MANAGEMENT ACCOUNTING

B.COM 3.5 B.B.A 3.3

LESSON 1 INTRODUCTION
The term Management Accounting is of recent origin. It was first coined by the British Team of Accountants that visited the U.S.A. under the sponsorship of Anglo-American Productivity Council in 195 with a view of highlighting utility of Accounting as an effective management tool. It is used to describe the modern concept of accounts as a tool of management in contrast to the conventional periodical accounts prepared mainly for information of proprietors. The object is to expand the financial and statistical information so as to throw light on all phases of the activities of the organisation.

All techniques which aim at appropriate control, such as financial control, budgeted control, efficiency in operations through standard costing, cost-volume-profit theory etc, are combined and brought within the purview of Management Accounting.

Management Accounting evolves a scheme of accounting which lays emphasis on the planning of future (logical forecasting), simultaneously finding the deviations between the actual and standards. Another significant feature of Management Accounting is reporting to top-management. Finally, accounting information should be presented in such a way as to assist the management in the formulation of policy and in the day-today conduct of business. For example, the published accounts of business concerns do not furnish management with information in a form that suggest the line on which management policies and actions should proceed. It requires further analysis classification and interpretation before the management can draw lessons from them for their guidance and action.

DEFINITION OF MANAGEMENT ACCOUNTING

Management Accounting may be defined as the presentation of accounting information in such a way as to assist the management in the creation of the policy and day-to-day operation of an undertaking Management Accounting of the Anglo-American to productivity.

The Institute of Chartered Accountants of England has defined it

Any form of accounting which enables a business to be conducted more efficiently can be regarded as Management Accounting.

Robert N. Anthony has defined Management Accounting as follows-

Management Accounting is concerned with accounting information that is useful to management.

According to American Accounting Association, Management Accounting includes the methods and concepts necessary for effective planning for, choosing among alternative business actions and for control through the evaluation and interpretation of performance. This definition is fairly illustrative.

According to Kohler, Forward Accounting includes Standard costs, budgeted costs and revenues, estimates of cash requirements, break even charts and projected financial statements and the various studies required for their estimation, also the internal controls regulating and safeguarding future operating.

Blending together into a coherent whole financial accounting, cost accounting and all aspects of financial management. He has used this term to include the accounting methods, systems and techniques which, coupled with special knowledge and ability, assist manageme4nt in its task of maximizing profits or minimizing losses. James Batty.

Thus all accounting which directly or indirectly providing effective tools to managers in enterprises and government organizations lead to increase in productivity is Management Accounting.

OBJECTIVES OF MANAGEMENT ACCOUNTING:

The basic objective of Management Accounting is to assist the management in carrying out its duties efficiently.

The objectives of Management Accounting are:

1. The compilation of plans and budgets covering all aspects of the business e.g., production, selling, distribution research and finance. 2. The systematic allocation of responsibilities for implementation of plans and budgets. 3. The organization for providing opportunities and facilities for performing responsibilities. 4. The analysis of all transactions, financial and physical, to enable effective comparisons to be made between the forecasts made and actual performance. 5. The presentations to management, at frequent intervals, of up-to-date information in the form of operating statements. 6. The statistical interpretation of such statements in a manner which will be of utmost assistance to management in planning future policy and operation.

To achieve the above objectives, Management Accounting employs three principles devices, viz.,-

1. Forward Looking Principle basis on the past and all other available data, forecasting the future and recommending wherever appropriate, the course of action for the future. 2. Target Setting Principle fixation of an optimum target which is variously known as standard, budget etc., and through continuous review ensuring that the target is achieved or exceeded. 3. The Principle of Exception instead of concentrating on voluminous masses of data, Management Accounting concentrates on deviations from targets (which are usually known as variances) and continuous and prompt analysis of the causes of these deviations on which to base management action.

SCOPE OF MANAGEMENT ACCOUNTING:

The scope of Management Accounting is wide and broad based. It encompasses within its fold a searching analysis and branches of business operations. However, the following facets of Management Accounting indicate the scope of the subject.

1. Financial Accounting. 2. Cost Accounting 3. Budgeting & Forecasting 4. Cost Control Procedure 5. Statistical Methods 6. Legal Provisions 7. Organisation & Methods

1. Financial Accounting: This includes recording of external transactions covering receipts and payments of cash, recording of inventory and sales and recognition of liabilities and setting up of receivables. It also preparation of regular financial statements. Without a properly designed accounting system, management cannot obtain full control and co-ordination. 2. Cost Accounting : It acts as a supplement to financial accounting. It is concerned with the application of cost to job, product, process and operation. It plays an important role in assisting the management in the creation of policy and the operation of undertaking. 3. Budgeting & Forecasting: These are concerned with the preparation of fixed and flexible budgets, cash forecast, profit and loss forecasts etc., in cooperation with operating and other departments. Management is helped by them. 4. Cost Control Procedure: It is concerned with the establishment and operation of internal report in order to convert the budget in to operating service. Management is helped by them by measuring actual results budgetary standards of performance. 5. Statistical Methods : These are concerned with generating statistical and analytical information in the form of graphs charts etc. of all department of the organization. Management need not waste time in understanding the facts and more time and energy can be utilized in sound plans and conclusions. 6. Legal Provisions: Many management decisions depend upon the provisions of various laws and statutory requirements. For example, the decision to make a fresh issue of shares depends upon the permission of controller of capital issues. Similarly, the form of published accounts, the external audit the

authority to float loans, the computation and verification of income, filing tax returns, making tax payments for excise, sales, payroll income etc., all depend on various rules and regulations passes from time to time. 7. Organization & Methods: They deal with organization, reducing the cost and improving the efficiency of accounting as also of office operations, including the preparation and issuance of accounting and other manuals, where these will prove useful.

It is clear that Management Accounting has a vital relation with all those areas explained above.

FUNCTIONS OF MANAGEMENT ACCOUNTING: The functions of management accounting may be said to include all activities connected with collecting, processing, interpreting and presenting information to management. The Management Accounting satisfies the various needs of management for arriving at appropriate business decisions. They may be described as follows:

1. Modification of Data: Accounting data required for decision making purposes is supplied by management accounting through resort to a process of classification and combination which enables to retrain similarities of details without eliminating the dissimilarities (e.g.) combination of purchases for different months and their breakup according to class of product, type of suppliers, days of purchase, territories etc. 2. Analysis & Interpretation of Data: The data becomes more meaningful with the analysis and interpretation. For example, when Profit and Loss account and Balance Sheet data are analyzed by means of comparative statements, ratios and percentages, cash-flow-statements, it will open up new directions for its use by management. 3. Facilitating Management Control Management Accounting enables all accounting efforts to be directed towards control of destiny of an enterprise. The essential features in any system of control are the standards for performance and measure of deviation therefrom. This is made possible

through budgetary control and standards costing which are an integral part of Management Accounting. 4. Formulation of Business Budgets: One of the primary functions of management is planning. It is done by Management Accounting through the process of budgeting. It involves the setting up of objectives, and the selection of the most appropriate strategies by comparing them with reference to some discriminating criteria. Probability, Probability, forecasting, and trends are some of the techniques used for this purpose. 5. Use of Qualitative Information: Management Accounting draws upon sources, other than accounting, for such information as is not capable of being readily convertible into monetary terms. Statistical compilations, engineering records and minutes of meeting are a few such sources of information. 6. Satisfaction of Informational Needs of Levels of Management: It serves management as a whole according to its requirements it serves top middle and lower level managerial needs to subserve their respective needs. For instance it has a system of processing accounting data in a way that yields concise information covering the entire field of business activities at relatively long intervals for the top management, technical data for specialized personnel regularly and detailed figures relating to a particular sphere of activity at short intervals for those at lower rungs of organizational ladder. The gist of Management Accounting can be expressed thus, it is a part of over all managerial activity not something grafted on to it from outside guiding and servicing management as a body, to derive the best return form its resources, both the itself and for the super system within which it functions. From the above discussions, one may come to the following conclusions about the fundamental approach in Management Accounting. Firstly, the Management Accounting functions is a managerial activity and it puts its finger in very pie without itself making them it guides and aids setting of objectives, planning coordinating, controlling etc. But it does not itself perform these functions.

Secondly it serves management as a whole top middle and lower level according to its requirements. But in doing so it never fails in keeping in focus the macro-approach to the business as a whole. Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach is to split all costs and benefits into two groups measurable and non measurable. It is easy to deal with measurable costs which are expressed in terms of money. But there are several ventures such as office canteens where the cost-benefits may not be monetarily measurable. LIMITATIONS OF MANAGEMENT ACCOUNTING Comparatively, Management Accounting is a new discipline and is still very much in a state of evolution. There fore it comes across the same impediments as a relatively new discipline has to face-sharpening of analytical tools and improvement of techniques creating uncertainty about their applications. 1. There is always a temptation to make an easy course of arriving at decision to intuition rather than taking the difficulty of scientific decision-making. 2. It derives its information from financial accounting, cost accounting and other records. Therefore, strength and weakness of Management Accounting depends upon the strength and weakness of basic records. 3. It is one thing to record, interpret and evaluate an objectives historical event converted into money figures, while it is something quite different to perform the same function in respect of post possibilities, future opportunities and unquantifiable situation. Execution of the conclusions drawn by the management accountant will not occur automatically. Therefore, a continuous effort to achieve the goal must be made at all levels of management. 4. Management Accounting will not replace the management and administration. It is only a toll of management. Of course, it will save the management from being immersed in accounting routine and process the data and put before the management the facts deviating from the standard in order to enable the management to take decisions by the rule of exception.

LESSON 2
FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING
The terms financial accounting, and management accounting, are not prices description of the activities they comprise. All accounting is financial in the sense that all accounting systems are in monetary terms and management, of course, is responsible for the content of financial accounting reports. Despite this close interrelation, there are some fundamental differences between the two and they are: 1. Subject Matter : Managements need to focus attention on internal details is the origin of the basic differences between financial accounting and management accounting. In financial accounting, the enterprise as a whole is dealt with while, in management accounting, attention is directed towards various parts of the enterprise which is regarded mainly as a combination of these segments. Thus financial statements, like balance-sheets and income statements, report on the overall status and performance of the enterprise but most management accounting reports are concerned with departments products, type of inventories, sales or other sub-division of business entity. 2. Nature Financial accounting is concerned almost exclusively with historical records whereas management accounting is concerned with the future plans and policies. Managements interest in the past is only to the extent that it will be of assistance in influencing companys future. The historical nature of financial accounting can be easily understood in the context of the purposes for which it was designed but management accounting does not end with the analysis of what has happened in the past and extends to the provision of information for use in improving results in future. 3. Dispatch In Management Accounting, there is more emphasis on furnishing information quickly then is the case with financial accounting. This is so because up-to-date information is absolutely essential as a basis for management action and management accounting would lose much of its utility if information required the time lag between the end of accounting period and the preparation of accounting records for the same, it has not been, and cannot be, totally eliminated. 4. Characteristics Financial accounting places great stress on those qualities in information which can command universal confidence, like objectivity, validity absoluteness, etc. whereas management accounting emphasizes those characteristics which enhance the value of information in a variety of uses, like flexibility, comparability etc. This difference is so important that a serious doubt has been raised as to whether both the types of characteristics can be preserved within the same framework.

5. Type of Data Used Financial accounting makes use of data which is historical quantitative, monetary and objective, on the other hand management accounting used data which is descriptive, statistical subjective and relates to future. Therefore management accounting is not restricted, as financial accounting is, to the presentation of data that can be certified by independent auditors. 6. Precision There is less emphasis in precision in management accounting because approximations are often as useful as figures worked out accurately. 7. Outside Dictates As financial accounting ahs been assigned the role of a reference safeguarding the interests of different parties connected with the operation of a modern business undertaking, outside agencies have laid down standards for ensuring the integrity of information processed and presented in financial accounting statements. Consequently, financial accounting statements are standardized and are meant for external use. So, far as management accounting is concerned, there is no need for clamping down such standards for the preparation and presentation of accounting statements as management is both the initiator and user of data. Naturally, therefore, management accounting can be smoothly adapted to the changing needs of management. 8. Element of compulsion These days, for every business, financial accounting has become more or less compulsory indirectly if not directly, due to a number of factors but a business is free to install, or not to install, a system of management accounting.

LESSON 3 FUNCTIONS OF FINANCIAL CONTROLLER

The gradual growth of management accounting has brought with it a recognition of the desirability of segregating the accounting function from other activities of a secretarial and financial nature in order to make possible a more accurate accounting control over multifarious, complex and sprawling business operations. As a natural corollary, controller has come into being by way of a skilled business analyst who, due to his training and experience, is the best qualified to keep the financial records of the business and to interpret these for the guidance of the management. It is not surprising, therefore, that controllership function has developed pari passu with the development of management accounting so much so that there is a tendency to record the two as synonymous. In a way, this is true because of controller in the United States does all that management accounting is expected to accomplish, in fact, controller is the pivot round which system of management accounting revolves. Generally speaking, controllership function embraces within its broad sweep and wide curves, all accounting functions including advice to management on course of action to be taken in a given set of circumstances with the object of completely eliminating the role of intuition in business affairs. Concept: There is no precise concept of controllership as it is still in an evolutionary state. Even if the concept was possible of being described, it cannot be said that, wherever a controller is in existence, he exercises all the functions that a theoretical controller is expected to do because the real meaning of the term is dependent upon the agreement between him and the undertaking the seeks to serve. However, the controllers Institute of America has drafted a seven-point concept of modern controllership. The hallmarks of the concept are: i. To establish, coordinate and administer, as an integral part of management, an adequate plan for the control of operations. Such a plan would provide, to the extent required in the business, for profit planning, programs for capital investing and financing, sales forecast, expense budgets and cost standards, together with the necessary procedure to effectuate the plan. To compare performance with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of business. This function includes the formulation and administration

ii.

of accounting policy and the compilation of statistical records and special reports as required. iii. To consult with all segments of management responsible for policy or action concerning any phase of the operations of business as it relates to the attainment of objectives and the effectiveness of policies, organization structure and procedures. To administer tax policies and procedures. To supervise and coordinate the preparation of reports to governmental agencies. To assure fiscal protection to the assets of the business through adequate internal control and proper insurance coverage. To continuously appraise economic and social forces and government influences and interpret their effect on business.

iv. v. vi. vii.

The controllers Institute, as well as the National Industrial conference Board of the United States, have spelt out the functions of the controller in still greater detail but the seven-point concept of modern controllership is board enough to leave no phase of policy or organization beyond the controllers jurisdiction. Through the concept has been laid down mainly from the functional point of view, it lifts the notion of controllership from pedestrian paper-shuffling to a top-management attitude that aids decision making, it broadens controllers outlook and provides him with specific goals. Status of Controller: There is no fixed place for the controller in the hierarchy of management. It is sometimes said that the status of controller is not ensured simply by virtue of his holding the office but depends, in no small measure, upon hi personality, mental equipment, industrial background and his capacity to convince others of his ability as well as integrity. Moreover, it would depend upon the terms of his appointment and, therefore, it is bound to vary with every individual undertaking. The terms of appointment may be fixed by the Board of Directors or may be included in the Articles of Association of the Company. As a matter of general principle, all accounting functions, even though remotely connected with finance, are included in the responsibilities of the controller. As the chief accounting authority, the controller normally has his place in the top-level management along with the Treasurer who looks after bank accounts and the safe custody of liquid assets. Usually, the elevation of Controller to the post of Vice-President Finance in taken for granted and is considered only a routine matter.

Modern Controller does not do any controlling, as is commonly understood, in terms of line authority over other departments, his decision regarding the best accounting procedures to be followed by line people are transmitted to the Chief Executive who communicates them by a manual of instructions coming down through line chain of command to all people affected by the procedures. Limitation: It is also necessary that the limitation of Controllers role imposed by the very nature of his work, must be borne in mind. Though the Controller helps in bringing together all phases of management, he does not pretend to solve the problems of production of marketing, he knows their nature and so can discuss in detail with all levels of management the financial implications of solutions they suggest.

LESSON 4
FINANCIAL STATEMENTS: According to the American Institute of Certified Public Accountants, Financial statements reflect a combination of recorded facts accounting conventions and personal judgements and the judgements and conventions applied affect them materially. This statement makes clear that the accounting information as depicted by the financial statements are influenced by three factors viz. recorded facts, accounting conventions and personal judgements. OBJECTIVES OF FINANCIAL STATEMENTS: 1. To provide reliable information about economic resources and obligations of a business and other needed information about changes in such resources or obligations. 2. To provide reliable information about changes in net resource [resources less obligations] arising out of business activities and financial information that assits in estimating the earning potentials of business. 3. To disclose to the extent possible, other information related to the financial statements that is relevant to the needs of the users of these statements. USES AND USERS OF FINANCIAL STATEMENTS: Different classes of people are interested in the financial statement analysis with a view to assessing the economic and financial position of any business or industrial concern in terms of profitability, liquidity or solvency. Such persons and bodies include: 1. Shareholders 2. Debenture-holders 3. Creditors 4. Financial institutions and commercial banks 5. Prospective investors 6. Employees and trade unions 7. Tax authorities 8. Govt. departments 9. The company law board 10. Economists and investment analysis, etc.

IMPORTANCE OF FINANCIAL STATEMENTS IMPORTANCE TO MANAGEMENT: Financial statements help the management to understand the position, progress and prospects of business results. By providing the management with the causes of business results, they enable them to formulate appropriate policies and courses of actions for the future. The management communicate only through these financial statements their performance to various parties and justify their activities and thereby their existence. IMPORTANCE TO THE SHAREHOLDERS These statements enable the shareholders to know about the efficiency and effectiveness of the management and also the earning capacity and the financial strength of the company. IMPORTANCE TO LENDERS/CREDITORS: The financial statements serve as a useful guide for the present suppliers and probable lenders of a company. It is through a critical examination of the financial statements that these groups can come to know about the liquidity profitability and long-term solvency position of a company. This would help them to decide about their future course of action. IMPORTANCE TO LABOUR: Workers are entitled to bonus depending upon the size of profit as disclosed by audited profit and loss account. Thus, P & L a/c becomes greatly important to the workers in wage negotiations also the size of profits and profitability achieved are greatly relevant. IMPORTANCE TO PUBLIC: Business is a social entity. Various groups of the society, though not directly connected with business, are interested in knowing the position, progress and prospects of a business enterprise. They are financial analysts, lawyers, trade associations, trade unions, financial press research scholars, and teachers, etc. Importance of National Economy: The rise & growth of the corporate sector, to a great extent, influences the economic progress of a country. Unscrupulous & fraudulent corporate managements shatters the confidence of the general public in joint stock companies which is essential for economic progress & retard economic growth of the country. Financial Statements come to rescue of general public by providing information

by which they can examine & asses the real worth of the company & avoid being cheated by unscrupulous persons. Limitations of Financial Statements: 1. It shows only historical cost. 2. It does not take into account the price level changes. 3. It considers only monetary aspects but does not consider some vital nonmonetary factors. 4. It is based on convention and judgement. Hence there is no accuracy. 5. Comparison of Financial Statements depends upon the uniformity of Accounting policies. 6. It is subject to window dressing.

LESSON 5
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
Financial Statement are indicators of the two significant factors: (i) Profitability, and (ii) Financial soundness Analysis and interpretation of financial statements, therefore, refer to such a treatment of the information contained in the income statement and the Balance Sheet so as to afford full diagnosis of the profitability and financial soundless of the business. TYPES OF FINANCIAL ANALYSIS Financial Analysis can be classified into different categories depending upon (i) The materials used and (ii) The modus operandi of analysis ON THE BASIS OF MATERIAL USED: According to this basis financial analysis can be of two types. (i) External Analysis: This analysis is done by those who are outsiders for the business. The term outsiders includes investors, credit agencies, government and other creditors who have no access to the internal records of the company. (ii) Internal Analysis: This analysis is done by persons who have access to the books of account and other information related to the business. On the basis of modus operandi. According to this, financial analysis can also be two types. (i) Horizontal analysis: In case of this type of analysis, financial statements for a number of years are reviewed and analyzed. The current years figures are compared with the standard or base year. The analysis statement usually contains figures for two or more years and the changes are shown recording each item from the base year usually in the from of percentage. Such an analysis gives the management considerable insight into levels and areas of strength and weakness. Since this type of analysis is

based on the data from year to year rather than on the date, it is also termed as Dynamic Analysis.

(ii) Vertical analysis: In case of this type of analysis a study is made of the quantitative relationship of the various terms in the financial statements on a particular date. For example, the ratios of different items of costs for a particular period may be calculated with the sales for that period such an analysis is useful in comparing the performance of several companies in the same group, or divisions or departments in the same company. TECHNIQUES OF FINANCIAL ANALYSIS A financial analyst can adopt one or more of the following techniques/tools of financial analysis. 1. Comparative Financial Statements: Comparative financial statements are those statements which have been designed in a way so as to provide time perspective to the consideration of various elements of financial position embodied in such statements. In these statements figures for two or more periods are placed side by side to facilitate comparison. Both the income statement and Balance Sheet can be prepared in the form of Comparative Financial Statements. Comparative Income Statement: The Income statement discloses net profit or Net Loss on account of operations. A comparative Income Statement will show the absolute figures for two or more periods, the absolute change from one period to another and if desired the change in terms of percentages. Since, the figures for two or more period are shown side by side, the reader can quickly ascertain whether sales have increased or decreased, whether cost of sales has increased or decreased etc. Thus, only a reading of data included in Comparative Income Statements will be helpful in deriving meaningful conclusions. Comparative Balance Sheet: Comparative Balance Sheet as on two or more different dates can be used for comparing assets and liabilities and finding out any increase or decrease in those items. Thus, while in a single Balance Sheet the emphasis is on persent position, it is on change in the comparative Balance Sheet. Such a Balance sheet is very useful in studying the trends in an enterprise.

The preparation of comparative financial statements can be well understood with the help of the following illustration. ILLUSTRATION : From the following Profit and Loss Accounts and the Balance Sheet of Swadeshi polytex Ltd. For the year ended 31st December, 1987 and 1988, you are required to prepare a comparative Income Statement and Comparative Balance Sheet. PROFIT AND LOSS ACCOUNT (In Lakhs of Rs.) Particular To Cost of Goods sold To operating Expenses Administrative Expenses Selling Expenses To Net Profit 20 30 150 800 20 40 190 1,000 800 1,000 1987 Rs. 600 1988 Rs. 750 By Net Sales *Assets 1987 Rs. 800 1988 Rs. 1,000

BALANCE SHEET AS ON 31ST DECEMBER (In Lakhs of Rs.) Liabilities Bills Payable Sundry Creditors Tax Payable 6% Debentures 6% Preference Capital Equity Capital Reserves 1987 Rs. 50 150 100 100 300 1988 Rs. 75 200 150 150 300 Cash Debtors Stock Land Building Assets 1987 Rs. 100 200 200 100 300 1988 Rs. 140 300 300 100 270

400 200 1300

400 245 1520

Plant Furniture

300 100 1300

270 140 1520

SOLUTION: Swadeshi Polytex Limited COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED 31ST DECEMBER AND 1988 (In Lakhs of Rs.) Absolute increase or decrease in 1988 1987 Net Sales Cost of Goods Sold Gross Profit Operating Expenses Administration Expenses Selling Expenses Total Operating Expenses 800 600 200 20 1988 1000 750 350 20 +200 +150 +50 +25 +25 +25 Percentage increase or decrease in 1988

30 50

40 60 190

+10 10 +40

+33.33 +20 +26.67

Operating Profit 150

Swadeshi Polytex Limited COMPARATIVE BALANCE SHEET AS ON 31ST DECEMBER, 1987, 1988 Figures in lakhs of rupees Assets 1987 1988 Absolute increase or decrease during 1988 Percentage increase (+) or decrease (-) during 1988 +40 +50 +50 +50 -10% -10% +40% -2.5% +17%

Current Assets: Cash Debtors Stock Total Current Assets Fixed Assets: Land Building Plant Furniture Total Fixed Assets Total Assets Liabilities & Capital: Current Liabilities Bills Payable Sundry Creditors Tax Payable Total Current Liabilities Long-term Liabilities : 6% Debentures Total Liabilities 400 575 +175 +43.75% 50 150 100 300 100 75 200 150 425 150 +25 +50 +50 +125 +50 +50% +33.33% +50% +41.66% +50% 100 300 300 100 800 1300 100 270 270 140 780 1520 -30 -30 +40 -20 220 100 200 200 500 140 300 300 740 40 100 100 240

Capital & Reserves 6% Pre. Capital Equity Capital Reserves Total Shareholders Funds Total Liabilities and Capital 1300 1520 220 17% 300 400 200 900 300 400 245 945 45 45 22.5 5%

2. Common size Financial Statements: Common size Financial Statements are those in which figures reported are converted into percentages to some common base. In the Income Statement that sale figure is assumed to be 100 and all figures are expressed as a percentage of this total. Illustration: Prepare a Common size Income Statement & Common-size Balance Sheet of Swadeshi Polytex Ltd., for the years ended 31st December, 1987 & 1988 SOLUTION: Swadeshi Polytex Limited COMMON SIZE INCOME STATEMENT FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988 (Figures in Percentage) 1987 Net Sales Cost of Goods Sold Gross Profit Opening Expenses: Administration Expenses Selling Expenses Total Operating Expenses Operating Profit 2.50 3.75 6.25 18.75 2 4 6 19 100 75 25 1988 100 75 25

Interpretation: The above statement shows that though in absolute terms, the cost of goods sold has gone up, the percentage of its cost to sales remains constant at 75%,

this is the reason why the Gross Profit continues at 25% of sales. Similarly, in absolute terms the amount of administration expenses remains the same but as a percentage to sales it has come down by 5%. Selling expenses have increased by 25%. This all leads to net increase in net profit by 25% (i.e., from 18.75% to 19%)

3. Trend Percentage: Trend Percentages are immensely helpful in making a comparative study of the Financial statements for several 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. Any year may be taken as base year. It is usually the earliest year. Any intervening year may also be taken as the base year. Each item of base year is taken as 100 and on that basis the percentages for each of the years are calculated. These percentages can also be taken as Index Numbers showing relative changes in the financial data resulting with the passage of time. The method of trend percentages is useful analytical device for the management since by substitution percentages for large amounts, the brevity and readability are achieved. However, trend percentages are not calculated for all of the items in the financial statements. They are usually calculated only for major items since the purpose is to highlight important changes. Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are the other tools of Financial Analysis which have been discussed in detail as separate chapters.

LESSON 6 RATIO ANALYSIS

Meaning and Nature of ratio analysis The term ratio simply means one number expressed in terms of another. It describes in mathematical terms the quantitative relationship that exists between two numbers, the terms accounting ratio. J. Batty points out, is used to describe significant relationships between figures shown on a Balance Sheet, in a Profit and Loss Account, in a Budgetary control System or in any other Part of the accounting organisation. Ratio Analysis, simply defined, refers to the analysis and interpretation of financial statements through ratios. Nowadays it is used by all business and industrial concerns in their financial analysis. Ratio are considered to be the best guides for the efficient execution of basic managerial functions like planning, forecasting, control etc. Ratios are designed to show how one number is related to another. It is worked out by dividing one number by another. Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion. For example, the current Assets and current Liabilities of a business on a particular date are Rs. 2.5 Lakhs and Rs. 1.25 lakhs respectively. The resulting ratio of current Assets and current Liabilities could be expressed as (i.e. Rs. 2,00,000/1,25,000) or as 200 per cent. Alternatively in the form of a proportion the same ratio may be expressed as 2:1, i.e. the current assets are two times the current liabilities. Ratios are invaluable aids to management and others who are interested in the analysis and interpretation of financial statements. Absolute figures may be misleading unless compared, one with another. Ratios provide the means of showing the relationship which exists between figures. Though there is no special magic in ratio analysis, many prefer to base conclusions on ratios as they find them highly useful for making judgments more easily. However, the numerical relationships of the kind expressed by ratio analysis are not an end in themselves, but are a means for understanding the financial position of a business. Generally, simple ratios or ratios compiled from a single year financial statements of a business concern may not serve the real purpose. Hence, ratios are to be worked out from the financial statements of a number of years. Ratios, by themselves, are meaningless. They derive their status partly from the ingenuity and experience of the analyst who uses the available data in a systematic manner. Besides, in order to reach valid conclusions, ratios have to be compared with some standards that are established with a view to represent the financial position of the business under review. However, it should be borne in mind that after computing the ratios one cannot categorically say whether a particular ratio is god or bad as the

conclusions may vary from business to business. A single ideal ratio cannot be applied for all types of business. Speedy compiling of ratios and their presentations in the appropriate manner are essential. A complete record of ratios employed in advisable and explanation of each, and actual ratios year by year should be included. This record may be treated as a part of an Accounts Manual or a special Ratio Register may be maintained. CLASSIFICATION OF RATIOS: Ratios can be classified into different categories depending upon the basis of classification. The traditional classification has been on the basis of the financial statement to which the determinants of a ratio belong. On this basis of ratios could be classified as: 1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of the items of the Profit and Loss account only e.g. Gross Profit ratio, stock turnover ratio, etc. 2. Balance sheet ratios, i.e., ratio calculated on the basis of figures of Balance sheet only, e.g., current ratio, debt-equity etc. 3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profit and loss account as well as the balance sheet, e.g. fixed assets turnover ratio, overall profitability ratio etc. However, the above basis of classification has been found to be guide and unsuitable because analysis of Balance sheet and Balance sheet and income statement can not be done in insalaion. The have to be studied together in order to determine the profitability and solvency of the business. In order that ratios serve as a toll for financial analysis, they are now classified as: (1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financial ratios, (a) Liquidity Ratios (b) Stability Ratios.

LESSON 7
PROFITABILITY RATIOS: Profitability is an indication of the efficiency with which the operations of the business are carried on. Poor operational performance may indicate poor sales and hence poor profits. A lower profitability may arise due to the lack of control over the expenses. Bankers, financial institutions and other creditors look at the profitability ratios indicator whether or not the firm earns substantially more than it pays interest for the use of borrowed funds and whether the ultimate repayment of their debt appears reasonably certain. Owners are interested to know the profitability as it indicates the return which they can on their investments. The following are the important profitability ratios: 1. OVERALL PROFITABILITY RATIOS: It is also called Return on investment (ROI) or Return On Capital Employed (ROCE) it indicates the percentage of return on the total capital employed in the business. It is calculated on the basis of the following formula. Operation Profit x 100 ------------------------------Capital employed The term capital employed has been given different meanings by different accountants. Some of the popular meanings are as follows: i) ii) iii) Sum-total of all assets whether fixed or current Sum-total of fixed assets Sum-total of long-term funds employed in the business, i.e.,

Share capital + Reserves & Surplus + Long Term loans + Non business assets + Fictitious assets. In Management accounting, the term capital employed is generally used in the meaning given in the third point above. The term Operating profit means Profit before Interest & Tax. The term Interested means Interested on long term borrowing. Interest on short term borrowings will be deducted for computing operating profit. Non-term borrowing will be deducted for computing operating profit. Non-trading incomes such as interested on Government

securities or non-trading losses or expenses such as loss on account of fire, etc., will also be excluded. 2. Return on Shareholders Funds: In case it is desired to work out the profitability of the company from the shareholders point of view, it should be computed as follows: Net Profit after interest & tax ---------------------------------------- x 100 Shareholders Funds The term Net Profit here means Net Incomes after Interest & Tax It is different from the Net Operating Profit Which is used for computing the Return on Total Capital Employed in the business. This because the shareholders are interested in Total Income after Tax including Net Non-operating Income (i.e., Non-operating Income Non-operating Expenses) 3. Fixed dividend Cover: This ratio is important for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders. The ratio is calculated as follows: Net Profit after Interest & tax Fixed dividend cover = ------------------------------------------------Preference dividend 4. Debt service coverage ratio: The interest coverage ratio, as explained above, does not tell us anything about the ability of a company to make payment of principle amounts also on time. For this purpose debt service coverage ratio is calculated as follows: Net Profit before interest & tax Debt service coverage ratio = --------------------------------------------------Principal Payment Instalment Interest + ----------------------------------------1 (Tax rate) The principle payment instalment is adjusted for tax effects since such payment is not deductible from net profit for tax purposes.

Net Profit Before Interest & Tax 5. Interest Coverage Ratio = ------------------------------------------------------Interest Charges Gross Profit 6. Gross Profit Ratio = ------------------------------------------------- x 100 Net Sales Net Profit 7. Net Profit Ratio = ------------------------------------------------ x 100 Net Sales Operating Profit Operating Profit Ratio = -------------------------------------------- x 100 Net Sales Operating Profit = Net Profit + Non-Operating expenses Non operating income Operating Cost 9. Operating Ratio = --------------------------------- x 100 Net Sales Amount available to Equity Shareholders 10. Earnings Per Share (EPS) = -----------------------------------------------------------Number of Equity Shares Market Price per Share 11. Price Earnings (P/E) Ratio = ------------------------------------------Earning Per Share

LESSON 8
1. Fixed assets turnover ratio : This ratio indicates the extent to which the investments in fixed assets contribute towards sales. If compares with a previous period, it indicates whether the investment in fixed assets has been judicious or not. The ratio is calculated as follows: Net Sales --------------------------------Fixed Assets (NET) 2. Working Capital Turnover Ratio: This is also known as Working Capital Leverage Ratio. This ratio indicates whether or net working capital has been utilized in making sales. In case a company can achieve higher volume of sales with relatively small amount of working capital, it is an indication of the operating efficiency of the company. The ratio is calculated as follows. Net Sales ---------------------------------Working Capital

Working capital turnover ratio may take different forms for different purposes. Some of them are being explained below: (i) Debtors turnover ratio (Debtors, Velocity): Debtors constitute an important constituent of current assets and therefore the quality of debtors to a great extent determines a firms liquidity. Two ratios are used by financial analysis to judge the liquidity of a firm. They are (i) Debtors turnover ratio, and (ii) Debt collection period ratio. The Debtors turnover ratio is calculated as under: Credit sales --------------------------------------------Average accounts receivable The term Accounts Receivable include Trade Debtors and Bill Receivable.

In case details regarding and closing receivable and credit sales are not available the ratio may be calculated as follows: Total Sales --------------------------------------------Accounts Receivable Significance: Sales to Accounts Receivable Ratio indicates the efficiency of the staff entrusted with collection of book debts. The higher the ratio, the better it is, Since it Would indicate that debts are being collected more promptly. For measuring the efficiency, it is necessary to set up a standard figure, a ratio lower then the standard will indicate inefficiency. The ratio helps in Cash Budgeting, since the flow of cash form customers can be worked out on the basis of sales. (ii) Debt collection Period ratio: The ratio indicates the extent to which the debts have been collected in time. It gives the average debt collection period. The ratio is very helpful to the lenders because it explains to them whether their borrowers are collecting money within a reasonable time. An increase in the period will result in greater blockage of funds in debtors. The ratio may be calculated by any of the following methods. Months (or days) in a year ---------------------------------------------------Debtors turnover Average Accounts Receivable x Months (or days) in a year (b) -------------------------------------------------------------------------------------Credit sales for the year Accounts receivable (c) ------------------------------------------------------------------Average monthly or daily credit sales In fact, the two ratios are interrelated Debtors turnover ratio can be obtained by dividing the months (or days)

(a)

In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the number of months (or days) in a year are divided by the debtors turnover, average debt collection period is obtained (i.e., 12/6 2 months) Significance: Debtors collection period measures the quality of debtors since it measures the rapidity or slowness with which money is collected from them. A short collection period implied prompt payment by debtors. It reduces the chances of bad debts. A longer collection period implies too liberal and inefficient credit collection performance. However, in order to measure a firms credit and collection efficiency its average collection period should be compared with the average of the industry. It should be neither too liberal nor too restrictive. A restrictive policy will result in lower sales which will reduce profits. It is difficult to provide a standard collection period of debtors. It depends upon the nature of the industry, seasonable character of the business and credit policies of the firm. In general, the amount of receivables should not exceed a 3-4 months credit sales. (iii) Creditors turnover ratio (Creditors velocity): It is similar to debtors Turnover Ratio. It indicates the speed with which the payment for credit purchases are made to the creditors. The ratio can be computed as follows: Credit Purchases ------------------------------------------Average accounts payable The term Accounts payable include Trade Creditors and Bills payable In case the details regarding credit purchases, opening closing accounts payable have not been given, the ratio may be calculated as follows: Total Purchases ---------------------------------Account Payable (iv) Debt payment period enjoyed ratio (Average age of payable):

The ratio give the average credit period enjoyed from the creditors. It can be computed by any one of the following methods: Months or days in a year (a) --------------------------------------------------Creditors turnover Average accounts payable x Months (or days) in a year (b) ---------------------------------------------------------------------------------------Credit purchases in the year Average accounts payable (c) ------------------------------------------------------------------------Average monthly (or daily) credit purchases Significance: Both the creditors turnover ratio and the debt payment period enjoyed ratio indicate about the promptness or otherwise in making payment of credit purchases. A higher creditors turnover ratio or a lower credit period enjoyed ratio. Signifies that the creditors are being paid promptly, thus enhancing the credit worthiness of company. However, a very favourable ratio to this effects also shows that the business is not taking full advantage of credit facilities which can be allowed by the creditors. Stock Turnover Ratio: This ratio indicate whether investments in inventory is efficiently used or not. It therefore, explains whether investment in inventories is within proper limits or not. The ratio is calculated as follows: Cost of goods sold during the year -----------------------------------------------------Average inventory Average inventory is calculated by taking stock levels of raw materials work in process, finished goods at the end of each months, adding them up and dividing by twelve. Inventory ratio can be calculated regarding each constituent of inventory. It may thus be calculated regarding raw materials, Work in progress & finished goods.

Cost of goods sold 1* -------------------------------------------------Average stock of finished goods Materials consumed 2** ---------------------------------------------Average stock of raw materials Cost of completed work 3*** -----------------------------------------Average work in progress The method discussed above is as a matter of fact the best basis for computing the stock Turnover Ratio. However, in the absence of complete information, the inventory Turnover Ratio may also be computed on the following basis. Net sales ------------------------------------------------Average inventory at selling Prices The average inventory may also be calculated on the basis of the average of inventory at the beginning and at the end of the accounting period. Inventory at the beginning of the accounting period + Inventory at the end of the accounting period Average Inventory = -------------------------------------------------------------------------------------2 Significance: As already stated, the inventory turnover ratio signifies the liquidity of the inventory. A high inventory turnover ratio indicates brisk sales. The ratio is, therefore, a measure to discover the possible trouble in the form of overstocking or overvaluation. The stock position is known as the graveyard of the balance sheet. If the sales are quick such as a position would not arise unless the stocks consists of unsalable items. A low inventory turnover ratio results in blocking of funds in inventory becoming obsolete or deteriorating in quality.

It is difficult to establish a standard ratio of inventory because it will differ from industry. However, the following general guidelines can be given. (i) The raw materials should not exceed 2-4 months consumption of the year. (ii) The finished goods should not exceed 2-3 months sales (iii) Work in progress should not exceed 15-30 days cost of sales. PRECAUTIONS: While using the Inventory Ratio, care must be taken regarding the following factors: (i) Seasonable conditions: If the balance sheet is prepared at the time of slack season, the average inventory will be much less (if calculated on the basis of inventory at the beginning of the accounting period & inventory at close of the accounting period). This may give a very high turnover ratio. (ii) Supply conditions: In case of conditions of security inventory may have to be kept in high quality for meeting the future requirements. (iii) Price trends: In case of possibility of a rise in prices, a large inventory may be kept by business. Reverse will be the case if there is a possibility of fall in prices. (iv) Trend of volume of business: In case there is a trend of sales being sufficiently higher than sales in the past, a higher amount of inventory may be kept.

LESSON 9
FINANCIAL RATIOS Financial Ratios indicate about the financial position of the company. Accompany is deemed to be financially sound if it is in a position to carry on its business smoothly and meetits obligions, both short term as well as longterm, without strain. It is a sound principle of finance that the short-term requirements of funds should be met out of short term funds and long-term requirements should be met out of long-term funds. For example if the payment for raw materials purchases are made through the issue debentures it will create a permanent interest burden on the enterprise. Similarly, if fixed assets are purchased out of funds provide by bank overdraft, the firm will come to grief because such assets cannot be sold away when payment will be demanded by the bank. Financial ratios can be divided into two broad categories: (1) Liquidity Ratios & (2) Stability Ratios (1) LIQUIDITY RATIOS: These ratios are termed as working capital or short-term solvency ratios. As enterprise must have adequate working-capital to run its day-to-day operations. Inadequacy of working capital may bring the entire business operation to a grinding halt because of inability of enterprise to pay for wages, materials & other regular expenses. CURRENT RATIOS: This ratio is an indicator of the firms commitment to meet its short-term liabilities. It is expressed as follows: Current assets ----------------------------Current Liabilities Current assets mean assets that will either be used up or converted into cash within a years of time or normal operating cycle of the business, whichever is longer. Current liabilities means liabilities payable within a year or operating cycle, whichever is longer, out of existing current assets or by creation of current liabilities. A list of items include in current assets & current liabilities has already been given in the performs analysis balance sheet in the preceding chapter.

Book debts outstanding for more than six months & loose tools should not be included in current assets. Prepaid expenses should be taken as current assets. An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency due to the fact that if the current assets are reduced to half, i.e., 1 instead of 2, then also the creditors will be able to get their payments in full. However a business having seasonal trading activity may show a lower current ratio at a creation period of the year. A very high current ratio is also not desirable since it means less efficient use of funds. This is because a high current ratio means excessive dependence on long-term sources of raising funds. Long-term liabilities are costlier than current liabilities & therefore, this will result in considerably lowering down the profitability of the concern. It is to be noted that the mere fact current ratio is quite high does not mean that the company will be in position to meet adequately its short-term liabilities. In fact, the current ratio should be seen in relation to the component of current assets & liquidity. If a large portion of the current assets comprise obsolete stocks or debtors outstanding for a long term, time, the company may fail even if the current ratio is higher then 2. The current ratio can also be manipulated very easily. This may be done either by either postponing certain pressing payments or postponing purchase of inventories or making payment of certain current liabilities. Significance: The current ratio is an index of the concerns Financial stability since it shows the extent of working capital which is the amount by which the current assets exceed the current liabilities. As stated earlier, a higher current ratio would indicate inadequate employment of funds while a poor current ratio is a danger signal to the management. It shows that business is trading beyond its resources. (II) QUICK RATIO: This ratio is also termed as acid test ratio or liquidity ratio. This ratio is ascertained by comparing the liquid assets (i.e., assets which are immediately convertible into cash without much loss) to current liabilities prepaid expenses and stock are not taken as liquid assets. The ratio may be expressed as: Liquid assets --------------------------Current liabilities Some accountants prefer the term Liquid Liabilities for Current Liabilities or the purpose of ascertaining this ratio. Liquid liabilities means liabilities which are payable within a short period. The bank over-draft (if it becomes a permenant mode of financing) & cash credit faculties will be excluded from current liabilities in such a case.

The ideal ratio is 1. This ratio is also an indicator of short-term solvency of the company. A comparison of the current ratio to quick ratio shall indicate the inventory hold-ups. For example if two units have the same current ratio but different liquidity ratio, it indicates over-stocking by the concern having low liquidity ratio as compared to the concern which has a higher liquidity ratio. Thus, debtors are excluded from liquid assets for the purpose of comparing super quick ratio. Current liabilities & liquid liabilities have the same meaning as explained above. The ratio is the more measure of firms liquidity position. However, it is not widely used in practice. STABILITY RATIO: These ratios help in ascertaining long term solvency of a firm which depends basically on three factors: (i) Whether the firm has adequate resources to meet its long term funds requirements. (ii) Whether the firm has used an appropriate debt-equity mix to raise long-term funds. (iii) Whether the firm earns enough to pay interest & instalment of long-term loans in time. The capacity of the firm to meet the last requirement can be ascertained by computing the various coverage ratios, already explained in the preceding pages. For the other two requirements, the following ratios can be calculated. (1) FIXED ASSETS RATIO: This ratio explains whether the firm has raised adequate long-term funds to meet its fixed assets requirements. It is expressed as follows: Fixed assets --------------------------Long Term funds

The ratio should not be more than 1. If it is less than 1, it shows that a part of the working capital has been financed through long-term funds. This is desiarable to some extent because a part of working capital termed as Core Working Capital is more or less is a fixed nature. The ideal ratio is 67. (ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capital structure of firm is made up or the debt-equity mix adopted by the firm. The following ratios fall in the category. (a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportion between fixed interest or dividend bearing funds & non-fixed interest or dividend bearing funds in the total capacity employed in the business. The fixed interest or dividend bearing funds include the funds provided by the debenture holders & preference shareholders. Non-fixed interest or dividend bearing funds are the funds provided by the equity shareholders. The amount, therefore, includes the Equity Share Capital & other Reserves. A proper proportion between the two funds is necessary in order to keep the cost of capital at the minimum. The capital gearing ratio can be ascertained as follows: Funds bearing fixed interest or fixed dividend -------------------------------------------------------------------Equity Shareholders Funds (b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain the soundness of the long-term financial position of the company. It is also known as External Internal equity ratio. Total long-term debt Debt Equity Ratio = -----------------------------------------Shareholders funds Significance: The ratio indicates the preparation of owners stake in the business. Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which the firm depends upon outsiders for its existence. The ratio provides a margin of safety to the creditors. It tells the owners the extent to which they can gain the benefits or maintain control with a limited investment.

(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishes relationship between the proprietors funds & the total tangible assets. It may be expressed as: Shareholders funds = -------------------------------Total tangible assets Significance: This ratio focuses the attention on the general financial strength of the business enterprise. The ratio is of particular importance to the creditors who can find out the proportion of shareholders funds in the total assets employed in the business. A high proprietary ratio will indicate a relatively little danger to the creditors etc., in the event of forced reorganization or winding up of the company. A low proprietary ratio indicates greater risk to the creditors since in the event of losses a part of their money may be lost besides loss to the properties of the business. The higher the rate, the better it is. A ratio below 50 percent may be alarming for the creditors since they may have to lose heavily in the event of companys liquidation on account of heavy losses. ADVANTAGES OF RATIO ANALYSIS Following are some of the advantages of ratio analysis: 1. Simplifies financial statements: Ratio Analysis simplified the comprehension of financial statements. Ratios tell the whole story of changes the financial condition of the business. 2. Facilitates inter-firm comparison: Ratio Analysis provides date for inter-firm comparison. Ratios highlight the factors associated with successful & unsuccessful firms. They also reveal strong firms & weak firms, over-valued & under valued firms. 3. Makes intra-firm comparision possible: Ratio Analysis also makes possible comparision of the performance of the different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past & likely performance in the future. 4. Helps in planning: Ratio Analysis helps in planning & forecasting. Over a period of time a firm or industry develops certain norms that may indicate future success or failure. If relationship changes in firms data over different time periods, the ratios may provide clues on trends and future problems. Thus Ratio can assist management in its basic functions of forecasting planning coordination, control and communication.

LIMITATIONS OF ACCOUNTING RATIOS 1. Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with the past results of the business or with the results of a similar business. However, such a comparision only provides a glimpse of the past performance and forecasts for future may not be correct since several other factors like market conditions, management policies, etc. may affect the future operations. 2. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements which suffer from a number of limitations. For example non-financial charges though important for the business are not revealed by the financial statements. If the management of the company changes, it may have adverse effect on the future profitability of the company but this cannot be judged by having a glance at the financial statements of the company. Financial statements show only historical cost but not market value. The comparision of one firm with another on the basis of ratio analysis without taking into account the fact of companies having different accounting policies will be misleading and meaningless. 3. Ratios alone are not adequate : Ratios are only indicators they cannot be taken as final regarding good or bad financial position of the business Other things have also to be seen. 4. Window dressing: The term window dressing means manipulations of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is. On account of such a situation presence of a particular ratio may not be a definite indicator of good or bad management. 5. Problem of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. 6. No fixed standards: No fixed standards can be laid down for ideal ratios. For example, current ratio is generally considered to be ideal if current assets are twice the current liabilities. However, in case of these concerns which have adequate arrangements with their bankers for providing funds when they require, it may be perfectly ideal if current assets are equal to slightly more than current liabilities.

7. Ratios area composite of many figures: Ratios are a composite of many different figures. Some cover a time period, others are at an instant of time while still others are only averages. A balance sheet figures shows the balance of the account at one moment of one day. It certainly may not be representative of typical balance during the year. It may, therefore, be conducted that ratio analysis, if done mechanically, is not only misleading but also dangerous. The computation of different accounting ratios & the analysis of the financial statements on their basis can be very well understood with the help of the illustrations given in the following pages: COMPUTATION OF RATIOS Illustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai Hind Ltd., Redraft the for the purpose of analysis and calculate the following ratios: i. ii. iii. iv. v. vi. Gross Profit Ratios Overall Profitability Ratio Current Ratio Debt-Equity Ratio Stock Turnover Ratios Liquidity Ratios

PROFIT AND LOSS ACCOUNT Db. Particulars Opening goods Opening materials stock stock of finished of raw 1,00,000 50,000 3,00,000 2,00,000 Sales Closing stock of raw materials Closing goods stock of finished 10,00,000 1,50,000 1,00,000 50,000 Cr.

Purchase of raw materials Direct wages

Profit on sale of shares

Manufacturing expenses Administration expenses Selling expenses & Distribution

1,00,000 50,000 50,000 55,000 10,000 3,85,000 13,00,000 BALANCE SHEET 13,00,000

Loss on sale of plant Interest on Debentures Net Profit

Liabilities Share Capital: Equity Share Capital Preference share capital Reserves Debentures Sundry Creditors Bills Payable

Rs. 1,00,000 1,00,000 1,00,000 2,00,000 1,00,000 50,000 6,50,000

Assets Fixed Assets Stock of raw materials Stock of finished Sundry debtors Bank Balance

Rs. 2,50,000 1,50,000 1,00,000 1,00,000 50,000

6,50,000

SOLUTION: INCOME STATEMENT Sales Less: Cost of sales Raw material consumed (op. Stock + Purchases Closing Stock) Direct Wages Manufacturing expenses Cost of production Add: Opening stock of finished goods Less: Closing stock of finished goods. Cost of goods sold Gross Profit Less: Operating Expenses: Administration expenses Selling and distribution expenses Net operating profit Add: Non-trading income: Profit on sale of shares Less: Non-trading expenses or losses: Loss on sale of plant Income before interest & tax Less: Interest on debentures Net Profit before tax 55,000 3,95,000 10,000 3,85,000 50,000 50,000 1,00,000 4,00,000 50,000 4,50,000 2,00,000 2,00,000 1,00,000 5,00,000 1,00,000 6,00,000 1,00,000 5,00,000 5,00,000 Rs. 10,00,000

BALANCE SHEET (OR POSITION STATEMENT) Rs. Bank balance Sundry debtors Liquid assets Stock of raw materials Stock of finished goods Current assets Sundry creditors Bills Payable Current liabilities Working Capital (Rs. 4,00,000 Rs. 1,50,000) Add Fixed assets Capital employed Less Debentures Shareholders net worth Less Preference share capital Equity shareholders net worth Equity shareholders net worth is represented by: Equity Share capital Reserves Ratios: (i) Gross Profit x 100 50,000 x 100 Gross Profit Ratio ----------------------------------------------------- = 50% Sales 10,00,000 50,000 1,00,000 1,50,000 1,50,000 1,00,000 4,00,000 1,00,000 50,000 1,50,000 2,50,000 2,50,000 5,00,000 2,00,000 3,00,000 1,00,000 2,00,000 1,00,000 1,00,000 2,00,000

Operating Profit x 100 (ii)

4,00,000 x 100 --------------------- =

Overall Profitability Ratio = ------------------------------- = 80% Capital employed

5,00,000

Current assets (iii) Current liabilities External equities (iv) Internal equities (or) Total long- term debt Total long-term funds (or) Total long-term debt Shareholders funds (v) Stock turnover ratio:

4,00,000 1,50,000 3,50,000 3,00,000

Current Ratio = ------------------------------- = -------------------------- = 2.67

Debt Equity Ratio: = -------------------------- = --------------------- = 1.17

2,00,000 5,00,000

------------------------------ = ----------------- = 0.40

2,0,00,000 3,00,000

----------------------------- = -------------------- = 0.67

Cost of goods sold

5,00,000

(a) As regards average total inventory = ---------------------------- = ----------------- = 2.5 Average inventory* (*) of raw materials as well as finished goods) (b) As regards average inventory of finished goods: Cost of goods sold 5,00,000 -------------------------------------------------- = ---------------- = 5 2,00,000

Average inventory of finished goods (c) As regard average inventory of raw materials: Materials consumed Average inventory of materials Liquid assets (iv) Liquid Ratio: ------------------------Current liabilities 1,50,000 = ----------------- = 1 1,50,000

1,00,000

2,00,000 1,00,000

-------------------------------------------------- = ---------------- = 2

ILLUSTRATION 2 : Following are the ratios to the trading activities of National Traders Ltd. Debtors Velocity Stock Velocity Creditors Velocity Gross Profit Ratio 3 Months 8 Months 2 Months 25 percent

Gross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/- closing stock of the year is Rs. 10,000 above the opening stock. Bills receivable amount to Rs. 25,000 and Bills payable to Rs. 10,000. Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry Creditors SOLUTION : (a) Sales: Gross profit Gross Profit Ratio = ------------------------- x 100 Sales

Gross profit = Rs. 4,00,000/4,00,000 Sales = ----------------------------- x 100 = Rs. 16,00,000 25 (b) Sundry Debtors : Debtors Debtors Velocity = --------------------- x 12 Sales Debtors Velocity of 3 months Presumably means that Accounts Receivable equal to 3 months Sales or of the years sales. Rs. 1,60,000 Account Receivable = --------------------- x 1 4 Less Bills Receivable Sundry Debtors 25,000 ------------------------3,75,000 ------------------------(c) Closing Stock: Cost of goods sold Stock Velocity = -----------------------------------------Average stock Cost of goods sold = Sales Gross profit = 16,00,000 4,00,000 = Rs. 12,00,000 4,00,000

12,00,000 Average Stock = ------------------------- x 8 12 Total of Opening and Closing stock = 8,00,000 x 2 = 16,00,000 = Rs. 8,00,000

Closing Stock is higher than Opening Stock by Rs. 10,000 16,00,000 - 10,000 Therefore, Opening Stock = --------------------------------2 = 7,95,000 Hence, Closing Stock = 7,95,000 + 10,000 or Rs. 8,05,000 (d) Sundry Creditors: Total Creditors Creditors Velocity i.e., = ------------------------------ x 12 Purchases Purchases = Cost of goods sold + Closing Stock opening Stock = 12,00,000 + 8,05,000 7,95,000 = Rs. 12,10,000 Creditors Velocity is 2 months, it means that Account Payable are 1/6th of the Purchases for the year Hence Account Payable Less : Bills Payable Sundry Creditors = = Rs. 2,01, 667 10,000 -------------------Rs. 1,91,667 --------------------

LESSON 10 FUNDS FLOW ANALYSIS

The technique of Funds Flow Analysis is widely used by the financial analyst, credit granting institutions and financial managers in performance of their jobs. It has become a useful tool in their analytical kit. This is because the financial statements, i.e., Income Statement and the Balance Sheet have a limited role to perform. Income statement measures flow restricted to transactions that pertain to rendering of goods or services to customers. The Balance Sheet is merely a static statement. It is a statement of assets and liabilities which does not focus major financial transactions which have been behind the balance sheet changes. One has to draw inferences after comparing the balance sheets of two periods. For example, if the fixed assets worth Rs. 2,00,000 are purchased during the current year by raising share capital of Rs. 2,00,000 the balance sheet will simply show a higher capital figure and higher fixed assets figure. In case, one compares the current years balance sheet with the previous year, then only one can draw an inference that fixed assets were acquired by raising share capital of Rs. 2,00,000. Similarly, certain important transaction which might occur during the course of the accounting year might not find any place in the balance sheet. For example, if a loan of Rs. 2,00,000 was raised and paid in the accounting year the Balance sheet will not depict this transaction. However, a financial analyst must know the purpose for which the loan was utilized and the source from which it was raised. This will help him in making a better estimate about the companys financial position and policies. The term fund generally refers to cash, to cash and cash equivalents, or to working capital. Of these the last definition of the term is by far the most common definition of fund. There are also two concepts of working capital gross and net concept. Gross working capital refers to the firms investment in current asset while the term net working capital means excess of current assets over current liabilities. It is in the latter sense in which the term funds is generally used. Current Assets: The term Current Assets includes assets which are acquired with the intention of converting them into cash during the normal business operations of the company. The broad categories of current assets, therefore, are 1. Cash including fixed deposits with banks. 2. Accounts receivable, i.e., trade debtors and bills receivable,

3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods, stores and spare parts. 4. Advances recoverable, i.e., the advances given to supplier of goods and services or deposit with government or other public authorities, e.g., customer, port authorities, advance income tax, etc. 5. Pre-paid expenses, i.e. cost of unexpired services e.g., insurance premium paid in advance, etc. Current Liabilities: The term Current Liabilities is used principally to designate such obligations whose liquidation is reasonably expected to require the use of assets classified as current assets in the same balance sheet or the creation of other current liabilities or those expected to be satisfied within a relatively short period of time usually one year. However, this concept of current liabilities has now undergone a change. The more modern version designates current liabilities as all obligations that will require within the coming year or the operation cycle, whichever is longer. The use of existing current assets or the creation of other current liabilities . in other words, the more fact that an amount is due within a year does not make it current liability unless it is payable out of existing current assets or by creation of current liabilities. For example debentures due for redemption within a year of the balance sheet date will not be taken as a current liability if they are to be paid out of the proceeds of a fresh issue of shares / debentures or out of the proceeds realized on account of sale of debentures redemption fund investments. The term current liabilities also includes amounts set apart or provided for any known liability of which the amount cannot be determined with substantial accuracy e.g., provision for taxation, pension etc., These liabilities are technically called provisions rather than liabilities. The broad categories of current liabilities are: 1. Accounts payable e.g., bill payable and trade creditors. 2. Outstanding expenses, i.e., expenses for which services have been received by the business but for which the payment has not made. 3. Bank-over drafts. 4. Short-term loans, i.e., loans from banks, etc., which are payable within one year from the date of balance sheet. 5. Advance payments received by the business for the services to be rendered or goods to be supplied in future. 6. Current maturities of long-term loans, i.e., long-term debts due within a year of the balance sheet date or installments due within a year in respect of these

loans, provided payable out of existing current assets or by creation of current liabilities, as discussed earlier. However, installments of long-term loans due after a year should be taken as non-current liabilities. Meaning of Flow of Funds The term Flow means change and therefore, the term Flow of Funds means Change in Funds or Change in working capital. In other words, any increase or decrease in working capital means Flow of Funds. USES OF FUNDS FLOW A STATEMENT Funds flow statement helps the financial analyst in having a more detailed analysis and understanding of changes in the distribution of resources between two balance sheet dates. In case such study is required regarding the future working capital position of the company, a projected funds flow statement can be prepared. The uses of funds flow statement can be put as follows. 1. It explains the financial consequences of business operations. Funds flow statement provides a ready answer to so many conflicting situations, such as: Why the liquid position of the business is becoming more and more unbalanced inspite of business making more and more profits. How was it possible to distribute dividends in excess of current earnings or in the presence of a new loss for the period? How the business could have good liquid position in spite of business making losses or acquisition of fixed assets? Where have the profits gone?

Definite answers to these questions will help the financial analyst in advising his employer / client regarding directing of funds to those channels which will be most profitable for the business. 2. It answers intricate queries. The financial analyst can find out answers to a number of intricate questions. What is the overall credit-worthiness of the enterprise? What are the sources of prepayment of the loans taken? How much funds are generated through normal business operations?

It what way the management has utilized the funds in the past and what are going to be likely use of funds? It acts as an instruments for allocation of resources. It is a test as to effective or otherwise use of working capital .

PREPARATION OF FUNDS FLOW STATEMENT In order to prepare a Funds Flow Statement, it is necessary to find out the sources and applications of funds. Sources of funds. The sources of funds can be both internal as well as external. Internal Sources: Funds from operations is the internal source of funds. However, following adjustments will be required in the figure of Net Profit for finding out real funds from operations. Add the following items as they do not result in outflow of funds: 1. Depreciation on fixed assets 2. Preliminary expenses or goodwill, etc., written off. 3. Contribution of debenture redemption find, transfer to general reserve, etc, if they have been deducted before arriving at the figure of net profit. 4. Provision for taxation and proposed dividend are usually taken as appropriations of profits only and not current liabilities for the purposes of Funds Flow Statement. This is being discussed in detail later. Tax or dividends actually paid are taken as applications of funds. Similarly, interim dividend paid is shown as an applications of funds. All these items will be added back to net profit, if already deducted, to find funds from operations. 5. Loss on sale of fixed assets. Deduct the following items as they do not increase funds; 1. Profit on sale of fixed assets since the full sale proceeds are taken as a separate source of funds and inclusion here will result in duplications. 2. Profit on revaluation of fixed assets. 3. Non-operating incomes such as dividend received or accrued dividend, refund of income tax, rent received or accrued rent. These items increase funds but they are non-operating incomes. They will be shown under separate heads as source of funds in the Funds Flow Statement.

In case the profit and Loss Account shows Net Loss, this should be taken as an item which decreases the funds. External Sources: These sources includes1. Funds from long-term loans 2. Sale of fixed assets 3. Funds from increase in share capital 4. Application of funds 5. Purchase of fixed assets 6. Payment of dividends 7. Payment of fixed liabilities. 8. Payment of tax liability. Technique for preparing a funds flow statement A funds flow statement depicts change in working capital. it will, therefore, be better for the students to prepare first a Schedule of Changes in Working Capital before preparing a funds flow statement. Schedule of changes in working capital The schedule of changes in working capital can be prepared by comparing the current assets and the current liabilities of two periods. It may be in the following form.

SCHEDULE OF CHANGE IN WORKING CAPITAL Items As --Current Assets Cash balance Bank balance Marketable securities Accounts receivable Stock-in-trade Prepaid expenses Current Liabilities Bank overdraft Outstanding expenses Accounts payable Net Increase / Decrease in Working Capital As on --Change Increase Decrease (+) (-)

Rules for preparing the Schedules: 1. Increase in a current asset, result in increase (+) in working capital 2. Decrease in current asset, results in decrease (-) in working capital 3. Increase in a current liability, results in decrease (-) in Working capital 4. Decrease in a current liability, results in increase (+) in Working capital Funds flow statement While preparing a funds flow statement, current assets and current liabilities are to be ignored. Alternation is to be given to changes in Fixed Assets and Fixed Liabilities. The statement may be prepared in the following form.

FUNDS FLOW STATEMENT Sources of funds: Issue of Shares Issue of Debentures Long-term Borrowing Sale of Fixed Assets Operating profit* Decrease in working capital Rs. ------------Application of Funds Redemption of Redeemable Preference Shares Redemption of Debentures Payment of other long-term loans Operating Loss* Payment of dividend, tax, etc. Increase in working capital* * Only one figure will be there. The change in working capital disclosed by the schedule of changes in working capital will tally with the change disclosed by the funds flow statement. Illustration 1: From the following balance sheet of X Ltd. On 31st December 1985 and 1986, you are required to prepare. 1. A schedule of changes in working capital 2. A funds flow statement Rs. ----------------

Liabilities Share Capital General Reserve Profit & Loss A/c Sundry Creditors Bills Payable Provision Taxation Provision doubtful debts

1985 Rs. 14,000 16,000 8,000 1,200 for 16,000 for 400

1986 Rs. 18,000 13,000 5,400 800 18,000 600

Assets

1985 Rs. 12,000 40,000 37,000 10,000 30,000 2,000 18,000 6,600

1986 Rs. 12,000 36,000 36,000 11,000 23,400 3,200 19,000 15,200

1,00,000 1,00,000 Goodwill Building Plant Investments Stock Bill Receivable Debtors Cash at Bank 1,55,600 1,55,800

1,55,600 1,55,800

The following additional information has also been given. 1. Depreciation charged on Plant was Rs. 4,000 and on Building Rs. 4,000 2. Provision for taxation of Rs. 19,000 was made during the year 1986. 3. Interim dividend of Rs. 8,000 was paid during the year 1986.

SCHEDULE OF CHANGES IN WORKING CAPITAL 1985 Current Assets: Cash at Bank Debtors Bills receivable Stock Current Liabilities Provision for doubtful debts Bills payable Sundry Creditors Total 400 1200 8000 600 800 5400 400 2600 13800 Rs. 6600 18000 2000 30000 1986 Rs. 15200 19000 3200 23000 6600 200 ----6800 Increase (+) Rs. 8600 1000 1200 Decrease (-) Rs.

FUNDS FLOW STATEMENT Sources Funds from operations Total sources Applications: Purchase of plant Tax paid Investments purchased Interim dividend paid Total application Net increase in working capital 29000 7000 Rs. 36000 36000 Rs. 3000 17000 1000

Working Notes: 1. Funds from operations: Profit & Loss account balance on 31st Dec., 1986 Add: Items which do not decrease funds from Operations Transfer to General Reserve Provision for Tax Depreciation: Plant Building Interim Dividend paid Less: Profit & Loss balance on 31st Dec., 1988 Funds from operations for the year 4000 4000 8000 39000 52000 16000 36000 4000 19000 Rs. Rs. 13000

2. Purchase of Plant. This has been found out by preparing the Plant Account. Plant Account To balance b/d To bank (Purchase of plant balancing figure) 37000 By Depreciation 3000 By balance c/d 40000 4000 36000 40000

3. Tax paid during the year has been found out by preparing a Provision for Tax Account. Provision For Tax Account To blank (being tax paid balancing figure) To balance c/d 18000 35000 35000 By balance b/d 17000 By P & L A/c 16000 19000

4. Investment have been taken as a fixed asset presuming that they are longterm investment.

LESSON 11 CASH FLOW ANALYSIS

Cash flow analysis is another important technique of financial analysis. It involves preparation of Cash flow statement for identifying sources and applications of cash. A cash flow statement is a statement depicting change in cash position from one period to another. For example, if the cash balance of business is shown by its Balance sheet on 31st December, 1978 at Rs. 20,000 while the cash balance as per its balance sheet on 31st December, 1979 is Rs. 30,000. There has been an inflow of cash of Rs. 10,000 in the year 1979 as compared to the year 1978. The cash flow statement explains the reasons for such inflows or outflows of cash, as the case may be. It also helps management in making plans for the immediate future. A cash flow statement can be prepared on the same pattern on which a funds flow statement is prepared. The change in the cash position from one period to another is computed by taking into account Sources and Application of cash. Format of a Cash Flow Statement A cash flow statement can be prepared in the following form:

Cash Flow Statement For the year ending on ... Balance as on 1.1.19... Cash balance Bank balance Issue of Shares Raising of long-term loans Sale of fixed assets Short-term borrowings Cash from operation Profit as per Profit and Loss Account Add/Less : Adjustment for non-cash items Add: Increase in current liabilities Decrease in current assets Less: Increase in current assets Decrease in current liabilities Total cash available (1) Less: Application of Cash: Redemption shares of redeemable preference ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ..... ...... ...... ...... ...... ...... ..... ...... ...... ......

Redemption of long-term loans Purchase of fixed assets Decrease in deferred payment liabilities Cash outflow on account of operation Tax paid Dividend paid Decrease in unsecured loans, deposits etc., Closing balances* Cash balance Bank Balance * There total should tally with the balance as shown by (1) (2)

DIFFERENCE BETWEEN CASH FLOW ANALYSIS AND FUNDS FLOW ANALYSIS Following are the points of difference between a Cash Flow Analysis and a Funds analysis. 1. A cash flow statement is concerned only with the change in cash position while a funds flow analysis is concerned with changed in working capital position between two balance sheet dates. Cash is only one of the constituents of working capital besides several other constituents such as inventories, accounts receivable, prepaid expenses. 2. A cash flow statement is merely a record of cash receipts and disbursements. Of course, it is valuable in its own way but if fails to bring to light many important changes involving he disposition of resources. While studying the short-term solvency of a business one is interested not only in cash balance but also in the assets which are easily convertible into cash. 3. Cash flow analysis is more useful to the management as a tool of financial analysis in short period as compared to funds flow analysis. It has rightly been said that shorter the period covered by the analysis, greater is the importance of cash flow analysis. For example, if it is to be found out whether the business can meet it obligations maturing after 10 years from now, a good estimate can be made about firms capacity to meet its long-term obligations if changes in working capital position on account of operations are observed. However, if the firms capacity to meet a liability maturing after one months is to be seen, the realistic approach would be to consider the projected change in the cash position rather than an expected change in the working capital position. 4. Cash is part of working capital and, therefore, an improvement in cash position results in improvement in the funds position but the reverse is not true. In other words, inflow of cash results in inflow of funds but inflow of funds may not necessarily result in inflow of cash. Thus, a sound funds position does not necessarily mean a sound position but a sound cash position generally means a sound funds position. 5. Another distinction between a cash flow analysis and a funds flow analysis can be made on the basis of the techniques of their preparation. An increase in a current liability or decrease in a current asset results in decrease in working capital and vice verse. While an increase in a current liability or decrease in a current asset (other than cash) will result in increase in cash and vice versa. Some people, as stated before, use of term funds in a very narrow sense of cash only. In such an event the two terms Funds and Cash will have synonymous meaning.

UTILITY OF CASH FLOW ANALYSIS 1. Helps in efficient cash management 2. Helps in internal financial management 3. Discloses the movement of cash 4. Discloses success or failure of cash planning LIMITATIONS OF CASH FLOW ANALYSIS 1. Cash flow statement cannot be equated with the Income Statement. An income statement takes into account both cash as well as non-cash items and, therefore, net cash flow does not necessarily mean net income of the business. 2. The cash balance as disclosed by the cash flow statement may not represent the real liquid position of the business since it can be easily influenced by postponing purchases and other payments. 3. Cash flow statement cannot replace the Income Statement or the Funds flow statement. Each of them has a separate function to perform. Illustration 1 From the following balances you are required to calculate cash from operations: Debtors Bills receivable Creditors Bills payable Outstanding expenses Prepaid expenses Prepared expenses Accrued Income Income received in advance Profit made during the year 1987 Rs. 50,000 10,000 20,000 8,000 1,000 800 600 300 .... 1988 Rs. 47,000 12,000 25,000 6,000 1,200 700 750 250 1,30,000

CASH FROM OPERATIONS Profit made during the year Add: Decrease in Debtors Increase in Creditors Increase in outstanding expenses Less: Increase in Bills Receivable Decrease in Bills payable Increase in Accrued Income Decrease in Income received in advance Cash from operation Illustration 2: Balance Sheets of A and B on 1.1.1988 and 31.12.1988 were as follows: BALANCE SHEET 1.1.88 Liabilities Creditors Mrs. Loan Loan Bank Capital As from Rs. 40,000 25,000 40,000 1,25,000 31.12.88 Rs. Assets 44,000 Cash .... Debtors 50,000 Stock 1,53,000 Machinery Building 2,30,000 2,47,000 1.1.88 Rs. 10,000 30,000 35,000 80,000 35,000 2,30,000 31.12.88 Rs. 50,000 50,000 25,000 55,000 60,000 2,47,000 2500 2000 150 50 4700 133600 3000 5000 100 8300 .... 1,30,000

During the year of a machine costing Rs. 10,000 (accumulated depreciation Rs. 3,000) was sold for Rs. 5,000. The provision for depreciation against Machinery as on 1.1.1988

was Rs. 25,000 and on 31.12.1988 Rs. 40,000. Net profit for the year 1988 amounted to Rs. 45,000. You are required to prepare Cash Flow Statement. Solution Cash Flow Statement Cash balance as on 1.1.1988 Add: Sources Cash from Operations Rs. Loan from Bank Sale of Machines Less: Applications: Purchase of Land Purchase of Building Mrs. As Loan repaid Drawings Cash Balance as on December 31, 1988 10,000 25,000 25,000 17,000 77,000 7,000 59,000 10,000 5,000 74,000 8,400 Rs. 10,000

Working Notes CASH FROM OPERATIONS Profit made during the year Add: Depreciation on Machinery Loss on Sale of Machinery Decrease in Stock Increase in Creditors Less: Increase in Debtors Cash from Operation 18,000 2,000 10,000 4,000 34,000 79,000 20,000 59,000 Rs. 45,000

Machinery Account (At Cost) To Balance b/d 1,05,000 By Bank By Loss on Sale of machinery By provision for Depreciation By balance c/d 1,05,000 5,000 2,000 3,000 95,000 1,05,000

PROVISION FOR DEPRECIATION To machinery A/c To balance c/d 3,000 By balance b/d 40,000 By P & L A/c (depreciation charged balancing figure) 43,000 25,000 18,000

43,000

LESSON 12 BUDGETS AND BUDGETARY CONTROL

The management is efficient if it is able to accomplish the objective of the enterprise. It is efficient when it accomplishes the objectives with minimum effort and cost. In order to attain long-range efficiency and effectiveness, management must chart out its course in advance. A systematic approach to facilitate effective management performances profitplanning and control, or budgeting. Budgeting is therefore an integral part of management. In a way, a budgetary control system has been described as a historical combination of a goal setting machine for increasing an enterprises profits, and a goal-achieving machine for facilitating organizational coordination and planning while achieving the budgeted targets. Definitions The Institute of Cost and Management Accountants, London, gives the following definitions: A budget is a financial and / or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and the employment of capital.* Budgetary control. The establishment of departmental budgets relating the responsibilities of executive to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of the policy, or to provide a firm basis for its revision. Thus, a budget is a predetermined statement of management policy during a given period which provides a standard for comparison with the results actually achieved. Budgetary control is a system of controlling costs which includes the preparation of budgets, coordinating the departments and establishing responsibilities, comparing actual performance with that of budgeted and acting upon results to achieve maximum profitability. Budgeting is essentially concerned with planning, and can be broadly illustrated by comparison with the routine a ships captain follows on each voyage. Operation of Budgetary Control The steps involved in a Budgetary Control system can be outlined as follows:

1. Establish a plan or target of performance which coordinates all the activities of the business. 2. Record the actual performance 3. Compare the actual performance with that planned. 4. Calculate the differences, or variances, and analyze use reasons for them. 5. Act immediately, if necessary, to remedy the situation. Objectives of Budgetary Control Briefly, the main objectives of budgetary control are: 1. To combine the ideas of all levels of management in the preparation of the budget. 2. To coordinate all the activities of the business. 3. To centralize control. 4. To decentralize responsibility to each manager involved. 5. To act as a guide for management decision-making when unforeseeable conditions affect the business. 6. To plan and control income and expenditure so that maximum profitability is achieved. 7. To direct capital expenditure in the most profitable direction. 8. To ensure that sufficient working capital is available for the efficient operation of the business. 9. To provide a yardstick against which results can be compared. 10. To show management where action is needed to remedy a situation. Basic Conditions for the Successful Operation of Budgetary Control Realistic Budget: The quality of the budget is very important for the successful operation of budgetary control. If should be realistic and operationally feasible. Flexible budget is normally a good budget as it take into consideration the dynamics of the business. It must be based on what is attainable, must suit the organizational facilities and complexities and must be flexible to accommodate the changing environment of the business.

Qualitative and Timely Reporting : Variances must be analyzed, interpreted and reported in a manner which is easily understandable. Reporting must be on time and bring out significant areas/points and be precise, simple and meaningful. Time is the essence of reporting and maintenance of time schedule enhances the value of reporting and leads to correction of many adverse events/trends which otherwise would have taken a heavy toll. Managements Attitude: The management must have a positive attitude towards budgetary control. Any scheme of control is a discipline and regulation. Management must have faith and confidence in the scheme. Management must take keen interest in the scheme of budgetary control and render whole-hearted support and cooperation in making this a success. Advantages of Budgetary Control The following are some of the most significant advantages of budgeting : 1. Budgeting compels management to plan for the future. The budgeting process forces management to look ahead and become more effective and efficient in administering business operations. It instills into managers the habit of evaluating carefully their problems and related variables before making any decisions. 2. Budgeting helps to coordinate, integrate, and balance the efforts of various departments in the light of the overall objectives of the enterprise. This results in goal congruency and harmony among the departments. 3. Budgeting facilitates control by providing definite expectations in the planning phase that can be used as a frame of reference for judging the subsequent performance. Undoubtedly, budgeted performance is a more relevant standard for comparison than past performance is based on historical factors which are constantly changing. 4. Budgeting improves the quality of communication. The enterprises objectives, budgets goals, plans, authority and responsibility and procedures to implement plans are clearly written and communicated through budgets to all individuals in the enterprise. This results in better understanding and harmonious relating among mangers and subordinates. 5. Budgeting helps to optimize the use of the firms resources, both capital and human. It aids in directing the total efforts of the firm into the most profitable channels. 6. Budgeting increase the morale and thereby the productivity of the employees by seeking their meaningful participation in the formulation of plans and

policies, bringing about a harmony between individual goals and the enterprises objectives, and by providing incentives for better performance. 7. Budgeting develops profit-mindedness and cost consciousness. 8. Budgeting permits the management to focus attention on significant matters through budgetary reports. Thus, it facilitates management by exception and thereby saves the managements time and energy. 9. Budgeting measure efficiency and thereby enables self-evaluation by the management, it also indicates the progress made in attaining the enterprises objectives. Problems of the Budgeting System The major problems in developing a budgeting system are: 1. Getting the support and involvement of all levels of management. 2. Developing meaningful forecasts and plans, especially the sales plan. 3. Inducing all individuals to get involved in the budgeting process, and gaining their full participation. 4. Establishing realistic objectives, procedures and standards of desired performance. 5. Applying the budgeting systems in a flexible manner. 6. Maintaining effective follow-up procedures, and adapting the budgeting system to changing circumstances. Limitations of Budgetary Control Management must consider the following limitations in using the budgeting system as a device to solve managerial problems: 1. Budgeting is not an exact science, its success depends upon the precision of estimates. Estimates are based on facts and managerial judgement. Managerial judgement can suffer from subjectivity and personal biases. The efficacy of budgeting thus depends upon the quality of managerial judgement. 2. A perfect system of budging cannot be organized in a short period. Business conditions change rapidly. Therefore, the budging system should be continuously adapted to changing circumstance. Budgeting has to be a continuous exercise, it is a dynamic process. Management should not lose

patience, it should go on trying various techniques and procedures in developing and using the budgeting system. 3. A skillfully prepared budget system will not by itself improve the management of an enterprise unless it is properly implemented. For the success of the budgetary system, it is essential that it is understood by all, and that the managers and subordinates put in concerted effort for accomplishing the budget goals. All persons in the enterprise must be fully involved in the preparation and execution of budgets, otherwise budgeting will not be effective. 4. Budgeting is a management tool, a way of managing, not the management itself. The presence of a budgetary system should not make management complacent. To get the best results, management should use budgeting with intelligence and foresight, along with other managerial techniques. Budgeting assets management, it cannot replace management.

5. Budgeting will be ineffective and expensive if it is unnecessarily detailed and complicated. A budget should be precise in format and simple to understand, it should be flexible in application. 6. Budgeting will hide inefficiencies instead of revealing them if there is not evaluation system. There should be continuous evaluation of the actual performance. The standards should also be re-examined regularly. Organisation for Budgetary Control 1. Creation of budget centres. Centres of departments should be established for each of which budgets can be set with the help of the head of department concerned. A budget centre is a centre or department or a segment of a an organisation for which budgets are prepared. Budgets should be set with the help of the heads of these centres so that these may be implemented more effectively. 2. Preparation of an organisatoin chart. This defines the functional responsibilities of each member of the management, and ensures that he knows his position in the company and his relationship with other members. 3. Establishment of a budgeted committee. In small companies budget officer or the accountant may coordinate all the work connected with budgets, but in large companies a budget committee is often established to formulate a general programme for preparing budgets and exercising overall control. The Chief Executive of the company may establish guiding principles but usually he delegates the responsibility for operating the system to the budget officer as secretary of the committee. This committee is composed of the chief executive, budget officer and heads of the main department such as those shown in Fig. 1. Each member will prepare his own initial budget or budgets, which will then be considered by the committee, and all budgets will be

coordinated. Usually many changes are necessary before the budgets can be finally integrated and approved. 4. Preparation of budget manual. This ia defined (by the I.C.M.A.) as a document which sets out the responsibilities of the persons engaged in the routine of, and the forms and records required for budgetary control. It is usually in loose-leaf form so that alternations can easily be made as and when required, appropriate sections can be issued to executives requiring them. An index will be provided so that information can be located quickly. Such a manual will usually prove invaluable, as it will include information such as: (a) Description of the system and its objectives, (b) Procedure to be adopted in operating system (c) Definitions of responsibilities and duties (d) Reports and statements required for each budget period (e) The accounts code in use. (f) Deadline by which data are to be submitted. 5. Budget Period: There is no right period for any budget. Budget periods may be short term and long term. If a business experiences seasonal fluctuations, the budget period will probably extend over one seasonal cycle. If this cycle covers, say two or three years, the long-term budget would cover the period, while the short-term budgets would perhaps be preparation on a monthly basis for control purpose. Short-term budgeting is usually costly to prepare and operate, while long-term budgeting may be considerably affected by unforeseen conditions. Budget periods frequently used in industry vary between one month and one year, the latter probably being the most commonly used as it fits in with the normally accepted accounting period. However, forecasts of much longer periods than a year may be used in the case of capital expenditure budgets, for example, which must be planned well in advance. A common practice in industry is to have a series of budget periods. Thus, the sales budget may cover the next five years, while production and cost budgets may cover only one year. These yearly budgets will be broken down into quarterly or even monthly periods. Where long-term budgets are operated it is usual to supplement them with short-term ones. 6. The key factor. This is the factor whose influence must first be assessed in order to ensure that functional budgets are reasonably capable of fulfillment. The key factor-known variously as the limiting or governing or principle budget factor is of vital importance. It may not be the same for each budget period, as the circumstances may change. It determines priorities in functional budget. Among the many key factors which may affect budgeting are the following:

a. Management i. Lack of capital, restricting policy ii. Lack of knowhow iii. Inefficient executives iv. Insufficient research into product design and methods.

LESSON 13
Classification of Budgets Though budgets can be classified according to various points of view the following bases of classification are generally in vogue: (a) Classification according to time factor (b) Functional classification (c) Classification according to flexibility factor. (A) Classification according to time factor. (1) Long-term Budgets (2) Short-term Budgets (3) Current Budgets: They cover a period of a month or so and as shot-term budgets, they get adjusted to prevailing circumstances. Sometimes, within the framework of a short-term budget, there are quarterly plans which are prepared by recasting the budget for a still shorter period on the basis of the performance of the immediate past. In a way, these quarterly budgets are meant to be an elaboration of the annual budget. (B) Functional Classification (1) Sales Budget, (2) Production Budget, (3) Personnel Budget (4) Purchase Budget : Correlated with sales forecast and production planning, it deals with purchases that are required for planned production. purchase would include both direct and indirect materials and goods. (5) Research Budget (6) Cash Budget (7) Capital Budget (8) Master Budget (9) Plant utilization Budget (10) Office and Administration Budget. This budget represents cost of all administrative expenses, such as managing directors salary, staff salaries and expenses of office management like lighting and cleaning. (C) Classification According to Flexibility (1) Fixed Budget: This is budget in which targets are rigidly fixed. Such budgets are usually prepared from one to three months in advance of the fiscal year to which they are applicable. Thus, twelve months or more may elapse before figures forecast for the December budget Are used to

measure actual performance. Many things may happen during this intervening period and they mayh make the figures go widely out of the line with the actual figures. Thought it is true that a fixed, or static budget as it is sometimes called, can be revised whenever the necessity arises, it smacks of rigidity and artificially so far as control over costs and expenses are concerned. Such budgets are preferred only where sales can be forecast with the greatest of accuracy which means, in turn, that the cost and expenses in relation to sales can be quite accurately ascertained. (2) Flexible Budget

LESSON 14
SALES BUDGET This is a forecast of total sales expressed and incorporated in quantities and / or money. A sales budget may be prepared by expressing turnover under any one or combination of the following: 1. Product or product group; 2. Territories, areas and countries; 3. Types of customers, e.g., National, Government, export, home, wholesales, or retails; 4. Salesman, agents or representatives, and 5. Period; such as quarters, months, weeks, etc. A sales budget may be prepared with the help of any one or more of the following methods. (1) Analysis of past sales: Analysis of past sales for a number of years, say 5 to 10 years, viz. long-term trend, seasonal trend, cyclical trend, sundry other factors. The long-term trend represents the movement of the fortunes of a business over many years. The seasonal trend may affect many types of business and hence this factor must be taken into account when studying figures for consecutive months over a number of years. The cyclical trend represents the fluctuations in the business activity due to the effect of the trade cycle. In order to study the cyclical trend it is desirable to disregard the effects to the long-term and seasonal trends. Sundry factors include, such as a strike in the industry or a serious fire or flood. From such analysis it will be possible to suggest future trends. In analyzing such sales, considerable help can be obtained from statistical reports produced by the trade units and commercial intelligence units, government publications, etc. (2) Studying the impact of factors affecting sale: Any change in the company policy or method should always be considered. For example, introduction of special discounts special salesmen, a new design of the product, new or additional advertising campaigns, improved deliveries, after-sales service should have some market effect on a sales budget. While preparing such forecasts, the sales manager must consider the opinion of divisional managers and other sales staff, the budget officer and the accountant. It will be observed that the preparation of a sales budget involves many factors and calls for a high degree of knowledge of conditions, and if ability to deduce fro

the known facts and various estimates the probable course of sales budget is prepared first. If production is the key factor, the production budget should be built up first and the sales budget must be drawn up within up within the limits imposed by the production budget. Illustration 1 AB Co. Ltd. manufactures two products, A and B, and sells them through two divisions North and South. For the purpose of submission of sales budget to the budget committee, the following information has been made available. Product A B North 4,000 at Rs. 9 3,000 at Rs. 21 South 6,000 at Rs. 9 45,000 at Rs. 21

Actual sales of the current year were: Product A B North 5,000 at Rs. 9 2,000 at Rs. 21 South 6,000 at Rs. 9 4,000 at Rs. 21

Market studies reveal that the product A, is popular but under-period. It is observed that if the price of A is increased by Re. 1 it will still find a ready market. On the other hand, B is over-period to customers and the market could absorb more if the sales price of B is reduce by Re. 1. The management has agreed to give effect to the above price changes. From the information relating to these price changes and reports from salesman, the following estimates have been prepared by divisional managers. Percentage increase in sales over current budget is: Product A B Product A B Prepare a Sales Budget North +10% +20% North 600 units 400 units South +5% +10% South 700 units 500 units

Additional sales above the estimated sales of divisional managers are:

Solution Sales Budget A B Co. Ltd. For the Year : 19 x 7 Prepared by ...................... Checked by ...................... Submitted on ....................
Division Product Budget Future Unit Value Qty North Total South Total Total (Summary) Total A B A B A B 5,000 4,000 9,000 7,000 6,000 13,000 12,000 10,000 22,000 10 20 10 20 Rs. 10 20 for Period Price Rs. 50,000 80,000 1,30,000 70,000 1,20,000 1,90,000 1,20,000 2,00,000 3,20,000 Qty 4,000 3,000 7,000 6,000 5,000 11,000 10,000 8,000 18,000 9 21 9 21 Rs. 9 21 Budget for Current Period Unit Price Value Rs. 36,000 63,000 99,000 54,000 1,05,000 1,59,000 90,000 1,68,000 2,58,000 Qty 5,000 2,000 7,000 7,000 4,000 11,000 12,000 6,000 18,000 9 21 9 21 Actual sales for Current Period Unit Price Value Rs. 9 21 Rs. 45,000 42,000 87,000 63,000 84,000 1,47,000 1,08,000 1,26,000 2,34,000

Production Budget Like the sales budget, the production budget is built up in terms of quantities and money. The quantities are entered at the beginning and, when the remainder of the budget have been built up and the cost of production calculated, the costs are entered to compile a production cost budget. In preparing the production budget, consideration should be given to the following:

(1) Principal budget factor, e.g., if sales be the budget factor then it should be the sales budget; otherwise other budgets. (2) Production planning and determination of optimum factory capacity. (3) The opening stocks, and stocks required to be carried at the end of the period. (4) The policy of the management regarding manufacture or purchase of components. The production budget may be classified under the following heads: (a) Products (b) Manufacturing department (c) Months, quarters, etc.

ABC Col. Ltd. (Production Budget (in units) Items Sales during the period Required stock on 31st Dec. Total Less Estimated Opening stock Estimated production Purchase Budget A purchase Budget gives the details of the purchase which must be made to meet the needs of the business. It includes all items of purchase. Such as raw materials, indirect materials and other equipments. The purchase budget for raw materials is the most important and the following factors are required to be considered in preparing this budget. (1) Opening and closing stocks. (2) Unfulfilled orders at the beginning of the budget period. (3) Storage space, economic buying quantity, and financial resources. A B 12,000 1,000 13,000 1,000 12,000 For the year..... Remarks 10,000 2,000 12,000 1,000 11,000

(4) The prices to be paid. Illustration 5 The following information regarding the stocks of materials required for the production programme of Ramesh Limited is available. Materials Estimated Consumption during 1983-84 (in kg) In 1st July 1983 On 30th June 1984 AB GH XY 9,03,000 6,90,000 5,47,000 20,000 10,000 30,000 17,000 20,000 33,000 Estimated Stocks (in kg)

Collating the details given above with the information contained in the Materials Budget, prepare the Purchase Budget of Ramesh Limited. Solution Ramesh Limited Purchase Budget (1983-84) Particulars Estimate Consumption Add: Stock required on 30-06-84 Total requirements Less: Estimated stock on 1st July 1983 Quantity to be purchased Price per kg (Estimate Estimated cost of purchase of materials (Rs) 9,00,000 3,50,000 2,20,000 20,000 9,00,000 Re. 1 10,000 7,00,000 50 p 30,000 5,50,000 40 p AB kg. 9,03,000 17,000 9,20,000 GH kg 6,90,000 20,000 7,10,000 XY kg 5,47,000 33,000 5,80,000

Preparation of Cash Budget A complete system of budgetary control makes the construction of cash budget easy. It is one of the functional budgets which is prepared along with other budgets. There are three recognized methods of preparing a cash budget. (a) The Receipts and Payment Method; (b) The Adjusted Profit and Loss Method; and (c) The Balance Sheet Method. Steps to be Adopted Cash Receipts Forecast; Cash receipts from sales, debtors, income from sales of assets and investments and probable borrowings should be forecast and brought into cash budget. Any lag in payment by debtors or by others shall be considered for ascertaining further cash inflows. Cash requirements forecast: Total cash outflows are taken out from operating budgets for the elements of cost, and from capital expenditure budget for the purchase of fixed assets. Adjustments are to be made for any lag in payments. Care must be taken to ensure that outstanding or accruals are excluded from the cash budget since this method is based on the concept of actual cash flows. Illustration 6 A newly started company Quick Co. Ltd., wishes to prepare cash budget from January. Prepare a cash budget for the first six months from the following estimated revenue and expenditure.

Month

Total Sales

Material

Wages

Production Overheads Rs. 3,200 3,300 3,300 3,400 3,500 3,600

Selling and distribution Overheads Rs., 800 900 800 900 900 1,000

Rs. Jan. Feb. Mar. Apr. May. June 20,000 22,000 24,000 26,000 28,000 30,000

Rs. 20,000 14,000 14,000 12,000 12,000 16,000

Rs. 4,000 4,400 4,600 4,600 4,800 4,800

Cash balance on 1st January was Rs. 10,000. A new machine is to be installed at Rs. 30,000 on credit, to be repaid by two equal installments in March and April. Sales commission @ 5% on total sales is to be paid within the month following actual sales. Rs. 10,000 being the amount of 2nd call may be received in March. Share premium amounting to Rs. 2,000 is also obtainable with 2nd call. Period of credit allowed to suppliers Period of credit allowed to customers Delay in payment of overheads Delay in payment of wages Assume cash sales to be 50% of total sales. 2 months 1 month 1 month month

Quick Co. Limited Cash Budget For the period January to June 1984
Details A Balance b/d B Receipts: Cash Sales (50%) Debtors Capital Share premium (A + B) Total C Payments Material Wages Production Overheads Commission Machinery (C) Total Balance (A+B+C) 18,000 29,800 20,000 6,100 8,800 15,200 20,000 2,000 2,000 10,000 39,000 4,200 800 1,000 9,200 11,000 10,000 2,000 64,800 20,000 4,500 900 1,100 15,000 44,800 12,000 45,000 14,000 4,600 800 1,200 15,000 38,900 13,000 33,100 14,000 4,700 900 1,300 24,300 14,000 37,800 12,000 4,800 900 1,400 22,600 Jan. Rs. 10,000 10,000 Feb. Rs. 18,000 11,000 Mar. Rs, 29,000 12,000 Apr. Rs, 20,000 13,000 May. Rs, 6,100 14,000 June Rs. 8,800 15,000

Flexible Budgets In those industries where the pattern of demand is stable, a fixed budget may be adequate, especially where the budget period is comparatively short. In such businesses it is possible to forecast sales with a considerable degree of accuracy. There are many undertakings where stable conditions are absent. In such concerns fluctuations in output might lead to violent deviations fromd the budget. In such concerns it is usual to adopt the flexible budgetary technique. A flexible budget is a budget which is designed to change in accordance with the level of activity actually attained. If flexible.

The owner of a car knows that the more he uses it per year the more it costs him to operate it. He also knows that the more he uses his car the less its costs per running metres. The reason for this lies in the nature of the expenses, some of which are fixed while others are variable or semivariable. Insurance, taxes, registration, and garaging are fixed costs; they remain the same whether the car is operated 1,000 or 2,000 kilometers. The costs of tyres, petrol oil, and repair are variable costs and depend largely upon the kilometers driven. Obsolescence and depreciation result in a combined type of cost that, although fluctuating to some degree upon the usage of the car, is semi-variable for it does not vary directly with the usage. The cost of operating the car per kilometer depends on the number of kilometers the car is used. The mileage constitutes the basis for judging the activity of the automobile. If the owners prepares an estimate of total cross and compares his actual expanses with the budget in keeping his expenses within the allowed limits, unless he takes the mileage factor into account. Originally, the flexible budget idea was applied principally to the control of departmental factory overhead. In recent years, however, the idea has been applied to the entire budget so that production budgets as well as selling and administrative budgets are prepared on a flexible basis. The construction of a flexible budget is identical with that of a fixed budget, except that a budget is calculated for each volume ranging from a possible 60 per cent to 100 per cent of capacity. When actual figures are available estimate previously determined for the level attained are compared with actual results, and the differences are noted. This end-of period comparison is used to measure the performance of each department head. It is this readymade method of comparison that makes the flexible budget a valuable instrument for cost control. The flexible budget assists in evaluating the effects of varying volumes of activity on profits and on cash position. Illustration 9 The following data are available in a manufacturing company for the half-year period ending 30th June, 1984. Fixed expenses: Wages and salaries Rent, rates, and taxes Depreciation Sundry administrative expenses Rs. (Lakhs) 8.4 5.6 7.0 8.9 29.9

Semi-variable capacity Indirect labour

expenses

50%

of 2.5 9.9 2.9 2.6 17.9

Maintenance and repairs Sales department salaries etc., Sundry administrative expenses

Variable expenses: @ 50% of capacity Material Labour Other expenses 24.0 25.6 3.8 53.4 It is assumed that fixed expenses remain constant for all levels of production semivariable expenses remain constant between 45% and 65% of capacity, increasing by 10% between 65% and 80% of capacity and 20% between 89% and 100% of capacity. Sales at the various levels are: 60% capacity 75% Capacity 90% Capacity 100% Capacity Rs. 100.00 lakhs 120.00 Lakhs 150.00 Lakhs 170.00 Lakhs

Prepare a flexible budget for the half-year and forecast the profits at 60%, 75%, 90% of capacity.

Solution Flexible Budget for the Half-Year Ending 30th June 1984 (showing the forecast of profit of different levels) Operating capacity Elements of cost A Fixed expenses: Wages and salaries Rent, rates and taxes Depreciation Sundry expenses 8.4 5.6 7.0 8.9 29.9 B. Semi-variable exp: Maintenance and repairs Indirect labour Sales Dept. salaries Sundry Adm. expenses 2.5 9.9 2.9 2.6 17.9 C. Variable expenses: Material Labour 24.0 25.6 28.80 30.72 36.00 30.47 43.20 46.08 48.0 51.2 2.5 9.9 2.9 2.6 17.9 2.75 10.89 3.19 2.86 19.69 3.00 11.88 3.48 3.12 21.48 3.00 11.88 3.48 3.12 21.48 8.4 5.6 7.0 8.9 29.9 8.4 5.6 7.0 8.9 29.9 8.4 5.6 7.0 8.9 29.9 8.4 5.6 7.0 8.9 29.9 50% 60% 75% 90% 100% Standard

Other expenses

3.8 53.4

4.56 64.08 111.88 -11.88

5.70 80.17 129.76 -9.76

6.84 96.12 147.50 +2.50

7.6 106.8 158.18 +11.82

Total cost of Production (i.e. Total of A, B and C) Profit (+) of Loss (-) Sales Less: Bills Payable Sundry Creditors

101.2

100.00 = = 10,000

120.00

150.00

170.00

Rs. 1,91,667

LESSON 15 CAPITAL BUDGETING

Concept of Capital Expenditure Every business concern has to face the problem on capital expenditure decisions some time or the other. Hence, planning for capital expenditure has become an integral part of policy making, management and budgetary control. Capital expenditure is one which is intended to benefit future periods and normally includes investment in fixed assets and other development projects. It is essentially a long-term function, and such for a decision to buy land, buildings or plant and machinery etc., would influence the activity of the business for a considerable period of time. Hence, it is essential to keep a close watch on capital expenditure at all times. Further, the advent of mechanization and automation has resulted in management being confronted with ever more frequent and difficult problems. Despite the fact that various techniques have been developed to assist management in its task of decision-making more effectively, the ultimate decision depends on the availability of relevant information which can be generated only by wellestablished capital expenditure budgeting system. The other commonly used nomenclatures for capital expenditure decision are Capital Budgeting, or Capital investment Decision, or simply Investment Decisions. Concept of capital Budgeting Capital budgeting normally refers to long-term planning for proposed capital outlays and their financing. It is the decision-making process by which firms evaluate the acquisition of major fixed assets whose benefits would be spread over several time periods. Succinctly, it involves current investment in which the benefits are expected to be received beyond one year in the future. The use of one year as a line of demarcation is, however, somewhat arbitrary. The main exercise in capital budgeting is to judge whether or not an investment proposals provides a reasonable return to investors which would be consistent with the investment objective of the business. Hence, capital budgeting involves generation of investment proposals, estimating costs and benefits (cash flows) for the investment proposals and evaluation of net benefits and selection of projects based upon an acceptance criterion. Importance of Capital Budgeting

1. Involves commitment of huge financial resources The capital investment involved is usually very large. It will have several far-reaching implications on the activities of business and may even seriously affect the very financial or flexibility of the business. It is these implications which make capital budgeting so important. 2. Wrong sale forecast may lead to over-or under-investment of resources It shows the possibility of expanding the production facilities to cover additional sales shown in the sales forecast. In fact the economic life of the asset acquired represents an indirect sales forecast for the duration of its economic life. Any error in this regord may result in over-or under-investment in fixed assets, i.e., excess production capacity or inadequate capacity. It also enables the cash forecast to be completed. 3. Leads to better timing of assets Capital budgeting may allow altimative forms of assets to be considered as replacement for assets which are wearing out or are in danger of becoming obsolete in other words, it would lead to better timing of asset purchases and improvement in quality of assets purchased. It helps to match efficiently the need for capital goods with their availability. It also assists in formulating a sound depreciation and asset replacement policy. 4. It ensures the selection of the right source of finance at the right time. Capital expenditure decisions involve substantial funds which may not be immediately, and automatically available. A well established capital budget would enable the management to decide in advance the source of finance and ensure their availability at the right time. Objective of capital Budgeting 1. Selection of the right mix of profitable projects. It may be said that the overall objectives of capital budgeting is to allocate the available investible funds among the competing capital projects in order to maximize the total profitability. This is made possible by employing the various evaluation techniques for the selection of investment projects which contribute the maximum towards the overall investment objective. In the case of public enterprises, capital budgeting may also assure fulfillment of other objective such as promotion of employment, development of backward regions, etc.

2. Capital Expenditure control. Control of capital expenditure is the next important objective of capital budgeting. This is achieved by forecasting the long-term financial requirements and thereby enabling the management to plan in advance to raise funds at the right time. The objective of preparing capital budget is to plan and then compare the actual capital expenditure with the budgeted figure for controlling costs. 3. Determining the required quantum and the right source of funds for investment. The next important objective of capital budgeting is to determine the funds required for long-term project and to see that such estimates fall in line with the companys financial policies. It also aims to compromise between the availability of funds and needs of the capital projects. Types of capital investment projects Investment projects may be classified in a number of ways. The following kinds of investment projects are commonly used by both private and public sector business units in their capital expenditure forecasts: (a) Expansion of existing product lines. (b) Expansion into new product lines. (c) Replacement and modernization schemes (d) Projects for the utilization of scraps, and also of surplus installed capacity (e) Cost reduction projects. The projects listed above are generally profit-oriented and therefore they may be evaluated on the basis of their costs and benefits. But there are investments which are undertaken by all business units and on which it would be difficult to measure returns, such as the following: (1) Safty precautions provision of safety devices and equipment may be demanded by various legal requirements. (2) Welfare projects: provision of sports facilities for employees may boost employees morale. This cannot be evaluated financially. (3) Service projects: provision of buildings and equipment for non manufacturing departments may be essential, but the return from investment on them cannot be evaluated.

(4) Research and development: This may be initiated to improve the company methods or products. It would be very difficult to measure the return on R&D for a considerable period of time. (5) Educational projects: Provision of company training course may be instrumental in improving the efficiency of employment but the returns from investment on such programmes may be difficult to evaluate. Relevant cost for capital expenditure decision Generally, costs and benefits in the form of cash flows are more relevant for capital budgeting then the conventional accounting cost and benefits because such costs and benefits normally encounter a number of measurement problems owing the factors such as method of depreciation, valuation of inventories, write-off etc., Different types of investment decisions call for different kinds of costs. not all costs which are used in conventional accounting system are relevant for investment decision making. A few items of relevant costs are: Future costs: Future costs are the projected or estimated costs. they are relevant for all types of investment decision past cost, though not relevant for decision-making, are useful to the extent that they furnish a starting point for future cost projections. While calculating these costs, factors such as market conditions, economic conditions, political situation, general trend in the price levels, probabilities relating to future production and sales, economic life of the project, etc. are to be taken into account. Opportunity costs: In simple terms, opportunity cost refers to the benefits of the best alternative foregone. As the investment in a project involves commitment of the firms investible funds it becomes relevant to consider the opportunity of getting some benefits by employing the resources on some other alternative. For example, in an expansion scheme the economic value of the space required rather than its book value is relevant. In a replacement decision, the realizable value rather then the book value of the old may be relevant as a reduction of the cost of replacement. This type of cost is relevant for all types of investment decision. Imputed cost is a kind of opportunity cost. It is the cost which is not actually incurred, but would be incurred in the absence of self-owned factors, e.g. cost of retained earnings, rent on company owned facilities, etc. Incremental or differential cost: It is the additional cost due to a change in the volume of business or nature of business activity. Hence it is useful for decisions such as adding new machinery, new product, changing a distribution channel etc. sometimes this cost is considered synonymous with marginal cost. But marginal cost has much limited meaning as it refers to the cost of an added unit of output.

Interest cost : Accounting reports normally ignore the imputed interest on capital which is relevant for decision-making purposes. Interest cost constitutes the minimum acceptance criterion for capital investment projects undertaken for profit. A firm must at least recover its money before it can realize a profit on its own investment. Depreciation and Income-tax: Depreciation is normally excluded while calculating cash flows for investment, appraisal and evaluation. But it is included for calculating the accounting rate of the project. Payment of taxes results in cash flows and therefore, is an important element in capital investment decisions. Income-tax has a number of effects on capital investment decisions. Hence, tax laws and applicable legal decisions emphasise the need for special skill in this area. Secondary costs and benefits: These costs and benefits are particularly relevant for the capital expenditure decision in public enterprises. They are external to the project implementing body and there for called external cost and benefits, or simply externalities. These are the costs and benefits, which are imposed on other sectorsgovernment, society or the economy as a whole during the construction and operation of the project and for which nothing is paid or received. There are two types of externalities, viz., technological and pecuniary. The smoke and dust pollution and noise etc., are examples of technological externalities pecuniary externalities are such as increasing rates of hire for factors of production, reduction in prices of substitute projects, etc. secondary benefits are the increase in profits that can be attributed to the increased activity of processors, merchants and others who handle the projects output or input. The major problems associated with these costs and benefits are their identification and measurement. However, for easy identification they should be related to the socioeconomic objectives assigned to the project. To measure these costs and benefits, shadow prices or imputed prices should be used. Capital Expenditure Control The control over capital expenditure is growing in importance as mechanization and automation are introduced and extended. However, formal capital budgeting is still undeveloped as it is of comparatively recent origin. Any system of capital expenditure control should have the following feature. Planned development: Capital expenditure should be carefully planned to include developments in each site or department to ensure that each unit in the group or company is developing in step with the overall plan preparation of capital budget will be essential, even when companies to not operate a complete system of budgetary control. Capital appropriations and payment must be planned well in advance.

Control of progress: A progress record is necessary to show the progress of each capital project. The budget and actual expenditure will be compared for analysis and control. These reports are also useful to ensure that the overall programme remains within the limits set by the policy of the company. Post-completion Audits: This is an important step of capital expenditure control. Post completion audits of projects determine. Where their actual value is in accordance with the one determined at the time of authorization. This review can be very important because it may reveal inefficiencies in the system, and it would provide experience which would help in avoiding repetition of mistakes. Forms and procedures: There should be a routine for controlling capital expenditure. A procedure should be adopted for the various stages requesting for capital expenditures, authorization, reporting the progress of such projects and audit. A well designed from should be used for the above purposes for better control.

LESSON 16
Methods of Ranking Investment Proposals The final step in a the capital budgeting system involves evaluating the profitability of the alternative project and selecting the best one. A firm may face a situation where more investment proposals may be available than investible funds. Some proposals may be good, some moderate, and many poor. Hence, a ranking procedure has to be evolved so that the available funds can be allocated among different proposals in a profitable manner. Essentially, the ranking procedure envisages relating of a stream of future benefits to the cost of investments. Among the various methods, the following are commonly used by many business concerns: Traditional or non-time value techniques i. ii. iii. iv. v. vi. vii. Payback period Average rate of return Modern or time value techniques Discounted cash flow methods Net present value Benefit / cost radio Internal rate of return

Payback period Business units, while selecting investment projects, would consider the recover of cost as the first and foremost concern, even though earning maximum profit is then ultimate goal. Payback period normally refers to the time required for recouping the initial investment in full with the help of the stream of annual cash flows generated by the project. It is also called pay-out or pay off period, expressed, as: C Payback period (PB) = -----------1 Where C = original coast of investment, and I = annual cash inflows. In the case of uneven cash inflows it may be expressed as

PB = P = Where X represents cash flows during periods 0,1,2,.....P represents payback period. The cash flows for the purpose of PB calculation, would be savings or earnings after payment of taxes but before depreciation. To illustrate, if a cash outlay of Rs. 30,000 is expected to yield a constant net cash flow (cash earnings minus cash expenses) of Rs. 12,000 P a for a period of 5 years, the PB is 2 years (Rs. 30,000 + Rs. 12,000). Selection criteria: Among the mutually exclusive or alternative projects whose PBs are lower than the cut-off period, the project with the shorter PB would be selected. In case there are budget constraints, the procedure would be to rank the projects in the ascending order of PBs and select the first X number of projects which the budget provision permit. However, with a views to making the selection process more realistic, a cut-off period or minimum payback ratio could be set up and all investment proposals for which the PB is greater than this cut-off period be rejected. Payback ratio is the inverse of the payback period. For a payback period of 4 years, the payback ratio is 1/4. Thus larger the payback ratio, better the project. Illustration 1 From the following advise the management as to which project is preferable based on payback period. The standard cut off period for the company is 5 years. Project A Rs. Capital cost Cash flows (savings before depreciation, but after taxes) Ist year IInd year IIIrd year IVth year Vth year VIth year 5,000 5,000 5,000 2,000 2,000 2,000 21,000 4,000 4,000 4,000 3,000 7,000 9,000 31,000 15,000 Project B Rs. 15,000

Solution Payback period = (5,000 + 5,000 + 5,000 = 15,000)

Project A 3 years

Project B 4 years

(Rs. 4,000 + 4,000 + 4,000 + 3,000 = 15,000)

The PBs of A and B are 3 years and 4 years respectively and thus project. A is adjudged superior to project B in terms of PB criterion since it is also shorter than the cut-off period. Merits of payback period: 1. It is easy to operate and simple to understand 2. This method is preferred on the ground that returns beyond three or four years are so uncertain that it is better to disregard them altogether in a planning decision. 3. It is appropriate for industries with a high rate of technological obsolescence in which the receipts beyond PB are regarded as totally uncertain. 4. This method is also useful to a concern which is short of cash and is eager to get back the cash invested in a capital expenditure project. 5. As the method considers the cash flows during the payback period of the project, the estimates would be reliable and the results may be comparatively more accurate. Despite the simplicity and ease of operation, this method suffers from several drawbacks. Demerits 1. The PB is more a liquidity than a profitability concept, for it places accent only on the recovery of cash outlay and stresses the importance of liquidity, that is recovery at the cost of profitability. 2. It does not consider the earnings beyond the payback period. This may lead to wrong selection of investment projects. Profitable projects with long gestation periods or projects which generate high returns only after a certain period of time may be rejected under this method. 3. The most serious limitation of this method is that it ignores the time value of money.

Average Rate of return Method (ARR) ARR is considered to be an improvement over the PB method for it considers the earnings of a project during its entire economic life. It is also known as Return on investment method. ARR = Average earnings or return -------------------------------------------------- x 100 Average investment

The average return is computed by adding all the earnings after depreciation, and dividing them by the projects economic life. Average investment is the simple average of the values of assets at the beginning and end of the useful life of the asset which in most cases, Would be zero. Though sometimes initial investment is used, average investment is more logical. Selection Criteria: The decision rule is that a project with the highest rate of return on investment is selected on condition that such rate is above the standard rate set, or the cut-off rate. Illustration 2 Calculate the average rate of return for project A and B from the following information. Project A Invested (Rs) Expected life (in years) Years 1 2 3 4 5 2,500 1,875 1,875 1,250 -7,500 3,750 3,750 2,500 1,250 1,250 12,500 25,000 4 Project B 37,500 5

Net earnings (after depreciation and taxes)

If the desired rate of return is 12%, which project should be selected?

Solution Project A Average return Rs. 7,500 4 -Rs. 1,875 Average investment Rs. 25,000 + 0 2 -Rs. 12,500 Average rate of return Rs. 1,875x100 Rs. 12,500 -15% Project B Rs. 12,500 5 Rs. 2,500 Rs. 37,500+0 2 Rs. 18,750 Rs. 2,500x100 Rs. 18,750 13.33%

Both the projects satisfy the minimum required rate of return. However, if the projects are mutually exclusive or alternative i.e. only one project is to be selected, project A will be selected as its ARR is higher than project B. if they are not mutually exclusive, and there are no budget constraints, both the projects will be selected. Merits: 1. This method is also easy to understand and simple to operate 2. The ARR method takes into account earnings over the entire economic life of the project. 3. This is really a profitability concept since it considers net earnings after depreciation, i.e., excess of earnings over original cost of investment. 4. Projects which differ widely in characted could be compared under this system.

Demerits 1. The most severe criticism of this method is that it ignores the time value of money.

2. Normally, a host of variants are to be resolved relating to its components viz., earnings and investment cost. For example, it may be the gross, net or average investment which is to be considered for computation. This may produce different rates of any one proposal. 3. Another problem in connection with the method is regarding a reasonable rate of return on investments. Some stipulate a minimum rate so that if projects do not satisfy this rate, they are summarily excluded from consideration.

LESSON 17
Discounted Cash Flow (DCF) Method or Time Adjusted Technique The discounted cash flow technique is an improvement on the pay-back period method. It takes into account both the interest factor as well as the return after the pay-back period. The method involves three stages. i. ii. iii. iv. Calculation of cash flows, i.e., both inflows and outflows (preferably after tax) over the full life of the asset. Discounting the cash flows so calculated by a discount factor Aggregating of discounted cash inflows and comparing the total with the discounted cash outflows. Discounted cash flow technique thus recognizes that Re 1 of today (the cash outflow) is worth more than Re. 1 received at a future date (cash inflow)

Discounted cash floe methods for evaluating capital investment proposals are of three types: (a) Net Present Value (NPV) Method (b) Excess Present value Index (or) Benefit Cost Ratio (c) Internal Rate of Return

NPV Method This is generally considered to be the best method for evaluating the capital investment proposals. In case of this method cash inflows and cash outflows associated with each project are first worked out. The present values of these cash inflows and outflows are then calculated at the rate of return acceptable to the management. This rate of return is considered as the cut-off rate and is generally determined on the basis of cost of capital suitably adjusted to allow for the risk element involved in the project. Cash outflows represent the investment and commitments of cash in the project at various points of time. The working capital is taken as a cash outflow in the year the project starts commercial production. profit after tax but before depreciation represents cash inflow. The Net present value (NPV) is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

The equation for calculation NPV is case of conventional cash flows can be put as follows: R1 ------ + (1 + k) R2 ------- + (1 + k)2 R3 -------- + (1 + k)3 Rn --------(1 + k)n

NPV =

Incase of non-convential cash inflow (i.e. where there are a series of cash inflows as well cash outflows ) the equation for calculating NPV is as follows:

NPV =

R1 ------ + (1 + k)

R2 ------- + (1 + k)2

R3 -------- + (1 + k)3

Rn --------(1 + k)n

11 10 ------ + (1 + k)

12 ------- + (1 + k)2

13 -------- + (1 + k)3

1n --------(1 + k)n

Where NPV = Net present value, R = Cash Inflows at different time periods, K Cost of Capital or Cut-off Rate, 1 = Cash outflows at different time periods. Accept or reject criterion. The net present value can be used as an accept or reject criterion. In cash the NPV is positive (i.e., present value of the cash inflows is more than present value of cash outflows) the project should be accepted. Illustration The Alpha Co. Ltd. is concidering the purchase of a new machine. The alternative machines (A and B) have been suggested, each having an initial cost of Rs. 4,00,000 and requiring Rs. 20,000 as additional working capital at the end of 1 st year. Earning after taxation are expected to be as follows:

Cash Inflows Year 1 2 3 4 5 Machine A 40,000 1,20,000 1,60,000 2,40,000 1,60,000 Machine B 1,20,000 1,60,000 2,00,000 1,20,000 80,000

The company has a target of return of 10% and on this basis, you are required to compare the profitability of the machines and state which alternative you consider financially preferable. Note: The following table gives the present value of Re.1 due in n number of years. Year 1 2 3 4 5 Present value at 10% 0.91 0.83 0.75 0.68 0.62

Solution The Alpha Company STATEMENT SHOWING THE PROFITABILITY OF THE TWO MACHINES Year Discount Machine A Cash Inflow Rs. 1 2 3 4 5 0.91 0.83 0.75 0.68 0.62 40,000 1,20,000 1,60,000 2,40,000 1,60,000 Present Value Rs. 36,000 99,600 1,20,000 1,63,000 9,200 5,18,400 4,18,200 Machine B Cash Inflow Rs. 1,20,000 1,60,000 2,00,000 1,20,000 80,000 Present value Rs. 1,09,200 1,32,800 1,50,000 81,600 49,600 5,23,200 4,18,200

Total present value of cash inflow Total present value of cash outflow (Rs. 4,00,000 + 20,000 x 91) Net present Value

1,00,200

1,05,000

Excess Present value Index : This is a refinement of the net present value method. Instead of working out the net present value, a present value index is found out by comparing the total of present value of future cash inflows and the total of the present value of future cash outflows. This can be put in the form of following formula. Excess Present Value Index. Present value of future cash inflows (Or) Benefits Cost (B/C) Ratio = ---------------------------------------------------------------- x 100 Present value of future cash outflows Excess present value Index provides ready comparison between investment proposals of different magnitudes. For example, A requiring an investment of Rs. 1,00,000 shows excess present value of Rs. 20,000 while another project B requiring an investment of Rs. 10,000 shows an excess on present value of Rs. 5,000. If absolute figures of present values are compared, Project A may to be profitable.

However, if excess present value index method is followed project B would prov e to be profitable. 1,20,000 Present Value Index for project A = ------------------------ x 100 = 120% 1,00,000 15,000 Present Value Index for Project B = ------------------------- x 100 = 150% 10,000

LESSON 18 INTERNAL RATE OF RETURN

Internal Rate of Return is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. In other words, it is the rate which discounts the cash flows to zero. It can be stated in the form of a ratio as follows: Cash Inflows ------------------- = 1 Cash outflows Thus, in case of this method the discount rate is not known but the cash outflows and cash inflows are known. For example, if a sum of Rs. 800 invested in a project becomes Rs. 1,000 at the end of a year, the rate of return comes to 25% calculated as follows: R 1 = ------------1+r Where I R r Thus: 1000 800 = ---------1+r Or 800r + 800 = 1,000 Or 800r = 200 = = = Cash Outflow, i.e., initial Investment Cash Inflow Rate of return yoclded by the Investment (or IRR)

200 Or r = ------------------ 25 or 25% 800 Illustration Cost of project Rs. 11,000 Cash inflow: Year 1 Year 2 Year 3 Year 4 Find out Internal Rate of Return Solution: I F = -------------------C F= I= C= Factor to be located Original investment Average cash inflow per year 6,000 2,000 1,000 5,000

The factor would be 11,000 F = -------------------- = 3.14 3,500 The factor thus calculated will be located in. Table II on the line representing number of years corresponding to estimated useful life of the asset. This would give the estimate

date of return to be applied for discounting the cash inflows for the internal rate of return. The rate comes to 10%. Year 1 2 3 4 Cash inflow 6,000 2,000 1,000 5,000 Discounting Factor at 10% 0.909 0.826 0.751 0.683 Total present value Present value 5,454 1,652 751 3,415 11,272

The present value at 10% comes to Rs. 272. The initial investment is Rs. 11,000. Internal rate of Return may be taken approximately at 10% In case more exactness is required another trial rate which is slightly higher than 10% (since at this rate the present value is more than initial investment) may be taken. Taking a rate of 12%, the following results would emerge. Year 1 2 3 4 Cash inflow 6,000 2,000 1,000 5,000 Discounting Factor at 10% 0.893 0.797 0.712 0.636 Total present value Present value 5,358 1,594 712 3,180 10844

The internal rate of return is this more than 10% but less than 12%. The exact rate may be calculated as follows:

Difference in calculated Present value and required net cash only Internal Rate of Return = ------------------------------------------- x Difference in rate Difference in calculated present values 11,272 - 11,000 = 10% + -------------------------------- x 2 11,272 10,844 272 = 10% + ------------- x 2 = 11.3% 428 The exact internal rate of return can be also calculated as follows: At 10% the present value is + 272 At 12% the present value is 156. The internal rate would, therefore, the between 10% and 12% calculated as follows: 272 = 10 + --------------------- x 2 272 + 156 = 10 + 1.3 = 11.3% Merits: The merits of discount cash flow method are as follows: (i) Discounted cash flow technique take into account the time value of money conceptually it is better than other techniques such as pay-back or accounting rate of return.

(ii)

The method takes into account directly the amount of expenses and revenues over the projects life. In case of other methods simply their averages are taken. The method automatically gives more weight to those money value which are nearer to the present period than those which are father from it. While in case of other methods, all money units are given the same weight which seems to be unrealistic. The method makes possible comparison of projects requiring different capital outlays, having different lives and different timings of cash flows, at a particular moment of time because of discounting of all cash flows.

(iii)

(iv)

Demerits: The following are the demerits of discounted cash flow method. (1) The method is difficult to understand and work out as compared to other method of ranking capital investment proposals. (2) The method takes into account only the cash inflows on account of a capital investment decision. As a matter of fact, the profitability or other wise of a capital proposal can be judged. Only when the net income (and not the cash inflow) on account of operations is considered. (3) The method is based on the presumption that cash inflow can be invested at the discounting rate in the new projects. However, this presumption does not always hold goods because it all depends upon the available investment opportunities.

LESSON 19
MARGINAL COSTING AND COST VOLUME PROFIT ANALYSIS
Marginal costing is a technique of ascertaining marginal costs or variable costs. it is not a system for cost ascertainment, but is mainly a technique to deal with the effect on profits of changes in volume or type of output. This technique may be used in conjunction with other methods of costing. Marginal costing is also known as direct costing or variable costing. The latter expressions are mainly used in the United States. Concept of Marginal Cost and Marginal Costing The concept of marginal cost has been borrowed from economic theory. To the economist, marginal cost is an incremental cost: he considers it as the addition to total cost which results from the production of one more unit of output. That is, it does not arise if the additional unit is not produced. The Institute of Costs and Management Accountants, London, defines marginal cost as: The amount at any given volume of output by which aggregate cost are changed if the volume of output is increased or decreased by one unit. As referred to here, a unit may indicate a single article, a batch of articles, an order a stage of production capacity, a processor a department, i.e., it relates to the change in output in the particular circumstances under consideration. Under marginal costing, costs are mainly classified into fixed costs and variable costs. the essential feature of marginal costing is that the product or marginal costs (i.e., those costs which are dependent on the volume of activity, are separated from the period or fixed costs, i.e., costs which remain unchanged with a change in the volume of activity. Variability with the volume of output is the main criterion for the classification of costs into product and period categories. Even the semi-variable costs have to be bifurcated into their fixed and variable components based on the variability criterion. In this regard, the absorption or conventional costing system differs from marginal costing. Under absorption costing system all manufacturing costs, whether of fixed or variable nature are treated as product costs. all companies which use marginal costing as an aid to managerial decision-making mainly use the absorption costing system.

PROFORMA MARGINAL COST STATEMENT Product X Sales Less: Variable cost Contribution Less fixed cost profit ................ ................ ................ Product Y ................ ................ ................ Total ................... ................... ................... ................... --------------

From the marginal cost statement, the following equations may be derived: Contribution = Sales Variable cost Contribution = Fixed cost + profit Fixed cost = Contribution profit Fixed cost = Contribution + Loss Contribution = fixed Cost + Loss Sales = Variable cost + Contribution Variable cost = Sales contribution Profit = Contribution fixed cost Loss = fixed cost contribution These equations may be used for solving problems of different types involving costvolume profit relationship. The Concept of Contribution and its Significance Contribution is the difference net sales and marginal costs, and it is used to recover fixed costs first. Any excess over fixed costs would be profits. When a business manufacturers more than one product, the computation of profits realized on individual products may be difficult due to the problem of apportionment of fixed costs to different products., the rationale of contribution lies in the fact that fixed costs are done away with

under marginal costing. The concept of contribution helps to determine the breakeven points, profitability of products, departments, etc., to select product-mix for profit maximization, and to fix selling prices under different circumstances such as trade depression, expert sales prices discrimination etc. contribution is the definite test to ascertain whether a product or process is worthwhile to continue among different products or processes. Problem of Key Factor, or Measurement of Profitability The contribution could be used as a measure to solve the problem of key factor. A key factor, otherwise called limiting factor, or principal budget factor, or scarce factor, may be defined as the factor which, over a period, will limite the volume of output, or which puts a limit on the efforts of the management to produce as many units of the selected products as it would like to when manufacture and sale of a product are confronted by the problem of key factor, the profitability of that particular product is then ascertained by relating the key factor used for the manufacture of the product, and its resulting contribution. Generally, sales would be the limiting factor but sometimes, materials, labour, plant capacity, etc., may be the inhibiting, factor when the key factor and contribution are given, the relative profitability may be calculated by employing the formula given below: Contribution Profitability = -----------------------Key factor For example, when material is in short supply, profitability is determined by dividing the contribution per unit by the quantity of materials used per unity when sales is the key factor, profitability is measured by contribution sales ratio, and so on. Advantages of Marginal Costing (a) Marginal costing is easy to understand. It can be combined with standard costing and budgetary control and thereby make the control mechanism more effective. (b) Elimination of fixed overhead from the cost of production prevents the effect of varying charges per unit, and also prevents the carrying forward of a portion of the fixed overheads of the current period to the subsequent period. As such cost and profit are not initiated and cost comparisons becomes more meaningful. (c) The problem of over or under absorption of overheads is avoided.

(d) A clear-cut division of costs into fixed and variable elements makes the flexible budgetary control system more easy and effective and thereby facilitated greater particle cost control. (e) If helps profit planning through break even charts and profit graphs comparative profitability can easily be assessed and brought to the notice of the management for decision-making. (f) It is an effective tool for determining efficient sales or production policies, or for taking pricing and tendering decisions, particularly when the business is at a low ebb. Managerial Uses of Managerial Costing: From the advantages stated above, the following may be listed as specific managerial uses: (a) Cost Ascertainment: Marginal costing technique facilitates not only the recording of costs but their reporting also. The classification of costs into fixed and variable components makes the top of cost ascertainment more easy. The main problem in this regard is only segregation of the semi-variable cost into fixed and variable elements. However, this may be overcome by adopting any of the methods already explained for the purpose. (b) Cost control: Marginal cost statements can be understood more easily by the management than those presented under absorption costing bifurcation of costs into fixed and variable enables management to exercise control over production cost and thereby effect efficiency. In fact, while variable costs are controllable at the lower levels of management, fixed costs can be controlled at the top level. Under this technique management can study the behaviour of costs at varying conditions of output and sales and thereby exercise better control over costs. Limitations of Marginal costing Despite its superiority over absorption costing, the marginal costing technique has its own limitations. (a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a major technical difficulty arises in drawing a sharp line of demarcation between fixed and variable costs. the distinction between them holds good only in the short run. In the long-run, however, all costs are variable.

(b) In marginal costing, greater importance is attached to the sales function thereby relegating the production function largely to a secondary position. But, the real efficiency of a business is to be assessed only by considering the selling and production functions together. (c) The elimination of fixed costs from the valuation of inventories is illogical since fixed costs are also incurred in the manufacture of goods. Further, it results in the understatement of the value of stock, which is neither the cost nor the market price. (d) Pricing decision cannot be based on contribution alone. Sometimes, the contribution will be unrealistic when increased production and sale are effected, either through extensive use of existing machinery or by replacing manuallabour by machines. Another possibility is that there is danger of too many sales being effected at marginal cost, resulting in denial to the business of inadequate profits. (e) Although the problem of over or under absorption of fixed overheads can by overcome to a certain extent, the same problem still persist with regard to variable overheads. (f) The application of this technique is limited in the case of industries in which according to the nature of business, large stocks have to be carried by way of work-in-progress (e.g. contracting firms) Practical Applications of Marginal Costing (a) Profit Planning: A business concern exists with the objective of making profits, and profits are the yardstick of its success profit planning is therefore a part of operations planning. It is the basis of planning cash, capital expenditure, and pricing. If growth and survival of a business are to be ensured, profit planning becomes an absolute necessary. Marginal costing assists profit planning through computation of contribution ratio. It enables planning of future operation in such a way as to either maximize profits pre maintain specified levels of profit. Normally, profits are affected by several factors, such as the volume of sales, marginal cost per unit, total fixed costs, selling price and sales mix etc., Hence management can achieve their profit goals by varying one or more of the above variables. Basic marginal costing equations which are useful in profit planning are as follows. Profit volume ratio (p/w ratio). This is the ratio of contribution to sales. Symbolically it is expressed as: Contribution C/S ratio or P/V ratio = --------------------------------- x 100 (as a percentage) Sales (S)

(1)

Contribution = Sales x P/V ratio Contribution Sales = -------------------------P/V ratio

(2) (3)

Brake Even point (BEP). This may be defined as that point of sales volume at which total revenue is equal to total costs. it is a no-profit no-less point. It may be derived from the equation (3). We may get Contribution at BEP ----------------------------P/V ratio

BEP (in Rs.)

At BEP, the contribution will be equal to fixed cost and therefore, the formula may be restructured as follow: Fixed Cost --------------------------P/V ratio Fixed Cost (F) ----------------------------Contribution per unit

BEP (in Rs.) =

BEP (in units) =

Margin of Safety (MS) : This represents the difference between salew or production at the selected activity, and the break-even sales or production. MS = Sales at the selected activity --- BEP C Sales at the selected activity = ---------------------P-V ratio F ---------------------P/V ratio

BEP =

C F profit (p) MS = ------------------------- ------------ ------------------- = ---------------------------

P/V ratio Where C-F = P

P/V ratio

P/V ratio

Margin of safety is also presented in percentages as follows: MS (Sales) x 100 ----------------------------------------Sales at selected activity Illustration 2 From the following information, calculate BEP and determine the net profit if sales are 25% above BEP Selling price per unit Rs. 50 Direct material cost per unit Rs. 20 Direct wages per unit : Rs. 10 Variable overheads per unit : Rs. 7.5 Fixed overheads (total) Rs. 50,000 Solution Marginal Cost Statement Rs. Selling price per unit Less: marginal cost per unit Materials Wages: Variable overheads: Contribution: Rs. 20.00 10.00 7.50 37.50 12.50 50.00

12.50

P/V ratio = ------------- x 100 = ---------------- x 100 = 25%

50

F P/V ratio BEP 25% of BEP Total sales Contribution

Rs. 50,000 25

BEP = ---------------- = ----------------------- x 100 = 2,00,000

= Rs. 2,00,000 = Rs. 50,000 ----------------------Rs. 2,50,000 = Sales x P/V ratio = Rs. 2,50,000 x 25% = Rs. 62,500 = Rs. 50,000 -------------------Net profit = Rs. 12,500 -------------------(b) Level of Activity Planning

Contribution at Rs. 2,50,000 sales Contribution Less: Fixed cost

Business concern may have plans either to expland or contract the level of activities depending upon the conditions prevailing in the market. Such planning is to be considered before events overtake the business. Marginal costing is very useful for taking such decisions by enabling management to compare the contribution at different levels of activities.

Illustration 5 Following is the Cost Structure of JB limited Levels of Activity Output (in puts) Costs (Rs.) Materials Wages Factory overheads Factory cost 48,000 14,400 25,600 88,000 56,000 16,800 27,200 1,00,000 64,000 19,200 28,800 1,12,000 60% 2,400 70% 2,800 80% 3,200

The factory is considering an increase of production to 90% level of activity. No increase in fixed overheads is expected at this level. The management requires a statement showing all details of factory costs at 90% level of activity.

Solution Marginal Cost Statement Level of activity = Output = Total cost Rs. Material Wages Variable overheads Fixed overheads Total factory cost 72,000 21,600 14,400 1,08,000 16,000 1,24,000 90% 3.600 units Per unit Rs. 20.00 6.00 4.00 30.00

Note: Factory overheads increase by Rs. 1,600 at each level of activity. Therefore, variable overheads must be Rs. 1,600 ----------------- = Rs. 4 per unit. At 80% level of activity, Factory overheads 400 units are Rs. 28,800 of which variable cost are Rs. 12,800 (Rs. 4 x 3,200), resulting in fixed overheads of Rs. 16,000 (Rs. 28,800 Rs. 12,800). (D) Profitable Mix of Sales A company which has a variety of product lines can employ marginal costing in order to determine the most profitable sales mix from a number of selected alternatives.

Illustration 6 The directors of AB Ltd. are considering the sales budget for the next budget period. The following information has been made available form the cost records. Product Z (per unit) Directed materials Selling price Direct wages (a) Rs. 2 per hour 10 hours 15 hours Rs. 40 Rs. 120 Product Y (per unit) Rs. 50 Rs. 200

Variable overheads : 100% of direct wages Fixed overheads : Rs. 20,000 p.a. You are required to present to the management a statement showing the marginal cost of each product, and to recommend which of the following sales mix should be adopted. (a) 450 units of Z and 300 units of Y (b) 900 units of Z only (c) 600 units of Y only (d) 600 units of Z and 200 units of Y

Solution Marginal cost statement Per unit Product Z Rs. Selling price Less: Materials cost Direct materials Direct wages Variable overheads 40 20 20 80 40 Selection of Alternatives Products Z Rs. 450 300 Y Contribution (450 x Rs. 40) + (300 x Rs. 90) Less: Fixed over-heads Profit 900 Z Contribution 36,000 36,000 20,000 25,000 18,000 Y Rs. 27,000 Total Rs. 45,000 50 30 30 110 90 Rs. 120 Rs. Product Y Rs. 200

(900 x Rs. 40) Less fixed cost Profit (c) 600 Y Contribution (600 x Rs. 90) Less: fixed cost Profit 600 Z, 200 Y Contribution (600 x Rs. 40) + (200 x Rs. 90) Less: Fixed cost Profit Thus, alternative (c) is the one recommended. (d) Marginal Costing and Pricing Determining the price of products manufactured by a company is often considered to be a difficult problem. However, the basic problem involved in pricing is the matching of demand and supply. Marginal costing is something used to determine prices, a simple and familiar example being the railway ticket. The normal fare will usually be more than the charge collected for excursion fare (concessional fare) for, the normal fare is calculated to cover all the railway costs, including fixed overheads which are a considerable item, whereas the excursion fare will probably cover only the marginal cost (which is relatively small) and some contribution towards profit. The marginal costing technique can help management in fixing price in such special circumstances as: (a) A trade depression in the industry. (b) Spare capacity in the factory (c) A seasonal fluctuation in demand. 24,000 18,000 54,000 20,000 16,000 54,000

20,000 34,000 42,000 20,000

22,000

(d) When it is desired to obtain a special contract. Cost volume profit Analysis Cost volume profit (CVP) analysis is an analytical tool for studying the relationship between volume cost, price and profits. It is an integral part of the profit planning process of the firm. However, formal profit planning and control involves the use of budgets and other forecasts, and the CVP analysis provides only an overview of the profit planning process. Besides, it helps to evaluate the purpose and reasonableness of such budgets and forecasts. Generally, CVP analysis provides answers to questions such as: (a) What will be the effect of changes in prices / costs and volume on profit? (b) What minimum sales volume need be effected to avoid losses? (c) What should be the level of activity to earn a target profit? (d) Which product is the most profitable and which product or operation of a plant should be discontinued? Etc Break Even Analysis The break-even analysis is the most widely known from of the CVP analysis. The study of CVP relationship is frequently referred to as break-even analysis. However, some state that up to the point of activity where total revenue equals total expenses, the study can be called as break-even analysis and beyond that point, it is the application of CVP relationship. Thus, a narrow in depredation of break-even analysis refers to a system of determining that level of activity where total revenue equals total cost i.e. the point of zero loss. The broader interpretation denotes a system of analysis that can be used to determine the probable profit at any level of activity. Practical Utility of Break-even Analysis Break-even Analysis can be used to show the effect of a change in any of the following profit factors: (1) Change in selling price (2) Change in volume of sales

(3) Change in variable costs (4) Change in fixed costs

LESSON 20 MANAGEMENT REPORTING

Information is the basis for decision making in an organisation. The efficiency of management depends, to a larger extent, upon the availability of regular and relevant information to those exercise the managerial functions. No planning and control procedure is complete without prompt and accurate feedback of operation results and availability of other information. For example, management must know how the actual profit performance collates with that of budgeted or standard or with past performances and to what extant the variation have been caused by various influencing factors. A regular system of reporting is considered as a better guarantee of efficiency and operation than reliance on personal qualities. Hence, it is essential that an effective and efficient reporting system is developed as part of accounting methods. Meaning The term reporting connotes different meanings as under: (A) Narrating some facts (B) Reviewing certain matter with its merits and demerits and offering comments. (C) Furnishing data at regular intervals in standards form. (D) Submitting specific information for particular purpose upon specific request instruction. Management reporting refers to the formal system whereby relevant required information is furnished to management by means of reports constantly. Thus, report is the essence of any management reporting system. The term Report normally refers to a formal communication which moves upward, i.e., for factual communication by a lower to a higher level of authority in response to order received from higher level. Reports provide means of checking the performance. A person, who is issued with orders or instructions to do certain things should report back what he has done in compliance thereof. Reports may be oral or written and also routine or special.

Objects of Reporting The primary object of management reporting is to obtain the required information about the operating results of the organisation regularly in order to use them for future planning and control. Another object is to secure understanding and approval of the judgment by the people engaged in various aspects of the work of enterprise. The second object is closely related to the first one and is important in terms of efficiency, morale and motivation. Essentials of a Good Reporting System Reporting system enables management at all levels to keep itself abreast of past performance as well as developments and it facilitates a check on individual operating levels. Based on reports, management takes crucial decisions. Hence, the essentials of good reporting system are as follows: 1. Proper form: In order to facilitate decision-making the information should be supplied in form. 2. Proper time: Promptness is very important because information delayed is information denied Reports are meant for action and when adversetendencise or events are noticed, action should follow forthwith. The sooner the report is made the quicker can be the corrective action taken. 3. Proper flow of information: The information should flow from the right level of authority to the level of authority where the decision are to be made. Further a complete and consistent information should flow in a systematic manner. 4. Flexibility: The system should be capable of being adjusted according to the requirement of the user. 5. Facilitation of evaluation: The system should distinctively report deviations from standards or estimates. Controllable factors should be distinguished from non-controllable factors and reported separately. 6. Economy: There is a cost for rendering information and such cost should be compared with benefits derived from the report or loss sustained by not having the report. Economy is an information aspect to be considered while developing reporting system. Models of Reporting Reports may be presented in the form of written statements, graphs, abd or oral. 1. Written statements

a. Formal financial statements: These statements may deal with any one or more of the following: i. Actual against the budgeted figures. ii. Comparative statements over a period of time b. Tabulated statistics: This statement may deal with statistical analysis of a particular type of expenditure over a period of time or sales of a product over a period in different regions, etc. c. Accounting ratios: The ratios may either form part of the formal financial statement or be given in the form separate statement. 2. Graphic reports The information may be presented by means of graphic reports which give a better visual view of the data than the long array of figures given instatements. Charts, diagrams and pictures are the usual form of graphic reports. They have the advantage of facilitating quick grasp of significant trends by receivers of information. 3. Oral reports Oral reports are mostly presented at group meetings and conferences with individuals. Basic Requisites of a Good Report A report is a vehicle carrying information to different levels of administration. Quality of decision-making depends to a large extent on the quality of information supplied and on the promptness and consistency of reporting. Good reporting is necessary for effective communication. hence a good report should possess the following basic requisites. 1. Promptness: It means that report must be prepared and presented on time. 2. From and content: A good report should have a suggestive title, headings, sub-headings, paragraph divisions, statistical figures, facts, dated etc. 3. Comparability: Reports are also meant for comparison. 4. Consistency: consistency envisages the presentation of the same type of information as between different reporting periods. Uniform procedure should be followed over period of time. 5. Simplicity: The report should be in a simple unambiguous and concise form 6. Controllability: It is necessary that every report should be addressed to a responsibility centre and present controllable and uncontrollable factors separately.

7. Appropriateness: Reports are sent to different levels of management and the form should be designed to suit the respective levels. 8. Cost considerations: The cost of maintaining the reporting system should commensurate with the benefits derived there form. 9. Accuracy: The report should be reasonably accurate.

Types of reports Routine Reports Reports which are submitted at periodical intervals on a regular basis covering routine matters e.g., variance analysis, financial statements, budgetary control statements are routine reports. Special Reports Reports which are submitted on particular occasions on specific request or instruction are special reports. Operating Reports These reports may be classified into control report information cum-venture measurement report. Control Report It is an important ingredient of control process and helps in controlling different activities of an enterprise. It provides information properly collected and analyzed to different levels of management. Information Report These reports provide information which are very much useful for future planning and policy formulation. Financial Reports These report contain information about the financial position of the business. They may be classified into Static Reports and Dynamic Reports. Static reports reveals the

financial position on a particular data e.g., balance sheet of a company. On the other hand, the dynamic report reveals the movement of funds during a specified period e.g. Fund flow statement, Cash flow statement.

MANAGEMENT ACCOUNTING MODEL QUESTION PAPER Time: 3 Hours PART A Answer any SIX questions All questions carry Equal marks Each answer to a theory question need not exceed One page 1. State the significance of management accounting. 2. What are the limitations of financial statements? 3. What is debt service coverage ratio? 4. State the significance of capital budgeting? 5. What is common size financial statements? 6. Determine which company is more profitable. A Ltd. Net profit ratio Turnover ratio 5% 6 times P & L A/c To Salaries To Rent To depreciation on plant To Printing & Stationary To Goodwill written off To Preliminary written off To Net Profit expenses 5,000 3,000 5,000 3,000 3,000 2,000 10,000 24,000 55,000 55,000 By Gross profit By Profit buildings on sale of 50,000 5,000 B Ltd 8% 3 times Max. marks: 100 (6 x 5 = 30)

7. Calculate the funds from operations from the following profit and loss account:

To Provision for tax

8. Calculate from the following information the break-even point and the net profit if the sales volume is Rs. 8,00,000, P/V ratio is 40% and margin of safety is 25%. 9. Prepare a production budget for three months ending March-31, 1999 for a factory producing four products, on the basis of the following information: Types of product Estimated stock on 1 1 1999 (units) 2000 3000 4000 3000 Estimated sales during Jan March 1999 (units) 10000 15000 13000 12000 Desired closing Stock on 31-3-99 (units) 3000 5000 3000 2000

A B C D

PART B Answer any FIVE questions All questions carry EQUAL marks Each answer to a theory need not exceed Three pages.

(5 x 14 = 70)

10. What is budgetary control? What are the objectives and advantages of budgetary control? 11. Discuss the different methods of ranking investment proposals. 12. What are the functions of management accounting? 13. X Ltd., furnishes you the following information: Year 1998 I Half Sales Profit Rs. 8,10,000 21,600 II Half 10,26,000 64,800

From the above you are required to compute the following assuming that the fixed cost remains the same in both the periods: i) ii) P/V ratio Fixed cost

iii) iv) v)

The amount of profit or loss where sales are Rs. 6,48,000 The amount of sales required to earn a profit of Rs. 1,08,000 From the balance sheets of A Ltd.; make out i) a statement of changes in the working capital and ii) Fund Flow statement. 1995 1996 70,000 Plant 48,000 Buildings 16,000 Stock 50,000 Bank 1995 1,15,000 80,000 2,00,000 1,60,000 97,000 25,000 6,77,000 1996 90,000 2,00,000 1,70,000 2,00,000 1,39,000 18,000 8,17,000

Share Capital General reserve Profit & Loss A/c Creditors Bills payable Provision for Tax

4,50,000 5,00,000 Goodwill 40,000 30,000 20,000 40,000

97,000 1,33,000 Debtors

6,77,000 8,17,000

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