne of steel)

5)

Unit of measurement (e.g., cost per meter of cloth or one litre of petrol)

Thus a cost unit is a unit of product, service or time in relation to which costs may be
ascertained or expressed. In other words cost unit is unit of measurement of cost. It
will be normally the quantity of product for which price is quoted to the consumers.
The selection of cost unit must be appropriate, natural to the business, easily
understandable and acceptable to all concerned. Firstly, it should offer convenience in
cost ascertainment. Secondly, it should be easier to associate expenses with cost units.
Thirdly, it should be according to the nature and prevailing practice of the business.
Some examples of cost unit for different products and services are given below:
Product/Activity

Cost Unit

Cement
Iron
Chemicals
Power
Coal
Bricks
Printing press
Paper
Transport

Per-tonne/per bag
Per-tonne/quintal
Per-tonne/kilogram/litre, etc
Per-kilowatt hour
Per tonne/kilogram
Per thousand
Per thousand copies
Per ream/per kilogram
Per passenger per kilometer/per
kilogram per kilometer
Per call
Per cubic foot/square foot
Per dozen or gross

Telephone
Timber
Pencils
4 2

Petrol
Television
Gold
Hotel
Nursing Homes
Cars

Per litre
Per set
Per gram
Per room per day
Per bed per day
Per car

Basic Cost Concepts

2.5.2 Cost Centre

A cost centre is location, person, or item of equipment (or group of these) for which
costs may be ascertained and used for the purpose of control. Thus a cost centre
refers to a section of business to which costs can be charged. It may consist of either
or a combination of the following :
Location : Factory, Department, Office, Warehouse, Stores, Sales Depot, etc.
Person : Salesman, a machine operator, customer, etc.
Equipment : Machine, Car, Truck, etc.
Types of Cost Centres : Cost centres may be divided into the following four types :
1)
2)
3)
4)

Process Cost Centre (Based on sequence of operations)

Production Cost centre (for regular production in a factory)
Operation Cost Centre (where various operations are involved in the production
process)
Service Cost Centre (for activities supporting the main production)

Thus identification or selection of cost centres depends on the nature and types of
industry. The identification of cost centres helps us in :
i)
ii)
iii)
iv)

ascertaining the centre-wise costs,

comparing the centre-wise costs periodically,
finding out the major trends of variance, and
applying the techniques of control to check undue, undesirable or unexpected
movements in cost.

A cost centre segregates operations, democrats activities, and distributes expenses.

This also helps in fixing responsibilities for every cost centre.
Check Your Progress A
1.

What is the concept of Cost ?

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2.

Distinguish between direct and indirect costs.

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3.

Give four examples of indirect expenses.

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

4 3

Fundamentals of
Accounting

4.

Distinguish between cost and loss.

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

5.

Give two examples of semi-variable costs.

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

6.

State whether each of the following statements is True or False

i)
ii)
iii)
iv)
v)
vi)
vii)

2.6

Variable cost remains fixed per unit but varies direct proportion to the
volume of output.
Variable costs are controllable.
Operating costing is used in transport industry.
Semi-variable costs vary in the same direction to the volume of output but
not direct proportion to the changes in the volume of output.
Fixed costs are also known as period costs.
Direct Material + Direct wages + Direct expenses = Works cost.
Works cost + Office overheads = Cost of production.

ELEMENTS OF COST

In order to understand and interpret the term cost, it will be necessary to

understand about the elements of cost. The following are the three elements
of costs: (1) Materials, (2) Labour, (3) Expenses
These can be further sub-dividend into as direct or indirect as follows :
Direct
Material
Labour
Expenses

Indirect
Material
Labour
Expenses

2.6.1 Materials
The term materials refers to those commodities which are used as raw materials,
components, or consumables for manufacturing a product. In other words, the
substance from which the product is made is known as materials. Materials can be
direct or indirect.
Direct Materials: All materials which become an integral part of the finished product
and which can be conveniently assigned to specific physical units is termed as Direct
Materials. Direct material generally becomes a part of the finished product. The
following are some examples of direct material :
i)

All materials or components specifically purchased, produced or requisitioned

from stores (e.g., sugar can for sugar, cloth for ready-made garments, cotton for
cloth, tyres for car, etc.)

ii)

Primary packing material (e.g., wrapping, cardboard, boxes etc.)

iii) Partly produced or purchased components

4 4

Indirect Materials: All materials which are used for purposes ancillary to the
business and which cannot conveniently be assigned to specific physical units is
termed as indirect materials. These materials cannot be conveniently identified with
individual cost units. Their cost is insignificant in the finished product. Pins, screws,
nuts, bolts etc., are some examples. There are some other items which do not
physically become part of the finished product. Examples are : Consumable stores,
lubricating oil, Greece, printing and stationery etc., These items do not form part of
the finished product.

Basic Cost Concepts

2.6.2 Labour
The workers employed for converting material into finished product or doing various
odd jobs in the business are known as Labour. Labour can be direct as well as
indirect.
Direct Labour: The workers who are directly involved, in the production of goods
are known as direct labour. They may be labourers producing manually or workers
operating machinery. Direct labour costs can be conveniently identified with a
particular product, job or process. For example, the wages paid to a machine
operator engaged in the manufacture of goods. The wages paid to such workers are
known as manufacturing wages.
Indirect labour : The workers employed for carrying out tasks incidental to
production of goods or those engaged for office work and selling and distribution
activities are known as indirect labour. The wages paid to such workers are known
as indirect wages. Indirect labour is of general character in nature and cannot be
conveniently identified with a particular unit of output. The examples of indirect
labour costs are : wages of storekeepers, foremen, directors fees, salaries of
salesman, etc.

2.6.3 Expenses
All expenses other than material and labour are termed as expenses. Expenses may
be direct or indirect.
Direct Expenses : Expenses which can be identified with and allocated to cost
centres or units are called direct expenses. These are the expenses which are
specifically incurred in connection with a particular cost unit. Direct expenses are
also called as chargeable expenses. The examples of such expenses are : Carriage
inwards, production royalty, hire charges of special equipment, cost of special
drawings, designs and layouts, experimental costs, etc.
Indirect Expenses : These are expenses which cannot be directly or wholly allocated
to cost centres or cost units. In other words, all expenses other than indirect material
and labour which cannot be directly attribute to a particular product, job or service
are called indirect expenses. Examples of such expenses are : Rent and Rates,
lighting and heating, advertising, insurance, repairs, carriage, etc.
The above elements of cost may be shown in the form of a chart as shown below:
Elements of Cost
Cost
s

Labour
s

Direct

Indirect
Overheads

Indirect

Expenses
s

Direct

Materials

Direct

Indirect
4 5

Fundamentals of
Accounting

All materials, Labour, expenses which cannot be identified as direct costs are termed
as indirect costs. The three elements of indirect costs viz., indirect materials, indirect
labour and indirect expenses are collectively known as overheads or on costs.
Overheads are grouped into three categories:
1)

Factory (or manufacturing) overheads,

2)

Office (or administrative) overheads, and

3)

Selling and distribution overheads.

1) Factory Overheads
All indirect manufacturing costs which cannot be identified with specific unit of
output are called factory overheads. It includes:
i)

Indirect material such as lubricants, oil, consumable stores etc.,

ii)

Indirect labour a such as gate-keepers salary, works managers salary etc., and

iii) Indirect expenses such as factory rent, depreciation on factory building and
equipment, factory insurance, factory lighting etc.,
iv) Factory overheads are also known as manufacturing overheads, indirect
production costs, factory on cost, overhead expenses etc.
2) Office Overheads
Indirect expenses incurred in connection with the general administration like
formulating policies, planning and controlling of a firm for attainment of its goal, are
included in these overheads. They include (i) indirect material used in office such as
printing and stationary material, brooms and dusters etc. (ii) Indirect labour such as
salaries payable to office manager, clerks, etc. and (iii) indirect expenses such as rent,
insurance, lighting of the office etc.,
3) Selling and Distribution Overheads
Selling and distribution overheads include all those costs which are incurred for
promoting and marketing the products. These include :
(i) Indirect material used such as packing material, printing and stationary
material etc, (ii) Indirect labour such as salaries of salesmen, sales manager, etc. and
(iii) Indirect expenses such as rent, insurance, advertising expenses etc.
The above classification of overheads can be shown with the help of the following
Figure:
Classification of Overheads
Overheads (Indirect Costs)
s

Selling and Distribution Overheads

s

Indirect
Indirect Indirect
Materials Labour Expenses

Office Overheads
s

Indirect
Indirect Indirect
Materials Labour Expenses

4 6

Factory Overheads

Indirect
Materials

Indirect
Labour

Indirect
Expenses

Basic Cost Concepts

2.7 TOTAL COST BUILD-UP

Components of Total Cost

Total cost of a product is the combination of direct costs and indirect costs. Direct
Costs, as you know, consist of direct materials, direct labour and direct expenses and
it is also known as prime cost. Indirect Costs known as overheads consists of factory
overheads, office overheads and selling and distribution overheads. Thus, the two
main components of total cost are: 1) Prime cost, and (2) Overheads.
If we add various costs one by one, we get the framework of total cost build up as
follows :
1)

Prime Cost: It consists of cost of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost. Thus,
Prime cost = Direct material + Direct Labour + Other direct expenses

2)

Factory Cost : It includes Prime Cost and factory overheads which consists of
indirect material, indirect labour and indirect factory expenses. The factory cost
is also known as works cost, production or manufacturing costs. Thus,
Factory Cost = Prime Cost + Factory Overheads

3)

Cost of Production: It comprises factory cost and office and administrative

overheads. It is also known as office cost. Thus,
Cost of Production = Factory Cost + Office and Administrative Overheads

4)

Total Cost: It comprises cost of production and selling and distribution

overheads. It is also called as cost of sales.
Total Cost = Cost of Production + Selling and Distribution overheads

The above framework of total cost building-up is shown in the following Figure :
Total Cost Build Up
Materials
Labour
Direct Expenses

Prime Cost
+
Factory
Overheads

Factory Cost
s+
Office
Overheads

Cost of
Production
+
Selling and
Distribution
Overheads

Cost of
Sales

Thus, the components of total cost are :

Prime Cost, (2) Works Cost, (3) Cost of Production, and (4) Cost of Sales.

2.8

COST SHEET

The elements of cost can be presented in the form of a statement called Cost Sheet.
A cost sheet is a statement showing the various components of total cost of output for
a certain period which acts as a guide to pricing decisions and cost control. It has
been defined as a document which provides for the assembly of the detailed cost of a
cost centre or cost unit. The cost sheet should be prepared properly and at frequent
intervals, i.e., weekly, monthly, quarterly, yearly etc. Cost sheet may be prepared
separately for each cost centre. Additional columns can also be provided for the
purpose of comparison of current data with the previous data.

4 7

Fundamentals of
Accounting

Cost Sheet, generally serves the following purposes :

i)
ii)

It provides total cost and cost per unit of production,

It gives the details regarding various elements of total cost, i.e., material, labour,
overheads, etc.,
iii) It gives scope for a comparative study of cost of production of the current period
with that of the previous period.
iv) It helps the management in taking managerial decisions relating to pricing
decisions, quotation of tenders, cost control etc.
The information to be shown in the cost sheet will depend upon the nature and
requirement of the enterprise. Generally, following information may be incorporated
into a cost sheet :
1)

Name of the product, cost centre or cost unit

2)

Period to which the statement relates

3)

Output of the period

4)

Details of various components of total cost

5)

Item-wise cost per unit

6)

Changes in stock position

7)

Cost of goods sold

8)

Profit or loss position

The Proforma of Cost sheet is given below :

Proforma of Cost Sheet
COST SHEET OF..................................................
For the month ending..................................................
Output..................nits
Total
Rs.
Raw Materials consumed :
Opening Stock of Raw of materials
Add : Purchases of Raw Materials
Less : Closing stock of raw materials
Direct Labour
Direct Expenses

.....................
.....................
....................

PRIME COST
Factory Overheads :
Rent
Depreciation on premises
Power and light
Indirect material
Indirect wages
Telephone Charges
Insurance etc.
WORKS COST
4 8

Per Unit
Rs.

Basic Cost Concepts

Office and Administrative Overheads:

Office salaries
Office rent
Office expenses, etc
COST OF PRODUCTION
(.................units)
Add Opening Stock of Finished goods
(.................units)
Less Closing Stock of Finished Goods
(.................units)
COST OF GOODS SOLD
(.................units)
Selling and Distribution Overheads :
Salaries and commission
Advertising
Packing expenses
Travelling expenses
Warehouse charges
Carriage outwards, etc.
COST OF SALES
(.................units)
PROFIT (LOSS)
SALES/SELLING PRICE

Look at the following illustration and see how a Cost Sheet is prepared with the
following information:
Illustration 1
From the following particulars of a manufacturing firm prepare a cost sheet showing
different components of total cost for the year ending 31st March, 2003.
Particulars
Stock of material (April 1, 2002)
Purchase of Raw materials
Stock of finished goods on
1-4-2002 (10,000 units)
Direct wages
Direct chargeable expenses
Finished goods sold (1,80,000 units)
Factory rent rates and power
Indirect wages
Depreciation on Plant and Machinery
Carriage Outwards
Carriage Inwards
Office rent and taxes
Telephone charges
Travelling expenses
Advertising
Depreciation on office premises
Stock of materials on 31.3.2003
Stock of finished goods on 31.3.2003 (12,000 units)

Amount (Rs.)
80,000
12,00,000
1,00,000
8,00,000
8,000
25,40,000
20,000
5,000
2,000
20,000
2,000
1,500
3,000
60,000
10,000
1,500
1,60,000
1,20,000

4 9

Fundamentals of
Accounting

Solution
Firstly, we have to find out the number of units produced during the year, before
preparing the cost sheet.
No. of Units
Closing Stock (31.3.2003)
Add: Number of Units sold

12,000
1,80,000
1,92,000

Less : Opening Stock (1.4.2002)

10,000

Number of units produced during the year

1,82,000

COST SHEET
for the year ending 31.3.2003
Output: 1,82,000 Units
Particulars
Raw Materials Consumed:
Opening Stock (1.4.2002)
Add: Purchase of Raw material
Add : Carriage inwards

Less : Closing stock of raw material

(as on 31.3.2003)
Direct wages
Other direct chargeable expenses

Total
Rs.
80,000
14,21,000
2,000
__________
15,03,000
1,60,000
__________

Prime Cost
Works Overheads:
Indirect wages
Factory rent, rates and power
Depreciation on plant and machinery

Works Cost
Office and Administrative Overheads:
Office rent and taxes
Telephone charges
Depreciation on office premises

5,000
20,000
2,000
______

1,500
3,000
1,500
_______

Cost of Goods Sold

(1,82,000 units @ Rs.12 per unit)
Add : Opening stock of Finished goods
(10,000 units @ Rs.12 per unit)

Less : Closing stock of Finished goods

(12,000 units @ Rs.12 per unit)
5 0

Per Unit
Rs.

13,43,000
8,00,000
8,000
_________
21,51,000

27,000
_________
21,78,000

6,000
_________
21,84,000

1,20,000

2,30,000
1,44,000

21,60,000

12.00

12.00

12.00

Cost of Goods Sold

(180,000 units)
Selling and Distribution Overheads:
Travelling expenses
Carriage outwards
Advertising
Cost of Sales
Profit

Basic Cost Concepts

60,000
20,000
10,000

SALES

2.9

90,000
_______
22,50,000
6,30,000

0.50
_______
12.50
3.50

28,80,000

16.00

CALCULATION OF RECOVERY RATES

Sometimes, you are required to calculate overheads recovery rates based on the cost
sheet prepared by you. Such rates are usually in respect of factory overheads and
administration overheads. Factory overhead rate is usually calculated as a percentage
of direct wages as follows:
Factory Overheads
Factory Overhead Rate = 100
Direct wages
Administration overhead rate is usually calculated as a percentage of works cost as follows:
Office Administration Overheads
Administration Overhead Rate = 100
Factory or Works Cost
Selling and distribution overheads rate may be computed either as a percentage of Works
cost or as a percentage of sales as follows :
Selling and Distribution Overheads
Selling and Distribution Overhead Rate = 100
Works Cost or Sales
Let us see the following illustration how the recovery rates are calculated :
Illustration 2
The following is the cost data relating to a manufacturing company for the period ending
December 31, 2002 :
Raw material purchased
Stock of raw material on 1-1-2002
Direct wages
Factory overheads
Carriage inwards
Selling and distribution overheads
Administration overheads
Stock of raw material on 31.12.2002
Sales during the year

Rs.
1,20,000
25,000
1,00,000
60,000
1,00,000
72,800
67,200
35,000
6,12,000

Find out a) Cost of Production

b) Cost of Sales
c) The Net Profit for the year
d) The percentage of factory overheads on direct wages
e) The percentage of administration overheads on works cost
f) The percentage of selling and distribution overheads on works cost and
g) The percentage of profit to cost of sales.
5 1

Fundamentals of
Accounting

Solution
Cost Sheet for the period ending December 31, 2002
Cost of Raw material consumed :
Stock of Raw Material (as on 1-1-2002)
Add : Raw material purchased
Add : Carriage inwards

Less : Stock of Raw Material (as on 31-12-2002)

Rs.
25,000
1,20,000
1,00,000

2,45,000
35,000

Direct Wages
PRIME COST
Factory Overheads
WORKS COST
Administration Overheads
(a) COST OF PRODUCTION
Selling and Distribution Expenses
(b) COST OF SALES
(c) PROFIT
SALES

(d)

(e)

(f)

2,10,000
1,00,000

3,10,000
60,000

3,70,000
67,200

4,37,200
72,800

5,10,000
1,02,000

6,12,000

Percentage of Factory Overheads to Direct Wages

=

Factory Overheads
100
Direct Wages

60,000
100
1,00,000

60%

Percentage of Administration Overheads to Works Cost

Administration Overheads
100
Works Cost

67,200
100
3,70,000

18.16%

Percentage of Selling and Distribution Expenses on Works Cost

=

5 2

Rs.

Selling and Distribution Expenses

100
Works Cost

Basic Cost Concepts

(g)

2.10

72,800
100
3,70,000

19.68%

Percentage of Profit to Cost of Sales

=

Profit
100
Cost of Sales

1,02,000
100
5,10,000

20%

STATEMENT OF QUOTATION

A manufacturer, sometimes, may be asked to quote a price for supply a particular

article with certain specifications. The term Quotation refers to quoting the
minimum price for obtaining a specific order. Such a price is quoted before the
commencement of actual production in anticipation of obtaining a particular order.
While quoting the price the manufacturer has to keep in view the likely impact of
inflationary trends on the input. Before submitting a tender or fixing price he must
have full information regarding cost of inputs like raw materials, wages, different
overheads and a reasonable amount of profit. On the basis of past records, he can
prepare a cost sheet incorporating inflationary trends in price levels of various
components of production. While quoting the price for such specific order, he has to
be cautious that the price is neither too high nor too low. In case the price is too high,
the tender will be rejected outright. On the other hand, if the price is too low, it will
result in either lower profit or loss. Therefore, it is important to estimate the cost as
accurately as possible.
Statement of quotation is prepared in the same manner as Cost Sheet as shown in
illustration 3
Illustration 3
A manufacturing company receives a quotation for the supply of 10,000 units of its
products. The costs are estimated as follows :
Raw material 80,000 kgs. @ Rs. 4 per kg.
Direct wages 10,000 hours @ Rs. 2 per hour
Variable overheads :
Factory @ Rs. 2.50 per labour hour
Selling and Distribution Rs. 30,000
Fixed Overheads :
Factory Rs. 10,000
Office and Administration Rs. 75,000
Selling and Distribution Rs. 20,000
The company adds 10% to its cost as its margin of profit. Prepare a Statement of
Quotation showing the price to be quoted.

5 3

Fundamentals of
Accounting

Solution
Statement of Quotation showing the price to be quoted for 10,000 units
Total
Rs.

Per Unit
Rs.

Estimated cost of Direct Materials

(80,000 kgs X Rs. 4 per kg)
Estimated Cost of Direct Labour
(10,000 hours X Rs. 2 per hour)
Estimated Prime Cost
Add : Estimated Factory Overheads :
Variable (10,000 hours X Rs. 2.50) 25,000
10,000
Fixed

3,20,000

32.00

20,000

2.00

3,40,000

34.000

35,000

35.00

Estimated Factory Cost

Add:Estimated Office and Administrative
Overheads
Estimated Cost of Production
Add: Estimated Selling and Distribution Overheads
Variable
Rs. 30,000
Fixed
Rs. 20,000
Estimated Cost of Sales
Add: Deserved Profit @ 10% on cost price
Estimated Selling Price

3,75,000
75,000

37.50
45.00

4,50,000

45.00

50,000
5,00,000
50,000
5,50,000

5.00
50.00
5.00
55.00

Sometimes, cost records for a particular period are given and the estimated cost of
material and labour of a work order are provided for the purpose of ascertaining its
selling price to be quoted. In such a situation, you should prepare the cost sheet first
and ascertain the recovery rates for factory overheads as a percentage to direct wages,
for administrative overheads as a percentage of works costs, and for selling and
distribution overheads as percentage of cost of goods sold or as suggested in the given
question. These rates must be duly adjusted with the anticipated changes, if any,
before preparing the statement of quotation. Look at the following illustration and
how the statement of quotation for a work order is prepared with the help of a give
cost data.
Illustration 4
The following figures have been obtained from the cost records of a manufacturing
company for the year 2002 :
Cost of Materials
Wages for Direct labour
Factory overheads
Distribution expenses
Administration expenses
Selling expenses
Profit

1,20,000
1,00,000
60,000
28,000
67,200
44,800
84,000

A work order was executed in 2003 and the following expenses were incurred :
Cost of Materials
Wages for labour

16,000
10,000

Assuming that in 2003 the rate for factory overheads went up 20%, distribution
charges went down by 10% and selling and administration charges went up by 12 1 2 ,
5 4

at what price should the product be quoted so as to earn the same rate of profit on the
selling price as in 2002. Show the full workings.

Basic Cost Concepts

Factory overheads are based on direct wages while administration, selling and
distribution expenses are based on factory cost.
Solution
Statement of Cost for the year 2002
Rs.
1,20,000
1,00,000
2,20,000
60,000
2,80,000
67,200
3,47,200
44,800
28,000
4,20,000
84,000
5,04,000

Cost of Direct Materials

Direct wages
PRIME COST
Factory Overheads
WORK COST
Administration Overheads
COST OF PRODUCTION
Selling Overheads
Distribution Overheads
COST OF SALES
Profit
SALES
Factory Overhead Rate

Factory Overheads
100
Direct Wages

60,000
100
1,00,000

60%

Administrative Overheads Rate

Selling Overheads Rate

Distribution Overhead Rate

Administration Overheads
100
Works Cost

67,200
100
2,80,000

24%

Selling Overheads
100
Works Cost

44,800
100
2,80,000

16%

Distribution Overheads

Works Cost

28,000
100
2,80,000

10%

100

5 5

Fundamentals of
Accounting

Rate of Profit

Profit
100
Cost of Sales

84,000
100
4,20,000

20% cost of sales

Statement of Quotation showing the price to be quoted for a work order

Cost of Direct Materials
Direct wages
PRIME COST
Factory Overheads : 60% of wages
Add 20% increase
WORK COST
Administration Overheads: 24% of works cost

1
Add : 12 increase
2
COST OF PRODUCTION
Selling Overheads : 16% of works cost

1
Add : 12 increase
2
Distribution Overheads : 15% of works cost
Less : 10% decrease
COST OF SALES
Profit (20% of Cost of Sales)
SALES

Rs.
16,000
10,000
26,000
6,000
1,200

7,200
33,200

7968
996

8,964
42,164

5312
664
3320
332

5,976
2,988
51,128.00
10,225.50
61,353.50

Check Your Progress B

1)

What is a cost Sheet ?

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2)

Name the basic methods of costing

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3)

Name different types of costing.

..........................................................................................................................
..........................................................................................................................

5 6

..........................................................................................................................

4)

What do you mean by quotation? Why is it necessary ?

Basic Cost Concepts

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
5)

State whether each of the following statement is True or False

i)
ii)
iii)
iv)
v)

2.11

Selling and distribution overheads are recovered on the basis of

percentage to cost of production.
Office and administrative overheads are recovered usually on the basis of
percentage to factory cost.
Factory overheads rate is usually calculated as a percentage of direct
wages.
Cost of sales = Factory cost + Selling and Distribution overheads.
Selling price = Cost of sales + Profit.

METHODS OF COSTING

Business enterprises are not alike. They are different from another in some way or
other. The basic principles and procedures of costing remains the same in all
industries but the method of analysis and presentation of cost of their products and
services vary from industry to industry. Therefore, the choice of a particular method
of costing depends upon the nature and types of the product or service provided by a
business unit. The various methods of costing can be summarized as follows :

2.11.1 Job Costing

Under this method, costs are ascertained for each job or work order separately. The
job may consist of a single unit or it may consist of identical or similar products under
a single work order. This method applies where work is undertaken against
customers requirements. Job costing is suitable to industries like printing, repairs,
foundries, interior decorators, building construction etc. Non profit organisations like
rehabilitation or street repair programmes also use job costing to ascertain cost of
individual projects. It can also be used in industries where different product lines are
manufactured. For example, a furniture manufacturer may produce a batch of similar
chairs, a batch of tables and so on. Each batch can be treated as a job for accounting
purposes. Job costing also found in service organisations like engineering,
consultancy and accounting firms. Job costing procedure is the same both in
manufacturing and service organisations, except that service units use no direct
material.
The purpose of job costing is to ascertain the cost of production of each job for fixing
selling prices, bidding, controlling costs and evaluating performance. It also provides
information for negotiating price increase with the customers.

2.11.2 Contract Costing

This method is used in case of big jobs and therefore, the principles of job costing are
applied to contract costing The contract work usually involves heavy expenditure,
spreads over a long period and is usually undertaken at different sites. Hence, each
contract is treated as a separate unit for the purpose of cost ascertainment and control.
Contract costing is also termed as terminal costing as the cost can be terminated at
some point and related to a particular job. Contract costing is employed in business
undertakings engaged in construction of buildings, roads, bridges, ship building and
other civil and mechanical engineering works.

5 7

Fundamentals of
Accounting

2.11.3 Batch Costing

This method of costing is used in industries where the production is carried on in
batches. Each batch consist of identical products which maintains its identity
throughout one or more stages of production. Each batch cost is used to determine the
unit of cost of products. On completion of the batch the cost per unit can be
calculated by dividing the total batch cost by the number of units produced. This
method of costing is suitable to industries where production consists of repetitive
production in nature and specified number of products are produced in one batch. It
is generally used in industries like engineering component industry, pharmaceuticals,
footwear, bakery, readymade garments, toy manufacturing, bicycle parts etc.

2.11.4 Unit Costing

Unit Costing is a method of cost accounting where costs are determined per unit of a
single product. This method is also called single or output costing. This method is
suitable to industries where production is continuous and uniform and engaging in the
production of a single product in two or three varieties. The cost per unit is found by
dividing the total cost by the total number of units produced. Where the product is
produced in different grades, costs are ascertained grad wise. It is suitable for
industries like collieries, quarries, brick works, flour mills, paper mills, cement, textile
mills, diaries etc.

2.11.5 Process Costing

Where a product passes through different processes and each process is distinct and
well defined the method employed for ascertaining the cost at each stage of production
is called process costing. Process costing is used in those industries where the
production is continuous and the final product is the result of sequence of operations
or processes. The finished product of one process will become the raw material of the
next process and the output of the last process will be the finished stock. The cost per
unit at each process will be calculated by dividing the total cost by the number of units
produced at each stage and the cost per unit of the final product is the average cost of
all the processes. During the course of processing of raw material, loss of some raw
material is unavoidable or it may give rise to the production of several products called
joint products or by products. Process costing is used in case of chemicals, paints,
textiles, bakeries, oil refining, food products, etc. Standardization of processes helps
the management to submit quotations in time without any delay. As actual and
budgeted costs are available in each process it facilitates managerial control by
evaluating the performance at each process level.

2.11.6 Operating Costing

Operating Costing is also called as service costing because this method is used in
those undertakings which provide services and are not engaging in manufacturing
tangible products. It is used for ascertaining the cost of operating a service such as
railways, roadways, airways, hotels, nursing homes, power supply, water supply etc.
In these undertakings the cost unit is a service unit which is as follows:

5 8

Undertaking
Canteen
Cinema
Electricity
Hospital
School/College
Transport

Cost Unit
per cup of tea
per seat
per kilo watt
per bed
per student
per passenger kilometer/per tonne kilometer

A large amount of capital is invested in fixed assets and comparatively less

working capital is required in these industries. Operating costing is different from
operation costing. Operating costing is used to determine the cost of providing a
service whereas operation costing is used to find out cost of each operation
in those of industries which produce goods consisting of a number of
operations.

Basic Cost Concepts

2.11.7 Multiple Costing

It is an application of more than one method of costing in respect of the same
product. This method is suitable in industries where a number of components are
manufactured separately and then assembled into a finished product. In cases of
motor car, type writer, television, refrigerators, etc., costs are to be ascertained for
each component as well as for finished product. This involves use of different
methods of costing for different components and so it is known as multiple or
composite costing.

2.11.8 Uniform Costing

The practice of using a common method of costing by a number of firms in the same
industry is known as uniform costing. Thus it is not a separate method of costing. It
simply refers to a common system using agreed concepts, principles and standard
accounting practices. This helps in making inter-firm comparisons and fixation of
prices.
It should be noted that there are two basic methods of costing. They are : (i) Job
costing, and (ii) Process costing. The other methods discussed above are simply
variants of these two methods.

2.12

TYPES OF COSTING

2.12.1 Marginal Costing

It is also known as Variable Costing. It may be defined which methods of costing
rebers to the process and practice of ascertaining costs of products and serrices, the
types of costing rebers to the techniqu of analysing and presenting costs for the
purpose of control and managerial decisions. The hypes of costing (also known as
techniques of costing) generally used are as follows:
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. It
is a technique of costing which emphasizes the distinction between product costs and
period costs. Only variable costs (direct material, direct labour, other direct expenses
and variable overheads) are allocated to products without taking into account fixed
costs. Fixed costs are treated as period costs and are charged to costing profit and
loss account of the period in which they are incurred. The profitability of the product
is based on the amount of contribution made by each product. Contribution is the
difference between selling price and marginal cost of sales. The price of a product
will be determined on the basis of marginal cost plus contribution. The difference
between the total contribution and total fixed cost represents the profit (Profit =
Contribution Fixed cost).
The technique of marginal costing is a valuable tool to management in making
managerial decisions like fixation of selling price, selection of suitable product mix,
selection of alternative methods of production, make or buy decisions, and also for
cost control.

5 9

Fundamentals of
Accounting

2.12.2 Absorption Costing

Absorption costing is a principle whereby fixed as well as variable costs are allotted
to cost units. It is a technique of charging all costs, both fixed and variable costs, to
production of a product. Absorption costing does not require a break-down of costs
into fixed and variable costs. As such fixed costs are treated as product costs under
absorption costing. The reports prepared under absorption costing can be used for
external use.

2.12.3 Historical Costing

It refers to a system of cost accounting under which costs are ascertained only after
they have been incurred. In other words, accounting is done in terms of actual costs
and not in terms of predetermined and standard costs. In the initial stages of
development of cost accounting, historical costing is the only system available for
ascertaining costs. This system is not useful for cost control and measuring the
performance efficiency of the concern. Moreover, it is not useful in price quotations
and production planning.

2.12.4 Standard Costing

It refers to the system of cost accounting under which costs are determined in advance
on certain predetermined standards. These are known as standards which indicate the
level of costs that should be attained under a given set of operating conditions. The
standard costs are compared periodically with the actual costs and underlying causes
for variances are analysed so that corrective action may be taken in time wherever
necessary. The Standard Costing is helpful to the management for cost control,
production planning, formulation of policies, measuring efficiencies, eliminating
inefficiencies, etc.

2.13

LET US SUM UP

Cost data is required by an organisation for the purpose of ascertaining profit or loss
periodically, to plan its future operations as well as to evaluate its performance and
cost control. It also requires to price its products or services, to value its inventory and
day to day operations of plans and policies. Costs indicates (i) an actual or estimated
expenditure (ii) a direct or indirect expenditure and (iii) it relates to a job, process,
product or services. Cost is a flexible concept. It varies with time, volume, firm,
method or purpose. There is difference between cost and loss. Cost signifies an
expenditure incurred for recurring some benefit and if no benefit is desired from a
particular expenditure, it is treated as loss.
Cost can be classified in various ways. On the basis of functions to which they relate,
costs are classified into manufacturing costs, administrative costs, selling and
distribution costs. On the basis of Identifiability with products costs can be classified
into direct costs and indirect costs. On the basis variability costs can be classified into
fixed costs, variable costs and semi variable costs. Costs can also be classified on the
basis of product or period. Product costs are those costs which are easily attributable
to products where as costs which are easily attribute to time interval are known as
period costs. Costs can also be classified on the basis of controllable and noncontrollable costs.

6 0

A cost unit is a unit of product, service or time in relation to which costs may be
ascertained or expressed. A cost centre is a location, person or item of equipment (or
group of these) for which costs may be ascertained and used for the purpose of
control. There are three elements of costs : (i) Materials (ii) Labour and (iii)

Expenses. These costs can be further sub-dividend into as direct or indirect costs.
Indirect costs are : indirect material, indirect labour, and indirect expenses. Indirect
costs are known as overheads. Overheads can be classified into factory overheads,
office overheads, selling and distribution overheads.

Basic Cost Concepts

The main components of total cost are prime cost, works cost, cost of production and
cost of sales. The elements of cost can be presented in the form of a statement called
cost sheet A cost sheet is a statement showing the various components of total cost
of output for a certain period which acts as a guide to pricing decisions and cost
control. Overhead recovery rates are based on the cost sheet. Sometimes, a statement
of quotations is required to be prepared in order to find out the price to be quoted to
the prospective buyer for obtaining a specific order. Such a price is quoted before the
commencement of actual production after taking into consideration the inflationary
trends in the price levels of various components of production.
There are various methods of costing. These are: (i) Job costing (ii) Contract costing
(iii) Batch costing (iv) Unit costing (v) Process costing (vi) Operating costing (vii)
Multiple costing (viii) Uniform costing. The types of costing refers to the techniques
of analysing and presenting costs for the purpose of control and managerial decisions.
The types of costing generally used are: (i) Marginal costing (ii) Absorption costing
(iii) Historical costing, and (iv) Standard costing.

2.14

KEY WORDS

Allocation: Distribution of expenditure among various cost centres.

Costing: The technique and process of ascertaining costs.
Cost Sheet: A statement showing different elements of cost relating to a particular
product or a job for a particular period.
Cost Centre: A location, person, equipment or department for which costs may be
ascertained and used for purpose of control.
Direct Expenses: Expenses or decrease in the same proportion on the increase or
decrease in the output.
Cost of Sales: Total cost of a product including selling and distribution expenses.
Prime Cost: Cost of direct expenses including direct materials and wages.
Semi-variable costs: Expenses which change with changes in output, but not in the
same proportion.
Works cost: Prime cost plus factory overheads.
Chargeable expenses: Other direct expenses.
By-product: A product of relatively small value produced incidentally from
processing the raw material for the main product.
Joint Product: Two or more products resulting from processing a particular raw
material.
Process Costing: A method of ascertaining the cost of a product at each stage or
process of manufacturing.
Contract Costing: A special form of job costing applicable to big projects which
involves huge cost to complete and is usually site-based.
Job Costing: Specific order costing involving accumulation of costs relating to a
single cost unit - the job - when each order is of comparatively short duration.
6 1

Fundamentals of
Accounting

2.15

ANSWERS TO CHECK YOUR PROGRESS

A)

i) True (ii) False iii) True (iv) True (v) True (vi) False (vii)True

B)

i) False (ii) True iii) True iv) False v) True

2.16

TERMINAL QUESTIONS

1)

Distinguish among variable, fixed and semi-variable costs. Why is this distinction important?

2)

fixed Costs are really variable. The more you produced the less they become.
Comment the statement.

3)

Describe briefly the different methods of costing and state the particular industries to which they can be applied.

4)

Distinguish between the following :

i)
ii)
iii)
iv)

Product cost and period cost

Controllable and uncontrollable cost
Variable and fixed costs
Direct and indirect costs

5)

Costs may be classified according to their nature and characteristics Explain.

6)

Cooling Ltd manufactured and sold 1,000 refrigerators in the year ending 31st
March, 2002. The summarized Trading and Profit & Loss Account is set out
below :
Rs.
Rs.

To Cost of Sales
To Direct Wages
To Other Manufacturing Cost
To Gross Profit c/d
To Management and Staff Salaries
To Rent, Rates and Insurance
To Selling Expenses
To General Expenses
To Net Profit

8,00,000
12,00,000
5,00,000
15,00,000
40,00,000
6,00,000
1,00,000
3,00,000
2,00,000
3,00,000
15,00,000

By Sales

40,00,000

By Gross Profit b/d

40,00,000
15,00,000

15,00,000

For the year ending 31st March, 2003, it is estimated that

a)
b)
c)
d)
e)
f)

Output and sales will be 1,200 refrigerators.

Prices of Material will go up by 20% on the level of previous year.
Wages will rise by 5%
Manufacturing costs will rise in proportion to the combined cost of Material and
wages.
Selling cost per unit will remain unaffected
Other expenses will also remain constant

You are required to submit a statement to the Board of Directors showing the price at
which the refrigerators should be marketed so as to show profit of 10% on selling
price.
6 2

(Answer : Estimated selling price Rs. 51,00,000 Profit Rs. 5,10,000)

7)

The following particulars have been made available from the Cost Ledger of a
Company :
Rs.

Stock of Raw materials on 31.12.2000

Stock of finished Goods on 31.12.2000
Purchase of Raw materials
Direct wages
Sales
Stock of Raw Materials on 31.12.2001
Stock of Finished goods on 31.12.2001
Works Overheads
Office and general Charges

Basic Cost Concepts

25,600
56,000
5,84,000
3,97,000
11,84,000
27,200
60,000
88,072
71,048

The company is required to submit a tender for a large machine. The Cost
Department estimates that the materials will cost Rs. 40,000 and wages to fabricate
the machine Rs. 24,000. The tender is to be made at a net profit of 20% on selling
price.
Prepare a statement showing a) Cost of materials used, b) total cost, c) percentage of
factory overheads to direct wages, and d) percentage of office overheads to works
cost.
Also prepare a statement of quotation showing the price at which the tender of the
machine can be submitted.
(Answer : Cost of materials used Rs. 5,82,400; Total Cost Rs. 11,38,520;
Percentage of Factory overheads to Direct Wages 22%; Percentage of Office
Overheads to Works Cost 6.65%; Price to be quoted in tender : Rs. 92,360)
Note : These questions will help you to understand the unit better.
Try to write answers for them. But do not submit your
answers to the University. These are for your practice only.

2.17

SOME USEFUL BOOKS

Arora, M. N. 2000, A Text Book of Cost Accountancy. Vikas Publishing House Pvt.
Ltd., New Delhi (Chapter 1-2).
Bhar, B. K. 1990. Cost Accounting : Methods and Problems. Academic Publishers,
Calcutta (Chapter 1-2)
Maheswari, S. N. and Mittal, S. N. 1990. Cost Accounting : Theory and Problems.
Shree Mahavir Book Dept, Delhi (Chapter I)
Nigam B. M. L. and Sharma G. L. 1990. Theory and Techniques of Cost Accounting.
Himalaya Publishing House, Bombay (Chapter 1-3)
Owler. L. W. J. and J. L. Brown 1984. Wheldons Cost Accounting. ELBS, London
(Chapter 1-2)

6 3

Fundamentals of
Accounting

UNIT 3 FINANCIAL STATEMENTS

Structure
3.0

Objectives

3.1

Introduction

3.2

Natural of Financial Statements

3.3

Contents of Financial Statements

3.3.1
3.3.2
3.3.3
3.3.4
3.3.5

Manufacturing Account
Trading Account
Profit and Loss Account
Profit and Loss Appropriation Account
Balance Sheet

3.4

Concept of Capital and Revenue

3.5

Revenue Recognition
3.5.1
3.5.2

3.6

Format of Financial Statements Non-corporate Entities

3.6.1
3.6.2

3.7

Revenue Recognition in Case of Sale of Goods

Revenue Recognition in Case of Rendering of Services
Conventional Format
Vertical Format

Corporate Financial Statements

3.7.1
3.7.2

Items Peculiar to Corporate Balance Sheet

Items Peculiar to Corporate Income Statement

3.8

Requirements for Corporate Financial Statements as per Schedule VI

3.9

Basic Principles Governing the Preparation of Financial Statements

3.10

Preparation of Corporate Financial Statements

3.11

Let Us Sum Up

3.12

Key Words

3.13

Terminal Questions

3.0

OBJECTIVES

After studying this unit you should be able to:

l

state the nature and contents of financial statements;

know the differences between capital and revenue;

know the prepration of non-corporate financial statements;

be acquainted with the items peculiar to corporate financial statements; and

prepare the profit and loss account and the balance sheet of a company as per the
requirements of the Companies Act.

3.1

64

INTRODUCTION

Accounting involves the collection, recording, classification and presentation of

financial data for the benefit of management and external agencies. For this purpose,
the transactions recorded in the books of accounts are periodically summarised and
presented in the form of two financial statements. One is the Balance Sheet or
Positional Statement and the other is Profit and Loss Account or Income Statement.

These are periodical reports which reflect the financial position and operating results
of the entire business for an accounting period, generally one year. These financial
statements are the basis for decision making by the management as well as outsiders.
However, the information presented in these statements must be analysed and
interpreted carefully before drawing conlcusions. In this unit we shall study the
preparation of financial statements both corporate and non-corporate entities as well
as the salient points involved in the preparation of these statements in the light of
Sections 210 to 223 and Part I and II of Schedule VI of the Companies Act, 1956.

3.2

Financial Statements

NATURE OF FINANCIAL STATEMENTS

Financial Statements are prepared by all forms of business organizations to ascertain

the result of operating, financial and investment activities and to know the financial
position on the date of closing of books of accounts. In case of sole trade or a
partnership firm, maintenance and preparation of financial statements is not
mandatory but desirable. However, in case of Joint Stock Company, Sections 209 and
210 of the Companies Act 1956 make it obligatory and compulsory to maintain and
prepare financial statements by the end of each accounting period. Thus, main
objective of financial statements is to serve the information needs of users of
accounting information. These financial statements are the basis for decision making
by the management as well as to the outsiders like investors and share holders,
creditors and Financiers, government authorities, etc.
Objectives of Financial Statements
The primary objective of financial statement is to assist in decision making.
These statements enable the users:
i) To make rational investment, credit and similar other financial decisions.
ii) To estimate future cash flow and bankruptcy risk assessment.
iii) To ascertain NAV (Net Assets Value) or Net worth of the enterprise after
evaluating the value of assets, resources owned and the claims thereon
(liabilities) in order to make share purchase and sale decisions, takeovers and
merger decisions.
iv) Collective bargaining decision relating to wages, working conditions and job security.
v) To make assessment of economic and financial decisions.
(vi) To form appropriate taxation and subsidy policy, regulatory policy and
employment policy.
Besides, the financial statements are tools of judging earning capacity and managerial
efficiency to facilitate comparison and help evaluate its own performance. Thus, these
provide necessary inputs for forecasting and other relevant decision-making purposes.
According to American Institute of Certified Public Accountants Financial
statements are prepared for the purpose of presenting periodical review or report on
progress by management and deal with the status of the investment in the business and
the results achieved during the period under review. Financial statements reflect a
combination of recorded facts, accounting-conventions and the personal judgment
and the judgments and conventions applied affect them materially. The soundness of
the judgments necessarily depends on the competence and integrity of those who make
them and on their adherence to generally accepted accounting principles and
conventions.
Hence, these financial statements must give sufficient analysis of the figures, without
unnecessary details to enable the users to understand its financial implications. This
calls forth for convention of materiality i.e. every material fact has to be disclosed

65

Fundamentals of
Accounting

which affect the decisions of the users of financial statements. It also demands that
any departure from previous years practice should clearly be indicated. In other
words the convention of consistency should strictly be adhered to. An enterprise has
to be consistent with reference to depreciation policy, inventory valuation policy and
other policy to facilitate horizonal and vertical comparison. Financial statements are
based on fundamental accounting assumptions of going concern, consistency and
accrual and are guided by major considerations governing the selection and
application of accounting policies.

3.3

CONTENTS OF FINANCIAL STATEMENTS

3.3.1 Manufacturing Account

Business concerns engaged in the activities of manufacturing or production of goods
which involves purchase of raw materials and in incurring of other manufacturing
expenses, prepare Manufacturing Account which shows the cost of raw materials
consumed, cost of conversion of raw materials into finished product and the cost of
goods produced. The cost of goods produced charged to Trading Account. The cost of
conversion includesDirect Expenses, Frieght or Carriage Inward, direct labour.
Productive wages/Factory wages and factory expenses, such as factory rent, fuel,
power and gas, etc.
Cost of goods produced = Raw materials consumed + Cost of conversion
If, however, there is opening and closing work in progress due adjustment is made
accordingly. Similarly, value of material residue, which is sold as scrap, is credited to
Manufacturing Account.
Thus, we can say
Cost of goods produced =

opening work-in-progress = cost of raw materials

consumed + cost of conversion closing work in
progress sale of scrap

Points to note regarding Manufacturing Account

66

1)

Work in progress: It refers to the value of incomplete or semi-finished goods

which includes cost of raw materials, and proportionate wages and direct expense incurred till this stage of semi completion. Opening and closing balances of
the same are shown to the debit and credit side respectively.

2)

Raw materials consumed: This shows the cost of materials used in the production process. This is arrived at by Adding the net purchases to the opening
balance of raw materials and deducting the closing balance of raw materials at
hand by the end of accounting period.

3)

Direct expenses: These expenses are incurred either on procurement or purchases of raw materials and on conversion thereof into finished product. It
includes productive wages, freight inward, cartage or carriage inward, etc. That
is, it includes direct labour and direct expenses (factory).

4)

Factory overheads or indirect expenses: Factory overheads refer to indirect

material, indirect labour and indirect expenses. These include cotton waste,
lubricating of machine oil, works manager, supervisor or foremans salary, fuel
and power, repairs and maintenance of factory machine, depreciation of factory
assets, rent, rates and taxes of the factory building, factory insurance, etc.

5)

Scrap: It denotes the value of material residue coming out of certain types of
processes. It is sold as scrap and credited to Manufacturing Account to arrive at
the correct cost of production.

6)

Cost of production: Manufacturing Account ascertains the cost of goods

manufactured during any accounting period as shown in the format of Manufacturing Account. The cost of production of goods produced is transferred to
Trading Account.

Financial Statements

3.3.2 Trading Account

Trading Account is prepared to know the result of trading operations. It shows the
gross profit or gross loss arising from buying and selling of goods in which the
business enterprise deals in. Gross profit or gross loss is the difference between sales
and cost of goods sold.
Cost of goods sold = opening stock + purchases (less returns) + direct
expenses closing stock
It is to be noted that Trading Account shows the result of trading operations under
normal conditions only. Abnormal losses (items) if any such as loss of stock due to
fire, theft or accident are credited to Trading Account, at cost.

Analysis of Items Appearing to the Debit Side of Trading Account

1) Opening Stock: It refers to the value of goods at hand at the end of last
accounting year. It becomes the opening stock for the current accounting year. It
represents the value of goods in which business deals in.
2) Purchases: It denotes the value of goods (in which the concern deals in) purchased
either for cost or on credit for the purpose of resale. However, if the goods so
purchased are returned or used by proprietor for self consumption, or distributed as
free samples or taken up by the employer for their use, or given as charity, or to be
sent on consignment, or used for any other purpose, except for resale, such amounts
shall be deducted from the total purchases.
3) Director Expenses: These expenses are incurred in connection with purchase,
procurement or production of goods. It also includes expenses which bring the goods
up to the point of sale. Examples of direct expenses are:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)

Carriage Inwards (carriage paid on purchases)

Freight Railways, Airways and Shipping
Transit Insurance
Loading charges
Packing
Import duty
Export duty
Custom duty
Dock dues
Octroi
Warehousing wages

However, for a manufacturer in addition to above direct expenses include

l)
m)
n)
o)
p)

Wages and salaries

Fuel, coal, power, gas and water
Factory heating*
Factory insurance*
Factory lighting*

67

Fundamentals of
Accounting

q)
r)
s)
t)

Foremans and Supervisors salary*

Other factory expenses*
Royalty on production*
Depreciation on Factory Building and machine*

These are also known as Factory overheads or Factory indirect expenses from cost
accounting point of view but for financial accounting purposes these are treated as
direct expenses.

It is to be noted that a manufacturer prepares a Manufacturing Account

where all the above mentioned direct expenses are debited. However, if in
any case Manufacturing Account is not prepared, then all such expenses
will be charged to Trading Account.

Analysis of Items Appearing to the Credit Side of Trading Account

1) Sale: It refers to the sale of goods in which business deals and includes both cash
and credit sales. It does not include sale of old, obsolete or depreciated assets which
were acquired for use in business. Similarly, goods returned by customers or goods
sent to customers on approval basis or sales tax, if any, included in sales price should
be excluded.
2) Abnormal Loss: It refers to abnormal loss of stock due to fire, theft or accident.
Since Training Account is prepared under normal conditions of the business, abnormal
loss, if any, is credited fully to the Trading Account.
3) Closing Stock: It refers to the value of goods lying unsold at the end of any
accounting year. The stock at the end is valued either at cost or market price,
whichever is less. Since Trial Balance generally does not include closing stock, the
following entry is recorded to incorporate the effect of closing stock in the Trading
Account.
Closing Stock A/c
To Trading A/c

Dr

However, if closing stock forms the part of Trial Balance it will not be
transferred to Trading Account but taken to Balance Sheet only.
In case goods have been sent to customer on approval (Sale/Return) basis, such goods
should be included in the value of closing stock if no approval has been received from
them.
Constituents of closing stock are:
i) Stock of Raw materials
ii) Work-in-progress or semi-finished goods
iii) Finished goods
remaining unsold at the end of the year,
lying unsold at different branches, if any,
lying unsold with the consignee
iv) Stores supplies = goods, materials required for converting the raw materials
into finished product, such as machine oil, cotton waste,
chemicals and machine spares (as per As-2)
68

Points to Remember
l

It is to be noted that Income Statement + (viz. Manufacturing/

Trading/Profit and Loss Account) is parepared on Accrual)
(Mercantile) basis (Accrual concept) covering an accounting period
(accounting period concept) during which expenses are matched with
revenue (Matching Concept) to ascertain the profit or loss of an
enterprise. That is why unpaid expenses are added as outstanding in
the Income Statement and shown as liability in the Balance Sheet.
Similarly income accrued but not received are credited to Income
Statement and shown as asset in the Balance Sheet.

It is important to remember that Outstanding Accrued or Prepaid,

if forming part of Trial Balance, then such items will be shown in the
Balance Sheet only and no treatment required in the Income
Statement.

Conversely, prepaid expenses are shown by way of deduction in

the Income Statement and treated as an asset in the Balance Sheet,
whereas income received in advance are subtracted from the income
received and shown as a liability in the Balance Sheet.

Financial Statements

3.3.3 Profit and Loss Account

This account is prepared to ascertain the net profit earned or net loss incurred by the
business concern during an accounting period. It starts with gross profit or gross loss
as disclosed by the Trading Account. It takes into account all the remaining direct
(normal and abnormal) expenses and losses related to or incidental to business. These
operating and non-operating expenses are charged to Profit and Loss Account and
shown to the debit side of the Profit and Loss Account.
The operating expenses include:
i)

All office or Administrative overheads such as rent, rates and taxes, office staff
salaries, printing and stationary, postage, telephone, office lighting, depreciation
on office equipment, etc.

ii)

Selling and Distribution overheads such as Salesmens salaries, commission on

sales, travelling expenses, advertisement and publicity, trade expenses, carriage
outward, bad debts, warehouse expenses, delivery van expenses, packing expenses and rebate to customers.
Non-operating expenses include financial expenses such as interest, bank
charges, discount on bill, abnormal losses (loss of goods due to fire, theft or
accident) and loss on sale of fixed assets, etc.
Whereas Non-operating incomes include income from investment and financing
activities, such as Interest Received, Rent Received, Dividend Received, Profit
on Sale of Investment, and Insurance Claims and other Miscellaneous Receipts,
like duty drawback and subsidy and apprenticeship premiums, etc. These
incomes are credited to Profit and Loss Account.

It is to be noted that if an enterprise prepares a Manufacturing Account, the factory

expenses (both direct and indirect) are charged to Manufacturing Account. If a
Manufacturing Account is not prepared, then direct factory expenses are charged to

69

Fundamentals of
Accounting

Trading Account and indirect factory expenses to Profit and Loss Account. Royallties
paid on production should be treated as direct expenses and royalties based on sales
as indirected expenses.
Some Important Points

70

1)

Salaries: Salaries paid/payable to employees including Directors salaries,

Managers salaries (except Work Managers salaries) should be debited to
Manufacturing Account. In case a concern does not prepare Manufacturing
Account, the same should be charged to Trading Account. Similarly, salaries and
wages should also be charged to Profit and Loss Account. But wages and
salaries be charged to Trading Account.

2)

Brokerge: This refers to brokerage paid on the items in which the business
trades in. Such as brokerage on buying and selling of goods in which the enterprise deals in is shown to the debit of Profit and Loss Account. However, any
brokerage paid on sale or purchase of assets is treated as of capital nature and
hence it is deducted from sale proceeds of the asset sold or added to the cost of
the asset required.

3)

Trade Expenses: These expenses are of miscellaneous nature and of

small amount and sometimes termed as Sundry expenses or Miscellaneous
expenses or even Petty expenses. These are debited to Profit and
Loss Account.

4)

Advertisement: Expenses on advertisement which are of revenue and recurring

nature are charged to Profit and Loss Account. Whereas cost of heavy advertisement the benefit of which is likely to cover more than one accounting year is
treated as deferred revenue expenditure. For example, a company incurs
Rs. 1,00,000 on advertisement and it is estimated that the benefit of this
advertisement expenditure is likely to extend over a period of four years. In this
case Rs. 25,000, i.e. one-fourth of total cost of advertisement will be charged to
current years Profit and Loss Account whereas three-fourths, i.e. Rs. 75,000,
will be taken to Balance Sheet to be treated as Deferred Revenue Expenditure.
However, advertisement expenses incurred for purchase of goods should be
charged to Trading Account. Advertisement expenses paid for acquiring a capital
asset are capitalised. Again, cost of advertisement in respect of sale of any
capital asset is deducted from the sale proceeds of the asset concerned and hence
not charged to profit and loss account.

5)

Rebate to Customers: It is an allowance given to a customer when his

purchases from the concern exceeds the certain limits say Rs. 200. In such cases
all those customers who make purchases from the company exceeding Rs. 200
will be entitled to rebate of 1% or 2% depending upon the policy declared
by the company. The amount of rebate so allowed is charged to Profit and Loss
Account.

6)

Duty drawback and subsidy: It is a refund of duties levied on purchases made

by exporter. It serves as an incentive to exporter. The duty drawback and cash
subsidy should be deducted from the purchases. But in practice it is treated as
income.

7)

Apprenticeship Premium: It is the fee charged by the business enterprise to train

persons in various trades. It is treated as revenue receipts and credited to Profit
and Loss Account.

8)

Factory Expenses: Factory expenses are of two types, viz. direct and indirect,
and both are shown in the Manufacturing Account. If a concern does not prepare
Manufacturing Account, then direct expenses are charged to Trading Account
and indirect expenses are debited to Profit and Loss Account.

9)

Royalties: Royalties are paid by the business concerns to the landlord, author of
a patentee for the right to use their land, copyrights or patents right. Payment of
such royalty sum based on sales is debited to Profit and Loss Account.
However, if royalty is paid on the basis of production, it is charged to Trading
Account.

Financial Statements

10) Free Samples and Publicity Expenses: These expenses are incurred to attract
cumtomers for increasing the volume of sale and as such are charged to Profit
and Loss Account. Similarly, money spent on prizes given to customers under the
scheme of sales promotion such as Bumper sales, Dhamaka sales are treated
as selling and distribution expenses. If a large sum is incurred on heavy
advertisement under a contract or whose benefits may accrue over a period of
more than one year, say four years, such expenses are spread over the period of
its benefits and a proportionate part is charged to Profit and Loss Account and
remaining is taken to Balance Sheet as deferred revenue expenditure.
11) Abnornal Losses and Insurance Claims: As a rule, the entire amount of
abnormal losses either arising from accident, fire or tgheft are credited to
Trading Account and debited to profit and loss account irrespective of the
insurance claims. The amount so received/settled/receivable from the insurance
company is credited to Profit and Loss Account.
Alternatively, Trading Account may be credited with the net abnormal loss
(abnormal loss insurance claim, if any) and insuracne claims and Profit and Loss
Account may be debited by net abnormal loss only.

3.3.4 Profit and Loss Appropriation Account

This account shows the distribution or appropriation of profit after the same has been
earned and computed. In case of sole proprietor, since entire amount of profit belongs
to him, no Profit and Loss Appropriation is prepared. However, this account is
prepared by partnership firms and Joint Stock Companies where there are several
claimants in the net profit. A partner shares earnings of the firm in the form of salary,
commission, interest and profit and credited to Profit and Loss Appropriation
Account.
However, a companys Profit and Loss Appropriation account shows the transfer from
Profit and Loss Account an amount equivalent to currnet years profit after tax.
This account is further credited by the reserves and provisions made last year, now no
longer required, such as Development Rebate Reserve and Provision for Tax, etc. The
following items are debited to Profit and Loss Appropriation Account:

Transfer to General Reserve

Transfer to Capital Reserve

Dividend Paid

Proposed Dividends

Bonus to Shareholders

Excess of actual tax liability over the provisions made last year

Corporate Dividend Tax, if any.

However, a detailed explanation of Profit and Loss Appropriation Account is to be

made under Corporate Financial Statements under 3.7 of this unit.

3.3.5 Balance Sheet

Balance sheet is a statement of assets and liabilities which helps us to ascertain the
financial position of a concern on a particular date, i.e. on a date when financial

71

Fundamentals of
Accounting

statements or final accounts are prepared or books of accounts are closed. In fact, it
treats the balances of all those ledger accounts standing to the debit or credit column
of the Trial Balance and which have not been squared up. These accounts relate to
assets owned, expensed incurred but not paid or not due, expenses due but not paid,
incomes accrued but not received or certain receipts which are not due or accrued. In
fact it deals with all those real and personal accounts which have not been
accounted for in the Manufacturing, Trading and Profit and Loss Accounts. Besides,
the balance sheet also treats all those items in the adjustments, whch affect Real or
Personal Accounts. The Nominal Accounts are treated in the Income Statement
(P&L A/c). A Balance Sheet aims to ascertain nature and amount of different assets
and liabilities so that the financial position could clearly be known to all those
concerned. Thus, the main function of the Balance Sheet is to depict the true picture of
the concern on a particular date.
Preparation and Presentation of Balance Sheet
The process of preparation and presentation of balance sheet involves two steps:
(i) Grouping and (ii) Marshalling. The first step refers to proper grouping of the
various items, which are of similar nature. For example, amount due from persons
who were sold goods on credit basis must be shown under the heading Trade
Debtors and must be distringuished from money owing other than due to credit sales
of goods. The second step involves marhsalling of assets and liabilities. It means
orderly arrangement in which assets and liabilities are presented or shown in the
Balance Sheet. There are two methods of presentation: (i) In order of Liquidity, and
(ii) In order of permanence.
Under the Liquidity Order, assets are shown on the basis of liquidity or realisability.
These are arranged in order of most liquid, more liquid, liquid, least liquid and
not liquid (fixed) assets. Similarly, liabilities are arranged in the order in which
these are to be paid or discharged. The liquility form is suiable for banking and other
financial companies.
Under the Order of Permanence, the assets are arranged on the basis of their useful
life. The assets which are to serve business for the longest period of time are shown
first, i.e. Fixed Assets, Semi Fixed, Current, Liquid and Most Liquid. Similarly, in
case of liabilities, after Capital, the liabilities are arranged as long term, medium term,
short term and current liabilites. The Companies Act has adapted permanency form
preparing balance sheet.
Some Important Items
1) Fixed Assets: Fixed assets are those assets, which are reuired for the purposes of
producing goods or rendering services. These are not held for resale in normal
course of business. Fixed assets are used for the purpose of earning revenue and
these are held for a longer period of time. These are also treated as Gross Block
(Fixed assets after depreciation) and Net Block (Fixed assets after depreciation). Investment in these assets is known as Sunk Cost. Examples of fixed
assets are Land and Building, Plant and Machinery, Furniture and Fixtures,
Tools and Equipments, Motor Vehicles, etc. All fixed assets are tangible by
nature.

72

2)

Intangible Assets: Intangible assets are those capital assets which do not have
any physical existence. Though cannot be touched or seen yet they have long life
and help to generate income. Such assets have value by virtue of the rights
conferred upon the owner by mere possession. Goodwill, trademarks, copyrights
and patents are the examples of intengible assets.

3)

Current Assets: Current assets include cash and other assets which are converted or realized into cash within a normal operating cycle or say within a year.

These are acquired either for the purpose of resale, or assisting and helping
process of production or rendering of service or supplying of goods. These assets
constantly keep on changing their form and contribute to routine transactions and
operations of business. Examples are, Cash in Bank, Bills Receivables, Debtors,
Stock, Prepaid Expenses, etc. Current assets are also known as floating assets or
circulating assets.
4)

5)

6)

7)

8)

Financial Statements

Liquid or Quick Assets: Those current assets whch can be converted into cash
at a very short notice or immediately without incurring much loss or exposing to
high risk. Quick assets can be worked out by deducting Stock (Raw materials,
work in progress or finished goods) and prepaid expenses out of total current assets.
Fictitious Assets: These are the non-existent worthless items which represent
unwritten off losses or cost incurred in the past which cannot be recovered in
future or realized in cash. Examples of such assets are preliminary expenses
(formation expense), Advertisement suspense, Underwriting - commission,
discount on issue of shares and debentures, Loss on issue of debentures and debit
balance of Profit and Loss Account. These fictitious assets are written off or
wiped out by debiting to Profit and Loss Account.
Wasting Assets: Assets with limited useful life by nature deplete over a limited
period of time are called wasting assets. These assets become worthless once its
utility is over or exhaust fully. Such assets are natural resources like, timer, coal
oil, mineral deposits, etc.
Contingent Assets: Contingent assets are probable assets which may or may not
become assets as it depends upon occurrence or non-occurrence of a specified
event or performance of a specified act. For example, a suit is pending in the
court of law against ownership title of any dispsuted property and if the suit is
decided in favour of the business concern it becomes the asset of the concern. On
the other hand, if the decision goes against the concern, the company cannot
claim to enjoy ownership rights. Thus, it remains a contingent asset as long as
the judgment is not pronounced by court. Such assets are shown by means of
footnote and hence do not form part of assets shown in the Balance Sheet. Beside
this hire purchase contract, uncalled share capital etc. are the other examples of
contingent assets.
Classification of Liabilities

Long Term Liabilities: These are the obligations which are to be met by the business
enterprise after a relatively long period of time. Such liabilities do not become due for
payment in the ordinary course of business operation or within normal operating
cycle. Debentgures, long term loans from Bank or financial institutions are the
examples of long-term liabilities.
Current Liabilities: Current liabilities are those liabilities which are payable within
normal operating cycle, i.e. within an accounting year. These may arise either out of
realization from current assets or by creating fresh current liability (obligation). Trade
creditors, Bill payable, Bank overdraft, Outstanding expenses, Short-term loan
(payable within twelve months or within accounting year) are examples of current
liabilities.
Contingent Liability: It is not an actual liability but an anticipated (probable liability
which may or may not become payable). It depends upon happending of certain events
or performance of certain acts. An element of uncertainty is always attached. A
contingent liability, thus, may or may not become a sure liability. Examples are,
liability for bills discounted, liability for acting as surety, liability arising on a suit for
damages pending in the court of law, liability for calls on partly paid shares, etc.
Contingent liabilities are shown as footnote under the Balance Sheet.
73

Fundamentals of
Accounting

3.4

CONCEPTS OF CAPITAL AND REVENUE

You know that a firm prepares Profit and Loss Account for ascertaining the net result
of business operations and the Balance sheet for determining the financial position of
the business. These are prepared with the help of Trial Balance which shows the final
position of all ledger accounts. All items appearing in the Trial Balance are transferrd
either to the Profit and Loss Account or to the Balance Sheet. As per rules, the items
of revenue nature are taken to the Profit and Loss Account and the items of capital
nature are shown in the Balance Sheet. In other words whether an item appearing in
the Trial Balance is to be taken to the Profit and Loss Account or the Balance Sheet
depends upon the capital and revenue nature of the item. If any item is wrongly
classified i.e., if an item of revenue nature is treated as a capital item or vice versa, the
Profit and Loss Account will not reveal the correct amount of profit and the Balance
Sheet will not reflect the true and fair view of the affairs of the business. It is therefore
necessary to determine correctly whether an item is of capital nature or of a revenue
nature and record it in the books accordingly. There are certain rules governing the
allocation of expenditures and receipts between capital and revenue which should be
clearly understood.
Capital and Revenue Expenditures
You incur expenditure on various items every day. You buy food items, stationery,
cosmetics, utensils, furniture, etc. Some of them are consumables and some are
durables. The benefit of expenditure on consumables like stationery, cosmetics, etc. is
derived over a short period. But in case of durables like furniture, utensils, etc., the
benefit spreads over a number of years. Same is true of business also. In business you
incur expenditure on two types of items: (i) routine items like stationery, and (ii) fixed
assets like machinery, builing, furniture, etc., whose benefit is available over a number
of years. In accounting terminology the first category of expenditure is called revenue
expenditure and the second one is called capital expenditure. Let us now study the
exact nature of capital and revenue expenditures.
Capital Expenditure: As stated above, when the benefit of an expenditure is not
exhausted in the year in which it is incurred but is available over a number of years it
is considered as capital expenditure. The following expenditures are usually treated as
capital expenditures:
1) Any expenditure which results in the acquisition of fixed assets such as land,
buildings, plant and machinery, furniture and fixures, office equipment,
copyright etc. you should note that such capital expenditure includes not only the
purchase price of the fixed asset but also the expenses incurred in connection
with their acquisition. Thus, the brokerage or commission paid in connection
with the acquisition of an asset, the freight and cartage paid for transportation of
machinery, the expenses incurred on its installation, the legal fees and
registration charges incurred in connection with purchase of land and buildings
are also treated as capital expenditure.
2) Any expenditure incurred on a fixed asset which results in (a) its expansion,
(b) substantial increase in its life, or (c) improvement in its revenue earning
capacity. Improvement in the revenue earning capacity can be in the form of
(i) increased production capacity, (ii) reduced cost of production, or
(iii) increased sales of the firm. Thus, cost of making additions to buildings and
the amount spent on renovation of the old machinery are also regarded as capital
expenditures. If you buy a second hand machinery and incur heavy expenditure
on reconditioning it, such expenditure is also to be treated as capital expenditure.
Similarly, expenditure on structural improvements or alterations to existing fixed
assets whereby their revenue earning capacity is increased, is also treated as
capital expenditure.
74

3)

Expenditure incurred, during the early years, on development of mines and land
for plantations till they become operational.

4)

Cost of experiments which ultimately result in the acquisition of a patent. The

cost of experiments which are not successful is not to be treated as capital
expenditure. It is treated as a deferred revenue expenditure which is written off
within two to three years.

5.

Legal charges incurred in connection with acquiring or defending suits for

protecting fixed assets, rights, etc.

Financial Statements

Revenue Expenditure: When the benefit of an expenditure is not likely to be

available for more than one year, it is treated as revenue expenditure. So all expenses
which are incurred during the regular course of business are regarded as revenue
expenditures. The examples of such expenses are:
1)

Expenses incurred in day-to-day conduct of the business such as wages, salaries,

rent, postage, stationery, insurance, electricity, etc.

2)

Expenditure incurred for buying goods for resale or raw materials for
manufacturing.

3)

Expenditure incurred for maintaining the fixed assets such as repairs and
renewals of building, machinery, etc.

4)

Depreciation on fixed assets. This can also be termed as revenue loss.

5)

Interest on loans borrowed for running the business. You should note that
any interest of loan paid during the initial period before production
commences, is not treated as revenue expenditure. It is treated as capital
expenditure.

6)

Legal charges incurred during the regular course of business such as legal
expenses incurred on collection from debtors, legal charges incurred on
defending a suit for damages, etc.

Deferred Revenue Expenditure

Sometimes, certain expenditure which is normally treated as revenue may be
unusually heavy and its benefit is likely to be available for more than one year. In such
a situation, it is considered appropriate to spread the cost of the expenditure over a
number of accounting years. Hence, it is capitalised and only a portion of the total
amount spent is charged to the Profit and Loss Account of the current year. The
balance is shown as an asset which wil be written off during the subsequent
accounting years. Such expenditure is called a Deferred Revenue Expenditure because
its charge to Profit and Loss Account has been deferred to future years. Some example
of such expenditure are:
1)

Expenditure incurred on advertising campaign to introduce a new product in the

market.

2)

Expenditure incurred on formation of a new company (preliminary expenses)

3)

Brokerage charges, underwriting commission paid and other expenses incurred in

connection with the issue of shares and debentures.

4)

Cost of shifting the plant and machinery to a new site which may involve
dismantling, removing and re-erection of the plant and machinery.

Let us take the case of expenditure on advertising campaign. It is not a routine

advertisement and the amount involved is unusually heavy. Its benefit will not
completely exhaust in one accounting year but will contunue over two to three years.
Hence, it is not proper to charge such expenditure to the Profit and Loss Account of

75

Fundamentals of
Accounting

one year. It is better to distribute it carefully over three years. So, in the first year we
may charge one-third of the amount spent to the Profit and Loss Account and show
the balance in the Balance Sheet as an asset. In the second year again we may charge
a similar amount to the Profit and Loss Account and show the balance as an asset. In
the third year. we may charge this balance to the Profit and Loss Account. Every
expenditure which is regarded as deferred revenue is treated in this way in the final
accounts.
Look at Illustration 1 and note how each expenditure has been treated and why.
Illustration 1
State whether the following items of expenditure would be treated as (a) capital
expenditure, (b) revenue expenditure, or (c) deferred revenue expenditure:
i)

Carriage on goods purchased Rs. 25.

ii)

Rs. 2,000 spent on repairs of machinery.

iii) Rs. 5,000 spent on white washing.

iv) Rs. 8,000 paid for import duty and cartage on the purchase of machinery from
west Germany.
v)

Rs. 25,000 spent on issue of equity shares.

vi) Rs. 14,000 spent on spreading new tiles on factory floors.

vii) Rs. 4,000 spent on dismantling, transportation and reinstalling plant and
machinery to new site.
viii) Rs. 60,000 spent on construction of railway siding.
ix) Rs. 20,000 spent on some major alterations to a theatre which made it more
comfortable and attractive.
x)

A second hand maching was bought for Rs. 10,000 and an amount of Rs. 6,000
was spent on its overhauling.

Solution
i)

It is a revenue expenditure as it relates to the goods for resale.

ii)

It is a revenue expenditure as it relates to the maintenance of a fixed asset.

iii) Same as no. (ii).

iv) It is a capital expenditure as it is spent in connection with the purchase of a fixed
assets.
v)

It would be treated as deferred revenue expenditure. It is a heavy amount incurred in connection with reising of capital for the company and so capitalised.
Even under the Indian Companies Act and the Indian Income Tax Act this
expenditure is allowed to be written off over a number of years.

vi) It is a revenue expenditure so it is treated as a sort of repairs not leading to any

increase in the earning capacity of a fixed asset.
vii) Normall expenditure on transportation etc. is revenue in nature. But this expenditure has been incurred on shifting to new site which is non-recurring in nature
and involves a heavy amount. Hence it shall be treated as a deferred revenue
expenditure.
viii) It is a capital expenditure as it is incurred on the construction of railway siding, a
fixed asset.
76

ix) It is a capital expenditure as the alterations made the theatre more comfortable
and attractive which is likely to increase its collections.
x)

Financial Statements

It is a capital expenditure as it is incurred on making the newly bought second

hand machinery operational.

Capital and Revenue Receipts

Receipts refer to amounts received by a business i.e., cash inflows. Receipts may be
classified as Capital Receipts and Revenue Receipts. It is necessary to note this
distinction clearly because only the revenue receipts are taken to the Profit and Loss
Account and not the capital receipts.
Capital Receipts: Capital receipts are the amounts received in the form of (a)
additional capital introduced in the business, (b) loans received, and (c) sale proceeds
of fixed assets. You are aware that a loan taken by the business is repayable sooner or
later. Similarly, additional capital received represents an increase in the proprietors
claim over the business assets. Thus these two items represent increase in liabilities of
the business and obviously are not incomes or revenues. These are capital receipts and
should be treated as such. The sale proceeds of a fixed asset are also treated as a
capital receipt because the amount received is not revenue earned in the normal course
of business. The capital receipts increase the liabilities or reduce the assets. They do
not affect the profit or loss.
Revenue Recipts: Revenue receipts are the amounts recived in the normal and regualr
course of business. They take the form of (a) sale proceeds of goods, and (b) incomes
such as interest earned, commission earned, rent received, etc. These receipts are on
account of goods sold or some services rendered by the business and as such they are
not repayable. All revenue receipts are treated as incomes and shown on the credit side
of the Profit and Loss Account.

3.5

REVENUE RECOGNITION

Revenue arises in the ordinary course of business activities of an enterprise from:

sales of goods,

rendering of services, and

use by others of enterprise resources yielding interest, royalties and dividends.

Revenue recognition is mainly concerned with the timing of recognition revenue in the
statement of profit and loss. According to AS-9, revenue is the gross in flow of cash,
receivables, or other consideration arising in the course of ordinary activities of an
enterprise.
The basic problem of revenue recognition lies in identifying of the accounting
period during which revenues are earned. There are several stages or activities in a
business before the revenues are earned and realized. Hence the problem arises
should revenue be recognized at the point of production, sale, delivery or receipt of
cash. According to Realisation Concept revenues are recognized at the point of
sale or services are rendered. However, there is no single uniform practice to
recognize various types of revenues according to one common principle. There are
guidelines, which help us in recognizing operating revenues and non-operating
revenues. Non-operating revenues include interest, dividend and rent and other
incomes which are not related to normal course of operation of the enterprise.
It is advisable to show operating and non-operating revenues separately in the
Profit and Loss Account.
77

Fundamentals of
Accounting

Following are some of the established practices to recognize revenue as per AS-9.

3.5.1 Revenue Recognition in Sale of Goods

Trading and Manufacturing organizations, in general, recognize revenue when sale is
effected. However, the following conditions should be satisfied:
i)

The property in goods is transferred for a price.

ii)

All significant risks and rewards have been transferred and no effective control is
retained by the seller.

iii) No significant uncertainty exists regarding the collection of amount of consideration.

Special Cases of Sale of Goods and applicability of AS-9
a)

b)
c)
d)

e)

f)
g)

h)

I)

j)

k)

Delivery of goods delayed at buyers request and buyer takes title and
accepts billing: Revenue should be recognized and the goods to be delivered at
any subsequent date should not be included in the inventory.
Goods delivered subject to installation and inspection: Revenue should be
recognized only after the installation and inspection is completed.
Sale on Approval: In case of sale on approval or return basis, revenue should be
recognized only when acceptance is received from buyer.
Sale subject to warranty: If sales are subject to a warranty, revenue recognition
should not be deferred but a provision should be made to cover the liability
which may arise under the terms and period of warranty.
Guaranteed Sales: Sometimes goods are sold and delivery is made giving the
buyer the unlimited right to return. This is under Money back guarantee, if not
completely satisfied. Under this situation it is apparent to recognize the revenue
at the point of sale and to make provisions for returns as well.
Consignment Sales: Revenues are recognized when the goods are sold to
customers by the consignee and at the time of dispatch of goods of consignor.
Cash on delivery Sales: If a sale has been effected under the terms of
Cash-on-delivery, revenue should be recognized only when cash is
received by seller.
Installment Sales: Revenues are recognized on delivery to the extent of normal
cash down price. However, interest on deferred payment should be recognized in
the ratio of amount outstanding.
Special Order: Where payment is received against the specific order of goods,
which are not in stock. Revenue from such sale should be recognized only when
goods are purchased or manufactured and are ready for delivery.
Sale/Repurchase Agreement: Where seller concurrently agrees to repurchase
the same goods at some late date, the flow of cash under such a situation will not
be recognized as revenue.
Sales to Distributors to Dealers for Resale: Revenues are recognized only if
significant risks of ownership have passed on distributors/dealers.

3.5.2 Revenue Recognition in Case of Rendering of Services

Revenue recognition in case of rendering services care based on the following
conditions:
i)

78

Revenue recognized either on completed service method or proportionate

completion method.
ii) No significant uncertainty exists regarding amount of consideration.
iii) It is reasonable to expect ultimate collection of consideration.

Under completed service method revenue are recognized only on completion of

service. In cases there are more than one act involved, revenue are recognized on
execution of all these acts.

Financial Statements

Proportionate completion method recognized revenue proportionate with the degree

of completion of services. If there are more than one act involved revenue are
recognized on execution of certain acts. Some examples of recognition of service
revenue are
1)

Installation Fee: In cases where installation fees are other than incidental to
sales, the revenue should be recognized only when the equipment is installed and
accepted by the customer.

2)

Advertising and Insurance Agency Commission: Revenue should be recognized when service is completed. For advertising agencies, media commission
will normally be recognized when the related advertisement or commercial
appears before the public, and the necessary intimation is received by the agency.
Insurance agency commission should be recognized on the effective
commencement renewal dates of the related policies.

3)

Financial Service Commissions: A financial service may be rendered as a single

act or may be provided over a period of time. Similarly, charge for such services
may be made as a single amount or in stages over the period of the service or the
life of the transaction to which it relates. Such charges may be settled in full
when made or added to a loan or other account and settled in stages.
The recognition of revenue should therefore have regard to:
a)

Whether the service has been provided one and for all or in an continuing
basis.

b)

The incidence of cost relating to service.

c)

Commission charged for arranging and granting of loan or other facilities,

should be recognized when a binding obligation has been entered into.
Commitment, facility or loan management fees which relate to
continuing obligations or service should normally be recognized over the
life of the loan or facility having regard to the amount of the obligation
outstanding, the nature of the service provided and timing of the costs
relating thereto.

Admission Fees: Revenue from artistic performance, banquets and other

special events should be recognized when the event takes place. When fees to a
number of events, it should be allocated to each event on a systematic and
rational basis.
Tution Fees: Revenue should be recognized over the period of instruction.
Entrance and Membership Fees: AS.9 recommends capitalization of entrance fees.
If membership fee permits only membership and all other services of products are paid
for separately or if there is a separate annual subscription, the fee should be
recognized as revenue when received. If the membersyhip fee entitles the member to
services or publications to be provided during the year, it should be recognized on a
systematic and rational basis having regard to the timing and nature of all services
provided.
Subscription for Publications: Revenue received or billed should be deferred and
recognized either on straight-line basis over time or where the items delivered
vary in value from period to period revenue should be based on the sales value
of the items delivered in relation to total sales value of all items covered by
the subscription.

79

Fundamentals of
Accounting

Exceptions to General Rule

1)

Revenue recognition at the point of production (Completed Production

Method): Under this method revenue are recognozid at the point of production.
It applies to case of agriculture. Extractive industries like gold, silver, uranium,
other metals and oil (crude) etc. revenue are recognized just after completion of
production even before the sales take place.

2)

Cash Basis: Under this, revenue are not recognized at the point of sale but when
cash is realized including outstanding, if any. This basis is applicable in case of
hire-purchase system where revenue are recognized on the basis of cash received
and installments due during the year.

3)

Revenue Recognition during the production period on percentage of

completion method: Under this method revenue are recognized on the basis of
contract value, associated costs, number of acts or other susitable basis. It is
applicable in case of long-term construction contracts where revenue are
recognized on the basis of degree of completion or what work certified bears to
cash received by the contractor.

4)

Time Basis: In many cases revenue are realized on the basis of time or period.
For example, interest on fixed deposits is credited to Profit and Loss Account on
time proportion basis, i.e. interest accrued yet not payable.

It is to be noted that revenue in case of Royalties are recognized on an accrual basis

in according with terms of agreement and, Dividends are recognized when the right to
receive payment is established.

3.6

FORMAT OF FINANCIAL STATEMENTS

(NON-CORPORATE ENTITIES)

The financial statements may be prepared and presented either in conventional (also
known as T form) or Vertical form. The basic purpose is to serve the information
needs of the users of accounting information. The idea is to present these accounting
figures in such a way that provides maximum input for decision-making purposes.
The income statement gives the clear picture operating efficiency of the enterprises by
disclosing the amount of gross profit or loss through Trading Account. At the same
time Profit and Loss Account reveals the overall net result the net profit or net
loss. The Balance Sheet, which is also known as position statement is required to
depict the true and fair view of state of affairs of business enterprise. Sole traders and
partnership firms are not requqired to comply any legal provisions as far as
presentation and formats of financial statements are concerned. However, these
income statements, meant basically for self consumption, must be prepared in
conformity with the accounting concepts, conventions and applicable accounting
standards.
The financial statements of non-corporate entities may be presented either of the
following ways:
1)

Conventional Format, and

2)

Vertical Format

3.6.1 Conventional Format

Following are the conventional formats of Income and Position statements:
80

Financial Statements

Format of a Manufacturing Account

For the year ended 31st March....
Dr.

Cr
Rs.

To
To

To

To

Opening Work-in progress

Raw materials consumed
Operating stock of Raw material
Add: Purchases
Less: Closing stock of
Raw material
Direct Expense
Productive Wages
Freight Inward Raw material
Cartage/Carriage Inward
Factory overheads
Salary of Works Manager
Gas, Fuel and Power
Factory Light
Rent, Rates and Taxes
Insurance of factory assets
Repairs of factory assets
Depreciation of factory assets
Other Factory Expenses

Rs.

---------

By Closing Work-in- Progress

By Sale of Scrap
By Cost of goods
produced-transferred
to Trading Account

-----

---------

-----

----------------------------------------***

***

Trading Account (A format)

For the year ended 31st March ....
Dr.

Cr
Rs.

To
To
To

*
*

Opening Stock (Finished Goods)

Transfer from Manufacturing A/c
or/and Purchases less returns
Direct Expense
Carriage/cartage Inward
Freight
Insurance-in-transit
Wages
Fuel and Power
Coal, Gas and Water
Packing (essential)
Octroi
Import duty
Consumable Stores
Royalty (based on output)

---------

---------------------------------

Rs.
By Sales less Returns
By Abnormal Loss:
(Transferred to
Profit and Loss A/c)
Loss by Fire
Loss by Accident
Loss by Theft
By Closing Stock
By Gross Loss A/c
(Balancing figure)

-----

---------

81

Fundamentals of
Accounting

*
*
To

Manufacturing Expenses
Excise Duty
Dock dues
Gross Profit A/c
(Balance fiture)**

---------

----***

***

* Concerns not preparing Manufacturing Account separately

** Balancing figure will be either gross profit or gross loss.
Profit and Loss Account (A format)
For the year ended 31st March ....
Dr.

Cr
Rs.

To Gross Loss* b/d

82

To Office & Administration Expenses:

Salaries of Office Staff
Office Rent, Rates and Taxes
Printing and Stationery
Postage and Telephone
Fire Insurance Premium
Audit Fees
Repairs and Maintenance
Legal Expenses
Office Lighting
Depreciation-office assets
Other Office Expenses
To Selling and Distribution Expenses:
Salesmens Salaries
Commission on Sales
Travelling Expenses
Brokerage
Trade Expenses
Advertisement and Publicity
Sales Promotion Expenses
Carriage Outward
Bad Debts
Provision for Bad Debts
Repairs of Vehicles
Depreciation on Vehicles
Warehouse Expenses
Warehouse Insurance
Warehouse Rent
Delivery Van Expenses
Packing Expenses
Rebate to Customers
Royalty on Sales
To Financing Expenses:
Discount Allowed
Interest on Capital
Discount of Bills
Bank Charges

-------

-------------------------------------------------------

Rs.
By Gross Profit b/d*

------

By Interest Received
By Dividend Received
By Rent Received
By Discount Received
By Profit on sale of fixed assets
By Profit on sale of Investment
By Insurance Claims
By DutyDraw Backs
By Apprenticeship Premium
By Miscellanceous Receipts
By Bad debts Recovered
By Net loss transferred
to Capital account
(Balancing figure)**

------------------------------------------------------------------

Financial Statements

To Abnormal Losses:
Transferred from Trading Account
(loss by Fire
Accident
Theft)
To Loss on sale of Fixed Assets
To Miscellaneous Expenses
To Net Profit Transferred to
Capital A/c (Bal. Figure)**
***
* Balancing b/d may be either Gross Profit or Gross Loss
** The Balancing figure may be either Net Profit or Net Loss

***

Profit and Loss Appropriation Account (A format)

For the year ended 31st March ....
Dr.

Cr
Rs.

To
To
To
To
To

Profit and Loss A/c (Net Loss)*

Interest on Partners Capitals
Salary to Partners
Commission to Partners
Balance (Transferred to
Partners Capital Accounts)**

Rs.
By Profit and Loss A/c (Net Profit)*
By Interest on Drawings
By Balance (transferred to
Partners Capital Account)

***
***
* There will either be Profit or Loss
** Represent balancing fiture a residual profit or loss to be shared by partners in
the profit sharing ratio.
Balance Sheet of ......... (A format)
as on 31st March .......
Liabilities

Rs.

Capital
----Add Profit or less Loss ----Less Drawings
-----

-----

Long Term Liabilities

Mortgaged Loan
Loan from Bank

---------

Current Liabilities
Sundry Creditors
Bills Payable
Income Received in Advance
Outstanding Expenses
Bank Overdraft

---------------------

Assets
Fixed Assets:
Goodwill
Land and Building
Plant and Machinery
Tools and Equipments
Motor Vehicles
Furniture and Fixtures
Patents and Trademarks

-------------------------------------------------

Investment (Long Term)

Current Assets:
Stock
Accrued Income
Prepared Expenses
Sundry Debtors
Bills Receivable
Short Term Investment
Marketable Securities
Cash and Bank Balance
Fictitious Assets:
Advertisement
Profit and Loss Account
Miscellaneous Expenditure

------------------------------------------------------------------------------------***

***
*The items in the above format have been shown in order of permanence.
Alternatively, this can be presented in order of liquidity as explained earlier.

83

Fundamentals of
Accounting

2.

From the following Trial Balance of Trader, you are required to prepare Trading
and Profit Account for the year ended 31st March 2001 and a Balancing Sheet as
on that date.
Trial Balance as on 31st March 2001

Dr.

Cr.
Particulars

Drawing Account
Plant and Machinery (1.4.2000)
Plant and Machinery
(1.4.2000)
Stock (1.4.2000)
Purchases
Returns Inward
Sundry Debtors
Furniture
Freight
Carriage Outward
Rent, Rates and Taxes
Printing and Stationary
Trade Expenses
Insurance Charges
Salaries and Wages
Cash in Bank
Cash in Hand
Postage and Telegram

Amount
Rs.
7,500
1,25,000
6,250
19,250
1,02,500
2,500
25,750
6,200
12,500
625
5,750
1,000
500
875
26,625
25,675
7,250
1,000

Particulars
Capital
Returns Outward
Sundry Creditors
Sales
Porivision for Bad
and Doubtful debts
Discount Received
Rent (up to 30.9.2002)

3,76,750

Amount
Rs.
1,50,000
1,250
22,500
2,00,000
500
1,000
1,500

3,76,750

Adjustments:

84

1)

Stock on 31st March 2001 was valued at Rs. 15,000

2)

Write off Rs. 750 as bad debts.

3)

Provision for Bad and doubtful debt is to be maintained at 5% on sundry debtors.

4)

Create a provision for discount on debtors and also reserve for discount on
creditors @ 2%.

5)

Charge depreciation @ 2% p.a. on Plant and machinery and @ 5% on furniture.

6)

Insurance prepaid was Rs. 125.

7)

Goods worth Rs. 6,250 were totally demaged in an accident. The insurance
company admitted claim of Rs. 5,000 on 28.3.2001.

Financial Statements

Solution
Trading Account
For the year ended 31st March 2001
Dr.

Cr.
Particulars

Amount
Rs.

Particulars

To Opening Stock
19,250
To Purchases
1,02,500
Less Returns
1,250 1,01,250
To Freight
12,500
To Gross profit transterred
to Profit & Loss A/c
85,750

Amount
Rs.

By Sales
2,00,000
Less Returns 2,500
By Closing Stock
By Insurance Claims
By Profit & Loss A/c
(Abnornal Loss)

2,18,750

1,97,500
15,000
5,000
1,250

2,18,750

Profit and Loss Account

Dr.

Cr.
Particulars

To
To
To
To
To
To
To
To

To
To
To
To

Amount
Rs.

Rent, Rates & Taxes

Printing and Stationary
Trade Expenses
Insurance
875
Less Prepaid
125
Salaries & Wages
Postage & Telegram
Bad debts
Provision for Bad and doubtful debts
(New reserve Rs. 1250-Old
reserve Rs. 500)
Provision for discount on debtors
Carriage outward
Abnormal loss (Accident)
Depreciation on:
Furniture
310
Plant & Machinery
25,625
(Rs. 25000 + Rs. 625)
To Net profit transfered A/c540
to capital

5,750
1,000
500
750
26,625
1,000
750
750

Particulars

Amount
Rs.

By Gross Profit b/d

By Discount Received
By Rent Received 1,500
Less Prepaid
750

85,750
1,000

By Reserve for discount

on creditors

750
450

475
625
1,250

25,935

87,950

87,950

Balance Sheet As on 31st March 2001

Dr.

Cr.
Liabilities

Add. Capital
Net Profit
Less Drawings
Sundry Creditors
Less Provision
Advance Rent

Amount
Rs.
1,50,000
22,540
1,72,540
7,500
22,500
450

Assets
Plant & Machinery
Additions

1,65,040

Less

Less

Dereciation
Furniture
Depreciation
Closing Stock
Sundry Debtors
Bad Debts

22,050
750

Less

Less

Provision @ 5%

Amount
Rs.
1,25,000
6,250
1,31,250
25,625
6,200
310
25,750
750
25,000
1,250
23,750

1,05,62
5,89
15,00

85

Fundamentals of
Accounting

Less

Provision for discount

Cash at Bank
Cash in hand
Insurance Claims
Prepaid Insurace

1,87,840

475

23,27
25,67
7,25
5,00
12
1,87,84

Illustration 3
The following is the Trial Balance of Mr. Mahesh as 31st December 2003. Prepare a
Trading and Profit & Loss Account for the year ended 2003 and Balance Sheet as on
31st December 2003.
Dr.

Cr
Rs.

Purchases
Opening Stock
Salaries Less Provident Fund
Drawinges
Provident fund remittances including

Proprietors contribution 50%

Rent Rs. 250 per month
Machinery
Wages
Furniture & Fittings
Electricity
Trade Expenses
Debtors
Interest on Loan
Commission
Building

1,80,000
10,000
5,400
5,000

Rs.

Sales
Loan (10% interest)
Creditors
Capital

2,05,000
10,000
15,000
55,000

1,200
2,750
29,000
3,000
5,000
550
1,500
10,500
900
200
30,000
2,85,000

2,85,000

Wages include Rs. 1,000 Paid for machinery erection charges. Purchases include cost
of moped scooter for Rs. 5,000 Proprietor has taken goods costing Rs. 1,000 for
which no entry has been made, Electricity outstanding Rs. 50. Goods costing Rs.
5,000 were destoyed by fire and insurance claim was receied for Rs. 4,000 Provide
depreciation at 10% on machinery, furniture & moped. Provide depreciation 5% on
Bulding. Closing stock is Rs. 12,000
Solution
Trading And Profit and Loss Account
For the year ended 31st December 2003
Dr.

Cr

Particulars
To
To
Less
Less
To
Less
To

86

Amount
Rs.

Opening Stock
Purchases
180,000
Purchase of Scooter
5,000
Drawings (goods used)
1,000
Wages
3,000
Erection charges
1,000
Gross Profit c/d

To Salaries
Add Subscription
Contribution

5,400
600
600

10,000
174,000

Particulars

By Sales
205,000
By Loss by fire transferred
to P&L A/c
5,000
By Closing Stock
12,000

2,000
36,000
222,000
By Gross Profit b/d
By Insurance claims
6,600

Amount
Rs.

222,000
36,000
4,000

To
Add
To
Add
To
To
To
To
Add
To
To
To

To

Rent
2,750
Outstanding
250
Electricity
550
Outstanding
50
Commission
Trade Expenses
Bad debts
Interest
900
Outstanding
100
Provision for Bad debts
Loss by fire (Trading A/c)
Depreciation on:
Building
Machinery
Furniture
Scooter
Net Profit

Financial Statements

3,000
600
200
1,500
500
1,000
1,000
5,000
1,500
3,000
500
500
15,100
40,000

40,000

Balance Sheet
As on 31st December 2003
Dr.

Cr
Liabilities

Capital
55,000
Add Net Profit
15,100
Less Drawings (5000 + 1000) 6,000

10% Loan
Creditors
Rent outstanding
Interest outstanding
Electricity Changes O/s

Amount
Rs.

64,100

10,000
15,000
250
100
50

89,500

Assets
Building
30,000
Less Depreciation
1,500
Machinery
29,000
Add Erection Charge 1,000
30,000
Less Depreciation (10%) (3,000)
Furniture
5,000
Less Depreciation
500
Scooter
5,000
Less Depreciation
500
Closing Stock
Debtors
10,500
Less Bad debts
500
Less Provision @ 10% 1,000
Insurance claims

Amount
Rs.
28,500

27,000
4,500
4,500
12,000

9,000
4,000
89,500

3.6.2 Vertical Format

Under vertical form various items of incomes and expenses, assets and liabilities are
arranged vertically to get some additional information about the operating efficiency
and financial position of the business enterprise. The vertical form of Income
Statement shows the gross profit, operating profit, net profit. The impact of nonoperating incomes and expenses cannot be ascertained if the Trading & Profit and
Loss Account is not prepared under vertical form. Similarly the Balance Sheet
discloses owners capital, borrowed capital, net working capital, etc. It is to be noted
that sole traders and partnership firms hardly adopt vertical form of financial
statements. Following formats will bring about a clarity of understanding of vertical
form of financial statements.
87

Fundamentals of
Accounting

Income Statement (A format)

For the year ending 31st March .....
Particulars

Figures at the end of

Previous Year Current Year

Sales/Turnover
Less Cost of Goods Sold*
Gross Profit
Less Administrative Expenses*
Less Selling and Distribution Expenses*
Operating Profit
Add Other Incomes* (Non-operating Incomes)
Less Financial Expenses (Non-operating Expenses)
Net Profit
Less Transfer to General Reserve and/or capital
account/accounts (in the form of profit,
salary, commission, etc.)
* Explained earlier under conventional form.

Rs.
--------------****
--------------****
--------------****
---------------

Rs.
--------------****
--------------****
--------------****
---------------

Operating vs Non-operating
Operating Profit/Loss
The excess of operating incomes over operating expenses represents operating
profit, whereas when operating expenses exceed operating income it results in
operating loss.
Operating incomes are those incomes which arise from operating activities in which
the enterprise deals in. For a trading concern, revenue arising from sale of goods in
which the enterprise deals in is treated as operating income. In fact, operating
activities are the principal revenue-producing activities of the entertprise. Operating
income measures the efficiency of a business enterprise, because these activities makeup the main business of the enterprise and are of recurring in nature. The operating
activities may be:
l

Purchasing and selling of goods.

Services and even securities by a Trading concern.

Exploration of natural resources by Extracting & Trading entity.

Granting of loans and advances by a Financial Institution.

Construction and development of colonies by construction enterprise.

Operating expenses are those expenses which are incurred in connection with main
revenue producing activities. These operating expenses may be classified under
various heads, such as office and administrative expenses and selling and
distribution expenses. A detailed list of these expenses has already been given under
conventional format of Profit and Loss Account under 3.6.1 of this unit. These
expenses are necessary to run the business enterprise but which are not directly related
to trading or manufacturing activities. These directly related expenses are termed as
direct expenses, which are charged to Manufacturing/Trading/Account. Hence
Operating Profit = Gross Profit Operating Expenses (Office and Selling
Distribution).
88

Financial Statements

Non-operating Incomes
Such incomes arise from other than major or principal revenue earning activities.
These are in the form of, in case of a manufacturing and trading concern, rent
received, interest received, dividend received, which are credited to Profit and Loss
Account. Profit on sale of fixed assets and the revenue arising from activities which
are incidental to main business, are treated as non-operating incomes. Such types of
incomes arise when unused portion of building used for business purposes is let-out or
idle funds of business invested either in shares, debentures, government securities or
deposited in a fixed deposit account. Since such incomes have nothing to do with the
business operation of the enterprise, these incomes are treated as non-operating
incomes.
It is to be noted that Interest and Dividend received by a Financial
Institution is treated as operating income because these incomes arise
from main/principal revenue earning activity.
Non-operating Expenses
These expenses are incurred on activities other than main or principal revenue earning
activities. These may be in the form of non-operating losses. Interest paid on
borrowings (financial overheads), loss on sale of fixed assets, loss on sale of
investment (held as an asset) are some of the examples of non-operating
expenses. Such expenses are also charged to Income Statement to ascertain the
overall net profit.
Balance Sheet of ........................ (A format)
As on 31st March ..........
Assets

Figures at the end of

Previous Year
Current Year

Fixed Assets
Less Depreciation
Net Fixed Assets

(a)

Stock-in Trade
Sundry Debtors
Bills Receivables
Cash and Bank balance
Total Current Assets*
TOTAL ASSETS (a+b)
Liabilities and Capital
Capital
Add Profit (Retained Earnings)
Less Drawings
Owners Equity

(b)

(c)

Sundry Creditors
Bills Payable
outstanding Expenses
Total Current Liabilities

(d)
TOTAL (c + d)

----------------------

----------------------

****
-----------------------------

****
-----------------------------

****
--------

****
--------

-----------------------------

-----------------------------

----------------------

----------------------

--------

--------

--------

--------

* The list is not exhaustive

89

Fundamentals of
Accounting

Activity
1)

What are operating and non-operating profits?

2)

What do you understand by Grouping and Marshalling of assets and liabilities?

3)

Write short notes on the following:

a)
b)
c)
d)
e)
f)
g)

4)

Outstanding of Expenses
Accrued Incomes
Intangible Assets
Fictitious Assets
Cost of Conversion
Cost of Goods Sold
Direct vs Indirect Expenses

Draw an imaginary Balance Sheet.

3.7

CORPORATE FINANCIAL STATEMENTS

The process of preparation of financial statements of companies is similar to that of

non-corporate entities except for certain peculiar items and legal requirements. The
corporate reporting has assumed great importance in recent years. The Company Law
Board, the Institute of Chartered Accountants of India and whole corporate world are
trying to bring about a total transparency in the matter of reporting. The fundamental
objective of corporate reporting is to communicate economic information about the
resources and performance of the reporting entity to the users of financial statements.
The professional bodies have also developed several (till date 28) accounting
standards for the purpose of preparing and disclosing accounting information in order:
1)

To serve the varied needs of users for decision-making purposes.

2)

To harmonise the diverse accounting practices.

3)

To ensure transparency, consistency, comparability, adequacy and

reliability of information-contents.

4)

To make accounting information more meaningful and useful.

5)

And to improve overall quality of presentation and reporting.

Since every interested party has a right to information which is merely not the
outcome of statue but is based on the principle of public accountability. The financial
statements which are prepared on the basis of various accounting postulates, concepts
and conventions, are supposed to endowed with many qualitative characteristics, viz.
understandability, relevance, materiality, reliability, faithful representation, substance
over form, neutrality, prudence, completeness and comparability.
General and Legal Requirements
Section 209 to 223 of the Companies Act, 1956 deal with provision governing
maintenance and preparation of financial statements.
Section 209 deals with the maintenance of proper books of accounts in respect of

90

1)

Receipts and disbursements of money,

2)

Sales and purchases of raw materials/goods,

3)

Description peratining to usage of raw material and labout, etc., and

4)

All assets and liabilities.

Section 209 also requires that books of accounts must show the True and fair view
of state of affairs of the company. Section 211 requires that the Balance Sheet must
give true and fair view of the results of operations. It simply implies that financial
statements should disclose every material information without any concealment of
facts and figures and in such a manner that working results and financial position of
the reporting enterprise, may correctly be interpreted in true spirits. It should be free
from personal biases and mis-statements. It will be possible only if financial
statements are prepared in accordance with generally accepted accounting principles
and in conformity with the various accounting standards as applicable to the reporting
enterprise. Companies (Amendment) Act 1999 has made it mandatory for companies
to comply with accounting standards set by ICAI. In case company fails to comply
with any of generally accepted accounting assumptions or standards, the fact should
be disclosed.

Financial Statements

Section 210 requires that financial statements should be presented to shareholders at

every Annual General Meeting along with the Auditors and Directors Reports. Every
Balance Sheet and Profit and Loss Account must be duly authenticated. These
statements must be signed by Manager or Secretary and by two directors, at least one
of whom must be managing director (Section 215).

3.7.1 Items Peculiar to Corporate Balance Sheet

Share Capital: Under this head following details are required to be disclosed:
1)

Details of Authorised, Issued and Subscribed Capital along with number and
nominal value of the shares with respect to preference and equity shares.

2)

Calls-in-Arrears must be deducted from Called-up Capital. However, Calls-inarrears on shares held by directors are to be shown separately. Similarly, Callsin-Advance should be treated as a separate items and shown accordingly.

3)

Forfeited Shares Account, if any, should be added to paid-up Capital which

forms the part of total of Balance Sheet. It is to be noted that the Authorised,
Issued and Subscribed capitals are not considered for the purpose of total of
Balance Sheet.

4)

Shares issued for consideration other than cash must be disclosed. Such as
shares allotted to transferor company under the agreement of takeover/merger,
Issue of bonus shares and the source thereof.

5)

If preference shares have been issued, the terms of redemption or conversion

along with the earliest date of redemption/conversion must be specified.

6)

Excess application money on account of over-subscription not requiring any

adjustment, should be refunded. If not, the money refundable must be shown as
part of current liabilities.

3.7.2 Reserves and Surplus

This may be in the following forms:
i)

Capital Reserves: It refers to those profits which are not earned from normal
business operations. Such profits are not available for the purpose of distribution
as dividend. It is created out of profit on sale of-fixed assets or investments held
as asset, profit on reissue of forfeited shares, pre-incorporation profit, profit on
revaluation of fixed assets, profit on purchase/acquisition of assets or profit on
purchase of business (excess of net assets over purchase price).

ii)

Capital Redemption Reserve: It is created when fully paid preference shares

are redeemed out of divisible profits of the company. This reserve may be
utilized for the purpose of issuing fully paid bonus shares to the members of the
company.

91

Fundamentals of
Accounting

iii) Securities Premium: When a company issues shares or debentures at a price

which is more than its face value, it is said to have issued shares/debentures at a
premium. The premium so received is transferred to Securities Premium
Account.
According to Section 78 of Companies Act, the premium may be utilized for
issuing fully paid bonus shares, writing off preliminary expenses, discount on
issue of shares or debentures, and providing premium on redemption of
preference shares or debentures.
iv) Revenue Reserves: These may be in the form of specific reserves or free
reserves and are created out of revenue profits of the company. Usually such
reserves are formed from annual appropriation. Specific Reserves are created
for specific purpose. For example, Dividend Equalisation Reserve is created to
meet the shortfall in the divisible profits of the company intends to follow a
stable dividend policy. Or to redeem the debentures, a sinking fund or a debenture redemption reserve may be created. Other specific reserves are Development
Rebate Reserve, Investment Allowance Reserve, Export Incentive Reserve, etc.
The term Fund is used when the money earmarked for any specific purpose is
invested in ourside securities. For example, if money appropriated for the
purpose of redemption of debentures is invested outside and business is termed as
Debenture Redemption Fund, if not invested outside but retained or ploughed
back in the business, it is called Debenture Redemption Reserve.
Surplus
The Credit balance of Profit and Loss Account or P&L Appropriation Account (i.e.
after making necessary transfer to reserves and appropriating for proposed interim or
final dividend including bonus, if any) is shown under the heading as surplus. If a
company has a debit balance of Profit & Loss Account, the same should be adjusted
under this head.
3)

Secured Loans: This refers to mortgaged loan or other loans, which are fully
secured either by a fixed or floating charge on the assets of the Company. It
includes loans from bank, financial institutions or from other companies provided these are secured against the specific or all assets of the company. Debentures are assumed to have first floating charge on the assets of the company. It is
to be noted that interest accrued and due on secured loans is to be treated as and
shown under Secured Loans. Loan from or guaranteed by directors should be
disclosed and shown separately. In case of debentures, the terms of redemption/
conversion and its earliest date of redemption/conversion be stated.

4)

Unsecured Loans: These are the loans against which no security stands a
pledged or mortgaged. It also includes amount not covered by the value of
security provided in respect of partly secured loans. It covers all loans which are
not at all secured such as

5)

92

Fixed Deposits from public

Loans and Advances from Subsidiaries
Short-term loans and Advances from Banks and others
Other Loans and Advances
It may include creditors for purchase of an asset.

Current Liabilities and Provisions: This heading is split in two sub-headings :

current liabilities and prosvisions.

Current Liabilities: It refers to those liabilities which are to be paid or payable within
a period of twelve months. It includes, Sundry Creditors, Bills Payable, Outstanding
Expenses, Income Received in Advance, Amount payable to Subsidiaries.

It is to be noted that short-term loans and interest outstanding thereon are to be shown
under Secured or Unsecured Loan as the case may be and not under Current
Liabilities.

Financial Statements

Provisions: Provisions such as Proposed dividend, Provision for Depreciation,

Repairs and Renewals, Provision for Doubtful Debts, Investment Fluctuation Reserve,
Provident Fund, Pension Fund etc. are shown separately under this head.
* Provision for Depreciation and Provision for Doubtful Debts may be
shown on the Assets side as a deduction from the asset concerned.
Contingent liabilities: As explained earlier, these liabilities are shown as a footnote
and include the following:
l
l
l
l
l

Liability for bills discounted

Claims against the company not acknowledged as debt
Uncalled liability on partly paid shares
Arrears of fixed cumulative preference dividends
Guarantee given by the Company on behalf of directors or other officers of the
Company
Estimated amount of contracts remaining to be executed on capital account not
provided for, and
Other money for which company is contingently liable.
It is to be noted that if any provision is made against any contingent
liability, the same is to be shown under the head provisions.

Fixed Assets
Under this head there are eleven types of fixed assets starting from goodwill to
vehicles. According to AS-10 a fixed asset is an asset held with the intention of being
used for the purpose of producing or providing goods or services and is not held for
sale in the normal course of business. Even assets which are not legally owned but
held for the purpose of production are treated and shown under this head. These
include assets acquired under hire-purchase agreement and assets taken on lease, after
considering the addition and disposal, if any. Valuation of fixed assets is made at cost
less depreciation after considering the addition and disposal, if any.
It is worth remembering that goodwill should be shown in the books only when it is
acquired for some consideration. According to AS26 internally generated goodwill
should not be recognized as an asset.
*As per Schedule VI the fixed assets are classified as follows:
1)
2)
3)
4)
5)
6)
7)
8)
9)
10)
11)

Goodwill
Land
Building
Leasehold
Railway Slidings
Plant and Machinery
Furniture and Fittings
Development of Property
Patents, Trade Marks and Designs
Live Stock
Vehicles

93

Fundamentals of
Accounting

In case of revaluation of fixed assets, every balance sheet subsequent to such

revaluation must show the revised figures with the date of increase or decrease in
place of original cost. In ascertaining the cost of an asset all expenditures incurred in
bringing the asset to its working condition should be included. This includes cost of
transportation, expenditure on trial runs. In case of land and building, stamp duty,
registration fee and architects fees should be capitalised.
Investments
As per AS-13 (Accounting for Investments), Investments are assets held by an
enterprise for earning income by way of dividends, interest and rentals, for capital
appreciation or for other benefits to the investing enterprise. Assets held as stock-intrade are not investments. Money invested outside business is termed as investments
which may be long term, current investment or an investment property.
According to AS-13, a current investment by its nature as readily realizable is
intended to be held for not more than one year, whereas an investment propery is an
investment in land or building that are not intended to be occupied substantially for
use by the enterprises.
Schedule VI requires investments to be shown as follows:
i)

Investments in Government or Trust Securities.

ii)

Investments in shares, debentures or bonds, fully paid up and partly paid

up and also different classes of shares.

iii)

Immovable properties

iv)

Investments in the Capital of partnership firms.

The following details about the investments must be given:

a)

Nature of investment.

b)

Mode of valuation of Investments.

c)

Aggregate amount of companys quoted investments and its market value.

d)

Aggregate amount of companys unquoted investments.

e)

Amount of fully paid and partly paid shares.

f)

Investment in subsidiary companies.

Current Assets, Loans and Advances

This is subdivided in two sub-headings:
A) Current Assets: As per the Guidance note issued by ICAI, current assets means
cash and other assets that are expected to be converted into cash or consumed in the
production of goods or rendering or services in the normal course of business and
include:
i)

Stock-in-trade (inventories of raw materials, work-in-progress finished

goods, stores and spare parts to be shown separately) including mode of
valuation.

ii)

Debtors should show the age-wise and security-wise classification such as

Debts outstanding for a period of more than six months and other debts.
Debtors considered good in respect of which company holds no security
other than the debtors personal security.
Debts considered doubtful or bad.
Debts due by directors on other officers

94

Debts due from other companies (subsidiaries)

Maximum amount due by directors or other officers of the company

(footnote through)

Financial Statements

Provision for doubtful debts is required to be deducted from sundry debtors

Provision should not exceed the amount considered from sundry debtors.
Provision should not exceed the amount considered doubtful or bad. Any
excess provision be shown under Reserve and Surplus.
iii)

Cash and Bank balances should be shown separately. Bank balances

should be classified into balances with scheduled banks and other banks
along with details of current account, saving bank and fixed deposits. Bank
overdraft, if any, should be shown under Sundry Creditors. This information of inclusion be disclosed in a footnote that the Sundry Creditors
include bank overdraft amounting to Rs....

B) Loans and Advances

The disclosure rules which are applicable to sundry debtors, the same should be
applied to Loans and Advances, i.e. these should be shown in age-wise, securitywise and reliability-wise classification. In addition the following should be shown:
i)
ii)
iii)
iv)
v)

Advances and loans to subsidiaries

Advances and loans to partnership firms in which the company or subsidiary is a partner
Bills of Exchange
Advances recoverable in cash or kind or for value (Rent, Rates and Insurance)
Balance with customers, port trust, etc. which are payable on demand

Miscellaneous Expenditure
These are the expenses incurred in earlier years but not written off. These include:
i)

Preliminary expenses (Formation expenses incurred on preparation of Memorandum and Articles of Association, legal fees, registration fee, etc.)

ii)

Share and Debentures issue expenses, such as brokerage, underwriting commission, discount on issue of share and debentures.

iii) Interest paid out of Capital during construction.

Such miscellaneous expenditure is written off over a period for which benefit is
available.
Profit and Loss Account (Debit balance)
This represents past unwritten-off losses. These are adjusted and written off against
the free reserves (divisible profits/revenue profits) to the available extent. Unabsorbed
amount is shown under this head.

3.7.2 Items Peculiar to Corporate Income Statement

Salient Features
Though the procedure and the process of preparation of Income Statement of a
Company and that of non-corporate entities are similar in principles, there are some
differences in the method of presentation and some additional items which form the
part of a corporate income statement. These differences are as under:
1)

Heading: Non-corporate entities name income statement as Trading and Profit

and Loss Account, while companies call it Income Statement or Profit and
Loss Account only. The items of Trading Account become the part of Income
Statement. No separate Trading Account is prepared.

95

Fundamentals of
Accounting

2)

3)

4)

Appropriation: Sole trader does not prepare any appropriation account, while
partnership firms and companies do. A companys Profit and Loss Account is
split up in to two parts above the line and below the line. All items of
appropriations are shown below the line and the remaining balance is transferred to the liabilities side of the balance sheet. A partnership firm prepares a
separate Profit and Loss Appropriation Account.
As per AS5 extraordinary items (abnormal nature), prior period items are
shown separately whereas in case of non-corporate entities, such items are stated
along with the normal and routine items.
Requirement: The Profit and Loss Account of a company should conform to the
requirements of Schedule VI of Companies Act 1956 and adhere to AS1; AS4
and AS5 recommendations, whereas non-corporate enterprises are not required
to do so.

5)

Income Tax: It is treated as an expense for the companies while for firms and
sole trade enterprise, it is treated as drawings.

6)

Companies Profit and Loss Account should disclose the figures for the previous
year along with the current years whereas non-company enterprises are not
required to show figures relating to previous year.

Treatment of Special Items of Profit and Loss Account

1)

Interest on Debenture and Loans: This item includes interest paid and payable
for the financial period for which accounts are prepared and shown to the debit
side of Profit and Loss Account. Likewise, interest due but remaining outstanding is taken to the liability side of the Balance Sheet. Interest on Debentures and
interest on secured loan outstanding, if any, is shown under the heading Secured
Loans whereas interest outstanding on unsecured loan is shown under unsecured loans.
It is to be noted that interest on loan for the construction period should be
capitalized and added to the cost of the asset concerned.

2) Tax on Interest on Debentures: As per Income Tax Act 1961, every company
must deduct tax at source (TDS) while paying interest to the debenture holders. The
amount so deducted shall be deposited with the Government treasury. The current
rates for TDS are as follows:
Debentures (listed)
Debentures (unlisted)

10.5% including surcharge

21% including surcharge

If A ltd. has to pay interest on its 9% debentures (listed) of the face value of Rs.
5,00,000, then gross interest will be Rs. 45,000 and tax deducted at source Rs. 4,725
balance shall be paid to the Debenture holders Rs. 40,275. The following entry is
recorded
Interest on Debentures A/c
To Debenture Holders A/c
To Income Tax Payable A/c

Dr

45,000
40,275
4,725

Income Tax deducted but not deposited with the Government is to be shown in the
Balance Sheet under the heading Current Liabilities.
It should be remembered that Profit and Loss Account will always be
debited with the gross amount of interest.
96

3)

Discount on Debentures/Loss on Issue/Debenture Issue Expenses: Discount

on issue of debentures, debenture issue expenses such as commission, brokerage,
etc. are premium payable on redemption (treated as loss on issue which may
include discount also) are to be written off as early as possible, or over the life
span of the debentures, depending upon the policy of the company in the absence
of any specific instructions in the question, such amount should be written off on
the basis of debentures outstanding. The unwritten off balance is to be shown on
the assets side of the Balance Sheet under the heading of Miscellaneous Expenditure.

Financial Statements

It should be remember that only written off amount is charged to Profit and Loss
Account.
4)

Prelimiary Expenses: As already explained under Balance Sheet items, it

appears on the assets side of the Balance Sheet under the heading Miscellaneous
Expenditure as long as it is not written off. The amount written off is charged to
Profit and Loss Account. If there is no specific instructions relating to the
amount to be written off, then the entire amount should be shown in the
Balance Sheet.

5)

Corporate Income Tax: This is shown under three stages.

i)

Advance Income Tax: As per Income Act 1961, the companies are required
to pay income tax on the profits earned. They have to deposit advance tax
under PAYE (Pay As You Earn) scheme on specific dates during the financial year. The advance tax so paid is adjusted against income tax liability.
The unadjusted amount of advance income tax is shown as an asset under
the heading Current Assets, Loans and Advances.

ii) Provision for Taxation: While preparing Profit and Loss Account, a
provision for income tax is created on the basis of current years profit to
meet the actual tax liability. The amount so provided depends on the prevailing tax rate. The current rate of corporate tax is 35% plus 5% surcharge for
domestic companies and 40% plus 5% surcharge for foreign companies. The
following entry is recorded.
Profit and Loss Account
Dr.
To Provision for Taxation A/c
AS22 Accounting for Taxes on Income recommends that the net balance, i.e.
excess of Advance Tax may be shown on the assets side or liabilities side of the
Balance Sheet as the case may be, till the final assessment is made and actual tax
liability is determined by the tax authorities.
iii) Determination of Actual Tax Liability: As per Income Tax rules, income
(profits) for the previous year is assessed and taxed in the assessment year.
When the assessment is completed the provision for taxation so created
may either fall short of actual tax liability or may exceed the tax liability.
Such a shortfall or excess is treated as prior period item (AS5) and
therefore its adjustment is made in the Profit and Loss Account but
below the line, either to the debit side (for shortfall) or to the credit
side (for excess).
On the other hand, the actual tax liability is compared with advance income
tax paid. In case actual tax liability is more than the amount of advance
tax paid the same may be paid or shown as a current liability in the
Balance Sheet and if advance tax paid exceeds, the difference being
refund should be stated under Current Assets Loans and Advances in the
Balance Sheet.
97

Fundamentals of
Accounting

Illustration 4
Extracts from a Trial Balance of a Company
As on 31st March, 2003.
Dr.
(Rs.)
Provision for Taxation (2001-02)
Advance Income Tax (for 2001-02)
Advance income Tax (for 2002-03)

Cr.
(Rs.)
2,50,000

2,60,000
3,00,000

Additional Information
i)

The actual tax liability for the year 2001-2002 amounted to Rs. 2,75,000

ii)

provision for Taxation for the year 2002-03 of Rs. 2,85,000 is required to be
made.

Show the relevant information in the relevant ledgers.

Solution
Profit and Loss Account (Extracts)
for the year ended 31st March 2003
Rs.
285,000

To Provision on for Taxation

(2002-03)

25,000

To provision for Taxation (2001-02)

(Rs 2,75000-2,50000)
Tax Liability-Provision

}
}

above the
line

below the
line

Balance Sheet (Extracts)

As on 31st March 2003
Liabilities

Rs.

Current Liabilities
Income Tax payable (2001-02)
(Tax liabilityAdvance Tax)
Rs. 2,75,000 Rs. 2,60,000)

15,000

Assets
Loans & Advances
Advance Tax
(Current Year)
Less Provision for
Taxation

Rs.

Rs.

3,00,000

2,85,000

15,000

Provision for Taxation (2001-02)

To Income Tax (Tax liability)

Rs.
275,000

275,000

98

By Balance b/d
By Profit & Loss A/c
(below the line)

Rs.
250,000
25,000

275,000

Financial Statements

Provision for Taxation (2002-03)

Rs.
To Balance C/d
2,85,000

Rs.
By Profit and Loss A/c
(above the line)

2,85,000

2,85,000
2,85,000

Illustration 5: From the following extract of a Trial Balance and the additional
information, show the treatment of taxation, in the relevant ledger accounts:
Trial Balance (Extracts)
As on 31st March 2002
Dr. (Rs.)
Provision for Taxation
Income Tax

Cr (Rs.)
1,20,000

1,10,000

Additional information: Provide Rs. 1,50,000 for provision for taxation.

Solution
Provision for Taxation A/c (old)
To Income Tax
To Profit and Loss A/c.
(below the line)

1,10,000
10,000

By balance b/d

1,20,000

1,20,000

1,20,000

Provision for Taxation A/c (New)

To balance c/d
(To be taken to liabilities)
side of B/S

Rs.
150,000

By Profit and Loss A/c.

(above the line)

150,000

Rs.
150,000

150,000

Profit and Loss Account (Extracts)

Rs.
To provision for Taxation
(New)

Rs.

150,000

-Above
the
line

- below
the
line

By Provision
for Taxation
10,000

99

Fundamentals of
Accounting

Balance Sheet (Extracts)

As on 31st March 2002
liabilities
Current liabilities and Provision
B. Provisions:
provision for Taxation

Assets

Rs.

15,000

Illustration 6
From the following particulars prepare necessary accounts for the year ending
31st March 2003:
Trial Balance (Extracts)
As on 31st March 2003
Dr.
Rs.
Provision for Taxation (1.4.2002)
Advanced Tax Paid (1.4.2002)
Tax Deducted at Source (1.4.2002)

Cr.
Rs.
4,59,000

4,20,000
3,500

On 1.1.2003, the assessment was completed and tax liability of Rs. 5,30,000 was
determined Advance payment of tax for the year 2002-03 amounted to Rs. 5,10,000.
A provision for taxation is to be made for Rs. 5,75,000 for the year ended 31st March
2003.
Solution
Provision for Taxation Account
To Income Tax A/c (Tax liability)

Rs.
5,30,000

By Balance b/d
By profit & Loss A/c
(below the line)

5,30,000
To Balance C/d

5,75,000

Rs.
4,50,000
80,000
5,30,000

By Profit & Loss A/c

5,75,000

Advance Income Tax account

Rs.
To Balance b/d

4,20,000

Rs.
By income Tax A/c

4,20,000

4,20,000
4,20,000

Income Tax Account (Tax liability)

Rs.
To Advance Income Tax A/c
To Tax Deducted at source A/c
To Bank A/c. (Balance Paid)
100

Rs.
4,20,000
3,500

By Provision for

5,30,000

Taxation A/c

1,06,500
5,30,000

5,30,000

Financial Statements

Profit and Loss Account

For the year ended 31st March 2003
Rs.

Rs.

To Provision for Taxation

(2002-03)
To Provision for Taxation

5,75,000

Above the line

80,000

below the line

(2001-02)
6) Managerial Remuneration
The payment of managerial remuneration is governed by the provisions of
sections 198 and 309 either by the Articles or by a ordinary/special resolution
passed by the company in general meeting. Managerial personnel refers to
managing director, whole-time director, part-time director and manager. The
provisions of Companies Act shall apply to a public company and private
company and a private company which is a subsidiary of a public company but to no
other private company.
The over all managerial remuneration payable by a public company or a private
company which is a subsidiary of a public company to its managerial personnel shall
not exceed 11% of the net profits for that financial year. Remuneration limit does not
include fees. Within the maximum limit of 11% a company may pay a monthly
remuneration to its managing or whole-time director in accordance with the provisions
of Section 309 or to its manager in accordance wit the provisions of Section 386 of
the Companies Act. In case there is no profit or inadequate profit for any year, the
company may pay remuneration as per the provisions of Schedule XIII of the
Company Act.
7) Contribution/donation to a Political party
Any contribution or donation to any political party must be disclosed separately
in the Profit and Loss Account. According to section 293, Government
companies and companies with less than three years are not allowed to make any
political contribution or donation. Those allowed can make such contribution up to
5% of its average profit. The average net profit for this purpose are to be
determined on the basis of the three immediately preceding financial years
profit as determined in accordance with the provision of Section 349 of the
Company Act.
8) Prior Period Items
The nature and amount of prior period items should be separately disclosed in the
Profit and Loss Account in a manner that there impact on the current profit or
loss can be perceived. In case, accounts are adopted in the annual general
meeting and if some adjustments relating to previous year are to be made, these
should be stated below the line, i.e. in the Profit net Loss Appropriation account as
per AS-5.
9) Extra-Ordinary items
Extraordinary items are incomes or expenses that arise from events or transactions
which are clearly distinct from the ordinary activities of the enterprise and therefore,
are not expected to recur frequently or regularly, these items should be disclosed in the
statement of profit and loss as a part of profit or loss for the period (AS-5). Fixed
assets destroyed in an earthquake is an example of Extraordinary items.

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Fundamentals of
Accounting

10) Contingencies and Events occurring after balance Sheet Date

As per AS-4, the amount of a contingent loss should the be provided for by a charge
in the statement of Profit and loss if:
i)

it is possible that future events will confirm that an asset has been impaired or a
liability has been incurred as at the Balance Sheet date and

ii)

A reasonable estimate of the amount of the resulting loss can be made.

The existence of a contingent loss should be disclosed in the financial statements if

either of the above condition is not met, unless the possibility of loss is remote.
Contingent gains should not be disclosed in the financial statements. Only virtually
certain gains should be recognized.
11) Appropriation and Disposition of Profits
Once the profits have been ascertained as per the statement of profit and loss, the next
step is the appropriation and disposition of the available profit. It includes:
i)

Transfer to general reserve and other reserves such as capital redemption reserve.
Development rebate reserve etc.

ii)

Transfer to sinking fund.

iii) Transfer to Dividend Equalization fund.

iv) Providing for interim or final dividend, and
v)

Paying bonus to share holders.

All these items are treated below the line or a separate Profit and loss
Appropriation Account is prepared.
12) Dividends
Dividends refers to that amount of divisible profits which is distributed among the
share holders of the company. A member (shareholder) is entitled to receive dividend
when it is declared by the Board of directors as per the provisions of the Article. The
Board has absolute right to recommend the rate of dividend to the declared subject to
the approval of shareholders and provisions of Articles of Association. However, the
shareholders cannot compel the Board recommend & declare dividend. It is to be
noted that dividend is always declared for the working of one financial year at the
annual general meeting. In case the dividend could not be declared at the annual
general meeting the same can be declared at the Extraordinary meeting. The power to
declare dividend is implied and does not require express authority either in the Articles
or Memorandum of Association. It should be remembered that, where a dividend has
been declared at Annual General Meeting, neither he company nor the directors can
declare a further dividend for the same year at the subsequent general meeting. It is
known as Final Dividend.

102

No devidend should be paid out of capital. Dividends should be paid in proportion to

the amount paid up on each share. No dividend shall be payable on calls in advance
unless authorised by the Articles. Dividend should be payable in cash except when it
is adjusted towards unpaid amount on shares or where bonus shares are issued.
According to Section 205 (2A) no company shall declare or pay dividend for any
financial year out of the profits from that year unless certain percentage of profit as
prescribed by Central Government not exceeding 10% has been transferred to reserve.
However, the company may voluntarily transfer higher percentage of the profit to its
revenue subject to the rules laid down under the Companies (Transfer of Profits to
Revenue) Rules 1975 as amended in 1976. A newly incorporated company is
prohibited to transfer more than 10% of its profits to revenue for the initial
three years.

i) Preference Dividend: The preference dividend is paid to Preference

shareholders at a pre-determined fixed rate on priority basis. These holders are
entitled dividend in preference to equity shareholders. However the preference
shareholders can claim dividend only out of profits and if it is declared at the
annual general meeting. If preference shares are of cumulative nature, the
arrears of preference dividend if any, shall be payable to preference
shareholders before any equity dividend. It should be noted that preference
shareholders cannot force the company to pay all the dividends including
arrears. If equity shareholders are not paid any dividend, preference
shareholders cannot claim any dividend from the company. It is to be noted
that the arrears of preference dividend are treated as a contingent liability
which appears as a foot note under the Balance Sheet.

Financial Statements

Notcumulative preference shares are not entitled to any arrears resulting from
non-payment of dividend due to losses or inadequate profits. If a company has issued
participating preference shares with a right to participate in the balance of profits, left
after paying fixed preference dividend and a certain percentage of equity dividend,
then the participating preference shareholders are entitled against a certain percentage
out of the balance (residua) profit as per the items of issue. For example 9%
preference shares may be issued with a further right to 40% of the excess dividend
over 20% paid to equity shareholders. If a company declares 25% dividend to equity
to equity shareholders, the preference shareholders will get 11% dividend. (9% plus
40% of (25%-20%) i.e., 2%).
ii) Unclaimed Dividend: According to Section 205 A of the companies Act 1956
dividends remaining unpaid must be deposited in the unpaid unclaimed Dividend
account within 42 days of declaration of dividend. Any claim thereafter, must be met
out of the unclaimed dividend account. Money so transferred to the aforesaid account
which remains unpaid or unclaimed for a period of seven years from the date of such
transfer, shall be transferred to Investor Education and Protection Fund maintained
u/s 205 of Companies (Amendment) Act 1999.
Unclaimed dividend appears on the liabilities side of Balance Sheet under the head
Current liabilities & Provisions.
iii) Proposed Dividend: Dividend recommended by the directors to be paid to
shareholders for any accounting period on or after the close of books of accounts but
before the Annual General Meeting, is known as proposed dividend. Once it is
approved by the shareholders in the General meeting, it becomes final dividend. It is to
be noted that rate of dividend declared cannot exceed the proposed dividend. Proposed
dividend is an appropriation of profit, hence it is shown to the debit side of profit and
loss Appropriation Account and on the liabilities side of balance sheet under the
heading Current liabilities and Provisions.
iv) Final Dividend: It is a dividend which is declared at the annual general meeting of
the shareholders. Such dividend is declared only after the close of books of accounts;
the share holders may reduce the rate of final dividend but cannot increase it. Once the
final dividend is declared it becomes the liability of the company. It should be noted
that when a final dividend is declared then interim dividend is not adjusted unless there
is any specific resolution for such adjustment. Final dividend is paid on paid up
Capital for the whole year as against the interim dividend, which is usually paid only
for six months. For example N Ltd. has 5,00,000 shares of 10 each Rs. 8 paid,
declares 5% p.a. interim dividend and final dividend @ 10% p.a., then the total
dividend will be Rs. 5,00,000 i.e. (Rs. 1,00,000 interim dividend + Rs. 4,00,000 final
dividend)
I.D. = (4, 00,000 5/100 6/12 = 1,00,000) + F.D. = (4,00,000 10/100)

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Fundamentals of
Accounting

v) Interim Dividend: A dividend declared by the Directors between two annual

general meetings of the company is known as interim dividend, where the directors
believe that the company will have sufficient profits available for dividends at the end
of the year, they may distribute a part of the profit as a part payment on account.
Payment so made in anticipation and on account of total dividend to be paid for the
year is treated as interim dividend. However, such payment must be authorised by the
Articles. Interim dividend should be declared only when the company has even a better
prospects for the second half as well. Regulation 86 of TableA provides that Board
may from time to time pay to the members such interim dividend as it appears to be
justified by the profits of the company. Thus, there is no limit on the number of
interim dividend the company may pay in a year. The payment of interim dividend
does not require approval of general meeting.
Companies (Amendment) Act 2000 has granted statutory recognition to the right of
directors to declare interim dividend. The term dividend now includes interim dividend
also. All provisions the Companies Act which apply to dividends have now become
applicable to interim dividends also. A company cannot declare any interim dividend
unless it has made:
i)

necessary provision for depreciation for the whole year.

ii)

prior adjustment of accumulated losses, if any

iii) and transfer to general reserve as required u/s 205 (2A)

Once an interim dividend is declared it becomes legally enforceable debt
against the Company. Prior to the Amendment Act 2000 the interim dividend
was not an enforceable debt Board had right to rescind the resolution
already passed.
The period, for which an interim divided is paid, is usually six months. However,
students should note that whether the rate of dividend includes the words per
annum or not. For example the directors of a company declare an interim dividend @
12% per annum, the interim dividend shall be calculated only for six months. If the
rate declared by directors is 12% and the words per annum are not mentioned, then
the dividend shall be calculated @ 12% without reference to time. i.e. 12% x amount
of paid up Capital. If the Capital of the company is Rs. 10,00,000 then
in the first case interim dividend will amount to Rs. 60,00 and in the second
case Rs. 1,20,000.
vi) Corporate Dividend Tax
Finance Act 1997 had exempted the dividend in the hands of shareholders and
introduced corporate dividend tax to be paid by the dividend paying company.
Thereafter, the corporate dividend tax was withdrawn by the Finance Act 2002
and the burden of tax was shifted on the shareholders and hence company was not
liable to pay any tax on dividend declared, distributed or paid between 1.4.2002. to
31.3.2003.
The Finance Act 2003 has again shifted the liability of such tax on the domestic
companies who shall be liable to pay additional tax on the amount declared,
distributed or paid by way of dividends on or after 1.4.2003. The rate of tax being
12.5% plus surcharge @ 2.5% which is equal to 12.8125%* This rate is applicable
for the financial year 2003-04.
Note: Students should verify the rate applicable because this rate may be changed by
the Finance Act 2004 or by the subsequent Finance Act. It is further to be noted that
dividends from domestic companies in the hands of shareholders are totally exempt
again. As per guidance not it is be treated as appropriation.
104

Financial Statements

13) Transfer to General Reserve

According to section 205 (2A) no company shall declare or pay dividend for any
financial year out of the profits for that unless a certain percentage of profits as
prescribed by the Central government not exceeding 10%, has been transferred to
reserve. As per the Central Government rules transfer to revenue should be made as
follows:
The Central Government has prescribed the following rules under the companies
(Transfer of profits to reserve) Rules 1975 as amended in 1976.
Rate of Dividend
(i)

If the rate of
dividend exceeds
(ii)

(iii)

(iv) If the rate of

dividend exceeds

Percentage of profits* to
be transferred to reserve

10%

but not

12.5%

2.5%

12.5%
15%
20%

to
to

15%
20%

5%
7.5%
10%

Accounting Treatment of Dividend

Illustration 7
X Ltd. has a paid up capital of Rs. 30,00,000 dividend into 2,00,000 equity shares of
Rs. 10 each and 10% 1,00,000 preference shares of Rs. 10 each. Other particulars
were as under.
Rs.
Opening balance of Profits and loss Appropriation Account
57,500
Net profit earned during the year (after Tax)
7,50,000
Dividend Declared for the year
22%
Prepare Profit and Loss Appropriation Account. Comply with necessary statutory
provisions.
Solution
Profit and Loss Appropriation Account
To
To
To
To
To

General Reserve (1)

Preference Dividend (2)
Equity Dividend
Corporate Dividend (3)
Tax
Balance c/d

Rs.
75,000
1,00,000
4,40,000
67,500
1,25,000
8,07,500

By Balance b/d
By Net Profit

Rs.
57,500
7,50,000

8,07,500

Working notes
(1) As per the provisions of the section 205 on a dividend of 22% a statutory
transfer of 10% on the net profit to be made.
(2) Declaration of equity dividend will automatically make the company liable to pay
preference dividend. No equity dividend can be paid without paying preference
dividend.
(3) A corporate dividend Tax (C.D.T.) @ 12.5% has been provided. A surcharge of
2.5% has been ignored for the sake of simplicity. However, the effective rate of
C.D.T. is 12.8123% including surcharge.

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Fundamentals of
Accounting

Illustration 8
Victor Ltd. disclosed the following particulars:
9% 80,000
50,000
30,000
20,000

Preference shares of Rs. 10 each fully paid

Equity shares of Rs. 10 each fully paid
Equity shares of Rs. 10 each Rs. 8 paid up
Equity shares of Rs. 10 6 paid up

Rs.
8,00,000
5,00,000
2,40,000
1,20,000

The directors proposed a dividend of 15% or equity shares and resolved to make the
following appropriations:

Transfer to general reserve as per the provisions of the section 205

Transfer to dividend equalisation fund
Rs. 1,75,000
Transfer to debenture Redemption Fund
Rs. 1,00,000
Transfer to Investment Allowance Reserve
Rs. 1,25,000

The netprofit (before tax) for the year amounted to Rs. 12,50,000 you are required to
prepare Profit and Loss Appropriation Account. Provide for income tax @ 50% and
Corporate Dividend Tax @ 12.5%
Solution
Profit and Loss Appropriation Account
To
To
To
To
To

To
To

Rs.
General Reserve1
31,250
Dividend Equalisation fund
75,000
Debenture Redemption Fund
1,00,000
Investment Allowance Reserve 1,20,000
Proposed Dividend
Preference Dividend
72,000
Equity Dividend
1,29,000
Corporate Dividend Tax2
On Rs. (72000 + 1,29,000)
25,125
Balance c/d
67,625

By Net Profit (After tax)

6,25,000

Rs.
6,25,000

6,25,000

Working
1.
2.

3.8

As per the statutory requirement, a transfer of 5% of the net profit after tax has
been made to General Reserve
Corporate dividend tax has beesn provided on the total dividend.

REQUIREMENTS FOR CORPORATE FINANCIAL

STATEMENTS AS PER SCHEDULE VI

The Balance Sheet of a company like any other business organisation is a statement of
assets and liabilities. However, in the case of a company, the nature of the details to be
shown and the order of the arrangement of the items must conform to the requirements
prescribed in Schedule VI, Part I of the Companies Act. There items are already
discussed under 3.7.1 of this Unit.
The requirements as to Profit and Loss Account are as follows:
i)

106

The Profit and Loss Account shall be so made out as clearly to disclose the result
of the working of the company during the period covered by the P&L account
and shall disclose every material feature, including credits or receipts and debits
or expenses in respect of non-recurring transaction or transactions of an
exceptional nature.

ii)

The Income Statement is not required to be split in the parts, such as

Trading Account, profit earned and appropriated. Schedule VI only
recommends to disclose gross profit, net profit and its appropriation there of.
This may be shown under one head of Income Statement or Profit and Loss
Account. Chargeable items are shown above the line whereas appropriations
below the line.

Financial Statements

iii) Figures relating to previous year should also be shown along with the current
years figures in a separate column.
iv) As far as possible information given in the statement must be complete in all
respects. Such as the details of turnover made by the company should disclose
sales in respect of each class of goods & their quantities separately. Likewise
commission paid to sole selling agents and to other agents should be shown along
with the brokerage.
v)

The Account should disclose quantities and values of various types of rawmaterial purchased and quantities and values of various products produced/
purchased including opening and closing balances there of and that of work-inprogress.

vi) The amount provided for depreciation, renewals or diminution in value of fixed
assets and the method adopted for making such provisions.
If no such provision has been made- the fact should be disclosed by way of note
including arrears of depreciation.
vii) The amount of interest on companys debentures and on other fixed period loans
be stated separately, including interest paid or payable to directors.
viii) The amount of Income Tax on profits as per Income Tax Act 1961 at the prescribed rate including other taxes if any, should be shown separately.
ix) Expenditure incurred on each of the following items be disclosed separately
a)
b)
c)
d)
e)
f)

Consumption of stores and spare parts

Power and fuel
Rent
Repairs to Building
Repairs to Machinery
i)
Salaries, Wages and bonus
ii) Contribution to provident and other funds
iii) Workmen and staff welfare expenses

g)

Insurance

h)

Rates and Taxes (excluding income tax)

i)
Miscellaneous expenses provided any item exceeds 1% of revenue of
Rs. 5,000
Whichever is higher be shown separately.

j)

Payment to Auditor
a)
b)

as auditor
as advisor in respect of
i)
ii)
iii)

k)

Taxation matter
Company law matters
Management services

Remuneration received by managing directors or managers either from the

company or its subsidiaries should be indicated separately including its
computation.

107

Fundamentals of
Accounting

x)

The Profit and Loss Account should disclose the various items of incomes
arranged under appropriate heads.
a) Turnover giving details in respect of each class of goods indicating
quantities of such sales for each class separately.
b) Amount of income from interest specifying the nature of the income
c) Income from investment stating from trade investments & other investments
d) Profit or losses or investments
e) Dividends including dividends from subsidiary companies
f) Miscellaneous incomes such as royalty, fees etc.
g) Foreign exchange earnings, if any

The Profit and Loss Account must be made out in such a manner that discloses true
and fair view of the profit or loss of the company for the current accounting year.
This means that items of extraordinary nature or those unrelated to companys
business or items relating to previous years (Prior Period items) should be separately
stated, if these are material.
Similarly amount drawn from reserves, profits from revaluation of assets or profits
arising due to change in method of accounting or major policy change in the method of
valuation higher the operating efficiency or position much better that it actually is
would be contraray to the spirit of law.

3.9

BASIC PRINCIPLES GOVERNING THE

PREPARATION OF FINANCIAL STATEMENTS

1) Materiality: It is a relative term. What is material for one company may be

immaterial for other. According to American Accounting Association (AAA) an item
should be regarded as material if there is reason to believe that knowledge of it would
influence the decision of informed investors, banks, creditors & other interested
parties. AS-5 sates that all material information and items should be disclosed which
are necessary and vital to make the financial statements more clear and
understandable operating efficiency wise and financial-position-wise. Treatment
of certain expenditure as capital by one company and revenue by the other is a clear
example of it. Hence materiality is purely matter of personal judgment which is guided
by size and nature of enterprise.

108

2) Prior Period Items: (AS-5)

As a matter of fact the Profit and Loss Account should disclose the profit or loss for
the period for which accounts are prepared, that is for the reported (current) period. If,
however, some items were omitted to be accounted for in the preparation of financial
statements then it is not possible to reopen the accounts for the previous year after it
has been adopted by the shareholders in the annual general meeting. The ICAI defines
Prior Period Items as incomes or expenses which arise in the current period as a
result of errors or omissions in the preparation financial statements of one or more
periods. The errors may occur as a result of mathematical mistakes, oversight
(omissions), misinterpretation of facts and wrong application of accounting policies or
a wrong or inaccurate estimate. Hence these items should be shown below the line
i.e. in the Profit and Loss Appropriation Account. However, prior period adjustments
do not cover

Minor omissions of accruals and prepayments

Prior periods revenue which was not accounted for on the ground of
prudential practice.

Recovery of bad debts written off earlier

Adjustments to the useful life of the depreciable assets

3) Extra Ordinary Items: (AS5)

Extraordinary items are income or expenses that arise from events or transactions that
are clearly distinct from the ordinary activities of the enterprise and, therefore, are not
expected to recur frequently and regularly (AS-5). These items are shown in the Profit
and Loss Account for the period but the nature of such items should be disclosed
separately. These include

Write down of inventories to net realizable value

Profit or loss on sale of fixed assets or long-term investments.

Reversals of provisions

Reversals of writing off of the fixed assets

Losses sustained on account of an earthquake.

Financial Statements

4) Change in Accounting Policies: (AS-5)

Accounting policies are the specific accounting principles and the methods of applying
these principles adopted by an enterprise in the preparation and presentation of
financial statements. A change in accounting policy is required by statue or by the
accounting standard setting body or if it is considered that the change will result in a
more appropriate presentation of the financial statements of the enterprise. Any
material effect of such a change in the current or subsequent periods should be
quantified and disclosed together with the reasons for the change. Following are the
change in policy:

A change in the method of charging depreciation from written down value

(WDV) to straight line method (SLM) and vice versa.

A change in the method of valuation of inventories.

However, a change in the estimated life of a machine is not a change in policy
but a change in estimate.

3.10

PREPARATION OF CORPORATE FINANCIAL

STATEMENTS

As already stated, the Board of Directors of the company shall present a Balance
Sheet as at the end of the period; and a Profit and Loss Account for that period at the
annual general meeting. In case of company not carrying on business for profit, an
Income and Expenditure Account shall be laid at the annual general meeting instead of
Profit and Loss Account. Every Profit and Loss Account shall also give a true and
fair view of profit or loss of the company for the financial year and shall comply with
the requirements of schedule VI. Every Insurance or Banking company or any
company engaged in the generation of electricity or any other class of company for
which the Profit and Loss Account has been specified under the Act governing such
class of company need not follow the Form given in Schedule VI to this Act. Similarly
every Balance Sheet shall give a true & fair view of the state of affairs of the
company as per Schedule VI. Any Insurance or Banking company or any company
engaged in generation or supply of electricity or any other class of company for which
a form of Balance Sheet has been prescribed under the Act governing such class of
company need not to follow such form.
Recently the Companies (Amendment) Act 1999 has made the compliance of
accounting standards mandatory. Accordingly every Profit and Loss Account and
Balance Sheet of the Company shall comply with the Accounting Standards.
However, in case of non-compliance the company must disclose the deviation from
the accounting standards. It should also state reasons for such deviation; and
financial effect if any, due to such deviation.
On the basis of requirements of Schedule VI and accounting standards following is the
format of Profit and Loss Account of a Company.

109

Fundamentals of
Accounting

Profit and Loss Account of ....

For the year ended 31st March ....
Figure
for the
previous
year
Rs.
...

Figures Figure
for the for the
current Previous
year
year
Rs.
Rs.
To Opening Stock

Figures
for the
current
year
Rs.

...

By Sales Less Returns

...

Raw Material

...

...

By Income from Services

...

...

Finished Goods

...

...

By Closing Stock

...

...
...

To Purchases (Raw materials)

Less Returns

...

...

Raw Materials

...

...

...

Work-in-progress

...

...

Finished Goods

...

...

...

By Gross Profit b/d

...

By Income from

...

To Stores & Spares (consumed)

...

...

To Power and Fuel

...

...

To Wages (Productive)

...

...

To Manufacturing Expenses

...

...

To Gross Profit c/d

xxx

...

xxx

...

To Rent

...

...

To Repairs to Building

...

By Profit on Sale of

...

To Repairs to Machinery

...

By Dividend Income

...

To Salaries & Bonus

...

By Miscellaneous

...

To Contribution to Provident

...

To Staff Welfare Expenses

...

To Contribution to

...

To Insurance

...

...

To Rates & Taxes

...

...

To Printing & Stationery

...

...

To Postage, Telegrams, Fax &

...

To Commission, Brokerage

...

To Bank Charges & Interest

...

To Depreciation

...

...

To Loss on sale of Investments

...

...

To Remuneration payable to

...

Investments
Investment

Incomes
Fund

Pension/Gratuity Fund

Telephone
and Discount

...
...
...
...

...
...

...
...
...

Directors & other

...

...

Managerial Personnel

...

...

To Auditors Fee

...

...

To Provision for Taxation

...

...

To Net Profit (transferred to

...

xxx

...

...

...

Profit & Loss Account)

110

...

...
xxx

xxx

xxx

Financial Statements

Schedule VI
(Part I - Form of Balance Sheet)
(Conventional Format)
Balance Sheet of...............
As on 31st March..............
Figure
for the
previous
year
Rs.

Liabilities

Share Capital
Authorised*.... shares of
Rs. ...... each.
Issued..... shares of Rs. Each
(*Various classes of shares and
their called up amount including
details of
- Shares issued for consideration
other than Cash
- Bonus Issue made, if any
Less Call Unpaid
(i) By Directors
(ii) By Other
Add. Forfeited shares
(amount actually paid)
Reserves & Surplus
(1) Capital Reserve
(2) Capital Redemption Reserves
(3) Securities Premium
(4) Others Reserves & specifying
the nature of each reserve and
amount in respect there of
Loss Debit balance of P&L A/c
(5) Surplus-Balance in
Profit and Loss Account after
providing for proposed
allocation namely
Dividend-Bonus, or Reserves
(6) Proposed Additions to Reserves
(7) Sinking Fund
Secured Loans
(1) Debentures
(2) Loans & Advances from Banks
(3) Loans & Advances from subsidiaries
(4) Other loans & Advances
* Interest accrued and due should be
Included in the respective sub-head)
* Nature of security to be specified in
each case)
* Terms of redemption or conversion of
debentures to be stated together with
earliest date of conversion/redemption.
Unsecured Loans
(1) Fixed Deposits
(2) Loans & Advances from subsidiaries
(3) Short-term loans & advances
(a) From Banks
(b) From Others
(4) Other loans and advances
(a) From Banks
(b) From Others

Figures Figure
for the for the
current Previous
year
year
Rs.
Rs.

Assets

Fixed Assets
Goodwill
Land
Building
Leasehold
Railway sidings
Plant and machinery
Furniture and Fittings
Development of Property
Patents, Trade Marks and
Designs
Live Stock and Vehicles etc.
Investments
Showing nature of Investment
and mode of valuation-cost
Or market value, and
distinguishing between
(1) Investments in Government
or Trust Securities
(2) Investments is Shares,
Debentures or bonds
(Giving details of classes
of shares along with their
paid up value)
(5) Immovable Properties
(4) Investments in Capital of
Partnership firms.
Current Assets, Loans and
Advances
(A) Current Assets
(1) Interest Accrued on
Investments
(2) Stores and Spare parts*
(3) Loose Tools
(4) Stock in Trade*
(5) Work-in Progress*
* Mode of valuation and
Amount in case of raw
materials
Sundry Debtors
(a) Debts outstanding for a
period exceeding six
months
(b) Other debts
(Less Provision)
In regard to sundry debtors,
particulars to be given
separately
(i) Debts considered good
and In respect of which
company is fully secured
(ii) Debts considered good

Figures
for the
current
year
Rs.

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Fundamentals of
Accounting

Current Liabilities & Provisions

A. Current Liabilities
(i) Acceptances
(ii) Sundry Creditors
(iii) Subsidiary Companies
(iv) Advance payments and
Unexpired discounts for the portion
for which value has still to be give
e.g. in the following classes of companies
Newspaper, Fire-Insurance, Theaters,
Clubs, Banking & Steamship Companies
(5) Unclaimed Dividends
(6) other Liabilities, if any
(7) Interest accrued but not due on loans

for which company holds

no security other than the
debtors personal security.
(iii) Debts considered doubtful
doubtful or bad.
(iv) Debts due by directors
or Other officers or any
of them either severally
or jointly with any other
person or debts due by
firms or private
companies respectively
in which any director or
a memberto be
separately stated.
(7a) Cash Balance at hand
(7b) Bank Balances
(i) With Scheduled banks &
(ii) With Others
(B) Loans and Advances
(8) (a) Advances loans to
Subsidiaries.
(b) Advances and loans to
Partnership firms in which
company or any of its
subsidiaries is a partner.
(9) Bills of Exchange
(10) Advance receivable in cash
or in kind or for value to be
received e.g. rate, taxes
Insurance etc.
(11) Balances on Current
Accounts with managing
Agents, secretaries and
Treasures.
(12) Balances with customs
Port trust (where payable
on Demand)
Misc. Expenditure
(1) Preliminary Expenses
(2) Expenses including
commission, or brokerage on
underwriting or subscription
of shares or debentures.
(3) Discount on issue of Shares
or debentures
(4) Interest paid out of capital
during construction period
(5) Development Expenditure
not adjusted
(6) Other items (specifying nature)
Profit and Loss Account
(Debit balance of P&L A/c
Carried forward after
adjusting uncommitted
(free) reserves, is any.)

B. Provision
(8) Provision for taxation
(9) Proposed dividends
(10) For Contingencies
(11) For Provident Fund Scheme
(12) For Insurance, Pension and
Similar Staff Benefit schemes
(13) Other provisions

xxx

112

xxx

xxx

xxx

Financial Statements

Footnote: to be shown separately such as:

1)
2)
3)
4)
5)

Claims against the Company not acknowledged as debts.

Uncalled liability on shares partly paid
Arrears of cumulative dividends
Estimated amount of contracts remaining to be executed on capital
account and not provided for.
Other money for which company is contingently liable.

Preparation of Financial StatementsConventional Format

Illustration 9
From the following Trial Balance of A Ltd., prepare a Profit and Loss Account of the
company for the year ended 31st March 2003 and a Balance Sheet as on that date.
Rs.
5,00,000 Equity shares of Rs. 10 each fully called
9% Debentures (Rs. 100 each)
Freehold Building
Plant and Machinery
Profit and Loss Account
Stock (1.4.2002)
S. Debtors and Creditors
Bills Payable
Purchases and Sales
Provision for Bad Debts
Bad Debts
General Reserves
Calls in Arrears
Goodwill
Interim Dividend Paid (1.11.2002)
Cash at Bank
Wages and Salaries
Office Expenses
Salaries of office and marketing staff
Interest on Debentures
Discount on Issue of Debentures

Rs.
50,00,000
20,00,000

40,50,000
28,00,000
2,75,000
7,50,000
9,50,000
19,75,000

4,25,000
3,75,000
45,25,000
45,000

25,000
3,50,000
75,000
3,00,000
4,92,500
1,60,000
6,95,500
77,000
5,15,000
90,000
40,000
1,29,95,000

1,29,95,000

Adjustments:
i)

Stock on 31st March 2003 was Rs. 8,75,000

ii)

Depreciate Plant & Machinery by 10% and write off 1/8th of the discount con
issue of debentures

iii) Maintain 5% provision for doubtful debts on debtors.

iv) Interest on debentures has been paid only for the first half
v)

Income tax @ 50% is to be provided. Corporate dividend tax is 12.5%

vi) There is a claim for Rs. 50,000 for workmens compensation, which has been
disputed by the company. The case is pending in the country of law.

113

Fundamentals of
Accounting

Solution
Profit and Loss Account
For the year ended 31st March 2003
To
To
To
To

Rs.
7,50,000
19,75,000
6,95,500
19,79,500

Stock (1.4.2002)
Purchases
Wages and Salaries
Gross Profit c/d

By Sales
By Closing Stock

54,00,000
To
To
To
To
To
To

To
To
To

Salaries
5,15,000
Office Expenses
77,000
Bad Debts
25,000
Provisions for bad debts
(Rs. 47,500 Rs. 45,000)
2,500
Depreciation
2,80,000
Interest on Debentures
Rs. 90,000
Add outstanding interest Rs. 90,000
1,80,000
interest on Debentures
Discount on issue of Deb.
5,000
Provision for Tax
4,47,500
Net Profit c/d
4,47,500

To Interim Dividend
To Corporate Dividend Tax
(Interim dividend
Rs. 4,92,500 x 12.5%)
To Balance c/d

Rs.
45,25,000
8,75,000

54,00,000
By Gross Profit b/d

19,79,500

19,79,500

19,79,500

4,92,500
61,563

By Balance b/d
2,75,000
By Profits and Loss A/c
(Net Profit)
4,47,500

1,68,437
72,22,500

7,22,500

Balance Sheet of A Ltd.

As on 31st March 2003
Liabilities
Called up & paid up Capital
5,00,00 shares of Rs. 10 each
Rs. 50,00,000
Less Calls-in-Arrears Rs. 75,000
Reserve & Surplus
General Reserve
Profit and Loss Account
Secured Loan
9% Debentures
Rs. 20,00,000
Interest outstanding
Rs. 90,000
Current Liabilities and Provisions
Current Liabilities
Sundry Creditors
Bills Payable
Provisions:
Provision for Tax
Corporate Dividend Tax
114

Rs.

49,25,000
3,50,000
1,68,437

20,90,000

4,25,000
3,75,000

Assets
Fixed Assets
Goodwill
Freehold Building
Plant & Machinery
(Rs. 28,00,000Rs. 2,80,000)
Current Assets, Loans
Advances
Current Assets
Stock
Debtors (Rs. 9,50,000Rs. 47,500)
Cash at Bank
Miscellaneous Expenditure
Discount on Issue
of Debentures
(Rs 40,000written off Rs 5000)

Rs.
3,00,000
40,50,000
25,20,000

8,75,000
9,02,500
1,60,000
35,000

4,47,500
61,563
88,42,500

88,42,500

Note: There is a contingent liability of Rs. 50,000 for workmens compensation

l

Financial Statements

No statutory transfer to general reserve is made, as the dividend paid does not
exceed 10% of paid up capital.
For the sake of simplicity surcharge on corporate dividend tax not taken into
account.

Illustration 10
Following in the Thial Balance of a limited Company as at 31st December, 2004.
Particulars
Credit

Debit

Share Capital
Cash in Hand
Rent
Prepaid Expenses
Repairs & Maintenance
Advances from Customers
General Reserve
Raw Materials at Cost
Sundry Creditors
Plant and Machinery
Power
Travelling and Conveyance
Auditors Fees
Cash at Bank
Land
Provision for Taxation
Furniture
Staff advances
Sundry Debtors
Misc. Income
Finished Goods at cost
Income-tax Advances
Misc. Expenses
Raw Materials consumption
Sales
Development Rebate Reserve
Building
Salaries, Wages & Bonus
Cash Credit from Bank

4,00,000

2,67,000
3,40,000
4,30,000
8,800
4,100
1,500
8,000
30,000
2,10,000
12,200
5,300
1,40,000
54,600
3,10,000
3,00,000
61,400
28,60,000
42,30,000
1,00,000
74,100
11,60,000
12,500

Total

56,97,100

6,200
5,300
4,600
8,600
50,000
3,00,000

56,97,100

The following additional information is also available:

i)

The authorised capital of the company is 80,000 equity shares of Rs. 10 each of
which 50% has been issued and has been recommended by the directors.
ii) A dividend of 15% on the paid up capital has been recommended by the
directors.
iii) The closing stock of finished goods at cost is Rs. 5,60,000.
iv) The development rebate reserve is no langer required.
v) Depreciation on plant and machinery amounting to Rs. 43,000 on furniture
amounting to Rs. 1,300 and on building amounting to Rs. 3,800 has been debited
to miscellanceous expenses.
vi) Surplus in profit and loss account after proposed dividends, is to be transferred
to general reserve.

115

Fundamentals of
Accounting

vii) Income-tax assessment for a prior year has been completed, fixing the income
tax liability at Rs. 1,55,000 (against which a provision of Rs. 80,000 and
advances of income tax of Rs. 70,000 exists in the books).
You are required to prepare:
i)

profit and loss account for the year ended 31st December, 2004; and

ii)

Balance sheet in the prescribed form as on that date.

Solution
A Company Limited
Profit and Loss Account
for the year ended 31st December, 2004
Particulars
To Open. Stock of finished goods
To Raw Materials consumed
To Gross Profit c/d
To Salaries, Wages and Bonus
To Power
To Rent
To Repairs and Maintenance
To Aduditors Fees
To Travelling and Conveyance
To Depreciation on:
Plant and Machinery
Furniture
Building
To Miscellanceous Expenses
To Provision for Taxation
To Net Profit for the year
To Provision for Taxation
(for a prior year)
To Statutory Reserve
To Proposed Dividend
To General Reserve (transfer)

Rs
3,10,000
28,60,000
16,20,000
47,90,000
11,60,000
8,800
5,300
8,600
1,500
4,100

Particulars
By Sales
By Clos. Stock of Finished
Goods
By Gross Profit b/d
By Miscellaneous Income

43,000
1,3000
3,800
13,300
169960
254940
16,74,600
75,000
12747
60,000
2,07,193

By Net Profit for the year

By Development Rebate Reserve
written Back

354940

Rs
42,30,000
5,60,000
47,90,000
16,20,000
54,600

16,74,600
2,54,940
1,00,000

354940

Note: Provision for taxation for the year is assumed to be 40% of the profit.

A Limited Company
Balance Sheet
as on 31st December, 2004
Particulars

116

Share Capital:
Authorised:
80,000 Equity shares of Rs. 10 each
Issued: Subscribed and Paid up:
40,000 Equity shares of Rs 10 each
fully paid up
Reserves and Surplus:
General Reserve:
Rs.
Brought forward
3,00,000
Add: ransfer from

Rs

8,00,000

4,00,000

Particulars

Rs

Fixed Assets:
Land at cost
Rs. 30,000
Building
77,900
Less: Depreciation
3,800 74,100
Plant and Machinery 4,73,000
Less: Depreciation
43,000 4,30,000
Furniture
13,500
Less: Depreciation
1300 12,200
Investments

Current Assets, Loans and

Profit and Loss A/c

Satutory Reserve
Development
Rebate Reserve:
Less: Transferred to
Profit and Loss A/c
Secured Loans:
Cash Credit from Bank
Unsecured Loans:
Current Provisions:
A. Current Liabilities:
Sundry Creditors
Income Tax Payable
Advances from Customers
B. Provisions:
Provisions for Taxation
Proposed Dividend

207193

5,07,193
12,747

1,00,000
1,00,000

Total

12,500

Advances:
A. Current Assets:
Raw Materials at cost
Finished Goods at cost
Sundry Debtrors
Cosh in Hand
Cash at Bank
B. Loans and Advances:
Staff Advances
Prepaid Expenses
Income Tax Advance

Financial Statements

2,67,000
5,60,000
1,40,000
6,200
8,000
5,300
4,600
2,30,000

3,40,000
85,000
50,000
2,99,960
60,000
17,67,400

17,67,400

Working Notes:
(i)

Provision for Taxation:

As per Trial Balance
Less: Adjustment for prior year provision

Rs
2,10,000
80,000
1,30,000

(ii)

Add. Provision for current year taxation

169,960

Provision taken to Balance Sheet

2,99,960

Prior year tax Adjustments:

Income Tax Liability for Prior Year

(iii)

Less: Prior Provision

80,000

Additional Provision to be made in current year

75,000

Total Tax Liability

1,55,000

Less: Advance Tax

70,000

Tax Payable

85,000

Advances Income Tax

Less: Adjustment against prior year completed assessment
Balance in Advance Income tax

(iv)

1,55,000

3,00,000
70,000
2,30,000

A sum equal to 5% to the net profits is required to be transferred to statutory

reserve as the rate of dividend is 15%.

117

Fundamentals of
Accounting

Illustration 11
The Bangalore Manufacturing Co. Ltd., was registened with a nominal capital of
Rs. 15,00,000 divided into equity shares of Rs. 100 each. On 31st March 2004 the
follwing ledger balances were extracted from the companys books.
Rs.
Equity Share Capial Called
up and paid up
Calls-in-arrears

11,50,000
18,750

Rs.
Preliminary Expenses

12,500

Freight and Duty

32,750

Goodwill

62,500

Plant and Machinery

9,00,000

Wages

Stock (1-4-2003)

1,87,500

Cash in hand

5,875

18,000

Cash at Bank

95,750
14,350

Fixtures

2,12,000

Sundery Debtors

2,17,500

Directors Fees

Buildings

7,50,000

Bad Debts

Purchases

4,62,500

Commission paid

18,000
36,250

Interim Dividend Paid

18,750

Salaries

Rent

12,000

6% Debentures

General Expenses

12,250

Sales

Debenture Interest

12,250

4% Government Securities

Bills Payable

95,000

Provision for Doubtful Debts

General Reserve

62,500

Sundry Creditors

Profit and Loss A/c

36,250

5,275

7,50,500
10,37,500
1,50,500
8,750
1,15,000

(Cr.) 1-4-2003

The stock on 31st March, 2004 was estimated at Rs. 2,52,000

The following adjustments were to be made:
1)

Final Dividend at 5% to be provided.

2)

Depreciation on Plant and Machinery at 10% and on Fixtures at 5%.

3)

Preliminary expenses to be written off by 20%.

4)

Rs. 25,000 were to be transferred to General Reserve.

5)

The provision for bad debts to be maintained at 5% on sundry debtors.

You are required to prepare the Trading and Profit and Loss Account and Profit and
Loss Appropriation Account for the year ended 31st March 2004 and the Balance
Sheet as on that date.

118

Financial Statements

Solution
Trading and Profit and Loss Account of the Bengal Manufacturing Co. Ltd.
for the year ending 31st March, 2004

To

Opening Stock (1-4-2004)

Purchases
Freight and Duty
Wages
Gross Profit c/d

To

Salaries
Commission
Rent
General Expenses
Directors Fees
Debenture Interest
Add. Outstanding
Interest
To Bad Debts
Add: Provision for
Bad Debts
Required @ 5%
on Debtors
Rs. 2,17,500
Less: Old Provision
for Doubtful
Dets

Rs.

Rs.

1,87,500
4,62,500
32,750
2,12,000
3,94,750

By Sales
10,37,500
Closing Stock (31-3-2004) 2,52,000
2,52,000

12,89,500
36,250
18,000
12,000
12,250
Rs.
14,350
12,500

By Gross Profit b/d

12,89,500
3,94,750

32,500
5,275

10,875
16,150

8,750
7,400

Depreciation on:
Plant & Machinery
@ 10%
Fixtures @ 5%

90,000
900

Preliminary Expenses (20%)

Provision for Taxation
Net Profit transferred to
Profit and Loss Appropriation A/c

90,9000
2,500
62,500

93,000
3,94,750

3,94,750

Calculation of Outstanding Interest

Interest on Rs. 7,50,000 debentures @ 6% for one year
Less: Debenture interest paid
Outstanding interest

Rs.
45,000
12,500
32,500

119

Fundamentals of
Accounting

Profit and Loss Appropriation Account

for the ending 31st March, 2004
Rs.
To Interim Dividend
Proposed Final Dividend
@ 5% on Rs. 11,31,250
(i.e. Rs. 11,50,000 called) up
capitalRs. 18,750 calls-in-arrears)
General Reserve
Balance c/d

18,750

Rs.
By Balance b/d (1-4-2003)
Net Profit for the year

56,562
25,000
29,538
1,29,850

36,250
93,600

1,29,850

Balance Sheet of the Bangalore Manufacturing Co. Ltd.

as at 31st March, 2004
Liabilities
Share Capital:
Rs.
Authorsed Capital: 15,000
equity shares of Rs. 100 each

Rs.

15,00,000

Called up and Paid up Capital:

11,500 shares of Rs. 100 each
fully calld up
11,50,000
Less: Calls-in-arrears
18,750

Assets

Rs.

Fixed Assets:
Goodwill
Buildings
Rs.
Plant & Machinery 9,00,000
Less: Depreciation
90,000

8,10,000
Fixtures
Less: Depreciation

18,000
900

11,31,250
Reserves and Surplus:
General Reserve
62,500
Add: Transferred during
the year
25,000
Profit and Loss Account
Secured Loans
6% Debentures
Debenture Interest Outsanding
Unsecured Loans
Current Liabilities & Provisions:
A. Current Liabilities:
Bills Payable
Sundry Creditors
B. Provisions:
Provision for Taxation
Proposed Dividends

62,500
7,50,000

87,500
29,538
7,50,000
32,500
Nil

95,000
1,15,000
62,500
56,562
23,59,850

17,100
Investments:
4% Government Securities
Current Assets, Loans and
Advances:
A. Current Assets:
Stock
Sundry Debtors 2,17,500
Less: Provision for
Bad Debts @ 5% 10,875
Cash in hand
Cash at Bank
B. Loans and Advances
Miscellanceous Expenditure:
(to the extent not written
off or adjusted)
Preliminary Expenses

1,50,000

2,52,000

2,06,625
5,875
95,750
Nil

10,000
23,59,850

Illustration 12
Spik and Span Ltd. was registered with an authorised capial or Rs. 3 lakh divided into
30,000 equity shares of Rs. 10 each. The company offered 15,000 shares for public
subscription of which Rs. 7.50 pen share was called up.

120

The following trral balance was drawn from the book of accounts as on March 31,
2004. You are required to prepare a Profit & Loss Appropriation Account for the year
ending on March 31, 2004 and Balance Sheet as on that date.

Debit
Rs.
23,800
52,900
5,000
8000
18,000
7,600
640
900
1,03,600
24,000
50,000
12,480
25,000
26,000

Land
Buildings
Calls in Arrear
Brokerage on Shares
Stores and Spare parts
Preliminary Expenses
Unexpired Insurance
Live Stock
Plant & Machinery
Loose Tools
Stock in trade at cost
Cash at Office
Cash Bank
Sundry Debtors
Share Capital
Sundry Creditors
Capital Reserve
Wages Outstanding
Godown Rent due
General Reserve
Employees Benefit Fund
Salaries Outstanding
Reserve for Doubtful Debts
Unpaid Dividends
Profit & Loss Accoaunt

Credit
Rs.

Financial Statements

1,12,500
1,24,600
30,800
1,820
700
16,800
3,000
1,000
1,300
700
57,500
Total

3,50,720

3,50,720

Out of the creditors of, Rs. 1,24,600 Rs. 84,600 were due to bank for a loan secured
by mortage on buildings and machinery, and Rs. 22,000 were due on account of loan
from subsidiary company.
The company earned a profit of Rs. 61,200 during the year. The balance
of profit brought forward from the previous year was Rs. 38,600 out of which it
was decided that Rs. 15,000 be paid as final dividend, Rs. 16,800 the carried to
General Reserve, Rs. 3,000 to Employees Benefit Fund. It was further resolved
that Rs. 7,500 be paid by way of interim dividend for the first half of the
current year.
Solution
Spik and Span Ltd.
Profit and Loss Appropriation A/c for the year ended March 31, 2004
Rs.
To Interim Dividend
To Balance of Profit
To Dividend
To General Reserve
To Employees Benefit Fund

7,500
57,500
15,000
16,800
3,00
99,800

Rs.
Balance as per P & L A/c for the
year ending March 31, 2003

38,600

Profit as per P & L A/c

61,200
99,800

121

Fundamentals of
Accounting

Spik & Span Ltd.

Balance Sheet as on March 31, 2004
Liabilities

Rs.

Share Capital:
Authorised
30,000 Equity Shares of
Rs. 10 each
Issued & Subscribed Capital:
15,000 Equity Shares of
Rs. 10 each Rs. 750 per
Share called up Rs. 1,12,500
Less Calls in Arrear Rs. 5,000

Assets

3,00,000

1,07,500
Reserves and Surplus:
Capital Reserve
General Reserve
Profit & Loss Account
Empioyees Benefit Fund
Secured Loans:
From Bank (Secured by
mortgage on buildings machinery)
Unsecured Loans:
From Subsidiary
Current Liabilities and
Provisions:
Sundry Creditors
Unpaid Dividends
Outstanding Wages
Outstanding Salary
Godown Rent due

30,800
16,800
57,500
3,000

Fixed Assets:
(Net Block)
Land
Buildings
Plant &
Machinery
Live Stock
Current Assets:
Stock in trade at cost
Stores & Spares
Loose Tools
Sundry Debtors
Less Reserve
for Dful Debts
Cash & Bank Balances
Loans and Advances:
Unexpired Insurance

Rs.
Rs.
23,800
52,900

103,600
900

1,81,200
50,000
18,000
24,000

26,000
1,300

24,700
37,480
640

84,600
22,000

Miscellanceous Expenditure
& Losses:
Preliminary Expenses
Brokerage on Shares

7,600
800

18,000
700
1,820
1,000
700
3,44,420

3,44,420

Adjustment: (1) Stock on 31st March 2003 was valued at Rs. 3,42,000
(2) Depreciate:
Plant and Machinery
Computers
patents & Trade Marks

15%
10%
5%

(3) Provision for Bad & doubtful debts is required at Rs. 2,040
(4) Provide for
Rent o/s
Rs.
3,200
Salaries o/s
Rs.
3,600
Proposed Dividend 15%
Provision for Income Tax 50% & Corporate Dividend tax 12.5%

122

Ans: Net Profit after Tax

Rs.
1,03,900
Corporate dividend
Rs.
12,000
Balance Sheet Total
Rs.
8,32,800
Corporate Tax = Rs. 6000 + Rs. 3600 = Rs. 9600
Rs. 96000 12.5% = Rs. 12000

Financial Statements

2. The following balances appeared in the books of ABC Co. Ltd. as on

December 31, 2004.
Particulars

Rs.

Paid up Capital
60,000 Equity Shares of Rs. 10 each
General Reserve
Unclaimed Dividend
Trade Creditors
Buildings at Cost
Purchases
Sales
Manufacturing Expenses
Establishment Charges
General Charges
Machinery at Cost
Motor Vehicle at Cost
Furniture at Cost
Opening stock
Book Debts
Investments
Depreciation Reserve
Advance Payment of Income Tax
Cash Balnce
Directors Fees
Investments Interest
Profit and Loos Account
(January 1,2004)
Staff Providend Fund

Rs.
6,00,000
2,50,000
6,526
36,858

1,50,000
5,00,903
10,83,947
3,59,000
26,814
31,078
2,00,000
30,000
5,000
1,72,058
2,23,380
2,88,950
71,000
50,000
72,240
1,800
8,544
16,848
37,500
21,11,223

21,11,223

From these balances and the following information prepare the Companys Balance
Sheet as on December 31, December 31, 2004 and its Profit and Loss Accout for the
year ended on that date.
a)

The stock on December 31, 2004 was Rs. 1,48,680.

b)

Provide Rs. 10,000 for depreciation on fixed assets, Rs. 6,500 for Managing
Directors Commission and Rs. 1,500 for the Companys contribution to the
Staff Providend Fund.

c)

Interest accrued on Investment amounted to Rs. 2,750.

d)

A Provision of Rs. 60,000 for taxes in respect of the profit for 2004 is
considered necessary.

e)

The directors propose a final dividend at 4% after transfering Rs. 50,000 to

general Reserve.

f)

A claim of Rs. 2,500 for workmens compensation is being disputed by the company.

g)

The Market value of investment as on 31.12 2004 amounts to Rs. 3,02,500.

(Ans: Net Profit after tax Rs. 74,268, P and L Appn. A/c Rs. 17,116, Balancer Sheet
Rs. 10,90,000).
123

Fundamentals of
Accounting

3) An inexperienced accountant has prepared the balance sheet of ABC Ltd. as follows:
Balance Sheet of A B C Limited
Liabilities

Rs

Assets

Trade Creditors

80,900

Stock:

Advances from Customers

42,260

Share Capital

8,00,000

Rs

In hand

3,60,480

With Agents

24,300

Profit & Loss A/c

45,630

Cash in hand

23,540

Provision for Taxes

95,000

Investments

20,000

Proposed Dividend

59,000

Fixed Assets:

Loan to Managing Director

5,000

Land

1,80,000

General Reserve

75,000

Plant & Machinery

Dev. Rebate Reserve

30,000

(W.D.V.)

Provision for Contingencies

23,000

Debtors

Share Premium A/c

22,000

Less: Provision

Forfeited Shares

3,000

4,10,000
2,15,450
9,300

For B/D

2,06,150
Bills Receiveable
Amount due from Agents
12,80,790

5,000
51,320
12,80,790

Redraft the above Balance Sheet in the form prescribed by Indian Companies Act,
1956 giving necessary details yourself.
4) The following balances have been extracted from AB Ltd. as on
September 30, 2004:
Rs.
Share Capital (Authorised and issued):
Equity (1,50,000 shares)
8% Redeemable Preference (400 shares)
Share Premiium
Preference share Redemption
General Reserve
Land (Cost)
Buildings (Cost less Depreciation)
Furniture (Cost Less Depreciation)
Motor Vehicle (Cost less Dep.)
Trading Accountgross Profit
Establishment Charges
Rates, Taxes and Insurance
Commission

124

Commission
Discount received
Directors Fees
Depreciation
Sundry Office Expenses
Payment to Auditors
Sundry Debtors and Creditors

Rs.
15,00,000
40,000
25,000

48,000
1,00,000
3,00,000
7,00,000
20,000
35,000
9,00,000
2,50,000
12,000
4,000
5,000
8,000
2,000
60,000
60,000
4,000
1,06,600

25,600

Financial Statements

Profit and Loss Account

(as on 30.9.2003)
Unpaid Dividend
Cash in hand
Cash at Bank in Current Account
Security Deposit
Outstanding Expenses
Investment in G.P. Notes
Stock-in-trade (at or below cost)
Provision for taxation (y/e 30.9.03)
Income tax paid under dispute (y/e 30.9.03)
Advanced payment of income-tax

10,000
2,000
12,000
1,95,000
10,000
6,000
2,00,000
3,53,000
70,000
1,00,000
2,20,000

Total

26,91,600

26,91,600

The following further details are available:

1)

The Preference shares were redeemed on 1st October, 2003 at a premium of 20%
but no entries were passed for giving effect thereto, except payment standing to
the debit of Preference Share Redemption A/c.

2)

Depreciation provided up to 30th September, 2004 is as follows:

a)
b)
c)

Buildings
Furniture
Moter Vehicles

2,10,000
20,000
60,000

3)

Establishment charges include Rs. 18,000 paid to Managing Director as minimum remuneration in terms of agreement which provides for a remuneration of
5% of annual net profits subject to the above minimum in the case of absence or
inadequacy of profitsw in the year.

4)

Payment to Auditors includes Rs. 1,000 for taxation work in addition to audit
fees.

5)

Market value of investments on 30th September 2004 Rs. 1,80,000

6)

Sundry Debtors include Rs. 40,000 due for a period exceeding six months.

7)

All receivables and deposits are considered good for realisation.

8)

Income-tax demand for the year ended 30.9.2003 Rs. 1,00,000 has not been
provided for against which an appeal is pending.

9)

Income-tax to be provided@ 55%.

10) Directors decide to transfer Rs. 25,000 to the General Reserve and to recommend
payment of dividend on equity shares at the rate of 5%.
11) Ignore previous years figures.
You are required to prepare the Profit and Loss Account for the year ended
30th September, 2004 and the Balance Sheet as at that date.
(Ans: Net profit after tax and commission Rs. 2,30,422,
Balance of P/L Appn. A/c
Balance Sheet Total

Rs. 1,40,422
Rs. 22,51,600).

Hint: 5% Remeneration Rs. 26950

125

Fundamentals of
Accounting

5) The following balances have ben extracted for the books of XYZ Company Ltd.
as on March 31, 2004.
Rs.
Freehold Land
Building
Furniture
Debtors
Stock (31 March 2004)
Cash at Bank
Cash in hand
Cost of Goods sold
Salaries and Wages
Misc. Expenses
Investment in Shares
Interest
Bad Debts
Repairs and Maintenance
Advance payment of
Income-tax

23,000
7,500
2,000
5,000
4,000
500
100
30,000
1,500
800
18,000
300
100
150
600

Rs.
Income from Investments
Provisions for doubtful debt
(1st April 2003)
Creditors
Provision for Depreciation
(1st April, 2003)
Buildings
Furniture
Suspense A/c
Equity Share Capital
6% Cumulative Pref.
Share Capital
Share Premium
Bank Overdraft
Sales
Profit and Loss A/c
(1st April, 2003)

93,550

1,200
200
2,000
500

36,750
8,000
1,000
5,000
38,000
250
93,550

The following further particulars are available:

1)

The land was revalued on 1st january, 2004 at Rs. 30,000 by an expert valuer
but no effect has been given in the books although the Directors have decided to
adjust the relavant amount.

2)

Provision for doubtful debt is to be adjusted to 5% on the amount of debtors.

3)

Equity Share Capital is composed of Rs. 10 Shares, 3640 shares were fully paid
and 50 on which a call of Rs. 3 remains unpaid.

4)

Suspense A/c represents money received from the new allottee for re-issue of
50 shares shares forfeited during the year for non-payment of the final call, but
no entry for adjustment thereof has been passed.

5)

Provision for taxation is to be made at 45%

6)

Market value of investments was Rs. 18,500 on 31st March 2004

7)

The company is managed by the Directors who are entitled to a remuneration of

3% on the annual net profits.

8)

Depreciation is to be charged on written down value of:

Building at 2%
Furniture at 10%

9)

The land and buildings of the company are mortgaged in favour of the bank as
security for overdraft sanctioned up to a limit of Rs. 25,000.

10) Dividend on Cumulative preference shares were in arrears for 5 years upto
March 31, 2004. The Directors have recommended payment of dividend for two
years.
Prepare Profit and Loss Account for the year ended March 31, 2004 and Balance
Sheet on that date.
126

Financial Statements

(Answer: Profit Rs. 5,999, Balance Sheet total Rs. 60,491)

6) Ajax Co. Ltd. had an authorised capital of 5,000 equity shares of Rs. 100 each.
As on December 31, 2003, 3000 shares were fully called up, and the following
balances were extracted from the companys ledger accounts.
Rs.

Rs.

Salary

4,85,000

Printing and Stationery

2,300

Purchases

3,20,000

Advertishing Expenses

7,300

Stock

75,000

Sundry Debtors

52,700

Manufacturing wages

70,000

Sundry Creditors

34,200

Insurance upto 31-3-2004

6,720

Plant & Machinery

83,500

Rent

6,000

General Reserve

60,700

18,500

Furniture

27,100

Discount Allowed

1,050

Building

84,580

General Expenses

9,050

Cash at Bank

Calls in Arrear

4,800

Loans from Managing Director

Profit and Loss A/c (Cr.)

21600

Bad Debts

Salaries

1,24,000
3,700
12,600

The following further information is given: (i) Depreciation to be charged on

Machinery and Furniture at 15% and 10% respectively; (ii) Provision for Taxation to
be made Rs. 19,000; (iii) Closing Stock Rs. 1,21,000; (iv) Outstanding liabilities:
Wages, Rs. 7,000; Salaries Rs. 8,200; Rent, Rs. 1,600; (v) Dividend at 5%
on paid-up capital to be provided; (vi) Rs. 10,000 to be transferred to
General Reserve.
Prepare Profit and loss Account for the year ended December 31, 2003 and Balance
Sheet (in proper form) as on that date.
(Answer: Profit for the year Rs. 28125, total of Balance Sheet Rs. 4,79,325).
7) The following balances are extracted from the books of ABC Ltd., as on
31 March, 2003.
Share Capital
Cash in hand
Repairs and Maintenance
Raw Materials at cost
Furniture
Sundry Creditors
Directors Fees
Plant and Machinery
Miscellaneous Expenses
General Reserve
Land
Finished Goods at cost
Sales
Buildings
Cash at Bank
Provision for Taxation
Sundry Debtors
Raw Materials Consumption

40,00,000
62,000
86,000
26,70,000
1,22,000
34,00,000
4,000
43,00,000
6.10,000
30,00,000
3,00,000
31,00,000
4,33,00,000
7,41,000
80,000
21,00,000
14,00,000
2,86,00,000

127

Fundamentals of
Accounting

Staff Advance
Advance from customers
Salaries, Wages and Bonus
Cash credit from Bank
Power
Prepaid expenses
Rent
Travelling and Conveyance
Auditors Fees
Miscellaneous Income
Income Tax Advance

53,000
5,00,000
1,16,00,000
1,25,000
88,000
46,000
53,000
41,000
15,000
5,46,000
30,00,000

The following further information is also given:

1)
2)
3)
4)
5)
6)

The authorised share capital of the company is 80,000. Equity Shares of Rs. 100
each which has been issued and subscribed to the extent of 50%.
Tax provision @ 6% is to be made on current years profits.
15% dividend on the paid-up share capial is recommended by the Directors.
The closing stock of finished goods at cost is Rs. 56,00,000.
Depreciation on assets amounting to Rs. 4,30,000 on Furiture and Rs. 33,000 on
Building has been debited to miscellanceous expenditure.
The surplus in profit and loss account is to be transferred to General Reserve
Account.

Prepare Profit and Loss Account and Balance Sheet as on 31.3.2003.

(Answer: Net Profit before tax Rs. 25,79,000
Total of Balance Sheet Rs. 1,57,04,000)
8) An inexperienced accountant has prepared the balance sheet ABC Ltd. as follows:
Balance Sheet of A B C Limited
Liabilities
Trade Creditors
Adances from Customers
Share Capital

Profit and Loss A/c

Provision for Taxes
Proposed Dividend
Loan to Managing Director
General Reserve
Dev. Rebate Reserve
Provision for Contingencies
Share Premium A/c
Forfeited Shares

Rs
80,900
42,260
8,00,000

45,630
95,000
59,000
5,000
75,000
30,000
23,000
22,000
3,000

Assets
Stock:
In hand
With Agents

Cash in hand
Investments
Fixed Assets:
Land
Plant and Machinery
(W.D.V.)
Debtors
2,15,450
Less: Provision
9,300
For B/D
Bills Receiveable
Amount Due from Agents

12,80,790
128

Rs

3,60,480

24,300
23,540
20,000
1,80,000
4,10,000

2,06,150
5,000
51,320
12,80,790

3.11

LET US SUM UP

Financial Statements

Financial statements are prepared by all forms of business organisations to ascertain

the operating results of the business and to know the financial position on a particular
date. Before preparing financial statements one must gain clarity about the nature of
certain items and their treatment in the final accounts. It is obligatory on the part of
companies to maintain and prepare financial statements by the end of each accounting
period. Manufacturing account is prepared to know the cost of goods produced while
Trading account is prepared to know the results of trading operations. Profit and loss
account is prepared to ascertain the net profit earned or net loss incurred by the
business concern during an accounting period. The operating and non-operating
expenses are charged to profit and loss account. The distribution or appropriation of
profit is shown under Profit and Loss Appropriation Account, which is also called
Below the Line.
Balance Sheet is a statement of assets and liabilities to ascertain the financial position
of a concern at a particular date. The assets and liabilities are presented either on the
basis of liquidity or performance. Under liquidity order assets are shown on the
basis of most liquid, liquid and least liquid assets. Liabilities are shown in the
order of payment. Under order of performance the assets are arranged on the basis
of their useful life whereas liabilities are shown on the besis of long term, medium
term, short term and current liabilities.
It is important to distinguish between capital and revenue to ascertain correct profit or
loss amount and fair view of the affairs of the business. There are certain rules which
guide us to determine whether a particular expenditure or receipt is of a capital nature
or of a revenue nature.
Revenue recognition is concerned with the timing of recognition revenue in the
statement of profit and loss. Realisation Concept recognises the revenue at the point
of sale or service rendered. Operating and non-operating revenues should be shown
separately while preparing Profit and Loss Account. There are some established
practices as per the Accounting Standards to recognise certain items as revenues. The
Accounting Standards have some established practices to recognise revenue in cases
of sale of goods, rendering services and financial services. But there are also certain
exception to this general rule.
The financial statements of non-corporate entities may be presented either in
conventional format or vertical format. Under vertical form various items of incomes
and expenses, assets and liabilities arranged vertically to get some additional
information about the operating efficiency and financial position of the business
enterprise. The sole traders and partnership forms hardly adopt vertical form of
financial statements. As regards preparation of Balance Sheet of a company, the
nature of details shown with respect to the liabilities and assets and the order of
arrangement of the items are prescribed in Schedule VI, Part I of the Companies Act.
There are two alternate proformas given in Schedule VI for the preparation of
Company Balance Sheets: (i) horizonal and (ii) vertical. Any of these forms may be
adopted for the Balance Sheet of a Company. Both the prescribed forms may require
that the figures of the previous year should be shown in a separate column along side
the figures of the current year.

3.12

KEY WORDS

Capital Expenditure: An expenditure which results in the acquisition of fixed asset

or addition to fixed asset, or an improvement in the earning capacity of the business.
Capital Receipt: Receipt in the form of additions to capital, liabilities or sale
proceeds of a fixed asset.

129

Fundamentals of
Accounting

Revenue Expenditure: An expenditure the benefit of which is limited to one year.

Revenue Receipt: Receipts on account of goods sold or services provided.
Deferred Revenue Expenditure: A revenue expenditure which involves a heavy
amount and the benefit of which is likely to spread over the years.
Appropriation: Distribution of profits.
Balance Sheet: Statement of assets and liabilities depicting the financial position at
the end of the financial year.
Below the line: Part of the Profit and Loss Account which shows the appropriation of
profits.
Above the line: Profit and loss account which shows the profit or loss before
appropriation of profits.
Contingent Liability: Liability which depends upon the happening of a certain event
Preliminary Exenses: Expenses incurred in connection with the formation and
registration of a company.
Profit and Loss Account: Income statement disclosing the results of operation (profit
or loss) for the financial year.
Dividend: Part of profits distributed to the equity shareholders.
Final Dividend: Dividend declared in the annual general meeting.
Provision for Taxation: The amount appropriated from profit for the liability arising
on account of payment of taxes.
Financial Statements: Annual statements of assets and liabilities (Balance Sheet) and
of income and expenditure (Profit and Loss Account).

3.13

TERMINAL QUESTIONS

1) Following is the Trial Balance of V.N. Ltd. as on 31st March 2003. Prepare
Trading and Profit and Loss Account and Balance Sheet after taking into account
the adjustments.
Opening Stock
Purchases/Sales
Bills Receivable/Bills Payable
Patents and Trade Marks
General Reserve
Cash at Bank
Plant and Machinery
Debtors and Creditors
Share Capital
Dividend paid for 2001-2002
Profit and Loss A/c (1.4.2002)
Sundry Expenses
Rent
Salaries
Computers
CarriageInward
Discount Received
Wages
Return outwards
130

Rs.
3,00,000
9,80,000
20,000
19,200

Rs.
13,60,000
28,000
62,000

1,84,800
1,16,000
1,10,000

70,000
4,00,000

36,000
94200
28,200
16,000
30,000
68,000
38,000
12,000
1,20,000
40,000
20,66,200

20,66,200

UNIT 5

TECHNIQUES OF
FINANCIAL ANALYSIS

Structure
5.0

Objectives

5.1

Introduction

5.2

Techniques of Financial Analysis

5.3

Common Size Statements

5.4

Comparative Statements

5.5

Trend Analysis

5.6

Ratio Analysis
5.6.1

Liquidity Analysis Ratios

5.6.2

Profitability Analysis Ratios

5.6.3

Profitability in Relation to Capital Employed (Investment)

5.6.4

Activity Analysis Ratios

5.6.5

Long-Term Solvency Ratios

5.6.6

Coverage Ratios

5.7

Dupont Model of Financial Analysis

5.8

Uses of Ratio Analysis

5.9

Limitations of Ratio Analysis

5.10 Let Us Sum Up

5.11 Key Words
5.12 Terminal Questions
5.13 Further Readings

5.0 OBJECTIVES
The objectives of this unit are to:
!

explain the need for analysing financial statements;

know different methods of analysing the financial statements;

understand how investors and others examine the performance of the

company through ratio analysis;

explain a few advanced financial analysis models with the help of ratio
analysis; and

caution the users of financial statements for some of the limitations of

financial statement analysis.

Analysis
An
Overview
of Financial
Statements

5.1 INTRODUCTION
In the previous units you would have been familiarised by many terms like what is a
firm, an entity, profit, loss, balance sheet, profit and loss account etc. You would
have seen that any business unit contains three major activities namely; operating,
financing, and investing. All the three activities transactions are contained in three
major financial statements namely, the Balance Sheet, the Profit and Loss Account,
and the Cash Flow Statement. While the Balance Sheet reveals the statement of
wealth at any given point of time, Profit and Loss Account reveals the income
earned and expenses incurred during the financial year. Cash Flow Statement
reflects the cash inflow or outflow of the above three major activities mentioned.
Most small investors like you invest in shares of varied companies with minimum
knowledge on the company itself. However, in most cases it so happens that the
small investors who do not understand much about the financial reports take the help
of the mutual funds. You would be reading more about mutual funds in some other
course. To familiarise you with the term, mutual funds are trusts or entities
managed by investment trusts and registered under the Trust Act. They pool the
money of the small investor and do the investment in shares and debentures or
bonds on behalf of them. Most often than not, the mutual funds give better returns to
the individual and small investors in comparison to the returns they would have
earned had they invested by themselves. This is because the mutual funds are
specialists in investing and gain significant experience and expertise in investing as
against the naive investors. The main reason being investors often do not find the
time to analyse and evaluate the financial credence of the company. This requires a
basic understanding of the financial statements disclosed by the company. Hence, a
layman who wishes to invest in companies or prefer to have any sort of dealings
with the company has to perform an analysis of the financial statements. This holds
good for any stakeholder of the company, be it the employee, or the shareholder, or
the supplier, the Government, the Tax authorities, the bankers and lenders etc.
The lending institutions need to analyse the financial statements to make sure the
company would be able to repay the loans. Similarly, the shareholder would like to
analyse the financial statements to find out the prospects of the company and
whether it would pay sufficient returns for the money invested. The Government
would also be interested in analyzing the financial statements of the company to
check whether the company is performing well like the other companies in the same
industry or whether it is functioning as a sick company. Hence the details taken out
of the financial statement analysis differs based on who analyse the financial
statements. Given the various objective of financial statement analysis lets move on
to find out how exactly financial statement analysis is performed.
Check Your Progress A
1)

Who and why would any one perform financial statement analysis?
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

Being an employee of your company, would you be interested in the analysis of

the financial statements of your company? If yes, why and what would be
analysing?
...........................................................................................................................
...........................................................................................................................

...........................................................................................................................

5.2 TECHNIQUES OF FINANCIAL ANALYSIS

Techniques of Financial
Analysis

Investors buy shares based on all kinds of information about a company. For
example, it may be that a particular firm has invented a new drug, or is a takeover
candidate, or has started exports to a boom region of the world or has discovered
new seams of gold. Any of these factors may be sufficient to give the shares a big
short-term boost.
But, despite all this, it is important to realise that profits are the key to a companys
long-term performance. Without profits a company cannot invest in growth, cannot
repay loans and cannot pay dividends. Eventually, its very survival may be in doubt.
And so most analysis is directed towards understanding the companys profits.
Financial analysis is done to try and predict the future performance of a company.
This of course has some limits. This is because your analysis will essentially be of
historical figures; yet you are trying to forecast the future. However, there are
experts who use technical analysis to predict the future stock prices using historical
data, where mostly the reality is not predicted. Also, you would have noticed that
analysis by some of the worlds top economists was unable to predict the recent
Asian economic implosion. So you should be aware of the fact that there are some
pretty important limitations to what you can expect from financial analysis.
Apart from this, its highly important to check whether the company is operating
efficiently. In the sense that it does not suffice by investing in the growth. It is
equally important that the company operates efficiently in comparison to its
competitors.
It is also necessary to be analyse the debt levels and how these may affect the
companys performance. When interest rates are low it can make good strategic
sense for a company to borrow heavily in order to invest for growth. But once
interest rates start heading up again it may be that the companys profits come
under threat, and it is important to gauge its ability to repay its loans.
So mostly financial analysis would be directed towards three major areas
Profitability, Productivity and Risk (determined by leverage or debt equity mix).
In order to perform the analysis, we need to do some sort of comparison. Generally
the comparison done could be of the following types : 1) Comparing the
performance of the interested company with the competitors, 2) Comparison
with the benchmark (either the competitor or some other benchmark company,
3) Comparison with the industry averages, and 4) Comparing the performance of
the company over the years. Second and third type of comparison is called cross
section analysis and fourth type of comparison is called time series analysis.
Hence this sort of analysis requires some organized techniques such as:
1)

Common size statement analysis

2)

Ratio analysis

3)

Comparative Statement Analysis (Cross Section analysis)

4)

Trend Analysis (Time Series analysis)

5)

Du Pont Analysis (Structured Ratio Analysis).

All the above are widely used techniques by experts across the world. You will
be learning the above techniques in detail in the coming sections.

Analysis
An
Overview
of Financial
Statements

Check Your Progress B

1)

List out the different techniques of performing financial analysis?

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

List out the major components that you would concentrate while analysing the
financial statements.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

3)

Suppose if you are interested in investing in any of the software company.

How would you decide which company to invest in the software industry.
List some of the factors that you would analyse and the procedure of analysis.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

5.3 COMMON SIZE STATEMENTS

When comparing your company with industry figures, make sure that the financial
data for each company reflect comparable price levels, and that it was developed
using comparable accounting methods, classification procedures, and valuation
bases.
Such comparisons should be limited to companies engaged in similar business
activities. When the financial policies of two companies differ, these differences
should be recognized in the evaluation of comparative reports. For example, one
company leases its properties while the other purchases such items; one company
finances its operations using long-term borrowing while the other relies primarily on
funds supplied by shareholders and by ploughing back the earnings. Financial
statements for two companies under these circumstances are not wholly
comparable.
Hence, you require some comparable basis to overcome this problem. Hence we use
common size statement. Common Size Statement represents a financial statement
that displays all items as a percentage of a common base figure. Such a statement
may be useful for noting changes in the relative size of the various elements.

In other words, it is a statement in which all items are expressed as a percentage of

a Base figure, which is used for analyzing trends and changing relationship among
Financial statement items. For example, all items in each years income statement
could be presented as a percentage of Net sales. This technique is quite useful
when you are comparing your business to other businesses or to averages from an
entire industry, because differences in size are neutralized by reducing all figures to
common-size ratios. Industry statistics are frequently published in common-size
form.

When performing a ratio analysis (you would be learning in detail about this in the
next section) of financial statements, it is often helpful to adjust the figures to
common-size numbers. To do this, one has to change each line item on a statement
to a percentage of the total. For example, on a balance sheet, each figure is shown
as a percentage of total assets, and on an income statement, each item is expressed
as a percentage of sales.

Techniques of Financial
Analysis

Hypothetical Common-Size Income Statement

2003

2002

2001

Sales

100%

100%

100%

Cost of Sales

65%

68%

70%

Gross Profit

35%

32%

30%

Expenses

27%

27%

26%

Taxes

2%

1%

1%

Profit

6%

4%

3%

The following gives the common size financial statements of ABC Industries Ltd.
Common Size balance Sheet Ratios of ABC Industries Ltd.
Year
SOURCES OF FUNDS :
Share Capital
Reserves and Surplus
Total Shareholders Funds
Secured Loans
Unsecured Loans
Total Debt
Total Liabilities
APPLICATION OF FUNDS :
Gross Block
Less: Accum. Depreciation
Net Block
Capital Work in Progress
Investments

2003-04 2002-03 2001-02 2000-01 1999-2000

2.78
2.27
4.23
5.28
5.15
57.80
56.99
55.07
49.55
48.51
60.59 59.26 59.30 54.83 53.65
23.49
30.54
16.34
23.48
23.76
15.92
10.20
24.37
21.69
22.59
39.41 40.74 40.70 45.17 46.35
100.00 100.00 100.00 100.00 100.00
100.84
36.82
64.01
3.98
13.41

100.57
32.45
68.12
3.30
8.29

101.83
47.55
54.27
2.06
27.01

95.40
36.13
59.27
1.30
23.79

80.90
29.03
51.87
14.91
18.63

CURRENT ASSETS, LOANS AND ADVANCES :

Inventories
14.98
10.71
9.24
7.15
6.11
Sundry Debtors
5.94
5.86
4.55
3.30
1.98
Cash and Bank Balance
0.29
3.79
0.40
4.24
21.24
Loans and Advances
25.07
22.00
22.44
16.10
7.38
Less: Current Liab. and Prov.
Current Liabilities
24.83
19.60
16.51
12.61
19.77
Provisions
2.94
2.61
3.47
2.55
2.36
Net Current Assets
18.50
20.16
16.66
15.64
14.59
Miscellaneous Expenses not w/o
0.09
0.14
0.00
0.00
0.00
Total Assets
100.00 100.00 100.00 100.00 100.00
Note : All items under the Use of Funds side have been presented as a percentage
of Total Assets and all items under the Sources of Funds are presented as
a percentage of Total liabilities.

Analysis
An
Overview
of Financial
Statements

Common Size Ratios of Income Statement of ABC Industries Ltd.

Year

2003-04 2002-03 2001-02 2000-01 1999-2000

Income :
Sales Turnover

100.00

100.00

100.00

100.00

100.00

Other Income

2.37

2.64

4.27

6.16

5.92

Stock Adjustments

4.86

---- 2.00

1.38

2.17

---- 1.43

Total Income

107.23 100.64 105.65 108.33 104.49

Expenditure :
Raw Materials

68.42

62.08

53.71

44.98

32.01

Excise Duty

8.77

7.23

11.21

15.47

18.16

Power and Fuel Cost

1.44

1.63

4.29

2.77

2.54

Other Manufacturing Expenses

2.97

3.22

4.54

6.85

9.73

Employee Cost

1.23

1.18

1.80

2.26

3.32

Selling and Administration

Expenses

4.99

4.19

5.10

4.72

5.90

Miscellaneous Expenses

0.72

1.15

0.86

1.34

1.70

Less: Preoperative Expenditure

Capitalised

0.01

0.00

0.01

0.02

0.11

18.70

19.98

24.16

29.95

31.23

3.10

4.02

5.28

6.36

6.86

15.59

15.96

18.87

23.59

24.37

Depreciation

5.66

6.20

6.80

8.07

8.05

Profit Before Tax

9.93

9.75

12.08

15.52

16.32

Tax

1.74

2.61

0.59

0.36

0.28

Profit After Tax

8.19

7.14

11.49

15.17

16.04

Adjustment below Net Profit

0.00

0.01

0.00

0.00

0.00

P & L Balance brought forward

5.44

4.76

7.56

7.15

9.86

Appropriations

6.96

5.91

9.66

11.34

15.24

P & L Bal. carried down

6.67

6.00

9.38

10.98

10.66

Equity Dividend

1.39

1.46

1.95

2.43

3.30

Preference Dividend

0.04

0.00

0.02

0.22

0.22

Corporate Dividend Tax

0.18

0.00

0.20

0.29

0.38

Equity Dividend (%)

0.10

0.10

0.18

0.25

0.35

Earning Per Share (Rs.)

0.06

0.07

0.11

0.14

0.17

Book Value

0.40

0.52

0.49

0.65

0.94

Extraordinary Items

0.01

0.70

0.05

0.32

0.06

Profit before Interest,

Depreciation and Tax
Interest and Financial Charges
Profit before Depreciation
and Tax

Note : All figures are expressed as a percentage of sales.

Vertical and Horizontal Analysis

Techniques of Financial
Analysis

Vertical analysis is the computation of percentages, ratios, turnovers, and other

measures of financial position and operating results for one fiscal period. When
these figures are compared with those from other periods, it becomes horizontal
analysis. For instance if you would have done the above conversion into
percentages for ABC industries for only year 2003 then it would have been Vertical
analysis. But what has been presented to you is the Horizontal Analysis of the
common size financial statements.
Activity 3
1)

Visit any companys website and download the annual report. Prepare
common size statement for two year period and write down your
understanding.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2)

What do you think is the purpose for the Common Size Financial Statement?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3)

Take any software firm and a manufacturing firm and perform common size
financial statement. Examine the difference and explain why they are
different.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

5.4 COMPARATIVE STATEMENTS

When you first look at a companys current financial figures it can be quite
overwhelming and, more often than not, a little confusing. But, if you were to
compare that data to that of the businesss historical performance, it becomes
significantly more meaningful. Hence it would make more sense to compare the
companys current financial numbers with monthly, quarterly, or annual data from
previous fiscal years. In this process you should notice some trends that will help
you map out the future of your business.
This is done the same way common size financial statement is done but a little
differently. A hypothetical example would help you understand the importance of
the same. The following example gives the comparative financial statements of a
hypothetical XYZ company. Despite calculating the percentage for each of the
year that is the vertical analysis, the horizontal analysis has also been performed in
the sense that the conversion is done over the years. This facilitates in comparing
the performance over the year but also with the industry average. The industry
average has also been given for the XYZ Company.

6.5
38.5

1.4

12.1

1.3

Pre-Tax Interest Cover

2.1

3.0

2.3

714.0
226.0

647.0
373.0

12,516.0

13,504.0

Rs.
33,395.0
19,891.0

2.4

769.0

0.1

0.6
0.5

2.2
0.3

2.5

39.0

41.5

%
100.0
58.5

2.1

1.4

2.1
0.7

1.9
1.1

2.9

37.5

40.4

%
100.0
59.6

Audited
2000

Sales to Assets
% Return on Assets
(Before Tax)
% Return on Equity
(Before Tax)

Depreciation

39.0

190.0
151.0

Pre-Tax Profit
Taxes

Net Profit

726.0
83.0

Interest Expense
Other Income

Operating Expenses

833.0

12,875.0

Gross Profit

Operating Profit

13,708.0

Sales
Cost of Sales

Rs.
33,013.0
19,305.0

Audited
1999

2.9

39.8

8.3

3.2

612.0

941.0

968.0
27.0

522.0
33.0

1,457.0

13,728.0

15,185.0

Rs.
37,021.0
21,836.0

Audited
2001

1.7

2.5

2.6
0.1

1.4
0.1

3.9

37.1

41.0

%
100.0
59.0

Audited
2002

2.5

24.7

6.5

3.3

540.0

780.0

801.0
21.0

526.0
30.0

1,297.0

15,657.0

16,954.0

Rs.
40,733.0
23,779.0

XYZ Company
Comparative Income Statement
for Fiscal Years Ended December ......

1.3

1.9

2.0
0.1

1.3
0.1

3.2

38.4

41.6

%
100.0
58.4

1.1

1.2

0.2

3.2

520.0

29.0

31.0
2.0

566.0
189.0

408.0

15,862.0

16,270.0

Rs.
43,412.0
27,142.0

Audited
2003

1.2

0.1

0.1
0.0

1.3
0.4

1.0

36.5

37.5

%
100.0
62.5

13.7

3.4

1.8

34.3

Industry
Average
%
100.0
65.7

( Rs. in Thousands)

Analysis
An
Overview
of Financial
Statements

9,198.0

1,875.0

Total Current Assets

Net Fixed Assets

1,300.0

Accrued Expenses

1,573.0

1.4

0.7

6.3

Quick Ratio

Debt to Worth

39.0

2,676.0

Current Ratio

Retained Earnings

Working Capital

11,526.0

Equity

Total Liab. & Equity

9,953.0

Total Liabilities

0.0

257.0

Deferred Taxes

Subord. Long-Term Debt

3,174.0

Long-Term Debt

0.0

6,522.0

Total Current Liabilities

Notes Payable-Officer

410.0

1,313.0

Accounts Payable

Taxes Payable

999.0

2,500.0

0.0

11,526.0

363.0

90.0

Current Maturities

Notes Payable

Other Current Liabilities

Total Liabilities and Equity

Total Assets

Intangibles

Notes Receivable

0.0

4,949.0

Other Assets

2,789.0

Inventories

727.0

Other Current

Accounts Receivable

733.0

Cash

Assets

Audited
1999
Rs.
%

0.3

23.2

100.0

13.6

86.4

2.2

0.0

27.5

56.7

0.0

3.6

11.3

11.4

8.7

21.7

0.0

100.0

3.1

0.8

0.0

16.3

79.8

42.9

24.2

6.3

6.4

3.9

1.1

2.4

488.0

4,253.0

9,073.0

1,855.0

7,218.0

257.0

0.0

3,902.0

3,059.0

0.0

594.0

1,179.0

992.0

294.0

0.0

0.0

9,073.0

278.0

82.0

0.0

1,401.0

7,312.0

4,027.0

2,186.0

499.0

600.0

Audited
2000
Rs.
%

39.0

46.9

99.8

20.4

79.4

2.8

0.0

43.0

33.6

0.0

6.5

13.0

10.9

3.2

0.0

0.0

100.1

3.1

0.9

0.0

15.4

80.6

44.4

24.1

5.5

6.6

3.0

1.1

2.6

941.0

5,037.0

9,730.0

2,435.0

7,295.0

129.0

0.0

4,082.0

3,084.0

0.0

377.0

1,221.0

1,182.0

304.0

0.0

0.0

9,730.0

193.0

0.0

97.0

1,319.0

8,121.0

4,778.0

2,137.0

712.0

494.0

Audited
2001
Rs.

9.7

51.8

99.9

25.0

74.9

1.3

0.0

42.0

31.6

0.0

3.9

12.5

12.1

3.1

0.0

0.0

100.1

2.0

0.0

1.0

13.6

83.5

49.1

22.0

7.3

5.1

XYZ Company
Comparative Balance Sheet
for Fiscal Years Ended December.......

2.2

0.8

2.4

780.0

5,173.0

10,315.0

3,242.0

7,073.0

0.0

0.0

3,392.0

3,681.0

0.0

507.0

1,158.0

1,751.0

265.0

0.0

0.0

10,315.0

107.0

0.0

74.0

1,280.0

8,854.0

5,795.0

2,155.0

724.0

180.0

Audited
2002
Rs.
%

7.6

50.2

99.9

31.4

68.6

0.0

0.0

32.9

35.7

0.0

4.9

11.2

17.0

2.6

0.0

0.0

99.8

1.0

0.0

0.7

12.4

85.8

56.2

20.9

7.0

1.7

3.6

1.3

3.5

(764.0)

6,582.0

11,435.0

2,507.0

8,928.0

0.0

0.0

6,261.0

2,667.0

0.0

0.0

1,646.0

922.0

99.0

0.0

0.0

11,435.0

116.0

0.0

0.0

2,070.0

9,249.0

5,909.0

2,220.0

888.0

232.0

Audited
2003
Rs.
%

(6.7)

57.6

100.0

21.9

78.2

0.0

0.0

54.8

23.4

0.0

0.0

14.4

8.1

0.9

0.0

0.0

99.9

1.0

0.0

0.0

18.1

80.9

51.7

19.4

7.8

2.0

39.5

55.7

20.2

35.5

15.8

2.0

7.4

100.0

0.9

7.0

25.9

66.8

40.3

17.2

2.5

6.8

Industry
Average
%

( Rs. in Thousands)

1.6

0.7

2.0

100.0

Techniques of Financial
Analysis

Analysis
An
Overview
of Financial
Statements

Activity 1
1)

Carefully read the comparative income statement of XYZ and write down
how the company has performed over the 5 year period and also its
performance in comparison to the industry.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

Visit any companys website and download their income statement for 5 year
period. Perform horizontal analysis. Collect the industry average for the
company and list down the performance of the company with respect to the
industry average.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

3)

List down the usefulness of the comparative financial statements.

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

5.5 TREND ANALYSIS

The earlier sections had exposed you to analyzing statements using horizontal and
vertical form as well as using the common size financial statements in the
comparative form. The horizontal analysis performed there, comparing the
performance of the XYZ company over the five year period indicates the time
series analysis or rather trend analysis. This is called as trend analysis because we
are trying to see if there is a pattern in the performance of the company over the
year which could help us forecast the performance of the company for the future.
Why this is useful? Its utmost useful because we are not only interested in the past
performance whereas our utmost interest lies in finding whether the company will
continue to perform the same way or in a better way in the coming years. Similar
analysis is done for investing in stocks. There are experts in Technical Analysis
who perform similar analysis of analyzing the trend of the prince movement of the
stock and predicting the future stock price. Similar analysis is done here as well.
But how and where can we use the trend analysis of the financial statements?
Trend analysis is a key to recognizing potential problems of a borrower. This is
important during the initial review of a loan application, as well as part of on-going
monitoring of a loan that has already been disbursed. Sound companies and weak
ones may have displayed some of the same trends, however, it is a pattern of many
negative trends that indicates a potential problem that needs to evaluated further.

10

Trend analysis involves spreading the financial statements and comparing similar
operating periods (i.e. year to year). This comparative analysis allows the reviewer
to identify both positive and negative trends. Once a pattern of negative trends are
identified further action should be taken. For a potential loan, additional information
or a detailed explanation should be obtained. The trends should be weighed
carefully in making or rejecting the loan. For loans that have already been made, a

pattern of negative trends requires fast action. Current financial information may
indicate a problem that will enable the reviewer time to react. The following is a
general discussion of some trends to look for in the review of financial statements:
1)

Decreasing cash position: This could be a lower level of cash or cash as a

percentage of total assets. Look for changes in deposit activity, draws on
uncollected funds, declining average monthly balances, etc.

2)

Slowdown in receivables collection: Could be an indication of distractions

in the business, neglect, changes in collection policies, etc.

3)

Significant increases in accounts receivable: This could be in the dollar

amount, percentage of assets or in accounts receivable to a single customer
(need aging of accounts receivable to determine).

4)

Rising inventories: Either in the dollar amount or as a percentage of total

assets. This may be an indication of a need to liquidate excessive or obsolete
inventory, lack of attention to purchasing, slowing of sales, etc.

5)

Slowdown in inventory turnover: This could indicate a slowdown in sales,

overbuying, production problems, and/or problems in the purchasing policies
of the business.

6)

Changes in sales terms/sales policies: Look for changes from cash sales
to instalment sales, leasing instead of selling, and other similar changes.

7)

A decline in liquid assets: This could be a dollar decline or a decline in

current assets (cash, accounts receivable, etc.) to total assets. As current
assets decline or become less liquid, a business may experience difficulties
meeting current liabilities.

8)

Changes in the concentration of fixed assets: Both declining and rising

concentrations of fixed assets should be reviewed. A decline could indicate
that funds needed to purchase fixed assets are being used for other purposes.
This can be a significant problem if a business is not replacing, renovating or
rehabilitating fixed assets as needed. A rise in fixed assets could be a
problem when done at the expense of other assets/operational need. Levels
of fixed assets should be compared to both historical financial statements and
industry averages.

9)

Revaluation of assets: A revaluation of assets on the financial statements

needs to be justified. If not justified, it impacts the financial picture of the
company.

Techniques of Financial
Analysis

10) Changes in liens of assets: Evidence of new subordinated debt should be

a concern. It could indicate a deteriorating financial situation.
11) A high or increasing concentration of assets in intangibles: The value
of intangible assets is difficult to establish. Typically, intangible assets are
eliminated from the financial review.
12) Increases in current debt: A rise that is tied to a concentration in trade
debt or no corresponding increase in assets should be viewed as a risk factor.
Increases in long-term debt: Increases in long term debt must be reviewed
carefully. If repayment is dependent on higher than historical or reasonable
projected sales, a concern should be raised.
13) An increase or major gap between gross and net sales: result or lower
quality, production problems, out-of-date product lines and other related
production and/or market factors.

11

Analysis
An
Overview
of Financial
Statements

14) An increase in debt to capital: This is of particular concern when the

current ratio is low. Undercapitalized firms will typically exhibit poor working
capital conditions.
15) Increase in cost of goods sold: An increase may indicated problems in the
operation or other expense areas.
16) Decline in profits compared to sales: The decline may be a result of poor
cost controls, management problems, failure to pass on increases in costs, etc.
17) Increases in bad debt: An increase as a percentage of sales usually
indicates poor collection procedures, management problems and/or
deterioration of the quality of the customer.
18) Assets rising faster than sales: This is an indication that increased assets
are not creating increases in sales.
19) Assets rising faster than profits: Assets are investments designed to create
profits. Concerns should be raised when increased assets are not resulting in
higher profits.
20) Significant variations in other areas of the financial statements: Marked
changes should always be examined!
21) An increase or major gap between gross and net sales: Result or lower
quality, production problems, out-of-date product lines and other related
production and/or market factors.
22) An increase in debt to capital: This is of particular concern when the
current ratio is low. Undercapitalized firms will typically exhibit poor working
capital conditions.
23) Increase in cost of goods sold: An increase may indicate problems in the
operation or other expense areas.
24) Decline in profits compared to sales: The decline may be a result of poor
cost controls, management problems, failure to pass on increase in costs, etc.
25) Increases in bad debt: An increase as a percentage of sales usually
indicates poor collection procedures, management problems and/or
deterioration of the quality of the customer.
26) Assets rising faster than sales: This is an indication that increased assets
are not creating increases in sales.
27) Assets rising faster than profits: Assets are investments designed to create
profits. Concerns should be raised when increased assets are not resulting in
higher profits.
28) Significant variations in other areas of the financial statements: Marked
changes should always be examined!
Apart from the above analysis one could adopt a simpler form of performing trend
analysis. This is done by performing what is called as the Index Number Trend
analysis.

Index-Number Trend Series

12

If you are trying to analyze financial data that span a long period of time,
mechanically trying to compare financial statements can turn into quite a
cumbersome task. If you find yourself in this boat, try to create an index-number
trend series to alleviate some of your confusion.

First, choose a base year to which all other financial data will be compared.
Usually, the base year is the earliest year in the group being analyzed, or it can be
another year you consider particularly appropriate.

Techniques of Financial
Analysis

Next, express all base year amounts as 100 percent. Then state corresponding
figures from following years as a percentage of the base year amounts. Keep in
mind that index-numbers can be computed only when amounts are positive.
Hypothetical Example

Sales
Index-Number Trend

2001

2002

2003

100,000

150,000

175,000

100%

150%

175%

The index-number trend series technique is a type of horizontal analysis that can
provide you with a long range view of your firms financial position, earnings, and
cash flow. It is important to remember, however, that long-range trend series are
particularly sensitive to changing price levels. For instance, the price level could
increase to greater extent for some years. A horizontal analysis that ignored such a
significant change might suggest that your sales or net income increased
dramatically during the period when, in fact, little or no real growth occurred.
Data expressed in terms of a base year can be very useful when comparing
your companys figures to those from government agencies and sources within
your industry or the business world in general, because they will often use an
index-number trend series as well. When making comparisons, be sure the
samples you use are in the same base period. If they arent, simply change one
so they match.

5.6 RATIO ANALYSIS

We have seen that most of us are interested in the bottom line of the company. Or
in other words analysing the profitability of a company. While the profit figure is
important, it however, does not give the complete picture of the performance of the
company. So one should not use the bottom line figure alone as a barometer for
some sort of an indicator. That would have severe repercussions. Take for instance
two companies A and B of the same industry. A has earned a profit of Rs. 100
Crs. And B has earned Rs. 1000 Crs. for the financial year 2003. Now one would
on the face of it say that Company B is better than company A. However, if it
should be wise enough to compare the profit earned with the level of investment
made to earn the profit. For instance, company A had spent about 500 Crs to
earn Rs 100 Cr. Profit and Company B had spent about Rs. 1000 Cr. to earn
Rs. 1000 Cr. profit. So its clear that profitability of company A is higher than
company B. In that the profit earned to the investment ratio is higher for company
A (100/500 = 20%) compared to company B (1000/10000 = 10%). Hence one
should look at profitability and not just profit figures. So the key point is that one
has to look into appropriate ratios not just absolute figures for comparison. Hence
ratio analysis would help understand the financial results better.
This often means working out a range of ratios. By doing so, a large amount of
complex information can be condensed into easily digestible and standardized form,
and numerous comparisons between different years for a single company, between
companies of varying sizes or between industries can be made. (Note that a ratio
in isolation generally has little meaning).
And it is important to note that ratios are just signals, or clues, rather than the
answers to complex questions about a company. Some might direct you to a

13

Analysis
An
Overview
of Financial
Statements

specific problem within the company, but many tell you no more than that something
needs further investigation.
A ratio can be expressed in various ways, including as a percentage, a fraction, a
times figure, a number of days, a rate or as a simple number.
The various ratios that are generally used have been summarized below.
5.6.1

Liquidity Analysis Ratios

A firm needs liquid assets to meet day to day payments. Therefore, liquidity ratios
highlight the ability of the firms to convert its assets into cash. If the ratios are low
then it means that money is tied up in stocks and debtors. Thus, money is not
available to make payments. This may cause considerable problems for firms in the
short run. It is often viewed that a value less than 1.5 implies that the company may
run out of money as its cash is tied up in unproductive assets.
Liquidity ratio helps in assessing the firms ability to meet its current obligations.
The following ratios come under this category:
i)

Current ratio;

ii)

Quick ratio; and

iii)

Net Working Capital Ratio.

i)

Current Ratio

The current ratio shows the relationship between the current assets and the current
liabilities. Current assets include cash in hand, cash at bank and all other assets
which can be converted into cash in the ordinary course of business, for instance,
bills receivable, sundry debtors (good debts only), short-term investments, stock etc.
Current liabilities consists of all the obligations of payments that have to be met
within a year. They comprise sundry creditors, bills payable, income received in
advance, outstanding expenses, bank overdraft, short-term borrowings, provision for
taxation, dividends payable, long term liabilities to be discharged within a year. The
following formula is used to compute this ratio:
Current Ratio =
ii)

Current Assets
Current Liabilities

Quick Ratio

The acid test ratio is similar to the current ratio as it highlights the liquidity of the
company. A ratio of 1:1 (i.e., a value of approximately 1) is satisfactory. However, if
the value is significantly less than 1 it implies that the company has a large amount
of its cash tied up in unproductive assets, so the company may struggle to raise
money in the short term.
Quick Ratio =

Quick Assets
Current Liabilities

Quick Assets = Current Assets---Inventories

iii)

14

Net Working Capital Ratio

The working capital ratio can give an indication of the ability of your business to pay
its bills.

Generally a working capital ratio of 2:1 is regarded as desirable. However, the

circumstances of every business vary and you should consider how your business
operates and set an appropriate benchmark ratio. A stronger ratio indicates a better
ability to meet ongoing and unexpected bills therefore taking the pressure off your
cash flow. Being in a liquid position can also have advantages such as being able to
negotiate cash discounts with your suppliers. A weaker ratio may indicate that your
business is having greater difficulties meeting its short-term commitments and that
additional working capital support is required. Having to pay bills before payments
are received may be the issue in which case an overdraft could assist. Alternatively
building up a reserve of cash investments may create a sound working capital
buffer. Ratios should be considered over a period of time (say three years), in order
to identify trends in the performance of the business.

Techniques of Financial
Analysis

The calculation used to obtain the ratio is:

Net Working Capital
Net Working Capital Ratio =
Total Assets
Net Working Capital = Current Assets -- Current Liabilities
Illustration 1
The Balance Sheet of X Company Ltd. as on March 31, 2005 is given below. You
are required to calculate the following ratios:
i)

Current ratio,

ii)

Quick ratio,

iii)

Net Working capital ratio.

Balance Sheet of X Company Ltd., as on 31.3.2005

Liabilities

Amount
Rs.

Assets

Amount
Rs.

Share Capital

20,000

Buildings

20,000

Reserves and Surplus

16,000

Plant and Mechinery

10,000

Debentures

10,000

Stock

8,000

Sundry Creditors

11,000

Sundry Debtors

7,000

Bank Overdraft

1,000

Prepaid expenses

2,000

Bills Payable

2,000

Securities

Provision for Taxation

1,000

Bank

2,000

Outstanding Expenses

1,000

Cash

1,000

62,000

12,000

62,000

Solution
i)

Current ratio =

Current Assets

Current Assets
Current Liabilities
= Cash Rs. 1000 + Bank Rs. 2000 + Securities Rs. 12000
+ Prepaid expenses Rs. 2000 + Sundry Debtors Rs. 7000
+ Stock Rs. 8000
= Rs. 32,000.

15

Analysis
An
Overview
of Financial
Statements

Current Liabilities = Outstanding expenses Rs. 1000 + Provision for taxation

Rs. 1000 + Bills payable Rs. 2000 + Bank overdraft
Rs. 1000 + Sundry creditors Rs. 11,000

Current ratio

ii)

= Rs. 16,000.
Current Assets
32,000
=
=
= 2 :1
Current Liabilities
16,000
Quick Assets

Quick ratio

Quick Assets

= Cash Rs. 1000 + Bank Rs. 2000 + Securities Rs. 12,000

+ Sundry Debtors Rs. 7,000

Current Liabilities

= Rs. 22,000.
Current Liabilities = Sundry creditors Rs. 11,000 + Bills payable Rs. 2000 +
Outstanding expenses Rs. 1000 + Provision for Taxation
Rs. 1000 + Bank overdraft Rs. 1000
= Rs. 16,000
Quick ratio

=
=

Quick Assets
Current Liabilities
22,000
16,000

= 1.37 : 1
iii)

Net Working capital ratio =

Net Working Capital

Net Working Capital

Total Assets

Current Assets -- Current Liabilities

Rs. 32,000 -- Rs. 16,000

Rs. 16,000

Net Working capital ratio =

=

16,000
32,000
1 : 2.

5.6.2 Profitability Analysis Ratios

Profitability ratios are the most significant - and telling - of financial ratios. Similar
to income ratios, profitability ratios provide a definitive evaluation of the overall
effectiveness of management based on the returns generated on sales and
investment.
Profitability in relation to Sales
Profits earned in relation to sales give the indication that the firm is able to meet all
operating expenses and also produce a surplus. In order to judge the efficiency of
management with respect to production and sales, profitability ratios are calculated
in relation to sales.
There are :

16

i)

Gross Profit Margin

ii)

Net Profit Margin

iii)

Operating Profit Margin

iv)

Operating Ratio.

Techniques of Financial
Analysis

i) Gross Profit Margin

This is also known as gross profit ratio or gross profit to sales ratio. This ratio may
indicate to what extent the selling prices of goods per unit may be reduced without
incurring losses on operations. This ratio is useful particularly in the case of
wholesale and ratail trading firms. It establishes the relationship between gross
profit and net sales. Its purpose is to show the amount of gross profit generated for
each rupees of sales. Gross profit margin is computed as follows:
Gross profit =

Gross profit
Net Sales

100

The amount of gross profit is the difference between net sales income and the cost
of goods sold which includes direct expenses. A high margin enables all operating
expenses to be covered and provides a reasonable return to the shareholders. If
gross profit rate is continuously lower than the average margin, something is wrong.
To keep the ratio high, management has to minimise cost of goods sold and improve
sales performance. Higher the ratio, the greater would be the margin to cover
operating expenses and vice versa.
Note : This percentage rate can --- and will --- vary greatly from business to
business, even those within the same industry. Sales location, size of operations and
intensity of competition etc., are the factors that can affect the gross profit rate.
Illustration 2
From the following particulars, calculate gross profit margin.
Trading Acount of ABC Company for the year ended March 31, 2005
Rs.
6,000
63,000
9,000
24,000

To Opening stock
To Net purchases
To Direct expenses
To Gross profit

By Net sales
By Closing stock

1,02,000

Rs.
96,000
6,000

1,02,000

Solution
Gross Profit Margin =
=

Gross Profit
Net Sales
24,000
96,000

100

100

= 25%
ii)

Net Profit Margin

This ratio is called net profit to sales ratio and explains the relationship between net
profit after taxes and net sales. The purpose of this ratio is to reveal the amount of
sales income left for shareholders after meeting all costs and expenses of the
business. It measures the overall profitability of the firm. The higher the ratio, the
greater would be the return to the shareholders and vice versa. A net profit margin
of 10% is considered normal. This ratio is very useful to control costs and to
increase the sales. It is calculated as follows:
Net Profit Margin =

Net Profit after taxes

Net Sales

100

17

Analysis
An
Overview
of Financial
Statements

Illustration 3
The Gross Profit Margin of a company is Rs. 12,00,000 and the operating expenses
are Rs. 4,50,000. The taxes to be paid are Rs. 4,80,000. The sales for the year are
Rs. 27,00,000. Calculate Net Profit Margin.
Solution
Net Profit Margin

Net Profit after taxes

100

Net Sales
Net Profit after taxes = Gross Profit --- Expenses --- Taxes
= Rs. 12,00,000 --- Rs. 4,50,000 --- Rs. 4,80,000
= Rs. 2,70,000
Net Profit Margin

2,70,000

100

27,00,000

= 0.10 or 10%
iii)

Operating Profit Margin

This ratio is a modified version of Net Profit Margin. It studies the relationship
between operating profit (also known as PBIT Before Interest and Taxes)
and sales. The purpose of computing this ratio is to find out the amount of
operating profit for each rupee of sale. While calculating operating profit, nonoperating expenses such as interest, (loss on sale of assets etc.) and non-operating
income (such as profit on sale of assets, income on investment etc.) have to be
ignored. The formula for this ratio is as follows:
Operating Profit Margin =

Operating Profit
Sales

100

Illustration 4
From the following particulars of Nanda and Co., calculate Operating Profit
Margin.
Profit and Loss Account of Nanda and Co. Ltd.
as on March 31, 2005
Rs.
To Opening Stock
To Purchases
To Manufacturing Expenses
To Gross Profit c/d

3,000
22,000

Rs.
By Sales

36,000

By Closing Stock

10,000

9,000
12,000
46,000

To Operating Expenses

4,000

To Administrative Expenses

2,000

To Interest on Debentures

1,000

To Net Profit

5,000
12,000

18

46,000
By Gross Profit b/d

12,000

12,000

Techniques of Financial
Analysis

Solution
Operating Profit Margin =
Operating Profits

Operating Profits
Sales

100

= Net Profit + Interest on Debenture (non-operating

expenses)
= Rs. 5000 + Rs. 1000 = Rs. 6,000

Operating Profit Maring =

Rs. 6,000

100 = 0.167 or 16.7 %

Rs. 36,000

A high ratio is an indicator of the operational efficiency and a low ratio stands for
operational inefficiency of the firm.
iv)

Operating Ratio

This ratio established the relationship between total costs incurred and sales. It may
be calculated as follows :
Cost of goods sold + Operating expenses
Operating Ratio =

Sales

100

Illustration 5
From the following particulars, calculate the Operating Ratio :
Rs.
Sales

5,00,000

Opening Stock

1,00,000

Purchases

2,00,000

Manufacturing Expenses

25,000

Closing Stock

30,000

Selling Expenses

5,000

Office Expenses

20,000

Solution
Operating Ratio =
Cost of Goods sold

Cost of goods sold + Operating expenses

Sales
=

Opening Stock + Purchases +

Manufacturing expenses ---- Closing Stock.

Rs. 1,00,000 + Rs. 2,00,000 + Rs. 25,000 -- Rs. 30,000

Rs. 2,95,000.

Operating Expenses =
=
Operating Ratio

100

Selling Expenses + Offices Expenses

Rs. 5000 + Rs. 20,000 = Rs. 25,000
Rs. 2,95,000 + Rs. 25,000
Rs. 5,00,000

= 0.64 or 64 %

High operating ratio is undesirable as it leaves a small portion of income to meet

other non-operating expenses like interest on loans. A low ratio is better and
reflects the efficiency of management. Lower the ratio, higher would be the

19

Analysis
An
Overview
of Financial
Statements

profitability. If operating ratio is 64%, it indicates that 64% of sales income has gone
to meet cost of goods sold and operating expenses and 36% is left for other
expenses and dividend.
The operating ratio shows the overall operating efficiency of the business. In order
to know how individual items of operating expenses are related to sales, individual
expenses ratios can also be calculated. These are calculated by taking operational
expenses like cost of goods sold, administrative expenses, selling and distribution,
individually in relation to sales (net).

5.6.3 Profitability in Relation to Capital Employed (Investment)

Profitability ratio, as stated earlier, can also be computed by relating profits to
capital or investment. This ratio is popularly known as Rate of Return on
Investment (ROI). The term investment may be used in the sense of capital
employed or owners equity. Two ratios are generally calculated:
i)

Return on Capital Employed (ROCE), and

ii)

Return on Shareholders Equity.

i) Return on Capital Employed (ROCE)

The ratio establishes the relationship between total capital and net operating profit
of the business. The purpose of this ratio is to find out whether capital employed is
effectively utilised or not. The formula for calculating Return on Capital Employed is:
Net Operating Profit
Return on Capital Employed =

Capital Employed

100

The term Net Operating Profit means Profit before Interest and Tax. The term
Interest means Interest on Long-term borrowings. Interest on short-term
borrowings will be deducted for computing operating profit. Similarly, non-trading
incomes such as income from investments made outside the business etc. or nontrading losses or expenses will also be excluded while calculating profit. The term
capital employed has been given different meanings by different accountants.
Three widely accepted terms are as follows:
1)

Gross Capital Employed

= Fixed Assets + Investments + Current Assets

2)

Net Capital Employed

= Fixed Assets + Investments + Net Working

Capital (Current Assets --- Current
Liabilities).

3)

Sum total of long term funds = Share capital + Reserves and Surpluses +
Long Term Loans --- Fictitious Assets --Non business Assets.

In managerial decisions the term capital employed is generally used in the meaning
given in the third point above.

20

Return on capital employed ratio is very significant as it reflects the overall

efficiency of the firm. The higher the ratio, the greater is the return on long-term
funds invested in the firm. It is also an indication of the effective utilisation of
capital employed. However, it is very difficult to set a standard ratio of return on
capital employed as a number of factors such as business risk, the nature of the
industry, economic conditions etc., may influence such rate. This ratio could be
supplemented with a number of ratios depending upon the purpose for which it is
computed.

Techniques of Financial
Analysis

Illustration 5
From the following financial statements, calculate return on capital employed.
Profit and Loss Account for the year ended 31.3.2005
Rs.
To Cost of goods sold

Rs.

3,00,000

To Interest on Debentures

By Sales

10,000

To Provision for Taxation

1,00,000

To Net Profit

1,00,000

5,00,000

By Income from
Investment

5,10,000

10,000

5,10,000

Balance Sheet as on 31.3.2005

Liabilities

Rs.

Assets

Rs.

Share Capital

3,00,000

Fixed Assets

4,50,000

Reserves

1,00,000

Investments in Govt. Bonds

1,00,000

10% Debentures

1,00,000

Current Assets

1,50,000

Profit and Loss a/c

1,00,000

Provision for Taxation

1,00,000
7,00,000

7,00,000

Solution
Return on Capital Employed =
Net Operating Profit

Net Operating Profit

Capital Employed

100

= Net Profit before Tax and Interest --- Income from

Investment
= Rs. 1,00,000 + 100,000 + 10,000 ---10,000
= Rs. 2,00,000

Capital Employed

= Fixed Assets + Current Assets --- Current Liability

= Rs. 4,50,000 + Rs. 1,50,000 --- Rs. 1,00,000
= Rs. 5,00,000
OR
= Share Capital + Reserves + Debentures + Profit and
Loss account --- Investments in Govt. Bonds
= Rs. 3,00,000 + Rs. 1,00,000 + Rs.1,00,000 +
Rs. 1,00,000 ---Rs. 1,00,000
= Rs. 5,00,000

Return on Capital Employed =

2,00,000
500,000

100

= 40 %
21

Analysis
An
Overview
of Financial
Statements

Return on Investment (ROI)

When you are asked to find out the profitability of the Company from the share
holders point of view, Return on Investment should be Computed as follows:
Return on Investment =

Net Profit after Interest and Tax

Shareholders Funds

100

The term Net Profit means Net Income after Interest and Tax. This is because
the shareholders are interested in Total Income after Tax including Net nonoperating income.
From illustration 5, Net profit after interest and tax will be Rs. 1,00,000 and Return
1,00,000
on Investment will be 20% i.e.(
100 )
5,00,000
ii) Return on Shareholders Equity
This ratio shows the relationship between net profit after taxes and Shareholders
equity. It reveals the rate of return on owners/shareholders funds. The term
shareholders equity is also known as net worth and includes Equity Capital,
Share Premium and Reserves and Surplus. The formula of this ratio is as follows:
Return on Shareholders Equity =

Net Profit after Tax and Preference Dividend

Shareholders Equity

Illustration 6
From the following Balance Sheet find Return on Shareholders Equity.
Balance Sheet of ABC Company Ltd. as on 31.3.2005
Liabilities
Equity Share Capital

Rs.
1,00,000

10% Preference Capital

50,000

Reserves

50,000

10% Debentures

50,000

Profit and Loss a/c

50,000

Provision for Taxation

50,000
3,50,000

Assets

Rs.

Fixed Assets

2,25,000

Current Assets

1,25,000

3,50,000

Solution
Net Profit After Tax and Prefence Dividend
100
Shareholders Equity
Net profit after, tax and prefence Dividend
10
= Rs. 50,000 ---- Preference dividend 5000 (Pref. capital 50,000
)
100
= Rs. 45,000
Shareholders equity = Equity capital + Reserves + Profit and Loss account
= Rs. 1,00,000 + 50,000 + 45,000
= Rs. 1,95,000
45,000
Return on Shareholders Equity =
100
1,95,000
Return on Shareholders equity =

22

= 23 %

The higher the ratio, the greater is the efficiency of the firm in generating profits on
shareholders equity and vice versa. The ratio is very important for the investors to
judge whether their investment in the firm generates a reasonable return or not.
This ratio is important to the management as it proves their efficiency in employing
the funds profitably.

Techniques of Financial
Analysis

Earnings Per Share

Earnings per Share (EPS) is an important ratio from equity shareholders point of
view as this ratio affects the market price of share and the amount of dividend to
be given to the equity shareholders. The earnings per share is calculated as follows:
Earnings Per Share (EPS) =

Net profit after Tax ---- Preference Dividend

Number of Equity Shares

Illustration 7
From the following information calculate Earnings per Share of X Company Ltd. :
Balance Sheet of X Company Ltd.
as on March 31, 2005
Liabilities
Equity Share Capital
(25,000 Share)
9% Preference Share Capital
Reserves and Surpluses
8% Long term Loans
Current Liabilities

Rs.
2,50,000

Assets
Plant and Machinery
Current Assets

Rs.
8,00,000
2,50,000

1,00,000
3,00,000
3,00,000
1,00,000
10,50,000

10,50,000

The net profit before interest and after Tax was Rs. 78,000.
Solution
Earnings per share

Net Profit after Tax ---- Preference Dividend

=
=

Number of Equity Shares

Rs. 78000 ---- 9000 (9% of Rs.1,00,000)
25,000
Rs. 69,000
25,000

= Rs. 2.76

The Earnings Per Share is useful in determining the market price of equity share
and capacity of the company to pay dividend. A comparison of earning per share
with another company helps to know whether the equity capital is effectively used
in the business or not.

5.6.4 Activity Analysis Ratios

Activity Analysis Ratio may be studied under the following three heads:
i)

Assets Turnover Ratio,

ii)

Accounts Receivable Turnover Ratio, and

iii)

Inventory Turnover Ratio.

Assets Turnover Ratio

The asset turnover ratio simply compares the turnover with the assets that the
business has used to generate that turnover. In its simplest terms, we are just saying
that for every Re. 1 of assets, the turnover is Rs. x. The formula for total asset
turnover is:

23

Analysis
An
Overview
of Financial
Statements

Sales
Assets Turnover Ratio =
Average Total Assets
Average Total Assets =

Beginning Total Assets + Ending Total Assets

2

Asset turnover is meant to measure a companys efficiency in using its assets.

The higher a companys asset turnover, the lower its profit margin tends to be
and visa versa .
Accounts Receivable Turnover Ratio
The debtor turnover ratio indicates the average time it takes your business to
collect its debts. Its worth looking at this ratio over a number of financial years to
monitor performance trends.
Use information from your annual Profit and Loss Statement along with the trade
debtors figure from your Balance Sheet for that financial year to calculate this
ratio.
A ratio that is lengthening can be the result of some debtors slowing down in their
payments. Economic factors, such as a recession, can also influence the ratio.
Tightening your business credit control procedures may be required in these
circumstances.
The debtor ageing ratio has a strong impact on business operations particularly
working capital. Maintaining a running total of your debtors by ageing (e.g.
current, 30 days, 60 days, 90 days) is a good idea, not just in terms of making sure
you are getting paid for the work or goods you are supplying but also in managing
your working capital.
The calculation used to obtain the ratio is:
Debtor Ageing Ratio (in days) =

No. of days (365) or months (12) in a year

Accounts receivables turnover ratio

Accounts Receivable Turnover Ratio =

Sales
Average Accounts Receivable

Average Accounts Receivable = (Beginning Accounts Receivable + Ending

Accounts Receivable) 2
Inventory Turnover Ratio
The inventory turnover ratio indicates how quickly your business is turning over
stock.
A high ratio may indicate positive factors such as good stock demand and
management. A low ratio may indicate that either stock is naturally slow moving or
problems such as the presence of obsolete stock or good presentation. A low ratio
can also be indicative of potential stock valuation issues. It is a good idea to monitor
the ratio over consecutive financial years to determine if a trend is developing.
It can be useful to compare this financial ratio with the working capital ratio. For
example, business operations with low stock turnover tend to require higher working
capital.
The calculation used to obtain the ratio is:
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventories
24

Average Inventories = (Beginning Inventories + Ending Inventories) 2

5.6.5

Long-term Solvency Ratios

Techniques of Financial
Analysis

The long-term solvency ratios are calculated to assess the long-term financial
position of the business. These ratios are also called leverage, or capital
structure ratios, or capital gearing ratios. The following ratios generally come
under this category :
i)

Debt-Equity Ratio/Total Debt Equity Ratio,

ii)

Proprietory ratio, and

iii) Capital Gearing ratio.

i) Debt-Equity Ratio/Total Debt Equity Ratio
It shows the relationship between borrowed funds and owners funds, or external
funds (debt) and internal funds (equity). The purpose of this ratio is to show
the extent of the firms dependence on external liabilities or external
sources of funds.
In order to calculate this ratio, the required components are external liabilities and
owners equity or networth. External liabilities, include both long-term as well as
short-term borrowings. The term owners equity includes past accumulated
losses and deferred expenditure. Since there are two approaches to work out
this ratio, there are two formulas as shown below :
Long-Term Debt
_____________
Owner's Equity

i)

Debt -Equity Ratio =

ii)

Total Debt-Equity Ratio =

Total Debt
_____________
Owner's Equity

In the first formula, the numerator consists of only long-term debts, it does
not include short-term obligations or current liabilities for the following
reasons :
1)

Current liabilities are of a short-term nature and the liquidity ratios

are calculated to judge the ability of the firm to honour current
obligations.

2)

Current liabilities vary from time to time within a year and interest thereon
has no relationship with the book value of current liabilities.

In the second formula, both short-term and long-term debts are counted in the
numerator. The reasons are as follows :
1)

When a firm has an obligation, no matter whether it is of short-term or

long-term nature, it should be taken into account to evaluate the risk of the
firm.

2)

Just as long-term loans have a cost, short-term loans do also have a cost.

3)

As a matter of fact, the pressure from the short-term creditors is often

greater than that of long-term loans.

25

Analysis
An
Overview
of Financial
Statements

Illustration 8
From the following Balance Sheet of Kavitha Ltd., Calculate Debt Equity Ratio :
Balance Sheet of Kavitha Ltd.
as on March 31, 2004
Amount
Assets
Rs.

Liabilities
Equity Capital
9% Preference Capital
Reserves and Surpluses
8% Debentures
Long-term loans
Creditors
Bills payable

1,50,000
60,000
40,000
80,000
1,20,000
30,000
65,000

Land and Buildings

Plant and Machinery
Sundry Debtors
Cash at Bank

5,45,000

Amount
Rs.
2,00,000
2,00,000
1,10,000
35,000

5,45,000

Solution
i)

Long-term
Liabilities/Debt
_______________________
Debt-Equity Ratio =
Owners Equity
Long-term liabilities

=
=
=

Long-term Loan + 8% Debentures

Rs. 1,20,000 + Rs. 80,000
Rs. 2,00,000

Onwers equity (Networth)

ii)

Equity Capital + Preference Capital +

Reserves and Surplus

Rs. 1,50,000 + Rs. 60,000 + Rs. 40,000

Rs. 2,50,000
Rs. 2,00,000

Debt -equity ratio

Total Debt-Equity Ratio

Rs. 2,50,000

= 0.8:1

Total Debt
Owners Equity

Total Debt= Long-term Loan + 8% Debentures + Bills Payable + Creditors

= Rs. 1,20,000 + Rs. 80,000 + Rs. 30,000 + Rs. 45,000
= Rs. 2,75,000
Total Debt to Equity Ratio =

Rs. 2,75,000
Rs. 2,50,000

= 1.1: 1

For analysing the capital structure, debt-equity ratio gives an idea about the relative
share of funds of outsiders and owners invested in the business. The ratio of longterm debt to equity is generally regarded as safe if it is 2:1. A higher ratio
may put the firm in difficulty in meeting the obligation to outsiders. The higher the
ratio, the greater would be the risk as the firm has to pay interest irrespective of
profits. On the other hand, a smaller, ratio is less risky and creditors will have
greater margin or safety.

26

What ratio is ideal will depend on the nature of the enterprise and the economic
conditions prevailing at that time. During business prosperity a high ratio may be
favourable and in a reverse situation a low ratio is preferred. The Controller of
Capital Issues in India suggests 2:1 as the norm for this ratio.

ii)

Techniques of Financial
Analysis

Proprietory Ratio

This ratio is also known as Equity Ratio or Networth to Total Assets Ratio. It
is a variant of Debt-Equity Ratio, and shows the relationship between owners
equity and total assets of the firm. The purpose of this ratio is to indicate the
extent of owners contribution towards the total value of assets. In other
words, it gives an idea about the extent to which the owners own the firm.
The components required to compute this ratio are proprietors funds and total
assets. Proprietors funds include equity capital, preference capital, reserves and
undistributed profits. If there are accumulated losses they are deducted from the
owners funds. Total assets include both fixed and current assets but exclude
fictitious assets, such as preliminary expenses; debit balance of profit and loss
account etc. Intangible assets, if any, like goodwill, patents and copy rights are taken
at the amount at which they can be realised . The formula of this ratio is as follows :
Proprietory Ratio =

Proprietors Funds
Total Assets

Taking the information from Illustration 3, the Proprietory Ratio can be calculated
as follows :
Proprietory Funds
Equity Capital
8% Preference Capital
Reserves and Surpluses

Rs.
1,50,000
60,000
40,000

Total Assets
Land and Building
Plant and Machinery
Debtors
Cash and Bank

2,50,000
Proprietory Ratio =
=

Rs.
1,20,000
2,00,000
1,10,000
35,000
4,65,000

Proprietors Funds
Total Assets
2,50,000
4,65,000

= 53.76 %

There is no definite norm for this ratio. Some financial experts hold the view that
proprietors funds should be from 67% to 75% and outsiders funds should be from
25% to 33% of the total assets. The higher the ratio, the lesser would be the
reliance on outsiders funds. A high ratio implies that the firm is not using
outsiders funds as much as would maximise the rate of return on the proprietors
funds. For instnace, if a firm earns 20% return on borrowed funds and the rate of
interest on such fund is 10% the proprietors would be able to gain to the extent of
10% on the oustiders funds. This increases the earning of the shareholders.
iii)

Capital Gearing Ratio

This ratio establishes the relationship between equity share capital on one hand and
fixed interest and fixed dividend bearing funds on the other. It does not take current
liabilities into account. The purpose of this ratio is to arrive at a proper mix
of equity capital and the source of funds bearing fixed interest and fixed
dividend.
For the calculation of this ratio, we require the value of (i) equity share capital
including reserve and surpluses, and (ii) preference share capital and the sources
bearing fixed rate of interest like debentures, public deposits, long-term loans, etc.
The following formula is used to compute this ratio :
Capital Gearing Ratio =

Equity Capital including Reserves and Surplus

Fixed Dividend and Interest bearing securities

27

Analysis
An
Overview
of Financial
Statements

Illustration 9
The following are the particulars extracted from the Balance Sheet of XYZ Ltd. as on
31.03.2005. Calculate Capital Gearing Ratio.
Rs.
Equity Share Capital
1,00,000
9% Preference Share Capital
60,000
Reserves and Surpluses
20,000
Long-term Loans
1,20,000
Solutio
Capital Gearing Ratio =

Equity Capital
Fixed dividend and interest bearing securities
Equity Share Capital + Reserves and Surpluses
9% Preference Share Capital + Long-term loans.
Rs. 1,00,000 + Rs. 20,000
Rs. 60,000 + Rs. 1,20,000

Rs. 1,20,000
Rs. 1,80,000

= 0.67 : 1
A firm is said to be highly geared when the sum of preference capital and all other
fixed interest bearing securities is proportionately more than the equity capital. On the
other hand, a firm is said to be lowly geared when the equity capital is relatively more
than the sum of preference capital and all other fixed interest bearing securities.
The norm suggested for this ratio is 2:1. However, the significance of this ratio largely
depends on the nature of business, return on investment and interest payable to outsiders.
Illustration 10
From the following particulars compute leverage ratios :
Balance Sheet of Raja Ltd.
as on March 31, 2005
Liabilities

Assets

Equity Share Capital

8% Preference Share Capital
Reserves
Profit and Loss Account
10% Debentures
Trade Creditors
Outstanding Expenses
Provision for Taxation
Proposed Dividend

Rs.
40,000
20,000
10,000
5,000
45,000
9,000
2,000
3,000
6,000

Land
Building
Plant and Machinery
Furniture
Sundry Debtors
Stock
Cash
Prepaid expenses

1,40,000
Solution
Leverage Ratios
1)

28

Long-term Debt

Debt Equity Ratio

Long-term Debt

10% Debentures

Rs. 45,000

Owners Equity

Rs.
22,000
24,000
38,000
5,000
22,000
13,000
14,000
2,000
1,40,000

Owners Equity

Debt Equity Ratio

2)

Equity Share Capital + 8% Preference Share

Capital + Reserves + Profit and Loss Account

40,000 + 20,000 + 10,000 + 5,000

Rs. 75,000
45,000

Techniques of Financial
Analysis

= 0.6 : 1

75,000

Total Debt Equity Ratio

Total Debt

10% Debentures + Trade Creditors

+ Proposed Dividend

45,000 + 9,000 + 2,000 + 3,000 + 6,000

Rs. 65,000

Equity is Rs. 75,000 as calculated in Debt Equity Ratio. Total Debt to Equity
Ratio =
3)

65,000
75,000

= 0.87 : 1

Proprietory Ratio

Proprietors Funds
Total assets

Proprietors Funds is same as Owners equity i.e., Rs. 75,000 as calculated in

Debt Equity Ratio.
Total Assets

Proprietory Ratio
4)

Land + Building + Plant and Machinery

+ Furniture + Current Assets

22,000 + 24,000 + 38,000 + 5,000 + 51,000

Rs. 1,40,000

Capital Gearing Ratio =

Equity Capital

Fixed Interest bearing

secuities

Capital Gearing Ratio

5.6.6

75,000

= 1:1.87

1,40,000

Equity Capital
Fixed Interest Bearing Securities

Equity Share Capital + Reserves + Profit and

Loss Account

40,000 + 10,000 + 5,000

Rs. 55,000

10% Debentures + 8% Preference Share Capital

45,000 + 20,000

Rs. 65,000

55,000
65,000

= 0.85 :1

Coverage Ratios

As mentioned earlier, leverage ratios are computed both from Balance Sheet and
Income Statement (Profit and Loss Account). Under Section 5.6.5 of this Unit
Long term Solvency Ratio you have studied the ratios computed from Balance
Sheet. Let us now discuss the second category of leverage ratios to be calculated
from Income Statement. These ratios are called Coverage Ratios.

29

Analysis
An
Overview
of Financial
Statements

In order to judge the solvency of the firm, creditors assess the firms ability to
service their claims. In the same manner, preference shareholders evaluate the
firms ability to pay the dividend. Theses aspects are revealed by the coverage
ratios. Hence, these ratios may be defined as the ratios which measure the
ability of the firm to service fixed interest bearing loans and other fixed
charge securities. These ratios are:
i)

Interest Coverage Ratio,

ii)

Dividend Coverage Ratio, and

iii)

Total Coverage Ratio.

i)

Interest Coverage Ratio

This ratio is also known as times interest earned ratios. It is used to assess the
firms debt servicing capacity. It establishes the relationship between Net Profit or
Earnings before interest and Taxes (EBIT). The purpose of this ratio is to reveal
the number of times that the Interest charges are covered by the Net Profit before
Interest and Taxes. The formula for this ratio is as follows:
Interest Coverage Ratio =

Net Profit before Interest and Taxes

Interest Charges

Illustration 11
The Net Profit after Interest and Taxes of a firm is Rs. 98,000. The interest and
taxes paid during the year were Rs. 16,000 and Rs. 30,000 respectively. Calculate
Interest Covereage Ratio.
Solution
Interest Coverage Ratio =

Net Profit before Interest and Taxes (EBIT)

__________________________________
Interest Charges

EBIT = Net Profit after Interest and Taxes + Taxes +Interest

= Rs. 98,000 + Rs. 30,000 + Rs. 16,000 = Rs. 1,44,000
Interest Coverage Ratio =

Rs.
1,44,000
__________
= 9 times or 9
Rs. 16,000

In the above illustration, the interest coverage ratio is 9. It implies that even if the
firms profit falls to 1/9th, the firm will be able to meet its interest charges. Hence, a
high ratio is an index of assurance to creditors by the firm. But too high a ratio
reflects the conservation attitude of the firm in using debt. On the other hand, a low
ratio reflects excessive use of debt. Therefore, a firm should have comfortable
coverage ratio to have credit worthiness in the market.
ii)

Dividend Coverage Ratio

This ratio indicates the relationship between Net Profit and Preference dividend.
Net profit means Net Profit, after Interest and Taxes but before dividend on
preference capital is paid. The purpose of this ratio is to show the number of times
preference dividend is covered by Net Profit after Interest and Taxes. To compute
this ratio. The following formula is used:
Net
Profit after Interest and Taxes
__________________________
Dividend Coverage Ratio =
Preference Dividend
30

Illustration 12
The Net Profit before Interest and Taxes of a Company was Rs. 2,30,000. The
Interest and taxes to be paid are Rs. 15,000 and Rs. 35,000 respectively. The preference
dividend declared was 20 per cent on the preference capital of Rs. 2,25,000. Caclulate
Dividend Coverage Ratio.

Techniques of Financial
Analysis

Solution
Net
Profit after Interest and Taxes
__________________________
Dividend Coverage Ratio =
Preference Dividend
Net Profit after Interest and Taxes = EBIT --- Interest --- Taxes
= Rs. 2,30,000 ---Rs. 15,000 --- Rs. 35,000 = Rs. 1,80,000
Preference Dividend

Dividend Coverage Ratio

= 20% on Rs. 2,25,000

20
___
= Rs. 2,25,000
= Rs. 45,000
100
Rs.
1,80,000
_________
= 4.5 times
Rs. 45,000

This ratio reveals the safety margin available to the prefereence shareholders. The
higher the ratio, the greater would be the financial strength of the firm and vice versa.
iii)

Total Coverage Ratio

Also known as Fixed Charge Coverage Ratio. This ratio examines the relationship
between Net Profit Before Interest and Taxes (EBIT) and Total Fixed Charges. The
purpose of this ratio is to show the number of times the total fixed charges are covered
by Net Profit before Interest and Taxes.
The components of this ratio are Net Profit Before Interest and Taxes (EBIT) and
Total Fixed Charges. The Fixed Charges include interest on loans and debentures,
repayment of principle, and preference dividend. It is calculated as follows:
Net Profit before Interest and Taxes
Total Coverage Ratio =
Total Fixed Charges
Illustration 13
The Net Profit Before Interest and Taxes of a firm is Rs. 84,000. The interest to be
paid on loans is Rs. 14,000 and preference dividend to be paid is Rs. 7,000. Calculate
Total Coverage Ratio.
Solution
Total Coverage Ratio =
Total Fixed Charges

=
=

Total Coverage Ratio =

Net Profit before Interest and Taxes

Total Fixed Charges
Interest + Preference dividend
Rs. 14,000 + Rs. 7,000 = Rs. 21,000
Rs. 84,000
Rs. 21,000

= 4 times or 4 to 1.

Check Your Progress C

1)

What is leverage ratio? Are leverage ratios and gearing ratios different?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

31

Analysis
An
Overview
of Financial
Statements

5.7 DUPONT MODEL OF FINANCIAL ANALYSIS

While ratio analysis helps to a great extent in performing the financial statement
analysis, most of the time, one would be left in confusion with umpteen ratio
calculation in hand. Hence one has to have a guided and structured form of ratio
analysis to get a complete picture of the overall performance and risk of the
company in a nut shell. This was made possible by the company DuPont. This
company had given a structured form of doing financial statement analysis for the
first time and from here on most analysts started using the technique.
The DuPont System of Analysis merges the income statement and balance sheet
into two summary measures of profitability: Return on Assets (ROA) and Return
on Equity (ROE). The system uses three financial ratios to express the ROA and
ROE: Operating Profit Margin Ratio (OPM), Asset Turnover Ratio (ATR), and
Equity Multiplier (EM).
The DuPont chart analysis has been explained with an example below.
To understand the Dupont analysis better, its better to condense the income
statement and balance sheet data in a required format as given below. The
following table gives the balance sheet and income statement of Asian Paints for
the year ending March 2001 and March 2002.
Asian Paints
Income Statement

2001

2002

Sales

1215

1331

Raw Material

696

749

Operating Expenses

320

331

Profit Before Interest and Tax (PBIT)

199

251

22

14

177

237

50

66

127

171

2001

2002

Net Worth

411

410

Debt

227

111

Total Liabilities

638

521

Net Fixed Assets

376

384

Inventory

199

156

Receivables

122

119

Investments

44

63

129

87

12

22

244

310

Total Assets

638

521

Current assets

462

384

Cost of debt

9.69

12.61

Interest
Profit Before Tax (PBT)
Tax
Profit After Tax (PAT)
Balance sheet

Other current assets

Cash
Less: Current Liabilities and Provision
Miscellaneous expenditure

32

DuPont Chart Financial Statement Analysis (Template)

Techniques of Financial
Analysis

Return on Networth
PBT/Networth
Leverage or Financial Risk
Debt to Networth

Impact of Leverage
(ROI - Kd)* Debt/Equity

Return on
Investment
PBIT/Total Assets

Asset Turnover Ratio (ATO)

Sales /Total Assets

Fixed Asset To
Sales /Fixed
Assets
Current Ratio
Current Assets/
Current Liabilities

Current Asset To
Sales /Current
Assets

Inventorry To
Sales/Inventory

Debtors To
Sales /Debtors
Collection Period
365 or 12 /Debtors To

Profit Margin
Profit /Sales

Raw Material to Sales

Raw Material/Sales

Conversion Cost to
Sales
Operating Expenses/
Sales

Interest on Sales
Interest /Sales

Where ROI implies Return on Investment; Kd represents Cost of Debt Capital;

PBT implies Profit Before Tax; PBIT implies Profit Before Interest and Tax;
Networth implies Equity Capital + Reserves and Surplus.
The above analysis is a good example of time series analysis. It implies comparing the
financial statements of the same company over the years. The results indicate that
Asian paints had done well during the year 2002. We need to find out the reasons that
had contributed to the good performance of the company. The ROA or ROI has
increased from 31% to 48%. This has been made possible due to the combined positive
effect of profit margin and the asset turnover ratios. The company was able to increase
its profit margin from 16% to 18% in 2002. This was made possible by cutting down on
raw material costs, conversion costs and interest expenses. Further to this, the company
was also able to maintain better efficiency in terms of productivity of assets. This
included improvement in overall asset turnover ratio, increase in current and fixed asset
turnover ratio and also inventory turnover ratio.

33

Analysis
An
Overview
of Financial
Statements

DuPont Chart Financial Statement Analysis of Asian Paints

2001

2002

Retrun on Networth
43.07
57.80

Leverage of Financial risk

0.55
0.27

Impact of leverage
11.87
9.63

Return on Investment
31.19
48.18

Assest Turnover ration (ATO)

1.90
2.55

Fixed Asset To
3.23
3.47

Current Asset To
2.63
3.47

Current Ratio
1.8934
1.24

Inventory To
6.11
8.53
Debtors To
9.96
8.53
Collection Period
(Months)
1.20
1.07

Profit Margin
16.38

18.86

Raw Material to Sales

57.28
56.27

Conversion Cost of Sales

26.34
24.87

Interest on Sales
1.81

1.05

The debtors turnover ratio has also improved indicating that the company is turning on
its receivables more frequently. This is also indicated in the low credit period that is
given to its customers. The credit period has reduced from 1.2 to 1.07 during 2002.
Besides this, the company also had a positive impact of the leverage impact. The debt
equity mix has come down for the period 2002, but still gave a positive impact and
hence boosted the returns to the shareholders by 9%. Hence the ROE moved to 57%
as against 43% in the year 2001. When one would compare the performance of
Asian paints with the industry average, the results would seem more interesting. Its
very difficult to see such alarming increasing returns and highly good performance.
This company should be performing well above the industry average.
Inter-Firm Comparison (Cross Section Analysis)

34

While the above analysis enabled you to compare the performance of the firm over
the years, most often this may not be alone helpful. You would be also interested in
seeing how the firm has performed over its counterparts. In the sense that, you might
want to see if Asian paints has performed well over the industry average or whether
Asian paints has performed well in comparison with the firms in the same industry.

This sort of analysis becomes most useful when you are doing the industry analysis
and when the company you are analysing is not the monopoly in the industry. This
would make sense to see why the company has either underperformed or over
performed in comparison to the other firms. This sort of analysis helps the analysts
forecasts the future market share, profitability and the sustainable growth rate of
the company in the presence of competition.

Techniques of Financial
Analysis

Check Your Progress D

1)

What is the basic benefit of using the DuPont form of financial statement
analysis?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2)

Take any other manufacturing companys annual report and perform similar
analysis to get a practice of DuPont analysis.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3)

What are the different ways in which this chart analysis can be used?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

5.8 USES OF RATIO ANALYSIS

Ratio analysis is used as a device to analyse and interpret the financial strength of
the enterprise. With the help of these ratios Financial statements can be analysed
and interpreted more clearly and conclusions can be drawn about the performance
of the business. The importance of a ratio analysis is widely recognised on account
of its usefulness as outlined below:
1)

It conveys inter-relationship between different items of the financial

statements: Since the ratios convey the inter-relationship between different
items of the Balance Sheet and Profit and Loss account, they reflect the
financial state of affairs and efficiency of operations more clearly than the
absolute accounting figures. For example, the net profit earned by a firm may
appear to be quite satisfactory if the amount of profit is large, say Rs. 5 Lakh.
But, the profit earned can not be regarded good unless it is ralated to the total
investment. If the capital invested is say Rs. 2 crore, the amount of profit
expressed as a percentage of investment comes to be only 2.5%. This cannot
be said to be satifactory performance. However, if the capital invested was
Rs. 50 Lakh, profit earned would be 10% of the capital investment which may
be considered reasonably good.

2)

Helps to judge the performance of the business: Efficiency of

performance of management and the overall financial position are revealed by
means of financial ratios which may not be otherwise apparent from a set of
accounting figures. The index of efficiency reflected in the ratios can be used
as the basis of management control. The trend of ratios over a period of time
can also be used for planning and forecasting purposes.

35

Analysis
An
Overview
of Financial
Statements

3)

Facilitates inter-firm and intra-firm comparison: Ratio analysis provides

data for inter and intra firm comparison. With the help of these data
comparison of the performance of different firms within the industry as well as
the performance of different divisions within the firm can be made and
meaningful conclusion can be drawn out of it as to whether the performance
of the firm is improving or deteriorating so as to make appropriate investment
decisions.

4)

To determine credit worthiness of the business: The credit worthiness of

the firm, its earning power, ability to pay interest and debt, prospects of growth,
and similar information are revealed by ratio analysis.These are required by
creditors, financiers, investors as well as shareholders. They make use of ratio
analysis to measure the financial condition and performance of the firm.

5)

Helpful to Government: The financial statement published by the industrial

units are used by the government to calculate ratios for determining short-term
long-term and overall financial position of the firms.These financial ratios of
industrial units may be used by the Government as indicators of overall
financial strength of industrial sector.

5.9 LIMITATIONS OF RATIO ANALYSIS

By now you should have mastered the techniques of ratio analysis and its
application at the various situations. However, before you start applying the ratios you
should be careful enough to be aware of some of its limitations while being used.

36

1)

You should be aware that many companies operate in more than one industry
take for instance companies like LandT, HLL, PandG etc. which does not
operate in only one business segment but in diversified businesses. So care
should be taken to ensure that segment level ratios are compared.

2)

Inflation has distorted balance sheets, in the sense that, the financial
statements do not account for inflation which implies that they do not represent
the real picture of the scenario. However, given not so high inflation it would
not affect the analysis much.

3)

Seasonal factors can greatly influence ratios. Hence, you should make sure
that you control for the seasonal differences. Better would be to perform the
ratio analysis on a quarterly basis to get the complete picture for the whole
year.

4)

With the kind of accounting scams breaking every other day, its not unusual to
find that Window-dressing could have been done. Though small investors have
no control on this and very little chance to get to know about the creative
accounting that is taking place one should not however loose sight into any sort
of discrepancies in the accounting.

5)

Its quite possible that different companies within an industry may use different
accounting practices which would make it difficult to compare the two
companies. In that situation it should be made sure that the changes are
accounted for and made sure that it would not affect the analysis.

6)

It could also be possible that different companies may use different fiscal
years. Say for instance one company may use the calendar year as its account
closing year while some others may use the fiscal year. In that process care
should be taken to compare the respective months or years adjusting for the
differences in the accounting year.

7)

The age of the company may distort ratios. So it should be take into account
that the companies you are comparing have some basic similarities. The longer

the company had stayed in business the ratios would be quite different from
the new entrants in the same industry. Such factors have to be accounted for.
8)

However, there is also possibility that innovation and aggressiveness may lead
to bad ratios. So one should not blindly depend on the numeric ratio figures
but try and understand why the company has bad ratios in any particular year
before jumping into wrong conclusions.

9)

There could also be possibility that the benchmark used for analyzing the ratios
may not be appropriate. The industry average may not be an appropriate or
desirable target ratio. One has to carefully pick the industry averages or the
benchmark ratios. As industry averages can be very rough approximations.

Techniques of Financial
Analysis

10) The other downside of the ratio analysis is that ratios should not be interpreted
one-way, e.g. a higher ratio may only be better up to a point. So one should
not assume that this will hold good in future. A company having a Profit
margin of 10% in 2003 does not necessarily indicate that it would have atleast
10% profit margin in the year 2004.

5.10 LET US SUM UP

Financial statements represent a summary of the financial information prepared in
the required manner for the purpose of use by managers and external stakeholders.
Financial reports are prepared basically to communicate to the external
shareholders about the financial position of the company that they own.
Different groups of users of financial statements are interested in different aspects
of a companys financial activities. Short-term creditors are interested primarily in
the companys ability to make cash payments in the short term; they focus their
attention on operating cash flows and current assets and liabilities. Long-term
creditors, on the other hand, are more interested in the companys long-term ability
to pay interest and principal and would not limit their analysis to the companys
ability to make cash payments in the immediate future. The focus of common
stockholders can vary from one investor to another, but generally stockholders are
interested in the companys ability to pay dividends and increase the market value
of the stock of the company. Each group may focus on different information in the
financial statements to meet its unique objectives
An important aspect of financial statement analysis is determining relevant
relationships among specific items of information. Companies typically present
financial information for more than one time period, which permits users of the
information to make comparisons that help them understand changes over time.
Financial statements based on absolute value and percentage changes and trend
percentages are tools for comparing information from successive time periods.
Component percentages and ratios, on the other hand, are tools for establishing
relationships and making comparisons within an accounting period. Both types of
comparisons are important in understanding an enterprises financial position, results
of operations, and cash flows.
Assessing the quality of information is an important aspect of financial statement
analysis. Enterprises have significant latitude in the selection of financial reporting
methods within generally accepted accounting principles. Assessing the quality of a
companys earnings, assets, and working capital is done by evaluating the
accounting methods selected for use in preparing financial statements.
Managements choice of accounting principles and methods that are in the best
long-term interests of the company, even though they may currently result in lower
net income or lower total assets or working capital, leads to a conclusion of high
quality in reported accounting information.

37

Analysis
An
Overview
of Financial
Statements

Financial accounting information is most useful if viewed in comparison with other

relevant information. Net income is an important measure of the financial success of
an enterprise. To make the amount of net income even more useful than if it were
viewed simply in isolation, it is often compared with the sales from which net income
results, the assets used to generate the income, and the amount of stockholders
equity invested by owners to earn the net income. Hence Ratio analysis is used as a
major tool.
Ratios are mathematical calculations that compare one financial statement item with
another financial statement item. The two items may come from the same financial
statement, such as the current ratio, which compares the amount of current assets with
the amount of current liabilities, both of which appear in the statement of financial
position (balance sheet). On the other hand, the items may come from two different
financial statements, such as the return on stockholders equity, which compares net
income from the income statement with the amount of stockholders equity from the
statement of financial position (balance sheet). Accountants and financial analysts have
developed many ratios that place information from a companys financial statements in
a context to permit better understanding to support decision making.
Often ratio analysis is performed in a more structured form called the Dupont model of
analysis. This helps the investors a better picture of the analysis and also more
meaningful and holistic picture of the financial position of the companies.

5.11 KEY WORDS

Accounting Ratio : Ratio of accounting figures presented in financial statements.
Common Size Balance Sheet : Statement of assets and liabilities showing each item
as a ratio (percentage) of the aggregate value of assets/1iabilities.
Common Size Income Statement : Statement of income and expenditure showing
each item as a ratio (percentage) of net sales.
Comparative Balance Sheet : Statement presenting changes in the value of assets,
liabilities and capital investment between two Balance Sheet dates.
Comparative Income Statement : Statement presenting changes in income and
expenditure over successive years.
Capital Employed : Long-term funds including owners capital and borrowed capital.
Capital Structure : Financial mix plan of debt and equity.
Financial Analysis : Process of examining the financial position and operating
performance with the help of information provided by the financial statement.
Financial Reporting : Communicating information based on financial data in the form
of reports.
Financial Ratios : Ratios indicating financial soundness of the firm. It is also called
leverage ratio.
Financial Statements : Annual statements of assets and liabilities (Balance sheet) of
income and expenditure (Profit and Loss account).
Intra-firm Comparison : Comparing financial data of one firm with the corresponding
data of comparable firm(s).
Intra-firm Comparison : Comparison of the financial data relating to one period with
those of previous periods in respect of the same firm.

38

Owners Equity : Shareholders funds including share capital (both preference and
equity) P & L A/c balance, reserves minus fictitious assets. It is also called net
worth.

Ratio : Measure of one value or number in relation to another.

Ratio Analysis : Computing, determining and explaining the relationship between
the component items of financial statements in terms of ratios.

Techniques of Financial
Analysis

Leverage Ratios : Ratios that evaluate the long-term solvency of a firm. These
are also called solvency ratios.
Liquidity Ratios : Ratios that assess the capacity of a firm to meet its short-term
liabilities.

5.12 TERMINAL QUESTIONS

1)

From the following balance sheet of XYZ Co. Ltd. calculate Return on
Capital employed.
Balance sheet as on 31.03.2005

Liabilities

Rs.

Assets

Rs.

Share Capital

6,00,000

Fixed assets

9,00,000

Reserves

2,00,000

Current assets

3,00,000

10% Debentures

2,00,000

Investment in

Provision for Taxation

2,00,000

Govt. securities

Profit and Loss A/c

2,00,000
14,00,000

2,00,000

14,00,000

Profit and loss for the period ended 31.03.2005

Rs.
To Cost of goods sold
To Interest on Debentures

6,00,000
20,000

To Provision for Taxation

2,00,000

To Net profit after Tax

2,00,000

Rs.
By Sales
By Income from investment

10,20,000

10,00,000
20,000

10,20,000

(Ans.: Operating profit : Rs. 4,00,000 Capital employed : Rs. 10,00,000 ROC = 40%).
2)

Following is the Profit and Loss Account of Shriram Company Ltd., for the
year ending March 31, 2005 and the Balance Sheet as on that date. You are
required to compute liquidity, long-term solvency, turnover ratios, and
profitability ratios both in relation to capital and sales.
Profit and Loss Account of Shriram Company Ltd.
for the year ending March 31, 2005

To Opening Stock
To Purchases

Rs.
90,000
9,00,000

To Direct Expenses

20,000

To Gross Profit c/d

4,00,000
14,10,000

By Sales
By Closing Stock

Rs.
12,60,000
1,50,000

14,10,000
39

Analysis
An
Overview
of Financial
Statements

To Operating Expenses:
Administrative
Expenses
40,000
Selling & Distribution
Expenses
60,000
To Non-operating
Expenses:
Loss on the sale
of shares
Interest

By GrossProfit b/d

4,00,000

1,00,000

10,000
30,000

40,000

To Provision for Taxation

40,000

To Net Profit

2,20,000
4,00,000

4,00,000

Balance Sheet of Shriram Company Ltd. as on March 31, 2005

Liabilities

Rs.

Assets

Rs.

Equity Share Capital

Land & Buildings

4,00,000

(60,000 shares of Rs. 10 each) 6,00,000

Plant & Machinery

3,20,000

Reserves & Surplus

Stock

1,50,000

50,000

Profit & Loss Account

1,60,000

Cash at bank

1,20,000

10% Debentures

3,00,000

Debtors

3,00,000

Creditors

1,80,000
12,90,000

12,90,000

(Ans.: Current ratio = 3.17 : 1, Quick ratio = 2.33:1

Gross profit ratio = 31.75%, Net profit ratio = 17.46%
Operating profit ratio = 23.89%
Operating ratio =76.19%
Return on capital employed = 27%
Return on Investment = 19.82%
Return on shareholders equity = 27.16%
Earning per share =3.67)
3)

The following is the Balance Sheet of X Co. Ltd. as on March 31, 2005.
Calculate the liquidity ratios.

Liabilities
Share Capital
Profit and Loss A/c
10% Debentures
Sundry Creditors
Outstanding Expenses
Provision for Taxation

Rs.
50,000
10,000
30,000
14,000
6,000
3,000

Assets
Plant and Machinery
Stock
Debtors
Bills Receivables
Short-term Securities
Cash

1,13,000
40

(Answer: Current Ratio = 2.304, Quick Ratio = 1.43)

Rs.
60,000
20,000
14,000
5,000
8,000
6,000
1,13,000

4)

Techniques of Financial
Analysis

From the following details, calculate leverage ratios.

Balance Sheet of ABC Ltd. as on March 31, 2005

Liabilities
Rs.
Assets
Equity Share Capital
1,00,000
8% Preference Share Capital
40,000
Reserves & Surpluses
30,000

Land
Plant and
Machinery 1,50,000

9% Long-term Loan

50,000

10% Debentures

60,000

Creditors

20,000

Less:
Accumulated
depreciation 30,000

Bills Payable

15,000

Accrued Expenses

5,000

Rs.
60,000

1,20,000

Stock

40,000

Debtors

70,000

Prepaid Expenses

5,000

Marketable Securities
Cash

20,000
5,000

3,20,000

3,20,000

Answer: Debt Equity Ratio = 0.647 : 1

Proprietory Ratio = 0.531 : 1
Total Debt Ratio = 0.469 : 1
5)

From the following details you are required to compute:

i)

Current Ratio

ii)

Operating Ratio

iii)

Stock Turnover Ratio

iv)

Total Assets Turnover Ratio

v)

Return on Shareholders Equity, and

vi)

Net Profit Ratio

Profit and Loss Account for the year
ended March 31, 2005
Rs.

To Opening Stock

50,000

To Purchases

3,40,000

To Incidental Expenses
To Gross Profit c/d

Rs.
By Sales

5,00,000

By Closing Stock

30,000

20,000
1,20,000
5,30,000

To Operating Expenses :
Selling and
Distribution

By Gross Profit b/d

1,20,000

By Non-operating Income:
20,000

Administrative 30,000

50,000

To Non-operating Expenses:
Loss on Sale of assets
To Net Profit

5,30,000

Interest

2,000

Profit on sale of
shares

3,000

5,000

2,500
72,500
1,25,000

1,25,000

41

Analysis
An
Overview
of Financial
Statements

Balance Sheet as on March 31, 2005

Liabilities

Rs.

Assets

Share Capital :
10,000 ordinary shares of
Rs. 10 each

Rs.

Land and Building

1,00,000

50,000

Plant and Machinery

Debtors

35,000

Reserves

22,500

Stock

30,000

Current Liabilities

45,000

Bank

2,500

Profit and Loss A/c

50,000
2,17,500

2,17,500

Answer : i) Current Ratio = 1.5:1,

ii)
iii) Stock Turnover Ratio = 9.5 times, iv)
v) Return on Shareholders
Equity = 42%,
6)

vi)

Operating Ratio = 0.86:1,

Net Assets Turnover
Ratio = 2.9 times,
Net Profit Ratio = 14.5%)

The following is the Balance Sheet of Dev Ltd. for the year ended March 31,
2005.

Liabilities

Rs.

Equity Capital
2,50,000
(2,500 share of Rs. 100 each)
7% Preference Capital

Assets

Rs.

Fixed Assets
9,00,000
Less: Depreciation 2,50,000

50,000

6,50,000

Reserve & Surpluses

2,00,000

Current Assets

6% Debentures

3,50,000

Cash

25,000

10% Investments

75,000

Current Liabilities
Creditors

30,000

Debtors

1,00,000

Bills Payable

50,000

Stock

1,50,000 3,50,000

Accured Expenses
Provision for Taxation

5,000
65,000
10,00,000

Additional Information :

Rs.

Net Sales

15,00,000

Purchases

13,00,000

Cost of Goods Sold

12,90,000

Profit before Tax

1,46,500

Profit after Tax

50,000

Operating Expenses

50,000

Market Value per Share

42

1,00,000

150

Calculate activity ratios and profitability ratios.

10,00,000

[ Answer :

Activity Ratios: Total Assets Turnover =1.5 times,

Stock Turnover =8.89 times.

Techniques of Financial
Analysis

Debtors Turnover = 15 times

Creditors Turnover = 10 times. Net Assets Turnover = 1.765 : 1
Profitability Ratio : Gross Operating Margin = 14%, Net Profit
Margin = 3.33% Gross Operating Margin = 10.67%,
Operating Ratio = 89.33%
ROCE = 18.82%, Return on Shareholders Equity = 10%

7)

EPS = Rs. 18-60

During the year 2005, Satyam Co. made sales of Rs. 4,00,000. Its gross
profit ratio is 25% and net profit ratio is 10% . The stock turnover ratio was
10 times. Calculate (i) Gross Profit, (ii) Net Profit , (iii) Cost of Goods Sold,
(iv) Operating Expenses.
Answer : i)
ii)

Gross Profit : Rs. 1,00,000

Net Profit : Rs. 40,000

iii) Cost of goods sold : Rs. 3,00,000

iv) Operating Expenses : Rs. 60,000)
8)

Following is the Profit and Loss Account and Balance Sheet of a company :
Profit & Loss Account for the year ended 31st March, 2005

Particulars

Rs.

Particulars

Rs.

To Opening Stock

3,00,000

By Sales

20,00,000

To Purchases

6,00,000

By Closing Stock

To Direct Wages

4,00,000

By Profit on Sale of Shares 1,00,000

5,00,000

To Manufacturing Expenses 2,00,000

To Administrative Expenses 1,00,000
To Selling and Distribution
Expenses

1,00,000

To Loss on Sale of Plant

1,10,000

To Interest on Debentures
To Net Profit

20,000
7,70,000
26,00,000

26,00,000

Balance Sheet as on 31st March, 2005

Liabilities

Rs.

Assets

Rs.

Equity share Capital

2,00,000

Fixed Assets

5,00,000

Preference Share Capital

2,00,000

Stock

5,00,000

Reserves

2,00,000

Sundry Debtors

2,00,000

Debentures

4,00,000

Bank

1,00,000

Sundry Creditors

2,00,000

Bills Payable

1,00,000
13,00,000

13,00,000
43

Analysis
An
Overview
of Financial
Statements

Examine the Profit & Loss A/c and Balance Sheet given above and calculate the
following ratios:
i)

Gross Profit Ratio

ii)

Current Ratio

iii)

Debt Equity Ratio

iv)

Liquidity Ratio

v)

Operating Ratio

vi)

Propreitory Ratio

vii) Total Assets to Debt Ratio 50%

(Answer : i)
ii)

Gross profit Ratio 50%

Current Ratio : 2. 67:1

iii) Debt Equity Ratio : 0.67:1

iv) Liquidity Ratio : 1:1
v) Operating Ratio : 60%
vi) Proprietory Ratio : 0.46:1
vii) Total assets to Debt Ratio : 3.25:1)
9)

With the help of the given information calculate following ratios:

(i) Operating Ratio, (ii) Current Ratio, (iii) Stock Turnover Ratio,
(iv) Debt Equity Ratio
Rs.
Equity Share Capital
9% Preference Share Capital
12% Debentures
General Reserve
Sales
Opening Stock
Purchases
Wages
Closing Stock
Selling and Distribution Expenses
Other Current Assets
Current Liabilities

(Answer : i)

Operating Ratio : 66.5

ii)

Current Ratio : 1.68:1

2,50,000
2,00,000
1,20,000
20,000
4,00,000
24,000
2,50,000
15,000
26,000
3,000
1,00,000
75,000

iii) Stock turnover ratio : 10.52 times

iv) Debt equity ratio : 33.05%)
10) Prepare a horizontal analysis of the balance sheet for Grant, Inc., by
computing the percentage change from 2004 to 2005 for each of the amounts
listed below. Comment on the results. (Figures in Rs.)
44

Balance Sheet of CC Ltd.

2005

2004

50,000

40,000

Accounts receivable

100,000

60,000

Inventory

150,000

100,000

Equipment, net

1,200,000

800,000

Total assets

1,500,000

1,000,000

Accounts payable

150,000

100,000

Bonds payable (long-term debt)

400,000

400,000

Common stock

600,000

300,000

Retained earnings

350,000

200,000

1,500,000

1,000,000

Cash

Total Liabilities & Shareholder Equity

Techniques of Financial
Analysis

11) Given below are the financial statements of Aventis Pharma for the year
ending March 2004 and 2005. Analyse and answer the questions
following the data.
Company Name

Aventis Pharma
2005

2004

Sales

609.92

675.81

Raw material consumed

185.93

207.84

Operating expenses

327.49

376.88

PBIT

96.5

91.09

Interest

1.48

0.41

PBT

95.02

90.68

TAX

47.09

32.7

PAT (NNRT)

47.93

57.98

2003

2002

Net worth

212.24

239

Borrowings

33.88

20.01

TL

246.12

259.01

Net fixed assets

158.44

149.95

Inventories

66.92

78.36

Sundry debtors

48.24

34.28

Cash and marketable securities

57.32

120.64

118.08

129.81

33.28

5.59

TA

246.12

259.01

Current assets

205.76

238.87

4.37

2.05

Less Current liabilities & provision

Other CA

Cost of debt

45

Analysis
An
Overview
of Financial
Statements

i)

Discuss the quality of a companys earnings, assets, and working capital.

ii)

Put the companys net income into perspective by relating it to sales,

assets, and stockholders equity.

iii)

Compute the ratios widely used in financial statement analysis and explain
the significance of each.

iv)

Analyze financial statements from the viewpoints of common stockholders,

creditors, and other stakeholders if any.

v)

Perform a Dupont analysis for the two years and list down your
observations and conclusions.

12) Given below is the Balance sheet of CC Company Ltd.

a)

Compute the following ratios for December 2004 and December 2003:
Current Ratio, Acid-test Ratio, and the Debt Ratio. Comment the
results.

b)

The income statement for 2002 reported: Net sales Rs. 1,600,000; Cost of
goods sold Rs. 600,000; and Net income Rs. 150,000. Compute the
following ratios for 2002: Inventory Turnover, Return on Sales, and Return
on Equity. Comment the results.

c)

Identify the ratios of most concern to Creditors. Explain why Creditors are
most interested in these ratios.

d)

Identify the ratios of most concern to Shareholders. Explain why

Shareholders are most interested in these ratios.

Balance Sheets

31.12.2004

31.12.2003

Rs.

Rs.

50,000

40,000

Accounts receivable

100,000

60,000

Inventory

150,000

100,000

Equipment, net

1,200,000

800,000

Total assets

15,00,000

10,00,000

Accounts payable

150,000

100,000

Bonds payable (long-term debt)

400,000

400,000

Common stock

600,000

300,000

Retained earnings

350,000

200,000

15,00,000

10,00,000

Cash

Total Liabilities

Note :

46

These questions will help you to understand the unit better. Try to write answers
for them. But do not submit your answers to the University. These are for your
practice only.

5.13 FURTHER READINGS

Techniques of Financial
Analysis

Daniel L. Jensen, Advanced Accounting (McGraw-Hill College Publishing, 1997).

Eric Press, Analyzing Financial Statements (Lebahar-Friedman, 1999).
Foster (2002), Financial Statement Analysis.
Gerald I. White, The Analysis and Use of Financial Statements (John Wiley &
Sons, 1997).
Horngren et al. (2002), Financial Accounting Pearsons Ed.
Howard M. Schilit (1993) Financial Shenanigans: How to Detect Accounting
Gimmicks & Fraud in Financial Reports by McGrahill.
Leopold Bernstein and John Wild, Analysis of Financial Statements (McGraw-Hill,
2000) .
Martin Mellman et. al, Accounting for Effective Decision Making
(Irwin Professional Press, 1994).
Mulford and Comiskey (2002), The Financial Numbers Game: Detecting Creative
Accounting Practices, John Wiley & Sons.
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists
(Prentice Hall, 1997).
Pinson, Linda (2001), Keeping the Books: Basic Record keeping and Accounting
for the Successful Small Business (5th Ed), Dearbon Publishing.
Wild, Bernstein and Subramanyam (7th Ed.), Financial Statement Analysis, Irwin
McGrawhill.

47

An
Overview
Analysis
of Financial
Statements

UNIT 6 STATEMENT OF CHANGES IN

FINANCIAL POSITION
Structure
6.0

Objectives

6.1

Introduction

6.2

Need for Changes in Financial Position

6.3

Statement of Changes in Financial Position---Meaning

6.4

Concept of Funds

6.5

Flow of Funds

6.6

Sources and Uses of Funds

6.7

Statement of Changes in Financial Position---Cash Basis

6.8

Statement of Changes in Financial Positions---Working Capital Basis

6.9

Funds Flow Statement

6.9.1

Schedule of Changes in Working Capital

6.9.2

Statement of Funds from Operations

6.9.3

Preparation of Funds Flow Statement

6.9.4

Steps in Preparation of Funds Flow Statements

6.10 Funds Flow Statement vs. Other Financial Statements

6.11 Importance of Funds Flow Statement
6.12 Let Us Sum Up
6.13 Key Words
6.14 Terminal Questions
6.15 Further Readings

6.0 OBJECTIVES
The objectives of this unit are to:

52

explain need for funds flow statement for investors and other stockholders in
addition to balance sheet and profit and loss account;

compare the differences between funds flow statement with other financial
statements;

familiar with the concept of funds;

explain the methodology for preparation of funds flow statement under

different methods; and

explain how funds flow statement can be used in real life for different decision
making.

Statement of Changes
in Financial Position

6.1 INTRODUCTION
As a student of accounting, you are aware of basic difference between Profit
and Loss Account and Balance Sheet on time scale. While Profit and Loss
Account is prepared for a period, Balance Sheet presents financial position at a
particular point of time. Is there any way for users to convert the Balance Sheet
into a flow statement? If the answer is yes, what is the use of such conversion?
Let us take the second issue to understand the concept. Balance Sheet shows
the sources of capital or funds for the assets that the firm holds or how the firm
spent its capital or funds on various assets. This is an important useful
information to the users of financial statements but it fails to tell how much of
assets have been added during the period and how such additional investments
are funded. In other words, the users would like to know whether the firm is
growing or not and if it is growing, what is the source of capital or funds. Users
would also like to know whether there is any change in the pattern of funding
over the years. Therefore, there is a need for converting the point statement into
flow statement. So, the next question is how to convert the Balance Sheet into
Funds Flow Statement. There are different levels at which one can achieve the
translation and the easiest and crude way is to find the differences in the values
of each Balance Sheet item.
To illustrate the idea of funds flow statement and also to get a quick idea on the
concept, let us have a look on the summary of Balance Sheet items of Ranbaxy
Laboratories Ltd., which is one of the largest players in the pharmaceutical
industry in India. The details are as follows:
Summary of Balance Sheet values of Ranbaxy Laboratories Ltd.
(Rs. in Crores)
Year
Share Capital
Reserves & Surplus
Loans
Current Liabilities and Provision
Total

2002

2001

2000

1999

1998

185.45

115.90

115.90

115.90

115.90

1686.06

1486.30

1466.76

1382.04

1284.94

6.90

125.98

255.81

322.88

424.93

935.37

586.67

417.98

308.71

307.49

2813.78 2314.85 2256.45

2129.53 2133.26

Fixed Assets

675.39

613.05

644.37

631.90

613.56

Investments

337.50

342.52

290.03

282.77

332.47

1800.89

1359.28

1322.05

1214.86

1187.23

Current Assets, Loans

& Advances
Total

2813.78 2314.85 2256.45

2129.53 2133.26

The above Balance Sheet values show how the values have changed
(increased or decreased) over the years. It also tells how the assets are funded
over the years. The following table shows the Balance Sheets values in
percentage format.
53

An
Overview
Analysis
of Financial
Statements

Summary of Balance Sheet values of Ranbaxy Laboratories Ltd. (in %)

(Rs. in Crores)
Year

2002

2001

2000

1999

1998

7%

5%

5%

5%

5%

60%

64%

65%

65%

60%

0%

5%

11%

15%

20%

33%

25%

19%

14%

14%

100%

100%

100%

100%

100%

Fixed Assets

24%

26%

29%

30%

29%

Investments

12%

15%

13%

13%

16%

Current Assets, Loans &

Advances

64%

59%

59%

57%

56%

100%

100%

100%

100%

100%

Share Capital
Reserves & Surplus
Loans
Current Liabilities and Provision
Total

Total

The picture is somewhat clear now but not complete. Ranbaxy, which used to have
about 20% of total funds through loans is now not raising any debt to fund its
assets. The company has turned almost zero-debt company over the period of
5 years. This decline is suitably compensated through an increase in current
liabilities. There is also an increase in current assets values over the years. While
these details are useful, the percentage analysis fails to show any movement of
funds in absolute value. Let us now simply take the difference of the values and
see how the picture looks over the years.
Summary of Changes in Balance Sheet values of Ranbaxy Laboratories Ltd.
(Rs. in Crores)
Year

2002

2001

2000

1999

Share Capital

69.55

0.00

0.00

0.00

199.76

19.54

84.72

97.10

---119.08

---129.83

348.70

168.69

109.27

1.22

498.93

58.40

126.92

-3.73

Fixed Assets

62.34

--- 31.32

12.47

18.34

Investments

--5.02

52.49

7.26

--- 49.70

441.61

37.23

107.19

27.63

498.93

58.40

126.92

--- 3.73

Reserves & Surplus

Loans
Current Liabilities and Provision
Total

Current Assets, Loans & Advances

Total

54

---67.07 ---102.05

The above table gives better picture. Over the years, Ranbaxy invested heavily on
current assets, loans and advances. The source of funds to meet this huge increase
in investments is primarily current liabilities and also from funds from operation.
The company reduced its loans value over a period of time by repaying loans. Once
you have this information, it is possible for you to examine how Ranbaxy is
comparable with other companies in the industries. For instance, if you find some of
the pharmaceutical companies are expanding faster than Ranbaxy, then as an
investor, you will worry about the future of the company. It is possible to perform
such analysis using funds flow statement. The funds flow statement, which we
have prepared above is bit crude and we need to make some adjustments to
prepare a good funds flow statement. This will dealt with in subsequent sections.

Statement of Changes
in Financial Position

Activity 1
1)

Refer Ranbaxy Laboratories Ltd. Balance Sheet. Prepare a statement to

show how the funds have moved from the year 1998 to 2002. Ignore the
funds flow of in between years i.e., assume Ranbaxy has not prepared any
balance sheet for in between years.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

List down major sources and uses of funds in descending order.

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

3)

Draw a broad conclusions on the flow of funds during this period.

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

6.2 NEED FOR CHANGES IN FINANCIAL

POSITION
Accounting Standard (Revised) - 3 has made funds flow statement redundant and
prescribed cash flow statement. Despite that why do we feel funds flow statement
is useful to users of accounts? Funds flow statement provides some further insight
into the Balance Sheet and particularly shows how the firm is able to get money to
take up several activities. It is possible to know what is the kind of funds mix that
the firm is using particularly a comparison of internal and external funds. For
instance, Ranbaxy heavily uses internal funds and depend little on external funds.
In contrast, Aurobindo Pharma Ltd. another major player in the pharmaceutical
industry uses debt substantially for the funding its activities.
Summary of Changes in Balance Sheet values of Aurobindo Pharma Ltd.
(Rs. in Crore)

Share Capital
Reserves & Surplus
Debt
Total

2002-03

2001-03

2000-03

1999-03

0.67

1.00

0.55

13.23

84.27

55.71

94.43

41.45

110.10

84.99

29.95

40.10

195.04

141.70

124.93

94.78

Funds flow statement can also be used to know how the resources raised are used.
For instance, we observed Ranbaxy spends most of the resources for increasing
current assets. Aurobindo Pharma also uses substantial part of the funds for
increasing current assets and it looks like that there is something which is driving
for the industry to build up more current assets. A further analysis shows that a
significant part of the currents assets are funding of receivables without
corresponding increase in sales. Though balance sheet also highlights an increase in
receivables values, it is not apparent that substantial part of the funds raised during
the period go for funding of such receivables.

55

An
Overview
Analysis
of Financial
Statements

It is possible to examine how healthy the financial policies of firms. For instance,
many firms would like to avoid using short-term capital for long-term purposes. It is
possible to identify whether firms in which you are interested use funds in a suboptimal way.
Activity 2
1) Pick up annual report of two or three companies belonging to software or any
other industry. Compare the changes in balance sheet values for two years
and write down the values here.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
2)

Write a brief on the sources of funds and where they are used. Also, compare
these figures between the companies and write down your views.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3)

Do you find all the companies are behaving in a same way? Mostly it will not
be and if so, why do you feel companies follow different strategies in raising
funds and using the same in different assets?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

6.3 STATEMENT OF CHANGES IN FINANCIAL

POSITION ----MEANING
Statement of changes in financial position is a statement which outlines the causes
of a change in the financial position of a company during an accounting period.
These causes are reflected in the movement of funds viz., inflows and outflows of
funds during the period. Therefore, it is called Funds Flow Statement in which the
inflows are shown as sources of funds and the out flows are shown as application
or uses of funds. The difference between the two (inflows and outflows) indicates
the net changes (increase or decrease) in the position of funds during the
accounting period.

6.4 CONCEPT OF FUNDS

56

The Balance Sheet gives a snapshot view at a point in time for the sources from
which a firm has acquired its funds and the uses, which the firm has made of these
funds. The flow statement explains the changes that took place in the Balance
Sheet account. Firms get funds from various sources. Broadly, we classify the
sources of funds into two categories namely, long-term funds and short-term funds,
Sources of long-term funds include equity share capital, funds provided by
operation, term loan, etc. Source of short-term funds consists of supplier credit and
any short-term borrowing. The term fund is broader compared to the term cash.
For instance, when a firm sells goods on credit, there is no cash flow and cash flow
statement ignores such transactions. On the other hand, funds flow statement treats
this source of funds from operating activities and treat the increased accounts
receivables as application of funds for working capital purpose. On the other hand,
if the firm collects receivables of last year, it appears in cash flow statement,
whereas it has no impact in funds flow statement because there is no change in

working capital. That is, while receivables decline its value, cash increases to that
extent and flow of funds is restricted within the working capital group. The concept
of funds simply denotes whether there is any change in Balance Sheet item at
aggregate level and such changes lead to an increase in fund or decrease in fund.
The following are certain activities, which will not affect fund flow statement and
any effect that arises out of these activities will be restricted to working capital
statement.
a)

Collection of bills receivable.

b)

Payment of bills payable.

c)

Purchase of Materials for cash or on credit basis.

d)

Sale of goods on cash or credit basis (except for the profit or loss component).

Statement of Changes
in Financial Position

The above items normally affect cash flow statement [cash part of item (c) and (d)].
There are several items, which affects funds flow and not cash flow statement.
A few of them are:
a)

Sale or purchase of goods on credit basis --- it affects funds from operation and
to a minor extent working capital statement.

b)

Purchase of fixed assets on credit basis.

c)

Expenses incurred but not paid.

d)

Income accured but not received.

e)

Changes in value of closing stock.

There are several items, which affect both funds flow and cash flow statement.
A few of them are:
a)

Fresh Equity

b)

Fresh loan or repayment of loan

c)

Purchase of fixed assets by paying cash

d)

Cash sales and purchases

e)

Cash Expenses

From the above discussion, it is clear that funds in funds flow statement means
changes in equity, liability or working capital. It includes both cash and non-cash
items. In this unit, for the purpose of funds flow statement, we use the net working
capital concept which refers to excess of current assets over current liabilities.
Activity 4
1)

A machine costing Rs. 70,000 (book value Rs. 40,000) was sold for
Rs. 25,000. What is the impact of this transaction on funds flow statement?
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

The book value of Inventory was Rs. 8 lakhs and market value is Rs. 6.50
lakhs. What is the effect of change in market value on funds flow statement?
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

57

An
Overview
Analysis
of Financial
Statements

3)

Finished goods worth of Rs. 3 lakhs was sold for Rs. 3.50 lakhs on cash. What
is the impact of this transaction on funds flow statement? Suppose if the above
sale is on credit basis, will it have different impact? Explain.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

4)

What do you understand the term fund in the context of funds flow
statement?
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

5)

Categorise the following items under current and non-current assets and
liabilities.
i)

Bank Balance ............................................................................................

ii)

Goodwill .....................................................................................................

iii)

Income received in advance ......................................................................

iv)

Share premium ..........................................................................................

6.5 FLOW OF FUNDS

Flow of funds means change in fund position or change in net working capital.
Whenever there is a change in the funds, it is presumed that flow of funds has
taken place. The flow of funds can be in the form of a inflow or an outflow. An
inflow of funds increases the working capital and an outflow of funds decreases the
working capital.
Flow of funds will takes place if a transaction involves a change in a current item
and change in a non-current item. A non-current item means either a non-current
asset (Fixed asset) or a non-current liability (long-term liability). There will be no
change in net working capital (flow of funds) if a transaction involves : (i) only the
current items or (ii) only the non-current items. In other words, a transaction,
involving a fixed asset/fixed liability on the one hand and a current asset/current
liability on the other, will alone result in flow of funds. Let us understand these rules
by taking up some examples.
1)

58

Transactions involving items from both current and non-current

categories which result in flow of funds:
i)

Purchased machinery for Rs. 30,000 : This transaction increases

machinery (a non-current asset) and reduces cash (a current assets).
The reduction in cash reduces current assets without any corresponding
reduction in current liabilities. As a results, the net working capital gets
reduced.

ii)

Shares issued for Rs. 2,00,000 : In this case, a non-current liability

(i.e., share capital) has increased and a current asset (i.e., cash) has
increased. Thus the current asset has increased without any
corresponding change in current liabilities. As a result, net working capital
gets increased.

2)

3)

Transactions affecting items in the current category only which do not

result in flow of funds:
i)

Cash collected from debtors Rs. 4000 : This transaction results in an

increase in cash (a current asset) and a decrease in debtors (a current
asset, again) by the same amount. Thus the total current assets remain the
same and there will be no change in the net working capital.

ii)

Acceptance given to creditors Rs. 3,000 : Both creditors and bills

payable are current liabilities. By giving acceptance to creditors, the amount
of creditors decreases and that of bills payable increases by the same
amount. Since this transaction does not affect the total amount of current
assets as also the total amount of current liabilities, the difference between
current assets and current liabilities remains unchanged. Thus, there is no
flow of funds and no change in the net working capital.

iii)

Paid creditors Rs. 1,000 : By paying the creditors cash (a current asset)
is reduced and the amount of creditors (a current liability) is also reduced
by the same amount. Therefore, the difference between the current assets
and current liabilities will be the same as it was before. So there will be no
flow of funds, which means no change in the net working capital.

Statement of Changes
in Financial Position

Transactions affecting items in the non-current category only which do

not result in flow of funds:
i)

Land exchanged for machinery Rs. 10,00,000 : Both land and

machinery are non-current assets. By exchanging land for machinery, the
book value of land is reduced and that of machinery is increased, but the
total of non- current assets remains unaffected. Further, it does not effect
any change in the current assets or the current liabilities. Hence, there will
be no change in the net working capital position.

ii)

Preference shares are converted into equity shares Rs. 10,00,000 :

Both preference share capital and equity share capital are non-current
items. As a result of conversion, the equity share capital stands increased
and the preference share capital gets reduced by the same amount. As no
current item is affected, there will be no change in net working capital.

iii)

Purchased land worth Rs. 50,000 and issued shares in consideration

thereof : This transaction increases the debit balance of the land account
and credit balance of share capital account Both land and share capital are
non- current items. Since no current items is involved, the net working
capital remains unaffected.

We can summarise the above analysis as follows :

1)

2)

There will be flow of funds if transaction involves:

i)

Current assets and non-current liabilities:

ii)

Current assets and non-current assets.

iii)

Current liabilities and non-current assets.

There will be no flow of funds if a transaction involves :

i) Non-current assets and non-current liabilities.
ii) Current assets and current liabilities.

59

An
Overview
Analysis
of Financial
Statements

For easy reference, the list of non-current and current items is given below :
Non Current Liabilities
Equity Share capital
Preference Share Capital
Debentures
Share Premium
Forfeited Shares

Non-Current Assets
Goodwill
Plant and Machinery
Furniture
Trade Marks, Patnets, Copyrights
Land and Buildings

Current Liabilities
Bank Overdraft
Bills Payable
Creditors
Outstanding Expenses
Incomes received in advance

Current Assets
Stock
Debtors
Bills Receivable
Income Outstanding
Cash at bank
Cash in hand

In order to know whether a transaction brings a change in working capital, it is

better to journalise the transaction and then classify the accounts of the
transaction to which account it belongs. If both the accounts of the transaction
belong to current category or non-current category, there will be no change in
working capital. On the otherhand if one account of transaction belongs to
current item and the other to non-current item, then there will be a change in
working capital.

6.6 SOURCES AND USES OF FUNDS

You have learnt that, funds represent that portion of current assets which is not
financed by current liabilities but is financed from the long-term/non-current
sources. You have also learnt that as and when a change takes place in current
items resulting from a change in non-current items the net working capital will be
affected. The increase and decrease in only non-current (long-term) assets and
liabilities alone will act as a source or an application (use) of funds. For the
preparation of funds flow statement it is necessary to find out the sources and
application of funds. Let us now identify the sources and application of funds.
Sources of Funds : The sources of funds can be classified as external sources
and internal sources. External sources of funds refer to sources of funds from
outside the business. These are : (a) raising additional capital, (b) increasing longterm borrowings, and (c) sale of fixed assets and long term investments. Internal
sources consist of funds that are generated internally by the organisation. Every
profitable sale brings in funds to the extent of the excess of sales revenue over cost
of goods sold. Such profits, called funds from operation, are also an important
internal sources of funds.

60

Application of funds : It may be noted that all funds raised through long term
source are not necessarily applied for financing the increase in net working capital.
A substantial part of this amount may be utilized for purchasing the fixed assets,
redemption of debentures or preference shares, payment of dividends and meeting
losses from operations, if any. In fact whatever is left the application of funds for
these purposes, will be the amount used for financing the increase in working
capital. Uses of funds thus are: (i) purchase of fixed assets or long term investments, (ii) redemption of debentures and preference shares, (iii) repayment of long
term loans, (iv) payment of dividends (v) meeting losses from operations (net loss),
and (vi) financing the increase in working capital.

6.7

Statement of Changes
in Financial Position

STATEMENT OF CHANGES IN FINANCIAL

POSITIONS --- CASH BASIS

There are two versions of the statement of changes in financial position. The
first version is called cash basis and the second one is called working-capital
basis. The cash basis of changes in financial position is to an extent close to
cash flow statement though it is presented in a different manner. This statement
first takes revenue and then removes all non-cash revenues and all cash related
revenues which are not recognised in computing revenues. In other words, at
this stage, we are interested to find out how much of cash is generated under
revenue head without bothering whether such revenue pertains to current year,
previous year or next year. Similarly, we consider expenses and then remove
all non-cash expenses and consider all cash expenses of previous period as well
as next period but not considered under the expenses value. For example, if
there is a payment for outstanding liability of previous year, it is also considered.
The difference of these two is funds or cash from operating activities. Next,
cash received from other sources are considered. In the last step, uses of
cash for capital transactions are considered to find out the net difference
between the sources and uses. The net difference shall be equal to net changes
in cash.
The main limitation or shortcoming of this method is its failure to segregate current
year income/expenses with other period income/expenses. Our next statement
overcomes this issue.

6.8

STATEMENT OF CHANGES IN FINANCIAL

POSITIONS---WORKING CAPITAL BASIS

As stated earlier, our main funds flow statement excludes all past and future
items and follows accrual and matching principle. Any such outstanding
expenses or prepaid expenses or income received in advance, etc. are adjusted
in a separate statement called working capital statement. Funds flow statement
under this method is prepared in two stages. The following diagram illustrates
the concept.
Assets

Liabilities + Equity
Permanent Capital

Fixed Assets

Share Capital + Reserves

Long-Term Loan

Current Assets

Current Liabilities

Funds derived from permanent capital are reduced by funds used for fixed
assets acquisition. The balance is the amount available for working capital purpose.
The working capital statement shows the difference between the current assets and
current liabilities. Thus the above format clearly brings out how much of long-term
funds are used for working capital or how much of short-term working capital is
used for long-term purpose.
In this unit our funds flow analysis is based on working capital concept which you
will study in detail under 6.9 Funds Flow Statement of present unit.

61

An
Overview
Analysis
of Financial
Statements

Activity 5
1)

Refer the two sets of Changes in Financial Positions statements. Briefly write
important differences between the two statements.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2.

Briefly write your understanding under each of the two formats which one you
feel is useful in your analysis.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

3.

List down atleast three financial transactions that leads to differences in funds
flow from operations.
.................................................................................................................
.................................................................................................................
.................................................................................................................
.................................................................................................................

6.9 FUNDS FLOW STATEMENT

Fund flow statement is intended to explain the magnitude, direction and the causes
of changes in the position of funds (net working capital) that took place during the
two balance sheets dates. Thus, it highlights the basic changes in the financial
structure, asset structure and the liquidity position of a business between two
balance sheet dates. But primarily, it reveals changes in the financial position of the
company by identifying the sources and application of funds resulting from financing
and investing decisions that took place during a particular period.
The preparation of fund flow statement involves essentially the following three steps:
1)

Schedule of Changes in Working Capital.

2)

Statement of Funds from Operations.

3)

Preparation of the Funds Flow Statement (on working capital basis).

6.9.1 Schedule of Changes in Working Capital

As explained earlier, the first step in the preparation of fund flow statement is to
prepare the schedule of changes in working capital. For this purpose, all non-current
items are to be ignored as the net working capital is simply the difference between
current assets and current liabilities.

62

In order to ascertain the amount of increase or decrease in the net working capital,
it could be noted that :

i)

an increase in any current asset, between the two balance sheet dates, results
in an increase in net capital and a decrease in any current asset result in a
decrease in net working capital; and

ii)

an increase in any current liability, between the balance sheet dates, decreases
the net working capital whereas a decrease a in any current liability increases
the net working capital.

Statement of Changes
in Financial Position

The schedule of changes in working capital may be prepared with the help of the
following specimen statement:
Proforma of Schedule of Changes in Working Capital

Particulars

Changes in Working
Capital
Previous Year Current Year Increase Decrease
Rs.
Rs.
(Debit)
(Credit)
Rs.
Rs.

Current Assets:
Cash in hand
Cash at Bank
Marketable Securities
Bills Receivable
Debtors
Stock
Prepaid Expenses
Current Liabilities:
Creditors
Bills Payable
Outstanding Expenses
Working Capital:
Increase/Decrease
in Working Capital

Illustration 1
From the following summarised Balance Sheets of ABC Ltd. as on 31st March,
2004 and 2005, prepare a schedule of changes in working capital:
Liabilities
Equity share capital

2004
Rs.

2005
Rs.

1,20,000

1,20,000

Preference share capital

Assets

2004
Rs.

2005
Rs.

90,000

75,000

Sundry debtors 1,20,000

72,000

Fixed assets

----

30,000

6,000

6,000

Profit and Loss a/c

12,000

16,200

Prepaid expenses 3,900

Debentures

33,000

38,400

Bank

Conditors

36,000

39,000

Bank Overdraft

37,500

14,400

2,44,500

2,64,000

General Reserve

Closing stock

30,000 1,05,000
600

1,500
10,500

2,44,500 2,64,000

63

An
Overview
Analysis
of Financial
Statements

Solution
Schedule of Changes in Working Capital
2004
Rs.

2005
Rs.

1,20,000

72,000

30,000

1,05,000

3,900

Changes in working capital

Increase (+) Decrease (--- )
Rs.
Rs.

Current Assets:
Sundry Debtors

---

48,000

75,000

---

1,500

---

2,400

600

10,500

9,900

1,54,500

1,89,000

Creditors

36,000

39,000

Bank Overdraft

37,500

14,400

73,500

53,400

81,000

1,35,600

Closing Stock
Prepaid Expenses
Bank

Current Liabilities:

Working Capital

3,000
23,100

Net increase in working

capital
54,600
1,35,600

6.9.2

54,600
1,35,600

1,08,000

1,08,000

Statement of Funds from Operations

You know that profit is an important source of funds. Profit is the result of revenue
over expenses. When a business earns profit the net working capital gets increased
to the extent of the profit earned. Therefore, the profit earned constitutes an
important element of the funds provided by operations. Certain items charged and
revenues earned actually do not involve any flow of funds during the current period.
Similarly, certain deferred revenue expenses written off like preliminary expenses,
discount on issue of shares etc. do not involve any outflow of funds. Hence, these
items are added back to the net profit in order to arrive at the amount of funds from
operations. Also there are certain non- operating incomes and expenses like profit
or loss on the sale of fixed assets, dividend from investment, etc. are taken into
account to arrive at net operating results of the business. The profit or loss arising
out of these transactions are not regular operations of business. Hence, the effect
of these items must not be taken into account while preparing funds from
operations, i.e., the profit on such items are to be excluded from the net profit and
loss must be added back to the net profit to ascertain the amount of funds from
operations. There are many items which are charged and credited to profit and loss
account but do not affect working capital. Hence, all such items need adjustment to
calculate funds from operations.
There are two methods to calculate Funds from Operations :

64

1)

Statement of Funds from Operations Method.

2)

Adjusted Profit and Loss Account Method.

Statement of Funds from Operations Method

Under statement form, all non-funds or non-trading charges which were already
debited to Profit and Loss Account are added back to net profit and all non-trading
incomes which were already credited to profit and loss account are to be subtracted
from the net profit. Funds from operations may be calculated with the help of the
following proforma:
Proforma of Statement of Funds from Operations
Rs.
Net Profit (Current year)
Add: Non-fund and non-trading charges :
(Already debited to P& L a/c)
Depreciation Preliminary expenses
Transfer to General Revenue
Transfer to Sinking Fund
Provision for Taxation
Proposed dividend
Loss on Sale of Fixed assets

Statement of Changes
in Financial Position

Rs.
xxx

...
...
...
...
...
...
Total

Less:
Non-fund items and non-trading Incomes:
(Already credited to P&L a/c)
Profit on sale of fixed assets
Profit on revaluation of fixed assets
Non-operating incomes:
Dividend received/accrued
...
Refund of Income tax
...
Rent received/accrued, etc.
...

xxxx
xxxx

...
...
...

...

Funds from Operations

xxx
xxxx

Note: In case Profit and Loss Account shows Net Loss, it should be taken as
an item which decreases funds and therefore, all the items shown under
Add head above should be subtracted and those shown under less head
should be added to the Net loss.
Adjusted Profit and Loss Account Method
Funds from Operations may also be computed in an Account Form which is as
follows:
Proforma of Adjusted Profit and Loss Account
To Depreciation
To Preliminary expenses
(written off )
To General Reserve
(Transfer)
To Sinking fund (Transfer)
To Provision for Taxation
To Proposed Dividend
To Loss on sale of fixed assets
To Net Profit
(current year)

xx
xx
xx
xx
xx
xx
xx
xx
xx
xxxx

By Net Profit
(previous year)
By Dividend Received
By Refund of Tax
By Rent Received
By Profit on Sale of
Fixed assets
By Profit on revaluation
of fixed assets
By Funds from operation
(Balancing figure)

xxx
xxx
xxx
xxx
xxx

xxx
xxx
xxxx

65

An
Overview
Analysis
of Financial
Statements

Illustration 2
From the following Profit and Loss Account, calculate funds from operations under
both the methods as stated above.
Profit and Loss Account
Rs.
To Opening Stock
To Purchases

1,28,000
1,60,000

Less : Returns

By Sales

4,10,000

Less:Returns

32,000 1,28,000

To Wages paid

Rs.
10,000

By Closing Stock

4,00,000
3,20,000

80,000

Add : Outstanding 40,000 1,20,000

To Gross Profit c/d

3,44,000
7,20,000

7,20,000

To Rent paid
40,000
To Salary
1,00,000
To Depreciation
12,000
To Discount on issue of shares 50,000

By Gross Profit b/d

3,44,000
By Interest on Investments 10,000

To Preliminary expenses
(written off)

20,000

To Goodwill (written off)

To Net Profit c/d

24,000
1,08,000
3,54,000

3,54,000

Solution
Method I
Statement of Funds from Operations
Rs.
Net Profit as per Profit and Loss account
Add: Depreciation

Rs.
1,08,000

12,000

Discount on issue of shares

50,000

Preliminary expenses

20,000

Goodwill written off

24,000

1,06,000
2,14,000

Less: Interest on investments

10,000

Funds from operations

10,000
2,04,000

Method II

To Depreciation

To Discount on issue
of shares

50,000

To Preliminary expenses

20,000

To Goodwill written off

24,000

To Net Profit
(Current year)
66

Adjusted Profit and Loss Account

Rs.
12,000
By Net Profit
(Previous year)
By Interest on investments

Rs.
---10,000

By Funds from operations 2,04,000

(Balancing figure)

1,08,000
2,14,000

2,14,000

When all the information is available, it is relatively easy to calculate the amount of
funds from operations. Some times, full information is not available and it becomes
necessary to dig out the hidden information on the basis of clues available. Let us
now study a few situations involving such items and learn how will these be
ascertained and adjusted for determining the amount of funds from operations.
1)

Statement of Changes
in Financial Position

Depreciation

It is a practice in every business to write off dipreciation on fixed assets which is

debited to Profit and loss account and a corresponding credit to Fixed asset
account. Since, both profit and loss account and the Fixed asset account are noncurrent accounts, depreciation is a non-fund item. It is neither a source nor an
application of funds. It is added back to operating profit to find out Funds
from operations.
When the profit and loss account is given, whether in full or as a summary thereof, the

amount charged as depreciation can be easily ascertaind. But when any details
regarding the income statement are not given, the depreciation amount is to be
ascertained from the data given in the balance sheet and from the other available
information. If the figures given in two Balance Sheets show the opening and
closing balances of the asset concerned at their depreciated value (cost less
depreciation till date) and there is no mention of purchase and sale of the asset
during that year, the difference between the opening and closing balance may be
considered as the depreciation charged during the years. Sometime, the fixed
assets are shown at cost on the assets side and the depreciation or, as a provision
for depreciation or as accumulated depreciation, is either shown as a deduction
from the fixed asset concerned or appears on the liabilities side. In such a situation,
the increase in the amount of accumulated depreciation during the year (assuming
that there were no purchases and sales of fixed assets) must be taken as the
amount of depreciation charged during that year. Study Illustrations 3 given below
and learn how will the amount of depreciation is to be ascertained.
Illustration 3
From the following, ascertain the amount of machinery for the year 2005:
Balance Sheet (asset-side only)
As on 31.12.2004

As on 31.12.2005

Rs.
80,000

Rs.
1,00,000

Furniture at Cost - less

depreciation

Other information : Depreciation Charged during the year on Machinery Rs. 8000
Solution
Machinery Account
Rs.
To Balance B/d

80,000

To Bank (Purchases)
(Balancing figure)

28,000
1,08,000

Rs.
By Depreciation

8,000

By Balanace c/d

1,00,000
1,08,000

Though the difference between the figures of the asset on two balance sheet dates
is Rs. 20,000, the value of machinery bought during the year is Rs. 28,000 and not
Rs. 20,000. This has been worked out after taking into account the amount of
Rs. 8000 as depreciation.
67

An
Overview
Analysis
of Financial
Statements

2)

Profit or Loss on Sale of Fixed Assets

When a fixed asset is sold at a price which is higher than its book value, the profit
on its sale is credited to profit and loss account. Hence, this amount will have to be
deducted from the net profit in order to ascertain the amount of funds from
operations. Similarly, when a fixed asset is sold at a loss (price is less than its book
value), the loss is charged to profit and loss account and it becomes necessary to
add back this amount to the net profit so as to show the correct amount of funds
from operations. The purpose of adjusting the amounts of profit or loss on sale of
fixed assets in the net profit is to avoid double counting of such profit or loss as the
same is already included/excluded in the amounts from the sale of the fixed assets
which would be shown separately as a source of fund. Thus, the actual sale of
fixed assets are shown as a source of funds, and, if there is a profit on sale it must
be subtracted from the net profit, and, if there is a loss the same must be added
back to the net profit. This adjustment is necessary for ascertaining the correct
amount of funds provided by operations.
If complete information is available with regard to purchase and sale of fixed assets
it will not be a problem to ascertain the amount of depreciation, value of assets
purchased, sale proceeds, gain/loss on such a sale and depreciation charged till the
date of sale of the assets sold. When detailed information is not available, then you
have to ascertain the hidden information. Look at the following illustration 4:
Illustration 4
Extracts of Balance Sheet
Liabilities

As on
31-12-04
Rs.

As on
31-12-05
Rs.

50,000

75,000

Accumulated
Depreciation

Assets

As on
As on
31-12-04 31-12-05
Rs.
Rs.

Machinery

37,500

90,000

Net profit for the year was Rs.75,000. Machinery with an original cost of
Rs. 12,500 was sold (accumulated depreciation on it being Rs. 5,000) for
Rs.10,000. Ascertain the amounts of depreciation, funds from operations, and
asset purchased.
Solution
Accumulated Depreciation Account
Rs.
To Depreciation on
Machinery sold
To Balance c/d

5,000
75,000
80,000

Rs.
By Balance b/d
By P& L A/cDepreciation charged
(Balancing figure)

50,000
30,000
80,000

Machinery Account
Rs.
To Balance b/d
To P & L A/c
(gain on sale)

37500
2,500

To Cash --- purchase

(balancing figure)

65,000
1,05,000

68

Rs.
By Accumulated
Depreciation

5,000

By Cash (sale)

10,000

By Balance c/d

90,000
1,05,000

Gain on Machinery Sold

Book Value
Less: Depreciation
Depreciated value
Sale price
Gain on sale
Funds from Operations:
Net profit as reported
Add : Depreciation charged
Less : Gain on Sale
Funds from Operations

Statement of Changes
in Financial Position

12,500
5,000
7,500
10,000
2,500

75,000
30,000
1,05,000
2,500
1,02,500

Note : The total sale proceeds of Rs. 10,000 will be shown as a source of fund in
the fund flow statement.
If we had merely compared the opening and closing balances of the accumulated
depreciation account, we would have wrongly concluded that depreciation charged
during the year was only Rs. 25,000. The sale of an old asset required that the
accumulated depreciation in respect there of should be transferred from
accumulated depreciation account to the concerned asset account, and it is only
after incorporating this entry that the actual depreciation charged during the year
can be correctly ascertained Thus, the depreciation charged during the year works
out to Rs. 30,000 and not Rs. 25,000. This amount of depreciation charged during
the year has been added back to the net profit, in order to ascertain funds from
operations as the same must have been debited to profit and loss account earlier.
3)

Profit or Loss on sale of Long term Investments

If a company made long term investment in other company, such investment must
be considered as non-current item like a fixed asset. If there is any profit or loss on
their sale, it would be dealt in the same manner as the profit or loss on the sale of
fixed assets. On the other hand, if the investments made are only for a short period,
in such a case the investments must be treated as an item of current asset. Any
changes in short term investments will appear in the schedule of changes in working
capital, otherwise it would appear directly in funds flow statement.
4)

Amortisation of Expenses and Writing Off of Intangible Assets

Sometimes, a firm decides to write off a portion of its intangible assets like goodwill,
patents, copy rights, etc., by charging it to the profit and loss account. Similarly, it
may decide to write off deferred revenue expenses, like preliminary expenses,
discount on issue of shares, etc., by charging some amount to the profit and loss
account. These write off amounts, like depreciation, are non-cash costs and reduce
the amount of profit. But they do not affect flow of funds. For this reason, such
amounts must be added back to the net profit to determine the amount of funds
provided by operations.
5)

Provision for Taxation

Provision for taxation represents the amount likely to be paid as tax after the
assessment is complete during the next accounting period. Thus, provision for taxes
is shown as a current liability in the balance sheet, and if for purposes of preparing
fund flow statement it is treated as such, this would appear in the schedule of
changes in working capital, and the amount of tax paid during the year will not be

69

An
Overview
Analysis
of Financial
Statements

shown as an application in the fund flow statement. However, as per practice, tax on
profits is normally treated as a non-current item for preparing the fund flow statement.
Hence, this will not be taken to the statement of changes in working capital. In fact,
the provision made during the current year will have to be added back to net profit to
find out the amount of funds from operations, as the same must have been debited to
profit and loss account earlier. As for the amount of tax paid, it must be shown as an
application of fund in the fund flow statement. It may be noted that if no additional
information is available, the provision for tax shown in the previous years balance
sheet shall be taken as the tax paid during the year, and the provision for tax shown in
current years balance sheet be treated as the amount of tax provided during the
current by debiting it to the current years profit and loss account. Of course, this
amount will have to be added back to net profit for ascertaining funds from
operations. This treatment of taxation is in strict conformity with the requirements of
the Accounting Standard on State of Changes in Position of Funds (AS-3).
6)

Proposed Dividends

Proposed dividend, as in the case of provision of taxation, can be treated either a

current liability or as a non-current liability and its treatment will differ accordingly. In
case it is treated as a current liability, it will appear as one of the items in the schedule
of changes in working capital and the amount of dividend paid will not be shown as an
application of funds in fund flow statement. But, as per the requirement of AS-3, the
proposed dividends are also to be treated as a non-current item for purposes of fund
flow statement. As such proposed dividends will not find a place in the schedule of
changes in working capital. The amount of proposed dividends relating to current year
if already deducted from profits, shall be added back for ascertaining the amount of
funds from operations, and the dividends actually paid during the year will be shown
as an application of funds. It may be noted that, just like provision for tax, if no details
are available, the proposed dividends shown in the previous years balance sheet shall
be taken as dividends paid during the year and the proposed dividends shown in
current years balance sheet shall be treated as the amount of dividends provided
during the current year by debiting it to the current years profit and loss appropriation
account.
7)

Provision for Doubtful Debts

Provision for doubtful debts is treated as a current item as it relates to an item of

current asset (debtors) and therefore it should appear in the schedule of changes in
working capital.

6.9.3 Preparation of Funds Flow Statement (on working capital

basis)
Funds flow statement is a statement which explains about the movement of funds
where from working capital originates and where into the same goes during the
accounting period. While preparing funds flow statement, current assets and current
liabilities are to be ignored and only changes in non-current assets and non-current
liabilities are taken into account. In otherwords, funds flow statement is prepared on
the basis of the changes in fixed assets, long term liabilities and share capital shown in
the Balance Sheet after taking into account the additional information given, if any.
This statement has two parts, Sources of funds and Application of funds. The
difference between sources and application of funds shows the net changes in the
working capital during a specified period. The transactions which increase working
capital are sources of funds and the transactions which decrease working capital are
application of funds. Therefore, funds flow statement is also called as a Statement of
Sources and Application of Funds, Inflow-outflow of Funds Statement etc.
70

This can be prepared either in a (1) Statement Form, or (2) Account Format as
given below:
1)

Statement of Changes
in Financial Position

Statement Form :
Proforma of Fund Flow Statement

Fund Flow Statement for the year ending ................................

A)

Sources of Funds :

Rs.

Rs.

1) Funds from operations

---------------

2) Issue of share capital

---------------

3) Issue of debentures

---------------

4) Long-term loans raised

---------------

5) Sale of fixed assets

-----------------------------

B)

xxxx

Uses of funds
1) Operating loss, if any

---------------

2) Redemption of preference share capital --------------3) Redemption of debentures

---------------

4) Repayment of long- term liabilities

---------------

5) Purchase of fixed assets

---------------

6) Payment of dividends (final and interim) --------------7) Payment of taxes

-----------------------------

Increase/Decrease in Working Capital (A-B)

2)

xxxx
xxxx

Account Format
Proforma of Fund Flow Statement
Fund Flow Statement for the year ending..............

Sources

Rs.

Uses

Rs.

Funds from operations .................

Operating loss, if any

Issue of Share capital

.................

Redemption of preference share capital .............

Issue of debentures

.................

Redemption of debentures

................

Long term loans raised .................

Repayment of long term loans

................

Sale of fixed assets

.................

Purchases of fixed assets

................

Decrease of Net
Working Capital

.................
.................

Payment of dividends (final and interim) ............

Payment of tax

(Balanicing figure)

.................

Increase of Net Working Capital

(Balanicing figure)

Total

................

................

Total
71

An
Overview
Analysis
of Financial
Statements

6.9.4

Steps in Preparation of Funds Flow Statement

To prepare funds flow statement, sources and application of funds have to be

ascertained. The usual sources of funds and uses of funds are as follows:
1)

Funds From Operation: Identify profit after tax but before any appropriation.
With that value, add the following values:
l

Depreciation on fixed assets

Any expenses written off during the year

Loss on sale of fixed assets and investments

Deduct the following:

l

Profit on sale of fixed assets and investments

Profit on revaluation of fixed assets

Non-operating incomes

2)

Fresh issue of Equity shares, issue of debentures, fresh loan from financial
institutions, etc. are next major sources of funds.

3)

Sale proceeds of fixed assets and investments are next source of funds.

4)

Non-operating income, which was deducted earlier to compute funds from

operation has to be added at this stage since it is also source of funds.

5)

The above four sources of funds give your gross value of funds generated
during the year. From this value deduct the following uses of funds of longterm nature.

6)

Purchase of fixed assets and investments has to be deducted.

7)

Repayment of loan, debentures, share repurchase are to be deducted.

8)

Payment of dividend, income-tax, etc., are to be reduced.

9)

The difference between the sources and uses of funds calculated above is
sources of funds from long-term operations.

10)

Find out changes in current assets and current liabilities values of two periods
and compute how much net change on working capital. The net changes in
working capital will be equal to net changes in long-term sources and uses.

6.10

FUNDS FLOW VS. OTHER FINANCIAL

STATEMENTS

Funds flow statement is unique compared to other statement since it converts a

stock statement (balance sheet) into a flow statement. As such, there is not much
of comparison or relationship between funds flow and other financial statements.
When compared to cash flow statements, which will be discussed in the next
section, funds flow gives a broader view of financial flow. While cash flow shows
how cash balance changed from one period to another period, funds flow statement
typically shows the changes in the balances of working capital, which includes cash
balance. Normally, funds flow statement is used to understand long-term stability of
business whereas cash flow statement is used to find out short-term stability. Cash
flow statement can be used to assess the quality of reported profit, whereas it
would be difficult to do such exercise with funds flow statement.

72

There are significant differences between funds flow statement and profit and loss
account. Though both of them are flow or period statement, profit and loss account
excludes all capital-related transactions like capital expenditure or capital receipts.

Funds flow statement considers both revenue and capital items. The only
relationship between the two statements is both are concerned with funds raised
through operating activities. To get funds from operating activities, we use profit
and loss statement and perform some adjustments.

Statement of Changes
in Financial Position

As discussed earlier, funds flow statement is a kind of extension of Balance Sheet.

There are number of similarities between the two statements. Many accounting
heads of both statements are common and the only difference is the valuation.
While Balance Sheet shows the figure as on a particular date, Funds Flow
Statement shows the period value. While Balance Sheets values are normally
positive, funds flow statement may show negative values on some of the items. For
instance, consider secured loan item of Balance Sheet. It might show a value of
Rs. 200 lakhs last year and Rs. 150 lakhs at the end of current year. Both are
positive values. In Funds Flow Statement, the secured loan account will have
negative value of Rs. 20 lakhs, since this much of amount is repaid and hence it is
application of funds. While Balance Sheet is a single statement, funds flow is
normally prepared in two stages and includes working capital statement.
Activity 3
1)

Visit some of the web sites of large Indian companies, which have also issued
American Depository Receipts (ADR). From the web sites, download the
P&L account as per Indian Accounting Standards and also P&L account
drawn under US accounting standards (called US GAAP). Compare the two
statements and then briefly write your overall observations.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2)

Why do feel that the two figures are different? List down some of the
dominant reasons.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3)

Now, you check the cash flow statement reported under two systems and list
down your observations.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

6.11

IMPORTANCE OF FUNDS FLOW

STATEMENT

An important contribution of funds flow statement is to know how funds have

moved between long-term and short-term needs of the organisation. It is generally
believed that organisation needs to match assets and liabilities on time scale though
assets are always equal to liabilities. For instance, if a firm raises funds through 364
days commercial paper and uses the money to buy a plant. There is a asset-liability
mismatch between the sources and uses of funds. Suppose, the interest rate is
10% and expected return from the project is 12%. Today, the project looks

73

An
Overview
Analysis
of Financial
Statements

profitable. But what will happen when the interest rate increases to 13% from 10%
at the end one year. If the commercial paper is renewed or new commercial paper
is substituted for the same, the project profitability turns negative. Further, what is
the assurance that the company would be in a position to roll-over the commercial
paper or substitute a new paper. If there is delay or difficulty in doing it, it will put
lot of pressure on the part of organisation. Thus, prudential norms require use of
long-term funds for long-term purpose and short-term funds for short-term needs,
which is mainly working capital. Since it is difficult to exactly match this way,
normally, if the flow is from long-term sources to short-term uses, then it is
considered to be a good funds management. Here again, too much of excessive use
of long-term funds for short-terms is not good. Funds flow statement shows how
efficient the firm is in managing two sources of funds.
Funds flow statement is also useful to ascertain whether the firm is liquid or not and
whether the firm is in a position to raise funds from operation to sustain its
activities. If the firm has set some budgets, which show the funding pattern of
future expansion, funds flow statement will be useful to compare whether we are
able to achieve the budget terms. If the funds flow statement is prepared for the
future years, then it is possible for the management to plan in advance how to
manage the funds and what steps need to be taken today to raise different sources
of funds.
An analysis of working capital statements will be useful to know where the need
for working capital arises. Other things being equal, it is desirable to reduce the
working capital since investments in working capital yield very low return or zero
return. It is also possible to compare this statement with budgets to control the
growth of working capital. Let us consider the Funds Flow Statement of BHEL to
understand this point.
Bharat Heavy Electricals Ltd.
Funds Flow Statement
(Rs. in Crores)
Year

2001-02

2000-01

1999-2000 1998-99 1997-98

881.15

443.53

715.52

667.64

827.08

Funds from Fresh Loans

0.00

784.90

70.58

0.00

0.00

Sale of Investments

0.00

0.00

4.76

9.00

110.96

Miscellaneous Sources

0.00

12.35

0.00

10.73

17.96

881.15 1240.78

790.86

Sources of Funds
Funds From Operation

Total

687.37 956.00

Application of funds
Decrease in Loan funds

381.10

0.00

0.00

219.43

508.48

Investments in Fixed Assets

173.44

181.98

152.60

243.53

315.64

Dividend

97.91

73.43

73.42

61.19

61.19

Miscellaneous Uses

20.69

0.00

238.63

0.00

0.00

673.14

255.41

464.65

Net Funds from long-term sources

208.01

985.37

326.21

163.22

70.69

Increase in Working Capital

208.01

985.37

326.21

163.22

70.69

Total

74

524.15 885.31

BHEL working capital is showing steady increase over the years. However, in all
the five years, BHEL was able to generate adequate long-term funds to meet the
increasing short-term needs.
Let us consider one more large Indian company to understand the issue. Sterlite
Industries funds flow statement given below shows wide variation in the flow of
funds. Of the five years, funds from long-term sources turned negative and it

means, short-term sources are used to fund the long-term needs. As we know,
Sterlite made a number of acquisition and in that process, there are some
deviations in resources planning. As you see, the company is setting right the
situation in 2001. by bringing down the gap and hopefully, it will come to normal in
year 2002.

Statement of Changes
in Financial Position

Sterlite Industries (India) Ltd.

Funds Flow Statement
(Rs. in Crores)
Year

2001-02

2000-01

1999-2000 1998-99

1997-98

----166.03

130.48

512.77

235.78

191.02

11.34

0.00

110.27

0.00

188.17

Sale of Investments

2.34

0.00

4.86

0.00

0.00

Miscellaneous Sources

2.53

1.20

35.85

10.88

0.52

----149.82

131.68

663.75

246.66

379.71

169.08

73.14

44.57

4.75

85.14

93.05

419.97

737.52

2.25

10.35

1.81

33.64

57.51

45.32

38.53

20

51.38

964.99

142.65

213.76

468.85

Net Funds from long-term sources

----201.20

----833.31

521.10

32.90

----89.14

Increase in Working Capital

----201.20

----833.31

521.10

32.90

----89.14

Sources of Funds
Funds From Operation
Funds from Fresh Loans

Total
Application of funds
Decrease in Loan funds
Investments in Fixed Assets
Purchase of Investments
Dividend
Miscellaneous Uses
Total

6.12

LET US SUM UP

The statement of changes of financial position explains the differences in various

assets and liabilities items of balance sheet between the beginning of the year and
end of the year. It converts balance sheet into a flow statement. An increase in
liability side means the organisation has generated funds during the period. There
are broadly three sources of funds - funds from operation, funds from other longterm sources like equity, loan, etc. and funds generated from working capital (e.g.
increase in payables). There are broadly two uses of funds namely, funds required
to buy assets and other long-term need and funds required for current assets
(purchase of inventory, funding receivables, etc.). Funds flow statement can be
prepared on cash basis or working capital basis. Funds flow on cash basis is similar
to cash flow statement and hence there is limited use since all companies are asked
to give cash flow statement under AS-3. Funds flow statement on working capital
basis throws some insight further on the flow of funds between long-term and
short-term needs of organisation.
Funds flow statement is not required under the current Accounting Standards
and hence very few companies provide such statement. Further, funds flow
statement is not free from window dressing since uses only the two principal
financial statements. Many organisations prepare funds flow statement for
internal purpose and normally it is compared with budgets to set right deviation
from budgets.

75

An
Overview
Analysis
of Financial
Statements

6.13 KEY WORDS

Funds: Cash or net working capital.
Flow of funds: Movement or change in the net working capital.
Current Assets : Cash and other assets that are converted into cash or consumed
in the production of goods in the normal course of business.
Fund Flow Statement: Statement which shows the sources (inflows) and uses
(outflows) of funds between two balance sheet dates.
Funds from Operations: The amount of net profit that acts as a source of fund
i.e., profit before charging certain non-cash costs and before crediting items like
profit on sale of fixed assets.
Current - liabilities : Liabilities payable within one year.
Gross Working Capital : Total of current assets.
Net Working Capital: Excess of current assets over current liabilities.
Non-Current Items: Long term asset and long-term liabilities.
Schedule of Changes in Working Capital: Statement which reveals the effect
of item wise change in current asset and current liabilities on the net working
capital between two balance sheet dates.
Working Capital: That part of the capital which is required for recoming operations
of a business as distinguished from capital invested in fixed assets.

6.14 TERMINAL QUESTIONS

1) Compared to two principal financial statements namely, Profit and Loss
Account and Balance Sheet, what is additional insight you get from funds flow
statement?
2) Funds flow statement is only supplementary to P&L Account and Balance
Sheet; it cant be substitute to P&L Account and Balance Sheet - Do you
agree to this statement? Explain your views.
3) Discuss a few basic differences between cash concept of funds flow
statement and working capital concept of funds flow statement.
4) A firm is found to have negative changes in working capital. What does it
mean? Is it good for the firm in the long-run if the negative change in working
capital continues for a long period?
5) Funds Flow Statement also suffers from window dressing of accounts and
hence fails to give true view of funds movement; for instance, funds from
operation can be increased by recording a few dummy sales - Do you agree
to this criticism? Give your views.
6) From the following figures, prepare Funds Flow Statement under both methods
and then give your comments and observations.
76

Year 1

Year 2

510000

620000

30000

80000

240000

375000

10000

5000

790000

1080000

Equity Share Capital

300000

350000

14% Preference Share Capital

200000

100000

14% Debentures

100000

200000

Reserves

110000

270000

Provision for Doubtful Debts

10000

15000

Current Liabilities

70000

145000

790000

1080000

Statement of Changes
in Financial Position

Assets
Fixed Assets (Net Block)
Investments
Current Assets
Discount on Issue of Debentures
Total
Liabilities

Total
Additional Details
a)

Provision for Depreciation stood at 150000 at the end of Year 1

and Rs. 190000 at the end of Year 2.

b)

During the year, a machine costing Rs. 70000 (book value Rs. 40000)
was disposed of for Rs. 25000.

c)

Preference shares redemption was carried out at a premium of 5%.

d)

Dividend @ 15% was paid on equity shares for the year 1 during the
year 2.

7) Following is the summarised Balance Sheet of Bombay Industries Ltd. as on

December 31, 2004 and 2005 :
Balance Sheet
Liabilities

2004
Rs.

2005
Rs.

Sundry Creditors

40,400

43,200

Bills Payable

10,800

12,200

2,600

1,000

22,000

21,000

Outstanding Rent
Mortgage Loan

Assets

2004
Rs.

2005
Rs.

Cash and Bank

44,600

47,800

Debtors

10,800

17,000

Stock-in-trade

44,000

67,200

Temporary Investments

30,200

8,000

Share Capital

2,80,000 3,20,000

Plant & Machinery

Reserves

1,12,600 1,31,600

Land

50,000

50,000

Long-term investment

62,200

35,200

Proposed Dividend

28,000

32,000

4,96,400 5,61,000

2,54,600 3,35,800

4,96,400 5,61,000

You are required to prepare schedule of changes in working capital.

77

An
Overview
Analysis
of Financial
Statements

8) Funds Flow Statements of two large Indian textile companies are given below.
Analyse and give your views on the performance of the companies.
Bombay Dyeing & Manufacturing Company Ltd
Funds Flow Statement (Rs in Cr.)
Year

2002-03

2001-02

2000-01 1999-2000 1998-99

Funds From Operation

68.18

-286.50

38.16

79.74

1122.22

Funds from Fresh Loans

88.45

667.58

Sale of Investments

193.33

115.38

Miscellaneous Sources

46.09

156.63

---47.09

153.54

79.74

1789.8

Decrease in Loan funds

0.00

305.42

4.48

65.23

0.00

Investments in Fixed Assets

-5.49

-21.08

31.76

17.49

847.61

156.94

0.00

0.00

16.35

421.94

11.54

7.83

8.20

12.30

12.30

0.00

0.00

9.30

7.01

29.78

162.99

292.17

53.74

Net Funds from long-term sources

---6.36

---339.3

99.8

---38.64

478.17

Increase in Working Capital

---6.36

---339.3

99.8

---38.64

478.17

Sources of Funds

Total
Application of funds

Purchase of Investments
Dividend
Miscellaneous Uses
Total

118.38 1311.63

Raymond Ltd.
Funds Flow Statement (Rs. in Crore)
Year

2002-03

2001-02

2000-01

1999-2000 1998-99

130.40

98.52

165.53

129.21

165.74

Funds from Fresh Loans

4.36

Sale of Investments

19.78

15.92

1.10

0.90

3.09

131.50

123.56

165.53

Decrease in Loan funds

49.69

237.51

140.79

71.51

Investments in Fixed Assets

75.41

53.05

---401.60

17.43

86.85

Purchase of Investments

24.66

421.61

89

Dividend

27.62

27.62

18.41

11.26

15.02

0.21

2.75

Total
Net Funds from long-term sources

177.38
---45.88

80.67
42.89

276.18
---110.70

Increase in Working Capital

--- 45.88

42.89

---110.70

Sources of Funds
Funds From Operation

Miscellaneous Sources
Total

132.30 181.66

Application of funds

Miscellaneous Uses

78

258.48 176.13
---126.20
5.53
---126.20

5.53

9)

Calculate the Funds from Operations from the following Profit and Loss
Appropriation Account.
Rs.

Rs.

Salaries
Rent
Depreciation on plant
Preliminary expenses
Written off

25,000
9,000
15,000

Printing and stationery

Goodwill written off
Provision for tax
Proposed dividends
Net Profit

9,000
9,000
12,000
8,000
72,000

15,000

1,65,000

1,65,000

6,000

Statement of Changes
in Financial Position

Gross profit

1,50,000

Profit on sale of
buildings:
Book value Rs. 45,000
Sold for
Rs. 30,000

(Answer: Rs. 1,07,000)

Note: Provision for tax is treated as a non-current item.
10) Calculate fund/loss from operations from the fol1owing data:
P & L Alc (credit balance) as on April 01, 2004

Rs.
70,600

P & L Ale (credit balance) as on March 31, 2005

30,000

Loss on issue of debentures

12,000

Operating expenses

28,000

Premium of expenses written Off

13,000

Transfer to general reserve

15,000

(Answer: Operating Loss: Rs.600 No adjustment is needed for operating

expenses.)
11) From the following Balance Sheets, prepare Statement of Changes in
Working Capital and Adjusted Profit and Loss A/c for ascertaining Funds
from Operations.
Liabilities

Share Capital

31.3.2004 31.3.2005
Rs.
Rs.
1,50,000

2,00,000

Assets

Goodwill

31.3.2004
Rs.

31.3.2005
Rs.

57,500

45,000

1,00,000

85,000

8% Redeemable

Buildings

Preference Share

Plant

40,000

1,00,000

Capital

75,000

50,000

Debtors

80,000

1,00,000

General Reserve

20,000

35,000

Stock

38,500

54,500

Profit & Loss A/c

15,000

24.000

Bills Receivable

10,000

15,000

Proposed Dividend

21,000

25,000

Cash

7,500

5,000

Creditors

27,500

41,500

Bank

5,000

4,000

Bills Payable

10,000

8,000

Provision for Tax

20,000

25,000

3,38,500

4,08,500

3,38,500

4,08,500
79

An
Overview
Analysis
of Financial
Statements

Additional Information
a)

Depreciation of Rs. 10,000 and Rs. 15,000 has been charged on Plant and
Buildings respectively.

b)

lncome tax of Rs. 17,500 has been paid during the year.

(Answer : Increase in Working Capital : Rs. 25,500; Funds from Operation

Rs. 1,09,000)
12) Prepare a statement of funds from operations and the schedule for changes in
working capital
Liabilities

31.3.2004 31.3.2005
Rs.
Rs.

Assets

Share Capital

25,00,000 20,00,000

Fixed Assets 15,50,000 15,00,000

Surplus
Proposed Dividend
Secured loans
Current liabilities

7,50,000
5,00,000

2,50,000
6,00,000

12,50,000 14,00,000
25,00,000 30,00,000

31.3.2004
Rs.

31.3.2005
Rs.

Investments
75,000
----Stock
37,50,000 39,37,500
Debtors
20,00,000 17,50,000
Cash & bank 1,25,000
62,500

75,00,000 72,50,000

75,00,000 72,50,000

Additional Information
a)

Dividend paid during 2004-05 Rs. 2,50,000.

b)

Depreciation on fixed assets for the year Rs. 1.5 lakh.

(Answer : Decrease in Working Capital: Rs. 6,25,000; Funds from operations

Rs. 8,00,000).
13)

From the following Balance Sheets of ABC company Ltd., prepare:

i)

Statement of Changes in Working Capital.

ii)

Funds Flow Statement.

Liabilities
Creditors
Bills Payable
12% Debentures
Share Capital
Profit & Loss a/c

31.3.2004 31.3.2005
Rs.
Rs.
45,000
35,000
80,000
1,25,000
42,000

20,000
23,000
----1,50,000
62,000

3,27,000

2,55,000

Assets
Goodwill
Cash
Debtors
Stock
Investments
Land (Cost)
Preliminary Expenses

31.3.2004 31.3.2005
Rs.
Rs.
5,000
70,000
90,000
1,20,000
10,000
27,000
5,000

12,000
25,000
98.000
87,000
15,000
15,000
3,000

3,27,000

2,55,000

Additional lnformation

80

i)

Land sold for Rs. 24,000

ii)

Dividend paid Rs. 30,000

iii)

Debentures redeemed at a premium of 10%.

(Ans : Net decrease in working capital Rs. 33,000 Funds operations : Rs. 41,000)

14) From the following Balance sheets of a Company as on 31st March, 2004 and
31st March 2005 you are required to prepare Schedule of Changes in the
Working Capital and a Funds Flow Statement
Liabilities

31.3.2004
Rs.

31.3.05 Assets
Rs.

Share Capital
1,00,000 1,50,000 Non-current Assets
Profit & Loss Account
40,000 60,000 Current Assets
Provision for Taxes
20,000 30,000 Discount on Issue
Proposed Dividend
10,000 15,000 of Shares
Creditors
25,000 37,000
Bills Payable
15,000 22,500
Outstanding Expenses
20,000 30,500
2,30,000 3,45,000

31.3.2004
Rs.

Statement of Changes
in Financial Position

31.3.05
Rs.

1,00,000 2,00,000
1,30,000 1,40,000
---

5,000

2,30,000 3,45,000

Additional Information is given below:

(i) Tax paid during 2004-05 Rs. 25,000; (ii) Dividend paid during 2004-05 Rs. 10,000.
(Answer : Net decrease in working capital : Rs. 20,000, Funds From operations :
Rs. 70,000)
Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.

6.15 FURTHER READINGS

Robert N Anthony and James S Reece, Management Accounting: Text and Cases,
Richard D. Irwins Inc, Homewood, Illinois.
M C Shukla, T S Grewal and S C Gupta, Advanced Accounts (Volume II),
S.Chand & Company Ltd. New Delhi.

81

Analysis of Financial
Statements

UNIT 7 CASH FLOW ANALYSIS

Structure
7.0

Objectives

7.1

Introduction

7.2

Need for Cash Flow Statement

7.3

Cash Flow Statements vs. Other Financial Statements

7.4

Preparation of Cash Flow Statement

7.4.1

Sources and Uses of Cash

7.4.2

Ascertaining Cash from Operations

7.5

Preparation of Cash Flow Statement

7.6

Regulations Relating to Cash Flow Statement

7.7

Cash Flow Statement Formats

7.8

Cash Flow from Operating Activities

7.9

Cash Flow From Investing and Financing Activities

7.10 Uses of Cash Flow Analysis

7.11 Distinctions between Funds Flow and Cash Flow Analysis
7.12 Let Us Sum Up
7.13 Key Words
7.14 Terminal Questions
7.15 Further Readings

7.0 OBJECTIVES
The objectives of this unit are to:
!

explain importance of cash flow statement for investors and other

stockholders;

compare the differences between cash flow statement with other financial
statements;

explain regulations relating to preparation of cash flows;

familiar with the methodology for preparation of cash flow statement and
different components of cash flow statement; and

comprehend how cash flow statement can be used in real life for different
decision making.

7.1 INTRODUCTION

82

The statement of cash flows, required by the Accounting Standard-3, is a major

development in accounting measurement and disclosure because of its relevance
to financial statement users. Cash Flow Statement is reasonably simple and easy
to understand. It is also difficult to fudge or manipulate the cash flow numbers
and hence often used as a way to test the real profitability of the firm. For
instance, if your company approaches a bank for a loan, your company will
normally highlight the profitability of your business as your strength. But the bank

manager may not be sure how you arrived at the profit, particularly when we read
lot of accounting related scams. Hence, the bank manager would like to examine
whether you have actually earned the profit or not. Cash Flow Statement will be
useful to examine whether the profits are realised and if so, to what percentage of
profit a firm has realised. In other words, a company that shows high level of
profit need not be liquid in cash. Suppliers of goods will also be interested to
examine the cash flow position of the company before supplying goods on credit.
Investor, who have no control on management, will also be interested in examining
the cash flow to supplement her/his analysis on profitability of the business.

Cash Flow
Analysis

Activity 1
1)

Before you read further, can you think about why profit reported in P&L
account might be misleading? Can you think about some examples of how
profit can be overstated?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2)

If you have identified some examples, can you think about why companies
resort to do such things and also how you can find out if you are an outsider?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

7.2

NEED FOR CASH FLOW STATEMENT

The primary objective of the statement of cash flows is to provide information

about an entitys cash receipts and cash payments during a period. The net effect
of cash flow is provided under different heads namely cash flow from operating,
investing and financing activities. It helps users to find answers to the following
important questions:
a)

Where did the cash come from during the period?

b)

What was the cash used for during the period?

c)

What was the change in the cash balance during the period?

The AS-3 identifies two important uses of cash flow statement as follows:
a)

A cash flow statement, when used in conjunction with the other financial
statements, provides information that enables users to evaluate the changes in
net assets of an enterprise, its financial structure (including its liquidity and
solvency) and its ability to affect the amounts and timing of cash flows in
order to adapt to changing circumstances and opportunities. Cash flow
information is useful in assessing the ability of the enterprise to generate cash

83

Analysis of Financial
Statements

and cash equivalents and enables users to develop models to assess and
compare the present value of the future cash flows of different enterprises. It
also enhances the comparability of the reporting of operating performance by
different enterprises because it eliminates the effects of using different
accounting treatments for the same transactions and events.
b)

Historical cash flow information is often used as an indicator of the amount,

timing and certainty of future cash flows. It is also useful in checking the
accuracy of past assessments of future cash flows and in examining the
relationship between profitability and net cash flow and the impact of changing
prices.

A Statement issued by Securities and Exchange Board of India in 1995 when it

made the cash flow statement mandatory also lists the above are primary objective
of requiring the listed companies to provide cash flow statement to the investors.
The importance of cash flow as a measure of corporate performance and as a
critical variable to appraise loan decisions has been supported by several influential
persons or organisations. The importance of cash flow statements is clear from the
following excerpts:
1)

Harold Williams (the then chairman of the SEC) made the following comments
in a speech to the Financial Executives Research Foundation:
Corporate earnings reports communicate, at best, only part of the story.
And, their most critical omission - in recognition that insufficient cash
resources are a major cause of corporate problems particularly in
inflationary times - is their failure to speak to a corporations cash
position. Indeed, in my view, cash flow from operations is a better
measure of performance than earnings-per-share. What should be
considered is more revealing analytical concepts of cash flow or cashflow-per-share, which reflect the total cash earnings available to
management - that is earnings before expenses such as depreciation and
amortization are deducted. An even more sophisticated - and, in my
opinion, more informative - analytical tool is free cash flow, which
considers cash flow after deducting such spiralling corporate costs as
capital expenditures. This technique allows (evaluation of ) the costs of
maintaining the corporations present capital and market position - cost
which are, in essence, expenses and cash flow obligations that should be
considered in determining the corporations financial position. Arthur
Young Views (January 1981).

2)

Robert Morris Associates, a national association of bank loan and credit

officers, advocates the use of cash flow analysis as a tool necessary to
evaluate, understand, and accurately determine a borrowers ability to repay
loans:
Banks lend cash to their clients, collect interest in cash, and require debt
repayment in cash. Nothing less, just cash. Financial statements,
however, usually are prepared on an accrual basis, not on a cash basis.
And projections? Same thing. Projected net income, not projected cash
income. Yet, cash repays loans. Therefore, we are compelled to shift our
focus if we truly wish to assess our clients ability to pay interest and
repay debt. We must turn our attention to cash, working through the
roadblocks thrown up by accrual accounting, to properly evaluate the
creditworthiness of our client. (RMA Uniform Credit Analysis,
Philadelphia, Robert Morris Associates, 1982).

84

Activity 2
1)

Cash Flow
Analysis

Pick up annual report of a company and show the Balance Sheet and Profit
and Loss account to your non-accounting friends. Ask them how comfortable
in reading the two statements and record their observation here.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

Now, show the Cash Flow statements to them and ask them whether they are
able to understand anything better about the company. Record their statements
here.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

3)

Examine the above two and record your overall assessment whether there is
any improvement in their understanding.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

7.3

CASH FLOW STATEMENT VS. OTHER

FINANCIAL STATEMENTS

The cash flow statement is different from other principal financial statements in
many different ways. Financial statements like P&L account and Balance Sheet
are prepared using accrual accounting principle. For instance, when a firm sells
its products, it is assumed that profit is realised. It is assumed as a going concern,
the firm will eventually realise its profits. Similarly, the expenses incurred against
the sale are assumed to have incurred or paid irrespective of the fact whether
cash is paid or not. Interest expenses are charged against profit though it is an
outcome of financing decision. Several non-cash expenses like depreciation are
also charged against profit. On the other hand, cash flow statement is prepared
on the principle for cash accounting concept. It is simply a summary of cash
book classified under three headings namely cash flow from operating, investing
and financing activities. In a broad context, the cash flow from operating activities
culls out all Profit and Loss Account entries of cash book (like sales, material,
wages, etc.,) and summarise the same. The cash flow from investing activities
summarises all the assets side entries like purchase of fixed assets, sale of fixed
assets, etc., of cash book. Finally, the cash flow from financing activities
summarises all the liability side entries like borrowing, repayment, fresh equity,
etc. of cash book. The following table shows the Cash Flow Statement of a
company, which simply summarises the cash book entries under different
headings, which are easily readable.

85

Analysis of Financial
Statements

Cash Flow Statement Under Direct Method

(A) Operating Activities
Cash Collection from Sales

115716

Less: Cash Paid for:

Raw Materials

(18478)

Direct Labour

(13452)

Overhead

(8758)

(40688)

Less: Cash Paid for Non-factory Costs:

Salaries and Wages
Other Sales and Administration

(14625)
(413)

(15038)

Cash Generated from Operation

59990

Add: Interest Earned

390

Net Cash from Operating Activities (X)

60380

(B) Investment Activities

Purchase of Plant Assets

(23000)

Short-term investments

(12000)

Net Cash Flow from Investing Activities (Y)

(35000)

(C) Financing Activities

Dividends paid
Net Cash Flow from Financing Activities (Z)
(D) Net Change in Cash (X ----- Y+Z)

(25000)
(25000)
380

Cash at the Beginning of the year

6000

Cash at the End of the Year

6380

Profit and Loss account is also equally readable but the problem is it may be
confusing too. For example, many companies as a part of expenditure, put an
additional entry titled changes in stocks or increase/decrease in stocks and
sometime add and sometime deduct the value from sales. For example, see the next
table, where we have reproduced Birla 3M Ltd. Profit and Loss Account for the
year ended 31st December, 2001. As an accounting student, you will know that this
is nothing but changes in opening and closing stock but a non-accounting reader will
get confused. Many readers are not aware of the meaning of depreciation and also
Balance in Profit and Loss Account Brought Forward. Starting from the year
2001-02, the P&L account has one more confusion for ordinary readers namely
Deferred Tax. To add further confusion, in the Balance Sheet, it has both
Deferred Tax Asset and Deferred Tax Liability. The mismatch between the
depreciation value and deferred tax value shown in P&L account and Balance
Sheet is further confusion to ordinary readers. As an accounting, you are familiar
with all these jargons but it is really a maze for ordinary readers. They will give up
after reading couple of pages.

86

The Balance Sheet is also equally puzzle to investors. Many students and even
executives ask us if the company has huge reserves and surplus, does it mean the
company has such amount of cash? Many of you after having some much
accounting background would still have the doubt. In fact, when we answer such
questions that Reserves will not be in the form of cash, then the next question is
where is it or where it has gone or when it is not in the form of cash, why is it called
Reserves? These are really genuine doubts to ordinary readers of financial
statements. To a great extent, cash flow statement is free of this kind of confusion.

Profit and Loss Account for the Year Ended 31 December, 2001
Schedule
Number

For the year

ended
31.12.2001

For the year

ended
31.12.2000

2,297,840,701

2,078,920,263

18,576,299

10,484,038

2,316,417,000

2,089,404,301

1,065,927,769

1,054,428,027

827,610,543

747,207,666

107,210,150

99,240,285

Depreciation

60,747,768

47,550,244

(Increase)/decrease in inventories

22,942,022

(59,994,012)

125,130

500,517

2,084,563,382

1,888,932,727

Profit from Operations

231,853,618

200,471,574

Profit before tax

231,853,618

200,471,574

93,900,000

92,938,485

Net Profit

137,953,618

107,533,089

Balance in Profit & Loss

(Account brought forward)

347,096,664

239,563,575

Balance Carried to Balance Sheet

485,050,282

347,096,664

Cash Flow
Analysis

Income:
Sales
Other Income

13

Expenditure:
Finished Goods Purchased (traded)
Manufacturing, Administrative
and Selling Expenses
Execise Duty Paid

Public issue expenses amortized

Provision for Income Tax

Notes to Accounts

16

Activity 3
1)

Visit some of the web sites of large Indian companies, which have also issued
American Depository Receipts (ADR). From the web sites, download the
P&L account as per Indian Accounting Standards and also P&L account
drawn under US accounting standards (called US GAAP). Compare the two
statements and then briefly write your overall observations.
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................

2)

Why do you feel that the two figures are different? List down some of the
dominant reasons.
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................

87

Analysis of Financial
Statements

3)

Now, you check the cash flow statement reported under two systems and list.
............................................................................................................................
............................................................................................................................
............................................................................................................................

7.4

CASH FLOW STATEMENTS

In the previous unit you have learnt that flow of funds means change in working
capital. An inflow of funds increases the working capital. Under cash flow
analysis, all movements of cash, rather than the inflow and outflow of working
capital would be considered. In other words, cash flow analysis, focuses attention
on cash instead of working capital. When the movements of cash (i.e., cash inflow
and cash outflow) is depicted in a statement, it is called Cash Flow Statement. Thus,
a cash flow statement summarises the causes of changes in cash position of a
business between two balance sheet dates. The flow of cash may be inflow or
outflow. When cash inflows are more than the cash outflows, there would be an
increase in cash balance. On the other hand, if cash outflows are more than the
cash inflows, there would be decrease in cash balance. The term cash includes both
cash and bank balances.
Availability cash, generally, determines the ability to meet the maturing obligations.
If cash is not available and current obligations cannot be met, it may result in
technical insolvency. Therefore, it is very essential for a business to maintain
adequate cash balance. A proper planning of the cash resources will enable the
management to have cash available whenever needed and employes surplus cash, if
any, to the most profitable or productive use. For this purpose, we prepare cash
flow statement which shows the sources and application during a year and the
resultant effect on cash balance.

7.4.1 Sources and Uses of Cash

The change in the cash position is computed by considering Sources and
Applications of cash which are as follows:
Sources of cash
The sources of cash includes:
1)

Cash from Operations

2)

Issue of Shares

3)

Issue of Debentures

4)

Long term Loans Raised

5)

Sale of Fixed Assets

Application (uses) of cash

Application of cash includes the following:

88

1)

Redumption of Preference Shares

2)

Redumption of Debentures

3)

Repayment of Loans

4)

Purchase of Fixed Assets

5)

Payment of Dividends

6)

Payment of Taxes

7.4.2

Cash Flow
Analysis

Ascertaining Cash from Operations

You have learnt that the main purpose of preparing a cash flow statement is to
explain the increase/decrease in the cash balance between the two balance sheet
dates and that it is prepared on the same pattern as the fund flow statement. Just
as the net profit is adjusted to ascertain the amount of funds from operations, the
funds from operations are now adjusted to ascertain the cash from operations. For
this purpose, you have to look at the changes in current assets and current liabilities
that have taken place during the year.
Conversion of Funds from Operations to Cash from Operations is necessary
because, under the working capital concept, funds from operations are based on
accrual concept of accounting, and total sales (whether credit or cash) and total
purchases (whether credit or cash) are recognised as sources and uses of working
capital respectively. But under a cash concept of funds only cash sales and
receipts from debtors are treated as sources of cash, while cash purchases and
payment to creditors are regarded as uses of cash. The same holds good for the
other incomes and expenses. Therefore, funds from operations (based on the
accrual concept) require conversion into cash from operations (based on cash
accounting). For example, assume that a business was started on 1-1-2003 and the
sales during the year were Rs. 3,00,000. Also assume that there were no closing
debtors. As there are no opening and closing debtors, it must be assumed that the
entire amount of Rs. 3,00,000 was realised by way of cash. Now assume that the
closing debtors on 31-12-2003 were Rs. 40,000. This would mean that the entire
amount of sales were not collected during the year. Since Rs. 40,000 (closing
debtors) was still to be realised, the cash from sales would be Rs. 2,60,000
(Rs. 3,00,000 ---Rs. 40,000).
The closing debtors on 31-12-2003 would become opening debtors on 1-1-2004.
Assume further that sales during 2004 were Rs. 4,00,000 and the closing debtors on
31-12-2004 were Rs. 50,000. In that case, the cash received from sales during the
year 2004 be ascertained as follows:
Opening Debtors as on 1-1-2004
Add : Sales during the year

Rs.
40,000
4,00,000

Less: Closing Debtors as on 31-12-2004

4,40,000
50,000

Cash from Sales during the year

3,90,000

The same result can also be obtained by subtracting the increase in debtors from
the sales during the year as shown hereunder.
Sales during the year (2004)
Less: Increase in Debtors during the year
(Closing debtors Rs. 50,000 ---- Opening debtors Rs. 40,000)
Cash from sales during the year

4,00,000
10,000
3,90,000

Cash from Operations can be calculated on the basis of the following equation:
Cash from Operations = Net profit + Opening Debtors at the beginning of the
year ---- Closing Debtors at the year end
or
= Net Profit + Decrease in Debtors
or
---- Increase in Debtors
89

Analysis of Financial
Statements

Similarly, in the case of credit purchases decrease in the creditors from one year to
another year will result in decrease of cash from operations because more cash
payments have been made to the creditors which will result in outflow of cash. On
the other hand, increase in creditors from one period to another will result in
increase of cash from operations as less amount has been paid to the creditors
which result in increase of cash balance in the business.
The effect of cash purchases in computing cash from operations can be calculated
as follows:
Cash from operations =

Net profit + Increase in Creditors

or
--- Decrease in Creditors

Similar is the case of Opening and Closing Stock. When opening stock is charged to
Profit and Loss account it reduces the net profit and when closing stock is credited
to Profit and Loss account it increases the net profit without corresponding change
in cash from operations. Therefore, the net profit needs for adjustments to arrive at
cash from operations as follows:
Cash from Operations = Net Profit + Opening Stock ---- Closing Stock
or
= Net Profit + Decrease in Stock
or
---- Increase in Stock
The effect of outstanding expenses, Incomes received in advance on cash from
operations is similar to the effect of Creditors i.e., any increase in these expenses
will result in increase in cash from operations and any decrease results in decrease
in cash from operations. This is on account of profit from operations calculated
after charging all expenses whether paid or outstanding. In case of income received
in advance, it is not be taken into account while preparing profit from operations as
it relates to the next year. Therefore, the cash from operations will be higher than
the actual net profit shown by the Profit and Loss Account. Therefore, it should be
added to net profit while calculating cash from operations. Prepaid expenses do not
have effect on the net profit for the year but it decreases cash from operations.
Prepaid expenses of the current year should be taken as an outflow of cash in the
cash flow statement, but the expenses paid in the previous year do not involve
outflow cash in the current year but they are charged to the Profit and Loss
Account. Therefore, prepaid expenses of the previous year which are related to
current year should be added back while calculating cash from operations. Similarly,
accrued income will increase the net profit for the year without corresponding
increase in cash from operations.
Therefore, the effect of prepaid expenses and accrued income on cash from
operations will be shown as follows:
Cash from operations = Net profit

+ Decrease in Prepaid Expenses and

Accrued Incomes
---- Increase in Prepaid Expenses and
Accrued Incomes

90

From the above discussion it may be summed up as increase in current assets and
decrease in current liability will have the effect of decrease in cash from
operations and decrease in current asset and increase in current liability will
have the effect of increase in cash from operations.

Cash Flow
Analysis

Illustration 1
Calculate Cash from Operations from the following information :
Profit and loss account for the year ended 31st March, 2005
Particulars
To Purchases
To Wages
To Gross Profit c/d

Rs.
40,000
10,000
10,000

Particulars

Rs.

By Sales

60,000

60,000
To Salaries
To Rent
To Depreciation on Plant
To Loss on Sale of Furniture
To Goodwill written off
To Net Profit

2,000
2,000
2,000
1,000
2,000
11,000

60,000
By Gross Profit b/d
By Profit on Sale of Building

20,000

10,000
10,000

20,000

Additional information:

Stock
Debtors
Creditors
Bills receivable
Outstanding expenses
Bills payable
Prepaid expenses

Balance as on
31st March, 2004
31st March, 2005
20,000
24,000
30,000
40,000
10,000
15,000
10,000
16,000
6,000
10,000
8,000
4,000
2,000
1,000

Calculate Cash from Operations.

Solution
Calculation of Cash from operations
Net Profit as per Profit and Loss account
Add : Non-cash items: (i.e., Items which
do not result in outflow of cash)
Depreciation on Plant
Loss on sale of Furniture
Goodwill written off
Increase in Creditors
Increase in Outstanding expenses
Decrease in Prepaid Expenses
Less: Non-cash items (i.e., items which
do not result in inflow of cash):
Profit on Sale of Building
Increase in Stock
Increase in Debtors
Increase in Bills receivable
Decrease in Bills payable
Outflow of Cash from Operations

Rs.
11,000
Rs.
2,000
1,000
2,000
5,000
4,000
1,000

10,000
4,000
10,000
6,000
4,000

15,000
26,000

34,000
(----) 8,000
91

Analysis of Financial
Statements

7.5

PREPARATION OF CASH FLOW

STATEMENT

The cash flow statement is similar to fund flow statement. You have learnt in
Section 7.4 that, apart from cash from operations, the source and uses of cash are
the same as those shown in the fund flow statement. Usually, cash flow statement
starts with the opening cash balance followed by the details of sources and uses of
cash. The opening balance plus the sources of cash minus the uses of cash should
be exactly to the closing balance of cash which is shown as the last item in the cash
flow statement. A cash flow statement can be prepared either in Vertical form or an
Account form as shown below:
Vertical Form of
Cash Flow Statement
for the year ending . . . . . . . . . . . .
Rs.
Cash Balance on 1.1.20 ..............
Add : Sources of Cash
Cash from Operations
Issues of shares
Raising of long-term loans
Sale of fixed assets

Rs.
..................

..................
..................
..................
..................
..................

Less: Uses of Cash

Redemption of redeemable preference shares ..................
Redemption of debentures
..................
Repayment of long-term loans
..................
Purchase of fixed assets
..................
Payment of tax
..................
Payment of Dividends
..................
..................
Cash Balance as on 31-12-20...........
Account Format
The cash flow statement can also be prepared in an account form starting with an
opening balance of cash on its debit side and ending with the closing balance of
cash on its credit side as shown below:
Account Form of
Cash Flow Account for the year ending.........
Rs.
Rs.
To Opening Cash Balance
......
By Redumption of Preference Shares...

92

To Cash from Operations

......

By Redumption of Debentures

......

To Issue of Shares

......

By Repayment of Long term Loans......

To Long term Loans

......

By Purchase of Fixed Assets

......

To Sale of Fixed Assets

......

By Payment of Tax

......

By Payment of Dividends

......

By Cash Balance (closing)

(Balancing figure)

......

7.6

REGULATIONS RELATING TO CASH FLOW

STATEMENT

Cash Flow
Analysis

Accounting standards in India are formulated by the Accounting Standards Board

(ASB) of the Institute of Chartered Accountants of India (ICAI). Though
International Accounting Standard Committee has revised the International
Accounting Standard-7 (IAS-7) in 1992 and switched over to cash flow statement,
Accounting Standard-3 (AS-3) of ASB, which is equivalent to earlier IAS-7, was not
revised till 1997. In 1997, ASB of ICAI revised the AS-3 in line with revised IAS-7
and issued an accounting standard on reporting cash flow information (see AS-3 full
text given in http://www.icai.org.). However, this standard was not been made
mandatory immediately in 1997. However, AS-3 was made mandatory for the
accounting period starting on or after 1st April 2001 for the following enterprises:
i)

Enterprises whose equity or debt securities are listed on a recognised stock

exchange in India, and enterprises that are in the process of issuing equity or
debt securities that will be listed on a recognised stock exchange in India as
evidenced by the board of directors resolution in this regard.

ii)

All other commercial, industrial and business reporting enterprises, whose

turnover for the accounting period exceeds Rs. 50 crore.

Since ASB of ICAI took a long time for the introduction of cash flow statement,
the SEBI had formed a group consisting of representatives of SEBI, the Stock
Exchanges, ICAI to frame the norms for incorporating Cash Flow Statement in the
Annual Reports of listed companies. The group has recommended cash flow
statement to be supplied by listed companies. SEBI, following the recommendation
of the group, has instructed the Governing Board of all the Stock Exchanges to
amend the Clause 32 of the Listing Agreement as follows:
The company will supply a copy of the complete and full Balance Sheet, Profit
and Loss Account and the Directors Report to each shareholder and upon
application to any member of the exchange. The company will also give a Cash
Flow Statement along with Balance Sheet and Profit and Loss Account. The
Cash Flow Statement will be prepared in accordance with the Annexure
attached hereto.
Cash Flow Statement, as a requirement in the Listing Agreement, has been made
effective for the accounts prepared by the companies and listed entities from the
financial year 1994-95. Cash Flow Statement, as a requirement of the Listing
Agreement, has been made effective for the accounts prepared by the companies
listed in stock exchanges from the financial year 1994-95.
Activity 4
1)

Read carefully the AS-3 given in http.//www.icai.org. Write in your own words,
the objectives, scope and benefit of the Cash Flow Information.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
93

Analysis of Financial
Statements

2)

Download the cash flow statement of a company (visit the web site) for two
years and read the statement carefully. Write your observation whether the
benefits stated in the AS-3 is actually true.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

3)

List down your difficulties in understanding cash flow statement given in the
annual reports.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

7.7 CASH FLOW STATEMENT FORMATS

94

The statement of cash flow requires restating of the information presented on

a Balance Sheet but in flow format. The Balance Sheet is prepared by
measuring the assets and liabilities at a point of time, usually as on March 31st
of the year. In flow statements, whether it is funds flow or cash flow, we
measure the changes in assets and liabilities during the period. For example,
the liability side of the Balance Sheets contains so many items, which are
essentially brought funds for the company. How much of cash is received
under each item or how much cash was given back on each item constitute
one part of the cash flow statement. Similarly, cash flows on the assets sides
are also computed. The changes in retain earning part of the Balance Sheet
actually reflect Profit and Loss Account. Cash Flow statement separately
computes cash generated and paid for various operating activities. Cash Flow
Statement can be prepared in two ways. They are called direct and indirect
method. Actually, these two methods differ on the part in which we compute
cash from operating activities. It may be noted that AS-3, IAS-7 and also
FASB Statement No. 95 all recommend presentation of the direct method in
the primary statement though firms are allowed to use either method.
However, companies normally provide the statement in indirect format and you
will shortly realise some of the reasons behind such practice. While direct
method logically summarises cash flow movement under broad operating
heads, indirect method works backward from Net profit and remove all noncash income and expenses to get cash from operating activities. The format
used under these two methods are given below:

Table 1
Cash Flow Statement Under Listing Agreement and IAS-7
IAS-7 (Indirect Method) /SEBI Format

Cash Flow
Analysis

IAS-7 (Direct Method)

A. Cash flow from operating activities

Net profit before tax & extraordinary items
Adjustments for:
Depreciation
Foreign Exchange
Investments
Operating Profit before working
capital changes
Adjustments for:
Trade and other receivables
Inventories
Trade Payables
Cash generated from operations
Less: Interest paid
Direct tax paid
Cash flow before extraordinary items
Extraordinary items
Net Cash from / (used in) operating
activities

A. Cash flow from operating activities

Cash receipt from customers

Cash generated from operation

Less: Interest paid
Income tax paid
Cash flow before Extraordinary items
Less: Extraordinary items
Net Cash from / (used in)
operating activities

B. Cash flow from investing activities

Purchase of fixed assets
Sale of fixed assets
Acquisition of companies
Purchase of investments
Sale of investments
Interest Received
Dividend Received
Net cash used in investing activities

B. Cash flow from investment activities

Purchase of fixed assets
Proceeds from sale of fixed assets
Investment in subsidiaries
Investment in trade investment
Loans and Advances Taken/(returned)
Current investments made
Interest/Dividend Received
Net cash used in investing activities

C. Cash flows from financing activity

Proceeds from issue of share capital
Proceeds from long-term borrowings(net)
Repayment of financial lease liabilities
Dividend paid
Net Cash used in financing activities

C. Cash flows from financing activity

Proceeds from issue of share capital
Proceeds from long-term borrowings
Repayment of Loans
Dividend paid
Net Cash used in financing activities

Net Increase in cash & cash equivalents

Net Increase in cash & cash equivalents

Less: Cash paid to suppliers & other

operating expenses

Direct Method
Under Direct method, the difference between cash receipts from customers and
cash paid to suppliers and other operating expenses represents cash generated
from operations. Both cash receipts from customers and cash paid to suppliers
and operating expenses can be calculated as follows:
Cash receipts from customers :
Cash sales during the year
xxx
Credit sales during the year
xxx
Add : Sundry debtors at the beginning
...
xxx
"
Bills receivable at the beginning
...
xxx

95

Analysis of Financial
Statements

Less : Sundry debtors at the end

"
Bills receivable at the end
Cash receipts from the Customers
Cash paid to Suppliers and employees
Cost of goods sold
Operating expenses
Add : Sundry creditors at the beginning
Bills Payable at the beginning
Outstanding expenses at the beginning
Stock at the end
Prepaid expenses at the end

xxx
...

xxx

xxx
xxx

Less: Sundry Creditors at the end

Bills Payable at the end
Stock at the beginning
Prepaid expenses at the beginning
Cash paid to Suppliers and employees

xxx
xxx

xxx
...
...
...
...
...
...
...
...
...

xxx
xxx

xxx
xxx

Under direct method all non-cash transactions such as depreciation, goodwill,

preliminary expenses, discount on shares and/or debentures etc. and loss or profit
on sale of assets and investments are to be ignored as these are non-cash
transactions. Similarly, non-operating income such as income from interest and
dividends are not to be considered.
The cash flows associated with extraordinary items like bad debts recovered,
insurance claim received, loss of stock by fire, earthquake etc., cash flows from
interest and dividends received and paid should be disclosed separately.
Cash flow from operating activities is computed under the following heads using a
set of equation listed against each.

96

Cash Flow Item

Methodology

Cash collection from

customers

Sales
-- Increase in Accounts Receivables
+ Decrease in AccountsReceivables

Cash Paid to suppliers

Cost of Goods Sold

-- Decrease in Inventory
+ Increase in Inventory

Cash Paid to Employees

Salary Expenses
-- Increase in accrued/outstanding Salaries payable
+ Decrease in accrued/outstanding Salaries
payable

Cash Paid for Other

operating expenses

Other Operating Expenses

-- Depreciation and other non-cash expenses
-- Decrease in prepaid expenses
-- Increase in outstanding operating expenses
+ Increase in prepaid expenses
+ Decrease in outstanding operating expenses

Cash paid/received for

interest

Net Interest Expenses (expense-income)

-- Increase in outstanding interest
+ Decrease in outstanding interest
-- Increase in interest receivable
+ Decrease in interest receivable

Cash from dividend or

other sources

Dividend or Other Income

+ Decrease in other income receivable
-- Increase in other income receivable

Cash Paid for Taxes

Tax Expense
-- Increase in deferred tax liability
+ Decrease in deferred tax liability
-- Decrease in deferred tax asset
+ Increase in deferred tax asset
-- Increase in taxes payable
+ Decrease in taxes payable
-- Decrease in prepaid taxes
+ Increase in prepaid taxes.

Cash Flow
Analysis

For some of you the above table may be confusing but it is relatively easier to
understand. The first item of the equation is actually the figure you get from P&L
account. We know the figure that has given in the P&L account is mostly based on
accrual concept and hence include non cash part. The second and subsequent
lines of the equation are actually for weeding out the non cash part to get the
cash part of the expenses. Take a simple item of the above table namely cash
paid to employees. The figure Salary and Wages given in the P&L account need
not be equal to actual salary and wages that the company has paid. For instance,
the company may not have paid March month salary on 31st March as many
companies pay their work on 7th of every month. We know this item will appear
under salary outstanding. To get the cash amount of salaries and wages, we need
to deduct, salary outstanding. Suppose, there is a salary outstanding at the beginning
of the year, which means that the company has not paid some salary last year.
Assume this value be Rs. 15 lakhs. At the end of the year, the company has not
paid March salary and assume this value be Rs. 25 lakhs. If the outstanding salary
account at the end of the year shows Rs. 25 lakhs, it means the company would
have paid Rs. 15 lakhs of the previous year salary during the current year. Though
this Rs. 15 lakhs will not be included in salary expense shown in P&L account
(there is no need to show this value as it relates to previous year expenses), we
need to consider the same for computing cash paid for salary, where we are not
bothered whether the expenses is related to last year or current year. Suppose, if
the salary expenses shown in the P&L account is Rs. 300 lakhs, we deduct from
Rs. 300 lakhs, a value equal to Rs. 10 lakhs (Rs.25 lakhs --- Rs. 15 lakhs) and state
that cash paid for salary is equal to Rs. 290 lakhs. This value represents Rs. 275
lakhs salary of this year and Rs. 15 lakhs salary of the previous year and both paid
during the year. Try to develop such logic for each of the equation to understand
the concept better.
A comprehensive illustration is provided in the next section.
Indirect Method
Under this method net profit or loss is adjusted for the non-cash items as well as
the items for non-operating incomes. The net profit or loss as shown by the profit
and loss account cannot be treated as cash from operations. As you are aware that
there are certain items like depreciation, goodwill, preliminary expenses etc., which
appear or the debit side of profit and loss account but do not affect cash. Such
items are added back to net profit. Similarly, items of non-trading incomes like profit
on sale of fixed assets, interest and dividend received on investments, refund of
taxes, provision for discount on creditors etc., which appear on credit side of profit
and loss account, should be deducted from net profit to find out cash from
operation.

97

Analysis of Financial
Statements

In addition to the above, there are also certain items which do not appear in the
profit and loss account, but have effect on cash. Such items represent changes in
current assets and current liabilities. All these adjustments must be made to the net
profit or loss as shown by the profit and loss account to ascertain actual amount of
cash flow from operations. The proforma for computing the actual cash flow from
operations is given below:
Proforma for
Computation of Cash Flow from Operating Activities
Rs.
Net Profit (Before tax and Extraordinary items)
Rs. ..........
Add : Adjustments for : Depreciation
..........
Misc. Expenses written off
..........
Foreign Exchange
..........
Loss on sale of fixed assets
..........
Interest expenses
..........
(----) Profit on sale of Fixed asset
..........
(----) Dividend received
.......... ..........
Operating Profit before Working Capital Changes
..........
Add : Adjustment for (working capital changes) :
Decrease in current assets (Excluding cash and equivalents) ........
Increase in current liabilities
..........
Less :Increase in current Assets
..........
Decrease in current Liabilities
..........
Cash generated from operating activities
Less :Income tax paid
Cash flow before extraordinary items
Add : Income from extraordinary items:
Bad debts recovered
..........
Insurance claim received
..........
Income from lottery
Gain from exchange operations etc.
..........
Less :Loss from extraordinary items :
Loss of stock from fire, floods etc.
..........
Loss from earthquake
..........
Loss from exchange operations
..........
Net Cash from Operating activities

..........

..........
..........
..........
..........

..........

..........
xxxx

Here under indirect method, you will be seeing a lot of adjustments. These
adjustments are mainly to remove non-cash items. For example, if a firm sells
Rs. 3000 worth of goods but received only Rs. 2000 and the balance is not received
at the end of the period, the receipt of Rs. 2000 can be found out using P&L and
Balance sheet values. Assume the company has an opening receivables balance of
Rs. 2000. Immediately after the sale, it should have gone up to Rs. 5000 and when
it collects Rs. 2000, the closing balance should be Rs. 3000. So, we have the
following figures in our P&L and Balance Sheet.

98

Receivables (opening balance)

Rs. 2000
Receivables (closing balance)
Rs. 3000
Sales
Rs. 3000
Thus, the cash collected from customers is equal to Opening Receivables Balance
plus Sales less Closing Receivables Balance i.e. Rs. 2000+3000 ---- 3000 = Rs. 2000.
Alternatively, we can deduct Rs. 1000 (which is the changes in opening and closing
receivable balance) as adjustment to see the impact of the credit sales on the cash.

We will discuss more on these issues in the next section. At this stage, you note
down that cash flow statement shows three important values: Net Cash Generated
through Operating Activities, Net Cash spent for Investing Activities and finally, net
cash generated through financing activities.

Cash Flow
Analysis

In the part one of the table, we have removed non-cash items and in the second
part, we removed the impact of changes in inventory. While removal non-cash
expenses or income included in the net income is obvious, when changes in current
assets and liabilities are adjusted. A firm invests in current assets (raw materials,
receivables, etc.) and acquire current liabilities mainly operating purpose. An
increase in current assets means spending some money to buy fresh current assets
during the period but not necessarily the firm incurs that amount fully. Since part of
the amount is received through current liabilities (creditors), we also look into the
changes in current liabilities. For instance, if inventory increases by Rs. 50 lakhs
and creditors also increases by Rs. 20 lakhs, it means the company has spent
Rs. 30 lakhs cash and hence it has negative impact on the cash value.

7.8

CASH FLOW FROM OPERATING

ACTIVITIES

We use an illustration to explain the three important items of cash flow statement.
Before you proceed further, read the Cash Flow Statement of Infosys Technologies
Ltd. given below:
Infosys Technologies Ltd .
Cash Flow Summary
Cash and Cash Equivalents at Beginning of the year
Net Cash from Operating Activities
Net Cash Used In Investing Activities
Net Cash Used In Financing Activities
Net Inc/(Dec) In Cash And Cash
Cash And Cash Equivalents At End of the year
Cash Flow From Operating Activities
Net Profit Before tax & Extraordinary Items
Adjustment For Depreciation
Interest(Net)
Dividend Received
P/L on Sales of Assets
P/L on Sales of Invests
Prov. & W/O(NET)
P/L In Forex
Others
Op. Profit Before Working Capital Changes
Adjustment For
Trade & other Receivables
Inventories
Trade Payables
Loan & Advances
Direct Taxes Paid
Cash Flow Before Extraordinary Items
Extraordinary Items
Gain on Forex Exchange Transaction
Net Cash Flow From Operating Activities

2001-02 2000-01 1999-00

577.74
508.37
416.66
834.22
560.49
259.41
--280.23
--451.3
--146.2
--104.77
--39.82
--21.54
449.22
69.37
91.71
1,026.96
577.74
508.37
2002-03 2001-02 2000-01
943.39
696.03
325.65
160.65
112.89
53.23
--51.23
--38.47
0
0
0
0
--0.09
--0.09
0
0
0
0
0
15.29
0
--13.26
--20.17
0
--139.96
--85.18
--36.71
899.5
680.3
342.17
--34.36
0
--5.16
--39.02
0
820.96

--166.2
0
60.93
--34.72
0
540.32

--58.3
0
42.65
--41.5
--35.54
249.48

13.26

20.17

9.93

834.22

560.49

259.41

99

Analysis of Financial
Statements

The first part of the table shows the summary of Cash Flows of Infosys
Technologies Ltd. and the second part lists detail working of Net Cash
Flow Operating Activities. Infosys has generated Rs. 834.22 cr. during the year
2001-02 through its operation against Rs. 560.49 cr. during the previous year.
How this is comparable with the net profit figure? It is comparable for this
company since during the year 2001-02, the company reported a net profit value
of Rs. 807.96 cr. But it need not be true for other companies where the net profit
and cash from operating activities may show substantial difference. For instance,
Pentamedia Graphics Ltd. has reported a net profit of Rs. 98.75 cr. for the year
ending March 2002 whereas for the same period, its cash flow from operating
activities is a negative value of Rs. 360.88 cr. There could be several reasons for
such wide difference between the reported book profit and cash flow from
operating activities.
In the Infosys Cash Flow Statement, the first part of the adjustment is related to
removing non-cash expenses and income and the second part of adjustment is
related to impact of changes in current assets and liabilities. In the third part, cash
arising out of extraordinary items is shown separately since the profit figure of the
first line excludes such extraordinary items. In terms of relative importance, the part
one adjustments are high value. While this may be true for companies like software
where working capital is not high, the second component may be large for
manufacturing companies. For instance, the cash flow statements of Cipla Ltd. for
the year ending 2002 shows an adjustment factor of Rs. 1.25 cr. (negative) for noncash items against Rs. 183.13 cr. (negative) for working capital items. The
adjustments relating to extra-ordinary items is not a regular feature and in the
Ciplas case, it has not shown any value in the last three years. An analysis of
component of the three operating items shows further insight on where the cash is
drained. A year-to-year comparison also shows how much of additional amount is
being pumped in each of these items. While such an analysis is possible with
balance sheets figures alone, an analysis on cash basis is much simpler and straight
forward without any accounting principles and policies related issues. Increasingly,
users of financial statement rely on cash flow statement for this reason.
Activity 5
1)

Collect Cash Flow from Operations of few companies and examine how is
related to Profit reported in P&L account?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2)

Compare the each components of cash flow from operating activity over the
period and record your observations here.
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

100

..........................................................................................................................

Cash Flow
Analysis

7.9 CASH FLOW FROM INVESTING AND

FINANCING ACTIVITIES
Measuring cash flow from investing and financing activities is simple and
straightforward. Any amount spent in purchase of fixed assets forms part of
investing activities. For instance if a firm spends Rs. 20 lakhs to buy new assets
and also sold Rs. 3 lakhs worth of assets for Rs. 8 lakhs, the net cash flow on
investing activities is Rs. 12 lakhs (Cash outflow of Rs.20 lakhs less Cash inflow
Rs. 8 lakhs). Similarly, it is easier to compute cash flow from financing activities.
Here we will try to find out the fresh equity and loan that the company has raised
during the period and from that we deduct loan amount repaid. In addition to this,
we also deduct dividend since dividend is outcome of financing activities. However,
you may wonder why interest is not deducted here since it is also related to
financing activity. There is no straight answer to this but accounting standards
require interest to be shown as an cash outflow item in operating activities.
The cash flow from investing and financing activities of Infosys is given below.
Infosys is spending a lot on fixed asset acquisition during the last three years. At
the same time, it is not raising any fresh capital and hence its cash flow financing
activities is also negative due to high dividend payment.
Cash Flow From Investing and Financing Activities of Infosys
Technologies Ltd.
Cash Flow From Investing Activities
Investment In Assets :
Purchased of Fixed Assets
Sale of Fixed Assets
Financial/Capital Investment:
Purchase of Investments
Sale of Investments
Investment Income
Interest Received
Dividend Received
Invest. in Subsidiaries
Net Cash Used in Investing Activities
Cash Flow From Financing Activities
Proceeds:
Proceeds from Issue of share capital
Dividend Paid
Others
Net Cash Used in Financing Activities

2002-03

2001-02

2000-01

----322.74
1.6

----463.4
0.23

----159.9
0.1

----10.32
0
0
51.23
0
0
----280.23
2002-03

----26.65
0
0
38.47
0
0
----451.3
2001-02

----13.08
0
26.69
0
0
0
----146.2
2000-01

0
----109.37
4.6
----104.77

0
----42.2
2.38
----39.82

1.76
----19.93
----3.37
----21.54

Illustration 2 Using the P and L account and Balance Sheet given below, prepare
Cash Flow Statement both under direct and indirect method.
Profit and Loss Account for the year ended 31st March, 2005
(Rs. in thousands)
Year 2004-05
Year 2003-04
Sales
111780
98050
Other Income
390
220
Cost of Goods Sold
41954
39010
Selling and Administrative Expenses
16178
12500
Profit Before Tax
54038
46760
Less: Income Tax
21615
18704
Profit After Tax
32423
28056

101

(b) Balance Sheet as on 31st March, 2005

Analysis of Financial
Statements

(Rs. in thousands)
Liabilities and Shareholder Equity
Equity Share Capital
Retained Earnings
Current Liabilities
Accounts Payable
Income Tax Payable
Dividend Payable
Total Liabilities
Assets
Fixed Assets
393000 (370000)
Less: Depreciation
92400 (90000)
Current Assets
Cash
Accounts Receivable: 20064
Less: Provision -(972)
Inventory : Raw Materials
Finished Good
Investments
Total Assets

As on 31-3-05
180000
134045

As on 31-3-04
180000
101622

3526
21615
---339186

4330
---25000
310952

300600

280000

6380

6000

19092
516
598
12000
339186

23568
636
748
---310952

Solution

Cash Flow Statement Under Direct Method (Rs. in thousands)

(A)

Operating Activities

Cash Collection from Sales

115716

Less: Cash Paid for:

Raw Materials

(18478)

Direct Labour

(13452)

Overhead

(8758)

(40688)

Less: Cash Paid for Non-factory Costs:

Salaries and Wages
Other Sales and Administration

(14625)
(413)

(15038)

Cash Generated from Operation

59990

Add: Interest Earned

390

Net Cash from Operating Activities

(B)

60380

Investment Activities
Purchase of Plant Assets

(23000)

Short-term investments

(12000)

Net Cash Flow from Investing Activities

(C)

Financing Activities
Dividends paid
Net Cash Flow from Financing Activities

(D)
102

(35000)

Net Change in Cash

(25000)
(25000)
380

Cash at the Beginning of the year

6000

Cash at the End of the Year

6380

Cash Flow Statement Under Indirect Method/as per Listing Agreement

(A)

Cash Flow
Analysis

Operating Activities

Profit After Tax or Net Income

32423

Adjustments for:
Depreciation

2400

Trade Receivables

4476

Inventories

270

Income Tax

21615

Accounts Payable

(804)

27957

Net Cash from Operating Activities

(B)

60380

Investment Activities
Purchase of Plant Assets

(23000)

Short-term investments

(12000)

Net Cash Flow from Investing Activities

(C)

(35000)

Financing Activities
Dividends paid

(25000)

Net Cash Flow from Financing Activities

(D)

(25000)

Net Change in Cash

380

Cash at the Beginning of the year

6000

Cash at the End of the Year

6380

Illustration 3
Prepare a Cash Flow Statement from the following information under both Direct
method and Indirect method:
Balance Sheet as on 31.12.2005
(Rs. in 000)
Liabilities

2005
(Rs.)

2004
(Rs.)

Assets

2005
(Rs.)

2004
(Rs.)

Share Capital

3,000

2,500

Cash and Bank balances

400

50

Reserves

6,820

2,760

Short-term investments

1,340

270

Long term debt

2,220

2,080

Sundry debtors

3,400 2,400

Sundry creditors

300

3,780

Interest receivable

Interest Payable

460

200

Income Tax Payable

800

Accumulated depreciation 2,900

200

----

Inventories

1,800 3,900

2,000

Long term investments

5,000 5,000

2,120

Fixed assets (cost)

4,360 3,820

16,500 15,440

16,500 15,440

Profit and loss account for the period ending Dec. 31, 2005
(Rs. in 000)
Rs.
To Cost of Sales

52,000

To Gross Profit

9,300
61,300

Rs.
By Sales

61,300

61,300

103

Analysis of Financial
Statements

To Administrative and
selling expenses
To Interest expense
To Foreign exchange loss
To Depreciation
To Net Profit (Before taxation
and Extraordinary item)

1820
800
80
900
6700

By Gross Profit b/d

9,300

By Dividend income
By Interest income

400
600

10,300
To Income Tax
To Net Profit c/d

600
6460

10,300
By Net profit b/d
By Insurance proceeds from
earthquake settlement

7,060

6,700
360
7,060

Additional information : (Figures are in Rs. 000)

1)

An amount of Rs. 500 was raised from the issue of share capital and a further
Rs. 500 was raised from long term borrowings.

2)

Interest expense was Rs. 800 of which Rs. 340 was paid during the period.
Rs. 200 relates to interest expense of the prior period was also paid during the
period.

3)

Dividends paid were Rs. 2,400.

4)

Tax deducted at source on dividends received (which was included in the tax
paid of Rs. 600 for the year) amounted to Rs. 80.

5)

During the period, the enterprise acquired fixed assets paying Rs. 700.

6)

Plant which costs Rs. 160 and accumulated depreciation of Rs. 120 was sold
for Rs. 40.

7)

Foreign exchange loss is due to change in exchange rates of short term

investments.

Solution
Cash Flow Statement (Direct Method)
A) Cash Flow from Operating activities
Cash receipts from customers (1)
Less : Cash paid to suppliers and employees (2)
Cash generated from operations
Less : Income Tax Paid (3)
Cash Flow before extraordinary item
Add : Proceeds from earthquake settlement
Net cash from operating activities
B) Cash Flows from Investing activities
Sale of Plant

(Rs. in 000)
2005 year
60,300
55,200
5,100
1,720
3,380
360
3,740
40

Interest received (Rs. 600 -- Rs. 200 Accrued interest)

400

Dividend received (Rs. 400 -- Tax deducted at source Rs. 80)

320
760

Less :
Purchase of fixed assets
104

Net cash from Investing activities

700
60

C)

Cash Flows from financing activities

Issue of share capital
Long term borrowing
Less : Repayment of long term debt (4)
Interest paid (5)
Dividend paid

Cash Flow
Analysis

500
500
1000
360
540
2,400
3,300
(----) 2300
1,500
320

Net cash used in financing activities

Net increase in cash and cash equivalents
Add : Cash and cash equivalent at the beginning
(Rs. 50 + Rs. 270 Short term Investments)
Cash and cash equivalent at the end
* [Rs. 400 + (Short term investments Rs. 1340 +
Loss in exchange rate Rs. 80)]

1,820*

Working Notes:
1)

Cash receipts form customers

Sales
Add : Sundry debtors at the beginning

(Rs. in 000)
61,300
2,400
63,700
3,400
60,300

Less : Sundry debtors at the end

2)

3)

4)

Cash paid to suppliers and employees

Cash of Sales
Administrative and selling expenses

(Rs. in 000)
52,000
1,820
53,820

Add : Opening creditors

"
Inventories at the end

3,780
1,800

Less : Creditors at the end

"
Opening inventories

300
3,900

Income tax paid

Tax paid (Including Tax deducted at source from
dividends received)
Add : Tax liability at the beginning

5,580
59,400
4,200
55,200
(Rs. in 000)
600

2,000
2600
Less : Tax liability at the end
800
1,800
Out of Rs.1800, tax deducted at source on dividends received (Rs.80), is
shown in Cash Flows from Investing Activities and balance of Rs. 1720 is to
be shown under cash flows from operating activities.
Repayment of long term borrowings
(Rs. in 000)
Long term debt at the beginning
2,080
Add : Long term debt made during the year
500
Less : Long term debt at the end

2,580
2,220
360
105

Analysis of Financial
Statements

5)

Interest Paid

(Rs. in 000)

Interest expense for the year

800

Add : Interest Payable at the beginning

200
1,000

Less : Interest payable at the end

460
540

Cash Flow Statement (Indirect Method)

(Rs. in 000)
Cash flows from operating activities
Net Profit before taxation and extraordinary item
Adjustments for:
+ Depreciation
900
+ Foreign exchange loss
80
+ Interest expense
800
--- Interest income
(---) 600
--- Dividend income
(---) 400
Operating Profit before Working Capital Changes
(---) Increase in sundry debtors
(---) 1,000
(+) Decrease in inventories
2,100
(---) Decrease in sundry creditors
(---) 3,480
Cash Generated from Operations
(---) Income tax paid (Rs. 1800 --- Tax deducted at source Rs. 80)
Cash flow before extraordinary item
Proceeds from earthquake settlement
Net Cash from Operating Activities
Cash flows from investing activities
(---) Fixed assets purchased
(---) 700
(+) Proceeds from sale of plant
40
(+) Interest received
400
(Interest income Rs. 600 --- Accrued interest Rs. 200)
(+) Dividend received
(Rs. 400 --- Tax deducted at source Rs. 80)
320
Net Cash from Investing Activities
Cash flows from financing activities
(+) Issue of additional capital
500
(+) Proceeds from long term borrowings
500
(---) Repayment of long term borrowings (Opening balance (---) 600
Rs. 2,080 + Borrowings during the year Rs. 500 --- Balance at
the end Rs. 2,220)
(---) Interest paid
(---) 540
(---) Dividend paid

(---) 2,400

Net Cash Used in Financing Activities

Cash & Cash equialent at the beginning (Rs. 50 + Rs. 270)
106

Cash and cash equivalent at the end

2005 year
6,700

780
7480

(---) 2,380
5,100
1,720
3,380
360
3,740

60

(---) 2,300
1,500
320
1,820

7.10

USES OF CASH FLOW STATEMENT

Cash Flow
Analysis

Cash flow statement is very useful to the financial management. It is used as a tool for
financial analysis for short term planning.
The preparation of cash flow statement has several uses. The more important uses
are as follows:
1)

Changes in cash balance between two points of time and the contributing factors
for such change are clearly revealed.

2)

The cash flow statement explains the reasons for:

3)

i)

the presence of very low cash balance inspite of huge operating profits: or

ii)

the presence of a higher cash balance inspite of a very low level of profits

Projected cash fow statements help the management in short-term planning and
several other ways like:
i)

Determination of additional cash requirements during a given period and

making timely arrangements

ii)

Identification of the size of surplus and the time for which such surplus
funds are likely to be available

iii)

Judging the ability of the firm to repay/redeem debentures/preferences

shares.

iv)

Examining the possibility of maintaining/increasing dividends

v)

Assessing the capability of finance, replacement of fixed assets

vi)

Assessing the capacity of the firm to finace expansion.

vii) More efficient and effective management of cash flows.

7.11

DISTINCTION BETWEEN CASH FLOW

ANALYSIS AND FUND FLOW ANALYSIS

Following are the major points of difference between cash flow analysis and fund flow
analysis:
1)

Fund flow analysis deals with the change in working capital position between two
balance sheet dates, whereas the cash flow analysis is concerned with the
change in cash position.

2)

Cash flow analysis is more useful as a tool in short-term financial planning,

whereas fund flow analysis is more useful in long-term financial planning.

3)

An increase in current liability or decrease in current asset (other than cash)

results in an increase in cash whereas such changes result in decrease in the net
working capital. Similarly, a decrease in any current liability or an increase in
current asset (other than cash) results in a decrease in cash, whereas such
changes increase the net working capital.

4)

Cash flow statement recognises 'cash basis of accounting' where as funds flow
statement is based on accrual basis of accounting.

5)

Cash flow analysis explains only the causes of cash variations, wheresas funds
flow analysis discloses the causes of overall working capital variations.

107

Analysis of Financial
Statements

Activity 6
1)

Compute the changes in cash flow from operating activities of Infosys

between Year 2001 & 2000 and 2002 & 2001.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

2)

Compute the changes in profit before taxes and depreciation of Infosys

between Year 2001 & 2000 and 2002 & 2001.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

3)

Compare whether the profit changes are in line with the changes in cash flow
from operating activities.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

4)

Repeat the above two steps for few companies and write your findings.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

7.12 LET US SUM UP

108

Cash Flow Statement and cash flow analysis have assumed importance
particularly when many companies have started adopting creative accounting
and earnings management. Realising the needs of new users as well as others,
regulating agencies have made reporting of cash flow statements mandatory.
Cash flow statement is easy to understand and difficult to manipulate. It
provides three important pieces of information on cash flow movements of the
firm --- how much cash is generated through operation, financing and how much
cash is spent for investment? It gives a clear and real picture about the internal
activities of the firm. There are two methods of preparation of cash flow
statements, namely direct and indirect method. While direct method gives more
details on cash flow from operating activities and also reader-friendly, indirect
method is more accounting oriented and fails to provide any additional
information. Unfortunately, many companies use indirect method though the
accounting standards allow both methods. This indirectly shows the eagerness
of management to withhold information unless it is required by the regulation.
Fortunately, the final figure is adequate to get good insight though additional
information will always be useful. Cash flow analysis are typically done by
comparing the changes in cash flow from operating activities from period to

period with the changes in profit levels of the firm. Such comparison is useful to
understand the quality of reported profit. Also, the cash flow from operating
activities are used to compare whether they are sufficient to meet the liabilities of
lenders and also contribute for further investments.

Cash Flow
Analysis

7.13 KEY WORDS

Cash Flow: Movement of cash i.e., cash in flow and cash outflow
Cash Flow Statement: Statement prepared to show the sources and uses of cash
between the two balance sheets dates.
Cash from Operations: Net profit adjusted for changes in the current items in
additional to the adjustments already made while ascertaining funds from
operations.

7.14

TERMINAL QUESTIONS

1)

How cash flow statement is different from income statement? What are the
additional benefits to different users of accounting information from cash flow
statement?

2)

List down any four important accounting transactions that increase the profit
but has no impact on cash flow statement.

3)

How does cash flow statement differ from funds flow statement? What are
the uses of cash flow statement?

4)

How does cash flow analysis help the management in decision making?

5)

What is a Cash Flow Statement? Explain the techniques of preparing a cash

flow statement.

6)

A summary of Cash Flow Statement of Shaheed Industries Ltd. for the last
few years is given below. The details of profit are also stated. Suppose you
are an analyst working for a leading mutual fund in India prepare a small
report on the performance of the company using these two pieces of
information.
Summary of Cash Flow Statement of Shaheed Industries Ltd.

Year

2003

2002

2001

2000

Cash and Cash Equivalents at

Beginning of the year

1,760.71

143.27

1,081.55

4,897.60

Cash from Operating Activities

6,642.31

7,523.00

4,748.08

1,630.55

Cash Used In Investing Activities

-- 6,575.53 -- 3,928.34 -- 2,423.89 -- 5,000.06

Cash Used In Financing Activities

-- 1,680.28 -- 1,977.22 -- 3,305.11

Net Inc/(Dec) In Cash And Cash

-- 1,613.50

1,617.44

Cash and Cash Equivalents at end

147.21

1,760.71

100.63

1,081.55

4,974.21

4,428.70

2,645.62

2,403.25

3,452.79

3,435.82

2,636.73

2,533.59

-- 446.54

-- 980.92 -- 3,816.05

of the Year
Net Profit Before tax &
Extraordinary Items
Depreciation

109

Analysis of Financial
Statements

7)

The following are the Balance Sheet of M/s. Rao Brother Private Ltd. as on
March 2004 and 2005

Liabilities

2004
Rs.

2005
Rs.

Assets

2004
Rs.

2005
Rs.

Equity Shares
12% Redeenable
Preference shares
Profit and loss a/c
General reserve
Debentures
Creditors
Provision for taxation
Bank overdraft

4,000

4,000

Fixed assets
Less : Depreciation

---100
200
600
1,200
800
1,250

1,000
120
200
700
1,100
1,000
680

4,100
1,100
3,000
2,000
3,000
30
120

4,000
1,500
2,500
2,400
3,500
50
350

8,150

8,800

8,150

8,800

Sundry Debtors
Stock
Prepaid expenses
Cash

Your are required to prepare a Cash Flow Statement.

(Ans. Cash from Operation Rs. 400, Sources Rs.1,600, Applications Rs. 800)
8)

ABC company supplies you the following Balance Sheets on 31 December:

Liabilities
Share capital

2004
Rs.

2005
Rs.

14,0000 148,000

Assets

2004
Rs.

2005
Rs.

Bank balance

18,000

15,600

Bonds

24,000

12,000

Receivable

29,800

35,400

Accounts Bills payable

20,720

23,680

Inventories

98,400

85,400

Provision for Doubtful debts 1,400

1,600

Land

40,000

60,000

Goodwill

20,000

10,000

206,200

206,400

Reserves & surplus

20,080

21,120

206,200 206,400

Following additional information has also been supplied to you :

i)Dividends amounting to Rs. 7000 were paid during the year 2004.
ii)

Land was purchased for Rs. 20,000.

iii)

Rs. 10,000 were written off for Goodwill during the year.

iv)

Bonds of Rs. 12,000 were paid during the course of the year. You are required to
prepare a Cash Flow Statement.
(Ans. Cash from Operations Rs. 28600, Sources Rs. 36,600,
Applications 39,000)

110

9)

From the following Balance Sheets of Alfa Ltd., prepare Cash Flow Statement
under both the methods:

Liabilities

2004

2005

Assets

Equity Share Capital

150,000
Profit & Loss A/c
42,500
Bank Loan
50,000
Accumulated Depreciation 40,000
Creditors
155,000
Proposed dividend
22,500

2,00,000
55,000
37,500
67,500
147,500
30,000

4,60,000

5,37,500

2004

2005

Fixed Assets
2,00,000
Stock
1,00,000
Debtors
1,05,000
Bill Receivable
40,000
Bank
15,000

275,000
112,500
95,000
55,000
---

Cash Flow
Analysis

4,60,000 5,37,500

Additional information A piece of machinery costing Rs. 30,000 on which accumulated depreciation was Rs. 7500 was sold for Rs. 15,000.
(Ans. Net Decrease in Cash Rs. 15,000)
10) The Profit and Loss Account of an enterprise for the year ended 31st March,
2004 stood as follows :
Rs.
1,00,000
9,30,000

To Opening Stock of Materials

To Purchase of Materials
To Wages
200,000
Add : Outstanding Wages
50,000 2,50,000
To Salaries
80,000
Add Outstanding Salaries
40,000
1,20,000
Less : Prepaid Salaries
5,000 1,15,000
To Office Expenses
60,000
To Selling & Distribution Expenses
40,000
To Depreciation
55,000
To Preliminary Expenses (written off) 12,000
To Goodwill (written off)
20,000
To Net Profit
88,000
16,70,000

Rs.
13,80,000
30,000
10,000

By Sales
By Dividend Received
Bt Commission Accrued
By Profit on Sale of Building:
Book value
5,00,000
Selling Price
6,20,000 1,20,000
By Closing Stock
1,30,000

16,70,000

Calculate the amount of Cash generated from Operating activities under both the
methods as per AS-3 (Ans: Rs. 70,000 )
11) From the following information , you are required to compute Cash Flow from
Operating Activities under (i) Direct Method and (ii) Indirect Method.
Profit & Loss Account
for the year ended 31st March, 2005
Particulars

Rs.

To Cost of Goods Sold

2,00,000
To Office Expenses
10,000
To Selling and Distribution Exp. 3,000
To Depreciation
4,000
To Loss on Sale of Plant
2,000
To Goodwill written off
4,000
To Income Tax paid
9,000
To Net Profit
40,000
2,72,000

Particulars
By Sales (including cash
sales Rs. 50,000)
By Profit on Sales of Land
By Interest Received

Rs.
2,50,000
10,000
12,000

2,72,000

111

Analysis of Financial
Statements

The following is the position of Current Assets and Current Liabilities :

Particulars
Stock
Debtors
Bills Receivable
Creditors
Bills Payable

As on 31st
March, 2004
20,000
13,000
8,000
9,000
7,000

As on 31st
March, 2005
18,000
10,000
9,000
15,000
6,000

3,000

5,000

Outstanding Office Expenses

(Ans: Cash flow from operating activities: Rs. 39,000

Cash Receipt from customers : Rs. 252,000
Cash paid to suppliers and Employees : Rs. 2,04,000)
12) From the following balance sheets prepare a cash flow statement.
Liabilities

31.12.2003

31.12.2004 Assets

31.12.2003

31.12.2004

Share Capital

2,00,000

250,000 Fixed Assets:

Reserves

100,000

120,000 Land

300,000

350,000

Profit & Loss A/c

1,20,000

1,50,000 Machinery

2,00,000

2,40,000

1,00,000

1,30,000

70,000

50,000

40,000

60,000

7,10,000

8,30,000

Debentures

90,000

1,00,000 Current Assets:

Accumulated

Inventory

Depreciation

60,000

80,000 Debtors

Current Liabilities:

Cash

Creditors

40,000

45,000

Bills Payable

65,000

40,000

Expenses Outstanding

35,000

45,000

7,10,000

8,30,000

Note: Machinery costing Rs. 40,000 (accunulated depreciation Rs. 10,000) was sold
for Rs. 35,000
(Ans. : Cash from Operation Rs. 55,000)
13)

Extracts of Balance Sheets of Messers Beta Company Ltd. are given below:

Liabilities

31.12.03

31.12.04

Rs.

Rs.

50,000

60,000

Share Capital

Creditors

54,000

70,000

Assets

31.12.03

31.12.04

Rs.

Rs.

Fixed Assets:

1,50,000

2,44,000

Stock in Hand

3,800

6,600

Debtors

76,000

67,000

Cash

36,000

13,750

Bills Receivable

17,500

19,000

Additional information
The profits for the year ended 31.12.2004 amounted to Rs. 48,000 before charging
depreciation & taxation. During the year 500 share were issued at Rs. 20 each. Interim
dividend paid during the year Rs. 6,950. Prepare cash flow statement.
112

(Answer : Cash flow from operation Rs. 68,700)

14) The following are the summarised Balance Sheets of Wye Ltd. as on 31st March,
2002 and 2003.
Liabilities
Share Capital:
Preference Capital
Equity Capital
General Reserve
Profit & Loss A/c
14% Debentures
Creditors
Provision for Taxation
Proposed Dividends
Bank Overdraft

2002
Rs.

2003
Rs.

4,00,000
20,000
`10,000
60,000
1,20,000
30,000
50,000
1,25,000

1,00,000
4,00,000
20,000
12,000
70,000
1,10,000
42,000
58,000
68,000

8,15,000

8,80,000

Assets
Fixed Assets
Less: Depreciation
Debtors
Stock
Prepaid Expenses
Cash

2002
Rs.

2003
Rs.

4,10,000
1,10,000
3,00,000
2,00,000
`3,00,000
3,000
12,000

4,00,000
1,50,000
2,50,000
2,40,000
3,50,000
5,000
35,000

8,15,000

8,80,000

Cash Flow
Analysis

You are required to prepare a Statement of Cash Flow.

[Cash from Operation Rs. 40,000; Cash Inflow Rs. 1,60,000
Cash Outflow Rs. 1,37,000]
[Note. Provision for Tax and Proposed Dividend are treated as Non-Current Liability.]
15) From the following Balance Sheets of Exe Ltd., you are required to prepare a Cash
Flow Statement:
Liabilities
Equity Share Capital
10% Preference
Share Capital
General Reserve
Profit & Loss A/c
Proposed Dividend
Creditors
Bills Payable
Provision for Taxation

2004
Rs.

2005
Rs.

3,00,000

4,00,000

1,50,000
40,000
30,000
42,000
55,000
20,000
40,000

1,00,000
70,000
48,000
50,000
83,000
16,000
50,000

6,77,000

8,17,000

Assets
Goodwill
Buiding
Plant
Debtors
stock
Bills Receivable
Cash in hand

2004
Rs.

2005
Rs.

1,15,000
2,00,000
80,000
170,000
77,000
20,000
15,000

90,000
1,70,000
2,00,000
2,00,000
1,09,000
30,000
18,000

6,77,000

8,17,000

Additional Information:
i)
Depreciation on Plant Rs.10,000
ii) Gain on Sale of Building Rs. 20,000
[Fund from Operation , Rs. 1,63,000, Cash from Operation Rs. 1,15,000 Cash
Inflow Rs. 2,80,000; Cash Outflow Rs. 2,62,000]
16) You are given the following Balance Sheets of International company Ltd., for the
years ending 31st December, 2002 and 2003.You are required to prepare a Cash
Flow Statement under i) Direct Method and ii) Indirect Method for the year
ended 31st December, 2003.
Liabilities
Equity Share Capital
General Reserve
Profit & Loss A/c
Accounts Payable
Short Term Loan
Provision for Taxation
Provision for Bad Debts

2002
Rs.

2003
Rs.

30,000
5,200
3,800
2,400
360
4,800
120
46,680

30,000
5,400
3,900
1,620
240
5,400
180
46,740

Assest
Land
Building
Short Term Investments
Inventories
Account Receivable
Bank Balance
Dicount on Issue of share

2002
Rs.

2003
Rs.

12,000
11,100
3,000
9,000
6,000
1,980
3,600
46,680

10,800
10,800
3,300
7,020
6,660
5,160
3,000
46,740

113

Analysis of Financial
Statements

Following additional information has also been supplied to you:

i)

A piece of land has been sold for Rs. 2,400 at a profit of 100%

ii)

Depreciation of Rs. 2,100 has been charged on Building.

iii)

Dividend paid during the year Rs. 4,500.

[Ans : Net increase in cash Rs. 3480 , cash balance as on 31-12-2003, Rs 8460]

17) Following are the comparative Balance Sheets of ABC Company Ltd. for the
years ended 31st December , 2002 and 31st December, 2003:
Liabilities

2002
Rs.

2003
Rs.

4,00,000

6,00,000

Machinery (at cost)

47,000

1,04,000

Computer

10,000

80,000

70,000

4,000

6,000

Accumulated Depreciation

30,000

51,000

Debtors

Creditors

66,000

80,000

Stock

7,000

9,000

6,34,000

9,30,000

Equity Share Capital

Profit & Loss A/c
Securities Premium
Debentures
Provision for Doubtful

Outstanding Expenses

Assest

2002
Rs.

2003
Rs.

2,00,000

2,60,000

2,00,000

Land

20,000

20,000

Cash at Bank

86,000

1,26,000

4,000

4,000

1,60,000

1,80,000

64,000

80,000

1,00,000

60,000

Prepaid Expenses

Investments

6,34,000 9,30,000

Additional Information :
i)

Dividend paid @ 8% on share capital during 2003.

ii)

Investments costing Rs. 40,000 were sold in 2003 for Rs. 50,000.

iii)

Machinery costing Rs. 18,000 on which Rs. 2,000 depreciation has been accumulated , was sold for Rs. 12,000 in the year 2003.
Prepare Cash Flow Statement for the year 2003 as per AS -3
[ Ans. Net Increase in Cash and Cash Equivalent : Rs. 40,000]

18) On the basis of the information given in the Balance Sheet of ABC Ltd. prepare
a Cash Flow Statement
Liabilities
Equity Share Capital
12% Debentures

2003

2004

1,50,000 2,00,000

Goodwill

2003

2004

35,000

10,000

50,000

75,000

Land and Buiding

10% Preference Share Capital 40,000

25,000

Machinery

75,000 1,00,000

General Reserve

30,000

37,500

Debtors

50,000

70,000

Creditors

47,500

42,500

Stock

37,500

25,000

Bills Payable

10,000

20,000

Cash

10,000

20,000

3,27,500 4,00,000

114

Assets

[Ans: Net increase in cash : Rs. 10,000]

1,20,000 1,75,000

327,500 4,00,000

19) From the following Balance Sheet of M/s Electronics Ltd. as on 31.12.2003 and
2004, prepare a Cash Flow Statement
Liabilities
Equity Share Capital

2003
Rs.

2004
Rs.

1,00,000

1,50,000

9% Redeemable Preference

Assets

2003
Rs.

2004
Rs.

Goodwill

10,000

5,000

Building

1,50,000

2,20,000

Share Capital

50,000

40,000

Plant

80,000

1,00,000

12% Debentures

51,000

69,000

Stock

60,000

75,000

General Reserve

30,000

20,000

Debtors

20,000

17,000

P & L A/c

50,000

70,000

Bills Receivable

8,000

9,000

12% Public Deposits

80,000

1,20,000

Accrued Income

10,000

6,000

Creditors

8,000

10,000

Bills Payable

6,000

4,000

Outstanding Expenses

3,000

1,000

3,78,000

4,84,000

Prepaid Expenses
Cash

-----

Cash Flow
Analysis

2,000

40,000

50,000

3,78,000

4,84,000

[Ans: Net increase in cash : Rs. 10,000]

AS-3 statement issued by ICAI has also contains an exhaustive illustration on
Cash Flow Statements. Students may visit the following link to see the
illustration. http://www.icai.org/common/index.html
Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University. These
are for your practice only.

115

UNIT 8

BASIC CONCEPTS OF
BUDGETING

Structure
8.0

Objectives

8.1

Introduction

8.2

Meaning of Budgeting

8.3

Definition of Budget and Budgetary Control

8.4

Objectives of Budgeting

8.5

Advantages of Budgeting

8.6

Limitations of Budgeting

8.7

Essentials of Effective Budgeting

8.8

Establishing a Budgeting System

8.9

Classification of Budgets

8.10 Let Us Sum Up

8.11 Key Words
8.12 Answers to Check Your Progress
8.13 Terminal Questions
8.14 Further Readings

8.0 OBJECTIVES
The main objectives of this unit are to acquaint you with:
l

the concepts of budgeting and budgetary control;

the establishment of effective budgeting system; and

classification of various types of budget.

8.1 INTRODUCTION
The efficiency of a management depends upon the attainment of the objectives of the
enterprise. It is effective when it achieves the objectives with minimum effort and
cost. This requires proper planning and therefore, management must chart out its
course of action in advance. One systematic approach for attaining effective
management performance is profit planning and control or budgeting. Profit planning
or budgeting is an integral part of management. Budgeting is an important control
technique of cost control. This is the process of pre-estimation of cost, revenue, profit
and other figures for the next year or period and on that basis, actual expenses
incurred, revenue generated/earned. Afterwards budget is used as a standard for
measuring actual performance. The deviations are found out and responsibility fixed
for deviations. Thus, this is indirectly management control process, which involves
planning, control, coordination, communication, etc. In this unit you will study about the
basic concept of budgeting, establishment of a system of budgeting and classification
of budgets.

Budgeting and
Budgetary Control

8.2 MEANING OF BUDGETING

In our daily life, we use to prepare budgets for matching the expenses with
income; and available funds can be invested in a profitable manner. Similarly in
business, budgets are prepared on the basis of future estimated production and
sales in order to find out the profit in a specified period. A budget is in the nature
of an estimate and is a quantified plan for future activities to coordinate and
control the use of resources for a specified period. Thus budget is a quantitative
statement of management plans and policies for a given period and is used as a
guide for the purpose of attaining the given objectives. It is also used as standard
with which actual performance is measured. Budgets must be prepared with full
knowledge and acceptance by the executives whose performance is to be
measured against the budget. Different types of budgets are prepared for
different purposes.
Budgeting may be defined as the process of preparing plans for future activities of
a business enterprise after considering and involving the objectives of the said
organization. This also provides process/steps of collection and comparison of
data, by which deviations from the plan, either favourable or adverse, can be
measured. This analysis is helpful in performance analysis, cost estimation,
minimizing wastage and better utilisation of resources of the organisation.

8.3 DEFINITION OF BUDGET AND BUDGETARY

CONTROL
Budgeting is a process, which includes two important functions: Budget and
Budgetary control. Budget is a planning function and budgetary control is a
controlling system or technique. A manager looks to the future, searches for
alternative courses of action and predetermines a course of action to be taken in
relation to known events and the possibilities of future problems. Thus, the budget
will do this work for the activities of a business enterprise. I.C.M.A., London
defines the budget as Budget is 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 object.
At the same time, controlling is the process of measuring current performances
and guiding them towards some predetermined goals. The essence of control lies in
checking existing actions against some desired results determined in the planning
process. Thus, the budgetary control is a tool of control to achieve the budgeted
goals. I.C.M.A., London defines budgetary control as, Budgetary control is the
establishment of budgets relating to the responsibilities of executives to the
requirement of a policy and the continuous comparison of actual with budgeted
results either to secure by individual action the objectives of that policy or to
provide a basis for its revision.

In nutshell, Budgetary control is a system and a technique which uses budgets

as a means of controlling all aspects of the business and is designed to assist
management in the allocation of responsibility and authority, in the measurement
of actual performance, in the analysis of variations between budgeted and
actual results and to develop basis of measurement, in the light of experience
gained and results achieved, with which to evaluate performance and efficiency
of the operations. Thus, a budget is a means and budgetary control is the end
result.

8.4 OBJECTIVES OF BUDGETING

Basic Concepts of
Budgeting

It is a well known fact that a planned activity has better chances of success than an
unplanned one. The budgeting is a forward planning and effective control tool. Thus,
the objectives of the budgeting are:
a)

To control the cost and increase revenue and thereby maximise profit, so as to
know profit at different level of production and best production level.

b)

To run production activities in efficient manner by lay behind the chances of

interruption in production process due to lack of material, labour etc.

c)

To bring about coordination between different functions of an enterprise, which is

essential for the success of any enterprise.

d)

To incorporate measures of calculation of deviations from budgeted results and

analysis of the same, whereby responsibility can be fixed and controlling
measures/action can be taken.

e)

To ensure that actions taken are in accordance with the targets and if required, to
take suitable corrective action.

f)

To predict short-term and long-term financial positions for better financial position
and management of working capital in better manner.

8.5

ADVANTAGES OF BUDGETING

The following are the advantages of budgeting:

a)

Budgeting leads to maximum utilisation of resources with a view to ensuring

maximum return.

b)

Budgeting increases the awareness about business enterprise at all levels of

management in the process of fulfillment of targets.

c)

Budgeting is helpful in better co-ordination between different functions/activities

of business/organisation and hence, better understanding between different
functions.

d)

Budgeting is a process of self-examination and self-criticism which is essential

for the success of any organisation.

e)

Budgeting makes a path for active participation and support of top management

f)

Budgeting enables the organisation to prefix its goals and push up the forces
towards their achievements.

g)

Budgeting stimulates the effective use of resources and creates an attitude of

cost consciousness throughout the organisation.

h)

It creates the bases for measuring performances of different departments as well

as different functions of the production activities.

8.6 LIMITATIONS OF BUDGETING

Inspite of the above advantages, budgeting has the following limitations:
a)

Forecasting, planning or budgeting is not an exact science and a certain amount

of judgement is present in any budgeting plan.
3

Budgeting and
Budgetary Control

b)

The basic requirement for the success of budgeting is the absolute support and
enthusian provided by the top management. If it is lacking at any time, the whole
system will collapse.

c)

Budgeting should be followed up by effective control action, this is often lacking

in many organisations, which defeats the very purpose of budgeting.

d)

The installation of budgeting system is an elaborate process and it takes time.

e)

It is only a source and not a target and hence, can not take the place of
management, while it is only a tool of management. Thus, the budget should be
regarded not as a master, but as a servant.

f)

It requires the experienced man-power, technical staff, analysis, control etc,

hence, it is costly affair.

8.7

ESSENTIALS OF EFFECTIVE BUDGETING

A good budgeting system requires good organisational system with lines of authority
and responsibility clearly mentioned. There must be perfect co-ordination among
different functions as well as participation of responsible managers / supervisors in the
decision making process. Thus, the main essentials of effective budgeting may be as
follows:
a)

There should be well-planned organisational set-up, authority and responsibility

clearly defined, budget committee should be formed consisting of all top
executives.

b)

There should be a good accounting system which provides accurate and timely
information.

c)

Variations should be reported promptly and clearly to the appropriate levels of

management.

d)

Budgets have no meaning unless they lead to control action as a consequence of

feedback provided.

e)

The whole system should enjoy the support and co-operation of top management.

f)

Staff should be strongly and properly motivated towards the systems.

g)

Budgets should be prepared on the basis of clearly defined business policies after
discussion held with the head of individual department so that they may provide
their suggestions in this regard.

8.8 ESTABLISHING A BUDGETING SYSTEM

For preparing an efficient budget, there is an urgent need of well-versed system for
preparing the budget. This process is required an efficient system of implementation
within the organisation. The main essentials of establishment of system of budgeting
are:

1)

Budget Centres

2)

Budget Committee

3)

Budget Officer

4)

Budget Manual

5)

Budget Period

6)

Budget Key Factor or Determining Principal Budget Factor

7)

Forecasting

8)

Determining Level of Activity

9)

Preparation of Budget

Basic Concepts of
Budgeting

Let us study each one of the above in detail.

1)

Budget Centres: Budget centre are defined as different sections of an

undertaking or an organisation, where budgetary control measures are to be applied

and for the purpose, separate budgets are to be prepared with the help of head of
these centres so that these may be implemented more efficiently.

2)

Budget Committee: The budget committee is a group of representatives of

various functions in an organisation, e.g. Sales Manager, Production Manager, R&D
Manager, Materials Manager, etc. As all functions are interrelated and any change in
ones target will have its impact on that of the others. Therefore, it is necessary to
discuss the targets so that a mutually agreed programme can be determined. This is
really the co-ordination in budget making. It is powerful force in knitting together the
various activities of the business and enforcing real control over operations. The
principle functions of a Budget Committee are:
a)

To provide departmental managers past data regarding performance, costs etc.

thus, helping them to prepare their respective budgets.

b)

To co-ordinate, receive, review the functional budgets in the light of general

policies and objective of the organisation.

c)

To approve the functional budgets after making necessary changes.

d)

To prepare and present the Master Budget on the basis of functional budgets, so
developed and approved for final considerations and approval of the Board of
Directors.

e)

To recommend action to be taken on the basis of variance analysis.

3)

Budget Officer: To link up or co-ordinate the various functions, to bring them

together and to co-ordinate their efforts in the matter of preparation of target figures,
there should be a person called Budget Officer or Budget Controller. He is enable to
provide ready data relating to all the functions. He is more or less the Secretary to the
Budget Committee. His duties will comprise mainly:
a)

Helping in preparation of the various budgets and their co-ordinations and

compilation into the master budget.

b)

Compiling information about actual performance on a continuous basis,

comparing it against the budget figures, ascertaining causes of deviation and
preparing reports based thereon and sending them to the appropriate executives.

c)

Bringing to the notice of the management the need for revision of budgets and
assisting them in the task, and

d)

Compiling information of all types for the purpose of efficient preparation of

budgets and proper reporting.

Budgeting and
Budgetary Control

4)

Budget Manual: Budget manual is defined as a document which sets

outstanding instructions, the responsibility of the persons engaged in, and the
procedures, forms and records relating to the preparation and use of budgets. Thus
budget manual is a booklet of budget policies which lays down the details of the
organisational set up with duties and responsibilities of executives including the
budget committee and budget officer and procedures to be followed for developing
budget in respect of various activities.
The following are some of the important matters dealt with in the budget manual:
a)

The dates by which preliminary forecasts and plans are to be submitted.

b)

The forms in which these are to be submitted and the person to whom these
are to be forwarded.

c)

The important factors that must be considered for each forecast or plan

d)

The categorisation of expenses, e.g., variable and fixed, and the manner in
which each category is to be estimated and dealt with.

e)

The manner of scrutiny and the personnel to carry it out.

f)

The matter which must be settled only with the consent of the managing
director, departmental manager, etc.

g)

The finalisation of the functional budgets and their compilation into the Master
Budget.

h)

The form in which the various reports are to be made out, their periodicity and
dates, the persons to whom these and their copies are to be sent.

i)

The reporting of the remedial actions.

j)

The manner in which budgets, after acceptance and issuance, are to be

revised or amended, and

k)

The matters to be included in budgets, on which action may be taken only with
the approval of top management.

5)

Budget Period: This is the period for which forecasts can reasonably be

made and budgets can be formulated. Budget periods vary between short-term and
long-term and no specific period can be laid down for all budgets. Normally, a
detailed budget for each responsibility centre is prepared for one year. In fact, the
length of the budget period depends on the type of the business, the length of the
manufacturing cycle from raw material to finished products, the ease or difficulty
of forecasting future market conditions and other factors. It should be kept in mind
that the budget period should be long enough to allow for the financing of
production well in advance of actual needs and also coincide with the financial
accounting period to compare actual results with budgeted estimates.

6) Budget Key Factor or Determining Principal Budget Factor: The key

factor is also known as limiting factor, governing factor, etc. and may be defined as
the factor which at a particular time or over a period will limit the activities of an
undertaking. The limiting factor is, usually, the level of demand for the products or
services of the undertaking, but it could be a shortage of one of the productive
resources, e.g. skilled labour, raw material, or machine capacity etc.. In order to
ensure that the functional budgets are reasonably capable of fulfillment, the extent
of the influence of this factor must be assessed.

The key factor is normally temporary in nature and is a constraint at a particular

point of time. In the long run, they can be overcome by proper planning and
management action.

The principal budget factor which will influence the targets may be : (i) customer
demand, (ii) plant capacity, (iii) availability of raw materials, (iv) availability of skilled
labour, (v) availability of adequate capital, (vi) storage capacity of raw material and
finished goods, (vii) space for plant installation, and (viii) governmental restrictions etc.

Basic Concepts of
Budgeting

7) Forecasting: Forecasting is the statement of events likely to occur. It connotes

a degree of looseness, so that it is usually the practice to judge the accuracy of
forecasts on the basis of actual performance, taking the latter to be correct. The
forecast of a function need not necessarily be well coordinated. The desired coordination could be obtained before the budget is finalised. A forecast forms the basis
for the budget. A budget indicates a target and it is a statement of planned events,
generally evolved from the forecast.
8)

Determining Level of Activity: The level of activities are determined on the

basis of information and estimates provided regarding / about future conditions and
activities of market and position of product in the market by departmental heads or
concerned managers. For this purpose, detailed discussions, analysis, preparation of
reports are to be done and then written report to be formed and submitted to budget
committee for their decision making.

9)

Preparation of Budget: After discussing all the factors, which may affect the

process of budgeting, the budget should be prepared. The manager who is responsible
for meeting the budgeted performance should prepare the budget for those areas for
which they are responsible. The preparation of the budget should be a bottom-up
process. This means, the budget should originate at the lowest levels of management
and be refined and co-ordinated at higher levels. This will enable managers to
participate in the preparation of their budgets and increases the probability that they will
accept the budget and strive to achieve the budgeted targets.
When all the budgets prepared by respective managers, then, they should be coordinated with each other and corrected in respect of organisational goal and then,
summarized into a Master Budget consisting of a Budgeted Profit and Loss Account,
a Balance Sheet and a Cash Flow Statement. After the Master Budget has been
approved, the budgets are to be passed down through the organisation to the appropriate
responsibility centre. The approval of the master budget gives the authority for the
manager of each responsibility centre to carry out the plans contained in each budget.

8.9 CLASSIFICATION OF BUDGETS

Budgets can be classified into different categories on the basis of time, functions or
flexibility. The different budgets covered under each category are shown in the
following chart :
Classification of Budgets

Time
l
Long-term
l
Short-term
l
Current

Function
l Sales
l Production
l Cost of Production
l Purchase
l Personnel
l Research
l Capital Expenditure
l Cash
l Master

Flexibility
l Fixed
l Flexible

Let us study all the above budgets briefly. You will study these budgets in detail in Unit 9.

Budgeting and
Budgetary Control

1)

Classification According to Time

The budget, on the basis of time, may be classified as :

a)

Long-term budget,

b)

Short-term budget, and

c)

Current budget.

Long-Term Budget : A budget designed for a long period is termed as a Long-term

budget. The period generally is of 5 to 10 years. These budgets are concerned with
planning of the operations of a firm over a considerably long period of time. They are
generally prepared in terms of physical quantities.
Short-Term Budget : The budget prepared for a period of less than 5 years is a
short-term budget. Generally short-term budgets are prepared for a period of one to
two years. They are generally prepared in terms of physical as well as in monetary
units.
Current Budget : The budget prepared for a period of a week, a month, or a quarter
is termed as a current budget. They are essentially short-term budgets adjusted to
current conditions or prevailing circumstances.

2)

Classification According to Function

Budgets can be classified on the basis of functions, they are meant to perform.
Different types of budgets under this head are as follows:
Sales Budget : This is the most important budget on which all other budgets are
based. The sales manager is responsible for preparation and execution of the budget.
The budget forecasts total sales in terms of quantity, value, items, periods, areas etc.
Production Budget :The budget is basically based on sales budget. It forecasts
quantity of production in terms of items, periods, areas, etc. The works manger is
responsible for the preparation of overall production budget and departmental works
manager is responsible for departmental production budgets.
Cost of Production Budget : It forecasts the cost of production. Separate budgets
are prepared for different elements of costs such as direct materials budget, direct
labour budget, factory overheads budget, office overheads budget, selling and
distribution overhead budget, etc.
Purchase Budget : The budget forecasts the quantity and value of purchases
required for production. It gives quantity-wise and period-wise information about the
materials to be purchased. It correlates with sales forecast and production planning.
Personnel Budget : The budget anticipates the quantity of personnel required during
a period for production activity. This may be further split up between direct and
indirect personnel budgets.
Research Budget : The budget relates to the research work to be done for
improvement in quality of the products or research for new products.
Capital Expenditure Budget : The budget provides a guidance regarding the
amount of capital that may be required for procurement of capital assets during the
budget period.

Cash Budgets : The budget is a forecast of the cash position, for a specific duration
of time for different time periods. It states the estimated amount of cash receipts and
cash payments and the likely balance of cash in hand at the end of different periods.

Master Budget : It is a summary budget incorporating all functional budgets in a

capsule form. It interprets different functional budgets and covers within its range the
preparation of projected income statement and projected balance sheet.

3)

Basic Concepts of
Budgeting

Classification According to Flexibility

Budget can also be classified in the following categories:

Fixed Budget : A budget prepared on the basis of a standard or a fixed level of
activity is called a fixed budget. It does not change with the change in the level of
activity. If the output and sales do not fluctuate from year to year or if an accurate
prediction of the same can be made, a fixed budget can be prepared.
Flexible Budget : A budget designed in a manner so as to give the budgeted cost of
any level of activity is termed as a flexible budget. Such a budget is prepared after
considering the fixed and variable elements of cost and the changes that may be
expected for each item at various levels of operation.
Check Your Progress
1)

What do you mean by Budgeting ?

.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................

2)

What is Budgetary Control ?

.............................................................................................................................
.............................................................................................................................
.............................................................................................................................
.............................................................................................................................

3)

4)

List out the essentials of a sound system of Budgeting.

1

..

..

..

Differentiate between a Forecast and a Budget.

............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................

Budgeting and
Budgetary Control

5)

6)

Fill in the blanks :

a)

The process of preparing and using budgets to achieve the objectives of

management is called ....................................... .

b)

............................ is a tool of control to achieve the budgeted goals.

c)

.................................... is a group of representatives of various functions

of an organisation for preparing budgets and exercising overall control.

d)

A book let of budget policies which lays down duties and responsibilities of
executives and procedures to be followed for preparation and
implementation of budget programme is called ..................................... .

e)

.......................... is the basis for preparation of the budget.

f)

The most important budget on which all other budgets are based is
................... .

g)

A summary of budget which contains all functional budgets in a capsule

form is called ............... .

h)

In the preparation of budgets ..................... limits the volume of budget activity.

i)

A budget may be defined as a ............... expression of a business plan for

a specified future period.

State whether each of the following statements is True or False.

a)

A budget is a means and budgetary control is the end result.

b)

Budget should be regarded as a master but not as a servant.

c)

Key factor can be overcome in the long-run by proper planning.

d)

Research budget relates to the improvement in quality and

development of the new products.

e)

Flexible budget gives details of budgeted cost at any level of activity. (

f)

A budget is both a plan as well as a control tool.

g)

A budget is a base while the forecast is the structure built on the base(

h)

A fixed budget is concerned with budgeting of fixed assets.

i)

A budget manual contains a summary of all functional budgets.

j)

A budget is a plan of the management for a future period expressed in

quantitative terms.
(

8.10 LET US SUM UP

10

A budget is in the nature of an estimate and is quantified plan for future activities
to coordinate and control the use of resources for a specified period. Budget is
used as a standard with which actual performance is measured. Budgeting is a
process which includes both budget and budgetory control. Budget is a planning
function and budgetory control is a system and technique which uses budgets as a

means of controlling all aspects of the business and is designed to assist

management in the measurement of actual performance, in the analysis of
deviations from the budgeted targets and to evaluate performance and efficiency
of the operations. A good budgeting system requires good organisational system
with the lines of authority and responsibility clearly mentioned. The important
essentials required for the establishment of a sound system of budgeting includes
budget centres, budget committee, budget officer, budget manual, budget period,
budget key factor, forecasting, determining level of activity and preparation of
budget.

Basic Concepts of
Budgeting

Budget may be classified on the basis of time, function and flexibility. On the
basis of time, budget may be classified as long term budget, short-term budget and
current budget. The classification of budget according to functions generally
include : Sales budget, production budget, cost of production budget, purchase
budget, personnel budget, research budget, capital expenditure budget, cash budget
and master budget. Budget can also be classified according to flexibility as fixed
and flexible budget.

8.11 KEY WORDS

Budget : A comprehensive and coordinated plan, expressed in financial terms, for
the operations and resources of an enterprise for some specific period in the future.
Budgeting : The process of preparing plans for future activities of a business
enterprise for attaining the objectives of an organisation.
Budgetory Control : The establishment of budgets relating to the responsibilities of
executives to the requirement of a policy and the continuous comparison of actual with
budgeted results either to secure by individual action the objectives of that policy or to
provide a basis for its revision.
Budget Centres : Different sections of an undertaking or an organisation, where
budgetory control measures to be applied and for the purpose, separate budgets are to
be prepared.
Budget Committee : A group of representatives of various functions in an
organisation
Budget Officer : A person who links up or coordinates the various functions, to
bring them together and coordinate their efforts in the matter of preparation of target
figures.
Budget Manual : A document which sets out standing instructions, the responsibility
of the persons engaged in, and the procedures, forms and records relating to the
preparation and use of budgets.
Budget Period : The period for which forecasts can reasonably be made and
budgets can be formulated.
Budget Key Factor : The factor which at a particular time or over a period will limit
the activities of an undertaking.
Forecasting : A statement of events likely to occur
Fixed Budget : A budget prepared on the basis of a standard or a fixed level of
activity
Flexible Budget : A budget designed in a manner so as to give the budgeted cost at
any level of activity.
Master Budget : A summary budget incorporating all functional budgets which is
finally approved, adopted and employed.

11

Budgeting and
Budgetary Control

8.12 ANSWERS TO CHECK YOUR PROGRESS

5)

6)

a)

Budgeting

b) Budgetary control

c) Budget Committee

d)

Budget Manual

e) A forecast

f) Sales budget

g)

Master budget

h) The key factor

i) Quantitative

a) True, b) False, c) True, d) True, e) False, f) True, g) True, h) False,

i) False, j) True

8.13

TERMINAL QUESTIONS

1)

Define budgeting and budgetory control. State the objective of Budgeting.

2)

What is budgeting ? What are the advantages and limitations of Budgeting ?

3)

What are the essentials of an effective system of Budgeting ? Explain

4)

What is a Budget Manual ? State briefly the contents of a budget manual.

5)

What do you mean by Budgeting ? Mention different types of budgets that a big
industrial concern would normally prepare.

6)

What are the essentials of establishment of sound system of Budgeting ?

7)

Explain the following :

i)

Budget Committee

ii)

Budget Officer

iii)

Budget Key Factor

iv)

Budget Period

8)

Explain in brief different types of budgets.

9)

A budget is a means and budgetory control is the end result. Explain.

Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University. These
are for your practice only.

8.14

FURTHER READINGS

Edward B. Deakin and Michael W. Maher, Cost Accounting, Richard D. Erwin, inc.,
Homewood, Illinois.
Lal Nigam B.M. and Sharma G.L., Advanced Cost Accounting, Himalaya
Publishing House, Bombay-4.
Indira Gandhi National Open University, Study Material MS-4 and MS-43.
Maheswari, S.N. 1987, Management Accounting and Financial Control, Sultan
Chand : New Delhi.

12

UNIT 9

PREPARATION AND
REVIEW OF BUDGETS

Preparation and
Review of Budgets

Structure
9.0

Objectives

9.1

Introduction

9.2

Sales Budget

9.3

Production Budget

9.4

Production Cost Budget

9.5

Materials Budget

9.6

Purchase Budget

9.7

Direct Labour Budget

9.8

Overheads Budget

9.9

Capital Expenditure Budget

9.10 Cash Budget

9.11 Master Budget
9.12 Revision of Budgets
9.13 Budget Report
9.14 Let Us Sum Up
9.15 Key Words
9.16 Answers to Check Your Progress
9.17 Terminal Questions
9.18 Further Readings

9.0 OBJECTIVES
The main objectives of this unit are to make you familiar with :
l
the preparation of different types of budgets;
l
the preparation of Master budget; and
l
review of different budgets.

9.1 INTRODUCTION
In the previous unit you have learnt about the basic concept of budgeting,
establishment of a sound system of budgeting and classification of budgets. You
have also learnt that budgeting is the principal instrument for projecting the future
costs and revenues which is an essential aspect of management accounting and
financial control. Budgeting helps in monitoring the present as well as past.
Preparation of budgets involves a number of forecast or projections. It starts with
sales forecasting and ends with the compilation of the master budget. In this unit you
will study about the construction of functional budgets.

9.2 SALES BUDGET

The sales budget is usually the keystone in planning and control of operation of a
business. Sales forecast serves as a base for the sales budget. The sales budget is
prepared in quantitative terms of units expected to be sold and the value expected to

17

Budgeting and
Budgetary Control

be realised. The Sales Manager should be made directly responsible for the
preparation and execution of sales budget. This is prepared according to the
requirements of the business while preparing sales budget. The useful classification
may be-products, territories, customers, salesmen, etc. More than one classification
may be employed. However, at the time of preparing sales budget the following
factors should be kept in mind:
(a) salesmens estimates (b) orders in hand (c) Past behaviour (d) Management
policies for future (e) seasonal fluctuations (f) availability of materials (g) plant
capacity (h) availability of finance (i) potential market (j) level of competition
(k) position of competitors, etc. Look at the following illustration how a sales budget is
to be prepared.
Illustration 1
Shri Ramu manufactures two types of toys, Raja and Rani and sell them in Agra and
Mumbai markets. The following information is made available for the current year
2003-2004:
Places/ Markets

Type of Toys

Budgeted Sales
2002-2003

Actual Sales
2002-2003

Agra

Raja

400 at Rs. 9 each

500 at Rs. 9 each

Rani

300 at Rs. 21 each

200 at Rs. 21 each

Raja

600 at Rs. 9 each

700 at Rs. 9 each

Rani

500 at Rs. 21 each

400 at Rs. 21 each

Mumbai

Market studies reveal that toy Raja is popular as it is under priced. It is observed that
if its price is increased by Rs.1 it will find a ready market. On the other hand, Rani is
over-priced and market could absorb more sales if its selling price is reduced to Rs.
20. The management has agreed to give effect to the above price changes.
On the above basis, the following estimates have been prepared by Sales Manager:
Product

% increase in Sales
Agra

Over Current Budget

Mumbai

Raja

+10%

+5%

Rani

+20%

+10%

With the help of an intensive advertisement campaign, the following additional sales
above the estimated sale are possible:
Product

Agra

Mumbai

Raja

60 units

60 units

Rani

40 units

50 units

You are required to prepare a budget for sales incorporating the above estimates.
18

Preparation and
Review of Budgets

Solution
Sales Budget
Budget for the year
Place

Agra

Mumbai

Total

Period 2003-2004
2002-2003

Actual Sales
2002-2003
Units
Price
Value
Rs.
Rs.

Product

Units

Price
Rs.

Value
Rs.

Raja

400

3600

500

Rani

300

21

6300

200

Total

700

9900

Raja

600

Rani

500

21

Total

11 0 0

Raja

1000

Rani
Total

Budget for the future

Units

Price
Rs.

Value
Rs.

4500

500

10

5000

21

4200

400

20

8000

700

8700

900

13000

5400

700

6300

700

10

7000

10500

400

21

8400

600

20

12000

15900

11 0 0

14700

1300

19000

9000

1200

10800

1200

10

12000

800

21

16800

600

21

12600

1000

20

20000

1800

25800

1800

73400

2200

32000

Working Note:
1)

Calculation of Budget Estimates

Raja-Budgeted
Increase

Advertisement effect

Rani-Budgeted
Increase

Advertisement effect

Agra

Mumbai

400

600

40 (+10%)

30 (+5%)

440

630

60

70

500

700

300

500

60 (+20%)

50 (+10%)

360

550

40

50

400

600

Thus a preliminary sales budget is prepared product wise, territory-wise and also
customer-wise and then a detailed budget is also prepared on the basis of salesmans
estimates. Both the budgets are to be compared and necessary adjustments are to
made to the final sales budget after taking into account the policy of the management.
Then the sales budget will be submitted to the budget committee for approval and
incorporation in the master budget.

9.3 PRODUCTION BUDGET

The Production Budget is a forecast of the production for the budget period. It
provides an estimate of the total volume of production product-wise with the
scheduling of operations by days, weeks and month and also a forecast of the
closing finished product inventory. It is based on sales budget. The Factory
Manager is the person generally made responsible for its preparation,

19

Budgeting and
Budgetary Control

administration and execution. This budget can also be prepared department-wise.

This budget is prepared in quantity terms only. The main factors, which are useful
in preparing production budgets are:
(a) Inventory Policies (b) Sales Requirements (c) Uniformity of Production (d) Plant
Capacity (e) Availability of inputs (f) Duration of Production.
Production may be computed as follows :
Units to be produced = Budgeted Sales + Desired Closing Stock of finished goods
Opening Stock of finished goods.
Illustration 2
A manufacturing company submits the following figures for the first quarter of 2002 :
Particulars

Product X

Product Y

Product Z

50,000

60,000

20,000

February

40,000

50,000

20,000

March

60,000

70,000

20,000

10

20

40

20%

10%

10%

Nil

10%

25%

50%

50%

50%

40,000

50,000

10,000

50%

50%

50%

Sales (units) January

Selling price per unit (Rs.)

Targets for Ist quarter 2003:
Increase in sales quantity
Increase in sales price
Opening stock on Jan. 1, 2003
(Percentage of sales)
Stock position on 31st March, 2003
Closing stock for January and February
(Percentage of subsequent months sales)

You are required to prepare the Sales and Production Budgets for the 1st quarter of
2003.

Solution
Sales Budget
January, 03

February, 03

March, 03

Total

Units

Rate
(Rs.)

Value
( Rs.)

Units

Rate
( Rs.)

Value
( Rs.)

Units

Rate
( Rs.)

Value
( Rs.)

Units

Product X

60,000

10

6,00,000

48,000

10

4,80,000

72,000

10

7,20,000

1,80,000 18,00,000

Product Y

66,000

22 14,52,000

55,000

22 12,10,000

77,000

22

16,94,000

1,98,000 43,56,000

Product Z

22,000

50 11,00,000

22,000

50 11,00,000

22,000

50

11,00,000

66,000 33,00,000

27,90,000 1,71,000

35,14,000

4,44,000 94,56,000

Total
20

1,48,000

31,52,000 1,25,000

Value
( Rs.)

Preparation and
Review of Budgets

Working Note :
1)

Calculation of Budget estimates

Product X :

Product Y :

Product Z :

Budgeted
Increase (20%)

Budgeted
Increase (10%)

Budgeted
Increase (10%)

January

February

March

50,000
10,000

40,000
8,000

60,000
12,000

60,000

48,000

72,000

60,000
6,000

50,000
5,000

70,000
7,000

66,000

55,000

77,000

20,000
2,000

20,000
2,000

20,000
2,000

22,000

22,000

22,000

Production Budget for the 1st Quarter 2003

(Units)

Particulars

January

February

March

Total

Product X : Sales Budget

Add : Closing Stock
(50% of subsequent month sales)

60,000

48,000

72,000

1,80,000

24,000
84,000

36,000
84,000

40,000
1,12,000

40,000
2,20,000

30,000

24,000

36,000

30,000

PRODUCTION BUDGET

54,000

60,000

76,000

1,90,000

Product Y : Sales Budget

Add : Closing Stock
(50% of subsequent month sales)

66,000

55,000

77,000

1,98,000

27,500

38,500

50,000

50,000

93,500

93,500

1,27,000

2,48,000

33,000

27,500

38,500

33,000

60,500

66,000

88,500

2,15,000

22,000

22,000

22,000

66,000

11,000
33,000

11,000
33,000

10,000
33,000

10,000
76,000

11,000

11,000

10,000

11,000

22,000

22,000

23,000

65,000

Less : Opening Stock

(50% of sales)

Less : Opening Stock

(50% of sales)
PRODUCTION BUDGET
Product Z : Sales Budget
Add : Closing Stock
(50% of subsequent month sales)
Less : Opening Stock
(50% of sales)
PRODUCTION BUDGET

Note : Closing stock as on 31st March, 2003 is given in the problem. Opening and
closing stock for January and February months have been calculated as per
the percentages given in the problem. Students should be noted that the
previous months closing stock will become opening stock of subsequent
month.

21

Budgeting and
Budgetary Control

9.4 PRODUCTION COST BUDGET

This budget is a forecast of the cost of production which has been planned in the
production budget. The production budget is prepared in terms of quantity to be
produced. The amount is shown in this budget. The total cost of production is
arrived at by adding the cost of materials, labour and manufacturing overheads.
The quantity of material, the time taken by labour and the estimated costs of
material, labour and expenses- all can be shown as part of production cost budget
also.
Illustration 3
The following information is abstracted from the books of a ABC Co. Ltd., for the six
months of 2005 in respect of product X :
The following units are to be sold in different months of the year 2005:
January

2,200

February

2,200

March

3,400

April

3,800

May

5,000

June

4,600

July

4,000

There will be work in progress at the end of the month. Finished units are equal to
half the sales of the next months stock at the end of every month (including
December, 2004). Budgeted production and production cost for the half-year ending
30th June, 2005 are as follows :
Production (units)

40,000

Direct material per unit

Rs. 5

Direct wages per unit

Rs. 2

Factory Overheads apportioned to production Rs.1,60,000

You are required to prepared Product Budget and Production Cost Budget for the six
months of year 2005.

Solution
Production Budget (in Units)
January

22

February

March

April

May

June

Estimated Sales

2200

2200

3400

3800

5000

4600

Add : Closing Stock

1100

1700

1900

2500

2300

2000

3300

3900

5300

6300

7300

6600

Less : Opening Stock

1100

1100

1700

1900

2500

2300

Production

2200

2800

3600

4400

4800

4300

Total

22,100

Preparation and
Review of Budgets

Production Cost Budget

(Production : 22, 100 units)
Rs.
Direct materials @ Rs. 5 for 22,100 units

1,10,500

Direct wages @ Rs. 2 for 22100 units

44,200

Factory Overheads @ Rs. 4 for 22100 units

(Rs. 1,60,000/40,000 units)

88,400

Total Production Cost

2,43,100

9.5 MATERIALS BUDGET

Materials are either direct or indirect. The Material budget generally deals only
with the direct materials. Indirect materials are generally included in overhead
budget. The material requirements are estimated on the basis of quantity of each
class of products to be produced by multiplying the exact material requirement
for each class of product by the number of units of that class. Material budget
can be prepared on the basis of standards or, historical data regarding
percentage of raw materials to total cost, adjusted for current price and normal
wastage of material.
The factors to be considered while preparing the Material Budget are : the
quantity of material required for the production budget, tentative dates by which
required material must be available, the availability of storage facilities as well as
credit facilities, price trends in the market, nature of the materials required etc.
Only direct materials are to be taken into account and indirect materials are not
taken into account as they are considered under overheads budget. The material
budget helps the management for proper planning of purchases. The object of the
budget is to ensure the availability of adequate quantities of materials as and when
required. It will be included in the Master Budget after the approval of Budget
Committee.
Illustration 4
The following information relates to a manufacturing company :
Targeted sales of product X 1,00,000 units. Each unit of product X requires 3 units of
material A and 4 units of material B.
Estimated opening balances at the commencement of the next year :
Finished product :

20,000 units

Material A

24,000 units

Material B

30,000 units

The desirable closing balances at the end of the next year are :
Finished Products :

28,000 units

Material A

26,000 units

Material B

32,000 units

From the above information prepare a Material Budget.

23

Budgeting and
Budgetary Control

Solution
Firstly, we have to find out the number of units to be produced. We know that,
Opening Stock + Production = Sales + Closing Stock
Units to be produced = Sales + Closing Stock Opening Stock
= 1,00,000 + 28,000 20,000
= 1,08,000 units
Material required :
Material A = 1,08,000 3 = 3,24,000 units
Material B = 1,08,000 4 = 4,32,000 units
Material Purchase Budget ( Units)
Particulars

Finished Product

Material required
A
B

Budgeted Production

1,08,000

3,24,000

4,32,000

Add : Opening Stock

(+) 20,000

1,28,000

( --) 24,000

3,00,000

( --) 30,000

Less : Closing Stock

( -- ) 28,000

( +) 26,000

(+) 32,000

Estimated product for sales

1,00,000

3, 26, 000

4, 34, 000

Estimated Material required :

4,02,000

9.6 PURCHASE BUDGET

Purchase Budget gives the details of material purchases to be made in the budget
period. It correlates with sales forecast and production planning. It deals with
purchases that are required for planned production. Purchases would include both
direct and indirect materials and goods. While placing the purchase orders material
manager has to see the orders on hand and unfulfilled orders at the beginning of the
budget period and adjust the purchases accordingly. Purchase budget enables the
budget officer to provide funds in the cash budget according to delivery schedules,
terms of payment and credit period. While preparing purchase budget the factors like
the opening and closing stock to be maintained, maximum and minimum stock
quantities to be maintained, economic order quantity level, the resources available, the
policy of management etc., should also be taken into account.
Budgeted Purchase Quantity = Budgeted Consumption Quantity +
Required Closing Stock Opening Stock.

9.7 DIRECT LABOUR BUDGET

24

The direct labour budget tells about the estimates of direct labour requirements
essential for carrying out the budgeted output. The quantity of labour, e.g. skilled,
unskilled, semi-skilled etc are estimated first. The time taken by them can be measured
in terms of man hours. Thereafter, the total cost of labour is estimated by multiplying
the rates of pay with the labour hours. The purpose of this budget is to ensure
optimum utilization of labour force.

Preparation and
Review of Budgets

9.8 OVERHEADS BUDGET

The overheads budget should be prepared in three parts as follows :
1)

Manufacturing Overhead Budget

2)

Administration Overhead Budget, and

3)

Selling and Distribution Overhead Budget.

Manufacturing Overhead Budget

The budget is an estimate of the manufacturing overhead costs to be incurred in the
budget period to achieve the targeted production. Manufacturing overheads include
indirect material, indirect labour, and indirect expenses related to the factory. The cost
of each and every item of these three components of manufacturing overhead is
separately estimated as per the requirements of production.
Administration Overhead Budget
Administration overhead includes the costs of framing policies, directing the
organisation and controlling the business operations. Most of the administration
expenses are normally unconnected with the volume of activity, therefore,
experience and anticipated changes in conditions are the guides for the preparation of
this budget.
Selling and Distribution Overhead Budget
The budget includes all expenses relating to selling, advertising, delivery of goods to
customers, etc. The overheads may be determined on the basis of sales targets being
allocated to different territories or salesman etc. Those expenses which generally vary
with the sales quantity are estimated on sales basis, others which are of a fixed nature,
are estimated on the basis of past experience and anticipated changes. The
responsibility for the preparation of this budget lies with the executives of the sales
departments. Let us prepare a sales overheads budget from the following illustration.
Illustration 5
Prepare a Sales Overheads Budget for the quarter ending 31st March, 2005 from the
estimates given below:
Rs.
Advertisement

12,500

Salaries of sales department

25,000

Expenses of sales department

7,500

Counter salesmen salaries and allowances

30,000

Commission to counter salesmen is payable at 1% of sales executed by them.

Travelling salesman are entitled to a commission at 10% on sales effected through
them and a further 5% towards expenses.
( Rs. )
Sales Territories

Sales at
Counters

Sales by
Travelling
salesmen

Total estimated
sales

4,00,000

50,000

4,50,000

6,00,000

75,000

6,75,000

7,00,000

1,00,000

8,00,000
25

Budgeting and
Budgetary Control

Solution
Sales Overheads Budget
For the period ended March 31, 2005
Estimated Sales in Territories
A
B
C
Rs.
Rs.
Rs.
4,50,000
6,75,000
8,00,000
Fixed Overheads:
Advertisement

12,500

12,500

12,500

Salaries of Sales Department

25,000

25,000

25,000

7,500

7,500

7,500

30,000

30,000

30,000

75,000

75,000

75,000

Counter salesmen commission

@ 1% on sales

4,000

6,000

7,000

Traveling salesmen commission

@ 10%

5,000

7,500

10,000

2,500

3,750

5,000

11,500

17,250

22,000

86,500

92,250

97,000

Expenses of Sales Department

Counter Salesmen's Salaries
and allowances
(a)
Variable Overheads:

Expenses @ 5% on Sales by
Travelling Salesmen
(b)
Total Sales Overheads (a) + (b)

9.9 CAPITAL EXPENDITURE BUDGET

The budget is the plan of the proposed outlay on fixed assets such as land, buildings,
plant and machinery. The budget is prepared after taking into account the available
productive capacities, probable reallocation of existing assets and possible improvement
in production techniques. etc.
Capital expenditure budget serves the following purposes :
i)

It facilitates long-term planning and policy-making.

ii)

It facilitates of replacing the old machinery by latest machinery or to change the

methods of production for reducing costs.

iii)

It helps in the estimates of capital requirement after taking into account the
disposable value of old assets.

iv)

It helps in the preparation of cash budget and also assessing the capital cost of
improving working conditions or adopting safety measures, etc.

9.10 CASH BUDGET

26

A Cash Budget is a summary statement of the firms expected cash inflows and
outflows over a projected time period. In other words, cash budget involves a
projection of future cash receipts and cash disbursements over various time intervals.

While preparing cash budget seasonal factors must be taken into account and in
practice cash budget is prepared on a monthly basis. The availability of other budgets
is tested in terms of cash availability. Cash budget is also called as cash flow
statement which indicates cash inflow and cash outflows. It is generally prepared for
a maximum period of one year.

Preparation and
Review of Budgets

A cash budget helps the management in (i) determining the future cash needs of the
firm, (ii) planning for financing of the needs; (iii) exercising control over cash and
liquidity of the firm.
The overall objective of a cash budget is to enable the firm to meet all its commitments in
time and at the same time prevent accumulations of unnecessary large balance with it.
Methods of Preparing Cash Budgets
There are basically three methods for preparing cash budgets.
1)

Receipts and Payments Method

2)

Adjusted Profit and Loss Account Method

3)

Balance Sheet Method

Let us study about these methods in brief.

1)

Receipts and Payments Method

Under this method, all receipts are added and out of the total, the sum of all payments
is deducted to arrive at the balance in hand. The closing balance in hand say, for a
particular month is the opening balance of the next month and is added to the total of
receipts so as to know the total availability of cash during the month. The receipts and
payments during the budget period are found out from various functional budgets
prepared. The credit allowed to debtors, the credit allowed to us by suppliers, the delay
in payment of wages and other expenses etc. are the factors, which are taken into
account to determine the timing of receipts and payments. Advance payments and
receipts are to be included but the payment in abeyance and income accrued on
outstanding are excluded from cash budget. Revenue as well as capital receipts and
payments are recorded in cash budget.
Illustration 6
A company newly starting manufacturing operations on 1st January 2003 has made
adequate arrangement for funds required for fixed assets. It wants you to prepare an
estimate of funds required as working capital. It is to be remembered that:
a)

In the first month there will be no sale, in the subsequent month sale will be 25%
cash and 75% credit. Customer will be allowed one month credit.

b)

Payments for purchase of raw materials will be made on one month credit basis.

c)

Wages will be paid fortnightly on the 22nd and 7th of each month.

d)

Other expenses will be paid one month in arrear except that 5% of selling
expenses are to be paid immediately on sale being effected.

The estimated sales and expenses for the first six months, spread evenly over the
period subject to (a) above are as under:
Rs.

Rs.

Sales

3,60,000

Administrative Expenses

54,000

Material Consumed

1,50,000

Selling Expenses

42,000

Depreciation on fixed assets

50,000

Wages

60,000

Manufacturing Exp.

48,000

27

Budgeting and
Budgetary Control

The article produced is subject to excise duty equal to 10% of the selling price. The
duty is payable on March 31, June 30, September 30, and December 31 for sales upto
February 28, May 31, August 31 and November 30 respectively.
Prepare Cash Budget for each of the six months indicating the requirement of working
capital.
Solution
Cash Budget
for the six months ended on June 30, 2003

Particulars

January
Rs.

February
Rs.

March
Rs.

April
Rs.

May
Rs.

June
Rs.

Opening Balance

(--) 7,500

(--) 45,000

Cash Sales

18,000

18,000

18,000

18,000

18,000

Receipts from customers

54,000

54,000

54,000

54,000

10,500

27,000

32,800

45,800

58,800

7,500

10,000

10,000

10,000

10,000

10,000

Materials

25,000

25,000

25,000

25,000

25,000

Manufacturing Exp.

8,000

8,000

8,000

8,000

8,000

Administrative Exp.

9,000

9,000

9,000

9,000

9,000

Selling Exp.

3,500

7,000

7,000

7,000

7,000

Excise Duty

7,200

21,600

7,500

55,500

66,200

59,000

59,000

80,600

Closing Balance (A--B) (--) 7,500

(--) 45,000

(--) 39,200

(--) 26,200

Receipts:

Cash Available (A)

(--) 39,200 (--) 26,200 (--) 13,200

Payments:
Wages

Total Payments (B)

(--) 13,200 (--) 21,800

Note : The Company needs overdraft facility to the extend indicated above for every
month.
2) Adjusted Profit and Loss Account Method

28

The budgeting done by Adjusted Profit and Loss account method is known as cash
flow statement and is more suitable for long-term forecasting. Under this method
profit is taken as equivalent to cash and necessary adjustments are done in respect of
non-cash transactions. The net estimated profit is taken as the base and non-cash
items like depreciation, outstanding expenses, provisions etc. already deducted to arrive
at the net profit are added back. The capital receipts, reduction in debtors, stocks,
increase in liabilities, issue of share capital and debentures are other items which are
added to compute the total cash receipts. The payments of dividends, prepayments,
capital payments, increase in debtors, increase in stock and decrease in liabilities are
deducted out of the total cash receipts. The profit adjusted this way denotes the
estimated cash available. The cash available during budget period is calculated in the
following form:

Preparation and
Review of Budgets

Cash Budget
For the period ending 31st March.
Rs.
xxx

Opening balance of Cash

Add :
Net profit for the year
Funds from operations :
Depreciation
Provision and write off
Loss on sale of assets

xxx

Less : Profit on sale of assets

Decrease in debtors
Decrease in Stocks
Decrease in other assets
Decrease in prepaid exps.
Increase in Capital
Increase in liabilities
Increase in debentures

xxx
xxx
xxx
xxx
xxx

xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx

xxx
xxx

Less :
Dividends
Capital payments
Repayment of loans
Increase in Debtors
Increase in Stock
Decrease in liabilities

xxx
xxx
xxx
xxx
xxx
xxx

Closing balance of Cash

xxx
xxx

Illustration 7
The following data are available to you. You are required to prepare a cash budget
according to Adjusted Profit and Loss method.
Balance Sheet as on 31st December, 2005
Liabilities

Amount
Rs.

Assets

Amount
Rs.

Share Capital

1,00,000

Premises

50,000

General Reserve

20,000

Machinery

25,000

Profit and Loss A/c

10,000

Debtors

40,000

Creditors

50,000

Closing Stock

20,000

Bills Payable

10,000

Bills Receivable

5,000

Prepaid Commission

1,000

Outstanding Rent

2,000

Bank
1,92,000

51,000
1,92,000
29

Budgeting and
Budgetary Control

Projected Trading And Profit and Loss Account

for the year ending 31st December, 2005
To Opening Stock
To Purchases
To Octori
To Gross Profit c/d
To Interest
To Salaries
To Depreciation (10% on
Premises and Machinery)
To Rent
Less: Outstanding
(Previous Year)

Rs.
20,000
1,50,000
2,000
43,000
2,15,000
3,000
6,000

By Sales
By Closing Stock

2,15,000
43,000
5,000

By Gross Profit b/d

By Sundry Receipts

7,500
6,000
2,000
4,000

Add-Outstanding
(Current Year)
1,000 5,000
To Commission
3,000
Add-Prepaid (Previous Year) 1,000 4,000
To Office Expenses
2,000
To Advertisement Expenses
1,000
To Net Profit c/d
19,500
48,000
To Dividends
8,000
To Addition to Reserves
To Balance c/d

Rs.
2,00,000
15,000

4,000
17,500
29,500

48,000
By Balance of Profit
(from last year)

10,000

By Net Profit b/d

19,500
29,500

Closing Balance of certain items:

Share Capital Rs. 1,20,000, 10% Debentures Rs. 30,000, Creditors Rs. 40,000, Debtors
Rs. 60,000, Bills Payable Rs. 12,000, Bill Receivable Rs. 4,000, Furniture Rs. 15,000
and Plant Rs. 50,000 (both these assets are purchased at the end of the year).
Solution
Cash Budget
For the period ending 31st December, 2005
Rs.
Rs.
Opening Balance as on 1st January, 2005
51,000
Add:
Net Profit for the year
19,500
Depreciation
7,500
Decrease in Bills Receivable
1,000
Increase in Bills Payable
2,000
Issue of Share Capital
20,000
Issue of Debentures
30,000
Decrease in Prepaid commission
1,000
Decrease of Stock
5,000
86,000
30

1,37,000

Less:

Purchase of Plant

50,000

Purchase of Furniture

15,000

Increase of Debtors

20,000

Decrease of Creditors

10,000

Decrease in Outstanding Rent

1,000

Dividends Paid

8,000

Closing Balance as on 31st December, 2005

3)

Preparation and
Review of Budgets

1,04,000
Rs. 33,000

Balance Sheet Method

Under this method, at the end of budget period a projected balance sheet is drawn up
setting out the various assets and liabilities, except cash and bank balances. The
balancing figure would be the estimated closing cash/bank balance. Thus, under this
method, closing balances other than cash/bank will have to be found out first to be put
in the budgeted balance sheet. This can be done by adjusting the anticipated
transaction of the year in the opening balances. If the liabilities are more than assets,
this reveals a balance of cash/bank and if assets exceed liabilities, it reveals a bank
overdraft. Thus, under Adjusted Profit and Loss method, the amount of cash is
computed by preparing a Cash Flow Statement and the same amount is computed as a
balancing figure under Balance Sheet method.
Illustration 8
Prepare the Cash Budget using Balance Sheet method on the basis of figures given in
illustration 7.
Solution
Budgeted Balance Sheet
as on 31st December, 2005
Liabilities

Amount
Rs.

Assets

Share Capital

1,20,000

Premises

Rs.

Amount
Rs.

50,000

10% Debentures

30,000

Less : Depreciation

General Reserve
(Rs. 20,000 +Rs. 4000)

24,000

Machinery

Profit and Loss A/c

17,500

Creditors

40,000

Furniture

15,000

Bills payable

12,000

Debtors

60,000

Outstanding Rent

1,000

2,44,500

Less: Depreciation

5,000

45,000

25,000
2,500

Bills Receivable

22,500

4,000

Plant

50,000

Closing Stock

15,000

Bank (Balancing Figures)

33,000
2,44,500
31

Budgeting and
Budgetary Control

9.11 MASTER BUDGET

Master Budget is a combination of all other budgets prepared for a specific period.
It shows the overall budget plan. All the budgets are coordinated into one
harmonious unit.
According to Rowland and William H. Harr, Master Budget is a summary of the
budget schedules in capsule form made for the purpose of presenting in one report
the highlights of the budget forecast. Thus, Master Budget sets out the plan of
operations for all departments in considerable detail for the budget period. The
budget may take the form of a Profit and Loss Account and a Balance Sheet as at
the end of the budget period.
The budget generally contains details regarding sales (net), production costs, cash
position, and key account balances like debtors, fixed assets, bills payable, etc. It
also shows the gross and the net profits and the important accounting ratios. It is
prepared by the Budget Officer and it requires the approval of the Budget
Committee before it is put into operation. If approved, it is submitted to the Board
of Directors for final approval. The Board may make certain alterations if
necessary before it is finally approved.
Illustration 9
A Glass Manufacturing Company requires you to calculate and present the budget for
the next year from the following information.
Sales:
Toughened glass

Rs. 3,00,000

Bent toughened glass

Rs. 5,00,000

Direct Material Cost

60% of Sales

Direct Wages

20 Workers @ Rs. 150 per month

Stores and spares

2 % on Sales

Depreciation on Machinery

Rs. 12,600

Light and Power

Rs. 5,000

Factory Overhead:
Indirect Labour:
Works Manager Rs. 500 per month
Foreman Rs. 400 per month
Repairs and maintenance 10% on direct wages
Administration, selling and distribution expenses Rs. 14,000 per year.
32

Preparation and
Review of Budgets

Solution
Master Budget
for the period ending on ..................
Sales (as per Sales Budget)

Rs.

Toughened Glass....... units @ Rs

3,00,000

Bent toughened glass ....... units @ Rs

5,00,000

Rs.

Rs.

8,00,000

Less- Cost of Production (as per Cost of Production Budget) :

Direct Materials (.... units @ Rs......) 4,80,000
Direct Wages

36,000
Prime Cost

5,16,000

Factory Overhead:
Variable: Stores and Spares (2% of Sales) 20,000

Fixed

Light and Power

5,000

Repairs and Maintenance

8,000

: Works Managers Salary

Foremans Salary
Depreciation
Sundries

33,000

6,000
4,800
12,600
3,600

Works Cost
Gross Profit
Less : Administration, Selling and Distribution Overheads
Net Profit

27,000
5,76,000
2,24,000
14,000
2,10,000

9.12 REVISION OF BUDGETS

Once a budget is fixed it should not be revised too frequently, as it loses its
importance. On the other hand, under changing conditions, a fixed or static budget
will lead to serious inaccuracies and will fail to serve as a control document and a
measuring tool. Normally, budgets are prepared well before the period of
commencement and naturally all the factors can not be foreseen with minute
accuracies. It is a recognised fact that business is dynamic and factors are ever
changing. Budget, in order to play its proper role changes must be incorporated if
they are significant. The revision of budgets may be necessitated on account of the
following reasons:
i)

Budgeting errors, detected at a later stage.

ii)

Change in external factors like material price-spiral, inflation in the prices of

fixed assets, increased wage rates, change in government policy, etc.
33

Budgeting and
Budgetary Control

iii)

Additional expenditure to meet contingencies of an unforeseen nature, e.g.

sudden loss on account of fire, strikes, lockouts, flood, tycoons, etc. If such
contingencies are of a temporary nature, the budgets are again reshaped in their
original form.

Illustration 10
A Company produces two products A and B and budgets at 70% level of activity for
the year 2003. It gives the following information :
Products

A
(Rs.)

B
(Rs.)

15

Direct wages per unit

Variable overhead per unit

Fixed overhead per unit

12

Selling price per unit

38

27

12000

18000

Raw material cost per unit

Production and sales (Units)

The managing director proposed to decrease sales to 8000 units and 12000 units of
Product A and B respectively and increasing the selling price to Rs. 40 in the case of
Product A and Rs. 30 in the case of Product B.
You are required to present the overall profitability under the original budget and
revised budget after taking the above proposal into consideration.
Solution
Budget
For the year 2004
Revised Budget

Particulars
A
Sales Units

Original Budget
Total

6,80,000

456,000

4,86,000

9,42,000

Rs.

Rs.

Rs

Rs

Rs

1,20,000

84,000

2,04,000

1,80,000

1,26,000

3,06,000

Labour

64,000

72,000

1,36,000

96,000

1,08,000

2,04,000

Variable O.H

32,000

36,000

68,000

48,000

54,000

99,000

Fixed O. H.

96,000

1,08,000

2,04,000

1,44,000

1,62,000

3,06,000

Total Cost (B)

3,12,000

3,00,000

6,12,000

8,000

60,000

68,000

Raw Material

Profit (A-B)

34

3,20,000

3,60,000

Rs.

Total

18000

Costs :

12,000

12000

Sales (Value in Rs.)(A)

8,000

4,68,000 4,50,000 9,18,000

(--) 12,000

36,000

The managing directors proposal is to be implemented as the profit is

increasing from Rs. 24,000 to Rs. 68,000 keeping in view other factors also.

24,000

Preparation and
Review of Budgets

9.13 BUDGET REPORT

Proper reporting is an essential element in budgetary control. The management must
be regularly informed about the results of various functions so that follow up actions
can be taken up without loss of time. The periodicity of reports depends on the nature
of operations involved. The budgetary control reports are prepared on the basis of the
budget reports. The comparison of budgeted and actual figures is made and deviations
taken out- all the relevant figures are presented in the control reports. On the basis of
the principle of management by exception, remedial and corrective action is taken.
The report may indicate the necessity of revision of the budget also.
The budget report should be prompt and factual and should have the requisite degree of
accuracy. The report should be prepared in such a manner that it reveals the
responsibility of a department or an executive and give full reasons for the variances
so that proper corrective action can be taken.

Check Your Progress

1)

2)

State the factors that should be kept in mind while preparing Sales Budget.
a)

..

d)

b)

e)

c)

f)

What are the components of functional budgets ?

..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................

3)

Specify the objectives of preparing capital expenditure budget.

..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................

4)

Why does revision of budget necessary ?

..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................

5)

Fill in the blanks :

a)

.................. is responsible for the preparation and execution of sales budget.

b)

Production budget is based on ...................................... budget.

c)

Purchase budget must correlate .......................... budget and ....................

budget.

35

Budgeting and
Budgetary Control

6)

d)

.............................. budget is the combination of all other budgets.

e)

The preparation of cash budget by the method of adjusted profit and loss
account is also known as............................... .

f)

Master budget is the summary of all components of .............................. .

State whether each of the following statement is true or false.

a)

The cost of materials, labor and manufacturing overheads constitutes total

cost of sales
[ ]

b)

The purpose of Direct labour budget is to ensure optimum utilisation of

[ ]
labour force.

c)

Direct materials are generally included in overhead budget.

d)

Once a budget is fixed there is no need to incorporate the changes in the

[ ]
budget however significant they are.

e)

Cash budget indicates the amount of loan required as well as the time when
[ ]
it is needed.

f)

A Master Budget is the master plan drawn up by the organisation for the
[ ]
budget period.

[ ]

9.14 LET US SUM UP

Budgeting is the main instrument for projecting the future costs and revenues and for
financial control of the organisation. Preparation of budgets involves a number of
forecasts or projections. It starts with sales forecasting and ends with the compilation
of the master budget. The sales budget is the keystone in planning and control of
operations of a business. Sales forecast serves as a base for the sales budget. The
Sales Manager is responsible for the preparation and execution of sales budget. In
addition to sales budget, other functional budgets are also prepared. The other
functional budgets are : i) Production Budget, ii) Cost of Production Budget,
iii) Material Budget, iv) Purchase Budget, v) Direct Labour Budget,
vi) Manufacturing Overhead Budget, vii) Administration Overhead Budget,
viii) Selling and Distribution Overhead Budget, and ix) Capital Expenditure Budget.
A cash budget is a summary statement of the firms expected cash inflows and
outflows over a projected time period. It is generally prepared for a maximum
period of one year. There are three methods of preparing cash budgets. They are :
i) Receipts and Payment Method, ii) Adjusted Profit and Loss Account Method, and
iii) Balance Sheet Method.

36

A master budget is a combination of all other budgets prepared for a specific

period. It shows the overall budget plan. The budget generally contains details
regarding sales, production costs, cash position and the key account balances. It
also shows profit and important accounting ratios. Revision of budgets is
necessary to incorporate the changing conditions for effective control. Revision of
budget may be necessitated due to budgeting errors, change in external factors and
additional expenditure to meet unforeseen contingencies. Proper reporting is an
essential element in budgetory control. The management must be regularly
informed about the results of various functions so that remedial and corrective
action may be taken well in time. The report may also indicate the necessity of
revision of budget also.

Preparation and
Review of Budgets

9.15 KEY WORDS

Cash Budget : A summary statement of future cash receipts and payments over a
projected time period.
Production Budget : A forecast of production expressed quantitatively for the budget
period.
Sales Budget : A budget expressed in quantitative terms of units expected to be sold
and the value expected to be realised for the budget period.

9.16 ANSWERS TO CHECK YOUR PROGRESS

5)

6)

a)

Sales Manager

b) Sales

d)

Cash flow statement

c) Sales, production

d) Master Budget

f) Functional budget

a) False b) True c) False d) False

e) True

f) True

9.17 TERMINAL QUESTIONS

1)

What is a Sales Budget ? How is it prepared ?

2)

Write short notes on the following :

i)

Sales Budget

ii)

Material Budget

iii)

Production Cost Budget

iv)

Overhead Budget

3)

What is a Cash Budget ? How is it prepared ?

4)

What is a Master Budget ? What are its Components ?

5)

From the following particulars, prepare a production budget of a manufacturing

company for the year ended 31st March, 2003.
Product

Sales Budget
(Units)

Estimated Stock (Units)

1-4-2002
31-3-2003

75,000

7,000

7,500

50,000

2,500

7,250

35,000

4,000

4,000

(Ans. A : 75,500 Units, B : 54, 750 Units, C : 35,000 Units)

6)

Prepare a material procurement budget (in units) from the following information :
Estimated sales of a product 40,000 units. Each unit of the product requires 3
units of Material A and 4 units of Material B. Estimated opening balance at the
beginning of the next year:
Units
Finished Products
5,000
Material A

19,000

Material B

31,000

The desired level of closing balances at the end of the next year :
Finished Products

7,000

37

Budgeting and
Budgetary Control

Material A

23,000

Material B

35,000

(Ans. Production 42,000 units, Material required : Material A : 1,30,000

units, Material B : 1,72,000 units)
7)

The budgeted expenses for production of 10,000 units in a manufacturing

company are given below. From the information prepare a budget for the
production of (a) 8000 units and (b) 6000 units. Assume that the administration
expenses are fixed for all levels of production:
Rs. Per unit
Materials

70

Labour

25

Variable Overheads

20

Fixed Overheads (Rs. 1,00,000)

10

Variable Overheads(Direct)

Selling expenses (10% fixed)

13

Administration expenses (Rs. 50,000)

Distribution expenses (20% Fixed)

7
Rs.155

( Ans. (a) Rs. 12,75,400 (b) Rs. 10,00,800 )

8)

A Company produces and sells three products : Product A, Product B and

Product C. The Company has divided its market into two areas as North zone
and South zone. The actual sales for the year 2003 were as follows :
North Zone

Products

Price per
Unit (Rs.)

No. of Units

South Zone
Price per
Unit (Rs.)

No. of Units

12

8,00,000

12

5,00,000

15

5,00,000

15

7,00,000

16

6,00,000

16

6,00,000

For the current year i.e, 2002, it is estimated that the sales of product A will go up
by 10% in South zone and of Product C by 50,000 units in North zone. The company
plans to launch an intensive advertisement campaign through which budgeted figures
for product B are to be increased by 20% in both the zones.
There will be no change in the pries of the product A and C but the price of Product B
will be reduced by Rs. 1.
38

You are required to prepare a sales budget for the year 2003.

Preparation and
Review of Budgets

Ans. :

9)

North
(Units)

South
(Units)

Total Budget
(Rs.)

Product A

8,00,000

5,50,000

162,00,000

Product B

6,00,000

8,40,000

201,60,000

Product C

6,50,000

6,00,000

200,00,000)

Andhra Ltd has three sales division at Chennai, Bangalore and Hyderabad.
It sells two products I and II. The budgeted sales for the year ending
31st December, 2002 at each place are given below:
Chennai

Product I

50,000 units @ Rs. 16 each

Product II

35,000 units @ Rs. 10 each

Bangalore

Product II

55,000 units @ Rs. 10 each

Hyderabad

Product I

75,000 units @ Rs. 16 each

The actual sales during the same period were :

Chennai

Product I

62,500 units @ Rs. 16 each

Product II

37,500 units @ Rs. 10 each

Bangalore

Product II

62,500 units @ Rs. 10 each

Hyderabad

Product I

77,500 units @ Rs. 16 each

From the reports of the sales department it was estimated that the sales budget for the
year ending 31st December, 2003 would be higher than 2002 budget in the following
respects :
Chennai

Product I 4000 units

Product II 2,500 units

Bangalore

Product II 6,500 units

Hyderabad

Product I

5,000 units

Intensive sales campaign in Bangalore and Hyderabad is likely to result in additional

sales of 12, 500 units of Product I in Bangalore and 9,000 units of Product II in
Hyderabad. Let us prepare a sales Budget for the period ending 31st December,
2003.
(Ans. :

Chennai :

Product I 54000 Units

Product II 37,500 Units

Bangalore :

Product I 12500 units

Product II 61,500 units

Hyderabad :

Product I 80,000 units

Product II 9000 units)

10) Draw a Material Procurement Budget (Quantitative) from the following

information:
Estimated sale of a product is 20,000 units. Each units of the product requires
3 units of material X and 5 units of Material Y.

39

Budgeting and
Budgetary Control

Estimated opening balance at the commencement of the next year :

Finished product
2,500 kgs.
Material X

6,000 units

Material Y

10,000 units

Materials on Order :
Material X

3,500 units

Material Y

5,500 units

The desirable closing balances at the end of the next year :

Finished Product

3,500 units

Material X

7,500 units

Material Y

12,500 units

Material on order :
Material X

4,000 units

Material Y

5,000 units

11) The Sales Director of Asian Company expects to sell 25,000 units of a particular
product next year. The Production Director consulted the storekeeper who gave
the necessary details as follows :
Two kinds of raw material, P and Q are required for manufacturing the product.
Each unit of the product requires 2 units of P and 3 units of Q. The estimated
opening balance at the commencement of the next year are :
Finished product

5,000 units

Raw Material P

6,000 units

Raw Material Q

7,500 units

The desirable closing balance at the end of the next year are :
Finished Products

7,000 units

Raw Material P

6500 units

Raw Material Q

8000 units

Prepare a statement showing Material Purchase Budget for the next year.
(Ans. : Material required for 25,500 units : P - 54,500 units, Q - 81,500 units)
12) A company is expecting to have Rs. 50,000 cash in hand on 1st April, 2005
and it requires you to prepare an estimate of cash position during the three
months, April to June 2005. The following information is supplied to you :
Sales
(Rs.)

40

Purchases
(Rs.)

Wages
(Rs.)

Expenses
(Rs.)

February

1,40,000

80,000

16,000

12,000

March

1,60,000

1,00,000

16,000

14,000

April

1,84,000

1,04,000

18,000

14,000

May

2,00,000

1,20,000

20,000

16,000

June

2,40,000

110,000

24,000

18,000

Preparation and
Review of Budgets

Additional Information :
a)

The credit period allowed by supplies is two months.

b)

25% of sales is for cash and credit period allowed to customers is one month.

c)

Delay in payment of wages and expenses is one month.

d)

Income tax Rs. 50,000 is to be paid in June 2005.

(Ans. : April Rs. 1,06,000, May Rs. 1,62,000, June Rs. 1,82,000)

13) A Company is expected to have Rs. 12,500 cash in hand on 1st July, 2005 and it
requires you to prepare a cash budget for the period July, 2005 to September,
2005 from the following particulars :
Sales
(Rs.)

Purchases
(Rs.)

Wages
(Rs.)

May

90,000

62,400

6,000

June

96,000

72,000

7,000

July

54,000

1,21,500

5,500

August

87,000

1,23,000

5,000

September

63,000

1,34,000

7,500

Creditors are paid in the month following the month of purchase. 50% of credit sales
are realised in the month following the credit sales and the remaining 50% in the
second month following. Delay in the payment of wages is one month.
(Ans.

Cash balance : July Rs. 26,500 (+), August Rs. 25,500 (--), September
Rs. 83,000(--) )

14) A company expects to have Rs. 37,500 cash in hand on 1st April, and requires
you to prepare an estimate of cash position during the three months, April, May
and June. The following information is supplied to you :
Sales
( Rs.)

Purchases
( Rs.)

Wages
( Rs.)

Factory
Expenses
( Rs.)

Office
Expenses
( Rs.)

Selling
Expenses
( Rs.)

February

75,000

45,000

9,000

7,500

6,000

4,500

March

84,000

48,000

9,750

8.250

6,000

4,500

April

90,000

52,500

10,500

9,000

6,000

5,250

May

1,20,000 60,000

13,500

11,250

6,000

6,570

June

1,35,000 60,000

14,250

14,000

7,000

7,000

Additional Information :
1)

Period of credit allowed by suppliers 2 months

2)

20% of sales is for cash and period of credit allowed to customers for credit is one
month

3)

Delay in payment of all expenses 1 month

4)

Income tax of Rs. 57,500 is due to be paid on June 15th.

5)

The company is to pay dividends to shareholders and bonus to workers of

Rs. 15,000 and Rs. 22,500 respectively in the month of April.

41

Budgeting and
Budgetary Control

6)

Plant has been ordered to be received and paid in May. It will cost
Rs. 1,20,000.
(Ans. : Cash balance : April (+) Rs. 11,700, May (--) Rs. 91,050,
June (--) Rs. 1,15,370 )

15) From the following information, you are required to prepare cash budget
according to Adjusted Profit and Loss method as well as Balance Sheet method.
Balance Sheet as on 1-1-2005
Liabilities
Share Capital
Reserves

Rs.

Assets

Rs.

5,00,000

Debtors

5,00,000

Stock and Stores

3,00,000

10,00,000

Debentures

3,00,000

Fixed assets

13,00,000

Public deposits

2,00,000

Cash balance

1,00,000

Current liability

2,00,000
22,00,000

22,00,000

Projected Trading and Profit and Loss A/c for the year ending 31-12-2005
Particulars
To Opening Stock
To Direct Cost of Production

Rs.
3,00,000
12,00,000

To Depreciation

1,00,000

To Variable selling and

distribution costs

2,00,000

To Net profit c/d

3,00,000

Particulars
By Sales
By Closing Stock

21,00,000
To Dividends
To Balance c/d

50,000

Rs.
15,00,000
6,00,000

21,00,000
By Net Profit b/d

3,00,000

2,50,000
3,00,000

3,00,000

Additional Information :
Collection of debtors and sales proceeds during the year Rs. 17,00,000, refund of
public deposits Rs. 1,00,000, increase in current liability Rs. 50,000
(Ans. : Cash balance as on 31.12.2005 : Rs. 3,00,000, Debtors as on 31.12.2005 :
Rs. 3,00,000 (Opening debtors Rs. 5,00,000 + Sales Rs. 15,00,000 Collection
from debtors Rs. 17,00,000)

42

16) From the following information prepare a cash budget under the Adjusted Profit
and Loss Account Method and Balance Sheet Method.

Balance Sheet as on 1-1-2005

Liabilities

Rs.

Share capital
Capital reserve
Profit and loss a/c
Debentures
Creditors
Accrued expenses

50,000
5,000
9,000
10,000
28,800
200
1,03,000

Assets
Land and buildings
Plant and Machinery
Furniture and fixtures
Closing stock
Debtors
Bank

Preparation and
Review of Budgets

Rs.
30,000
20,000
5,000
4,000
26,000
18,000
1,03,000

Forecast Trading, and Profit and Loss Account

For the Year ending 31-12-2005
Particulars
Opening Stock
Purchases
Gross Profit c/d
Salary and wages
Add Outstanding
Depreciation :

Rs.
4,000
60,000
26,000
90,000
2500
500

3000

Plant and Machinery

2,000

Furniture and fixture

1,000

Administrative expenses

3,500

Selling expenses

2,500

Net Profit c/d

Particulars
Sales
Closing Stock

Rs.
80,000
10,000

Gross profit b/d

Interest received

90,000
26,000
100

14,100
26,100

26,100

Dividend paid

10,000

Balance b/d

Balance c/d

13,100

Net profit b/d

23,100

9,000
14,100
23,100

The following are the additional information for the year 2005 : shares were
issued for Rs. 10,000, and debentures were issued for Rs. 2,000.
On 31-12-2005, the accrued expenses were Rs. 500, Debtors Rs. 20,000, Creditors
Rs. 30,000, and Land and buildings, Rs. 40,000.
(Ans : Cash balance as on 31.12.2005 : Rs. 28,600, Balance Sheet total : Rs.1,20,600)
Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University. These
are for your practice only.

9.18

FURTHER READINGS

Edward B. Deakin and Michael W. Maher, Cost Accounting, Richard D. Erwin, inc.,
Homewood, Illinois.
Lal Nigam B.M. and Sharma G.L., Advanced Cost Accounting, Himalaya Publishing
House, Bombay-4.

43

UNIT 10 APPROACHES TO
BUDGETING
Structure
10.0

Objectives

10.1

Introduction

10.2

Fixed Budgeting

10.3

Flexible Budgeting

10.4

Difference between Fixed and Flexible Budgeting

10.5

Appropriation Budgeting

10.6

Zero Based Budgeting (ZBB)

10.7

Performance Budgeting

10.8

Budgetary Control Ratios

10.9

Behavioural Consideration

10.10

Let Us Sum Up

10.11

Key Words

10.12

Answers to Check Your Progress

10.13

Terminal Questions

10.14

Further Readings

10.0 OBJECTIVES
After studying this unit you will be able to know:
l

different approaches for the preparation of budgets;

the process of adjusting the budget to reflect actual conditions; and

the differences between planned activity and actual activity.

10.1 INTRODUCTION
In the previous Unit you have learnt the preparation and review of various types
of budgets. You have also learnt about the development of the master budget
for planning and control of costs. In this unit, you will study about different
approaches to budgeting and further to examine the use of the budget as a tool
for performance evaluation and control. The actual performance is compared
with the budgeted programme and the variances are analysed and investigated
so that corrective action may be taken well in time to ensure the success of the
business.

10.2 FIXED BUDGETING

44

According to C.I.M.A., London, a fixed budget is a budget which is designed to

remain unchanged irrespective of the level of activity actually attained. Thus, a budget
prepared on the basis of a standard or fixed level of activity is known as a fixed
budget. It does not change with the change in the level of activity. Therefore, it

becomes an unrealistic yardstick in case the level of activity actually attained does not
confirm to the one assumed for budgeting purposes. The management will not be in a
position to assess the performance of different heads on the basis of budgets prepared
by them because they can serve as yardsticks only when the actual level of activity
corresponds to the budgeted level of activity. Fixed budget is useful when there is no
significant variation between the budgeted output and the actual output. It does not
consider variances due to changes in the volume. In the industries where the pattern
of demand is stable a fixed budget may be adequate, especially where the budget
period is comparatively short. In such concerns it is possible to forecast sales with a
considerable degree of accuracy.

Approaches to
Budgeting

10.3 FLEXIBLE BUDGETING

Flexible budget, also known as variable or sliding sale budget, is a budget which is
designed to furnish budgeted costs for any level of activity actually attained. Flexible
budgeting technique may be employed to adjust other budgets according to current
conditions arising out of seasonal variations or changes in the length of the working
period etc.
According to C.I.M.A., London, a flexible budget is a budget designed to change in
accordance with the level of activity actually attained. Thus, a budget prepared in a
manner so as to give the budgeted cost for any level of activity is known as a flexible
budget. Such a budget is prepared after considering the fixed and variable elements of
cost and the changes that may be expected for each item at various levels of
operations.
Under this method, a series of budgets would be prepared at different levels of activity.
Variable items are shown in the budget as per the level of output. Fixed costs are
shown at the same amount irrespective of level of output. Sales value is computed and
entered into the flexible budget. The position of profit or loss will be revealed at the
various levels of activity. Management will take a decision to operate at a particular
level of activity where the profit is maximum taking into account all other factors.
A flexible budget is more realistic, useful and practical. The likely changes in the actual
circumstances are taken into account while preparing a flexible budget. The technique
is highly useful for control purposes. Actual performance of an executive may be
compared with what he should have achieved in the actual circumstances and not with
what he should have achieved under quite different circumstances.
Illustration 1
A Company producing electronic watches, estimates the following factory overhead
costs for producing 5,000 units:

Indirect Materials
Indirect Labour
Inspection Costs
Heat, Light and Power
Expendable tools
Supervision costs
Equipment depreciation
Factory rent

Rs.
16,000
30,000
16,000
8,000
8,000
8,000
4,000
4,000
45

Budgeting and
Budgetary Control

Indirect labour, indirect material and expendable tools are entirely variable. Heat,
light and power and inspection costs are variable to the extent of 50%, 40%
respectively. Other costs are fixed costs a month.
Prepare a flexible budget for production of 4,000 and 6,000 units per month. Also
find out the average factory overheads per unit for these two production levels.
Solution
Flexible Budget
for the production of 4,000 and 6,000 units per month
5000 Units
Rs.

4000 Units
Rs.

6000 Units
Rs.

Overheads:
Indirect Material

16,000

12,800

19,200

Indirect Labour

30,000

24,000

36,000

Inspection Costs

16,000

14,720

17,280

Heat, Light and Power

8,000

7,200

8,800

Expendable tools

8,000

6,400

9,600

Supervision Costs

8,000

8,000

8,000

Equipment depreciation

4,000

4,000

4,000

Factory rent

4,000

4,000

4,000

94,000

81,120

1,06,880

18.80

20.28

17.81

Average factory overheads

per unit
Illustration 2

A manufacturing company is presently working at 50% capacity and produces

1000 units at a cost of Rs. 360 per unit. The details of cost are given below :
Rs.
Material

200

Labour

60

Factory Overhead

60 (Rs. 24 fixed)

Administrative overheads

40 (Rs. 20 fixed)
Rs. 360

The current selling price of the product per unit is Rs. 400. At 60% of its capacity,
material cost per unit increases by 2% and selling price per unit falls by 2%.
At 80% of its capacity, material cost per unit increases by 5% and selling price per
unit falls by 5%. Estimate profits at 60% and 80% level of output and offer your
suggestions.
46

Approaches to
Budgeting

Solution
Flexible Budget
(Showing the forecast of Profit at different levels)
Elements of Cost
50%
(1000 Units)
Rs.

Level of Output
60%
(1200 Units)
Rs.

80%
(1600 Units)
Rs.

Material

200

204

210

Labour

60

60

60

Factory Overhead (Variable)

36

36

36

Administrative O.H. (Variable)

20

20

20

Marginal Cost per Unit

316

320

326

Sales Per unit

400

392

380

84

72

54

Total contribution

84,000

86,400

86,400

Fixed Overhead
(Rs. 24 + Rs. 20)

44,000

44,000

44,000

Profit
(Contribution Fixed OH)

40,000

42,400

42,400

Contribution per Unit

(Sales Marginal Cost)

Suggestion : It is advisable to operate at 60% level of capacity as the profit at 80%

capacity is the same. More risk is involved at 80% capacity as more production, more
working capacity, more efforts still profit remains the same.
Illustration 3
The following data belongs to a manufacturing company for the year ending
31st March, 2005. You are required to prepare a flexible budget for the year 31-3-2005
and forecast the profit at 60%, 75%, 90% and 100% of capacity.
Fixed Expenses :

Rs.
(Lakhs)

Wages and salaries

4.2

Rent, rates and taxes

2.8

Depreciation

3.5

Administrative expenses

4.5

Total

15.0

Semi-Variable expense : @ 50% of capacity

Maintenance and repairs

1.5

Indirect Labour

4.7

Sundry administrative expenses

2.7

Total

8.9
47

Budgeting and
Budgetary Control

Variable expenses : @ 50% of capacity

Material

12.0

Labour

12.8

Other direct expenses

2.0
26.8

It is estimated that fixed expenses remain constant for all levels of production; semivariable expenses remain constant between 45% and 65% of capacity, increasing
by10% between 65% and 80% of capacity and 20% between 80% and 100% of
capacity.
Sales at various levels are :
50% capacity Rs. 45 lakh
60% capacity Rs. 50 lakh
75% capacity Rs. 60 lakh
90% capacity Rs. 75 lakh
100% capacity Rs. 85 lakh
Solution
Flexible Budget for the year ended 31st March, 2005
(Rs. in lakh)
Elements of Cost

Level of Output
50%

60%

75%

90%

100%

Wages and salaries

4.2

4.2

4.2

4.2

4.2

Rent, Rates and taxes

2.8

2.8

2.8

2.8

2.8

Depreciation

3.5

3.5

3.5

3.5

3.5

Administrative expense

4.5

4.5

4.5

4.5

4.5

15.0

15.0

15.0

15.0

15.0

Maintenance and repairs

1.5

1.5

1.65

1.80

1.80

Indirect labour

4.7

4.7

5.17

5.64

5.64

Sundry admn. Expenses

2.7

2.7

2.97

3.24

3.24

8.9

8.9

9.79

10.68

10.68

Material

12.0

14.4

18.0

21.60

24.0

Labour

12.8

15.36

19.2

23.04

25.6

2.0

2.40

3.0

3.60

4.0

26.8

32.16

40.2

48.24

53.6

50.7

56.06

64.99

73.92

79.28

Fixed expenses :

Semi-Variable Expenses :

Variable expenses :

Other direct expenses

Total cost of Production
Profit/Loss
48

Sales

(--) 5.7 (--) 6.06 (--) 4.99 (+) 1.08 (+)5.72

45.00

50.00

60.00

75.00

85.00

10.4 DIFFERENCE BETWEEN FIXED AND

FLEXIBLE BUDGETING

Approaches to
Budgeting

The differences can be outlined as follows:

1)

Fixed budgeting is inflexible and remains the same irrespective of the volume of
business activity, whereas flexible budgeting can be suitably recast quickly to suit
changed conditions.

2)

Fixed budgeting assumes that conditions would remain static, whereas, flexible
budgeting is designed to change according to a change in the level of activity.

3)

Under fixed budgeting, costs are not classified according to fixed, variable and
semi-variable, while, under flexible budgeting, costs are classified according to
nature of their variability.

4)

Under fixed budgeting, actual and budgeted performances cant be correctly

compared if the volume of output differs, while under flexible budgeting,
comparisons are realistic since the changed plan figures are placed against actual
ones.

5)

Under fixed budgeting, cost cannot be ascertained if there is a change in the

circumstances, while, under flexible budgeting, costs can easily be ascertained at
different levels of activity. The task of fixing prices becomes smooth.

10.5 APPROPRIATION BUDGETING

Generally budgets are prepared for the regular business activities and they cover the
operational activities of an organisation. However, it is not true that budgets are only
useful for operational activities, these may also prepare for any particular purpose, like
for constructing any particular building, development activities, where revenue is not
concerned, only expenditures are there. When budgets are prepared only for a
particular activity/work, that is called Appropriation Budget. These budgets are related
to only one activity /work and on completion of that particular activity the purpose of
this budget ends. Hence, this type of budget are always relate /cover different activities
in an organisation.

10.6 ZERO BASED BUDGETING (ZBB)

The technique of zero based budgeting suggests that an organisation should not only
make decisions about the proposed new programmes but it should also, from time to
time, review the appropriateness of the existing programmes. Such review should
particularly done of such responsibility centres where there is relatively high proportion
of discretionary costs.
Zero based budgeting, as the term suggests, examines a programme or function or
responsibility from scratch. The reviewer proceeds on the assumption that nothing
is to be allowed. The manger proposing the activity has, therefore, to prove that the
activity is essential and the various amounts asked for are reasonable taking into
account the volume of activity. Nothing is allowed simply because it was being done or
allowed in the past. Thus, it means writing on a clean slate.
Peter A. Pyhrr defined the zero based budgeting as an operating planning and
budgeting process which requires each manager to justify his entire budget requests in
detail from scratch (hence zero basis). Each manager states why he should spend any
money at all. This approach requires that all activities be identified as decision
packages which would be evaluated by systematic analysis ranked in order of
importance.

49

Budgeting and
Budgetary Control

Thus, a cost-benefit analysis is done in respect of every function or process. It has to

be justified while framing budgets. The assumption underlying zero base budgeting is
that the budget for the previous period was zero, therefore whatever costs are likely to
be incurred or spending programmes are chalked out, justification or the full amount is
to be given. Under conventional system of budgeting, however, the justification is to be
submitted by the manager only in respect of the increase in the demand for allotment
of funds in excess over the budget for the previous period. Thus, instead of
functionally-oriented spending approach, programme-oriented and decision-oriented
approach is followed under zero based budgeting.
Advantages of ZBB
1)

This system is decision oriented.

2)

The technique is relatively elastic, because budgets are prepared every year as
zero base.

3)

It reduces wastage, eliminates inefficiency and reduces the overall cost of

production because every budget proposal is on the basis of cost-benefit ratio
after careful evaluation of different alternatives and the one which is best is
approved.

4)

It provides for a greater possibility of goal congruence.

5)

It takes into consideration inflationary trends, competitor games and consumer

behaviour.

6)

It vastly improves financial planning and management information system in view

of its revolutionary approach.

Disadvantages of ZBB
1)

It is possible to quantify and evaluate budget proposals involving financial matters

but computation of cost-benefit analysis is not possible in respect of non-financial
matters.

2)

The cost of administration of zero based budgeting is high.

3)

It may be difficult to search out various alternatives for the same activity.

4)

Some decision packages are inter-related which may be difficult to rank.

5)

Ranking the decision is a scientific technique. Every manager can not be

expected to have the necessary technical expertise in this matter.

6)

Zero based budgeting dismisses that the past is irrelevant and thereby challenges
the fundamental theory of continuity. Budgeting is a continuous process of
estimating and forecasting about the future and is based on past happenings.

10.7 PERFORMANCE BUDGETING

Performance budgets are framed in such a manner that items of expenditure and
receipts for a budget period related to a specific responsibility centre are linked with
the physical performance of that centre. The main issue involved in the preparation of
performance budgets is the development of work programmes and performance
expectation by assignment of responsibility. It is essential for the attainment of the
objectives.

50

In this approach, there is not only a financial plan but also a work plan in terms of
work done or end-products produced. Thus, it gives a broader view to the budget as a
plan and programme of action rather than only as an instrument for obtaining funds. In
fact, it makes the integration of inputs with the outputs of a development programme.

According to National Institute of Bank Management, performance budgeting

technique is, the process of analysing, identifying, simplifying and crystallising specific
performance objectives of a job to be achieved over a period, in the framework of the
organisational objectives, the purpose and objectives of the job. The technique is
characterised by its specific direction towards the business objectives of the
organisation.

Approaches to
Budgeting

The main objectives of performance budgeting are :

i)

to coordinate the physical and financial aspects,

ii)

to improve the budget formulation, review and decision making at all levels of
management,

iii)

to facilitate better appreciation and review by controlling authorities as the

presentation is more purposeful and intelligible,

iv)

to make more effective performance audit possible, and

v)

to measure progress towards long term objectives which are envisaged in a

development plan.

Performance budgeting requires preparation of periodic performance reports.

Such reports compare budget and actual data, and show variances. Their
preparation is greatly facilitated if the authority and responsibility for the
incurence of each cost element is clearly defined within the firms
organisational structure. The responsibility for preparing the performance
budget of each department lies on the respective department head. Periodic
reports from various sections of a department will be required by the
departmental head who will submit a summary report about his department to
the budget committee. The report will be in the form of comparison of budgeted
and actual figures both periodic and cumulative. The purpose of preparing these
reports is to promptly inform about the deviations in actual and budgeted activity
to the person who has the necessary authority and responsibility to take
necessary action to correct the deviations from the budget.
Thus, performance budgeting lays immediate stress on the achievement of
specific goals over a period of time. However, in the long-run it aims at
continuous growth of the organisation so that it continues to meet the dynamic
needs of its growing clientele. It enables the organisation to be sensitive and
adaptive, preventing it from developing rigidities which may retard the process of
growth.
A comparison of the master budget with the flexible budget and with actual
results forms the basis for analyzing difference between plans and actual
performance. The difference between operating profits in the master budget
and operating profits in the flexible budget is called an activity variance. When
the change from the master budget to the flexible budget is due to changes in
sales volume, the activity variance is known as the sales volume variance. The
variance may be favourable or unfavourable variance. Let us take the following
illustration.
Illustration 4
Z Ltd had a profit plan approved for selling 5,000 units per month at an average price
of Rs. 10 per unit. The budgeted variable cost of production was Rs. 4 per unit and
the fixed costs were budgeted at Rs 20,000, the planned income being Rs. 10,000
per month. Due to shortage of raw materials, only 4,000 units could be produced and
the cost of production increased by 50 paisa per unit. The selling price was raised by
51

Budgeting and
Budgetary Control

Rs. 1.00 per unit. In order to improve the producti1on process, an expenditure of
Rs. 1,000 was incurred for research and development activities.
You are required to prepare a Performance Budget and find out the variance.
Solution
Z Ltd
Performance Budget
Original Plan
(5000 units)
Rs.

Adjusted Plan
(4000 units)
Rs.

Actual Position
(4000 units)
Rs.

Variance
(Rs.)

Sales Revenue

50,000

40,000

44,000

4000 (F)

Variable Costs

20,000

16,000

18,000

2000 (U)

Contribution

30,000

24,000

26,000

2000 (F)

Fixed Costs

20,000

20,000

21,000

1000 (U)

Net Income

10,000

4,000

5,000

1000 (F)

Flexible budget variance = Rs. 5000 Rs. 4000 = Rs. 1000 (F)
Illustration 5
From the following information prepare the performance budget of ABC Company Ltd
for the month of December, 2005.
Variables

Actual (Based on
actual activity of
10,000 units sold)

Flexible Budget
(based on actual
activity of 10,000
units sold)

Master budget
(based on a
prediction of
8,000 units sold)

Sales Revenue

Rs.
2,10,000

Rs.
2,00,000

Rs.
1,60,000

Manufacturing costs

1,05,440

1,00,000

80,000

Marketing and
administrative costs

11,000

10,000

8,000

Fixed costs

65,000

60,000

60,000

Solution
Performance Budget of ABC Co. Ltd for the month of December 2005
Variables

Actuals
(based on
actual activity
of 10,000
units sold

Variance

Variance

Master
Budget
(based on a
prediction
of 8000
units sold)

Rs.
2,10,000

Rs.
10,000 (F)

Rs.
2,00,000

Rs.
40,000 (U)

Rs.
1,60,000

1,16,440

6,440 (U)

1,10,000

22,000 (U)

88,000

93,560

3,560 (F)

90,000

66,000 (U)

72,000

Less : Fixed Cost

65,000

5,000 (F)

60,000

60,000

Profit

28,560

1440 (U)

30,000

18,000 (F)

12,000

Sales Revenue
Less: Mafg. Costs
and Administrative
costs

52

Flexible
Budget
(Based on
actual activity
of 10,000
units sold)

Total Variance from Flexible Budget = Rs. 1440 (U)

Total Variance from Master Budget = Rs. 18,000 Rs. 1440 = Rs. 16,560 (F)

10.8 BUDGETARY CONTROL RATIOS

Approaches to
Budgeting

Three important ratios are commonly used by the management to find out whether the
deviations of actuals from budgeted results are favourable or otherwise. These ratios
are expressed in terms of percentages. If the ratio is 100% or more, the trend is taken
as favourable. The indication is taken as unfavourable if the ratio is less than 100.
These ratios are:
1)

Activity Ratio

2)

Capacity Ratio

3)

Efficiency Ratio

Let us study these ratios in brief.

1)

Activity Ratio

It is the measure of the level of activity attained over a period. It is obtained when the
number of standard hours equivalent to the work produced are expressed as a
percentage of the budgeted hours.
Standard hours for actual production
Activity Ratio =
Budgeted hours

2)

100

Capacity Ratio

This ratio indicates whether and to what extent budgeted hours of activity are actually
utilised. It is the relationship between the actual number of working hours and
maximum possible number of working hours in budget period.
Actual hours worked
Capacity Ratio =

3)

Budgeted hours

100

Efficiency Ratio

The ratio indicates the degree of efficiency attained in production. It is obtained when
the standard hours equivalent to the work produced are expressed as a percentage of
the actual hours spent in producing that work.
Standard hours for actual production
Efficiency Ratio =

Actual hours worked

100

Illustration 6
A factory manufactures two types of articles namely X and Y. Article X takes 10 hours
to make and article Y requires 20 hours. In a month (25 days of 8 hours each) 500
units of X and 300 units of Y are produced. The budget hours are 8500 per month. The
factory employs 60 men in the department concerned. Compute Activity Ratio,
Capacity Ratio and Efficiency Ratio.

53

Budgeting and
Budgetary Control

Solution
Standard hours for actual production

Hrs.

X : 500 units 10

5,000

Y : 300 units 20

6,000
11,000

Budgeted Hours

8,500

Actual Hours worked (60 8 25 )

12,000

Standard hours for actual production

Activity Ratio

=
Budgeted hours
11000
=

8500

100 = 129%

Actual hours worked

Capacity Ratio =
Budgeted Ratio

12000
8500

100

100 = 141%

Standard hours for actual production

Efficiency Ratio =
Actual hours worked
11,000
=

12,000

100

100

100 = 92%

10.9 BEHAVIOURAL CONSIDERATION

Basically budgets are prepared on the basis of past data available after considering the
changes in future conditions. However, it must be kept in mind that human behaviour is
volatile in nature. So, the preferences will change in future if there are changes in level
of living, earning capacity, awareness about the new product, health consciousness,
etc. Therefore, at the time of preparing the budget, the factors which affect the
behaviour of human being, must be considered, because, these factors make drastic
changes in the demand position of any product and budget estimates will not find near
to actual data/ results.
Check Your Progress
1)

54

State the differences between fixed and flexible budgeting.

a)

......................................................................................................................

b)

......................................................................................................................

c)

......................................................................................................................

d)

......................................................................................................................

2)

Approaches to
Budgeting

What is meant by Appropriation Budgeting ?

.............................................................................................................................
.............................................................................................................................
.............................................................................................................................

3)

What are the budgetory control ratios ?

.............................................................................................................................
.............................................................................................................................
.............................................................................................................................

4)

5)

Fill in the blanks :

a)

A budget which is designed to remain unchanged irrespective of the level

of activity is called ..........................

b)

A budget which is prepared to change according to the level of activity is

called ..........................

c)

When a budget is prepared only for a particular activity such budgeting is

called ..........................

d)

A system of establishing financial plans beginning with an assumption of

no activity is called ..........................

e)

The difference between operating profits in the master budget and flexible
budget is called .......................... variance.

State whether each of the following statement is true or false.

a)

Fixed budgeting is useful when there is no significant variations

in the budgeted output and actual output

[ ]

b)

Incase of industries where the demand for goods is stable and

budget period is short flexible budgeting is suitable for them

[ ]

c)

Flexible budgeting is also called sliding scale budget.

[ ]

d)

Budgets are prepared only for operational activities of an

organisation

[ ]

e)

A zero-base budgeting is prepared on the assumption that the

budget for previous period is nil

[ ]

f)

Performance budgeting lays immediate stress in the achievement

of specific goals over a period of time.

[ ]

g)

Fixed budget is suitable for fixed expenses

[ ]

h)

Every item of budget has to be justified when a zero based

budgeting is prepared.

[ ]

i)

Fixed budget is more useful than a flexible budget.

[ ]
55

Budgeting and
Budgetary Control

10.10 LET US SUM UP

A budget prepared on the basis of a standard level of activity is known as fixed budget.
It does not change with the change in the level of activity. It is useful when there is no
significant changes between the budgeted output and actual output. Flexible budget is
a budget prepared in a manner so as to give the budgeted cost for any level of activity.
The likely changes in the actual circumstances are taken into account while preparing
the flexible budget. A series of budgets would be prepared at different levels of
activity. Budgets are prepared not only for regular business activities but also for any
particular purpose. When budgets are prepared for only a particular activity it is called
appropriation budget. This type of budget cover different activities in an organisation.
Zero based budgeting suggests that an organisation should not only make decisions
about the proposed new programmes but it should also, from time to time, review the
appropriateness of the existing programmes. The underlying assumption of zero base
budgeting is that the budget for the previous period is zero, therefore whatever costs
are likely to be incurred are chalked out and full amount is to be given.
Performance budgeting requires preparation of periodic performance reports. Such
reports compare budget and actual data, and show variances. There are three
important ratios commonly used by the management to find out whether the deviations
of actuals from budgeted results are favoruable or otherwise. These ratios are :
Activity ratio, capacity ratio and efficient ratio.

10.11

KEY WORDS

Appropriation Budgeting : A budget which is prepared only for a particular

activity/work
Flexible Budget : A budget which is designed to change in accordance with the
level of activity attained.
Fixed Budget : A budget which remains unchanged whatever the actual level of
activity.
Zero-Based Budgeting : A system of establishing financial plans beginning with an
assumption of no activity and justifying each programme or activity level.

10.12 ANSWERS TO CHECK YOUR PROGRESS

4)

(a) Fixed budgeting

(b) flexible budgeting
(d) Zero based budgeting (e) Activity

5)

a)
f)

True
True

b)
g)

False
True

c)
h)

True
True

d)
i)

(c) Appropriation budgeting

False
False

e)

True

10.13 TERMINAL QUESTIONS

56

1)

What are fixed and flexible budgets? Differentiate between these two.

2)

What do you understand by zero base budgeting? How is it different from

traditional budgeting?

3)

Why do accountants prepare a budget for a period that is already over when we
know the actual results by then? Explain.

4)

Why is a variable costing format useful for performance evaluation?

5)

What are the three important control ratios? Explain them in brief.

6)

Performance budgeting requires preparation of periodic performance reports

Explain.

7)

A single product manufacturing company is currently producing 12,000 units (at

60% capacity). The following particulars relating to its cost structure are
available :
Per Unit (Rs.)
Direct materials
5
Direct Labour (Variable)
2
Manufacturing overheads (60% fixed)
5
Administrative overheads (fixed)
2
Selling and distribution overheads (40% variable)
3
Cost of sales

Approaches to
Budgeting

17

Profit

Selling price

20

You are required to prepare a flexible budget for 60%, 80% and 100% activity
levels taking into account the following additional information :
1)

if activity exceeds 60%, a 5% quantity discount on raw materials on account

of increase in the total quantity will be received

2)

The present fixed cost structure will remain constant upto 90% capacity,
beyond which a 20% increase in cost is expected.

3)

The present unit selling price will remain constant upto 70% activity level,
beyond which a 2 % reduction in original price for increase in activity by
every 5% is contemplated.
(Ans. At 60% : Rs. 36,000, at 80% : Rs. 71,200, at 100 : Rs. 53,080)

8)

The following data are available in a manufacturing company for the period of a
year.
Rs. ( 000)
Fixed expenses :
Wages and salaries

950

Rent, rates and taxes

660

Depreciation

740

Sundry administrative expenses

650

Semi-variable expenses : (at 30% of capacity)

Maintenance and repairs

350

Indirect labour

790

Sales department salaries etc.

380

Sundry administrative expenses

280

Variable expense : (at 50% of capacity)

Materials

2,170

Labour

2,040

Other expenses

790
9800

57

Budgeting and
Budgetary Control

Assume that the fixed expense remain constant for all levels of production; semivariable expenses remain constant between 45% and 65% of capacity, increasing
by 10% between 65% and 80% capacity, and by20% between 80% and 100%
capacity.
Sales at various levels are :
Rs. (Lakhs)
50% capacity

100

60% capacity

120

75% capacity

150

90% capacity

180

100% capacity

200

Prepare the flexible budget for the year and forecast the profits at 60%, 75%
90% and 100% of capacity.
(Ans. : 60% Rs. 12 lakhs, 75% Rs. 25.2 lakh, 90% Rs. 38.4 lakhs, 100%
Rs. 47.4 lakhs)
9)

A manufacturing Co. Ltd operates a system of flexible budgetary control.

A flexible budget is required to show levels of activity of 80%, 90% and 100%.
The following information is available :
1)

Sales, based on normal level of activity of 80% are 8,00,000 units at Rs. 10
each. If output is increased to 90%, it is thought that the selling price should
be reduced by 2 % , and if output reached is 100%, it would be necessary
to reduce the original price by 5% in order to reach a wider market.

2)

Prime costs are :

Direct material
Direct labour
Direct expense

Rs. 3.50
Rs. 1.25
Rs. 0.25
Rs. 5.00

If output reaches at 90% level of activity as above, the purchase price of

raw material will be reduced by 5%.
3)

Variable overheads, salesmens commission is 5% on sales value.

4)

Semi-variable overheads at normal level of activity are :

Supervision
Power
Heat and light
Maintenance
Indirect labour
Salesmens expenses
Transport

Rs.
80,000
70,000
40,000
50,000
1,00,000
60,000
2,00,000

Semi-variable overheads are expected to increase by 5% if output reaches a

level of activity of 90%, and by a further 10% if it reaches the 100% level.
58

5)

Fixed overheads are :

Rs.

Rent and rates

1,00,000

Depreciation

4,00,000

Administration

7,50,000

Sales department

2,00,000

Advertising

5,00,000

General

Approaches to
Budgeting

50,000

(Ans : 80% Rs. 10 lakhs, 90% Rs. 1363750, 100% Rs. 1507000)
10) A department of a Company X attains sales of Rs. 3,00,00 at 80% of its normal
capacity and its expenses are given below :
Administration Costs:
Salaries : Rs. 45,000, General expenses 2% of sales,
Depreciation Rs. 3,750, Rates and taxes Rs. 4,375
Selling Costs :
Salaries 8% of sales, Travelling expenses 2% of sales,
Sales expenses 1% of sales, general expenses 1% of sales.
Distribution Costs :
Wages Rs. 7,500, Rent 1% of sales, other expenses 4% of sales.
Prepare a flexible administration, selling and distribution costs budget, operating at
90% and 100% of normal capacity.
90%
100%
(Ans. : Administration costs
Rs. 59,875
Rs. 60,625
Selling Costs
Rs. 40,500
Rs. 45,000
Distribution Costs
Rs.14,375
Rs. 26,250
Total

Rs. 1,14,750

Rs. 1,31,875

11) From the following particulars relating to XYZ company for the month of
November, 2003 prepare a report comprising actual results with the flexible and
master budget.
Units produced and sold

: 50,000 (Budgeted sales 45,000 units)

Selling price per unit

: Rs. 10 (Budgeted Rs. 11 per unit)

Actual variable cost per unit

: Rs. 5 (Budgeted Rs. 4 per unit )

Actual fixed overhead

: Rs. 83, 000 (Budgeted Rs. 80,000)

Actual fixed administration cost

: Rs. 96,000 (Budgeted Rs.1,00,000)

Actual Variable administration Cost : Rs. 62,500 (Budgeted Rs. 1 per unit)
(50,000 units @ 1.25 per unit)
[Ans. : Total variance from flexible budget : Rs. 1,27,500 (Unfavourable)]
Total variance from Master budget : Rs. 2,39,000
(Unfavourable) ]

59

Budgeting and
Budgetary Control

12) From the following controllable and non-controllable costs relating a

manufacturing company for 31st March, 2003, prepare a performance budget by
comparing actual results with the flexible and master budget :
Standard budget based on 20,000 units :
Controllable Costs :

Non Controllable Costs :

Rs.

Rs.

Indirect Labour

70,000

Supervision

34,000

Indirect material

20,000

Rates and taxes

12,000

Fuel and power

56,000

Insurance

Maintenance

12,000

Depreciation

2,000
15,000

1,58,000

63,000

The actual production during the year was as follows :

Controllable costs :

Actual Costs
Rs.

Indirect labour
Indirect material
Fuel and power
Maintenance

Non-controllable costs :
Supervision
Rates and taxes
Insurance
Depreciation

Budget based on
18,000 units actuals
Rs.

63,000
21,000
56,000
12,000
1,52,000

65,000
18,000
51,400
11,600
1,46,000

32,980
12,000
2,000
15,000
61,980

31,600
12,000
2,000
15,000
61,600

[Ans. Total Variance from flexible budget : Controllable costs Rs. 6000 (U),
Non Controllable Costs : Rs. 1380 (U), Total variance from Master budget :
Controllable costs : Rs. 6000 (F) Uncontrollable costs : Rs. 1020 (F) ]

Note :

These questions will help you to understand the unit better. Try to write answers
for them. But do not submit your answers to the University. These are for your
practice only.

10.14 FURTHER READINGS

Prem Chand, 1969, Performance Budgeting, Academic Books : New Delhi.
Pyhrr, Peter, A. 1973, Zero Base Budgeting, John Wiley and, Sons ; New York.`

60

____________________________________________________________
UNIT 11: STANDARD COSTING
_____________________________________________________________
Introduction
One of the prime functions of management accounting is to facilitate managerial control
and the important aspect of managerial control is cost control.

The efficiency of

management depends upon the effective control of costs. Therefore, it is very important
to plan and control cost. Standard costing is one of the most important tools, which helps
the management to plan and control cost of business operations. Under standard costing,
all costs are pre-determined and pre determined costs are then compared with the actual
costs. The difference between pre-determined costs and the actual costs is known as
variance which is analysed and investigated to the reasons. The variances are then
reported to management for taking remedial steps so that the actuals costs adhere to predetermined costs. In historical costing actual costs are ascertained only when they have
been incurred. They are useful only when they are compared with predetermined costs.
Such costs are not useful to management in decision-making and cost control. Therefore,
the technique of standard costing is used as a tool for planning, decision-making and
control of business operations. In this unit you will study the basic concepts of standard
costing.
Meaning of Standard Cost
Standard costs are predetermined cost which may be used as a yardstick to measure the
efficiency with which actual costs has been incurred under given circumstance. To
illustrate, the amount of raw material required to produce a unit of product can be
determined and the cost of that raw material estimated. This becomes the standard
material input. If actual raw material usage or costs differ from the standards, the
difference which is called variance is reported to manager concerned. When size of the

variance is significant, a detailed investigation will be made to determine the causes of

variance
According to the chartered Institute of Management Accountants (C.I.M.A) London,
Standard cost is the predetermined cost based on technical estimates for materials,
labour and overhead for a selected period of time for a prescribed set of working
conditions.
The Institute of Cost and Works Accountants defines standard costs as Standard costs
are prepared and used to clarify the final results of a business, particularly by
measurement of variations of actual costs from standard costs and the analysis of the
causes of variations for the purpose of maintaining efficiency of executive action.
Thus standard costs is a predetermined which determines what each product or service
should be under given circumstances. From the above definitions we may note that
standard costs are:
i)

Pre-determined cost: Standard cost is always determined in advance and

ahead of actual point of time of incurring of costs.

ii)

Based on technical estimated: Standard cost is determined only on the basis of

a technical estimate and on a rational basis.

iii)

For the purpose of Comparison: The very purpose of standard cost is to aid
the comparison with actual costs.

iv)

Based for price fixing: The prices are fixed in advance and hence the only
variation basis is the standard cost.

Standard Cost and Estimated Costs

Estimates are predetermined costs which are based on historical data and is often not very
scientifically determined. They usually compiled from loosely gathered information and
therefore, they are unsafe to use them as a tool for measuring performance. Standard
costs are predetermined costs which aims at what the cost should be rather then what it
will be. Both the standard costs and estimated costs are used to determine price in

advance and their purpose is to control cost. But, there are certain differences between
these two costs as stated below:
Differences between Standard costs and Estimated Costs:
The following are some of the important differences between standard cost and estimated
cost:
Standard Cost

Estimated Cost

Standard cost emphasizes as what the cost Estimated cost emphasizes on what the cost
should be in a given set of situations.

will be.

Standard costs are planned costs which are Estimated costs are determined by taking
determined by technical experts after into consideration the historical data as the
considering

levels

of

efficiency

and basis and adjusting it to future trends.

production
It is used as a devise for measuring It cannot be used as a devise to determine
efficiency

efficiency.

It only determines expected

costs.
Standard costs serve the purpose of cost Estimated costs do not serve the purpose of
control

cost control.

Standard costing is part of cost accounting Estimated costs are statistical in nature and
process

may not become a part of accounting.

It is a technique developed and recognised It is just an estimate and not a technique

by management and academecians
It can be used where standard costing is in It may be used in any concern operating on
operation

a historical cost system.

Concept of Standard Costing

Standard costing is a technique used for the purpose of determining standard cost and
their comparison with the actual costs to find out the causes of difference between the

two so that remedial action may be taken immediately.

The Charted Institute of

Management Accountants, London, defines standard costing as the preparation of

standard costs and applying them to measure the variations from actual costs and
analysing the causes of variations with a view to maintain maximum efficiency in
production.
Thus, standard costing is 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. When actual costs differ from standards the difference is called variance and
when the size of the variance is significant a detailed investigation will be made to
determine the causes of variance, so that remedial action will be taken immediately.
Thus, standard costing involves the following steps:
1.

Setting standard costs for different elements of costs

2.

Recording of actual costs

3.

Comparing between standard costs and actual costs to determine the variances

4.

Analysing the variances to know the causes thereof, and

5.

Reporting the analysis of variances to management for taking appropriate

actions wherever necessary.

The system of standard costing can be used effectively to those industries which are
producing standardised products and are repetitive in nature. Examples are cement
industry, steel industry, sugar industry etc. The standard costing may not be suitable to
jobbing industries because every job has different specifications and it will be difficult
and expensive to set standard costs for every job. Thus, standard costing is not suitable in
situations where a variety of different kinds of tasks are being done.
Objectives of Standard Costing:
1.

Cost Control: The most important objective of standard cost is to help the

management in cost control. It can be used as a yardstick against which actual costs can

be compared to measure efficiency. The management can make comparison of actgual

costs with the standard costs at periodic intervals and take corrective action to maintain
control over costs.
2.

Management by Exception: The second objective of standard cost is to help the

management in exercising control over the costs through the principle of exception.
Standard cost helps to prescribe standards and the attention of the management is drawn
only when the actual performance is deviated from the prescribed standards.

It

concentrates its attention on variations only.

3.

Develops Cost Conscious Attitude: Another objective of standard cost is to

make the entire organisation cost conscious. It makes the employees to recognise the
importance of efficient operations so that costs can be reduced by joint efforts.
4.

Fixation of Prices:

To help the management in formulating production policy

and helps in fixing the price quotations as well as in submitting tenders of various
products. This can be done with accuracy with standard cost than the actual costs. It also
helps in formulating production policies.

Standard costs removes the reflection of

abnormal price fluctuations in production planning.

5.

Fixing Prices and Formulating Policies:

Another object of standard cost is to

help the management in determining prices and formulating production policies. It also
helps the management in the areas of profit planning, product-pricing and inventory
pricing etc.
6.

Management Planning:

Budget planning is undertaken by the management

at different levels at periodic intervals to maximise the profit through different product
mixes. For this purpose it is more convenient using standard costing than actual costs
because it is done on scientific and rational manner by taking into account all technical
aspects.

Check your progress A

1.

2.

3.

Standard costing involves in determining

i)

Standard Costs

ii)

Actual Costs

iii)

Estimated Costs

The difference between actual costs and standard cost is known as

i)

Profit

ii)

Variance

iii)

Historical Cost

The purpose of standard costing is to

i)

Reduce Costs

ii)

Measure Efficiency

iii)

Control Prices

4.

Distinguish between standard cost and estimated cost

5.

What do you understand about standard cost and standard costing.

True or False Statements

a.

Standard costing is suitable to job industries where different kinds of tasks are
being done.

b.

(False)

Standard costing is used effectively in those industries which are producing

standardized products and are repetitive in nature.

c.

(True)

Budgeting is the process of preparing plans for future activities of an

enterprise. (True)

d.

Standard costing is suitable for small business. (False)

e.

The figure based on the average performance of the past after taking into
account the seasonal/cyclical changes is called expected standards.

(False)

f.

The success of a standard costing depends upon the reliability and accuracy of
the standards.

(True)

Standard Costing and Budgeting

Budgeting may be defined as the process of preparing plans for future activities of
the business enterprise after considering and involving the objectives of the said
organisation. This also provides process/steps of collection and preparation of data, by
which deviations from the plan can be measured.

This analysis helps to measure

performance, cost estimation, minimizing wastage and better utilisation of resources of

the organisation. Thus, budgets are prepared on the basis of future estimated production
and sales in order to find out the profit in a specified period. In other words Budget is an
estimate and a quantified plan for future activities to coordinate and control the uses of
resources for a specified period. According to Institute of Cost and Works Accountants,
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. Budgeting is a process which includes both the functions of budget and
budgetory control. Budget is a planning function and budgetory control is a controlling
system or a technique. You might have already studied the budgeting in detail in Block
3, under Unit-8: Basic Concepts of Budgeting.
The objective of the standard costing and budgeting is to achieve maximum
efficiency and cost control. Under both the systems actual performance is compared with
predetermined standards, deviations, if any, are analysed and reported. Budgeting is
essential to determine standard costs while standard costing is necessary for planning
budgets. Both are complimentary in nature and in determining the results. Besides
similarities there are certain differences between standard costing and budgeting which
are as follows:

Standard costing
1.

Budgeting

Standard costing is based on 1.

It is based on standard cost, historical costs

technical information and is fixed

and estimates.

scientifically.
2.

Standard costs are used mainly for 2.

Budgets

the manufacturing function and

functional departments such as sales,

also

purchase, production, finance, personnel

for

marketing

administration

and

functions.

Therefore, it does not require

are

department.

prepared

Therefore,

for

it

different

requires

functional coordination.

functional coordination.
3.

Standard costs emphasises the 3.

Budgets emphasises cost levels which

cost levels which should be

should not be exceeded.

reduced
4.

In standard costing variances are 4.

In Budgeting, variances are not revealed

usually

through accounts and control in exercised

revealed

through

accounts.

by putting budgeted figures and actuals

side by side.

5.

In standard costing, a detailed 5.

No further analysis is required if costs are

analysis is needed in case of

within the budget.

variances.
6.

Standard costing sets realistic 6.

Budgets generally set maximum limits of

yardsticks and therefore, it is

expenditure

more useful for controlling and

effectiveness of expenditure.

without

considering

the

reducing costs.
7.

Standard cost is revised only 7.

Budgeting is done before the beginning of

when there is a change in the

each accounting period.

basic assumptions and basis.

8.

Standard costs are based on the 8.

Budgets are set on the basis of present

basis

level of efficiency.

of

standards

set

by

management.

9.

Standard costing cannot be used 9.

Budgeting can be done either wholly or

partially. Standards will have to

partly.

be set for all elements of cost.

10. Standard cost is a projection of 10.
cost accounts.

Budgeting is a projection of financial

accounts.

Advantages of Standard Costing

The introduction of Standard Costing system may offer many advantages. It varies from
one business to another. The following advantages may be derived from standard costing
in the light of the various objectives of the system:
1.

To measure efficiency:

Standard Costs provide a yardstick against which

actual costs can be measured. The comparison of actual costs with the standard cost
enables the management to evaluate the performance of various cost centres. In the
absence of standard costing, efficiency is measured by comparing actual costs of different
periods which is very difficult to measure because the conditions prevailing in both the
periods may differ.
2.

To fix prices and formulate policies:

Standard

determining prices and formulating production policies.

costing

is

helpful

in

The standards are set by

studying all the existing conditions. It also helps to find out the prices of various
products. It helps the management in the formulation of production and price policies in
advance and also in the areas of profit planning product pricing, quoting prices of tenders.
It also helps to furnish cost estimates while planning production of new products.
3.

For Effective cost control:

One of the most advantages of standard

costing is that it helps in cost control. By comparing actual costs with the standard costs,
variances are determined. These variances facilitate management to locate inefficiencies
and to take remedial action against those inefficiencies at the earliest.

4.

Management by exception: Management

by

exception

means

that

each

individual is fixed targets and every one is expected to achieve these given targets.
Management need not supervise each and everything and need not bother if everything is
going as per the targets. Management interferes only when there is deviation. Variances
beyond a predetermined limit may be considered by the management for corrective
action. The standard costing enables the management in determining responsibilities and
facilitates the principle of management by exception.
5.

Valuation of stocks: Under standard costing, stock is valued at standard cost and

any difference between standard cost and actual cost is transferred to variance account.
Therefore, it simplifies valuation of stock and reduces lot of clerical work to the
minimum level.
6.

Cost consciousness: The emphasis under standard costing is more on cost

variations which makes the entire organisation cost conscious. It makes the employees to
recognise the importance of efficient operations so that efforts will be taken to reduce the
costs to the minimum by collective efforts.
7.

Provides incentives: Under standard costing system, men, material and

machines can be used effectively and economies can be effected in addition to enhanced
productivity. Schemes may be formulated to reward those who achieve targets. It
increases efficiency, productivity and morale of the employees.
Limitations of Standard Costing
In spite of the above advantages, standard costing suffers from the following
disadvantages:
1.

Difficulty in setting standards:

Setting standards is a very difficult task as it

requires a lot of scientific analysis such as time study, motion study etc. When standards

10

are set at high it may create frustration in the minds of workers. Therefore, setting of a
correct standards is very difficult.
2.

Not suitable to small business:

The system of standard costing is not

suitable to small business as it requires lot of scientific study which involves cost.
Therefore, Small firms may find it very difficult to operate the system.
3.

Not suitable to all industries:

The standard costing is not suitable to those

industries which produces non-standardised products and also not suitable to job or
contract costing. Similarly, the application of standard costing is very difficult to those
industries where production process takes place more than one accounting period.
4.

Difficult to fix responsibility:

Fixing responsibility is not an easy task.

Variances are to be classified into controllable and uncontrollable variances because

responsibility can be fixed only in the case of controllable variances. It is difficult to
classify controllable and uncontrollable variances for the variance controllable at one
situation may become uncontrollable at another time. Therefore, fixing responsibility is
very difficult under standard costing.
5.

Technological changes:

Standard costing may not be suitable to those

industries which are subject to frequent technological changes. When there is a change in
the technology, production process will require a revision of standard. Frequent revision
of standards is a costly affair and therefore, the system is not suitable for industries where
methods and techniques of production are subject to fast changes.
In spite of the above limitations, standard costing is a very useful technique in
cost control and performance evaluation. It is very useful tool to the industries producing
standardised products which are repetitive in nature.

11

Pre-requisites for success

In establishing a system of the standard costing, there are a number of
preliminaries which are to be considered. These include:
1.

Establishment of Cost Centres

2.

Classification of Accounts

3.

Types of Standards

4.

Setting Standard Costs

Let us study the above in detail

1.

Establishment of Cost Centres:

A cost centre is a location, person or an item

of equipment (or group of these) in respect of which costs may be ascertained and related
to cost units. A centre which relates to persons is referred to as a personal cost centre and
a centre which relates to location or to equipment as an impersonal cost centre. Cost
centres are set up for cost ascertainment and cost control. While establishing cost centres
it should be noted that who is responsible for which cost centre. In many cases each
department or function will form a natural cost centre but there may also have a number
of cost centres in each department or function. For example, there may be six machines
in a manufacturing department, each machine may be classified as a cost centre. Cost
centres are essential for establishing standards and analysing the variances.
2.

Classification of Accounts: Accounts are classified to meet a required purpose.

Classification may be by function, revenue item or asset and liabilities item. Codes and
symbols are used to facilitate speedy collection and analysis of accounts.
3.

Types of Standards: The standard is the level of attainment accepted by

management as the basis upon which standard costs are determined. The standards are
classified mainly into four types. They are:
i)

Ideal Standard:

The ideal standard is one which is set up under ideal

conditions. The ideal conditions may be maximum output and sales, best possible prices

12

for materials, most satisfactory rates for labour and overhead costs. As these conditions
do not continue to remain ideal, this standard is of little practical value. It does provide a
target or incentive for employees, but is usually unattainable in practice.
ii)

Expected Standard:

This is the standard which is actually expected to be

achieved in the budget period, based on current conditions. The standards are set on
expected performance after allowing a reasonable allowance for unavoidable losses and
lapses from perfect efficiency. Standards are normally set on short term basis and
requires frequent revision. This standard is more realistic than ideal standard.
iii)

Normal Standard:

This represents an average figure based on the

average performance of the past after taking into account the fluctuations caused by
seasonal and cyclical changes. It should be attainable and provides a challenge to the
staff.
iv)

Basic Standard:

This is the level fixed in relation to a base year.

The principle used in setting the basic standard is similar to that used in statistics when
calculating an index number. The basic standard is established for a long period and is
not adjusted to the present conditions. It is just like an index number against which
subsequent price changes can be measured. Basic standard enables to measure the
changes in cost. It serves as a tool for cost control purpose because the standard is not
revised for a long period. But it cannot be used as a yard stick for measuring efficiency.
4.

Setting Standard Costs:

The success of a standard costing system depends

upon the reliability and accuracy of the standards. Therefore, every case should be taken
into account while establishing standards. The number of people involved with the
setting of standards will depend on the size and nature of the business. The responsibility
for setting standards should be entrusted to a specific person. In a big concern a Standard
Costing Committee is formed for this purpose. The committee consists of Production
Manager, Personnel Manager, Production Engineer, Sales Manager, Cost Accountant and
other functional heads. The cost accountant is an important person, who has to supply
the necessary cost figures and coordinate the activities of budget committee. He must
ensure that the standards set are accurate and present the statements of standard cost in
most satisfactory manner.

13

Standard costs are set for each element of cost i.e., direct materials, direct labour
and overheads. The standards should be set up in a systematic manner so that they can be
used as a tool for cost control. Briefly, standard costs will be set as shown below:
i)

Standard Cost for Direct Materials:

If material is used for manufacturing a product it is known as direct

material. Direct material cost involves two things (a) Quantity of materials and (b) Price
of materials. Firstly, while setting standard for quantity of material, the quality and size
of the material should be determined. The standard quantity of material required for
producing a product is decided by the technical experts in the production department.
While fixing standard for material quantity, a proper allowance should be given to normal
loss of materials. Normal loss will be determined after careful analysis of various factors.
Secondly, standard price for the material is to be determined. Setting standard price for
material is difficult because the prices are regulated more by the external factors than the
company management. Before fixing the standard, factors like prices of materials in
stock, price quoted by suppliers, forecast of price trends, the price of materials already
contracted, provision for discounts, packing and delivery charges etc., should be
considered.
ii)

Setting Standards for Direct material:

The labour involved in manufacture of a product is known as direct

labour. The wage paid to such workers is known as direct wages. The time required for
producing a product should be ascertained and labour should be properly graded. Setting
of standard cost of direct labour involves fixation of standard time and fixation of
standard rate.

Standard time is fixed by time or motion study or past records or

estimates. While fixing standard time normal ideal time is to be allowed for normal
delays, idle time, other contingencies etc. The labour rate standard refers the wage rate
applicable to different categories of workers. Fixation of standard rate will depend upon
various factors take demand for labour, policy of the organisation, influence of unions,
method of wage payment etc. If any incentive scheme is in operation then anticipated

14

extra payment to the workers should also be included in determining standard rate. The
Accountant will determine the standard rate with the help of the Personnel Manager,.
The object of fixing standard time and labour rate is to get maximum efficiency in the use
of labour.
iii)

Setting Standards for Direct Expenses

Direct expenses are those expenses which are specifically incurred in

connection with a particular job or cost unit.

These expenses are also known as

chargeable expenses. Standards for these expenses must also be determined. Standards
for these may be based on past performance records subject to anticipatory changes
therein.
iv)

Setting Standards for Overheads

Indirect costs are called overheads. These costs are those which cannot be

assigned to any particular cost unit and are incurred for the business as a whole. The
overheads are classified into fixed, variable and semi-variable overheads.

Standard

overhead rate is determined for these on the basis of past records and future trend of
prices. It will be calculated per unit or per hour. Setting standard for overhead cost
involves the following two steps:
a) Determination of the standard overhead costs, and
b) Determination of the estimates of production
Standard overhead absorption rate is computed with the help of the following
formula:
Standard overhead for the period
Standard overhead rate = --------------------------------------------(per hour)
Standard hours for the period
or
Standard overhead for the period
Standard overhead rate = ------------------------------------------------------(per hour)
Standard production (in units) for the period

15

The purpose of setting standard overhead rate is to minimise overhead costs.

Overhead rates are more useful to the management if they are divided into fixed and
variable components. When overheads are divided into fixed and variable, separate
overhead absorption rates are to be calculated with the help of the following formulae:
Standard Variable Overhead for the Period
Standard Variable Overhead Rate = -------------------------------------------------------Standard Production (in Units or Hours) for the Period
Standard Fixed Overhead for the Period
Standard Fixed Overhead Rate = -------------------------------------------------------Standard Production (in Units or Hours) for the Period

Standard Hour
Production may be expressed in different units of measurement such as kilos,
tones, litres, numbers etc. When a concern produces different types of products, the
production will be expressed in different units. It is difficult to aggregate the production
which is expressed in different units. To over come this difficulty, the production is to be
expressed in a common measure known as Standard Hour. The standard hour is the
quantity of output which should be produced in one hour. A standard hour may be as A
hypothetical hour which represents the amounts of work which should be performed in
one hour under stated conditions. A measure of standard hour is useful for the purpose
of comparison of performance of one department to another. It is also useful to compute
efficiency and activity ratios. For example if 20 units of product A are produced in 2
hour, and 40 units of product B are produced in 5 hours, the standard hours represent 10
20 Units
40 Units
units of product A (-----------)and 8 units of product B (-------------). Therefore, standard
2 hrs
5 hrs
hour is the quantity of production of a given product for one clock hour.
Revision of Standards
Standard cost is based on a number of factors. These factors some may be
internal or external may vary from time to time depending upon different situations.
16

Standard cost may become unrealistic if it is not revised according to the changed
circumstances. Then a question arises what would be the period in which standards
should be set? If the standard is set for a shorter period it is expensive and frequent
revision of standards will impair the utility and purpose of the standard cost. If the
standard is set for a longer period it may not be useful particularly during periods of high
inflation and rapidly changing technological environment.

Therefore, standards are

normally set for a fixed period of one year and revised annually at the beginning of
accounting period. If there are major changes, a revision may also be required within the
accounting period. If there are minor changes, the causes of difference between actual
and standards may be explained without being revised the standards. There are certain
conditions which necessitate the revision of standard costs. These conditions are:
i)

Changes in price levels of materials, labour and overheads

ii)

Technological changes

iii)

Changes in production methods or product mixes

iv)

Changes in plant capacity utilization

v)

Errors discovered in setting standards

vi)

Changes in designs or specification

vii)

Changes in the policy of organisation

viii)

Changes in government policy affecting the product or organisation, etc.

Check your progress B

1.

State some of the conditions under which a revision of stand cost takes place

2.

Explain the concept of standard hour.

a)

Standard hour is a hypothetical hour which represents the amount of work

to be done in one hour under given circumstances (True)

17

b)

To control cost either standard costing or budgetory control should be

used but not both the techniques. (False)

c)

Standard cost is used as a yardstick to measure the efficiency with which

actual cost has been incurred. (True)

d)

Standard cost is a projection of costs accounts whereas budgeting is a

projection of financial accounts. (True)

e)

Standards are normally set for a longer period and revised annually.
(False)

Terminal Questions
1.

What is Estimating Costing and how does it differ from Standard Costing?

2.

What do you understand by standard costing. Give a suitable definition to explain

your answer.

3.

What is Standard Costing? State the objectives of standard costing.

4.

Give a comparative account of standard costing and budgeting.

5.

Write a detailed note explaining the advantages and limitations of standard

costing.

6.

How do you ensure the success of a standard costing method in your organisation

7.

Write notes on the following:

a)

Ideal standard

18

b)

Expected standard

c)

Normal standard

d)

Basic standard

8.

Explain the meaning of Standard Hour.

9.

Write a note on Revision of Standards.

10.

How are standards fixed? Explain.

11.

A company has decided to introduce a system of standard costing. What are the
preliminaries to be considered before developing such a system? Explain.

19

Unit 13:

Variance Analysis II

After having studied the first part of variance analysis consisting of material and labour
variances. Let us proceed to analysis of variances relating to overheads. Now the
overheads variance analysis is different from variance analysis relating to materials and
labour. Here the overheads and inputs are already determined. These pre determined
overheads and inputs are called the standard. The overhead is considered in terms of
predetermined rate and is applied to the input. There can be different bases for the
absorption of overheads e.g., labour hours, machine tools, output (in units), etc.
Overhead variances may be classified into fixed and variable overhead variances and
fixed overhead variance can be further analysed according to the courses. In case of
variable overheads, it is assured that variable overheads vary directly with production so
that any change in expenditure can affect costs. Some authors say that a variance may
arise through inefficiency, but as these costs are usually very small per unit of output, it is
to be ignored and any variance in variable overhead is attributed to expenditure variance.
Considering the fixed overheads cost, the difficulty arises in determining standard
overhead rates. This is so because this is dependent on the volume or level of activity.
Any change in volume or level of activity causes a change in the overhead rate.
Therefore the fixing the volume or level of activity is a crucial aspect in determining
standard overhead rate. Now if the management decides to change the normal volume or
level of activity, without a corresponding change in the fixed amount of overheads, then a
change occurs in the overhead rate. Here it may be noted that in the case of material or
labour variances, the volume decision does not in any way influence the fixation of
standard rate. So to resolve this problem, normally the Budget is used in place of the
standard.
Another important thing to be noted in case of overhead analysis is that different writers
use different modes of computation of overhead variance and also different
terminologies.

E.g. spending variance is same as expenditure variance and volume

variance is same as capacity variance.

After having discussed the preliminary aspect of overhead variance, now we go about the
analysis of the overhead cost variances.
Classification of Overhead Variance
The term overhead includes indirect material, indirect labour and indirect expenses. It
may relate to factory, office and selling and distribution centres. Overhead variance can
be classified as sown in the following diagram:
Overhead Cost Variance
Variable Overhead Cost Variance

Fixed Overhead Cost Variance

Expenditure
Variance
Efficiency
Variance

Volume
Variance
Capacity
Variance

Calender
Variance

Overhead cost variance is the difference between standard cost of overhead absorbed in
the output achieved and the actual overhead cost. Simply, it is the difference between
total standard overheads absorbed and total actual overheads incurred. Therefore, the
formula for overhead cost variance is as follows:
Overhead Cost Variance = Total Standard Overheads Total Actual Overheads
(OHCV)
The overhead cost variance may be divided into variable overhead cost variance and
fixed overhead cost variance. Fixed cost variance may be further divided as fixed
expenditure variance and fixed volume variance. Fixed volume variance may again be

sub-divided into efficiency variance, capacity variance and calendar variance. Let us
study, how these variances are calculated.
1. Variable Overhead Cost Variance (V.OH.C.V): This variance is the difference
between the standard variable overhead and the actual variable overhead. The formula is:
Variable Overhead Cost Variance
= Standard Variable overhead for actual output Actual Variable Overhead
Where,
Standard Variable Overhead
= Standard hours allowed for actual output X Standard Variable Overhead Rate
Standard Variable Overheads
Standard Variable Overhead Rate = ---------------------------------------Standard Output
It is stated earlier that there are two basic variances, price and volume. If volume does
not affect the cost per unit the only variance to be calculated is price variance known as
the variable overhead variance. But when assumed that variable overheads do not move
directly with output, the variable overhead variances are to be calculated on similar lines
as to fixed overhead variances which you will study later. In this unit, we are assuming
that variable overheads do change directly with the output and infact it is the practice that
many firms follow and by a number of writers on the subject.
Variable overhead cost variances arise due to the following reasons:
i)

Advance payment of overheads

ii)

Outstanding overheads during the current period

iii)

Payment of past outstanding overheads during the current period

iv)

Incurring of abnormal overheads like repairs to machinery due to break down,

expenses due to spoilage, defective workmanship or excessive overtime work,
etc.

Illustration 1
From the following information, calculate the variable overhead variance::
Standard output

400 Units

Actual output

500 Units

Standard variable overheads :

Rs.1800

Actual variable overheads

Rs.2000

Solution
Variable Overhead Variance
= Standard Variable overhead for actual output Actual Overhead
Where,
Standard Variable Overheads
= Standard hours allowed for actual output X Standard Variable Overhead Rate
Standard Variable Overheads
Standard Variable Overhead Rate = ---------------------------------------Standard Output
Rs.1800
= --------------- = Rs.4.50
400 units
Variable Overhead Variance = (500 Units X Rs.4.50) Rs.200

= Rs.2250 Rs.200
= Rs.250(F)
Let us take another illustration and calculate variable overhead variance.
Illustration 2
Budgeted production for a month

: 3000 kgs.

Budgeted variable overheads

: Rs.15600

Standard time for one kg. of output : 20 hours

Actual production in the month

: 250 kgs.

Actual overheads

: Rs.14000

Actual hours

: 4500 hours

Solution
Variable Overhead Variance
= Standard Variable overhead for actual output Actual Variable Overhead
Standard Variable Overheads
Standard Variable Overhead Rate = ---------------------------------------Standard Output
Rs.15600
= ---------------

= Rs.2.60

3000 kgs
6000hrs. ( ------------- X 1 kg )
20hrs

Variable OH Variance= (4500 hrs X Rs.2.60) Rs. 14000

= Rs.11700 Rs.14000
= Rs. 2300 (A)

Fixed Overhead Variances

The treatment of these variances differ from that of variable overhead variable because of
the fact that the fixed overheads are incurred anyway and do not vary with change in
production levels. These have to be apportioned to production on a basis. Now the
standard recovery rate is fixed by considering the budgeted fixed overhead by budgeted
or normal volume, regardless of actual activity.

It also can be on the basis of

managements idea of normal volume, which may considerably differ from actual volume
or even actual time taken. So when overheads are actually incurred, they may be over
recovered or under-recovered. This over or under recovery is known as the variance.
Now this variance can be on the basis of output (in units) or standard time.
1. Fixed Overhead Variance

It is also called fixed overhead cost variance by

some writers, and represents the total fixed overhead variance.

Actually it is the

difference between the Standard fixed overhead charged on the basis of actual fixed
overhead.
Symbolically we can express it as:
Fixed Overhead Variance = Standard Fixed Overhead Actual Fixed Overheads
= Std. hours for X Std. fixed Actual Fixed O.H.
actual output
O.H. rate

Fixed Overhead Variance may be further subdivided into tow:

A)

Fixed overhead volume variance

B)

Fixed overhead expenditure variance

A) Fixed Overhead Volume Variance: Also called as activity variance by some

writers, this is the difference between the Budgeted hours based on normal volume and

the standard hours for actual output. Now the variance occurs because all the overheads
cannot actually be absorbed or may be over absorbed in some cases.
Symbolically we can compute this variance as follows:
Fixed overhead volume variance
= Standard Rate of recovery of fixed overheads X (Standard hours Budgeted hours)
Where,
Budgeted fixed overheads
Standard rate of recovery of fixed overheads = ---------------------------------Budgeted hours
Fixed overhead volume variance can be sub-divided into:
i)

Fixed overhead efficiency variance

ii)

Fixed overhead calendar variance

iii)

Fixed overhead capacity variance

i) Fixed Overhead Efficiency Variance: This is the difference between actual hours
taken to complete a work and standard hours that should have been taken to complete a
work and standard hours that should have been taken to complete the work. It measures
the efficiency of performance. Symbolically we can express it as
Fixed overhead efficiency variance
= Standard fixed rate of recovery X (Standard Hours Actual hours)
of overheads

for actual output

ii) Fixed Overhead Calender Variance: This variance arises due to the actual time
consumed, expressed in terms of hours or days as the case may be, being different from

standard time that should have been taken. In other words, it is due to the difference
between the number of working days in the budgeted period and the number of actual
working days in the period to which the budget is applied. This variance is obtained by
multiplication of the standard rate of recovery of fixed or overhead by difference between
revised budgeted hours and budgeted hours.
Symbolically it can be expressed as:
Fixed Overhead Calender Variance
= Standard Rate of Recovery of fixed overheads (per hour) (Revised Budgeted
Hours Budgeted Hours)
or
= (Actual no. of working days Standard no. of working days) X Standard rate of
recovery of fixed overheads (per day)
The calendar variances arises due to the extra holidays declared to celebrate the
anniversary of the firm or on the death of a national leader or any other reason. It arises
only in exceptional circumstances as normal holidays are taken into account while setting
the standards. When there is no change in the working days then there should be no need
for a calendar variance. Generally, this variance is adverse, but sometimes it shows
favoruable variance where there are extra working days.

iii) Fixed Overhead Capacity Variance: This variance arises due to difference between
Revised Budgeted Hours and the actual hours taken multiplied by the standard rate of
recovery of fixed overheads.
Symbolically we can express this as:
Fixed overhead capacity variance
= Standard rate of recovery of fixed overheads X (Actual hours Revised

Budgeted hours)
Where,
Revised Budgeted Hours = Standard hours per day X Actual no. of days
This variance arises when there is difference between utilization of plant capacity of
planned and actual utilization of plant capacity. It may be due to the factors like idle
time, strikes, power failure etc.

This variance can be both favourable a well as

unfavourable. If the actual hours worked is more than revised budgeted hours it is
favourable and vice versa.
Check:
Fixed overhead volume variance
= Fixed overhead efficiency variance + Fixed overhead capacity variance + Fixed
overhead calendar variance
Note: When there is no calendar variance, the calculation of capacity variance has to be
modified as follows:
Capacity variance = Standard Rate of recovery of fixed overheads X (Actual hours
Budgeted Hours)
Check
Fixed overhead Volume Variance = Efficiency Variance + Capacity Variance
A) Fixed Overheads Expenditure Variance:

Now his variance actually measures the

difference between the expenditure that is actually incurred and the budgeted fixed
overheads. It is also known as budget variance or spending variance.

Illustration 3
The following information is given to you:
Budget

Actual

Production (units)

10,000

10,400

Fixed overheads (Rs.)

20,000

20,400

Man hours

20,000

20,100

Calculate the following:

i)

Fixed overhead variance

ii)

Expenditure variance

iii)

Fixed overhead volume variance

iv)

Fixed overhead efficiency variance

v)

Fixed overhead capacity variance

Solution:
Budgeted Fixed overheads
Standard rate of recovery of fixed overhead = ---------------------------------------Budgeted hours
Rs. 20,000
= ---------------- = Rs. 1
20,000
Budgeted hours
Standard hours for actual output = ----------------------- X Actual output
Budgeted output
20,000
= ------------- X 10,400
10,000

= 20,800 hours
i) Fixed overhead variance =
(Std. hours for actual output X Std. fixed O.H. rate) Actual Fixed overheads
= (20,800 hours X Rs. 1) Rs.20,400
= Rs. 20,800 Rs. 20,400
= Rs. 400 (F)
ii) Expenditure Variance = Budgeted F. OH Actual F. OH
= Rs.20,000 20,400
= Rs.400 (A)
iii) Fixed overhead volume variance =
Std. Recovery rate of FOH X (Std. hours for actual output Budgeted hours)
= Rs. 1 X (20,800 20,000)
= Rs.800 (F)
iv) Fixed overhead Efficiency Variance =
Std. Recovery rate of F.OH X (Std. hours for actual output Actual hours)
= Rs.1 X (20,800 20,100)
= Rs.700 (F)
v) Fixed overhead capacity variance =
Std. rate of recovery of F.OH X (Actual hours Budgeted hours)
= Rs.1 X (20,100 20,000)
= Rs.1.00 (F)
Check:
Fixed O.H. Volume Variance = Efficiency Variance + Capacity Variance
Rs.800(F)

= Rs.700(F) + Rs.100(F)

Illustration 2:
ABC Company Ltd. has furnished you the following information for the month of
January 2005:
Budget

Actual

Output (units)

15,000

16,250

Working days

25

26

Hours

30,000

33,000

Fixed overheads (Rs.)

45,000

50,000

You are required to calculate fixed overhead variances.

Solution:
Budgeted hours

30,000

Standard hours per unit = ----------------------- = --------------- = 2 hours

Budgeted output

15,000

Standard hours per actual output = 16,250 units X 2 hrs

= 32500 hrs.
Budgeted overheads
Standard fixed overhead rate (per hour) = ---------------------------Budgeted hours
Rs.45,000
= ----------------- = Rs.1.50
30,000

i) Fixed overhead variance =

(Std. hours for actual output X Std. fixed O.H. rate) Actual Fixed overheads
= (32,500 hours X Rs.1.50) Rs.50,000
= Rs. 48,750 Rs. 50,000
= Rs. 1250 (A)
ii) Fixed Overhead Expenditure Variance = Budgeted F. OH Actual F. OH
= Rs.45,000 Rs.50,000
= Rs.5000 (A)
iii) Fixed overhead volume variance =
Std. Recovery rate of FOH X (Std. hours for actual output Budgeted hours)
= Rs. 1 X (20,800 20,000)
= Rs.800 (F)
iv) Fixed overhead Volume Variance =
Std. Fixed OH Recovery rate X (Std. hours for actual output Actual hours)
= Rs.1.50 X (32,500 30,000)
= Rs.1.50 X 2500
= Rs.750 (A)
v) Fixed overhead calender variance =
Std. rate of recovery of F.OH X (Revised budgeted hours Budgeted hours)
= Rs.1.50 X (31,200 30,000)
= Rs.1800 (F)
Revised budgeted hours = Std. hours per day X Actual no. of days
30,000
= ----------- X 26 = 31,200 hours
25
v) Fixed overhead capacity variance =

Std. Fixed OH Recovery rate X (Actual hours Revised Budgeted hours)

= Rs.1.50 X (33,000 31,200)
= Rs.1.50 X 1800
= Rs.2700 (F)
Check:
i) Fixed O.H. Variance =
Efficiency Variance + Efficiency Variance + Capacity Variance + Calender Variance
Rs.1250(A) = Rs.5000(A) + Rs.750(A) + Rs.2700(F) + Rs.1800(F)
Rs.1250(A) = Rs.1250(A)
ii) Fixed Volume Variance =
Efficiency Variance + Calender Variance + Capacity Variance
Rs.3750 (F) = Rs.750(A) + Rs.1800(F) + Rs.2700(F)
Rs.3750(F) = Rs.3750(F)
Fixed Overhead expenditure variance =
Budgeted fixed overheads Actual fixed overheads
Now check:
Fixed overhead variance =
Fixed overhead expenditure variance + Fixed overhead volume variance

Exercises:
You are given the following data relating to two factories of a company. You are
required to compute all the overhead variance:
I
Budgeted

II
Actual

Budgeted

Actual

Hours

2000

18700

20000

16500

Variable

48000

46000

25000

26000

40000

39000

27000

29000

Overheads
Fixed
Overheads

You are also given that the actual hours taken in case of both departments exceeded by
10%
(Ans.

II

V.O.H.V.

Rs.5200(A)

Rs.7250(A)

F.O.A.V.

Rs.5000(A)

Rs.8750(A)

F.O.Vl.V.

Rs.6000(A)

Rs.6750(A)

F.O.E.V.

Rs.3400(A)

Rs.2025(A)

F.O.C.V.

Rs.2600(A)

Rs.4725(A)

F.O.Ex.V.

Rs.1000(F)

Rs.2000(A)

Sales Variances
The Variances so far we learnt relate to cost of goods manufactured viz., material, labour
and overheads. The purpose of variance analysis is complete unless sales variance is
included in the presentation of information to management.

Sales Variances are

calculated by two methods viz., sales value method (or Turnover Method) and sales
margin or profit method. Sales variances arise due to the changes in price and changes in
sales volume. A change in value may be due to the change in quantity or a change in
sales mix.
Sales variance can be understood with the help of the following chart:

Sales Variances
Sales Value Variance

Sales Price
Variance

Sales Margin Variance

Sales Volume
Variance

Sales Quantity
Variance

Sales Price
Variance

Sales Mix
Variance

Sales Mix
Variance

Sales Volume
Variance
Sales Quantity
Variance

Sales variance may be studies under two heads, namely Sales Value Variance and Sales
Mix or Profit variances. Again Sales Value Variance is subdivided into Sales Price
Variance and Sales Volume Variances. Sales Volume Variance may again be subdivided
into Sales Quantity Variance and Sales Mix Variance. Similarly, Sales Margin Variances
may be divided into Sales Price Variance and Sales Volume Variance. Sales volume
Variance is subdivided into Sales Mix Variance and Sales Quantity Variance. Now, let
us study there Sales Variances in detail.
Sales Value Variance
This Variance is also called Sales revenue variance. This is the net variance of sales as a
whole. It is the difference between budgeted sales and actual sales. The formula for
computing this variance is:
Sales Value Variance = Actual Sales Budgeted Sales
If actual sales are more than the budgeted sales a favourable variance would be reported
and vice versa. This variance is on account of difference in price or volume of sales. It is
further subdivided into two variances as (i) Sales price variance and (ii) Sales volume
variance.
(i) Sales Price Variance

This variance measures the impact of change in selling price on the turnover as a whole.
It is measured by the difference between Standard sales and Actual sales.
The formula is:
Sales Price Variance =
Actual Quantity Sold X (Actual Selling Price Standard Selling Price)
Or
Sales Price Variance = Actual Sales Standard Sales
(ii) Sales Volume Variance
This variance measures the impact of changes in quantum of products sold. Sales volume
variance is the difference between the standard sales and budgeted sales. If the standard
sales are more than the budgeted sales, it gives rise to favourable variance and vice versa.
The formula is:
Sales Volume Variance = Standard Sales Budgeted Sales.
Or
= Standard Price X (Budgeted Quantity Actual Quantity)
Where,
Standard Sales = Standard Price X Actual Sales
This variance may arise due to unexpected competition, ineffective advertising, lack of
proper supervision, etc.
In the case of multi product situations, Sales Volume Variance can be further subdivided
into (i) Sales Quantity Variance and (ii) Sales Mix Variance. These two sub-variance
can be calculated as follows:

(i) Sales Quantity Variance

It is the difference between the Budgeted Sales and Revised standard sales. The formula
is:
Sales Quantity Variance = Revised Standard Sales Budgeted Sales
Or
= (Revised Standard Quantity Budgeted Quantity) X Std. Price
Where,
RSQ = Total actual Quantity X Standard Ratio of Units
(ii) Sales Mix Variance
This variance arises when the proportion of actual sales mix. It is the difference between
Revised Standard Sales and Standard Sales. The formula is:
Sales Mix Variance = Actual Sales Revised Sales
Or
= (Actual Quantity Revised Standard Quantity) Std. price of each product
Where,
RSQ = Total Actual Quantity X Standard Ratio of units
Check
Sales Value Variance = Price Variance + Volume Variance
Sales Volume Variance = Sales Mix Variance + Sales Quantity Variance
Illustration
You are given the following data. Compute Sales Variance based on Turnover.

Product
Budget

Actual

Units

3000

2000

1000

Price (Rs.)

30

20

10

Total (Rs.)

90000

40000

10000

Units

3500

2400

500

Price (Rs.)

35

25

Total (Rs.)

122500

60000

2500

Total

140000

185000

Solution
1,40,000
1) Standard Price per Unit of Standard Mix = -------------- = Rs.23.33
6,000
2) Revised Standard Sales = Total Actual Sales X Std. Ratio
: A 6400 X 3/6 = 3200
:

B 6400 X 2/6 = 2133

C 6400 X 1/6 = 1067

3) Standard Ratio of Units = A:B:C = 3000 : 2000 : 1000

= 3:2:1
4) Computation of Standard Sales = Standard Price X Actual Sales
Product

Total

Units

3500

2400

500

6400

Price(Rs.)

30

20

10

Total (Rs.)

105000

48000

5000

1) Sales Value Variance = Actual Sales Budgeted Sales

158000

Product

Total

Budgeted Sales (Rs.) 90000

40000

10000

140000

Actual Sales (Rs.)

122500

60000

2500

185000

Variance (Rs.)

32500 (F)

20000 (F)

7500 (A)

45000(F)

Total

Budgeted Sales (Rs.) 10500

48000

5000

158000

Actual Sales (Rs.)

122500

60000

2500

185000

Variance (Rs.)

17500 (F)

12000 (F)

2500 (A)

27000 (F)

3) Sales Price Variance = Actual Sales Standard Sales

Product

4.a) Sales Quantity Variance =

(Revised Standard Quantity Budgeted Quantity) X Standard price unit of std. mix
A : (32003000) X Rs.30 = 6000 (F)
B : (21332000) X Rs.20 = 2660 (F)
C : (10671000) X Rs.10 = 6000 (F)
-------------Total

Rs.9330 (F)
--------------

b) Sales Mix Variance = (Actual Quantity Revised Standard Quantity ) X Std. price
A : (32003500) X Rs.30 = 9000 (F)
B : (24002133) X Rs.20 = 5340 (F)
C : ( 5001067) X Rs.10 = 5670 (F)
-------------Total =

Rs.8670 (F)
--------------

Check:
Sales Revenue Variance = Sales Price Variance + Sales Volume Variance
45000 (F)

= 27000 (F) + 18000 (F)

Sales Volume Variance = Sales Quantity Variance + Sales Mix Variance

18000 (F)

= 9330 (F) + 8670 (F)

= 18000 (F)

Sales Margins or Profit Variances Method

These can also be called profit variances, as sales margin is nothing but profit. Now, this
variance is very essential as management takes key decisions based on profitability.
Individually the cost variances or revenue variance (sales variances as based on turnover)
cannot convey any clear meaning. But profit variances do so.
Sales Margin Variance
This can also be called as Overall profit variance. This represents the difference
between the Budgeted Sales margin or Budgeted Profit and Actual Sales Margin or
Actual Profit. The formula is:
Sales Margin Variance = Budgeted Sales Margin Actual Sales Margin
Sales Margin Variance can be subdivided into:
1. Sales Price Variance and
2. Sales Volume Variance

1. Sales Price Variance (Based as Margins)

This variance arises due to the difference between the Standard Price of quantity of sales
and actual price of sales. In other words, it is the difference between Standard Profit and
Actual Profit.
Sales Price Variance = Standard Profit Actual profit
Or
= Actual Quantity (Standard Profit per unit Actual Profit per unit)
Where,
Std. profit = A.Q X Std. profit per unit
If the actual profit is greater than the standard profit, the variance is favourable and vice
versa. This variance can arise due to the following reasons:
(i)

Rise in price levels net anticipated earlier

(ii)

Fall in price due to availing discounts and bulk buying

(iii)

Intense competition not foreseen earlier

2. Sales volume Variance (based on Margins)

This variance arises due to quantity of goods being sold differing from quantity of goods
budgeted to be sold. Now this can arise due to
- Intense competition unforeseen earlier or inefficiency of sales personnel
Symbolically this can be represented as:
Sales Volume Variance = Standard profit per unit (Standard Quantity Actual Quantity)
If the actual quantity is greater than standard quantity, the variance is favourable and vice
versa. This variance can be further sub-divided in case of multi-product selling units
into:-

(i)

Sales Quantity variance

(ii)

Sales Mix Variances

(i) Sales Quantity Variance

This is the difference between budgeted profit and revised standard profit.
Symbolically:
Sales Quantity Variance =
Standard profit per unit X (Standard quantity Revised Standard Quantity)
RSQ = Total AQ X Standard ratio
If RSQ is greater than SQ, the variance is favourable and vice versa.
(ii) Sales Mix Variance
This arises due to the proportion of these items constitution the standard mix different
from the actual proportion. It is difference between Revised Standard Profit and Standard
Profit.
Symbolically;
Sales Mix Variance =
Standard Profit per unit X (Revised Standard quantity Actual quantity)
If the actual quantity is more than RSQ, the variance is favourable and vice versa.
Illustration
A toy company gives you the following data for a month. You are required to calculate
the variance based on profit

Toy

Budgeted

Actual

Quantity

Rate

Cost per unit Quantity

Rate

900

50

45

1000

55

650

100

85

700

95

1200

75

65

110

78

Solution:
Statement of Budged Profit and Actual Profit per unit
Toy

SQ

SP (Rs.)

Total

Cost per Total

sales

unit

cost unit per unit profit

(Rs.)

(Rs.)

(Rs.)

(Rs.)

(Rs.)

Profit

Total

900

50

45000

45

40500

4500

650

100

65000

85

55250

15

9750

1200

75

90000

65

78000

10

12000

2750

200000

173750

26250

Actuals
A

1000

55

55000

45

45000

10

10000

700

95

66500

85

59500

10

7000

1100

78

85800

65

71500

13

14300

2800

207300

176000

Revised Standard Quantity (RSQ) = Total Actual Quantity X Std. Ratio

= 2800 X (18:13:24)
18
A = 2800 X ----- = 916
55
13
B = 2800 X ----- = 662
55

31300

24
C = 2800 X ----- = 1222
55
Calculation of Profit Variances
1) Sales Margin Variance = Budgeted Profit Actual Profit
Toy

Budgeted Profit (Rs.)

Actual Profit (Rs.)

Variance (Rs.)

4500

10000

5500 (F)

9750

7000

2750(A)

12000

14300

2300 (F)

Total

26250

31300

5050 (F)

2) Sales Price Variance = Standard Profit Actual Profit

Where,
Standard Profit = Actual Quantity X Profit per unit
Toy

Standard Profit (Rs.) Actual Profit (Rs.)

Variance (Rs.)

5000

10000

5500 (F)

10500

7000

3500 (A)

11000

14300

3300 (F)

Total

26250

31300

4800 (F)

3) Sales Volume Variance =

Standard Profit per unit X (Standard Quantity Actual Quantity)
Toy

Std. profit X Std. quantity (Rs.)

Actual Quantity (Rs.)

Variance (Rs.)

5 X 900

1000

500 (F)

15 X 650

700

1000 (F)

10 X 1200

1100

1000 (A)

Total

250 (F)

4) Sales Quantity Variance =

Standard profit per unit X (Standard Quantity Revised Standard Quantity)
Toy

Std. profit X Std. quantity

RSQ

Variance (Rs.)

5 X 900 -

916

80 (F)

15 X 650 -

662

180 (F)

10 X 1200 -

1222

220 (F)

Total

480 (F)

II Sales Mix Variance =

Standard profit per unit X (Revised standard quantity actual quantity)
Toy

Std. profit (Rs.) X Revised std. quantity -

Actual quantity

Variance (Rs.)

5X

916

1000

420 (F)

15 X

662

700

570 (F)

10 X

122

1100

1220 (A)

Total

230 (A)

Check
Sales Volume Variance = Sales Quantity Variance + Sales Mix Variance
250 (F)

480 (F) + 230 (A)

Sales Margin Variance = Sales Price Variance + Sales Volume Vaiance

5050(F)

CONTROL RATIOS

4800 (F) + 250 (F)

Now Standard costing is used by the management of an organisation as a control

technique variance computed would given ideal to the management to study the extent
of variation from the standards as are set by them. These variances are expressed in
monetary terms and do not per se give any idea of trends over a period of time.
Therefore, in order to study trends, Control Ratios are used, which are computed using
data used for variance analysis and give an idea to the management of an organisation
about the trends over a period at a time or from period to period.
The main Control Ratios are:
Standard Hours for Actual Production
1.

Activity Ratio = -------------------------------------------------- X 100

Standard Hours for Budgeted Production

Available Working Days

2.

Calender Ratio = ---------------------------------- X 100

Budgeted Working Days

Standard Hours for Actual Output

3.

Efficiency Ratio = ----------------------------------------------- X 100

Actual Hours

Budgeted Hours
4.

Standard Capacity Usage Ratio = ------------------------------------ X 100

Maximum Possible Hours

Actual Hours Worked

5.

Capacity Utilisation Ratio = -------------------------------------- X 100

Maximum possible hours in
Budgeted period

Disposition of Variances
The organisation, where standard costing system is not in use, accounting records contain
only actuals and there will be no variances. When standard costing system is used then
accounting records contain both standard costs and actual costs. The variances arise at
the end of the accounting period and the management should take corrective measures for
the disposal of variances. The accountants suggests several methods for treating the
variances which were as follows:
1.

Allocate the Variances to Inventories

According to this method the variances are distributed over stocks of raw materials, wage
costs, overheads or finished stock valued at cost.
Now when this happens the real costs only enter the account books and consequently are
reflected in the financial statements. The adjustment of variances is made only in the
general ledger and not in subsidiary books. The distribution of variances is not done to
products. As variances are not actuals. Losses should not be taken to profit and loss
account. The standard costs and variances that are observed are displayed for control
purposes to the management.
2.

Transfer to Profit and Loss Account

According to this method the stocks of inventories work in progress and finished goods
are valued at standard cost and variances are transferred to the P & L A/c. Now this
method ensures that valuation of stock is done uniformly and variances are transferred
thereby revealing the extent of variation to the management.

3.

Transfer to the Reserve Account

Under this method, variances are carried formal to the next financial year as deferred
item by crediting the same to a reserve account to be set off in the subsequent year or
years. The favourable and adverse variances may cancel each other in the course of
reasonable time. This method is useful in cases where reasonable fluctuations occurs and
the variance may be disposed off during the course of time.
4.

Combination of (1) and (2) methods

Though the above first two methods easy to follow, management upon their needs choose
a combination of the above two methods. The variances which are controllable and arise
out of over sight or carelessness of officials can be transferred to profit and loss a/c, the
uncontrollable can be absorbed by the cost of inventories.

EXERCISES
1)

Explain how the variance analysis relating to overheads differ from that relating
to material and labour

2)

In what ways can we analyse sales variances. Explain in detail.

3)

Write short notes as the following:

i)

Variable overhead expenditure variance

ii)

Fixed overhead volume variance

iii)

Fixed overhead calendar variance

iv)

Variable overhead efficiency variance

v)

Sales margin variance

vi)

Sales price variance (based on turnover)

vii)

Sales volume variance

4)

A Company manufacturing two products operates standard costing system. The

Standard overhead content of each product in cost centre 101 is Product A Rs.
2.40 (8 direct hours @ Rs. 0.30 per hour) Product B Rs. 1.80 (6 direct labour
hours @ Rs.0.30 per hour. The rate of Rs. 0.30 per hour is arrived at as follows:
Budgeted overhead RS.570
Budgeted Direct Labour Hours 1,900
For the month of October the following data was recorded for cost centre 101
Output of Product A

100 Units

Output of Product B

200 Units

No opening or closing stock

Actual Direct labour hours working 2,320
Actual overhead incurred Rs.640
a. You are required to calculate total overhead variance for the month of October
b. Show its division into
i. Overhead Expenditure Variance
ii. Overhead Volume Variance
iii. Overhead Efficiency Variance
5)

In a factory the standard units of production for the year were fixed at 1,20,000
units and estimated overhead expenditure were estimated to be:
Rs.
Fixed

12,000

Variable

6,000

Semi-variable

1,800

Actual production during April of the year was 8000 units. Each month has 20
working days. During the months in question there was one statutory holiday.
Actual overhead amounted to:
Fixed

1190

Variable

6000

Semi-variable 192
Semi variable charges are considered to include 60% expenses of fixed nature.
Find out expenditure, volume, calendar variances.
6)

Standard

Actual

No. of working days

20

22

Man hours per day

8000

8400

Output per man hour in unit

1.0

0.9

Overhead Cost (Rs.)

1,60,000

1,68,000

Calculate Overhead Variances:

7)

a)

Overhead Cost Variances

b)

Overhead Efficiency Variances

c)

Overhead Capacity Variance

d)

Overhead Calender Variance

The sales manager of a company engaged in the manufacture and sale of three
products P, Q and R gives you the following information for the month of
October, 1982.
Budgeted Sales
Product

Units Sold

Selling Price per Unit

2000

Rs.012

2000

Rs.8

2000

Rs.5

Actual Sales
P

1500 units for Rs.15000

2500 units for Rs.17500

3500 units for Rs.21,000

You are required to calculate the following variances:

a)

Sales Price Variance

b)

Sales Volume Variance

C)

Sales Quantity Variance

8)

d)

Sales Mix Variance

e)

Sales Revenue Variance

From the following Budgeted and Actual figures, calculate the variances in
respect of profit.
Budget
Sales 2000 units @ Rs.15 each

30000

Cost of sales @ Rs.12 each

24000
-------

Profit

6000
-------

Actual
Sale 1900 unit @ Rs.14 each

26,600

Cost of sales @ Rs.10 each

19,000
--------

Profit

7,600
--------

UNIT 14

RESPONSIBILITY
ACCOUNTING

Responsibility Accounting

Structure
14.0

Objectives

14.1

Introduction

14.2

The Concept of Responsibility Accounting

14.3

Profit Planning and Control

14.4

Design of the System

14.5

Uses of Responsibility Accounting

14.6

Essentials of Success of Responsibility Accounting

14.7

Segment Performance

14.8

Measuring Segment Performance

14.9

14.8.1

Return on Investment

14.8.2

Residual Income

Transfer Pricing

14.10 Methods of Transfer Pricing

14.10.1 Market Price Based
14.10.2 Cost Price Based

14.11 Let Us Sum Up

14.12 Key Words
14.13 Answers to Check Your Progress
14.14 Terminal Questions
14.15 Further Readings

14.0 OBJECTIVES
After studying this unit, you should be able to:
!

know how cost and management accounting will be used for managerial planning
and control.

appreciate the structure and process in designing responsibility accounting system;

understand the concept of responsibility centres;

familiar with different methods of evaluating the performance of different

segments of an organisation; and

identify the benefits, and essentials of success of measuring and reporting of costs
by managerial levels of responsibility.

14.1 INTRODUCTION
Responsibility accounting has been very much a part of cost and management
accounting for a while now. It has emerged as a widely accepted practice within
budgeting. But mind that responsibility accounting is not a separate system of

69

Standard Costing

management accounting. It does not involve any significant change in accounting

theory or generally accepted accounting principles. Else, it represents one of the three
sets of management accounting information. The two other sets are full cost
information and differential cost information. In this unit you will study about the
concept of responsibility accounting, design of the system and uses of responsibility
accounting. In addition to this you will also learn performence evaluation of different
segments besides transfer pricing.

14.2

THE CONCEPT OF RESPONSIBILITY

ACCOUNTING

The framework of responsibility accounting was developed by Professor A.J.E.

Sorgdrager titled Particularisation of Indirect Costs. As the title suggests,
responsibility accounting is a cost accounting system established on a responsibility
basis. A basis is said to be responsible where actual results are as close to planned
results as possible. As such, the variances are minimal. Planned results could be
stated in budgets and standards. Properly speaking, responsibility accounting is a
method of budgeting and performance reporting created around the structure of the
organization. Individual managers are hold accountable for the costs within their
jurisdiction. The purpose, obviously, is to exercise control over the operations. Hence,
in simple words, it could be described as a system of collecting and reporting
accounting data on the basis of managerial level. It may be defined as the approach to
accountability- identification of cost, with the persons responsible for their incurrence.
Performance is evaluated by assigned responsibilities. Reporting on performance is on
the lines of organizational structure. There is a separate report for each box of the
organization chart.
The concept emphasizes personalization of costs by putting questions as to where
the cost was incurred and who were responsible for it. The technique seeks to control
costs at the starting point. Broadly speaking, responsibility accounting is designing the
accounting system according to answerability of the manager. The accumulation
classification, measurement and reporting of financial data is so arranged that it
promotes the fixing of precise responsibility on the concerned manager. Horngreen
rightly says, Responsibility accounting focuses on people and not on things. It is
designed to present managers with information relating to their individual fields of
responsibility. The message is that since all items of income, operating costs, other
expenses and capital expenditure are the responsibility of some manager, none should
be left unassigned.
Responsibility accounting considers both historical and future costs. For some
purposes, the activity of responsibility centers is expressed in historical amounts. For
others, these are expressed in estimated future amounts.

14.3 PROFIT PLANNING AND CONTROL (PPC)

As mentioned earlier responsibility accounting is an important piece of the budgetary
system. It provides for the reporting of operating data and budget comparisons to the
individuals and groups who have organizational responsibility. Responsibility
accounting, measures plans by budgets, and actions by actual results of each
responsibility centre. If fully developed, it has a built-in budgetary system which
perfectly fits the organizational chart. Budgeting provides the measuring stick by
which the actual performance can be judged. Budgets, along with responsibility
accounting provides systematic help to the managers if they interpret the feedback
carefully.

70

When an integrated and comprehensive view is taken of budgeting, it becomes Profit

Planning and Control (PPC). Desired or target profit figures are planned and
controlled through a set of budgets. Here, responsibility accounting is the dominant

concept as control is its crux. Performance is measured by using actual results.

Traditional cost accounting had been focused on determinining the cost of products and
services. In responsibility accounting, this is reversed. Costs are no longer associated
with products and services. Else, the focus is on planning and control needs of
management. Costs initially accumulated for control purposes are then recast for
product costing purposes. The control aspect is emphasized by summarizing and
reporting costs on the basis of individual responsibility before those costs are merged
for product cost purposes.

Responsibility Accounting

14.4 DESIGN OF THE SYSTEM

In designing a system, one has to decide upon its structure and the process. So is the
responsibility accounting. Its structure rests on the responsibility centres. The process
consists of bifurcating costs into controllable and non-controllable groups, flexible
budgeting, and performance reporting. These three dimensions of the process and,
then, the structural reorganization could be called the principles or fundamentals of
responsibility accounting. These are being discussed below:
1)

Establishing Responsibility Centers : A responsibility centre (RC) is an

organizational unit. It exists because of some functional activity for which each
specific manager is made responsible. Setting up of responsibility centres,
therefore, becomes the first step. A large decentralized organization has to be
restructured in terms of areas of influence. In ascending (i.e., rising) order of
autonomy, these are cost centres, revenue centres, profit centres, and investment
centres. The depth of use of responsibility accounting in the enterprise depends on
the delegation of authority and assignment of responsibility. In a cost centre the
manager is responsible only for the costs (expenses) incurred in his sub-unit.
When actual costs of his sub-unit differ from budgeted costs then the manager
must explain the significant variances. In a revenue centre, the manager is
responsible for generating revenues too upto the budgeted levels. In a profit
centre, the manager goes beyond, and is responsible also for profit performance.
For instance, the manager of a furniture department of a departmental store is
responsible for earning a profit on the furniture sold. He is expected to earn the
budgeted amount of profit during the period. In an investment centre, the
manager has the responsibility and control over the assets that are used to carry
on its activities. For example, individual departments of a departmental store, and
individual branches of a chain stores are investment centres. The manager of the
concerned department is expected to achieve some target rate of return on
investment. It should be noted that investment centre differs from a profit centre
as investment centre is evaluated on the basis of the rate of return earned on the
assets invested in the sub-unit or segment while a profit centre is evaluated on the
basis of excess of revenue over the revenue for the period. Control can be
exercised only though managers who are responsible for what the organization
does. It is based on the principle that a managers performance, should be
assessed only on the factors that are within his span of control. Each managerss
budget contains costs and revenues within his span of control. Generally costs
are accumulated by departments.
Subsidiary revenue and expense accounts are created for each centre. These enable
accounting transactions to be recorded not only by revenue and expense category, but
also by the responsibility centre incurring the transaction. The accounting system can
then summarize transactions by descriptive category for public reporting purposes,
and by responsibility centre for purposes of performance evaluation. These accounts
indicate how, at the lowest reporting level in an organization, performance reports
show costs incurred in a division by descriptive category. At higher reporting levels,
summaries reflect total costs incurred in subordinate responsibility centres.

2)

Limits to Controllable Costs: Once the responsibility centres have been

established in a company, costs and revenues under the control of each therein

71

Standard Costing

need be indicated. In responsibility accounting, the basis of classifying

costs is controllability--- the capability of the manager of a responsibility
centre to influence (i.e., increase or decrease) them. As such, costs are
accumulated and reported in the two groups of controllable and noncontrollable costs. The former are those which can be changed by the
head of the responsibility centre. He has the ability to regulate the
quantity or price or both of an item by his managerial action.
Uncontrollable costs, obviously, are the costs which cannot be increased
or decreased within a given time span at the discreation of the manager.
But these can be changed at higher levels of management authority.
Generally, costs of raw materials, direct labour and operating supplies are
controllable. Fixed costs are non-controllable such as rentals, depreciation,
and insurance on equipment. In this setup, no allocation of common or
joint costs takes place, which by their very nature are quite indirect.
Allocation is always an arbitrary process.
3)

Flexibile Budgeting: Responsibility accounting starts with the

assumption that budgets are flexible. They have to be prepared for
several levels of activity, instead of one static level. When actual output
has been obtained, a fresh budget is prepared threof. Comparison of
actual results is made against the budget targets freshly prepared for that
level. It would be a weak analysis to use a budget based on a level of
activity that differs from the actual level of activity. A performance
budget is the flexible budget adjusted to the actual level attained. Flexible
budgeting permits comparison of actual costs with budgeted costs that
have been recast to changes in production volume. It would be recalled
that flexible budgets are prepared either by the mathematical function or
formula method, or the multi-activity method.

4)

Performance Reporting: Each responsibility centre has to periodically

report about its performance, the feedback. A report has both financial
and statistical parts. It shows income, expenses and capital expenditures.
Statistics such as volume of production, cost per unit, and manpower data
are also provided. Typically, performance reports will disclose the actual
costs incurred, the budgeted costs, and a variance, which is the difference
between the actual and budgeted amounts. Normally these amounts will
be summarized by the responsibility centre for the month being reported
and also for the current year-to-date. The purpose is to take timely and
corrective action. Performance reports could be monthly, weekly, or even
daily depending on the size of the organization and significance of the
item. In addition, the report must be given to the manager while the
information is still useful. Reports received weeks after the period are of
little value. Further, once the performance reports are prepared,
management need only to consider the significant variances from the
budget. This is what is being referred to as management by exception.

Difficulties

72

Responsibility accounting is a conceptually appealing tool for motivation and

control. But many organizations in practice do not achieve these objectives. Two
major difficulties in implementing a successful responsibility accounting system are:
Accumulation of mass of dats, and Development of appropriate performance
measures. However, cost accumulation at such a detailed level throughout an
organization is made practicable by the use of computer-based cost accounting
systems. Computer programs can quickly summarize costs for each descriptive
category for purposes of product costing and producing a traditional income
statement. Similar programs can summarize costs by responsibility centres and
generate the associated performance reports. Thus, the problem of data
accumulation, although a substantial one can now be overcome through the use of

computer technology. As a result, the problem of developing appropriate performance

measures has become the more difficult one to resolve.

Responsibility Accounting

For a budgetary system to serve as an effective means of control, cost and revenues
goals must be adopted by each manager and accepted as individual objectives. This is
most likely to occur when budgeted goals are reasonable and realistically attainable and
yet challenging. The cost accountant is in a position to identify these performance
measure and to isolate the costs incurred in each responsibility centre. These costs
must then be categorized as controllable and uncontrollable before the reporting
structure is developed. These decisions will have a sound impact on the effectiveness
of the system. Generally, responsibility accounting systems are used in conjunction with
standard costs. A major task then of the cost accountant is of the development and
then interpretation.

14.5 USES OF RESPONSIBILITY ACCOUNTING

Responsibility accounting which focuses on managerial levels is an important aid in the
management control process. It has several uses and confers many benefits. These
are listed below:
i)

Performance Evaluation : This is perhaps the biggest benefit. With

responsibility localized, it is possible to rate individual managers on a cost basis.
When a manager is held responsible for whatever he does, he become extravigilant. Responsibility accounting system provides the manager with information
that helps controlling operations and evaluating the performance of subordinates.

ii)

Delegating Authority : Large business firms can hardly survive without proper
delegation of authority. By its very nature, responsibility accounting makes it
happen. Decentralisation of power is its keypoint and, hence, delegation of
authority follows.

iii)

Motivation : Responsibility accounting is the use of accounting information for

planning and control. When the managers know that they are being evaluated,
they are prompted to put their heart and soul in meeting the targets set for them.
It acts as a great stimulus. As a matter of fact, responsibility accounting is based
on the motivating individual managers to maximum performance. The targets
provide goals for achievement and serve to motivate managers to increase
revenues or decrease costs.

iv)

Corrective Action : If performance is unsatisfactory, the person responsible

must be identified. It is only after identification of the erring subordinate that the
corrective action can be taken. Under responsibility accounting, as areas of
authority are clearly laid down, such corrective action becomes easier. The
control action to be effective must occur immediately after identification of the
causes of the problem. The longer control action is deferred, the greater the
unfavourable financial effect.

v)

Management by Objectives : The heads of divisions and departments are

assigned definite objectives before the commencement of the period. They are
held answerable for the attainment of these targets. Shortfalls are punished and
excesses rewarded. Such a system helps in establishing the principle of
management by objectives (MBO)

vi)

Management by Exception : Performance reporting here, is on exceptions or

deviations from the plan. The idea runs throughout the responsibility accounting.
It helps managers by spending their time on major variances with greatest
potential improvements. The concentration of managerial attention on exceptional
or unusual items of deviation rather than on all is the key to success of the
system.

73

Standard Costing

vii) High Morale and Efficiency: Once it is clear that rewards are linked to the
performance, it acts as a great morale booster. Great disappointment will be
caused if an operating foreman is evaluated on the decisions in which he was not
a party.

14.6

ESSENTIALS OF SUCCESS OF
RESPONSIBILITY ACCOUNTING

Responsibility accounting by itself, does not give any benefits. Its success is dependent
on certain conditions. These are:
1)

Support of all levels of management through Participative budgeting. Budgeted

performance is basic to responsibility accounting. Most managers will be
responsive to a budget which they have helped to develop. If the budget of the
responsibility centre is produced by a process of negotiation between its manager
and immediate supervisor, he will work to attain it. He will more actively pursue
the goals and accept the resulting performance measures as equitable. Effective
motivations and control based on appropriate performance measures does not
occure by accident. They must be carefully considered during the design of the
system.

2)

The system is based on individual managers responsibility. It is the manager who

incur costs and should be held accountable for each expenditure

3)

Separation of costs into controllable and non-controllable categories.

4)

Restructuring the organization along the decision-making lines of authority.

5)

An organization plan which establishes objectives and goals to be achieved.

6)

The delegation of authority and responsibility for cost incurrence through a system
of policies and procedures.

7)

Motivation of the individual by developing standards of performance together with

incentives.

8)

Timely reporting and analysis of difference between goals and performance by

means of a system of records and reports.

9)

A system of appraisal or internal auditing to ensure that unfavourable variances

are clearly shown. Then, follow-up and corrective action need be applied.

In responsibility accounting revenues and expenses are accumulated and reported by

levels of responsibility with a view to comparing the actual costs with the budgeted
performance data by the responsible manager. The whole effort is towards satisfying
the data requirements for responsive control.
Check Your Progress A
1)

What do you understand about Responsibility Accounting?

................................................................................................................................
................................................................................................................................
................................................................................................................................
................................................................................................................................

74

2)

Responsibility Accounting

What are the stages that are involved in the process of Responsibility
Accounting?
1).............................................................................................................................
2) .............................................................................................................................
3) .............................................................................................................................
4) .............................................................................................................................

3)

Specify any four essential conditions for the success of Responsibility

Accounting.
1) .............................................................................................................................
2) .............................................................................................................................
3) .............................................................................................................................
4) .............................................................................................................................

4)

State whether the following statements are True or False:

i)

Responsibility accounting emphasises on personalisation of costs.

ii)

Responsibility accounting is based on historical costing only.

iii)

The degree of responsibility of a cost centre, in a responsibility accounting,

depends upon the level of delegation of authority.
[
]

iv)

Responsibility accounting is not based on the assumption that budgets are

flexible.
[
]

v)

Setting up of responsibility centres is the first step in the process of

responsibility accounting.

14.7

SEGMENT PERFORMANCE

A segment or division may be either a profit centre having responsibility for both
revenues and operating costs, or an investment centre, having responsibility for
assets in addition to revenues and operating costs.
The manager of each segment are free to take decisions regarding the performance
of their centres. When an orgainzation grows it is inevitable to create divisions or
segments to control operations of different divisions. This requires accounting
information which discloses not only the objectives and performances of divisions
but also whether or not each division is performing in the interest of the organization
as a whole. This section illustrates how segment data should be presented so that
meaningful decisions regarding segment performance can be taken.
A managers performance is evaluated generally on the basis of comparison of
costs incurred with costs budgeted. It is therefore, important to allocate appropriate
costs to the respective segments. While allocating the costs, the costs relating to
general administration or head office should not be charged to any segment as these
costs remain constant irrespective of the volume of sales by each department. Let
us see the following illustration:

75

Standard Costing

Illustration 1
A simplified representation of organization of Digital Co. Ltd. is presented below:

President

Vice President
Marketing

Advertising Credit
Sales
Manager
Manager Manager

Vice President
Manufacturing

Production
Manager
Sewing
Department

Production
Engineer

Cutting
Department

The company manufacturers cloth potholders in a simple process of cutting the

potholders in various shapes and then sewing the contrasting pieces together to form
the finished potholder.
The accounting system reports the following data for the year 2004-05:
Budgeted
Rs.

Actual
Rs.

500

300

3,100

3,400

Advertising

400

400

Credit reports

120

105

Sales representatives travel exp.

900

1,020

Sales commissions

700

700

Cutting labour

600

660

50

45

Sewing labour

1,700

1,840

Cutting utilites

80

70

800

800

90

95

Vice-President, Marketing office exp.

2,000

2,140

Production engineering expense

1,300

1,220

Sales management office expenses

1,600

1,570

Production managers office exp.

1,800

1,700

Vice-President, manufacturing office expenses

2,100

2,010

Bad debt losses

Cloth used

Thread

Credit department salaries

Sewing utilities

Using the data given, prepare responsibility accounting reports for the two vice-presidents.
Solution

76

Responsibility accounting tailors reports to each level of management to include those

items which they can control and for which they are responsible. The items for which
they are responsible are generally determined by the organization structure as reflected
in the organization chart. Responsibility report highlights variances to assist in the
process of management by exception. Reports for higher-level managers are in
summary form in order to avoid flooding them with more detail than is needed.

With these general ideas in mind, one can turn to the responsibility reports required by
the problem. Each report is assumed to contain a one-line summary of the expenses of
the subordinate departments. From the organization chart, the contents of the reports
will, therefore, be as follows:
Vice-president, marketing

: Sales expense + advertising expense + credit

expense

Sales expense

: Sales representatives travel expense + sales

commissions + sales management office

Advertising expense

: Advertising

Credit expense

: Credit reports + credit department salaries +

bad debt losses

Vice-president, manufacturing

: Production expense + production engineering

expense + production managers office
expenses

Production Manager

: Sewing department + cutting department, i.e.

thread + sewing labour + sewing utilities +
cloth used + cutting labour + cutting utilities

Responsibility Accounting

Notice that these reports do not contain the expenses of the vice-presidents offices.
Although sometimes included, they are not here on the ground that the vice presidents
cannot control their own salaries, the major component of these categories. If they are
excluded on these reports, they would be included as an item on the presidents report,
where they are controllable.
Since the lower level reports are summarized in the higher-level reports, it is usually
easier to begin with the lower-level reports.
Budgeted
i)

Variance

Production Manager
Controllable expense report:

ii)

Actual

Rs.

Rs.

Rs.

Sewing department

1,840

1,980

140U

Cutting department

3,780

4,130

350U

Total

5,620

6,110

490U

Production departments

5,620

6,110

490U

Production managers expenses

1,800

1,700

100F

Production engineers expenses

1,300

1,220

80F

Total

8,720

9,030

310U

3,200

3,290

90U

400

400

Credit expense

1,420

1,205

215F

Total

5,020

4,895

125F

Vice-President, Manufacturing
Controllable expense report:

iii)

Vice-President, Marketing
Controllable expenses summary:
Sales managers expense
Advertising expense

77

Standard Costing

Probably the most significant variances are in the production departments, with an
average unfavourable variance of
8.7 percent (

490 100
) of the budgeted amount and the credit department, with a
5620

favourable variance of 15.1 percent ( 215 100 ) of the budgeted amount. The credit
1420
department variance results primarily from a better than normal bad debt loss
experience. The production departments variance should be investigated if 8.7 percent
appears large relative to past experience.
Illustration 2
Kelly Services Ltd. has five plants---A,B,C,D and E. Each plant has a forming, cleaning
and packing department. Each level of management at the company has responsibility
over costs incurred at its level. The budget for the year ended March, 2005 has been
set up as follows:
Plant

Budgeted Cost (Rs.)

1,35,000

1,22,500

1,08,400

1,35,000

1,35,000

Budgeted information for Plant C is as follows:

Rs.
Plant managers office

2,350

Forming department

30,000

Cleaning department

55,450

Packing department

20,600

Budgeted information for Plant C forming department is as follows:

Rs.
Direct material
Direct labour
Factory overhead

8,333
15,000
6,667

The following additional budgeted costs available:

78

Presidents Office

Rs.
16,250

Vice President---Marketing

20,000

Vice President---Manufacturing office

4,167

Responsibility Accounting

The following actual costs were incurred during the year:

Plant

Budgeted Cost Rs.

1,27,650

1,24,300

1,08,475

1,31,100

1,36,800

Actual costs for Plant C Forming department were as follows:

Rs.
Direct materials
Direct labour

333

Under budget

4,000

Under budget

Factory overhead

333

Over budget

Actual cost for Plant C plant manager were:

Rs.
Plant managers office

2,475

Cleaning department

57,500

Packing department

22,500

Forming department

Actual costs for the presidents level were:

Rs.
Presidents Office

16,375

Vice president---marketing

29,800

Vice-president---manufacturing

6,33,315

Prepare a responsibility report for the year showing the details of the budgeted, actual
and variance amounts for levels 1 through 4 for the following areas:
Level 1-Forming department---Plant C
Level 2-Plant manager---Plant C
Level 3-Vice president-manufacturing
Level 4-President.
Solution
Kelly Services
Responsibility Report for the Year ended March 2005
Budgeted

Actual

Variance

Rs.

Rs.

Rs.

Presidents Office

16,250

16,375

125

Vice-president---marketing

20,000

29,800

9,800

Vice-president---manufacturing

6,40,000

6,33,315

(6,752)

Total Controllable costs

6,76,250

6,79,490

3,173

Level 4-President:

79

Standard Costing

Level 3-Vice President---Manufacturing

Vice-president---manufacturing office:

4,167

4,990*

823

Plant A

1,35,000

1,27,650

(7,350)

Plant B

1,22,500

1,24,300

1,800

Plant C

1,08,400

1,08,475

75

Plant D

1,35,000

1,31,100

(3,900)

Plant E

1,35,000

1,36,800

1,800

Total Controllable Costs

6,40,067

6,33,315

(6752)

2,350

2,475

125

Forming department

30,000

26,000

(4,000)

Cleaning department

55,450

57,500

2,050

Packing department

20,600

22,500

1,900

1,08,400

1,08,475

75

8,333

8,000

(333)

15,000

11,000

(4,000)

6,667

7,000

333

30,000

26,000

4,000

Level 2 - Plant Manager ---Plant C:

Plant managers office

Total controllable costs

Level 1-Forming Department-Plant C:

Direct material
Direct labour
Factory overhad
Total controllable costs
*

The difference in the actual total controllable cost arrived and the figure as given
in the illustration is to be treated as the actual cost of manufacturing office of vice
president.

( ) Variance favourable (Figures within parentheses indicate favourable variances)

14.8 MEASURING SEGMENT PERFORMANCE

The primary purpose of a responsibility accounting is to determine the individual
segment performance of an organization. The managers of different cost centres of
the organisation are responsible to earn acceptable profit measured in terms of
segment margin, or rate of return on sales for the profit centre. Segment margin
represents the amount of income that has been earned by the particular segment.
The manager of an investment centre is responsible for earning a rate of return on the
segments investment in assets. There are various criteria to measure divisional
performance such as profit on turnover, sales per employee and sales growth etc.
The most popular criteria are:
1)

Return on Investment (ROI)

2)

Residual Income (RI)

14.8.1 Return on Investment

80

Divisional operating profit is generally, used as a common measure of performance.

But divisional profit by itself does not provide a basis for measuring a divisions

performance in generating a return on the funds invested in the division. For example,
Division A and Division B had an operating profit of Rs.1,00,000 and Rs.80,000
respectively does not necessarily mean that Division A was more successful than
Division B. The difference in profit levels may be due to the difference in the size of
the divisions. Therefore, a suitable measure may be used to scale the profit for the
amount of capital invested in the division. One common method is Return on
Investment (ROI) which will be calculated as follows :
Profit
Return on Investment = 100
Capital employed

Responsibility Accounting

Or
Profit
Sales
ROI =
Sales
Capital employed
If the investment in the Division A and Division B, in the above example was
Rs. 10,00,000 and Rs.5,00,000 respectively,
Rs.1,00,000
then ROI would be 10% (i.e. 100)
Rs. 10,00,000
Rs.80,000
If investment in respective divisions is considered,
and 16% ( i.e., 100 ).
Division B is more profitable than division A.
Rs.5,00,000
The ROI of partial segment must be high enough to provide adequate rate of return for
the firm as a whole. It is always better to require a segment to earn a higher minimum
rate of return on their investment. To improve this rate of return, a segment can
increase its return on sales, increase its investment turnover or do both. The other way
of increasing ROI is to reduce expanses and investment. If a segment reduces its
investment without reducing sales, its ROI will increase. The ROI for the firm as a
whole must not fail to meet the goals of top management. Though ROI is used widely
to measure the segment performance, it has many limitations. One of the most
limitations is that it can motivate managers to act contrary to the aims of goal
congruence. If managers are encouraged to have a high ROI, they may turn down
investment opportunities that are above the minimum acceptable rate, but below the
current ROI of the divisional performance. For example, where a division earns a profit
100000
of Rs.1,00,000 for an investment of Rs.4,00,000, the ROI is 25% 100 .
400000

Suppose there is an opportunity to make an additional investment of Rs.2,00,000 which

would earn a profit of Rs.40,000 per annum. The ROI for additional investment is
investment is 20%

Rs. 40,000
100 . Assume that the company requires a
Rs.2,00,000

minimum requires a minimum return of 15 per cent on its investment, the additional
investment clearly qualifies, but it would reduce the investment centre ROI from 25%
to 23.3%

Rs. 1,00,000 + Rs. 40,000

i.e. : 100 .
Rs. 4,00,000 + Rs. 2,00,000

Consequently the manager of the division might decide not to make such an investment
because the comparison of old and new returns would imply that performance had
worsened. The centres manager might hesitate to make such investment, even though

81

Standard Costing

the investment would have positive benefit for the company as a whole. To over come
this drawback, Residual Income Method is used to evaluate the acceptability of a
project proposal.
Illustration 3
Peacock Company Ltd. has six segments for which the following information is
available for the year 31st March, 2005:
I
(Rs. in
Lakhs)

II
(Rs. in
Lakhs)

III
(Rs. in
Lakhs)

IV
(Rs. in
Lakhs)

V
(Rs. in
Lakhs)

VI
(Rs. in
Lakhs)

Capital
employed

1500

1200

3000

2400

4500

6000

Sales

3000

3000

6000

3600

18000

12000

Net profit

150

300

150

720

450

1200

You are required to measure the performance of different segments.

Solution
The return on investment can be analysed as follows:
Segments
I

II

III

IV

VI

Profit/ Sales
(Profit Sales
100)

5%

10%

2.5%

20%

2.5%

10%

Turnover of
capital (Sales

2.5

1.5

10%

25%

5%

30%

10%

20%

Capital
Employed)
ROI (Profit
Capital
Employed
100)

The above analysis gives the following conclusions regarding the performance of
different segments:

82

1)

The manager of segment I is not showing a satisfactory level of ROI even though
his turnover of capital is not too bad. He must be motivated to increase his profit
sales ratio.

2)

Segment II is performing well as profit, sales ratio and turnover of capital, are
relatively good.

3)

The performance of segment III is not satisfactory as its profit margin and
capital turnover is Poor.

4)

The performance of segment IV is good as its profit margin is high with a

reasonable capital turnover.

5)

In respect of segment VI, the manager should be motivated to increase its profit
margin but maintains a very good turnover of capital.

6)

The manger of segment VI is performing well comparing to other segments, as it

maintains a good ROI, fairly good capital turnover and reasonably good profit
margin.

The segments which show a low capital turnover should be investigated and remedial
action should be initiated particularly in segments IV, I and III.

Responsibility Accounting

14.8.2 Residual Income

Residual income is the profit remaining after deduction of the cost of capital on
investment. It is the excess of net earnings over the cost of capital. Any income
earned above the cost of capital is profit to the firm. The cost of capital charged to
each division will be the same rate that is applicable to the organization as a whole.
The more the income earned above the cost of capital, the better off the firm will be.
The Residual Income may be calculated as follows:
RI = Profit (Capital Charge Investment Centre Asset)
Where, capital is the minimum acceptable rate of return on investment.
This method is used as a substitute for or along with ROI as means of evaluating
managerial performance and motivates the managers to act to the aims of goal
congruence. The firm is interested to maximise its income above the cost of capital.
If the divisional managers are measured only through ROI, they will not necessarily
maximise RI. If managers are encouraged to maximise RI, they will accept all
projects above the minimum acceptable rate of return. That is why most managers
recognise the weakness of ROI and take into account when ROI is lowered by a new
investment.
Illustration 4
A division of a company earns a profit of Rs.1,00,000 for an investment of
Rs.4,00,000. There is an opportunity to make an additional investment of Rs.2,00,000
which earns an annual income of Rs.40,000. You are required to calculate residual
income if the company requires a minimum return of 15 per cent on its investment
and comment.
Solution
Before the additional Investment:
RI

= Rs.1,00,000 (15% of Rs.4,00,000)

= Rs.1,00,000 Rs.60,000
= Rs.40,000

RI from additional Investment

RI

= Rs.40,000 (15% of 2,00,000)

= Rs.40,000 Rs.30,000
= Rs. 10,000

Total Residual Income on an investment of Rs.6,00,000 is Rs.50,000. The

additional investment increases residual income and is improving the measure of
performance.
Illustration 5
Sunrise Company has three divisions A, B and C. The investment in these divisions
amounted to Rs.2,00,000, Rs.6,00,000 and Rs.4,00,000 respectively. The profits in
these divisions were Rs.50,000, Rs.60,000 and Rs.80,000 respectively. The cost of
capital is 10 per cent. From the above data, comment the performance of the three
divisions.

83

Standard Costing

Solution
Divisions
A

Profit

Rs. 50,000

Rs. 60,000

Rs. 80,000

Investment

Rs. 2,00,000

Rs.6,00,000

Rs. 4,00,000

10%

20%

ROI

Profit
100
Investment

RI = Profit Cost of
capital :

25%
50,000
100
2,00,000

Rs. 30,000
(50,00020,000)

)(

60,000
100
6,00,000

) (

80,000
100
4,00,000

NIL
Rs.40,000
(60,00010% of 6,00,000) (80,00010% of 4,00,000)

In terms of profit division C has done best performance. If evaluation is done on the
basis of ROI criteria division A is the best performer. If residual income is the
criterian, division C is the best.
Check Your Progress B
1)

What do you mean by ROI.

.................................................................................................................................
.................................................................................................................................

2)

Why do RI method is used to perfomance evelution?

........................................................................................................................
........................................................................................................................

3)

ABC Company has assets worth Rs.2,40,000, operating profit of Rs. 60,000 and
cost of capital 20%. Compute Return on Investment and Residual income

4)

Under what conditions would the use of ROI measure inhibit goal congruent
decision making by a division manager?
.....................................................................................................................
.....................................................................................................................

5)

What are the advantages of using Residual Income Method?

.........................................................................................................................
.........................................................................................................................

6)

State which of the following statements is True or False.

i)

Administration and overhead costs should not be changed to any segment in

evaluating segment performance
( )

ii)

Segment margin represents the amount of income that has been earned by
the organisation
( )

iii)

It is always better to have a minimum rate of return on investment in the

evaluation of segment performance.
(

ROIand RI both the methods are to be used in performance evaluation. (

iv)
84

14.9 TRANSFER PRICING

Responsibility Accounting

Large businesses are organized into different divisions for effective management
control. When the business is organized into divisions and if one division supplies its
finished output as input to another division, there arise the question of transfer pricing.
Transfer price is the price at which the supplying division prices its transfer of output to
the user division. The price assigned to the interdivisional transfer of output represents
a revenue of the selling division and a cost of the buying division. It should be noted
that there is only an internal transfer and not a sale. Transfer prices are set at the
time of the transfer rather than waiting until the manufacturing process is completed
and the goods are sold to someone outside the company. As the pricing of these goods
or services is likely to have an impact on the performance evaluation of divisions,
setting an appropriate transfer pricing is a problem. Questions like what should be the
transfer price? Whether it should be equal to manufacturing cost of selling division or
the amount at which the selling division could sell its output externally? Or should the
transfer price be negotiated amount between the selling divisions cost of
manufacturing and the external market price? etc. whould arise. Selection of transfer
price to some extent depends upon the nature of the product, type of the product and
policy of the organization. Transferer would like to obtain the highest possible price
while the transferee would require the lowest possible price. Goal congruence should
be taken into account while fixing the transfer price because the actions of one division
should not have a detrimental effect on the group as a whole.

14.10 METHODS OF TRANSFER PRICING

There are different methods for pricing the output of one division to another. The
selection of an appropriate transfer price will have significant impact on decision
making, product costing and performance evaluation of different divisions in the
organization.
Generally transfer pricing methods can be classified into two broad categories. They
are: (1) Market Price Based and (2) Cost - based. There are a number of alternative
methods within each of the above two methods and these are discussed below.

14.10.1 Market Price Based

This method consist of the following methods:
a)

Market Price

b)

Adjusted Market Price, and

c)

Negotiated Price

a) Market Price: When a market price is available or when there is a comparable

product on the market and its price is available, this price can be used as a transfer
price. Both the selling and buying divisions can sell and buy as much as they can at
this market price. Managers of both the selling and buying divisions are indifferent
trading with each other or with outsiders. From the companys perspective this is fine
as long as the supplying unit is operating at capacity. The market price is useful for
fixing transfer price when there is a competitive external market for the transferred
product. An advantage of this method is that it can be regarded as the opportunity cost
to a division in so far as there is choice whether or not to purchase from external
market. Additionally managers have control over their transfer price so performance
measurement is facilitated. Another advantage of this method is that it helps to assure
profit independence of the divisions. Any gain of the selling division do not get passed
on to the buying division.
b) Adjusted Market Price: This price is based on the above market price, but it is
adjusted to allow for the fact that such cost as sales commission and bad debts should
not be incurred within the divisions.

85

Standard Costing

c) Negotiated Price: This price can occur when there is some basis on which to
negotiate between the divisional managers. The negotiated price, normally, may be a
market price or a cost price. For example, one basis may be the contribution margin
on the product being transferred divided between the transferor and the transferee or it
may be the total cost which the transferer could suggest or the market price which the
transferee could suggest. Both the divisions could negotiate between these two
figures. Sometimes the negotiated price may be based on manufacturing cost plus an
extra percentage added to approximate market price.
Whatever the basis chosen, the company should be careful in avoiding arbitrary price
between the divisions. The arbitrary price may be rewarding to one division and
prevailing to another division. Some times negotiated prices are imposed by company
top level, but this could not hamper the autonomy of divisional managers and distorting
the financial performance of any division.

14.10.2 Cost Price Based

Another method to be followed for charging transfer price for the transfer of output
from one division to another division is Cost Price. When external markets do not exist
or when the information about external market prices is not readily available,
companies may elect to use some of cost based transfer pricing methods as stated
below:
a)

Absorption Cost

b)

Cost Plus Profit Margin

c)

Marginal Cost

d)

Standard Cost

e)

Opportunity Cost

Let us study about these methods in brief.

a) Absorption Cost: Absorption or full cost is based on the total cost incurred in
manufacturing a product. When cost alone is used for transfer pricing, the selling
division cannot realise any profit on the goods transferred. This method has a
disadvantage that any excess cost on account of inefficiency may be passed on to the
other divisions.
b) Cost Plus Profit Margin: Under absorption costing when cost alone is used for
transfer pricing, the selling division cannot make any profit on the goods transferred.
This is disincentive to selling division. To overcome this problem, some companies set
transfer price on cost plus profit margin. This includes the cost of the item plus a mark
up or other profit allowance. Under this method, the selling division obtains a profit
contribution on the units transferred. It also benefits the transferring division if
performance is measured on the basis of divisional operating profits. At the same time,
it has also similar drawback of absorption costing that the inefficiencies if any, may
also creep into the other divisions.
c) Marginal Cost: Another method to be followed for transfer pricing is the
marginal cost. All costs that change in response to the change in the level of activity
should be taken into account for the transfer price while transferring output from one
division to another division. But this method fails to motivate divisional managers
because it makes no contribution towards fixed overheads and profit.

86

d) Standard Cost: If actual costs are used as the basis for the transfer, any
variances or inefficiencies in the selling division are passed along to the buying division.
To promote responsibility in the selling division and to isolate variances within divisions,
standard costs are usually used as a basis for transfer pricing in cost based systems.
Use of standard costs reduces risk to the buyer. The buyer knows that the standard
costs will be transferred and avoids being charged with the sellers cost overruns.

e) Opportunity Cost: It represents the opportunity which has been foregone by

following one course of action rather than another. Thus, if goods are transferred
internally the organization could lose a contribution to profit which could have been
obtained from an external sale. Generally, an opportunity cost approach will be used to
establish a range of transfer prices in situations where the market is imperfect.

Responsibility Accounting

If the selling division has sufficient sales in the intermediate market such that it would
have had to forgo those sales to transfer internally, the transfer price should be equal
to differential cost to the selling division plus implicit opportunity cost to company if
goods are transferred internally. The formulae is:
Transfer Price = Differential cost to the selling division + Implicit opportunity cost to
company if goods are transferred internally.
Differencial costs are those costs that change in response to alternative course of
action. In estimating differential cost, the manager concerned unit has to determine
which costs will be effected by an action and how much they will change. As long as
the transfer price is greater than the opportunity cost of the selling division and less
than the opportunity cost of the buying division, a transfer will be encouraged. A
transfer is in the best interest of the company if the opportunity cost for the selling
division is less than the opportunity cost for the buying division.
Transfer Prices are an important factor in the measurement of divisional
performance. Whatever the method of transfer pricing is adopted it should be not only
fair to each division concerned but it should also be in the best interest of the
company as a whole. Use of bad transfer price may lead to conflict among the
different divisions of the organisation and hamper the ultimate objective of the
enterprise.

14.11 LET US SUM UP

Responsibility cost information is one of the three types of management and cost
accounting information. The two others are full cost, and differential cost
information. Responsibility accounting, also called Responsibility reporting is a
system of responsibility reporting and control at each managerial level. It is built
around functional activity for which specific managers are accountable. In designing
a system, one has to look into its structure and the process. The four fundamental
principles or techniques of responsibility accounting are: (i) Restructuring the
organization in terms of responsibility centres viz. cost revenue, profit or investment
centres, (ii) Bifurcating costs into controllable and uncontrollable categories, (iii)
Flexible budgeting, and (iv) Performance reporting. The first technique gives the
structure; and the other three the process of implementing responsibility accounting.
Since the focus is on responsibility centres, it has several uses and gives many
benefits. It is an important aid in the management control process. A responsibility
accounting system provides information that helps control operations, and evaluate the
performance of subordinates. It facilitates corrective action, management by
objectives, and delegation of authority. It is a morale booster too as rewards are
linked to the accomplishment. The success of the system depends, apart from other
things, on active cooperation amongst the managers. Further, it is adopted by large
decentralized organizations where departments and divisions could be treated as
managerial levels of responsibility.
The primary purpose of responsibility accounting is to measure the performance of
individual divisions. The most popular criteria to be used in measuring the divisional
performance is Return on Investment and Residual Income.
Transfer price is the price at which the supplying division prices its transfer of output to
the user division. The selection of an appropriate transfer price will have significant
impact on decision making and performance evaluation of different divisions of the
company. There are different methods at which transfer price can be set. These
methods can be classified as Market Price based and Cost based. The market price

87

Standard Costing

based consists of (a) market price, (b) adjusted market price, and (c) negotiated price
methods. Cost based method may again be sub-divided into (a) absorption cost
(b) Cost plus profit margin, (c) Marginal Cost, (d) Standard cost and (e) Opportunity
cost methods. Whatever the method of transfer price followed, the divisional
managers should not forget goal congruence of the organisation because the action of
one division should not have a detrimental effect on the group as a whole.

14.12 KEY WORDS

Cost Centre: A responsibility level where employees are concerned only with cost
management.
Controllable Cost: A cost for which the departmental supervisor is able to exert
influence over the amount spent.
Flexible Budget: A budget prepared using the actual sales volume realized by a
segment. It is used for computing the effects of differences between actual sales
prices and costs, and budgeted sales prices and costs on the profit goals of the
segment.
Investment Centre: A responsibility level whose manager is concerned not only with
cost management but also with revenue generation and investment decisions.
Management by Exception: A management principle by which managers
concentrate their attention on exceptional or unusual items in the performance reports.
Non-controllable Cost: A cost assigned to a department or responsibility centre that
is not incurred or controlled by the department head.
Negotiated Price: Either the market price or cost price which is negotiated between
divisional managers.
Performance Report: A report produced by each decision centre which discloses
budgeted and performance measures, and variances from the budget.
Profit Center: A responsibility level in which performance is measured in terms of
budgeted profits and has responsibility for both income and expenses.
Responsibility Centre (RC): A unit or segment of the organization in which a
specific manager has the authority and responsibility to make decisions.
Transfer Price: The price at which the supplying division prices its transfer of output
to the user division.

14.13 ANSWERS TO CHECK YOU PROGRESS

A) 4) i) True
B)

ii) False

iii) True iv) False v) True

3) ROI : 25% and RI : Rs. 1200

6) i) True, ii) True, iii) False, iv) True

14.14 TERMINAL QUESTIONS

88

1)

Responsibility accounting is a responsibility set-up of management accounting.

Comment.

2)

Define Responsibility Accounting. How does it differ from conventional cost

accounting?

3)

Is it fair to opine that responsibility accounting is a method of budgeting and

performance reporting created around the structure?

4)

While designing a responsibility accounting system for a decentralized corporation,

discuss the steps in terms of the structure and the process.

5)

Explain how the choice of the responsibility center type (cost revenue, profit or
investment) affects budgeting and performance reporting.

7)

Explain clearly the terms cost centre, revenue centre, profit centre, and
investment centre, and their utility to management.

8)

a)

Why should non-controllable costs be excluded from performance reports

prepared in accordance with responsibility accounting?

b)

Why is a flexible budget rather than a stable budget used to evaluate

production departments?

9)

Responsibility Accounting

How may controllable and uncontrollable costs be handled in a responsibility

accounting sytem?

10) Give the pre-requisites for the success of a responsibility accounting system.
11) The following information related to the operating performance of three divisions
of a company for the year 2005.
Division
A

Contribution (Rs.)

50,000

50,000

50,000

Investment (Rs.)

4,00,000

5,00,000

6,00,000

Sales (Rs.)

24,00,000

20,00,000

16,00,000

No. of employees

22,500

12,000

10,500

You are required to evaluate the performance using rate of Return on Investment
(ROI) and Residual Income (RI) criteria.
12) The operating performance of the three divisions of Excel Company Ltd. for 2005
is as follows:
Division
A (Rs.)

B (Rs.)

C (Rs.)

Sales

3,80,000

17,00,000

20,00,000

Operating Profit

20,000

50,000

1,00,000

Investment

2,00,000

6,25,000

8,00,000

a)

Using the rate of return on investment and residual income as the criteria
which is the most profitable division?

b)

Which of the two measures in your openion gives the better indication of
over all performance.

13) The managers of Divisions X and Y in Beta Company Ltd. are considering the
possibility of investment in a project. The estimated cost of the proposed project

89

Standard Costing

to be Rs. 2,00,000. The present ROI of X and Y divisions are 10 per cent and 25
per cent respectively. The Company uses a cost of capital of 15% in evaluating
the projects. The details of the project are as follows:
Division
X (Rs. 000)
Investment
Life in years

Y (Rs. 000)

Rs.400

Rs.400

10

10

Estimated costs and revenues:

Revenue

420

440

Costs:

Direct materials

200

160

Direct wages

40

80

Power

20

20

Consumable stores

12

12

Maintenance

20

Depreciation

80

80

Total Cost

372

360

Surplus
48
40
Note : These questions will help you to understand the unit better. Try to write
answerstofor
them. the
Butproposals
do not submit
theRIUniversity.
These
You are required
evaluate
on theyour
basisanswers
of ROI to
and
and also comment.
are for your practice only.

14.15

FURTHER READINGS

J. Lewis Brown, Leslie R. Howard, Managerial Accounting and Finance,

Machonald & Evans Ltd., London.
Davidson, Maher, Stickney, Weil, Managerial Accounting, Holt-Sounders International Editions, New York.
Nigam and Sharma, Advanced Cost Accounting, Himalaya Publishing House,
Bombay.
Arora, M.N., Cost Accounting, Vikas Publishing House Pvt. Ltd., New Delhi.

90

UNIT 15 MARGINAL COSTING

Structure
15.0

Objectives

15.1

Introduction

15.2

Segregation of Mixed Costs

15.3

Concept of Marginal Cost and Marginal Costing

15.4

Income Statement under Marginal Costing and Absorption Costing

15.5

Marginal Costing Equation and Contribution Margin

15.6

Profit-Volume Ratio

15.7

Managerial Uses of Marginal Costing

15.8

Limitations of Marginal Costing

15.9

Summery

15.10

Key Words

15.11

Answers to Check Your Progress

15.12

Terminal Questions

15.13

Further Readings

15.0 OBJECTIVES
The aims of this unit are:
!

to introduce you with the concept of marginal costing;

to explain the income statement under marginal costing and how it differs from
absorption costing; and

to discuss the merits and limitations of marginal costing along with developing a
marginal cost equation uses of marginal costing in managerial decisions.

15.1 INTROUDCTION
The elements of costs can be divided into fixed and variable costs. You have learnt
these elements of cost in detail under Unit 2. You have also learnt that there are
certain costs which are a combination of fixed and variable costs. These costs are
called semi-variable costs. It is necessary to segregate the mixed costs into fixed and
variable costs for managerial decisions. In this unit you will study about different
methods of segregating mixed costs, the concept of marginal cost and marginal costing
and its managerial uses in decision making.

15.2 SEGREGATION OF MIXED COSTS

The elements of cost can be divided into two categories. Fixed and variable costs.
Fixed costs are those costs which do not very but remain constant within a given
period of time in spite of fluctuations in production Variable costs changes in direct
proportion to the change in output. There are certain costs, which are a combination of
fixed, and variable costs. It contains a fixed element as well as a unit cost for variable

CostOverview
An
Volume Profit
Analysis

expenses. Such costs increase with production but the change is less than the
proportionate change in production. These costs are called semi-variable or semi-fixed
or mixed costs. Example of these costs are depreciation, power, telephone etc. Rent of
the telephone is fixed in a given period and per unit call charges is a variable
component. For decision making, it becomes necessary to segregate the mixed costs
into fixed and variable costs.
Methods of Segregating Mixed Cost
The following methods are applied to segregate the mixed costs into fixed costs and
variable costs:
1)

Analytical Method : A careful analysis of mixed cost is done to determine how

far it varies with production. Some semi-variable costs may have 60 percent
variability while other have 40 percent variability. Accuracy of this method
depends upon the knowledge, experience and judgement of the analyst. This
method is simple but not scientific.

2)

High Low Method : This technique was developed by J.H. William. In this
method, the difference in two production levels i.e. highest and lowest, are
compared out of the various levels. Since the fixed cost component remains
constant, any increase or decrease in total semi-variable cost must be attributed to
the variable portion. The variable cost per unit can be determined by dividing
difference in total semi-variable cost with the difference in production units at two
levels.

Illustration 1
From the following information, find out the fixed and variable components.
Production (in units)

Semi-Variable Costs
Rs.

100

1500

200

2000

250

2250

300

2500

Highest production is 300 units, then semi-variable costs is Rs. 2500. Lowest production
is 100 units, then semi-variable costs is Rs. 1500.
Variable cost per unit

Difference in Costs
Difference in Volume

Rs. 2500 Rs. 1500

300 100

Rs. 1000
= Rs. 5
200

Total semi-variable costs = Fixed cost + Variable costs per unit production

2500

= F + Rs. 5 300 units

= Rs. 1000

High-low method is based on observations of extreme data, hence the result may not
be very accurate as it is based on extreme points and may not be true for normal
situation.

Marginal Costing

Scatter Diagram Method

In this method, production and semi-variable cost data are plotted on a graph paper and
tentative line of best fit is drawn. The following steps are involved :
!

Volume of production is plotted on x-axis and semi-variable costs on y-axis.

Corresponding semi-variable costs of each volume of production are plotted on a

graph.

A line of best fit is drawn through the points plotted. The point where this line
intersects with y-axis, depicts the fixed cost.

Variable cost can be determined at any level by subtracting the fixed cost
element. The slope of the total cost curve is the variable cost per unit
Total Semi-Variable Cost

Semi Variable
Cost

Fixed Cost

Output
The accuracy of line of best fit, depends upon the judgement and experience of the
analyst. One may draw slightly up or slightly down, the intercept on y-axis will change
or two analyst may draw a line having different slopes. This method involves analysts
subjectivity and may not give accurate results.
Method of Least Square :
This method is based on econometric technique, in which line of best fit is drawn with
the help of linear equations.
The equation of a straight line is
y = a+bx
Where a is the intercept on y-axis and b is the slope of the line. Hence a is the
fixed cost component and b is the slope or tangent of the line or variable cost per
unit. From the above equation, two equation can be drawn.
y = na + b x
xy = a x + bx2
Solving the equations, will give us the value of a (fixed cost) and b (variable cost
per unit).
Illustration 2
From the following semi-variable cost information, compute the fixed cost and variable
cost components.
Production
(Units)
100

Semi-variable
(Rs.)
1200

200

1350

150

1250

190

1380

180

1375

CostOverview
An
Volume Profit
Analysis

Solution
Month

Production X

Semi-variable Y

X2

XY

April
May
June
July
August

100
200
150
190
180

1200
1350
1250
1380
1375

10000
40000
22500
36100
32400

120000
270000
187500
262200
247500

X = 820

Y = 6555

X 2 141000

XY = 1087200

Total

Y = na + b X
XY = a X + b X2
Solving these equations
6555 = 6 a + 820 b
1087200 = 820 a + 141000 b
a = Rs. 1004.632
b = Rs. 1.868
After segregating the mixed costs into fixed cost and variable costs, the fixed
component is added to fixed costs and variable component to variable costs. Now we
have only two costs i.e. fixed costs and variable costs.

15.3 CONCEPT OF MARGINAL COST AND

MARGINAL COSTING
The term Marginal Cost is defined as the amount at any given volume of output by
which the aggregate costs are changed if the volume of output is increased or
decreased by one unit. In this context a unit may be single article, a batch of articles or
an order. It is the variable cost of one unit of a product or a service. For example, the
cost of 100 articles is Rs. 50,000 and that of 101 articles is Rs. 50,450, the marginal
cost is Rs. 450 (i.e., Rs. 50,450 50,000).
Thus, the total cost is the aggregate of fixed cost and variable cost and if production is
increased by one more unit, its cost can be computed as follows:
TCn = FC + vQ

..

(1)

TCn+1 = FC + v (Q +1) ..

(2)

MC = v

(Subtracting 1 from 2)

Marginal costing may be defined 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. The concept of marginal costing is based on the behaviour
of costs that vary with the production level. In marginal costing, costs are classified
into fixed and variable costs. Even semi-variable costs are analysed into fixed and
variable. The stock of work-in-progress and finished goods are valued at marginal
cost. Marginal cost is equal to the increase in total variable cost because within the
existing production capacity, an increase in variable one unit of production will cause an
increase in variable costs only. The fixed costs remain same. In marginal costing, only
variable costs are considered in calculating the cost of product, while fixed costs are
treated as period cost which will be charged against the revenue of the period. The
revenue generated from the excess of sales over variable costs is called contribution.
Mathematically,

Marginal Costing

Total sales Variable costs = Contribution

Sales = Variable cost + Contribution
Sales Variable cost

= Fixed cost profit/loss

Contribution Fixed costs

= Profit

For example, the selling price of a product is Rs. 30 per unit and its variable cost is
Rs. 20, the contribution per unit is Rs. 10. Let us take the following illustration how the
profit is determined by using marginal costing technique.
Illustration 3
From the following particulars find out the amount of profit earned during the year
using the marginal costing technique :
Product

Output (units)

10,000

20,000

60,000

Selling Price (per unit)

Rs. 10

Rs. 10

Rs. 5

Variable cost (per unit)

Rs. 6

Rs. 7. 50

Rs. 4. 5 0

Total Fixed Cost Rs. 80,000.

Solution
Statement of Cost and Profit (Marginal Costing)
Product
A
Rs.

B
Rs.

C
Rs.

Total
Rs.

Sales Revenue

100,000

200,000

300,000

600,000

Marginal Costs

60,000

150,000

270,000

480,000

Contribution

40,000

50,000

30,000

120,000

Fixed Costs

----

----

----

80,000

Profit

----

----

----

40,000

Thus the technique of marginal costing assumes that the difference between the
aggregate value of sales and the aggregate value of variable costs or marginal costs,
provides a fund (called contribution) to meet the fixed costs and balance is the profit.
The concept of contribution is a very useful tool to management in managerial
decisions making.

15.4 INCOME STATEMENT UNDER MARGINAL

COSTING AND ABSORPTION COSTING
In marginal costing, the stock of work-in-progress and finished goods are valued at
marginal cost not including the fixed costs. Whereas under full costing or absorption
costing, the cost of product is determined after considering both fixed and variable
costs.

CostOverview
An
Volume Profit
Analysis

Let us explain the difference in the two methods with the help of an illustration given
below :
Illustration 4
Given
Production

= 100,000 units

Sales 90,000 units @ Rs. 3 per unit

Variable manufacturing costs
= Rs. 2 per unit
Fixed overheads
= Rs. 50,000
Selling and distribution costs
= Rs. 10,000 of which Rs. 4000 is variable
Prepare the income statement under absorption costing and marginal costing.
Solution
Income Statement
(Under Absorption Costing)
Rs.
Sales 90,000 units @ Rs. 3
Less: Manufacturing costs :
Variable costs
100,000 units @ Rs. 2
Fixed overheads

2,70,000
Rs.
200,000
50,000
2,50,000

Less : Closing stock 10,000 units

25,000

2,25,000

2,50,000 10,000
100,000
Gross margin (Rs. 2,70,000 Rs. 2,25,000)

45,000

Less : Selling and distribution costs

10,000

Profit (Rs. 45,000 Rs. 10,000)

35,000

Income Statement
(Under Marginal Costing)
Rs.
2,70,000

Sales 90,000 units @ Rs. 3 per unit

Less : Marginal Costs
Variable manufacturing costs :
100,000 units @ Rs. 2 per unit
Less : Closing inventory of 10,000 units @ Rs. 2

Rs.
200,000
20,000
1,80,000

Add : Variable selling and distribution costs

4,000

Contribution
(Sales Rs. 2,70,000 Variable Cost Rs. 1,84,000)

1,84,000
86,000

Less Fixed Costs :

Fixed overheads
Fixed selling and distribution
6

Profit (Rs. 86,000 Rs. 56,000)

50,000
6,000

56,000
30,000

The profit computed under marginal costing is Rs. 5000 less in comparison to full
costing. The closing stock under absorption costing is valued at Rs. 2.50 per unit (fixed
and variable cost) whereas under marginal costing it is Rs. 2 per unit (only variable
cost). The difference is of Rs. 0.50 per unit on a closing inventory of 10,000 units
which amounts to Rs. 5,000.

Marginal Costing

We can draw the following inferences:

1)

When all costs are variable costs, then both the methods will report the same net
income.

2)

When sales and production are in balance (no opening or closing stock) both the
methods will again report the same profit.

3)

When there is a closing stock (and no opening stock) the net income reported
under absorption costing will be higher than that reported under marginal costing.
Thus the technique of absorption costing may lead to odd results particularly for
seasonal business in which stock level fluctuates widely from one period to
another.

4)

When there is a opening stock (and no closing stock), the profit under marginal
costing will be more than the profit reported under absorption costing.

5)

When the closing stock is more than the opening stock (presuming that both
opening and closing stocks are valued at same price), profit reported under
marginal costing will be less than the profit reported under full costing or
absorption costing.

The technique of absorption costing may also lead to rejection of a profitable business.
An order at a price which is less than the total cost may be refused, though this order
may be profitable. Look at the following illustration:
Illustration 5
XYZ Ltd. has a capacity to production 100,000 units and company is presently
operating at 70% capacity. The company is selling its product at Rs. 120 each. The
cost information is as follows.
Per Unit

Total

Variable Cost

Rs. 60

Rs. 42,00,000

Fixed Costs

Rs. 30

Rs. 21,00,000

Total

Rs. 90

Rs. 63,00,000

The company has received an order for 20,000 units at Rs. 70 per unit. Should the order
be accepted or rejected.
Solution
Under absorption costing, cost includes both fixed as well as variable cost. Thus the
cost per unit is Rs. 90 and the order at Rs. 70 per unit be rejected. Under marginal
costing, only variable costs are considered. When company will supply extra 20,000
units, only variable cost will increase and fixed cost will remain same.
The fixed cost of Rs. 21,00,000 is already recovered by operating at 70% installed
capacity. Thus the order will increase the profit.
7

CostOverview
An
Volume Profit
Analysis

Before Order
Rs.

Order
Rs.

After Order
Rs.

Sales 70,000 @ Rs. 120

84,00,000

14,00,000
(20,000 Rs. 70)

98,00,000

Variable costs @ Rs. 60

42,00,000

12,00,000

54,00,000

Contributions

42,00,000

200,000

44,00,000

Fixed costs

21,00,000

Profit

21,00,000

----200,000

21,00,000
23,00,000

Accepting the order enhances the profit by Rs. 200,000.

The difference between absorption costing and marginal costing arises mainly due
to recovery of fixed overheads and valuation of inventory.
Valuation of Stocks
In absorption costing, stocks of work-in-progress and finished goods are valued at
works cost or cost of production, which includes fixed costs also. Where as in
marginal costing, stocks are valued at marginal cost or variable cost only. This
method does not result in carrying over of fixed cost of one period to another, as it
happens in the case of absorption costing. In other words, valuation of stock is done
at a lower price in marginal costing, thus profit will differ under two methods of
costing.
Absorption of Overheads
In absorption costing, both fixed and variable overheads are charged to production
while in marginal costing only variable overheads are charged to production. Thus
under absorption costing, there will be either over-absorption or under absorption of
fixed overheads, where as in marginal costing, the actual amount of fixed overheads
is wholly charged to contribution. Hence profit will differ.
Let us see following illustration how the profit fluctuates under both these methods
when there is opening and closing stock of inventory:
Illustration 6
XYZ Ltd. produces one product. Its quarterly budget of sales, cost of sales and
production is as follows:
Quarterly Budget
Sales 40,000 units @ Rs. 3
Cost of Sales :
Rs.
Variable Manufacturing Costs
60,000
Fixed Manufacturing Costs
12,000
Total Cost
Gross Profit
Less Selling and Distribution Costs (Fixed)
Net Operating Profit
8

Total
Rs.

Per Unit
Rs.

1,20,000

72,000
48,000
28,000
20,000

1.50
0.30
1.80
1.20
0.70
0.50

The actual production and sales on a quarterly basis is as follows:

(units)

Quarter I

Quarter II

Quarter III

Quarter IV

9,000

2,000

Production

40,000

45,000

35,000

38,000

Sales

40,000

36,000

42,000

40,000

9,000

2,000

Opening Inventory

Closing Inventory

Marginal Costing

Prepare quarterly income statement under absorption costing and marginal costing.
Solution
Income Statement
(under Absorption Costing)

Sales
Manufacturing Costs :
Opening inventory*
Variable Costs
(Rs. 1.50 per unit)
Fixed overheads
Cost of goods
Less Closing Stock*
Cost of Sales
Gross Profit (Sales Cost of Sales)
Less Fixed Selling Costs
Profit

Quarter I
Rs.

Quarter II
Rs.

Quarter III
Rs.

Quarter IV
Rs.

1,20,000

1,08,000

1,26,000

1,20,000

0
60,000

0
67,500

16,200
52,500

3,600
57,000

12,000
72,000
0
72,000
48,000
28,000
20,000

12,000
79,500
16,200
63,300
44,700
28,000
16,700

12,000
80,700
3,600
77,100
48,900
28,000
20,900

12,000
72,600
0
72,600
47,400
28,000
19,400

*Opening and closing stock is valued at full cost i.e. fixed and variable which is
0.30 + 1.50 respectively = Rs. 1.80.
Income Statement
(Under Marginal Costing)

Sales

Quarter I

Quarter II

Quarter III

Quarter IV

1,20,000

1,08,000

1,26,000

1,20,000

Costs of Sales :
Cost of opening inventory*

13,500

3,000

Variable Mfg. Exp.

60,000

67,500

52,500

57,000

Cost of good available for sale

60,000

67,500

66,000

60,000

13,500

3,000

60,000

54,000

63,000

60,000

60,000

54,000

63,000

60,000

Fixed Mfg. Cost

12,000

12,000

12,000

12,000

Fixed Selling Exp.

28,000

28,000

28,000

28,000

20,000

14,000

23,000

20,000

Less Closing Stock*

Cost of Sales :
Contribution
(Sales Cost of Sales)
Less Fixed Costs :

Net Profit

*Opening stock and closing stock is valued at marginal cost i.e. Rs. 1.50 per unit.
9

CostOverview
An
Volume Profit
Analysis

The main features of marginal costing are:

1)

All costs are classified in fixed and variable costs. Variable cost per unit remains
same and fixed costs remain same in total regardless of the changes in
production.

2)

Fixed costs are considered period costs and variable costs are considered as
product costs. Hence fixed costs are not included in product cost.

3)

Stock of work-in progress and finished goods are valued at marginal costs or
variable costs.

4)

The difference in the value of opening stock and closing stock does not affect the
unit cost of production as all the product costs are variable costs.

Direct Costing and Marginal Costing are used inter-changeably. As both the techniques
are more or less same. In direct costing, costs are classified into direct and indirect
costs. Direct costs are those which can be directly allocated to cost unit or cost centre
while indirect costs can not be allocated to cost unit or costs centre directly. The only
difference between the two is that some fixed cost could be considered to be direct
costs under certain circumstances.

15.5 MARGINAL COSTING EQUATION AND

CONTRIBUTION MARGIN
In full costing or absorption costing, all costs are classified into three broad classesmanufacturing, administrative and selling. In the income statement, manufacturing
costs are deducted from the sales revenue to get the gross margin or gross profit then
administrative and selling expenses are deducted from gross margin to arrive at net
operating income. Under marginal costing, costs are clarified into fixed and variable
expense. All variable costs, whether they are manufacturing, administrative or selling
are deducted from sales revenue. The difference is called contribution margin or
marginal income. All fixed costs are recovered from the contribution and balance is
profit or loss.
Illustration 7
Two companies A Ltd. and B Ltd. sell the same type of product. Their income
statement are as follows:

Sales
Less Variable Cost
Fixed Costs
Profit

A Ltd.
Rs.
2,40,000
96,000
64,000
80,000

B Ltd.
Rs.
2,40,000
1,20,000
40,000
80,000

State which company is likely to earn greater profit if there is: (i) heavy demand,
(ii ) poor demand for its products.
Solution

10

Sales
Variable Cost
Contribution
P/V Ratio (Contribution Sales)

A Ltd.
Rs.

B Ltd.
Rs.

2,40,000
96,000
1,44,000
0.60

2,40,000
1,20,000
1,20,000
0.50

In case of A Ltd., every sale of Rs. 100 gives a contribution of Rs. 60 whereas in case
of B Ltd. every sale of Rs. 100 provides a contribution of Rs. 50. In case of heavy
demand, profit of A Ltd. will rise much faster in comparison to B Ltd. During poor
demand or decline in sales of Rs. 100 will lead to decline in contribution in A Ltd. and
B Ltd. by Rs. 60 and Rs. 50 respectively.

Marginal Costing

Mathematically,
Sales = Variable cost + Fixed cost Profit.
Sales Variable cost = Fixed Cost Profit
Sales Variable cost = Contribution
Contribution Fixed cost = Profit
To make profit, contribution should be greater than fixed cost. Further, to maximize
profit, contribution should be maximized. When contribution is equal to fixed cost, then
a firm is at no profit no loss point called break even point which you will study in
detail under Unit 16.

15.6

PROFIT-VOLUME RATIO

Profit volume ratio or contribution to sales ratio is a relationship between contribution

and sales. It is the ratio between contribution per product to turnover of the
product. Mathematically,
P/V Ratio

Sales variable cost

Sales

Contribution
Sales
Variable cost

1 --

Sales

Fixed cost + profit

Sales

Change in contribution
Change in sales

Change in Profit
Change in sales

Profit-volume ratio depicts the soundness of the companys product. Profit volume
analysis is used to determine break even for a product, a group of products and to
know how the profit changes if changes are made in price, volume, costs or any
combination of these. But P/V graph does not show how cost varies with the change
in the level of production. The profit volume ratio and contribution has a direct
relationship. The profit volume ratio can be improved by improving the contribution
and contribution can be improved by :
i)

increasing the selling price

ii)

decreasing the marginal or variable costs.

iii)

putting more emphasis on those products which have higher profit volume ratio.
11

CostOverview
An
Volume Profit
Analysis

Profit Volume Graph

For preparing the profit volume graph, following steps are involved :
l

Sales are depicted on x-axis and profit and loss on y-axis.

X-axis divides the graph into two parts. The lower area of the x-axis depicts loss
and upper area depicts the profit. When sales is zero, loss is equal to fixed cost.

At a particular level of sales volume, the profit is depicted on y-axis. Both the
points are joined by a straight line called profit line.

The point where profit line inter-sects the x-axis is called the break even point.

The angle between sales line and profit line is called angle of incidence.

Illustration 8
Construct profit volume graph with the help of the following data:
XYZ Ltd. reports the following results on 31st March, 2004 :
Sales @ Rs. 3 each

Rs. 3,00,000/-

Variable cost Rs. 2 each

Rs. 2,00,000/-

Fixed cost

Rs. 50,000/-

Construct the P/V chart.

Solution
Contribution
P/V ratio =
Contribution

Sales
= Sales Variable Cost
= Rs. 3,00,000 Rs. 2,00,000
=

Rs. 1,00,000.
Profit-Volume Graph

Y
+50,000
Profit

Contribution line
0

X
Loss area

-50,000
Fixed cost
12

BEP

200,000

Sales volume

On X-axis, OX represents sales volume, on Y-axis OY represents profit while OY

loss. OFC represents fixed cost. The line FCP represents Fixed cost and profit as well
as total contribution. BE is the break-even point. The area BEX represents margin of
safety while XBEP profit area. PBEX is the angle of incidence. You will be
acquainted with all these terms in detail in Unit 16.

Marginal Costing

Where a company is manufacturing more than one product of varying profitability, the
profit-volume graph can be constructed as follows :
Illustration 9
XYZ ltd. produces three products X, Y and Z. The cost data is as follows:
Fixed Cost

Rs. 25,000
X
Rs.

Y
Rs.

Z
Rs.

Sales

50,000

25,000

30,000

Variable Costs

20,000

20,000

18,000

You are required to

i)

Calculate the Profit- Volume ratio of each products, and

ii)

Prepare a profit- volume ratio chart.

Solution
X
Rs.

Y
Rs.

Z
Rs.

Total
Rs.

Sales

50,000

25,000

30,000

105,000

Variable Costs

20,000

20,000

18,000

58,000

Contribu0tion

30,000

5,000

12,000

47,000

3/5 or 0.60 5/25 or 0.20 12/30 or 0.40

47/105 or 0.45

Profit - volume ratio

The sequence should be X, Z and Y. (Descending order of P/V Ratio)

Product

Sales

Variable Contribution Cumulative Fixed

Cost
Contribution Costs

Cumulative Cumulative
Profit
Sales

50,000

20,000

30,000

30,000

25,000

5,000

50,000

30,000

18, 000

12,000

42,000

25,000

17,000

80,000

25,000

20,000

5,000

47,000

25,000

22,000

105,000

13

CostOverview
An
Volume Profit
Analysis

Profit-Volume Graph (Multi-products)

Y

30

Profit (Rs. 000)

20

10

20

40

60

80

100

120 Sales (Rs. 000)

10

20

30

15.7

MANAGERIAL USES OF MARGINAL

COSTING

Marginal Costing is a useful tool to management in taking various policy decisions,

profit planning and cost control. Following are a few of the managerial problem where
marginal costing is helpful in decision making:
1)

Price Fixation

2)

Accepting Special Order and Exploring Additional Markets

3)

Profit Planning

4)

Key Factors or Limiting Factor

5)

Sales Mix Decisions

6)

Make or Buy Decisions

7)

Adding or Dropping Decisions

8)

Suspension of Activities

1)

Price Fixation

Under marginal costing, fixed costs are ignored and price is determined on the basis of
variable costs (marginal). In normal business conditions, the price fixed must cover full
costs otherwise firm will incur losses. In certain circumstances like trade depression,
dumping, seasonal fluctuation in demand, highly competitive market etc. pricing is fixed
with the help of marginal costing rather than full costing.

14

During trade depression, the price may go down even below the full cost of the
product. In such case, the management has to decide whether to close down the
production activities until the recession is over or continue the production activities. In
case, the production activities are closed down, the firm will incur loss equal to its fixed

cost or un-escapable costs. The main emphasis of management is to minimise its

losses. The firm should continue its production activities so long as the selling price is
more than the marginal costs because any contribution earned will help in recovery of
the fixed costs which results in reduction of loss.

Marginal Costing

Dumping means selling the product in foreign market at a price less than its total cost.
The firm recover its fixed cost from the domestic market and marginal cost of the
product becomes the basis for price fixation. Similarly if the firm produces product of
seasonal demand or perishable goods marginal costing is more useful technique than
full costing.
Suppose the marginal cost of a product is Rs. 50 per unit and fixed cost is Rs. 200,000
per annum. Selling price of the product is Rs. 55 per unit and 10,000 units can be sold
at this price.
Per Unit
Rs.

Total
Rs.

Marginal Cost

50.00

500,000

Fixed Cost

20.00

200,000

Total Cost

70.00

700,000

The selling price is less than the total cost of the product, yet is beneficial to continue
the production activity. The contribution earned is Rs. 5 per unit and total contribution is
Rs. 50,000. This will reduce the loss by Rs. 50,000. If the firm discontinue production
activity, then loss will be Rs. 200,000 (Fixed Cost). Hence the firm should continue
production activity.
If the selling price is less than marginal cost, loss will be more than the fixed costs.
Hence the firm should fix the price equal to or above the marginal cost in special
circumstances. Production should be discontinued if the price obtained is below the
marginal cost so that the loss may not be more than fixed costs.
2)

Accepting Special Order and Exploring Additional Markets

In case of spare capacity, a firm can increase its total profits by accepting an special
order above the marginal cost and at a price lower than its regular selling price. The
additional contribution earned from the special order will be the additional profit to the
firm. When additional order is accepted at a price below prevailing price to utilise idle
capacity, it should be carefully seen that it will not affect the normal market and
goodwill of the company. The special order from a local dealer should not be accepted
as it will affect the relationship with other dealers.
Illustration 10
The company is operating at 60% of the installed capacity (total capacity of 10,000
units per month). Its monthly fixed expenses is Rs. 6 lakhs per month. The other costs
are:
Direct Material

Rs. 55 per unit

Direct Labour

Rs. 10 per unit

Variable Expenses

Rs. 25 per unit

The company has invested Rs. 1 crore in the business and is currently earning a return
of 7.2 per cent per annum before taxes. The managing director is prepared to accept
new business at any price which will raise the return on investment to 20 per cent
before taxes. A special offer was received for 4000 units every month if the product
is supplied at Rs. 120 per unit. Would you advise the company to accept the offer?

15

CostOverview
An
Volume Profit
Analysis

Solution
Total Capacity

10,000 units per month

Present Production

6000 units per month

Fixed Cost

Rs. 6 lakhs per month

Marginal Cost

Rs. 90 per unit

Return on Investment

7.2 per cent

Annual Profit

Rs. 7,20,000

Profit per month

Rs. 60,000

The selling price per unit will be

Output 6000 units
Per Unit (Rs.)

Total (Rs.)

Direct Cost

90

5,40,000

Fixed Cost

100

6,00,000

Total Cost

190

11,40,000

10

60,000

200

12,00,000

Profit
Selling Price

The total cost of the product is Rs. 190 per unit. The company has received the offer
at Rs. 120 per unit. It appears that if the offer is accepted, the company will loose
Rs. 70 per unit. Hence the offer be rejected. But this analysis is fallacious as fixed cost
will not change when production is increased. Here only variable cost which changes.
Thus the selling price should be compared with the marginal cost which is Rs. 90 per
unit. If the order is accepted each unit will provide Rs. 30 contribution towards profit.
If the order is accepted then the profit position will be as follows:
Output

Sales

Present 6000 units

Per Unit
Total
Rs.
Rs.

Order 4000 units

Per Unit
Total
Rs.
Rs.

10,000 units
Total
Rs.

200

12,00,000

120

4,80,000

16,80,000

Variable Cost

90

5,40,000

90

3,60,000

9,00,000

Contribution

110

6,60,000

30

1,20,000

7,80,000

Fixed Costs

100

6,00,000

----

----

6,00,000

10

60,000

30

1,20,000

1,80,000

Profit

Return on Investment =

1,80,000 12 100
1 crore

= 21.6%

The above statement provides that if the company accepts the offer, it will earn
additional Rs. 1,20,000 per month. The return on investment is enhanced from 7.2 per
cent to 21.6%. Before accepting the offer, following factors must be evaluated :

16

The lower selling price for this offer, should not affect adversely the regular
customers and goodwill of the company.

Decrease in price should not create a doubt in the customers mind about the
quality of the product.

No possibility of any other more profitable use of unutilised capacity.

3)

Marginal Costing

Profit Planning

Marginal costing is very helpful in determining the level of activity to achieve the
planned profits. The separation of costs in to fixed and variable aid management
further in planning and evaluating the profit resulting from a change in volume, a
change in selling price, a change in fixed costs and variable costs.
Illustration 11
XYZ Ltd. is manufacturing and selling a product whose cost data is as follows:
Per Unit
Rs.

Total
Rs.

Current Sale (20,000 units)

20

400,000

Variable Cost (20,000 units)

10

200,000

Fixed Cost

100,000

Profit

100,000

It is proposed to reduce the selling price due to competition by 10 per cent. How many
units are to be sold to maintain the present profit level ?
Solution
New selling price after 10% reduction = Rs. 18
Contribution

= Selling price Variable Cost

= Rs.18 Rs.10 = Rs. 8 per unit

Desired Contribution = Fixed Cost + Profit

= Rs. 100,000 + Rs.100,000 = Rs. 200,000

Sales required to earn desired profit (units) =

Desired Contribution

Contribution Per Unit

Rs. 2,00,000
= 25,000 units
Rs. 8

Fixed Cost + Desired profit

Desired Sales
(Value)

P/V ratio
Rs. 2,00,000 Rs. 18
---
Rs. 8

= Rs. 4,50,000
4) Key Factors or Limiting Factor
The marginal costing technique provides that the product with highest contribution per
unit is preferred. This inference holds true so long as it is possible to sell as much as it
can produce. But sometimes an organisation can sell all it produces but production is
limited due to scarcity of raw material, labour, electricity, plant capacity or capital.
These are called key factors or limiting factors. A key factor or limiting factor puts a
limit on production and profit of the firm. In such situation, management has to take a
decision whose production is to be increased, decreased or stopped. In such cases,

17

CostOverview
An
Volume Profit
Analysis

selection of the product is done on the basis of contribution per unit of scarce factor of
production. The key factor or scarce factor should be utilized in such a manner that
contribution per unit of scarce resource is the maximum.
Mathematically,

Contribution
Profitability =
Key Factor

For example, if raw material is the limiting factor, the profitability of each product is
determined by contribution per Kg of raw material. If machine capacity is a limiting
factor then contribution per machine hour is calculated. It electricity is the limiting
factor, then contribution per unit of electricity of each product is calculated.
Illustration 12
A company produces two products X and Y. The cost information is as follows:
Product

Sale Price

Rs. 20

Rs. 15

Variable Cost

Rs. 10

Rs. 8

Required Machine hours per unit

Sales Potential (Units)

1000

1200

Available production hours

2000

Calculate and find the best product mix.

Solution
Product

Sale Price

Rs. 20

Rs. 15

Variable Cost

Rs. 10

Rs. 8

Contribution

Rs. 10

Rs. 7

Required machine hours per unit

Contribution per machine hour

Rs. 5

Rs. 7

Product Y gives the highest contribution per machine hours. The best solution would be
to produce Y to the maximum extent that can be sold and remaining hours should be
devoted for production of X. Hence 1200 units of Y be produced and remaining 800
hours be devoted to product X which means 400 units of X. Thus the optimum mix is
400 units of X and 1200 units of Y.
5)

Sales Mix Decision

In marginal costing, profit is calculated by subtracting fixed cost from contribution. It

means management should try to maximise the contribution. When a business firm
produces variety of product lines, then problem of best sales mix arises. The best sales
mix is that which yields the maximum contribution. The products which gives the
maximum contribution are to be retained and their production should be increased
keeping in view the demand. The products, which yield less contribution, should be
reduced or closed down depending upon the situation.
Illustration 13
18

State which of the following sales mix you would recommend to the management?

Elements of cost

X
Rs.

Sale Price

200

150

Direct Material

100

80

Direct Labour

40

30

Variable Overheads

20

20

Fixed Overheads

Marginal Costing

Y
Rs.

: Rs. 100,000

Alternative Sales Mix :

a)

2000 units of X and 2000 units of Y

b)

3000 units of X and 1000 units of Y

c)

4000 units of X and Nil units of Y

Solution
Product

X
Rs.

Y
Rs.

Sale Price

200

150

Direct Material

100

80

Direct Labour

40

30

Variable Overheads

20

20

Contribution per unit

40

20

Choice of Sales Mix :

Sales Mix (1) :

Contribution on
2000 units of X @ Rs. 40 per units

80,000

2000 units of Y @ Rs. 20 per units

40,000

Rs. 120,000

Total Contribution
Sales Mix (2) :

Sales Mix (3) :

Rs.

Contribution on

Rs.

3000 units of X @ Rs. 40 per unit

120,000

1000 units of Y @ Rs. 20 per unit

20,000

Rs. 140,000

Rs. 1,60,000

Contribution on
4000 units of X @ Rs. 4 0 per unit

Sales mix 3 gives the highest contribution and is the best mix among the above
alternatives.
6)

Make or Buy Decision

A particular component used in the main product may be purchased or may be

manufactured in its own factory by utilising the idle capacity of the existing facilities. In
such make or buy decision, the marginal cost of manufacturing in the unit is compared

19

CostOverview
An
Volume Profit
Analysis

with the purchase price from the market. If marginal cost is less than the purchase
price, then the component should be manufactured in its own unit, otherwise it should
be purchased from the market. Fixed expenses are not taken in the cost of
manufacturing on the assumption that they have been already incurred, the additional
cost involved is only variable cost.
Illustration 14
XYZ Ltd. produces a variety of products and components. Their cost information and
purchase prices are as follows:
X
Rs.

Y
Rs.

Z
Rs.

Direct Material

12

Direct Labour

16

Variable Overhead

Fixed Cost

20

10

15

45

25

Bought out price

One of these products can be produced in the factory and rest two are to be bought
from outside. Select the component which should be bought from outside ?
Solution
Comparative Cost Sheet
X
Rs.

Y
Rs.

Direct Material

12

Direct Labour

16

Variable Overhead

Marginal Cost

18

24

12

Bought out price

15

45

25

----3

+21

+13

Saving (--) or increase (+)

Z
Rs.

It is clear from the above statement that Y should be produced in its own unit as
its marginal cost is much lower than the purchase price and other two
components i.e., X and Z be purchased from the market.
7)

20

Adding and Dropping

An organisation may have a number of product lines or departments. Certain

product lines or departments may turn out to be unprofitable with the passage of
time or due to technological developments. Production of such products or
departments can be discontinued. The marginal costing approach assist in these
situations to take a decision. It helps in the introduction of a new product line and
work as a good guide for deciding the optimum mix keeping in mind the available
resources and demand of the product. The contribution of different products or
departments is to be compared and the product or department whose P/V ratio is
the lowest is to be dropped out. The following illustration explains how marginal
costing technique helps the management in decision making.

Marginal Costing

Illustration 15
A company manufactures three products whose cost data is given below.
Product

X
(Rs.)

Y
(Rs.)

Z
(Rs.)

Selling Price

100

80

90

Direct Material

20

12

16

Direct Labour

16

16

16

Variable Overhead

16

12

15

The management wants to drop out Product Y as it is not profitable. What

advice would you like to give the management ?
Solution
Comparative Cost Statement
Product

X
(Rs.)

Selling Price

Y
(Rs.)
10 0

Z
(Rs.)
80

90

Less Marginal Cost :

Direct Material

20

12

16

Direct Labour

16

16

16

Variable Overhead

16

Contribution
P/v ratio

52

12

48
48%

40
40

50%

15

47
43

47.77%

Product Y is the most profitable product line as its P/V ratio is the highest when
compared to products X and Z.
8) Suspension of Activities
During trade recession and cut throat competition the demand of the product is not
adequate to cover the fixed costs, management may consider to suspend the
operations for the time being. If certain portion of fixed expenses is escapable e.g.
salary of temporary staff then size of contribution should exceed the escapable fixed
costs. In some units when production is restarted after suspension, some additional or
special costs are incurred like overhauling of the plant and machinery. These costs are
called additional costs of shut down. These costs are deducted from the escapable
fixed costs and amount of contribution is compared with the net escapable fixed costs.
If the contribution is greater than the net escapable fixed cost, the production should be
continued and vice versa.
Net Escapable Fixed Costs
Shut down point
=
Contribution per unit
Net escapable fixed cost

Total fixed cost for the period unescapable

fixed costs + additional costs of shut down.

Illustration 16
XYZ Ltd. is manufacturing 200,000 boxes per annum when working at normal
capacity. The cost information is as follows :
Rs.
Direct Material
=
8.00
Direct Labour
=
2.00
Variable Overheads
=
3.00
Fixed Overheads
=
3.00
Total Cost
=
16.00

21

CostOverview
An
Volume Profit
Analysis

The selling price is Rs. 20 per unit. It is estimated that in the next quarter only 10,000
units can be produced and sold. Management plans to shut down the plant and
estimating that fixed cost can be reduced to Rs. 80,000 for the quarter. The fixed
overheads are incurred uniformly throughout the year. Additional cost of plant shut
down is Rs. 10,000.
From the above information you are requested to decide the following:
a)

Whether the plant should be shut down for a period of three month

b)

Calculate the shut down point for three months.

Solution
Rs.
a)

Sale Price
Marginal Costs :

16
Rs.

Direct Material

Direct Labour

Variable Overheads 3
Contribution :

13
Rs. 3 per unit.

Fixed Overhead = Rs. 3 200,000 = Rs. 600,000 per annum

Fixed overheads for quarter
If plant is operated, the loss is :
Total contribution on 10,000 units
(10,000 units Rs. 3)

Rs. 600,000
= Rs. 1,50,000
4

Rs.
= 30,000

Fixed Cost

= 150,000

Loss (Fixed cost Contribution)

= 120,000

If plant is closed, then loss will be :

Unescapable fixed cost

= Rs. 80,000

Addition shut down cost

= Rs. 10,000

Total Loss

= Rs. 90,000

As is evident from the above calculations that the plant should be closed down for the
quarter, so that the loss will be reduced by Rs. 30,000.
b)

Shut down point

Net Escapable Fixed Cost = Total Fixed Cost for the period Shut down costs +
additional costs.
= Rs. 150,000 Rs. 80,000 + Rs. 10,000 =
Shut down point

22

Rs. 80,000

Net Escapable Fixed Cost

Contribution Per Unit

Rs. 80,000
Rs. 3

26,667 units per quarter

For suspension of business activity, only costs should not be taken into consideration,
there are other factors also like, employees interest, fear of plant obsolescence, loss
of customers in future, government action, perishable raw material and company is
having a huge stock of material, etc.

Marginal Costing

Check Your Progress

A)

B)

C)

Fill in the blanks:

i)

The technique of marginal costing is based on classification of costs in to

___________ and ____________.

ii)

Contribution is the sum of _________ and ___________.

iii)

In marginal costing, closing stock is valued at __________________.

iv)

Profit-volume ratio is the relationship between ___________ and

__________.

v)

In absorption costing, closing stock is valued at ________________.

State whether each of the following statement is True or False.

i)

Fixed cost per unit remains constant.

[T

F]

ii)

Variable cost per unit remains constant

[T

F]

iii)

Absorption costing is not as suitable for decision making as

marginal costing is

[T

F]

iv)

Semi-variable costs consists of fixed costs and factory costs [ T

F]

v)

Fixed costs are not taken in to consideration in valuation of

work-in-progress in marginal costing

F]

[T

From the following choose the most appropriate answer

1)

2)

Contribution margin is also known as

a)

Gross profit

b)

Net profit

c)

Earning before tax

d)

Marginal income

Contribution is the difference between

a)

Sales and variable cost

b)

Sales and fixed cost

c)

Sales and total cost

d)

Factory cost and profit

23

CostOverview
An
Volume Profit
Analysis

3)

4)

5)

6)

15.8

When fixed cost is Rs. 20,000 and Profit volume ratio is 25 per cent, then
break even point will occur at
a)

Rs. 5000

b)

5000 units

c)

Rs. 80,000

d)

80,000 units

Period cost means

a)

Variable cost

b)

Fixed costs

c)

Prime cost

d)

Factory cost

If profit-volume ratio is 25 per cent and sales is Rs. 100,000, the variable
cost will be
a)

Rs. 25,000

b)

Rs. 50,000

c)

Rs. 75,000

d)

None of the above

The valuation of stock in marginal costing as compared to absorption

costing is
a)

Higher

b)

Lower

c)

Same

d)

None of the above

LIMITATIONS OF MARGINAL COSTING

The marginal costing has the following limitations :

24

1)

Difficulty in cost Analysis : Separation of costs into fixed and variable

becomes very difficult under certain circumstances and in certain business
situations. The accuracy of marginal costing results depends upon how accurately
costs are classified.

2)

Inappropriate basis of pricing : In marginal costing, there is a danger of too

many sales being made at marginal cost or marginal cost plus some contribution,
resulting in under recovery of fixed overheads. This situation will arise during
depression or increasing competition.

3)

Under valuation of inventory : In marginal costing, inventories are valued at

variable costs. It may create problems in inter firm transfer of goods at marginal
costs resulting in higher profits. Employees may demand higher salaries and other
benefits. Exclusion of fixed costs from inventory cost seems to be against the
accepted accounting procedure.

4)

Same marginal cost per unit : This assumption is partly true within a limited
range of activity. Scarcity of labour and material brings change in price, trade
discount of bulk purchases, changes in the productivity of men etc. will influence
the marginal cost per unit.

5)

Not suitable to all concerns : This technique may not be suitable in those
industries which have large stock of work-in-progress e.g. contact and ship
building industry. If fixed expenses are not included in valuation of work-inprogress losses may occur in the initial years till the contract is completed. On
completion of the contract, huge profit will be depicted.

6)

New Technology : With the development of science and technology, new cost
efficient machines are available resulting in reduction in labour costs and
increased fixed costs. The system of costing, which ignores significant portion of
cost i.e. fixed cost, can not be very effective.

Marginal Costing

15.9 LET US SUM UP

The elements of costs are material, labour and expenses. These elements of costs are
broadly put into two categories: fixed and variable costs. The cost of product or
process can be ascertained by absorption costing and marginal costing. In absorption
costing or full costing, cost of a product is determined after considering both fixed and
variable cost. Whereas in marginal costing only variable costs are considered in
calculating the cost of product and fixed costs are charged against the revenue
(consideration) of the period. Marginal costing is a definite improvement over the
absorption costing.
Marginal costing involves computation of marginal cost. The marginal cost is also
called variable costs. It comprises of direct material, direct labour and variable
overheads. Marginal costing helps the management in taking various managerial
decisions like price fixation, profit planning, add and drop decisions, make or buy
decision, sales mix decision etc.
Marginal costing technique has some limitations. The categorisation of expenses into
fixed and variable elements is tedious and complex task. The behaviour of per unit
variable and total fixed cost is questionable as assumed in marginal costing. Inspite of
these limitations, marginal costing is a useful technique for decisions making in several
business decisions.

15.10

KEY WORDS

Absorption costing or full costing: A technique where all costs, fixed and variable,
are allocated to cost unit.
Break Even Point: A level of production activity, where sales revenue is equal to
variable cost and fixed cost or contribution equal to fixed cost. It is also called no
profit, no loss point.
Contribution: The difference between sale price and variable costs is called
contribution.
Marginal Cost: It comprises of direct material, direct labour and variable overheads
or cost of producing one additional unit.
Marginal Costing: It is a technique where only variable costs are considered while
computing the cost of product. The fixed costs are met against the total contribution of
all the products taken together.

15.11 ANSWERS TO CHECK YOUR PROGRESS

A) i) Fixed and Variable,
ii) Fixed Cost and Profit, iii) variable cost,
iv) contribution and sales, v) full cost
B) i) F, ii) T, iii) T, iv) F, v) T
C) 1) D, 2) A, 3) C, 4) B, 5) C, 6) D

25

CostOverview
An
Volume Profit
Analysis

15.12 TERMINAL QUESTIONS

1) Under what conditions, the income statement prepared under full costing or
absorption costing and marginal costing will give similar results.
2) State the conditions, the income statement prepared with absorption costing and
marginal costing will give different results.
3) Explain the application of marginal costing in managerial decision making.
4) How semi-variable costs or mixed costs can be segregated into fixed and variable
components.
5) The profit is the product of the P/V ratio and the margin of safety. Comment.
6) What are the limitations of marginal costing techniques?
7) A manufacturer produces a car component. The cost sheet of the component is as
follows:
Material

4.00

Direct Labour

2.00

Variable Overheads

1.50

Fixed Overheads

2.50
10.00

A foreign manufacturer who uses this car component offers to purchase 20,000 units
at Rs. 13 per component against the usual price of Rs. 15 per unit. If this offer is
accepted the fixed expenses will go up by Rs. 40,000 annually.
Would you accept this offer? Are there any other considerations, which may affect
your decision?
(Yes, profit increases by Rs. 70,000)
8)

The management of company worried about the performance of Department X

and wants to close the department. The following data is supplied by the cost
accountant.
Department
X
Rs.

Y
Rs.

Z
Rs.

Sales

40,000

60,000

1,00,000

Variable Costs

36,000

48,000

60,000

6,000

9,000

15,000

Total Cost

42,000

57,000

75,000

Profit or Loss

---2 0 0 0

+3000

+2500

Fixed costs (apportioned on the basis of sales)

a)

You are required to advise management in respect of closure of department X.

b)

On the above, the specific fixed costs are ascertained as follows: X Rs. 2000;
Y Rs. 13000; and Z Rs. 5000 and the balance of Rs. 10,000 is treated as
general fixed overheads.
(Answer : (a) Continue X (b) Close Y, Total Profit Rs. 26,000)

9)
26

A Company manufacturers and markets three products X, Y and Z. All the three
products are manufactured from the same set of machines. Production is limited

by machine capacity. From the data given below, indicate the priorities for product
X, Y and Z with a view to maximising profits.
X

Raw Material per unit

11.00

16.25

21.00

Direct Labour per unit

2.50

2.50

2.50

Variable Overheads

1.50

2.25

3.50

25.00

30.00

35.00

40

20

20

Selling Price
Machine time required per unit in minutes

Marginal Costing

(Answer : Y, Z and X. Contribution per unit : 0.225, 0.45, 0.4 respectively.)

9)

XYZ Ltd. produces three products and cost data is as follows:

X
Rs.

Y
Rs.

Z
Rs.

100

75

50

0.10

0.20

0.40

40,000

25,000

10,000

50.00

50.00

50.00

Selling price per unit

P/V Ratio
Maximum sales potential (in units)
Raw material content as % of variable costs

The fixed expenses are estimated at Rs. 6,80,000. The company uses a single raw
material in all the products. Raw material is in short supply and the company has a
quota for the supply of raw materials to the extent of Rs. 18,00,000 per annum for
the manufacture of its products to meet its sales demand.
a)

Calculate the product mix which will give the maximum overall profits keeping the
short supply of raw materials.

b)

Compute the maximum profit.

[Answer : (a) Product mix of X, Y and Z are 10,000, 25,000 and 10,000 units
respectively; (b) Profit Rs. 95,000 ]

Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.

15.13 FURTHER READINGS

Kishore, Ravi M., Management Accounting with Problems and Solutions, Taxmann
Allied Services Pvt. Ltd. New Delhi, 2000.
Horngren, C.T., Gary L. Sundem and Frank H. Selto, Management Accounting,
Prentice Hall of India, New Delhi, 1994.
Kaplan, R.S., Advanced Management Accounting, Engle Wood Cliffs, NJ.,
Prentice Hall Inc.

27

UNIT 16 BREAK EVEN ANALYSIS

Structure
16.0

Objectives

16.1

Introduction

16.2

Break Even Analysis

16.3

Break Even Point

16.4

Impact of Changes in Sales Price, Volume, Variable Costs and Fixed Costs
on Profits

16.5

Required Sales for Desired Profit

16.6

Sales Volume Required to Earn a Desired Profit Per Unit

16.7

Sales Required to Maintain Present Profit

16.8

Margin of Safety

16.9

Angle of Incidence

16.10 Break Even Charts

16.11 Profit Volume Graph
16.12 Assumption in Break Even Analysis
16.13 Let Us Sum Up
16.14 Key Words
16.15 Answers to Check Your Progress
16.16 Terminal Questions
16.17 Further Readings

16.0 OBJECTIVES
After studying this unit you should be able to:
l

understand the concept of break even analysis, impact of change in sales

volume, price, variable cost, fixed costs on profits;

apply cost-volume profit relationship for profit planning;

understand the concept of margin of safety, angle of incidence, and profit

volume ratio in decision making; and

examine the assumptions and limitations of the break even analysis

16.1 INTRODUCTION

32

In this unit you will learn about the concept of break-event point and finding out of
break even point through mathematical equation and graphic representation You
will be acquainted with the relationship between Cost, Volume and Profit and its
impact on planning and evaluation of business operations. You will also study the
concepts of margin of safety, angle of incidence, limiting factor and profit volume
ratio in decision making. The unit also deals with the underlying assumptions of
break even analysis.

16.2 BREAK EVEN ANALYSIS

Break Even Analysis

The analysis of cost behaviour is necessary for planning, control and decision making.
Analysis of cost behaviour means analysis of variability of each cost element in
relation to the level of output. Every cost follows some definite behaviour pattern. For
example total variable costs varies in direct proportion to the volume of output but per
unit variable cost remains same. Examples of such costs are direct material, direct
labour, packaging expenses, selling commission etc. These costs are called product
costs and are controllable, as they incur only when production takes place. Whereas
fixed costs remains same irrespective to the level of output but per unit fixed cost goes
on decreasing with the increasing level of out put as fixed cost scattered over a large
number of units. Examples of such expenses are rent, rates and insurance, executives
salary, audit fees etc. These costs are also called period costs and are uncontrollable.
The mixed costs or semi-variable costs have both the elements variable and fixed.
These costs also change in the same direction in which volume of output changes but
this change is less than proportionate change in output. Examples of such costs are
power, telephone, depreciation, etc. Thus the concept of break even analysis is a
logical extension of marginal costing. It is based on the same principle of classifying
the costs into fixed and variable.
Semi-variable costs are segregated in fixed and variable components as discussed in
the earlier chapter. Fixed component is added in fixed costs and variable component
with variable cost. Thus the costs are classified into two water tight compartments i.e.
fixed and variable.
The cost behaviour play a significant role in decision making. The relationships in
volume, cost and profit shows that if volume increase by 10 per cent (say), then cost
will not increase by 10 per cent. Because only variable cost will increase and fixed
costs remain same and unit fixed cost declines. Consequently, profit will not increase
by 10 per cent but more than that and vice versa. The level of production changes
due to many reasons, such as recession or boom, competition, introduction of new
product, increase in demand, scarce raw material etc. The management wants to
know the effect of these changes on profit. The break-even analysis helps the
management in decision making in these situations.
The study of cost-volume-profit relationship is some time called as break even
analysis. In the opinion of some, it is a misnomer as break even analysis depicts a
point where costs and total sales revenue is same. Beyond this point, it is called costvolume-profit relationship. Some hold the view, that break even analysis can be
interpreted in two senses narrow and broad sense. In narrow sense, it refers to
determine the level of output where total costs equal to total revenue i.e. no profit, no
loss. In the broad sense, it is used to determine the probable profit at any level of
output.

16.3 BREAK EVEN POINT

It is a point where sales revenue equals the costs to make and sell the product and no
profit or loss is reported. In the words of Keller and Ferrara, the break even point of
a company or a unit of a company is the level of sales income which will equal to the
sum of its fixed costs and variable costs. Charles T. Horngren define it, the break
even point is that point of activity (sales volume) where total revenues and total
expenses are equal, it is the point of zero profit and zero loss.
There are two methods of calculating break even point. Mathematical method and
Graphical method.

33

Cost Volume Profit

Analysis

16.3.1 Mathematical Method

The break even point through mathematical method can be found out either by
i)

Equation Method, or

ii )

Contribution Margin Technique.

Equation Method
We know,
Sales Variable costs Fixed cost = Profit (S --- VC FC = P)
Sales Variable costs = Fixed costs + Profit (S --- VC = FC + P)
Sales minus variable costs is called Contribution. (S --- VC = C)
Contribution = Fixed costs + Profit (C = FC + P)
At break even point, profit is zero.
Contribution = Fixed Costs (at break even point)
or
(SP ---- VC) Q = F
Where, SP is selling price, VC is the variable costs, F is a fixed costs and Q is the
number of units produced and sold. Look at the following illustration how the breakeven point is to be calculated:
Illustration 1
Calculate the break even point from the following information :
Selling price

= Rs. 3 per unit

Variable cost

= Rs. 2 per unit

Fixed cost

= Rs. 90,000

Estimated sales for the period = 100,000 units or Rs. 300,000

Suppose the units to be produced and sold at break even point is Q, then
Sales Variable Costs = Contribution = Fixed Costs
3Q2Q

= 90,000

= 90,00 0 units

When we produce and sell 90,000 units, then total sales revenue is Rs. 2,70,000
(90,000 units Rs. 3 ) and total cost is Rs. 2,70,000, (VC Rs. 2 90000
units = 1,80,000 + F C Rs. 90,000)
Contribution Margins Technique
Contribution per unit means difference between selling price and variable costs
or
Contribution per unit = Selling price per unit Variable Cost per unit
Total Contribution = Sales Revenue Total Variable Costs

34

Break even point can be expressed in terms of units to be produced and sold or in
terms of value of goods. At break even point, we know

Break Even Analysis

Break Even Point in Units

Sales Variable Costs =
or
(SP VC) Q
=
or

Fixed Costs
Fixed Costs
Fixed Costs

Q = BEP (in units)

SP per unit VC per unit

or
Q

Fixed Costs
Contribution Per Unit

Break Even Point in Value

Multiplying both sides by selling price (SP),

or

SP Q = BEP (in value)

BEP (in value)

or

Fixed Cost SP per unit

Contribution per unit
Fixed Costs Sales
Total Sales Total Variable Costs
Fixed Costs Sales
Total Contribution

Let us calculate the break-even point with the help of above equations by using the
information given in illustration 1
BEP (in units)

BEP (in value)

BEP (in value)

Fixed Costs
SP VC

Rs. 90,000
Rs. 3 Rs. 2

Fixed Cost Selling Price

SP VC

Fixed Costs Selling Price

Contribution per unit

Rs. 90,000 Rs. 3

Rs. 3 Rs. 2

Rs. 2,70,000

Fixed Costs Total Sales

Total Sales Variable Costs

Rs. 90,000 Rs. 300,000

= Rs. 2,70,000
Rs. 300,000 Rs. 200,000

= 90,000 units

It shows that a firm will be at a break even point when it is producing and selling
90,000 units or having a sale of Rs. 2,70,000.
Profit / Volume Ratio (P/V ratio)
Total contribution divided by total sales is called profit-volume ratio or contribution
ratio (P/V ratio). Break-even point can be determined with the help of P/V ratio.

35

Cost Volume Profit

Analysis

P/V ratio

Contribution
Sales

Sales Variable Cost

Sales

Variable Cost
Sales

Or
Fixed Cost + Profit
P/V Ratio =

F+P
=

Sales
BEP (in value)

Fixed Costs Total Sales

Total Sales Variable Costs

Fixed Costs Total Sales

Total Contribution

Fixed Costs
Total Contribution Total Sales
Fixed Costs
P\V Ratio

Variable Costs to Sales is called Variable Cost Ratio.

BEP (in value) =

Fixed Costs
Variable Costs
1
Sales

It should be noted that firms producing one product line only, the calculation of breakeven point is preferred in units and firms having a variety of product lines, calculation of
break even point is preferred in value. P/V ratio can also be expressed in the form of
percentage by multiplying by 100. Look at the following illustration.
Illustration 2
XYZ Ltd. is manufacturing and selling four types of products A, B, C and D. The sales
mix and variable costs are as follows:
Product
A
B
C
D

Sales per month

2,00,000
1,50,000
1,00,000
2,50,000

Variable Cost Ratio

50%
50%
75%
40%

The fixed costs are Rs. 1,50,000 per month. Calculate break even point.
Solution
Firstly calculate the variable costs and contribution.
Particular
Sales (Rs.)
Variable Costs (Rs.)
Contribution (Rs.)
Fixed Costs (Rs.)
36

Profit (Rs.)

A
2,00,000
1,00,000
1,00,000
-

B
1,50,000
75,000
75,000
-

C
1,00,000
75,000
25,000
-

D
2,50,000
1,00,000
1,50,000
-

Total
7,00,000
3,50,000
3,50,000
1,50,000
2,00,000

P/V Ratio

Total Contribution = Rs. 3,50,000

= 0.50 (i.e., 50%)
Total Sales
Rs. 7,00,000

Break Even Point (in value) =

Rs. 1,50,000
0.50

Variable Cost Ratio

Variable Costs
Rs. 3,50,000
=
= 0.50 (i.e., 50%)
Total Costs
Rs. 7,00,000

BEP (in value)

Break Even Analysis

= Rs. 3,00,000

Fixed Costs
Rs. 1,50,000
=
= Rs. 3,00,000
Variable Costs
1 0.50
1
Total Sales

Break-even point as percentage of estimated capacity utilisation : Break-even

point can also be calculated as a percentage of estimated sales or capacity utilisation
by dividing the break-even sales by the estimated capacity sales/utilisation.
Illustration 3
The ratio of variable costs to sales is 70 percent. The break even point occurs at
60 percent of the capacity. Find the break even point sales when fixed costs are
Rs. 90,000. Also compute profit at 75% of the capacity sales.
Solution
As the variable cost to sales ratio = 70%
We know
P/V ratio or Contribution ratio

= 1

VC
= 1 0.70
Sales

= 0.30
BEP (in value)

Fixed Cost
Rs. 90,000
=
P/V Ratio
30

= Rs. 3,00,000
BEP occurs at 60 per cent of the capacity utilisation
Capacity Utilisation
Sales
60%

Rs. 3,00,000

75%
We can apply unitary method or proportion method
X

Rs. 3,00,000 75
=
60

Rs. 3,75,000

Now we can compute, contribution earned when sales is Rs. 3,75,000. Sales
multiplied by P/V ratio gives the contribution.
Contribution = Sales P/V Ratio

Profit

Rs. 3,75,000 30%

Rs. 1,12,500

Contribution Fixed Costs

Rs. 1,12,500 Rs. 90, 000

Rs. 22,500

37

Cost Volume Profit

Analysis

16.3.2 Graphical Method

The break-even point can also be shown graphically. The BEP chart shows the
relationships between cost, volume and profit at various levels of output. Fixed costs,
variable costs and sales revenues are shown on Y-axis and volume of out on X-axis.
The break-even point is that point at which the total cost line and total sales line
intersect each other. This point represents no profit, no loss.
The following steps are involved in construction of break even chart:
l

Sales volume is plotted on x-axis. Sales volume may be expressed in terms of

value (rupee), units or as percentage of capacity.

Cost and Revenue are depicted in y-axis. Fixed costs remains constant
irrespective to the sales volume. Hence it is parallel to the x-axis and starts
from Rs. 90,000. (Data of illustration 1) Variable cost starts from (0,0)
because no sales volume, no variable cost and as the volume increases variable
cost also increases. When a parallel line of variable cost drawn from the fixed
cost line in y - axis, it depicts the total cost line. The sales revenue curve also
starts from (0,0).

The point of intersection of sales revenue line and total cost line depicts, break
even point. It occurs at a point of 90,000 units on x-axis and Rs. 2,70,000
(in terms of value) on y-axis.

The area to the left side of break even point depicts loss zone as cost curve is at a
higher level and sale revenue line is at a lower level. The area to the right hand
side of break even point is call profit zone as sale revenue line lies at a higher level
than the total cost line.

The angle formed by the intersection of sale value line and total cost line is known as
angle of incidence. Larger the angle, lower is the break even point and vice versa.

Let us draw a break even chart with the help of the following illustration.
Illustration 4
Let us draw a break-even chart with the help of data given below at different
production levels of 0, 80,000, 90,000, 1,00,000 1,10,000, and 1,20,000 units.
Sale Price

Rs. 3 per unit

Variable Cost =

Rs. 2 per unit

Fixed Cost

Rs. 90,000

Solution
The costs and profits and different levels of output is computed as follows :
Output

Variable Cost Fixed Cost Total Cost

Rs.
Rs.
Rs.

Sale Rev.
Rs.

Profit
Rs.

90,000

90,000

90,000

80,000

1,60,000

90,000

2,50,000

2,40,000

10,000

90,000

1,80,000

90,000

2,70,000

2,70,000

1,00,000

2,00,000

90,000

2,90,000

3,00,000

10,000

1,10,000

2,20,000

90,000

3,10,000

3,30,000

20,000

1,20,000

2,40,000

90,000

3,30,000

3,60,000

30,000

The above data if presented on a graph, it appears as follows :

38

Break Even Analysis

Break Even Chart

360

Angle of
incidence

Costs/sales Revenues (in 000 rupees)

340
320

Profit

Pr
of
it
zo
ne

380

Total cost

Break even
point

300
280

Margin of
Safety

260
240
220
200

Sales revenue

180

Variable cost

160

Lo
ss
A
re
a

140

100

Fixed cost

80
60
40
20
0
10

20

30

40

50

60

70

80

90 100 110 120 130 140

Output (in 000 units)

Contribution break even chart

From this chart we can ascertain the contribution earned at different levels of activity.
Under this method, total cost line is not drawn instead the contribution line is drawn
from the (0.0) point or origin. Intersection of cost line and sales line does not arises in
this case as break even point occurs at where contribution is equal to fixed cost. When
contribution is greater than fixed cost it is profit and vice versa. The contribution break
even chart shows the contribution at different levels of activity and any level of activity
below the BEP will not cover the fixed cost.
Let us represent the data as given in illustration 4 by means of contribution break-even
Chart.
Solution :
Output

Variable Cost Fixed Cost

(Rs.)
(Rs.)

Total Cost
(Rs.)

Sale Rev. Contribution

(Rs.)
(Rs.)

90,000

90,000

80,000

1,60,000

90,000

2,50,000

2,40,000

80,000

90,000

1,80,000

90,000

2,70,000

2,70,000

90,000

1,00,000

2,00,000

90,000

2,90,000

3,00,000

1,00,000

1,10,000

2,20,000

90,000

3,10,000

3,30,000

1,10,000

1,20,000

2,40,000

90,000

3,30,000

3,60,000

1,20,000

39

Cost Volume Profit

Analysis

Contribution Break Even Chart

Y
Sales curve

Variable costs

Contribution curve
Profit area

16.4

Fixed cost

BEP

Loss
Area

Output

IMPACT OF CHANGES IN SALES PRICE,

VOLUME, VARIABLE COSTS AND FIXED
COSTS ON PROFITS

16.4.1 Impact of Sale Price Changes on Profit

Suppose the normal sales volume of X Y Z Ltd. is 1,00,000 units, selling at a price of
Rs. 3 per unit. The variable cost is Rs. 2 per unit, fixed cost is Rs. 90,000. The capital
investment is Rs. 1,00,000. Let us study the impact of change in price on profit under
two conditions i.e. increase in price by 5 per cent and 10 per cent and decrease in price
by 5 per cent and 10 per cent.m
Impact of Change in Sales Prices on Profit
Sl.
No.

Decrease in Price
10%

5%

Normal
Volume

Increase in Price
5%

10%

1.

Outputs (units)

1,00,000

1,00,000

1,00,000

1,00,000

1,00,000

2.

Sales ( Rs.)

2,70,000

2,85,000

3,00,000

3,15,000

3,30,000

3.

Variable Costs
( Rs.)

2,00,000

2,00,000

2,00,000

2,00,000

2,00,000

4.

Marginal Income
or Contribution
(2-3) ( Rs.)

70,000

85,000

1,00,000

1,15,000

1,30,000

5.

Fixed Costs (Rs.)

90,000

90,000

90,000

90,000

90,000

6.

Operating Profit /
Loss (4-5) (Rs.)
----20,000

----5,000

10,000

25,000

40,000

% Change in
Profit

----300%

----150%

----

150%

300%

Break even
point (units)

1,28,571

1,05,882

90,000

78,261

69,231

7.
8.

40

Particulars

9.

P/V Ratio

0.2592

0.2982

0.3333

0.3651

0.3939

10.

Return on
Investment %

----20%

----5%

10.00

25.00

40.00

Break Even Analysis

From the above table, we can draw the following inferences:

1)

A small change in price brings wide fluctuations in operating profit. For

example 5 per cent decrease in price brings 150 per cent decrease in profit and
vice versa. The change is 30 times.
The change can be computed as follows:
=

% Change in Profit
% Change in Price

When price declines by 5 percent, then change in profit is

=

15 0 %

= 30 times

5%
There is an inverse relationship in change in price and change in break even
point. When price increase other factors remains same, the break-even point
declines.
Increase in sale price leads to higher contribution resulting in lower break even
point and vice versa. A lower number of units have to be sold in order to recover
the fixed cost.
2)

Profit-Volume Ratio: There is a direct relationship in change in price and

change in profit volume ratio. With change in price, the contribution also changes
consequently P/V ratio also changes.

3)

Return of Investment: Like in operating profits, the change in price has a

magnified impact on return on investment.

16.4.2 Impact of Volume Changes on Profit

Let us study the impact of change in volume on profit in the above-mentioned
example.
Sl.
No.

Decrease in Price
Particulars

Increase in Price

Normal
Volume

10%

5%

5%

10%

80,000

90,000

1,00,000

1,10,000

1,20,000

1.

Outputs (units)

2.

Sales ( Rs.)

2,40,000 2,70,000

3,00,000

3,30,000

3,60,000

3.

Variable Costs ( Rs.)

1,60,000 1,80,000

2,00,000

2,20,000

2,40,000

4.

Contribution ( Rs.) (2-3)

80,000

90,000

1,00,000

1,10,000

1,20,000

5.

Fixed Costs (Rs.)

90,000

90,000

90,000

90,000

90,000

6.

Operating Profit
(4-5) ( Rs.)

---- 10,000

10,000

20,000

30,000

7.

% Change in Profit

-200

-100

100

200

8.

Break even point

(units)

90,000

90,000

90,000

90,000

90,000

Percentage

0.3333
or
33.33%

0.3333
or
33.33%

0.3333
or
33.33%

0.3333
or
33.33%

0.3333
or
33.33%

Return on
Investment (%)

---10.00

10.00

20.00

30.00

9.

10.

P/V Ratio

41

Cost Volume Profit

Analysis

From above table, the following inferences can be drawn:

1)

Percentage Change in Profit: A small change in sales volume brings a wide

fluctuation in profit. For example, a 10 per cent change in sales volume leads to a
100 per cent change in profit. It is called operating leverage or operating elasticity.
Mathematically, it is
OL or OE

% Change in Profit
% Change in Sales

The operating leverage or operating elasticity is the degree of responsiveness or

sensitivity of operating profit to change in sales. In the above example, operating
leverage or operating elasticity is
OL or OE =

% Change in Profit
% Change in Sales

100%
10%

= 10 times

It depicts that 1 percent change in sales leads to 10 times change in operating profit i.e.
10 per cent.
2)

Break Even Point: There is no impact on the break-even point. Because

contribution per unit (Sale Price Variable Costs) and fixed costs are not
influenced by the change in volume. Thus break even point is unaffected when
there is a change in sales volume.

3)

P/V Ratio: Like break even point, there is no impact on profit volume ratio as
contribution per unit and sale price per unit is same as at normal level.

4)

Return on Investment: Like in operating profit, the impact of change in sale

volume has a magnified impact on return on investment.

16.4.3 Impact of Change in Price and Volume on Profit

Sl.

Particulars

No.

Normal
Volume

Increase in Price
5%
10%
Decrease in Volume
10%
20%

1.

Outputs (units)

1,20,000 1,10,000

1,00,000

90,000

80,000

2.

Sales ( Rs.)

3,24,000 3,13,500

3,00,000

2,83,500

2,64,000

3.

Variable Costs ( Rs.)

2,40,000 2,20,000

2,00,000

1,80,000

1,60,000

4.

Contribution ( 3-2)

84,000

93,500

1,00,000

1,03,500

1,04,000

5.

Fixed Costs ( Rs.)

90,000

90,000

90,000

90,000

90,000

6.

Operating Profit

----6,000

3,500

10,000

13,500

14,000

7.

% Change in Profit

----160.00

-65.00

---

35.00

40.00

8.

Break even point (units)

1,28,571 1,05,882

90,000

78,261

69,231

9.

P/V Ratio
Percentage

10.

42

Decrease in Price
10%
5%
Increase in Volume
20%
10%

Return on Investment (%)

0.2592
or
25.92

0.2982
or
29.82

0.3333
or
33.33

0.3651
or
36.51

0.3939
or
39.39

6.00

3.5

10.00

13.50

40.00

Activity: 1 Try to draw the inferences from the above table and also prepare the
similar tables for increasing and decreasing the fixed costs and variable cost and study
the impact on profit, break even profit, P/V ratio etc.

16.5 REQUIRED SALES FOR DESIRED PROFIT

Break Even Analysis

Break even point equation can be extended to estimate the profit and loss at different
levels of production. At break even point, profit is zero but for calculating the sales
volume required to earn a desired profit, the profit value is put as desired profit. The
following equations can be derived for this purpose.
Sales Variable Costs
or
Contribution

= Fixed Costs + Desired Profit

Sales Volume Required (in Units)

Fixed Costs + Desired Profit

SP VC (Per unit)

Fixed Costs + Desired Profit

Contribution Per Unit

(Fixed Cost + Desired Profit) Sales

Sales Variable Costs

(Fixed Cost + Desired Profit) Sales

Total Contribution

Fixed Costs + Desired Profit

P/V Ratio

Fixed Costs + Desired Profit

1 Variable Costs/Sales

= Fixed Costs + Desired Profit

Sales Volume Required (in Value)

Illustration 5
A company producing a single product and sells it at Rs. 10 per unit. Variable cost is
Rs. 6 per unit and fixed cost is Rs. 40,000 per annum. Calculate (a) Break even point,
(b) Sales volume required to earn a profit of Rs. 60,000 per annum
Solution
Contribution

SP VC = Rs. 10 Rs. 6

Rs. 4 per unit

Fixed Costs
Contribution Per Unit

Rs. 40,000
= 10,000 units
Rs. 4

BEP (in value)

Fixed Costs
P/V Ratio

P/V Ratio

Total Contribution
Total Sales

Rs. 40,000
= 0.40
Rs. 1,00,000

BEP (in units)

BEP

Rs. 40,000
0.40

Rs. 1,00,000

43

Cost Volume Profit

Analysis

Sales volume required to

earn a desired profit (in units) =
=

Rs. 40,000 + Rs. 60,000

Rs. 4

Rs. 1,00,000
= 25,000 units
Rs. 4

Sales volume required to

earn desired profit (in value) =
=

16.6

Fixed Costs + Desired Profit

Contribution Per Unit

Fixed Costs + Desired Profit

P/V Ratio
Rs. 40,000 + Rs. 60,000
=
0. 40

Rs. 2,50,000

SALES VOLUME REQUIRED TO EARN A

DESIRED PROFIT PER UNIT

If we add the desired profit per unit with variable cost and apply the same equations,
the result will provide us the sales volume required to earn a desired profit per unit.
In Units
Sales Volume Required
(in units)

Fixed Cost
SP (VC + DP)

Where DP is desired profit per unit

In Value
Sales Volume Required =
(in value)

Fixed Cost
VC + P
1 -----

Selling Price
Fixed Cost

(VC + Desired Percentage of Profit on Sales)

1 -----

SP

Illustration 6
The cost information computed by the cost accountant is as follows :
Sales

= 1,00,000 units

Selling Price

= Rs. 10 per unit

Variable cost or out of pocket-costs

= Rs. 6 per unit

Fixed costs or burden

= Rs. 60,000 per annum

Compute the following :

44

a)

Break even points in units and value

b)

Make a profit of Rs. 40,000

c)

Make a profit of Rs. 2 per unit

d)

Make a profit of 30% on sales

Break Even Analysis

Solution
a)

Break Even Point (in units)

Contribution per unit

BEP in units

SP VC

Rs.10 Rs. 6 = Rs. 4 per unit

Fixed Costs
Contribution per unit

Rs. 60,000
= 15,000 units
Rs. 4

SP VC
SP

Rs. 10 Rs. 6
= 0.40
Rs. 10

Fixed Costs
P/V Ratio

Rs. 60,000
0.40

In Value
P/V or Contribution Ratio

BEP in value

b)

= Rs. 1,50,000

Sales volume required to earn a profit of Rs. 40,000

In units
=

Fixed Costs + Desired Profit

Contribution per unit
Rs. 60,000 + Rs. 40,000
= 25,000 units
Rs. 4

In Value

c)

Fixed Costs + Desired Profit

P/V Ratio

Rs. 60,000 + Rs. 40,000

= Rs. 2,50,000
0.40

Sales volume required to earn a profit of Rs. 2 per unit

In Unit
=

Fixed Costs
SP (VC + P)

60,000
= 30,000 units
Rs. 10 (Rs. 6+Rs. 2)

Fixed Costs
1 (VC +PD)/SP

60,000
1 (6+2) / 10

In Value

60,000
2/10

= Rs. 3,00,000

45

Cost Volume Profit

Analysis

d)

Sales volume required to earn a profit of 30% on sales

In unit

Fixed Cost
SP (VC + 30% of SP)
Rs. 60,000
= 60,000 units
Rs. 10 (6+3)

=
In Value
=

Fixed Costs
1 (VC +30% of SP) / SP

60,000
1 (6+3) / 10

= Rs. 6,00,000

Calculations of selling price per unit for a particular break even point.
We know

BEP Units

Fixed Costs
Contribution Per Unit

Contribution per unit

Fixed Costs
BEP Units

Selling price per unit Variable cost per unit = Contribution per unit
Selling price per unit = Contribution per unit + Variable Cost per unit
Thus
Selling Price per unit

Fixed Costs

+ Variable Cost

Desired BEP
Illustration 7
Given Fixed Costs

Rs. 40,000

Selling Price Per Unit

Rs. 40

Variable Cost

Rs. 30

The break-even point in this case is

BEP Units

=
=

Rs. 40,000
Rs. 40 Rs. 30

Rs. 40,000
Rs. 10

4000 units

What should be selling price per unit, if management wants to reduce the break-even
point from 4000 units to 2500 units?
Solution
Selling price per unit

Fixed Costs
+ VC
Desired B E P

Rs. 40,000
+ Rs. 30
2500 units

=
46

Rs. 16 + Rs. 30 = Rs. 46 per unit

16.7

SALES REQUIRED TO MAINTAIN PRESENT

PROFIT

Break Even Analysis

Calculating the sales volume required to meet the proposed expenditure

Because of high competition in the market, the management plans an aggressive
promotion policy to boost the sales, which requires an extra expenditure. In such
cases, management wants to know the additional sales volume required to cover the
expected increase in expenditure.
Here the logic should be to cover the extra expenditure, how much additional units to
be sold. Suppose contribution per unit is Rs. 10 per unit and a company spends Rs.
1,00,000 extra on advertisement, then logically company must sell 10,000 extra units to
cover this expenditure. Thus the formula should be
In units
Additional Sales Volume Required =

Proposed Expenditure
Contribution per unit

In value
Additional Sales Volume Required =

Proposed Expenditure
P/V Ratio

Illustration 8
Sales

10,000 units

Fixed Cost

Rs.1,00,000

Variable Cost

Rs. 2,00,000

The selling price is Rs. 36 per unit. The company is spending Rs. 100,000 on
advertisement to promote its product. Find the sale volume required to earn the present
profit.
Solution
Extra sales volume required to meet the additional publicity expenditure of Rs. 1,00,000
so as to maintain the present profit level is worked out as follows:
Variable Cost Per Unit

Rs. 2,00,000
10,000 units

= Rs. 20 per unit

Contribution Margin

Rs. 36 Rs. 20

= Rs. 16 per unit

Addition sales required (in units) =

Rs. 1,00,000
Rs. 16

= 6,250 units

When a company sells 6,250 unit extra, then present level of profit will be maintained.
For example, before spending money the company was earning a profit of Rs. 60,000
which is as follows:
Profit

Contribution Fixed Cost

Rs. 16 x 10,000 Rs. 1,00,000

Rs. 1,60,000 Rs. 1,00,000

= Rs. 60,000

When sales volume increase to 16,250 units (i.e. 10,000 units + 6,250) then profit
will be
= Rs. 16 16,250 Rs. 2,00,000 (F. C. Rs. 1,00,000 + Advertisement Rs. 1,00,000)
= Rs. 2,60,000 Rs. 2,00,000 = Rs. 60,000

47

Cost Volume Profit

Analysis

Calculating the sales volume required to offset price reduction

Some time management wants to follow the policy of price reduction or increasing
commission to dealers for increasing the sales or to face the competition. In these case
new values are used for calculations and formula remains the same.
Illustration 9
ABC Ltd. manufactured and markets a product whose cost data is as follows:
Material Costs

Rs. 16 per unit

Conversion (Variable Cost)

Rs. 12 per unit

Dealers Margin

Rs. 4 per unit (10% of selling price)

Selling Price

Rs. 40 per unit

Fixed Cost

Rs. 5,00,000

Present Sales

90,000 units

Capacity Utilisation

60%

Management has following two suggestions, which alternative is better so as to

maintain the present profit level?
a)

Reduction in Selling Price by 5%

b)

Increasing the dealers margin by 25% over the existing rates

Solution
Total variable costs

Rs. 16 + Rs.12 + Rs. 4

= Rs. 32 per unit

Contribution per unit =

Rs. 40 Rs. 32

= Rs. 8 per unit

Present Profit Level =

Rs. 8 Rs. 90,000 Rs. 5,00,000 = Rs. 2,20,000

a)

First alternative : Price reduction by 5%

New selling price = (Rs. 40 Rs.2) = Rs. 38 per unit
New Dealers Commission

= 10% of Rs. 38 = Rs. 3.80

New Contribution

= Rs. 38 ( Rs. 16 + Rs. 12 + Rs. 3.80)

= Rs. 6.20 per unit

Sales volume requires to earn a desired profit (in units)

=
Sales volume Required =
(in units)
=
b)

FC + DP
Contribution per unit
Rs. 5,00,000 + Rs. 2,20,000
Rs. 6.20
Rs. 7,20,000
= 1,16,129 units
Rs. 6.20

Second Alternative : Increasing dealers commission by 25%

New Dealers Commission = Rs. 4+25% of Rs. 4 = Rs. 5 per unit

48

New Contribution

= Rs. 40 (Rs. 16 + Rs. 12 + Rs. 5) = Rs. 7 per unit

Sales required ( in units)

Rs. 5,00,000 + Rs. 2,20,000

Rs. 7

= 1,02,857 units

In the second alternative, lesser units are required to be sold as compared to the first
alternative. Contribution margin is also high in second alternative. Hence second
alternative is better in comparison to the first alternative.

Break Even Analysis

Calculating new sales volume or new selling price to offset the impact of
change in variable costs and fixed costs.
When a company introduces new production plans or improve the process, then
generally variable costs and fixed costs also change. In such situation, there are two
alternatives before the management to earn the same profits either to increase the
sales volume or increase the selling price when costs increases and vice versa. The
new sales volume needed to earn the same profit, when only variable costs changes,
then new contribution is calculated by changing the variable cost and break even
equation remains same. If management wants to change the selling price and volume
remains the same, then new selling price is :
New selling price = Old selling price + (new variable cost --- old variable cost)
When fixed cost changes, then fixed costs is replaced by a new fixed cost in the
equation and new volume of sales can be computed to earn the same profit. If
management thinks that selling price be changed and volume remain the same, then
new selling price is :
New selling price = Old selling +

New fixed cost --- old fixed costs

Volume of production

The logic is change in selling price is incremental change in variable cost and / or fixed
cost per unit is added in selling price so as to earn the same profit. Look at the
following illustration how the new selling price is calculated when there is change in
variable and fixed costs :
Illustration 10
The cost information supplied by the cost accountant is as follows:
Sales 20,00 units @ Rs. 10 per unit

Rs. 2,00,000

Variable cost Rs. 6 per unit

Rs. 1,20,000

Contribution

Rs. 80,000

Fixed Cost

Rs. 30,000

Profit

Rs. 50,000

Calculate the (a) new sales quantity and (b) new selling price to earn the same profit if
i)

Variable cost increases by Rs. 2 per unit

ii)

Fixed cost increase by Rs. 10,000

iii)

Variable cost increase by Rs. 1 per unit and fixed cost reduces by Rs. 10,000

Solution
i)

Variable cost increases by Rs. 2

F + DP
a)

New sales quantity required =

SP--- Vn

where Vn is the new variable cost

=

Rs. 30,000 + Rs. 50,000

Rs.10 --- Rs.8

Rs. 80,000
Rs.2

= 40,000 units
49

Cost Volume Profit

Analysis

b)

New selling price

=

Old selling price + change in variable cost per unit

Rs. 10 + Rs. 2 = Rs. 12 per unit

To earn the same amount of profit, management should either increase the production
to 40,000 units or increase the selling price to Rs. 12 per unit
ii)

Fixed costs increases by Rs. 10,000

a)

Sales volume needed to earn a desired profit

=

Fn + DP
SP-VC

Fn is the new fixed costs

=
b)

Rs. 40,000 + Rs. 50,000

=
Rs. 10 --- Rs. 6

22,500 units

New selling price

=

Fn Fo
Q

SPo +

SPo is old selling price, Fn is new fixed cost and Fo is old fixed cost.
=

10 +

Rs. 40,000 Rs. 30,000

20,000 units

= Rs. 10.50

To earn the same amount of profit i.e. Rs. 50,000 management should either increase
the sales volume to 22,500 units or increase the selling price to Rs. 10.50.
iii)

Variable cost increase by Rs. 1 per unit and fixed cost reduces by Rs. 10,000.
a)

Sales volume required to earn a desired profit

=

=
b)

Fn + DP
SP Vn
Rs. 20,000 + Rs. 50,000
Rs. 10 --- Rs. 7

Rs. 70,000
Rs. 3

= 23,333 units

New Selling price

(VCn VCo )

SPo +

Rs. 10 +

Rs. 1 0 Rs. 0 . 5 0 + Rs. 1

R s . 1 0 . 50

+ Fn Fo

Rs. 20,000 Rs. 30,000

20,000 units

+ Rs. 7 --- Rs. 6

To earn the same profit i.e. Rs. 50,000 management should either increase the sales to
23,333 units or increase the selling price to Rs. 10.50.
50

Illustration 11

Break Even Analysis

The cost data of XYZ Ltd. is as follows:

Product X

Product Y

Product Z

80,000
50,000
30,000
---------

1,00,000
60,000
40,000
---------

20,000
10,000
10,000
---------

Sales (40 : 50 : 10) (Rs.)

Variable Costs (Rs.)
Contribution (Rs.)
Fixed (Rs.)
Profit

Total
Rs.
2,00,000
1,20,000
80,000
50,000
30,000

Calculate :
i)

Break Even Point, and

ii)

Break even point if sales mix ratio is changed to 30:50:20

Solution
i)

Break Even Point

When company is producing multi products, then for computing break even
equation in terms of value should be used.
BEP (in value )

Fixed Costs Total Sales

Total Sales --- Variable costs

Rs. 50,000 Rs.2,00,000

Rs. 2,00,000 Rs.1,20,000

Rs. 50,000 Rs.2,00,000

= Rs. 1,25,000

Rs. 8 0 , 0 0 0
ii)

Change in Sales Mix Ratio

New Sales mix

X : Y: Z = 30:50:20

Sales
X

Rs. 2 , 0 0 , 0 0 0

30
=
100

Rs. 6 0 , 0 0 0

Rs. 2 , 0 0 , 0 0 0

50
=
100

Rs. 1 , 0 0 , 0 0 0

Rs. 2 , 0 0 , 0 0 0

20
100

Rs. 40,000

Variable Cost Ratio (as variable cost per unit remains same)
X

Rs. 5 0 , 0 0 0
Rs.8 0 , 0 0 0

5
8

Rs. 6 0 , 0 0 0
=
Rs. 1 , 0 0 , 0 0 0

6
10

Rs.1 0 , 0 0 0
Rs. 2 0 , 0 0 0

1
2

51

Cost Volume Profit

Analysis

Sales (Rs.)
60,000
1,00,000
Variable Costs (Rs.)
37,500
60,000
Contribution (Rs.)
22,500
40,000
Fixed Costs
--------Profit
--------Break even point after change in sales mix
=

Fixed Costs Sales

Sales --- Variable Costs

Rs. 50,000 Rs. 2,00,000

Rs. 2,00,000 Rs. 1,17,500

Rs. 1,21,212.12

Total
Rs.
2,00,000
1,17,500
82,500
50,000
32,500

40,000
20,000
20,000
---------

Rs. 50,000 Rs.2,00,000

Rs. 82,500

Illustration 12
A firm produces and sells three products A, B and C. From the following data,
calculated the break even point.
Product

No. of Units Sold

SP per unit
Rs.

VC per unit
Rs.

600

50

30

1500

60

45

1000

30

15

Fixed costs are Rs. 33,000 per year.

Solution
Firstly we calculate the over all P/V ratio which is :
=
Product

SP VC
SP

or 1

SP

VC

(Rs.)

(Rs.)

50

B
C

VC
SP

P/V Ratio

Total
Sales
(Rs.)

%Sale
Proceeds

Overall
P/V Ratio

30

0.40

30,000

0.20

0.08

60

45

0.25

90,00

0.60

0.15

30

15

0.50

30,000

0.20

0.10

Rs. 1,50,000

1.00

0.33

The overall P/V ratio is 0.33 (P/V Ratio % sales proceeds). P/V ratio can also be
computed as per preceding illustration.
Overall Break Even Point

52

Fixed Costs
P/V ratio

Rs. 33000
0.33

= Rs. 1,00,000

Break Even Analysis

The break up of total sales at Break Even Point will be:

% Sales Proceeds

Sales proceeds

No. of Units

0.20

Rs. 20,000

400

0.60

Rs. 60,000

1000

0.20

Rs. 20,000

667

Rs. 1,00,000

16.8 MARGIN OF SAFETY

The margin of safety is the difference between actual sales and sales at break even point.
M/S = Actual Sales Sales at BEP
Suppose the actual sales of X Y Z Ltd. (example given in 16.3) is 1,20,000 units and
sales at break even point is 90,000 units, then
M/S = 1,20,000 units 90,000 units = 30,000 units
Sale price was Rs. 3 per unit.
M/S = Rs. 3,60,000 Rs. 2,70,000 = Rs. 90,000
It can be expressed in terms of Rupees or in units, and is a absolute measure. It can be
expressed in relative terms and is
Actual Sales Sales at Break Even Points

M/S =

100

Actual Sales

Rs. 1,20,000 Rs. 90,000

Rs. 1,20,000

100

30,000
100 = 25%
1,20,000

If we use the sales data in terms of rupees and compute the relative margin of safety,
the answer will remain the same, for example
M/S

Rs. 3,60,000 Rs. 2,70,000

100
Rs. 3,60,000

Rs. 90,000
100 = 25%
Rs. 3,60,000

Margin of safety can also be computed from profit and P/V ratio, which is
M/S

Profit
P/V Ratio

Higher margin of safety provides greater protection to the company. The size of
margin of safety is an indicator of soundness of business. It shows how much sales
may decrease before the firm will suffer a loss. Sales beyond the break-even point
represent margin of safety. Larger the margin of safety, greater the soundness of the
business, smaller the margin of safety, weaker will be the soundness of the business.
The following actions help in improving the margin of safety:
1)

Increase the level of production

2)

Reduce the fixed and / or variable costs

3)

Increase the selling price

4)

Substitute the existing product with more profitable products

5)

From the product mix, remove the product whose contribution ratio is very low

53

Cost Volume Profit

Analysis

Illustration 13
Calculate the P/V ratio, fixed expenses and break even point from the following data:
Sales

Rs. 6,00,000

Profit

Rs.

Margin of safety

Rs. 1,60,000

40,000

Solution
We know
M/S

Profit
P/V ratio

P/V Ratio

Profit
M/S

Rs. 40,000
Rs. 1,60,000

P/V ratio sales

0.25 Rs. 6,00,000 = Rs. 1,50,000

Contribution

Fixed Costs + Profit

Fixed Cost

Contribution --- Profit

Rs. 1,50,000 Rs. 40,000

Rs. 1,10,000

FC
P/V Ratio

Contribution

BEP (in value)

= 0.25

1,10,000
0.25

= Rs. 4 , 4 0 , 0 0 0

16.9 ANGLE OF INCIDENCE

The angle formed at the intersection of the total sales revenue line and the total cost
line is called the angle of incidence. It depicts the difference between the slope of the
total sales revenue line and total cost line. Graphically it is as follows :
A

Sales

C
Total cost
B
Angle of incidence

Fixed cost

54

BEP
Output (in units)

Angle ABC is the angle of incidence. It reflects the responsiveness or sensitivity of

profit to variation in the volume sold. The higher the angle of incidence, the greater the
responsiveness of profits to variation in the sales volume and vice versa. In subsection
16.4 of this unit, we observed that small change in sales brings wide fluctuations in
profits.

Break Even Analysis

Activity 2
During boom period high angle of incidence is better and in recession period low angle
of incidence is better? Comment.
........................................................................................................................................
........................................................................................................................................
........................................................................................................................................
........................................................................................................................................
........................................................................................................................................

16.10 BREAK EVEN CHARTS

The effect of change in sales volume, price and costs on profit can be depicted
graphically as follows :

16.10.1 Effect of Price Change on Profit

When price is increased, the slope of sales revenue line become more steep and break
even point lowers from BEP0 to BEP1, the margin of safety increases from BEP0X to
BEP1X angle of incidence also increases. The reverse happens in case of decrease in
price.
Y

Profit after
change in price
Old
Sales Line

Profit before
change in price

(R s)

New
Sales Line
BEP0
BEP1

Variable cost
Fixed cost
Total cost
New M/S
Old M/S

BEP1

BEP0
Output (units)

Actual Sales

55

Cost Volume Profit

Analysis

16.10.2 Effect of Change in Fixed Cost on Profit

Increase in fixed cost leads to increase in break even point, lowers the margin of
safety and no impact on angle of incidence (Parallel lines)

Sales Line
New total cost

(Rs.)

BEP1
BEP0
Variable cost
New fixed cost
Old fixed cost

Total cost

Old M/S
New M/S
X
Actual Sales

BEP0 BEP1
Output (units)

16.10.3 Effect of Change in Variable Cost

Increase in variable costs leads to higher break even point, lowers the margin of safety
and reduces the angle of incidence.

New profit
Old profit

Sales Line

New variable cost

Old variable cost

BEP1
BEP0

Fixed cost
Old M/S

New M/S
X
BEP0 BEP1
56

Output (units)

Actual Sales

Activity 3
Try to find out the relationships between change in price, fixed cost, variable costs and
volume on profit, margin of safety and profit volume ratio through the following equations:
Break Even Point (in units)

Break Even Point (in value) =

Break Even Analysis

Fixed Cost
Sale Price Variable Cost Per Unit
Fixed Costs
P/V Ratio

Margin of Safety

= Actual Sales Sales at BEP

P/V Ratio

Sales Variable Costs

Contribution
=
Sales
Sales

16.11 PROFIT VOLUME GRAPH

Profit-Volume Graph is the graphical representation of the relationship between profit
and volume. It shows profit or loss at different levels of output. It is also called the P/V
graph. This type of graph may be preferred to know the profit or loss directly at
different levels of activity. Following steps are involved in the construction of profitvolume graph:
1)

Fixed Costs and profits are depicted on the y-axis or vertical axis.

2)

Sales are shown on the x-axis or horizontal axis.

3)

Area above the sales line (x-axis) is a profit area and below it is the loss
area. At zero output, the loss equals to fixed cost. Profit at a particular sales
level is depicted on y-axis above the sales line.

4)

After plotting profits and fixed costs, these two points are joined by a diagonal
line which is called profit line or contribution line or fixed cost recovery line or
profit-volume line. The break even point occurs at a point where contribution line
intersects the horizontal line.

Let us see the following illustration how a P/V graph is prepared.

Illustration 13
Prepare a P/V graph with the help of the following data :
Output
=
2, 0 0 , 0 0 0 units
Sales
=
Rs.6,00,000
FC
=
Rs. 1 , 0 0 , 0 0 0
VC
=
Rs.4 , 0 0 , 0 0 0
Profit
=
Rs.1 , 0 0 , 0 0 0
Solution
Profit Volume Graph

Y
+100,000
Profit

Contribution line
0

X
Loss area

BEP

Sales volume

200,000

-100,000
Fixed cost

57

Cost Volume Profit

Analysis

Better P/V ratio is an index of sound financial health. P/V ratio can be improved by
taking following steps:
!

Increase in Sale Price

Decrease in variable costs

Change in sales mix, i.e. producing more of an item where P/V ratio is high along
with demand or droping or decrease the production of a products whose P/V ratio
is very low as per situation.

Illustration 14
ABC Ltd., a multi product company, furnishes the following data:
Particulars
Sales (Rs)

Period I

Period II

45,000

50,000

40,000

43,000

Total Cost (Rs)

Assuming that there is no change in price and variable costs. Fixed expenses are
incurred equally in the two periods. Calculate the following :
i)

Profit volume ratio

ii)

Fixed expenses

iii)

Break even point

iv)

Percentage M/S to sales in Period II

v)

Sales required to earn profit of Rs. 1 0 , 0 0 0

vi)

Profit when sales is Rs. 8 0 , 0 0 0 .

Solution
Sales
(Rs.)

i)

Total Cost
(Rs.)

Period II

50,000

43,000

7,000

Period I

45,000

40,000

5000

Change

5000

3000

2000

P/V Ratio =

Change in Profit

Change in Sales
ii)

Period II

= 0.40

Rs. 5000

Contribution

Sales P/V ratio

Contribution

Rs.50,000 0.40 = Rs. 20,000

Contribution

Fixed Cost + Profit

Rs. 2 0 , 0 0 0

F C + Rs. 7 0 0 0

FC

Rs. 1 3 , 0 0 0

Contribution

Rs.4 5 , 0 0 0 0 . 4 0 = Rs. 1 8 , 0 0 0

FC

Contribution Profit

Rs.18,000 Rs. 5000 = Rs. 13000

Break even point

BEP (in value)

=
=

58

Rs. 2000

Fixed expenses
Period I

iii)

Profit
(Rs.)

Fixed Costs
P/V Ratio
Rs.13,000
0.40

Rs. 32,500

iv)

Margin of Safety (M/S)

% of M/S to sales

Actual Sales --- BEP (in value)

Rs. 50,000 Rs. 32,500

Rs. 17,500

Rs.17,500

Break Even Analysis

100

Rs.50,000
=
v)

35%

Sales required to earn a desired profit of Rs. 10,000

=

FC + DP
P/V Ratio

Rs.13,000 + Rs.10,000
0.40

vi)

Rs. 57,500

Sales P/V ratio

Rs.8 0 , 0 0 0 0 . 4 0

Rs. 32,000

Contribution FC

Rs. 32,000 --- Rs. 13,000

Rs. 19,000

Profit when sales is Rs. 80,000

Contribution

Profit

Activity 4 : Think on the following relationships:

1)

An increase in selling price increases the amount of contribution resulting in

higher P/V ratio or contribution ratio and vice versa.

2)

An increase in fixed cost increases the break-even point but does not affect the
P/V ratio.

3)

An increase in variable cost per unit reduces the contribution per unit, increases
the break-even point and lowers the P/V ratio and vice versa.

4)

Increase in P/V ratio lowers the break even point and vice versa.

16.12 ASSUMPTION IN BREAK EVEN ANALYSIS

Break even analysis is based on certain assumption, which are:
1)

All costs can be segregated in two parts i.e., fixed and variable.

2)

Fixed costs remains constant at various levels of activity.

3)

Variable costs changes directly with production. It means variable cost per unit
remains constant.

4)

Selling price per unit remains constant at all various levels of activity.

5)

Technological methods and efficiency of men and machines will not be changed.

6)

Production and sales are perfectly synchronized i.e., no inventory exists in the
beginning or at the end of the period.

59

Cost Volume Profit

Analysis

7)

Either there is only one product or if several products are being produced and sold
then sales mix remains constant.

8)

Break even analysis assumes linear relationship in total costs and total revenues.

9)

Break even analysis ignores the capital employed in the business.

The above assumptions are also the limitations of this analysis e.g. selling price per unit
and variable cost per unit remains constant at any level of activity. The production and
sales can be increased upto the maximum plant capacity so long as contribution is
positive. This assumption is valid if it is not necessary to reduce the selling price per unit
to increase the sales.
The variables cost per unit do not have a linear relationship with level of production
because of laws of return. In economic theory, initially total cost will increase at a
decreasing rate, then at a constant rate and finally at increasing rate.
Further production and sales are not perfectly synchronized as there will be some
opening and closing inventory. Technological methods and efficiency of men and
machines keeps changing. To increase the sales, price concessions are offered to the
customers. The break even chart, therefore becomes curve-linear having the following
shape.
Y
Sale Revenue
Cost/Sales Revenue
( Rs.)

Total Cost
BEP2

BEP1

0
Sales Volume

In curve-linear model, the optimum production level is where the total revenue exceeds
the total cost by the largest amount. There are two break-even points, one at the lower
capacity level and other at the higher capacity level. No firm would like to operate at a
lower level then BEP1 as it is loss zone and beyond BEP2 point which is again a loss
zone. The economists model is valid over a range of activity and it allows production,
inputs costs, selling price to vary. The accountant model is valid only for a short relevant
range of activity where only quantity varies, price and cost structure is constant.
Check Your Progress
A. 1)

60

In cost-volume-profit analysis, profit is determined by

a)

Sales Revenue x P/V ratio - Fixed Cost

b)

Sales units x contribution per unit - fixed costs

c)

Total contribution - Fixed cost

d)

All the above

2)

3)

4)

Variable costs per unit

a)

Goes on increasing with production

b)

Goes on decreasing with production

c)

Remains constant with change in production

d)

None of these

Break Even Analysis

Variable cost are those which

a)

Are directly apportioned to cost unit or cost centre

b)

Varies directly with production

c)

Depends upon the demand

d)

Depends upon the sale

In accounting, marginal cost per unit goes on, __________ with increase in
production

5)

6)

7)

8)

a)

Increases

b)

Decreases

c)

Remain constant

d)

None of these

Which is not a fixed cost

a)

Property tax

b)

Power

c)

Insurance premium

d)

Rent

Fixed cost per unit _________with increase in production

a)

Increases

b)

Decreases

c)

Remains constant

d)

Cant say

Semi variable cost are segregated into fixed and variable costs with the help of
a)

Scatter diagram

b)

Method of least square

c)

High and low points method

d)

All the above

Telephone charges is a
a)

Fixed cost

b)

Variable cost

c)

Semi-variable cost

d)

Marginal cost

61

Cost Volume Profit

Analysis

9)

The break even points in units is equal to

a)

Fixed cost/PV ratio

b)

Fixed cost x sales/total contribution

c)

Fixed cost/contribution per unit

d)

Fixed cost/total contribution

10) At the break-even point, which equation will be true.

a)

Variable cost - fixed cost = contribution

b)

Sales = variable cost + fixed cost

c)

Sales - fixed cost = contribution

d)

Sales contribution = variable cost

11) When fixed costs increases, the break even point

a)

Increases

b)

Decreases

c)

No effect

d)

Cant say

12) When variable costs decreases, then break even point

a)

Increases

b)

Decreases

c)

No effect

d)

Cant say

13) When selling price decreases, then break even point

a)

Increases

b)

Decreases

c)

No effect

d)

Cant say

14) When sales increases then break even point

a)

Increases

b)

Decreases

c)

Remains constant

d)

None of these

15) Contribution is

62

a)

Fixed cost + profit

b)

Sales - variable cost

c)

Fixed cost loss

d)

All the above

Break Even Analysis

16) P/V ratio is

a)

Profit/volume

b)

Contribution/sales

c)

Profit/contribution

d)

Profit/sales

17) Profit - volume ratio is improved by reducing

a)

Variable cost

b)

Fixed cost

c)

Both of them

d)

None of them

18) The price reduction policy, ______ the P/V ratio and _______ the break even
point
a)

Reduces, reduces

b)

Reduces, increases

c)

Increases, reduces

d)

Increases, increases

19) Shut down point occurs when

a)

Net profit is zero

b)

Sale revenue - variable cost + fixed costs

c)

Losses are greater than fixed cost

d)

None of the above

20) The break even point and shut down point are
a)

Synonymous

b)

Anonymous

c)

Different

d)

Cant say

21) The sales of a firm is Rs. 3,00,000, fixed cost is Rs. 90,000, and variable costs
are Rs. 2,00,000, the break even point will occur at
a)

2,70,000 units

b)

Rs. 2,70,000

c)

Rs. 3,25,000

d)

3,25,000 units

22) The financial accounts of a firm reveals the position at two time periods is as
follows:
Period

Sales Rs.

Profit Rs.

2,30,000

50,000

II

3,00,000

80,000

63

Cost Volume Profit

Analysis

The profit volume ratio for the firm will be

a)

3/7

b)

5/8

c)

3/8

d)

13/53

23) The fixed cost of a firm is Rs. 90,000, variable cost per unit is Rs. 2 and sale
price is Rs. 3 per unit. The break even point will occur at
a)

30,000 units

b)

50,000 units

c)

90,000 units

d)

Rs. 90,000

24) The sales volume in value required to earn the target profit, the formula is
a)

Target profit/contribution per unit

b)

(Fixed cost + Target profit) P/V ratio

c)

Fixed cost + Target profit/contribution on per unit

d)

(Fixed cost + Target profit) / PV ratio

25) The contribution per unit is Rs. 2 and fixed costs are Rs. 15,000 for earning a
profit of Rs. 50,000, the company must have sales of
a)

Rs. 1,30,000

b)

Rs. 1,00,000

c)

32,500 units

d)

Rs. 32,500

26) Margin of safety is expressed as

a)

Profit / P/V ratio

b)

(Actual sales --- sales at BEP ) / Actual sales

c)

Actual sales --- Sales at BEP

d)

All of the above

27) The margin of safety point lies

64

a)

To the left of break even point

b)

To the right of break even point

c)

On break even point

d)

Cant say

Break Even Analysis

28) The sale at a BEP for a firm is Rs. 4,80,000 and the actual sales made by the
firm Rs. 8,00,000, the margin of safety will be
a)

Rs. 12,80,000

b)

Rs. 3,20,000

c)

Rs. 4 , 8 0 , 0 0 0 / 8 , 0 0 , 0 0 0

d)

Rs. 800,000

29) The profit of a company is Rs. 30,000 by selling 10,000 units at a price of Rs.
10 per unit. The variable cost to sale ratio is 60 per cent. Find margin of safety
level.
a)

Rs. 75,000

b)

Rs. 30,000

c)

Rs. 1,00,000

d)

Rs. 12,000

30) In the above question, determine the break even point

a)

Rs. 20,000

b)

Rs. 25,000

c)

Rs. 30,000

d)

Rs. 4 0 , 0 0 0

B) State whether the following statement are True or False.

i)

Contribution is the difference between the total sales and fixed cost

ii)

At break even point contribution equals to fixed cost

iii)

Profit volume graph shows profit or loss at different levels of sales

iv)

Profit volume graph can also be called P/V graph

v)

P/V ration can be improved by decreasing the selling price

vi)

P/v ratio can be improved by reducing the fixed costs

vii)

Margin of safety may be improved by increasing selling price and reducing

fixed cost
[ ]

viii) At break-even point sales equal to total cost

16.13 LET US SUM UP

Break even analysis helps is ascertaining the level of production where total costs
equals to total revenue. Below this level of production, there are losses and above this
point depicts the profit zone. Like marginal costing this analysis is also based on cost
classification into fixed and variable costs. Break even analysis helps in measuring the
effect of charges in volume, costs, selling price and product mix on profit. In fact,
break even analysis is cost-volume profit analysis.
Break even point can be determined both mathematically (equation technique and
contribution margin technique) and graphically. It is expressed in terms of units or in
65

Cost Volume Profit

Analysis

value terms. This technique is very useful in profit planning and decision making. It can
be applied to estimate profits at a given sales volume, sales volume required to earn a
desired profit, calculating sale volume required to offset price reduction, ascertaining the
margin of safety, measuring the effect of changes in profit factors etc. The other tools in
this analysis are profit-volume ratio, margin of safety and angle of incidence.
There are inherent limitations in the break even analysis classification of costs into
fixed and variable costs, fixed costs remains fixed, variable cost per unit is constant,
selling price per unit is constant etc. In spite of its limitation the break even point is a
useful technique in decision making if it used by those who understand its limitations.

16.14 KEY WORDS

Break Even Point is the level of sales (volume or value) where total costs equals to
total revenue or no profit no loss point.
Cost-volume-Profit analysis is technique to study the effects of costs and volume
variations on profit.
Margin of Safety is the difference between actual sales and sales at break even point.
It shows the amount by which sales may decrease before losses occur.
Profit Volume Ratio is a relationship between contribution to sales.
Mixed Costs are those costs which has both fixed and variable elements. These are
also known as semi-variable costs.

16.15 ANSWERS TO CHECK YOUR PROGRESS

A
1

13

19

25

14

20

26

15

21

27

10

16

22

28

11

17

23

29

12

18

24

30

B)

i) False ii) True iii) True iv) True v) False vi) False vii) True viii) True

16.16 TERMINAL QUESTIONS

66

1)

Cost-volume profit analysis and break even point analysis are same Comment?

2)

What are different methods of computing break even point?

3)

The break even chart is an excellent planning device Comment.

4)

Explain the significance of Profit-Volume ratio, Margin of Safety and Angle of

Incidence?

5)

What is Contribution ? How does it helps the management in taking managerial

decisions?

Break Even Analysis

6)

Describe three ways to lower down the break even point?

7)

What are various ways to improve the margin of safety and P/V ratio?

8)

A 10 per cent increase in production and sales leads to more than 10 percent
increase in profit Explain

9)

ABC Ltd. manufactures and sells four type of products under the brand names
of P, Q, R and S. The sale mix in value comprises of 34%, 40%, 16% and 10%
of P,Q, R and S respectively. The total budgeted sales (100%) are Rs. 60,000 per
month. Operating costs are:
Variables costs ratio is (variable costs on % of sales)
P

60%

65%

70%

40%

Fixed costs is Rs. 15,000 per month. Calculate the break even point for the
products on an overall basis. (Ans BEP Rs. 39062.50)
10) Explain from the following data, how the reduction in selling price would affect
the break even point and margin of safety.
Selling price per unit

Rs. 20

Variable costs Material

Rs. 6

Labour

Rs. 4

Variable overheads

Rs. 2

Fixed overheads is Rs. 8000. Full capacity of the plant is 5000 units. Reduced
selling price is Rs. 16 per unit.
[Ans. BEP increase by 1000 units and M/S decrease by Rs. 32000]
11) The sales manager of a company found that with fixed cost Rs. 50,000, sales
are increased from Rs. 30,000 to Rs. 4,00,000 and profit increased by Rs.
40,000. Compute the profit when sales is Rs. 5,00,000.
[Ans. Rs. 1 , 5 0 , 0 0 0 ]
12) ABC Ltd., has a margin of safety 37.5% with an overall contribution sale ratio
of 40%. The fixed cost is Rs. 5 lakhs.
Calculate the following:
i)

Break even point

ii)

Total Sales

iii)

Total variables costs

iv)

Profit

[Ans. (i) Rs. 12,50,000

(iv) Rs. 3,00,000]

(ii) Rs. 20,00,000

(iii) Rs. 12,00,000

13) The P/V ratio of a concern is 50% and margin of safety is 40%. Calculate the
net profit of the sales is Rs. 1,00,000.
[Ans. Profit Rs. 20,000]

67

Cost Volume Profit

Analysis

14) X Ltd has earned a contribution of Rs. 2,00,000 and net profit of Rs. 1,50,000
on sales of Rs. 8,00,000. What is the break even point and margin of safety.
[Ans. Rs. 2 , 0 0 , 0 0 0

M/S is Rs. 6,00,000]

15) From the following cost information:

Sales (Rs)
Profit (Rs.)

2001

2002

1,50,000

2,00,000

30,000

50,000

Calculate:
i)

P/ V ratio

ii)

Break even point

iii)

Sales required to earn a profit of Rs. 80,000

iv)

Profit when sales is Rs. 2,50,000

[Ans. (i) 0.40) (ii) Rs. 75,000 (iii) Rs. 2,75,000 (iv) Rs. 70,000 ]
Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.

16.17 FURTHER READINGS

Horngren, C.T., Gary L. Sundem and Frank H. Selto, Management Accounting,
Prentice Hall of India, New Delhi, 1994.
Kaplan, R.S., s, Engle Wood Cliffs, NJ., Prentice Hall Inc.

68

UNIT 17 RELEVANT COSTS FOR

DECISION MAKING
Structure
17.0 Objectives
17.1

Introduction

17.2 Relevant Costs for Decision Making

17.2.1

Concept of Relevant Costs

17.2.2

Concept of Differential Costs

17.2.3

Decision-Making Process

17.2.4

Selling Price Decisions

17.2.5

Exploring New Markets

17.2.6

Make or Buy Decisions

17.2.7

Expand and Contract

17.2.8

Sales Mix Decisions

17.2.9

Alternative Methods of Production

17.2.10 Plant Shut Down Decisions

17.2.11 Acceptance of Special Order
17.2.12 Adding or Dropping a Product Line
17.2.13 Replacement of Machinery

17.3 Let Us Sum Up

17.4 Key Words
17.5 Answers to Check Your Progress
17.6 Terminal Questions

17.0 OBJECTIVES
After studying this unit, you should be able to:
!

distinguish between the different types of costs;

distinguish between the nature of costs;

present different alternatives before the decision making; and

selection out of different alternatives.

17.1 INTRODUCTION
The analysis of costs plays a vital role in selecting the alternatives available before the
management. Costs could shape alternative opportunities and therefore, it influences
and shapes future profits. Management is not only interested in the historical cost
analysis but it is also interested to study those costs, which are influencing the future

69

Cost Volume Profit

Analysis

operations. After analyzing different types of costs according to their nature, one can
be able to select one out of the various optimal alternatives. When costs are future
oriented then only they remain important for the decision maker. In this unit you will
study the importance of relevant costs for decision making.

17.2 RELEVANT COSTS FOR DECISION MAKING

With different objectives the different costs concept is always there. It is pertinent to
use the word relevant while providing the information about costs. When the costs are
not changing with the different alternatives and remain fixed in nature then they
become irrelevant or sunk costs. When management wants to select any of the
alternatives available before them and take decision then the relevant costs become
very important.

17.2.1 Concept of Relevant Costs

Relevant cost is a cost of decision. You may call it decision cost, as it is always
relevant with the selection of one out of different alternatives. If decision is being
taken and any cost is increased because of the change in decision, that particular cost
becomes relevant cost. Relevant cost is always for future and not for the analysis of
the past decisions. These costs are Future Costs and they differ to different
alternatives. We focus on the future whether it may be 10 seconds after or it may be
10 years later.
Relevant costs are also known as differential costs. Relevant costs differ among the
different alternatives. For example, if an engineering graduate wants to start his own
work shop and he has a choice to complete his postgraduation. Relevant costs to
continue his studies are fees and books. Irrelevant costs are clothes and his residential
arrangements, which will incur under both the circumstances.

17.2.2 Concept of Differential Costs

Differential cost is the difference between the costs of alternatives. Difference in total
cost between the two alternatives available. It is also known as net relevant cost.
Differential cost is not calculated per unit. It is calculated as total cost and then the
difference is being calculated between the two levels of production or is being
calculated between the two alternatives. Both variable costs and fixed costs may be
differential cost when there is a change in both these costs in response to alternative
course of action. When a decision does not affect either the variable or fixed costs
then there is no differential costs. It is a technique of costing and not a method. Only
relevant costs of the option are being considered. It is normally calculated on sales
basis, which gives revenue. Decision cannot be taken only on the basis of differential
cost analysis as other factors like government policies, social and financial causes,
investment and the behaviour of the workers are also the influential part of the
decision-making process. Conditions and costs of different alternatives always differ,
so the differential costs once calculated cannot be used without adjustments for the
other decisions. As differential costs are relevant costs for future, so irrelevant costs
should be known. The costs which do not change as a result of decision are irrelevant
costs. Fixed costs are irrelevant costs as they do not change if production is expanded
upto certain level.

17.2.3

Decision-Making Process

Decision-making is a process of selecting any of the alternatives available after

evaluation of all the options. Selection of one alternative out of two or more should
maximize the profits of the concern. Decision-making is very much related with
70

future planning with a particular goal. In this process, available information

regarding the options should be analyzed properly to make a beneficial decision for
the benefit of the organization. Before taking decision firstly one should recognise
the problem, secondly identify the various alternatives, thirdly evaluate different
alternatives with helps of cost benefit analysis and finally adopt the most profitable
course of action.

Relevant Costs for

Decision Making

Differential cost analysis is a very useful technique to the management in formulating

policies and making the following decisions:
1)

Selling Price Decisions

2)

Exploring New Markets

3)

Make or Buy Decisions

4)

Expand and Contract

5)

Sales Mix Decisions

6)

Alternative Methods of Production

7)

Plant Shut Down Decisions

8)

Acceptance of Special Order

9)

Adding or Dropping a Product Line

10. Replacement of Machinery

Let us study each one of these in detail.

17.2.4

Selling Price Decisions

Pricing process is different in different industries. It differs according to the nature,

cost and demand of the product. Every producer accepts the different criterion for
pricing his product. Effect of changes in selling price can easily be understood with the
help of the following illustration.
Illustration 1
X Ltd. produces and markets ballpoint pens. Due to competition, the company
proposes to reduce the selling price. From the following information, examine the
effects of reduction in selling price by (a) 5%, (b) 10% and (c) 15%

Present Sales 3,000 units

Variable Costs
Fixed Costs
Net Profit

Rs.

Rs.

-----

3,00,000

1,80,000
70,000

2,50,000
50,000

Indicate the number of units to be sold if the company wants to maintain the same
profits in each of the above cases.

71

Cost Volume Profit

Analysis

Solution
Statement of Cost and Profit
Particulars

Present
Price
Price
Price
price Reduction Reduction Reduction
by 5%
by 10%
by 15%

Selling price per unit (Rs.)

100

95

90

85

60

60

60

60

40
1,20,000

35

30

25

1,20,000

1,20,000

1,20,000

Required units to be sold

Less: Units sold at present price

3,429
3,000

4,000
3,000

4,800
3,000

Additional Units required to be sold

to earn the same amount of Profit

429

1,000

1,800

Less: Variable cost (Rs.)

Contrubution (Rs.)
Contribution for 3,000 units (Rs.)
Contribution required to maintain
same profit (Rs.)

Decision: If company reduces the selling price by 5% then it requires 429 pens more
to sell to earn the same amount of profit. If it accepts the second option to reduce the
price by 10% then it requires 1,000 pens more to sell to earn the same amount, and if it
accepts the third alternate to reduce the price by 15% then it require 1,800 pens more
to sell to earn the same amount.
Working Notes:
1)

It has been assumed that in all the options, fixed costs remain unchanged and to
earn the same amount of profit the contribution should remain the same.

2)

Calculation of Required Units to be sold to earn the same amount has been
mentioned with the use of the following formulae:

Required Sales =

Required Contribution
Contribution per Unit

Rs. 1,20,000
=

Rs. 35

= 3,429 units required to

be sold if selling price
is being reduced by 5%

17.2.5 Exploring New Markets

Decisions regarding new market can be taken if the home market is not affected. If
we sell the commodity to the foreign market at lower price and they re-export to our
existing customers at lesser price what we charge to our customers, then there
cannot be a decision in favour of new market even if profit or contribution is
increased. It is advisable only when other things being remain same in the home or
present market. To make use of the existing capacity, export and new market is the
best alternate. With the following illustration, one can understand about the new
market decision.
Illustration 2

72

X Ltd. manufactures 1,000 units p.a. at a cost of Rs. 40 per unit and there is a
demand of the whole production at a price of Rs. 42.5 per unit in the home market.
There is a fall in the demand in the home market in the year 2003 and the whole
production can be sold in the home market at a selling price of Rs. 37.2 per unit.
The cost analysis for 1,000 units is as follows:

Relevant Costs for

Decision Making

Rs.
Materials

15,000

Wages

11,000

Variable Expenses

6,000

Fixed Expenses

10,000

2,000 Units can be sold in the foreign market at a explored price of Rs. 35.5 per unit.
It is also estimated that for additional 1,000 units of the product the fixed cost will
increase by 10%. Advise the management.
Solution
Statement showing the Effects of Selling Goods in the Foreign Market
Particulars

Year 2002
Home market
1,000 units
Rs.

Year 2003
Home market
1,000 units
Rs.

Foreign market
Total
2,000 units 3,000 units
Rs.
Rs.

Materials

15,000

15,000

30,000

45,000

Wages

11,000

11,000

22,000

33,000

6,000

6,000

12,000

18,000

Marginal cost

32,000

32,000

64,000

96,000

Sales

42,500

37,200

71,000

1,08,200

Contribution
(Sales Marginal Cost)

10,500

5,200

7,000

12,200

Less : Fixed cost

10,000

10,000

2,000

12,000

500

(4,800) Loss

5,000

200

Variable expenses

Profit / (Loss)

It is advisable to accept the proposal for sale in the foreign market as it converts loss
of Rs. 4,800 of home market into a net profit of Rs. 200.

17.2.6 Make or Buy Decisions

Decisions about, whether a manufacturer of goods or services should produce goods
or services within the factory or purchase them from the market. This type of
decision is needed when the concern organization is producing the item, which is also
available in the market at cheaper rate. If, purchased from the open market,
retrenchment of workers becomes inevitable or may not be able to reduce the fixed
costs of the factory. During the processing of the alternatives available other than
cost factor should also be considered. Some of these are quality of the product
available in the market, regularity of the supply, expected fluctuations in the demand
and reliability of the supplier. The processing and designing of the item of a product
should be kept as a secret, then this cannot be purchased from the market and it
should be produced at the floor of the factory. The following example makes this
concept easy to understand:
Illustration 3
With the help of the following data, a manufacturer seeks your advice whether to buy an
item from the market or to produce it at the floor of the factory:

73

Cost Volume Profit

Analysis

Present
(Buy)

Particulars

Proposed
(Make)

Rs.

Rs.

Sales

16,00,000

16,00,000

Costs: Variable

11,20,000

10,24,000

3,60,000

4,00,000

8,00,000

9,00,000

Fixed
Capital required
Advise the management.
Solution

Statement of Cost and Profitability

Particulars

Buy
Rs.

Make
Rs.

Sales ( S )

16,00,000

16,00,000

Less : Variable Costs

11,20,000

10,24,000

Contribution ( C )

4,80,000

5,76,000

Less : Fixed Costs

3,60,000

4,00,000

Profit ( P )

1,20,000

1,76,000

30%

36%

7.5%

11%

15%

19.6%

P/V Ratio (C/ S multiplied by 100)

Percentage of profit on sales (P/S multiplied by 100)
Return on capital employed (P/Capital multiplied by 100)

Decision: By describing the above statement making of the item at the floor is
better than to buy.
Working Note: Total costs would be reduced by Rs. 56,000 and by the same
amount the profit would also increase. P/V Ratio and profit on sale increase by
6 % and 3.5% respectively. Return on capital employed will also increase by
4.6 %.

17.2.7 Expand and Contract

In any factory, if there is scope of expansion and there is a possibility to purchase
the same item on contract basis from the market then we would look at the total
cost of both the alternate. It can be understood easily with the following example:
Illustration 4
X Ltd. has two factories A and B. A is running at 70% of installed capacity
(Installed capacity is 12,000 units) and B Factory supplies its requirements by
working at 80% of its installed capacity. The cost structure of the B factory is
given below:
74

Materials

Rs. 16,800

Labour

Rs.

6,000

Apportioned Fixed Overheads

Rs.

7,500

Variable Overheads

Rs. 4,200

Total

Rs. 34,500

Relevant Costs for

Decision Making

The production of A factory is to be increased to 80% capacity. The component

produced in B factory can be purchased from the market at Rs. 4.00 per unit. As the
cost of B factory exceeds Rs. 4 per unit, it is proposed to obtain the additional
requirement from the market instead of getting it from B factory. Advise the
management.
Solution
A factory can produce 12,000 units at 100% capacity and is working at 70%
capacity means it is producing 8,400 units. B factory is working at 80% capacity to
fulfill the needs of A factory. B factory when working at 100% capacity can
produce 84,000 / 80% = 10,500 units, so if A factory is working at 100% capacity
B factory cannot fulfill the requirement of A factory. If A factory is working at 80%
capacity that is 9,600 units (80%of 12,000). B factory will be required to produce
1,200 units more (9,600 8,400). For this analysis, the following statement is
required:
Statement showing costs of buying and manufacturing for 1200 units
Cost of Manufacturing
1,200 units
Rs.

Cost of Buying
1,200 units
Rs.

Material (16,800 / 8,400) 1,200

2,400

---

Labour (1,200 multiplied by 0.50)

600

---

Variable overhead (4,200 / 8,400) 1,200

600

---

Component

Costs of buying @ Rs. 4.00 per unit

Total Costs (Rs.)

---

4,800

3600

4,800

Decision: B factory will continue supply to A factory as manufacturing cost of

Rs. 1,200 (Rs. 4800 -- Rs. 3600) less than the cost of buying. So it is advisable to
expand B factory. It is presumed that fixed cost will not change after the expansion.

17.2.8 Sales Mix Decisions

The relative contribution of quantities of products or services constitutes total
revenues. It becomes difficult to analyze the profitability of the product when more
than one product is produced. To establish most profitable sales mix it becomes
necessary to get the most profitable sales mix by considering all the alternatives. Look
at following example.
Illustration 5
X Ltd. produces and sells four products A, B, C and D. The analysis of income from
each product has been shown in the following statement. Which of these product lines
would you like to continue and which would you like to drop?

75

Cost Volume Profit

Analysis

Income Statement
Particulars

Products
A
Rs.

B
Rs.

C
Rs.

D
Rs.

Total
Rs.

Sales

6,80,000

29,20,000

8,00,000

6,00,000

50,00,000

Less Variable Cost

4,00,000

5,70,000

5,50,000

5,80,000

21,00,000

Gross Contribution

2,80,000

23,50,000

2,50,000

20,000

29,00,000

Salesmen

50,000

7,00,000

70,000

20,000

8,40,000

Warehouse

40,000

7,00,000

60,000

10,000

8,10,000

Packing

30,000

2,00,000

50,000

2,000

2,82,000

Delivery

30,000

3,00,000

40,000

8,000

3,78,000

Total Variable Selling Costs: 1,50,000

19,00,000

2,20,000

40,000

23,10,000

1,30,000

4,50,000

30,000

20,000

5,90,000

1,10,000

Less : Variable Selling Costs:

Net Contribution
Less: Fixed Selling Cost

Contribution for Fixed

Administrative Cost
& Profit

4,80,000

Less: Fixed Administration

Costs

1,88,000

Net Profit

2,92,000

Solution
By looking at the above statement it is concluded that selling price of the product D is
not able to recover its variable costs even, so, the production of product D should be
stopped immediately. It shows the loss of Rs. 20,000 in net contribution.
Gross contribution of product Y is also not satisfactory so management can reconsider
about the use of resources engaged in the production of Y.

17.2.9 Alternative Methods of Production

The decision to be taken is of the nature of selecting one machine out of one or more
available in the market for production or to purchase the ready goods for further
processing from the market. In these cases, cost is considered and the decision is
taken in favour of the lowest cost occurring sector. Look at illustration 6 and see how
a decision will be taken out of alternative methods of production.
Illustraton 6
X Ltd. has to install a machine for the production of a part of a new product to be
launched by them. Two machines B and C are being considered. Their details are
given below:
76

Details

Machine B

Machine C

2,00,000

4,40,000

4,000

10,000

Life in Years

10

10

Salvage value in Rs.

Nil

40,000

Material per unit in Rs.

30.00

30.00

Production cost per unit (other than depreciation)

45.00

45.00

Apportioned overheads

2,000

2,000

Cost in Rs.
Annual Capacity in units

Relevant Costs for

Decision Making

Interest is @ 10% per annum. The part is available in the market @ Rs. 90 per unit
and can be sold at a net price of Rs. 85 per unit. The company requires 6,000 units per
annum. Advise the management.
Solution
Statement of cost of Depreciation and Interest per annum
Particulars

Cost of
Machine B
Rs.

Cost of
Machine C
Rs.

Initial Investment needed

Less Salvage Value

2,00,000
Nil

4,40,000
40,000

Net Value of Machine to be depreciated

2,00,000

4,00,000

Depreciation p.a.for 10 years

20,000

40,000

Interest on initial investment @10% p.a.

20,000

44,000

Statement showing Comparative Costs in Different Alternatives

Particulars

Cost, if
Cost of
Cost of
purchased Machine B Machine C
Rs.
Rs.
Rs.

Units purchased
Units produced
Surplus units to be sold in the open market

6,000
---

2,000
4,000
--

-10,000
4,000

Annual requirement (units)

6,000

6,000

6,000

Rs.
---

Rs.
1,20,000
1,80,000
20,000
20,000

Rs.
3,00,000
4,50,000
40,000
44,000

3,40,000

8,34,000

Cost of material @ Rs. 30 per unit

Production cost @ Rs. 45 per unit
Cost of Depreciation p.a.
Cost of interest @ 10% per annum
Total Cost of production
Add : Cost of purchases @
Rs. 90 per unit
Less : Sale proceeds of surplus
production @ Rs. 85 per unit
Net Cost of 6,000 units

--

5,40,000

1,80,000
--

Rs. 5,40,000

-3,40,000

Rs. 5,20,000 Rs. 4,94,000

77

Cost Volume Profit

Analysis

Decision: In all the above three alternatives the last alternate that is to purchase machine
C is the cheapest and so company should purchase in the machine C and install it.

17.2.10

Plant Shut Down Decisions

This type of decision is being taken when the nature of business is seasonal, cut-throat
competition and other un-favourable conditions of the market are there. While taking
the decision of Shut Down of the going concern the behaviour of costs should be
considered.
When one shuts down his plant, there are some avoidable, traceable or escapable fixed
costs such as salaries of temporary workers and salary of sales man, which can be
stopped by this decision. Some unavoidable or un-escapable cost are : depreciation on
fixed assets, rent of office and factory, insurance, interest and salaries of permanent
staff. These can not be stopped by shutting down the plant temporarily.
Some additional cost of Shut Down or Reopening Costs should be considered as the part
of the unavoidable costs. Normal decisions are for maximizing the profits; but Shut Down
decision is for reducing the loss as it always considers the savings under loss. Calculation
of net avoidable costs can be made through the following formulae:
Net Avoidable FC = Total FC (Un-avoidable FC + Re-opening Costs)
If the loss by taking the decision of Shut Down is less than the continuity of the
business then the decision of Shut Down may be considered as favourable in short
term. Some aspects other than costs should also be considered, such as utility of the
goods by the consumers, benefits of the employees, obsolescence of machinery,
goodwill of the concern, objection by the labour unions and the government
interference. Shut Down Point can be calculated by marginal cost method by the
following formulae:
Net Avoidable Fixed Cost
Shut Down Point (in Units)

Shut Down Point (in Value) =

Contribution per Unit

Net Avoidable Fixed Cost
P/V Ratio

There is a great difference between the Shut Down of a business and stopping the
production of one type of product. If production of any type of product is stopped then
the fixed cost of that product can be allocated to the remaining products; but when the
plant is being Shut Down, the remaining fixed costs are the loss for the concern. You
may have already learnt it in Unit 15 under the head 15.7. Managerial uses of Marginal
cost.

17.2.11 Acceptance of Special Order

If any producer is not utilizing plants full installed capacity and he receives special
order for the product and that will not make any adverse impact on our present sale
then the offer will be accepted if it increases contribution. This can be illustrated by
the following illustration:
Illustration 7
Y Ltd. is working on 80% capacity and its Flexible Budget is as follows:

78

Output 60,000 units, sales value Rs. 12,00,000, material cost Rs. 30,000, wages
Rs. 2,10,000, variable expenses Rs. 1,20,000, Semi-variable expenses Rs. 70,000
and fixed costs Rs. 2,00,000.

A proposal for additional sale of 7,500 units is available, if it is accepted and supplied at
Rs. 14.00 each. The semi-variable overheads increases by Rs. 2,500 for the additional
production. Advise the management.

Relevant Costs for

Decision Making

Solution
Statement of Marginal Cost and Profitability
Particulars

Production of
60,000 units
Rs.

Material @ Rs. 0.50

Production of
Additional 7,500
units
Rs.

Total Units:
67,500
Rs.

30,000

3,750

33,750

Wages @ Rs. 3.5

2,10,000

26,250

2,36,250

Variable Expenses @ Rs. 2

1,20,000

15,000

1,35,000

70,000

2,500

72,500

4,30,000

47,500

4,77,500

12,00,000

1,05,000

13,05,000

7,70,000

57,500

8,27,500

Semi-variable expenses
Marginal cost
Sales
Contribution = (S-V)
Less Fixed Costs
Profit

70,000
7,00,000

---

70,000

57,500

7,57,500

Decision: If the proposal for additional supply of 7,500 units is accepted then contribution
increases by Rs. 57,500 and profit also increases by the same amount. So it is advisable
to accept the offer for additional supply. It is assumed that this supply will not affect the
present market for its product.

17.2.12 Adding or Dropping a Product Line

It is obvious to add or drop a product line to increase the profitability of the business. For
this purpose it is needed to analyze all the details available. Profitability should be assessed
in the existing framework and then the profitability of all the alternatives should be compared
and then the decision should be taken.
Look at the following illustration :
Illustration 8
A factory manager seeks your advice whether he should drop one item from his product
line and replace it with another. Present cost and production data per unit are as follows:
Product

Price
(Rs.)

Variable Costs
(Rs.)

% Sales in
Total Sales

Tables

60

40

50

Chairs

100

60

10

Book Stands

200

120

40

Total Fixed cost per annum

Rs.

7,500

Current Sales of the year

Rs. 25,000

The change under consideration consists in dropping the line of chairs and replacing it
with a line of Sofa. If this drop and add change is made the manager forecasts the
following data regarding cost and output:

79

Cost Volume Profit

Analysis

Product

Price
(Rs.)

Variable Costs
(Rs.)

60

40

30

Sofa

160

60

20

Book Stands

200

120

50

Tables

% Sales in
Total Sales

Total Fixed cost per annum

Rs. 7,500

Projected Sales of the year

Rs. 26,500

Is this proposal feasible? Advise the management.

Solution
Statement of profitability for current production
Particulars

Tables
Rs.

Chairs
Rs.

Selling Price

60

100

200

-----

Less Variable Cost %

40

60

120

-----

Contribution

20

40

80

-----

33.33%

40%

40%

-----

12,500

2,500

10,000

25,000

4,167

1,000

4,000

9,167

Less Fixed Costs

---

---

---

7,500

Profit

----

---

---

1,667

P/V Ratio
Sales of Rs. 25,000 in the
ratio of 50%, 10% & 40%
Contribution (P/V
multiplied by Sales)

Book Stands
Rs.

Total
Rs.

Statement of profitability for projected production

Particulars

Sofa
Rs.

Book Stands
Rs.

Total
Rs.

Selling Price

60

160

200

-----

Less Variable Cost

40

60

120

-----

Contribution

20

100

80

-----

33.33% or 1/3

62 %

40 %

-----

Sales of Rs. 26,500 in the

ratio of 30%, 20% & 50%

7950

5300

13250

26,500

Contribution (P/V
multiplied by Sales)

2650

3313

5300

11,263

P/V Ratio

80

Tables
Rs.

Less Fixed Costs

-----

-----

-----

7,500

Profit

-----

-----

-----

3,763

Decision: After analyzing the above statements it is observed that if the proposal is
accepted then the profit will increase by Rs. 2,096 (i.e., Rs. 3,763 Rs. 1,667). It is
presumed that the demand of the proposed products will remain in the market.
Therefore the proposed is to be accepted.

Relevant Costs for

Decision Making

17.2.13 Replacement of Machinery

It becomes necessary to replace the old machinery by a new because of the
obsolescence of the old one or the renovation of the old one. Objective of replacing the
old machinery by a new machine is to reduce the cost of production and to increase
the revenue. While deciding the replacement of machinery factors like operating cost,
technological development, return on capital, demand for the product, opportunity cost
of the capital, availability of raw material, labour etc, should be taken into
consideration. The replacement of machinery is assessed either by marginal cost
analysis or differential cost analysis but the later is more appropriate and is much in
use. Let us study in brief the factors to be considered for the replacement of
machinery
i)

Operating Cost: Comparative study of the operating cost of the old and the new
machinery should be done. Per unit cost of production by old machinery and the
new one can be analyzed by the comparative statement.

ii)

Technological Development: New inventions are taking place every day. The
chances of new inventions should be taken into consideration before the decision
of replacement.

iii)

Return On Capital: Return on capital on the new investment should be feasible.

What will be the amount of loss while selling the old?
Demand for the Product: Production will be increased by the use of the new
machine and the demand for the increased production should be estimated. If the
production at full capacity cannot be sold, then what percentage of the capacity
can be sold and at this point of utilization of the capacity would it be possible to
keep the price competitive. Market trend of the product should also be analyzed.
If the nature of the product is not going to last for a greater period then the
decision regarding change of machinery is not required.

v)

Assessment of the Opportunity Cost of the Capital: If the capital needed for
the replacement is being used for any other alternative would the capital yield
more. If it is so then the decision of replacement should be dropped.

vi)

Availability of Raw Material and Skilled Labour: Availability of raw material

and skilled labour to run the machinery should be studied before replacing the
machine.

Illustration 9
The following facts relate to two machines:
Existing Machine
Capital cost (Rs.)

New Machine

10,00,000

40,00,000

60

52

120

120

Fixed expenses (Rs.)

1,00,000

4,00,000

Annual output (units)

20,000

40,000

10

10

Marginal cost per unit (Rs.)

Selling price per unit (Rs.)

Life of machines (years)

The existing machine has worked for 5 years. Its present resale value is Rs. 4,00,000.
The scrap value of the machine may be taken as nil, Advise whether new machine
should be installed if rate of interest is 10 %.
81

Cost Volume Profit

Analysis

Solution
Statement of Differential Cost And Incremental Revenue
Particulars

Existing Machine
Cost
Rs.

Sales

Revenue
Rs.

New Machine
Cost
Rs.

24,00,000

Total Marginal Cost

Total Fixed Cost

Depreciation on
original cost

Cost
Rs.

48,00,000

12,00,000

20,80,000

1,00,000

4,00,000

Interest on additional
capital outlay on
36,00,000 @ 10 %
(Rs. 40,00,000
Rs. 4,00,000)

Revenue
Rs.

Incremental
Revenue
Rs.
24,00,000

3,60,000
1,00,000

4,00,000

Loss on sale of
machinery

14,00,000

Profit

10,00,000

1,00,000

33,40,000 19,40,000
14,60,000

4,60,000

Decision: It is clear from the above statement that installation of new machinery is
beneficial as incremental revenue is Rs 24,00,000 where as the differential cost is
Rs. 19,40,000. After installing the new machine the total increase in the revenue will
be Rs. 4,60,000.
Working Note:
1)

Total cost of the machine is Rs. 10,00,000 and life is for 10 years and it has
been used for 5 years. The present book value of existing machine is Rs.
5,00,000. So, the loss on sale of old machine is = Rs. 1,00,000. (Rs. 5,00,0004,00,000)

2)

The net amount required to install new machine is Rs. 3,60,000 i.e., after
deducting the amount of Rs. 4,00,000 received on sale of existing machinery.

3)

Loss on sale of existing machinery is to be included in the total cost of new

machinery for evaluation of new proposal.

4)

Opportunity cost of the capital has not been considered.

Check Your Progress

1)

What do you understand about relevant cost and irrelevant costs ? Give one
example.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

82

...........................................................................................................................

2)

Explain the concept of differential cost.

Relevant Costs for

Decision Making

................................................................................................................................
................................................................................................................................
................................................................................................................................
................................................................................................................................
3)

What is decision making process ?

................................................................................................................................
................................................................................................................................
................................................................................................................................
................................................................................................................................

4)

List out four managerial applications of differential cost analysis .

1 ................................................................ 3. .
2. ............................................................... 4. .

5)

6)

State whether the following statements are True or False:

i)

Relevant cost analysis is used for future decision making and not for past
decisions

ii)

Relevant costs are also known as differential costs

iii)

Differential cost is always calculated per unit and not on total cost of two
alternatives

iv)

Differential costs and marginal costs are the same

v)

Fixed costs are not taken into account for differential cost analysis.

X Ltd. produces 1,000 articles at the following costs:

Components

Rs.

Rs.

Materials

4,00,000

Wages

3,60,000

Factory Overheads: Fixed

Variable
Fixed Administrative Overhead
Selling Overheads: Fixed
Variable
Total

1,20,000
2,00,000

1,00,000
1,60,000

3,20,000
1,80,000
2,60,000
15,20,000

1,000 units @ Rs. 1,550 can be consumed in home market. Foreign market can
consume 4,000 articles of this product if rate can be reduced to Rs. 1,250 per article.
Is the foreign market worth trying?
7)

The present volume of sales in a factory is 30,000units and the management has
installed modern machinery to increase the production to 6 times. The present
selling price is Rs. 24 per unit. Six successive levels with equal increments
83

Cost Volume Profit

Analysis

reaching up to 1,80,000 units are contemplated sales. The reduction in selling

price is expected to be Rs. 2 at each higher level of sales. Fixed cost of
Rs. 1,32,000 will not change Other costs at different levels are given below:
Production (units in000)

30

60

90

120

150

180

Variable cost (in Rs. 000)

4.18

8.18 12.78 15.78 17.78 19.02

Semi Variable Cost (in Rs. 000)

1.50

1.50

1.70

1.70

2.00

2.00

Prepare a statement of differential cost and incremental revenue and give your advice
as to which level of production should be adopted to gain maximum

17.3 LET US SUM UP

Before taking a decision, one must analyze the alternatives available before him and
then one should take a decision, which is beneficial to the management. The decision
should be in such a way that it increases the profit of the company. When we take a
decision for a short period, normally we look at the contribution we receive in all the
available alternatives and compare them and one should accept the alternate, which
provides more contribution, as in shorter period it is presumed that fixed costs will not
change. If a decision is to be taken for a long period when the fixed costs will also
change then one should take the decision through differential cost system. So, costs
become relevant when decisions are being taken. In long-run variable and fixed costs
normally change. Total differential cost and incremental revenue is considered in this
method of analyzing for longer period.

17.4 KEY WORDS

Alternative: Options
Administrative Cost : A cost which relates to the enterprise as a whole
Book Value : The amount shown in books of account for an asset
Contribution Margin : Excess of sales revenue over all variable expenses
Differential analysis : Process of estimating the consequence of alternative actions
while taking a decision by decision-makers
Differential cost : The costs which will change in response to a particular course of
action.
Interest : The cost for using money.
Make or buy decision : A managerial decision about whether the firm should
produce internally or purchase it from outside
Opportunity Cost : The present value of income/costs that could be earned from
using an asset in its best alternative uses.
Residual value : The estimated realisable value of an asset after use.
Relevant costs : Costs that are different under different alternatives
Short run : Period of time over which capacity will not be changed.
Decision: Deciding one out of the many options
Differential Cost: Change in the cost
Incremental revenue: Increase in the revenue
Semi variable costs: A cost, which has both variable and fixed elements.
84

Sunk Costs: Past costs which are unavoidable because they cannot be changed

17.5

ANSWERS TO CHECK YOUR PROGRESS

5)

i) True ii) true iii) False iv ) False v ) False

6)

Statement Showing Differential Cost And Incremental Revenue

Components

Rs.

Sales of 4,000 units @ Rs.1250 (incremental revenue)

Relevant Costs for

Decision Making

Rs.

50,00,000

Differential costs:
Materials (4,00,000/1,000)4,000

16,00,000

Labour (3,60,000/1,000)4,000

14,40,000

Factory O.H. (2,00,000/1,000)4,000

8,00,000

Selling O.H. (1,60,000/1,000)4,000

6,40,000

Net profit or incremental profit

44,80,000
5,20,000

Decision: It is better to accept the foreign proposal, as it will increase the profit by
Rs. 5,20,000. It is assumed that this acceptance will not affect the home market and
the fixed cost will remain same.
7)

Statement of Differential Cost And Incremental Revenue

Production Selling
Sales Variable Semi- Fixed
in Units Price per Revenue Cost Variable Cost
(000)
Unit
(Rs.
(Rs. Cost (Rs. (Rs.
000) 000)
000) 000)

Total Differential Incremental

Cost
Cost
Revenue
(Rs. (Rs. 000) (Rs. 000)
000)

30

24

720

4.18

1.50

132 137.68

60

22

1320

8.18

1.50

132 141.68

4.00

600

90

20

1800

12.78

1.70

132 146.48

4.80

480

120

18

2160

15.78

1.70

132 149.48

3.00

360

150

16

2400

17.78

2.00

132 151.78

2.30

240

180

14

2520

19.02

2.00

132 153.02

1.24

120

Decision: Production level can be increased up to the equalization of incremental

revenue and the differential cost. In this case both of these are equal at the level of
90,000 units but the incremental revenue increases till the production level is achieved
at 1,50,000 units. After this level incremental revenue is decreases so the production
fixed at 1,50,000 units will provide the optimum level of profit.

17.6 TERMINAL QUESTIONS

Questions
1)

What do you understand by differential costing ? How does it differ from

managerial costing?

2)

Explain the practical applications of differential costing.

3)

X Company Ltd. manufactures a product. You are required to prepare a

statement showing differential cost and incremental revenue. At what volume
the company should set its level of production ?

85

Cost Volume Profit

Analysis

Output
(in 000 units)

Selling price
Per unit

Total semi-fixed
cost per unit

Total variable
Cost per unit

Total fixed cost

per unit

30

24

1.50

4.18

1.32

60

22

1.50

8.18

1.32

90

20

1.70

12.78

1.32

120

18

1.70

15.78

1.32

150

16

2.00

17.78

1.32

180

14

2.00

19.02

1.32

(Ans : Production at 1,50,000 units will provide optimum level of profit)

4)

5)

What considerations are involved in taking decision of the following :

i)

Make or buy decisions

ii)

Dropping a product or adding a new product

iii)

Shut-down of plant

Golden company Ltd produces a product which is yielding a profit of

Rs. 14,00,000 after charging fixed costs of Rs. 10,00,000 per annum. The selling
price of the product is Rs. 50 per unit and has a variable cost of Rs. 20 per unit.
The management wants to make changes in the selling price of the product. The
following options are open to the management.

Alternatives

Reduction in Selling Price

Increase in quantity to be sold

5%

10%

7%

20%

10%

25%

Evaluate the above alternatives and advise the management which alternative yields
maximum profit ?
(Ans : Contribution : 1. Rs. 2 4 , 2 0 , 0 0 0
3. Rs. 2 5 , 0 0 , 0 0 0

2. Rs. 25,44,000 and

Decision : Alternative 2 gives maximum profit.

6)

X Company Ltd is producing 10,000 articles and its cost data is given below :
Variable Cost per unit
:
Rs. 26
Fixed overheads
:
Rs. 10
Total Cost
:
Rs. 36
A manufacturer offers the same commodity for Rs. 32 per unit. The analysis of
the cost data shows that Rs. 60,000 of fixed overheads will be incurred
regardless of production.
You are requested to suggest that should company X make or buy the article ?
(Ans : Cost of making product Rs. 30, Difference of Rs. 2. is in favour of
making the product)

7)

86

The total fixed cost of a company for producing a product price is Rs. 15 lakhs,
the selling price per unit is Rs. 50 and the variable cost per unit is Rs. 40. The
company is incurring losses for the past several years due to lack of demand.
The company wants to shut down the plant till the demand picks up. The

avoidable costs are estimated at Rs. 4,00,000. Should the company discontinue
production till the demand picks up ? Advise the management.

Relevant Costs for

Decision Making

(Ans. If the companys sales are at least Rs. 55,00,000, it should not be
shut down )

Fixed Cost Avoidable cost

Hint : Shut down sales =
P/V ratio

8)

A firm manufactures and sells three products X, Y and Z. Their cost data is
given below:
Product :

5,000

12,500

17,500

Selling Price (Rs.)

15

Variable Cost (Rs.)

11

Production (Units) :

Fixed Cost

Rs. 1,05,000

There is no under utilisation of production capacity. Fixed costs are allocated on

the basis of units produced. There is no difference in the manufacturing time of
each product. The management proposes to drop product A as it contributes a
loss of Rs. 2 per unit as calculated below :
Selling price

Rs. 9

Variable cost

Rs. 8

Fixed cost
(Rs. 105000 35000 units)

Rs. 3
Rs. 11
Loss per unit

Rs. 2

The management proposes to add product S in place of product A as more units

of product S can be produced and sold in the market whose selling price and
variable cost per units is Rs. 8 and Rs. 7.75 respectively. It is estimated that
12,000 units of product S can be sold if product A is dropped. You are
requested to advise the management.
(Ans : Contribution : Product A : Rs. 1. Profit would decrease by
Rs. 5000 if the product A is dropped.
Product S : Rs. 0.25 p. If product S is added in place of
product A profit will decrease by Rs. 2000)

Note : These questions will help you to understand the unit better. Try to write
answers for them but do not submit your answers to the University. These
are for your practice.

87

UNIT 18 REPORTING TO
MANAGEMENT
Structure
18.0

Objectives

18.1

Introduction

18.2

Concept of Management Reporting

18.3

Objectives of Reporting

18.4

Reporting Needs at Different Managerial Levels

18.5

Types of Reports

18.6

Modes of Reporting

18.7

Essentials of Successful Reporting (Guiding Principles)

18.8

Let Us Sum Up

18.9

Key Words

18.10 Answers to Check Your Progress

18.11 Terminal Questions

18.0 OBJECTIVES
After studying this unit, you should be able to :
!

understand the report for the specific purpose;

follow the pattern of reports and apply these to your decisions;

prepare good reports;

know the needs of the reports; and

use the reports for data base.

18.1

INTRODUCTION

The purpose of reporting is to provide the information needed by the concerned party.
The value of information is determined by how the information meets the needs of the
users. This information creates an atmosphere for internal decision makers. The
communication of the information between two or more parties through reports is
known as reporting. Report is the essence of the management information system.
Report is a statement containing facts and if they contain accounting information and
data they are called accounting reports. So, report may be known as process of
providing accounting information to those who needs to make decisions. Report may
be for the past, present and for the future developments. In this unit you will study
about the objectives of reporting, need of reporting at different managerial levels, types
and modes of reporting and essentials of a successful reporting.

18.2
88

CONCEPT OF MANAGEMENT REPORTING

Reporting can be defined as communication of statements with related information

between the two parties. The process of providing information to the management is
known as management reporting. These reports are provided to the various levels of

management on regular basis to keep the management abreast about the effectiveness
of their respective responsibility. Reporting is an important function of the management
accountant as the efficient and smooth working of the business depends upon the good
reporting. The effectiveness of reporting to management to a large extent depends
upon the form and timing of its presentation. The process of reporting to management
is concerned with proper selection of financial and operating data, arranging
information in a proper form, analysing and interpreting the data and then reporting it to
the management through an appropriate method.

Reporting to
Management

18.3 OBJECTIVES OF REPORTING

Main objectives of reporting can be divided under the following heads:
Accounting reports consist of financial statistics. Management cannot analyse all
significant facts regarding its business especially in case of large scale production
where the business operations are more complex in nature. Accounting reports helps
to get full information about the its entire operative activity of the firm.
i)

Providing accounting information: Accounting reports consist of financial

statistics. Management may not analyse all significant facts regarding its business
operations especially in case of large scale production where the business
operations are more complex in nature. Accounting reports help to get full
information about its entire operative activity of the firm. Thus important
objective of the reporting is to provide accounting information to operating and top
level management in accurate form in understandable brief manner.

ii)

To take right decision: To help the management in taking the right decisions
with suitable statements provided by the management accountant.

iii)

Acceptability of the decision by all: Reporting leads to motivate people,

increases efficiency and boosting the morale of the people engaged in the various
aspects of the work of the enterprise.

iv)

Maximizing the profits: To achieve this ultimate goal of any business reporting
at the right time, at right place to the right person in right manner becomes an
essential feature.

v)

For better control: Abnormal events can be checked in time by obtaining the
necessary information in respect of each operating activity. Control through
reports become effective as compared to personal investigations.

18.4 REPORTING NEEDS AT DIFFERENT

MANAGERIAL LEVELS
Reporting is the lifeline of the organization. It helps in planning and control and works
as a media of communication and stimulates corrective action. Accounting system
becomes useless, if the business has no system of reporting because all decisions are
normally based on reporting system.
Need of reporting differs at different management levels. This also differs to the user
community also. There are three levels of management and the reports can be
classified according to the needs as follows:
1)

Top-Level Management Reports

2)

Middle Level Management Reports

3)

Lower Level Management Reports

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Cost Volume Profit

Analysis

1)

Top Management Reports

At this level reports are concerned with the following matters:
l

For determining the aims of the enterprise;

For formulation of policies and plans;

For delegation of responsibility in successful manner to executives for the best

utlization of resources; and

For formulating special significant plans.

It can be assumed that top brass of the business only needs reports for cost and
operational control. The report submitted to the level should be brief or we can call
it a summarized statement, which provides an overall view on the subject. Previously
these reports used to be submitted within the time framework. The time framework
may be monthly, quarterly or yearly. With the use of information technology and the
real time accounting, the whole time framework has been changed and now these
can be made available online.
Reports to top level management consist of the following:
a)

Reports to the Board of Directors

b)

Reports to the Chief Finance Officer

c)

Reports to the Chief Production officer, and

d)

Reports to the Chief Executive Marketing and Sales .

Let us study these reports in brief.

a)

Reports to the Board of Directors : Generally, following reports are to be

submitted to the Board of Directors and the Chief Executive Officer (C.E.O.):
i)

Different budgets,

ii)

Machine utilization statement

iii)

Work force utilization statement

iv)

Cost analysis statement

v)

Fund flow statement

vi)

Cash flow statement, and

vii) Balance sheet and income statement

b)

Reports to the Chief Finance Officer : Following reports are to be

submitted to the Chief Finance Officer (C.F.O.) :
i)

Cash flow statement,

ii)

Funds flow statement,

iii)

Abstract of receipts and payments and

iv) Report regarding any special problem such as make or buy,

replacement of old assets or any other.
c)

90

Reports to the Chief Production Officer: Following reports are to be

submitted to the Chief Production Officer (C.P.O.) :
i)

Cost analysis statement

ii)

Machine utilization report

iii)

Work force utilization statement

d)

2)

iv)

Materials statement,

v)

Production statement showing budgeted and actual with variance and

vi)

Overheads cost statement

Reporting to
Management

Report to the Chief Executive Marketing and Sales : Following reports

are to be submitted to the Chief Executive Marketing and Sales:
i)

Sales summary

ii)

Reports on credit collection

iii)

Reports of orders received and executed and outstanding orders

iv)

Report on stock of finished goods

Middle Level Management Reports

The middle level management consists of the heads of various departments. The
reports at this level should show the efficiency and cost data relating to different
departments. At this level execution of plans formulated by the top management
is worked out and all the managers in each department are concerned with this.
It is also the function of middle level management to coordinate different
activities of different departments. The reports at middle level management
consists of the following:
a)

Report to the General Manager : The following Reports are to be submitted

to the General Manager :
i)

Administration budget,

ii)

Cash and capital budget,

iii) Salaries statement of staff and

iv) Research and development budget
b)

Report to the Finance Manager : The reports to be submitted to the Finance

Manager are:
i)

Funds flow statement

ii)

Cash flow statement

iii) Cash and bank reports

iv) Debtors collection period reports
v)
c)

Average payment period reports

Reports to the Purchase Manager : The following reports are to be

submitted to the Purchase Manager:
i)

Stock level of raw material,

ii)

Use of raw material,

iii) Raw material budget and actual purchases, and

iv) Budgeted cost and actual cost of purchases
d)

Reports to the Works Manager : The reports submitted to the Works

Manager are:
i)

Production cost report

ii)

Raw material budget and actual consumption

iii) Production budget and actual production

iv) Idle time report
v)

Idle capacity report

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Cost Volume Profit

Analysis

e)

Reports to the Sales and Marketing Managers : The following reports

are to be submitted to the Sales and Marketing Manager:
i)

Report of budgeted and actual sales,

ii)

Report of orders booked and executed,

iii) Statement of sales ,

iv) Finished goods stock position and
v)

Position of collections and debtors.

With modernization and adoption of computers in the business house, the

reporting period has been reduced tremendously and the data are ready at
hand and these can be used to prepare reports instantly. Middle level
management is connected on line with the computers within the organization,
so preparation of reports has become easy.
3)

Lower Level Management Reports

At this level foremen and supervisors are concerned at the floor and they
prepare their reports physically without any expert opinion. They are
concerned with the daily work and they infuse a certain amount of
competitive spirit among the workers by comparing the output per man per
hour in a similar job. These reports include the following factors:
i)

Workers efficiency report,

ii)

Daily production report,

iii)

Workers utilization report and

iv)

Scrap report

v)

Over-time report

vi)

Material spoilage report

vii) Accident report etc.

18.5 TYPES OF REPORTS

Reports can be classified in various ways in which the different reports are presented
to the management such as :
1)

Users Reports

2)

Reports Based on Information

3)

Reports Based on Nature

4)

Functional Classification of Reports

Let us study each of them in brief.

1)

Users Reports
Depending upon users, reports can be classified as follows :

92

i)

Internal Users Report

ii)

Special Reports

iii)

Routine Reports

iv)

Management Level Reports

v)

External Users Reports

Reports can be prepared according to the users. They can be:

i)

Internal Users: Reports, which are prepared for the use of different levels
of management and for the use of the employees are known as the reports for
internal users. These are not public documents. These reports are aimed to
different levels of management.

ii)

Special Reports: These reports play a vital part in decision-making. They

are prepared for specific reasons. While preparing this type of report the problem
under study should be clearly be defined and understood and effect of cost and
income should be considered. Comparison of cost of study and estimation of
cost and income relating to the problem should also be considered. These
reports can be prepared for any of the problems relating to : i) market analysis
ii) Make or buy decisions iii) Problems of raw material iv) Technological
changes v) labour problems vi) Cost reduction schemes or any other problems
as discussed in Unit 18 of this course.

Reporting to
Management

iii) Routine Reports: These are only control reports and they are required only
when a control system exists. These are prepared daily as per scheduled time
regarding activities. Production operation reports, cost reports, research and
development reports, various budget reports, utilization of man, machine and
material reports, report regarding customer default, sales and distribution report,
administration reports, income statement and balance sheet and cash flow
statement are included in this classification.

2)

iv)

Management Level Reports: Main classification of these reports have

been provided while describing the reporting needs at different management
levels at 18.3.3.

v)

Reports for External Users: These reports are prepared for the external
users who have interest in the enterprise. They are the shareholders,
debenture holders, creditors, bankers, other financial institutions, stock
exchange and the Government. They may be interested in knowing the
financial position, progress made, future-plans and growth of the company.
While preparing these reports, the information regarding the interest of all
the external users should be taken into consideration. For example, the
profit and loss account and balance sheet are prepared every year and these
statements are to be filed with the Registrar of Companies and also stock
exchange authorities.

Reports Based on Information

There are two types of information reports. They are : i) Operating Reports,
and ii) Financial Reports.
i)

Operating Reports: These reports convey the information regarding the

operations of the business at different functional levels. These reports are
used to review and control the total production and to improve the interdepartmental efficiency. Operating reports can further be classified as
information reports and the control reports.
l

Information Reports: The reports prepared for this purpose should be

simple and clear in respect of various operating activities. These reports
are of three types, viz., trend reports, analytical reports and activity report.
In trend reports, comparative information is provided over a period
regarding the direction or trend of different activities. Analytical reports
are based on the horizontal comparison of results. This provides information
in an analytical manner about comparison of different activities for a
particular period. When reports are prepared for any particular activity
of the business then they are known as activity reports. Segment reports
are also information reports.

93

Cost Volume Profit

Analysis

ii)

3)

Control Reports : These reports are prepared to help the managers

in controlling the operations of the business. Various responsibility
centers are established in every business to have an effective control.
To know the performance of each responsibility center reports are
prepared for them. First important aspect regarding the performance
of the center manager and the other is concerned with the economic
performance of the center towards the goal or the business, are the
main features of these reports. These reports can be current control
reports or they can be summary control reports. Summary control
reports can be master summary control reports or these can be
subsidiary summary control reports.

Financial Reports : Financial reports differ from control or information

reports. They are necessary to know the success or failure of the
managements responsibility to shareholders through the accounting. These
reports can be of two types viz., dynamic financial reports and static
financial reports. Dynamic financial reports show the changes took place
during the year in the financial position of the business. These reports
include report of financial change, financial control reports and effective use
of funds reports. Static financial reports provide the information regarding
the position of assets and liabilities. They include balance sheet and certain
additional statements for individual items of the balance sheet.

Reports Based on Nature

There are three types of reports based on nature:

4)

i)

Enterprise Reports : These are the reports, which give a detailed

description of the various operating activities and financial position of the
business. They are generally meant for the external users i.e. bankers,
financial institutions, shareholders and government authorities. They are
generally regular and include annual accounts, directors reports, auditors
report. It is obligatory under Companies Act to furnish these reports.

ii)

Control Reports : These reports have already been discussed under the
head reports based on information.

iii)

Investigative Reports : These reports are specially prepared only when

to investigate a particular problem. These types of reports contain findings
and suggestions to solve the problem. These reports are helpful in taking a
decision on a particular problem.

Functional Classification of Reports

These reports are normally for the particular function or for a particular department
or for joint activity. They are also of two types:
i)

Individual Activity Report : Report is prepared for the individual activity

of a single department working under the supervision of one executive is
known as individual activity report.

ii)

Joint Activity Report : This report is prepared when joint efforts are
made in performing the activity. When the details are necessary then they
should be included in appendix. Then the results of all the joint activities are
considered under the supervision of the main supervisor.

18.6 MODES OF REPORTING

94

There are three modes of reporting:, 1) Written 2) Graphic, and 3) Oral. These
reports are further divided as follows :

Reporting to
Management

Modes of Reporting
Written

Graphic

Oral

1.

Financial Statements

1. Charts

1. Group meetings

2.

Tabulated Information
Conferences and
Individual Talks

2. Diagram and Pictures

2. Conferences and
Individual talks

3.
1)

2)

3. Graphs

Accounting Ratios
Written Reports : Written reports are prepared in the different forms to provide
information. These are as follows:
l

Financial Statements: These statements provide the information regarding

the data of actual performance with budgeted figures and comparative
statements containing information over a period.

Tabulated Information: Information related with expenditure, production,

sales and distribution is furnished in the form of tables so that the data can
easily be analyzed.

Accounting Ratios: Accounting ratios play a vital role for the

interpretation of accounting and financial statements. Different liquidity
ratios, profitability ratios, efficiency ratios and capital structure ratios may be
used for this purpose

Graphic Reporting: Graphic reporting is very common in these days to present

information to the management. These reports can be submitted in the form of
graphs, diagram, pictures and charts. They are prepared when quick action is
needed.
The common charts and diagrams usually included in a report are :
i)

Line Graphs : To show, for example, cumulative actual sales against

budget and/or against previous years actuals;

ii)

Bar Charts : Generally used for showing comparison of month-wise sales

and expenses budgeted and actuals;

iii) Pie Charts : Commonly used to show in a circular diagram the distribution
of the total sales revenue among costs, profits as also the total costs among
the different constituent elements.
3)

Oral Reporting : Oral reporting may take place in the form of (1) Group
meeting, (2) Conferences, and (3) Individual talks. These oral meetings cannot be
part of important decisions, but they furnish a common platform to discuss the
problems genuinely. For decision- making the written reports have a upper hand
over all types of reports.

18.7 ESSENTIALS OF SUCCESSFUL REPORTING

(GUIDING PRINCIPLES)
Business report is a media of communication that contains factual, correct and clear
information and it should be able to add to the knowledge of the recipient. It should be
easy to understand the problem of the event reported to him. Accounting reports
become ideal if they follow the following guidelines:

95

Cost Volume Profit

Analysis

1)

Content and the shape : While making a draft of the report the following heads
should be kept in mind:
1.1 Suitable title : Title should be short and suitable to the content.
1.2 Time : It should give time and the person for whom it is prepared.
1.3 Facts : Report should contain facts and not the opinions.
1.4 Totals : Where statistics are required, only relevant data should be provided
and details may be given in appendix.
1.5 Objectives : Contents should serve the purpose for which it is prepared.
1.6 Synchronize : The contents should be in logical sequence.

2)

Precise : Report should not be lengthy. It should be precise, specific and concise.
It should not contain irrelevant matter. If details are necessary then they should
be included in appendix.

3)

Accuracy : The information provided in the reports should be accurate.

4)

Comparable : It should be prepared in such a manner that comparison with past

and predetermined standards can be made.

5)

Simple : Report should be simple and should not contain any ambiguity.

6)

Timeliness : Reports should be prepared and presented in time, so that decisions

can be taken promptly and further deviations checked.

7)

Consistency : For comparison consistency is necessary. Uniform system of

collection, classification and presentation of the information should be followed.

8)

Attractiveness : The report should be eye-catching in the sense that it does not
go unheeded by the users.

9)

Jargon : All technical jargon should be avoided as for possible since the reader
may not understand these and, therefore, may become hostile to even the spirit of
the report.

10) Highlighting Deviations : Report should highlight the variations and trouble
spots which are significant to the organisation.
11) Assumptions : Assumptions used in the preparation of reports should be stated
neatly, precisely and separately.
12) Effective Communication : Report that communicates effectively to all levels
of management stimulates action and influence decisions. Detailed planning,
codification and timely processing of data are the essential requisites for effective
reporting.
13) Figures and data : These should be presented is a tabular form preferably in
annexure at the end of the report.
Check Your Progress
1)

Define reporting to management.

................................................................................................................................
................................................................................................................................

96

................................................................................................................................

2)

Explain any two objectives of reporting.

Reporting to
Management

................................................................................................................................
................................................................................................................................
................................................................................................................................
3)

What is control report?

................................................................................................................................
................................................................................................................................
................................................................................................................................

4)

What are the types of reports, which are required by the middle level of
management? Name any five.
1. ................................................... 3 ................................... 5 ...............................
2. ................................................... 4 ...................................

5)

What are the different modes of reporting?

................................................................................................................................
................................................................................................................................
................................................................................................................................

18.8 LET US SUM UP

One should be very clear about the objective of the report before preparing it. He
should be able to clearly define and understand the problem for which the report is
going to be presented. Needs of report differs at different management levels. So this
should be decided that which level of management will use the particular report. Mode
of reporting is also important regarding the presentation. Report will be a users report
or information report or any other type of report. Certain guiding principles such as
brief, sequencing, consistency, comparability, timeliness, accuracy, attractiveness,
simplicity, shape and contents are very important and these should be taken into mind
while preparing a report.

18.9 KEY WORDS

Static Financial Report : Providing information about the position of assets and
liabilities of the concern.
Graphic Reports : Information supplied in the form of Charts, Diagrams, Pictures
etc.
Reporting : Providing information to the person concerned.
Dynamic Financial Report : The information regarding the change that took place in
the position of assets and liabilities of a firm
Operating Reports : Information regarding the operating of a business at different
functional levels
Accuracy: correct, right
Consistency: Uniformity
Synchronize: Clear sequence

97

Cost Volume Profit

Analysis

18.10 ANSWERS TO CHECK YOUR PROGRESS

4)

5)

Names of five reports:

1.

Administrative Budget

2.

Funds Flow Statement

3.

Cash Flow Statement

4.

Stock Level of Raw Material

5.

Production Cost Report

Modes of Reporting:
1.

Written: Financial Statements

Tabulated Information
Accounting Ratios

2.

Graphic: Charts
Diagram and Pictures
Graphs

3.

Oral:

Group Meetings
Conferences and Individual Talks

18.11 TERMINAL QUESTIONS

1)

What do you mean by accounting reports? What are the different types of
reports for internal use? Discuss each of them.

2)

What are the special reports? What matters may be covered by the special
reports?

3)

Describe the reporting needs of different levels of management and how a

system of reporting can satisfy it?

4)

What are the essentials of a good report? Describe.

5)

Explain the different types of the reports that are used in an enterprise

6)

Accounting Reports are a matter of necessity for the management and not a
matter of convenience Discuss.
Note: These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.

98

UNIT 19 RECENT DEVELOPMENTS

IN ACCOUNTING
Structure
19.0

Objectives

19.1

Introduction

19.2

Scope and Limitation of Conventional Financial Accounting

19.3

Inflation Accounting

19.4

Human Resources Accounting

19.5

Social Accounting

19.6

Environmental Accounting

19.7

International Accounting

19.8

Strategic Cost Management

19.9

Activity Based Costing

19.10

IT Developments in Accounting

19.11

Let Us Sum Up

19.12

Terminal Questions

19.13

Further Readings

19.0 OBJECTIVES
The objectives of this unit are to:
!

explain some of the recent developments in financial and management

accounting;

give an overview on special accounting issues like inflation accounting, human

resources accounting, environmental accounting and international accounting;

give an overview on activity based costing and cost reduction methods; and

review developments of information technology that are related to accounting.

19.1 INTRODUCTION
The primary role of accounting is to record financial transaction and summarise the
same in a useful format. Financial accountants prepare three principal financial
statements by summarising huge volume of financial transactions namely Profit and
Loss Account, Balance Sheet and Cash Flow Statement. While these three are
reported in annual reports, they also prepare a number of statements for internal
purpose. Cost Accountants prepare a number of statements mainly for internal
purpose and the primary objective of the exercise is to find out the cost of
production. However, the world of accounting or accountant is fast changing.
Modern accountants are expected to be more intelligent than doing a mere
compiling job. You might have seen that even smaller companies are started using
computer software for accounting. With simplification in tax laws, the role of

99

Cost Volume Profit

Analysis

accountant in tax administration is also diminishing. Accountants are also expected to

provide more information about the non-conventional information. When machines
dominate industrial world, accountants are asked to provide more information about
material things of the firm. Today, in many firms, knowledge is asset. Since financial
reports stated above are not geared to provide such information, accountants are asked
to provide additional information. There is also lot of concerns about the social
behaviour of corporate sector. Hence many are interested in knowing the firms effort
on social responsibility and environment. Special reports are devised to address some
of these issues. In this unit, we will briefly discuss some of these reports and recent
developments. Each item discussed here are full subject on its own and depending on
your interest, you can specialise in one or more of the subjects either taking up some
specific issue and mastering them by reading some specialised books or attending
some courses on these topics. It is to be noted that accountants today, are expected to
be more intelligent since computers replaced conventional accountants in many firms.
Activity 1
1)

It is the time for you to interact with some of your friends who are in accounting
profession. Have a general chat with them and note down what they have
observed as recent trends in accounting profession.
................................................................................................................................
................................................................................................................................
................................................................................................................................

2)

Take any annual report of some well known companies and find out how much of
space they spend in providing non-financial information?
................................................................................................................................
................................................................................................................................
................................................................................................................................

19.2 SCOPE AND LIMITATION OF

CONVENTIONAL FINANCIAL ACCOUNTING
It is interesting to know why companies are suddenly focussing on some of the reports,
which we mentioned in the introduction. Alternatively, what is the wrong with the
conventional accounting reports? Accounting reports such as profit and loss account,
balance sheet and cash flow statements provide wealth of information but the question
is whether it is adequate to know about the current or future performance of the
companies. Secondly, not all stakeholders are interested only in knowing the profit or
income details. Future of companies depends on current strength and such strength is
not reflected in the accounting reports. This is particularly true for new economy or
knowledge based companies, which is seeing phenomenal growth in recent times.
Also, many stakeholders would be interested to corporate social behaviour. Some of
the prominent limitations are listed below:
a)

100

The balance sheet is often based on historical value. It fails to show the true
value of the firm in that context. Suppose a company owns 10 acres land in Delhi
or Mumbai, which was purchased some 40 years back at the rate of Rs. 10000
per acre. Is it right on the part of the company to show the value of the land at
the same price in 2003 when the cost of land is several 100 times more than the
purchase value? The above applies to many industrial machines which are used
in the firm but are efficiently managed beyond their normal life. How to reflect
true and fair value of such assets?

b)

Is human resource of a firm not an asset? Today, every company is proudly

stating that they have so many engineers, doctors, etc. in their company. If so,
what is the value of such intangible pool of expertise inside the company?
Conventional accounting treat salaries and wages paid to such employees as an
expense but fails to recognise the value of human resources.

c)

Can a company be focussed narrowly and always aiming to maximise profit? Is it

not fair to provide something to society particularly when they spoil natural
resources in their normal operation? Many developed nations are shifting their
high-pollution industries to the third world countries to have a clean air in their
countries. When these countries shift their base to third world nations, it is
legitimate expectation of the citizens of these countries that these companies
spend sufficient amount to control pollution and other side effects.

d)

Companies have changed the way in which it is operating business. Many

concepts such as just in time (JIT), Total Quality Management (TQM), Flexible
Manufacturing System, etc. are common today. But only very few companies
have changed their costing system. For instance, salaries and wages of many
manufacturing companies constitute an insignificant portion of the total cost but
our costing system not only report the labour cost but also uses the same as cost
allocation basis in some cases. Is it not desirable to change our costing system to
get some reliable cost data?

e)

Traditionally, firms use IT only for accounting purpose and such accounting was
standalone without any linkages to mainstream business operation. Today,
accounting information is extensively used and also IT is extensively used
throughout the organisation. Is it right or economical or efficient to have
standalone IT system for each functional area? Is it not desirable to have an
integrated accounting system or more specifically enterprise wide resource
planning (ERP), which performs not only accounting but several other business
operations in a total integrative manner?

Recent Developments in
Accounting

Activity 2
1)

We listed few reasons why accounting or accountants need to change from

conventional outlook. Can you apply these ideas into anyone of the companies or
to your own company and list out your findings?
................................................................................................................................
................................................................................................................................
................................................................................................................................

2)

Find out from your IT friend how ERP is different from that of accounting pages
like Tally.
................................................................................................................................
................................................................................................................................
................................................................................................................................

3)

Do you feel that spending money on social and environment is wastage of

corporate resources? What do these firms get in return by spending such amount?
................................................................................................................................
................................................................................................................................
................................................................................................................................

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Cost Volume Profit

Analysis

19.3 INFLATION ACCOUNTING

Inflation rate is the percentage change in the price level from the previous period. The
primary objective of inflation accounting is to correct conventional historical cost
accounts for the understatement of inventory and plant used in production, i.e. the cost
of goods sold and depreciation, in order to prevent erosion of capital during inflation.
That is, inflation accounting is used to provide information that is useful to present and
potential investors and creditors and other users in making decisions (and) in assessing
the amounts, timing, and uncertainty of prospective cash receipts from dividends or
interest and the proceeds from the sale, redemption, or maturities of securities or loans.
Inflation accounting was of interest when many developing economies were suffering
inflation rates of 25% or more. Now that rates are in single figures, the debate on the
need of inflation accounting is subdued. Some of the related objectives are:
a)

To show the real profit and loss for the period under consideration as against the
profit or loss on the basis of historical cost;

b)

To show the real value of the assets and liabilities instead of historical cost; and

c)

To ensure that sufficient funds will be available to replace the various assets
when the replacement becomes due.

This objective is generally achieved by the current cost method, which is also much
more responsive to the general objectives of financial reporting. There are alternative
methods like Current Purchasing Power Method, Constant Dollar Accounting Method,
etc. Under the current cost accounting method, fixed assets, stocks, stocks consumed,
etc. are shown in the financial statements at their value to the business and not at the
depreciated value or original cost. Depreciation for the year is calculated on the
current value of the fixed assets. All these things normally leads to reduction in profit
worked out under this method compared to normal historical based profit. Since the
discussion beyond this input is out of the scope of the subject, interested students are
advised to refer to Statement of Standard Accounting Practice (SSAP) 16.
There are limitations to inflation accounting and the failure to recognize them has led to
unnecessary complexity in some methods. Inflation accounting cannot isolate or
condense into one earnings number all of the effects of inflation on a company. It is
simply an improved system of measurement which brings financial statements into
harmony with current costs and values. Such improved statements provide a
foundation for analysis of a companys economic earnings and financial position in an
inflationary environment, including any special effects of inflation.
Activity 3
1)

What is the purpose of using inflation index in the preparation of accounting?

................................................................................................................................
................................................................................................................................
................................................................................................................................

2)

Suppose a company provides inflation-adjusted accounting. In your opinion, who

gains most by using such accounting statement?
................................................................................................................................
................................................................................................................................

102

................................................................................................................................

3)

Recent Developments in
Identify a few old cement or fertiliser companies, which have been established
Accounting
some 20 years back. Compare their book value and market value of the company
or price per share. Do you feel that the book value is not representative of current
market value? If so, do you feel that use of inflation accounting resolve such
inconsistency?

................................................................................................................................
................................................................................................................................
................................................................................................................................

19.4 HUMAN RESOURCES ACCOUNTING

In the case of manufacturing firms, most of the assets are in physical form. These
could be easily traced and valued. Hence its not much difficult to find the value of the
firm. Other than the physical assets, manufacturing firms also have assets like
intangible assets like goodwill, brand value etc. are to a greater extent possible to give
an approximate value. The most important is human capital, the ability of employees to
do the things that ultimately make the company work and succeed, particularly in the
case of software firms, the main asset is human being. Is it possible to value human
being? Can we assign a value every individual in the firm? Should we have to value the
human beings, just because they form the main asset in the IT firms? Yes it is utmost
necessary. As in most software companies though the projects are completed on a
team basis, the skills of each individual and his contribution is utmost important. Further,
its not only important only for IT firms it could also be more helpful if such value is
given to employees in manufacturing firm also, so that human beings get to know what
is the value they are contributing to the organisation and how much are they able to
improve in providing the value addition. Hence human resource accounting became
important. But not every company understands their contribution to the bottom line or
knows how to manage them to drive even better financial results, even though they
account for as much as 80 per cent of the worth of a corporation.
What is needed is measurement of abilities of all employees in a company, at every
level, to produce value from their knowledge and capability. Human Resource
Accounting (HRA) is basically an information system that tells management what
changes are occurring over time to the human resources of the business. HRA also
involves accounting for investment in people and their replacement costs, and also the
economic value of people in an organization. The current accounting system is not able
to provide the actual value of employee capabilities and knowledge. This indirectly
affects future investments of a company, as each year the cost on human resource
development and recruitment increases.
The information generated by HRA systems can be put to use for taking a variety of
managerial decisions like recruitment planning, turnover analysis, personnel
advancement analysis and capital budgeting, which can help companies save a lot of
trouble in the future. In India, there are very few companies like BHEL, Infosys and
Reliance Industries, which have implemented HRA and some are working on it.
Infosys, which started showing human resource as an asset in its balance sheet, has
been reaping high market valuations.
Companies can derive many benefits by going in for HRA. Not only can they measure
the return on capital employed on total organisational assets (including the human
assets), but the resources can also be planned accordingly. Once organisations realise
the actual benefit and take it as a growth process, it will only help them in increasing
their shareholders value. When a company is able to assess an individuals worth, it
helps in increasing its own worth. Basically HRA can be tracked through two

103

Cost Volume Profit

Analysis

methods: cost-based analysis and value-based analysis. The cost-based approach

focuses on the cost parameters, which may relate to historical cost, replacement cost,
or opportunity cost. The value-based approach suggests that the value of human
resources depends upon their capacity to generate revenue. This approach can be
further sub-divided into two broad categories: non-monetary and monetary.
The disposition of resources can also be examined by allocating relative human asset
values to different job grades. HRA also helps in examining expenditure on personnel
and in re-appraisal of expenditure on services and training. It can also serve as a key
factor in case of mergers and takeover decisions, where the human asset value
becomes a relevant factor. Another very significant role, which HRA can help in
creating, is goodwill for a company. The company can project itself in having best
practices with superior policies in place. Experts believe that this may help the
organisation attract more investments.
Infosys in its balance sheets shows Human Resources value at Rs. 9539.15 cr. as on
March 31, 2002. The HRA section of Infosys Annual Report states the following:
The dichotomy in accounting between human and non-human capital is fundamental. The
latter is recognized as an asset and is therefore recorded in the books and reported in the
financial statements, whereas the former is totally ignored by accountants. The definition
of wealth as a source of income inevitably leads to the recognition of human capital as one
of several forms of wealth such as money, securities and physical capital.
The Lev & Schwartz model has been used by Infosys to compute the value of the human
resources as on March 31, 2002. The evaluation is based on the present value of the future
earnings of the employees and on the following assumptions:
1.

Employee compensation includes all direct and indirect benefits earned both in India
and abroad.

2.

The incremental earnings based on group/age have been considered.

3.

The future earnings have been discounted at 17.17% (previous year 21.08%), this
rate being the cost of capital for Infosys. Beta has been assumed at 1.41 based on the
average beta for software stocks in US.

While HRA as a concept has been present in India for more than a decade, with
BHEL taking a lead, it is only now that the awareness is being translated into
application. However, in terms of awareness and acceptance, the level is still low as
many companies take little initiative to make the numbers public to shareholders,
despite having the data. And there is a lack of an industry standard. This means that
every company has to evolve its own standard, which can become a tedious process,
considering that most of them are still involved in improving their business. Industry
bodies like Nasscom can help set a standard.
Activity 4
1)

What is HRA? How different is it from Human Resource Management.

................................................................................................................................
................................................................................................................................
................................................................................................................................

2)

How wide is the application in the area of human resources valuation in India?
Name few companies that are implementing HR valuation.
................................................................................................................................
................................................................................................................................

104

................................................................................................................................

3)

What are the benefits of human resource accounting for the companies and also
for the employees?

Recent Developments in
Accounting

................................................................................................................................
................................................................................................................................
................................................................................................................................

19.5 SOCIAL ACCOUNTING

Social accountability is about being answerable to the people affected by your actions.
Leading organizations now engage relevant stakeholders, including employees,
suppliers, consumers, regulators, NGOs and communities, in open, consequential
dialogue at all levels of business decision-making and activity. They also volunteer
information to these stakeholders on their social performance, thereby making
themselves accountable to these interest groups. Social and ethical accounting, auditing
and reporting is still relatively new in many developing or third world nations, but is
gaining acceptance internationally as the primary demonstration of social
accountability. A social report is the result of a thorough evaluative process focused on
the social impact of a business on all its various stakeholders.
Social accounting and audit is a framework which allows an organisation to build on
existing documentation and reporting and develop a process whereby it can account
for its social performance, report on that performance and draw up an action plan to
improve on that performance, and through which it can understand its impact on the
community and be accountable to its key stakeholders. The social accounting process
should be driven by a rigorous methodology that involves the collection, analysis and
interpretation of quantitative and qualitative data. The accounting systems should be
standardized to facilitate verification by a third party. A social report represents the
disclosure of the companys social performance in the same way that the annual report
discloses financial performance.
Social accounting is not just a public relation exercise but a strategic intervention that,
in addition to disclosing social performance, serves to steer the company in a
transformation process. This strategic effect is achieved by adhering to the principle of
full disclosure. Both negative and positive performances are declared in the final
report. Consequently the corporation is compelled to perform and the social report has
a level of legitimacy that run-of-the-mill PR efforts do not have.
Effective reputational risk management contributes significantly to gaining and
maintaining a competitive advantage. Todays informed consumers are increasingly
concerned with the ethical characteristics of a business. And companies that have
values closely aligned with wider societal demands are better placed to recruit and
retain talented employees. A brand associated with ethical business conduct is better
protected in the global market because it enjoys hardier loyalty. Engaging in a social
accounting process, thoroughly and transparently, will enhance your companys
competitive edge. Some of the social indicators are as follows:
1)

Quality of Management

2)

Human Rights

3)

Environmental Performance

4)

Health and Safety

5)

Stakeholder Relationships

6)

Corporate Social Investment

7)

Employment Equity

8)

Products and Services

105

Cost Volume Profit

Analysis

Through dialogue with stakeholders, an organization identifies social and ethical

indicators that will objectively reflect its performance in relation to corporate values
and objectives. The choice of indicators is based on the organizations statement of
values and the standards, codes and guidelines to which the organization subscribes; on
stakeholders perception of the organizations performance against its values, and in
respect of their specific needs and concerns; and on best practices established in
societies that are part of the social accounting scope, weighed against the societal
needs of the South African context.
Decision-makers must consequently determine which parts of the organization, such as
divisions, departments or sites, are to be measured. The process of improving social
and ethical performance takes time and an organization may choose to limit disclosure
while setting performance targets and goals for more comprehensive reporting over
time. These decisions should be declared in the social report if credibility is to be
maintained. Once indicators have been established and the parts of the organization to
be evaluated identified, relevant data must be collected. Initially this may prove
challenging because there is seldom a system in place for deliberately measuring social
impacts. Producing the first social performance report will educate the organization as
to the nature of Social Impact Accounting Systems (SIAS) needed for rigorously and
objectively measuring performance.
Collected data is analysed and a social performance report is produced. The manner in
which publication and distribution is addressed may be taken as indicative of the
organizations commitment to ethical and socially responsible business practice.
Consequently, the report should be afforded the care and status devoted to the
traditional annual report on financial performance. And in the same way that a
companys financial performance is audited for assurance, social performance should
be submitted to the same intense scrutiny.
The core business of community and social enterprises and of community organisations
is to achieve some form of social, community or environmental benefit. Financial
sustainability or profitability is essential to achieving that benefit, but subsidiary to it.
The organisation and all the people associated with it or affected by it need to know if
it is achieving its objectives, if it is living up to its values and if those objectives and
values are relevant and appropriate. That is what the social accounting process aims to
facilitate.
A full set of Social Accounts is likely to include the following:

106

1)

A report on performance against the stated objectives (How well have we done
what we said we would do? )

2)

An assessment of the impact on the community (Can this be measured? What do

people think?)

3)

The views of stakeholders on our Objectives and Values (Are we doing the
right things? Are we walking our talk?)

4)

A report on environmental performance (Are we living lightly and minimizing

resource consumption?)

5)

A report on how we implement equal opportunities (Do we effectively encourage

social inclusion?)

6)

A report on our compliance with statutory and voluntary quality and procedural
standards (Do we do what is expected of us, and more?)

Keeping social accounts gives us the information we need qualitative and quantitative
to tell us how we are performing and what people think about what we do, and how
we do it. This is a social balance sheet so that all stakeholders can decide for

themselves whether to use, work for, support, or invest in the organisation. Through the
production of audited social accounts the organisation can fulfil its accountability to its
stakeholders. The overarching principle of social accounting and audit is to achieve
continuously improved performance relative to the chosen social objectives and to the
stated values. Six specific key principles have been identified from recent theory and
practice as underpinning the concept and good practice.

Recent Developments in
Accounting

19.6 ENVIRONMENTAL ACCOUNTING

Environmental accounting is defined as the accountants contribution towards
environmental sensitivity in organizations. It gained prominence in the 1990s. The
emphasis on the social responsibilities of the accountancy profession is not new, having
been led to prominence by the social accounting debate of the 1970s. The social
consciousness of the accountancy profession was started to receive its attention. It
focused on extending accountability to numerous stakeholders by necessitating
disclosure of social information in corporate annual reports. The accountability function
of accounting was believed to be fulfilled by reporting (financial and social) information
that stakeholders would find useful in their decision making process.
This led to the appearance of environmental, employee and ethical information on a
voluntary basis in modern day corporate annual reports. Unfortunately, social
accounting as discussed in the earlier section, failed to make its way into the
mainstream accounting agenda, largely due to lack of mandatory standards to guide it
and value judgments associated with determination of social responsibilities of an
organization. In spite of this, there has been renewed interest in social accounting in
the 1990s, triggered by the urgency associated with reducing environmental problems
that exist today.
Practical developments of environmental accounting saw tremendous growth in
research, with various initiatives and proposals being put forward by accountancy
bodies and related international organizations. In essence, environmental accounting
now plays a vital role in daily commercial undertakings, attempting to ensure that
development is not at odds with environmental protection. The potential for
accountants to make a significant contribution towards environmental consciousness in
organizations has been envisaged through their managerial, auditing and reporting skills.
Increasingly, the emphasis has shifted from social accounting in general to a more
specific environmental accounting. These days, social accounting has become
synonymous with the term social and environmental accounting (SEA), a linkage that
places due emphasis on the importance of environmental issues.
The fundamental premise behind environmental accounting is that organizations should
internalize environmental costs. Currently, these costs are externalized, which means
that the society bears the impact of an organizations adverse activities on the
environment, largely due to the fact that is a public good. Internal environmental
accounting mechanisms such as life cycle costing or even full cost accounting attempt
to trace costs of the organizations activities on the environment. It is believed that
once organizations are made accountable for these costs, they would be compelled to
minimize the potentially harmful effects of such activities. Further, environmental
accounting requires organizations to forecast the potential environmental impact of
their activities and accordingly estimate contingent liabilities and create provisions for
environmental risk.
Accountants role in environmental issues extends beyond management of the internal
mechanisms (environmental management accounting). They could be responsible for
the disclosure of environmental information, primarily in corporate annual reports, but
also through some other communication media. Environmental reporting provides
accountability to the wider society of the organizations commitment to environmental

107

Cost Volume Profit

Analysis

consciousness. Disclosure could constitute monetary information such as

environmental costs, liabilities, provisions and contingencies, coupled with quantitative
and descriptive information such as ecological data (for example, physical
measurement of environmental impacts), environmental policies, targets and
achievements.
The Environmental Accounting was first considered a new field in accounting in during
1998 by the intergovernmental work group ISAR (United Nations Inter governmental
Working Group of Experts on International Standards of Accounting and Reporting).
Jointly with this work, ISAR has been coordinating efforts with IAPC (International
Auditing Practices Committee) to formalize a group of audit standards for verification
of the environmental performance reported on accounting statements. This work group
basically emphasised the need for environmental accounting to cover the following
basic objectives: (a) assistance of professionals in other fields of knowledge; (b) give
the status of the information system of the analyzed company, as regards the
preparation of its internal controls to provide its financial accounting with relevant
information on environmental aspects; and (c) effective contribution of various
external intervenors, as the consulting specialists, certification companies and
independent auditors, to grant an independent opinion on specific aspects of the report.
The concept of sustainable development catching on rapidly, corporate and industrial
houses across the world are increasingly incorporating the environmental element in
their day-to-day business operations. They are clear in their perception that along with
quality, safety of the environment, too, is an important factor in making a business
successful.
Activity 5
1)

Take the annual report of top 5 companies in the Petrochemicals industry and find
out which part of the report covers the environmental accounting if given?
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................

2)

How efficiently companies follow the environmental accounting requirements?

Do you find any deviance from what they actually practice and what they report
in their financial reports? If so, given an instance of any company violating the
same.
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................

19.7 INTERNATIONAL ACCOUNTING

108

Many Indian companies, particularly in pharmaceutical and software industry have

overseas operations. With trade liberalisation in place, many Indian companies would
be future multinationals. When firms operations move international, not only on
manufacturing and marketing but also investors, accounting of different business
operations located at different countries under one roof becomes difficult. There are
two potential problems that an accountant faces in dealing with such consolidation.

Accounting standards differ in several countries and investors of those countries

require the financial statements using their countries accounting standards to enable
them to compare the company with other company. For instance, if you are a
shareholder of Hindustan Lever Ltd., or Castrol India Ltd. you would like to have the
financial statements under Indian GAAP. Think about an investor of Unilever located
either in Netherlands or UK, who has majority stake in Hindustan Lever. While
consolidating the Hindustan Levers Ltd. financial statements with Unilever statements,
the investors of Unilever expects Hindustan Levers Ltd., financial data also reflects
their countries GAAP. The task turns complex further if the shareholders are located
in different countries. For instance, Infosys or many other top rated Indian companies
shares are held by several FIIs whose investors are located across the globe and
investors of ADR of these companies are also located in different parts of globe. If
Infosys prepares financial statements only on the basis of Indian GAAP, they will not
be happy. By virtue of agreement with overseas stock exchanges, Infosys may be
required to present a separate statement following the US GAAP. But what about the
investors in Japan, who has also purchased shares of infosys either directly or
indirectly through FII. Today, many companies started giving separate financial
statement using major countries GAAP to satisfy the investors of those countries.
While it adds cost of compiling financial reports, it brings lot of goodwill.

Recent Developments in
Accounting

Firms operating in different countries also have certain peculiar problem. For instance,
your companys overseas venture would have posted increased profit during a period
but when you convert the profit in your currency, you might be alarmed to see that
profit has actually come down from the previous year if there is a currency
depreciation in the country. On the other hand, the performance of overseas country
might have actually come down but when we convert the same to our currency, the
performance might have improved if our currency appreciates during the period.
Handling multi-currency business operations in consolidation is another complex task in
international accounting.
Activity 6
1)

Collect or download from the companys website the annual report of Infosys or
Wipro or Asian Paints. Read the statement of significant accounting polices of
consolidated financial statements. List down your observation/understanding?
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................

2)

Visit http://www.icai.org and locate Accounting Standard page. Download AS 21

and AS 27. Write a one page note on each accounting standard after reading the
same.
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................

19.8 STRATEGIC COST MANAGEMENT

The field of management accounting has also seen considerable changes in recent
times. When industrialisation was limited and economies were closed for external
competition and also having restricted internal competition, managers decision making
scope was normally restricted to few operational decision making such as production
optimisation, product mix, setting discount policies, etc. Conventional cost and financial
accounting provide adequate information for such decisions. However, over a period
of time, business environment has completely changed and internal and external

109

Cost Volume Profit

Analysis

110

competitions have become the order of the day. Top management of any firm, small,
medium, large or multinational, are increasingly spending time on strategic decision and
cost and financial data are extensively used along with input drawn from the
environment, which includes competitors financial and non-financial information. A
new discipline called strategic cost management or strategic management
accounting addresses these issues. The following issues are typically addressed using
cost input from strategic perspective:
a)

Value Chain Analysis : Let us take an example of a product say television

which we use daily in our life to understand the concept. The television set
which you are using is giving you some value - educative or entertainment value.
There are so many organisations, which are involved in the whole process of
manufacturing and delivering the television to you. All these organisations are
adding value at each stage to the product and what you get finally the collective
amount of all value addition. The value chain analysis looks into how much of
value addition has taken place at each stage of the whole process. It helps the
organisations to identify the place where they need to be there to maximise the
reward and at the same time using their expertise. If all organisations try to
reduce the total cost of the value chain, then customers get benefit out of such
exercise. For instance, if you are manufacturing PET bottles, which are used by
many mineral water manufacturing companies you have two options in setting up
your plant. One, you can put up a centralised huge plant to achieve economies of
scale but force your customers to hold more inventory since without bottles, it is
difficult to run the plant. Alternatively, you can put up smaller plants near
manufacturer. While this will add cost of manufacturing, but it will bring down
inventory level. As PET bottle manufacturer, you need to look beyond your
costing and see the value chain.

b)

Activity-based-costing (ABC) : ABC looks into a firm as a bunch of activities

and hence focuses more on activity analysis, cost associated in performing such
activities and then finally ways to perform the activities better while reducing the
cost. ABC provides more accurate cost data than conventional costing system
and such reliable costing is often required for strategic decision. ABC is also
useful to identify value added and non-valued activities.

c)

Customer cost analysis : Do you feel all your customers are equally important
to you? If you ask this question to MD of a large company, the answer will be
most probably Yes since today every company wants to be customer focussed
and it is immaterial whether the customer is small customer or large customer.
Suppose you ask another question to the same MD - are all your customers
equally profitable? The answer need not be Yes and often the answer is No.
Customers are increasingly demanding and hence the cost of providing services
to customers significantly differ from customers to customers. How many
companies trace the cost up to the customer level? They normally stop costing
exercise upto the product level and that too with some ad hoc overhead
allocation. You need reliable cost data to measure customer profitability.

d)

Competitor cost analysis: Can you run a company without understanding

competitor? The answer would be probably yes in some 15 years back and
today it is a strong NO. What do you want know about the competitor ?
Apart from several other things, you would like to know their cost structure. An
understanding of their cost structure is helpful in several ways. For instance, if
the material cost of the competitors is lower than your company, you can start
looking for alternative source of buying or changing material quality or change.

e)

Target costing: Here, costing of product starts before the product gets into the
production stage. Many experts find that the best way to reduce the cost is spend
time while products are under development. Because, once a product design is

completed, about 80% of the costs are pre-determined. For instance, imagine you Recent Developments in
Accounting
want to construct a hotel and run profitably. The operating cost of running a hotel
is relatively small compared to fixed cost. So the best way to reduce the cost is
to spend more time and energy in drawing the construction plans and
economically using the space, material and other items. This applies to many
manufactured products like watch or television or air-conditioner. Target costing is
done with the help of set of employees drawn from several functional areas, who
together participate in the development exercise with a single goal of designing a
product whose cost is less than target cost.
In addition to the above, there are several other strategic cost management techniques
like life-cycle costing, capacity costing, etc. For all these techniques, activity based
costing is used as a principle cost information. we will discuss briefly the activity based
costing. Under 19.9 of this Unit.
Activity 7
1)

How value chain analysis is different from value analysis?

................................................................................................................................
................................................................................................................................
................................................................................................................................

2)

Indian Railways moves passengers and goods from one place to other place. Can
you perform value chain analysis for Indian Railways and find out how they can
add value to passengers and business communities, which use the freight service?
................................................................................................................................
................................................................................................................................
................................................................................................................................

3)

Compare whether the profit changes are in line with the changes in cash flow
from operating activities.
................................................................................................................................
................................................................................................................................
................................................................................................................................

4)

Suppose one of the co-operative banks want to consult you in helping customer
cost analysis. Can you briefly tell how you can go about in helping the bank?
................................................................................................................................
................................................................................................................................
................................................................................................................................

19.9 ACTIVITY BASED COSTING

Accurate and relevant cost information is critical to any organisation that hopes to
maintain, or improve, its competitive position. For years, firms operated under the
assumption that their cost information actually reflected the costs of their products and
services when, in reality, it did nothing of the kind. Over-generalised cost systems were
actually misleading decision makers, causing them to make decisions inconsistent with
their organisations needs and goals, principally because of misallocated costs.

111

Cost Volume Profit

Analysis

Activity-based costing (ABC) is a valuable concept that can be used to correct the
shortcomings in the cost systems of the past. It is a means of creating a system that
ultimately directs an organisations costs to the products and services that require those
costs to be incurred. ABC can be used this way because it provides a cross-functional,
integrated view of the firm, its activities and its business processes.
As a result, in many organisations, ABC has evolved beyond the point of simply
developing more accurate and relevant product, process, service and activity costs.
These organisations use ABC as a means of improving operations by managing the
drivers of the activities that cause costs to be incurred. They are using ABC to support
major decisions on product lines, market segments and customer relationships, as well
as to simulate the impact of process improvements. Organisations involved in Total
Quality Management processes are using both the financial and non-financial
information of ABC as a measurement system.
The basic distinction between traditional cost accounting and ABC is as follows:
traditional cost accounting techniques allocate costs to products based on attributes of
a single unit. Typical attributes include the number of direct labour hours required to
manufacture a unit, purchase cost of merchandise resold, or number of days occupied.
Allocations, therefore, vary directly with the volume of units produced, cost of
merchandise sold, or days occupied by the customer. In contrast, ABC systems focus
on activities required to produce each product or provide each service based on each
products or services consumption of the activities.
Using ABC, overhead costs are traced to products and services by identifying the
resources, activities and their costs and quantities to produce output. A unit of output
(a driver) is used to calculate the cost of each activity. Cost is traced to the product or
service by determining how many units of output each activity consumed during any
given period of time. An ABC system can be viewed in two different ways. The cost
assignment view provides information about resources, activities and cost objects. The
process view provides operational (often non-financial) information about cost drivers,
activities and performance.
ABC does not only apply to manufacturing organisations, it is also appropriate for
service organisations such as financial institutions, and medical care providers and
government units. In fact, some banking firms have been applying the concept for
years under another name - unit costing. Unit costing is used to calculate the cost of
banking services by determining the cost and consumption of each unit of output of
functions required to deliver the service.
Activity 8
1)

How ABC is different from that of conventional costing?

................................................................................................................................
................................................................................................................................
................................................................................................................................

2)

Can you list at least three examples where ABC gives different cost value
compared to conventional costing?
................................................................................................................................
................................................................................................................................
................................................................................................................................

112

3)

List down any three uses of ABC in strategic cost application?

Recent Developments in
Accounting

................................................................................................................................
................................................................................................................................
................................................................................................................................

19.10 IT DEVELOPMENTS IN ACCOUNTING

Accounting is one of the earliest operation that has seen computerisation in the
commercial world. Today, we have reached a stage in which almost all accounting
operations are done through computers. What is the use of computers in accounting?
Book-keeping is monotonous job and it is best done by machine than men. Further,
accuracy and speed of the operation improves considerably. Most importantly,
transactions are entered only once and all further operations are done by the machine.
Compare this with manual operations in which someone keep basic day books,
someone posts it to ledger and prepares trial balance and someone prepares financial
reports. When the level of computerisation expands and includes several other
business operations, the task improves considerably.
Today, many companies are using Enterprise Resource Planning (ERP) software like
SAP, Peoplesoft, etc. ERP attempts to integrate all departments and functions across a
company to create a single software program that runs off one database. For instance,
if your planning is very good, the ERP system operates like this. Suppose, the inventory
level has come down below certain level. Your ERP system immediately generates
purchase order and electronically placed the same to the pre-defined vendor. When the
vendor supplies the material, you are making two entries - one at the stores level for
the receipt of the material and one at the accounts department for invoice data. The
machine compares the two and pass the bill for payment. On the due date, cheques
are printed and accounting of payment is done electronically.
What is the use of such integration? It avoids duplication of systems and data entry or
data transport from system to another. Major benefit of ERP is better planning and
control. Suppose, you have made a plan for the next year sometime around January
2003 (for the period of April 2003 to March 2004). Sometime around July you have
found that the performance of the first quarter is better than what you have expected
and hence you want to increase your target and reset the budget. While it may be
easier to change overall budget values, no one knows what will be changes required at
various stages unless there is an integration. Planning doesnt end with the boardroom.
To translate the planning into action, changes are required every stages and people
should realise what kind of problems it may pose when we change the plan. For
instance, such an upward revision may require additional working capital or identifying
new supplier for the material or booking of additional railway wagon. ERP software
typically identifies all such problems and helps you to optimise using simple to advance
modelling.

19.11 LET US SUM UP

Accounting primarily complies monetary transactions taken place between the
company and others and prepares financial statements. Accounting information is used
by several users. A significant part of the accounting system is today handled by
computers and hence requires accountants to upgrade the skills. Top management as
well as other stakeholders expect accountant to provide useful information in addition
to traditional income statement and balance sheet. For instance, the profit shown under
profit and loss account is unreliable in a situation of high inflation or when the assets
are very old. The company may not have adequate funds to meet the expenditure.
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Cost Volume Profit

Analysis

Accountants are expected to provide insight on the future growth prospects of

companies in an inflationary condition. Similarly, stakeholders, particularly those other
than shareholders, would be interested to know the contribution of company to social
causes and how it respects environmental and other issues. Though in a narrow sense,
shareholders are not concerned on this issue, their interest is also affected if the firm
fails to consider the interest of society. Shareholders interest of automobile companies,
textile companies, tobacco companies, etc. is affected if these companies fail to
comply environmental issues. Accountants are also expected to provide information of
intangibles, which are particularly relevant for knowledge-based companies and other
service organisations. Human Resources Accounting, Brand Valuation, etc. are
important pieces of information that stakeholders expect to be incorporated in the
balance sheet. In addition to these inputs, accountants are expected to provide lot of
inputs that are used for strategic decision making process. For instance, accountants
have to collect the details on product-wise, geographic-wise, customer-wise, etc. and
also information pertaining to competitors. Accountant inputs are extensively used for
bench marking exercises and also decision such as out-sourceing. Since the
stakeholders are geographically spread all over the world, many companies are
showing accounting results under several accounting standards to satisfy the needs of
investors, employees, suppliers, customers and government authorities of several
countries. Modern accountants are also expected to be computer-savvy and be
familiar to work in a computerised networking environment. Companies spend
substantial money in IT and integrate all their operations. While on the one hand,
accountants role is declining on account of computerisation, accountant contribution
and involvement at high-end are increasing. For instance, today accounting processes
are centralised and concepts like shared service operation are emerging. In this, the
shared service operation provider maintains the accounts of several companies and
general many value added reports for the management. In other words, accounting
profession is as challenging as any other professions and also highly rewarding.
Interested students can refer the Shareholders Information section of the Annual
Report of Infosys Technologies Limited (page numbers (page number 137 to 162).
It covers intangible assets score sheet, human resources accounting and value-added
statement, brand valuation, balance sheet (including intangible assets), current-costadjusted financial statements, economic value-added (EVA) statement, ratio analysis,
statutory obligations, value reporting and management structure. It gives you a real life
perspective on current trends in accounting. You can download the report from the
companys website (http://infosys.com/investor/reports/annual/Infosys_AR03.pdf).

19.12 TERMINAL QUESTIONS

1) When conducting a social audit, what are the things must a company do?

114

2)

What is the benefit of companies being socially responsible?

3)

For what type of industries, Human Resource Accounting is most suitable? Is it

relevant to countries like India? Explain.

4)

Inflation rates have come down in the last few years in many countries including
India. Do you feel inflation accounting has a role? Discuss your answer.

5)

Is environmental accounting PR exercise? How do you perform environmental

accounting and auditing of fertiliser company?

6)

How does activity based costing differ from traditional costing approach?

7)

What is the role of cost accounting/cost data in strategic management?

8)

Suppose your company wants to pursue product differentiation strategy. How as an

accountant you will be useful for this exercise?

9)

List down some of the major benefits to a company on account of computerised Recent Developments in
Accounting
accounting system.

10) How implementation of ERP is different from computerisation of accounting function?

Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.

19.13 FURTHER READINGS

Bowman, E. H. and M. Haire. 1976. Social Impact Disclosure and Corporate Annual
Reports. Accounting, Organizations and Society 1(1): 11-21.
Brandon, C. H. and J. P. Matoney, Jr. 1975. Social Responsibility Financial Statement.
Management Accounting (November): 31-34.
Cowen, S. S., L.. B. Ferreri and L. D. Parker. 1987. The Impact of Corporate
Characteristics on Social Responsibility Disclosure: A Typology and Frequency-based
Analysis. Accounting, Organizations and Society 12(2): 111-122.
Elias, N. and M. Epstein. 1975. Dimensions of corporate social reporting. Management
Accounting (March): 36-40.
Geoffrey Whittington (1983), Inflation Accounting: An Introduction to the Debate,
Cambridge University Press.
Gray, R. 2002. The Social Accounting Project and Accounting Organizations and
Society Privileging Engagement, Imaginings, New Accountings and Pragmatism Over
Critique? Accounting, Organizations and Society 27(7): 687-708.
Jack Quarter, Laurie Mook, Betty Jane Richmond (2002),What Counts: Social
Accounting for Non Profits and Cooperatives, Prentice -Hall.
Lehman, G. 1999. Disclosing new worlds: A Role for Social and Environmental
Accounting and Auditing. Accounting, Organizations and Society 24(3): 217-241
Lyn M Fraser and Aileen Ormiston, Understanding Financial Statements
(Sixth Edition), Prentice-Hall of India Private Ltd. New Delhi
Pramanik, Kumar A. (2002) Environmental Accounting and Reporting, New Delhi,
Deep & Deep, 2002.
Robert Bloom Araya Bebessay, Inflation Accounting: Reporting of General and
Specific Price Changes, Greenwood Publishing Group.
Roberts, R. W. 1992. Determinants of Corporate Social Responsibility Disclosure:
An application of stakeholder theory. Accounting, Organizations and Society
17(6): 595-612.

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