Accounting For Managers PDF

349E180
346E120
1 - 24
ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
Master of Business Administration(MBA)

MBA (Financial Management)
First Year
ACCOUNTING FOR MANAGERS

LESSONS : 1 – 24
Copyright Reserved
2
(For Private Circulation Only)

MBA (MASTER OF BUSINESS ADMINISTRATION)
MBA (FINANCIAL MANAGEMENT)
FIRST YEAR
Editorial Board
Dr. M. Nagarajan
Dean
Faculty of Arts
Annamalai University
Annamalainagar.
Members
Dr. C. Samudhrarajakumar Dr. A. Rajamohan
Professor and Head Professor and Head
Department of Business Administration Management Wing - DDE
Annamalai University Annamalai University
Annamalainagar. Annamalainagar.
Internals
Dr. M.G. Jayaprakash Mr. K. Siva
Assistant Professor Assistant Professor
Management Wing - DDE Management Wing - DDE
Annamalai University Annamalai University
Annamalainagar Annamalainagar
Externals
Dr. V. Balachandran Dr. N. Kannan
Registrar i/c and Professor Professor
Department of Corporate secretary ship Department of Management Studies
Alagappa University Sathya Bama University
Karaikudi Chennai
Lesson Writers
Units : I - III Units : IV - VI
Dr. D. Senthil Dr. K. Murugadoss

Assistant Professor Assistant Professor and Head
Management Wing - DDE Department of Commerce
Annamalai University Periyar Government Arts College
Annamalainagar Cuddalore
1
MASTER OF BUSINESS ADMINISTRATION (MBA)

FIRST YEAR
Syllabus
Objectives
The purpose of this course is to acquaint the students with the various
concepts, techniques, methods, process of accounting, data analysis,
interpretation, decision making in the area of various accounting.
Unit–I
Introduction to Accounting – Origin – Concept And Growth – Financial
Accounting-- Purpose – Use and Role – Responsibilities of Financial Manager,
Management Accounting and Cost Accounting – Financial Accounting Rules,
Concepts And Convention – Generally Accepted Accounting Principles – Accounting
Standards - Implications on Accounting System – Process of Accounting, Rules Of
Book Keeping And Books of Accounts – Double Entry- Book Keeping – Journal –
Ledger – Trail Balance – Preparation of Profit and Loss Account And Balance Sheet-
Use Of These Statements By Management – Meaning of Depreciation – Basic
Features of Depreciation – Objectives – Methods – Depreciation Policy.
Unit–II
Analysis Of Financial Statements – Comparative Financial And Operating
Statements – Common Size Statements – Trend Analysis – Ratio And Their Uses –
Types of Ratio and their Meaning – Using Ratio to Understand the Financial Status
and Performance of Organization - Construction of Balance Sheet Using Ratios –
Dupont Analysis – Interpretation of Ratios. Funds Flow Statement – Preparations of
Fund Flow Statement – Cash Flow Statement – Evolution of Funds And Cash Flow
Analysis.
Unit–III
Marginal Costing – Definition – Distinguishing Between Marginal Costing and
Absorption Costing – Break Even Point Analysis – Graphical Representation of
Break Even Analysis – Contribution – P/V Ratio – Margin of Safety – Decision
Making Under Marginal Costing – Key Factor Analysis –Make or Buy Decision –
Export Decision – Sales Man Decision.
Unit–IV
Budget and Budgetary Control – Definition – Objectives – Budgetary Control –
Essentials of A Successful Budgetary Control – Limitations – Master Budget –
Classification of Budget – Flexible Budget – Sales Budget – Production Budget –
Material Budget – Labour Budget – Work Over Head Budget – Administrative Over
Head Budget – Capital Expenditure Budget – Cash Budget – Zero Base Budget –
Organization For Budgetary Control.
ii
Unit–V
Capital Budgeting – Importance – Process – Evolution of Investment Proposal –
Payback Method –Net Present Value Method – Average Rate Of Return Method –
Discounted Flow Method – Time Adjusted Rate of Return Method – Net Terminal
Value Method – Excess Present Value Index Method – Advantages And
Disadvantages Comparison And Contrast – Capital Rationing.
Unit–VI
Cost Accounting – Purpose – Classification of Cost and Their Uses – Allocation
of Cost – Types of Costing – Activity Based Costing – Elements of Cost – Cost Sheet
Preparation – Cost Centre – Standard Costing And Variance Analysis – Advantages
of Cost Accounting – Cost Centre and Cost Unit–Methods Of Costing – Techniques
of Costing
Reporting to Management- Objectives of Reports – Reports for Different Levels
of Management – Preparation of Reports.
Reference Books
1. R.S.N. Pillai, Management Accounting S. Chand, Chennai, 2014.
2. Bagavathi V., Pillai,R.S.N., Cost Accounting, S. Chand, Chennai, 2010.
3. N. P. Srinivasan, M. Sakthivel Murugan, Accounting for Management, S.
Chand, Chennai, 2010.
4. Mani, P.L., N. Vinayaraman, K.L. Nagarajan, Principles of Accountancy,
S. Chand, Chennai, 2014.
5. Jain and Narang, Cost Accounting Principles and Practices Kalayani
Publishers, 2013.
6. Ambrish Gu pta , Financial Accounting for Management: An Analytical
Perspective, 4th Edition, Pearson, 2012.
7. Maheswari S.K., A Textbook of Accounting for Management, 3rd Edition
Vikas Publishing House, 2013.
8. Donna Philbrick, Charles T. Horngren, Introduction to Financial
Accounting 9th Edition, Pearson 2008.
9. William J.Burns, Accounting for Managers: Text & Cases, 2nd Edition
South-Western College, 1998.
10. M.Y Khan and Jain, Management Accounting, Tata McGraw hill, 2006.
11. Ambrish Gu pta, Financial Accounting for Management: An Analytical
Perspective Pearson Education India, 2008
12. Dr. RK Mittal, Management Accounting and Financial Management, FK
Publications, 2012.
13. S. Ramanathan, Accounting for Management, Oxford University Press,
2014.
iii
14. I.M Pandey, Management Accounting, 9th Edition, Vikas publishers,

New Delhi, 2009.
15. Colin Drury, Management Accounting for Business Decisions, 3rd
Edition Thomson Publications, 2005.
16. John Burns, Martin Quinn, Liz Warren, Joao, Oliveira Management
Accounting, McGraw Hill Education, 2013.
17. Ray Proctor, Managerial Accounting Decision Making and Performance,
4th edition, Pearson Education, 2012.
Journals and Magazines
1. Research Journal of Finance and Accounting
2. Journal of Financial Reporting and Accounting.
3. The International Journal of Accounting Research.
4. The International Journal of Accounting.
Web Resources
1. www2.le.ac.uk/study/postgrad/.../financeeconomics/mngtfinance
2. www.managerialaccounting.org/
3. www.lboro.ac.uk/study/.../accounting-financial-manage ment
4. onlinelibrary.wiley.com/journal/10.1111/(ISSN)1467-646X
5. www.rsm.nl/master/msc.../mscba-accounting-financial-manage ment
iv
MASTER OF BUSINESS ADMINISTRATION (MBA)

FIRST YEAR
CONTENTS
L. NO. LESSON NAME PAGE NO.
1 Financial accounting principles and concepts 1
2 Accounting Records And Systems 15

Preparation of Financial Statements: Trading and
3 28
Profit and Loss Account
4 Preparation of Balance Sheet 41
5 Analysis and interpretation of Financial Statement 62
6 Ratio Analysis 68
7 Fund Flow Statements 98
8 Cash Flow Statement 113
9 Marginal Costing 131
10 Marginal Costing – Cost volume Profit Analysis 141
11 Break Even Chart 155
12 Application of Marginal Costing Techniques 161
13 Introduction to Budget 173
14 Budgetary Control 177
15 Types of Budgets 186
16 Zero base budgeting & Master budget 217

17 Importance of Capital Budgeting 221
18 Capital Budgeting Process 227
19 Methods of Evaluating Capital Investment Proposal 233
20 Introduction to Cost Accounting 266
21 Importance of Cost Accounting 276
22 Essentials of good Cost Accounting System 314
23 Standard Costing and Variance Analysis 322
24 Reporting to Management 371

1
LESSON 1
FINANCIAL ACCOUNTING PRINCIPLES AND CONCEPTS
1.1 INTRODUCTION
Accounting is aptly called the language of business. This designation is applied
to accounting because it is the method of communicating business information.
The basic function of any language is to serve as a means of communication.
Accounting duly serves this function. The task of learning accounting is essentially
the game as the task of learning a new language. But the acceleration of change in
business organisation has contributed to increasing the complexities in this
language. Like other languages, it is undergoing continuous change in an attempt
to discover better means of communicating.
1.2 OBJECTIVES
After reading this lesson the student should be able to:
 Know the evolution and meaning of accounting,
 Understand the nature and role of accounting.
 Appreciate the importance of accounting as an information system and
 Understand the profession of accounting and its specialized branches.
1.3 CONTENT
1.3.1 Definition of accounting
1.3.2 Evolution of accounting
1.3.3 Objective of accounting
1.3.4 Functions of accounting
1.3.5 Meaning of Management Accounting
1.3.6 Management accounting vs cost accountings
1.3.7 Accounting concepts
1.3.8 Accounting conversion
1.3.9 Accounting standards
1.3.10Financial manager- Role and Duties
1.3.1 DEFINITION OF ACCOUNTING
Before attempting to define accounting, it may be made clear that there is no
unanimity among accountants as to its precise definition. Anyhow, let us examine
three popular definitions on the subject.
American Institute of Certified Public Accountants (AICPA) which defines
accounting as “the art of recording, classifying and summarizing in a significant
manner and in terms of money, transactions and events, which are, in part at least,
of a financial character and interpreting the results thereof”.
American Accounting Association defines accounting as “the process of
identifying, measuring and communicating economic information to permit
informed judgements and decision by users of the information”.
2
Accounting has been defined by the American Accoun ting Association

Committee as: ".... the process of identifying measuring and communicating
economic information to permit informed judgements and decisions by users of the
information." This may be considered as a good definition because of its focus on
accounting as an aid to decision making.
Of all definitions available, this is the most acceptable one because it
encompasses all the functions which the modern accounting system perform
1.3.2 EVOLUTION OF ACCOUNTING
Accounting is as old as money itself. It has evolved as have medicine, law and
most other fields of human activity in response to the social and economic needs of
society. For the most part early accounting dealt only with limited aspects of the
financial operations of private or governmental en terprises. Complete accounting
system for an enterprise which came to be called as "Double Entry System" was
developed in Italy in the 15 th century. The expanded business operations initiated
by the Industrial Revolution required increasingly large amounts of money which in
turn resulted in the development of the corporation form of organisations. As
corporations became larger, an increasing number of individuals and institutions
looked to accountants to provide economic information about these enterprises. For
e.g. prospective investors and creditors sought information about a corporation's
financial status. Government agencies required financial information for purposes
of taxation and regulation. Thus accounting began to expand its function of
meeting the needs of relatively few owners to a public role of meeting the needs of a
variety of interested parties.
1.3.3 OBJECTIVE OF ACCOUNTING
i) To keeping systematic record: It is very difficult to remember all the
business transactions that take place. Accounting only provides promptly recording
all the business transactions in the books of account.
ii) To ascertain the consequences of the operation: Accounting helps in
ascertaining result i.e., profit earned or loss suffered in operation of the business
during a particular period. For this purpose, a business entity prepares either a
Trading and Profit and Loss account or an Income and Expenditure account which
shows the profit or loss of the business by matching the items of revenue and
expenditure of the same period.
iii) To determine the financial position of the business: In addition to profit,
a businessman must know his financial position i.e., availability of cash, position of
assets and liabilities etc. This helps the businessman to know his finan cial
strength. Financial statements are barometers of health of a business entity.
iv) To monitoring the liquidity position of the business: Financial reporting
should provide information about how an enterprise obtains and spends cash,
about its borrowing and repayment of borrowing, about its capital transactions,
cash dividends and other distributions of resources by the enterprise to owners and
about other factors that may affect an enterprise’s liquidity and solvency.
3
v) To safeguard the business properties: Accounting provides up to date

information about the various assets that the firm possesses and the liabilities the
firm owes, so that nobody can claim a payment which is not due to him.
vi) To facilitate rational decision making: Accounting records and financial
statements provide financial information which help the business in making
rational decisions about the steps to be taken in respect of various aspects of
business.
vii) To satisfy the requirements of law: Entities such as companies, societies,
public trusts are compulsorily required to maintain accounts as per the law
governing their operations such as the Companies Act, Societies Act, and Public
Trust Act etc. Maintenance of accounts is also compulsory under the Sales Tax Act
and Income Tax Act.
1.3.4 FUNCTIONS OF ACCOUNTING
Accounting is important to all discharges the following vital functions:
1. Keeping systematic records of the business transaction
2. Protecting the Business Properties:
3. Communicating the results of business operation (net profits, assets,
liabilities) to management
4. fulfilling the legal requirements such as Companies Act, Income Tax Act,
1.3.5 MEANING AND DEFINITION OF MANAGEMENT ACCOUNTING
A number of definitions are available on the subject management accounting.
Before attempting to see the various definitions it may be added that there is no
unanimity among the management accountants as to its precise definition.
The Institute of Chartered Accountants of England
"Any form of accounting which enables a business to be conduc ted more
efficiently can be regarded as Management Accounting". This definition is of a
general nature and hence it is not of much use.
Robert N. Anthony
"Management Accounting is concerned with accounting information that is
useful to management". Anthony's sweet and simple definition does not shed much
light on all phases of Management Accounting.
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 performances". As compared to other
definitions this definition is broader in nature covering three vital areas of
management. Viz. planning, decision -making and controlling.
Some other standard definitions on the subject are given below:
Institute of Chartered Accountants of India:
"Such of its techniques and procedures by which accounting mainly seeks to
aid the management collectively have come to be known as management
accounting".
4
John Sizer:
"Management Accounting may be defined as the application of accounting
techniques to the provision of information designed to assist all levels of
management in planning and controlling the activities of the firm".
1.3.6 MANAGEMENT ACCOUNTING VS COST ACCOUNTING
Costing has been defined as classifying, recording and appropriate allocation of
expenditure for the determination of the costs of products or services. Cost
accounting will tell the management as to how the busine ss has fared at each stage
of operation. But cost accounting will not tell them anything about the future policy
to be adopted. It is here that management accounting differs from cost accounting.
The aim of management accounting is not to collect information as such but to
utilise the information collected in order to help the management to formulate their
future policy and to make important policy decisions.
Though there is a difference between management accounting and cost
accounting in their objective yet their functions are complementary in nature.
Management accounting depends heavily on cost data and other information
derived from cost records. In one way, management accounting is an expansion of
cost accounting. Like cost accounting, management accounting involves reporting
at frequent intervals rather than at the end of a year or half-year.
Cost accounting deals primarily with cost data. But management accounting
involves the consideration of both costs and revenues. It is a broader concept than
cost accounting. It not only reports costs but also uses them to assist management
in planning possible alternate courses of action.
Conceptually speaking management accounting is a blending together of cost
accounting, financial accounting and all aspects of financial management. It has a
wider scope as a tool of management. But it is not a substitute for other accounting
functions. It is a continuous process of reporting cost and financial data as well as
other relevant information to management.
1.3.7 ACCOUNTING CONCEPTS
The important accounting concepts are discussed here under:
1 Business entity concept: It is generally accepted that the moment a
business enterprise is started it attains a separate entity as distinct from the
persons who own it.
This concept is extremely useful in keeping business affairs, strictly free from
the effect of private affairs of the proprietors. In the absence of this concept the
private affairs and business affairs are mingled together in such a way that the true
profit or loss of the business enterprise cannot be ascertained nor its financial
position. To quote an example if the proprietor has taken Rs.5000/- from the
business for paying house tax for his residence, the amount should be deducted
from the capital contributed by him. Instead if it is added to the other business
expenses then the profit will be reduced by Rs.5000/ and also his capital more by
the same amount. This affects the results of the business and also its financial
5
positions. Not only this since the profi t is lowered, the consequential tax payment
also will be less which is against the provisions of the Income Tax Act.
2 Going Concern Concept: This concept assumes that unless there is valid
evidence to the contrary a business enterprise will continue to operate for a fairly
long period in the future. The significance of this concept is that the accountant
while valuing the assets of the enterprise does not take into account their current
resale values as there is no immediate expectation of selling it. More over,
depreciation on fixed assets is charged on the basis of their expected lives rather
than on their market values.
When there is conclusive evidence that the business enterprise has a limited
life the accounting procedures should be appropriate to the expected terminal date
of the enterprise. In such cases, the financial statements should clearly disclose the
limited life of the enterprise and should be prepared from the quitting concern point
of view rather than from a 'going concern' point of view.
3 Money Measurement Concept: Accounting records only those transactions
which can be expressed in monetary terms. This feature is well emphasized in the
two definitions on accounting as given by the American Institute of Certified Public
Accountants and American Accounting Principles Board. The importance of this
concept is that money provides a common denomination by means of which
heterogeneous facts about a business enterprise can be expressed and measured in
a much better way. For e.g. when it is stated that a business owns Rs. 10,00,000
cash, 500 tons of raw materials, 10 machinery items, 30,000 square metres of land
and building etc., these amounts cannot be added together to produce a meaningful
total of what the business owns. However, by expressing these items in monetary
terms Rs 10,00,000 cash Rs 5,00,000 worth of raw materials, Rs 10,00,000 worth
of machinery items and Rs 30,00,000 worth of land and building - such an addition
is possible.
A serious limitation of this concept is that accounting does not take into
account pertinent non-monetary items which may significantly affect the
enterprise. For instance, accounting does not give information about the poor
health of the President, serious misunderstanding between the production and
sales manager etc., which have serious bearing on the prospects of the enterprise.
Another limitation of this concept is that money is expressed in terms of its value at
the time a transaction is recorded in the accounts. Su bsequent changes in the
purchasing power of money are not taken into account.
4 Cost Concept: This concept is yet another fundamental concept of
accounting which is closely related to the going concern concept. As per this
concept:
i) an asset is ordinarily entered in the accounting records at the pri ce paid to
acquire it i.e., at its cost and ii) this cost is the basis for all subsequent accounting
for the asset.
6
The implication of this concept is that the purchase of an asset is recorded in

the books at the price actually paid for it irrespective of its market value. For e.g. if
a business buys a building for Rs.30,00,000 'the asset would be recorded in the
books at Rs.30,00,000 even if its market value at that time happens to be
Rs.40,00,000. However, this concept does not mean that the asset will al ways be
shown at cost. This cost becomes the basis for all future accounting for the asset. It
means that the asset may systematically be reduced in its value by charging
depreciation. The significant advantage of this concept is that it brings in objectivity
in the preparations and presentation of financial statements. But like the money
measurement concept this concept also does not take into account subsequent
changes in the purchasing power of money due to inflationary pressures. This is'
the reason for the growing importance of inflation accounting.
5 Dual aspect concept: This concept is the core of accounting. According to
this concept every business transaction has a dual aspect. This concept is
explained in detail below:
The properties owned by a business enterprise are referred to as assets and the
rights or claims to the various parties against the assets are referred to as equities.
The relationship between the two may be expressed in the form of an equation as
follows;
Equities = Assets
Equities may be subdivided into two principal types: the rights of creditors and
the rights of owners. The rights of creditors represent debts of the business and are
called liabilities. The rights of the owners are called capital. Expansion of the
equation to give recognition to the two types of equities results in the following
which is known as the accounting equation:
Liabilities + Capital = Assets
It is customary to place 'liabilities' before 'capital' because creditors have
priority in the repayment of this claims as compared to that of owners. Sometimes
greater emphasis is given to the residual claim of the owners by transferring
liabilities to the other side of the equation as:
Capital = Assets - Liabilities
All business transactions, however simple or complex they are result in a
change in the three basic elements of the equation. This is well explained with the
help of the following series of examples:
i) Mr. Krishna commenced business with a capital of Rs. 300,000. The result of
this transaction is that the business being a separate entity, gets cash-an asset of
Rs. 300,000 and has to pay to Mr. Krishna Rs. 300,000. This transaction can be
expressed in the form of the equation as follows:
Capital = Assets
Krishna 300,000 Cash 300,000
7
ii) Purchased furniture for Rs. 50,000: The effect of this transaction is that cash
is reduced by Rs. 50,000 and a new asset viz. furniture worth Rs. 50,000 comes in
thereby rendering no change in the total assets of the business. The equation after
this transaction will be:
Capital = Assets
Krishna a Cash + Furniture
300,000 = 250,000 + 50,000
(iii) Borrowed Rs. 200,000 from Mr. Gopal: As a result of this transaction both
the sides of the equation increase by Rs. 200,000 -cash balance is increased and a
liability to Mr. Gopal is created. The equation will appear as follows:
Creditors +Krishna = Cash + Furniture
200,000 + 300,000= 450,000 + 50,000
(iv) Purchased goods for cash Rs. 300,000: This transaction does not affect the
liabilities side total nor the asset side total. Only the composition of the total assets
changes i.e. cash is reduced by Rs. 300,000 and a new asset viz. stock worth Rs.
30,000 comes in. The equation after this transaction will be as follows:
Creditors +Krishna = Cash + Stock + Furniture
200,000 + 300,000 = 15,000+300,000 + 50,000
(v) Goods worth Rs. 100,000 are sold on credit to Mr. Ganesh for Rs. 120,000.
The result is that stock is reduced by Rs. 10,000 a new asset namely debtor (Mr.
Ganesh) for Rs. 12,000 comes into picture and the capital of Mr.Krishna increases
by Rs. 20,000 as the profit on the sale of goods belongs to the owner. Now the
accounting equation will look as under:
Creditors + Krishna = Cash + Debtors + Stock + Furniture
200,000 + 320,000 = 150,000 + 120,000 + 200,000 + 50,000
(vi) Paid electricity charges Rs.3000: This transaction reduces both the cash
balance and Mr.Krishna’s capital by Rs.3000. This is so because the expenditure
reduces the business profit which in turn reduces the owner's equity. The equation
after this will be:
Creditors +Krishna = Cash + Debtors + Stock + Furniture
200,000 + 317,000= 147,000 + 120,000 + 200,000 + 50,000
Thus it may be seen that whatever is the nature of transaction, the accounting
equation always tallies and should tally. The system of recording transactions
based on this concept is called double entry system.
8
6 Accounting period concept: In accordance with the going concern concept it

is usually assumed that the life of a business is indefinitely long. But owners and
other interested parties cannot wait until the business has been wound up for
obtaining information about its results and financial position. For e.g. if for te n
years no accounts have been prepared and if the business has been consistently
incurring losses, there may not be any capital at all at the end of the tenth year
which will be known only at that time. This would result in the compulsory winding
up of the business. But if at frequent intervals information are made available as to
how things are going then corrective measures may be suggested and remedial
action may be taken. That is why, Pacioli wrote as early as in 1494: "frequently
accounting makes for long friendship". This need leads to the accounting period
concept.
According to this concept accounting measures activities for a specified interval
of time called the accounting period. For the purpose of reporting to various
interested parties one year is the usual accounting period. Though Pacioli wrote
that books should be closed each year especially in a partnership, it applies to all
types of business organisations.
7 Periodic matching of costs and revenues: This concept is based on the
accounting period concept. It is widely accepted that desire of making profit is the
most important motivation to keep the proprietors engaged in business activities.
Hence a major share of attention of the accountant is being devoted towards
evolving appropriate techniques for measuring profits. One such technique is
periodic matching of costs and revenues.
In order to ascertain the profits made by the business during a period, the
accountant should match the revenues of the period with the costs (expenses) of
that period. By 'matching' we mean appropriate association of related revenues and
expenses pertaining to a particular accounting period. To put it in other words,
profits made by a business in a particular accounting period can be ascertained
only when the revenues earned during that period are compared with the expenses
incurred for earning that revenue. The question as to when the payment was
actually received or made is irrelevant. For e.g. in a business enterprise which
adopts calendar year as accounting year, if rent for December 2015 was paid in
January 2016, the rent so paid should be taken as the expenditure of the year
2015, revenues of that year should be matched with the costs incurred for earning
that revenue including the rent for December 2015 though paid in January 2016. It
is on account of this concept that adjustments are made for outstanding expenses,
accrued incomes, prepaid expenses etc. while preparing financial statements at the
end of the accounting period.
The system of accounting which follows this concept is called as mercantile
system. In contrast to this there is another system of accounting called as cash
system of accounting where entries are made only when cash is received or paid, no
entry being made when a payment or receipt is merely due.
9
8 Realisation Concept: Realisation refers to Inflows of cash or claims to cash

like bills receivables, debtors etc. arising from the sale of assets or rendering of
services. According to Realisation concept, revenues are usually recognized in the
period in which goods were sold to customers or in which services were rendered.
Sale is considered to be made at the point when the property in goods passes to the
buyer and he becomes legally liable to pay. To illustrate this point, let us consider
the case of A, a manufacturer who produces goods on receipt of orders. When an
order is received from B, a starts the process of production and delivers the goods
to B when the production is complete. B makes payment on receipt of goods. In this
example, the sale will be presumed to have been made not at the time of receipt of
the order but at the time when goods are delivered to B. But there are certain
exceptions to this aspect of the concept Two among them are:
(i) Sale on hire purchase basis wherein the ownershi p of the goods passes to
the hire purchaser only when the last hire is paid but still sales are presumed to
have been made to the extent of instalments received and instalments outstanding;
and
(ii) Contract accounts - though the contractee is liable to pay only when the
whole contract is complete as per terms of the contract, yet the profit is calculated
on the basis of work certified year after year according to certain accepted
accounting norms.
A second aspect of the realisation concept is that the amou nt recognized as
revenues is the amount that is reasonably certain to be realized. However, lot of
reasoning has to be applied to ascertain as to how certain 'reasonably certain' is.
Yet, one thing is clear, that is, the amount of revenue to be recorded may be less
than the sales value of the goods sold and services rendered. For e.g. when goods
are sold at discount, revenue is recorded not at the list price but at the amount at
which sale is made. Similarly, it is on account of this aspect of the concept that
when sales are made on credit though entry is made for the full amount of sales,
the estimated amount of bad debts is treated as an expense and the effect on net
income is the same as if the revenue were reported as the amount of sales minus
the estimated amount of bad debts. For instance, if a businessman makes credit
sales of Rs. 500,000/- during a period and if the estimated amount of bad debts is
Rs.2500, revenue is reported as Rs. 500,000 and there is a bad debt expense of Rs.
2,500. The effect on net income is the same as if the revenue were reported as
Rs.4,97,500.
1.3.8 ACCOUNTING CONVENTIONS
1 Convention of Conservatism: It is a world of uncertainty. So it is always
better to pursue the policy of playing safe. This is the principle behind the
convention of conservatism. According to this convention the accountant must be
very careful while recognizing increases in an enterprise's profits rather than
recognizing decreases in profits. For this the accountants have to follow the rule,
anticipate no profit but provide for all possible losses' while recording business
10
transactions. It is on account of this convention that the inventory is valued 'at cost
or market price whichever is less', i.e., when the market price of the Inventories has
fallen below its cost price it is shown at market price i.e., the possible loss is
provided and when it is above the cost price it is shown at the cost price i.e., the
anticipated profit is not reduced. It is for the same reason that provision for bad
and doubtful debts, provision for fluctuation in investments, etc., are created. This
concept affects principally the current assets.
The main function of accounting is to provide correct and full information
about the business enterprise. But this is affected by the convention of
conservatism as pointed out by the critics of this convention. They argue that it
encourages the accountant to build secret reserves by resorting to excess provision
for bad and doubtful debts etc. as a result of which not only the Income is affe cted
but also the financial state of affairs of the business. Further it is also against the
convention of full disclosure about which we are going to see right now.
2 Convention of full disclosure: The emergence of joint stock company form
of business organisation resulted in the divorce between ownership and
management. This necessitated the full disclosure of accounting Information about
the enterprise to the owners and various other interested parties. Thus it became
the 'convention of full disclosure' is very important. By this convention it is implied
that accounts must be honestly prepared and all material information must be
adequately disclosed therein. But it does not mean that all information that
someone desires are to be disclosed in the financi al statements. It only implies that
there should be adequate disclosure of information which is of considerable
importance to owners, investors, creditors. Governments, etc. In Sachar Committee
Report (1978) it has been emphasised that openness in Company affairs is the best
way to secure responsible behaviour. It is in accordance with this convention that
Companies Act, Banking Companies Regulation Act, Insurance Act etc., have
prescribed performance of financial statements to enable the concerned companie s
to disclose sufficient information. The practice of appending notes relative to
various facts on items which do not find place in financial statements is also in
pursuance to this convention. The following are some examples:
(a) Contingent liabilities appearing as a note
(b) Market value of investment appearing as a note
(c) Schedule of advances in case of banking companies.
3 Convention of Consistency: According to this concept it is essential that
accounting procedures, practices and methods should remain unchanged from one
accounting period to another. This enables comparison of performance in one
accounting period with that in the past. For e.g. if material Issues are priced on the
basis of FIFO method the same basis should be followed year after year. Similarly, if
depreciation is charged on fixed assets according to diminishing balance method it
should be done in subsequent year also. But consistency never implies inflexibility
as not to permit the Introduction of improved techniques of accounting. However, if
11
Introduction of a new technique results in inflating or deflating the figures or profit

as compared to the previous periods, the fact should be well disclosed in the
financial statement.
4 Convention of Materiality: The implication of this convention is that
accountant should attach importance to material details and ignore insignificant
ones. In the absence of this distinction accounting will unnecessarily be
overburdened with minute details. The question as to what is a material detail and
what is not is left to the discretion of individual accountant. Further an item which
is material for one purpose may become Immaterial for another. According to
American Accounting Association, an item should be regarded as material if there is
reason to believe that knowledge of it would influence the decision of informed
investor'. Some examples of material financial information are: fall in the value of
stock, loss of markets due to competition, change in the demand pattern due to
change in Government regulations etc. Examples of insignificant financial
information are: ignoring of paise while preparing company financial statement,
rounding of income to nearest ten for tax-purposes etc. Sometimes if it is felt that
an immaterial item must be disclosed, the same may be shown as footnotes or in
parenthesis according to its relative importance.
1.3.9 ACCOUNTING STANDARDS MANDATORY AS ON SEPTEMBER 1, 2014
AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring after the Balance Sheet Date
AS 5 Net Profit or Loss for the period, Prior Period Items and Changes in
Accounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts (revised 2002)
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003),
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Employee Benefits (revised 2005)
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income.
12
AS 23 Accounting for Investments in Associates in Consolidated Financial

Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Joint Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent` Liabilities and Contingent Assets
1.3.10 FINANCIAL MANAGERS - ROLE & DUTIES
The role of a financial manager is a complex one, requiring both an
understanding of how the business functions as a whole and specialized financial
knowledge.
The manager is responsible for managing the budget. This involves allocating
money to different projects and segments so that the business can continue
operating, but the best projects get the necessary funding.
The manager is responsible for figuring out the financial projections for the
business. The development of a new product, for example, requ ires
an investment of capital over time. The finance manager is responsible for knowing
how much the product is expected to cost and how much revenue it is expected to
earn so that s/he can invest the appropriate amount in the product. This is a lot
tougher than it sounds because there is no accurate financial data for the future.
The finance manager will use data analyses and educated guesses to approximate
the value, but it's extremely rare that s/he can be 100% sure of the future cash
flows.
Figuring out the value of an operation is one thing, bu t it is another thing to
figure out if it's worth financing. There is a cost to investing money, either
the opportunity cost of not investing it elsewhere, the cost of borrowing money, or
the cost of selling equity. The finance manager uses a number of tools, such as
setting the cost of capital (the cost of money over time, which will be explored in
further depth later on) to determine the cost of financing.
At the same time that this is going on, the financial manager must also ensure
that the business has enough cash to pay upcoming financial obligations without
hoarding assets that could otherwise be invested. This is a delicate dance between
short-term and long-term responsibilities.
The Chief Financial Officer is the head of the financial department and is
responsible for all of the same things as his/her subordinates, but is also the
person who has to sign off that all of the company's financial statements are
accurate. S/he is also responsible for financial planning and record-keeping, as
well as financial reporting to higher management.
The financial manager is not just an expert at financial projections, s/he must
also have a grasp of the accounting systems in place and the strategy of the
business over the coming years.
13
1.4 REVISION POINTS

1. Language of Business: Accounting is the language of business.
2. Accounting: Accounting is the art of recording, classifying, summarizing
and interpreting business transactions.
3. Accounting to an information system: As an information system
accounting provides operating information, financial accounting
information, management accounting information and cost accounting
information.
4. Accounting is a service function: Accounting function is a service
function. The role of accountant is advisory in character.
5. Tax Accounting: Deals with preparation of tax returns and analyses tax
implications.
6. International Accounting: Concerned with the special problems
associated with the international trade of multi - national business
organisations.
7. Social responsibility accounting: This branch of accounting measures
the social effects of business decisions.
8. Inflation Accounting: This system of accounting regularly records all
items in financial statements at their current values.
9. Human resources accounting: The importance of human resources in a
company's earning process and total assets is reported in this kind of
accounting.
1.5 INTEXT QUESTIONS
1. Why accounting is called the language of business?
2. What are the functions of accounting?
3. Accounting as a social science can be viewed as an information system.
Examine.
4. Distinguish between Public accounting and private accounting.
1.6 SUMMARY
Accounting is rightly called the "language of business". It is as old as money
itself. It is concerned with the collecting, recording, evaluating and communicating
the results of business transactions. Initially meant to meet the needs of a relatively
few owners, it gradually expanded its function to a public role of meeting the needs
of a variety of interested parties. Broadly speaking all citizens are affected by
accounting in some way. Accounting as an information system possesses all the
three features of a system. Accounting is also viewed as a profession with
accountants engaging in private and public accounting. As in many other areas, of
human activity a number of specialized fields in accounting also have evolved as a
result of rapid changes in business and social needs.
1.7 TERMINAL EXERCISES
1. Accounting does not record non-financial transactions because of:
a. Accrual concept
14
b. Cost concept
c. Continuity concept
d. Money measurement concept
Correct Answer: d
2. Which of these are is not a fundamental accounting assumption?
a. Going concern
b. Consistency
c. Conservatism
d. Accrual
Correct Answer: c
3. Fixed assets and current assets are categorized as per concept of:
a. Separate entity
b. Going concern
c. Consistency
d. Time period
Correct Answer: b
1.8 SUPPLEMENTARY MATERIAL
1. www.icai.org
2. www.icmai.org
1.9 ASSIGNMENT
1. Is accounting a staff function or line function? Explain with reasons.
2. Give an account of the various branches of accounting.
3. "Accounting is a service function' Discuss this statement in the context of a
modern manufacturing business.
4. Distinguish between Financial Accounting and Management Accounting.
1.10 SUGGESTED READINGS
1. Antony and Reece: 'Accounting Principles', Richard D. Irwin, Inc. Home
wood, Illinois.
2. Fess/Warren: 'Financial Accounting’, South Western Publishing
Company, Ohio.
3. M.C. Shukla& T.S. Grewal: Advanced Accounts, S. Chand& Company New
Delhi.
1.11 LEARNING ACTIVITIES
1. “There are no externally imosed generally accepted accounting principles
for management accounting .”
2. In the light of the above statement, discuss giving illustration the nature
and scope of management accounting.
1.12 KEYWORDS
Concepts, conventions, accounting standards, business entity, dual aspects,
realisation
15
LESSON 2
ACCOUNTING RECORDS AND SYSTEMS
2.1 INTRODUCTION
During the accounting period the accountant records transactions as and when
they occur. At the end of each accounting period the accountant summarises the
Information recorded and prepares the Trial Balance to ensure that the double
entry system has been maintained. This is followed by certain adjusting en tries
which are to be made to account the changes that have taken place since the
transactions were recorded. When the recording aspect has been made as complete
and up to-date as possible, the accountant prepares financial statements reflecting
the financial positions and the results of business operations. Thus the accounting
process consists of three major parts:
i) the recording of business-transactions, during the period;
ii) the summarizing of information at the end of the period and
iii) the reporting and interpreting of the summary information
The success of the accounting process can be judged from the responsiveness
of financial reports to the needs of the users of accounting information.
2.2 OBJECTIVES
 understand the rules of debit and credit
 apply the rules of debit and credit in journalising the transactions
 prepare ledger accounts and balance them
 prepare a trial balance
 realise the importance of adjustment entries and closing entries
2.3 CONTENT
2.3.1 The account
2.3.2 Debit and credit
2.3.3 Journal
2.3.4 The trial balance
2.3.5 Closing entries
2.3.6 Adjustment entries
2.3.1 THE ACCOUNT
The transactions that take place in a business enterprise during a specific
period may effect increases and decreases in assets, liabilities, capital, revenue and
expense items. To make up to-date information available when needed and to be
able to prepare timely periodic financial statements, it is necessary to maintain a
separate record for each item. For e.g. it is necessary to have a separate record
devoted exclusively to record increases and decreases in cash, another one to
record Increases and decreases in supplies, a third one to machinery, etc. The types
of record that is traditionally used for this purpose is called an account. Thus an
16
account is a statement wherein Information relating to an item or a group of similar

items are accumulated. The simplest form of an account has three parts;
i) a title which give the name of the item recorded in the account.
ii) a space for recording increases in the amount of the item and
iii) a space for recording decreases in the amount of the item.
This form of an account known as a T account, because of its similarity to the
letter T is illustrated below.
Title
Left side (Debit side) Right side (Credit side)
KINDS OF ACCOUNTS
Accounts are of various types as shown below:
Accounts
Personal Impersonal
(relating to individuals,
firms, companies, banks, etc.)
Real Nominal
(relating to assets like plant, (relating to expenses, losses and
building, cash etc.) incomes like salary paid, rent
received, electricity paid. Interest
received etc.)
2.3.2 DEBIT AND CREDIT

The left-hand side of any account is called the debit side and the right-hand
side is called the credit side. Amounts entered on the left hand side of an account,
regardless of the title of the account, are called debits and the amounts entered on
the right hand side of an account are called credits. To debit(Dr-) an account means
to make an entry on the left-hand side of an account and to credit (Cr.) an account
means to make an entry on the right- hand side. The words debit and credit have
no other meaning in accounting, though in common parlance, debit has a negative
connotation, while credit has a positive connotation.
Double entry system of recording business transactions is universally followed.
In this system for each transaction the debit amount must equal the credit amount.
If not, the recording of transactions is incorrect. The e quality of debits and credits
is maintained in accounting simply by specifying that the left side of asset accounts
is to be used for recording increases and the right side to be used for recording
17
decreases, the right side of a liability and capital accounts is to be used to record
increases and the left side to be used for recording decreases. The account balances
when they are totaled, will then conform to the two equations:
1. Assets = Liabilities + Owners equity
2. Debits = Credits
From the above arrangement we can state the rules of debits and credits are as
follows:
Debit signifies Credit signifies
1. Increase in asset accounts 1. Decrease in asset accounts.
2. Decrease in liability accounts 2. Increase in liability accounts
3. Decrease in owners’ equity accounts 3. Increase in owners’ equity accounts
From the rule that credit signifies increase in owners’ equity and debit signifies
decreases in it, the rules of revenue accounts and expense accounts can be derived.
While explaining the dual aspect concept in an earlier lesson we have seen that
revenues increase the owners’ equity as they belong to the owners. Since owners’
equity accounts increases on the credit side, revenue must be credits. So, if the
revenue accounts are to be decreased they must be debited. Similarly, we have seen
that expenses decrease the owners’ equity. As owners’ equity accounts decrease on
the debit side expenses must be debits. Hence to increase the expenses accounts
they must be debited and to decrease it they must be credited. From the above we
can arrive at the rules for revenues and expenses as follows:
Debit signifies Credit signifies
Increase in expenses Decrease in expenses
Decrease in revenues Increase in revenues
Golden Rules for Debit and Credit:

1. Personal Accounts – a) Debit the receiver
b) Credit the giver
2. Real Accounts – a) Debit what comes in
b) Credit what goes out
3. Nominal Accounts – a) Debit all expenses and losses
b) Credit all incomes and gains
The Ledger
A ledger is a set of accounts. It contains all the accounts of a specific business
enterprise. It may be kept in any of the following two forms:
I. Bound ledger and
II. Loose Leaf Ledger
18
A bound ledger is kept in the form of book which contains all the accounts.
These days it is common to keep the ledger in the form of loose -leaf cards. This
helps in posting transactions particularly when mechanised system of accounting is
used.
2.3.3 JOURNAL
When a business transaction takes place the first record of it is done in a book
called journal. The journal records all the transactions of a business in the order in
which they occur. The journal may therefore be defin ed as a Chronological records
of accounting transaction. It shows names of accounts that are to be debited or
credited, the amounts of the debits and credits and any additional but useful
information about the transaction. A journal does not replace but precedes the
ledger. A proforma of a journal is given in illustration 1
1.Journalise the following transactions in the books of x &Co.
June
2016 Particulars
Rs.
1 Started business with a capital of 60,000
2 Paid in to bank 30,000
4 Purchased goods from Kamal on credit 10,000
6 Paid to Shriram 4,920
6 Discount allowed by him 80
8 Cash Sales 20,000
12 Sold to Hameed 5,000
15 Purchased Goods form Bharat on Credit 7,500
18 Paid Salaries 4,000
20 Received from Prem 2,480
19
Solution:
In the books of X&Co.
June Dr. Cr.

Particulars L.F
2016 Rs. Rs.
1 Cash A/c Dr. 60,000
To Capital A/c 60,000
(Capital brought into the business)
2 Bank A/c 30,000
To Capital A/c 30,000
(Cash paid in to bank)
4 Purchases A/c 10,000
To Kamal’s A/c 10,000
(Purchased goods for Kamal on credit)
6 Shriram’s A/c Dr. 4,920
To Cash A/c 4,920
(Cash paid to Shriram)
6 Shriram’s A/c Dr. 80
To Cash A/c 80
(Cash allowed by Shriram)
8 Cash A/c Dr. 20,000
To Sales A/c 20,000
(Cash sales effect)
12 Hameed’s A/c Dr. 5,000
To Sales A/c 5,000
(Goods sold to Hameed)
15 Purchases A/c Dr. 7,500
To Bharat’s A/c 7,500
(Purchased Goods from Bharat)
18 Salaries A/c Dr. 4,000
To Cash A/c 4,000
(Salaries Paid)
20 Cash A/c Dr. 2,480
To Prem’s A/c 2,480
2.3.4 THE TRIAL BALANCE

The Trial Balance is simply a list of the account names and their balances as
on a given time with debit balances in one column and credit balances in another
column. It is prepared to ensure that the mechanics of the recording and posting of
the transactions have been carried out accurately. If the recording and posting have
20
been accurate then the debit total and credit total in the Trial Balance must tally
thereby evidencing that an equality of debits and credit has been maintained. It
also serves as a basis for preparing the financial statements. In this connection it is
but proper to caution that mere agreement of the debit and credit totals in the Trial
Balance is not conclusive proof of account recording and posting. There are many
errors which may not affect the agreement of Trial Balance like total omission of a
transaction, posting the right amount on the right side but of a wrong account etc.
The points which we have discussed so far can very well be explained with the
help of the following simple illustration
Illustration 2
January 1 — Started business with Rs.3,00,000
January 2 — Bought goods worth Rs.2,00,000
January 9 — Received order for half of the good from'G'
January 12 — Delivered the goods, G invoiced Rs. 130,000
January 15 — Received order for remaining half of the total goods
purchased.
January 21 — Delivered goods and received cash Rs. 1,20,000
January 30 — G makes payment
January 31 — Paid salaries Rs. 21,000
— Received interest Rs.5,000
Let us now analyse the transactions one by one.
January 1-Started business with Rs.3,00,000
The two accounts Involved are cash and owners’ equity. Cash, an asset
increases and hence it has to be debited. Owners' equity, a liabili ty also increases
and hence it has to be credited.
January 2-Bought goods worth Rs.2,00,000
The two accounts affected by this transaction are cash and goods (purchases).
Cash balance decreases and hence it is credited and goods on hand, an asset.
Increases hence it is to be debited.
January 9 - Received order for half of goods from ‘G'
No entry is required as realisation of revenue will take place only when goods
are delivered (Realisation concept).
January 12 -Delivered the goods, 'G’ invoiced Rs.1,30,000
This transaction affects two Accounts-Goods (Sales) a/c and Receivables a/c.
Since it is a credit transaction receivables increase (asset) and hence is to be
debited. Sales decreases goods on hand and hence Goods (Sales) a/c is to be
credited. Since the term 'goods' is used to mean purchase of goods and sale of
goods, to avoid confusion purchase of goods is simply shown as Purchases a/c and
Sale of goods as Sales a/c.
January 15 -Received order for remaining half of goods.
No entry.
21
January 21 -Delivered goods and received cash Rs.120000

This transaction affects cash a/c and Sale a/c. Since cash is realised, the cash
balance will increase and hence cash accounts is to be debited. Since the stock of
goods becomes Nil due to sale. Sales a/c is to be credited (as asset in the form of
goods on hand has reduced due to sales).
January 30 – ‘G' makes Payment
Both the accounts affected by this transaction are asset accounts-cash and
receivables. Cash balance Increases and hence it is to be debited and receivables
balance decreases and hence it is to be credited.
January 31 -Paid Salaries Rs.21000
Because of payment of salaries cash balance decreases and hence cash
account is to be credited. Salary is an expense and since expense has the effect of
reducing owners' equity and as owners' equity account decreases on the debit side,
expenses account is to be debited.
January 31 -Received Interest Rs.5000
The receipt of Interest Increases cash balance and hence cash a/c is to be
debited. Interest being revenue which has the effect of increasing the owners'
equity, it has to be credited as owners’ equity account increases on the credit side.
When journal entries for the above transactions are passed, they would be as
follows:
Date Particulars L.F Debit Credit
January-1 Cash a/c (Dr) 300000
Capital a/c (Cr) 300000
January-2 Purchase a/c (Dr) 200000
Cash a/c (Cr) 200000
January-12 Receivables a/c (Dr) 130000
Sales a/c (Cr) 130000
Sales a/c (Cr) 120000
Receivables a/c (Cr) 130000
January-31 Salaries a/c (Dr) 21000
Cash a/c (Cr) 21000
Interest a/c (Cr) 5000
Now the above journal entries are posted into respective ledger accounts
which in turn are balanced.
Debit Cash a/c Credit

Capital a/c 300,000 Purchases 200,000
Sales a/c 120,000 Salaries a/c 21,000
Receivables a/c 130,000 Balance 33,4000
Interest 5,000
5,5,5000 55,5000
22
Dr Capital a/c Cr
Balance 300,000 Cash 300,000
Dr Purchases a/c Cr Cash a/c

200,000 Balance 200,000
Dr Receivable a/c Cr
Sales a/c 130,000 Cash 130,000
Dr Sales a/c Cr
Balance 2,50,000 Receivable a/c 1,30,000
Cash a/c 1,20,000
2,50,000 2,50,000
Dr Salaries a/c Cr
Cash a/c 21,000 Balance 21,000
Dr Interest a/c Cr
Balance 5,000 Cash a/c 5,000
Trial Balance
Debit Credit
Cash 3,34,000 Capital 300,000

Purchases 2,00,000 Sales 250,000
Salaries 21,000 Interest 5,000
5,55,000 5,55,000
2.3.5 CLOSING ENTRIES

Periodically, usually at the end of the accounting period, all revenue account
balances are transferred to an account called Income Summary or Profit and Loss.
account and are then said to be closed. (A detailed discussion on Profit and Loss
account can be had in a subsequent chapter). The balance in the Profit and Loss
account, which is the net income or net loss for the period, is then transferred to
the capital account and thus Profit and Loss account is also closed. In the case of
corporation, the net Income or net loss is transferred to retained earnings account
which is a part of owner's equity. The entries which are passed for transferring
these accounts are called as closing entries. Because of this periodic closing of
revenue and expense accounts, they are called as temporary or nominal accounts
23
whereas assets, liabilities and owners’ equity accounts, the balances of which are
shown on the balance sheet and are carried forward from year to year are called as
permanent or real accounts.
The principle of framing a closing entry is very simple. If an account is having a
debit balance, then it is credited and the Profit and Loss account is debited.
Similarly, if a particular account is having a credit balance, it is closed by debiting
it and crediting the Profit and Loss account.
In our example Sales account and interest account are revenues and Purchases
account and Salaries account are expenses. Purchases account is an expense
because the entire goods have been sold out in the accounting period itself and
hence they become cost of goods sold out. This aspect would become more clear
when the reader proceeds to the Chapter on Profit and Loss account. The closing
entries would appear as follows:
(1) Profit and Loss a/c (Dr) 2,210

Salaries a/c (Cr) 210
Purchases a/c (Cr) 2,000
(2) Sales a/c (Dr) 2,500
Profit and Loss a/c (Cr) 2,500
(3) Interest a/c (Dr) 50
Profit and Loss a/c (Cr) 50
Now Profit and Loss a/c. Retained Earnings a/c and Balance Sheet can be
prepared which would appear as follows:
Dr Profit and Loss Account Cr
Purchases a/c 2,000 Sales a/c 2,500
Salaries a/c 210 Interest a/c 50
Retained Earnings a/c 340
2,550 2,550
Dr Retained Earnings a/c Cr

Balance 340 Profit and Loss a/c 340
340 340
Dr Balance Sheet Cr
Cash 3,340 Capital Retained Earnings 3,000
340
3,340 3,340
2.3.6 Adjustment Entries

Because of the adoption of accrual accounting, after the preparation of Trial
Balance, adjustments relating to the accounting period have to be made in order to
24
make the financial statements complete. These adjustments are needed for
transactions which have not been recorded but which affect the financial position
and operating, results of the business. They may be divided into four kinds: two in
relation to revenues and the other two in relation to expenses. The two in relation to
revenue are:
(i) UNRECORDED REVENUES: i.e. income earned for the period but not
received in cash. For e.g. interest for the last quarter of the accounting period is yet
to be received though fallen due. The adjustments entry to be passed is:
Accrued interest a/c (Dr)
Interest a/c (Cr)
(ii) REVENUES RECEIVED IN ADVANCE: i.e. income relating to next period
received in the current accounting period, e.g. rent received in advance. The
adjustment entry is:
Rent a/c (Dr)
Rent received in advance a/c (Cr)
The two relating to expenses are:
(i) UNRECORDED EXPENSES: i.e. expenses were incurred during the period
but no record of them as yet been made. e.g. Rs.500 wages earned by an employee
during the period remaining to be paid. The adjustment entry would be:
Wages a/c (Dr)
Accrued wages a/c (Cr)
(ii) PREPAID EXPENSES: i.e., expenses relating to the subsequent period paid
in advance in the current accounting period. An example which frequently cited is
insurance paid in advance. The adjustment entry would be:
Prepaid Insurance a/c (Dr)
Insurance a/c (Cr)
In the above four cases unrecorded revenues and prepaid expenses are assets
and hence debited (as debit may signify increase in assets) and revenues received in
advance and unrecorded expenses are liabilities and hence credited (as credit may
signify increase in liabilities).
Besides the above four adjustments, some more are to be done before preparing
the financial statements. They are:
1. Inventory at the end.
2. Provision for Depreciation.
3. Provision for Bad Debts.
4. Provision for Discount on receivables and payables.
5. Interest on capital and Drawings.
2.4 REVISION POINT
Account: It is a statement wherein information relating to an item or a group of
similar items are accumulated.
25
Debit and credit: Debit signifies increase in asset accounts, decrease in

liability accounts and decrease in owners’ equity accounts. To debit(Dr-) an account
means to make an entry on the left-hand side of an account and to credit (Cr.) an
account means to make an entry on the right- hand side. The words debit and
credit have no other meaning in accounting, though in common parlance, debit has
a negative connotation, while credit has a positive connotation.
Trial Balance
The Trial Balance is simply a list of the account names and their balances as
on a given time with debit balances in one column and credit balances in another
column. A Trial Balance is prepared to ensure equality of debits and credits.
1. Explain the following:
a. A journal
b. An Account
c. A Ledger
2. Bring out relationship between a journal and a ledger.
3. Explain the significance of Trial Balance.
4. Why adjustments entries are necessary?
5. Narrate the rules of debit and credit.
6. Distinguish nominal accounts from real accounts.
7. Explain the mechanism of balancing an account.
8. How and why closing entries are made?
2.6 SUMMARY
The transactions that take place in a business enterprise durin g a specific
period may effect increases and decreases in assets, liabilities, capital, revenue and
expense items. The left-hand side of any account is called the debit side and the
right-hand side is called the credit side. Double entry system of recording business
transactions is universally followed. In this system for each transaction the debit
amount must equal the credit amount. When a business transaction takes place
the first record of it is done in a book called journal . The Trial Balance is simply a
list of the account names and their balances as on a given time with debit balances
in one column and credit balances in another column.
2.7 TERMINAL QUESTIONS
1. Purchases book records:
a. All cash purchase b. All credit purchases
c. Credit Purchases of Goods in d. None of the above
Trade
Ans : C
2. The debts written off as bad, if recovered subsequently are
a. Credited to Bad Debts b. Credited to Debtors Account
Recovered Account
26
c. Debited to Profit and Loss d. None of the above

Account
Ans : a
3. Amount realized from the sale of securities (Investments) purchased
earlier is an example of
a. Revenue Expenditure b. Capital Receipt
c. Deferred Revenue Expenditure d. Capital Expenditure
Ans : b
4. Ledger is also called –
a. Principal Book b. Subsidiary Book
c. Day Book d. Proper Book
Ans : a
1. www.icai.org
2. www.icmai.org
2.9 ASSIGNMENT
1. “How would you differenciate between direct and indirect cost”?give suitable
illustration.
1. Antony and Reece: 'Accounting Principles', Richard D. Irwin, Inc. Home wood,
Illinois.
2. Fess/Warren: 'Financial Accounting’, South Western Publishing Company,
Ohio.
3. M.C. Shukla& T.S. Grewal: Advanced Accounts, S. Chand& Company New
Delhi.
4. R.L. Gupta and M Radhaswamy: 'Advanced Accounts', Vol.1, Sultan Chand &
Sons, New Delhi.
1. The following transactions relate to a business concern for the
month of March 2016. Journalise them, post into ledger accounts, balance and
prepare the Trial Balance.
March 1 - Started business with a capital of Rs.9000.
March 2 - Purchased furniture Rs.300
March 3 - Purchased goods Rs.6000.
March 11 - Received order for half-of goods from ‘C’
March 15 - Delivered goods, 'C' Invoiced Rs.4000.
March 17 - Received order for the remaining half of goods.
March 21 - Delivered goods, cash received Rs. 3800.
March 31 - Paid wages Rs.300.
2.12 KEYWORDS
Debit, Credit, Journal, Trial Balance
27
LESSON 3
PREPARATION OF FINANCIAL STATEMENTS: TRADING AND PROFIT
AND LOSS ACCOUNT
3.1 INTRODUCTION
Ascertainment of the periodic income of a business enterprise is perhaps the
foremost objective of the accounting process. This objective is achieved by the
preparation of profit and loss account or the income statement. Profit and loss
account is generally considered to be of greatest interest and importance to end-
users of accounting information. Whereas the balance sheet enables them to know
the financial position of the business enterprise as of a particular date, the profit
and loss account enables them to find out whether the business operations have
been profitable or not during a particular period. The important distinctions which
one needs to make between the balance sheet and the income statement is that the
balance sheet is on a particular date while the profit and loss account is for a
particular period. It is for this reason that the balance sheet is categorised as a
status report (as on a particular date) while the profit and loss account as a flow
report (for a particular period). Usually the profit and loss account is accompanied
by the balance sheet as on the last date of the accounting period for which the
profit and loss account is prepared.
3.2 OBJECTIVES
 understand the meaning of income and expense
 prepare a Profit and Loss account
 appreciate the linkage between Profit and Loss account and Balance
Sheet.
 Understand the various methods of inventory valuation
 develop an understanding of the various methods of depreciation.
3.3 STRUCTURE
3.3.1 Preparation of trading accounts
3.3.2 Relationship between Balance Sheet and Income Statement.
3.3.3 Concepts underlying Profit and Loss Account
3.3.4 Methods of Inventory Valuation
3.3.5 Depreciation of Fixed Assets
3.3.1 PREPARATION OF TRADING ACCOUNTS
Trading A/c is prepared to ascertain the Gross Profit. Gross Profit is difference
between net sales and cost of goods sold.
A specimen of Trading Account is given below:
28
Particular Rs. Particulars Rs

To Opening Stock XXX By Sales X XXX
To Purchases X
Less: Returns(X) XXX Less: Returns(X)
By Closing Stock
XXX
XXX
To Carriage Inwards XXX
XXX
To Wages
To Cross Profit
XXX XXX
3.3.1.1 Cost of Goods sold: When income is increased by the sale value of
goods or services sold, it is also decreased by the cost of these goods or services.
The cost of goods or services sold is called the cost of sales. In manufacturing firms
and retailing business it is often called the cost of goods sold. The complexity of
calculation of cost of goods sold varies depending upon the nature of the business.
In the case of a trading concern which deals in commodities it is very simple to
calculate the cost of goods sold and it is done as follows:
Opening Stock XXX

Add: Purchase XXX
Freight XXX
Goods available for sale XXX
Less: Closing stock XXX
Cost of goods sold XXX
when a number of products are manufactured because it involves the

calculation of the work in progress and valuation of inventory. The methods of
valuation of inventory are explained separately at the end of this chapter. The cost
of goods sold as shown in the income statement of the Pondicherry Distilleries
would have been calculated as follows:
3.3.1.2 Gross Profit: The excess of sales revenue over cost of goods sold is the
gross margin or gross profit. In the case of multiple -step income statement it is
shown as a separate item. Significant managerial decisions can be taken by
calculating the percentage of gross profit on sale. This percentage indicates the
average mark up obtained on products sold. The percentage varies widely among
29
industries, but healthy companies in the same industry tend to have similar gross
profit percentages.
3.3.1.3 Operating Expenses: Expenses which are incurred for running the
business and which are not directly related to the company's production or trading
are collectively called as operating expenses. Usually operating expenses include
administration expenses, finance expenses, depreciation and selling and
distribution expenses. Administration expenses generally include personnel
expenses also.
However sometimes personnel expenses may be shown separately under the
heading 'Establishment Expenses' as is done in the case of Pondicherry Distilleries
under Schedule IX.
Schedule IX: Establishment Expenses
(Rs. in '000)
Salaries and Wages 24,27,000
Bonus and Incentive 4,67,000
P.F. Contribution 1,46,000
Gratuity 1,48,000
Pension 51,000
Employees Welfare Expenses 1,75,000
34,14,000
The important methods of providing depreciation are given in a separate section

at the end of this chapter.
Until recently most companies included expenses on research and development
as part of general and administrative expenses. But nowadays the amount should
be shown separately. This is so because the expenditure on research and
development could provide an important clue as to how cautious the company is in
keeping its products and services up to date.
3.3.1.4 Operating Profit: Operating profit is obtained when operating
expenses are deducted from gross profit.
3.3.1.5 Non-operating Expenses: These are expenses which are not related to
the activities of the business e.g. loss on sale of asset, discount on shares written
off etc. These expenses are deducted from the income obtained after adding other
Incomes to the operating profit. Other Incomes or miscellaneous receipts have
already been explained. The resultant profit is called as profit(or) earnings before
interest and tax (EBIT)
3.3.1.6 Interest Expenses: Interest expense arises when part of the expenses
is met from borrowed funds. The FASB requires separate disclosure of interest
30
expense. This item of expense is deducted from income or earnings before interest
and tax. The resultant figure is profit (or) earnings before tax (EBT)
3.3.1.7 Income Tax: The provision for tax is estimated based on the quan tum
of profit before tax. As per the corporate tax laws the amount of tax payable is
determined not on the basis of reported net profit but the net profit arrived at has
to be recomputed and adjusted for determining the tax liability. That is why the
liability is always shown as a provision.
3.3.1.8 Net Profit: This is the amount of profit finally available to the
enterprise for appropriation. Net profit is reported not only in total but also per
share of stock. This per share amount is obtained by dividing the total amount of
net profit by the number of shares outstanding. The net profit is usually referred to
as profit, or earnings after tax. This profit could either be distributed as dividends
to shareholders or retained in the business. Just like gross profit percentage, net
profit percentage on sales can also be calculated which will be of great use for
managerial analysis.
3.3.2 RELATIONSHIP BETWEEN BALANCE SHEET AND INCOME STATEMENT
The amount of net Income reported on the income statement together with the
amount of dividends, explains the change in retained earnings between the two
balance sheets prepared as of the beginning and end of the accounting period. For
e.g. in the balance sheet of Pondicherry Distilleries the retained earnings as on 1st
April stood at Rs.84,03,260 whereas it amounted to Rs. 1,03,81,683 in the balance
sheet as on 31 st March. The reason for this increase is explained in the statement of
retained earnings which is a part of income statement. Thus it can be stated that
there exists a definite and close relationship between balance sheet and income
statement.
3.3. 3 CONCEPTS UNDERLYING PROFIT AND LOSS ACCOUNT
As in the case of balance sheet, many concepts are involved to the preparation
of income statement also. For example, the in come statement is prepared for a
particular accounting period. Here the concept involved is accounting period
concept. Similarly, revenues, are recognised to the period to which goods were sold
to customers or to which services were rendered. This is to ac cordance with
realisation concept. Another concept which has to be followed is the concept of
conservatism. It is because of this concept that provision for bad and doubtful
debts, provisions for fluctuation to investments. etc. are created. It is to accordance
with the concept of consistency that material issues are priced on the basis of the
same method year by year and so is the case with depreciation methods. The
simple equation which is followed to ascertain income is Revenues- Expenses =
Income and this equation is to accordance with yet another important concept
known as concept of periodic matching of costs and revenues.
3.3. 4 METHODS OF INVENTORY VALUATION
Valuation of Inventory is a difficult exercise both for manufacturing concerns
and trading concerns. In the case of manufacturing concerns raw materials
31
required for production are purchased at different times and at different prices.
They are issued for production as and when required. It is very difficult to find out
from which specific purchase the issues are made. Hence the valuation of materials
Issued and closing stock of materials becomes difficult. Similarly trading concern
buy stock at different prices and at different times. They go on adding their
purchases to their current stock while at the same time selling them. It would be
impossible to identify the cost price of the commodities sold by pointing out the
time of their purchases and the corresponding purchase price. As a step towards
solving this problem many methods of inventory val uation are developed.
The important among them are:
i) First-in-First-out Method (FIFO)
ii) Last-in-First-out Method (LIFO)
iii) Weighted Average Method
1. First-in-First-out Method: This method is based on the assumption that
costs should be charged against revenue to the order in which they were incurred.
This method assumes that materials issued or goods sold are those which represent
the earliest purchases. This would mean that the materials or goods which remain
in stock, after the issues or sales are those which represent the most recent
purchases. Illustration1 explains the mechanism of this method.:
Illustration 1
Rs.
January 1 Opening Inventory 200 units @Rs.10 2,000
March 31 Purchases 400 units @Rs.11 4,400
June 1 Purchases 500 units @Rs.12 6,000
September 30 purchases 300 units @Rs.l3 3,900
December 1 Purchases 200 units @Rs.l4 2,800
1600 units 19,100
The physical verification on December 31 shows that 250 units are in stock. In
accordance with the assumption that the inventory is composed of the most recent
costs, the cost of 250 units is determined as:
Most recent costs December 1 200 units@Rs.l4 2800
Next most recent costs 50 units@Rs.l3 650
September 30 250 units 3450
Deduction of the Inventory of Rs.3450 from Rs. 19,100 worth of

materials/goods available for issues/sales gives Rs. 15,650 as the cost of goods
sold.
2 Last-in-First-Out Method: The LIFO method is based on the assumption
that the most recent costs incurred should be charged against revenue i.e., this
method assumes that the materials issued or goods sold are those which are most
32
recently purchased. It would follow, therefore, that the goods held in stock
represent earlier purchase. Based on data presented in
Illustration 2 the cost of the closing inventory is determined as:
Earliest Costs January 1200 units @ Rs.10 2000
Next earliest costs March 3150 units @ Rs.11 550
250 units 2,550
Deduction of the closing inventory of Rs.2550 from the Rs. 19,100 worth of
materials/goods available for issues/sales gives Rs. 16,550 as the cost of goods
sold.
3 W eighted Average Method: This method is based on the assumption that
costs should be charged against revenue in accordance with the weighted average
unit cost6 of the materials issued or goods sold.
The weighted average unit cost is determined by dividin g the total cost of the
materials or goods by the number of units.
Continuing the data given in Illustration 1 the weighted average cost of 1600
units and the cost of the inventory are determined in the following manner:
Weighted average unit cost Rs. 19,100 = Rs. 11.9375
1,600 units
Cost of inventory 250 units @ Rs. 11.9375 = Rs. 2,984
Deduction of the closing inventory of Rs. 2,984 from the Rs. 19,100 worth of
materials/goods available for issues/sales gives Rs. 16,116 as cost of goods sold
which represents the average of the costs incurred.
The FIFO method and the weighted average method are perhaps the most
extensively used methods. The main argument for FIFO method is that the cost of
the goods issued or sold closely reflects the price trend in the markets. Weighted
average method is preferred because of the 'smoothing of purchase costs achieved
by this method which enables to even out the wide fluctuations in the purchase
prices. The LIFO method is followed by a relatively small number of companies as
the application of this method is not liked by corporation laws in various countries.
Yet many companies use LIFO method for the purpose of internal reporting.
3.3.6 DEPRECIATION ON FIXED ASSETS
With the passage of time, all fixed assets lose their capacity to render services,
the only exception being land. Accordingly, a fraction of the cost of the asset is
chargeable as an expense in each of the accounting periods in which the asset
renders services. The accounting process for thi s gradual conversion of capitalised
cost of fixed assets into expense is called depreciation. Two factors contribute to the
decline in the usefulness of fixed assets: One is deterioration, the other is
obsolescence. Deterioration is the physical process we aring out whereas
obsolescence refers to loss of usefulness due to the development of improved
33
equipment or processes, changes in style or other causes not related to the physical
condition of the asset.
The International Accounting Standards Committee defines depreciation as
follows: "Depreciation is the allocation of the depreciable amount of an asset over
the estimated useful life".
The useful life in turn is defined as:
Useful life is the period over which a depreciable asset is expected to be used by
the enterprise."
The depreciable amount is defined as:
"Depreciable amount of a depreciable asset is its historical cost in the financial
statements, less the estimated residual value."
Residual value or salvage value is the expected recovery or sales value of the
asset at the end of its useful life.
Methods of Depreciation: The amount of depreciation of a fixed asset is
determined taking into account the following three factors: its original cost. its
recoverable cost at the time it is retired from service and the length of its life. Out of
these three factors the only factor which is accurately known is the original cost of
the asset. The other two factors cannot be accurately determined until the asset is
retired. They must be estimated at the time the asset is placed in service. The
excess of cost over the estimated residual value is the amount that is to be recorded
as depreciation expense during the asset's lifetime. There are no hard and fast rules
for estimating either the period of usefulness of an asset or its residual value at the
end of such period. Hence these two factors which are interrelated are affected to
a considerable extent by management policies.
Let us consider the following example: A machine is purchased for Rs. 10000
with an estimated life of five years and estimated residual value of zero. The
objective of depreciation accounting is to charge this net cost of Rs. 10,000
(Original cost- residual value) as an expense over the 5-year period. How much
should be charged as an expense each year? To help us in this regard we are
having, the following four frequently used methods of computing depreciation.
i) Straight line method.
ii) Units of production method.
iii) Diminishing balance method.
iv) Sum-of-the-years-digits method.
It is not necessary that an enterprise employ a single method of calculating
depreciation for all classes of its depreciable assets. But in accordance with the
convention of consistency, once a method of depreciation is selected the same
method should be followed throughout.
1. Straight Line Method: Straight line method assumes that the level of
service provided by a fixed asset is even in all the years of its life. Hence this
34
method provides for equal annual charges to expense over the estimated life of the
asset. To illustrate let us assume that the cost of a machine is Rs. 11,000, its
estimated residual value is Rs. 1,000 and its estimated life is 5 years. The annual
depreciation is calculated as follows.
Rs. 11.000 (cost) - Rs.1000 (estimated residual value)

5 years (estimated life)
= Rs.2000 per year
The annual depreciation can also be calculated as a percentage on net cost
(cost-residual value). The annual percentage is obtained by dividing 100 by the
number of years of life. To continue our illustration, the percentage would be 100/5
= 20 and applying this percentage on the net cost we get annual depreciation as
1000 x 20/100= Rs.2000
This method is fairly simple method and provides a uniform allocation of costs
to periodic revenue. Hence it is widely used.
2. Units – of- Production Method: In this method depreciation calculation are
done based on the estimated productive capacity of the asset concerned.
Depreciation is first calculated in terms of an appropriate unit of production, such
as hours, kilometers or number of operation. Then annual depreciation is
computed by multiplication of the unit depreciation by the number of units used
during the period. To continue with the same example if the machine is expected to
have an estimated life of 10,000 hours the deprecation for one hour is calculated as
follows:
Rs. 10000 (net cost)
10000 (estimated hours) = Re. 1.00 per hour
If during a particular year, the machine was used for 3000 hours the
depreciation charge for that year would be 3000x1=Rs.3000.
3. Diminishing Balance Method: This method results in a diminishing
periodic depreciation charge over the estimated life of the asset. Under this method
each year’s depreciation is found by applying a rate to the net book value of the
asset, as at the beginning of that year. Next book value at a particular point of time
is the original Cost less total depreciation accumulated up to that point of time.
The rate to be applied to the net book value is usually double the straight line
depreciation rate. To continue our example, the straight line rate we got is 20%
and therefore, the diminishing balance rate would be its double i.e. 40% . This 40%
is applied to the original cost of the asset for the first year and thereafter to the net
book value over the estimated life of the asset. The asset’s estimated residual value,
if any, is not taken into account for the calculation of net book value. However,
care should be taken to ensure that the asset is not depreciated below its residual
value in the last year. Table1 illustrates this method of depreciation.
35
Table 1
Book value at Depreciation Book value at

Year the beginning Rate for the year end of the
of the year year.
Rs. Rs. Rs.
1. 11,000 40% 4,400 6,600
2. 6,600 40% 2,640 3,960
3. 3,960 40% 1,584 2,376
4. 2,376 40% 950 1,426
5. 1,426 40% 426* 1,000
10,000
• In the last year the actual depreciation is Rs. 570 i.e. 40% of Rs. 1,426 and
the book value, therefore, at the year end would have been Rs.856. But since in the
last year the asset should not be depreciated below Its residual value, the
depreciation for the last year should be Rs.426 which is calculated as follows: Rs.
1426 (book value at the beginning of the year) minus Rs. 1000 (estimated residual
value).
4. Sum-of-the-Years-Digits Method: Under this method depreciation for each
year is computed by applying a fraction to the net cost of the asset. The
denominator of the fraction remains constant and it is the, sum of the digits
representing the year of life. To continue our example, the estimated life is 5 years
and hence the denominator would be 5+4+3+2+1 = 15. The numerator of the
fraction is the number of remaining years of life and it changes every year. In our
example the fraction to be applied on the net cost of Rs. 10,000 would be:5/15 in
the first year 4/15 in the second year, 3/15 in the third year, 2/15 in the fourth
year and 1/15 in the last year. The depreciation schedule under this method for
our example would appear as in Table 6-II
Table 2
Year Net Cost Rate Depreciation for the year
1. 10,000 5/15 3,333

2. 10.000 4/15 2,667
3. 10,000 3/15 2,000
4. 10.000 2/15 1,333
5. 10.000 1/15 667
10,000
36
Both the diminishing balance and the sum-of-the-years-digits method provide

for a higher depreciation charge in the first year of the use of the asset and a
gradually declining periodic change thereafter. Hence they are frequently referred to
as accelerated method of depreciation.
Chart 6-1 shows the Comparative amounts of annual depreciation charges
under straight-line method, diminishing, balance method and sum-of-the-years-
digits method.
Impact of Depreciation Methods on Profit Measurement: Just now we have
seen that depending on the method used, we have a different amount of charge for
annual depreciation. It may also be noted that over the entire life of the asset the
total amount of depreciation charge cannot be different.
The difference is only in the annual depreciation charge. The impact of annual
depreciation charge on profit measurement under various methods of depreciation
assuming an annual profit of Rs. 30,000 each year is shown in Table 6-III.
Table 3
Year Profit Depreciation Profits sum of
before St. Line Diminishing sum-of St. line under the years
Depreciation the years Diminishing
1. 30,000 2,000 4,400 3,333 28,000 25,600 26,667
2. 30,000 2,000 2,640 2,667 28,000 27,360 27,333
3. 30,000 2,000 1,584 2,000 28,000 28.416 28,000
4. 30.000 2,000 950 1,333 28,000 29,050 28,667
5. 30,000 2,000 426 667 28,000 29,574 29,333
150.00 10,000 10,000 10,000 140,000 140,00 140,000
It may be seen from the Table that over the life of the asset there is no
difference in the total profit after depreciation. Only there is difference in the
annual profits after depreciation. If the enterprise wants to show hi gher profits in
the initial years, it is better the straight line method of depreciation is followed.
3.4 REVISON POINT
1. Status Report: Position on a particular date
2. Flow Report: Financial position for a particular period
3. Income: Revenues - Expenses
4. Expense: Item of cost applicable to an accounting period
5. Cost of goods sold: Opening stock + Purchase + Freight – Closing stock
6. Gross Profit: Excess of sales revenue over cost of goods sold Operating
Expenses: Expenses incurred for running the business
7. Operating profit: Gross profit - Operating expenses
37
8. Non-operating expenses: Expenses which are not related to the activities

of the business.
9. Net Profit: Amount of profit finally available to the enterprise for
appropriation.
3.5 INTEXT QUESITONS
1. What is an expenditure? When it becomes an expense?
2. What is income? Can we say that an increase in owners’ equity is always
due to generation of income?
3. Does a su bstantial balance in retained earnings indicate the presence of a
large cash balance. Explain.
4. Explain the important methods of depreciation.
5. Explain the concepts underlying the preparation of Profit and Loss
account.
6. Distinguish the following:
(1) Gross Profit.
(2) Operating Profit.
(3) Earnings before interest and tax.
(4) Earnings after tax.
7. Bring out the relationship between the following:
(1) Owners' equity and income.
(2) Profit and Loss account and Balance Sheet.
8. Distinguish between cash discount and trade discount.
3.6. SUMMARY
The profit and loss account or income statement summarises the revenues and
expenses of a business enterprise for an accounting period. The information on the
income statement is regarded by many to be more important than information on
the balance sheet because the income statement reports the results of operations
and enables to analyse the reasons for the enterprises' profitability or lack thereof.
A close relationship exists between income statement and balance sheet; the
statement of retained earnings which is a concomitant of income statement
explains the change in retained earnings between the balance sheets prepared at
the beginning and the end of the period.
1. Purchase Price of Machine Rs. 80,000 . Installation Charges Rs. 20,000
Residual Value Rs. 40,960. Uesful life 4 Years . The rate of depreciation
under WDV Method is :
a. 25 %
b. 20 %
c. 14.76 %
d. None
38
Correct Answer: b
2. When depreciation is recorded by charging to Provision for Depreciation
Account , the asset apears
a. at Original Cost
b. at Original Cost less depreciation
c. at market value
d. at realizable value
Correct Answer: a
3. Depreciation is ------
a. a Cash Expenditure like other normal expenses
b. a Cash Operating Expense
c. a Non-Cash Operating Expense
d. a Non-Cash Non-Operating Expense
Correct Answer: c
4. The beginning stock of the current year is overstated by Rs. 500 and
closing stock is overstated by Rs. 1,200.
The Profit of the current Year will be :
a. Rs. 1,700 (overstated)
b. Rs. 1,200 (understated)
c. Rs. 1,700 (understated)
d. Rs. 700 (overstated)
Correct Answer: d
5. The adjustments to be made for prepaid expenses is:
a. Add prepaid expenses to respective expenses and show it as an
asset
b. Deduct prepaid expenses from respective expenses and show it
as an asset
c. Add prepaid expenses to respective expenses and show it as a
liability
d. Deduct prepaid expenses from respective expenses and show it
as a liability
Correct Answer: b
6. If average stock is Rs. 20,000. Closing stock is Rs. 4,000 more than
value of opening stock. Closing stock will be:
a. Rs. 16,000
b. Rs. 18,000
39
c. Rs. 20,000
d. Rs. 22,000
Correct Answer: d
1. www.icai.org
2. www.icmai.org
3.9 ASSIGNMENT
1. 'Depreciation is a process of valuation of fixed assets'- Do you agree with this
statement Discuss
2. Bring out a distinction between:
(1) Straight line method and Diminishing value methods of depreciation.
(2) FIFO and LIFO methods of inventory valuation.
3.10. SUGGESTED READINGS
1. R.L.Gupta and M.Radhaswamy: Advanced Accounts. Vol.I, Sultan Chand
& Sons. New Delhi.
2. M.C.ShukIa&T.S.Grewal: Advanced Accounts. S.Chandand Company. New
Delhi.
Collect the financial information regarding trading organisation and prepare
trading account and profit and loss account. Bring out the efficiency of the
organisation on this basis.
3.12 KEYWORDS
Gross profit, Net profit, Cost of sales, Depreciation
40
LESSON – 4
PREPARATION OF BALANCE SHEET
4.1 INTRODUCTION
The basic objective of accounting is to convey information. This is achieved by
different financial statements prepared by a business enterprise. One of the most
Important financial statements is the Balance Sheet. A balance sheet shows the
financial position of a business enterprise as of a specified moment of time. That is
why it is very often called a statement of financial position. It contains a list of the
asset and liabilities and capital of a business entity as of a specified date. Usually
at the close of the last day of a month or a year.
4.2 OBJECTIVES
 understand the conceptual basis of a balance sheet
 comprehend the form and method of presentation of a balance sheet
 classify the different assets and liabilities
 prepare a balance sheet from the given balances of accounts of
 a business enterprise
4.3 CONTENT
4.3.1 Conceptual basis of a balance sheet
4.3.2 Form and presentation of balance sheet
4.3.3 Accounting concepts underlying the balance sheet
4.3.4 Classification of items in the balance sheet
4.3.1 CONCEPTUAL BASIS OF A BALANCE SHEET
The balance sheet is basically a historical report showing the cumulative effect
of past transactions. It is often described as a detailed expression of the following
fundamental accounting equation which has already been explained in detail in an
earlier chapter:
Assets = Liabilities + Owners' Equity (capital)
Assets are costs which represent expected future economic benefits to the
business enterprise. However, the rights to assets have been acquired by the
enterprise as a result of past transactions. Liabilities also result from past
transactions; they represent obligations which require settlement in the future
either by conveying assets or by performing services. Implicit in these concepts of
the nature of assets and liabilities is the meaning of owners' equity as the resid ual
interest in the assets of the enterprise.
4.3.2 FORM AND PRESENTATION OF A BALANCE SHEET
Two objectives are dominant in presenting information in a balance sheet. One
is clarity and readability; the other is disclosure of significant facts within the
framework of the basic assumptions of accounting. Balance sheet classification,
terminology and the general form of presentation should be studied with these
objectives in mind.
41
Conventions of Preparing the Balance Sheet:

There are two conventions of preparing the balance sheet -- the American and
the English. According to the American convention assets are shown on the left
hand side and the liabilities and the owners' equity on the right hand side. Under
the English convention just the opposite is followe d i.e. assets are shown on the
right hand side and the liabilities and owners' equity are shown on the left hand
side.
Form of Presenting the Balance Sheet:
There are two forms of presenting the balance sheet - account form and report
form. When the assets are listed on the left hand side and liabilities and owners’
equity on the right hand side we get the account form of balance sheet. It is so
called because it is similar to an account. An alternative practice is the report form
of balance sheet where the assets are listed at the top of the page and the liabilities
and owners’ equity are listed beneath them. In Illustration 5.3.1 we have followed
the account form of balance sheet. When the above balance sheet is prepared in
report form
Listing of Items on the Balance Sheet:
Assets in balance sheet are generally listed in two ways -
In the order of liquidity or according to time i.e. in the order of the degree of
ease with which they can be converted into cash or 11) in the order of permanence
or according to purpose i.e., in the order of the desire to keep them in use. Some
assets cannot be easily classified. For e.g. investments can be easily sold but the
desire may be to keep them. Investments may therefore be both liquid and semi-
permanent that is why they are shown as a separate item in the balance sheet.
Liabilities can also be grouped in two ways either in the order of urgency of
payment or in the reverse order. The various assets and liabilities grouped in the
two orders will appear as follows:
Assets Liabilities
Cash Bills payable
Bank Creditors
Marketing securities Outstanding expenses
Bills revivable Income received in advance
Debtors provision for Income-Tax
Inventory Mortgage loan
Prepaid Expenses Debentures
Investments
Owner's equity
Furniture and Fixtures
Plant and Machinery
Land and Buildings
patents
Trade marks
good wills
42
Order of Permanence
Assets Liabilities
Goodwill Owners equity
Trade Marks Debentures
Patents Mortgage loan
Land and Buildings Provision for Income-tax
Plant and Machinery Income received in advance
Furniture and Fixtures Outstanding expenses
Investments Creditors
Prepaid expenses Bills payable
Inventory
Debtors
Bills receivable
Marketable Securities
Bank
Cash
Whatever is the order, it is always better to follow the same order for both
assets and liabilities. In the illustration the order of liquidity has been followed.
4.3.4 ACCOUNTING CONCEPTS UNDERLYING THE BALANCE SHEET
In the balance sheet of SAU and Sons unde r illustration the amounts are
expressed in money and reflect only those matters that can be measured in
monetary terms. The entity involved SAU and Sons and the balance sheet pertains
to that entity rather than to any of the individuals associated with it. The
statements assume that SA U and Sons is a going concern. The asset amounts
stated are governed by cost concept. The dual aspect concept is evident from the
fact that the assets listed on the left hand side of this balance sheet are equal in
total to the liabilities and owners’ equity listed on the right hand side. Thus in the
balance sheet the following five accounting concepts are involved: business entity
concept, money measurement concept, going concern concept, cost concept and
dual-aspect concept.
4.3.5 CLASSIFICATION OF ITEMS IN THE BALANCE SHEET
Although each individual asset or liability can be listed separately on the
balance sheet, it is more practicable and more informative to summarize and group
related items into categories called as accoun t classifications. The classifications or
group headings will vary considerably depending on the size of the business, the
form of ownership, the nature of its operations and the users of the financial
statements. For e.g. while listing assets, the order of liquidity is generally used by
sole traders, partnership firms and banks whereas joint stock companies by law
follow the order of permanence. As a generalisation which is subject to many
exceptions, the following classification of balance sheet items is suggested as
representative.
43
Assets
Current Assets
Investments
Fixed Assets
Intangible Assets
Other Assets
Liabilities:
Current Liabilities
Long term liabilities
Owners’ equity:
Capital
Retained Earnings
4.3.5.1 Classification of Assets
Current Assets: Current assets are those which are reasonably expected to be
realised in cash or sold or consumed during the normal operating cycle of the
business enterprise or within one year, whichever is longer. By operating cycle, we
mean the average period of time between the purchase of goods or raw materials
and the realisation of cash from the sale of goods or the sale of products produced
with the help of raw materials. Current assets generally consist of cash, marketable
securities, bills receivables, debtors, inventory and prepaid expenses. Cash: Cash
consists of funds that are readily available for disbursement. It includes cash kept
in the cash chest of the enterprise as also cash deposited on call or current
accounts with banks.
Marketable securities: These consist of investments that are both readily
marketable and are expected to be converted into cash within a year. These
investments are made with a view to earn some return on cash that otherwise
would be temporarily idle.
Account Receivable: Accounts receivables consist of amounts owed to the
enterprise by its consumers. This represents amounts usually arising out of normal
commercial transactions. These amounts are listed on the balance sheet at the
amount due less a provision for portion that may not be collected. This provision is
called as provision for doubtful debts. Amounts due to the enterprise by someone
other than a customer would appear under the heading other receivables rather
than accounts receivables. If the amounts due are evi denced by written promises to
pay, they are listed as bills receivables. Accounts receivables are expected to be
realised in cash.
Inventory: Inventory consists of: i) goods that are held in stock for sale in the
ordinary course of business, ii) work-in-progress that are to be currently consumed
in the production of goods or services to be available for sale. Inventory is expected
to be sold either for cash or on credit to customers to be converted into cash. It may
be noted in this connection that inventory relates to goods that will be sold in the
ordinary course of business. A van offered for sale by a van dealer is inventory. A
44
van used by the dealer to make service calls is not inventory;' it is an item of
equipment which is a fixed asset.
Prepaid expenses: These items represent expenses which are usually paid in
advance such as rent, taxes, subscriptions and insurance. For e.g., if rent for three
months for the building is paid in advance then the business acquires a right to
occupy the building for three months. This right to occupy is an asset. Since this
right will expire within a fairly short period of time it is a current asset.
Long Term Investments: The distinction between a marketable security
shown under current asset and as an investment is entirely based on time factor.
Those investments like investments in shares, debentures. bonds etc. that will be
retained for more than one year or one operating cycle will appear under this
classification.
Fixed Assets: Tangible assets used in the business that are of a permanent or
relatively fixed nature are called plant assets or fixed assets. Fixed assets include
furniture, equipment, machinery, building and land. Although there is no standard
criterion as to the minimum length of life necessary for classification as fixed
assets, they must be capable of repeated use and are ordinarily expected to last
more than a year. However, the asset need not actually be used continuously or
even frequently. Items of spare equipments held for use in the event of bre akdown
of regular equipment or for use only during peak periods of activity are included in
fixed assets.
With the passage of time, all fixed assets with the exception of land lose their
capacity to render services. Accordingly, the cost of such assets sho uld be
transferred to the related expense amounts in a systematic manner during their
expected useful life. This periodic cost expiration is called depreciation. While
showing the fixed assets in the balance sheet the accumulated depreciation as on
the date of balance sheet is deducted from the respective assets.
Intangible Assets: While tangible assets are concrete items which have
physical existence such as buildings, machinery etc., intangible assets are those
which have no physical existence. They cannot be touched and felt. They derive
their value from the right conferred upon their owner by possession. Examples are:
goodwill patents, copyrights and trademarks.
Fictitious Assets: These items are not at all assets. Still they appear in the
asset side simply because of a debit balance in a particular account not yet written
off e.g. debit balance in current account of partners, profit and loss account etc.
4.3.5.2 Classifications of Liabilities
Current liabilities: When the liabilities of a business enterprise are due within
an accounting period or the operating cycle of the business, they are classified as
current liabilities. Most of current liabilities are incurred in the acquisition of
materials or services forming part of the current assets. These liabilities are
expected to be satisfied either by the use of current assets or by the creation of
other current liabilities. The one-year time interval or current operating cycle
45
criterion applies to classifying current liabilities also. Current liabilities g enerally

consist of bills payable, creditors, outstanding expenses, income -received in
advance, provision for income-tax etc.
Accounts payable: These amounts represent the claims of suppliers related to
goods supplied or services rendered by them to the business enterprise for which
they have not yet been paid. Usually these claims are unsecured and are not
evidenced by any formal written acceptance or promise to pay. When the enterprise
gives a written promise to pay money to a creditor for the purchase of goods or
services used in the business or the money borrowed then the written promise is
called as bills payable or notes payable. Amounts due to financial institutions
which are suppliers of funds, rather than of goods or services are termed as short-
term loans or some other name that describes the nature of the debt Instrument,
rather than accounts payable.
Outstanding expenses: These are expenses or obligations incurred in the
previous accounting period but the payment for which will be made in the nex t
accounting period. A typical example is wages or rent for the last month of the
accounting period remaining unpaid. It is usually paid in the first month of the
next accounting period an4 hence It is an outstanding expense.
Income received in advance: These amounts relate to the next accounting
period but received in the previous accounting period. This item of liability is
frequently found in the balance sheet of enterprises dealing in the publication of
newspapers and magazines.
Provision for Taxes: This is the amount owed by the business enterprise to
the Government for taxes. It is shown separately from other current liabilities both
because of the size and because the amount owed may not be known exactly as on
the date of balance sheet. The only thi ng known is the existence of liability and not
the amount.
Long term Liabilities: All liabilities which do not become due for payment in
one year and which do not require current assets for their payment are classified as
long-term liabilities or fixed liabilities. Long term liabilities may be classified as
secured loans or unsecured loans. When the long-term loans are obtained against
the security of fixed assets owned by the enterprise they are called as secured or
mortgage loans. When any asset is not attached to these loans they are called as
unsecured loans. Usually long-term liabilities include debentures and bonds,
borrowings from financial institutions and banks, pu blic debts, etc. Interest
accrued on a particular secured long term loan, should be shown under the
appropriate sub-heading.
Contingent Liabilities: Contingent liabilities are those liabilities which may or
may not result in liability. They become liabilities only on the happening of a
certain event. Until then both the amount and the liabi lity are uncertain. If the
event happens there is a liability; otherwise there is no liability at all. A very good
example for contingent liability is a legal suit pending against the business
46
enterprise for compensation. If the case is decided against the enterprise the
liability arises and in the case of favourable decision, there is no liability at all.
Contingent liabilities are not taken into account for the purpose of totaling of
balance sheet.
4.3.5.3 Capital or Owners Equity
As mentioned earlier in this chapter owners’ equity is the residual interest in
the assets of the enterprise. Therefore, the owners’ equity section of the balance
sheet shows the amount the owners have invested in the entity. However, the
terminology 'owners' equity, varies with different forms of organisations depending
upon whether the enterprise is a joint stock company or sole proprietorship /
partnership concern.
Sole Proprietorship / Partnership Concern: The ownership equity in a sole
proprietorship or partnership Is usually reported on the balance sheet as a single
amount for each owner rather than distinction between the owner's initial
investment and the accumulated earnings retained in the business. For e.g. in a
sole-proprietor's balance sheet for the year 2016, the capi tal account of the owner
may appear as follows.
Rs
Owner's capital as on 1/1/2016 50,000
Add 2016-Proflt 30,000
80,000
Less 2016-Drawlngs 5,000
Owner's capital as on 31/12/2016 75,000
Joint Stock Companies: In the case of Joint stock companies, according to

the legal requirements, owners’ equity is divided into two main categories. The first
category called share capital or contributed capital is the amount the owners have
invested directly in the business. The second category of owners’ equity is called
retained earnings.
Share capital is the capital stock pre-determined by the company at the time of
registration. It may consist of ordinary share capital or preference share capital or
both. The capital stock is divided into units called as shares and that is why the
capital is called as share capital. The entire predetermined share capital called as
authorised capital need not be raised at a time. That portion of authorised capital
which has been issued for subscription as of a date is referred to as issued capital.
Retained earnings is the difference between the total earning to date and the
amount of dividends paid out to the shareholders to date. That is, the difference
represents that part of the total earnings that have been retained for use in the
business. It may be noted that the amount of retained earnings on a given date is
47
the accumulated amount that has been retained in the business from the beginning
of the Company's existence up to that date. The owners’ equity Increases through
retained earnings and decreases when retained earnings are paid out in the form of
dividends.
Adjusting items for preparing balance sheet.
adjustment Adjusting entry Treatment in balance
sheet
1.Outstanding Expenses a/c. Dr Shown on liabilities side
expenditure To Outstanding esp./c
2.Prepaid expenses Prepaid expenses. a/c Dr Shown on the asset side
To expenses. a/c
3.Closing stock Closing stock a/c Dr Shown on the asset side
To Trading .a/c
4.Accrued income Accrued income. Dr Shown on the asset side
To income a/c
5.Depreciation a. Depreciation a/c Dr Shown by way of
To Asset a/c deducting from respecting
asset of the asset side.
b. Depreciation a/c
To provision for
depreciation a/c
6.Provission for bad Profit &loss a/c Dr Deducting from sundry
debts To provision for bad debtors on the asset side
debts.
7. Provision for Profit &loss a/c Dr Deducting from sundry
discount To provision for discount debtors on the asset side
8.Reserve for Reserve for discount Shown by way of
discount on creditors on creditors a/c Dr deduction from sundry
creditors.
To profit and loss a/c
9.Income received in Income a/c. Shown on liabilities side
Advance To Income received in
Advance a/c
48
Illustrations1:
1.on 31.03.2015 the following trial balance was prepared from the books of
Krishna:
Particulars Dr.(Rs) Cr.(Rs)
Sundry debtors 50600 -
Sundry creditors 10000
Bills Receivables 5000
Plant machinery 75000
Purchases 90000
Capital 70000
Freehold premises 50000
Salaries 11000
Wages 14400
Postage and stationary 750
Carriage in 750
Carriage out 1000
Bad debts 950
Bad debts provision 350
General charges 1500
Cash at bank 5300
Cash in hand 800
Bills payable 5000
Reserve 20000
Sales 231700
Closing stock 30000
Total 337050 337050

49
The following adjustments are required:

1. Raju gets a salary of Rs. 9000 p.a.
2. Allow 5% interest on capital,
3. Bad debts provision to be adjusted to 2.5% on sundry debtors.
4. 2.5% of the net profit to be credited to reserve.
5. It was discovered in April 2014 that stock sheet as on 31.03.2014 were
overcast by Rs 1000.
You are required to prepare Trading and Profit and loss account for the year
ended 31 st march 2015 and a balance sheet as at that date.
Solution
Trading A/C for the year ending 31 st march 2015
Particular Rs particular Rs
To purchase 90,000 By sales 2,31,700
Less overcast stock 1,000
To wages 89,000
To carriage inward 14,400
To Gross profit
750
1,27,550
2,31,700
2,31,700
50
Profit and Loss A/C
To salaries 11,000
Add O/S 9,000 1,27,550
By Gross profit
20,000
To post & stationary 750
1,000
To carriage out
To Bad Debts 950

Add: new provision 1265
2215
1,865
Less: old provision 350
1,500
To General charges
3,500
To Interest on Capital
To Net Profit transferred to 98,935

Capital account
Total 1,27550
1,27550
51
Balance Sheet as at 31 st march 2015
Liabilities (Rs.) Assets (Rs.)

Capital 70,000.00 Plant & Machinery 75000.00
Add: Interest on Freehold premises 50000.00
capital 3,500.00 Sundry debtors 50600
73500.00 Less: provision 1265
Add: Net profit 96416.60 169961.60 49335.00
Sundry creditors 10000.00 Bills receivable 5000.00
Bills payable 5000.00 Closing stock 30000.00
Reserve 20000.00 Overstated Stock 2014 1000.00
Add:2 ½ % Net P. 2473.40 22473.40 Cash at bank 5300.00

Cash in hand 800.00
O/S salaries 9000.00
216435.00 216435.00
Illustrations2: From the following trial balance of X and Y. You are required to
prepare Trading and Profit & Loss Account for the year ended 31st March2016 and
Balance sheet as on that date after considering the following adjustments.
TrialBalanceason31stMarch2016
Particulars Rs. Rs.
Opening Stock 17,500 -
Salaries and Wages 4,600 -
Cash in hand 6,000 -
Purchase and Sales 1,12,600 2,65,000
Office Expenses 4,300 -
Productive Wages 7,000 -
Bills Receivable 4,000 -
Legal Expenses 3,300 -
Bad debts 1,900 -
Works Managers Salary 5,600 -
Commission 1,800 2,500
Investments 42,000 -
Debtors 67,500 -
Creditors - 92,000
Bank over draft - 88,000
Pate nts 38,000 -
Loose Tools 28,000 -
Furniture 65,000 -
Goodwill 80,000 -
Interest - 1,600
Land &Building 1,25,000 -
Capital Accounts:
Neela - 1,10,000
52
Sheela - 1,05,000
Drawings:
20,000 -
NeelaSheela 30,000 -
6,64,100 6,64,100
Adjustments:
1. Partners shares Profit and losses equally.
2. The Closing Stock cost Rs. 25,000/-market value Rs. 19,000/-.
3. NeelahaswithdrawngoodsworthRs.800/-for personal use.
4. DepreciateLandandBuildingat10%p.a.andLooseTools15%p.a.
st
TradingAccountfortheyearended31 March2016
Particulars Rs. Particulars Rs.
To Opening Stock to Purchases 17,500 By Sales 2,65,000

To Productive Wages 1,12,600 By Goods with drawn by
To Works Manager’s Salary 7,000 Neela 800
To Gross Profit 5,600 By Closing Stock 19,000
1,42,100
2,84,800 2,84,800
Profit&LossAccountfortheyearended31stMarch2016
To Salaries &Wages to 4,600 By Gross Profit By 1,42,100

4,300 Co mmission By 2,500
Office Expenses to
3,300 Interest 1,600
Legal Expenses to
1,900
Bad Debts 1,800
To Commission to Depreciation
Loose Tools 4,200
Land & Building to 12,500
Net Profit
Mr.X 56,800
Mr.Y 56,800
113600
1,46,200 1,46,200
53
Balance Sheet as on31st March2016
Liabilities Rs. Rs. Assets Rs. Rs.

Capital Accounts Cash in hand 6,000
Mr X: balance 1,10,000 Bills Rece ivable 4,000
(+)Net Profit 56,800 Investments 42,000
(–)Drawings 20,000 Sundry Debtors 67,500
(–)Goodstaken 800 1,46,000 Stock 19,000
Patents Loose 38,000
1,05,000 n 28,000
MrY.:balance Tools (–) Dep
(+)Net Profit 56,800 15% Furniture 4,200 23,800
(–)Drawings 1,31,800 65,000
30,000
Goodwill 1,25,000 80,000

Bank Over draft 88,000 Land & Building
1,12,500
n
Sundry Creditors 92,000 (–)Dep 10% 12,500
4,57,800 4,57,800
Illustration3:From the following Trial balance of Mr. X and Mr. Y. You are
required to prepare Trading and Profit & Loss Account for the year ending31st
Mar.2016 and balance sheet as on that date after consideration the adjustments
given below.
TrialBalanceason31stMarch,2016
Dr. Cr.

Stock(01.04.15) 35,000 Sales 3,30,000
Salary and Wages 9,200 Discount 4,800
Cash 10,000 Creditors 20,000
Purchases 2,25,200 Bank Overdraft 10,000
Sundry Expenses 8,600 Interest on Investments 7,200
Productive Wages 14,000 Capital Accounts
Bills Receivable 8,000 Ram 60,000
Law charges 3,000 Shyam 40,000
Bad Debts 1,000
Works Expenses 6,000
Commission 3,000
Investments 20,000
Debtors 40,000
Trade Marks 8,000
Tools and Equipments 6,000
54
Furniture 12,000
Od will 13,000
Building 50,000
4,72,000 4,72,00
0
Adjustments:
1. Partners shares Profit and Losses in the equal ratio.
2. Closing Stock cost price Rs. 40,000/-market value Rs. 45,000/-.
3. Uninsured goods worth Rs. 10,000/-were lost by fire.
4. Un paid Salary and Wages Rs. 2,100/-.
Trading Account for the year ended 31st Mar.2016

To Opening Stock to Purchases 35,000 By Sales 3,30,000

To Productive Wages 2,25,200 By Uninsured Goods lost by
To Works Expenses 14,000 fire 10,000
To Gross Profit c/d 6,000 By Closing Stock 40,000
99,800
3,80,000 3,80,000
Profit & Loss Account for the year ended31stMar2016

To Sundry Exp. 8,600 By Gross Profit by Discount by 99,800

To Law Charge 3,000 Interest on 4,800
To Bad Debts 1,000 Investment 7,200
To Commission 3,000
To Salaries 9,200
(+)Outstanding 2,100 11,300
To Uninsured Goods
Lost by fire 10,000
To Net Profit
Mr. X 37,450
Mr. Y 37,450 74,900
1,11,800 1,11,800
55
Balance Sheet as on31stMar2016
Capital Accounts Cash 10,000

Mr.X:balance 60,000 Bills Receivable 8,000
(+)Net Profit 37,450 97,450 Investments 20,000
Debtors 40,000
Trademarks 8,000
Mr.Y:balance 40,000 77,450 Tools and
(+)Net Profit 37,450
Equipments 6,000
Creditors 20,000 Closing Stock 40,000
Bank Overdraft 10,000 Furniture 12,000

Outstanding Goodwill 13,000
Salaries & Wage 2,100 Building 50,000
2,07,000 2,07,000
Illustration4:
From the following Trial Balance of Mr. X and Mr. Y, you are required to
prepare a Trading and Profit and Loss Account for they earended 31st March 2010
and the Balance Sheet as on that date, after taking into the consideration the
additional information:
TrialBalanceason31stMarch2010
Particulars Debit(Rs.) Credit(Rs.)
Opening Stock 17,500 -

Salaries and Wages 4,600 -
Cash in hand 5,000 -
Purchases and Sales 1,12,600 1,65,000
Office Expenses 4,300 -
Productive Wages 7,000 -
Bills Receivable 4,000 -
Legal Expenses 1,500 -
Bad Debts 500 -
Works Manager’s Salary 3,000 -
Commission 1,500 2,400
Investments 10,000 -
Debtors and Creditors 20,000 10,000
Bank Overdraft - 5,000
56
Patents 4,000 -
Loose Tools 3,000 -
Furniture 6,000 -
Goodwill 6,500 -
Interest on Investment - 3,600
Land and Building 25,000 -
Capital Accounts:
Mr.X - 30,000
Mr.Y - 20,000
2,36,000 2,36,000
Adjustments:
1. Partners share Profits and Losses in their capital ratio.
2. The Closing Stock–Cost Rs. 30,000/-Market Value Rs. 22,500/-
3. JaganhaswithdrawngoodsworthRs.600/-for his personal use.
4. Uninsured goods worth Rs. 5,000/-were destroyed by fire.
5. Rs.225/-written off as bad debts from Debtors.
6. OutstandingSalariesandWagesRs.400/-.
7. DepreciationonLandandBuildingat7½%.
Solution:
M/s.X & Y
Trading, Profit & Loss Account for the year ended 31-03-2010
To Opening Stock 17,500 By Sales 1,65,000
To Purchases 1,12,600 By Goods with drawn(Jagan) 600
To Productive Wages 7,000 By Goods Lost by Fire 5,000
To Work Manager’s Salary 3,000 By Closing Stock 30,000
To Gross Profit c/d 60,500
2,00,600 2,00,600
To Salaries & Wags 4,600 By Gross Profit c/d 60,500

(+)Outstanding 400 5,000 By Commission 2,400
To Office Expense 4,300 By Interest on Investment 3,600
To Legal Expense 1,500
500
To Bad Debts
225
(+)Additional B.D. 725
To Commission 1,500
To Loss by Fire 5,000
To Depreciation on
Land& Building 1,875
To Net Profit Capital
Mr.X(3/5) 27,960
Mr.Y(2/5)18640 14,640 46,600
56,500 56,500
57
Balance Sheet as on 31-3-2010
MrX’s Capital Goodwill 6,500

Balance b/d 30,000 Land & Building 25,000
(+)Net Profit 27,960 (-)Depreciation 1,875 23,125
51,960 57,360 Furniture 6,000

(-)Drawings 600 Loose Tools 3,000
Mr.Y’s Capital Patents 4,000

Balance b/d 20,000 Investments 10,000
18,640 20,000
(+)Net Profit 38,640 Bills Receivable 4,000
Creditors 10,000 Debtors

19,775
Bank Overdraft 5,000 (-)Bad debts 225
Outstanding Closing Stock 30,000

Salaries & Wages 400 Cash in Hand 5,000
1,11,400 1,11,400
4.4 REVISION POINT
1. Asset: Costs which represent expected future economic benefits to the
business enterprise.
2. Liabilities: Represent obligations which require settlement in the future.
3. Current Assets: Assets which are reasonably expected to be realised in
cash or sold or consumed during the normal operating cycle of the
business enterprise or within one year, whichever is longer.
4. Operating cycle: The average period of time between the purchase of goods
or raw materials and the realisation of cash from the sale of goods
5. Fixed Assets: Tangible assets used in the business that are of a permanent
or relatively fixed nature.
6. Intangible Assets: Those assets which have no physical existence.
7. Fictitious Assets: Not assets but appear in the asset side simply because of
a debit balance in a particular account not yet written off.
8. Current liabilities: Liabilities due within an accounting period or the
operating cycle of the business.
9. Long Term Liabilities: Liabilities that become due for payment after one
year.
58
10. Contingent Liabilities: Items which become a liability only on the

happening of a certain event.
11. Capital or Owners Equity: This is the residual interest in the assets of the
enterprise.
1. Discuss the accounting concepts and conventions.
2. What is dual aspect concept?
3. What do you understand by convention of materiality?
4. What is an accounting equation?
5. Explain the following
a. Assets
b. Liabilities
c. Fictious assets
d. Income received in advance
e. marketable securities
6. What are the accounting concepts involved in a balance sheet?
7. Explain the conceptual basis of a balance sheet.
8. What are the two forms of presenting a balance sheet?
9. Why the joint stock companies follow the order or permane nce while
listing the assets and liabilities on the balance sheet?
10. What is meant by operating cycle?
11. What is a contingent liability? Why is it not to be included in the total of
the balance sheet?
12. Why investments are neither shown under current assets nor under
fixed assets?
13. Explain owners, equity. How is it to be presented on the Balance Sheet
of a concern?
14. Distinguish with suitable examples the following
a. Fixed assets and current assets
b. Contingent liabilities and current assets.
4.6 SUMMARY
Balance sheet is one of the most important financial statements which shows
the financial position of a business enterprise as of a particular date. It lists as on a
particular date, usually at the close of the accounting period, the assets and
liabilities and capital of the enterprise. An analysis of balance sheet together with
profit and loss account will give vital information about the financial position and
59
operations of the enterprise. The analysis becomes all the more useful and effective
when a series of balance sheets and profit and loss accounts are studied.
4.7 TERMINAL EXERCISE
1. "Proposed dividends" is shown in the Balance Sheet of a company under
the head:
a. Provisions
b. Reserves and Surplus
c. Current Liabilities
d. Other Liabilities
Correct Answer: a
2. Balance Sheet of a company is prepared in the format prescribed in/by
a. Income Tax Act
b. Schedule VI of the Companies Act,1956
c. By CAG
d. By ICAI
Correct Answer: b
3. Which of the following would not appear on a conventional balance
sheet?
a. income taxes payable
b. funds from operations
c. cash surrender value of life insurance
d. appropriation for contingencies (restriction of retained earnings)
e. patents
ANS: b
4. Tangible assets on the balance sheet should include:
a. equipment
b. taxes payable
c. trademarks
d. bonds payable
e. none of the answers are correct
ANS: a
1. www.icai.org
2. www.icmai.org
4.9 ASSIGNMENT
1. Give adjustment entries for the following:
(a) income received in advance
(b) prepaid expenses
(c) closing stock
(d) provision for doubtful debts
60
(e) out standing income

(f) out standing expenses
(g) provision for discounts on debtors.
1. R.L. Gupta and M Radhaswamy: 'Advanced Accounts', Vol.1, Sultan Chand
& Sons, New Delhi.
2. M.C. Shukla& T.S. Grewal: 'Advanced Accounts', S. Chand and Company,
New Delhi.
1. From the following balances relating to Rolta India Limited prepare the Balance
Sheet as at 30th June 2016.
(a) Equity capital 36,42,58,510
(b) Reserves & surplus 23,58,26,861
(c) Debentures 1,03,36,000
(d) Secured Loans 21,27,57,441
(e) Fixed assets 37,07,93,048
(f) Investments 5,94,80,459
(g) Inventories 20,78,28,095
(h) Sundry Debtors 10,21,66,468
(i) Cash & Bank balances 1,49,87,264
(j) Other current assets 57,75,568
(k) Loans and advances 12,49,59,370
(l) Current liabilities 4,71,71,358
(m) Provisions 4,64,19,410
(n) Miscellaneous Expenditure 3,07,79,308
The balance sheet may be prepared in account form and report form.
4.12 KEYWORDS
Asset, liability, balance sheet, proforma statement
61
LESSON – 5
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT
5.1 INTRODUCTION
A financial statement is an organized collection of data according to logical and
consistent accounting procedures. Its purpose is to convey an understaning of
some financial aspects of a business firm. It may show a position at a moment of
time as in the case of a balance sheet, or may reveal a series of activities over a
given period of time, as in the case of an income statement.
The term financial statement generally refers to two basic statement.: i. The
income statement and ii. Balance sheet. Of course, a business may also prepare iii.
A statement of retained earnings and iv. A statement of changes in financial
position in addition to the above two statements
5.2 OBJECTIVES
 After reading this lesson the student should be able to:
 understand the various financial statement like income statement,
 Statement of retained earing, statement of changes in financial position.
 And types of financial analysis.
5.3 CONTENT
5.3.1 Income statement
5.3.2 Balance sheet
5.3.3 Types of financial analysis
5.3.4 Techniques of financial analysis
5.3.5 Limitations of financial analysis
5.3.1 INCOME STATEMENT
The income statement is generally considered to be the most useful of all
financial statements. It explains what has happened to a business as a result of
operations between two balance sheet dates. For this purpose it matches the
revenues and costs incurred in the process of earn ing revenues and shows the net
profit earned or loss suffered during a particular period.
5.3.2 BALANCE SHEET
It is a statement of financial position of a business at a specified moment of
time. It represents all assets owned by the business at a particul ar moment of time
and the claims of the owners and outsiders against those a sets at that time.
Statement of retained earnings.
The term retained earnings means the accumulated excess of earnings over
losses and dividends. The balance shown by the income statement is transferred to
the balance sheet through this statement, after making necessary appropriations. It
is thus, a connecting link between the balance sheet and the income statement.
Statement of changes in financial position (SCFP)
The balance sheet shows the financial condition of the usiness at a particular
moment of time while the income statement discloses the results of operations of
business over a period of time.
62
Financial statements are indicators of the two significant factors:

1. profitability and
2. financial soundness
analysis and interpretation of financial statements, therefore, refers 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 soundness of the
business
5.3.3 TYPES OF FINANCIAL ANALYSIS
financial analysis can be classified into different categories depending upon
i. the material used and ii. the modues operandi of analysis
1. on the basis of material used
According to this basis, financial analysis can be of two types
i. External analysis. The analysis is done by those who are outsiders for the
business. The term outsiders includes investors, credit agencies,
government agencies and other creditors who have no access to the
internal records of the company. These persons mainly depend upon the
published financial statement. Their analysis serves only a limited
purpose. The position of these analysis has improved in recent times on
account of increasd governmental control over companies and government
alregulations requiring more detailed disclosure of information by the
companies in their financial statement.
ii. Internal analysis . this analysis is don e by persons who have acdcess to
the books of account and other information related to the business. Such
an anlysis can, therefore, be done by ex3ecutives and employees of the
organization or by officers appointed for this purpose by the government or
the court under powers vested in athem. The analysis is done depending
up on the objective to be achieved through this analysis
2. on the basis of modus operandi
according to this, financial analysis can also be of two types
i. Horizontal analysis . in case of this type of analysis, financial statements
for a number of years are reviewed and analyse. The current years
figures are compared with the standared or base year. The analysis
statement usually contains figures for tow or more years and the
changes are shown regarding each item from the base year usually in
the form 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 form year to year rather
than on one 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 ite ms in the financial statement
on a particular date. For example, the ratios of different items of costs
63
for a particular period may be calculated with the sales for the period.
Such analysis is useful in comparing the performance of several
companies in the same group, or divisions or departments in the same
company. Since this analysis depends on the data for one period, this is
not very conducive to a proper anal ysis of company financial position. It
is also called static analysis as it is frequently used for referring to ratios
developed on one date or for one accounting period.
It is to be noted that both analysis – vertical and horizontal – can be done
simultaneously also. For example, the income statement of a company for several
years may be given. Horizontally it may show the cange in different elements of cost
and sales over a number of years. On the other hand, vertically it may show the
percentage of each element of cost to sales.
5.3.4 TECHNIQUES OF FINANCIAL ANALYSIS
A financial analyst can adopt one or more of the following techniques/tools of
financial analysis
Comparative financial statements
Comparative financial statement are those statement which have been designed
in a way so as to provide time perspective to the consideration of various elements
of financial position embodies in such statements. In these statemen t 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.
Common size financial statement
Common size financial statements are those in which figures reported are
converted into percentages to some common base. In the income statement the sale
figure is assumed to be 100 and all figures are expressed as a percentage of this
total.
Trend percentages
Trend percentages are immensely helpfull 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.
Funds flow analysis
Funds flow analysis has become an important tool in the analytical kit of
financial analysts, credit grating institutions and financial mangers. This is
because the balance sheet of a business reveals its financial status at a particular
point of time. It does not sharply focus those major financial transactions which
have been behind the balance sheet changes.
Cost volume profit analysis
Cost volume profit analysis is an important tool of profit planning. It studies
the relationship between cost, volume of production, sales and profit. Of course, it
is not strictly a technique used for analysis of financial statements.
64
Ratio analysis
This is the most important tool available to financial analysis for their work. An
accounting ratio shows the relationship in mathematical terms between two
interrelated accounting figures.
5.3.5 LIMITATIONS OF FINANCIAL ANALYSIS
Financial analysis is only a means
Financial analysis is a means to an end and not the end itself. The analysis
should be used as a starting point and the conclusion should be drawn not in
isolation, but keeping in view the overall picture and prevailing economic and
political situation
Ignores price level changes
Financial statements are normally prepared on the concept of historical costs.
They do not reflect values in terms of current costs. Thus, the financial analysis
based on such financial statements or accounting figures would not portray the
effects of price level changes over the period.
Financial statements are essentially interim reports
The profit shown by profit and loss account and the financial position as
depicted by the balance sheet is not exact..
Accounting concepts and conventions
Financial statements are prepared on the basis of certain accounting concepts
and conventions. On account of this reason the financial position as disclosed by
these statements may not be realistic. For example, fixed assets in the balance
sheet are shown on the basis of going concern concepts. This means that value
placed on fixed assets may not be same which may be relaised on their sale. On
account of convention of conservatism the income statement may not disclose true
income of the business since probable losses are considered with probable incomes
are ignores.
Influence of personal judgements
Many items are left to the personal judgement of the accountant. For example,
the method of depreciation, mode of amortization of fixed assets, treatments of
deferred revenue expenditure – all depend on the personal judgement of the
accountant. The soundness of such judgement will necessarily depend upon his
competence and integrity. However, the convention of consistency acts as a
controlling factor on making indiscreet personal judgements
Disclose only monitory of facts
Financial statement do not depict those facts which cannot be expressed in
terms of money. For example, development of a team of loyal and efficient workers,
enlightened management, the reputation and prestige of management with the
public. Are matters which are of considerable importance of 4 th business, but hey
are nowhere depicted by financial statements
65
5.4 REVISION POINT

Techniques of financial analysis:
1. Comparative financial statements
2. Common size financial statement
3. Trend percentages
4. Funds flow analysis
5. Cost volume profit analysis
6. Ratio analysis.
5.5 INTEXT QUESTION
1. Explain the meaning of the term `financial statements’. State their nature
and limitations.
2. Explain the different types of financial analysis.
3. Explain the various tools of financial analysis.
4. Justify the need for analysis and interpretation of financial statements.
5.6 SUMMARY
Financial statements are prepared primarily for decision making. The
statement are not an end in themselves, but are useful in decision making.
Financial analysis is the process of determining the significant operating and
financial characteristics of a firm from accounting data. The profit and loss account
and balance sheet are indicators of two significant factors – profitability and
financial soundness.
1. Gross profit is the difference between:
a. net income and operating income
b. revenues and expenses
c. sales and cost of goods sold
d. income from continuing operations and discontinued operations
e. gross sales and sales discounts
ANS: C
2. Which of the following would be included in operating income?
a. interest income for a manufacturing firm
b. rent income for a leasing subsidiary
c. gain from sale of marketable securities for a retailer
d. dividend income for a service firm
e. none of the answers are correct
1. www.icai.org
66
2. www.icmai.org
5.9 ASSIGNMENT
1. Collect the annual reports of any public limited company for a period of 5
years. Calculate the trend percentages and prepare a report.
1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.
2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
5.11 LEARNING ACTIVITY
1. Collect financial information from any pharmaceutical company and apply
different techniques of financial analysis and tabulate the performance of the
company.
5.12 KEYWORDS
Horizontal analysis, Vertical analysis, Rretained earnings
67
LESSON – 6
RATIO ANALYSIS
6.1 INTRODUCTION
Ratio analysis is one of the techniques of financial analysis where ratios are
used as a yard stick for evaluating the financial condition and performance of a
firm. Analysis and interpretation of various accounting ratios gives a skilled and
experienced analyst, a better understanding of the financial condition and
performance of the film than what he could have obtained only through a perusal of
financial statement.
6.2 OBJECTIVES
 Understand the different types and classification of ratios.
 Understand the objectives, advantages, limitation of ratios
 Understand the steps involve the preparation of ratios.
6.3 CONTENT
6.3.1 Meaning of ratios
6.3.2 Classification of ratios
6.3.3 Objectives of Ratio analysis
6.3.4 Advantages
6.3.5 Limitations of ratios
6.3.6 Steps involved in preparation of Ratio analysis
6.3.1 MEANING OF RATIOS
A ratio is a simple arithmetical express of the relationship of the number to
another.
Obviously, no purposes will be served by comparing two sets figures which are
not at all connected with each other. Moreover, absolute figures are unfit for
comparison.
Ratios can be expressed in two ways:
1. Times. When one value is divided by another, the unit used to express the
quotient is termed as “Times’. For example, if out of 100 employee in a
factory, 80 are present, the attendance ratio can be expressed as follows:
=80/100=.8Times
2. Percentage. If the quotient obtained is multiplied by 100, the unit of
expression is termed as” percentage”. For instance, in the above example,
the attendance ratio as a percentage of the total number of the employee is
as follows:
= .8 X 100 =80%
3. Accounting ratios are, therefore, mathematical relationship expressed
between inter-connected accounting figures.
68
6.3.2 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 the ratios could be
classified as:
Balance sheet Ratios, e.g. ratios calculated on the basis of the figures of
balance sheet only, e.g., current ratio, debt-equity ratio, etc.
Profit and loss Account Ratios, i.e., ratios calculated on the basis of the item of
the profit and loss account only, e.g., gross profit ratio, stock turnover ratio, etc.
Composite Ratios or inter-statement ratio, ratio based on the figure of profit
and loss account as well as the balance sheet, e.g.., fixed assets turnover ratio,
overall profitability ratio, etc.
Ratios are classified according to profitability and solvency as follows:
1. Profitability Ratios
2. Coverage Ratios
3. Turn Over Ratios
4. Financial Ratios
a. Liquidity Ratios b. Stability Ratios
6.3.2 PROFITABILITY RATIOS
Return on investment = (operating profit / capital employed) * 100
i. Return on total capital employed = (net operating profit before interest
and tax / total capital employed ) * 100
ii. Return on shareholders funds = (net profit after interest and tax /
shareholders funds) * 100
iii. Return on equity shareholders funds = (net profit after interest, tax and
preference dividend / equity shareholders funds ) * 100
iv. Return on total assets = (net profit after tax / total assets ) * 100
Significance of return on investment
 It shows the earnings capacity of proprietors funds
 It is important to prospective investors an d shareholders
 High ratio will improve the market price of the share in stock exchange
 High ratio enables the management to raise finances easily even from
external resources
 A high ratio gives scope for more retained earnings which can be used
for expansion, diversification and consequential developme nt of
business
 When the ratio has been high for a period of 4 or 5 years, shareholders
can expect the company to issue bonus shares.
69
Net profitaftertax and Perferencedividend

Earnings per share
Number of equity shares
Marketpriceequity share
priceearningratio 
Earning Per Shares
Cross profit
Gross profitratio   100
Net Sales
Net operating profit

Net profitratio   100
Net Sales
Dividend per equity Shares

Pay out ratio 
Earningperequity Shares
Dividend per Share

Dividend yield ratio   100
MarketPrice Sales
6.3.2.1 Coverage ratios
These ratios indicate the extent to which the interests of the persons entitled to
get a fixed return or a scheduled repayment as per the agreed terms are safe. The
higher the cover, the better it is. These ratios are of three types
1. Fixed interest cover = Income before interest and tax / Interest charges
2. Fixed dividend cover = Net profit after interest and tax / Preference
dividend
3. Debt service coverage ratio = Net profit before interest and tax /
(Principal repayment + Interest expences)
6.3.2.2 Turnover ratios
These ratios indicate the efficiency with which the capital employed is rotated
in the business. Higher the rate of rotation, the greater will be their profitability .the
overall profitability ratio can be classified into
Net operatingProfit
Net Profit ratio   100
Sales
70
Sales
Turnoverratio 
Capitalemployed
Net Sales
Fixed assetsturnoverratio 
Fixed assets(net)
Net Sales
Working capital turnover ratio 
Working capital
Credit Sales
Debtors turnover ratio 
Average accounts receivable
Or
Total Sales
Debtors turnover ratio 
Accounts receivable
The ratio may be calculated by any of the following methods :
Months( day ) in a year

Debit collection Period ratio 
Debtors turnover
Months( or day ) in a year

Average accounts receivable
Credit Sales for the year
Accounts receivable
Average monthly or daily credit sales
Credit purchases
Creditor's turnover ratio 
Average accounts payable
Or
Total purchases
Creditor's turnover ratio 
Accounts payable
71
Months(day)in year
Debit payment period ratio 
Creditors turnover
Months(day)in year
Average accountspayable 
Credit purchasesin the year
Average accounts payable

Average monthly(or daily) credit purchases
Cost of goods sales duringthe year

Stockturnover ratio -
Average inventory
6.3.2.3 Financial ratios

Financial ratios indicate about the financial position of the company. Financial
ratios can be divided into two broad categories
1. Liquidity ratios 2. Stability ratios
Liquidity ratios
Current Assets
Current ratio -
Current Liabilities
Liquid Assets
Quick ratio -
Current Liabilities
Cash and maketable securites

Superquick ratio -
Current Liabilitis
Or
Cash and maketable securites

Superquick ratio -
Quick Liabilitis
72
Quick assets
Defensiveinterval ratio -
Projected daily cash requirements
Stability ratios
Fixed assets
Fixed assets ratio -
Long term funds
Capital structure ratios

Funds bearing fixed interest or fixed dividends
Capital gearing ratios -
Total capital employed
Or
Funds bearing fixed interest or fixed dividends

Capital gearing ratios -
Equity shareholders funds
Debt equity ratio =

External equities
Debt equity ratio 
Internal equities
Or
Total long term debt
Total long term funds
Or
Shareholders funds
Total long term funds
Or
Total long term debt

Shareholders funds
Proprietary ratio
Shareholders
Proprietary ratio 
Total tangible assets
73
6.3.3 OBJECTIVES OF RATIO ANALYSIS

1. To determine the financial soundness of the firm i.e. Liquidity of the firm
2. To judge the solvency of the firm by working out leverage ratios
3. To assess the profitability of the firm by the present shareholders and
prospective investors
4. Management can measure the operational efficiency of the firm by
means of operating ratios and turnover ratios
5. It provides basis not only for intra firm comparison but also for inter
firm comparison
6. Comparison with base year financial statements will help the
management in controlling the affairs of the firm.
6.3.4 ADVANTAGES:
The following are the important managerial uses of the ratio analysis:
1. Ratio analysis simplifies the financial statements. It tells the whole story of
changes in the financial condition of the business.
2. Ratio analysis provides data for inter-firm comparisons. It highlights the
factors in relation to success or failure of activities.
3. Ratio analysis helps in panning and forecasting. Ratio can assist
management, in its basic functions or forecasting, planning, coordination,
control and communications.
4. Ratio may be used as measure of efficiency for inter-firm and intra firm
comparisons.
5. They act as an index of the efficiency of the enterprise. As such they serve as
instrument of management control.
6. Ratio analysis is an effective instrument which, when properly used, is
useful to assess important characteristics of business like liquidity,
solvency, profitability etc.
6.3.5 LIMITATIONS OF RATIOS
Financial statement analysis through ratios is useful because they highlight
relationships between items in the financial statement. Howeve r they have a
number of limitations which should be kept in mind while preparing or using them.
1. Ratios are based on accounting figures given in the financial statements.
However, accounting figures are themselves subject to deficiencies,
approximations, diversity in practice or even manipulation to some extent.
Therefore, ratios are not very helpful in drawing reliable conclusions.
2. Ratios have inherent problem of comparability. Companies otherwise
similar may employ different accounting methods, which can cause
problems in comparing certain key relationships. For example, inventory
turnover can be different for a company using FIFO than for the other
company using LIFO method of inventory valuation. Similarly the differences
in accounting methods relating to depreciation, estimates of the life of asset,
74
amortization of intangibles and preliminary expenses, treatment of

extraordinary items etc, can create the problem of comparability among the
companies even in the same industry.
3. Inflation may limit the utility of accounting ratios. Due to inflation, historical
cost based financial statements and accounting figures do not reflect current
value figures, especially in the case of assets purchased at different dates by
the different enterprises. Since financial statements are not adjusted in
terms of inflation effect, accounting ratios calculated have distortions and
become deceptive. Sometimes, gain over time in sales, net income and other
key figures disappear when the accounting data are adjusted for changes in
price levels.
4. Accounting ratios are not totally dependable and they much be used after
giving due weight age to general economic conditions, industry situation,
position of firms within the industry, mode of operations, size of firm,
diversity of product which can make the business enterprises completely
dissimilar and thus affect the computation of accounting ratios.
5. The different methods of computation also influence the utility of accounting
ratios. The different concepts used for determining numerator and
denominator in a particular accounting ratio will not help in drawing reliable
conclusions even in identical situations.
6.3.6 STEPS INVOLVED IN PREPARATION OF RATIO ANALYSIS
1. Compilation of financial data
2. Study of data
3. Systematic classification of data
4. Scientific arrangement of classified groups of data
5. Establishing relationship with related data for further comparison
6. Supplementing with appropriate comments
7. Analysis
8. Interpretation of the analysis
Illustration. 1
The following figures are extracted from the balance sheet of ABC ltd as on 31 st
December 2015 and 2016
2015 2016
Rs. Rs.
Stock 25000 40000
Debtors 10000 16000
Cash at bank 5000 4000
Creditors 8000 15000
Bills payable 2000 3000
Provision for taxes 5000 7000
Bank overdraft 5000 15000
75
Calculate the current ratio and acid test ratio for the two years
Solution:
Current assets:
= Stock + Debtors + Cash at Bank
= Rs. 25000 + Rs.10000 + Rs.5000 = Rs.40000 (2006)
= Rs.40000 + Rs.16000 + Rs.4000 = Rs.60000 (2007)
Current liabilities:
= Creditors + bills payable + provision for taxes + overdraft
= Rs.8000 + Rs.2000 + rs.5000 + Rs.5000 = Rs.20000 (2006)
= Rs.15000 + Rs.3000 + Rs.7000 + Rs.15000 = Rs.40000 (2007)
Liquid assets
= Rs.10000 + Rs.5000 = Rs.15000 (2006)
= Rs.16000 + Rs.4000 = Rs.20000 (2007)
Liquid liabilities
= Rs.8000 + Rs.2000 + Rs.5000 = Rs.15000 (2006)
= Rs.15000 + Rs.3000 + Rs.7000 = Rs.25000 (2007)
Currentassets
Currentration =
Currentaliabilities
Rs.40000
2015 = = 2:1
Rs.20000
Rs.60000
2016 = = 1.5:1
Rs.20000
Liquidassets
Acidtestratio = = 2:1
Liquidliabilities
Rs.15000
2015 = = 1:1
Rs.15000
Rs.20000
2016 = = 0.8:1
Rs.25000
76
Illustration 2.
Rs.
Equity share capital 1000000
10% pref. share capital 500000
18 % debentures 800000
Loan at 15 % (long period) 140000
Current liabilities 300000
General reserve 800000
Find out capital gearing from the above particulars

Solution:
10% pref. share capital + 18% debentures + long peri od Loan
Capital gearing ratio =
Equity share capital + General reserve
Rs.500000 + Rs.800000 + Rs.140000

=
Rs.1000000 + Rs.800000
Rs.1440000
=
Rs.1800000
= 0.8
Since the ratio is less than one, it is low geared.
Illustration 3.
Rs.
Preference share capital 300000
Capital reserve 500000
Profit & loss account 200000
6% debentures 500000
Bills payable 120000
Provision for taxation 180000
Outstanding creditors 160000
77
Calculate Debt equity ratio

Solution:
External equities
Debt equity ratio =
Internal equities
Rs. 120000
Debt equity ratio =
Rs. 210000
= 0.57 or 4:7
It means that for every four rupees worth of the creditors investment, the
shareholders have invested seven rupees. That is external are equal to 57% of
shareholders fund.
Illustration 4
The following is the balance sheet of a company as on 31 st march
Liabilities Rs. Assets Rs.
Share capital 200000 land and buildings 140000
Profit & loss account 30000 plant and machinery 350000
General reserve 40000 stock 200000
12% debentures 420000 sundry debtors 100000
Sundry creditors 100000 bills receivables 10000
Bills payable 50000 cash at bank 40000
840000 840000
Calculate
1. Current ratio
2. Quick ratio
3. Inventory to working capital
4. Debt to equity ratio
5. Proprietary ratio
6. Capital gearing ratio
7. Current assets to fixed ratio
Solution
Current assets
Current ratio =
Current liabilities
Rs.350000
Current ratio = = 2.33:1
Rs.150000
78
Liquid assets
Quick ratio =
Liquid liabilities
Rs.150000
Quick ratio = = 1:1
Rs.150000
Inventory
Inventory to working capital =
Working capital
Rs.200000
= = 1:1
Rs.200000
Working capital = current assets – current liabilities

= Rs.350000 – Rs.1500000 = Rs.200000
Long term debts

Debt to equity ratio =
Shareholders fund
Rs.420000
= = 1.56:1
Rs.270000
(Or)
Long term debts
=
Shareholders fund + Long term debts
Rs.420000
= = 0.6 : 1
Rs.270000 + Rs. 420000
Proprietary ratio = shareholders fund

Total assets
= Rs.270000 = 0.32: 1
Rs.840000
Fixed interest bearing securities
Capital gearing ratio =
Equity share capital
79
Rs.420000
= = 2.1: 1
Rs.200000
current assets
Current assets to fixed assets ratio =
Fixed assets
Rs.350000
= = 0.71 : 1
Rs.490000
Illustration 5
From the following balance sheet, compute the following ratios:
1. Current ratio
2. Liquid ratio
3. Absolute liquid ratio
4. Proprietary ratio
5. Assets proprietorship ratio
a. Fixed assets to proprietors equity
b. Current assets to proprietors equity
6. Debt equity ratio
7. Stock to current assets ratio
8. Stock to working capital ratio
9. Current assets to working capital ratio
10. Current assets to liquid assets ratio
11. All long term funds to working capital ratio
12. Tangible assets to working capital ratio
Balance sheet as on 31 st December 2015
Equity share capital 200000 Plant and machinery 200000

10% preference share capital 100000 Land and buildings 200000
20% Debentures 100000 Stock 150000
Reserves and surplus 100000 Debtors 50000
Loan (long term) 50000 Cash 100000
Creditors 100000
Bank overdraft 50000
700000 700000
Solution:
Computation of required components:
80
1. Current assets :
Rs.
Stock 150000
Debtors 50000
Cash 100000
300000
2. Current liabilities :
Rs.
Creditors 100000
Bank overdraft 50000
150000
3. Liquid assets :
Rs.
Debtors 50000
Cash 100000
150000
4. Liquid liabilities :
Rs.
Creditors 100000
5. Absolute liquid assets :
Rs.
Cash 100000
6. Proprietors equity :
Rs.
Reserve and surplus 100000
300000
7. Total fixed/tangible assets
Rs.
Plant and machinery 200000
Land and buildings 200000
400000
8. Total debts
Rs.
Loan (long term) 50000
300000
9. Working capital
Current assets – current liabilities
Rs.300000 – Rs. 150000 = Rs.150000
81
10. Long term funds

1 Rs.
10% pref. share capital 100000
Loan 50000
250000
11. Total assets
Fixed assets + current assets
Rs.400000 + Rs.300000 = Rs.700000
1. Current ratio = current assets / current liabilities = Rs. 300000 /

Rs.150000 = 2: 1
2. Liquid ratio = liquid assets / liquid liabilities = Rs.150000 / 100000 =
1.5 : 1
3. Absolute liquid ratio = absolute liquid assets / liquid liabilities =
Rs.100000 / 100000 = 1 : 1
4. Proprietary ratio = proprietors equity / total assets = Rs.400000 /
Rs.700000 = 0.57: 1
5. Asset proprietorship ratio
I. Fixed assets to proprietary equity : fixed assets / proprietors equity
= Rs. 400000 / Rs.400000 = 1: 1
II. Current assets to proprietors equity : current assets / proprietors equity

= Rs.300000 / Rs.400000 = 0.75:1
2. Debt equity ratio

= total debts / proprietors equity
= Rs.300000 / Rs.400000 = 0.75:1
3. Stock to working capital ratio

= stock / working capital
= Rs.150000 / Rs.150000 = 1:1
4. Stock to current asset ratio

= Stock /current asset
= Rs.150000 / Rs.300000 = 0.5: 1
5. Current assets to working capital ratio
= Current assets / working capital
82
= Rs.300000 / Rs.150000 = 2:1
6. Current assets to liquid asset ratio

= Current assets / liquid assets
= Rs.300000 / Rs.150000 = 2:1
7. All long term funds to working capital ratio

= All long term funds / working capital
= Rs.250000 / Rs.150000 = 1.67: 1
8. Tangible assets to working capital ratio

= tangible assets / working capital
= Rs.400000 / Rs.150000 = 2.67: 1
= preference shares + debentures / equity share capital
= Rs. 200000 / Rs.200000 = 1:1
Illustration 6
The following is the balance sheet of XYZ ltd
Liabilities Rs Assets Rs.
10% preference share capital 500000 goodwill 100000
Equity share capital 1000000 land & building 650000
8% debentures 200000 plant 800000
Long term loan 100000 furniture & fixture 150000
Bills payable 60000 bills receivables 70000
Sundry creditors 70000 sundry debtors 90000
Bank overdraft 30000 bank balance 45000
Outstanding expenses 5000 short term investments 25000
Prepaid expenses 5000
Stock 30000
1965000 1965000
From the balance sheet calculate:
a) current ratio
b) acid test ratio
c) absolute liquidity ratio
Solution:
a. Current Ratio = Current Assets / Current Liabilities
Current Assets = Rs.70000 + Rs.90000+ Rs.45000 + Rs.25000 + Rs.5000 +
Rs.30000
83
= Rs.265000
Current Liabilities = Rs.60000 + Rs.70000 + Rs.30000 + Rs.5000 = Rs.165000
Current Ratio = Rs.265000 / Rs.165000 = 1.61
b. Acid Test Ratio = Liquid Assets / liquid liabilities

Liquid assets = Rs.60000 + Rs.70000 + Rs. 5000 = Rs.135000
Stock and prepaid expenses have been excluded from current assets in order to
arrive at liquid assets
Liquid liabilities = Rs.60000 + Rs.70000 + Rs.5000 = Rs.135000
While calculating liquid liabilities, bank overdraft has to be excluded form
current liabilities as it is treated as a continuous arrangement
Acid test ratio = Rs.230000 / Rs.135000 = 1.704
a. absolute liquidity ratio = absolute liquid assets / current liabilities

Absolute liquid assets = Rs.45000 + Rs.25000
= Rs.70000
Absolute liquidity ratio = Rs.70000 / Rs.165000 = 0.42
Illustration 7
The cost of goods sold of ESP ltd is Rs.500000. the opening stock / inventory is
Rs.40000 and the closing inventory is Rs.60000 (at cost)
Inventory turnover ratio = cost of goods sold / average inventory at cost
= 500000 / (40000 + 60000)/2
= 500000 / 50000
= 10 times
Illustration 8
M/s.X co. supplies you the following information for the year ending 31 stdec 2015:
Credit sales: Rs.150000; cash sales: Rs.250000; Returns inward: Rs.25000;
opening stock: Rs.25000; closing stock: Rs.35000
Find out: inventory turnover when gross profit ratio is 20%
Solution:
Inventory turnover = cost of goods sold / average stock
First of all cost of goods sold will be calculated
Net sales = Rs. 150000 + Rs.250000 – Rs.25000
= Rs.375000
Gross profit on sales = 375000 X 20
100
84
= Rs.75000
Cost of good sold = Net sales – Gross profit
= Rs.375000 – Rs.75000
= Rs.300000
Average stock = (opening stock + closing stock)/ 2
= (Rs.25000 + Rs.35000) / 2
= Rs.30000
Inventory turnover = Rs.300000 / Rs.30000
= 10 times
Illustration 9
Find out a. debtors turnover and b. average collection period from the following
information
31st march 2015 31st march 2016
Rs. Rs.
Annual credit sales 500000 600000
Debtors in the beginning 80000 90000
Debtors at the end 100000 110000
Days to be taken for the year: 360
Solution
Average debtors = (Opening Debtors + Closing Debtors) / 2
Debtors turnover = Net Credit Annual Sales / Average Debtors
Year 2015 year 2016

Average debtors = (80000 + 100000)/2 (90000 + 110000)/2
= Rs.90000 Rs.100000
A. debtors turnover = 500000 / 90000 600000 / 100000
= 5.56 times 6 times
B. Average collection period = No. of working days / debtors turnover
Year 2006 year 2007
= 360 / 5.56 360 / 6
= 64.7 days 60 days
= or 65 days (approx)
85
Illustration 10
From the following information, calculate average collection period:
Rs.
Total sales 100000
Cash sales 20000
Sales returns 7000
Total debtors at the end of the year 11000
Bills receivables 4000
Bad debts provision 1000
Creditors 10000
Solution:
Average collection period = (Debtors + bill receivable) / net credit sales per day
Net credit sales
Rs.
Total sales 100000
Less cash sales 20000
Credit sales 80000

Less returns 7000
73000
Net credit sales per day = 73000 / 365 = 200

Average collection period = 11000 + 4000 / 200
= 75 days
Illustration 11
From the following information calculate average payment period
Rs.
Total purchases 400000
Cash purchases 50000
Purchases returns 20000
Creditors at the end 60000
Bills payable at the end 20000
Reserve for discount on creditors 5000
Solution
Average payment period
= (creditors + bills payable) / net credit purchases per day
86
= (creditors + Bills payable) / Net credit purchases * 365

Net credit purchases Rs.
Total purchases 400000
Less cash purchases 50000
350000
Less returns 20000
Net credit purchases 330000
Average payment period = (60000 + 20000) * 365 / 330000
= 80000 *365 / 330000
= 88.48 days
Note:
1. 365 days have been taken in a year
2. Reserve for discount on creditors is not considered while calculating average
collection period because total creditors before deducing such reserve are to
be taken
Illustration 12
Rs.
Cash 10000
Bills receivables 5000
Sundry debtors 25000
Stocks 20000
Cost of sales 150000
Working capital turnover ratio = Cost of Sales / Net Working Capital

Current assets = Rs.10000 + 5000 + 25000 + 20000
= Rs.60000
Current liabilities = Rs.30000
Net working capital = Current Assets – Current Liabilities
= Rs. 60000 – 30000
= Rs.30000
Working capital turnover ratio = 150000 / 30000
= 5 times
Illustration 13
The ratios relating to cosmos ltd are given as follows
Gross profit ratio : 15 %
Stock velocity : 6 months
Debtor’s velocity : 3 months
87
Creditor’s velocity : 3 months

Gross profit for the year ending December 31, 2015 amounts to Rs.60000.
closing stock is equal to openi ng stock
Find out
sales
a. closing stock
b. sundry debtors
c. sundry creditors
Solution
sales :
Gross profit ratio = gross profit / sales * 100
15 % = Rs.60000 / sales
Sales = Rs. 60000 * 100 / 15
= Rs. 400000
closing stock
Stock velocity = average stock / cost of goods sold
Cost of goods sold = sales – gross profit
= Rs.400000 – Rs.60000
= Rs.340000
6/12 = average stock / 340000
Average stock = 340000 * 6/ 12
= Rs.170000
Since opening and closing stocks are the same so stock is Rs.170000
sundry debtors
Debtors velocity = total debtors * No. of months / sales
= total debtors * 12 / Rs.400000
Total debtors = 400000 * 3 / 12
= Rs.100000
sundry creditors
For calculating sundry creditors, the figure for credit purchases will be required
Cost of goods sold = opening stock + purchases – closing stock
Rs.340000 = Rs.170000 + Purchases – Rs.170000
Purchases = Rs.340000
Creditors velocity = total creditors * No. of months / purchases
= total creditors * 12 / Rs.340000
Total creditors = Rs.340000 * 3 / 12
= Rs. 85000
88
Illustration 14
The following information is given:
Current ratio: 2.5
fixed assets turnover ratio: 2 times
Liquidity ratio: 1.5
average debt collection periods: 2 months
Working capital: Rs. 300000
Stock turnover ratio: 6 times (Cost of sales / closing stock)
fixed assets: shareholders net worth 1: 1
Gross profit ratio: 20%
reserves: share capital 0.5: 1
Draw up a balance sheet from the above information
Solution
1. Current Liabilities And Current Assets :
Net working capital = current assets – current liabilities
Current ratio = 2.5
Let current liabilities be x to current assets will be 2.5 x
Net working capital = 2.5 x – x
Rs. 300000 = 2.5x – x
Rs. 300000 = 1.5x
X = Rs.300000/1.5 = Rs.200000
When current liabilities are Rs.200000, current assets will be
200000 x 2.5 = Rs.500000
Liquid assets = 200000 x 1.5 = Rs.300000
2. Stock :
Stock = current assets – liquid assets
Stock = Rs.500000 – Rs.300000 = Rs.200000
3. Cost Of Sales
Stock turnover ratio = cost of sales / stock
6 = cost of sales / Rs.200000
Cost of sales = Rs.200000 x 6 = Rs.120000
4. Sales
Cost of sales + gross profit
Gross profit = Rs.1200000 x 20 / 80 = Rs.300000
89
Sales = Rs.1200000 + Rs.300000 = Rs.1500000

5. fixed assets
Fixed assets turnover ratio = sales / fixed assets
2 = Rs.1500000 / fixed assets
Fixed assets = Rs.1500000 / 2 = Rs.750000
6. Debtors:
Average debt collection period = total debtors x no. of months / sales
2 = total debtors x 12 / 1500000
Total debtors = 1500000 x 2 / 12 = Rs.250000
7. Shareholders Net Worth
Fixed assets: shareholders net worth 1: 1
Rs.750000: Rs.750000
8. Share Capital:
Reserves: share capital 0.5: 1
Shareholders net worth = share capital + reserves
Rs.750000 = 1 + 0.5
Share capital = Rs.750000 x 1 / 1.5 = Rs.500000
Reserves = Rs.750000 – Rs.500000 = Rs.250000
9. Long Term Debts :
Long term debts = total assets – (shareholders net worth + current liabilities)
= Rs.1250000 – Rs.950000
Long term debts = Rs.300000
Note: sales have been used for fixed assets turnover ratio; cost of sales
could also be used here
Balance sheet
Share capital 500000 fixed assets 750000
Reserves 250000 liquid assets 300000
Long term debts 300000 stock 200000
Current liabilities 200000 ……….
1250000 1250000
90
Illustration 15
Fromthefollowinginformation,youarerequiredtoprepareaBalanceSheet.
Particulars Rs.
Working Capital 75,000
Reserves and Surplus 1,00,000
Bank Overdraft 60,000
Current Ratio 1.75
Liquid Ratio 1.75
Fixed assets to proprietors’ Funds .75
Long-term liabilities Nil
Solution:
Balance Sheet
Share capital 2,00,000 Fixed Assets 2,25,000
Reserves & Surplus 1,00,000 Stock 60,000
Bank Overdraft 60,000 Debtors and Cash 1,15,000
Creditors 40,000
4,00,000 4,00,000
Workings:
1. Current Assets
Current Ratio=1.75
Working Capital should be=.75
175 175
W orking Capital =Rs.75,000 =Rs.1,75, 000
75 75
2. Liquid Assets(Debtors and Cash)
LiquidRatio–1.15
If current assets are175 liquid assets shouldbe115
175 115
Current Assets =Rs.1,75,000 =Rs.1,15, 000
175 175
3. Stock
Current Assets–Liquid Assets
=Rs.1,75,000–Rs.1,15,000
=Rs.60,000
91
4. Fixed Assets
Share holders’ Equity should be equal to total net assets. Proprietary ratio–7.5
If fixed assets are75 to proprietors’ funds net current assets should be 25 of the
total net assets.
75 75
Net Current Assets =Rs.75,000 =Rs.2,25,000
25 25
5. Share holders’ Funds
Iffixedassetsare75shareholders’fundsshouldbe100
100 100
Fixed Assets =Rs.2,25,000 =Rs.3, 00, 000
75 75
ShareCapital=Shareholder’sFunds–ReservesandSurplusRs.3,00,000–1,00,000 =
Rs.2,00,000
6. Creditors
Currentassets–WorkingCapital–BankOverdraftRs.1,75,000–75,000–60,000=
Rs.40,000
DU PONT ANALYSIS
In ratio analysis, Du-Pont Control Chart shows the relationship of net profit
margin ratio and total investment turnover ratio for calculating return on total
investment ratio (ROI). If company wants to increase return on investment (ROI), it
has to concentrate to increase net profi t margin and total investment turnover
ratio.
92
6.4 REVISION POINT

Ratio Formulae
1. Current ratio Current assets / Current liabilities
2. Quick ratio Quick assets / Current liabilities
3. Inventory turnover ratio Cost of goods sold / Average inventory
4. Debtors (receivables) Annual Net credit sales /Average accounts
turnover ratio receivables
5. Debt (receivables) 365 days/52 weeks/ 12 months
collection period Debtors turnover ratio
6 Creditors turnover ratio Net Credit Purchase / Average Creditor Net
7.Average Credit Payment period 365 days/52 weeks/ 12 months
Creditor turnover ratio
8. working capital Turnover Net Sale .
working Capital
9. Fixed Asset Turnover ratio Net sale or cost of sale

Net fixed assets
10. Current assets turnover ratio Net sales .
Current assets
11. Debt- equity ratio Total long term debt
Shareholders’ funds
12. Total assets to debts Total assets .
Long term debts
13. Proprietary ratio Shareholders Funds
Total assets
14. Gross Profit ratio Gross Profit/Net Sales × 100
15. Net Profit Ratio Net profit / Net Sales × 100
16. Operating ratio Operating cost X 100
Net sales
17. Operating profit ratio Operating profit X 100
Net sales
18. Return on capital employed Net profit before interest, tax &dividend X 100
(ROI) Capital employed
19. Earnings per share (EPS) Net income after interest, tax and
Preference dividend X 100
Number of equity shares
20. Dividends per share Dividends amount .
Numbers of equity share
93
21. Price earning ratio Market price of share

EPS
22. Dividend payout ratio Dividend per share
Earning per share
6.5 INTEXT QUESTION
1. What do you mean by Ratio Analysis?
2. What are various types of ratios?
3. What relationships will be established to study:
4. Inventory turnover
5. Trade receivables turnover
6. Trade payables turnover
7. Working capital turnover
8. The liquidity of a business firm is measured by its ability to satisfy its
9. Long-term obligations as they become due. What are the ratios used for
this purpose?
10. The average age of inventory is viewed as the average length of time
inventory is held by the firm for which explain with reasons.
6.6 SUMMARY
Ratio analysis is an important and age-old technique of financial analysis. The
data given in financial statement in absolute form are dumb and are unable to
communicate anything. Ratios are relative form of financial data and very useful
technique to check upon the efficiency with which working capital is being used in
the enterprise.
6.7 TERMINAL QUESTION
1. Net Profit Ratio Signifies :
(a) Operational Profitability
(b) Liquidity Position,
(c) Big-term Solvency
(d)Profit for Lenders. ANS:a
2. Working Capital Turnover measures the relationship of Working Capital with:
(a)Fixed Assets
(b)Sales
(c)Purchases
(d)Stock. ANS:a
3. Inventory Turnover measures the relationship of inven tory with:

(a) Average Sales
(b)Cost of Goods Sold,
(c)Total Purchases,
(d) Total Assets. ANS:b
94
4. In Current Ratio, Current Assets are compared with:

(a)Current Profit
(b)Current Liabilities,
(c)Fixed Assets
(d)Equity Share Capital ANS:b
5. ABC Ltd. has a Current Ratio of 1.5: 1 and Net Current Assets of Rs. 5,00,000.
What are the Current Assets?
(a)Rs. 5,00,000 (b)Rs. 10,00,000,
(c)Rs. 15,00,000 (d) Rs. 25,00 ANS:c
6. Ratio of Net Income to Number of Equity Shares known as
(a)Price Earnings Ratio
(b) Net Profit Ratio,
(c)Earnings per Share
(d) Dividend per Share ANS:c
7. A firm has Capital of Rs. 10,00,000; Sales of Rs. 5,00,000; Gross Profit of Rs.
2,00,000 and Expenses of Rs. 1,00,000. What is the Net Profit Ratio?
(a)20%
(b) 50%
(c)10%
(d)40% ANS:a
8. XYZ Ltd. has earned 8% Return on Total Assets of Rs. 50,00,000 and has a Net
Profit Ratio of 5% . Find out the Sales of the firm.
(a) Rs. 4,00,000
(b)Rs. 2,50,000,
(c)Rs. 80,00,000
(d)Rs. 83,33,333 ANS:c
9. Which of the following is a measure of Debt Servic e capacity of a firm?
(a)Current Ratio
(b)Acid Test Ratio
(c) Interest Coverage Ratio
(d) Debtors Turnover ANS:c
10. Which of the following helps analysing return to equity Shareholders?
(a) Return on Assets
(b) Earnings Per Share,
(c) Net Profit Ratio
(d)Return on Investment ANS:b
www.icai.org
www.icmai.org
95
6.9 ASSIGNMENT
1. What are liquidity ratios? Discuss the importance of current and liquid
ratio.
2. How would you study the Solvency position of the firm?
3. What are various profitability ratios? How are these worked out?
4. The current ratio provides a better me asure of overall liquidity only
when a firm’s inventory cannot easily be converted into cash. If
inventory is liquid, the quick ratio is a preferred measure of overall
liquidity. Explain.
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
From the disclosed financial information from any capital goods company for
the current period collected from website, evaluate the performance through
profitability ratio and turn over ratio.
6.12 KEYWORDS
Liquid assets, proprietary, dept, capital gearing, current assets.
96
LESSON – 7
FUND FLOW STATEMENTS
7.1 INTRODUCTION
The funds statement aims to su pplement the two conventional statements. It
shows information that can only be obtained through analysis and interpretation of
income statements and opening and closing balance sheets. This information
relates to the overall investment and financial activities of the company, showing
the principle sources and application of funds.
7.2 OBJECTIVES
 Understand the statement of changes in working capital.
 Understand the meaning of fund flow statement.
 Understand the preparation of fund flow statement.
7.3 CONTENT
7.3.1 Need for fund flow analysis
7.3.2 Meaning of fund
7.3.3 Meaning of fund flow statement
7.3.4 Importance of fund flow statement
7.3.5 Limitations of fund flow statement
7.3.6 Statement of changes in working capital
7.3.7 Statement of fund flow
7.3.1 NEED FOR FUND FLOW ANALYSIS
The traditional package of financial statements has as such limited role to play
in financial analysis. The balance sheet is a statement of assets and liabilities on a
particular date and portrays the financial position as on that particular date.
Similarly the income statement will show in more detail only the pro fit or loss
arising out of the productive and commercial activities of the enterprise during that
period. However, they fail to throw light on those major financial transactions,
which are behind the balance sheet changes. In order to ascertain such major
financial transactions, or movement of financial resources or funds, a separate
statement is prepared by comparing the balance sheets of two periods. This
statement is variously known as funds flow statement or statement of sources and
uses of funds.
By recording these changes in the financial structure that have resulted from
the companies trading activities, and at the same time indicating the reasons for
those changes, the funds statement serves the dual role of an accounting reports
and an analytical tool. This is so because the funds statement can be used as part
of budgetary process in forecasting the company’s financial requirement for the
future.
97
7.3.2 MEANING OF FUND

Funds flow statement is a widely used tool in the hands of financial executives
for analyzing the financial performance of a concern. Funds keep on moving in a
business which itself is based on a going concern concept. In a narrow sense, it
means cash only and a funds flow statement prepared on this basis is called as
cash flow statement. Such a statement enumerates net effects of the various
business transactions on cash and takes into account receipts and disbursements
of cash. In a broader sense, the term fund refers to money values in whatever form
it may exist. Here funds means all financial resources in the form of men, material,
money, machinery etc. but in a popular sense the term funds mean working capital
i.e. the excess of current assets over current liabilities. When the funds move
inwards or outwards, they cause a flow or rotation of funds. The work fund here
means net working capital
Working capital is ordinarily understood as excess of current assets over
current liabilities. Some persons call total current assets as gross working capital
and current assets minus current liabilities as net working capital or net current
assets. In other words, the term fund stands for net working capital or net current
assets or free current assets.
The important components of current assets are
Cash in hand
Cash at bank
Bills receivable
Stocks
Debtors
Income earned but not received
Prepaid expenses etc
Similarly the important components of current liabilities are
Creditors
Bills payable
Debts due within a year
Provision for bad debts etc
7.3.3 MEANING OF FUND FLOW STATEMENT
Funds flow statement is a statement in summary form that indicates the
changes in items of financial position between tow different balance sheet dates
showing clearly the sources and application of funds. The major purpose of the
funds statement is to provide a detailed pre sentation for the results of financial
management, as distinguished from operating management. It summarizes the
financing and investing activities of the enterprise. The statement shows directly
the information that the readers of financial reports could otherwise obtain only by
making an analysis and interpretation of published balance sheets and statements
of income and retained earnings.
98
The fund flow statement is a financial statement which reveals the methods by
which the business has been financed and how it has used its funds between the
opening and closing balance sheet date. Thus a fund flow statement is a report on
movement of funds explaining wherefrom working capital originates and where into
the same goes during an accounting period. This state ment consists of two parts –
1. Sources of funds and 2. Application of funds. The difference between the two
shows the net change in the working capital during the period. It is to be
remembered that only those transactions can find place in this statement which
affect the net working capital of the firm. The fund flow statement is a supplement
to the two principal financial statements. While supplementing the position
statement, it describes the sources from which additional funds were derived and
uses to which these funds were put. The transactions which increase working
capital are sources of funds and the transactions which decrease working capital
are application of funds.
7.3.4 IMPORTANCE OF FUND FLOW STATEMENT
Funds flow statement is a useful tool in the financial manager’s analytical kit.
The basic purpose of this statement is to indicate where funds came from and
where it was used during the certain period. Following are the uses of this which
show its importance
1. Funds flow statement determines the financial consequences of
business operations. It shows how the funds were obtained and used in
the past. Financial manager can take corrective actions
2. The management can formulate its financial policies – dividend, reserve
etc. On the basis of the statement
3. It serves as a control device, when comparing with budgeted figures. The
financial manager can take remedial steps, if there is any deviation
4. It points out the sound and weak financial position of the enterprises
5. It points out the causes for changes in working capital
6. It enables the bankers, creditors or financial institutions in assessing
the degree of risk involved in granting credit to the business
7. The management can rearrange the firms financing more effectively on
the basis of the statement
8. Various uses of funds can be known and after comparing them with the
uses of previous years, improvement or downfall in the firm can be
assessed.
9. The statement compared with the budget concerned will show to what
extent the resources of the firm were used accordin g to plan and what
extend the utilization was unplanned
10. It tells whether sources of funds are increasing or decreasing or
constant.
99
7.3.5 LIMITATIONS OF FUND FLOW STATEMENT

1. The statement lacks originality because it is only rearrangement of data
appearing in accounts books
2. It indicates only the past position and not future
3. It indicates fund flow in a summary form and it does not show various
changes which take place continuously
4. When both the aspects of a transaction are current, they are not
considered
5. When both the aspects of a transaction are non current, even then they
are not included in this statement
6. It is not an ideal tool for financial analysis
7. It is not an original statement but simply a rearrangement of data in the
financial statements
7.3.6 STATEMENT OF CHANGES IN WORKING CAPITAL
Since a funds flow statement depicts changes in working capital. It will be
better to prepare first the schedule of changes in working capital before preparing a
funds flow statement. The statement of changes in workin g capital or simply called
working capital statement is prepared with the help of current assets and current
liabilities. There is not effect of additional information given separately, and such
information will affect only the funds flow statement. While preparing the statement
of changes in working capital, the current assets may be shown either at their gross
values, showing provisions as current liabilities, or at their net values after
deducting such provisions. The usual items are provision for doubtful debts,
provision for loss of stock, provision for discount on debtors etc. the purpose of this
statement to find out the net change in working capital
The format of the statement is as follows
Statement of changes in working capital
Previous Curre nt Effect of change in working
year year capital
Rs. Rs. Increase Rs. Decrease Rs.
Current assets
Cash
Bank
B/R
Debtors
Stock
Prepaid expenses
100
Total (a)
Current liabilities
Outstanding expenses
B/P
Creditors
Total (b)
Working capital (a-b)
Net increase/decrease in
working capital
Rules for preparing the statement of changes in working capital

1. Increase in a current asset, results in increase (+) in working capital
2. Decrease in a current asset, result in decreases (-) in working capital
3. Increase in current liabilities, results in decrease (-) in working capital
4. Decrease in current liabilities, results in increase (+) in working capital
7.3.7 STATEMENT OF FUND FLOW
The total difference between the total sources and application will be shown as
either increase or decrease in working capital or funds and this could be verified
with the net increase/decrease in working capital as derived from the above
statement. The change in working capital may also be verified by calculating
working capital separately.
While preparing a funds flow statement current asset and current liabilities are
to be ignored. Attention is to be given to changes in fixed assets and fixed liabilities.
Statement of sources and application of funds
sources Rs. Applications Rs.
Issue of shares Redemption of shares
Issue of debentures Redemption of debentures
Long term and medium term loans Repayment of loans
Purchase of investment
Sales of investments Purchase of fixed assets
Sales of fixed assets Payment of dividends
Trading profits Funds lost from operations
Non trading income Non trading payments
Net decrease in working capital as Net increase in working capital as
per schedule of changes in working per schedule of changes in working
capital capital
Total Total
101
Illustration 1
From the following information, calculate funds from operation
Profit and loss account
Rs. Rs.
To expenses: By Gross profit b/d 200000
Operation 100000 By Gain on sale of buildings 20000
Depreciation 40000 By Other income 2000
To Loss on Sale of Machinery 10000
To Advertisement Suspense A/C 5000
To Discount of Debtors 500
To Discount on Issue of Shares 500
To Goodwill W/Off 12000
To Preliminary Expenses W/Off 2000
To Net Profit 52000
222000 222000
Solution
Calculation of funds from operation
Rs. Rs.
Reported current profit 52000
Add : items not affecting funds:
Depreciation 40000
loss on sale of machinery 10000
advertisement suspense a/c 5000
discount on issue of shares 500
goodwill w/off 12000
preliminary expenses w/off 2000 69500
121500
Less : non operating income :
Gain on sale of buildings 20000
Other income 2000 22000
Funds from operations 99500
Note: other income Rs.2000 should be shown as a separate source in the funds
flow statement.
102
Illustration: 2
Calculate the funds from operations from the following
Profit and loss account
Rs. Rs.
To Salaries 15000 By Gross Profit 20000
To Rent 15000 By Profit on Sale of Land 5000
To Depreciation 10000 By Net Loss 35000
To Printing Expenses 5000
To Goodwill W/Off 3000
To Provision for Tax 4000
To Loss on Sale of Plant 2000
To Proposed Dividends 6000
60000 60000
Solution
Calculation of funds from operations
Rs. Rs.
Reported net loss (-) 35000
Add: items not affecting funds
Depreciation 10000
Goodwill written off 3000
Provision for taxation 4000
Loss on sale of plant 2000
Proposed dividends 6000 25000
(-)10000
Less: non operating income
Profit on sale of land (-)5000
Funds lost from operation (-)15000
Illustration 3:
From the following particulars prepare a funds flow statement for the year
ended 31 st December 2015.
Rs.
Net profit before writing off goodwill 21500
Depreciation written off on fixed assets 3500
Good will written off from profits 5000
Dividends paid 7000
Shares issued for cash 10000
Purchase of machinery 20000
Increase in working capital 8000
Solution:
Working notes:
Computation of funds from operations
Net profit before writing off goodwill Rs.21500
103
Add: Depreciation 3500

Funds from operations 25000
Goodwill need not be adjusted as it is not written off from profits

Funds flow statement
Sources Rs. Applications Rs.
Issue of shares 10000 Machinery purchased 20000
Funds from operations 25000 Dividends paid 7000
Increase in working capital 8000
35000 35000
Illustration 4
Following are the comparative balance sheets of accompany for the year 2006
and 2007
Balance sheet
Liabilities 2015 2016 Assets 2015 2016
Rs. Rs. Rs. Rs.
Share capital 70000 74000 Cash 9000 7800
Debentures 12000 6000 Debtors 14900 17700
Creditors 10360 11840 Stock 49200 42700
Profit & loss a/c 10740 11360 Goodwill 10000 5000
land 20000 30000
103100 103200 103100 103200
Additional information
Dividend were paid totaling Rs, 4000
Land was purchased for Rs.15000
You are required to prepare a statement showing changes in working capital
and a funds flow statement
Solution
Statement showing changes in working capital
2015 2016 Effect on working capital
Rs. Rs. Increase Rs. Decrease Rs.
Current assets
Cash 9000 7800 1200
Debtors 14900 17700 2800
Stock 49200 42700 6500
73100 68200
104

Creditors 10360 11840
Working capital 62740 56360
Net decrease in working capital 6380 6380
62740 62740 9180 9180
Funds flow statement for the year ended 31.12.2016

source Rs, Application Rs.
Issue of shares 4000 Purchase of land 15000
Funds from operations 14620 Redemption of debentures 6000
18620 Dividends paid 4000
Net decrease in working capital 6380
25000 25000
Workings
Adjusted P & L a/c
Rs. Rs.
To goodwill written off 5000 By opening balance 10740
To dividend paid 4000 By funds from operations 14620
To depreciation on land 5000 (bal. fig)
To closing balance 11360
25360 25360
Land a/c
Rs. Rs.
To opening balance 20000 By depreciation (bal. fig) 5000
To cash (purchase) 15000 By closing balance 30000
35000 35000
Illustration 5
From the following balance sheets of XYZ for the year ended on 31 st December
2015 and 2016. Prepare a statement showing sources and application of funds and
schedule of changes in working capital
105
liabilities 2015 2016 assets 2015 2016

Rs. Rs. Rs. Rs.
Creditors 106000 70000 Debtors 181000 170000
Profit & loss a/c 14000 31000 Stock 121000 136000
Plant 75000 100000
520000 676000 520000 676000
Solution:
STATEMENT OF SOURCES AND APPLICATION OF FUNDS
For the year ended 31 st December 2016
Issue of shares 175000 Plant purchased 25000
(Rs.575000 – Rs.400000) (Rs.100000 – Rs.75000)
Funds from operations 17000 Increase in working capital 167000
192000 192000
SCHEDULE OF CHANGES IN WORKING CAPITAL
2015 2016 Changes in working capital
Increase Decrease
Rs. Rs. Rs. Rs.
Current assets :
Cash 143000 270000 127000 -
Debtors 181000 170000 - 11000
Stock 121000 136000 15000 -
445000 576000
Current liabilities
Creditors 106000 70000 36000
106000 70000
Net increase in working capital 167000 167000

total 506000 506000 178000 178000
106
FUND FROM OPERATION

Rs. Rs.
To balance c/d 31000 By balance b/d 14000
By funds from operation 17000
31000 31000
Illustration 6
The following are the summarized balance sheets of XYZ ltd as on 31 st
December 2015 and 2016
Capitals & liabilities 2015 2016 Assets 2015 2016
Rs. Rs. Rs. Rs.
Capitals Fixed assets
10% preference shares 100000 110000
Equity shares 220000 250000 Machinery 200000 230000
Share premium 20000 26000 Buildings 150000 176000
Profit & loss 104000 134000 Land 18000 18000
12% debentures 70000 64000 Current assets
Current liabilities Cash 42000 32000
Creditors 38000 46000 Debtors 38000 38000
Bills payable 5000 4000 Bills receivable 42000 62000
Provision for tax 10000 12000 Stock 84000 98000
Dividends payable le 7000 8000
574000 654000 574000 654000
Prepare a statement of sources and applications of finds

Solution
FUND FLOW STATEMENT
Funds from operations 30000 Purchase of machinery 30000
(Rs.134000 – Rs.104000) (Rs.230000 – Rs.200000)
Issue of 10% preference shares 10000 Purchase of buildings 26000
107
(Rs.110000 – Rs.100000) (Rs.176000 – Rs.150000)

Issue of equity shares 30000 Redemption of debentures 6000
(Rs.250000 – Rs.220000) (Rs.70000 – R.64000)
Share premium 6000 Increase in working capital 14000
(Rs.26000 – Rs.20000)
76000 76000
STATEMENT OF CHANGES IN WORKING CAPITAL
2015 2016 Changes in working capital
Increase Decrease
Rs. Rs. Rs. Rs.
Current assets
Cash 42000 32000 10000
Debtors 38000 38000
Bills receivables 42000 62000 20000
Stock 84000 98000 14000
Total (A) 206000 230000
Current liabilities
Creditors 38000 46000 8000
Bills payable 5000 4000 1000
Provision for tax 10000 12000 2000
Dividend payable 7000 8000 1000
Total (B) 60000 70000
Working capital (A) : (B) 146000 160000
Net increase in working capital 14000 14000

Total 160000 160000 35000 35000
7.4 REVISION POINT
1. Fund From Operation is to be determined on the basis of Profit and Loss
Account. The operating profit revealed by Profit and Loss Account represents
the excess of sales revenue over cost of goods sold.
108
2. A Statement of Changes in Working Capital is prepared before preparation of

fund flow statement. it is essential to prepare first the schedule of changes
in working capital and fund from operations. Statement of changes in
working capital is prepared on the basis of items in current assets and
current liabilities of between two consecutive balance sheet years.. This
statement helps to measure the movement or changes of working capital
during a particular period.
3. Fund Flow Statement is a statement summarizing the substantial financial
changes in items of financial position which have occurred between the two
different balance sheet dates. This statement is prepared on the basis of
"Working Capital" concept of funds.
1. What is meant by the term “fund”?
2. What is fund flow statement?
3. State the transactions that do not affect the flow of funds.
4. What is fund from operations?
7.6 SUMMARY
Mainly two comparative balance sheets at the beginning and end of a period are
used for preparing a funds flow statement. In addition, a summarized income
statement and retained earning statement or at least material information from
these statements is required in order to obtain information relating to funds from
operation and ownership transactions. These are the basic minima and not
maxima. Additional information, if available, will sharpen the firms financial profile
as reveled by the statement
The funds flow analysis involves the preparation of two statements viz
1. statement or schedule of changes in working capital and
2. sources and uses of funds statement
1. Which of the following will result into application of fund ?
a. payment to creditors
b. issue of share capital
c. sales of plant
d. purchase of land
ans : d
2. profit made by a business concern will result of in equal increase of
a. cash balance
b. net working capital
c. gross works capital
d. networth of the business
ans. d
3. state which of the following is non current liabilities
109
a. sundry creditors
b. debentures
c. outstanding expenditure
d. bank over draft
ans. B
www.icai.org
www.icmai.org
7.9 ASSIGNMENT
1. Define fund flow statement. Examine its uses and significances for
management
2. What are the causes for changes in working capital. Explain
3. “ a fund flow statement is better substitute for an income statement”.
Discuss.
4. Suggest some items which may be added back to net profit to get a total
fund provided by profitable operation for fund flow statement. Illustrate your
answer.
5. Is fund flow statement necessary because of the limitations of profit and loss
account and balance sheet. In what respect is the fund statement equally
significant.
6. “ fund flow statement presents a decision view of business”. Comment.
Collect the disclosed consecutive two years balance sheet for any one
information sector company from website prepare fund flow statement and evaluate
the performance.
7.12 KEY WORDS
Fund fiow, Working capital, Fund from operation.
110
LESSON – 8
CASH FLOW STATEMENT
8.1 INTRODUCTION
A cash flow statement is a statement depicting change in cash position from
one period to another. When the concept of funds is used to mean ‘cash’ the funds
flow analysis would be called cash flow analysis.
8.2 OBJECTIVES
 understand the meaning of cash flow statement.
 Understand the difference between the fund flow statement and cash
flow statement.
 Understand the steps in preparation of cash flow statement.
8.3 CONTENT
8.3.1 Meaning of cash flow statement
8.3.2 Difference between fund flow statement and cash flow statement
8.3.3 Distinction between cash flow statement and receipts and payments a/c
8.3.4 Limitation of cash flow statement
8.3.5 Managerial uses or advantages of cash flow analysis
8.3.6 Steps in preparation of cash flow analysis
8.3.1 MEANING OF CASH FLOW STATEMENT
It is an analysis based on the movement of cash and bank balance. Such
movements of cash are depicted in a statement called cash flow statement. It is a
statement of changes in financial position prepared on cash basis. While preparing
cash flow statement, two types of cash flows, viz., actual cash flows and notional
cash flows are identified. Actual cash flows refer to the actual movements of cash
into or out of business. Purchase of fixed assets for cash, borrowing from bank or
financial institutions, redemption of debentures etc are a few examples of cash
flows. But notional cash flows result only in the case of incre ase or decrease in
current assets. Notional cash flows result in indirect cash movements into or out of
business. For example, increase in debtors does not result in any actual cash out
flows since it is part of credit sales. But at the same time, cash flo ws out of
business take place in form of material cost, labor cost, and overheads etc incurred
on the goods sold on credit.
8.3.2 DIFFERENCE BETWEEN FUND FLOW STATEMENT AND CASH FLOW STATEMENT
1. The fund flow statement shows the causes of changes in net work ing capital
whereas the cash flow statement shows the causes for the changes in cash.
2. Cash flow statement is started with the opening and closing balances of cash
while there are no opening or closing balances in fund flow statement
3. Cash flow statement deals only with cash whereas fund flow statement deals
with all the components of working capital
111
4. Cash flow statement is useful for short term financing while fund flow
statement is useful for long term financing
5. Cash flow statement is based on cash basis of accounting while the fund
flow statement is based on accrual basis of accounting
6. Cash flow statement depicts only the changes in cash position, while fund
flow statement is concerned with the changes in working capital between
two balance sheet dates
7. Cash is a part of working capital. Improvement in cash position, as indicated
by cash flow statement can be taken as an indicator of improved working
capital position. But the reverse is not true. That is sound fund position may
not necessarily mean sound cash position
8.3.3 DISTINCTION BETWEEN CASH FLOW STATEMENT AND RECEIPTS AND PAYMENTS
A/C
There appears to be many common points in cash flow statement and receipts
and payments accounts. Yet, there are differences between the two
1. The cash flow statement is prepared to disclose the amount of cash
generated from operation and other sources and the amount of outflow,
being cash payments during the period. Receipts and payments account
contains cash receipts and cash payments
2. The cash flow statement can be prepared form the balance sheets of two
dates. The receipts and payments account cannot be prepared so.
8.3.4 LIMITATION OF CASH FLOW STATEMENT
Cash flow statement is a useful tool of financial analysis. However it suffers
from some limitations, which are as follows:
1. Cash flow statement only reveals the inflow and outflow of cash. The cash
balance disclosed by this statement may not depict the true liquid position.
There are controversies over a number of items like cheques, stamps, postal
orders etc. to be included in cash.
2. A cash fund statement cannot be equated with the income statement. An
income statement takes into account both cash and non cash items. Hence
cash fund does not mean net income of the business
3. Working capital being a wider concept of funds, a fu nds flow statement
presents a more complete picture than cash flow statement.
8.3.5 MANAGERIAL USES OR ADVANTAGES OF CASH FLOW ANALYSIS
1. It is very helpful in understanding the cash position of a firm. Since cash is
the basis for carrying on business operations, the cash flow statement is
very useful in evaluating the current cash position
2. it helps management to understand the past behavior of the cash cycle and
to control the uses of cash in future
112
3. The repayment of loans, replacement of assets and other such programs can
be planned on its basis.
4. It throws light on the factors contributing to the reduction of cash balance in
spite of increase in income or vice versa.
5. A comparison of the cash flow statement with the cash budget for the same
period helps in comparing and controlling cash expenditure
6. The cash flow statement is helpful in making short term financial decisions
relating to liquidity, and the ways and means position of the firm.
8.3.6 STEPS IN PREPARATION OF CASH FLOW ANALYSIS
Cash flow statement takes into account only those transactions which result in
immediate inflow and outflow of cash. The preparation of cash flow statement
involves the following stages
1. Calculation of cash from operations
2. Changes in non current liabilities, i.e. Share capital, debentures, loans, and
mortgages.
3. Changes in non current assets i.e. Building, plant, machine and furniture
etc.,
8.3.6.1 Cash from operation
It includes cash received against profit and inflow or outflow of cash due to
change in current assets and current liabilities. Calculation of cash from operation
involves the following
(1) Calculation of operational profit
Excess of current year profit over the previous year profit is assumed to be in
the form of cash, if all transactions are in cash. It should be noted that profit here
means operating net profit. While calculating this operating net profit we have to
take into account only operating income and operating expenses will be added to it
and non operating income are to be deducted. In case of adjustment, it is advisable
to prepare adjusted profit and loss account and calculate profit from operation in
the same way as we do calculate in case of funds flow statement. The following
adjustments are to be made to the net profit.
(2)Non operating expenses: These expenses do not result in outflow of cash
but the net profit is reduced due to the effect of these expenses. In other words,
cash from operation increases in comparison to profit
(3)Depreciation: Depreciation is charged on fixed assets. It appears at the
debit side of profit and loss a/c and thus reduces profit. Depreciation is non cash
item, so it does not reduce cash. In order to ascertain operating profit depreciation
will be added to net profit. When preparing profit and loss account to find out profit
earned during the year, the depreciation account will be written at the debit side of
the profit and loss a/c.
113
(4)Amortization of intangible assets: Intangible assets consist of those

assets, which cannot be seen or touched. These assets are goodwill , patents right
and trade marks etc. in order to calculate cash generated from operations, we have
to add back these items to the items to the profit made during the year. In case of
preparing adjusted profit and loss account intangible assets written off is posted at
the debit side to calculate profit earned during the year
(5)Amortization of deferred expenses: These expenses are actually revenue
expenditure but they are capitalized and written off over certain year’s preliminary
expenses, discount or loss on issue of shares, debentures and deferred revenue
expenditure. When these assets are written off, they are charged out of profit and
loss account and thus reduce profit. Cash will not be reduced. It is therefore,
necessary that the amount written off for these assets should be added to profit to
find out the profit earned during the year
(6)Loss on sale of fixed assets: The profit of the year will reduce with this loss
but cash will not reduce. It is therefore necessary that this item should be added to
the profit to ascertain the amount of operating profit
(7)Provision for doubtful debts and discount on debtors: This provision
reduces profit without reducing cash. As such the item should be added to profit
ascertain the operating net profit.
(8)Creation of reserves: Certain reserves and funds are created to meet certain
known or unknown liabilities. These reserve and funds may be general reserve,
reserve fund, sinking fund, capital redemption reserve, dividend equalization and
workmen compensation funds etc. these funds are charged out of profit and loss
a/c so they reduce profit. These are not cash items, so the outflow of cash does not
take place. In order to calculate operating net profit these reserves and funds are
added to profit to calculate operati ng net profit.
(9)Non operating income: Income not concerned with the day to day affairs of
the business is known as not operating income. Profit or gain on sale of fixed
assets, refunds of taxes, receipts of interest, dividend and compensation are the
examples of the non operating income. These items are posted at the credit side of
profit and loss account, so they increase profit of the business without increasing
cash balance. Non operating income should be deducted from profit to find out
operating net profit.
(10)Changes in the current liabilities and current assets (except cash) :
Current assets consist of debtors, stock, bills receivable prepaid expenses, accrued
income, short term investment etc. values of individual current assets may either
increase or decrease
8.3.6.2.Changes in non current liabilities: Changes in non current liabilities
may also result in inflow and outflow of cash. Inflow of cash will take place in the
following cases.
114
(1) Issue of shares or increase in capital : increase in the value of share capital
during the current year in comparison to previous year is supposed to be the issue
of shares, which will undoubtedly bring cash into business and inflow of cash will
take place.
(2)Issue of debentures: If additional debentures have been issued during the
current year, inflow of cash will take place. Increase the balance of debentures
during the current year as compared to the previous year is assumed to be issue of
debentures.
(3)Increase in loan or mortgage: If the balance of loan or mortgage increases
during the current year, it will be assumed that additional loans have been
borrowed and cash flow inside the business has taken place
The change in the value of non current liabilities will result in the outflow of
cash in the following cases:
(4)Redemption of share capital or decrease in share capital : In certain cases
company redeems its redeemable preference shares and thus outflow of cash takes
place. Decrease in the balance of capital during the current year is assumed to be
the redemption
(5)Repayment of debentures: Debentures are the loans taken by the company.
These debentures are redeemed as per the terms of issue. Redemption of
debentures will result in outflow of cash. Decrease in the value of debentures is
assumed to be payment of debentures.
(6)Decrease in loan or mortgage: in case of payment of loan or mortgage, cash
will reduce and outflow of cash will takes place
(7)Payment of tax and dividend: Payment of taxes and dividend is the normal
feature of the company. Whenever taxes and dividends are paid cash goes outside
the business. If the balance of provision of taxation regarding previous and current
years is given, it may be assumed that the previous year’s provision of taxes has
been paid during the current year. In case of adjustment provision for tax account
is prepared to calculate the amount of taxed paid during the year. The same
treatment is accorded to dividend.
8.3.6.3.Changes in non current assets:
Change in non current assets generally fixed assets also results in inflow or
outflow of cash.
Sale or decrease in the value of fixed assets: sometimes the company sells a
part of its land, building, plant, machinery, furniture and vehicles etc. the sale
fetches cash and inflow of cash takes place. Decrease in the value of fixed assets is
assumed to be its sales.
Cash from operations: cash from operations for the purpose of cash flow
statement is the net flow. Funds from operations represent the net flow in a rough
way. Further adjustments as discussed above are required to arrive at the net flow
of cash. This is tabled below:
115
Cash from operations

Rs. Rs.
Add:
Decrease in debtor’s xxx
Decrease in stock xxx
Decrease in accrued income xxx
Decrease in prepaid expenses xxx
Increase in creditor’s xxx
Increase in outstanding expenses xxx xxx
Less:
Increase in debtor xxx
Increase in stock xxx
Increase in accrued income xxx
Increase in prepaid expenses xxx
Decrease in creditor’s xxx
Decrease in outstanding expenses xxx xxx
REPORT FORM
CASH FLOW STATEMENT
For the year ended 31 st December ……….
Rs. Rs.
Opening balances
Cash
Bank
Add: sources of cash: ---
Issue of shares ---
Issue of debentures ---
Raising of long term loans ---
Sale of fixed assets ---
Dividends ---
Cash from operations ---
Total of cash inflow (A) ---
116
Less: application of cash: ---

Redemption of preference shares ---
Repayment of debentures ---
Purchase of fixed assets ---
Repayment of long term loans ---
Payment of taxes ---
Payment of dividend ---
Cash lost in operations ---
Total applications (B) ---
CASH BALANCE (Cash + bank) ---
ACCOUNT FORM
CASH FLOW STATEMENT
For the year ended 31st December….
Inflow Rs. Outflow Rs.
Opening Balances - Redemption of Preference Shares -
Cash - Repayment of Debentures -
Bank - Purchase of Fixed Assets -
Issue of Shares - Repayment of Long Term Loans -
Issue of Debentures - Payment of Taxes -
Long Term Loans - Cash Lost in Operations
Sale of Fixed Assets - -
Dividends - Closing Balance
Cash from Operation - Cash Bank -
Illustration 1. After taking on to consideration the under mentioned items, Jain
Ltd, make a net profit of Rs.100000 for the year ended 31 st ended December 2015
Rs.
Loss on sale of machinery 10000
Depreciation on building 4000
Depreciation on machinery 5000
Preliminary expenses written off 5000
Provision of taxation 10000
Gain on sale of buildings 8000
117
Find out cash from operation

Solution:
Computation of cash from operation
Rs. Rs
Net profit, as profit & loss a/c 100000
Add : Loss on sale of machinery 10000
Depreciation on building 4000
Preliminary expenses written off 5000
Provision of taxation 10000
Goodwill written off 5000 39000
139000
Less : Gain on sale of buildings 8000 8000
Cash from operations : 131000
Illustration 2. Statement of financial position of Ram Seth is given below:

1.1.2015 31.12.2016 1.1.2015 31.12.2016
Accounts payable 29000 25000 cash 40000 30000
capital 739000 615000 Debtors 20000 17000
Stock 8000 13000
Buildings 100000 80000
Fixed assets 600000 500000
768000 640000 768000 640000
Additional information:
1. There were no drawings
2. There was no purchase or sale of either buildings or fixed assets.
Prepare cash flow statement
CASH FLOW STATEMNT
Rs. Rs.
Cash balance on 1st Jan 40000 Cash outflows:
Add : Cash inflows Addition to stock 5000
Decrease in debtors 3000 Decrease in accounts payable 4000
118
Funds lost in operation 4000

13000
Cash balance on 31st December 30000
43000 43000
Workings:
Net loss for the year 2016
Rs. Rs.
Capital at the end 615000
Capital at the beginning 739000
Cash lost in operations 124000
Less : Non cash charges
Depreciation on building (Rs.100000 – Rs.80000) 20000
Depreciation on fixed assets (Rs.600000 – Rs.500000)
100000 120000
Lost in the trading operation 4000
Illustration 3.
The balance sheets of a firm as on 31 st December 2015 and 2016 are given below
2006 2007 2006 2007
Rs. Rs. Rs. Rs.
Share capital 100000 160000 Fixed assets at cost 152000 200000
Retained earnings 70250 85300 Inventory 93400 89200
Accumulated depreciation 60000 4000 Debtors 30800 21100
12% debentures 50000 Expenses prepaid 3950 3000
Sundry creditors 28000 48000 Bank 28100 20000
308250 333300 308250 333300
The following additional information for 2016 is also given:

1. Net profit Rs,27050
2. Depreciation charged Rs.10000
3. Cash dividend declared during the period Rs.12000
4. An addition to the building was made during the year at a cost of
Rs,78000 and fully depreciated equipment costing Rs.30000 was
discarded as no salvage being realized,
119
Prepare a cash flow statement

Solution
CASH FLOW STATEMENT
Rs. Rs.
Opening balance of cash at bank 28100 Outflow of cash:
Add : cash inflows : Redemption of debentures 50000
Issue of shares 60000 Payment of dividend 12000
Decrease in inventory 4200 Addition to buildings 78000
Decrease in debtors 9700 Expenses prepaid 3000
Increase in creditors 20000 143000
Operating profit 41000 Closing balance of cash at bank 20000
163000 163000
Cash in flow from operating profit:

Net profit for 2016 27050
Add: non fund items already debited to
Profit & loss account:
Sundry expenses prepaid 3950
Provision for Depreciation 10000
13950
41000
FIXED ASSETS ACCOUNT

Rs. Rs.
To balance B/d 152000 By accumulated depreciation 30000
To bank 78000
230000 By balance c/d 200000
230000
ACCUMULATED DEPRECIATION A/C
Rs. Rs.
To fixed assets 30000 By balance b/d 60000
To balance c/d 40000 By profit & loss a/c 10000
70000 70000
120
Illustration 4 .
The comparative balance sheets of a company are given below
2015 2016 2015 2016
Rs. Rs. Rs. Rs.
Debentures 6000 3000 Book debts 7450 8850
Creditors 5180 5920 Stocks 24600 21350
Provision for doubtful debts 350 400 Land 10000 15000
Profit and loss 5020 5280 Goodwill 5000 2500
51550 51600 51550 51600
Additional information available is:

1. Dividends paid amounted to Rs,1750
2. Land was purchased for Rs.5000 and amount provided for the
amortization of goodwill amounted to Rs,2500
3. Debentures were repaid to the extent of Rs.3000
Prepare a cash flow statement

Solution:
CASH FLOW STAEMENT
Cash inflow Rs.
Cash balance on 1.1.2015 4500
Issue of shares 2000
Cash from operations 7150
13650
Cash outflow: Rs.
Purchase of land 5000
Payment of dividend 1750
Repayment of debentures 3000
Cash balance in 31.12.2007 3900
13650
.
121
Workings:
Cash from operations Rs.
Profit for 2015 5280
Add: 260
Dividend 1750
Decrease in stocks 3250
Increase in provision for doubtful debts 50
Increase in creditors 740
8550
Less: increase in creditors 1440
Cash from operation 7150
Illustration 5 :
From the following particulars prepare cash flow and fund flow statement of XYZ ltd
1st Jan 2015 31st Dec. 2016
Rs. Rs.
Cash 5000 4000
Debtors 40000 45000
Stock 30000 25000
Land 30000 40000
Buildings 50000 55000
Machinery 70000 80000
225000 249000
Current liabilities 35000 40000
Loan from ‘A’ 25000
Bank loan 40000 30000
Capital 150000 154000
225000 249000
During the year, XYZ brought an additional capital of Rs.10000 and his
drawings during the year were Rs.31000
Provision for depreciation on machinery: opening balance Rs.30000 and closing
balance Rs.44000
No depreciation need be provided for other assets
122
Solution
CASH FLOW STATEMENT
Rs. Rs.
Opening balance of cash 5000 Purchase of land 10000
Additional capital 10000 Purchase of buildings 5000
Decrease in stocks 5000 Purchase of machinery 20000
Increase in current liabilities 5000 Increase in debtors 5000
Repayment of bank loan 10000
Loan from ‘A’ 25000 Drawings 31000
Cash : operating profit 35000 Closing balance of cash 4000
85000 85000
Workings:
LAND ACCOUNT
Rs. Rs.
To balance b/d 30000 By balance c/d 40000
To cash purchase (balancing figure ) 10000
40000 40000
BUILDINGS ACCOUNT
Rs. Rs.
To balance b/d 50000 By balance c/d 55000
To cash purchase (balancing figure ) 5000
55000 55000
MACHINERY ACCOUNT
Rs. Rs.
To balance b/d 70000 By depreciation 10000
(Rs.40000 – Rs.30000)
To cash purchase (balancing figure ) 20000 By Balance c/d 80000
90000 90000
CAPITAL ACCOUNT
Rs. Rs.
To Cash (drawings ) 31000 By Balance b/d 150000
To balance c/d 154000 By cash (Addition) 10000
By Profit & loss (Profit) 25000
(Balancing figure)
185000 185 000
123
CASH OPERATING PROFI

Rs.
Profit made during the year 25000
Add: Depreciation charged during the year (Non cash Item) 10000
Cash operating profit 35000
SCHEDULE OF CHANGES IN WORKING CAPITAL

1.1.2015 31.12.2016 Changes in working capital
Increase Decrease
Rs. Rs. Rs. Rs.
Current assets :
Cash 5000 4000 1000
Debtors 40000 45000 5000
Stock 30000 25000 5000
75000 74000
Current liabilities
Current liabilities 35000 40000 5000
35000 40000
- 6000 6000
Net decrease in working capital 40000 40000 11000 11000
FUNDS FLOW STATEMENT

Rs. Rs.
Additional capital 10000 Purchase of land 10000
Loan from ‘A’ 25000 Purchase of buildings 5000
Loan from operating profit 35000 Purchase of machinery 20000
Drawings 31000
Net decrease in working capital 6000 Repayment of bank loan 10000
76000 76000
Illustration 6
From the following balance sheets you are required to prepare a cash flow
statement
Liabilities 2015 2016 assets
2015 2016
Rs. Rs. Rs. Rs.
Trade creditors 70000 45000 Debtors 120000 115000
Profit & loss 10000 23000 Stocks 80000 90000
Land 50000 66000
280000 318000 280000 318000
124
Solution
CASH FLOW STATEMENT
For the year 2016
Cash inflow Rs. Cash outflow Rs.
Cash in hand (Jan 2007) 30000 Business operation (A) 17000
Issues of shares 50000 Purchase of land 16000
(Rs.250000 – Rs.200000) (Rs.66000 – Rs.50000)
Cash in hand (Dec. 2007) 47000
80000 80000
Workings:
(A)
Rs.
Profit (December 2016) 23000
Less: Profit (January 2016) 10000
Add: decrease in debtors
(Rs.120000 – Rs.115000) 5000
Less: increase in stock 18000
(Rs.90000 – Rs.80000) 10000
Less: decrease in creditors
(Rs.70000 – Rs.45000) 25000 (-) 35000
Outflow of cash by operation 17000
8.4 REVISION POINTS
1. Cash flow statement deals with flow of cash which includes cash
equivalent as well as cash.
2. Cash flow statement is a summary of cash receipts and disbursements
during a certain period. Cash flow statement is prepared as per AS-3
3. There are two methods for preparing cash flow statement : (i) Direc t
method (ii) Indirect method.
4. Cash flow statement shows three categories of cash inflows and outflows
i.e. (i) Operating activities (ii) Investing activities (iii) Financing activities
5. Operating activities are the revenue generating activities of the enterprise.
6. Investing activities constitute the acquisition and disposal of long term
assets and other investments not included in cash and its equivalents.
7. Financing activities are activities that result in change in the size and
composition of the share capital and borrowings of the enterprise.
125
8. The cash flows from extraordinary items are to be stated separately as

arising from operating, investing and financing activities.
1. What is meant by cash flow statement?
2. How will you determine cash from operations?
3. Enumerate the source of cash and uses of cash
4. State the limitations of cash flow statement
8.SUMMARY
A cash flow statement is a statement depicting change in cash position from
one period to another. When the concept of funds is used to mean ‘cash’ the funds
flow analysis would be called cash flow analysis. Cash flow statement takes into
account only those transactions which result in immediate inflow and outflow of
cash. The preparation of cash flow statement involves the following stages
1.Calculation of cash from operations 2.changes in non current liabilities, i.e. Share
capital, debentures, loans, and mortgages. 3.Changes in non current assets i.e.
Building, plant, machine and furniture etc.,
1. Cash from operations is equal to
a. Net profit after tax
b. Net profit plus increase in current asset
c. Net profit plus decrease in current liabilities
d. Net profit plus non cash expenses plus decrease in current assets
Ans : d
2. Which of the following is not an inflow of cash
a. Acquisition of asset
b. Issue of debenture for cash
c. Funds from operation
d. Sale of fixed asset
Ans : a
3. Increase in the amount of bills payable result in
a. Decrease in cash
b. No change in cash
c. Increase in cash
d. None of these
Ans : c
www.icai.org
www.icmai.org
126
8.9 ASSIGNMENT
1. Describe the operating investing and financing activities of a firm in the
context of cash flow statement
2. Depreciation is a non cash expense. Still it is an integral part of cash
flow. Explain.
3. Describe in brief the procedure of determining cash flow from operating
activities as per indirect method of AS-3. Take an appropriate example
to illustrate your answer.
Collect the disclosed consecutive two years balance sheet for any one power
sector company from website prepare cash flow statement and evaluate the
performance.
8.12 KEY WORDS
Cash from operation, Operating activities , Investing activities , Financing
activities.
127
LESSON – 9
MARGINAL COSTING
Marginal costing – definition – distinguishing between marginal costing and
absorption-breakeven point analysis-graphical representation of breakeven
analysis- contribution-p/v ratio-margin of safety -decision making under marginal
costing –key factor analysis-make or buy decision-export decision –sales man
decision
9.1 INTRODUCTION
Marginal costing may be defined as the technique of presenting cost data
wherein variable costs and fixed costs are shown separately for managerial
decision-making. It should be clearly understood that marginal costing is not a
method of costing like process costing or job costing. Rather it is simply a method
or technique of the analysis of cost information for the guidance of management
which tries to find out an effect on profit due to changes in the volume of output.
9.2 OBJECTIVES
 To understand the meanings of marginal cost and marginal costing
 To distinguish between marginal costing and absorption costing
 To ascertain income under both marginal costing and absorption costing
9.3 CONTENT
9.3.1 Need for Marginal Costing
9.3.2 Meaning and definition Marginal costing
9.3.3 Features of Marginal Costing
9.3.4 Advantages of Marginal Costing
9.3.5 Disadvantages of Marginal Costing
9.3.6 Marginal Costing versus Absorption Costing
9.3.1 NEED FOR MARGINAL COSTING
1. Variable cost per unit remains constant; any increase or decrease in
production changes the total cost of output.
2. Total fixed cost remains unchanged up to a certain level of production and
does not vary with increase or decrease in production. It means the fixed
cost remains constant in terms of total cost.
3. Fixed expenses exclude from the total cost in marginal costing technique
and provide us the same cost per unit up to a certain level of production.
9.3.2 MEANING AND DEFINITION MARGINAL COSTING
Marginal costing is formally defined as the accounting system in which variable
costs are charged to cost units and the fixed costs of the period are written-off in
full against the aggregate contribution. Its special value is in decision making.
The term ‘contribution’ mentioned in the formal definition is the term given to
the difference between Sales and Marginal cost. Thus marginal cost = variable cost
ie, direct labour + direct material + direct labour+variable overheads
128
Marginal Costing: Marginal Costing may be defined as "the ascertainment by

differentiating between fixed cost and variable cost, of marginal cost and of the
effect on profit of changes in volume or ty pe of output." With marginal costing
procedure costs are separated into fixed and variable cost. According to J. Batty,
Marginal costing is "a technique of cost accounting pays special attention to the
behaviour of costs with changes in the volume of output." This definition lays
emphasis on the ascertainment of marginal cost.
There are different phrases being used for this technique of costing. In UK,
marginal costing is a popular phrase whereas in US, it is known as direct costing
and is used in place of marginal costing. Variable costing is another name of
marginal costing.
Contribution may be defined as the profit before the recovery of fixed costs.
Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to
fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just
equal to fixed cost (C = F). this is known as break even point.
The concept of contribution is very useful in marginal costing. It has a fixed
relation with sales. The proportion of contribution to sales is known as P/V ratio
which remains the same under given conditions of production and sales.
Marginal cost
The term marginal cost sometimes refers to the marginal cost per unit and
sometimes to the total marginal costs of a department or batch or operation. The
meaning is usually clear from the context.
Marginal cost may also be defined as the "cost of producing one additional unit
of product." Thus, the concept marginal cost indicates wherever there is a change
in the volume of output, certainly there will be some change in the total cost. It is
concerned with the changes in variable costs. Fixed cost is treated as a period cost
and is transferred to Profit and Loss Account.
The basic assumptions made by marginal costing are following:
1. Total variable cost is directly proportion to the level of activity. However,
variable cost per unit remains constant at all the levels of activities.
2. Per unit selling price remains constant at all leve ls of activities.
3. All the items produced by the organisation are sold off.
9.3.4 FEATURES OF MARGINAL COSTING
The main features of marginal costing are as follows:
1. Marginal costing is used to know the impact of variable cost on the volume
of production or output.
2. Contribution of each product or department is a foundation to know the
profitability of the product or department.
3. Break-even analysis is an integral and important part of marginal costing.
129
4. Costs are classified on the basis of fixed and variable costs only. Semi-fixed
prices are also converted either as fixed cost or as variable cost.
5. Fixed cost is recovered from contribution and variable cost is charged to
production.
6. Fixed costs which remain constant regardless of the volume of production do
not find place in the product cost determin ation and inventory valuation.
7. Fixed costs are not considered for valuation of closing stock of finished
goods and closing WIP.
8. Marginal or variable costs such as direct material, direct labour and variable
factory overheads are treated as the cost of the product.
9. Under marginal costing, the value of finished goods and work in process is
also comprised only of marginal costs. Variable selling and distributions are
excluded for valuing these inventories.
10. Profitability of various levels of activity is determined by cost volume profit
analysis.
9.3.5 ADVANTAGES OF MARGINAL COSTING
Marginal costing are easy to operate and simple to understand.
Marginal costing is helpful to determine profitability at different level of
production and sale.
Fixed overhead recovery rate is easy
Break even analysis and P/V ratio are useful techniques of marginal costing.
The effects of alternative sales or production policies can be more readily
available and assessed, and decisions taken would yield the maximum return to
business.
Evaluation of different departments is possible through marginal costing
technique.
Marginal costing is useful to various levels of management. It is useful in
decision making about fixation of selling price, export decision and make or buy
decision
As fixed cost is not controllable in short period, it helps to concentrate in
control over variable cost.
9.3.6 DISADVANTAGES
 Marginal cost has its limitation since it makes use of historical data
while decisions by management relates to future events.
 The separation of costs into fixed and variable is difficult and sometimes
gives misleading results.
 It ignores fixed costs to products as if they are not important to
production.
 It fails to recognize that in the long run, fixed costs may become
variable.
130
 Difficulty to classify properly variable and fixed cost perfectly, hence

stock valuation can be distorted if fixed cost is classify as variable.
 Under marginal costing, stocks and work in progress are understated.
The exclusion of fixed costs from inventories affect profit, and true and
fair view of financial affairs of an organization may not be clearly
transparent
9.3.7 PRESENTATION OF COST DATA UNDER MARGINAL COSTING AND ABSORPTION
COSTING
Marginal costing is not a method of costing but a technique of presentation of
sales and cost data with a view to guide management in decision-making.
The traditional technique popularly known as total cost or absorption costing
technique does not make any difference between variable and fixed cost in the
calculation of profits. But marginal cost statement very clearly indicates this
difference in arriving at the net operational results of a firm.
MARGINAL COSTING PRO-FORMA
Rs. Rs.
Sales Revenue xxxxx
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add Production Cost (Valued @ marginal cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ marginal cost) (xxx)
Marginal Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution xxxxx
Less Fixed Cost (xxxx)
Marginal Costing Profit xxxxx
ABSORPTION COSTING PRO-FORMA
Rs. Rs.
Sales Revenue xxxxx
Less : Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
131
Total Production Cost xxxx

Less : Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx
Reconciliation Statement for Marginal Costing and Absorption Costing Profit
Marginal Costing Profit xx
ADD xx
(Closing stock – opening Stock) x OAR
= Absorption Costing Profit xx
Income Statement under Marginal Costing

Income Statement
For the year ended 31-03-2016
Particulars Amount Total
Sales 25,00,000
Less: Variable Cost:
Cost of goods manufactured 12,00,000
Variable Selling Expenses 3,00,000

132
Variable Administration Expenses 50,000
15,50,000
Contribution 9,50,000
Less: Fixed Cost:
Fixed Administration Expenses 70,000
Fixed Selling Expenses 1,30,000 2,00,000
7,50,000
Marginal Costing versus Absorption Costing
After knowing the two techniques of marginal costing and absorption costing,
we have seen that the net profits are not the same because of the following reasons:
1. Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because
of difficulty in forecasting costs and volume of output. If these balances of under or
over absorbed/recovery are not written off to costing profit and loss account, the
actual amount incurred is not shown in it. In marginal costing, however, the actual
fixed overhead incurred is wholly charged against contribution and hence, there
will be some difference in net profits.
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at
marginal cost, but in absorption costing, they are valued at total production cost.
Hence, profit will differ as different amounts of fixed overheads are considered in
two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
a. When there is no opening and closing stocks, there will be no difference in
profit.
b. When opening and closing stocks are same, there will be no difference in
profit, provided the fixed cost element in opening and closing stocks are of
the same amount.
c. When closing stock is more than opening stock, the profit under
absorption costing will be higher as comparatively a greater portion of fixed
cost is included in closing stock and carried over to next period.
133
d. When closing stock is less than opening stock, the profit under absorption
costing will be less as comparatively a higher amount of fixed cost
contained in opening stock is debited during the current period.
The features which distinguish marginal costing from absorption costing are as follows.
The main use of marginal costing are to help with short-term decision-making
in the forms of break-even analysis, margin of safety, target profit, contribution
sales ratio, limiting factors and special order pricing whereas the use of absorption
costing are to calculate profit and to calculate inventory valuation for financial
statements.
In marginal costing costs are classified as either fixed or variable and
contribution to fixed costs is calculated as selling price less variable costs whereas
in absorption costing overheads are charged to output through an overhead
absorption rate, often on the basis of direct labour hours or machine hours
Main focus of Marginal costing is marginal cost and contribution whereas
absorption costing focusses in all overheads charged to output, calculating profit
and calculating inventory values
The usefulness of Marginal costing are concept of contribution is easy to
understand and useful for short-term decision-making, but no consideration of
overheads whereas Absorption costing is acceptable under IAS 2, Inventories
appropriate for traditional industries where overheads are charged to output on the
basis of direct labour hours or machine hours
The limitations of Marginal costing are costs have to be identified as either fixed
or variable, all overheads have to be recovered, otherwise a loss will be made, not
acceptable under IAS 2, Inventories and calculation of selling prices may be less
accurate than other costing methods whereas the limitations of absorption costing
are not as useful in short-term decision-making as marginal costing and may
provide less accurate basis for calculation of selling prices where overheads are
high and complex in nature
Illustration 1
A manufacturing company XYZ produces and sells a product and the following
information is derived from the company. Prepare profit statements using the
marginal costing and absorption costing methods.
number of product manufactured 5,000
number of product sold 4,500
selling price Rs.110 per product
direct materials Rs.30 per product
direct labour Rs.40 per product
fixed production overheads Rs.1,00,000
134
Solution
XYZ Limited
Statement of profit or loss for the year ended 31 December 2015
Marginal costing Absorption costing
Rs. Rs. Rs. Rs. .
Sales revenue at Rs.110 each 4,95,000 4,95,000
Variable costs
Direct materials at Rs.30 each 1,50,000 1,50,000
Direct labour at Rs.40 each 2,00,000 2,00,000
3,50,000
Less Closing inventory (marginal cost)
500 chairs at Rs.70 each 35,000
3,15,000
Fixed production overheads 1,00,000 1,00,000
4,50,000
Less Closing inventory (absorption cost)
500 chairs at Rs.90 each 45,000
Less Cost of sales 4,15,000 405,000
Profit 80,000 90,000
9.4 REVISION POINT

Marginal Costing: It is ascertainment of the marginal cost which varies directly
with the volume of production by di fferentiating between fixed costs and variable
costs and finally ascertaining its effect on profit.
Absorption costing: It is defined as a method for accumulating the costs
associated with a production process and apportioning them to individual products.
This type of costing is required by the accounting standards to create an inventory
valuation that is stated in an organization's balance sheet.
1. What do you understand by Marginal Costing?
135
2. Define Marginal Costing Briefly explain the features of marginal costing.

3. What are the differences between Absorption costing and Marginal costing?
4. Briefly explain the advantages and limitations of Marginal costing.
5. Explain with suitable illustrations the following statements:
i. ‘In the very long run all costs are differential’.
ii. ‘In the long run profit calculated under absorption costing will be the
same as that under variable costing’.
9.6 SUMMARY
Marginal cost is the cost management technique for the analysis of cost and
revenue information and for the guidance of management. The presentation of
information through marginal costing statement is easily understood by all
mangers, even those who do not have preliminary knowledge and implications of
the subjects of cost and management accounting. Absorption costing and marginal
costing are two different techniques of cost accounting. Absorption costing is widely
used for cost control purpose whereas marginal costing is used for managerial
decision-making and control. Marginal costing helps with short-term decision.
making. The cost of a product can be ascertained by any of the two techniques – (a)
Absorption Costing; and (b) Marginal Costing.
In case of absorption costing, the cost of a product is determined after
considering both fixed and variable cost while in case of marginal costing only the
variable costs are considered for computing the cost of a product. The fixed costs
are met against the total contribution given by all the products taken together.
1. one of the basic difference between marginal costing and absorption
costing is regarding the treatment of
a. prime cost
b. variable cost
c. fixed overhead
d. direct materials.
Ans (c)
2. absorption costing differ from marginal costing is the
a. fact that standard costs can be used with absorption costing but
not with marginal costing
b. amount of costs assigned to individual units of products
c. kind of activities for which each can be used
d. amount of fixed cost that will be incurred
Ans(b)
www.icai.org
www.icmai.org
136
9.9 ASSIGNMENT
1.Give a comparative description of absorption costing and marginal costing.
1. P.Das Gupta: Studies in Cost Accounting, Sultan Chand & Sons, New
Delhi.
2. Jain &Narang: Advanced Cost Accounting, Kalyani Publishers.
3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4. S.N.Maheswari: Management Accounting And Financial Control, Sultan
Chand & Sons.
5. V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.
1. From the following particulars, prepare cost statement under
a. Absorption costing
b. Marginal costing
No of units produced 20000
Cost per unit: materialsRs.10
Procutive labour 6
Factory OH 4(50% fixed)
Administrative OH 3(60% fixed)
Selling OH 2 (100% variable on units sold)
No of units sold 19000
Selling price per unit Rs.40
9.12 KEY WORDS
Marginal costing, absorption costing, variable costing, fixed costing.
137
LESSON –10
MARGINAL COSTING – COST VOLUME PROFIT ANALYSIS
10.1 INTRODUCTION
Cost Volume Profit Analysis is used to measure inter relationship between
costs, volume and profit at various level of activity. Cost Volume Profit Analysis (C V
P) is a systematic method of examining the relationship between changes in the
volume of output and changes in total sales revenue, expenses (costs) and net
profit. In other words. it is the analysis of the relationship existing amongst costs,
sales revenues, output and the resultant profit.
10.2 OBJECTIVES
 To understand the contribution, profit volume analysis break even point.
 This lesson help to solve some problems of cost volume analysis.
10.3 CONTENT
Some solved problems on the topic of P/V ratio, break even point sales etc.,
From the above equation, we may derive the following equations:
Break-Even Point [BEP]:

BEP may be defined as that level or point of sales volume at which the total
revenue is equal to total costs. It is a no-profit, no-loss point.
It may be expressed as follows:
Margin of Safety [MS]:

MS may be defined as the excess of actual sales or production at the selected
activity over break-even sales or production.
138
Margin of Safety = Actual sales – Break-even sales or point It may be calculated as

follows:
Margin of safety (in rupees) = Profit (P)/ P/V ratio
Margin of safety (in units) = Profit / Contribution per unit
Margin of safety may also be expressed as a percentage on actual sales as
follows:
Margin of safety sales ratio = margin of safety (sales)/ actual sales at selected
activity x 100
Illustration 1
From the following information, find out the amount of profit earned during the
year using marginal cost technique
Fixed cost Rs.5,00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 1,50,000 units
Solution
Contribution = selling price – marginal cost

Rs.22,50,000 – Rs. 15,00,000
(1,50,000 x 15) - (1,50,000 x 10) = Rs. 7,50,000
Contribution = fixed cost + profit
Rs.7,50,000 = 5,00,000 + profit
Rs.7,50,000 – 5,00,000 = profit
Profit = Rs. 2,50,000
Illustration 2
Find the profit from the following data
Rs.
Sales 160,000
Marginal cost 120,000
Break- even point 120,000
Solution
P/V ratio = (sales – variable cost)/sales x 100
= (160,000 – 120,000)/160,000 x 100
= 25%
B.E.P = Fixed cost / P/V ratio
60,000 = fixed cost / 25%
139
Fixed cost = 120,000 x 25% = Rs.30,000

Profit = (sales x P/V ratio ) – fixed cost
= (160,000 x 25% ) – 30,000
= 40,000 – 30,000
= Rs.10,000
Illustration 3
From the following particulars calculate the break even point
Rs.
Variable cost per unit 12
Fixed expenses 60,000
Selling price per unit 18
Solution
B.E.P (in units 0 = fixed cost / contribution per unit
(Selling price variable cost = contribution)
(Rs.18 – Rs.12 = 6)
Rs.60,000 / Rs. 6 = 10,000 units
B.E.P sales = 10,000 x Rs.18 = Rs.1,80,000
Illustration 4
A company estimates that next year it will earn a profit of Rs.,100,000. The
budgeted fixed costs and sales are Rs.2,50,000 and 9,93,000 respectively. Find out
the break even point for the company
Solution
B.E.P = F X S / contribution
Contribution = S – V = F + P
F+P = Rs.2,50,000 + Rs.100,000 = Rs.3,50,000
B.E.P sales = 2,5,0,000 x 9,93,000 / 3,50,000
, = Rs.709286
Illustration 5
From the following particulars, find out the selling price per unit if B.E.P is to
be brought down to 9,000 units
Rs.
Variable cost per unit 75

Fixed expenses 2,70,000
Selling price per unit 100
140
Solution
Let us assume that the contribution per unit at B.E sales of 9,000 is x.
B.E.P = Fixed cost / contribution per unit
Contribution per unit is not known. Therefore
9000 units = 2,70,000 / x
9000 x = 2,70,000
X = 30
Contribution is Rs.30 per unit, in place of Rs.25. therefore, the selling price
should be Rs.105 i.e Rs.75 + Rs.30
Illustration 6
From the following data, calculate break even point expressed in terms of units
and also the new B.E.P, if selling price is reduced by 10%
Rs.
Fixed expenses
Depreciation 2,00,000
Salaries 2,00,000
Variable expenses
Materials 3 per unit
Labour 2 per unit
Selling price 15 per unit
Solution
= 4,00,000 / 10 = 40,000 units.
When the selling price is reduced by 10% selling price becomes Rs.15-1.50 =
Rs.13.50 per unit. So, contribution = Rs.13.50 – Rs.5 = Rs.8.50
= 4,00,000 / 8.50 = 47059 units
Illustration 7
From the following information, find out the amount of profit earned during the
year using marginal costing technique
Fixed cost Rs,6,00,000
Variable cost Rs.10 per unit
Output level 2,00,000 units
Solution
141
Marginal cost statement

Sales (2,00,000 x 15) 30,00,000
Less: variable cost( 2,00,000 x 10) 20,00,000
Less: fixed cost 6,00,000
Profit 4,00,000
Illustration 8
Fixed overhead Rs.2,40,000
Variable overhead Rs.4,00,000
Direct wages Rs.3,00,000
Direct materials Rs.8,00,000
Sales Rs.20,00,000
Calculate the break even point and P/V ratio
Solution
Statement showing contribution
Rs. Rs.
Sales 20,00,000
Less variable cost
Direct materials 8,00,000

Direct wages 3,00,000
Variable overhead 4,00,000 15,00,000
P/V ratio = (contribution/ sales) x 100
= (5,00,000 / 10,00,000) x 100 = 50%

Break even point = fixed cost/ P/V ratio
= 2,40,000 / 50% = Rs.4,80,000

Illustration 9
Marginal cost Rs.4800
Selling price Rs.6000
Calculate P/V ratio
142
Solution
P/V ratio = contribution / sales x 100 = (Rs.6000 – Rs.4800)x 100 / Rs.3000
=(Rs.1200 / Rs.3000) x 100
= 40 %
Illustration 10
The sales turnover and profits during two periods are as under:
Period I : sales Rs.20 lakhs; profit Rs.2 lakhs
Period II : sales Rs.30 lakhs; profit Rs.4 lakhs
Calculate P/V ratio
Solution:
P/V ratio = change in profit /change in sales x 100
= (Rs.4,00,000 – Rs.2,00,000 x 100)/ (Rs.30,00,000 -Rs.20,00,000)
= 2,00,000/10,00,000 x 100
= 20%
Illustration 11
The following date are obtained from the records of a company
First year second year
Rs. Rs.
Sales 80,000 100,000
Profit 10,000 14,000

Calculate the break even point
Solution
B.E.P (Sales ) = Fixed cost / P/V ratio

P/V ratio = change in profit/ change in sales x 100
= 4,000 /20,000 x 100 = 20%
Fixed cost = contribution – profit or sales x P/V ratio
Fixed cost = 80,000 x 20 /100 – Rs.10,000
= 16,000 – 10,000 =6,000
B.E.P (sales ) = 6,000 x 100 / 20 = Rs.30,000
Illustration 12 Company earned a profit of Rs.60,000 during the year 2015-16. If

the marginal cost and selling price of a product are Rs.8 and Rs.10 per unit
respectively. Find out the amount of margin of safety
143
Solution
Contribution per unit = selling price – marginal cost
= Rs.10 – Rs.8 = Rs.2
P/V ratio = contribution / sales x 100
= 2/10 x 100 = 20%
Margin of safety = Profit / P/V ratio = Rs.60,000 / 20%

= Rs.3,00,000
Illustration 13
From the following details find out a. profit volume ratio, b. B.E.P, c. margin of
safety
Rs.
Sales 1,00,000
Total costs 80,000
Fixed costs 20,000
Net profit 20,000
Solution
1. P/V ratio = ( sales – variable expenses) / sales x100

= (1,00,000 – 60,000 )/1,00,000 x 100
= 40
2. B.E.P = Fixed cost / P/V ratio

= 20,000 / 40% or 20,000 x 100 / 40
= Rs.50,000
3. Margin of safety = profit / P/V ratio
= 20,000 / 40%
= 20,000 x 100 / 40
= Rs.50,000
Or
Margin of safety = actual sales – sales at B.E.P
= 1,00,000 – 50,000
= Rs.50,000
144
Illustration 14
The following information was obtained from a company in a certain year
Rs.
Sales 1,00,000
Variable costs 60,000
Fixed costs 30,000
Find the P/V ratio, break even point and margin of safety.
Solution
P/V ratio = (S – V) / S X 100 = (1,00,000 – 60,000) / 1,00,000 X 100 = 40%

Break even point= F / P/V ratio = 30,000 / 40% = Rs.75,000
Margin safety = Profit / P/V ratio = 10,000 / 40% = Rs.25,000
Or = sales – break even sales = Rs.1,00,000 – Rs.75,000
= Rs.25,000
10.4 REVISION POINT

The term Contribution refers to the difference between Sales and Marginal Cost
of Sales.
P/v ratio helps in the determination of break even point and margin of safety
Break even point is a point at which there is no profit or no loss of a particular
sales volume.
Margin of safty is difference between actual sales and break even sales.
10.5 INTEXT QUESTION
1. What are the important decision making areas of Marginal costing?
2. What do you understand by Cost Volume Profit Analysis?
3. Briefly explain the objectives of cost volume profit analysis.
4. Explain Marginal cost equation.
5. What is Contribution? How it is computed?
6. What do you understand by Break-Even Analysis?
7. Write short notes on :
(a) Profit Volume ratio. (b) Margin of Safety.
(c) Break-Even chart. (d) Angle of Incidence.
10.6 SUMMARY
This lesson explains a cost volume-profit analysis. Cost volume-profit
analysis examines the behavior of total revenues, total costs, and operating income
145
(profit) as changes occur in the output level, selling price, variable cost per unit,
and/or fixed costs of a product or service. The reliability of the results from CVP
analysis depends on the reasonableness of the assumptions.
10.7 TERMINAL QUESTION
1. Marginal costs is taken as equal to
a) Prime Cost plus all variable overheads
b) Prime Cost minus all variable overheads
c) Variable overheads
d) None of the above
ANSWER: a)
2. If total cost of 100 units is Rs 5000 and those of 101 units is Rs 5030
then increase of Rs 30 in total cost is
a) Marginal cost
b) Prime cost
c) All variable overheads
ANSWER: a)
3. Marginal cost is computed as
a) Prime cost + All Variable overheads
b) Direct material + Direct labor + Direct Expenses + All variable
overheads
c) Total costs – All fixed overheads
d) All of the above
ANSWER: a)
4. Marginal costing is also known as
a) Direct costing
b) Variable costing
c) Both a and b
ANSWER: c) Both a and b
5. Which of the following statements are true?
A) Marginal costing is not an independent system of costing.
B) In marginal costing all elements of cost are divided into fixed and
variable components.
C) In marginal costing fixed costs are treated as product cost.
D) Marginal costing is not a technique of cost analysis.
a) A and B
b) B and C
c) A and D
d) B and D
ANSWER: a)
146

www.icai.org
www.icmai.org
10.9 ASSIGNMENT
1. Why might the operating profit calculated by CVP analysis differ from the
net income reported in financial statements for external reporting?
2. Why does the accountant use a linear representation of cost and revenue
behaviour in CVP analysis? How is this justified?
3. The typical cost-volume-profit graph assumes that profits increase
continually as volume increases. What are some of the factors that might
prevent the increasing profits that are indicated when linear CVP analysis
is employed?
4. “The assumptions of CVP analysis are so simplistic that no firm would
make a decision based on CVP alone. Therefore, there is no reason to learn
CVP analysis.” Comment.
5. “A person going to work for a hospital, which is a not-for-profit
organization. Because there are no profits, He will not be able to apply any
CVP analysis in his work.” Do you agree with this statement? Why or why
not?
1. P.Das Gupta: Studies in Cost Accounting, Sultan Chand & Sons, New
Delhi.
2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
Chand & Sons.
5. V.K.Saxena And C.D.Vashist: Advanced Cost And Management Accounting,
Sultan Chand & Sons, New Delhi.
You are required to calculate the break even point in the following information
The fixed cost for the year is Rs.80,000; variable cost per un it for the single
product being made is Rs.4. estimated sales for the period are valued at
Rs.2,00,000. The number of units involved coincides with the expected volume of
output. Each unit sells at Rs.20.
Calculate break even point by applying important formulae
10.12 KEY WORDS
Contribution, breakeven point, profit volume ratio, margon of safty.
LESSON – 11
147
BREAK EVEN CHART

11.1 INTRODUCTION
The breakeven point can also be represented in graphical form. Hence
graphical representation of break even point is known as break even chart. It is also
an important aid to profit planning. It has been defined as “ a chart which shows
the profitability or otherwise of an undertaking at various levels of activity and as a
result indicates the point at which neither profit nor loss is made”.
A break even chart can provide n ot only break even point but also other
information such as
1. The profit/loss at different levels
2. The sales value or unit can be known
3. It shows the variable cost, fixed cost and total cost
4. The margin of safety
5. The angle of incidence, indicating the rate at which profit is being made.
11.2 OBJECTIVES
 To understand the graphical representation of break even chart
 To understand the assumption of break even chart
 To understand the advantages and limitation of break even chart
11.3 CONTENT
11.3.1 Assumption of break even chart
11.3.2 Advantages of break even chart
11.3.3 Limitations of break even chart
11.3.4 Construction of break even chart
11.3.1 ASSUMPTION OF BREAK EVEN CHART
1. Fixed costs remain constant and do not change with level of activity
2. Costs are divided into fixed and variable costs. Variable costs change
according to the volume of production
3. Variable costs vary with the volume of output but price of variable costs
such as wage rate, price of materials, supplies, will be unchanges
4. Selling price remains the same at different levels of activity
5. There is no change in the product mix and in the level of efficiency
6. Policies of management do not change
7. No change in manufacturing process is due to non static operating efficiency
8. As the number of units produced and sold are the same, there is no closing
or opening stock.
11.3.2 ADVANTAGES OF BREAK EVEN CHART
1. Total cost, variable cost and fixed cost can be determined
2. Break even output or sales value can be determined
148
3. Cost, volume and profit relationship can be studied, and they are very
useful to the managerial decision making.
4. Inter firm comparison is possible
5. It is useful for forecasting plans and profits.
6. The best products mix can be selected.
7. Total profits can be calculated
8. Profitability of different levels of activity, various products or profits ie.
plans can be known.
9. It is helpful for cost control.
11.3.3 LIMITATIONS OF BREAK EVEN CHART
1. Accurate classification of cost into fixed and variable is not possible.
2. Constant selling price is not true
3. Detailed information cannot be shown in the chart form.
4. No importance is given to opening and closing stocks.
5. Cost, volume and profit relation can be known, capital amount, market
aspects, effect of government policy etc., which are important for decision
making cannot be considered from break even chart.
Illustration 1
You are given the following data for the costing year of a factory
Budget output 200000 units
Fixed expenses Rs.500000
Variable expenses Rs.5 per unit
Draw a break even chart showing the break even point. If the selling price is
reduced to Rs.9 per unit, what will be the new break even point
Solution
B.E.P = F.C / S-V
= 500000/5
= 100000 Units
B.E.S = 100000 X Rs.10
= Rs. 1000000
If selling price is reduced to Rs.9, then the contribution will be Rs.4
The new B.E.P = 500000/4
= 125000 units
B.E.S = 125000 X Rs.9
= Rs.1125000
149
20
PROFIT
LE
SA
S
LE
SA
COST AND SALES (IN LAKHS OF RUPEES)
15
T
OS
Rs. 11,25,000
LC
TA
TO
Rs. 10,00,000
VARIABLE COST
10 NEW B.E.P
5
SS
LO
FIXED COST
0 25 50 75 100
OUTPUT (IN '000 UNITS)
11.3.4 CONSTRUCTION OF BREAK EVEN CHART

1. x-axis( A horizontal line) is represents Sales volume can be shown in the
form of rupees or units
2. Y axis represents revenues, fixed and variable costs. A vertical line is also
spaced in equal parts.
3. Draw the sales line from point o onwards. Cost lines may be drawn in two
ways (i) fixed cost line is drawn parallel to x axis and above it variable cost
line is drawn from zero point of fixed cost line. This line is called the total
cost line (ii) in the second method the variable cost line is drawn from
point o and above this, fixed cost line is depicted running parallel to the
variable cost line. This line may be called total cost line. (fig.2)
4. The point at which the total cost cuts across the sales line is the break -
even point and volume at this point is break-even volume.
5. The angle of incidence is the angle between sales and the total cost line. It
is formed at the intersection of the sales and the total cost line, indicating
the profit earning capacity of a firm. The wider the angle the greater is the
profit and vice versa. Usually, the angle of incidence and the margin of
safety are considered together to show that a wider angle of incidence
coupled with a high margin of safety would indicate the most suitable
conditions.
150
Illustration 2
A company budgeted for the year 2016, sales Rs.1000000 (selling price being
Rs.40 per unit), fixed costs Rs.360000 and variable costs Rs.520000. find out break
even point a. taking into consideration the budgeted figure and b. assuming 10%
increase in fixed costs. Also draw a break even chart.
Solution
a. B.E.P (Budgeted figures) = fixed cost x sales / contribution
= 360000 x 1000000 / 480000
= Rs.750000
b. B.E.P ( 10 % increase in fixed cost) = (fixed costs + 10% increase) x sales /

contribution
= (360000 + 36000) x 1000000 / 480000
= Rs. 825000
10
b.BEP (Rs .825000)
9
8 INE
L
ST
COST AND REVENUE (IN LAKHS OF RUPEES)
CO a .BEP (Rs .750000)

AL
OT
7 b.T
6 INE
TL
COS
AL
OT
5 a.T b.FIXED COST LINE
3 a.FIXED COST LINE

E
LIN
LE
SA
0 1 2 3 4 5 6 7 8 9 10
SALES (IN LAKHS OF RUPEES)

151
Illustration 3
A company produces 100000 units of an article and sells them at the rate of
Rs.5 each. The marginal cost per unit is 60% of the selling price and total fixed
costs of the concern are Rs.100000.
Draw a break even chart showing a. break even point, b. margin of safety
Solution
Computation of BEP
a. BEP = fixed cost x sales / contribution
= 100000 x 500000 / 200000
b. Margin of safety = Rs.500000 – 250000

= Rs.250000
5 E
LIN
INE
TL
LE
4 S
SA
CO
TAL
a. TO
3 BEP b.
MARGIN OF SAFETY
2
FIXED COST LINE
1
0 1 2 3 4 5

152
illustration
The following figures relate to a particular year working at 100% capacity level
in a manufacturing concern
Rs.
fixed overheads 1,20,000
variable overheads 2,00,000
direct wages 1,50,000
direct materials 4,10,000
sales 10,00,000
represent the above figures on the break even chart and determine from the
chart the break even point. Verify your results by calculations
solution :
sales 10,00,000
less : variable cost 7,60,000
contribution 2,40,000
fixed cost 1,20,000
profit 1,20,000
10,00,000
10
E
IN
SL
IT
OF
LE
PR
8
SA
COST AND SALES (IN LAKHS OF RUPEES)
B.E.P E AD
RH
OVE
6 LE
IAB
V AR
DIRECT WAGES
4 DIRECT MATERIAL
FIXED COST
2
0 2 4 6 8 10
OUTPUT AND SALES

153
Illustration 4
The following are the budgeted data of a company
Rs
Sales 1200000
Variable costs 600000
Fixed costs 360000

Find out the break even point at a. the budgeted data , b. assuming 20%
increase in variable cost. Also construct a break even chart.
Solution
a. BEP = Fixed cost x sales / contribution
= Rs.360000 x 1200000 / 600000
= Rs.720000
b. 20% increase in variable costs

BEP = Fixed costs x sales / S – V ( increased)
= Rs.360000 x 1200000 /1200000 - 720000
= 900000
Rs.1080000
12 New Total cost
ii. BEP (Rs.900000) Rs.960000

10 Total cost
8
i. BEP (Rs.720000)
6
4 FIXED COST LINE
0 2 4 6 8 10 12

154
11.4 REVISION POINTS

The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs
at various levels of activity shown on the same chart as the variation of income or
sales, revenue with the same variation in activity. The point at which neither profit
nor loss is made is known as the "break-even point".
1. From the following data, calculate:
(a) P I V Ratio.
(b) Profit when sales are Rs. 40,000.
(c) New break-even point if selling price is reduced by 20% .
(d) break-even chart.
Fixed Expenses Rs. 8,000.
Break-Even point Rs. 10,000.
[Ans : (a) Profit volume ratio 40% . (b) Profit when sales are Rs. 40,000 is Rs. 8,000.
2.from the following data ,compute the break even point by means of a break even
chart:
Selling price per unit Rs 2.50
Variable cost per unit Rs 2.00
Total fixed costs Rs 20,000.
11.6 SUMMARY
The cost analysis approach to decision making is used when the decisions
affect costs and revenues and, hence, profit. A break-even chart is a graphical
presentation which indicates the relationship between cost, sales and profit. The
chart depicts fixed costs, variable cost, break-even point, profit or loss, margin of
safety and the angle of incidence. Such a chart not only indicates break-even point
but also shows the estimated cost and estimated profit or loss at various level of
activity. Break-even point is an important stage in the break-even chart which
represents no profit no loss.
Fill in the blanks
1. In break even chart , X axis represents _________
Ans: volume of production or sales.
2. In break even chart , Y axis represents _________
Ans: cost and revenue in rupee value.
3.In profit / volume chart, break even point takes place where________ line
and______
155
Line intersect each other.

Ans: profit, sales.
www.icai.org
www.icmai.org
11.9 ASSIGNMENT
1. 1.what are the various applications of the break – even charts?
2. Enumerate the various criticisms usually leveled against break-even
chart.
3. State four different methods of finding out the break-even point
graphically.
1. P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons, New
Delhi.
Chand & Sons.
5. V.K.Saxena And C.D.Vashist: Advanced Cost And Management A ccounting,
Sultan Chand & Sons, New Delhi.
11.11 LEARNING ACTIVITES
1.Draw a break-even chart on the basis of following data:
Plant capacity: 1,60,000 units per year
Fixed cost: Rs 4,00,000 Variable cost: Rs 5 per unit
Selling price: Rs 10 per unit.
2.(a) Plot the following data on a graph and determine the break-even point
Direct labour Rs 100 per unit
Direct material Rs 40 per unit
Variable overheads 100% of direct labour
Fixed overheads Rs 60,000
Selling price Rs 400 per unit
(b) In order to increase efficiency in production, the concern instal s improved
machinery which results in fixed overhead of Rs. 20,000 but the variable overhead
is reduced by 40% . You are required to plot the data on the above graph and to
determine the new breakeven point assuming that there is no change in sale price.
11.12 KEY WORDS
Chart ,intersect, X-axis, Y-axis.
156
LESSON – 12
APPLICATION OF MARGINAL COSTING TECHNIQUES
12.1 INTRODUCTION
Marginal costing helps the management in decision making in respect of the
following vital areas:
 Selection of a profitable product mix
 Profit planning
 Make or buy decision
 Decision to accept or reject a bulk order
 Introduction of a new product
 Choice of technique
 Key factors
Application of marginal costing techniques with rele vant illustrations
Illustration 1
P/V ratio is 60% and the marginal cost of the product is Rs.50. what will be the
selling price?
Solution
Selling price = variable cost / (100-P/V ratio) = Rs.50/ (100-60%)
= 50 x 100 / 40 = Rs.125
Verification P/V ratio = contribution / sales x 100 = (S-V)/S x 100
= (Rs.125 – 50)/125 x 100 = 75/125 x 100 = 60%
Illustration 2
From the following data, calculate
1. P/V ratio
2. Profit when sales are Rs.30,000
3. New break even point if selling price is reduced by 20%
Fixed expenses Rs.4000
Break even point Rs.10,000
Solution
1. Break even sales = fixed expenses/ P/V ratio
P/V ratio = fixed expenses / break even sales
= 4000 /10000 x 100 = 40%
2. When sales are Rs.20000, the profit is
= sales x P/V ratio – fixed expenses
157
= 30000 x 40% - 4000

= Rs.12000 – Rs.4000 = Rs.8000
3. If selling price is reduced by 20%, the new break even point would be Rs.80
(say Rs.100 – Rs.20)
Variable cost per unit = 100 – 40% = Rs.60
New P/V ratio = (80-60) / 80 x 100 = 25%
New break even point = 4000 x 100 / 25 = Rs.16000
Illustration 3
A company has a P/V ratio of 40% . By what percentage must sales be
increased to offset
a. 10% reduction selling price
b. 20% reduction selling price
Solution
If sales are 100 units @Re.1 per unit then
Sales Rs.100
Contribution Rs.40
Variable cost Rs.60
a. If selling price is reduced by 10%
Sales Rs.90
Contribution Rs.30
Variable cost Rs.60
Volume of sales to maintain the same contribution will be equal to
= contribution / new contribution x new sales
= 40/30 x 90 = Rs.120
Thus the selling price is reduced by 10%, the volume of sales will have to be increased by
20%
a. If selling price is reduced by 20%
Sales Rs.80
Contribution Rs.20
Variable cost Rs.60
Volume of sales to maintain the same contribution will be equal to
= contribution / new contribution x new sales
= 40/20 x 80 = Rs.160
158
Thus the selling price is reduced by 20%, the volume of sales will have to be increased by
60%
Illustration 4
A company produces and sells 100 units of A per month at Rs,20. Marginal
cost per unit is Rs.12 and fixed costs are Rs.400 per month. It is proposed to
reduce the selling price by 20% . Find the additional sales required to earn the same
profit as before.
Solution
Present profit Rs.
Sale price of 100 units @ Rs.20 2000
Less: marginal cost of 100 units (100 x Rs.12) 1200
Contribution 800
Less : fixed cost 400
Net profit 400
At reduced price, to earn the same amount of profit, the sales required is
= (fixed cost + desired profit) / contribution
= (400 +500) / (16 – 12)
= 225 units
Additional units = 125
12.2 OBJECTIVES
 To understand the decision making in respect profit planning, product mix,
make or buy, key factors.
12.3 CONTENT
12.3.1 Product mix
12.3.2 Profit planning
12.3.3 Decision to make or buy
12.3.4 Key factors
12.3.1 PRODUCT MIX
One of the more common decision-making problems is a situation where there
are not enough resources to meet the potentials a lesdemand, and so a decision has
to be made about what mix of products to produce, using what resources there
areas effectively as possible. A limiting factor could be sales if there is a limit to
sales demand but any one of the organization's Resources (labor, materials and
soon) may be insufficient to meet the level of production demanded. It is assumed
in limiting factor accounting that management wishes to maximize profit and that
159
profit will be maximized when contribution is maximized (given no change in fixed

cost expend it ure incurred). In other words, marginal costing ideas are applied.
Contribution will be maximized by earning the biggest possible contribution from
each unit of Limiting factor.
Illustration 5
From the following data, calculate
1. Break even point expressed in amount of sales in rupee s,
2. Number of units that must be sold to earn a profit of Rs. 80000 per year
Rs.
Sales 20 per unit
Variable manufacturing cost 11 per unit
Variable selling cost 3 per unit
Fixed factory overhead 540000 per year
Fixed selling cost 252000 per year
Solution
1. Break even point = total fixed cost/ contribution per unit
= 792000 / 20 – 14
= 792000 / 6
= 132000 units
Break even sales = break even units x selling price per unit
= 132000 units x Rs.20
= Rs.2640000
2. Sales units at desired profit = (fixed cost + desired profit) / contribution
= (792000 + 80000) / 6
= 145333 units
Illustration 6
Present the following information to show to the management: a. the marginal
product cost and the contribution per unit; b. the total contribution and profit
resulting from each of the following sales mixtures.
Product per unit
Rs.
Direct materials A 10
B 9
Direct wages A 3
B 2
Fixed expenses Rs. 800
Variable expenses are allocated to products as 100% of direct wages
160
Sales price A Rs,20

B Rs.15
Sales mixtures:
a. 1000 units of product A and 2000 units of B
b. 1500 units of product A and 1500 units of B
c. 2000 units of product A and 1000 units of B
Solution
a. Marginal cost statement A B
Rs. Rs.
Direct materials 10 9
Direct wages 3 2
Variable overheads (100%) 3 2
Marginal cost 16 13
Sales price 20 15
Contribution 4 2
a. Product mix choice a b c
Rs. Rs. Rs.
I II III
Total sales (1000 x 20 + (1500x20 + 1500 x15) (2000x20+1000 x 15)
2000 x 15) = 50000 = 52500 = 55000
Less. Marginal cost (1000 x 16 + 2000 x 13) (1500x16+1500 x 13) (2000x16+1000 x 13)
= 42000 = 43500 = 45000
contribution 8000 9000 10000
Less : fixed costs 800 800 800
profit 7200 8200 9200
Therefore , sales mixture III will give the highest profit and as such, mixture III
can be adopted.
12.3.2 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, planning becomes an
absolute necessity. Marginal costing assists profit planning through computation of
contribution ratio.
It enables planning of future operations in such a way as to either maximize
profits or maintain specified levels of profits. Normally, profits are affected by
several factors such as the volume of sales, marginal cost per unit, total fixed costs,
selling price, sales mix, etc. Hence, management can achieve their profit goals by
varying one or more of the above variables.
161
Illustration 7
The Delhi Mixy Co. manufactured and sold 1000 mixies last year at a price of
Rs.800 each, the cost structure of a mixy is as follows
Rs.
Materials 200
Labour 100
Variable cost 50
Marginal cost 350
Factory overhead (fixed ) 200
Total cost 550
Profit 250
Sales price 800
Due to heavy competition, price has to be reduced to Rs.750 for the coming
year. Assuming no change in costs, state the number of mixies that would have to
be sold at the new price to ensure the same amount of total profits as that of the
last year.
Solution
Profit for 1000 mixies = 100 x 250 = rs.250000
Contribution at the price of Rs.750 = 750 – 350 = Rs.400
P/V ratio = contribution per unit / sales price per unit = 400 / 750
Sales required at Rs.750 per mixy to earn a profit of Rs,250000 \
= (fired cost + profit)/ P/V ratio
= (200000 + 250000) / 400/750 = Rs. 843750
= sales in units = 843750 / 750 = 1125 mixies
Or (F.C + profit ) / contribution per unit
= 20000 + 250000 / 400
= 1125 mixies
12.3.3 DECISION TO MAKE OR BUY
The make-or-buy decision is the act of making a strategic choice between
producing an item internally (in-house) or buying it externally (from an outside
supplier). The buy side of the decision also is referred to as outsourcing. Make -or-
buy decisions usually arise when a firm that has developed a product or part—or
significantly modified a product or part—is having trouble with current suppliers,
or has diminishing capacity or changing demand.
Factors that may influence firms to make a product ( suggest these
considerations that favor making a part in -house)
 Cost considerations (less expensive to make the part)
 Desire to integrate plant operations
 Productive use of excess plant capacity to help absorb fixed overhead
(using existing idle capacity)
162
 Need to exert direct control over production and/or quality

 Better quality control
 Design secracy is required to protect proprietary technology
 Unreliable suppliers
 No competent suppliers
 Desire to maintain a stable workforce (in periods of declining sales)
 Quantity too small to interest a supplier
 Control of lead time, transportation, and warehousing costs
 Greater assurance of continual supply
 Provision of a second source
 Political, social or environmental reasons (union pressure)
 Emotion (e.g., pride)
Factors that may influence firms to buy a part externally include:
 Lack of expertise
 Suppliers' research and specialized know-how exceeds that of the buyer
 cost considerations (less expensive to buy the item)
 Small-volume requirements
 Limited production facilities or insufficient capacity
 Desire to maintain a multiple-source policy
 Indirect managerial control considerations
 Procurement and inventory considerations
 Brand preference
 Item not essential to the firm's strategy
Illustration 8
XYZ limited has acquired a machine at a cost of Rs.250000. The estimated
operating costs for each year of the working life of the machine and its estimated
sale value ( scrap) at the end of each year are given below:
Year Operating cost Scrap value at the
in Rs. end of the year
1 100000 130000
2 120000 80000
3 150000 60000
4 180000 30000
5 220000 10000
If the price of a new machine is always Rs.2 lakhs, when will it be
advantageous to replace the machine after the first year?
163
Solution
year Differential Differential loss in Total loss
operating costs scrap value (differential)
Rs. Rs. Rs.
2 20000 50000 70000
3 30000 20000 50000
4 30000 30000 60000
5 40000 20000 60000
The above table shows that in case the machine is replaced at the end of third
year the total loss is minimum at Rs.50000. hence, the machine should be replaced
at the end of the third year.
12.3.4 KEY FACTORS
A key factor is defined as the factor in the activities of an undertaking which, at
a particular point of time or over a period, will limit the volume of output. . If a
factor of production is in short su pply, then the best-paying product becomes that
which yields the highest contribution per unit of limiting factor. Profitability=
Contribution/
Key Factor
Thus, Contribution per unit of key factor may be ascertained & maximized
according to priority (ranking). Some examples of key factors are:
a. Materials-Scarce Raw Material; Restrictions by licenses, etc.
b. Labour-General Shortage; Shortage of a particular type of labour.
c. Plant-Imbalance; Insufficient capacity due to shortage of capital, supply, etc.
d. Management-Shortage of efficient staff; policy decisions.
e. Capital-Shortage of capital; insufficient research activity
f. Sales-Market demand; insufficient advertisement.
12.4 REVISION POINT
Profit planning
Profit planning is the planning of future operations to attain maximum profit.
Under the technique of marginal costing, the contribution ratio, i.e., the ratio of
marginal contribution to sales, indicates the relative profitability of the different
products of the business whenever there is any change in volume of sales, marginal
cost per unit, total fixed costs, selling price, and sales-mix etc.
Hence marginal costing is an useful tool in planning profits as it ensures
sufficient return on capital employed.
Pricing of Products:
Sometimes pricing decisions have to be taken to cater to a recessionary market
or to utilise spare capacity where only marginal cost is recovered. For export
market, sometimes full cost is loaded to the sale price to remain competitive.
Sometimes special prices are to be offered with expansion in mind, fixation of price
below cost can be made on a short-term basis.
164
product mix
The most-profitable product mix can be determined by applying marginal
costing technique. Fixed cost remaining constant, the most profitable product-mix
is determined on the basis of contribution only. That product-mix which gives
maximum contribution is to be considered as best product mix.
Key factor
A key factor is a factor which limits the volume of production and profit of
business. It may be scarcity of any factor of production such as material labour,
capital, plant capacity etc. Usually, when there is no key or limiting factor, the
product is selected on the basis of highest P/V ratio of the product. But with key
factor the selection of product will be on the basis of contribution per unit of
limiting/key factor of production.
Make-or-Buy Decision:
A company may have idle capacity which may be utilised for making a
component or a product, instead of buying them from outside sources. In taking
such ‘make-or-buy’ decision, a comparison should be made between the variable (or
marginal) cost of manufacture of the product and the supplier’s price for it.
1. Mention any four important factors to be considered in Marginal Costing
Decisions.
2. State the non cost factor to be considered in make or buy decision.
12.6 SUMMARY
Resources (labor, materials and so on) may be insufficient to meet the level of
production demanded. It is assumed in limiting factor accounting that management
wishes to maximize profit and that profit will be maximized when contribution is
maximized (given no change in fixed cost expenditure incurred). In other words,
marginal costing ideas are applied. Contribution will be maximized by earning the
biggest possible contribution from each unit of Limiting factor. If growth and
survival of a business are to be ensured, planning becomes an absolute necessity.
Marginal costing assists profit planning through computation of contribution ratio.
The make-or-buy decision is the act of making a strategic choice between producing
an item internally (in-house) or buying it externally (from an outside supplier). The
buy side of the decision also is referred to as outsourcing.
1. Make or buy decisions are made by comparing _________________ cost
with outside purchase price
Ans: variable
2. Key factor is taken into consideration to judge the _____________ of
different products whenever there is any shortage.
Ans : profitability
3. The system most useful for making decisions of the make or buy and
similar other ones is called _______________ costing
Ans : marginal
165

www.icai.org
www.icmai.org
12.9 ASSIGNMENT
1. Explain with suitable illustrations the following statements
“In the very long run all costs are differential ”
“In the long run profit calculated under absorption costing will e the
same as that under variable costing”
2. Marginal costing is the administrative tool for the management to
achieve higher profits and efficient operation. Discuss.
1. P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons, New
Delhi.
Chand & Sons.
5. V.K.Saxena And C.D.Vashist: Advanced Cost And Management Accounting,
Sultan Chand & Sons, New Delhi
1.A machine which originally costs Rs 12,000 has an estimated life of 10 years
and is depreciated at the rate of Rs 1,200 per year. It has been unused for some
time, however, as expected production orders did not materialise. A special order
has now been received which would require the use of the machine for two months.
The current net realisable value of the machine is Rs 8,000. If it is used for the
job, its value is expected fall to Rs 7,500. The net book value of the machine is Rs
8,400. Routine maintenance of the machine currently costs Rs 40 per month. With
use, the cost of maintenance and repairs would increase to Rs 60 per month. What
would be the relevant cost of using the machine for the order so that it can be
charged as the minimum price for the order.
I. Comment on the relative probability of the following two products
Production cost per unit
Product ‘A’ Product ‘B’
Rs. Rs.
Materials 200 150

wages 100 200
fixed overhead 350 100
Variable Overhead 150 200
Profit 200 350
1000 1000
output per week 200 units 100 units
166
solution
profitability statement
product A Product B
(per unit) (per unit)
Rs. Rs.
Selling price 1000 1000
Less: marginal cost
Materials 200 150
Wages 100 200
Variable overhead 150 450 200 550
Contribution 550 450
Less: fixed cost 350 100
Profit 200 350
Total profit (200 x 200) 40000 (100x350) 35000
P/V ratio = contribution per unit / selling price per unit x 100
= 550 /1000 x 100 = 55%
= 450/1000 x 100 = 45%
Contribution per unit and total profit is higher in case of product A though
profit per unit of product B is higher. If output is the key factor, then product A is
better. On the other hand, if there is no limit to output, then product B wou ld be
more profitable.
12.12 KEY WORDS
Product mix, make or buy, key factor,
167
LESSON 13
INTRODUCTION TO BUDGET
13.1 INTRODUCTION
To achieve the organizational objectives, an enterprise should be managed
effectively and efficiently. It is facilitated by chalking out the course of action in
advance. Planning, the primary function of management helps to chalk out the
course of actions in advance. But planning has to be followed by continuous
comparison of the actual performance with the planned performance, i. e.,
controlling. One systematic approach in effective follow up process is budgeting.
Different budgets are prepared by the enterprise for different purposes. Thus,
budgeting is an integral part of management.
In the business world, a budget is a statement showing the expected income
and expenditure for a specific future period. Thus, budgeting is required
everywhere in national, domestic and business affairs.
13.2 OBJECTIVES
After completing this Lesson you should be able to Know
 Meaning of Budget
 Meaning of budgeting
 Important elements of Budgeting
13.3 CONTENT
13.3.1 Definition of Budget
13.3.2 Elements of Budgets
13.3.3 Characteristics of a Budget
13.3.4 Budgeting
13.3.5 Elements of Budgeting
13.3.1 DEFINITION OF BUDGET
Budget is a systematic plan for utilization of all types of resources, at its
command. It acts as a barometer of a business as it measures the success from
time to time, against the standard set for achievement.
‘A budget is a comprehensive and coordinated plan, expressed in financial
terms, for the operations and resources of an enterprise for some specific period in
the future’. (Fremgen, James M – Accounting for Managerial Analysis)
‘A budget is a predetermined detailed plan of action developed and distributed
as a guide to current operations and as a partial basis for the subsequent
evaluation of performance’. (Gordon and Shillinglaw)
‘A budget is a financial and/or quantitative statement, prepared prior to a
defined period of time, of the policy to be pursued during the period for the purpose
of attaining a given objective’. (The Chartered Institute of Management
Accountants, London)
168
13.3.2 ELEMENTS OF BUDGET

The basic elements of a budget are as follows:-
1. It is a comprehensive and coordinated plan of action.
2. It is a plan for the firm’s operations and resources.
3. It is based on objectives to be attained.
4. It is related to specific future period.
5. It is expressed in financial and/or physical units.
13.3.3 CHARACTERISTICS OF A BUDGET:
The main characteristics of a budget are:
 A Comprehensive Business Plan showing what the enterprise wants to
achieve.
 Prepared in Advance.
 For a Definite Period of Time.
 Expressed in quantitative form, physical or monetary terms, or both.
 For achieving a given objective.
 A proper system of Accounting is essential.
 System of Proper Fixation of Authority and Responsibility has to be in
place.
Need of Budget
A budget is prepared to have effective utilisation of resources and for the
realisation of objectives, as efficiently as possible.
13.3.4 BUDGETING
Budgeting is the process of preparing and using budgets to achieve
management objectives. It is the systematic approach for accomplishing the
planning, coordination, and control responsibilities of management by optimally
utilizing the given resources. In other words Budgeting is a technique of
formulating budgets.
Budgeting is the whole process of designing, implementing and operating
budgets. The main emphasis in this is short-term budgeting process involving the
provision of Resources to support plans which are being implemented.
‘The entire process of preparing the budgets is known as Budgeting’ (J.
Batty)
‘Budgeting may be said to be the act of building budgets’ (Rowland&Harr)
13.3.5 ELEMENTS OF BUDGETING
1. A good budgeting should state clearly the firm’s expectations and
facilitate their attainability.
2. A good budgeting system should utilize various persons at different
levels while preparing the budgets.
169
3. The authority and responsibility should be properly fixed.

4. Realistic targets are to be fixed.
5. A good system of accounting is also essential.
6. Wholehearted support of the top management is necessary.
7. Budgeting education is to be imparted among the employees.
8. Proper reporting system should be introduced.
9. Availability of working capital is to be ensured.
1. Budget is a Pre-determined Statement of Management Policy During a
Given Period Which provide a standard for comparison with the results
Actually achieved
2. Budgeting is a technique of formulating budgets.
3. Elements of Budget It is a comprehensive plan for the firm resources,
It is related Specific future period and expressed in financial or physical unit
4. Characteristic of a budget It is prepared in advance for a definite period of
time
5. Elements of Budgeting Should express the firms expectation, realistic
target are fixed, good accounting system is essential, top management
support is necessary, working capital is to be ensured
13.5 IN TEXT QUESTIONS
1. Define Budget
2. What do you mean by Budgeting?
3. What are the Basic elements of budgets?
13.6 SUMMARY
Budget is a systematic plan for utilisation of all types of resources, at its
command. It acts as a barometer of a business as it measures the success from
time to time, against the standard set for achievement. A budget is prepared to
have effective utilisation of resources and for the realisation of objectives, as
efficiently as possible. Budgeting is the process of preparing and using budgets to
achieve management objectives. It is the systematic approach for accomplishing the
planning, coordination, and control responsibilities of management by optimally
utilizing the given resources. In other words Budgeting is a technique of
formulating budgets. Elements of Budget It is a comprehensive plan for the firm
resources, It is related Specific future period and expressed in financial or physical
unit. Elements of Budgeting Should express the firms expectation, realistic target
are fixed, good accounting system is essential, top management support is
necessary, working capital is to be ensured.
170

1 ………………………..is a detailed plan of operations for specific future period.
2. …………………………is a technique of formulating budgets.
3. The entire process of preparing the budgets is known as…………………
1. Pillai.R.S.N, Bagavathi Management Accounting S. Chand & company Ltd.
2. Antony Robert.N And Reece, James.S Management Accounting Principles
Tata McGraw Hill
13.9 ASSIGNMENTS
1. What are the important points to be considered for a good budget?
2. Narrate the characteristics of a budget
3. Explain the Elements of a budgeting.
1. http://dosen.narotama.ac.id/
2. http://www.osbornebooksshop.co.uk/
3. http://www.fao.org/
4. http://www.icaiknowledgegateway.org/
Go to the nearby organization and observe how budgets are Prepared?
13.12 KEYWORDS
Budget, Budgeting, Budgetary Control
171
LESSON 14
BUDGETARY CONTROL
14.1 INTRODUCTION
The Budgetary control has now Became an essential e tool of the
management for controlling costs and maximizing profit. Cost can be reduced,
Wastage can be prevented and proper relationship between costs and income can
be established only when the various factors of production are combined in
profitable way. The resources of a Business effectively utilized by efficient conduct
of its operations. This requires careful working out of proper plans in advance, co-
ordination and control of activities on the part of the management.
14.2 OBJECTIVES
After completing this Lesson you should be able to know
 Meaning of Budgetary Control
 Requirement of sound Budgeting system
 Installation of Budgetary control System
14.3 CONTENT
14.3.1 Definition of Budgetary Control
14.3.2 Elements of Budgetary Control
14.3.3 Budget, Budgeting and Budgetary Control
14.3.4 Requirement of Sound Budgetary System
14.3.5 Objectives of Budgetary Control
14.3.6 Installation of Budgetary Control System
14.3.7 Essentials of Effective Budgeting
14.3.8 Standard Costing VS Budgetary Control
14.3.1 DEFINITION OF BUDGETARY CONTROL
Budgetary Control as, “the establishment of the budgets relating to the
responsibility of executives to the requirements of a policy and the continuous
comparison of actual with budgeted result either to secure by individual action the
objectives of that policy or to provide a firm basis for its revision” - CIMA, London
‘Budgetary Control is a planning in advance of the various functions of a
business so that the business as a whole is controlled’. (W heldon)
‘Budgetary Control is a system of controlling costs which includes the
preparation of budgets, coordinating the department and establishing
responsibilities, comprising actual performance with the budgeted and acting upon
results to achieve maximum profitability’. (Brown and Howard)
14.3.2 ELEMENTS OF BUDGETARY CONTROL
1. Establishment of budgets for each function and division of the
organization.
2. Regular comparison of the actual performance with the budget to know
the variations from budget and placing the responsibility of executives to
achieve the desired result as estimated in the budget.
172
3. Taking necessary remedial action to achieve the desired objectives, if

there is a variation of the actual performance from the budgeted
performance.
4. Revision of budgets when the circumstances change.
5. Elimination of wastes and increasing the profitability.
14.3.3 BUDGET, BUDGETING AND BUDGETARY CONTROL
A budget is a blue print of a plan expressed in quantitative terms. Budgeting
is a technique for formulating budgets. Budgetary Control refers to the principles,
procedures and practices of achieving given objectives through budgets.
According to Rowland and William, ‘Budgets are the individual objectives of
a department, whereas Budgeting may be the act of building budgets. Budgetary
control embraces all and in addition includes the science of planning the budgets to
effect an overall management tool for the business planning and control’.
14.3.4 REQUIREMENT OF A SOUND BUDGETING SYSTEM
The following are the essential requirements of a sound budgeting system :
 Clear lines of authority and responsibility have to be established
throughout the organization and the authority and responsibility of
different levels of management and departmental executives are clearly
defined.
 The organizational goal should be quantified and clearly stated. These
goals should be within the frame work of organisation’s strategic and long
range plans. The setting of budgets is not a process detached from
planning of the company’s overall policy. A well defined business policy
and objective is a prerequisite for budgeting.
 The budget system should be established on the highest possible level of
motivation. All levels of management should participate in setting budgets.
Since this can produce more realistic targets, lead to better understanding
of corporate objectives and the constrains within which organization
works. Participation in budgeting process will motivate the personnel to
achieve budget levels of efficiency and activity.
 The budget control system should provide for a degree of flexibility
designed to change in relation to the level of activity attained and the
impact of changes in sales and production levels on revenue, expenses are
known. It enables more accurate assessment of managerial and
organizational performance.
 Proper communication systems should be established for management
reporting and information service so that information relating to actual
performance is presented to the manager responsible for it promptly to
enable the manager to know the nature of variations so that remedial
action is taken wherever necessary.
 Educating the budget process and creation of cost awareness atmosphere
will lead to effective implementation of budgets.
173
 The top management’s involvement in budget process is essential for

successful implementation of the budgets. It should take interest not only
in setting the budgets and targets but also to check upon the actual
attainment, motivating the personnel, rewarding for achievements,
investigation into reasons for any deviation of actual from budgeted
results, taking punitive action wherever necessary.
 A sound system for generating accurate and reliable and prompt
accounting information is basis for successful implementation of budget
system in an organization.
14.3.5 OBJECTIVES OF BUDGETARY CONTROL
Budgetary Control assists the management in the allocation of responsibilities
and is a useful device to estimate and plan the future course of action. The general
objectives of budgetary control are as follows:
1.Planning
a) A budget is an action plan and it is prepared after a careful study and
research.
b) A budget operates as a mechanism through which objectives and policies
are carried out.
c) It is a communication channel among various levels of management.
d) It is helpful in selecting a most profitable alternative.
e) It is a complete formulation of the policy to be pursued for attaining given
objectives.
2.Co-Ordination
It coordinates various activities of the business to achieve its common
objectives. It induces the executives to think and operate as a group.
3. Control
Control is necessary to judge that the performan ce of the organization confirms
to the plans of business. It compares the actual performance with that of the
budgeted performance, ascertains the deviations, if any, and takes corrective action
at once.
14.3.6 INSTALLATION OF BUDGETARY CONTROL SYSTEM
There are certain steps necessary to install a good budgetary control system in
an organization. They are as follows:
1. Determination of the Objectives
2. Organization for Budgeting
3. Budget Centre
4. Budget Officer
5. Budget Manual
6. Budget Committee
7. Budget Period
8. Determination of Key Factor
174
1.Determination of Objectives
It is very clear that the installation of a budgetary control system presupposes
the determination of objectives sought to be achieved by the organization in clear
terms.
2.Organization for Budgeting
Having determined the objectives clearly, proper organization is essential for
the successful preparation, maintenance and administration of budgets. The
responsibility of each executive must be clearly defined. There should be no
uncertainty regarding the jurisdiction of executives.
3.Budget Centre
It is that part of the organization for which the budget is prepared. It may be a
department or any other part of the department. It is essential for the appraisal of
performance of different departments so as to make them responsible for their
budgets.
4.Budget Officer
A Budget Officer is a convener of the budget committee. He coordinates the
budgets of various departments. The managers of different departments are made
responsible for their department’s performance.
5.Budget Manual
It is a document which defines the objectives of budgetary control system. It
spells out the duties and responsibilities of budget officers regarding the
preparation and execution of budgets. It also specifies the relations among various
functionaries.
6.Budget Committee
The heads of all important departments are made members of this committee.
It is responsible for preparation and execution of budgets. The members of this
committee may sometimes take collective decisions, if necessary. In small concerns,
the accountant is made responsible for the same work.
7.Budget Period
It is the period for which a budget is prepared. It depends upon a number of
factors. It may be different for different concerns/functions.
The following are the factors that may be taken into consideration while
determining budget period:
a. The type of budget,
b. The nature of demand for the products,
c. The availability of finance,
d. The economic situation of the cycle and
e. The length of trade cycle
8.Determination of Key Factor
Generally, the budgets are prepared for all functional areas of the business.
They are inter related and inter dependent. Therefore, a proper coordination is
necessary. There may be many factors that influence the preparation of a budget.
175
For example, plant capacity, demand position, availability of raw materials, etc.
Some factors may have an impact on other budgets also. A factor which influences
all other budgets is known as Key factor.
The key factor may not remain the same. Therefore, the organization must pay
due attention on the key factor in the preparation and execution of budgets.
14.3.7 ESSENTIALS OF EFFECTIVE BUDGETING
A budgetary control system can prove successful only when certain
conditions and attitudes exist, absence of which will negate to a large extent the
value of a budget system in any business. Such conditions and attitudes which are
essential for effective budgeting are as follows:
Support of Top Management: If the budget system is to be successful, it must
be fully supported by every member of the management and the impetus and
direction must come from the very top management. No control system can be
effective unless the organisation is convinced that the top management considers
the system to be import.
Participation by Responsible Executives: Those entrusted with the
performance of the budgets should participate in the process of setting the budget
figures. This will ensure proper implementation of budget programmes.
Reasonable Goals: The budget figures should be realistic and represent
reasonably attainable goals. The responsible executives should agree that the
budget goals are reasonable and attainable.
Clearly Defined Organisation: In order to derive maximum benefits from the
budget system, well defined responsibility centers should be built up within the
organization. The controllable costs for each responsibility centers should be
separately shown.
Continuous Budget Education: The best way to ensure the active interest of
the responsible supervisors is continuous budget education in respect of objectives,
potentials & techniques of budgeting. This may be accomplished through written
manuals, meetings etc., whereby preparation of budgets, actual results achieved
etc., may be discussed.
Adequate Accounting System: There is close relationship between budgeting
and accounting. For the preparation of budgets, one has to depend on the
accounting department for reliable historical data which primarily forms the basis
for many estimates. The accounting syste m should be so designed so as to set up
accounts in terms of areas of managerial responsibility. In other words,
responsibility accounting is essential for successful budgetary control.
Constant Vigilance: Reports comparing budget and actual results should be
promptly prepared and special attention focused on significant exceptions i.e.
figures that are significantly different from those expected.
Maximum Profit: The ultimate object of realizing the maximum profit should
always be kept uppermost.
176
Cost of the System: The budget system should not cost more than it is worth.
Since it is not practicable to calculate exactly what a budget system is worth, it only
implies a caution against adding expensive refinements unless their value clearly
justifies them.
Integration with Standard Costing System: Where standard costing system
is also used, it should be completely integrated with the budget programme, in
respect of both budget preparation and variance analysis.
14.3.8 STANDARD COSTING VS. BUDGETARY CONTROL
Standard costing and budgetary control have the common objective of cost
control by establishing pre-determined targets. The actual performances are
measured and compared with the pre-determined targets for control purposes. Both
the techniques are of importance in their respective fields and are complementary
to each other.
Points of Similarity:
There are certain basic principles which are common to both standard
costing and budgetary control. These are:
1. The establishment of pre-determined targets of performance
2. The measurement of actual performance
3. The comparison of actual performance with the pre -determined targets.
4. The analysis of variances between the actual and the standard
performance
5. To take corrective measures, where necessary.
Points of Difference:
In spite of so much similarity between standard costing and budgetary
control, there are some important differences between the two, which are as follows:
Standard Costing Budgetary Control
Scope Standard costs are developed Budgets are compiled functions
mainly for the manufacturing of the business such as sales,
function and sometimes also for purchase, production, cash,
making and administration capital expenditure, research &
functions development, etc.,
Intensity Standard costing is intensive in Budgetary control is extensive
application as it calls for in nature and the intensity of
detailed analysis of variances analysis tends to be much less
than that in standard costing.
Relation to In standard costing, variances In budgetary control, variances
accounts are usually revealed through are normally not revealed
accounts through accounts and control is
exercised by statistically putting
budgets and actual side by side.
Usefulness Standard costs represent Budgets usually represent an
realistic yardsticks and, are upper limit on spending without
therefore, more useful for considering the effectiveness of
controlling and reducing costs. the expenditure in terms for
output.
177
Basis Standard cost are usually Budgets may be based on

established after considering previous year’s costs without
such vital matters as any attention being paid to
production capacity, methods efficiency.
employed and other factors
which require attention when
determining an acceptable level
of efficiency.
Projection Standard cost is a projection of Budget is a projection of
financial accounts.
cost accounts

1. 1.Budgetary Control is a planning in advance of the various functions
of a business so that the business as a whole is controlled.
2. Objectives of Budgetary control includes planning, Coordination and
control.
3. Elements of Budgetary Control Includes the establishing of Budgets,
Regular Comparison, Revision of Budgets, and elimination of wastes
4. Installation of Budgetary Control involves certain necessary steps in
an organizations
5. 5.Essentials of Effective Budgetary Control includes support of top
Management, Participation by responsible executives, Responsible
Goals.
1. Define Budgetary Control.
2. What do you mean Budget Centre?
3. Who is a Budget Officer?
4. What do you mean by Budget Manual ?
5. What do you mean by Budget Period?
14.6 SUMMARY
Budgetary Control is a system of controlling costs which includes the
preparation of budgets, coordinating the department and establishing
responsibilities, comprising actual performance with the budgeted and acting upon
results to achieve maximum profitability. An objective of budgetary control includes
planning, Coordination and control. Elements of Budgetary Control Includes the
establishing of Budgets, Regular Comparison, Revision of Budgets, and elimination
of wastes .Installation of Budgetary Control involves certain necessary steps in an
organizations Determination of the Objectives ,Organization for Budgeting ,Budget
Centre ,Budget Officer, Budget Manual ,Budget Committee ,Budget Period
,Determination of Key Factor .Essentials of Effective Budgetary Control includes
support of top Management, Participation by responsible executives, Responsible
Goals.
178

1. The heads of all important departments are made members of this
……………………committee.
2. ……………………………………… document which defines the objectives of
budgetary control system.
3. …………………………….is that part of the organization for which the budget
is prepared.
4. A ……………….. officer is a convener of the budget committee.
1. http://ebooks.narotama.ac.id/
3. http://www.osbornebooksshop.co.uk/
5. http://www.icaiknowledgegateway.org/
14.9 ASSIGNMENTS
1. Discuss the various advantages and essentials for the success of
Budgetary Control.
2. What purpose is served by instituting a budgetary control system in an
organization having both manufacturing and selling activities?
3. Explain how to install the budgetary control system.
1. Pillai.R.S.N, Bagavathi Management Accounting S. Chand & company Ltd.
2. Antony Robert.N And Reece, James.S Management Accounting Principles
Tata McGraw Hill
3. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,
Jaipur)
4. Pandey. I. M. — Management Accounting (S. Chand & Sons.)
Visit any organization which is nearby you and availing permission from the
finance department Observe how the budgetary control system is installed by
considering all important requirements of the Budgets.
14.12 KEYWORDS
Budgetary Control, Planning, Coordination,, Control, Budget Centre, Budget
Officer, Budget Manual, Budget Committee, Intensity, Standard Costing, Budget
Period.
179
LESSON 15
TYPES OF BUDGETS
15.1 INTRODUCTION
The budgets are classified according to their nature. The budge ts may be
classified according to function, flexibility, time. Functional budget is one which
relates to a function of the business. Flexible budget is one which is designed to
change in relation to the level of activity attained. On the basis of time, the budget
can be classified as Long term budget, Short term budget ,Current budget ,Rolling
budget .
15.2 OBJECTIVES
 Classification of Budgets according to Function, Flexibility and Time
 Preparation of different types of Budgets
 Advantages and Disadvantages of Budgetary Control
15.3 CONTENT
15.3.1 Types/Classification of Budget
15.3.2 According to Function
15.3.3 Classification according to Flexibility
15.3.4 Classification according to Time
15.3.5 Advantages of Budgetary Control
15.3.6 Limitations of Budgetary Control
15.3.7 Preparation of Budgets
15.3.1 TYPES/CLASSIFICATION OF BUDGETS
Budget can be classified into three categories from different points of view.
They are:
1. According to Function
2. According to Flexibility
3. According to Time
15.3.2 ACCORDING TO FUNCTION
Sales Budget
The budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget.
Production Budget
It estimates quantity of production in terms of items, periods, areas, etc. It is
prepared on the basis of Sales Budget.
Cost of Production Budget
This budget forecasts the cost of production. Separate budgets may also be
prepared for each element of costs such as direct materials bu dgets, direct labour
budget, factory materials budgets, office overheads budget, selling and distribution
overheads budget, etc.
180
Purchase Budget
This budget forecasts the quantity and value of purchase required for
production. It gives quantity wise, money wise and period wise particulars about
the materials to be purchased.
Personnel Budget
The budget that anticipates the quantity of personnel required during a
period for production activity is known as Personnel Budget
Research Budget
This budget relates to the research work to be done for improvement in
quality of the products or research for new products.
Capital Expenditure Budget
This budget provides a guidance regarding the amount of capital that may
be required for procurement of capital assets during the budget period.
Cash Budget
This budget is a forecast of the cash position by time period for a specific
duration of time. It states the estimated amount of cash receipts and estimation of
cash payments and the likely balance of cash in hand at the end of different
periods.
Master Budget
It is a summary budget incorporating all functional budgets in a capsule
form. It interprets different functional budgets and covers within its range the
preparation of projected income statement and projected balance sheet.
15.3.3 ACCORDING TO FLEXIBILITY
On the basis of flexibility, budgets can be divided into two categories. They are:
1. Fixed Budget 2. Flexible Budget
1.Fixed Budget
Fixed Budget is one which is prepared on the basis of a standard or a fix ed
level of activity. It does not change with the change in the level of activity.
2.Flexible Budget
A budget prepared to give the budgeted cost of any level of activity is termed as
a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a bu dget
designed to change in accordance with level of activity attained’. It is prepared by
taking into account the fixed and variable elements of cost.
15.3.4 ACCORDING TO TIME
On the basis of time, the budget can be classified as follows:
1. Long term budget 2. Short term budget
2. Current budget 4. Rolling budget
1.Long-Term Budget
A budget prepared for considerably long period of time, viz., 5 to 10 years is
called Long-term Budget. It is concerned with the planning of operations of the
firm. It is generally prepared in terms of physical quantities.
181
2.Short-Term Budget
A budget prepared generally for a period not exceeding 5 years is called Short-
term Budget. It is generally prepared in terms of physical quantities and in
monetary units.
3.Current Budget
It is a budget for a very short period, say, a month or a quarter. It is adjusted to
current conditions. Therefore, it is called current budget.
4.Rolling Budget
It is also known as Progressive Budget. Under this method, a budget for a
year in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter which has
rolled down are dropped and the figures for the next month/quarter are added.
This practice continues whenever a month/quarter ends and a new month/quarter
begins.
15.3.5 ADVANTAGES OF BUDGETARY CONTROL
The following are the advantages of budgetary control system.
1.Profit Maximization
The resources are put to best possible use, eliminating wastage. Proper control
is exercised both on revenue and capital expenditure. To achieve this, proper
planning and co-ordination of various functions is undertaken. So, the system
helps in reducing losses and increasing profits.
2.Co-ordination
Co-ordination between the plans, policy and control is established.
The budgets of various departments have a bearing with each other, as
activities are interrelated. As the size of operations increases, co-ordination
amongst the different departments for achieving a common goal assumes more
importance. This is possible through budgetary control system.
As all the personnel in the management team are involved and coordinated,
there is bound to be maximum profits.
Budgetary control system acts as a friend, philosopher and g uide to the
management.
3.Communication
A budget serves as a means of communicating information throughout the
organisation. A sales manager for a district knows what is expected of his
performance. Similarly, production manager knows the amount of material, labour
and other expenses that can be incurred by him to achieve the goal set to him. So,
every department knows the performance expectation and authority for achieving
the same.
4.Tool for Measuring Performance
Budgetary control system provides a tool for measuring the performance of
various departments. The performance of each department is reported to the top
management.
182
The system helps the management to set the goals. The current performance
is compared with the pre-planned performance to ascertain deviations so that
corrective measures are taken, well at the right time.
It helps the management to economise costs and maximise profits.
Economy
Planning at each level brings efficiency and economy in the working of the
business enterprise. Resources are put to optimum use. All this leads to
elimination of wastage and achievement of overall efficiency.
Determining Weaknesses
Actual performance is compared with the planned performance, periodically,
and deviations are found out. This shows the variances highlighting the
weaknesses, where concentration for action is needed.
Consciousness
Budgets are prepared in advance. So, every employee knows what is
expected of him and they are made aware of their responsibility. So, they do their
job uninterrupted for achieving, what is set to him to do.
Timely Corrective Action
The deviations are reported to the attention of the top management as well
as functional heads for suitable corrective action, in time. In the absence of
budgetary control, deviations would be known only at the end of the period. There
is no time and opportunity for necessary corrective action.
Motivation
Success is measured by comparing the actual performance with the planned
performance. Suitable recognition and reward system can be introduced to motivate
the employees, at all levels, provided the budgets are prepared with adequate
planning and foresight.
Management by Exception
The management is required to exercise action only when there are deviations.
So long as the plans are achieved, management need not be alerted. This system
enables the introduction of ‘Management by Exception’ for effective delegation and
control.
Overall Efficiency
Everyone in the management is associated with the preparation of budget.
There is involvement from the top functionaries and each one knows how the target
fixed can be achieved. Budgets once, finally, approved by the Budget Committee, it
represents the collective decision of the organisation. With the implementation of
budgetary control, there would be over all alertness and improved working in all the
departments, with better coordination.
Budgetary Control acts like an impersonal policeman to bring all round
efficiency in performance.
Optimum Utilisation of Resources
As there is effective control over production, the resources of the
organisation would be put to optimum utilisation.
183
15.3.6 LIMITATIONS OF BUDGETARY CONTROL

Budgetary control is a sound technique of control but is not a perfect tool.
Despite many good points, it suffers from the following limitations:
Uncertainty of Future
Budgets are prepared for the future periods. So, budgets are prepared, with
certain assumptions. There is no certainty that all the assumptions prevail in
future. With the change in assumptions, the situation, in future, changes. Due to
this, the utility of budgetary control reduces.
Problem of Co-ordination
The success of budgetary control, largely, depends upon effective co-
ordination. The performance of one department depends on the performance of the
other department. To ensure necessary co-ordination, organisation appoints a
budget officer. All organisations cannot afford the additional expenditure involved
with the appointment of a budget officer, separately. In case, budget officer is not
appointed, lack of co-ordination results in poor performance.
Not a Substitute for Management
Budgetary control helps in decision-making, but is not a su bstitute for
management. A budgetary programme can be successful, if there is proper
administration and supervision.
Discourages Efficiency
Every person is given a target to achieve. So, everyone is concerned only
achieving the target of his own. This is the common tendency. Even capable and
competent people too would concentrate just to achieve their individual targets. So,
budgets may become managerial constraints, unless suitable award or incentive
system is introduced. In the absence of award system to recognise efficiency and
exceptional talents, budgets may dampen the people, with initiative and
enthusiasm.
Timely Revision Required
Budgets are prepared on certain assumptions. When those conditions do not
prevail, it becomes inevitable to revise the budget. Such frequent revision of
budgets reduces reliability and value. Revision of budgets involves additional
expenditure too.
Conflict among Different Departments
For the success of budgetary control, co-ordination of the different departments
is essential. Every department is concerned with the achievement of the individual
department’s goal, not concerned with the final goal of the enterprise. In this
process, each department tries to secure maximum fund allocation and this creates
conflict among the different departments.
Depends upon Support of Top management
The success of budgetary control depends upon the su pport of top
management. If the top management is not enthusiastic for its success, the
budgetary control collapses. So, the wholehearted interest of top management is
highly essential for its implementation, in its true spirit, to make it workable and
succeed.
184
15.3.7 PREPARATION OF BUDGETS

I. Sales Budget
Sales budget is the basis for the preparation of other budgets. It is the
forecast of sales to be achieved in a budget period. The sales manager is directly
responsible for the preparation of this budget. The following factors are taken into
consideration:
a. Past sales figures and trend
b. Salesmen’s estimates
c. Plant capacity
d. General trade position
e. Orders in hand
f. Proposed expansion
g. Seasonal fluctuations
h. Market demand
i. Availability of raw materials and other supplies
j. Financial position
k. Nature of competition
l. Cost of distribution
m. Government controls and regulations
n. Political situation.
Example
1. The Royal Industries has prepared its annual sales forecast, expecting to
achieve sales of 30,00,000 next years. The Controller is uncertain about the pattern
of sales to be expected by month and asks you to prepare a monthly budget of
sales. The following is the sales data pertained to the year, which is considered to
be representative of a normal year:
Month Sales Month Sales
January 110000 July 260000
February 115000 August 330000
March 100000 September 340000
April 140000 October 350000
May 180000 November 200000
June 225000 December 150000
Prepare a monthly sales budget for the coming year on the basis of the above
data.
185
Answer
Sales Budget
Sales estimation
Month Sales(given) based on cash sales ratio given
January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000
February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000
March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000
April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000

May 1,80,000 (1,80,000/25,00,000) x 30,00,000 = 2,16,000
June 2,25,000 (2,25,000/25,00,000) x 30,00,000 = 2,70,000
July 2,60,000 (2,60,000/25,00,000) x 30,00,000 = 3,12,000

August 3,30,000 (3,30,000/25,00,000) x 30,00,000 = 3,96,000
September 3,40,000 (3,40,000/25,00,000) x 30,00,000 = 4,08,000
October 3,50,000 (3,50,000/25,00,000) x 30,00,000 = 4,20,000

November 2,00,000 (2,00,000/25,00,000) x 30,00,000 = 2,40,000
December 1,50,000 (1,50,000/25,00,000) x 30,00,000 = 1,80,000
Total 25,00,000 30,00,000

Note: Sales budget is prepared based on last year’s month-wise sales ratio.
2. M/s. Alpha Manufacturing Company produces two types of products, viz.,

Raja and Rani and sells them in Chennai and Mumbai markets. The following
information is made available for the current year:
Market Product Budgeted Sales Actual Sales
Raja 400 units @ 9 each 500 units @ 9 each
Chennai
Rani 300 units @ 21 each 200 units @ 21 each
Raja 600 units @ 9 each 700 units @ 9 each
Mumbai
Rani 500 units @ 21 each 400 units @ 21 each
Market studies reveal that Raja is popular as it is under priced. It is observed

that if its price is increased by1 it will find a readymade market. On the other hand,
Rani is overpriced and market could absorb more sales if its price is reduced to `
20. The management has agreed to give effect to the above price changes.
186
On the above basis, the following estimates have been prepared by Sales
Manager:
% increase in sales over current budget

Product
Chennai Mumbai
Raja +10% + 5%
Rain + 20% + 10%

With the help of an intensive advertisement campaign, the following additional
sales above the estimated sales of sales manager are possible:
Product Chennai Mumbai
Raja 60 units 70 units
Rani 40 units 50 units
You are required to prepare a budget for sales incorporating the above
estimates.
Answer: Sales Budget
Budget for Budget for

curren t year Actual sales future period
Area Product Units Price Value Units Price Value Units Price Value
Raja 400 9 3600 500 9 4500 500 10 5000
Chennai Rani 300 21 6300 200 21 4200 400 20 8000
Total 700 9900 700 8700 900 13000
Raja 600 9 5400 700 9 6300 700 10 7000
Mumbai Rani 500 21 10500 400 21 8400 600 20 12000
Total 1100 15900 1100 14700 1300 19000
Raja 1000 9 9000 1200 9 10800 1200 10 12000
Rani 800 21 16800 600 21 12600 1000 20 20000
Total
Total
Sales 1800 25800 1800 23400 2200 32000
W orkings
187
1. Budgeted sales for Chennai
All in Units Raja Rani

Budgeted Sales 400 300
Add: Increase (10%) 40 (20%) 60
440 360
Increase due to advertisement 60 40
Total 500 400
2. Budgeted sales for Mumbai
All in Units Raja Rani

Budgeted Sales 600 500
Add: Increase (5%) 30 (10%) 50
630 550
Increase due to advertisement 70 50
Total 700 600
II. Production Budget
The production budget is an estimate of the quantity of goods that must be
produced during the budget period. The aim of the production function will
presumably be to supply finished goods of a specified quality to meet marketing
demands. The sum of sales requirements plus changes in stock levels of finished
goods gives the production requirements for the period being budgeted. In order to
construct the production budget we need the level of sales expected and the desired
levels of stock of finished goods. The following formula is used for calculation of
units to be produced.
Production = Sales + Closing stock – Opening stock
Production budget should be developed keeping in view the optimal balance
between sales, inventories and production so as to result in minimum cost. Once
the production level is determined, it becomes the starting point for the direct
materials, direct labour and manufacturing overhead budgets.
Production = Sales + Closing Stock – Opening Stock
Example
3 The sales of a concern for the next year is estimated at 50,000 units. Each
unit of the product requires 2 units of Material ‘A’ and 3 units of Material ‘B’. The
estimated opening balances at the commencement of the next year are:
Finished Product : 10,000 units
Raw Material ‘A’ : 12,000 units
188
Raw Material ‘B’ : 15,000 units

The desirable closing balances at the end of the next year are:
Finished Product : 14,000 units
Raw Material ‘A’ : 13,000 units
Raw Material ‘B’ : 16,000 units
Prepare the materials purchase budget for the next year.
Answer
Production Budget (All in Units)
Estimated Sales 50,000

Add: Estimated Closing Finished Goods 14,000
64,000
Less: Estimated Opening Finished Goods 10,000
Production 54,000
Materials Purchase Budget
Material ‘A’ Material ‘B’

(all in Units)
Material Consumption 1,08,000 1,62,000
Add: Closing stock of materials 13,000 16,000
1,21,000 1,78,000
Less: Opening stock of materials 12,000 15,000
Materials to be purchased 1,09,000 1,63,000
W orkings
Materials consumption: Material ‘A’ Material ‘B’
Material required per unit of production 2 units 3 units
For production of 54,000 units 1,08,000 1,62,000
III. Cash Budget

It is an estimate of cash receipts and disbursements during a future period of
time. “The Cash Budget is an analysis of flow of cash in a business over a future,
short or long period of time. It is a forecast of expected cash intake and outlay”
(Soleman, Ezra – Handbook of Business administration)
189
Procedure for Preparation of Cash Budget

1. First take into account the opening cash balance, if any, for the beginning
of the period for which the cash budget is to be prepared.
2. Then Cash receipts from various sources are estimated. It may be from
cash sales, cash collections from debtors/bills receivables, dividends,
interest on investments, sale of assets, etc.
3. The Cash payments for various disbursements are also estimated. It may
be for cash purchases, payment to creditors/bills payables, payment to
revenue and capital expenditure, creditors for expenses, etc.
4. The estimated cash receipts are added to the opening cash balance, if any.
5. The estimated cash payments are deducted from the above proceeds.
6. The balance, if any, is the closing cash balance of the month concerned.
7. The closing cash balance is taken as the opening cash balance of the
following month.
8. Then the process is repeatedly performed.
9. If the closing balance of any month is negative i.e the estimated cash
payments exceed estimated cash receipts, then overdraft facility may also
be arranged suitably.
Example:
From the following budgeted figures prepare a Cash Budget in respect of
three months to June 30, 2006.
Month Sales Materials W ages Overheads
January 60,000 40,000 11,000 6,200
February 56,000 48,000 11,600 6,600
March 64,000 50,000 12,000 6,800
April 80,000 56,000 12,400 7,200
May 84,000 62,000 13,000 8,600
June 76,000 50,000 14,000 8,000
Additional Information
1. Expected Cash balance on 1 st April, 2006 – 20,000
2. Materials and overheads are to be paid during the month following the
month of supply.
3. Wages are to be paid during the month in which they are incurred.
190
4. All sales are on credit basis.

5. The terms of credits are payment by the end of the month following the
month of sales: Half of credit sales are paid when due the other half to
be paid within the month following actual sales.
6. 5% sales commission is to be paid within in the month following sales
7. Preference Dividends for30,000 is to be paid on 1 st May.
8. Share calls money of 25,000 is due on 1 st April and 1 st June.
9. Plant and machinery worth10,000 is to be installed in the month of
January and the payment is to be made in the month of June.
Answer:
Cash Budget for three months from April to June, 2006
Particulars April May June

Opening Cash Balance 20,000 32,600 (-) 5,600
Add: Estimated Cash
Receipts:
Sales Collection from debtors 60,000 72,000 82,000
Share call money 25,000 25,000
TOTAL ------- A 1,05,000 1,04,600 1,01,400
Less: Estimated Cash
Payments:
Materials 50,000 56,000 62,000
Wages 12,400 13,000 14,000
Overheads 6,800 7,200 8,600
Sales Commission 3,200 4,000 4,200
Preference Dividend --- 30,000
Plant and Machinery --- --- 10,000
TOTAL ------- B 72,400 1,10,200 98,800
Closing Cash Balance (A-B) 32,600 (-) 5,600 2,600
WORKINGS:
Sales Collection: Payment is due at the month following the sales. Half is paid
on due and other half is paid during the next month. Therefore, February sales `
50,000 is due at the end of March. Half is given at the end of March and other half
is given in the next month i.e., in the month of A pril. Hence, the sales collection for
the month of April will be as follows:
For April – Half of February sales (56,000 x ½)= 28,000 Plus
Half of March Sales (64,000 x ½)= 32,000
Total Collection for April= 60,000
191
Similarly, the sales collection for the months of May and June may be
calculated
1. Materials and Overheads: These are paid in the following month. That is
March is paid in April, April is paid in May and May is paid in June
2. Sales Commission: It is paid in the following month. Therefore
For April – 5% of March Sales (64,000 x 5 /100) = 3,200
For May – 5% of March Sales (80,000 x 5 /100) = 4,000
For April – 5% of March Sales (84,000 x 5 /100) = 4,200
IV. Flexible Budget
A flexible budget consists of a series of budgets for different level of activity.
Therefore, it varies with the level of activity attained. According to CIMA, London, A
Flexible Budget is, ‘a budget designed to change in accordance with level of activity
attained’. It is prepared by taking into account the fixed and variable elements of
cost. This budget is more suitable when the forecasting of demand is uncertain.
Points to be remembered while preparing a flexible budget
1. Cost has to be classified into fixed and variable cost.
2. Total fixed cost remains constant at any level of activity.
3. Total Variable cost varies in the same proportion at which the level of
activity varies.
4. Fixed and variable portion of Semi-variable cost is to be segregated.
Example
5. The following information at 50% capacity is given. Prepare a flexible budget
and forecast the profit or loss at 60% , 70% and 90% capacity.
Expenses at 50% capacity
Particulars
(`000)
Fixed expenses: Rs.
Salaries 5,000
Rent and taxes 4,000
Depreciation 6,000
Administrative expenses 7,000
Variable expenses:
Materials 20,000
Labour 25,000
Others 4,000
Semi-variable expenses:
Repairs 10,000
Indirect Labour 15,000
Others 9,000
192
It is estimated that fixed expenses will remain constant at all capacities. Semi-
variable expenses will not change between 45% and 60% capacity, will rise by 10%
between 60% and 75% capacity, a further increase of 5% when capacity crosses
75% .Estimated sales at various levels of capacity viz.,60% . 70% and 90%
respectively of Rs.1,10,000 1,30,000 and Rs.1,50,000.
Answer
Flexible Budget (Showing Profit & Loss at various capacities)
Capacities
Particulars 50% 60% 70% 90%
Fixed Expenses:
Salaries 5,000 5,000 5,000 5,000
Rent and taxes 4,000 4,000 4,000 4,000
Depreciation 6,000 6,000 6,000 6,000
Administrative expenses 7,000 7,000 7,000 7,000
Variable expenses:
Materials 20,000 24,000 28,000 36,000
Labour 25,000 30,000 35,000 45,000
Others 4,000 4,800 5,600 7,200
Semi-variable expenses:
Repairs 10,000 10,000 11,000 11,500
Indirect Labour 15,000 15,000 16,500 17,250
Others 9,000 9,000 9,900 10,350
Total Cost 1,05,000 1,14,800 1,28,000 1,49,300
Profit (+) or Loss (-) (-) 4,800 (+) 2,000 (+) 700
Estimated Sales 1,10,000 1,30,000 1,50,000
Example
6. The following information relates to a flexible budget at 60% capacity. Find
out the overhead costs at 50% and 70% capacity and also determine the overhead
rates:
Expenses at 60%
Particulars capacity
Variable overheads:
Indirect Labour 10,500
Indirect Materials 8,400
Semi-variable overheads:
Repair and Maintenance(70% fixed; 30% variable) 7,000
193
Electricity(50% fixed; 50% variable) 25,200

Fixed overheads:
Office expenses including salaries 70,000
Insurance 4,000
Depreciation 20,000
Estimated direct labour hours 1,20,000 hours
Answer Flexible Budget
50 % 60% 70%
Capacity Capacity Capacity
Variable overheads:
Indirect Labour 8,750 10,500 12,250
Indirect Materials 7,000 8,400 9,800
Semi-variable overheads:
Repair and Maintenance (1) 6,650 7,000 7,350
Electricity(2) 23,100 25,200 27,300
Fixed overheads:
Office expenses including salaries 70,000 70,000 70,000
Insurance 4,000 4,000 4,000
Depreciation 20,000 20,000 20,000
Total overheads 1,39,500 1,45,100 1,50,700
Estimated direct labour hours 1,00,000 1,20,000 1,50,000
Overhead rate per hour 1.395 1.21 1.077
Workings:
1. The amount of Repairs and maintenance at 60% Capacity is 7,000. Out of
this, 70% (i.e4,900) is fixed and remaining 30% (i.e2,100) is variable. The
fixed portion remains constant at all levels of capacities. Only the variable
portion will change according to change in the level of activity. Therefore,
the total amount of repairs and maintenance for 50% and 70% capacities
are calculated as follows:
Repairs and maintenance 50% 60% 70%

Fixed (70%) 4,900 4,900 4,900
Variable (30%) 1,750 2,100 2,450
Total 6,650 7,000 7,350
194
2. Similarly, electricity expenses at different levels of capacity are calculated as

follows:
Electricity 50% 60% 70%
Fixed (50%) 12,600 12,600 12,600

Variable (50%) 10,500 12,600 14,700
Total 23,100 25,200 27,300

Exercise
1. With the following data for a 60% activity, prepare a budget for production
at 80% and 100% capacity
Production at 60% activity 600 units
Material Rs. 100 per unit
Labour Rs. 40 per unit
Expenses Rs. 10 per unit
Factory Expenses Rs. 40,000 (40% fixed)
Administration Expenses Rs. 30,000 (60% fixed)
{ Ans: Total Variable Cost at 60% Rs.1,68,000 at 70% Rs.2,10,000 and Fixed
cost Rs.34,000}
2. The expenses for the production of 5,000 units in a factory are given as
follows:
Per Unit Rs.
Materials 50
Labour 20
Variable Overhead 15
Fixed Overhead (Rs. 50,000) 10
Administrative Expenses (5% Variable) 10
Selling Expenses (20% fixed) 6
Distribution Expenses (10% fixed) 5
Total Cost of Sales per Unit 116
You are required to prepare a budget for the production of 7,000 units and
9,000 units.
{ Ans: Total Variable Cost for 7,000 Units Rs.6,63,600 for 9,000 units
Rs.8,53,200 and Fixed cost Rs.1,06,000}
Note: 1.
In the problem, expenses per unit are calculated on the production level of
5,000 units. So, administrative expenses were Rs. 10 per unit, when the production
level was 5,000 units. So, total administrative expenses were Rs. 50,000. Out of
195
which, 5% was variable cost (Rs. 0.50 per unit) and balance 95% was fixed cost,
which works out to Rs. 47,500. Fixed costs Rs. 47,500 are constant, whatever be
the level of activity.
Note 2:
Total Selling Expenses are Rs. 30,000. Out of which, 20% were fixed costs,
which works out Rs. 6,000. Balance amount was variable cost Rs. 24,000, which
works out to Rs. 4.80 per unit.
Note 3:
Total Distribution costs were Rs. 25,000. Out of which 10% were fixed costs,
which works out to Rs. 2,500. Balance amount was variable cost Rs. 22,500, which
works out to Rs. 4.50 per unit.
3. Prepare a Production Budget for each month and summarized Production
Budget for the six months period ending 31st Dec., 1989 from the following of
product X.
(i) The units to be sold for different months are as follows:
Jul-89 1,100
August 1,100
September 1,700
October 1,900
November 2,500
Dec-89 2,300
Jan-90 2,200
(ii) There will be no work in progress at the end of any month.

(iii) Finished units equal to half the sales for the next month will be in stock at
the end of each month (including June 1989).
(iv) Budgeted production and production cost for the year ending 31st
December, 1989 are as follows:
Production Units 22,000
Direct Materials Per Unit Rs. 10
Direct Wages Per Unit Rs. 4
Total Factory Overheads Apportioned to Product Rs. 88,000

196
Answer:
July Aug Sep Oct Nov Dec
Opening Stock 550 550 850 950 1250 1150
Closing Stock 550 850 950 1250 1150 1100
Production 1100 1400 1800 2200 2400 2250
4. Following are the budget estimates of a repairs and maintenance

department, which are to be used to construct a flexible budget for the ensuing
year.
Planned at 6,000 Planned at 9,000

Details of Cost Direct Hours Direct Hours
All in Rs.
Employees salaries 28,000 28,000
indirect Repair Material 42,000 63,000
Miscellaneous Cost 16,000 20,500
i. Prepare a flexible budget for the department up to activity level of
10,000 direct repair hours using increment of 1,000 hours.
ii. What would be the budget allowance for 9,500 direct repair hours?
Ans: Note 1: Indirect Repair Material is a Variable Overhead, so absorbed @ of
Rs.7 per Direct Hours
Note 2: Miscellaneous cost is a semi -variable cost, containing fixed cost and
variable cost components. Fixed cost is Rs. 16,000. Balance amount Rs. 4,500
(20,500 – 16,000) is variable cost component, which works out to Rs. 1.50 per hour
(4,500/3,000).
Note 3: At 9,500 hours, for the incremental increase of 500 hours, the cost
increases by Rs. 4,250 due to the following:
Variable Cost
Indirect Repair Material (@ Rs. 7 per hour) = 500 × 7 = 3,500
Semi-fixed cost miscellaneous cost
(@ Rs. 1.50 per hour Variable cost component) = 500 × 1.50 = 750
Total incremental cost= 4,250
Direct Hours 6000 7000 8000 9000 9500 10000
Total cost 86000 94500 103000 111500 115750 120000
5. Prepare a Cash-Budget of a company for April, May and June 2015 in a

columnar form using the following information:
197
(All in Rs.)
Month, 2015 Sales Purchases Wages Expenses
January (Actual) 80,000 45,000 20,000 5,000
February (Actual) 80,000 40,000 18,000 6,000
March (Actual) 75,000 42,000 22,000 6,000
April (Budgeted) 90,000 50,000 24,000 7,000
May (Budgeted) 85,000 45,000 20,000 8,000
June (Budgeted) 80,000 35,000 18,000 6,000
You are further informed that:
a. 10% of the purchases and 20% of the sales are for cash;
b. The average collection period of the company ½ month and the credit
purchases are paid off regularly after one month;
c. Wages are paid half monthly, and the rent of Rs. 500 included in
expenses is paid monthly;
d. Cash and Bank Balance as on A pril, was Rs. 15,000 and the company
wants to keep it at the end of every month approximately this figure, the
excess cash being put in fixed deposits in the bank.
6. From the following forecast of income and expenditure, prepare a cash
budget for the months January to April 2016.
(All in Rs.)
Months Sales Purchases Wages Manufacturing Administrative Selling
(Credit) (Credit) Expenses Expenses Expenses
2015, 30,000 15,000 3,000 1,150 1,060 500
Nov
2015, 35,000 20,000 3,200 1,225 1,040 550
Dec
2016, 25,000 15,000 2,500 990 1,100 600
Jan
Feb 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570
April 40,000 25,000 2,600 1,200 1,180 710
Additional information is as follows:
1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant ‘purchased on 15th January for
Rs. 5,000, a Building has been purchased on 1st March and the payments
are to be made in monthly instalments of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st on the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 2016 is Rs. 15,000
198
Other Exercise for practice

1. M.K. Exports Ltd. wishes to arrange overdraft facilities with its bankers
during the period April-June 2006 when it will be manufacturing mostly
for stocks. Prepare a cash budget for this period from the following data,
indicating the extent of the bank facilities the company will require at the
end of each month.
Period (2006) Sales (Rs.) Purchases (Rs.) W ages (Rs.)
February 180000 124000 12000
March 192000 144000 14000
April 108000 243000 11000
May 174000 246060 10000
June 126000 268000 15000
50% of the sales are realised in the following the sales and the remaining 50%
in the second month following. Creditors are paid in the month following the month
of purchase. Cash at bank on 1 st April 2006 is Rs.25000.
2. Prepare a flexible budget for production at 80% and 100% activity on the
basis of the following information:
Production at 50% capacity 5000 Units
Raw Materials Rs.80 per unit
Direct Labour Rs.50 per unit
Direct Expenses Rs.15 per unit
Factory Expenses Rs.50000 (50% fixed)
Administration Expenses Rs.60000 (60% variable)
3. Draw up a flexible budget for overhead expenses on the basis of the following
data and determine the overhead rates at 70% , 80% and 90% plant capacity.
At 80% Capacity
Rs. Variable Overheads:
Indirect labour 12,000
Stores including spares 4,000
Semi-variable Overheads:
Power (30% fixed, 70% variable) 20,000
Repairs and maintenance (60% fixed, 40% Variable) 2,000
Fixed Variable:
Depreciation 11,000
Insurance 3,000
Salaries 10,000
Total Overheads 62,000
Estimated direct labour hours 1,24,000 hrs.
199
4. The expenses budgeted for production of 10000 units in a factory are

furnished below:
Rs. per Unit
Material 70
Labour 25
Variable Overheads 20
Fixed overheads (Rs.100000) 10
Variable expenses (direct) 5
Selling expenses (10% direct) 13
Distribution expenses (20% fixed) 7
Administration Expenses (Rs.50000) 5
Total 155
Prepare a budget for the purpose of (a)8000 units and (b)6000 units.
Assume that administration expenses are rigid for all levels of production.
5. From the following data, prepare a flexible budget for production of 40000
units and 75000 units, distinctly showing variable cost and fixed cost as
well as total cost. Also indicate element-wise cost per unit. Budgeted
output is 100000 units and budgeted cost per unit is as follows:
Rs.
Direct Material 95
Direct Labour 50
Production overhead (variable) 40
Production overhead (fixed) 5
Administration overhead (fixed) 5
Selling overhead (10% fixed) 10
Distribution overhead (20% fixed) 15
6. Z limited has prepared the budget for the production of 100000 units from
a costing period as under:
Per Unit (Rs.)
Raw Materials 10.08

Direct Labour 3.00
Direct Expenses 0.40
Works overhead (60% fixed) 10.00
Administration overhead (80% fixed) 1.60
Sales overhead (50% fixed) 0.80
200
Actual production in the period was only 60000 units. Prepare budgets for the
original and revised levels of output.
7. A department of AXY company attains sales of Rs.600000 at 80% of its
normal capacity. Its expenses are given below:
Rs.
Office salaries 90,000

General expenses 2% of sales
Depreciation 7,500
Rent and rates 8,750
Selling Costs:
Salaries 8% of sales
Travelling expenses 2% of sales
Sales office 1% of sales
General expenses 1% of sales
Distribution Costs:
Wages 15,000
Rent 1% of sales
Other expenses 4% of sales
Draw up Flexible Administration, Selling and Distribution Costs Budget,
operating at 90% , 100% & 110% of normal capacity.
8. A company is expecting to have Rs.25000 cash in hand on 1 st April 2006
and it requires you to prepare cash budget for the three months. A pril to
June 2006. The following information is supplied to you.
Period Sales (Rs.) Purchases (Rs.) W ages (Rs.) Expenses (Rs.)
(2006)
February 70000 40000 8000 6000
March 80000 50000 8000 7000
April 92000 52000 9000 7000
May 100000 60000 10000 8000
June 120000 55000 12000 9000
Other Information:
a. Period of credit allowed by suppliers is two months:
b. 25% of sale is for cash and the period of credit allowed to customers for
credit sale is one month;
c. Delay in payment of wages and expenses one month
d. Income tax Rs.25000 is to be paid din June 2006.
201
9. The following data relate to bookshop Ltd: The financial manager has made
the following sales forecasts for the first five months of the coming year,
commencing from 1 st April, 2006:
Month Sales (Rs.)
April 40,000
May 45,000
June 55,000
July 60,000
August 50,000
Other data:
i. Debtor’s and Creditor’s balance at the beginning of the year are
Rs.30000 & Rs.14000 respectively. The balance of other relevant assets
and liabilities are:
Cash Balance Rs. 7,500; StockRs.51,000; Accrued Sales Commission
Rs. 3,500
ii. 40% sales are on cash basis. Credit sales are collected in the month
following the sale .
iii. Cost of sales is 60% on sales
iv. The only other variable cost is a 5% commission to sales agents. The
Sales commission is paid in a month after it is earned.
v. Inventory(stock) is kept equal to sales requirements for the next two
months budgeted sales.
vi. Trade creditors are paid in the following month after purchases.
vii. Fixed costs are Rs.5000 per month including Rs.2000 depreciation.
You are required to prepare a Cash Budget for the months of April, May and
June,2006 respectively.
10. Prepare a Clash Budget for the three months ending 30 th June 2006 from the
information given below:
Period Sales Materials Wages Overheads
(2006) (Rs.) (Rs.) (Rs.) (Rs.)
February 14000 9600 3000 1700
March 15000 9000 3000 1900
April 16000 9200 3200 2000
May 17000 10000 3600 2200
June 18000 10400 4000 2300
202
(b). Credit terms are: sales and debtors – 10% sales are on cash, 50% of the
credit sales are collected next month and the balance in the following month.
Creditors – Materials 2 Months
Wages ¼ month
Overheads ½ month
(c). Cash and bank on 1 st April, 2006 is expected to be Rs.6000
(d). Other relevant information are:
i. Plant and machinery will be installed in February 2006 at a cost of
Rs.96000. The monthly instalment of Rs.2000 is payable from April
onwards.
ii. Dividend @ 5% on Preference Share capital of Rs.200000 will be paid on
1st June.
iii. Advance to be received for sale of vehicles Rs.9000 in June.
iv. Dividends from investments amounting to Rs.1000 are expected to be
received in June.
v. Income tax (advance) to be paid in June is Rs.2000
11. The following information relates to Rs. ‘000
Month W ages Materials Overhead Sales

incurred Purchased
February 6 20 10 30
March 8 30 12 40
April 10 25 16 60
May 9 35 14 50
June 12 30 18 70
July 10 25 16 60
August 9 25 14 50
September 9 30 14 50
1. It is expected that cash balance on 31 st May will be Rs.22000
2. The wages may be assumed to be paid within the month they are
incurred
3. It is the company’s policy to pay creditors for materials three months
after receipt.
4. Debtors are expected to pay creditors for materials three months after
receipt
5. Included in the overhead figure is Rs.2000 per month which represen ts
depreciation on two cars and one delivery van.
6. There is a one month delay in paying the overhead expenses.
203
7. 10% of the monthly sales are for cash and 90% are sold on credit.
8. A commission of 5% is paid to agents on all the sales on credit but, this
is not paid until the month following the sales to which it relates; this
expense is not included in the overhead figure shown.
9. It is intended to repay a loan of Rs.25000 on 30 th June.
10. Delivery is expected in July of a new maching costing Rs.45000 of which
Rs.15000 will be paid on delivery and Rs.15000 in each of the following
months.
11. Assume that overdraft facilities are available, if required.
You are required to prepare a cash budget for the three months of June, July
and August.
12. With the following data at 60% activity, prepare a budget at 80% and 100%
activity.
Production at 60% capacity 600units
Materials Rs.120 per unit
Labour Rs.50 per unit
Expenses Rs.20 per unit
Factory Expenses Rs.60000 (40% fixed)
Administration Expenses Rs.40000 (60% fixed)
13. For production of 10000 Electrical Irons, the following are budgeted expenses:
Per Unit Rs.
Direct materials 60
Direct labour 30
Variable overhead 25
Fixed overhead (Rs.150000) 15
Variable expenses (direct) 5
Selling expenses (10% fixed) 15
Administration expenses (Rs.50000 rigid of all levels of production) 5
Distribution expenses (20% fixed) 5
Total cost of sales per unit 160
Prepare a budget for production of 6000, 7000 & 8000 irons, showing distinctly
marginal cost and total cost.
204
14. A company produces a standard product. The estimated costs per unit are as
follows:
Raw materials Rs.4; Wages Rs.2; Variable overhead Rs.5
The semi-variable costs are:
Indirect materials Rs.235; Indirect labour Rs.156; Repairs Rs.570
The variable costs per unit included in semi -variable are:
Indirect materials Re.0.05; Labour Re.0.08 and Repai e.0.10.
The fixed costs are Factory Rs.2000; Administration Rs.3000; Selling Rs.2500.
The above cost are 70% of normal capacity production i.e. 700units. The selling
price is Rs.30 per unit. Prepare Flexible Budget for 80% and 100% normal
capacities from the above information.
15. The following data are available in a manufacturing company for a yearly
period:
Fixed Expenses:
Rs. Lakhs
Wages & salaries 9.5
Rent, rates & taxes 6.6
Depreciation 7.4
Sundry administration expenses 6.5
Semi-variable expenses (At 50% of capacity):

Maintenance and repairs 3.5
Indirect labour 7.9
Sales department salaries, etc 3.8
Sundry administration salaries 2.8
Variable expenses (At 50% of capacity):
Materials 21.7
Labour 20.4
Other expenses 7.9
Total Cost 98.0
Assume that the fixed expenses remain constant for all levels of production;
semi-variable expenses remain constant between 45% and 65% of capacity,
increasing by 10% between 65% and 80% capacity and by 20% between 80% and
100% capacity.
205
Sales at various level are:

50% capacity Rs. Lakhs 100 75% capacity Rs. Lakhs 150
60% capacity Rs. Lakhs 120 90% capacity Rs. Lakhs 180
100% capacity Rs. Lakhs 200
Prepare a flexible budget for the year and forecast the profit at 60% , 75% ,
90% and 100% of capacity.
16. A company expects to have Rs.37500 cash in hand on 1 st April, and requires
you to prepare an estimate of cash position during the three months, April, May &
June. The following information is supplied to you:
Sales Purchases W ages Factory Office Selling
(Rs.) (Rs.) (Rs.) expenses expenses expenses
(Rs.) (Rs.) (Rs.)
February 75000 45000 9000 7500 6000 4500
March 84000 48000 9750 8250 6000 4500
April 90000 52000 10500 9000 6000 5250
May 120000 60000 13500 11250 6000 6570
June 135000 60000 14250 14000 7000 7000
Other Information:
1. Period of credit allowed by suppliers – 2 months
2. 20% of sales is for cash and period of credit allowed to customers for
credit is one month.
3. Delay in payment of all expenses – 1 month
4. Income tax of Rs.57500 is due to be paid on June 15 th.
5. The company is to pay dividends to shareholders and bonus to workers
of Rs.15000 and Rs.22500 respectively in the month of April.
6. Plant has been ordered to be received and paid in May. It will cost
Rs.120000.
1. Sales Budget The budget which estimates total sales in terms of items,
quantity, value, periods, areas, etc is called Sales Budget.
2. Production Budget It estimates quantity of production in terms of
items, periods, areas, etc. It is prepared on the basis of Sales Budget.
3. Cost of Production Budget This budget forecasts the cost of
production
4. Purchase Budget This budget forecasts the quantity and value of
purchase required for production.
5. Personnel Budget The budget that anticipates the quantity of
personnel required during a period for production activity is known as
Personnel Budget
206
6. Research Budget This budget relates to the research work to be

done for improvement in quality of the products or research for new
products.
7. Capital Expenditure Budget This budget provides a guidance
regarding the amount of capital that may be required for procurement of
capital assets during the budget period.
8. Cash Budget This budget is a forecast of the cash position by time
period for a specific duration of time..
9. Master Budget It is a summary budget incorporating all functional
budgets in a capsule form.
10. Fixed Budget Fixed Budget is one which is prepared on the basis of a
standard or a fixed level of activity.
11. Flexible Budget A budget prepared to give the budgeted cost of any
level of activity is termed as a flexible budget.
12. Long-Term Budget A budget prepared for considerably long period of
time, viz., 5 to 10 years is called Long-term Budget.
13. 13.Short-Term Budget A budget prepared generally for a period not
exceeding 5 years is called Short-term Budget.
14. Current BudgetIt is a budget for a very short period, say, a month or a
quarter. It is adjusted to current conditions.
15. Rolling Budget. Under this method, a budget for a year in advance is
prepared.
15.6 SUMMARY
Sales Budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget. Production Budget estimates quantity of
production in terms of items, periods, areas, etc. It is prepared on the basis of Sales
Budget.
Cost of Production Budget forecasts the cost of production. Separate budgets
may also be prepared for each element of costs such as direct materials budgets,
direct labour budget, factory materials budgets, office overheads budget, selling and
distribution overheads budget, etc.
Purchase Budget forecasts the quantity and value of purchase required for
production. It gives quantity wise, money wise and period wise particulars about
the materials to be purchased.
Personnel Budget that anticipates the quantity of personnel required during a
period for production activity is known as Personnel Budget. Research Budget
relates to the research work to be done for improvement in quality of the products
or research for new products. Capital Expenditure Budget provides a guidance
regarding the amount of capital that may be required for procurement of capital
assets during the budget period. Cash Budget is a forecast of the cash position by
207
time period for a specific duration of time. It states the estimated amount of cash
receipts and estimation of cash payments and the likely balance of cash in hand at
the end of different periods. Master Budget is a summary budget incorporating all
functional budgets in a capsule form. It interprets different functional budgets and
covers within its range the preparation of projected income statement and projected
balance sheet. Fixed Budget is one which is prepared on the basis of a standard or
a fixed level of activity. It does not change with the chan ge in the level of activity.
Flexible Budget is prepared to give the budgeted cost of any level of activity is
termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a
budget designed to change in accordance with level of activity attained’. It is
prepared by taking into account the fixed and variable elements of cost. Long-Term
Budget is prepared for considerably long period of time, viz., 5 to 10 years is
called Long-term Budget. It is concerned with the planning of operations of the
firm. It is generally prepared in terms of physical quantities. Short-Term Budget is
prepared generally for a period not exceeding 5 years is called Short-term Budget. It
is generally prepared in terms of physical quantities and in monetary units.
Current Budget is a budget for a very short period, say, a month or a
quarter. It is adjusted to current conditions. Therefore, it is called current budget.
Rolling Budget is also known as Progressive Budget. Under this method, a budget
for a year in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter which has
rolled down are dropped and the figures for the next month/quarter are added.
This practice continues whenever a month/quarter ends and a new month /
quarter begins.
1. What do you mean by cash Budget?
2. What do you mean by flexible Budget?
3. What do You mean by Performance Budget?
4. What do you mean by capital Expenditure Budget?
5. What do you mean Rolling Budget?
1. ……………………. prepared to give the budgeted cost of any level of
activity is termed as a flexible budget.
2. The budget which estimates total sales in terms of items, quantity,
value, periods, areas, etc is called ……………………………..
3. The budget that anticipates the quantity of personnel required during a
period for production activity is known …………………………….
4. .………………………………., a budget for a year in advance is prepared.
5. …………………..budget relates to the research work to be done for
improvement in quality of the products or research for new products
208

1. https://ocw.mit.edu
2. http://kesdee.com/
3. http://simplestudies.com/
4. http://repository.um.edu.my/
5. http://www.cimaglobal.com/
15.9 ASSIGNMENTS
1. 1.Explain the points to be taken care while preparing the Flexible Budget.
2. Enumerate the importance of research Budgets
3. Highlight the advantages of cash budgets which is prepared by a seasonal
manufacturing company.
4. Throw a light on production Budget
Jaipur)
3. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and
Management Accounting ( Malik and Co.)
Visit the different ty pes of Manufacturing company and take a note on how
they are preparing the different types of budgets.
15.12 KEYWORDS
Sales Budget, Production Budget, Cost of Production Budget, Purchase
Budget, Personnel Budget, Research Budget, Capital Expenditure Budget, Cash
Budget, Master Budget, Fixed Budget, Flexible Budgets, Long term Budget, Short
Term Budget, Current Budget, Rolling Budget.
209
LESSON 16
ZERO BASE BUDGETING & MASTER BUDGET
16.1 INTRODUCTION
Zero Base Budgeting is a new management technique aimed at cost reduction
and optimum utilization of resources. This technique was introduced by the U.s
Department of Agriculture in 1961. Petewr. A. Phyrr designed its basic frame work
in 1970 and popularized its wider use in the private sector. In 1979, President
Jimmy Carter issued a mandate asking for the use of ZBB throughout the federal
Government agencies for controlling state expenditure. The technique Become quite
popular in the U.S. A master Budget is the summary budget for the entire
enterprise and embodies the summarized figures for various activities. This budget
is known as summary budget or finalized profit plan. This budget includes the
budgeted position of the profit and loss as well as balance sheet. Master budget is
prepared by committee and becomes target for the compan y.
16.2 OBJECTIVES
 Importance of ZBB
 Advantages and Disadvantages of ZBB
 Objectives of Performance Budgeting
 Master Budget and its Importance
16.3 CONTENT
16.3.1 Zero Base
16.3.2 ZBB- Definition
16.3.3 Advantages of ZBB
16.3.4 Limitations of ZBB
16.3.5 Performance Budgeting
16.3.6 Objectives of Performance Budgeting
16.3.7 Master Budget
16.3.1 ZERO BASE BUDGETING (ZBB)
ZBB is starting from scratch. Every year is taken as a new year and previous
year is not taken as the base, in the preparation of budgets. Rather zero is taken as
the base . Something will not be allowed simply because it was allowed in the past.
ZBB proceeds on the assumption that nothing is to be allowed. A manager has to
justify why he wants to spend. The manager proposing an expenditure or activity
has to prove that it is essential and the amounts asked for are reasonable.
16.3.2 ZBB - DEFINITION
“It is a planning and budgeting process which requires each manager to justify
his entire budget request in detail from scratch (Zero Base) and shifts the burden of
proof to each manager to justify why he should spend money at all.
210
The approach requires that all activities be analyzed in decision packages,

which are evaluated by systematic analysis and ranked in the order of importance”.
– Peter A. Phyrr.
It implies that-
 Every budget starts with a zero base
 No previous figure is to be taken as a base for adjustments
 Every activity is to be carefully examined afresh
 Each budget allocation is to be justified on the basis of anticipated
circumstances
 Alternatives are to be given due consideration
16.3.3 ADVANTAGES OF ZBB
1. Effective cost control can be achieved
2. Facilitates careful planning
3. Management by Objectives becomes a reality
4. Identifies uneconomical activities
5. Controls inefficiencies
6. Scarce resources are used judiciously
7. Examines each activity thoroughly
8. Controls wasteful expenditure
9. Integrates the management functions of planning and control
10. Reviews activities before allowing funds for them.
16.3.4 LIMITATIONS OF ZERO BASE BUDGETING
The following are the important limitations of zero base budgeting :
1. It is very time consuming and a large amount of additional paper work is
involved.
2. It expects a high degree managerial skill because it demands a clear
understanding by the organization as a system.
3. Its application is limited ; it cannot directly be applied to direct
materials, direct labour and overheads associated with production
function.
16.3.5 PERFORMANCE BUDGETING
It involves evaluation of the performance of the organization in the context of
both specific as well as overall objectives of the organization. It provides a definite
direction to each employee and a control mechanism to top management.
Definition
Performance Budgeting technique is the process of analyzing, identifying,
simplifying and crystallizing specific performance objectives of a job to be achieved
over a period of the job. The technique is characterized by its specific direction
towards the business objectives of the organization. – The National Institute of
Bank Management.
211
The responsibility for preparing the performance budget of each department

lies on the respective departmental head. It requires preparation of performance
reports. This report compares budget and actual data and shows any existing
variances. To facilitate the preparation, the departmental head is supplied with the
copy of the master budget appropriate to his function.
16.3.6 OBJECTIVES OF PERFORMANCE BUDGETING
The following are the main objectives of performance budgeting.
1. To establish the correlation between physical and financial aspects of
each activity and programme.
2. To evaluate the progress against both the short term and long term
objectives.
3. To facilitate performance auditing and to make it more effective.
4. To improve the budget formulation at various levels of management
5. To improve the review, decision making and control at all levels of
management.
16.3.7 MASTER BUDGET
Master budget is a comprehensive plan which is prepared from and
summarizes the functional budgets. The master budget embraces both operating
decisions and financial decisions. When all budgets are ready, they can finally
produce budgeted profit and loss account or income statement and budgeted
balance sheet. Such results can be projected monthly, quarterly, half-yearly and at
year end. When the budgeted profit falls short of target it may be reviewed and all
budgets may be reworked to reach the target or to achieve a revised target approved
by the budget committee.
1. Zero Base Budgeting The approach requires that all activities be analyzed
in decision packages, which are evaluated by systematic analysis and
ranked in the order of importance”.
2. Master Budget is the summary Budget incorporating the functional
Budgets which is finally approved, adopted and employed.
3. Performance Budgeting technique is the process of analyzing, identifying,
simplifying and crystallizing specific performance objectives of a job to be
achieved over a period of the job.
1. Define ZBB
2. Define Master Budget
3. Define performance Budget
16.6 SUMMARY
ZBB is a planning and budgeting process which requires each manger to
justify his entire budget request in detail from scratch and shifts the bu rden of
212
proof to each manager to justify why he should spend money at all. The approach
requires that all activities be analyzed in decision packages which are evaluated by
systematic analysis and ranked in the order of importance. A master Budget is the
summary budget for the entire enterprise and embodies the summarized figures for
various activities. This budget is known as summary budget or finalized profit plan.
This budget includes the budgeted position of the profit and loss as well as balance
sheet. Master budget is prepared by committee and becomes target for the
company.
1. …………………………………………… is a comprehensive plan which is
prepared from and summarizes the functional budgets
2. …………………………………….technique is the process of analyzing,
identifying, simplifying and crystallizing specific performance objectives of a
job to be achieved over a period of the job.
3. …………………………………… is a new management technique aimed at cost
reduction and optimum utilization of resources.
1. http://study.com/
2. https://www.efinancemanagement.com
3. http://www.investopedia.com/
4. http://www.bbamantra.com/
5. http://www.accountingtools.com/
6. http://www.csus.edu/
7. http://site.iugaza.edu.ps/
16.9 ASSIGNMENTS
1. Enumerate the importance of ZBB in the present context.
2. Highlight the importance of master Budget in the present scenario.
1. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)
2. Khan, Jain — Management Accounting (S. Chand & Sons.)
Management Accounting ( Malik and Co.)
You can made attempt to identify which company is following the ZBB
system and know the reason for it.
16.12 KEYWORDS
Zero Base Budgeting, Performance Budgeting, Master Budget.
213
LESSON 17
IMPORTANCE OF CAPITAL BUDGETING
17.1 INTRODUCTION
Capital budgeting decisions are of paramount importance in financial
decisions, because efficient allocation of capital resources is one of the most crucial
decisions of financial management. Capital budgeting is budgeting for capital
projects. It is significant because it deals with right kind of evaluation of projects.
The exercise involves ascertaining / estimating cash inflows and outflows, matching
the cash inflows with the outflows appropriately and evaluation of desirability of the
project. It is a managerial technique of meeting capital expenditure with the overall
objectives of the firm. Capital budgeting means planning for capital assets. It is a
complex process as it involves decisions relating to the investment of current funds
for the benefit to be achieved in future. The overall objective of capital budgeting is
to maximize the profitability of the firm / the return on inve stment.
Capital Budgeting is the process of making investment decision in Fixed assets
or Capital expenditure. Capital Budgeting is also known as Investment decision
making, planning of capital acquisition, planning of capital expenditure, analysis of
capital expenditure.
17.2 OBJECTIVES
 Meaning of Capital Budgeting
 Need and importance of Capital Budgeting
17.3 CONTENT
17.3.1 Capital Expenditure
17.3.2 Capital Budgeting Definition
17.3.3 Need and Importance of Capital Budgeting
17.3.1 CAPITAL EXPENDITURE
A capital expenditure is an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a number of
years in future. The following are some of the examples of capital expenditure.
1. Cost of acquisition of permanent assets such as land & buildings, plant
& machinery, goodwill etc.
2. Cost of addition, expansion, improvement or alteration in the fixed
assets.
3. Cost of replacement of permanent assets.
4. Research and development project cost etc.
5. Capital expenditure involves non-flexible long term commitment of
funds.
17.3.2 CAPITAL BUDGETING – DEFINITION
“Capital budgeting” has been formally defined as follows.
“Capital budgeting is long-term planning for making and financing
proposed capital outlay”. - Charles T. Horngreen
214
“The capital budgeting generally refers to acquiring inputs with long-term

returns”. - Richards & Greenlaw.
“Capital budgeting is concerned with the allocation of the firms’ source
financial resources among the available opportunities. The consideration of
investment opportunities involves the comparison of the expected future streams of
earnings from a project with the immediate and subsequent streams of earning
from a project, with the immediate and subsequent streams of expenditure” - G.C.
Philippatos,
“Capital budgeting consists in planning development of available capital for the
purpose of maximizing the long-term profitability of the concern” - Lyrich
“Capital budgeting involves the planning of expenditure for assets, the
returns from which will be realized in future time periods”. Milton H. Spencer
It is clearly explained in the above definitions that a firm’s scarce financial
resources are utilizing the available opportunities. The overall objective of the
company from is to maximize the profits and minimize the expenditure of cost.
Further, the long-term activities are those activities that influence firms operation
beyond the one year period. The basic features of capital budgeting decisions are:
 There is an investment in long term activities
 Current funds are exchanged for future benefits
 The future benefits will be available to the firm over series of years.
 The Investment of Funds in long term activities which are usually non-
flexible.
 Each project involves huge amount of funds
Objective :
1. To find out the profitable capital expenditure.
2. Ensure efficient control over large investment and expenditures.
3. To find out the quantum of finance required for to capital expenditure.
4. To facilitate long – range planning.
5. To evaluate the merits of each proposal to decide which project is best.
17.3.3 NEED AND IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the goal of the firm. There are many factors
responsible for determining the need for capital investment like Expansion,
Diversification, Obsolescence, Wear and tear of old equipment, Productivi ty
improvement, Replacement and modernization and so on.
When the investments are profitable the firm’s value will increase and they
add to the shareholders’ wealth. The investment will add to the shareholders’
wealth if it yields benefits, in excess of the minimum benefits as per the opportunity
cost of capital.
The need and importance of capital budgeting has been explained as follows:
1. Long-term Implication
Capital expenditure decision affects the company's future cost structure over a
long time span. The investment in fixed assets increases the fixed cost of the firm
215
which must be recovered from the benefit of the same project. If the investment
turns out to be unsuccessful in future or give less profit than expected, the
company will have to bear the extra burden of fixed cost. Such risk can be
minimized through the systematic analysis of projects which is the integral part of
investment decision.
2. Irreversible Decision
Capital investment decision are not easily reversible without much financial
loss to the firm because there may be no market for second-hand plant and
equipment and their conversion to other uses may not be financially viable. Hence,
capital investment decisions are to be carried out and performed carefully and
effectively in order to save the company from such financial loss. The investment
decision which is undertaken carefully and effectively can save the firm from huge
financial loss aroused due to the selection of unfavorable projects.
3. Long-term Commitments of Funds
Capital budgeting decision involves the funds for the long-term. So, it is long-
term investment decision. The long-term commitment of funds leads to the financial
risk. Hence, careful and effective planning is must to reduce the financial risk as
much as possible.
The significance of capital budgeting can also analyzed with the help of
following points.
 Capital budgeting involves capital rationing. This is the available funds that
have to be allocated to competing projects in order of project potential.
Normally the individuality of project poses the problem of capital rationing
due to the fact that required funds and available funds may not be the same.
 Capital budget becomes a control device when it is employed to control
expenditure. Because manned outlays are limits to actual expenditure, the
concern has to investigate the variation in order to keep expenditure under
control.
 A firm contemplating a major capital expenditure programme may need to
arrange funds many years in advance to be sure of having the fun ds when
required.
 Capital budgeting provides useful tool with the help of which the
management can reach prudent investment decision.
 Capital budgeting is significant because it deals with right mind of
evaluation of projects. A good project must not be rejected and a bad project
must not be selected. Capital projects need to be thoroughly evaluated as to
costs and benefits.
 Capital projects involve investment in physical assets such as land, building
plant, machinery etc. for manufacturing a product as against financial
investments which involve investment in financial assets like shares, bonds
or mutual funds. The benefits from the projects last for few to many years.
 Capital projects involve huge outlay and last for years.
216
 Capital budgeting thus involves the making of decisions to earmark funds

for investment in long term assets yielding considerable benefits in future,
based on a careful evaluation of the prospective profitability / utility of such
proposed new investment.
It is clear from the above discussion what capital investment proposals involve
a. Longer gestation period
b. Substantial capital outlay
c. Technological considerations
d. Irreversible decisions
e. Environmental issues
f. Independent proposals
g. Mutually exclusory proposals
4. Permanent Commitments of Funds
The investment made in the project Results in the permanent commitment of
Funds. The greater risk is also involved because of permanent commitment of
Funds.
5. National Importance
The selection of any project results in the employment opportun ity, economic
growth and increase per capital income. These are the ordinary positive impact of
any project selection made by any company.
1.Capital Expenditure A capital expenditure is an expenditure incurred for
acquiring or improving the fixed assets, the .benefits of which are expected to be
received over a number of years in future.
2. Capital Budgeting Capital budgeting involves the planning of expenditure
for assets, the returns from which will be realized in future time periods
3. The need and importance of capital budgeting has been explained as
Long-term Implication Irreversible Decision .Long-term Co mmitments of Funds,
Permanent Commitments of Funds, National Importance.
1.Define capital Budgeting
2.Define Irreversible Decision
3.What do you mean by Long term implication?
17.6 SUMMARY
Capital Budgeting is the process of making investment decision in capital
expenditures. A capital Expenditure is an expenditure incurred for acquiring or
improving the fixed assets, the benefits of which are expected to be received over a
number of years in future. Capital expenditure involves non flexible long term
commitment of funds. Capital Budgeting is also known as long term investment
decision. Capital Budgeting decisions are among the most crucial and critical
business decisions. Special care to be taken in making these decisions on account
217
of the following reasons; heavy investment, permanent commitment of funds, long

term effect on profitability, irreversible in nature .
1. …………………………..is the process of making investment decisions in
capital expenditures.
2. ………………………..is an expenditure incurred for acquiring or improving
the fixed assets, the benefits of which are expected over a number of years
in future.
1. http://www2.fiu.edu/
3. https://msu.edu
4. http://people.hss.caltech.edu/
6. http://umanitoba.ca/
7. http://isites.harvard.edu/
8. wps.prenhall.com/wps
9. https://www.cfainstitute.org
10. www.cengage.com
11. www.hss.caltech.edu
17.9 ASSIGNMENTS
1. Examine the need and importance of Capital Budgeting.
2. Highlight the basic features of capital Budgeting Decisions.
Management Accounting (Malik and Co.)
2. Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)
3. Agarwal. M.R. — Managerial Accounting (Garima Publications)
4. Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
Identify the importance of capital budgeting and relates with any one of the
organizations which is nearby you and correlate how they are giving importance to
capital Budgeting
17.12 KEYWORDS
Capital Budgeting, Capital Expenditure, Long-term Implication, Irreversible
Decision. Long-term Commitments of Funds, Permanent Commitments of Funds,
National Importance.
218
LESSON 18
CAPITAL BUDGETING PROCESS
18.1 INTRODUCTION
Capital budgeting is a complex process as it involves decisions to the
investment of current funds for the benefit to be achieved in future and the future
is always uncertain. A capital Budgeting process may involve a number of steps
depending upon the size of the concern, nature of projects, their numbers,
complexities and diversities etc. That is, capital budgeting decision of a firm has a
pervasive influence on the entire spectrum of entrepreneurial activities. Hence they
require a complex combination and knowledge of various disciplines for their
effective administration, such as economics, finance mathematics, economic
forecasting, projection techniques and techniques of financial control.
18.2 OBJECTIVES
 Capital Budgeting Process and Their Kinds
 Various factors influencing Capital Investment Decision
18.3 CONTENT
18.3.1 Capital Budgeting Process
18.3.2 Factors Influencing Capital Investment Decisions
18.3.3 Kinds of Capital Budgeting Decisions
18.3.4 Investment Evaluation Criteria
18.3.5 Features Required by Investment Evaluation Criteria
18.3.1 CAPITAL BUDGETING PROCESS
The important steps involved in the capital budgeting process are:
(1) Project generation,
(2) Project evaluation,
(3) Project selection and
(4) Project execution.
1. Project Generation. Investment proposals of various types may originate at
different levels within a firm. Investment proposals may be either proposals to add
new product to the product line or proposals to expand capacity in existing product
lines. Secondly, proposals designed to reduce costs in the output of existing
products without changing the scale of operations. The investment proposals of any
type can originate at any level. In a dynamic and progressive firm there is a
continuous flow of profitable investment proposals.
2. Project evaluation. Project evaluation involves two steps:
i) Estimation of benefits and costs and
ii) Selection of an appropriate criterion to judge the desirability of the projects.
The evaluation of projects should be done by an impartial group. The
criterion selected must be consistent with the firm’s objective of maximizing its
market value.
219
3. Project Selection. There is no uniform selection procedure for investment

proposals. Since capital budgeting decisions are of crucial importance, the final
approval of the projects should rest on top management.
4.Project Execution. After the final selection of investment proposals, funds
are earmarked for capital expenditures. Funds for the pu rpose of project execution
should be spent in accordance with appropriations made in the capital budget.
18.3.2 FACTORS INFLUENCING CAPITAL INVESTMENT DECISIONS
The main factors which, influence capital investment are:
1. Technological change
In modem times, one often finds fast obsolescence of technology. New
technology, which is relatively more efficient, takes the place of old technology; the
latter getting downgraded to some less important applications. However, in taking a
decision of this type, the management has to consider the cost of new equipment
vis-a-vis the productive efficiencies of the new as well as the old equipments.
However, while evaluating the cost of new equipment, the management should not
take into, account its full accounting cost (as the equipment lasts for years) but its
incremental cost. Also, the cost of new equipment is often partly offset by the
salvage value of the replaced equipment.
2. Competitors ‘strategy
Many a time an investment is taken to maintain the competitive strength of the
firm; If the competitors are installing new equipment to expand output or to
improve quality of their products, the firm under consideration will have no
alternative but to follow suit, else it will perish. It is, therefore, often found that the
competitors’ strategy regarding capital investment plays a very significant role in
forcing capital decisions on a firm.
3. Demand forecast
The long-run forecast of demand is one of the determinants of investment
decision. If it is found that there is a market potential for the product in the long
run, the dynamic firm will have to take decisions for capital expansion.
4. Type of management
Whether capital investment would be encouraged or not depends, to a large
extent, on the viewpoint of the manage ment. If the management is modern and
progressive in its outlook, the innovations will be encouraged, whereas a
conservative management discourages innovation and fresh investments.
5. Fiscal policy
Various tax policies of the government (like tax concessi ons on investment
income, rebate on new investment, and method of allowing depreciation deduction
allowance) also have favourable or unfavourable influence on capital investment.
6. Cash flows
Every firm makes a cash flow budget. Its analysis influences capital investment
decisions. With its help the firm plans the funds for acquiring the capital asset. The
220
budget also shows the timing of availability of cash flows for alternative investment
proposals, thereby helping the management in selecting the desired project.
7. Return expected from the investment
In most of the cases, investment decisions are made in anticipation of
increased return in future. While evaluating investment proposals, it is therefore
essential for the firm to estimate future returns or benefits accruing from the
investment.
8. Minimum Rate of Return on Investment
Every management expects a minimum rate of return or cut – off rate on
capital investment. It refers to the point of below which a project would not be
accepted.
9. Future earnings
The future earnings may be uniform or Fluctvating. Even though, the company
expects guaranteed future earnings in total which affects the choice of a project.
10. Ranking of the capital investment proposal
Only one profitable project out of many and huge amount is available in the
hards of management there is no need of ranking of capital investment proposal.
Ranking is necessary if there is many profitable projects in hand and limited funds
is available in the hards of management.
18.3.3 KINDS OF CAPITAL BUDGETING DECISIONS
The overall objective of capital budgeting is to maximise the profitability of a
firm or the return on investment. This objective can be achieved either by
increasing the revenues or by reducing costs. Thus, capital budgeting decisions can
be broadly classified into two categories:
1. Those which increase revenue, and
Those which reduce costs
The first category of capital budgeting decisions is expected to increase revenue
of the firm through expansion of the production capacity or size of operations by
adding a new product line. The second category increases the earnings of the firm
by reducing costs and includes decisions relating to replacement of obsolete,
outmoded or worn out assets. In such cases, a firm has to decide whether to
continue with the same asset or replace it. Such a decision is taken by the firm by
evaluating the benefit from replacement of the asset in the form of reduction in
operating costs and the cost/cash outlay needed for replacement of the asset. Both
categories of above decisions involve investment in fixed assets but the basic
difference between the two decisions lies in the fact that increasing revenue
investment decisions are subject to more uncertainty as compared to cost reducing
investment decisions.
Further, in view of the investment proposals under consideration, capital
budgeting decisions may also be classified as.
1. Accept / Reject Decisions
221
2. Mutually Exclusive Project Decisions

3. Capital Rationing Decisions.
i.Accept / Reject Decisions
Accept / reject decisions relate to independent project which do not compete
with one another. Such decisions are generally taken on the basis of minimum
return on investment. All those proposals which yield a rate of return higher than
the minimum required rate of return or the cost of capital are accepted and the rest
are rejected. If the proposal is accepted the firm makes investment in it, and if it is
rejected the firm does not invest in the same.
(ii) Mutually Exclusive project Decisions
Such decisions relate to proposals which compete with one another in such a
way that acceptance of one automatically excludes the acceptance of the other.
Thus, one of the proposals is selected at the cost of the other. For example, a
company may have the option of buying a new machine, or a second hand machine,
or taking an old machine on hire or selecting a machine out of more than one
brand available in the market. In such a case, the company may select one best
alternative out of the various options by adopting some suitable technique or
method of capital budgeting. Once one alternative is selected the others are
automatically rejected.
iii) Capital Rationing Decisions
A firm may have several profitable investment proposals but only limited funds
to invest. In such a case, these various investments compete for limited funds and,
thus, the firm has to ration them. The firm effects the combination of proposals
that will yield the greatest profitability by ranking them in descending order of their
profitability.
18.3.4 INVESTMENT EVALUATION CRITERIA
The capital budgeting process begins with assembling of investment proposals
of different departments of a firm. The departmental head will have innumerable
alternative projects available to meet his requirements. He has to select the best
alternative from among the conflicting proposals. This selection is made after
estimating return on the projects and comparing the same with the cost of capital.
Investment proposal which gives the highest net marginal return will be chosen.
Following are the steps involved in the evaluation of an investment:
1. Estimation of cash flows
2. Estimation of the required rate of return
3. Application of a decision rule for making the choice
18.3.5 FEATURES REQUIRED BY INVESTMENT EVALUATION CRITERIA
A sound appraisal technique should be used to measure the economic worth of
an investment project. Porter field, J.T.S. in his book, Investment Decisions and
Capital Costs, has outlined some of the features that must be had by sound
investment evaluation criteria.
It should consider all cash flows to determine the true profitability of the
project.
222
It should provide for an objective and unambiguous way of separating good

projects from bad projects.
It should help ranking of projects according to their true profitability.
It should recognise the fact that bigger cash flows are preferable to smaller
ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects that project which
maximizes the shareholders’ wealth.
It should be a criterion which is applicable to any conceivable investment
project independent of others.
Capital budgeting process are project generation, Project evaluation, Project
selection and project execution.
Capital Budgeting decisions can be broadly clarified in to categories namely
those which increase revenue, those which reduce the cost.
I15.5 INTEXT QUESTIONS
1. What are the steps involved in project evaluation?
2. What are the factors influencing capital investment decision?
3. What do you mean by capital Budgeting process?
18.6 SUMMARY
Capital budgeting process involves the following steps project generation,
project evaluation, project selection, project execution. The main factors which,
influence capital investment are:
Technological change, competitors strategy, demand forecast, ty pe of
management, fiscal policy, cash flows, return expected from the investment,
minimum rate of return on investment, future earnings, ranking the capital
investment proposal. The steps involved in the evaluation of an investment criteria:
Estimation of cash flows, Estimation of the required rate of return ,Application of a
decision rule for making the choice. capital budgeting decisions can be broadly
classified into two categories:. Those which increase revenue and those which
reduce costs.
1. ……………………………………………. decisions relate to independent project
which do not compete with one another.
2. ………………………helps the management to avoid over investment and
under investments.
3. The …………………………………….process begins with assembling of
investment proposals of different departments of a firm.
223
3. https://msu.edu
10. www.cengage.com
18.9 ASSIGNMENTS
1. Critically examine the various steps involved in capital budgeting process.
2. Outline financial management techniques of evaluation of capital investment
in fixed asset.
4. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD, Jaipur)
Identify a company of your choice and interact with the finance manger
regarding Capital budgeting process, investment evaluation criteria .
18.12 KEYWORDS
Project generation, Project evaluation, Project selection, Project execution,
Accept / Reject Decisions, Mutually Exclusive Project Decisions , Capital
Rationing Decisions.
224
LESSON 19
METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSAL
19.1 INTRODUCTION
The capital Budgeting techniques or evaluation of investment proposals have
considerably gained the importance. This is more true in the modern business
environment. After the introduction of New Economic Policy, the environments in
the industry and service sector have considerably changed. Number of mergers,
acquisition, and joint ventures and continues innovation are being experienced in
the markets. Therefore it is very difficult to arrive at decision for financing the
project. It is absolutely essential for every business entity to make use of this scare
resource on the most profitable lines. Following are some of the important methods
used in practice in evaluating the investment proposals.
19.2 OBJECTIVES
 Various techniques of investment Appraisal
 Discounted and Non-Discounted Cash Flow Methods
 Merits and demerits of Various techniques
19.3 CONTENT
19.3.1 Techniques of Investment Appraisal
19.3.2 Non-Discounted Cash Flow Criteria
19.3.3 Discounted Cash Flow Criteria
19.3.4 Discounted Cash Flow Techniques Merits
19.3.5 Discounted Cash Flow Techniques Demerits
19.3.6 Comparison between NPV and IRR
19.3.1 TECHNIQUES OF INVESTMENT APPRAISAL
There are many methods for evaluating or ranking the investment proposals. In
all these methods, the basic approach is to compare the investments in the project
to the benefits derived there from. These methods can be categorized as Follows:
19.3.2 NON-DISCOUNTED CASH FLOW CRITERIA / TRADITIONAL METHODS
Pay-back period
Discounted payback period
Accounting rate of return (ARR)
19.3.3 DISCOUNTED CASH FLOW (DCF) CRITERIA
Net present value (NPV)
Internal rate of return (IRR) / Excess PV Index method/benefit
Profitability index (PI) / Benefit cost ratio
Non-discounted Cash Flow Criteria
Payback period Method
This method is popularly known as pay off, pay-out, recoupment period method
also. It gives the number of years in which the total investment in a particular
225
capital expenditure pays back itself. This method is based on the principle that
every capital expenditure pays itself back over a number of years. It means that it
generates income within a certain period. When the total earnings (or net cash-
inflow] from investment equals the total outlay, that period is the payback period of
the capital investment. An investment project is adopted so long as it pays for itself
within a specified period of time — says 5 years or less. This standard of
recoupment period is settled by the management taking into account a number of
considerations. While there is a comparison between two or more projects, the
lesser the number of payback years, the project will be acceptable.
The formula for the payback period calculation is simple when the cash inflow
is even throughout life of the project/ Machine/ Capital investment. First of all,
net-cash-inflow (Profit after Tax Before Depreciation) is determined. Then we divide
the initial cost (or any value we wish to recover) by the annual cash-inflows and the
resulting quotient is the payback period. As per formula:
If the annual cash-inflows are uneven, then the calculation of payback

period takes a cumulative form. We accumulate the annual cash-inflows till the
recovery of investment and as soon as this amount is recovered, it is the expected
number of payback period years. An asset or capital expenditure outlay that pays
back itself early comparatively is to be preferred.
Payback Method – Merits
The payback period method for choosing among alternative projects is very
popular among corporate managers and according to Quirin even among Soviet
planners who call it as the recoupment period method. In U.S.A and U.K. this
method is widely accepted to discuss the profitability of foreign investment.
Following are some of the advantages of pay back method:
1. It is easy to understand, compute and communicate to others. Its quick
computation makes it a favorite among executive who prefer snap answers.
2. It gives importance to the speedy recovery of investment in capital assets.
So it is useful technique in industries where technical developments are in
full swing necessitating the replacements at an early date.
3. It is an adequate measure for firms with very profitable internal investment
opportunities, whose sources of funds are limited by internal low
availability and external high costs.
4. It is useful for approximating the value of risky investments whose rate of
capital wastage (economic depreciation and obsolescence rate) is hard to
predict. Since the payback period method weights only return heavily and
ignores distant returns it contains a built-in hedge against the possibility of
limited economic life.
226
5. When the payback period is set at a large “number of years and incomes
streams are uniform each year, the payback criterion is a good
approximation to the reciprocal of the internal rate of discount.
Payback Method – Demerits
This method has its own limitations and disadvantages despite its simplicity
and rapidity. Here are a number of demerits and disadvantages claimed by its
opponents:-
1. It treats each asset individually in isolation with the other assets, while
assets in practice cannot be treated in isolation.
2. The method is delicate and rigid. A slight change in the division of
labour and cost of maintenance will affect the earnings and such may
also affect the payback period.
3. It overplays the importance of liquidity as a goal of the capital
expenditure decisions. While no firm can ignore its liquidity
requirements but there are more direct and less costly means of
safeguarding liquidity levels. The overlooking of profitability and over
stressing the liquidity of funds can in no way be justified.
4. It ignores capital wastage and economic life by restricting consideration
to the projects’ gross earnings.
5. It ignores the earning beyond the payback period while in many cases
these earnings are substantial. This is true particularly in respect of
research and welfare projects.
6. It overlooks the cost of capital which is the main basis of sound
investment decisions.
In perspective, the universality of the pay back criterion as a reliable index of
profitability is questionable. It violates the first principle of rational investor
behaviour-namely that large returns are preferred to smaller ones. However, it can
be applied in assessing the profitability of short and medium term capital
expenditure projects.
Accounting Rate of Return Method
It is also known as Accounting Rate of Return Method / Financial Statement
Method/ Unadjusted Rate of Return Method also. According to this method, capital
projects are ranked in order of earnings. Projects which yield the highest earnings
are selected and others are ruled out. The return on investment method can be
expressed in several ways a follows:
(i) Average Rate of Return Method
Under this method we calculate the average annual profit and then we divide it
by the total outlay of capital project. Thus, this method establishes the ratio
between the average annual profits and total outlay of the projects.
As per formula,
227
Thus, the average rate of return method considers whole earnings over the
entire economic life of an asset. Higher the percentage of return, the project will be
acceptable.
(ii) Earnings per unit of Money Invested
As per this method, we find out the total net earnings and then divide it by the
total investment. This gives us the average rate of return per unit of amount (i.e.
per rupee) invested in the project. As per formula:
The higher the earnings per unit, the project deserves to be selected.
(iii) Return on Average Amount of Investment Method
Under this method the percentage return on average amount of investment is
calculated. To calculate the average investment the outlay of the projects is divided
by two. As per formula:
Here:
Average Annual Net Income does not mean average Annual Cash-inflow
Average Investment may be of the following:
OR
OR
228
Thus, we see that the rate of return approach can be applied in various ways.
But, however, in our opinion the third approach is more reasonable and consistent.
Accounting Rate of Return Method – Merits
This approach has the following merits of its own:
1. Like payback method it is also simple and easy to understand.
2. It takes into consideration the total earnings from the project during its
entire economic life.
3. This approach gives due weight to the profitability of the project.
4. In investment with extremely long lives, the simple rate of return will be
fairly close to the true rate of return. It is often used by financial
analysis to measure current performance of a firm.
Accounting Rate of Return Method – Demerits
1. One apparent disadvantage of this approach is that its results by different
methods are inconsistent.
2. It is simply an averaging technique which does not take into account the
various impacts of external factors on over-all profits of the firm.
3. This method also ignores the time factor which is very crucial in business
decision.
4. This method does not determine the fair rate of return on investments. It is
left to the discretion of the management.
Discounted Cash flows (DCF) Techniques (or) Time Ad jested Method
Another method of computing expected rates of return is the present value
method. This method involves calculating the present value of the cash benefits
discounted at a rate equal to the firm’s cost of capital. The method is popularly
known as Discounted Cash flow Method. The concept of DCF valuation is based on
the principle that the value of a business or asset is inherently based on its ability
to generate cash flows for the providers of capital. To that extent, the DCF relies
more on the fundamental expectations of the business than on public market
factors or historical precedents, and it is a more theoretical approach relying on
numerous assumptions. A DCF analysis yields the overall value of a business (i.e.
enterprise value), including both debt and equity. In simple the “present value of
an investment is the maximum amount a firm could pay for the o pportunity of
making the investment without being financially worse off.”
Key Components of a DCF:
Free Cash flow (FCF): Cash generated by the assets of all the business (both
tangible and intangible) available for distribution to all providers of capital . FCF is
229
often referred to as unlevered free cash flow, as it represents cash flow available to
all providers of capital and is not affected by the capital structure of the business.
Terminal value (TV): Value at the end of the FCF projection period (Horizon
Period).
Discount rate or Present Value factor (PV) – The rate used to discount the
projected FCFs and terminal value to their present values.
The financial executive compares the present values with the cost of the
proposal. If the present value is greater than the net investment, the proposal
should be accepted. Conversely, if the present value is smaller than the net
investment, the return is less than the cost of financing. Making the investment in
this case will cause a financial loss to the firm. There are four methods to judge the
profitability of different proposals on the basis of this technique
(i) Net Present Value Method
This method is also known as Excess Present Value or Net Gain Method. To
implement this approach, we simply find the present value of the expected net cash
inflows of an investment discounted at the cost of capital and subtract from it the
initial cost outlay of the project. If the net present value is positive, the project
should be accepted: if negative, it should be rejec ted.
NPV = Total Present value of cash inflows – Net Investment
If the two projects are mutually exclusive the one with higher net present value
should be chosen. The following example will illustrate the process:
Assume, the cost of capital after taxes of a firm is 6% . Assume further, that the
net cash-inflow (after taxes) on a Rs. 5,000 investment is forecasted as being
2,800 per annum for 2 years. The present value of this stream of net cash-inflow
discounted at 6% comes to 5,272 (1,813 x 2800).
Therefore, the present value of the cash inflow = 5,272

Less present value of net investment = 5,000
Net Present value = 272
(ii) Internal Rate of Return Method

This method is popularly known as time adjusted rate of return
method/discounted rate of return method also. The internal rate of return is
defined as the interest rate that equates the present value of expected future
receipts to the cost of the investment outlay. This internal rate of re turn is found by
trial and error. First we compute the present value of the cash-flows from an
investment, using an arbitrarily elected interest rate. Then we compare the present
value so obtained with the investment cost. If the present value is higher than the
cost figure, we try a higher rate of interest and go through the procedure again.
Conversely, if the present value is lower than the cost, lower the interest rate and
repeat the process. The interest rate that brings about this equality is defined as
230
the internal rate of return. This rate of return is compared to the cost of capital and
the project having higher difference, if they are mutually exclusive, is adopted and
other one is rejected. As the determination of internal rate of return involves a
number of attempts to make the present value of earnings equal to the investment,
this approach is also called the Trial and Error Method,
iii. Profitability Index (PI) Method
This method is otherwise called benefit cost ratio method or Desirability
Factor. One major disadvantage of the present value method is that it is not easy to
rank projects on the basis of net present value particularly when the cost of
projects differs significantly. To compare such projects the present value
profitability index is prepared. The index establishes relationship between cash-
inflows and the amount of investment as per formula given below:
NPV GPV
PI = --------------- x 100 OR -------------------- x 100
Investment Investment
For example, the profitability index of the Rs. 5,000 investment discussed in
Net Present Value Method above would be:
OR
The higher profitability index, the more desirable is the investment. Thus, this
index provides a ready compatibility of investment having various magnitudes. By
computing profitability indices for various projects, the financial manager can rank
them in order of their respective rates of profitability.
(iv) Terminal Value Method
This approach separates the timing of the cash-inflows and outflows more
distinctly. Behind this approach is the assumption that each cash-inflow is re-
invested in other assets at the certain rate of return from the moment, it is received
until the termination of the project. Then the present value of the total compounded
sum is calculated and it is compared with the initial cash-outflow. The decision rule
is that if the present value of the sum total of t he compounded re-invested cash-
inflows is greater than the present value of cash-outflows, the proposed project is
accepted otherwise not. The firm would be different if both the values are equal.
231
This method has a number of advantages. It incorporates the advantage of re-

investment of cash-inflows by compounding and then discounting it. Further, it is
best suited to cash budgeting requirements. The major practical problem of this
method lies in projecting the future rates of interest at which the intermedi ate cash
inflows received will be re-invested.
19.3.4 DISCOUNTED CASH FLOW TECHNIQUES – MERITS
1. This method takes into account the entire economic life of an investment
and income there from. It gives the rate of return offered by a new project.
2. It gives due weight to time factor of financing. In the words of Charles
Horngreen “Because the discounted cash-flow method explicitly and
routinely weights the time value of money, it is the best method to use for
long-range decisions.
3. It permits direct comparison of the projected returns on investments with
the cost of borrowing money which is not possible in other methods.
4. It makes allowance for differences in the time at which investment
generate their income.
5. This approach by recognising the time factor makes sufficient provision for
uncertainty and risk. It offers a good measure of relative profitability of
capital expenditure by reducing the earnings to the present values.
19.3.5 DISCOUNTED CASH FLOW TECHNIQUES – DEMERITS
This method is criticized on the following grounds:
1. It involves a good amount of calculations. Hence it is difficult and
complicated one. But this criticism has no force.
2. It is very difficult to forecast the economic life of any investment exactly.
3. The selection of cash-inflow is based on sales forecasts which are in
itself an indeterminable element.
4. The selection of an appropriate rate of interest is also difficult.
19.3.6 COMPARISON BETWEEN NPV AND IRR (NPV V S. IRR)
The Net Present value method and the Internal Rate of Return Method are
similar in the sense that both are modern techniques of capital budgeting and both
take into account the time value of money. In fact, both these methods are
discounted cash flow techniques. However, there are certain basic differences
between these two methods of capital budgeting:
i. In the net present value method the present value is determined by
discounting the future cash flows of a project at a predetermined or specified
rate called the cut off rate based on cost of capital. But under the internal
rate of return method, the cash flows are discounted at a suitable rate by hit
and trial method which equates the present value so calculated to the
amount of the investment. Under IRR method, discount rate is not
predetermined.
232
ii. The NPV method recognizes the importance of market rate of interest or cost
of capital. It arrives at the amount to be invested in a given project so that
its anticipated earnings would recover the amount invested in the project at
market rate. Contrary to this, the IRR method does not consider the market
rate of interest and seeks to determine the maximum rate of interest at
which funds invested in any project could be repaid with the earnings
generated by the project.
iii. The basic presumption of NPV method is that intermediate cash inflows are
reinvested at the cut off rate, whereas, in the case of IRR method,
intermediate cash flows are presumed to be reinvested at the internal rate of
return.’
iv. The results shown by NPV method are similar to that of IRR method under
certain situations, whereas, the two give contradictory results under some
other circumstances. However, it must be remembered that NPV method
using a predetermined cut-off rate is more reliable than the IRR method for
ranking two or more capital investment proposals.
(a) Similarities of Results under NPV and IRR
Both NPV and IRR methods would show similar results in terms of accept or
reject decisions in the following cases:
1. Independent investment proposals which do not compete with one
another and which may be either accepted or-rejected on the basis of a
minimum required rate of return.
2. Conventional investment proposals which involve cash outflows or
outlays in the initial period followed by a series of cash inflows.
The reason for similarity of results in the above c ases lies on the basis of
decision-making in the two methods. Under NPV method, a proposal is accepted if
its net present value is positive, whereas, under IRR method it is accepted if the
internal rate of return is higher than the cut off rate. The projec ts which have
positive net present value, obviously, also have an internal rate of return higher
than the required rate of return.
(b) Conflict between NPV and IRR Results
In case of mutually exclusive investment proposals, which compete with one
another in such a manner that acceptance of one automatically excludes the
acceptance of the other, the NPV method and IRR method may give contradictory
results. The net present value may suggest acceptance of one proposal whereas, the
internal rate of return may favour another proposal. Such conflict in rankings may
be caused by any one or more of the following problems:
1. Significant difference in the size (amount) of cash outlays of various
proposals under consideration.
2. Problem of difference in the cash flow patterns or timings of the various
proposals and
3. Difference in service life or unequal expected lives of the projects.
233
Exercise:
1) Equipment A has a cost of 75,000 and net cash flow of `20,000 per year for
six years. A substitute equipment B would cost ` 50,000 and generate net cash flow
of ` 14,000 per year for six years. The required rate of return of both equipments is
11 per cent. Calculate the IRR and NPV for the equipments. Which equipment
should be accepted and why?
Solution:
Equipment A
NPV = 20,000 x PVAF 6, 0.11 - 75,000
= 20,000 x 4.231 - 75,000
= 84,620 - 75,000 = ` 9,620

20,000 x PVAF 6, r
IRR = = 75,000
75,000 / 20,000
PVAF6,r = = 3.75
From the present value of an annuity table, we find:
PVAF 6,0.15
= 3.784
PVAF 6,0.16
= 3.685
Therefore,
3.784 – 3.75 IRR = r = 0.15 + 0.01
3.784 – 3.685 = 0.15 + 0.0034 = 0.1534 or IRR = 15.34%
Equipment B:
NPV = 14,000 x PVAF6,0.11 - 50,000
= 14,000 x 4.231 - 50,000
59,234 - = Rs
= 50,000 9,234
IRR = 14,000 x PVAF 6,r = 50,000
50,000 /
PVAF6,r = 14,000 = 3.571
234
From the present value of an annuity table, we find:
PVAF 6,0.17 = 3.589
PVAF 6,0.18 = 3.498
Therefore,
Equipment A has a higher NPV but lower IRR as compared with equipment B.
Therefore equipment A should be preferred since the wealth of the shareholders will
be maximized.
5) For each of the following projects compute (i) pay -back period, (ii) post pay-
back profitability and (iii) post-back profitability index
a) Initial outlay ` 50,000
Annual cash inflow
(after tax but before depreciation) ` 10,000
Estimated life 8 Years

b) Initial outlay ` 50,000
Annual cash inflow (after tax but before depreciation)

First three years ` 15,000
Next five years ` 5,000
Estimated life 8 Years
Salvage ` 8,000
Solution:
a) i) Pay-back period = Investment / Annual Cash Flow
= 50,000 / 10,000 = 5 Years
ii) Post pay back profitability
= Annual cash inflow
(Estimated life–payback period)
= 10,000 (8 – 5) = 30,000
235
iii) Post back profitability index

= 30,000 / 50,000 x 100 = 60%
b) i) As the case inflows are the equal during the life of the investment
payback period can be calculated as:
1st year’s cash inflow 15,000

2nd year’s cash inflow 15,000
3rd year’s cash inflow 15,000
4th year’s cash inflow 5,000
50,000
Hence, the pay-back period is 4 years.
ii) Post pay back profitability
= Annual cash inflow x remaining life after pay –back period)
= 5,000 x 4
= 20,000
iii) Post back profitability index
= 20,000 / 50,000 x 100
= 40%
6) X Ltd. is considering the purchase of a machine. Two machines are available E
and F. the cost of each machine is 60,000. Each machine has expected life of 5
years. Net profits before tax (50% ) and after depreciation (20% WDV) during
expected life of Five years of the machines are given below:
Year E (Machine) F (Machine)
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000

236
Solution:
Statement of Profitability
Machine E Machine F
Year
PBTAD Tax 50% PATD PBTAD Tax 50% PATD
1 15,000 7,500 7,500 5,000 2,500 2,500
2 20,000 10,000 10,000 15,000 7,500 7,500
3 25,000 12,500 12,500 20,000 10,000 10,000
4 15,000 7,500 7,500 30,000 15,000 15,000
5 10,000 5,000 5,000 20,000 10,000 10,000
Total 85,000 42,500 42,500 90,000 45,000 45,000
Machine E Machine F
Average profit after tax 42,500 x 1/5 = 8,500 45,000 x 1/5 = 9,000
Average investment 60,000 x ½ = 30,000 60,000 x ½ = ` 30,000
Average return on 8,500/30,000 x 9,000/30,000 x
average 100 = 28.33% 100 = 30%
Thus, machine F is more profitable.
Capital Rationing – Meaning
Capital rationing refers to a situation where a firm is not in a position to invest
in all profitable projects due to the constraints on availability of funds. We know
that the resources are always limited and the demand for them far exceeds their
availability, it is for this reason that the firm cannot take up all the projects though
profitable, and has to select the combination of proposals that will yield the greatest
profitability.
Capital rationing is a situation where a firm has more investment proposals
than it can finance. It may be defined as “a situation where a constraint is placed
on the total size of capital investment during a particular period”. In such an event
the firm has to select combination of investment proposals that provide the highest
net present value subject to the budget constraint for the period. Selecting of
projects for this purpose will require the taking of the following steps:
i. Ranking of projects according to profitability index or internal’-rate of return.
Selecting projects in descending order of profitability until the budget figures
are exhausted keeping in view the objective of maximizing the value of the firm.
PRACTICAL PROBLEMS
1. Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the
project is
237
5 years. Calculate the pay-back period. (Ans:3 years).

2. A project costs Rs. 20,00,000 and yi elds annually a profit of Rs. 3,00,000
after
Depreciation @ 12½% but before tax at 50% . Calculate the pay -back period.
(Ans: 5 years )
1. Certain projects require an initial cash outflow of Rs. 25,000. The cash
inflows for 6years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs.
7,000 and Rs. 3,000.Calculate payback period. (Ans: 3 yrs 2month )
2. F ltd is considering two projects. each requires an investment of
Rs.10,000.the firm cost of capital is 10% ,the net cash inflows from
investment in the two projects X and Y are as follows :
Year X Y
1 5000 1000
2 4000 2000
3 3000 3000
4 1000 4000
5 - 5000
6 - 6000
The company has fixed 3 years pay-back period as the cut-off point, state
which project should be accepted .
Ans: Traditional pay-back period for:
Project X= 2 years &4 Months (2.33 years) Project Y=4 years.
Discounted pay-back period @ 10% Project:
X=2.95 years & project Y=4.79 years
1. KK Ltd has two projects under consideration which are mutually exclusive.
the projects have to be depreciated on straight line basis and the tax rate
may be taken as 50% .
Year Profit before Depreciation
A(Rs.) B(Rs)
1 80,000 20,000
2 60,000 40,000
3 40,000 60,000
4 20,000 80,000
5 10,000 1,00,000
Calculate payback period.
[Ans project A=2 Years ,4 months ;B = 3 years 2 months ]

238
2. A company is considering the purchase of the following machines:

Automatic machine Ordinary machine
Cost (Rs) 2,24,000 60,000
Life (Years ) 5½ 8
Sales (Rs) 1,50,000 1,50,000
Cost :
Materials 50,000 50,000
Labour 12,000 60,000
Variable OH 24,000 20,000
Compute the payback period and profitability beyond the payback period.
[Ans:payback period Automatic = 3.5 yrs , Ordinary = 3 yrs ; profitability beyond PB
period: automatic =Rs 1,28,000, Ordinary = Rs 1,00,000 ]
MM Ltd is considering the purchase of new machine which will carry out
operations performed by labour. A and B are alternative models. From the following
information, you are required to prepare a profitability statement and workout the
pay-back period in respect of each machine:
Particulars M achine A M achine B
Estimated life of machines years 5 6
Cost of machine 1,50,000 2,50,000
Cost of indirect materials 6,000 8,000
Estimated savings in scrap 10,000 15,000
Additional cost of maintenance 19,000 27,000
Estimated savings in direct wages:
Number of Employee not required 150 200
Wages per employee 600 600
Taxation is to be regarded as 50% of profit (ignore depreciation for calculation
of tax).which model would you recommend? State your reasons.
(Ans: payback period in case of machine A is 4 years and in case of machine
B,it is 5 years.Hence ,Machine A is preferred)
No project is acceptable unless the yield is 10% Cash inflows of certain project
along with cash outflow are given below:
Year Outflow Rs. Inflow Rs.
0 1,50,000
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000
The salvage value at the end of 5 th year is Rs.40,000. Calculate the NPV.
[Ans:8,860]
239
A Ltd. has under consideration the following two projects. their details are as
under:
Project X Project Y
Investment in machinery Rs.10,00,000 15,00,000
Working capital 5,00,000 5,00,000
Life of machinery 4 yrs 6 yrs
Scrap value of machinery 10 % 10 %
Tax rate 50 % 50 %
Income before depreciation and
tax at the end of year
1 8,00,000 15,00,000
2 8,00,000 9,00,000
3 8,00,000 15,00,000
4 8,00,000 8,00,000
5 - 6,00,000
6 - 3,00,000
You are required to calculate the accounting rate of return and suggest which
project is to be preferred.
(Ans: ARR Project X Rs =19.1% ,Project Y Rs = 17.75% )
1. A new capital project costing Rs.140 Lakhs will yield on an average a profit
before tax and depreciation of Rs.50 lakhs .depreciation will be Rs.20 lakhs
per annum and the tax rate is 50% . Work out the pay_back period and
return on investment.
Ans. Pay_back period = 4 years, ARR(on original investment)=10.71% ARR(on
average investment)= 21.43 %
2. A project requires initial investment of Rs 85,000 and is expected to give
cash flows of Rs 18,000, Rs25,000,Rs 10,000,Rs.25,000 and Rs. 30,000 for
5 years respectively. the project has a salvage value of Rs.10,000. The
companys target rate of return is 10% .calculate the profitability of the
projects by using profitability index method. (Ans: P.I = 1.017)
3. A project costs Rs.16,000 and is expected to generate cash inflows of
Rs.4,000 each for 5 years .calculate internal rate of return . (Ans .8%)
4. MM Limited considering a project with an Initial investment of Rs1,80,000,
the life of the project is four years and estimated net annual cash flows are
as follows
240
Year Rs
1 45,000
2 60,000
3 90,000
4 60,000
Calculate internal rate of return [Ans:14.49 %]
Easwar limited company is considering an investment in a project with a
capital outlay of Rs.2,00,000. The estimated annual income after depreciation but
before tax is Rs. 1,00,000; each in the first and second year 80,000; each in the
third and fourth year and Rs.40,000 in the fifth year. Depreciation may be taken
at 20% on original cost and taxation at 50% of net income you are required to
evaluate the project according to each of the following method:
a) Payback period method
b) Rate of return on original investment method
c) Rate of return on average investment method
d) Net present value method discounting in flow at 10%
YEAR 1 2 3 4 5
P.V.F 0.909 0.826 0.751 0.683 0.621
Ans : a)2.25 years b)20 % c) 40 % d) 1,08,130
The expected cash flows of a project are as follows :
Year 0 1 2 3 4 5
Cash 1,00,000 20,000 30,000 40,000 50,000 30,000
flow
The cost of capital is 12% calculate:
a) NPV (b) IRR (c) Payback period and (d) Discounted payback period
Ans: a ) 19,060 b) 20.56% c) 3 years 2 months d) 3 yrs 11 months
Capital rationing
A ltd. has an investment budget of Rs.25 Lakh for next year.it has under
consideration three projects A,B and C(B and C are mutually exclusive )and all of
them can be completed within a year. Further details are given below :
Project Investment required Net present value
A 14 5.6
B 12 7.2
C 10 5.0
Recommend the best policy to utilize budget, supported by proper reasoning
[Ans: A&B is not possible as investment required exceeds Rs.25 lakh.
B&C is not possible as they are mutually exclusive projects:
241
A&C is only possible option thought NPV is lowest(i.e.,10.6lakh]

1. In capital rationing situation (investment limit Rs.25 Lakh ),suggest the
most desirable feasible combination on the basi s of the following data
(indicate justification)
Project Initial outlay NPV
A 15 6
B 10 4.5
C 7.5 3.6
D 6 3
Project B and C are mutually exclusive.
[Ans: Projects A and B combination give highest NPV of Rs. 10.50 lakh. by
undertaking these projects wealth maximization is possible]
2. APJ Ltd. has the following proposals
Project Cost Net present value
A 1,00,000 20,000
B 3,00,000 35,000
C 50,000 16,000
D 2,00,000 25,000
E 1,00,000 30,000
Total funds available are Rs.3, 00,000 determine the optimal combination of
projects assuming that (i) the projects are divisible and (ii) if the projects are not
divisible
[Ans
i. The company can get a NPV OF Rs.72,125 by selecting projects
C+E+A+ ¼ of D;
ii. (ii)Combination of A+C+E(Total outlay Rs 2,50,000) is the best it gives a
maximum NPV of Rs.66,000]
3. Ram Ltd is considering the following six proposals
Project Cost NPV
1 1,000 210
2 6,000 1,560
3 5,000 850
4 2,000 260
5 2,500 500
6 500 95
You are required to calculate the profitability index for each projects and rank
them which projects would you choose if the total funds are Rs.8000.
[Ans: P.I:P1:1.21; P2:1.26; P3:1.17; P4:1.13; P5:1.20; P6:1.19;1,2 and 6 is the
best combination as it gives the highest NPV of Rs.1,865]
242
OTHER PROBLEMS FOR BEST PRACTICE

1. Evaluation of Cash Flows. Below are the cash flows for two mutually
exclusive projects.
year CFX CFY
0 (5,000) (5,000)
1 2,085 0
2 2,085 0
3 2,085 0
4 2,085 9,677
a. Calculate the payback for both projects.

b. Initially, the cost of capital is uncertain, so construct NPV profiles for the two
projects (on the same graph) to assist in the analysis. The profiles cross at what
cost of capital? What is the significance of that?
c. It is now determined that the cost of capital for both projects is 14% . Which
project should be selected? Why?
d. Calculate the MIRR for both projects, using the 14% cost of capital.
Answers: a. 2.4 yrs, 4 yrs; b. 10% ; c. X; d. MIRRX = 19.69%
2. More practice with Cash Flow Evaluation. Cash flows for two mutually
exclusive projects are shown below:
year CFM CFN
0 (100) (100)
1 10 70
2 60 50
3 80 20
Both projects have a cost of capital of 10% .
a. Calculate the payback for both projects.
b. Calculate the NPV for both projects.
c. Calculate the IRR for both projects.
d. Calculate the MIRR for both projects.
Answers: a. 2.4 yrs, 1.6 yrs; b. Rs.18.78, Rs.19.98; c. 18.1% , 23.56% ; d.
16.5% , 16.9% ;
3. Expansion Project. A machine has a cost of Rs.180. It will have a life of 3
years, and will be depreciated straight line to zero salvage value. It will result in
sales revenue of Rs.200 per year and cash operating costs of Rs.110 per year. Use
of the machine will require an increase in working capital of Rs.70 for the 3 years,
243
beginning at year 0. The appropriate discount rate is 8% and the firm’s tax rate is
40% .
a. Calculate the initial cash flow at time 0.
b. Calculate the annual operating cash flows (they are identical each year).
c. Calculate the relevant terminal cash flows at the end of year 3.
d. What is the NPV for the machine?
Answers: a. -250; b. 78; c. 70; d. Rs.6.58
4. Inflation adjustment: A project requires an initial investment of Rs.8,000,
has a 4-year life and provides expected cash flows as follows, based on year 1 prices
and costs:
Annual revenue = Rs.5,000
Annual cash operating costs = Rs.2,000
Annual depreciation = Rs.2,000
Terminal cash flow = 0
Cost of capital = 14% and Tax = 30%
a. Calculate the annual operating cash flows without adjusting for inflation.
(Are these cash flows real or nominal?) Calculate the associated NPV.
b. Adjust the cash flows to reflect the effects of inflation, which is expected to
affect sales revenue and cash operating expenses at the rate of 4% annually. (Are
these cash flows real or nominal?) Calculate the associated NPV.
c. Which NPV is the correct one for evaluating the project?
Ans: a. -Rs.133; b. Rs.202
5. Mutually Exclusive Projects with Unequal Lives. Murray’s Coffee House
is trying to choose between two new coffee bean roasters. The required rate of
return for either machine is 10% . Shown below are the after-tax cash flows
associated with each machine:
year CFX CFY
0 (50,000) (30,000)
1 20,000 20,000
2 20,000 20,000
3 20,000
4 20,000
a. Calculate the replacement chain NPV for each project.

b. Calculate the equivalent annual annuity for each project.
c. Which project should be selected? Why?
244
Answers: a. RCNPV X = Rs.13,397, RCNPV Y = Rs.8,604; b. EAA X = Rs.4,226,

EAA Y = Rs.2,714
6. Risk Adjustment and Project Selection. Acme Mfg is considering two

projects, A & B, with cash flows as shown below:
period CFA CFB
0 -50,000 -100,000
1 20,000 60,000
2 20,000 25,000
3 20,000 25,000
4 20,000 25,000
The opportunity cost of capital for A is 14 percent. The opportunity cost of

capital for B is 10 percent.
a. Calculate the NPV for each project.
b. Calculate the IRR for each project.
c. Which project(s) should be accepted in each of the following situations?
(1) The projects are mutually exclusive and there is no capital constraint.
(2) The projects are independent and there is no capital constraint.
(3) The projects are independent and there is a total of Rs.100,000 of financing
for capital outlays in the coming period.
d. Explain why the cost of capital for A might be higher than for B.
Answers: a. NPVA = Rs.8,274, NPV B = Rs.11,065; b. IRRA = 21.86% , IRRB =
16.08%
8. Replacement project: Existing machine was purchased 2 years ago at a
cost of Rs.3,200. It is being depreciated straight line over its 8 year life. It can be
sold now for Rs.3,000 or used for 6 more years at which time it will be sold for an
estimated Rs.500. It provides revenue of Rs.5,000 annually and cash operating
costs of Rs.2,000 annually.
A replacement machine can be purchased now for Rs.7,800. It would be used
for 6 years, and depreciated straight line. It will result in additional sales revenue
of Rs.1,500 annually, but because of its increased efficiency it would reduce cash
operating costs by Rs.600 per year. The new machine would require additional
inventories of Rs.700, and accounts receivable would increase by Rs.300. Its
expected salvage value in 6 years is Rs.2,000.
The tax rate is 40% and the required rate of return is 13% . Should the old
machine be replaced?
245
a. Calculate the incremental cash flow at time 0.

b. Calculate the incremental annual operating cash flows that result from the
new machine.
c. Calculate the incremental terminal cash flow.
d. Show the incremental CFs in the table below.
Year Cash Flow
0 ________
1 ________
2 ________
3 ________
4 ________
e. Calculate the NPV for this project.
Answers: a. –Rs.6,040; b. Rs.1,620; c. 1,900; e. 1,349
Pay back period
(A) When Cash inflows are uniform
Initial investment Rs.2,00,000
Annual cash inflow Rs.50,000
Pay back period = Original Investment
Annual cash inflow
= 2,00,000
50,000 = 4 Years
(B) When cash inflows are not uniform
It investment in a project Rs.8,00,000 and net cash inflows after tax but before
depreciation are estimated for the next 6 years as Rs.20,000, Rs.25,000,
Rs,20,000, Rs.30,000, Rs.35,000 and Rs.15,000 Respectively, pay back period is
calculated as follows.
Solution
Year Cash Inflow Cumulative cash inflows
1 Rs.20,000 Rs.20,000
2 Rs.25,000 Rs.45,000
3 Rs.20,000 Rs.65,000
4. Rs.30,000 Rs.95,000
At end of 4 th year the cumulative cash inflow exceeds the investment of
Rs.80,000
Pay back period = 3 Years + 15000
30000
= 3 Years + ½ year
= 3.5 Year
246
ARR on original investment method

Annual average net earnings
ARR = x 100
Original investment – scrap value
ARR on average investment method
Annual average net earnings

ARR = x 100
Average investment
Average investment = Original investment

2
Average investment = Original investment – Scrap value of asset
Original invest – scarp value
Average investment = + Additional working
2 + scrap capital value

Discount Factor
1 where
(1+r) n
r – Discount rate
n – No of years
For example
Discounting factor at 10% rate for a period of 5 year
P.V. Factor for 1st year = 1 = 1 = 0.909
(1 + 1) 1 1. 1
P.V. Factor for 2nd year = 1 = 1 = 0.826
(1 + 1) 2 1. 21
247
P.V. Factor for 3rd year = 1 = 1 = 0.751
(1 + 1) 3 1. 33
ARR
The following data relating to two machines x and y

Mac x Mar y
Original cost Rs.2,00,000 Rs.2,00,000
Estimated life in year 5 5
Expected salvage value Rs. 20,000 Rs. 40,000
Additional working capital
Needed on average Rs. 40,000 Rs. 30,000
Income tax rate 40% 40%
Estimated incomes before depreciation and tax
X y
1st year 60,000 1,00,000
2nd year 80,000 80,000
3rd year 1,00,000 1,60,000
4th year 1,20,000 40,000
5th year 1,40,000 1,80,000
Depreciation is to be charges under SLM. you are required to calculate the

accounting rate of return on the average investment for both the machines.
Solution
ARR on average investment
= average annual net earnings x 100
Average investment
Aug Invest = org. invest – scrap values + Add net + scrap value working
2 capital
248
Mac X = 2,00,000 – 20,000 + 40,000 + 20,000
= Rs.1,50,000
Mac Y = 2,00,000 – 40,000 + 30,000 + 40,000
= Rs.1,50,000
ARR of Mac X = 38,400 x 100 = 25.6%
1,50,000
Working notes
Calculation of average annual net earnings
Mac X
Ave annual earnings before dep and tax
60,000 + 80,000 + 1,00,000 + 1,20,000 + 1,40,000 = 1,00,000
(-) Dep. 2,00,000 – 20,000 = 36,000
5 64,000
(-) Tax at 40% = 64000 x 40% = 25600
Average annual net earnings, after = 38400
Dep. and tax
Mac Y
Avg annual earnings before depreciation and tax

249
= 1,00,000 + 80,000 + 1,60,000 + 40,000 + 1,80,000 = 1,12,000
(-) Dep. 2,00,000 – 40,000 = 32,000
5 = 80,000
(-) Tax 40% = 80,000 x 40% = 32,000
Ave annual net earnings after dep and tax = 48,000

Profitability Index and NPV method
Two projects a and b which mutually exclusive are being under
consideration. Both of them require an investment of Rs.1,00,000 each. The net
cash inflows are estimated as under.
Year A B
1 10,000 30,000
2 40,000 50,000
3 30,000 80,000
4 60,000 40,000
5. 90,000 60,000
The company’s targeted rate of return on investment is 12% you are required to
access the projects on the basis of the present values, using, 1)NPV Method 2)
Profitability Index Method.
Present values of Re 1 at 12% interest for five years are given below.
1 year : 0.893 : 2nd Yr : 0.797 ; 3rd year
st
0.712 ; 4th year 0.636 ; 5th year 0.567
Statement showing present values of projects

Project B
PV lf Re 1 at 12% Project A cash
Year Present Cash
pa inflows P.V.
value inflow
(1) (2) (3) (4) (5) (6)
1. 0.893 10,000 8930 30,000 26790
2. 0.797 40,000 31880 50,000 39850
3. 0.712 30,000 21360 80,000 56,960
4. 0.636 60,000 38160 40,000 25,440
5. 0.567 90,000 51,030 60,000 34,020
1,51,360 1,83,060
250
1) NPV Project A B
Present value of cash inflow 1,51,360 1,83,060
(-) Initial invest 1,00,000 1,00,000
51,360 83,060
Project B is accepted because higher NPV
2) Profitability Index (PI)
PI = PV of cash inflow
PV of cash outflow
Project A Project B
PV of cash inflows 1,51,360 1,83,060
PV of cash outflow 1,00,000 1,00,000
(Initial invest)
PI = 1,51,360 1,83,060
1,00,000 1,00,000
= 1.5136 1.8306
Project B is accepted because higher P.I

1. Pay Back Method It gives the number of years in which the total
investment in a particular capital expenditure pays back itself.
2. Accounting Rate of Return method, capital projects are ranked in
order of earnings. Projects which yield the highest earnings are selected
and others are ruled out.
3. Average Rate of Return method establishes the ratio between the
average annual profits and total outlay of the projects.
4. Earnings per unit of money gives us the average rate of return per unit
of amount (i.e. per rupee) invested in the project.
5. Return on Average amount of Investment method under this method
the percentage return on average amount of investment is calculated.
6. Net Present Value Method we simply find the present value of the
expected net cash inflows of an investment discounted at the cost of
capital and subtract from it the initial cost outlay of the project. If the
net present value is positive, the project should be accepted: if negative,
it should be rejected.
251
7. Internal Rate of Return Method The internal rate of return is defined

as the interest rate that equates the present value of expected future
receipts to the cost of the investment outlay.
8. Profitability Index Method The present value profitability index
establishes relationship between cash-inflows and the amount of
investment.
9. Terminal Value Method approach is the assumption that each cash-
inflow is re-invested in other assets at the certain rate of return from the
moment; it is received until the termination of the project.
1. Define Internal Rate of Return.
2. What do you mean by Pay Back period ?
3. What do you mean by terminal value method?
4. What do you mean by profitability Index Method?
19.6 SUMMARY
There are number method are used for evaluating capital investment proposals.
Different firms may use different methods for evaluating the project proposals.
While evaluating two basic principles are kept in view namely, the bigger benefits
are always preferable to small ones and that early benefits are always better than
the deferred ones. While evaluating, the following methods are usually followed. Pay
Back Method It gives the number of years in which the total investment in a
particular capital expenditure pays back itself. Accounting Rate of Return method,
capital projects are ranked in order of earnings. Projects which yield the highest
earnings are selected and others are ruled out. Average Rate of Return method
establishes the ratio between the average annual profits and total outlay of the
projects. Earnings per unit of money gives us the average rate of return per unit of
amount (i.e. per rupee) invested in the project. Return on Average amount of
Investment method under this method the percentage return on average amount of
investment is calculated.Net Present Value Method we simply find the present value
of the expected net cash inflows of an investment discounted at the cost of capital
and subtract from it the initial cost outlay of the project. If the net present value is
positive, the project should be accepted: if negative, it should be rejected. Internal
Rate of Return Method The internal rate of return is defined as the interest rate
that equates the present value of expected future receipts to the cost of the
investment outlay. Profitability Index Method The present value profitability index
establishes relationship between cash-inflows and the amount of investment.
Terminal Value Method approach is the assumption that each cash-inflow is re-
invested in other assets at the certain rate of return from the moment; it is received
until the termination of the project.
1. The technique of long term planning for proposed capital outlays and their
financing termed as ………………………………………. .
252
2. The minimum rate of return expected on a capital investment project is

termed as…………………….. .
3. The rate of interest at which the present value of expected cash inflows
from a project equals the present value of expected cash outflows of the
same project is termed as…………………………. .
4. ………………………………….is the annual average yield on a project.
5. The period needed to recoup, in the form of cash inflows from operations,
the initial money invested is termed as………………………..
3. https://msu.edu
10. www.cengage.com
19.9 ASSIGNMENTS
1. Critically evaluate the net present value criterion.
2. Evaluate internal rate of return as a investment criterion.
3. Describe and evaluate the average rate of return method.
4. Critically evaluate the payback period as method of investment appraisal.
Jaipur)
Go to an organization and observe in what ways investment appraisal are
evaluated. Find the positive and negative things i n the appraisal
19.12 KEYWORDS
Pay Back Period, accounting rate of return, Net present value, Internal rate of
return, Profitability index method, Terminal value method, Average Investment,
original Investment, Annual cash inflow, Average annual profits after tax, total
earnings, scrap value.
253
LESSON 20
INTRODUCTION TO COST ACCOUNTING
20.1 INTRODUCTION
Cost Accounting is a branch of accounting and has been developed due to
limitations of financial accounting. Financial accounting is primarily concerned
with record keeping directed towards the preparation of Profit and Loss Account
and Balance Sheet. It provides information regarding the profit and loss that the
business enterprise is making and also its financial position on a particular date.
The financial accounting reports help the management to control in a general way
the various functions of the business but it fails to give detailed reports on the
efficiency of various divisions.
The limitations of Financial Accounting which led to the development of cost
accounting are as follows.
20.2 OBJECTIVES
After completing this Lesson you should be able to Know
 What is cost, costing and cost control?
 Objectives and Principles of Cost Accounting
 Difference Between Cost Accounting VS Financial Accounting VS
Management Accounting
20.3 CONTENT
20.3.1 Limitation of Financial Accounting
20.3.2 Branches of Accounting
20.3.3 Meaning and Scope of Cost Accounting
20.3.4 Cost Accounting
20.3.5 Costing
20.3.6 Cost Control
20.3.7 Objectives of Cost Accounting
20.3.8 General Principles of Cost Accounting
20.3.9 Difference between Financial Accounting and Cost Accounting
10.3.10 Management VS Cost Accounting
20.3.11 Difference between Management Accounting and Cost Accounting
20.3.1 LIMITATIONS OF FINANCIAL ACCOUNTING
1. No clear idea of operating efficiency: Sometimes profits in an organization
may be less or more because of inflation or trade depression and not due to
efficiency or inefficiency. But financial accounting does not give a clear reason for
profit or loss.
2. W eakness not spotted out by collective results: Financial Accounting
shows the net result of an organization. When the profit and loss account of an
organization, shows less profit or a loss, it does not give the reason for it or it does
not show where the weakness lies.
254
3. Does not help in fixing the price: In Financial Accounting, we get the total
cost of production but it does not aid in determining prices of the products,
services, production order and lines of products.
4. No classification of expenses and accounts: In Financial Accounting, we
don’t get data relating to costs incurred by departments, processes separately or
per unit cost of product lines, or cost incurred in various sales territories. Further
expenses are not classified as direct or indirect, controllable and uncontrollable
overheads and the value added in each process is not reported.
5. No data for comparison and decision making: It does not supply useful
data to management for comparison with previous period and for taking various
financial decisions as introduction of new products, replacement of labour by
machines, price in normal or special circumstances, producing a part in the factory
or buying it from outside market, production of a product to be continued or given
up, priority accorded to different products, investment to be made in new products
or not etc.
6. No control on cost: Financial Accounting does not help to control materials,
supplies, wages, labour and overhead costs.
7. Does not provide standards to assess the performance : Financial
Accounting does not help in developing standards to assess the performance of
various persons or departments. It also does not help in checking that costs do not
exceed a reasonable limit for a given quantum of work of the requisite quality.
8. Provides only historical information: Financial Accounting records only
the historical costs incurred. It does not provide day -to-day cost information to the
management for making effective plans for the future.
9. No analysis of losses: It does not provide complete analysis of losses due to
defective material, idle time, idle plant and equipment etc.. In other words, no
distinction is made between avoidable and unavoidable wastage.
10. Inadequate information for reports: It does not provide adequate
information for reports to outside agencies such as banks, government, insurance
companies and trade associations.
11. No answer for certain questions: Financial Accounting will not help to
answer questions like:-
a. Should an attempt be made to sell more products or is the factory
operating to capacity?
b. if an order or contract is accepted, is the price obtainable sufficient to
show a profit?
c. if the manufacture or sale of product A were discontinued and efforts make
to increase the sale of B, what would be the effect on the net profit? (d)
Why the profit of last year is of such a small amount despite the fact that
output was increased substantially? Etc.
20.3.2 BRANCHES OF ACCOUNTING
Accounting may broadly be classified into Seven categories:-
1. Financial Accounting
255
2. Cost Accounting and

3. Management Accounting
4. Inflation Accounting:
5. Social Accounting
6. Value –Added Accounting
7. Human Resource Accounting
Financial Accounting is concerned with recording, classifying and summarizing
financial transactions and preparing statements relating to the business in
accordance with generally accepted accounting concepts and conventions. It is
mainly meant to serve all parties external to the operating responsibility of the firm
such as shareholders and creditors of the firm besides providing information about
the overall operational results of the business while management accounting is
concerned with accounting information which is useful for the management it is the
presentation of accounting information in such as way as to assist “the
management in the creation of policy an d day to day operation of the undertaking.
20.3.3 MEANING AND SCOPE OF COST ACCOUNTING
The term cost accountancy is wider than the term cost accounting. According
to the Terminology of Management and Financial Accountancy Published by the
Chartered Institute of Management Accountants, London, cost accountancy means,
“the application of costing and cost accounting principles, methods and techniques
to the science, art and practice of cost control. It includes the presentation of
information derived there from for the purpose of managerial decision making.
20.3.4 COST ACCOUNTING
Cost accounting is the process of accounting for costs. It embraces the
accounting procedures relating to recording of all income and expenditure and the
preparation of periodical statements and reports with the object of ascertaining and
controlling costs. It is thus the formal mechanism by means of which costs of
products or services are ascertained and controlled.
20.3.5 COSTING
Costing is “the technique and process of ascertaining costs.” Cost
accounting is different from costing in the sense that the former provides only the
basis and information for ascertainment of cost. Once the information is made
available the costing can be carried out arithmetically by means of memorandum
statements or by method of integral accounting. However, the two terms costing
and cost accounting are often used interchangeably. No such distinction has also
been observed for the purpose of this book. Wheldon has given an exhaustive
definition of costing after expanding the ideas contained in the definitions of the
terms ‘costing and cost accounting’. According to him costing is, “the classifying
recording and appropriate allocation of expenditure for the determination of the
costs of products or services; the relation of these costs to sales values; and the
ascertainment of profitability”.
20.3.6 COST CONTROL
According to the Institute of Cost and Works Accountants of India, cost control
means “The act of power of controlling or regulatin g or dominating or commanding
256
costs through the application of management tools and techniques to the

performance of any operation to most predetermined objectives of quality, quantity,
value and time oat an optimum outlay”.
20.3.7 OBJECTIVES OF COST ACCOUNTING
The main objectives of cost accounting can be summarized as follows:-
1. Ascertaining Costs: - The first and foremost objective of cost accounting is
to find out cost of a product, process or service. The other objectives which
have been mentioned hereafter scan be achieved only when the costs have
been ascertained.
2. Determining Selling Price: - Business enterprises are run on a profit –
making basis. It is thus necessary that the revenue should be greater than
the costs incurred in producing goods an d services from which the revenue
is to be derived. Cost accounting provides information regarding the cost to
make and sell such products or services.
3. Measuring and Increasing Efficiency: - Cost accounting involvers a study
of the various operations used in manufacturing a product or providing a
services. The study facilitates measuring of the efficiency of the organisation
as a whole as well as of the departments besides devising means of
increasing the efficiency.
4. Cost Control and Cost Reduction: - Cost accounting assists in cost control
it uses techniques such as budgetary control, standard costing etc. for
controlling costs. Budgets are prepared will in advance. The standards for
each item of cost are determined, the actual costs are compared with the
standard costs and variances are found out as to their causes. This greatly
increases the operating efficiency of the enterprise. Besides it, cost is
required to be reduced also constant research and development activities
help in reduction of costs without compromising with the quality of goods or
services.
5. Cost Management: - The term ‘Cost Management’ includes the activities of
managers in short-run and long-run planning and control of costs. Cost
management has a broad focus. It includes both cost control and lost
reduction. As a matter of fact cost management is often invariably linked
with revenue and profit planning. For instance, to enhance revenue and
profits, the management often deliberately incurs additional costs for
advertising and product modifications.
6. Ascertaining Profits: - Cost accounting also aims at ascertaining the profits
of each and every activity. It produces statements at such intervals as the
management may require. The financial statements prepared under
financial accounting, generally once a year or half – year, are spaced too far
apart in time to meet the needs of the management. In order to operate the
business at a high level of efficiency, it is essential for the management to
257
have a frequent review of production, sal es and operating results. Cost

accounting provides daily, weekly or monthly volumes of units produced,
accumulated costs together with appropriate analysis so that quantum of
profit and profitability is known.
7. Providing Basis for Managerial Decision – Making: - Costs accounting
helps the management in formulation operative policies. These policies may
relate to any of the following matters:-
a. Determination of cost – volume – profit relationship.
b. Shutting down or operating at a loss.
c. Making or buying from outside supplies.
d. Continuing with the existing plant and machinery or replacing them by
improved and economical means.
20.3.8 GENERAL PRINCIPLES OF COST ACCOUNTING
The following may be considered as the General Principles of Cost
Accounting:
1. A cost should be related to its causes: Cost should be related as closely as
possible to their causes so that cost will be shared only among the cost units
that pass thorough the department of which the expense are related
2. A cost should be charged only after it has been incurred: While
determining the cost of individual units those costs which have actually
been incurred should be considered. For example, a cost unit should not be
charged to the selling costs, while it is still in the factory. Selling costs can
be charged with the products which are sold.
3. The convention of prudence should be ignored: Usually accountants
believe in historical costs and while determining cost, they always attach
importance to historical cost. In Cost Accounting this convention must be
ignored, otherwise, the management appraisal of the profitability of the
projects may be vitiated. According to W.M. Harper, “a cost statement
should, as far as possible, give facts with no known bias. If a contingency
needs to be taken into consideration it should be shown separately and
distinctly”.
4. Abnormal costs should be excluded from cost accounts: Costs which are
of abnormal nature (eg. Accident, negligence etc.) should be ignored while
computing the cost, otherwise, it will distort costs figures and mislead
management as to working results of their undertaking under normal
conditions.
5. Past costs not to be charged to future period: Costs which could not be
recovered or charged in full during the concerned period should not be taken
to a future period, for recovery. If past costs are included in the future
period, they are likely to influence the future period and future results are
likely to be distorted.
6. Principles of double entry should be applied wherever necessary:
Costing requires a greater use of cost sheets and cost statements for the
purpose of cost ascertainment and cost control, but cost ledger and cost
control accounts should be kept on double entry principle as far as possible.
258
20.3.9 DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING:

Basis Financial Accounting Cost accounting
(i) Objective It provides information about the It provides information of
financial performance and ascertainment of cost to control
financial position of the business. cost and for decision making
about the cost.
(ii) Nature It classifies records, presents and It classifies, records, presents,
interprets transactions in terms and interprets in a significant
of money. manner the material, labour
and overheads cost.
(iii) Recording It records Historical data. It also records and presents the
of data estimated/budgeted data. It
makes use of both the historical
costs and pre-determined costs.
(iv) Users of The users of financial accounting The cost accounting
information statements are shareholders, information is used by internal
creditors, financial analysts and management at different levels.
government and its agencies, etc.
(v) Analysis of It shows the profit/ loss of the It provides the details of cost
costs and organisation. and profit of each product,
profits process, job, contracts, etc.
(vi) Time Financial Statements are Its reports and statements are
period prepared for a definite period, prepared as and when required.
usually a year.
(vii) A set format is used for There are not any set formats
Presentation presenting financial information. for presenting cost information.
of
information
20.3.10 MANAGEMENT VS. COST ACCOUNTING
Management accounting collects data from cost accounting and financial
accounting. Thereafter, it analyzes and interprets the data to prepare reports and
provide necessary information to the management.
On the other hand, cost books are prepared in cost accounting system from
data as received from financial accounting at the end of each accounting period.
20.3.11 THE DIFFERENCE BETWEEN MANAGEMENT AND COST ACCOUNTING ARE AS
FOLLOWS:
Basis Cost Accounting Management Accounting
1. Objectives The main objective of cost The primary objective of
accounting is to assist the management accounting is to
management in cost control provide necessary information
and decision-making. to the management in the
process of its planning,
controlling, and performance
259
evaluation, and decision-

making.
2. Data Used Cost accounting system uses Management accounting uses
quantitative cost data that can both quantitative and
be measured in monitory qualitative data. It also uses
terms. those data that cannot be
measured in terms of money.
3. Primary role Determination of cost and cost Efficient and effective
control are the primary roles of performance of a concern is
cost accounting. the primary role of
management accounting.
4. Dependence Success of cost accounting Success of management
does not depend upon accounting depends on sound
management accounting financial accounting system
system. and cost accounting systems of
a concern.
5. Base Cost-related data as obtained Management accounting is
information from financial accounting is the based on the data as received
& Data base of cost accounting. from financial accounting and
cost accounting.
6. Benefits Provides future cost-related Provides historical and
decisions based on the predictive information for
historical cost information. future decision-making.
7. Use of Cost accounting reports are Management accounting
Report useful to the management as prepares reports exclusively
well as the shareholders and meant for the management.
creditors of a concern.
8. Use of Only cost accounting principles Principals of cost accounting
Principles are used in it. and financial accounting are
used in management
accounting.
9. Statutory Statutory audit of cost No statutory requirement of
Requirement accounting reports are audit for reports.
necessary in some cases,
especially big business houses.
10. Restriction Cost accounting is restricted to Management accounting uses
of Data cost-related data. financial accounting data as
well as cost accounting data.

1. Cost Accounting is a branch of accounting and has been developed due to
limitations of financial accounting
2. Cost accounting is the process of accounting for costs.
260
3. Costing is the technique and process of ascertaining costs.

4. Cost accounting is different from costing in the sense that the former
provides only the basis and information for ascertainment of cost.
5. cost control means the act of power of controlling or regulating or
dominating or commanding costs through the application of management
tools and techniques to the performance of any operation to most
predetermined objectives of quality, quantity, value and time oat an
optimum outlay.
6. Objectives of cost accounting includes ascertain cost, determining
selling price, measuring and increasing efficiency, cost control and cost
reduction, cost management, ascertaining profit, providing basis for
managerial decision making.
1. Define costing.
2. Define cost control
3. What do you mean by cost accounting?
4. Define financial accounting
5. Define management accounting
20.6 SUMMARY
The terms costing and cost accounting are often used interchangeably. Cost
accountancy is very wide term. . Cost accountancy includes costing, cost
accounting, cost control and cost audit. cost accountancy means, the application
of costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control. It includes the presentation of information derived
there from for the purpose of managerial decision making. cost control means the
act of power of controlling or regulating or dominating or commanding costs
through the application of management tools and techniques to the performance of
any operation to most predetermined objectives of quality, quantity, value and time
oat an optimum outlay. Objectives of cost accounting includes ascertain cost,
determining selling price, measuring and increasing efficiency, cost control and cost
reduction, cost management, ascertaining profit, providing basis for managerial
decision making. general principles of cost accounting is A cost should be related
to its causes, a cost should be charged only after i t has been incurred, the
convention of prudence should be ignored, abnormal costs should be excluded from
cost accounts, past costs not to be charged to future period, principles of double
entry should be applied wherever necessary
The difference between financial accounting and cost accounting is based on
objectives, nature, recording of data, user of information analysis of costs and
profits, time period, presentation of information. The difference between
Management accounting and cost accounting is based on objectives, data used,
primary role, dependence, base information and data benefits, use of reports, use
of principle, statutory requirement, restriction of data.
261

1. …………………………………..accounting is a branch of accounting and has
been developed due to limitations of financial accounting.
2. ………………………………..accounting is primarily concerned with record
keeping directed towards the preparation of Profit and Loss Account and
Balance Sheet
3. ………………………………. accounting is the process of accounting for costs.
4. …………………………………..is the technique and process of ascertaining
costs.
1. http://eacharya.inflibnet.ac.in/
2. http://costkiller.net/
3. http://www.icsi.in/
4. http://icmai.in/
5. http://www.newagepublishers.com/
6. https://www.coursehero.com
7. http://imr.ac.in/
8. http://www.dphu.org/
9. basiccollegeaccounting.com/
10. http://www.naturalproductsinsider.com/
11. http://www.yourarticlelibrary.com/
12. http://kafco.in/
20.9 ASSIGNMENTS
1. What are the essential principles of good costing system.
2. A good costing system of costing serves as a means of control over
expenditure and helps to secure economy in manufacture. Discuss
3. State and explain the difference between cost accounting and financial
accounting.
1. Arora .M.N Cost Accounting Principles and Practice Vikas publishing
House PVT Ltd
2. Jain and Narang Cost Accounting
3. Pillai R.S.N, Bagavathi Management Accounting S.Chand company
1. Meet a cost accountant and discuss with him regarding the objectives
and principles of cost accounting.
20.12 KEYWORDS
Costing, Cost Accounting, Cost Control, Management Accounting, Cost
accounting, Financial Accounting,
262
LESSON 21
IMPORTANCE OF COST ACCOUNTING
21.1 INTRODUCTION
Compare with financial accounting, cost accounting is relatively a recent
development. Cost accounting started as a branch of financial accounting, but now
it is regarded as a system in its own right. The vital importance that cost
accounting has acquired in the modern age is because of the growth of complexities
in modern industry. Cost accounting has primarily developed to meet the needs of
management. Cost accounting provides detailed cost information to various levels
of management for efficient performance of their functions.
21.2 OBJECTIVES
 Importance of Cost Accounting
 Classification and elements of Costs
 Components of total cost
21.3 CONTENT
20.3.1 Importance of Cost Accounting
20.3.2 Installation of Cost Accounting System
20.3.3 Classification Of Cost
20.3.4 Elements of Cost
20.3.5 Items Excluded from Cost Accounts
20.3.6 Components of Total Costs
20.3.7 Adjustment for Inventories
20.3.8 Cost Sheet
21.3.1 IMPORTANCE OF COST ACCOUNTING
1. Costing helps in periods of trade depression and trade competition:-
In periods of trade depression the business cannot afford to have leakages
which pass unchecked. The management should know where economies may be
sought, waste eliminated and efficiency increased. The business has to wage a
wax for its survival. The management should know the actual cost of their
products before embarking on any scheme of reducing the prices on giving tenders.
Adequate costing facilitates this.
2. Aids in price fixation:-
Though economic law & supply and demand and activities of the competitors,
to a great extent, determine the price of the article, cost to the producer does play
an important part. The producer can take necessary guidance from his costing
records.
3. Helps in estimate:-
Adequate costing records provide a reliable basis upon which tende rs and
estimates may be prepared. The chances of losing a contract on account of over –
rating or losing in the execution of a contract due to under – rating can be
263
minimized. Thus, “ascertained costs provide a measure for estimates, a guide to

policy, and a control over current production”.
4. Helps in channeling production on right lines:-
Costing makes possible for the management to distinguish between profitable
and non-profitable activities profit can be maximized by concentrating on profitable
operations and eliminating non-profitable ones.
5.Wastages are eliminated:-
As it is possible to know the cost of the article at every stage, it becomes
possible to chock various forms of waste, such as time, expenses etc. or in the use
of machine, equipment and tools.
6.Costing makes comparison possible:-
If the costing records are regularly kept, comparative cost data for different
periods and various volumes of production will be available. It will help the
management in forming future lines of action.
7.Provides data for periodical profit and loss accounts:-
Adequate costing records supply to the management such data as may be
necessary for preparation of profit and loss account and balance sheet, at such
intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial
accounts thus helps in presentation of better information before the management.
8.Aids in determining and enhancing efficiency:-
Losses due to wastage of material, idle time of workers, poor supervision etc.,
will be disclosed if the various operations involved in manufacturing a product are
studied by a cost accountant. The efficiency can be measured and costs controlled
and through it various devices can be framed to increase the efficiency.
9. Helps in inventory control:-
Costing furnishes control which management requires in respect of stock of
materials, work-in-progress and finished goods.
10. Helps in cost reduction:-
Costs can be reduced in the long run when alternatives are tried. This is
particularly important ion the present day context of global competition cost
accounting has assumed special significance beyond cost control this way.
11. Assists in increasing productivity
Productivity of material and labour is requi red to be increased to have
growth and more profitability in the organisation costing renders great assistance
in measuring productivity and suggesting ways to improve it.
21.3.2 INSTALLATION OF COST ACCOUNTING SYSTEM
It is essential to undertake a prelimi nary investigation installing a suitable
system of cost accounting to know the feasibility of installing cost accounting
system to such business.
264
Essential Conditions: The following conditions are essential for successful

functioning of the costing system:-
i. Material control system should be very efficient
ii. The role of cost accounting must be clear.
iii. The methods of wage payment must be sound and well designed.
iv. The cost report should be printed forms to facilitate quick compilation.
v. The cost and financial accounts must be integrated so as to facilitate
reconciliation of profit.
21.3.3 CLASSIFICATION OF COST:
Costs can be classified based on the following attributes:
 Based on Nature
 Based on Degree of Traceability of the Product
 Based on Controllability
 Based on Relationship with Accounting Period
 Based on Association with the Product
 Based on Functions
 Based on Change in Activity or Volume
Based on Nature
In this type, material, labor and overheads are three costs, which can be
further sub-divided into raw materials, consumables, packing materials, and spare
parts etc.
Based on Degree of Traceability of the Product
Direct and indirect expenses are main types of costs come under it. Direct
expenses may directly attributable to a partic ular product. Leather in shoe
manufacturing is a direct expenses and salaries, rent of building etc. come under
indirect expenses.
Based on Controllability
In this classification, two types of costs fall:
 Controllable - These are controlled by management like material labour
and direct expenses.
 Uncontrollable - They are not influenced by management or any group
of people. They include rent of a building, salaries, and other indirect
expenses.
BASED ON RELATIONSHIP WITH ACCOUNTING PERIOD
Classifications are measured by the period of use and benefit. The capital
expenditure and revenue expenditure are classified under it. Revenue expenses
relate to current accounting period. Capital expenditures are the benefits beyond
265
accounting period. Fixed assets come under category of capital expenditure and
maintenance of assets comes under revenue expenditure category.
Based on Association with the Product
There are two categories under this classification:
 Product cost - Product cost is identifiable in any product. It includes
direct material, direct labor and direct overheads. Up to sale, these
products are shown and valued as inventory and they form a part of
balance sheet. Any profitability is reflected only when these products are
sold. The Costs of these products are transferred to costs of goods sold
account.
 Time/Period base cost - Selling expenditure and Administrative
expenditure, both are time or period based expenditures. For example,
rent of a building, salaries to employees are related to period only.
Profitability and costs are depends on both, product cost and
time/period cost.
Based on Functions
Under this category, the cost is divided by its function as follows:
 Production Cost - It represents the total manufacturing or production cost.
 Commercial cost - It includes operational expenses of the business and
may be sub-divided into administration cost, and selling and distribution
cost.
Based on Change in Activity or Volume
Under this category, the cost is divided as fixed, variable, and semi-variable
costs:
 Fixed cost - It mainly relates to time or period. It remains unchanged
irrespective of volume of production like factory rent, insurance, etc. The
cost per unit fluctuates according to the production. The cost per unit
decreases if production increases an d cost per unit increases if the
production decreases. That is, the cost per unit is inversely proportional to
the production. For example, if the factory rent is Rs 25,000 per month and
the number of units produced in that month is 25,000, then the cost of rent
per unit will be Rs 1 per unit. In case the production increases to 50,000
units, then the cost of rent per unit will be Rs 0.50 per unit.
 Variable cost - Variable cost directly associates with unit. It increases or
decreases according to the volume of production. Direct material and direct
labor are the most common examples of variable cost. It means the variable
cost per unit remains constant irrespective of production of units.
 Semi-variable cost - A specific portion of these costs remains fixed and the
balance portion is variable, depending on their use. For example, if the
minimum electricity bill per month is Rs 5,000 for 1000 units and excess
266
consumption, if any, is charged @ Rs 7.50 per unit. In this case, fixed

electricity cost is Rs 5,000 and the total cost depends on the consumption
of units in excess of 1000 units. Therefore, the cost per unit up to a certain
level changes according to the volume of production, and after that, the cost
per unit remains constant @ Rs 7.50 per unit.
21.3.4 ELEMENTS OF COST
There are three broad elements of cost:-
a. Material
b. Labour
c. Expenses
a. Material: - The substance from which the product is made is known as
material. It may be in a raw or a manufactured state. It can be direct as well as
indirect.
Direct Material: - All material which becomes an integral part of the finished
product and which can be conveniently assigned to specific physical units is termed
as “Direct Material”.
Following are some of the examples of direct material:-
i. All material or components specifically purchased produced or
requisitioned from stores.
ii. Primary packing material (e.g. – cartoon, wrapping, cardboard, boxes etc.)
iii. Purchased or partly produced components.
Direct material is also described as raw-material, process material, prime
material, production material, stores material, constructional material etc.
Indirect Material: - All material which is used for purposes ancillary to the
business and which cannot be conveniently assigned to specific physical units is
termed as “Indirect Material”.
Consumable stores, oil and waste, printing and stationery etc. are a few
examples of indirect material
Indirect material may be used in the factory the office or the selling and
distribution division.
b. Labour: - For conversion of materials into finished goods, human effort is
needed such human effort is called labour. Labour can be direct as well as
indirect.
Direct labour: - Labour which takes an active and direct part in the
production of a particular commodity is called labour. Direct labour costs are,
therefore specially and conveniently traceable to specific products.
Direct labour is also described as process labour, productive labour, operating
labour, manufacturing labour, direct wages etc.
267
Indirect labour:- labour employed for the purpose of carrying out tasks
incidental to goods or services provided, is indirect labour such labour does
not alter the construction, composition or condition of the product. It cannot be
practically traced to specific units of output wages of store – keepers, foreman, time
– keepers, directors, fees, salaries of salesmen, etc. are all examples of indirect
labour costs.
Indirect labour may relate to the factory the office or the selling and
distribution division.
c. Expenses: - Expenses may be direct or indirect.
Direct expenses: - These are expenses which can be directly, conveniently and
wholly allocated to specific cost centers or cost units. Examples of such expenses
are: hire of some special machinery required for a particular contract, cost of
defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as “chargeable expenses”.
Indirect expenses:- these are expenses which cannot be directly, conveniently
and wholly allocated to cost centers or cost units.
OVERHEADS:- It is to be noted that the term overheads has a wider meaning
than the term indirect expenses overheads include the cost of indirect material,
indirect labour besides indirect expenses.
Indirect expenses may be classified under the following three categories:-
(a) Manufacturing (works, factory or production) expenses:-
Such indirect expenses which are incurred in the factory and concerned with
the running of the factory or plant are known as manufacturing expenses.
Expenses relating to production management and administration are included
there in. Following are a few items of such expenses:
Rent, rates and insurance of factory premises, power used in factory building,
plant and machinery etc.
(b) Office and Administrative expenses
These expenses are not related to factory but they pertain to the management
and administration of business such expenses are incurred on the direction and
control of an undertaking example are :- office rent, lighting and heating, postage
and telegrams, telephones and other charges; depreciation of office building,
furniture and equipment, bank charges, legal charges, audit fee etc.
(c)Selling and Distribution Expenses:-
Expenses incurred for marketing of a commodity, for securing orde rs for the
articles, dispatching goods sold, and for making efforts to find and retain customers
are called selling and distribution expenses examples are:-
Advertisement expenses cost of preparing tenders, traveling expenses, bad
debts, collection charges etc.
Warehouse charges packing and loading charges, carriage outwards, etc.
268
ELEMENTS OF COST
The above classification of different elements of cost can be presented in the
form of the following chart:
21.3.5 ITEMS EXCLUDED FROM COST ACCOUNTS

There are certain items which are included in financial accounts but not in cost
accounts. These items fall into three categories:-
Appropriation of profits
i. Appropriation to sinking funds.
ii. Dividends paid
iii. Taxes on income and profits
iv. Transfers to general reserves
v. Excess provision for depreciation of buildings, plant etc. and for bad debts
vi. Amount written off – goodwill, preliminary expenses, underwriting
commission, discount on debentures issued; expenses of capital issue etc.
vii. Capital expenditures specifically charge d to revenue
viii. Charitable donation
Matters of pure finance
(a) Purely financial charges:-
i. Losses on sale of investments, buildings, etc.
ii. Expenses on transfer of company’s office
iii. Interest on bank loan, debentures, mortgages, etc.
iv. Damages payable
v. Penalties and fines
vi. Losses due to scrapping of machinery
vii. Remuneration paid to the proprietor in excess of a fair reward for
services rendered.
(b) Purely financial incomes:-
i. Interest received on bank deposits
ii. Profits made on the sale of investments, fixed assets, etc.
iii. Transfer fees received
269
iv. Rent receivable

v. Interest, dividends, etc. received on investments.
vi. Brokerage received
vii. Discount, commission received
Abnormal gains and losses:-
i. Losses or gains on sale of fixed assets.
ii. Loss to business property on account of the ft, fire or other natural
calamities.
In addition to above abnormal items (gain and losses) may also be excluded
from cost accounts. Alternatively, these may be taken to costing profit and loss
account.
21.3.6 COMPONENTS OF TOTAL COST
Prime cost: - It consists of costs of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost.
Factory cost:- It comprises of prime cost and in addition works of factory
overheads which includes costs of indirect material, indirect labour and indirect
expenses of the factory. The cost is also known as works cost, production or
manufacturing cost.
Office cost: - If office and administrative overheads are added to factory cost
office cost is arrived at this is also termed as administrative cost or the total cost of
production.
Total cost:- Office cost or total cost of production selling and distribution
overheads are added to the total cost of production to get the total cost or the cost
of sales.
Cost of sales or total cost. The various components of total cost can be
depicted through the help of the following chart:-
Components of Total cost
Direct material plus
Direct labour plus Prime cost or Direct cost or First cost
Direct expenses
Prime cost plus
works cost or factory or production cost or

manufacturing cost
Works overheads
270
Work cost plus office and
Cost of Production
Administrative overheads
Office cost plus selling
And distribution overheads Cost of Sales or Total Cost
20.3.7 ADJUSTMENTS FOR INVENTORIES

For the purpose of Accounting the stock or inventory may be of three type’s
viz., Stock of Raw Material, Stock of Work in Progress or Semi finished Goods and
Stock of Finished Goods. At the time of ascertaining the cost of a product these
items should be accounted in a proper manner then only correct amount of cost at
different stages can be arrived and the aim of the cost accounting can be achieved.
The following adjustments may have to be made for inventories of raw materials,
work – in – progress and finished goods while computing the different components
of cost:
21.3.8 COST SHEET

Cost sheet is an analytical statement of expenses relating to production of an
article which informs regarding total cost, per unit cost and quantity of production.
According to Wheldon, “Cost sheets are prepared for the use of management
and consequently, they must include all the essential details which will assist the
manager in checking the efficiency of production.”
In the words of C.I.M.A., London, “Cost sheet is a cost schedule or document
which provides for the assembly of the estimated detailed cost in respect of a cost
centre or cost unit”
When cost per unit of production is not necessary to calculate then a
statement of cost is prepared to ascertain total cost and profit or loss on
production.
271
Cost Sheet or Statement of Cost (without Inventory or stock value)
For the year ending………………
Output……………units
Total Cost Cost Per

Particulars Unit
Rs. Rs.
Direct Materials Consumed Xxx x.xxxx
Direct Wages Xxx x.xxxx
Direct Charges or Chargeable Expenses Xxx x.xxxx
Prime Cost Xxx x.xxxx
Works Overhead Xxx x.xxxx
W orks Cost Xxx x.xxxx
Administrative or Office Overhead Xxx x.xxxx
Cost of Production or Cost of Goods Sold Xxx x.xxxx
Selling and Distribution Overhead Xxx x.xxxx
Selling Cost or Total Cost Xxx x.xxxx
Profit Xxx x.xxxx
Sales Xxx x.xxxx
Cost Sheet or Statement of Cost or Production Statement
(with Inventory or stock value)
Output…………units
Total Cost Cost Per

Particulars Unit
Rs. Rs.
Opening stock of Raw Material

xxx
Add: Purchase of Raw Material and Purchase

272
Expenses
xxx
xxx
Less: Closing Stock of Raw Material

xxx
Direct Materials Consumed Xxx x.xxxx
Direct Wages Xxx x.xxxx
Direct Charges or Chargeable Expenses Xxx x.xxxx
Prime Cost Xxx x.xxxx
Works Overhead Xxx x.xxxx
Gross W orks Cost Xxx x.xxxx
Add: Opening Stock of Work in Progress Xxx -
Xxx -
Less: Closing Stock of Work in Progress Xxx -
W orks Cost Xxx x.xxxx
Administrative or Office Overhead Xxx x.xxxx
Cost of Production Xxx x.xxxx
Add: Opening stock of Finished Goods Xxx -
Xxx -
Less: Closing Stock of Finished Goods Xxx -
Cost of Goods Sold Xxx x.xxxx
Selling and Distribution Overhead Xxx x.xxxx
Total Cost Xxx x.xxxx
Profit Xxx x.xxxx
Sales or Selling Price Xxx x.xxxx
Practical Problems
273
Illustration 1 Calculate prime cost from the following information:-

Direct material - Rs. 40,000, Direct labour - Rs. 30,000 Direct expenses - Rs.
25.000
Solution: Prime cost = Direct Material + Direct labour + Direct expenses
= Rs. 40,000 + Rs.30, 000 + Rs. 25,000
= Rs. 95,000
Illustration 2.Calculate prime cost from the following information:-
Opening stock of raw material = Rs. 12,500
Purchased raw material = Rs. 75,000
Expenses incurred on raw material = Rs. 5,000
Closing stock of raw material = Rs. 22,500
Wages Rs. 47,600 Direct expenses Rs. 23,400
Solution: - Calculation of raw material consumed:-
Raw material consumed = Opening stock of material + purchases of Raw
material + expenses incurred on raw material - closing stock of raw material
= Rs 12,500 + Rs 75,000 + Rs 5,000 – Rs 22,500
= Rs. 92,500 – Rs 22,500
= Rs. 70,000
Prime cost = Raw material consumed + Direct labour + Direct expenses
= Rs 70,000 + Rs 47,600 + Rs 23,400
= Rs 1, 41,000
OR
It can be shown in vertical form such as cost sheet
Particular Details Amount (Rs)
(Rs)
Opening stock of raw material 12,500
Add:- Purchase 7,500
Add:- Expenses incurred on purchases 5,000
Raw material available 92,500
Less :- closing stock of raw material 22,500
RAW MATERIAL CONSUMED 70,000
Add:- Direct wages or labour 47,600
Add:- Direct expenses 23,400
PRIME COST 1,41,000
274
Illustration 3. Calculate works cost or factory cost from the following details:-
Raw material consumed = Rs 50,000

Direct wages = Rs20, 000
Direct expenses = Rs 10,000
Factory expenses 80% of direct wages
Opening stock of work in progress = Rs 15,000
Closing stock of work in progress = Rs 21,000
Solution: - Calculation of factory cost

Particular Amount (Rs) Amount (Rs)
Direct material consumed 50,000
Add:- Direct wages 20,000
Add:- Direct Expenses 10,000
-------------
Prime cost 80,000
Add:- Factory expenses 16,000

--------------
Current manufacturing cost 96,000
Add:- Opening stock of work in progress 15,000
--------------
Total goods processed during the period 1,11,000
Less:- Closing sock of work in progress 21,000
--------------
Factory cost or work cost 90,000
Illustration 4. Calculate cost of production from the following information:-
Raw material purchased = Rs 42,500
Freight paid = Rs 5,000
Labour charges = Rs 12,500
Direct expenses = Rs 10,000
Factory overhead 80% of Direct labour charges
Administrative overhead = 10% of work cost

275
Opening stock Closing stock
Raw material 8,000 10,000
Work in progress 7,500 9,000
Solution: - Calculation of cost of production:-

Material purchased 42,500

Add:- freight 5,000
-------------
Total cost of material purchased 47,500
Add:- Opening stock of Raw material 8,000
------------
Material available for consumption 55,500
Less:- Closing stock of Raw material 10,000
------------
Raw material consumed 45,500
Add:- Direct labour charges 12,500
Add:- Direct expenses 10,000
Prime cost 68,000
Add:- Factory overhead 10,000
------------
Current manufacturing cost 78,000
------------
Total goods processed during the period 85,500
Less:- Closing stock of work in progress 9,000
------------
Factory cost 76,500
Add:- Administrative overhead 7,650
------------
Cost of production 84,150
Illustration 5. Prepare cost sheet from the following particular in the book of B.
M. Rehman
Raw material purchased = Rs. 1, 20,000
Paid freight charges = Rs 10,000
Wages paid to laborers = Rs 35,000

276
Directly chargeable expenses = Rs 25,000
Factory on cost = 20% of prime cost
General and administrative expenses = 4% of factory cost
Selling and distribution expenses = 5% of production cost
Profit 20% on sales
Opening stock Closing stock
Raw material 15,000 20,000
Work in progress 17,500 24,000
Finished goods 20,000 27,500
Solution:-
Book of B. M. Rehman
Cost sheet
Raw material purchased 1,20,000

Add:- freight charges 10,000
---------------
Total cost of raw material purchased 1,30,000
Add:- opening stock of raw material 15,000
---------------
Cash of raw material available 1,45,000
Less:- closing stock of raw material 20,000
--------------
Raw material consumed 1,25,000
Add:- wages paid to labours 35,000
Add:- Directly chargeable expenses 25,000
--------------
Prime cost 1,85,000
Add:- Factory overhead 20% of prime cost 37,000
---------------
Current manufacturing cost 2,22,000
---------------
Total goods processed during the period 2,39,500
277
Less:- closing stock of work in progress 24,000

---------------
Factory on work cost 2,15,500
Add:- General & administrative expenses 4% of factory 8,620
cost ---------------
Cost of production 2,24,120
Add:- opening stock of finished goods 20,000
--------------
Goods available for sales 2,44,120
Less:- closing stock of finished goods 27,500
--------------
Cost of goods sold 2,16,620
Add:- selling and distribution expenses 5% of 11,206
production cost --------------
Cost of sales 2,27,826
Add:- Profit 56,956.50
---------------
Sales 2,84,782.50
Illustration 6. Prepare cost sheet in the book of M. B. Rehman from the
following particulars.
Opening stock: - Raw material = Rs 5,000

Finished goods = Rs 4,000
Closing stock: - Raw material = Rs 4,000
Finished goods = Rs 5,000
Raw material purchased = Rs 50,000
Wages paid to laboures = Rs 20,000
Chargeable expenses = Rs 2,000
Rent and Taxes = Rs 7,400
Power = Rs 3,000
Experimental expenses = Rs 600
Sale of wastage of material = Rs 200
Office management salary = Rs 4,000
Office printing & stationery = Rs 200
Salaries to salesman = Rs 2,000
Commission to traveling agents = Rs 1,000
Sales = Rs 1,00,000
278
Solution:-
Book of B. M. Rehman
Cost sheet
Particular Details (Rs) Amount (Rs)
Raw material purchased 50,000

Add:- Opening stock of raw material 5,000
---------------
Raw material for consumption 55,000
Less:- closing stock of raw material 4,000
---------------
Raw material consumed 51,000
Less:- Sale of wastage of materials 200
------------- 50,800
Add:- Direct labour 20,000
Add:- Direct chargeable expenses 2,000
--------------
Prime cost 72,800
Add:- Factory overhead
Rent & Taxes 7,400
Power 3,000
Experimental charges 600
-------------- 11,000
Factory cost 83,800
Add:- Administrative overhead:-
Office management salary 4,000
Office printing & stationery 200
--------------- 4,200
Cost of production 88,000
Add:- Opening stock of finished goods 4,000
-------------
Goods available for sales 92,000
Less:- closing stock of finished goods 5,000
-------------
Cost of goods sold 87,000
Add:- selling and distribution overhead:-
Salaries of salesman 2,000
Commission to traveling agent 1,000
-------------- 3,000
Cost of sales 90,000
Profit 10,000
--------------
Sales 1,00,000
279
Illustration 7. The cost of sale of production ‘A’ is made up as follows:-

Material used in manufacturing Rs 5,500
Material used in packing material Rs 1,000
Material used in selling the product Rs 150
Material used in the factory Rs 175
Material used in the office Rs 125
Labour required in production Rs 1,000
Labour required for supervision in factory Rs 200
Expenses direct factory Rs 500
Expenses indirect factory Rs 100
Expenses office Rs 125
Depreciation of office building Rs 75
Depreciation on factory plant Rs 175
Selling expenses Rs 350
Freight on material Rs 500
Advertising Rs 125
Assuming that all products manufactured and sold, what should be the selling
price be fixed to obtain a profit of 20% on selling price.
Solution
Cost Sheet
Particular Amount Amount Amount
(Rs) (Rs) (Rs)
Direct material:-
Material used in manufacturing 5,500
Material used in Packing material 1,000
Freight on material 500
------------- 7,000
Direct wages:-
labour require in production 1,000
Direct expenses:- Direct factory 500
------------
Prime cost 8,500
Add:- Factory overhead

280
Indirect material used in factory 75
Indirect labour required for 200

supervision
Indirect factory expenses 100
Depreciation factory 175
------------- 275
------------- 550
Factory on works cost 9050
Add:- office & administrative expenses
Indirect material 125
Indirect expenses office 125
Indirect depreciation 75
------------ 200
------------- 325
Total cost of production 9375
Add:- selling and distribution

overhead:-
150
Indirect material
Indirect expenses 350
Advertisement 125
------------ 475
------------- 625
Cost of sales 10,000
Profit 2,500
-----------
Sales 12,500
281
Illustration 8.
Prepare a statement of cost from the following trading and P/L account for the
year ending March 31, 2008
Particular Amount Particular Amount
(Rs) (Rs)
To opening stock material 12,000 By sales 2,00,000
Finished goods 40,000 By closing stock 20,000
material
To purchases 1,20,000 Finished goods 50,000
To cost of moulds 3,000
To salary of factory manger 1,000
To depreciation of machine 800
To gross profit 63,200
------------ -----------
2,70,000 2,70,000
---------- ----------
To office salary 9,000 By Gross profit 63,200
To salesman salary 6,000 By interest from 800
bank
To insurance of office 1,000 By dividend received 200
building
To godown expenses 800 By rent received 900
To directors fees 2,000
To telephone charges 700
To showroom expenses 1,200
To delivery van expenses 1,500
To preliminary expenses 2,000
To interest on deb. 700
To market research exp. 600
To net profit 39,000
-------------- --------------
65,100 65,100
-------------- --------------
282
Solution
Statement of cost
(For the year ending 31 st March 2008)
Particular Details (Rs) Amount (Rs)
Direct material or Raw material purchased 1,20,000
Add:- opening stock of raw materials 12,000
Raw material for consumption 1,32,000
Less:- Closing sock of raw materials 20,000
Raw material consumed 1,12,000
Add:- Direct labour 30,000
Prime cost 1,42,000

Add:- Factory overhead:-
Cost of moulds 3,000
Factory manager salary 1,000
--------------- 4,800
---------------
Factory cost 1,46,800
Add:- office and administrate overhead
Salary 9,000
Insurance 1,000
Directors fees 2,000
Telephone charges 700
--------------- 12,700
-------------
Cost of production 1,59,500
Add:- Opening stock of finished goods 40,000
--------------
Goods available for sales 1,99,500
Less:- Closing stock of finished goods 50,000
--------------
Cost of goods sold 1,49,500
Add:- selling & distribution ext:-
Salesman’s salary 6,000
Insurance (godown) 800
Showroom expenses 1,200
Expenses of delivery van 1,500
Market research expenses 600
------------- 10,100
----------------
Cost of sales 1,59,600
Profit 40,400
----------------
Sales 2,00,000
283
Illustration 9.
The following inventory data relate to Nazia Ltd.
Inventories
Opening Closing
Finish goods Rs 1,100 Rs 950
Work in progress Rs 700 Rs 800
Raw materials Rs 900 Rs 950
Additional information:-
Cost of goods available for sales = Rs 6840

Total goods processed during the period = Rs 6540
Factory on cost = Rs 1670
Direct material used = Rs 1930
Requirements:-
i. determine raw material purchase
ii. determine the direct labour and cost incurred
iii. determine the cost of goods sold
Solution
(i) Raw material purchased:-
Raw material consumed = opening stock + purchases – closing stock
OR Rs 1,930 = Rs 900 + Purchases – Rs 950
OR Rs 1,930 + Rs 50 = purchases
Rs 1,980 = Raw material purchased
(ii) Direct labour cost:-
Cost of goods processed during the year = Rs 6,540
Less: - Opening work in progress = Rs 700
---------------
Rs 5,840
Less: - Factory overheads = Rs 1,670
---------------
Prime cost = Rs 4,170
Less: - Raw material consumed = Rs 1930
--------------
Direct labour cost = Rs 2,240
(iii) Cost of goods sold:-
= cost of goods available for sales – closing stock finished goods
= 6840 – 950 = Rs 5890
Illustration 10.
Mr. Zia furnishes the following data related to the manufacture of a standard
product during the month of August 2008
284
Raw material consumed - Rs 15,000

Direct labour - Rs 5,000
Machine hours worked - Rs 900
Machine hour rate - Rs 5
Administration overheads = 20% of works cost
Selling overheads - Rs 0.50 per unit
Unit produced - Rs 17,100
Unit sold - 16,000 @ Rs 4 per unit
You are required to prepare a cost sheet from the above showing:-
a. The cost per unit
b. Cost per unit sold and profit for the period
Solution
Book of Zia - Cost sheet
(For the month of August 31, 2008)
Direct material consumed 15,000 0.878
Direct labour 5,000 0.292
Direct expenses 4,000 0.233
-------------- --------------
Prime cost 24,000 1.403
Factory overheads
(900 hours @ Rs 5 per hour) 4,500 0.263
-------------- ---------------
W ork cost 28,500 1.666
Administrative overheads
@ 20% of works cost 5,700 0.333
-------------- ---------------
Cost of production 34,200 2,000
Less:- closing stock on August 31, 2008
(1100 units @ Rs 2 per unit) 2,200 -----
----------- --------------
Cost of goods sold 32,000 2.000
Selling overheads @ Rs 0.50 per unit for 8,000 0.50
16000 ----------- -------------
Cost of sales 40,000 2.50
Profit 24,000 1.50
------------ ------------
Sales (1600 unit) 64,000 4.00
285
* Closing stock = unit produced - units sold

= 17100-16000 = 1100 units
Practical problems (Short Answers)
1. Opening stock of raw material - Rs 15,000
Closing stock of raw material - Rs 20,000
Material purchased - Rs 1, 20,000
Find raw material consumed
(Ans. 1, 15,000)
2. Raw material consumed - Rs 1, 02,000
Raw material for consumption - Rs 1, 10,000
Raw material purchased - Rs 1, 00,000
Find opening & closing stock of raw material (Ans. Rs 10,000 and Rs 8,000)
3. Prime cost - Rs 1, 85,000

Current manufacturing cost - Rs 2, 22,000
Total goods processed during the period - Rs 2, 39,500
Works cost - Rs 2, 15,000
Find factory overheads, opening and closing stock of work in progress
(Ans. Rs 37,000, Rs 17,500 and Rs 24,000)

4. Cost of production - Rs 11,206
Goods available for sales - Rs 12,206
Cost of goods sold - Rs 10,831
Cost of Sales - Rs 11, 391
Sales - Rs 12,000
Find opening and closing stock of finished goods, selling expenses and profit or
loss (Ans. Rs 1,000, Rs 1,375, Rs 560 and Rs 609 profit)
5. Direct material consumed - Rs 60,000
Direct labour 50% of material consumed
Direct expenses - 33¹/³% of direct labour
Factory overheads - 40% of direct labour
Office overheads - on cost 66²/³% of works
Find office cost (Ans. Rs 1, 20,000)
PRACTICAL PROBLEMS (long answers)
1. From the following particulars prepare a cost sheet showing the total cost
per tone for the period ended 31 st December 1998
286
Rs Rs
Raw material 33,000 Director’s fees (office) 2,000
Productive wages 35,000 Factory cleaning 500
Direct expenses 3,000 Sundry office expenses 200
Unproductive wages 10,500 Estimating 800
Factory rent and terms 7,500 Factory stationery 750
Factory lighting 2,200 Office stationery 900
Factory heating 1,500 Factory insurance 1,100
Motive power 4,400 Office insurance 500
Haulage 3,000 Legal expenses 400
Director’s fees (works) 1,000 Rent of warehouse 300
Depreciation of Unkeeping of delivery vans 700
- plant and machinery 2,000 Bank charges 50
- office building 1,000 Commission on sales 1,500
- delivery vans 200 Loose tools written off 600
Bad debts 100 Rent and taxes (office) 500
Advertising 300 Water supply 1,200
Sales department 1,500
Salaries
The total output for the period has been 10,000 tones.
(Ans. Prime cost Rs 71,000 works cost Rs 1,08,050 office cost Rs 1,13,600 total
cost Rs 1,18,200 cost per tone Rs 11.82)
2. Prepare a cost sheet to show the total cost of production and cost per unit of
goods manufactured by a company for the month of July 1994. Also find out the
cost of sales.
Rs Rs
Stock of raw materials1-7-94 3,000 Factory rent & rates 3,000
Raw materials purchased 28,000 Office rent 500
Stock of raw materials 31-7-94 4,500 General expenses 400
Manufacturing wages 7,000 Discount on sales 300
Depreciation on plant 1,500 Advertisement 600
Loss on sale of a part of plant 300 Expenses to be charged 2,000
fully income tax paid
The number of units produced during July 1994 was 3,000
The stock of finished goods was 200 and 400 units on 1-7-1994 and 31-7-1994
respectively. The total cost of units on hand on 1-7-1994 was Rs 2,800. All these
had been sold during the month.
287
(Ans. Prime cost Rs 33,500 factory cost Rs 38,000 cost of production Rs 38,900
cost of sales Rs 37416)
3. The following particulars relating to the year 1994 have been taken from the
books of a chemical works manufacturing and selling a chemical mixture:
Rs Rs
Stock on 1st Jan. 1994
Raw materials 2,000 2,000
Finished mixture 500 1,750
Factory stores ------ 7,250
Purchases
Raw materials 1,60,000 1,80,000
Sales
Finished mixture 1,53,050 9,18,000
Factory scrap ------ 8,170
Factory wages ------ 1,78,650
Power ------ 30,400
Depreciation of machinery ------ 18,000
Salaries
Factory ------ 72,220
Office ------ 37,220
Selling ------ 41,500
Expenses
Direct ------ 18,500
Office ------ 18,200
Selling ------ 18,000
Stock on 31 December 1994
st
Raw material 1,200

Finished mixture 450
The stock of finished mixture at the end of 1994 is to be valued at the factory
cost of the mixture for that year. The purchase price of raw–materials uncharged
throughout 1994.
Prepare a statement giving the maximum possible information about cost and
its break up for the year 1994.
(Ans. Prime cost Rs 3,77,800 factory cost Rs 5,16,200 cost of production of
finished mixture sold Rs 5,71,852 cost of sales Rs 6,31,352)
288
4. Calculate
a. Value of raw-materials consumed
b. Total cost of production
c. Cost of goods sold and
d. The amount of profit from the following particulars:
Rs Rs
Opening stock Power 2,000
Raw – materials 5,000 Factory heating and lighting 2,000
Finished goods 4,000 Factory insurance 1,000
Closing stock Experimental Expenses 500
Raw – materials 4,000 Sales of wastage of 200
materials
Finished goods 5,000 Office management salaries 4,000
Raw – materials purchased 50,000 Office printing and 200
stationery
Wages paid to labourers 20,000 Salaries of salesmen 2,000
commission of traveling
agent
Chargeable expenses 2,000
Factory rent, rates & taxes 5,000 Sales 1,00,000
(Ans. (a) Rs 50,800, (b) Rs 87,500, (c) Rs 89,500, (d) Rs 10,500)
[Hint sales of raw-materials wastage of Rs 200 has been deducted from the cost
of raw-materials]
5. The cost of the sale of product ‘X’ is made up as follows:
Rs
Materials used in manufacturing 10,20
Materials used in packing materials 2,500
Materials used in selling the product 350
Materials used in office 75
Materials used in factory 125
Labour required in producing 2,500
Salary paid to works manager and other principal officers of the factory 450
Expenses – indirect office 250
Expenses – direct factory 1,000
Bad debts 300
Packing expenses 150
Lighting and heating charges of the factory 200
Expenses – indirect factory 125
289
Assuming that all the products manufactured are sold, what should be the
selling price to obtain a profit of 20% on cost price?
Illustrate in a chart fork for presentation to your mange, the division of costs of
product ‘X’
[Ans. Prime cost Rs 16,200, works cost Rs 17,100 cost of sales Rs 18,225 sales
Rs 21,870]
6. Calculate the prime cost, factory cost, total cost of production and cost of
sales from the following particulars:
Rs.
Raw materials consumed 12,000
Directly chargeable expenses 500
Wages paid to labourers 2,500
Grease, oil, cotton waste etc. 25
Salary manager and clerks 1,750
Insurance of stock of raw materials 300
Consumable stores 400
Printing and stationery:
Factory 50
Office 200
Sales deptt. 100
----------- 350
Rent of office building 150

Depreciation :
Factory premises 200
Office furniture 50
Delivery vans 75
--------- 325
Power and fuel 500
Contribution to provident fund of factory employees 1,000
Salaries of administrative directors 100
Bank charges 75
Cost of samples 250
Salaries of sales manger 300
Advertising 500
Packing material 350
Storage in stocks of finished goods 20
290
[Ans. Prime cost Rs 15,000, factory cost Rs 19225 total cost of production Rs
19,800 cost of sales Rs 21,395]
7. Calculate
1. Value of raw-materials consumed
2. Total cost of production
3. Cost of goods sold and
4. The amount of profit from the following particulars:
Rs
Opening stock:
Raw materials 1,350
Finished goods 2,500
Closing stock:
Raw-materials 750
Finished goods 1,500
Raw materials purchased 20,000
Wages paid to labourers 8,000
Direct expenses 1,250
Experimental expenses 450
Factory printing and stationery 350
Rent :
Factory 250
Office 120
-------- 370
Wages of fireman 1,000
Lighting – office 125
Audit fees 150
Telephone expenses 500
Advertising 1,250
Market research expenses 550
Salary of godown – keepers 175
Traveling expenses 750
Commission of traveling agent 500
Sales 50,000
[Ans. (a) value of raw – materials consumed Rs. 20,600 (b) Total cost of
production Rs 32,795, (c) cost of goods sold Rs 33,795, (d) profit Rs 12,980]
291
8. Prepare a statement of cost from the following trading and profit and loss
account for the year ending 31 st March, 1995.
Particulars Rs Particulars Rs
Opening stock: Sales 1,00,000
Materials 8,000 Closing stock:
Finished goods 25,000 Materials 15,000
Purchase of materials 70,000 Finished goods 30,000
Direct labour 10,000
Grease, oil etc. 500
Salary of storekeeper 700
Power & fuel 800
Gross profit c/d 30,000
------------- -------------
1,45,000 1,45,000
------------- -------------
Lighting: Gross profit b/d 30,000
Office 500 Dividends received 2,000
Sales deptt. 650 Interest on loan 600
Depreciation: Transfer fees 1,450
Office premises 1,000 Received
Delivery vans 750
Fees of office manager 2,000
Bank charges 1,500
Selling expenses 1,500
Sales commission 500
Preliminary expenses 3,000
Packing expenses 1,100
Dividends paid on 1,000
Share capital of company
Discount on debentures 500
Net profit 20,000
------------ -----------
34,000 34,000
292
[Ans. Prime cost Rs 73,000, works cost Rs 75,000, total cost of production Rs
80,000 cost of goods sold Rs 75000 cost of sales Rs 79,000 profit Rs 21,000]
9. The following data relate to the manufacture of standard product during the four
week ending on 28 th Oct. 1994.
Raw materials consumed Rs 20,000
Direct wages Rs 12,000
Machine hr worked 950 (hrs)
Machine hour rate Rs 2.00
Office overhead 15% on works cost
Selling overhead Rs 0.37 per unit
Units produced 20,000
Units sold @ Rs 2.50 each 18,000
Prepare a statement from the above showing:
a. The cost of production per unit, and
b. The profit for the period
[Ans. (a) Rs 1,949 (b) Rs 3,258
10. A firm has purchased a plant to manufacture a new product, the cost data for
which is given below:
Estimated annual sales 24,000 units
Estimated costs:
Material Rs 4.00 per unit
Direct labour Rs 0.60 per unit
Overheads Rs 24,000 per year
Administrative expenses Rs 28,800 per year
Selling expenses 15% of sales
Calculate the selling price if profit per unit is Rs 1.02
[Ans. Rs 9.20]
11. Prepare a cost sheet from the following data to find out profit and cost per unit:
Raw materials consumed Rs 1,60,000
Direct wages Rs 80,000
Factory overheads 20% of direct wages
Office overheads 10% of factory cost
Selling overheads 12,000
Unit produced 4,000
Units sold 3,600
Selling price Rs 100 per unit
[Ans. Prime cost Rs 2,40,000, factory cost Rs 2,56,000, cost of production Rs
2,81,600, cost of sales Rs 2,65,440, profit Rs 94,560]
293

1. IMPORTANCE OF COST ACCOUNTING includes Costing helps in periods
of trade depression and trade competition, aids in price fixation, helps in
estimation, helps in channeling production on right lines, wastages are
eliminated
2. Installation of Cost Accounting System It is essential to undertake a
preliminary investigation installing a suitable system of cost accounting to
know the feasibility of installing cost accounting system to such business.
3. ELEMENTS OF COST There are three broad elements of cost namely
Material, Labour and Expenses
4. OVERHEADS It is to be noted that the term overheads has a wider
meaning than the term indirect expenses overheads include the cost of
indirect material, indirect labour besides indirect expenses.
5. Components of total cost It includes prime cost , factory cost, office
cost and total cost.
1. Define Material.
2. Define labour.
3. Define Expenses.
4. Define overheads.
5. What are the elements of cost.
21.6 SUMMARY
IMPORTANCE OF COST ACCOUNTING includes Costing helps in periods of
trade depression and trade competition, aids in price fixation, helps in estimation,
helps in channeling production on right lines, wastages are eliminated, costing
makes comparison possible, provides data for periodical profit and loss accounts,
aids in determining and enhancing efficiency, helps in inventory control, helps in
cost reduction, assists in increasing productivity.
Installation of Cost Accounting System It is essential to undertake a preliminary
investigation installing a suitable system of cost accounting to know the feasibility
of installing cost accounting system to such business. Essential Conditions: The
following conditions are essential for successful functioning of the costing system:-
Material control system should be very efficient., The role of cost accounting must
be clear. ,The methods of wage payment must be sound and well designed. The cost
report should be printed forms to facilitate quick compilation. The cost and
financial accounts must be integrated so as to facilitate reconciliation of profit.
Costs can be classified based on the following attributes: Based on Nature,
Based on Degree of Traceability of the Product, Based on Controllability, Based on
Relationship with Accounting Period, Based on Association with the Product, Based
on Functions, Based on Change in Activity or Volume
294
ELEMENTS OF COST: There are three broad elements cost :Material, Labour,
Expenses .Material: - The substance from which the product is made is known as
material. It may be in a raw or a manufactured state. It can be direct as well as
indirect .Labour: - For conversion of materials into finished goods, human effort is
needed such human effort is cal led labour. Labour can be direct as well as
indirect. Expenses: - Expenses may be direct or indirect
OVERHEADS:- It is to be noted that the term overheads has a wider meaning
than the term indirect expenses overheads include the cost of indirect material,
indirect labour besides indirect expenses.
Components of total cost : Prime cost: - It consists of costs of direct material,
direct labour and direct expenses. It is also known as basic, first or flat cost.
Factory cost:- It comprises of prime cost and in addition works of factory
overheads which includes costs of indirect material, indirect labour and indirect
expenses of the factory. The cost is also known as works cost, production or
manufacturing cost. Office cost: - If office and administrative overheads are added to
factory cost office cost is arrived at this is also termed as administrative cost or the
total cost of production. Total cost:- Office cost or total cost of production selling
and distribution overheads are added to the total cost of production to get the total
cost or the cost of sales. Cost of sales or total cost. Cost sheets are prepared for the
use of management and consequently, they must include all the essential details
which will assist the manager in checking the efficiency of production.
1. …………………………………..is an analytical statement of expenses relating
to production of an article which informs regarding total cost, per unit cost
and quantity of production.
2. …………….. consists of costs of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost.
3. The substance from which the product is made is known as
……………………..
4. For conversion of materials into finished goods, human effort is needed
such human effort is called ………………………
4. http://icmai.in/
295
21.9 ASSIGNMENTS
1. What are the main benefits that may be expected from installation of a
costing system in a manufacturing business.
2. Costing system has become a essential tool in the hands of
management-Comment
3. Money spent on costing installing a costing syste m is not an expenses
but an investment. Give your views.
1. Arora .M.N Cost Accounting Principles and Practice Vikas publishing
House PVT Ltd
2. Jain and Narang Cost Accounting
3. Pillai R.S.N, Bagavathi Management Accounting S.Chand company
Visit a nearby organization and prepare a report on how the organization had
installed the cost accounting system
21.12 KEYWORDS
Material, Labour, Expenses, Overheads, Cost sheet, Prime cost, factory cost ,
office cost, works cost, total cost,
296
LESSON 22
ESSENTIALS OF GOOD COST ACCOUNTING SYSTEM
22.1 INTRODUCTION
The essentials of good cost accounting system should have stability as well as
specialty designed system. It should have executive support. The cost of installing
and operating system should be justified by results produced. In order to derive
maximum benefits from a costing system, well defined cost centers and
responsibilities centers should be built within the organization. Controllable and
non-controllable costs of each responsibility center should be separately shown.
It should have integration with the financial accounts .Well trained and
educated staff should be employed to operate the system. The cost accounting
department should prepare the accurate reports. Resources should not be wasted
on collecting and compiling cost data not required.
22.2 OBJECTIVES
 Essentials of good cost accounting
 Importance of cost centre, Profit centre
 Techniques of costing
 Different types of costing
22.3 CONTENT
22.3.1 Essentials of Good Cost Accounting System
22.3.2 Advantages of Cost Accounting
22.3.3 Limitations of Cost Accounting
22.3.4 Cost Units
22.3.5 Cost Centre
22.3.6 Profit Centre
22.3.7 Methods of Costing
22.3.8 Techniques of Costing
22.3.1 ESSENTIAL OF A GOOD COST ACCOUNTING SYSTEM
A good cost accounting should possess the following essential features:
i. It should be simple, practical and capable of meeting the business
concern requirements.
ii. Accurate data should be used by cost accounting system; otherwise it
may distort the output of the system.
iii. To develop a good system of cost accounting necessary co-operation and
participation of executives from various departments of the business is
needed.
iv. The cost of installing and operating the system should be result oriented
v. It should not sacrifice the utility by introducing unnecessary details.
vi. For the introduction of the system a carefully phased programmed
should be prepared by using network analysis.
297
vii. Management should have faith on costing system and works as a

helping hand for its development and success.
22.3.2 THE ADVANTAGES OF COST ACCOUNTING
Cost accounting is the process of collecting and interpreting information to
determine how an organization earns and uses funds. There are multiple
advantages to using cost accounting, since it provides vastly more actionable
information than the financial statements produced through financial accounting.
Here are the key advantages of cost accounting to consider:
 Cost object analysis. Revenues and expenses can be clustered by cost
object, such as by product, product line, and distribution channel, to
determine which ones are profitable or require further support.
 Discovers causes. An effective cost accountant not only locates problems
within a company, but also drills down through the data to determine the
exact cause of the issue, and also recommends solutions to management.
 Trend analysis. Costs can be tracked on a trend line to discover expense
surges that may be indicative of long-term trends.
 Modeling. Costs can be modeled at different activity levels. For example, if
management is contemplating the addition of a second shift, cost accounting
can be used to derive the additional costs associated with that shift.
 Acquisitions. The cost structures of possible acquisition candidates can be
examined to see if costs can be pruned in some areas, thereby justifying the
cost of the acquisition.
 Project billings. If a company is billing a customer based on costs incurred,
cost accounting can be used to accumulate costs by project and roll this
information into customer billings.
 Budget compliance. Actual costs incurred can be compared to budgeted or
standard costs, to see if any part of a business is spending more than
expected.
 Capacity. The ability of a business to support increased sales levels can be
examined by exploring the amount of its excess capacity. Conversely,
equipment that is idle can be sold off, thereby reducing the asset base of the
organization.
 Inventory valuation. The cost accountant is usually tasked with
accumulating the cost of inventory for financial reporting purposes. This
includes charging direct labor to inventory, as well as allocating factory
overhead to inventory.
22.3.3 LIMITATIONS OF COST ACCOUNTING
Cost Accounting has certain limitations. Important among them are as follows:
a) Based on estimates: Indirect costs are not charged fully to a product or
process. It is charged to all the products and processes on the basis of estimates.
Actual cost varies from estimated cost. Due to these limitations, all cost accounting
results are taken as mere estimates.
298
b) Lack of uniformity: Procedures of cost accounting followed by different

organisations are different for different products. There is no uniformity. There is
also possibility of difference in pricing material issues for production. All these lead
to different cost results for the same operation.
c) Many conventions: There are many conventions for classification of costs,
pricing of material issues, apportionment of indirect costs, adoption of marginal or
standard cost, etc. These create difficulty in determining the exact cost, because no
one type of cost is suitable for all. Purposes and in all circumstances.
d) Expensive: Cost accounting is expensive. It involves lots of clerical won for
maintaining various costing records for different purposes. For medium and small
size concern, the benefit derived from costing system may not justify the cost
involved.
e) Result requires reconciliation: Information and results provided b;
financial accounting and cost accounting may be different for the as activity. This
requires reconciliation to find out correctness of the two before taking any decision.
f) Dependent: It is not an independent system of accounting. It defends on
other accounting systems.
g) Does not include all items of expense and income: Items of purely
financial nature such as interest, financial charges, discount and loss on issue of
shares and debentures, etc. are not taken into consideration in Cost Accounting.
h) Not an exact science: Like other accounting system, it is not an exact]
science but an art that has developed through theories and practices.
22.3.4 COST UNITS
The Chartered Institute of Management Accountants, London, defines a unit of
cost as “a unit of quantity of product, service or time in relation to which costs may
be ascertained or expressed”. The forms of measurement used as cost units are
usually the units of physical measurements like number, weight, area, length,
value, time etc.
Following are some examples of cost unit.
Industry / Product Cost unit basis
Automobile Numbers
Brick works Per 1000 bricks
Cement Per Tonne
Chemicals Litre, Gallon, Kilogram, Ton
Steel Tonne
Sugar Tonne
Transport Passenger-Kilometre, Tonne Kilometer
22.3.5 COST CENTRE
According to Chartered Institute of Management Accountants, London, cost
centre means “a location, person or item of equipment (or group of these) for which
costs may be ascertained and used for the purpose of cost control”.
299
Cost centre is the smallest organizational sub- unit for which separate cost
collection is attempted. Thus cost centre refers to one of the convenient unit into
which the whole factory organization has been appropriately divided for costing
purposes. Each such unit consists of a department or a sub-department or item of
equipment or , machinery or a person or a group of persons.
For example, although an assembly department may be supervised by one
foreman, it may contain several assembly lines. Some times each assembly line is
regarded as a separate cost centre with its own assistant foreman.
The selection of suitable cost centres or cost units for which costs are to be
ascertained in an undertaking depends upon a number of factors which are listed
as follows.
1. Organization of the factory
2. Conditions of incidence of cost
3. Requirements of the costing system i.e. Suitability of the units or centres
for cost purposes.
4. Availability of information
5. Management policy regarding making a particular choice from several
alternatives
22.3.6 PROFIT CENTRE
A profit centre is that segment of activity of a business which is responsible
for both revenue and expenses and discloses the profit of a particular segment of
activity. Profit centres are created to delegate responsibility to individuals and
measure their performance.
22.3.7 METHODS OF COSTING:
Depending upon the nature of the business and the types of its products,
numbers of methods of cost ascertainment are used in practice. The methods of
costing are as follows:
a) Job Costing: In this system the cost of each job is ascertained separately
which is suitable in all cases where work is undertaken on receiving a customer’s
order. Like a printing press, motor work shop etc.
b) Batch Costing: It is considered as the extension of job costing. It represents
a number of small orders passed through the factory in batch. Each batch here is
treated as a separate unit of cost.
c) Contract Costing: It is suitable for the firms which are engaged in the work
of construction of bridges, roads, buildings etc.
d) Single or Output Costing: It is used in the business where a standard
production is turned out and it is desired to find the cost of a basic unit of
production.
e) Process Costing: It is a method of costing used to asce rtain the cost of a
product which may passes through various processes before completion.
300
f) Operating Costing: The cost of providing a service is known as operating

cost and the methods to ascertain the cost of such services is known as operating
costing.
g) Multiple Costing: In multiple costing, a combination of two or more
methods of costing is used in conjunction to determine the cost of final product.
This method is used by the industries where different components are separately
manufactured and subsequently assembled into the finished product. For e.g.:
Motor car, Television, Ships etc.
22.3.8 TECHNIQUES OF COSTING
For ascertaining cost, following techniques of costing are usually used:-
a) Uniform Costing: The practice in which common methods of costing for
different undertakings in the same industry are used is known as uniform costing.
b) Historical Costing: In this technique, ascertainment of cost is done after
they have been incurred but the utility of this technique is limited.
c) Direct Costing: The practice of charging all direct costs to operations,
processes or products leaving all indirect costs to be written off against profit’s in
which they arise are called as direct costing.
d) Absorption Costing: In this all costs, both variable and fixed are charged to
production, operations or processes.
e) Marginal Costing: The method of ascertaining marginal cost by
differentiating between fixed and variable costs. This technique is used to ascertain
effect of changes in volume or type of output over the profits.
f) Standard Costing: The preparation of standard costs and applying them to
measure the variations from actual cost and analyzing the causes of variations with
a view to maintain maximum efficiency in production is known as standard costing.
g) Activity Based Costing: ABC is a system that focuses on activities as
fundamental cost objects and utilizes the cost of these activities as building blocks
or compiling the costs of other cost objects.
1. Essentials of good costing system are as follows suitability, specially
designed system, support of executives, cost of the system, clearly defined
cost center, controllable costs.
2. Cost unit is a unit of quantity of product, service or time in relation to
which costs may be ascertained or expressed
3. Cost centre means “a location, person or item of equipment (or group of
these) for which costs may be ascertained and used for the purpose of cost
control
4. A profit centre is that segment of activity of a business which is
responsible for both revenue and expenses and discloses the profit of a
particular segment of activity
301
5. The methods of costing are as follows Job costing, Batch Costing,

Contract Costing, Single Costing, Process Costing, Operating Costing,
Multiple Costing
6. Techniques of costing are usually used for Uniform costing, Historical
Costing, Direct costing, Absorption costing, Marginal Costing, Standard
operating costing, ABC costing.
1. Define cost units
2. Define profit centre
3. Define profit centre
4. Define Job Costing
5. Define Process Costing
6. Define Uniform Costing
22.6 SUMMARY
Essentials of good costing system are as follows suitability, specially designed
system, support of executives, cost of the system, clearly defined cost center,
controllable costs. cost unit is a unit of quantity of product, service or time in
relation to which costs may be ascertained or expressed. cost centre means “a
location, person or item of equipment (or group of these) for which costs may be
ascertained and used for the purpose of cost control. A profit centre is that segment
of activity of a business which is responsible for both revenue and expenses and
discloses the profit of a particular segment of activity. The advantages of cost
accounting are cost object analysis, discove rs causes, trend analysis, modeling,
acquisitions’, project billings, budget compliance, capacity, inventory valuation.
Some of the methods of costing are Job Costing is the system the cost of each job
is ascertained separately which is suitable in all cases where work is undertaken on
receiving a customer’s order. Batch Costing represents a number of small orders
passed through the factory in batch. Job Costing is the system the cost of each job
is ascertained separately which is suitable in all cases whe re work is undertaken on
receiving a customer’s order. Like a printing press, motor work shop etc. Contract
Costing is suitable for the firms which are engaged in the work of construction of
bridges, roads, buildings etc. Single or Output Costing is used in the business
where a standard production is turned out and it is desired to find the cost of a
basic unit of production. Process Costing is a method of costing used to ascertain
the cost of a product which may passes through various processes before
completion. Operating Costing is the cost of providing a service is known as
operating cost and the methods to ascertain the cost of such services is known as
operating costing. In multiple costing, a combination of two or more methods of
costing is used in conjunction to determine the cost of final product. This method is
used by the industries where different components are separately manufactured
and subsequently assembled into the finished product. For e.g.: Motor car,
Television, Ships etc. For ascertaining cost, following techniques of costing are
usually used the practice in which common methods of costing for different
undertakings in the same industry are used is known as uniform costing.
302
Historical Costing technique, ascertainment of cost is done afte r they have

been incurred but the utility of this technique is limited. The practice of charging all
direct costs to operations, processes or products leaving all indirect costs to be
written off against profit’s in which they arise are called as direct co sting. In
Absorption Costing all costs, both variable and fixed are charged to production,
operations or processes. Marginal Costing is the method of ascertaining marginal
cost by differentiating between fixed and variable costs. This technique is used to
ascertain effect of changes in volume or type of output over the profits. The
preparation of standard costs and applying them to measure the variations from
actual cost and analyzing the causes of variations with a view to maintain
maximum efficiency in production is known as standard costing. Activity Based
Costing (ABC) is a system that focuses on activities as fundamental cost objects
and utilizes the cost of these activities as building blocks or compiling the costs of
other cost objects.
1. ……………………………….means a location, person or item of equipment (or
group of these) for which costs may be ascertained and used for the
purpose of cost control.
2. ……………………………………..are created to delegate responsibility to
individuals and measure their performance.
3. 3…………………………………………………. is a system that focuses on
activities as fundamental cost objects and utilizes the cost of these
activities as building blocks or compiling the costs of other cost objects.
4. ………………………….. is suitable for the firms which are engaged in the
work of construction of bridges, roads, buildings etc.
4. http://icmai.in/
22.9 ASSIGNMENTS
1. Costing systems are classified according to the nature of operations . Set
out the classification with a brief description of the operations covered
by each heading.
303
2. The classification of cost as controllable and non controllable depends

upon a point of reference. Explain.
3. Cost may be classified in a variety of ways according to their nature and
the information needs of management .Explain and discuss this
statement giving examples of classification required for different
purpose.
1. Arora M.N. Cost Accounting Principles and Practices Vikas Publishing
House PVT LTD
2. Laxmi Narain Cost Accounting S.Chand & Company Ltd.
Go to a nearby manufacturing company and observe what type of costing
system has been implemented and observe which the techniques of job costing has
been followed.
22.12 KEYWORDS
Cost unit, Cost center, Profit centre, Job costing, batch costing, Contract
costing, Process costing, Operating costing, Multiple costing, Uniform costing,
Historical costing, Marginal costing, Standard costing, ABC costing .
304
LESSON 23
STANDARD COSTING AND VARIANCE ANALYSIS
23.1 INTRODUCTION
The word "Standard" means a "Yardstick" or "Bench Mark." The term "Standard
Costs" refers to Pre-determined costs. Brown and Howard define Standard Cost as a
Pre-determined Cost which determines what each product or service should cost
under given circumstances. This definition states that standard costs represent
planned cost of a product.
Standard Cost as defined by the Institute of Cost and Management
Accountant, London "is the Predetermined Cost based on technical estimate for
materials, labour and overhead for a selected period of time and for a prescribed set
of working conditions.",
Standard costs are the basis of the system of standard costing. They are the
predetermined costs of manufacturing a single unit or a number of product units
during a specific period in the immediate future. They are the planned costs of a
product under current and/or anticipated operating conditions. Here is a definition
of the term standard cost:
The standard cost is a pre-determined cost which is calculated from
management’s standards of efficient operation and the relevant necessary
expenditure. Thus, it is clear from these definitions that standard costs represent
the costs that should have been incurred under the expected circumstances.
In a standard cost system, each unit of product has a standard material cost, a
standard labour cost, a standard overhead cost for each product centre. The total
standard cost for the period under consideration is obtained by multiplying these
standard unit costs by the number of units flowing through the cost centre in that
period.
23.2 OBJECTIVES
 The purpose and importance of Standard costing
 Variance analysis and its importance
 Different types of variances
23.3 CONTENT
23.3.1 Purpose of Standard Costing
23.3.2 Historical or Actual Cost
23.3.3 Difference between Standard Costing and Historical Cost
23.3.4 Importance of Standard Cost
23.3.5 Standard Costing
23.3.6 Standard Cost VS Budgetary Control
23.3.7 Limitation of Standard Costing
305
23.3.8 Advantages of Standard Costing

23.3.9 Variance Analysis
23.3.10 Types of Variances
23.3.1 PURPOSES OF STANDARD COSTS
Standard costs are used for:
1. Establishing budgets.
2. Controlling costs and motivating and measuring efficiencies.
3. Promoting possible cost reduction.
4. Simplifying costing procedures and expediting cost reports.
5. Assigning costs to materials, work-in-process and finished goods
inventories.
6. Forming the basis for establishing bids and contracts and for setting
selling prices.
23.3.2 HISTORICAL OR ACTUAL COSTS:
Historical costs are actual costs. They are recorded after they have been
incurred. One major responsibility of cost accounting department is to record the
different types of cost and ascertainment of actual cost of production total
production cost as well as production cost per unit.
23.3.3 DIFFERENCE BETWEEN STANDARD COSTS AND HISTORICAL COSTS
1. The main difference between standard cost and historical cost is of
recording them. Standard cost is a pre-determined cost while actual cost is
an after-production recorded cost. Thus, standard cost is of forward nature
while historical costs are actual and of historical nature.
2. Historical costs are actual costs which have been actually incurred while
standard costs are reasonably attainable Ideal costs.
3. Historical costs relate to past, hence not useful for control purposes. On
the other hand, standard costs relate to future, hence they are very useful
in controlling the costs.
23.3.4 IMPORTANCE OF STANDARD COSTS
Standard costs are very useful for managerial control and planning. The
limitation of historical costing system in this respect has given the way to the wide-
spread use of standard costs. Though the historical costs have their own value.
They form the basis of financial accounting and reporting but they have certain
serious drawback from the point of view of modern management.
 Actual costs are received -very late. These data are available to the
management after the expiry of accounting period and closing the
accounts. Hence, the management cannot c ontrol them.
 They do not provide any yardstick to ascertain the efficiency of the
operations and performances.
306
 They cannot become the basis of budgeting, planning and price

determination because they are based on past situations.
Standard costs are free from the above drawbacks and possess the following
advantages:
 It is often simpler and requires less work than an actual cost system. It
is economical in terms of time as well as money.
 They provide yardsticks against which- actual costs are compared and
ascertain efficiency or inefficiency of actual performances.
 They provide a valuable guidance to management in the formulation of
price and production policies.
 They, being pre-determined costs, are useful in cost planning and
budgetary control.
 The use of standard costs in the organisation makes the people cost
conscious, economical and efficient. It - assists in effective delegation of
authority also.
23.3.5 STANDARD COSTING
Standard Costing is a concept of accounting for determination of standard for
each element of costs. These predetermined costs are compared with actual costs to
find out the deviations known as "Variances." Identification and analysis of causes
for such variances and remedial measures should be taken in order to overcome
the reasons for Variances.
Chartered Institute of Management Accountants England defines Standard
Costing as "the Preparation and use of standard costs, their comparison with actual
costs and the analysis of variances to their causes and points of incidence."
From the above definition, the technique of Standard Costing may be
summarized as follows:
a. Determination of appropriate standards for each element of cost.
b. Ascertainment of information about actual and use of Standard Costs.
c. Comparison of actual costs with Standard Costs, the differences known as
Variances.
d. Analysis of Variances to find out the causes of Variances.
e. Reporting to the responsible authority for taking remedial measures.
23.3.6 STANDARD COSTING AND BUDGETARY CONTROL COMPARED
Standard costing and budgetary control both are closely interrelated. They both
aim at the improvement of the system of managerial control. They both achieve the
same objective of maximum efficiency and cost control by establishing pre -
determined standards, comparing actual performance with the predetermined
standard and taking necessary steps to improve the situation, where necessary.
307
The nature of both of these techniques is forward looking. However, they differ
in the following respects:
 The scope of budgetary control is wider. It is an integrated plan of action a
co-ordinated plan in respect of all functions of an enterprise. The scope of
standard costing is limited to the operating level. Here too it is further
linked to costs. Budgetary control is extensive whereas standard costing is
intensive in its application. The budgets embrace revenues as well as costs
and all functions and activities - sales, purchase, finance, capital
expenditure, personnel etc. in addition to production whereas the coverage
of standard costing is limited to costs only.
 Budgetary control requires functional co-ordination whereas standard
costing does not require such co-ordination since it is possible -to think
even of one aspect of cost.
 It is possible to introduce the standard costing into the accounting routine
itself. In such a case, the variances are given out by the accounting system
itself. Budgetary control cannot be introduced into the accounting system.
 In standard costing standards are based on technical assessment whereas
budgetary targets are based on past actuals adjusted to future trends. The
standards set up under standard costing are attainable level of
performance whereas the actual expenditure should not normally exceed.
Thus, they differ in approach.
 Budgets are projection of final accounts while standard costs are
projection of only cost accounts.
 By nature, budgetary control emphasizes the forecasting aspect of the
future operations while the scope and utility of standard costing is limited
to only operating level of the concern.
 In standard costing, variances are analysed in details according to their
originating causes and are revealed through different accounts whereas in
budgetary control, the degree of variance analysis tends to be much less
and variances are not revealed through the accounts but are revealed in
total. Thus standard costing and budgetary control are two different
aspects of the process of managerial control. But they both are
complementary to each other and should be used simultaneously in order
to achieve maximum efficiency and economy.
It is often emphasized that budgetary control and standard costing cannot
function independently. This opinion is supported by the fact that both methods
use pre-determined costs for the coming period. Strictly speaking, this is not true
but it is a fact that both function better in conjunction with each other. When
standard costs have been determined, it is relatively easy to compute budgets for
production costs and sales. With the use of standard costs, a budget becomes a
summary of standards for all items of revenue and costs. On the other hand, in
308
determining standard costs it is essential to ascertain the level of output for the
period and this is much easier when budgeted level has been formulated
23.3.7 APART FROM THE ABOVE THE STANDARD COSTING HAS THE FOLLOWING
LIMITATIONS:
1. Standard costing is expensive and a small concern may not meet the cost.
2. Due to lack of technical aspects, it is difficult to establish standards.
3. Standard costing cannot be applied in the case of a- concern where non-
standardized products are produced.
4. Fixing of responsibility is difficult. Responsibility cannot be fixed in the case
of uncontrollable variances.
5. Frequent revision is required while insufficient staff is incapable of operating
this system.
6. Adverse psychological effects and frequent technological changes will not be
suitable for standard costing system.
23.3.8 ADVANTAGES OF STANDARD COSTING
The following are the important advantages of standard costing:
1. It guides the management to evaluate the production performance.
2. It helps the management in fixing standards.
3. Standard costing is useful in formulating production planning and price
policies.
4. It guides as a measuring rod for determination of variances.
5. It facilitates eliminating inefficiencies by taking corrective measures.
6. It acts as an effective tool of cost control.
7. It helps the management in taking important decisions.
8. It facilitates the principle of "Management by Excepti on."
9. Effective cost reporting system is possible.
23.3.9 VARIANCE ANALYSIS
Standard Costing guides as a measuring rod to the management for
determination of "Variances" in order to evaluate the production performance. The
term "Variances" may be defined as the difference between Standard Cost and
actual cost for each element of cost incurred during a particular period. The term
"Variance Analysis" may be defined as the process of analyzing variance by
subdividing the total variance in such a way that management can assign
responsibility for off-Standard Performance.
The variance may be favourable variance or unfavourable variance. When the
actual performance is better than the Standard, it presents "Favourable Variance."
Similarly, where actual performance is below the standard it is called as
"Unfavourable Variance."
309
Variance analysis helps to fix the responsibility so that management can

ascertain –
 The amount of the variance
 The reasons for the difference between the actual performance and
budgeted performance
 The person responsible for poor performance
 Remedial actions to be taken
23.3.10 TYPES OF VARIANCES:
Variances may be broadly classified into two categories
(A) Cost Variance and
(B) Sales Variance.
(A) Cost Variance
Total Cost Variance is the difference between Standards Cost for the Actual
Output and the Actual Total Cost incurred for manufacturing actual output.
The Total Cost Variance Comprises the following:
i. Direct Material Cost Variance (DMCV)
ii. Direct Labour Cost Variance (DLCV)
iii. Overhead Cost Variance (OCV)
I. Direct Material Variance:
The following variances constitute materials variances:
Material Cost Variance:

Material cost variance is the difference between the actual cost of direct
material used and standard cost of direct materials specified for the output
achieved. This variance results from differences between quantities consumed and
quantities of materials allowed for production and from differences between prices
paid and prices predetermined.
This can be computed by using the following formula:
Material cost variance = (AQ X AP) – (SQ X SP)
310
Where
AQ = Actual quantity
AP = Actual price
SQ = Standard quantity for the actual output
SP = Standard price
Material Usage Variance:
The material quantity or usage variance results when actual quantities of
raw materials used in production differ from standard quantities that should have
been used to produce the output achieved. It is that portion of the direct materials
cost variance which is due to the difference between the actual quantity used and
standard quantity specified.
As a formula, this variance is shown as:
Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard
Price
A material usage variance is favourable when the total actual quantity of
direct materials used is less than the total standard quantity allowed for the actual
output.
Various reasons for occurrence of Material usage variance:
Material usage variance may be caused by:
1. Substitution of materials which are non-standard.

2. Materials results in variations in yields.
3. Changes in product designs, tools, machinery or method of processing
which have not yet been recognized in standards.
4. Excess materials not returned to the stores.
5. Inspection which is too rigid.
6. There are no proper tools or machines.
7. Inadequately trained, poorly supervised, careless or dissatisfied
workmen have caused loss or destruction of materials.
8. Machines & tools are not kept in good working conditions.
Example:1
Compute the materials usage variance from the following information:
Standard material cost per unit Materials issued
Material A — 2 pieces @ Rs. 10=20 (Material A 2,050 pieces)
Material B — 3 pieces @ Rs. 20 =60 (Material B 2,980 pieces)
Total = 80
Units completed 1,000
311
Solution:
Material usage variance = (Actual Quantity – Standard Quantity) x Standard
Price
Material A = (2,050 – 2,000) x Rs. 10 = Rs. 500 (unfavourable)
Material B = (2980 – 3000) x Rs. 20 = Rs. 400 (favourable)
Total = Rs. 100 (unfavourable)
It should be noted that the standard rather than the actual price is used in
computing the usage variance. Use of an actual price would have introduced a price
factor into a quantity variance. Because different departments are responsible,
these two factors must be kept separate.
(a) Material Mix Variance:
The materials usage or quantity variance can be separated into mix variance
and yield variance.
For certain products and processing operations, material mix is an important
operating variable, specific grades of materials and quantity are determined before
production begins. A mix variance will result when materials are not actually placed
into production in the same ratio as the standard formula. For instance, if a
product is produced by adding 100 kg of raw material A and 200 kg of raw material
B, the standard material mix ratio is 1: 2.
Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix
variance will be found. Material mix variance is usually found in industries, such
as textiles, rubber and chemicals, etc. A mix variance may arise because of
attempts to achieve cost savings, effective resources utilisation and when the
needed raw materials quantities may not be available at the required time.
Materials mix variance is that portion of the materials quantity variance which
is due to the difference between the actual composition of a mixture and the
standard mixture.
It can be computed by using the following formula:
Material mix variance = (Standard cost of actual quantity of the actual mixture
– Standard cost of actual quantity of the standard mixture)
Or
Materials mix variance = (Actual mix – Revised standard mix of actual input) x
Standard price
Revised standard mix or proportion is calculated as follows:
Standard mix of a particular material/Total standard quantity x Actual input
Example:2
A product is made from two raw materials, material A and material B. One unit
of finished product requires 10 kg of material.
312
The following is standard mix:

Material A 20% 2kg @ `20 = `40
Material B 80% 8kg @ `10 = `80
100% 10kg @ `12 = `120
During a period one unit of product was produced at the following costs:
Material A 8kg @ `20 = `40
Material B 4kg @ `12.5 = `50
12kg @ `17.5 = `80
Compute the materials mix variance.

Solution:
S tan dard Pr oportionof a Particularmix
Re vised S tan dard Pr opotion X Actualinput
TotalS tan dardquantity
Revised Standard Proportion :
Material A = 2/10 x 12 = 2.40kg
Material B = 8/10 x 12 = 9.60kg
Material A = (8 kg – 2.40kg) x 20
= 5.60 x 20 = `112.0 (unfavourable)
Material B = (4kg – 9.6) x 1.00
= 5.60 x 10 = `56(favourable)
Total mix variance = `56 (unfavourable)
Material mix variance = (Actual proportion – Revised standard proportion of

actual input) x Standard price.
(b) Materials Yield Variance:
Materials yield variance explains the remaining portion of the total materials
quantity variance. It is that portion of materials usage variance which is due to the
difference between the actual yield obtained and standard yield specified (in terms
of actual inputs). In other words, yield variance occurs when the output of the final
product does not correspond with the output that could have been obtained by
using the actual inputs. In some industries like sugar, chemicals, steel, etc. actual
yield may differ from expected yield based on actual input resulting into yield
variance.
The total of materials mix variance and materials yield variance equals
materials quantity or usage variance. When there is no materials mix variance, the
313
materials yield variance equals the total materials quantity variance. Accordingly,
mix and yield variances explain distinct parts of the total materials usage variance
and are additive.
The formula for computing yield variance is as follows:
Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit
Example:3
Standard input = 100 kg, standard yield = 90 kg, standard cost per kg of
output = ` 200
Actual input 200 kg, actual yield 182 kg. Compute the yield variance.
Solution :
Standard yield for the actual input = 90/100 x 200 = 180 kg
Yield variance = (Actual yield – Standard yield for the actual input) x
Standard cost per unit (per kg)
= 182 – 180 x ` 200
= 2 x 200 = ` 400(favourable)
The above yield variance can be computed by using another formula also, e.g.,
Yield variance = (Actual Loss – Standard Loss on Actual Input) x Standard Cost
per unit
= 182-180 x `200
= 2 x 200 = ` 400 (favourable)
In this example, there is no mix variance and therefore, the materials usage
variance will be equal to the materials yield variance.
The above formula uses output or loss as the basis of computing the yield
variance. Yield variance can also be computed on the basis of input factors only.
The fact is that loss in inputs equals loss in output. A lower yield simply means
that a higher quantity of inputs has been used and the anticipated or standard
output (based on actual inputs) has not been achieved.
Yield, in such a case, is known as sub-usage variance (or revised usage
variance) which can be computed by using the following formula:
Sub-usage or revised usage variance = (Revised Standard Proportion of Actual
Input – Standard quantity) x Standard Cost per unit of input
314
Example:4
Standard material and standard price for manufacturing one unit of a product
is given below:
Standard Material Standard Price

Material A 5 kg @ ` 40
Material B 3 kg @ ` 60
The actual production of the product is 400 units

The actual material A 2,500 kg @ ` 39
B 1,000 kg @ ` 62.5
Calculate the materials sub-usage variance
Materials yield variance always equal sub-usage variance. The difference lies
only in terms of calculation. The former considers the output or loss in output and
the latter considers standard inputs and actual input used for the actual output.
Mix and yield variance both provide useful information for production control,
performance evaluation and review of operating efficiency.
Materials Price Variance:
A materials price variance occurs when raw materials are purchased at a
price different from standard price. It is that portion of the direct materials which is
due to the difference between actual price paid and standard price specified and
cost variance multiplied by the actual quantity. Expressed as a formula,
315
Materials price variance = (Actual price – Standard price) x Actual quantity

Materials price variance is unfavourable when the actual price paid exceeds the
predetermined standard price. It is advisable that materials price variance should
be calculated for materials purchased rather than materials used. Purchase of
materials is an earlier event than the use of materials.
Therefore, a variance based on quantity purchased is basically an earlier
report than a variance based on quantity actually used. This is quite beneficial from
the viewpoint of performance measurement and corrective action. An early report
will help the management in measuring the performance so that poor performance
can be corrected or good performance can be expanded at an early date.
Recognizing material price variances at the time of purchase lets the firm
carry all units of the same materials at one price—the standard cost of the material,
even if the firm did not purchase all units of the materials at the same price. Using
one price for the same materials facilities management control and simplifies
accounting work.
If a direct materials price variance is not recorded until the materials are
issued to production, the direct materials are carried on the books at their actual
purchase prices. Deviations of actual purchase prices from the standard price may
not be known until the direct materials are issued to production.
In simple the various reasons for occurrence of Material price variance:
Material price variance may be caused by:
1. Materials market price’s fluctuations.
2. Purchasing in lots which are non-standards.
3. Purchasing from suppliers who are located unfavorably, as a result of
which additional cost of transportation has been incurred.
4. During transit, excessive shrinkage or losses has arisen.
5. Purchasing from the suppliers other than those who has offered the
most favourable terms.
6. On account of delay in payments, cash discount cannot be availed.
7. For the purpose of special handling or faster transportation, additional
charges are required to be paid.
8. Purchases on emergency basis- to place rush orders at any price for
immediate delivery.
9. Fraud is there in purchases.
10. Due to unavailability of planned materials, substitute material is
required to be bought.
Example:5
Assuming in Example 1 that material A was purchased at the rate of Rs 10
and material B was purchased at the rate of Rs 21, the material price variance will
be as follows:
316
Materials price variance = (Actual Price – Standard Price) x Actual Quantity

Material A = (10 – 10) x 2,050 = Zero
Material B = (21 – 20) x 2,980 = 2980 (un-favourable)
Total material price variance = Rs 2980 (un-favourable)
The total of materials usage variance and price variance is equal to materials
cost variance.
II. Labour Variances:
Direct labour variances arise when actual labour costs are different from
standard labour costs. In analysis of labour costs, the emphasis is on labour rates
and labour hours.
Labour variances constitute the following:
Labour Cost Variance:
Labour cost variance denotes the difference between the actual direct wages
paid and the standard direct wages specified for the output achieved.
This variance is calculated by using the following formula:
Labour cost variance = (AH x AR) – (SH x SR)
Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate
1. Labour Efficiency Variance:

The calculation of labour efficiency or usage variance follows the same pattern
as the computation of materials usage variance. Labour efficiency variance occurs
when labour operations are more efficient or less efficient than standard
performance. If actual direct labour hours required to complete a job differ from the
number of standard hours specified, a labour efficiency variance results; it is the
difference between actual hours expended and standard labour hours specified
multiplied by the standard labour rate per hour.
Labour efficiency variance is computed by applying the following formula:
Labour efficiency variance = (Actual hours – Standard hours for the actual
output) x Std. rate per hour.
317
Example:6
Standard labour hour per unit = 5 hr
Standard labour rate per hour = Rs 30
Units completed = 1,000
Labour cost recorded = 5,050 hrs @ Rs 35
Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable)
It may be noted that the standard labour hour rate and not the actual rate is
used in computing labour efficiency variance. If quantity variances are calculated,
changes in prices/rates are excluded, and when price variances are calculated,
standard quantities are ignored.
(i) Labour Mix Variance:
Labour mix variance is computed in the same manner as materials mix
variance. Manufacturing or completing a job requires different types or grades of
workers and production will be complete if labour is mixed according to standard
proportion. Standard labour mix may not be adhered to under some circumstances
and substitution will have to be made. There may be changes in the wage rates of
some workers; there may be a need to use more skilled or expensive types of
labour, e.g., employment of men instead of women; sometimes workers and
operators may be absent.
These lead to the emergence of a labour mix variance which is calculated by using the
following formula:
Labour mix variance = (Actual labour mix – Revised standard labour mix in
terms of actual total hours) x Standard rate per hour
Example:7
Class Proportion
A 50% 3 hours @ `40 =`120
B 50% 3 hours @ `20 =` 60
100% 6 hours `30 =`180
In a period, many class B workers were absent and it was necessary to

substitute class B workers. Since the class A workers were less experienced with
the job, more labour hours were used.
The recorded costs of a unit were:
Class Proportion
A 75% 6 hours @ `40 =`240

B 25% 2 hours @ `20 =` 40
100% 8 hours `35 =`280
318
Labour mix variance will be calculated as follows:

Labour mix variance = (Actual proportion – Revised standard proportion of
actual total hours) x standard rate per hour
Revised standard proportion:
3
Class A   8  4 hours
6
3
Class B   8  4 hours
6
Applying the formula
Class A = (6-4) x `40 = `80 (unfavourable)
Class B = (2-4) x `20 = `40 (favourable)
Total labour mix variance = `40 (favourable)
(ii) Labour Yield Variance:
The final product cost contains not only material cost but also labour cost.
Therefore, gain or loss (higher or lower output than the standard output) should
take into account labour yield variance also. A lower output simply means that final
output does not correspond with the production units that should have been
produced from the hours expended on the inputs.
It can be computed by applying the following formula:
Labour yield variance = (Actual output – Standard output based on actual
hours) x Av. Std. Labour Rate per unit of output.
Or
Labour yield variance = (Actual loss – Standard loss on actual hours) x Average
standard labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which
is computed in terms of inputs, i.e., standard labour hours and revised labour
hours mix (in terms of actual hours).
Labour efficiency sub-variance is computed by using the following formula:
Labour efficiency sub-variance = (Revised standard mix – standard mix) x
Standard rate
2. Labour Rate Variance:
Labour rate variance is computed in the same manner as materials price
variance. When actual direct labour hour rates differ from standard rates, the
result is a labour rate variance. It is that portion of the direct wages variance which
is due to the difference between actual rate paid and standard rate of pay specified.
The formula for its calculation is:
Labour rate variance = (Actual rate – Standard rate) x Actual hours
Using data from the example given above, the labour rate variance is Rs
25,250, i.e.,
Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250
(unfavourable)
319
The number of actual hours worked is used in place of the number of the
standard hours specified because the objective is to know the cost difference due to
change in labour hour rates, and not hours worked. Favourable rate variances arise
whenever actual rates are less than standard rates; unfavourable variances occur
when actual rates exceed standard rates.
3. Idle Time Variance:
Idle time variance occurs when workers are not able to do the work due to
some reason during the hours for which they are paid. Idle time can be divided
according to causes responsible for creating idle time, e.g., idle time due to
breakdown, lack of materials or power failures. Idle time variance will be equivalent
to the standard labour cost of the hours during which no work has been done but
for which workers have been paid for unproductive time.
Suppose, in a factory 2,000 workers were idle because of a power failure. As
a result of this, a loss of production of 4,000 units of product A and 8,000 units of
product B occurred. Each employee was paid his normal wage (a rate of? 20 per
hour).
A single standard hour is needed to manufacture four units of product A
and eight units of product B.
Idle time variance will be computed in the following manner:
Standard hours lost:
Product A = 4, 000/ 4 = 1,000 hr. Product B = 8, 000 / 8 = 1,000 hr.
Total hours lost = 2,000 hr. Idle time variance (power failure)
2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)
III. Overhead Variances:
The analysis of factory overhead variances is more complex than variance
analysis for direct materials and direct labour. There is no standardisation of the
terms or methods used for calculating overhead variances. For this reason, it is
necessary to be familiar with the different approaches which can be applied in
overhead variances.
Generally, the computation of the following overhead variances are
suggested:
320
(1) Total Overhead Cost Variance:

This overall overhead variance is the difference between the actual overhead
cost incurred and the standard cost of overhead for the output achieved.
This can be computed by applying the following formula:
(Actual overhead incurred) – (Standard hours for the actual output x Standard
overhead rate per hour)
Or
(Actual overhead incurred) – (Actual output x Standard overhead rate per unit)
To illustrate the overall overhead variance, assume that the actual overhead for
a department amounts to Rs 1,00,000 for the month of January and standard (or
allowed) hours for work performed total 4,500 hours, while actual hours used are
5,000.
If overhead rate is Rs 20 per hour, the overall overhead variance will be the following:
Actual department overhead `1,00,000
Overhead charged to production(4500 hr x `20) ` 90,000
Overall or net overhead variance (Unfavourable) ` 10,000
(2) Variable Overhead Variance:

It is the difference between actual variable overhead cost and standard variable
overhead allowed for the actual output achieved.
The formula for computing this variance is as follows:
(Actual Variable Overhead Cost) – (Actual Output x Variable Overhead rate per unit)
Or
(Actual Variable Overhead Cost) – (Std. hours for actual output x Std. Variable
(3) Fixed Overhead Variance:
This variance indicates the difference between the actual fixed ove rhead cost
and standard fixed overhead cost allowed for the actual output.
This variance is found by using the following formula:
Fixed Overhead Variance = (Actual Fixed Overhead Cost – Fixed Overhead
absorbed)
Or
(Actual Fixed Overhead Cost) – (Actual Output x Fixed Overhead rate per unit)
Or
(Actual fixed overhead cost) – (Std. hours for actual output x Std. fixed
(4) Variable Overhead Expenditure (Spending or Budget) Variance:
This variance indicates the difference between actual variable overhead and
budgeted variable overhead based on actual hours worked.
321
This variance is found by using the following:

(Actual variable overhead – Budgeted variable overhead)
(5) Variable Overhead Efficiency Variance:
This variance is like labour efficiency variance and arises when actual hours
worked differ from standard hours required for good units produced. The actual
quantity produced and standard quantity fixed might be different because of higher
or lower efficiency of workers employed in the manufacturing of goods.
This variance is found by using the following formula:
(Actual hours – Standard hours for actual output) x Standard variable overhead
rate per hour
(6) Fixed Overhead Expenditure (Spending or Budget) Variance:
This variance indicates the difference between actual fixed overhead and
budgeted fixed overhead.
(Actual fixed overhead – Budgeted fixed overhead)
If actual fixed overhead costs are greater than budgeted fixed costs, an
unfavourable variance results because actual costs exceed the budget. Actual
overhead costs seldom equal budgeted costs because property tax rates may
change, insurance premiums may increase or equipment changes may affect
depreciation rates. As an illustration, assume that a company completed 36,000
units (equal to 18,000 standard production hours) in 18,500 hours at the recorded
fixed cost of Rs 7,51,000. The standard fixed cost rate per hour is Rs 40. Therefore,
Expenditure variance = (Actual fixed overhead costs – Budgeted fixed overhead
costs)
That is, = 7,51,000 – (18,500 x 40)
= 7,51,000 – 7,40,000
= Rs 11,000 (Unfavourable)
The expenditure or budget variance provides management with information
which helps in controlling costs. The budget variance is usually prepared on a
departmental basis and the factors that cause the budget variances are, therefore,
controllable by departmental managers.
(7) Fixed Overhead Volume Variance:
Volume variance relates to only fixed overhead. This variance arises due to the
difference between the standard fixed overhead cost allowed (absorbed) for the
actual output and the budgeted fixed overhead based on standard hours allowed
for actual output achieved during the period. The variance shows the over-or-
under-absorption of fixed overheads during a particular period. If the actual output
is more than the standard output, there is over-absorption and variance is
favourable. If actual output is less than the standard output, the volume variance
is unfavourable.
322

(Budgeted fixed overhead applied to actual output – Budgeted fixed overhead
based on standard hours allowed for actual output)
Or
(Actual production – Budgeted production) x Std. fixed overhead rate per unit
Volume variance is further sub-divided into three variances:
(8) Fixed Overhead Calendar Variance:
It is that portion of volume variance which is due to the difference between the
number of actual working days in the period to which the budget is applicable and
budgeted number of days in the budget period.
If actual working days is more than the budgeted working days, the variance is
favourable as work has been done on days more than budgeted or allowed and vice-
versa.
The formula is as follows:
(No. of actual working days – No. of budgeted working days) x Std. fixed
overhead rate per day. Calendar variance can be computed based on hours or
output.
Then the formulae are:
Hours Basis:
Calendar Variance = (Revised Budget Capacity hours – Budget Hours) x Std.
Fixed Overhead rate per hour
If revised budgeted capacity hours are more than the budgeted hours, the
variance will be favourable. In the reverse situation, the variance will be
unfavourable.
Output Basis:
Calendar Variance = (Revised budgeted quantity in terms of actual number of
days worked – Budgeted quantity) x Standard fixed overhead rate per unit
If revised budgeted quantity is more than the budgeted quantity; the variance is
favourable; if revised budgeted quantity is less, the variance will be unfavourable.
(9) Fixed Overhead Efficiency Variance:
It is that portion of volume variance which arises when actual hours of
production used for actual output differ from the standard hours specified for that
output. If actual hours worked are less than the standard hours, the variance is
favourable and when actual hours are more than the standard hours, the variance
is unfavourable.
The formula is:
Fixed Overhead Efficiency Variance = (Actual hours – Standard hours for actual
production) x Fixed overhead rate per hour
Fixed Overhead Efficiency Variance = (Actual production – Standard production
as per actual time available) x Fixed overhead rate per unit
323
(10) Fixed Overhead Capacity Variance:

It is that part of fixed overhead volume variance which is due to the difference
between the actual capacity (in hours) worked during a given period and the
budgeted capacity (expressed in hours). The formula is
Capacity Variance = (Actual Capacity Hours – Budgeted Capacity) x Standard
fixed overhead rate per hour
This variance represents idle time also. If actual capacity hours are more than
the budgeted capacity hours, the variance is favourable and if actual capacity
hours are less than the budgeted capacity hours the variance will be unfavourable.
In case actual number of days and budgeted number of days are also given,
then budgeted capacity hours will be calculated in terms of actual number of days
and it will be known as revised budgeted capacity hours, i.e., budgeted hours in
actual days worked.
In this situation, the formula for calculating capacity variance will be as follows:
Capacity Variance = (Actual Capacity hours – Revised Budgeted Capacity
hours) x Standard fixed overhead rate per hr.
In the above formula, the variance will be favourable if actual capacity hours
are more than the revised budgeted hours. However, if actual capacity hours are
lesser than the revised budgeted hours, the variance will be adverse as lesser hours
means that lesser actual hours have been worked taking the actual days utili sed
into account.
Two-way, Three-way and Four-way Variance Analysis:
The above overhead variances are also classified as Two-way, Three-way and
Four-way variance.
The different variances under these categories are listed below:
(A) Two-way Variance Analysis:
The two-way analysis computes two variances budget variance (sometimes
called flexible budget or controllable variance) and volume variance, which means:
i. Budget variance = Variable spending variance + Fixed spending (budget)
Variance + Variable efficiency variance
ii. Volume variance = Fixed volume variance
(B) Three -Way Variance Analysis:
The three-way analysis computes three variances spending, efficiency and
volume variances. Therefore,
(i) Spending variance = Variable spending variance + Fixed spending
(budget) variance
(ii) Efficiency variance = Variable efficiency variance
(iii) Volume variance = Fixed volume variance
(C) Four-way Variance Analysis:
The four-way analysis includes:
(i) Variable spending variance
324
(ii) Fixed spending (budget) variance

(iii) Variable efficiency variance
(iv) Fixed volume variance.
Problem 1:
Budgeted hours for month of March = 180 hours
Standard rate of article produced per hour = 50units
Budgeted fixed overhead = Rs 27, 000
Actual Production = 9, 2000 units
Actual hours for Production = 175 hours
Actual fixed Overhead Costs = Rs 28, 000
Calculate Overhead Cost Variances.
Solution:
1. Overhead Cost Variance:
(Actual Overhead Cost – Standard Overhead of actual output)
(Rs 28,000-9,200 units x 3)
Rs 28,000 – 27,600 = Rs 400 (unfavourable)
Standard Overhead rate per unit = Rs 27,000/(180 hrs x 50) = 27,000/9, 000 =
Rs 3
2. Overhead Expenditure Variance:
(Actual Overhead – Budgeted Overhead)
(Rs 28,000 – 27,000) = Rs 1,000 (unfavourable)
3. Overhead Volume Variance:
(Budgeted Overhead for actual output – Budgeted fixed overhead)
(Rs 3 x 9,200 units – 2,700)
(27,600 – 27,000) = Rs 600 (favourable)
It can be calculated in the following manner also:
(Actual Production – Budgeted Production) x Std. rate per unit
(9,200 – 9,000) x Rs 3 = Rs 600 (favourable)
Or
(Budgeted hrs for actual production – Budgeted hours) x Std. rate per hour
( 184 hrs-180) x Rs 150
4 x 150 = Rs 600 (favourable)
For 9,000 units standard hours required = 180 hrs.
For 9,200 units standard hours (9, 200 x 180)/9, 000 = 184 hrs
325
Problem 2:
From the following data, calculate overhead variances:
Budgeted Actual
Output 15,000 units 16,000 units
No. of working days 25 27
Fixed overheads ` 3,00,000 ` 3,50,000
Variable overheads ` 4,50,000 ` 4,70,000
There was an increase of 5% in capacity
Solution:
1. Total Overhead Cost Variance:
Actual overhead cost – (Actual units x Std. Rate)
(Rs 3,05,000 + 4,70,000) – (16,000 x Rs 50)
Rs 7,75,000 – Rs 8,00,000 = Rs 25,000 (favourable)
Standard rate = Standard Overhead /Standard Output
2. Variable Overheads Variance:
Actual variable cost – (Actual units x Std. Rate)
4,70,000 – (16,000 x Rs 30)
Rs 4,70,000 – Rs 4,80,000 = Rs 10,000 (favourable)
3. Fixed Overhead Variance:
Actual fixed overhead cost – (Actual units x Std. Rate of fixed overhead)
3,05,000-(16,000 x 20)
3,05,000 – 3,20,000 = Rs 15,000 (favourable)
4. Volume Variance:
(Actual units x St. rate) – Budgeted fixed overheads
(16,000 x Rs 20) – Rs 3,00,000 = Rs 20,000 (favourable)
5. Expenditure Variance:
Actual fixed overheads – Budgeted fixed overheads
Rs 3,05,000 – Rs 3,00,000 = Rs 5,000 (unfavourable)
6. Capacity Variance:
Std. Rate x (Revised budget units – Budgeted units)
Revised budgeted units = Budgeted units + Increase in capacity
= 15,000 + 5/100 x 15,000= 15,750 units 100
= Capacity variance
= Rs 20 (15,750 units – 15,000 units)
= Rs 20 x 750 = Rs 15,000 (favourable)
326
7. Calendar Variance:
Increase or decrease in production due to more or less working days x Std. rate
per unit within 25 days, standard production with increased capacity = 15,750
units within 2 days (27 – 25),
production will be increased by = (15, 750 x 2)/25 = 1,260 units
Calendar variance = 1,260 units x Rs 20
= Rs 25,200 (favourable)
8. Efficiency Variance:
Std. rate x (Actual production – Std. production)
Standard production:
Budgeted production = 15,000 units
Production increased due to increase in capacity 5% = 750 units
Now budgeted production = 15,000 + 750 = 15,750 units
Production increased due to 2 more working days
Units for 2 days = (15, 750 x 2)/25 days = 1,260 units
Total units = 15,750 + 1,260
= 17,010 units
Efficiency Variance = Rs 20 (16,000 units – 17,010 units)
Rs 20 (- 1,010 units) = Rs 20,200 (unfavourable)
Problem 3:
In department A the following data is submitted for the week ending 31st October:
Standard output for 40 hours per week 1,400 units
Standard fixed overhead `1,40,000
Actual output 1,200 units
Actual hours worked 32 hrs
Actual fixed overhead `1,50,000
Prepare a statement of variances

Solution
Basic calculation:
Budgeted overhead `1,40,000
Actual overhead `1,50,000
Standard output (in units) ` 1,400
Actual output (in units) ` 1,200
Standard hours 40 hrs
327
Actual hours 32 hrs
Standard output
1. S tan dard production per standard hours 
Standard hours
1,400
  35 units
40
Standard fixed overhead
2. S tan dard fixed overhead rate per units 
Standard hours
Rs.1,40,000
  Rs.100
1,400
Standard fixed overhead

3. S tan dard fixed overhead rate per hours 
Standard hours worked
Rs.1,40,000
  Rs.3,500
40
Statement of fixed overhead variances of department A:
A. Expenditure variance:
(Actual overhead – Budgeted overhead)
Rs 1,50,000 – Rs 1,40,000 = Rs 10,000 (Adverse)
B. Volume variance:
Std. fixed overhead rate per unit x (Actual output – Budgeted output)
Rs 100 (1,200 – 1,400) = Rs 20,000 (Adverse)
C. Total overhead cost variance:
(Actual overhead – Overhead recovered by actual output)
Rs 1,50,000 – Rs 1,20,000 = Rs 30,000 (Adverse)
(a) Efficiency variance:
Std. fixed overhead rate per unit x (Actual production – Std. production for
actual hours)
Rs 100 (1200 – 32 x 35) = Rs 8000 (Favourable)
(b) Capacity variance:
Std. fixed overhead rate per hour (Actual hours – Standard hours)
Rs 3,500 (32 – 40) = Rs 28,000 (Adverse)
Problem 4:
A Cost Accountant of a company was given the following information regarding the
overheads for February, 2012:
328
(a) Overheads cost variance Rs 1,400 adverse.

(b) Overheads volume variance Rs 1,000 adverse.
(c) Budgeted hours for February 2012, 1,200 hours.
(d) Budgeted overheads for February 2012, Rs 6,000.
(e) Actual rate of recovery of overheads Rs 8 per hour.
You are required to assist him in computing the following for February, 2012:
(1) Overheads expenditure variance.
(2) Actual overheads incurred.
(3) Actual hours for actual production .
(4) Overheads capacity variance.
(5) Overheads efficiency variance.
(6) Standard hours for actual production.
Solution:
Computation of Required Variances
(1) Overheads Expenditure Variance
= Overheads Cost Variance – Overheads Volume Variance
= Rs 1,400 (A) – Rs 1,000 (A)
= Rs 400 (A)
(2) Actual Overheads incurred
= Budgeted Overheads + Overhead Expenditure Variance
= Rs 6,000 + Rs 400 (A)
= 6,400
(3) Actual hours for actual production
Actual overheads incurred/Actual rate of recovery of overheads per hour
= Rs 6,400/8 = 800 hours
(4) Overheads Capacity Variance
= Standard Overhead x (Actual Hours – Budgeted Hours)
= 5 x (800 hours – 1,200 hours)
= Rs 2,000 (A)
= Standard Rate of Overhead = Budgeted overheads / Budgeted hours
= Rs 6, 000/1, 200 = Rs 5 per hour
(5) Overhead Efficiency Variance
= Overheads Volume variance – Overhead Capacity variance
= Rs 1,000 (A) – Rs 2,000 (F)
= Rs 1,000 (F)
329
330
(6) Standard Hours for Actual Production

Volume Variance
= Standard Overheads Rate x (Standard hours for Actual Production –
Budgeted Hours) or 1,000 (A) = 5 (x- 1,200)
or 1,000 (A) = 5 x – 6,000
or -5 x = – 5,000
or x = 1,000 hours
Problem 5:
New India Company uses a standard costing system. The company prepared its
budget for 2012 at 10,00,000 machine hours for the year. Total budgeted overhead
costs is Rs 12,50,00,000. The variable overhead rate is Rs 100 per machine hour
(Rs 200 per unit).
Actual results for 2012 are as follows:
Machine hours 9,60,000 hrs.
Output 4,98,000 units
Variable over head `10,08,00,000
Fixed overhead Spending variance ` 60,00,000 A
Required:
(I) compute for the fixed overhead
(a) Budgeted amount
(b) Budgeted cost per machine hour
(c) Actual cost
(d) Volume variance
(II) Compute variable overhead spending variance and variable overhead
efficiency variance.
Solution:
(I) For fixed overhead:
(a) Budgeted Amount:
Total budgeted overhead = Rs 12,50,00,000
Less: Budgeted variable overhead (10,00,000 machine hrs x Rs 100 budgeted
rate per machine hour) = 10,00,00,000
Budgeted fixed overhead 2,50,00,000
(b) Budgeted (fixed) cost per machine hour:
= Rs 2,50,00,000 budgeted amount/10,00,000 budgeted machine hours
= Rs 25 per machine hour
(c) Actual cost (fixed):
It is calculated through fixed overhead spending variance.
Fixed overhead spending variance = Actual cost incurred – Budgeted amount
331
Actual cost = Budgeted amount + Unfavourable spending variance

= 2,50,00,000+ 60,00,000 A
= Rs 3,10,00,000
Because fixed overhead spending vari ance is unfavourable, the amount of
actual costs is higher than the budgeted amount.
(d) Production Volume Variance:
Budgeted variable overhead per unit = Rs 200
Budgeted variable overhead rate = Rs 100 per machine hour
Therefore budgeted machine hours allowed per unit = Rs 200/Rs 100
= 2 machine hours
Formula:
Budgeted fixed overhead – Fixed overhead absorbed or allowed for actual
output units
= Rs 2,50,00,000 – (Rs 25 per machine hour x 2 machine hours per unit x
4,98,000 units)
= Rs 2,50,00,000 – Rs 2,49,00,000 (absorbed fixed overhead)
= Rs 1,00,000 Adverse
Or
Another formula:
(St hrs for actual production – Budgeted hrs) x St. fixed overhead rate per hr
= (2 x 4,98,000) – (10,00,000 hrs) x Rs 25
= (9,96,000 hrs – 10,00,000 hrs) x Rs 25
Or
Another formula:
(Budgeted production – Actual production) x St. fixed overhead rate per unit
Standard fixed overhead rate per unit = Budgeted fixed overhead/Budgeted
units
= Rs 2,50,00,000/5,00,000 units
= Rs 50 per unit
Budgeted units = 2 machine hour needed for 1 unit
In 10,00,000 machine hours, units produced will be
= 10,00,000/2 = 5,00,000 units
Now, applying the formula
(5,00,000 units – 4,98,000 units) x Rs 50
= 2,000 units x Rs 50 = Rs 1,00,000 Adverse
332
(II) For Variable overhead

(a) Variable overhead spending variance:
(Budgeted Variable overhead cost – Actual Variable overhead)
Budgeted variable overhead cost = Actual hrs works x St. Variable overhead
rate per hour
= 9,60,000 hrs x Rs 100
= Rs 9,60,00,000
Now, applying the formula
(Rs 9,60,00,000 – Rs 10,08,00,000)
Or
Another formula:
(St. machine hr rate – Actual machine hr rate) x Actual hrs worked
= (Rs 100 – Rs 10, 08, 00, 000/9, 00, 000 hrs) x 9, 60, 000 hrs
= (Rs 100 – Rs 105) x 9,60,000 hrs
(b) Variable overhead efficiency Variance:
(St. hours for actual output – Actual hrs) x St. Variable overhead rate per hour
= ((4,98,000 units x 2 hrs) – 9,60,000 hrs) x Rs 100
= (9,96,000 hrs – 9,60,000 hrs) x Rs 100
= 36,000 hours x Rs 100
= Rs 36,00,000 Favourable
Note:
The other variances, although not asked in the question, have been computed
as below.
(Ill) For Fixed overhead:
Calender Variance, Efficiency Variance, Capacity Variance.
(a) Fixed overhead Calender Variance:
= (Budgeted hrs – Revised budgeted Capacity hrs) x St. fixed overhead rate per
hour
= (10,00,000 hrs – 2 hrs x 4,98,000 units) x Rs 25
= (10,00,000 hrs – 9,96,000 hrs) x Rs 25
= 4,000 hrs x 25 = Rs 1,00,000 Adverse
Variance is adverse because of lesser use of hours available.
(b) Fixed overhead Efficiency Variance:
(st. hr for actual production – Actual hrs) x Fixed overhead rate per hour
= (2 hrs x 4,98,000 units) – 9,60,000 hrs ) x 25
333
= (9,96,000 hrs – 9,60,000 hrs) x 25

= 36,000 hrs x Rs 25
= Rs 9,00,000 F
It is favourable because actual hrs are less than standard hours.
(c) Fixed Overhead Capacity Variance:
(Budgeted Capacity hrs – Actual Capacity hours) x St. fixed overhead rate per
hr
= (9,96,000 hrs – 9,60,000 hrs) x Rs 25
= 36,000 hrs x Rs 25
Since actual hours are less than budgeted hours, in terms of capacity
utilisation, it indicates Adverse Variance
Fixed Overhead Expenditure Variance:
(also known as Spending or Budget Variance)
(Budgeted fixed overhead – Actual fixed overhead)
= Rs 2,50,00,000 – Rs 3,10,00,000
This is already given in the question.
Fixed Overhead Variance:
(budgeted fixed overhead cost – Actual fixed overhead cost)
Budgeted fixed overhead cost =
(i) Actual output units x St. fixed overhead rate per unit
Or
(ii) St. hours for actual output x St. fixed overhead rate per hour
Applying the formula:
(i) (4,98,000 units x Rs 50 per unit) – Rs 3,10,00,000
= 2,49,00,000-3,10,00,000
Or
(ii) (9,96,000 hrs x Rs 25 per hr) – Rs 3,10,00,000
= Rs 2,49,00,000 – Rs 3,10,00,000
Verification:
Fixed overhead Variance = Fixed overhead expenditure variance + Fixed
overhead volume variance
Rs 61,00,000 A = Rs 60,00,000 A + Rs 1,00,000 A
334
Variable Overhead Variance:

(Budgeted variable overhead cost – Actual variable overhead cost) Budgeted
variable overhead cost =
(i) Actual output units x St. variable overhead rate per unit
Or
(ii) St. hours for actual output x St. variable overhead rate per hour
(i) (4,98,000 units x Rs 200 per unit) – Rs 10,08,00,000
= Rs 9,96,00,000 – Rs 10,08,00,000
Or
(ii) (9,96,000 hrs x Rs 100) – Rs 10,08,00,000
= Rs 9,96,00,000 – Rs 10,08,00,000
Verification:
Variable overhead variance = Variable overhead expenditure variance +
Variable overhead efficiency variance
Rs 12,00,000 A = Rs 48,00,000 A + Rs 36,00,000 F
Rs 12,00,000 A = Rs 12,00,000 A
Total Overhead Cost Variance:

(Budgeted overhead cost – Actual overhead cost)
Budgeted overhead cost =
(i) Actual output units x St. overhead rate per unit
Or
(ii) St. hours for actual output x St. overhead rate per hour
St. overhead rate per unit = Variable overhead rate + Fixed overhead rate = Rs
200 + Rs 50 = Rs 250
Or
St. overhead rate per hour =
= Variable overhead rate per hour + Fixed overhead rate per hour
= Rs 100 + Rs 25 = Rs 125
(i) (4,98,000 units x Rs 250) – (Rs 3,10,00,000 + Rs 10,08,00,000)
= Rs 12,45,00,000 – Rs 13,18,00,000
335
Or
(ii) (9,96,000 hrs x Rs 125) – (Rs 3,10,00,000 + Rs 10,08,00,000)
= Rs 12,45,00,000-Rs 13,18,00,000
Verification:
Total overhead cost variance = Fixed overhead cost variance + Variable
overhead cost variance
Rs 73,00,000 A = Rs 61,00,000 A + Rs 12,00,000 A
Rs 73,00,000 A = Rs 73,00,000 A
Problem 6:
The following information has been extracted from the books of Goru Enterprises which is
using standard costing system:
Actual output = 9,000 units
Direct wages paid = 1,10,000 hours at Rs 22 per hour, of which 5,000 hour,
being idle time, were not recorded in production
Standard hours = 10 hours per unit
Labour efficiency variance = Rs 3,75,000 (A)
Standard variable Overhead = Rs 150 per unit
Actual variable Overhead = Rs 16,00,000
You are required to calculate:
(i) Idle time variance
(ii) Total variable overhead variance
(iii) Variable overhead expenditure variance
(iv) Variable overhead efficiency variance.
Solution:
Actual output = 9,000 units
Idle time = 5,000 hours
Production time (Actual) = 1,05,000 hours
Standard hours for actual production = 10 hours/unit x 9,000 units = 90,000
hours.
i.e. Standard rate x (Standard Production time – Actual production time) = Rs
3,75,000 (A).
SR (90,000 – 1,05,000) = – 3,75,000
SR = -3,75,000/-15,000 = Rs 25
(i) Idle time variance = 5,000 hours x 25 Rs hour = Rs 1,25,000. (A)
(ii) Standard Variable Overhead = Rs 150/unit
336
Standard hours = 10 hours/unit

Standard Variable Overhead rate/hour =150/10 = Rs15/hour
Total Variable Overhead variance = Standard Variable Overhead – Actual
Variable Overhead
= Standard Rate x Standard hours – Actual rate x Actual hours
= (15) x (10 x 9,000) – 16,00,000
= 13,50,000 -16,00,000
Total Variable Overhead Variance = 2,50,000 (A)
(iii) Variable Overhead Expenditure Variance = (Standard Rate x Actual Hours)
– (Actual Rate x Actual Hours)
= (15 x 1,05,000) – 16,00,000
= 15,75,000 – 16,00,000
= Rs 25,000 (A)
(iv) Variable Overhead Efficiency Variance = Standard Rate x (Standard Hours
for actual output – Actual hours for Actual output)
= 15 (90,000 – 1,05,000)
= 15 (-15,000)
= Rs 2,25,000 (A)
Alternative Solution:
Actual Output = 9,000 Units
Idle time = 5,000 hrs
Direct Wages Paid = 1,10,000 hours @ Rs 22 output of which 5,000 hours
being idle, were not recorded in production.
Standard hours = 10 per unit.
Or
Standard Rate (Standard Time – Actual Time) = – 3,75,000
Or (90,000 – 1,05,000) = – 3,75,000/Standard Rate.
Or Standard Rate = Rs 25/-
(i) Idle time variance = Standard Rate x Idle time
25 x 5,000 = Rs 1,25,000 (A)
(ii) Standard Variable Overhead/unit =150
Standard Rate = 150/10 = Rs 15/hour
Standard Quantity = 10 hours
Actual Variable Overhead = 16,00,000
337
Standard Variable Overhead = 150 x 9,000 = 13,50,000

Actual Variable Overhead = 16,00,000
Total Variable Overhead Variance = 2,50,000 (A)
(iii) Variable Overhead expenditure Variance = Standard Variable Overhead for
actual hours – Actual Variable Overhead
= (150 x 1,05,000)-16,00,000
= 15,75,000-16,00,000
= 25,000 (A)
(iv) Variable overhead efficiency variance = (Standard Variable Overhead for
actual output – Standard Variable Overhead for Actual hours)
= 15 (10 hours x 90,000 units – 1,05,000)
= 15 (90,000 – 1,05,000)
= 15 (- 15,000)
= 2,25,000 (A)
Problem 7:
The Norkhill Furniture Company has the following standard cost per unit of furniture:
`
Direct material (50 feet of lumber @ `400 per 100 feet) 200
Direct labour (3hours @ ` 100) 300
Variable overhead(3 direct labour hours @ `50) 150
Fixed Overhead (`3,00,000 per month / 3,000 monthly direct
Labour hours) x 3 direct labour hours 300
------
950
------
For July 2012, when 1100 units of furniture were produced, the following
information is available:
Lumber purchased: 50,000 feet at Rs 390 per 100 feet
Lumber used: 56,000 feet
Direct labour: 3,100 hours @ Rs 105
Variable overhead: Rs 1,55,000
Fixed Overhead: Rs 2,90,000
Any materials price variance is assigned to the purchasing department at the
time of purchase.
You are required to:
(a) Prepare a flexible budget for the actual level of activity.
338
(b) Prepare a complete analysis of all variances, including a three-way analysis

of overhead variances.
Solution
a. Flexible Budget
Flexible Budget Actual Variance
Am. (`) (`) (`)
Material (`200 ×1,100) 2,20,000 2,18,400 1,600(F)
Labour (`300 ×1,100) 3,30,000 3,25,500 4,500(F)
Variable (`150 ×1,100) 1,65,000 1,55,000 10,000(F)
Total 7,15,000 6,98,900 16,100(F)
Fixed overhead costs 3,00,000 2,90,000 10,000(F)
Total manufacturing costs 10,15,000 9,98,900 26,100)
b. Variances
i Material Price Variance = (AP-SP) × AQ
= (`390 – 400) × 560
= `5600 (F)
ii Material Usage Variance = (AQ-SQ) × SP
= (`560 – 550) × `400
= `4,000 (A)
iii Labour rate Variance = (AR-SR) × AH
=(`105–100) × `3,100
= `15,500 (A)
iv Labour efficiency Variance = (AH-SH) × SR
=(`3,100–3,300) × `100
= `20,000 (F)
Three-way Analysis of Overhead Variances:

(i) Spending variance = (Actual Overhead costs – Budgeted overhead costs
based on actual hours)
= 4,45,000 – (Rs 3,00,000 + 100 x 33,100 hours)
= 4,45,000- 4,55,000
= Rs 10,000 (F)
339
(ii) Efficiency variance

= (Budgeted overhead costs based on actual hours – Budgeted overhead costs
based on Std. hours)
= (Rs 4,55,000 – (Rs 3,00,000 + Rs 50 x 3300 hrs)
= 4,55,0000 – 4,65,000
= Rs 10,000 (F)
(iii) Volume variance
= (Budgeted overhead Costs based on Std. hours in terms of actual units –
Applied over head costs)
= (Rs 150 x 3300 hrs) – (Rs 150 x 3100 hrs)
= Rs 4,95,000 – 4,65,000
= Rs 30,000 (F)
Problem 8:
Jumbo Food Products Ltd. operates a system of standard costing and in
respect of one of its products which is manufactured within a single cost centre,
data for one week have been analysed as follows:
The production and sales achieved resulted in no changes of stock. You are
required to compute:
(i) The actual output;
(ii) Actual profit;
(iii) Actual price per kg of material;
(iv) Actual rate per labour hour;
(v) Amount of production overhead incurred;
(vi) Amount of production overhead absorbed;
(vii) Production overhead efficiency variance;
(viii) Selling price variance;
(ix) Sales volume profit variance.
Standard Cost Data Per Unit `

Direct materials 10 kgs of `1.5 15.00
Direct Wages 5 hours at ` 4.00 20.00
Production Overheads 5 hours at ` 5.00 25.00
60.00
Other overheads may be ignored.
340
Profit Margin is 20% of Sale price
Budgeted Sales are ` 60.000 per week.

Actual `
Sales 59,760
Direct Materials 12,870
Direct Wages 16,324
Analysis of Variances Adverse Favourable

Direct materials Price 1170 ---
Usage --- 750
Direct Labour Rage --- 636
Efficiency 360 ---
Production Overheads Expenditure --- 400
Volume 360 750
Solution
Jumbo Food Products Ltd.
i Actual Output
Actual Direct Wage Cost ` 16324
Less : Adverse Labour Efficiency Variance (Adv) ` 360
` 15964
Add: Labour Rate Variance (Fav) ` 636
Total Standard direct wage cost ` 16624
Output = Total standard direct wages cost ÷ Standard direct wages
per unit = 16600 ÷ 20 = 830 units
Alternatively
Actual direct materials ` 12870
Less : Adverse material price variance ` 1170
` 11700
Add: Favourable material usage variance ` 750
Total standard material cost ` 12450
341
ii Actual Profit
Actual Sales ` 59760
Less : Direct Material `(12870)
Direct Wages `(16324)
Production Overhead(830 x 25) 20750 ` 636
Less : Favourable O.H. Variances
Expenditure (400)
Volume (750) ` 19600
Actual Profit ` 10966
iii The Actual Price per kg of Material
Direct materials ` 12870
Less : Adverse price variance ` 1170
Total Standard Material Cost ` 11700
Total standard material cost ÷ Standard price kg = 11700 ÷ 1.50 =
7800 kg
Iv Actual Rate Per Labour hour

Actual direct wages ` 16324
Add: Favourable Labour rate variance ` 636
Total Standard Wages Cost ` 16960
Actual hours worked = standard ÷ Std. Wages/unit
= 16930 ÷ 20 x 5 hours
= 4240 hours
Actual rate per labour hour : ` 16324/4240 ` 385

v The Amount of Production Overhead incurred
Standard Production overhead (830 x 25) = ` 20750
Less: Favourable O.H. Variance : Expenditure ` 400
Volume ` 750 ` 1150
` 19600
vi The Amount of Production overhead absorbed

Units produced x standard overhead absorption rate =
830 x ` 25 = ` 20750
342
vii Production Overhead Efficiency Variance

(Standard Production overhead for actual hours worked –
standard production overhead for actual production)
= (4240 hours x `5 – 830 units x `25
= `21200 - `20750 = `450(Adv)
viii Selling Price Variance

(Actual sales value realised – Standard value of actual sales)
= (`59760(given) – 830 units x `60 x 1.25 ÷ 1.00)
(20% on sales price i.e. `255 on cost)
= (`59760 - `62250) = `2490 (Adv)
ix Sales Volume Profit Variance

(Standard Sales margin on actual sales – Standard sales margin as per
standard cost data)
= (830 units x `15 – 800units x `15)
= `12450 - `12000
= `450 (Fav)
(Standard Sales Margin = (`75 - `60) = `15
Illustration:9
Rush Ltd. has furnished you the following data:
Budget Actual Dec.2011
No. of Working days 25 27

Production in Units 20000 22000
Fixed Overheads N 30000 N 31000
Budgeted fixed overhead rate is N1 per hour, In Dec. 2011, the actual hours
worked were 31500.
Calculate the following variances i) Efficiency Variance ii) Capacity Variance iii)
Volume Variance iv) Expenditure Variance and v) Total Overhead Variance.
Solution:
Recovered Overhead = Budgeted Overhead/Budgeted Output X Actual Output
= 30000/20000 X 22000 = 33000
Efficiency Variance = Standard Rate per hour X (Standard Hours for actual
production - Actual
Hours
343
= N 1 X (33000 - 31500) = N 1500 (F)

Capacity Variance = Standard Rate per Hour X (Actual Hours - Budgeted
Hours)
=N 1 X (31500 - 30000) = N 1500 (F)
Volume Variance = Recovered Overhead - Budgeted Overhead
= N 33000 - N 30000 = N 3000 (F)
Expenditure Variance = Budgeted Overhead - Actual Overhead
= N 30000 - N 31000 = N 1000 (A)
Total Overhead Variance = Recovered Overhead - Actual Overhead

= N 33000 - N 31000 = N 2000 (F)
Verification:
FOCV = FOExp.V + FOVV
N 2000(F) = N 1000 (A) + N 3000(F)
FOVV = FOEff.V + FOCap.V
N 3000 (F) = N 1500 (F) + N 1500 (F)
Illustration:10
RSV Ltd. has furnished you the following information for the month of August
2011.
Budget Actual
Output (Units) 30000 32500
Hours 30000 33000
Fixed Overhead N 45000 N 50000
Variable Overhead N 60000 N 68000
Calculate the Variances

Solution:
Standard Hour per Unit = Budgeted Hours/ Budgeted Units
= 30000/30000
= 1 hour
Total standard overhead rate per hour = Budgeted Overheads/Budgeted Hours
= 105000/30000
= N 3.50 per hour
Standard fixed overhead rate per hour = Budgeted fixed overhead/ Budg eted Hours
344
= 45000/30000
= N 1.50
Standard Variable Overhead Rate per hour = Budgeted Variable Overheads /

Budgeted Hours
= 60000/30000
= N2
Overhead Cost Variance = Recovered Overheads - Actual Overheads
Recovered Overheads = Standard Rate per Unit X Actual Output
= 32,500 X N 3.50
= N 113,750
Total Overhead Cost Variance = N 113750 - N 118000

= N 4250 (A)
Variable Overhead Cost Variance = (N2x32,500) - N 68000
= N 3000 (A)
Fixed Overhead Cost Variance = N 48,750 - N 50000
= N 1250 (A)
Expenditure Variance = Budgeted Overheads - Actual Overheads
= N 45000 - N 50000
= N 5000 (A)
Volume Variance = Recovered Overheads - Budgeted Overheads
= N 48750 - N 45000
= N 3750 (F)
Efficiency Variance = Standard Rate X (Standard hours for actual Output -
Actual Hours)
= N 1.50 X (32500 (1) - 33000)
= N 750 (A)
Capacity Variance = Standard Rate X (Actual Hours - Budgeted Hours)
= N 1.50 X (33000 - 30000)
= N 4500 (F)
(B) Sales Variances
The Variances stated above are related to the cost of goods sold. Quantum of
profit is derived from the difference between the cost and sales revenue. Cost
Variances influence the amount of profit favourably or adversely depending upon
345
the cost from materials, labour and overheads. In addition, it is essential to analyse
the difference between actual sales and the targeted sales because this difference
will have a direct impact on the profit and sales. Therefore the analsysis of sales
variances is important to study profit variances.
Sales Variances can be calculated by Two methods:
I. Sales Value Method and
II. Sales Margin or Profit Method.
I.Sales Value Method
The method of computing sales variance is used to denote variances arising
due to change in sales price, sales volume or the sales value.
The sales variances may be classified as follows:
(a) Sales Value Variance
(b) Sales Price Variance
(c) Sales Volume Variance
(d) Sales Mix Variance
(e) Sales Quantity Variance
II. Sales Margin or Profit Method
Under this method of variance analysis, variances may be computed to show
the effect on profit.
The sales variance according to this method can be classified as follows:
(1) Sales Margin Value Variance
(2) Sales Margin Volume or Quantity Variance
(3) Sales Margin Price Variance
(4) Sales Margin Mix Variance
Sales variance is the difference between the actual value of sales achieved in
a given period and budgeted value of sales. There are many reasons for the
difference in actual sales and budgeted sales such as selling price, sales volume,
sales mix.
Sales variance can be calculated by using any of the following two methods:
A. Sales variance based on turnover
B. Sales variances based on margin (i.e.,contribution margin or profit)
The first approach i.e., sales variance based on turnover, accounts for
difference in actual sales and budgeted sales. The sales variances using margin
approach accounts for difference in actual profit and budgeted profit. In the margin
method, it is assumed that cost of production is constant, i.e., no difference is
assumed between actual cost of production and standard cost of production.
The reason for this assumption is that cost variances are calculated separately
to analyse the difference between actual cost and standard cost of production.
346
Therefore, cost side of the sales variance is assumed constant under the margin
method.
Sales variances computed under these two methods show different amounts of
variance.
The different sales variances under these two approaches and their formula are
given below:
A. Sales Variances Based on Turnover:
(i) Sales Value Variance:

Also known as sales variance, this variance shows the difference between
actual sales value and budgeted sales value.
The formula is:
Sales Value Variance = (Actual value of sales – Budgeted value of sales)
Actual sales = Actual quantity sold x Actual selling price
Budgeted sales = Standard quantity x Standard selling price
Or
Sales value variance = (Actual quantity x Actual selling price) – (Standard
quantity x Standard selling price)
If actual sales are more than the budgeted sales, there is favourable variance
and if actual sales are less than the budgeted sales, unfavourable variance arises.
(ii) Sales Price Variance:
This variance is due to the difference between actual selling price and standard
or budgeted selling price.
The formula is:
Sales price variance = (Actual selling price – Budgeted selling price) x Actual
quantity
347
If actual selling price is less than the budgeted selling price, variance is
favourable and if actual selling price is more than the budgeted selling price, there
will be unfavourable sales price variance.
(iii) Sales Volume Variance:
Sales volume variance arises when the actual quantity sold is different from the
budgeted quantity. If actual sales quantity exceeds the budgeted sales quantity,
there is a favourable sales volume variance and if actual quantity sold is less than
the budgeted quantity, the variance is unfavourable .
The formula is:

Sales volume variance = (Actual quantity – Budgeted quantity) x Budgeted
selling price
Sales volume variance is divided into two variances:
(i) Sales mix variance
(ii) Sales quantity variance
(i) Sales Mix Variance:
Sales mix variance is one part of overall sales volume variance. This variance
shows the difference between actual mix of goods sold and budgeted mix of goods
sold.
The formula is:

Sales Mix Variance = (Actual Mix of quantity sold – Actual quantity in standard
proportion) x Standard selling price
Or
Sales Mix Variance = (Budgeted price per unit of actual mix – Budgeted price
per unit of budgeted mix) x Total actual quantity.
If actual sales mix are more than the mix in standard or budgeted proportion,
the variance is favourable and if actual mix sales are less than the standard mix (of
actual sales), the variance is unfavourable. Similarly, if budgeted price per unit of
actual mix is more than the budgeted price per unit of budgeted mix, favourable
variance will arise. In the reverse situation, variance will be unfavourable.
(ii) Sales Quantity Variance:
This variance is also a part of overall volume variance. This variance shows the
difference between total actual sales quantity and total budgeted sales quantity. If
total actual quantity is more than the total budgeted quantity, variance will be
favourable and if total actual quantity is less than the total budgeted quantity,
there will be unfavourable sales quantity variance.
The formula is:
348
Sales quantity variance = (Total actual quantity – Total budgeted quantity) x

Budgeted price per unit of budgeted mix
The total of sales mix variance and sales quantity variance will be equal to
sales volume variance.
B. Sales Variance Based on Margin (i.e., Contribution Margin or Profit):
The sales variances using margin approach show the difference in actual profit
and budgeted profit only whereas sales variances based on turnover show the
difference between total actual sales and total budgeted sales.
The following sales variances are calculated if margin or profit is the basis of
calculation:
Sales Variances based on Margin or Profit
(i) Total Sales Margin Variance:

This variance indicates the aggregate or total variance under the margin
method. This variance shows the difference between actual profit and budgeted
profit.
The formula is:
Total sales margin variance = Actual Profit – Budgeted profit
If actual profit is more than the budgeted profit, variance will be favourable and
if actual profit is less than the budgeted profit, unfavourable variance will arise.
(ii) Sales Margin Price Variance:
This variance is one part of total sales margin variance and arises due to the
difference between actual margin per unit and budgeted margin per unit. It is
significant to note that, assuming cost of production being constant, the difference
in the actual margin and budgeted margin will only be because of the difference
between actual selling price and budgeted selling price. The formula for calculating
sales margin price variance is
Sales Margin Price Variance = (Actual Margin per unit – Budgeted Margin per
unit) x Actual quantity
349
If actual margin per unit is more than the budgeted margin per unit, favourable
variance will be found and if actual margin is less than the budgeted margin,
variance will be unfavourable.
(iii) Sales Margin Volume Variance:
This variance shows the difference between actual sales units and budgeted
sales units.
The formula is:
Sales Margin Volume Variance = (Actual quantity – Budgeted quantity) x
Budgeted Margin per unit.
If actual sales units are more than the budgeted sales units, variance will be
favourable and if actual sales units are less than the budgeted sales units,
unfavourable variance will arise.
Sales margin volume variance can be calculated using another formula which is:
Sales margin volume variance = (Standard profit on actual quantity of sales –
Budgeted profit)
If standard profit exceeds budgeted profit, variance will be favourable and if
standard profit is less than the budgeted profit, unfavourable variance will emerge.
Sales margin volume variance consists of:
(i) Sales margin mix variance and
(ii) Sales margin quantity variance.
(i) Sales Margin Mix Variance:
This variance shows the difference between actual mix of goods and budgeted
(standard) mix of goods sold.
The formula is:
Sales Margin Mix Variance = (Actual sales mix – Standard proportion of actual
sales mix) x Budgeted margin per unit.
If budgeted margin per unit on actual sales mix is more than the budgeted
margin per unit on budgeted mix, variance will be favourable. In the reverse
situation, unfavourable variance will arise.
(ii) Sales Margin Quantity Variance:
This variance will be found when the total actual sales quantity in standard
proportion is different from the total budgeted sales quantity.
The formula is:
Sales Margin Quantity Variance = (Actual sales in standard proportion –
Budgeted sales) x Budgeted margin per unit on budgeted mix
If actual sales (in standard proportion) are more than the budgeted sales,
variance will be favourable and if actual sales are less than the budgeted sales,
unfavourable variance will arise.
350

1. Standard Costing is a concept of accounting for determination of standard
for each element of costs.
2. Cost Variance Total Cost Variance is the difference between Standards
Cost for the Actual Output and the Actual Total Cost incurred for
manufacturing actual output. The Total Cost Variance Comprises the
following: Direct Material Cost Variance (DMCV),Direct Labour Cost
Variance (DLCV) ,Overhead Cost Variance (OCV)
3. Direct Material cost Variance is divided into Material Price Variance and
material usage variance.
4. Labour cost variance is divided into Labour Rate Variance, Labour time
Varience
5. Overhead Variance is divided into fixed and variable overhead variances
6. Sales Variances The Variances stated above are related to the cost of
goods sold. Quantum of profit is derived from the difference between the
cost and sales revenue. Cost Variances influence the amount of profit
favourably or adversely depending upon the cost from materials, labour
and overheads. In addition, it is essential to analyse the difference between
actual sales and the targeted sales because this difference will have a
direct impact on the profit and sales. Therefore the analsysis of sales
variances is important to study profit variances. Sales Variances can be
calculated by Two methods: Sales Value Method and Sales Margin or Profit
Method.
7. Turnover Method or Sales Value Method is classified into Price Variance
and Volume Variance
8. Margin Method is classified into price variance and volume Variance
1. Define Standard Costing
2. Define Cost Variance
3. Define sales Variance
4. What do you mean by Direct material Cost Variance?
5. What do you mean by Direct Labour cost Variance?
6. What do you mean by Over head Cost Variance?
7. What do you mean by Labour Rate Variance?
8. What do you mean by Labour time Variance?
9. What do you mean by fixed Overhead Variance?
10. What do you mean by Variable Overhead Variance?
11. What do you mean by Turnover Method?
351
12. What do you mean by Margin Method?

23.6 SUMMARY
Standard costing is an effective management tool for planning, coordination
and control of business .It is a technique of cost control. Its gives better results
when it is employed with budgetary control. It has been devised to overcome some
of the limitation of historical costing. Variance means difference. In standard
costing variance means the difference between the standard costs and the actual
costs. Incurred during a period. Variance for each element of cost should be
ascertained regularly. If the actual cost is less than the standard cost it is termed
as favorable variance. On the other hand if the actual cost is more than the
standard cost, it is known as Adverse or unfavourable variance. Variances are
classified into controllable and uncontrollable variance. When the variance is due to
inefficiency of a cost centre, it is said to be controllable variance. On the other hand
, uncontrollable variances arise due to external reasons like increase in price of
material. This type of variance is not controllable and no particular individual can
be held responsible for it. The aim of standard costing is cost control. The cost
control is exercised by ascertaining and analyzing the variances and talking
immediate corrective steps. The following are the different types of variances
Variance may be broadly classified into two categories (A) Cost Variance and (B)
Sales Variance. (A) Cost Variance Total Cost Variance is the difference between
Standards Cost for the Actual Output and the Actual Total Cost incurred for
manufacturing actual output. The Total Cost Variance Comprises the following:
Direct Material Cost Variance (DMCV),Direct Labour Cost Variance (DLCV)
,Overhead Cost Variance (OCV)
(B)Sales Variances
The Variances stated above are related to the cost of goods sold. Quantum of
profit is derived from the difference between the cost and sales revenue. Cost
Variances influence the amount of profit favourably or adversely depending upon
the cost from materials, labour and overheads. In addition, it is essential to analyse
the difference between actual sales and the targeted sales because this difference
will have a direct impact on the profit and sales. Therefore the analsysis of sal es
variances is important to study profit variances. Sales Variances can be calculated
by Two methods: Sales Value Method and Sales Margin or Profit Method.
1. Labour mix variance is a sub division of ………………………….Variance.
2. Material Price Variance arises due to reasons like………………….
And………………….
3. The most important purpose of standard costing is to
………………….Costs
4. When standard cost is more than the actual cost it is called as
………………Variance.
352
5. Material price variance is the responsibility of ………………………………

2. http://www.cimaglobal.com/
4. http://www.futureaccountant.com/
5. http://www.cmaontario.org/
6. http://s3.amazonaws.com/
7. http://www.civilserviceindia.com/subject/Management/notes/standard
-costing-and-variance
8. http://www.slideshare.net/speedkings/standard-costs-and-variance-
analysis
23.9 ASSIGNMENTS
1. Calculation of variances in standard costing is not an end itself, but a
means to an end . Discuss
2. Setting standards is the most important mission of standard cost
system. These should be set with the greatest care and sound judgment.
Discuss the statement and show how standards are fixed for different
element of cost.
1. Arora M.N. Cost Accounting Principles and Practices Vikas Publishing
House PVT LTD
2. Laxmi Narain Cost Accounting S.Chand & Company Ltd.
Select an organization of your choice and observe how standard costing are
implemented and prepare draft.
23.12 KEYWORDS
Material variance, Labour variance, Overhead variance, Sales variance,
Material Cost Variance, Material price Variance, Material Usage Variance, Material
Mix Variance, Material Yield Variance, Labour Cost Variance, Labour Rate
Variance, Labour Efficiency Variance ,Idle time Variance, Labour Mix Variance,
Labour Yield variance, sales quantity Variance, sales Margin Volume Variance,
Sales Margin Mix Variance, Sales Price Variance,
353
LESSON – 24
REPORTING TO MANAGEMENT
24.1 INTRODUCTION
The success or otherwise of any busine ss undertaking depends primarily on
earning revenue that would generate sufficient resources for sound growth. To
achieve this objective, the management should discharge its functions efficiently
and effectively. The reporting systems are highly useful to the management for
effective planning and control. A regular system of reporting is considered as a
better guidance for prompt decision making. Hence, it is necessary to have a good
management reporting system.
24.2 OBJECTIVES
 The meaning of management reporting
 Objectives of management reporting
 Different types of management reporting
24.3 CONTENT
24.3.1 Definition of Management Reporting
24.3.2 Objectives of Management Reporting
24.3.3 Essentials of Good Reporting System
24.3.4 Classification of Management Report
24.3.1 DEFINITION OF MANAGEMENT REPORTING
According to Kohler reporting refers to "A body of information organized for
presentation or transmission to others. It often includes interpretations,
recommendations and findings with supporting evidence in the form of other
reports."
'Management Reporting' may be defined as "A system of communication,
normally in the written form, of facts which should be brought to the attention of
various levels of management who use them to take suitable action." In other words
the process of providing information to the management is known as Management
Reporting. The word "Information" refers to the data processed or evaluated for a
specific purpose.
Dr. Maheshwari has also defined Management reporting system as "an
organized method of providing each manager with all the data and only those data
which he needs for his decisions, when he needs them and in a form which aids his
understanding and stimulates his action."
24.3.2 OBJECTIVES OF MANAGEMENT REPORTING
1. To obtain the required information relating to the business to discharge its
managerial functions of planning. organizing, controlling. directing, and
decision making etc. efficiently and effectively.
2. To ensure the operational efficiency of the concern.
354
3. To facilitate the maximum utilization of resources.

4. To secure industrial understanding among people who are engaged in
various aspects of work of enterprise.
5. To enable to motivating improving discipline and morale.
6. To help the management for effective decision making.
24.3.3 ESSENTIALS OF GOOD REPORTING SYSTEM
The following are the essentials of a good management reporting system :
1. Proper Form: A good report should have a comprehensive form with
suggestive title, heading, sub heading and number of paragraphs as and
where necessary for easy and quick reference.
2. Contents: Simplicity is one of the requisites of reporting in relation to the
contents of a report. Further the contents should follow a logical sequence.
Wherever necessary the contents should be represented in the form of
visual aids such as charts and diagrams etc.
3. Promptness: It means that the system should ensure the preparation and
submission of report at the proper time. It facilitates business executives
to make suitable decisions based on quick reports without delay.
4. Accuracy: Information conveyed should be accurate. This means that the
person responsible for reporting should have sufficient care in preparing
the report as correctly as possible within the parameters of possible
accuracy in this regard.
5. Comparability: In order to ensure that the furnished information is
useful, it is essential that reports are also meant for comparison. The
report should provide information about both the actual and the budgeted
performance of the budget period. So that meaningful comparison can be
made to find out the deviations and to initiate appropriate action.
6. Consistency: In order to make a meaningful and useful comparison,
uniform accounting principles and procedures should be followed on
consistent basis over a period of time for collection, classification and
presentation of accounting information.
7. Relevancy: The report should be presented with relevant data to disclose
the fact in unambiguous terms. Because, inclusion of both the relevant
and the irrelevant data in the management reports may result in faulty
decisions. Therefore, the contents expressed therein should reveal the
reporter's greater consciousness of expression with reference to length and
time in particular.
8. Simplicity: The report should be as far as possible in simple form. In
other words, the report should avoid technical jargons, duplication of work
and presented in a simple style.
9. Flexibility: The system should be capable of being adjusted according to
the requirement of the users.
355
10. Cost-Benefit Analysis: Cost-Benefit Analysis should be made and the cost
of reporting should commensurate with the expenditure involved.
11. Principle of Exception: Since the time and effort of managerial personel
are precious, the principle of management by exception has become the
rule of the day instead of exception. It is necessary therefore to draw the
attention of management, through reports, only towards exceptional
matters.
12. Controllability: It is necessary that every report should be addressed to a
responsibility centre and analysed the factors into controllable and
uncontrollable separately. So that the head of the responsibility centre can
be held responsible only for controllable variance but not for variances
which are beyond his control.
Further, in order to assist the management to imitate remedial measures,
probable reasons for the factors of uncontrollable should also be incorporated in
the reports.
24.3.4 CLASSIFICATION OF MANAGEMENT REPORTING
Basically, there are two ways to report to the management. They are :
 Oral Report and
 Written Report.
The Written Reports may be classified into number of ways. The following are
the important types:
I According to Objects:
a. External Reports
b. Internal Reports
i. Reports Meant for Top Management
ii. Reports Meant for Middle Level Management
iii. Reports Meant for Junior Level Management
II According to Period:
1. Routine Reports
2. Special Reports
III According to Functions:
a. Operating Reports
(1) Control Reports
(2) Information Reports
(3) Venture Measurement Reports
b. Financial Reports
(1) Static Reports
(2) Dynamic Reports
According to Object or Purposes
356
(A) External Reports: These reports prepared for persons outside the business
such as Government. shareholders. bankers. investors and financial institutions
etc. External Reports usually represent published annual reports. Annual Reports
of Trading. Profit and Loss Accounts and Balance Sheet of the Indian Companies
are to be prepared in terms of Schedule VI of the Indian Companies Act of 1956.
(B) Internal Reports : Internal Reports are those which are prepared for internal
uses of different level of management. It is also called as Management Reports.
These reports are not meant for disclosure to those who are outsiders to the
business. They do not have to comply with any statutory requirements. From the
managerial point of view the reports can be classified into the following categories :
(1) Report Meant for the Top Level of Management
(2) Report Meant for the Middle Level of Management
(3) Report Meant for the Junior Level of Management
(1) Report Meant for the Top Level of Management
Top Level Management is concerned with the formulating policies planning
and setting goals and objectives. This level of management consisting of the Board
of Directors including Chairman. Managing Directors. General Manager or any
other chief executive as the case may be. The report to this level of management
should be specifically summarized with all aspects of operating performance
together with a comparison of actuals with budgeted performance. The usual
reports sent to this level of management are:
(a) Reports on budgeted and actual profit
(b) Reports on sales and production
(c) Capital budget
(d) Master budget
(e) Periodical financial reports
(f) Plant utilization report
(g) Machine and labour utilization report
(h) Reports on research and development activities
(i) Project evaluation report
(j) Report on stock of raw materials, work in progress and finished goods
(k) Overhead cost absorption and efficiency reports
(l) Reports on selling and distribution overhead.
(2) Reports Meant for Middle Level Ma nagement
The Middle Management is constituted of the heads of all departments such as
production department headed by production manager. marketing department
headed by marketing manager and so on. This level of management is concerned
with the functioning and control of their departments. They act mainly as
coordinating executives to administer policies directly through operating
supervisors and evaluate their performance. Hence, they may require more detailed
357
information about their departments and at frequent intervals. Generally, the

middle level management should receive the following reports at different intervals:
(a) Purchase Manager:
(1) Reports on material price and usage variance
(2) Reports on material carrying cost, loss of material in the storage etc.
(3) Reports on trends in the pertaining of various items of materials.
(b) Materials Manager:
(1) Reports on stock of raw materials, work in progress and finished goods
(2) Reports on material wastage and losses
(3) Reports on stock of materials planning an d control
(4) Reports on level of materials stock at the stores
(5) Reports on surplus and deficiency report.
(c) Production Manager:
(1) Reports on budgeted and actual production
(2) Reports on overtime work and ideal time
(3) Reports on labour utilization statement
(4) Reports on machine utilization statement
(5) Reports on scrap production cost
(6) Reports on any accident causing dislocation of activity.
(d) Sales Manager:
(1) Reports on budgeted and actual sales
(2) Reports on sales efficiency
(3) Reports on orders received and orders executed
(4) Reports on cash sales and credit sales
(5) Reports on stock of finished goods
(6) Reports on market share and market potential
(7) Reports on sales promotion efficiency.
(8) Reports Meant for Junior Level Management
The lower level management is directly responsible for executing various
policies assigned by top management. This level of management is constituted of
Foremen, Supervisors and sectional in charges etc. They are in touch with the day-
to-day performance of their section. The report meant for this level are mainly in
terms of physical units. The usual reports sent to this level are:
(1 ) Reports on labour efficiency variance
(2) Reports on ideal time, overtime and machine utilization
(3) Reports on materials usage variance
(4) Reports on credit collections and outstanding
1. Objectives of Management reporting
2. Essentials of Good reporting system
358
3. Classification of management Reporting

1. What is meant by management reporting?
2. What do you mean by Eternal Reports?
3. What do you mean by Internal Reports?
4. What do you mean by financial Reports?
5. What do you mean by Operating reports?
24.6 SUMMARY
Good management reporting system should have the following things proper
form, contents, promptness, accuracy, comparability, consistency, relevancy,
simplicity, flexibility, cost benefit analysis , principle of exception, comfort ability.
Objectives of Management Reporting system are given below; To obtain the
required information relating to the business to discharge its managerial functions
of planning. organizing, controlling. directing, and decision making etc. efficiently
and effectively. To ensure the operational efficiency of the concern. To facilitate the
maximum utilization of resources. To secure industrial understanding among
people who are engaged in various aspects of work of enterprise. To enable to
motivating improving discipline and morale. To help the management for effective
decision making. Basically, there are two ways to report to the management.
They are :Oral Report and Written Report.
The Written Reports may be classified into number of ways. The following are
the important ty pes(A)According to Objects: External Reports ,Internal Reports,
Reports (B) According to Period: Routine Reports, Special Reports(C)According to
Functions: Operating Reports, Financial Reports.
1. ………………………reports prepared for persons outside the business
such as Government. Shareholders. Bankers. Investors and financial
institutions etc.
2. ……………………………….Reports are those which are prepared for
internal uses of different level of management.
1. http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-
31-Reporting-to-Management.pdf
2. https://www.treasury.qld.gov.au/publications-resources/financial-
accountability-handbook/5-1-management-reporting.pdf
24.9 ASSIGNMENTS
1. What do you understand by the term reporting to management?. What
matters would you include for reporting to board of directors?.
2. What are the points to be kept in mind while preparing the report?.
359

2. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot,
Jaipur)
Jaipur)
Choose an organistion of your choice and see how reports are prepared and
identify how it was reporting to the management
24.12 KEYWORDS
Oral Report, Written Report, External Reports, Internal Reports, Reports,
Routine Reports, Special Reports, Operating Reports, Financial Reports.

360
Reference: Chapter-31-Reporting-to-Management.pdf “A Textbook of

Financial Cost and Management Accounting” http://dosen.narotama.ac.id/wp-
content/uploads/2013/02
Reference Books
 Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and
Management Accounting (Malik and Co.)
 Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)
 Agarwal. M.R. — Managerial Accounting (Garima Publications)
 Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
 Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot,
Jaipur)
 Khan, Jain — Management Accounting (S. Chand & Sons.)
 Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting (RBD,
Jaipur)
 Pandey. I. M. — Management Accounting (S. Chand & Sons.)
346EN120 / 349EN180
ANNAMALAI UNIVERSITY PRESS : 2016 – 2017

Accounting For Managers PDF

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Accounting For Managers PDF

Caricato da

Copyright:

Formati disponibili

349E180

Master of Business Administration(MBA)

ACCOUNTING FOR MANAGERS

(For Private Circulation Only)

Dr. D. Senthil Dr. K. Murugadoss

MASTER OF BUSINESS ADMINISTRATION (MBA)

14. I.M Pandey, Management Accounting, 9th Edition, Vikas publishers,

MASTER OF BUSINESS ADMINISTRATION (MBA)

L. NO. LESSON NAME PAGE NO.

1 Financial accounting principles and concepts 1

2 Accounting Records And Systems 15

5 Analysis and interpretation of Financial Statement 62

7 Fund Flow Statements 98

8 Cash Flow Statement 113

9 Marginal Costing 131

10 Marginal Costing – Cost volume Profit Analysis 141

11 Break Even Chart 155

12 Application of Marginal Costing Techniques 161

13 Introduction to Budget 173

14 Budgetary Control 177

15 Types of Budgets 186

16 Zero base budgeting & Master budget 217

18 Capital Budgeting Process 227

19 Methods of Evaluating Capital Investment Proposal 233

20 Introduction to Cost Accounting 266

21 Importance of Cost Accounting 276

22 Essentials of good Cost Accounting System 314

23 Standard Costing and Variance Analysis 322

24 Reporting to Management 371

Accounting has been defined by the American Accoun ting Association

v) To safeguard the business properties: Accounting provides up to date

The implication of this concept is that the purchase of an asset is recorded in

6 Accounting period concept: In accordance with the going concern concept it

8 Realisation Concept: Realisation refers to Inflows of cash or claims to cash

Introduction of a new technique results in inflating or deflating the figures or profit

AS 23 Accounting for Investments in Associates in Consolidated Financial

1.4 REVISION POINTS

account is a statement wherein Information relating to an item or a group of similar

2.3.2 DEBIT AND CREDIT

Golden Rules for Debit and Credit:

In the books of X&Co.

June Dr. Cr.

2.3.4 THE TRIAL BALANCE

January 21 -Delivered goods and received cash Rs.120000

Debit Cash a/c Credit

Balance 300,000 Cash 300,000

Dr Purchases a/c Cr Cash a/c

Cash 3,34,000 Capital 300,000

2.3.5 CLOSING ENTRIES

(1) Profit and Loss a/c (Dr) 2,210

(2) Sales a/c (Dr) 2,500

Profit and Loss a/c (Cr) 2,500

(3) Interest a/c (Dr) 50

Profit and Loss a/c (Cr) 50

Dr Retained Earnings a/c Cr

2.3.6 Adjustment Entries

Debit and credit: Debit signifies increase in asset accounts, decrease in

c. Debited to Profit and Loss d. None of the above

Particular Rs. Particulars Rs

Opening Stock XXX

when a number of products are manufactured because it involves the

The important methods of providing depreciation are given in a separate section

Deduction of the Inventory of Rs.3450 from Rs. 19,100 worth of