FINANCIAL STATEMENT ANALYSIS Introduction The importance of financial statements as a source of factual data has increased tremendously in recent

years. A financial statement is an organized collection of data according to logical and consistent accounting procedure. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show a position at a moment in time in the case of a balance sheet, or may reveal a series of activities over a period of time, as in the case of an Income Statement. In other words, financial statements are prepared for the purpose of presenting a 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 statement include at least two basic statements: (i) the Profit and Loss Account, and (ii) the Balance Sheet. Beside these two statements an organization particularly a company may also prepare a statement of Retained Earnings which is also termed as Profit and Loss Appropriation Account. These statements present a mass of complex data in absolute monetary terms and indicate little about the profitability, solvency, liquidity and efficiency of the business. The focus of financial analysis is on key figures contained in the financial statements. Actually the figures given in financial statements do no speak anything themselves. Financial analysis consists in separating facts according to some definite plan, arranging them in a group according to certain circumstances, and then presenting them in a convenient and easily read and understandable form. Definition In the words of Hampton, it is the process of determining the significant operating and financial characteristics of a firm from accounting data. Moore and Jaedicke have defined financial analysis as A process of synthesis and summarization of financial and operative data with a view to getting an insight into and interpretation of financial statements as a technique of xraying the financial position as well as the progress of a company. Kennedy and MacMillan have opined that by establishing strategic relationships between the components of balance sheet and profit and loss account and other operative data, it unveils the meaning and significance of the various items embodied in the financial statements. Metcalt and Titard have defined financial statements analysis as a Process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firms position and performance. These definitions clearly show that both analysis and interpretation is intended to serve both the internal and the external parties in their respective fields of decision making. Management Accounting practice The 2000 financial statements by Sony Corporation are accompanied by a statement issued by Price Water House Coopers LLP, the Companys auditor and one of the largest public accounting firms in the world. This statement indicates that in the auditors opinion; the financial statements of the company are in conformity with generally accepted accounting principles and that they present fairly the financial activities of the company for 1999. Objectives of Financial Statements The following are the important objectives of financial statements. 1. 2. 3. 4. 5. To provide adequate information about the financial performance and the assets-liabilities position of the entity; To provide useful information which can gainfully be utilised to predict, compare and evaluate the entitys earning capability. To provide sufficient information which can be utilized by both the internal and the external parties to predict, compare and evaluate the financial soundness of the entity. They should also enable the parties to predict, compare and evaluate the potential funds flow in terms of both amount, time and associated uncertainty. To provide required information to enable the users of financial statements to evaluate the ability or performance of managerial personnel to utilise the companys resources for the purpose of accomplishing the primary corporate objective. To provide information primarily to those who have limited authority or resources to obtain the required information. That means, to provide information to those who depend only on the financial statements for information.

From the above, it is unequivocal that the financial statements aim primarily in satisfying the informational requirements of external parties who gather much of their required data from the financial statements. Of course, these statements are also used by the internal parties. Steps involved in financial statement Analysis The process of financial statement analysis consists of the following six steps, i) Determination of scope and objectives of analysis ii) Study of financial statements

iii) iv) v) vi)

Collection of relevant information Rearrangement of data Analysis of data by analytical techniques and Interpretation, presentation and preparation of reports.

Try Your self As an Investor, assume you have just inherited a large sum of money and are looking for a company in which to invert. You have got the financial statements, balance sheets, income statements and statements of cash flows from three different companies of interest to you. What will be your primary objective in choosing a company in which to invest your money ? what key items or relationships will you look for in each financial statements that will help you decide in which company to invest? Our comments appear on page no Types of Financial Analysis There are a number of bases on which analysis and interpretation may be classified into two or more groups. Number of firms, party who is analyzing and interpreting, number of years figures used, etc. become the base for classification of analysis and interpretation. However, the modus operandi and the material used are, as identified by Man Mohan and Goyal, the two common bases used for classification.

Types of Financial Analysis

On the basis of material used

On the basis of modus operandi

External AnalysisI

On the basis of material used. According to material used, financial analysis can be of two types (a) Analysis Analysis Analysis external analysis, and (b) internal analysis. (a) External Analysis. This analysis is done by outsiders who do not have access to the detailed internal accounting records of the business firm. These outsiders include Investors, potential investors, creditors, potential creditors, government agencies, credit agencies, and the general public. For financial analysis, these external parties to the firm depend almost entirely on the published financial statements. External analysis, thus serves only a limited purpose. However, the recent changes in the government regulations requiring business firms to make available more detailed information to the public through audited published accounts have considerably improved the position of the external analysis. (b) Internal Analysis. The analysis conducted by persons who have access to the internal accounting records of a business firm is known as internal analysis. Such an analysis can, therefore, be performed by executives and employees of the organization as well as government agencies which have statutory powers vested in them. Financial analysis for managerial purposes is the internal type of analysis that can be effected depending upon the purpose to be achieved. II On the basis of modus operand. According to the method of operation followed in the analysis, financial analysis can also be of two types: (a) horizontal analysis (b) vertical analysis. (a) Horizontal Analysis. Horizontal analysis refers to the comparison of financial data of a company for several years. The figures for this type of analysis are presented horizontally over a number of columns. The figures of the various years are compared with standard or base year. A base year is a year chosen as beginning point. This type of analysis is also called Dynamic Analysis as it is based on the data from year to year rather than on data of any one year. The horizontal analysis makes it possible to focus attention on item over several periods with a base year may show a trend developing. Comparative statements and trend percentages are two tools employed in horizontal analysis. (b) Vertical Analysis. Vertical analysis refers to the study of relationship of the various items in the financial statements of one accounting period. In this types of analysis the figures from financial statement of a year are compared with a

Internal

Horizontal

Vertical

base selected from the same years statement. It is also known as Static Analysis. Common-size financial statements and financial ratios are the two tools employed in vertical analysis. Since vertical analysis considers data for one time period only, it is not very conductive to a proper analysis of financial statements. However, it may be used along with horizontal analysis to make it more effective and meaningful. Techniques of Analysis The analysis and interpretation of financial statements is used to determine the financial position and results to operations as well. A number of methods or devices are used to study the relationship between different statements. An effort is made to use those devices which clearly analyse the position of the enterprise. The following methods of analysis are generally used: i. ii. iii. iv. v. vi. vii. Comparative Statements Common-size statements Trend Analysis Funds flow Analysis Cash Flow Analysis Ratio Analysis Cost-Volume-Profit Analysis

The first three method i.e., comparative statements, common-size statements, trend analysis are discussed in the following pages of this lesson. Ratio analysis, funds flow, cash flow, and cost volume profit analysis have been discussed in separate lessons later in the study material. Comparative Financial Statements Any financial statement that reports the comparison of data of two or more consecutive accounting period is known as comparative financial statement. According to A.F. Foulke Comparative financial statements are statements of the financial position of a business so designed as to provide time prospective to the consideration of various elements of financial position embodied in such statements. Such a statement spotlights trends and established relationship between items that appear on the same row of a comparative financial statement. It discloses changes in items on financial statements over time in both rupees and percentage form. Each item (such as debtors) on a row for one fiscal period is compared with the same item in a different period. The analyst calculates the absolute changes-the difference between the figures of one year and the next and also the percentage change from one year to the next, using the earlier year as the base year. Much valuable information is obtained from financial statements in this manner. The analyst will get benefit from such a comparative study particularly because he will discover the key factors which have affected profitability or financial position of the concern. Common Size Statement Financial statement that depict financial data in the shape of vertical percentage are known as common size statement. Such statements provide readers with vertical analysis of the profit and loss account and balance sheet. In such statements all figures are converted to a common unit by expressing them as a percentage of a key figure in the statement. The total of financial statement is reduced to 100 and each item is shown as a component to the whole. For example in profit and loss account, the figures of each item is expressed as a percentage of sales. Likewise, assets and liabilities can be shown as percentage of total assets and total equities respectively in common-sized balance sheet. Thus, expressing each monetary item of the financial statement as a percentage of some total of which that item is a part, transforms a financial statement into what is referred as common-size statement. Such a statement shows the relative significance of the items contained in the financial statement and facilitate comparisons. It points out efficiencies and inefficiencies that are otherwise difficult to see, and for this reason is a valuable management tool. A common-size statement is especially useful when data for more than one year are used. Trend Analysis A variation of horizontal analysis is trend analysis, in which percentage changes are calculated for a number of successive years instead of between two years. The method of calculating trend percentages involves the calculation of percentage relationship that each item bears to the same item in the base year. Trend analysis uses an index number to show increase or decrease in related items over the years. For index numbers, one year, the base year is equal to 100 and on that basis the percentage for each of the items of each of the years are calculated. However, trend percentages are not calculated for all the items in the financial statements. They are usually calculated only for major items since the purpose is to bring to light the important changes in the financial position of the concern. Trend analysis is important because, with its long-run view, it may

point to basic changes in the nature of the business to indicate the direction of movement over long-time and helps the analyst to form an opinion as to whether favourable or unfavourable tendencies have developed.

RATIO ANALYSIS Introduction Ratio Analysis is an important tool for analyzing financial statements. The financial executives need certain yardstick to evaluate the financial position and performance of the business. Ratio analysis is considered a significant yardstick in this direction. In this technique, various types of ratios are calculated. With their help, comparisons of firms financial position can be made with other firms financial position. Before discussing different types of ratios, it is necessary to explain meaning and importance of ratio analysis. Meaning of Ratio Ratio is an assessment of one number in relation to the other. The relationship between two figures can be established on the basis of some logical methods, which is called ratio. In other words, a ratio is simply one number expressed in terms of another. For example, where the current assets of business at the end of year are Rs.2,00,000 while the current liabilities are Rs.40,000. The ratio would be 5 which comes by dividing current assets of Rs.2,00,000 by current liabilities of Rs.40,000. This is known as merely a quotient. There is another way of its expression, i.e. in terms of percentage. Here, it can also be stated that current assets are 500% of current liabilities or current assets are 5 times of current liabilities. Robert Anthony defined a Ratio as simply one number expressed in terms of the other. When the mathematical relationship between two items is expressed with reference to the items shown in financial statements, then it is called Accounting Ratio. Here an accounting ratio is defined as quantitative relationship between two or more items of the financial statements. A large number of ratios can be computed from the basis of financial statements-balance sheet and profit and loss account. Accounting ratios provide the necessary basis for inter-firm comparison, viz., to evaluate which business has the over-all operational efficiency, rate of profit on capital employed. Importance of Ratio Analysis The inter relationship that exists among the different items appeared in the financial statements, are revealed by accounting ratios. Ratio analysis of a firms financial statements is of interest to a number of parties, mainly, shareholders, creditors, financial executives etc. Shareholders are interested with earning capacity of the firm; creditors are interested in knowing the ability of firm to meet its financial obligations; and financial executives are concerned with evolving analytical tools that will measure and compare costs, efficiency, liquidity and profitability with a view to making intelligent decisions. The importance of ratio analysis are discussed below, in brief i. Aid to measure general efficiency. Ratios enable the mass of accounting data to be summarized and simplified. They act as an index of the efficiency of the enterprise. As such they serve as an instrument of management control. ii. Aid to measure financial solvency. Ratios are useful tools in the hands of management and other concerned to evaluate the firms performance over a period of time by comparing the present ratio with the past ones. They point out firms liquidity position to meet its short term obligations and long term solvency. iii. Aid in forecasting and planning. Ratio analysis is an invaluable aid to management in the discharge of its basic function such as planning, forecasting, control etc. The ratios that are derived after analyzing and scrutinizing the past result, helps the management to prepare budgets to formulate policies and to prepare the future plan of action etc. iv. Facilitate decision-making. It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency. They help management in decision-making.

v. Aid in corrective action. Ratio analysis provides inter firm comparison. They highlight the factors associated with successful and unsuccessful firms. If comparison shows an unfavourable variance, corrective actions can be initiated. Thus, it helps the management to take corrective action. vi. Aid in intra firm comparison. Intra firm comparisons are facilitated. It is an instrument for diagnosis of financial health of an enterprise. It facilitates the management to know whether the firms financial position is improving or deteriorating by setting a trend with the help of ratios. vii. Act as a good communication. Ratios are an effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners and other interested parties. The communications by the use of simplified and summarized ratios are more easy and understandable. viii. Evaluation of efficiency. Ratio analysis is an effective instrument which, when properly used, is useful to assess important characteristics of business liquidity, solvency, profitability etc. A study of these aspects may enable conclusions to be drawn relating to capabilities of business. ix. Effective tool. Ratio analysis helps in making effective control of the business measuring performance, control of cost etc. Effective control is the keynote of better management. Ratio ensures secrecy. Management Strategy Management determines the financial structure of the company. The financial (or capital) structure is the proportion of debt and equity capital and the particular forms of debt (eg Long Versus Short) and equity (eg common versus preferred) choosen to finance the assets of the firm. Management maximizes the firms value by minimizing the firms cost of financing the assets. When determining the financial structure, management must consider the impact of changes in the structure of its financial reports because creditors frequently use financial ratios in debt agreements. with firms. The agreements (called debt covenants) frequently require the firm to repay the debt if the firms financial ratios fall outside of predetermined ranges identified in the agreements. Thus manger must be aware of these pre existing agreements and the associated accounting ratios when considering a change to their capital structure via additional borrowing or issuing additional equity. Steps in Ratio Analysis

i) ii) iii)

Selection of relevant information. The first step in ratio analysis is to select relevant information from financial statements and calculate appropriate ratios required for decision under consideration. Comparison of calculated ratios. In order to assess the relative meaning, the ratios calculated are compared with the past ratios and industry ratios. Interpretation and reporting. The third step in ratio analysis is to interpret the significance of various ratios, draw inferences and to write a report. The report may recommend specific action in the matter of the decision situation or may present alternatives with comparative merits or it may just state the facts and interpretation.

Classification of Ratios Ratios may be classified in a number of ways keeping in view the particular purpose. Ratios indicating profitability are calculated on the basis of the profit and loss account; those indicating financial position are computed on the basis of the balance sheet and those which show operating efficiency or productivity or effective use of resources are calculated on the basis of figures in the profit and loss account and the balance sheet. This classification is rather crude and unsuitable to determine the profitability and financial position of the business. To achieve this purpose effectively, ratios may be classified as i) ii) iii) iv) v) Profitability ratios Coverage ratios Turnover ratios Financial ratios Leverage ratios

These are discussed one by one as follows Management Accounting Practice Media General financial Services continuously updates financial ratios for individual companies and provides norms for entire Individual companies and provides norms for entire industries. As an example of industry norm data , the average current ratios of several Industry, grouping are shown below for a recent year.

Industry group Air transportation (major carriers) Retail (general merchandise) Retail (apparel) Whole sale (grocery) Manufacture (computers) Telephone (regional) Limitations of Ratio Analysis

Average Current rate 0.9 to 1 1.9 to 1 2.3 to 1 1.2 to 1 1.6 to 1 0.8 to 1

Computations of ratios are very simple and easy to understand. They must be used very carefully. While using ratio, an analyst must take into mind certain limitations of ratios, otherwise the results may be misleading. The limitations of ratio technique are given below i. Simple ratio has no use: A simple ratio would not be able to convey anything. They can be useful only when they are computed in a large number. ii. Effect of limitations of accounting: There are certain limitations of accounting. So the effect of these limitations has its impact upon the ratios because they are computed from historical accounting records. iii. Lack of proper standards: Ratios are compared with the standard norms to find out results. But there is lack of exact and well accepted absolute standard. iv. Past is not an indicator of future: On the basis of calculated ratios, forecast is done for future. But the past is not an indicator of future. v. Differences in definitions: There are differences of opinion about various financial terms like gross profit, net profit, capital employed etc. Due to this, comparisons become difficult. vi. Effect of personal opinion: Ratios are only means of financial analysis. They can be affected by personal opinion of the analyst. So this can be taken into consideration while making use of ratios. vii. Not substitute of judgement: Ratio analysis technique provides useful information to the various users. But it cannot be substitute of sound judgement, although it is a helpful tool in applying judgements to otherwise complicated situations. So conclusions drawn with the help of ratios should be verified with other techniques too. viii. The ratio analysis technique is unsuccessful in inter-firm comparison in case of those concerns which are not associated or comparable. ix. Ratios may make the comparative study complicated and misleading on account of changes in price-level.

Summary of Ratios Objectives of Analysis (1) (a) Short term Financial Position Or Test of Liquidity Ratios to be computed (2) Current Ratio Basis Components (3) Current Assets Current Liabilities Liquid / Quick Assets Current /Quick Liabilities Absolute Liquid Assets Current Liabilities __Cost of Goods sold ___ Average Inventory at Cost Net Credit Annual Sales Average Trade Debtors

1.

2. 3.

Quick or Acid Test or Liquid Ratio (for immediate solvency) Absolute Liquid Ratio Inventory / Stock Turnover Ratio Debtors or Receivables Turnover Ratio / Velocity

(b)

Current Assets Movement or Efficiency or Activity Ratios

1. 2.

3. 4. 5. 6. (c) Analysis of Long term Financial Position or Test of Solvency 1.

Average Collection Period Creditors / Payables Turnover Ratio / Velocity Average Payment Period Working Capital Turnover Ratio Debt Equity Ratio

__Total Trade Debtors__ Net Credit Sales per day Net credit Annual Purchase Average Trade Creditors Total Trade Creditors Average Daily purchases ____Cost of Sales___ Net working capital Outsiders Funds Shareholders Funds Or External Equities Internal Equities ___Funded Debt____ x100 Total Capitalization Long term Debt Shareholders Debt Shareholders Funds Total Assets Total Liabilities to Outsiders Total Assets Fixed Assets (after depreciation Shareholders Funds Fixed Assets (after dep.) Total Long term Funds ___Current Assets___ Shareholders Funds Net Profit (before interest & taxes) Fixed Interest Charges EBIT = ---------------------------------Total Fixed Charges Net Profit (after interest & income tax) = ----------------------------------Preference Dividend Annual cash flow (before interest & taxes) = -----------------------------------Sinking fund approp. interest +-------------------------1 Tax Rate CF = -----------SFD 1 +-----1T Gross Profit --------------------------- x 100 Net Sales Operating Cost -------------------------- x 100 Net Sales Particular Expense -------------------------------- x 100 Net Sales

2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Funded Debt to Total Capitalization Ratio Ratio of Long term Debt to Shareholders Funds (Debt Equity) Proprietary or Equity Ratio Solvency Ratio Fixed Asset Net Worth Ratio Fixed Assets Ratio or Fixed Assets to Long term Funds Ratio of Current Assets to Proprietors Funds Debt Service, or Interest Coverage Ratio Total Coverage or Fixed Charge Coverage Preference Dividend Coverage Ratio Cash to Debt Service Ratio

12.

Or Debt cash flow Coverage

(d) (i)

Analysis of Profitability General Profitability

1. 2. 3.

Gross Profit Ratio Operating Ratio Expense Ratio

4. 5. ii. Overall Profitability 1.

Net Profit Ratio Operating Profit Ratio Return on shareholders Investments or Net Worth (R.O.I)

Net Profit after tax -------------------------------- x 100 Net Sales Operating Profit ------------------------------ x 100 Net Sales Net Profit (after interest & tax) -------------------------------- x 100 Shareholders Funds Net profit after tax - Preference Dividend ---------------------------------x 100 Paid-up Equity Capital Net Profit after tax and preference dividend ---------------------------------Number of Equity Shares Adjusted Net Profit -------------------------------- x 100 Gross Capital Employed Adjusted Net Profit ---------------------------- x 100 Net Capital Employed Sales or Cost of Sales --------------------------Capital Employed Dividend per Share ---------------------------Market value per share Dividend per Equity Share -------------------------------Earnings per share Market Price per Equity Share ----------------------------------Earning per share Eq. Share Capital + Reserves & Surplus --------------------------Pref. Capital + Long term debt bearing fixed interest Shareholders funds + Long term Liabilities ----------------------------------Long term liabilities Outsiders Funds ------------------------------Shareholders Funds Fixed Assets -------------------------Funded Debt Current Liabilities ------------------------------Shareholders Funds

2.

Return on Equity Capital

3.

Earnings Per Share (E.P.S)

4. 5. 6. 7. 8. 9. (e) Analysis of Capital Structure of Leverage 1.

Return on Gross Capital Employed Return on Net Capital Employed Capital Turnover Ratio Dividend Yield Ratio Dividend Pay out Ratio or Pay out Ratio Price Earnings Ratio (P/E Ratio) Capital Gearing Ratio

2.

Total investment to Long term Liabilities

3.

Debt Equity Ratio

4. 5.

Ratio of Fixed Assets to Funded Debt Ratio of Current Liabilities to proprietors Funds

6.

Ratio of Reserves to Equity Capital Financial Leverage

Reserves --------------------------- x 100 Equity Share Capital Earnings Before Int. & Tax (EBIT) -----------------------------EBIT Interest & Preference Dividend Contribution -------------------------EBIT

7.

8.

Operating Leverage

FUNDS FLOW ANALYSIS Introduction We found that a balance sheet as a static one showing no movement of funds, whereas a profit loss statement is a motion picture view of how the change in the owners equity comes about. However, retained earnings is merely one of the many balance sheet items. Over time, practically every other item in the balance sheet undergoes a change. For instance additional capital may be brought in, loans may be raised or retired, fixed assets acquired or disposed off, inventories built up or consumed and so on. Also, while a business may show considerable profits in a certain year, there may be practically no cash in the business to meet the operational requirement. Or else, despite borrowing a considerable amount of working capital, the management may still find it difficult to support their inventory. Why do these happen? How did they happen? These are questions which are not answered by either the balance sheet or profit and loss statement. The financial statement which attempts to answer these questions is the Statement of Changes in Financial Position (SCFP). Other common names for the same statement. `Sources and Applications (Users) of Funds and Cash Flow Statement, The more pretentious names include Money Provided and its Disposition. Summary of Financial Operations, Financial Expansion and Replacement, where Got and where Gone Statement. Concept of Funds Accountants vary in their opinions as regards the meaning of the word fund. It has been interpreted in various ways, including i. Literal cash: This includes un-deposited cash and demand deposits in banks. A Funds Flow statement, prepared on this basis, is similar to a Cash Flow Statement and, therefore, shows results corresponding to those obtained from a set of books kept on the basis of cash receipts and disbursement. ii. Shortterm monetary assets: This includes marketable securities readily convertible into cash in addition to literal cash as stated above. This concept of fund has the advantage of eliminating from the reports, transactions which represent the conversion of monetary assets into cash, or transfers of cash into nearcash items. iii. Net monetary assets: These are also described as net quick assets or as the sum of cash on hand or in bank, cash in the process of collection (i.e., shortterm receivables) and secondary cash reserves, such as temporary holdings of government bonds or other highly marketable securities, less cash in the process of disbursement (i.e., shortterm payables). The advantage of this concept is that by netting many of the shortterm cash movements, the more basic cash flows are highlighted.

iv. Working capital: Probably, the most common definition of funds is net working capital (i.e., current assets less current liabilities). Used in this sense, the statement of sources and uses of funds is the same as a statement of sources and uses of working capital or a statement of working capital flow. The working capital concept of fund is said to have several advantages. These are: (i) a funds statement constructed on the basis of the working capital is readily articulated with the income statement and the balance sheet, (ii) it closely follows the traditional definitions used in financial reporting and is, therefore, more easily understood by the users of financial statements who are acquired with conventional accounting procedures; and (iii) it tend to concentrate on the information presented on the infrequent interfirm transactions rather than on the daytoday transactions resulting from regular operations. It has been proposed as a means of presenting the general liquidity of firm. v. All financial resources: This term is conceived as the purchasing or spending power, or as all financial resources arising, as several writes have pointed out, from the external rather than internal transactions of the firm. In other words, this concept is extended to include assets or financial resources which do not affect or flow through the working capital accounts. However, the concept of funds as working capital is the most popular one and in this lesson we shall generally refer to funds as working capital and a funds flow statement as a statement of sources and application of funds. Meaning and Definition of Funds Flow Statement A Funds Flow Statement is also known as a Funds Statement, Statement of Sources and Applications of Fund, Where Got Where Gone Statement, Statement of Derivation and Deposition of the Means of Operation or by similar other titles. Irrespective of the name by which a funds flow statement may be called, an attempt is generally made to report the flow of funds (both positive and negative) during a period or between two points in time, and to assess its impact on working capital. Thus, the funds, Flow Statement is a Statement which shows the movement of funds and is a report of the financial operations of the business undertaking. It indicates various means by which funds were obtained during a particular period and the way in which these funds were employed. In simple words, it is a statement of sources and applications of funds. Definition The funds Flow Statement describes the sources from which additional funds were derived and the use to which these funds were put. - Anthony R.N. A Statement of Sources and application of funds is a technical device to analyze the changes in the financial condition of a business enterprise between two dates. - Foulke The Fund Statement is an important device for bringing to light the underlying financial movements, the ebb and flow of funds. - Patton and Patton Uses of Funds Flow Statement The Following are the important uses which the management can derive from the funds flow statement; i) The funds flow statement (FFS) acts as a supplementary statement to the traditional financial statements, viz., balance sheet and P&L account; ii) The FFS furnishes the information about the sources from which the company has mobilized the resources or fund during the year. iii) It also presents the details which spell out clearly the manner in which the mobilized fund has been utilised or employed during the year. iv) It guides the management to evolve proper divided and retention policies and also about the issue of bonus shares; v) Through the FFS, the management is able to plan for the retirement of long term and other debits; vi) It helps to know how the changes in working capital took place and the factors which caused the change in working capital; vii) It also sheds light on the efficiency of management in the working capital management. viii) The statement is most useful to the lending authorities for the sanction of loans to the company; ix) It guides the management about the allocation of resources and the priorities in the allocation of resources; x) It presents in brief the financial consequences of transactionsboth operational, financial and investment.

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Limitations of funds flow statement. i) ii) iii) iv) v) vi) The statement lacks originality because it is only rearrangement of data appearing in accounts books. It indicates only the post position and not future. It indicates funds flow in a summary form and it does not show various changes which take place continuously When both the aspects of a transaction are current, they are not considered When both the aspects of a transaction are non correct, even then they are not included in this statement. Funds flow statement is not a substitute of an income statement or a balance sheet. It provides only some additional information as regards charges in working capital.

CASH FLOW STATEMENT Introduction In this chapter our focus is on the development of the statement of cash flows and on its use as a tool for assessing the well being of a company. The importance of cash in the entire economic life of a firm can hardly be exaggerated. A firm may operate profitably, yet it may find it difficult to meet its commitments, including payment of wages, taxes, dividends, etc. This may be because either the amount of cash available may be far less than the profit earned during the period or the cash may have been used for some other purpose. Again, at times, cash may be flowing in much faster than it is being disbursed. So, during periods of temporary cash accumulation, the finance manager may seek some outlet for these funds (temporary investments). The opposite of this situation generally requires the arrangement of the required amount from appropriate sources. Thus, the management must know the movement of cash during a period for efficiently running its operations. A cash flow analysis is considered to be a tool in the hands of the management in this respect. A cash flow statement shows changes in the financial position of a firm on cash basis. In other words, it shows the net effects of the various transactions of a firm during a period on cash and explains the causes of changes in the position of a firm between two balance sheet dates. It is called the cash flow statement because it shows the various sources and applications of cash during a period and their net impact on the cash balance. In June 1995, the Securities and Exchange Board of India (SEBI) amended clause 32 of the Listing Agreement requiring every listed company to give along with the balance sheet and profit and loss account, a cash flow statement prepared in the prescribed format, showing separately cash flows from operating activities, investing activities and financing activities. Recording the importance of cash flow statement, the Institute of Chartered Accountants of India (ICAI) issued. A S-3 Revised : Cash flow Statements in March, 1997. The revised accounting standard supersedes AS 3 Changes in Financial Position, issued in June 1981. The Objectives of the cash flow statement as give in AS 3 (Revised) are as under. Information about the cash flows of an enterprise is useful in providing users of financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprises to utilise those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation. The statement deals with the provision of information about the historical changes in cash and cash equivalent of an enterprise by means of a cash flow statement which classified cash flows during the period from operating, investing and financing activities.

Definition of Cash In preparing a statement of cash flows, the term cash is broadly defined to include both cash and cash equivalents. Cash comprises cash on hand and demand deposit with banks. Cash equivalents consist of short term, highly liquid investments such as treasury bills, commercial paper, and money market funds. Such investments are made solely for the purpose of generating a return on funds that are temporarily idle. Instead of simply holding cash, most companies invest their excess cash reserves in these types of interest-bearing assets that can be easily converted into cash. These short term, liquid assets are usually include in marketable securities on the balance sheet. Since such assets are equivalent to cash. They are included with cash in preparing a statement of cash flows. Cash flows are inflows and outflows of cash and cash equivalents. It means the movement of cash into the organization and movement of cash out of the organization. The difference between the cash inflow and outflow is known as net cash flow which can be either net cash inflow or net cash out flow.

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Management Accounting Practice In 1999, Procter and Gamble Company (P & G ) reported a $ 3,763 million net Income, yet it had $ 5,544 million in cash provided by operating activities in its statement of cash flows. This significant difference ($ 1,781 million) was caused primarily by depreciation and amortization, and to a lesser extent by a growth in accounts payable and other liabilities. During 1999 P&G also purchased $ 2828 million in capital assets [ investing activities ] and paid $ 1,628 million is dividends and $ 2,533 to purchase treasury stock (financing activities) Purposes of Cash Flow Statement The basic purpose of a statement of cash flows is to provide information about the cash receipts and cash payments of a business entity during the accounting period, (The term cash flows includes both cash receipts and cash payments.) In addition, the statement is intended to provide information about the investing and financing activities of the company during the period. A statement of cash flows assists investors, creditors, and other in assessing such factors as The companys ability to generate positive cash flows in future period. The Companys ability to meet its obligations and to pay dividends The Companys need for external financing. Reasons for differences between the amount of net income and the related net cash flows from operating activities. Both the cash and non cash aspects of the Companys investment and financing transactions for the period. Causes of the change in the amount of cash equivalents between the beginning and the end of the accounting period. Stated simply, a statement of cash flows helps users of financial statements evaluate a companys ability to have sufficient cash both on a short run and on a long run basis, For this reason, the statement of cash flows is useful to virtually everyone interested in the companys financial health; short and long time creditors, investors, management and both current and prospective competitors. Limitations of cash flow statement Cash flow statement is a useful tool of financial analysis. However, it suffers from some limitations, which are as follows i) A cash flow statement only reveals the inflow and out flow of cash. The balance disclosed by this statement may not depict the true liquid position. There are controversies over a number of items like cheque, stamps, postal orders etc to be included in cash. ii) A cash flow statement cannot be equated with the income statement. An income statement takes into account both cash and non cash items. Hence, cash fund does not mean net income of the business. iii) Working capital being a wider concept of funds, a funds flow statement presents a more complex picture than cash flow statement. Distinction between Cash flow and Funds flow statement There are some basic difference between the two statements. These points are given below. i. Base Meaning Cash Flow Statement Cash Flow Statement is a statement which reflect sources and uses of cash. The scope of cash flow is limited. It is based on the narrow concept of fund, i.e., cash only. Under Cash Flow Statement, cash is an important factor. It is the part of Working Capital. Cash Flow Statement is Prepared to disclose only changes in cash position. Adjustments for prepaid and outstanding Fund Flow Statement Fund Flow Statement is that which reflects changes in the Working Capital or Fund. The fund is a broader term. It is a wider concept of fund. The fund or working capital includes cash, stock, debtors, bills and receivables, temporary investments. Fund flow statement is prepared to depict the changes in working capital between two balance sheet dates. While preparing fund flow statement,

ii. iii.

Scope Component

iv.

Object

v.

Conversion

12

or Adjustments of data vi. No. of Statements

expenses and incomes are made in preparation of Cash Flow Statement in order to convert the data from accrual basis to cash basis. Under Cash Flow Statement, only one statement is prepared.

there is no need for such conversion as this statement gives recognition to the accrual basis. Two statements are prepared in Fund Flow Analysis (i) Schedule of Working Capital changes, and (ii) Statement of sources and uses of fund. There is no place for showing opening and closing balance of cash and fund flow statement. In mid term and long term planning, fund flow statement is useful. It is not necessary that an improved fund position will be an indicator and sound cash position. Increase in current liabilities or decrease incurrent assets brings decrease in working capital and vice versa.

vii.

Opening and Closing Balance of Cash Use

In this statement cash Balance (opening and closing) is shown. The use of Cash flow statement is in financial analysis and cash planning, Cash Flow Statement may be worked as an indicator of improved working Capital.

viii. ix

10.

Impact of changes on cash and working capital

Increase in current liability or decrease in Current Assets brings increase in cash and vice versa

COST ACCOUNTING Introduction An organizations accounting system must provide a good map that links the costs and the processes used to create goods and / or services. Employees need this information to assess how well they use the companys resources. Determining the least costly combination of direct labour, direct materials, and overhead to create a product or service is critical for an organization to remain competitive. A good cost accounting system will provide a map to match the processes that consume resources with associated costs so that managers can decide how to best provide products or services to customers. Cost accounting concepts and practices have to be understood thoroughly. Students, who try to remember the concepts without undertaking them will not be able to apply them to various business situations. Hence, a through understanding of the concepts and constant practice of them are essential.

13

10.2

Definition

Cost accounting may be defined as a specialized branch of accounting which involves classification, accumulation, assignment and control of costs. Following are some important definitions of cost accounting According to W.W Bigg. Cost accounting is the provision of such analysis and classification of expenditure as will enable the total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted. According to Wheldon. Cost accounting is the application of accounting and costing principles, methods and techniques in the ascertainment of costs and the analysis of savings and / or excesses as compared with previous experience or with standards. According to Charted Institute of Management Accountants (C.I.M.A) England. Cost accounting is the process of accounting for costs from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units. In its widest usage, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of activities carried out or planned. In short cost accounting is the process of accounting for costs with the object of ascertaining and controlling costs. Objective of Cost Accounting Following are the objectives of cost accounting i. ii. iii. To ascertain cost : The primary objective of cost accounting is to ascertain the cost per unit of production and the cost of each element of expenditure, job, process etc. To determine selling price : Another objective of cost accounting is determine selling price by providing information about the composition of total cost of the product or service. To Control Cost : Cost accounting involves the study of the different operations of manufacturing job wise, department wise, operation wise, division wise. This facilitate controlling of costs. Standard costing and budgetary control are costing techniques to control cost. To prepare financial statements : A proper cost accounting system provides almost instant information regarding production, sales , operating costs, stock or raw materials, work in progress and finished products. This helps in preparation of financial statements i.e. Profit and Loss Account and Balance Sheet. To Formulate operating policies: Cost accounting provides useful information to plan and execute operating policies. Cost accounting helps the management in taking various managerial decisions like profitable product mix, utilization of unused capacity, make or buy a component , operating at a loss or closing down the business, introduction of a new product.

iv.

v.

Management Accounting Practice The US Congress passed legislation requiring hospitals that receive reimbursements from medic aid and medical to measure and report the average unit cost of their Products such as heart transplants , tonsillectomies and deliveries (births). Thus hospitals must develop cost accounting system capable of determining the average cost of providing each of this types of services. Cost Accounting and Financial Accounting The main function of cost accounting and financial accounting is to provide information. As such, both branches of accounting are related to each other to a very large extent. Points of Similarity Following are the points of similarity between cost accounting and financial accounting i. ii. Both financial accounting and cost accounting are based on double entry system i.e., principles of debits and credits. Transactions are recorded in monetary terms in both financial accounting and cost accounting.

14

iii. iv.

Recording of accounting information is done in both the systems with the same basic documents. Both systems show cost and profit.

Points of Distinction In spite of above points of similarly cost accounting and financial accounting differ in the following respects: i. Basis of Distinction Purpose Financial Accounting Its purpose is to determine profit for the accounting period and to show the financial position of the concern at the end of the accounting period. It provides information to external groups i.e., shareholders, creditors, investors etc. Maintenance of Financial accounting is necessary to meet the requirements of the Income Tax, Companies Act and other laws of the country. Financial accounts are prepared according to accounting standards and accounting principles and statutory requirements. Transactions are recorded, classfied and analysed into personal, real and nominal accounts i.e., according to the nature of expenditure Financial accounts show the profit of the business as a whole and does not show profit for each product, process etc. Financial accounting observes the accounting period which is normally a year. Its emphasis is on accuracy It is historical in nature and is concerned with historical data . It does not provide for adequate control over costs. Cost Accounting Its purpose is to provide detailed cost information for cost ascertainment, cost control and decision making. It provides information to management. Maintenance of cost accounts is voluntary except in some industries. There are no statutory provisions regarding preparation and presentation of cost accounts. Transactions are recorded classified and analysed objectively i.e., according to the purpose for which the cost is incurred. Cost accounts show the profit made on each job, process or product. Cost accounting makes day to day reporting like a movie picture. It aims at continuous reporting at short intervals say weekly. Its emphasis is to ascertain and to control cost It is concerned with historical as well as pre-determined data. It provides for a detailed system of control over cost.

ii. iii.

Interested groups Necessity

iv. v.

Mode of presentation Recording of transactions Analysis of Profits Reporting

vi. vii.

viii. ix. x.

Emphasis Nature Control

Advantages of Cost Accounting Important advantages of a cost accounting system may be listed as below To the Management The emergence of cost accountings is mainly to serve the needs of management. Cost accounting offers a number of advantages to the management which are given below. i. ii. iii. iv. Ascertainment of Costs Cost accounting provides useful information to the management which helps management to ascertain the cost per unit of production and the cost of each element of expenditure, job, process etc. Price Fixation Cost accounting provides information about the composition of total cost of the product or service. This helps management in fixing up the selling price. Measurement of Efficiency Cost accounting allows for proper and timely measurement of cost and consequently efficiency. Management can measure the efficiency by distinguishing between profitable and unprofitable activities. Inventory Control Cost accounting furnishes information which management requires in respect of inventory control which improves the efficiency of the plant. Various cost accounting techniques like perpetual inventory system, ABC analysis etc. facilitate better inventory control.

15

v. vi.

Managerial Control Cost accounting aims at reducing waste, securing economies, better selling and higher profits. Hence, cost accounting is a useful tool of managerial control. Helpful in Maximizing the profits Cost accounting helps in increasing the profits by disclosing the sources of loss or waste and by suggesting such controls so that waste, leakage, spoilage and inefficiencies of all departments may be detected and prevented. Useful in the period of Depression and Competition Cost accounting is useful to management in all the times including the period of boom and demand revival. But the need for having through system of costing is greater in the trade depression, trade competition and seasonal variations. The management must know the actual cost before adopting any scheme of price reduction. Data for Financial Statements Adequate costing records provide to the management such data as may be necessary for preparation of profit and loss account and balance sheet.

vii.

viii.

To The Creditors Creditors are immensely benefited by the installation of a costing system. Creditors can base their judgment about the profitability and future prospects of the enterprise upon the studies and reports submitted by the cost accountants. It has become a policy with most of the banks that no loans to industrial firms are made unless such firms have complete cost accounting systems which produce cost reports showing satisfying trends. To the Employees Cost Accounting is also of benefit to employees of the organization having a proper costing system. Workers are benefited because they are remunerated by results and wage negotiations. Employees benefit because of the system of incentive plans and bonus, etc. which is instituted to promote cost reduction. To the National Economy An efficient costing system benefits the economy as a whole. Some of the benefits are following i. ii. iii. iv. An efficient costing system brings prosperity to the concerned business enterprise. This results into stepping up the government revenue in form of more direct and indirect taxes. Since cost accounting promotes efficiency and optimum utilization or resources of firms, it leads to stability in their functioning. Control of costs, elimination of wastages and inefficiencies lead to the progress of the industry and in consequence of the nation as a whole. Efficiency brought about by cost accounting leads to reduced prices for the consumers. Objections against Cost Accounting Following are some objections raised against cost accounting i. ii. It is unnecessary It is often said that cost accounting is not necessary. A good number of enterprises have conducted their business without cost accounting and that too quite efficiently. It is inapplicate It is often argued that cost accounting be applied to all types of industries; costing can be applied only in manufacturing enterprises. But this is not true cost accounting has a very wide application and can be used in all types of business whether manufacturing or non manufacturing. It is a failure It is often argued that many business houses have failed inspite of having a system of cost accounting.

iii.

16

iv.

It is expensive The most powerful argument against the cost accounting is that costing system is expensive, i.e., it involves a considerable amount of expenditure to install and run since it required apportionment of costs and absorption of overheads requiring huge amount of clerical work. Problem of reconciliation of cost and financial accounts The information and results shown by cost accounts are different from that of financial accounts. It is very difficult and costly to reconcile the two types of accounts. Cost differences The principles of cost accounting keep on changing. Further, there is divergence in cost accounting procedures. Difference producers may be adopted for apportioning overheads and joint costs. Thus, the costs of production of two enterprises may differ due to different procedures adopted by them. Such different are bound to create confusion.

v. vi.

Factors to be considered before installation of a costing system The preliminary considerations governing the installation of a cost accounting system may be listed as under. i. Nature of business No Single system of cost accounting can be suitable for every type of business. Selection of proper system of costing should be made only after through study of the nature of product, stages of production, operations involved etc. Nature of product The nature of the product determines to a large extent the type of cost accounting system to be adopted. A product requiring high value of material requires and efficient system of material control. Objective The objectives and information which the management wants to achieve and acquire are also considered. If the management wants to expand its operations, the system of costing should be designed to give maximum attention to production aspect. On the other hand, if the concern has limited market for its products and it wants to increase the sales, the selling aspect would require greater attention. Informal Organisation Besides finding out the formal organization structure, the cost accountant should try to estimate the role of the informal organization. This would help him to solve various problems which may remain unsolved within the formal organization structure. Informative and simple The costing system to be introduced should be simple and informative. It should be capable of furnishing all types of information required, regularly and systematically so that continuous study and check up of the progress of business is possible. Prompt reporting The cost data should not only be accurate but should also be made available promptly and regularly so that decisions can be taken as quickly as possible. Maintenance of records Accumulation of cost information necessarily means maintenance of detailed cost records. A choice should be made between integral and non integral accounting of systems. In case of integral accounting of system, no separate set of books are maintained for costing transactions. In case of non integral costing system, separate books are maintained for cost and financial transaction and at the end of the accounting period, the results of the two sets of books are reconciled. Flexibility Cost accounting system should be flexible and capable of adapting to the changing requirements of the business.

ii. iii.

iv.

v.

vi. vii.

viii.

Elements of cost Cost is the amount of expenditure incurred on a given thing and to ascertain the cost of a given thing. According to Ryall (Dictionary of Costing), In practically all cases a cost is the sum of three groups or components the purchase or transfer price of material, the cost of the hire of labour and the value of other disbursements made or expenditure incurred in achieving the desired product or result. Thus, the total cost is the sum of materials, wages and overheads (i.e., all other expenses). Prime cost is the aggregate of Direct Materials, Direct Wages and Direct Expenses. Overhead is the aggregate of Indirect Materials, Indirect Wages and Indirect expenses. This can be divided into Factory, Administration, Selling and Distribution overheads depending on the department in which the expenses are incurred. Thus, the total cost is the sum of prime cost and all four kinds of overheads. The difference between the sales and total cost is the profit made or loss incurred, i.e., if the total cost is less than sales, difference is the profit and if the total cost is more than the sales, the difference is the loss. If both are

17

equal, it is the break even point i.e. the profit at which the profit or loss is nil. A diagram as given below shows the elements of cost described as under:

ELEMENTS OF COST

Material Cost

Labour Cost

Other Expenses

Direct Materials Cost

Indirect Materials Cost

Direct Labour Cost

Indirect Direct Labour Expenses Cost

Indirect Expenses

Overheads
Direct Materials Materials which are present in the finished product or can be identified in the product are called direct materials. For example, cloth in dress making ; materials purchased for a specific job etc. Note However in some cases a material may be direct but it is treated as indirect, because it is used in small quantities or due to Work suitable reason. Overheads Overheads Overheads any otheroverheads Direct Labour Labour which can be identified or attributed wholly to a particular job, product or process or expended in converting raw materials into finished products is called direct labour. For example, labour engaged on the actual production of the product in carrying out the necessary operations for converting the raw materials into finished product. Direct expenses It includes all expenses other than direct material or direct labour which are specially incurred for a particular product or process. Examples of direct expenses includes excise duty, royalty, surveyors fees etc.

Production or

Administration

Selling

Distribution

Indirect materials Materials which do not normally form part of the finished product are known as indirect materials These are Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.) Stores used by service departments like power house, boiler house, canteen etc.

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Indirect labour Labour costs which cannot be allocated but can be apportioned to or absorbed by cost units or cost centres is known as indirect labour. Examples of indirect labour includes charge hands and supervisors ; maintenance workers ; etc . Indirect expenses Expenses other than direct expenses are known as indirect expenses. Factory rent and rates, insurance of plant and machinery, power, light, heating, repairing, telephone etc., are some examples of indirect expenses . Overheads it is the aggregate of indirect material costs, indirect labour costs and indirect expenses. The main groups into which overheads may be subdivided are the following: (i) (ii) (iii) (iv) Production or Works overheads Administration overheads Selling overheads Distribution overheads SPECIMEN COST SHEET Cost Sheet for the period ___________ Production ________ Units Total Cost Rs. Direct Material Consumed : Opening stock Add: Purchase Less: Closing Stock Cost of drawings Direct Expenses Primary Packing materials PRIME COST Add: Works / Factory overheads : Indirect Materials Indirect Wages Factory Rent and Rates Factory Lighting and Heating Power and Fuel Repairs and Maintenance Drawing Office Expenses Research and Experiment cost Depreciation of Factory Plant Works stationery Insurance of factory Works Managers salary WORKS COST/FACTORY COST / MANUFACTURING COST Add: Office and Administrative Overheads Office Salaries Office Rent and Rates Lighting and Heating Cleaning Telephone and Postage Printing and Stationery Depreciation of office Furniture Depreciation of office Equipment Insurance Legal Expenses COST OF PRODUCTION Add: Selling and Distribution Overheads Cost per unit Rs.

19

Advertising Salesmen Salaries Samples and Free gifts Sales Office Rent Sales Promotion Expenses Packing and Demonstration Showroom Rent and Rates Commission Traveling Expenses Warehouse Rent and Rates Repair of Delivery vans Carriage freight Out wards etc. COST OF SALES -

MARGINAL COSTING AND BREAK EVEN ANALYSIS Introduction Two general approaches are used for costing products for the purpose of valuing inventories and cost of goods sold. One approach is called absorption costing. Absorption costing is generally used for external financial reports. The other approach called variable costing, is preferred by some companies for internal decision making and must be used when an income statement is prepared in the contribution format Ordinarily, absorption costing and variable costing produce different figures for net income and the difference can be quite large. Under variable costing, only those cost of production that vary with output and treated as product cost. This would generally include direct material, direct labour and the variable portion of manufacturing overhead. Fixed manufacturing overhead is treated as cost of the period and charged to the period. Variable costing is sometimes referred to as direct costing, marginal costing, differential costing, incremental costing and comparative costing. The break even profit analysis examines the behavior of total revenues, total costs and operating income as changes occur in the output level, the selling price, the variable cost per unit and/ or the fixed costs of a product. Mangers use cost volume analysis to help answer questions such as: How will total revenues and total costs be affected if the output level changes. In this way marginal costing and break even analysis guides managers planning. Marginal cost The Institute of Cost and Management Accountants, London, has defined marginal cost as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. In this context, a unit may be a single unit, a batch of articles, an order, a stage of production capacity, a process or a department. Suppose the cost of production of 1,000 units is Rs. 6,000 and that of 1,001 units is Rs. 6,004, the marginal cost is Rs. 4. Marginal cost is the variable cost comprising the cost of direct materials consumed, direct wages paid and the variable overhead incurred for producing the additional unit. The ICMA, England has defined marginal cost as the cost for producing one additional unit of product. It has also been defined as, the amount charges in the aggregate cost due to changes in the existing level of production by one unit. An analysis of these definitions reveals that the marginal cost is the cost of producing an additional unit. That means, marginal cost refer to the extra costs for the production of an additional unit. Marginal costing The institute of Cost and Works Accountants of India (ICWAI) defines marginal costing as, A method that considers only the variable cost as cost of production, leaving out period costs to be absorbed from the marginal contribution. Batty defines marginal costing as, a technique of cost accounting which pays special attention to the

20

behaviour of costs with charges in the volume of output. When compared to the definition by the ICWAI, the definition by the chartered Institute of Management Accountants (CIMA), England appears to be more comprehensive. Because, the CIMA, England defines marginal cost and effect of changes in volume or type of output on the companys profit, by segregating total costs into variable and fixed costs. Marginal costing has been defined by the Institute of Cost and Management Accountants as the ascertainment, by differentiating between fixed costs and variable costs, of marginal costs and of the effect on profit of changes in volume or type of output. Thus, marginal costing is not a system of ascertaining cost, such as process costing, job costing, operating costing etc., but a special technique which is concerned with the changes in costs resulting from changes in the volume or range of output. J.Batty has defined Marginal costing as a technique of cost accounting which pays attention to the behaviour of costs with changes in the volume of output. It is said to be superimposed upon a system of job costing or process costing. Management Accounting Practice British Airways : British Airways is a Major air line with flight operations throughout the world. A recent annual report listed the companys break even passenger load factor for each of the past five years. This factor is defined as the average percentage of seats. That must be filled for the air lines operating revenues to equal its operating costs and interest expense. The break even passenger load factor for the most recent year listed in the annual report was 64.5% Features of Marginal Costing Marginal costing technique has the following main features (1) Marginal costing is not a method of costing like process costing, job costing, operating costing etc., but a technique dealing with the effects of changes in the cost, volume, price, sales mix on the profits. (2) Under marginal costing technique, cost of production comprises of variable costs only. As such the valuation of the finished good and work-in-progress is made on the basis of variable costs. (3) Fixed costs do not form part of cost of production for the purposes of marginal costing. They are treated separately and may be charged wholly to the Profit and Loss Account for the accounting period. (4) The profitability of a product or department is ascertained in terms of Contribution or Contribution Margin. Contribution represents the difference between sales value and marginal cost of sales. The aggregate of contribution for all products is called fund. (5) For marginal costing techniques prices of the various products are fixed by the manufacturing concerns on the basis of marginal cost and marginal contribution.

STEPS INVOLVED IN MARGINAL COSTING The technique of marginal costing involves the following steps. (a) Differentiation between fixed costs and variable costs: (b) Ascertainment of marginal costs ; and (c) Ascertaining the effect on profit due to changes in volume or type of output i.e., the determination of cost-volume-profit relationship. The steps involved in marginal costing are explained below: (a) Difference Between Fixed Costs and Variable Costs Marginal costing technique involves the segregation of all costs into fixed costs and variable costs. Costs may be divided into fixed costs, variable costs and semi-fixed or semi-variable costs. Fixed cost may be defined as a cost which tends to remain unaffected in aggregate by changes in the volume of output. Fixed costs are generally referred to as period costs as they are incurred on the basis of time and do not vary directly with volume or rate of output such as rent, rates, insurance premium etc. Variable cost may be defined as a cost which tends to change in aggregate in direct proportion to changes in output. Variable costs mainly depend on output and are sometimes referred to as direct costs. Examples of variables costs are direct material cost, direct wages, direct expenses etc. Semi- variable cost or semi-fixed cost is a cost which is partly fixed and partly variable. It tends to change in aggregate with changes in volume of output but not directly in proportion to such changes. Examples of semivariable costs are repairs and maintenance, cost of supervision etc. (b) Ascertainment of Marginal Cost

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Under the marginal costing technique only variable costs are applied to products. The cost of production is the marginal cost of production and the cost of sales is the marginal cost of sales. Marginal cost refers to the aggregate of prime cost and all variable overheads. Prime cost is the aggregate of direct material cost, direct wages and direct or chargeable expenses. All variable overheads means variable overheads plus the variable portion of Semi-variable overheads. Semi-variable overheads are partly fixed and partly variable, and require segregation into fixed and variable elements. The variable portion is added to fixed overheads thus forming part of marginal cost whereas the fixed portion is added to fixed overheads and the total fixed overheads are treated as separate costs. These separate costs are related to time and hence known as period costs. The main problem to a cost accountant is to segregate the semi-variable overhead into fixed and variable elements. Segregation or separation of semi-variable overhead into fixed and variable elements can be done by adopting various methods such as Comparison method, High and Low points method, Equation method, Averages method, Graphical method or Least Square method. (c) Cost-Volume-Profit Relationship: Herman C Heiser, in his book, Budgeting Principles and practice writes that the most significant single factor in profit planning of the average business is the relationship between the volume of business, cost and profit. As the term itself suggests the cost-volume-profit analysis is the analysis of three variables, viz cost, volume and profit. It explores the relationship existing amongst costs, revenue, activity levels and the resulting profit. The cost volume profit (C.V.P) analysis is an extension of marginal costing. It makes use of the principles of marginal costing. It is an important tool of short term planning and is more relevant where the proposed changes in the level of activity are relatively small. The C.V.P. analysis is highly in taking short term decisions. In addition the analysis of the cost-volume-profit relationship provides answers to questions such as (i) What should be the minimum level of sales to avoid losses? (ii) What should be the sales level to earn desired profits? (iii) What will be the effect of changes in costs, prices and volume on profits? (iv) What will be the effect of changes in sales-mix on profits? (v) What will be the revised break-even point in case there is a change in costs, prices, volume or sales-mix? (vi) Which product is most profitable and which one is the least profitable? (vii) Should the sale of a product be discontinued? And so on. Tools or Techniques of Marginal Costing You have learnt that marginal costing requires the ascertainment of the effects of changes in volume or type of output on profits or the cost-volume-profit analysis. The assessment of cost-volume-profit analysis requires the study of the following tools : (a) Contribution (b) P/V Ratio (c) Break-even Point (d) Margin of Safety (e) Angle of Evidence (f) Break-even Charts and Profit Graph or Profit-Volume Graph The last two tools are applied for the graphical presentation of cost-volume-profit relationship. (A) Contribution Margin Concept Contribution margin is a concept that is developed for internal reporting to Management. The same basic cost and revenue data that are reported externally are used in preparing contribution reports. The cost data are merely grouped as given in the Exhibit to compute contribution margin:

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Exhibit-1 Grouping of costs for contribution margin I. A. Variable Cost Manufacturing costs (Product cost) (i). Direct Material (ii) Direct Labour (iii) Variable Factory Overhead B. Other cost (Non product costs) (i) Selling (ii) Administration (only variable portion) II. Fixed Costs. A. Manufacturing Costs (Product costs) 1. Fixed Factory overhead B. Other cost (Non Product costs) 1. Selling 2. Administration (only fixed portion)

Contribution margin is defined as revenue less variable costs. Fixed costs are then subtracted from the contribution margin to equal the net income. Contribution margin is also known as gross margin. Contribution margin concept emphasizes variable and fixed costs. It represents the amount available after sales revenue has covered all variable costs. Variable costs here include both product as well as less product costs. The contribution margin is the amount available to cover fixed costs, both product and non poroduct costs and provides net income. If variable cost of a certain product is Rs. 20,000, fixed cost Rs. 15,000 and selling price Rs. 40,000, them contribution will be Rs. 20,000. You know contribution = Selling price - Variable cost Here selling price= Rs. 40,000 and variable cost = Rs. 20,000. Therefore, contribution = Rs. 40,000 Rs. 20,000 = Rs. 20,000. Contribution can be also find out by adding fixed cost with profit of the business (ie., FC+P). Advantages of Contribution : The knowledge of contribution margin is a valuable aid to management in the decision- making process. A few advantages resulting from the knowledge of contribution margin may be summarized as follows (i) (ii) (iii) (iv) (v) (vi) (vii) It helps in the determination of the profitability of various products, processes, departments etc. Contribution helps the management in taking a decision on the proposal to introduce a new product in the market. It assists in the fixation of the selling price of the product. It helps the management in making buy or make decision. It assists in determining the break-even point. It guides the management in the selection of the profitable sales-mix or the profitable method of production. It also helps in determining whether it is worthwhile to continue a product among different products.

(B) Profit/ Volume Ratio or Contribution/ Sales Ratio Profit volume ratio expresses the relationship of contribution to sales. It is popularly known as P/V Ratio. The P/V ratio denotes the amount of contribution per rupee (or hundredth) of sales revenue. P/V ratio may be expressed as: Sales- Variable Cost P/V Ratio = Sales Or Contribution = Sales Normally the P/V Ratio is expressed is percentage. Fixed cost + Profit or Sales

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If expressed as a percentage: Contribution X 100 Sales Assuming the sales price to be Rs. 50,000 and variable cost Rs. 40,000 P/V Ratio = 50,000-40,000 P/V Ratio = 50,000 10,000 = 50,000 = 20% P/V Ratio can also be calculated as follows : Change in Contributions P/V Ratio = Change in Sales And since fixed cost is constant or common in two periods. Change in Profits P/V Ratio = Change in Sales A high P/V ratio denotes high profitability while a low P/V ratio is an indicator of low profitability. The basic property of P/V ratio is that it remains constant at various levels of sales activity since the variable costs change directly in proportion to changes in the volume of output. A change in the fixed costs does not affect the P/V ratio. The management always tries to increase the P/V ratio since by doing so the contribution margin towards meeting fixed costs and profits is increased. The P/V ratio can be increased by: (i) increasing the selling price per unit; or (ii) reducing the marginal cost per unit by new and improved methods of production; or (iii) selling more profitable products where relative contribution is larger, thereby improving the overall P/V ratio. Uses of P/V Ratio Profit Volume ratio is one of the most important ratios to be taken care of in any business. P/V ratio helps the management in making various decisions. the important ones are given below: (i) Ascertaining the relative profitability of different sections of the business such as sales area, product lines, methods of production etc. (ii) Determining the break-even point i.e., the point of no profit and no loss. (iii) Determining the amount of profit at a given volume of sales. (iv) Calculating the volume of sales required to earn a desired amount of profit. (v) Calculating the volume of sales required to maintain the present amount of profit under the conditions of change in selling price. Break-even Analysis A breakeven analysis is performed to identity the level of operation at which the entity has covered all cost but has not yet earned any profit. The breakeven point identifies the volume of activity at which total revenues equal total costs. This is often important part to management because it represents a minimum acceptable level of operations. Ofcourse, the desirability of the profit on the investment increases as profit increase, but profitable operation can only result when the level of activity exceeds the break even point. Break even analysis in units: The breakeven point is defined as the level of operations at which total revenues equal total costs. The analysis can be for an entire firm, a division, or a separate department Breakeven analysis utilize the contribution margin approach to computing net income, which splits costs into a fixed and variable. Equation for Breakeven point in Unit:X 100 X 100

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The breakeven point in unit can be computed by dividing total fixed costs (F) by the contribution margin provided by each unit. FC (or) Contribution margin per unit S-VC The contribution margin per unit is sales price per unit (S) less variable cost per unit (VC). You can understand well the concept of break even point with the help of an illustration. Look at Illustration 3, which gives you idea to calculate break-even point in units. Break even in units = Illustration-3. From the following information in relation to a manufacturing concern, calculate the break-even point in units. Output : 3,000 units Variable Cost per unit : Rs. 30 Selling Price per unit : Rs. 40 Total Fixed Cost : Rs. 15,000. Solution : Contribution per unit = Selling Price per unit Variable Cost per unit = Rs. 40- Rs. 30 = Rs. 10 Total Fixed Cost ---------------------Contribution per unit = Rs. 15,000 ------------Rs. 10 = 1,500 Units Total Fixed costs

Break even Point = (in unit)

At the sales level of 1,500 units, total contribution available will be Rs. 15,000 (1,500 Units x Rs. 10) which is equal to total fixed costs. As such at the sales level of 1,500 units, there shall neither be profit nor loss. Break even Point in Value : The break-even for a single product firm can also be determined in terms of rupee value of sales volume. For calculating the break-even point for sales, the following formulas are applied. (i) Break even Point Total Fixed cost (for sales) = -------------------------------- X Selling Price per unit Contribution per unit (ii) Break-even Point Total Fixed cost (for sales) = ------------------------------- X Total sales Total Contribution (iii) Break-even Point Total Fixed cost (for sales) = ------------------------------P/V Ratio From the Illustration 3 we can calculate the break-even point in sales volume. (i) Break-even Point Total Fixed cost (for sales) = ------------------------------- X Selling Price per unit Contribution per unit Rs. 15,000 = ----------------- X Rs.40 Rs.10 = Rs. 60,000 (ii) Break-even Point (for sales) Total Fixed cost = ------------------------------- X Total sales Total Contribution

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= Output = 3000 units. Total sales = 3,000 units X RS. 40 = Rs. 1,20,000 Total contribution = 3,000 units X Rs. 10 = Rs. 30,000 (iii) Break-even Point (for sales)

Rs. 15,000 ----------------- X Rs. 1,20,000 Rs. 30,000 Rs. 60,000

Total Fixed cost 15,000 = ------------------------------- X ------------P/V Ratio 25% = 100 15,000 x --------25 = Rs. 60,000

Note :

Contribution P/V Ratio = --------------------- X 100 Sales 30,000 = -------------- X 100 = 25% 1,20,000

Break Even Point as a percentage of Capacity : A number of business concerns are interested in ascertaining the break-down point as a percentage of estimated sales of capacity. It can be done by dividing the capacity sales by the break-even sales. For example, in illustration (2), if the firm has an estimated capacity of 5,000 units of the product, the firm breaks even at 30% of the capacity. 1,500 units Rs. 60,000 --------------- X 100 or ----------------- X 100 5,000 units Rs. 2,00,000 Direct calculation of the break-even point as a percentage of estimated capacity can be done if the total amount of contribution at estimated capacity is known, by applying the following formulae: Break-even Point Fixed Cost (as a percentage of capacity) = ------------------------------------------------------------ X 100 Total contribution (at estimated capacity) Continuing Illustration (2), where Total Fixed cost is Rs. 15,000 Total Contribution is Rs. 50,000 (at estimated capacity of 5,000 units) Break-even Point Total Fixed Cost (as a percentage of capacity) = ---------------------------- X 100 Total Contribution Rs. 15,000 = --------------------- X 100 Rs. 50,000 = 30 % Assumptions of Break-Even Analysis The break-even analysis is based on the following assumptions (i) All costs can be segregated into fixed and variable components. (ii) Total fixed costs remain constant at all levels of production. (iii) Total variable costs fluctuate directly in proportion to changes in volume of output but the variable cost per unit remains constant. (iv) Selling price per unit remains constant and does not change with changes in volume or due to other factors. (v) The firm concerned is a single-product concern or if it is a multi-product concern, there is no change in the sales-mix. (vi) The number of units produced and sold is the same so that there is no opening or closing stock. (D) Margin Of Safety (M.S.)

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(i) (ii)

Every manufacturer is interested in knowing the extent by which he is above the break-even point, which is technically known as margin of safety. Margin of safety may be defined as the excess of actual or budgeted sales over the breakeven sales. The margin of safety can be ascertained as follows Margin of Safety = Actual Sales (or Budgeted Sales) Sales at Break-even Point. Or Profit Margin of Safety = --------------P/V Ratio

The margin of safety, if expressed as a percentage of sales, will be : Actual Sales Break- even Sales Margin of Safety Ratio = --------------------------------------------------- X 100 Actual Sales Illustration 4. From the following data, calculate the P/V ratio, B.E.P., and Margin of Safety Sales Rs. 80,000 Variable Costs 40,000 Fixed Costs 24,000 64,000 --------------------------Profit 16,000 ---------------Solution (a) P/V Ratio Sales Variable Cost = ----------------------------------- X 100 Sales Rs. 80,000 Rs. 40,000 = --------------------------------- X 100 Rs. 80,000 Rs. 40,000 = ---------------- X 100 = 50% Rs. 80,000 Total Fixed cost = ------------------------------P/V Ratio Rs. 24,000 = ---------------50%

(b) ) Break-even Point (for sales)

(c)

100 = 24,000 X------- = Rs. 48,000 50 Margin of Safety = Actual Sales Sales at Break-even Point = Rs. 80,000-Rs. 48,000 = Rs. 32,000 Profit = -------------P/V Ratio Rs. 16,000 = ---------------50% 100 = 16,000 X ------ = 32,000 50 If it is desired to calculate Margin of Safety Ratio : Actual Sales- Break-even Sales Margin of Safety Ratio = ---------------------------------------------Actual Sales

Alternatively Margin of Safety

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Rs. 80,000 Rs. 48,000 = --------------------------------------- X 100 Rs. 80,000 The margin of safety shows the extent to which sales may fall before the firm suffers a loss. Larger the margin of safety, more safer is the firm. In times of depression when the demand for the firms product is falling, a high margin of safety is particularly significant. In case of a firm having a low P/V ratio, the margin of safety is low. In case both the P/V ratio and margin of safety are low, management should explore the possibilities of increasing the selling price per unit without affecting sales volume adversely or by reducing the variable cost per unit by employing new improved methods of production.

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