1

B.COM

COST ACCOUNTING

Unit-I

INTRODUCTION

Meaning of Cost;

Cost Accounting is that part of accounting which identifies, measures, analyses and

reports the various elements of direct and indirect cosrs associated with

manufacturing of goods or providing costs of services.

Cost Accountancy:-

The Institute of Cost and Management Accountants (I.C.M.A) London defines

Cost Accountancy as " The application of costing and cost accounting principles,

methods and techniques to the science, art and practice of cost control and the

ascertainment ofprofitability. It includes the presentation of information derived

there from for the purposre of managerial decision making."

In simple words Cost Accountancy is a wider term which contains theoretical and

practical aspects of several subjects like costing, Cost Accounting, Budgetary

control, cost control and cost audit.

Fixed cost:-

Fixed costs are those costs which tend to remain unaffected by changes in level of

activity or volume of output with in a specified range of activity or output during a

given period of time.

In simple words the relationship between volume and fixed cost per unit is an

inverse one; however it remains unaffected irrespective of volume of production

within a given capacity. Examples of fixed costs arc rent and rates of factory

buildings, insurance of buildings, depreciation or buildings etc. which remain

constant within a specified capacity.

2

Variable Cost :-

Variable costs are those costs which tend to vary directly with the volume of

output or level of activity.

In simple words, the relationship between volume and variable costs is linear. It

means that variable cost per unit tends to remain fixed irrespective of level of

output. Examples of variable costs are direct material costs, direct labour costs and

other direct expenses such as power.

Semi-variable Cost

Semi-variable costs are those costs which are partly fixed and partly variable, that

is both fixed and variable elements are present in these costs.

The fixed component represents the cost of providing capacity which remains

constant within the capacity whereas the variable component represents the cost

of using the capacity which vary with the output in direct proportion. Examples of

semi-variable costs are telephone bill, power, repairs and maintenance costs.

Controllable Costs

According to R.N.Anthony and GA. Weish "An item of cost is controllable if the

amount of cost incurred in (or assigned to) a responsibility centre is significantly

influenced bythe actions of the manager of the responsibility centre. Otherwise it

is non-controllable".

In other words, a cost is a controllable one if that cost can be influenced and

regulated during a given period by the actions of a particular individual who is in

the charge of the responsibility ' or cost centre, e.g. direct material, direct tabour and

some of the overhead expenses.

Uncontrollable Costs :-

Uncontrollable costs are those costs which are beyond the control of a given

individual during a given period of time. It means that they are not affected by the

actions of the lower level management, e.g. fixed expenses like salary, rent,

insurance and taxes.

Cost Unit:-

Institute of Cost and Management Accountant (I.C.M.A) London defines 'Cost

as "A quantitative unit of product or service in relation to which costs are

3

ascertained." It is a device for the purpose of breaking up or splitting of costs into

smaller subdivisions ittributable to products or services. Example : Passanger

kilometre in case of transport, bed day in .i^e of a hospital, One barrel in case of

petroleum.

Cost Centre :-

Institute of Cost and Management Accountant (I.C.M.A) London defines a osi

Centre'as "A location, a person or an item of equipment (or a group of these) in

respect which costs may be ascertained and related to cost units."

In simple words, a cost centre is the smallest organisational segment or area of

activity .imulate costs. A cost centre is an individual activity or a group of similar

activities for which .: as are accumulated. Example : a cost centre may be a location

(a department or section), an area a sales area) or an item of equipment (a machines

delivery vehicle) etc.

Inventory/Material Control

Material Control may be defined as "a systematic control over purchasing, storing

consumptions of material, so as to maintain a regular and timely supply of

materials, at ike same time avoiding over stocking."

The Official Terminology defines inventory control as "The systematic regulation

of . els." There are three stages where material control are exercised viz:-

(i) At the time of purchase of materials.

(ii) At the time of storage of materials, and

(iii) At the time of issue of materials to different jobs.

Bin Card:-

A Bin Card is a quantitative record of the receipts, issues and closing balances of

terns of stores. Each item is accompanied by a seperate Bin card and each

transaction of receipt md issue of materials is posted to the Bin card.

A Bin card is recorded and maintained by the store keeper inside the store.

Stores Ledger:-

A Stores Ledger contains the record of both quantity and value of materials-

receipts, issues and balance of materials.

4

The Stores Ledger is recorded and maintained by the costing department. Economic

Order Quantity (E.O.Q):-

E. O. Q may be defined as the most economic andfavourable quantity to be

purchased time when the stock reaches the ordering level. It helps in maintaining

the materials at optimum level with minimum cost.

The total cost of a material consists of

(a) Total acquisition cost.

(b) Total ordering cost.

(c) Total carrying cost.

ABCAnalysis:-

The ABC method is an analytical method of stock control which aims at

entrating efforts on those items where attention is needed most.

Under this system the materials stocked may be classified into a number of

categories

according, to their importance i.e their value and frequency of replenishment during

a period. Under this system, materials are classified into three groups. GROUP A.

Those are high value items. GROUP B. Those are medium value items. GROUP C.

Those are low - value materials.

Maximum Stock Level :-

Maximum Level represents the maximum quantity of an item of material which

can be held at any time. Stock is not allowed to exceed this level. Its object is to

avoid

(i) Overstocking of materials.

(ii) Blockade of capital unnecessarily, and

(iii) Unnecessary storage cost.

Maximum stock Level = (Re-order Level'+ Re-order Quantity) -(Minimum

Consumption x Minimum Re-ordering Period)

Minimum Stock Level:-

Jt is the level below which stocks are not allowed to fall. So it is a quantity of

material which the Organisation must maintain at all times. The quantity is fixed

5

in such a way that the production may not be held up due to shortage of material. So

this level of stock is known as Buffer Stock or Safety Stock.

Minimum Stock Level - Re-order Level - (Normal Consumption x Normal Re-order

Period)

Re-order Level :-

Re-order Level is the point at which purchase requisition for fresh supplies is

initiated by the Stores department. This level falls in between the maximum and

minimum level.

According to WHELDON, // is that level of inventor which should be equal to the

maximum consumption during the lead time.

Re-order Level= Minimum Stock Level + (Average Consumption x Average Lead

Period)

Labour Turnover:-

Labour turnover may be defined as the rate of change in the labour force in an

Organisation during a specified period.

Labour turnover may be represented by the ratio Number of workers leaving during

the period. Average number of workers employed during that period. Labour

turnover is usually expressed as a rate or percentage in order to facilitate

comparison between two periods and between two undertakings.

Idle Time :-

Idle time may be defined as the time during which no production is obtained

although wages are paid for that period. In other words, it means payment made to

a worker for a period during which he remains idle and does nor-work.

Idle time is represented by the difference between the time as per the attendance

record and the time booked for different jobs.

Cost Allocation :-

"Cost Allocation "is the process ofdirect identification ofoverheads with cost

centres An expense which is directly identifiable with a specific cost centre is

allocated to that centre.

In simple words, Cost Allocation' means the allotment of the whole item without

division to a particular department or cost centre.

6

As for example: Salary of the foreman of a production department to be charged to

that production department.

Cost Apportionment

Cost apportionment means "the allotment ofproportions ofitems of cost to cost

centres or cost units. " Such allotment of an expense is made on same equitable

basis. It happens when an expenditure is common to various cost centres.

It simple words, Cost Apportion-ment'means charging of an overhead expense to

two or more departments or cost centres.

As e.g. The rent of a buildings is not allocated but is apportioned to various

Absorption of Overhead :-

The process of recovering overheads in the cost of the production is known as

Overhead Absorption.

In other words it means charging each unit ofproduction with its share of

overhead expenses to ascertain the total cost ofeach unit. i.e. charging of

production overhead to cost units! The charge is made to each job in order to

recover the indirect cost and such charging of overheads to units of production is

known as absorptibn.of overhead .

Process Costing :-

According to Institute of Cost and Management Accountants (I.C.M.A)

Lo.ndon "Process Costing is that form of operation costing which applies where

standardised

foods are produced." Thus it is a method of ascertaining the cost of a product at

each process or age of manufacture.

Process Costing represents a type of cost procedure for continuous or mass

production industries.

Process costing is suitable for certain manufacturing industries like, chemical,

mining; and public utility industries like iron and steel, cement, chemicals, oil

refining, coal etc.

7

Normal Loss:-

Normal Process Loss is the loss which is inherent in production process and

which annot be avoided. As such, such loss is inherent in any production process, it

can be estimated in i\ ance on the basis of past experience and data.

Normal loss may occur due to evaporation, shrinkage, chemical reaction, moisture,

etc.

Cost of normal loss of units is charged to good units manufactured. 26. Abnormal

Loss :-

It is that part of loss which is unusual to the process and may arise due to some

foreseen factors and represents a loss which is over and above the normal loss.

The causes of abnormal loss are sub-standard materials, accidents, carelessness, bad

designs, etc.

Such loss represents the cost of material, tabour and overhead incurred on the

wastage.

Job Costing:-

It is a method of costing by which the cost of a job is ascertained. It is adopted by

those concerns which produce goods or do jobs against specific orders and not for

stock and eventual sales.

Job costing is used in the production of goods of non-repetitive nature, where a

job card is prepared for each job.

This method is applicable to printing, machine tool manufacturing, general

engineering work shop, house building ship building, garage, etc..

Operating Costing :-

According to Institute of Cost and Management Accountant (I.C.M.A) London

Operating costing is "that form of operation costing which applies where

standardised services are provided either by an undertaking or by a service cost

centre an within an undertaking". Thus it is a method of costing of an unit of

service.

In simple words, operating costing also known as services costing and is specially

used where services are rendered and articles are not produced.

Batch Costing :-

8

Batch Costing is a method of ascertaining cost of a group of similar items at a

time. Batch costing is an extension of Job Costing. It consists of a number of similar

products. A batch may consist of number of small orders passed through the factory

in a batch. Each batch is considerd as a cost unit and cost is ascertained for such a

batch.

Cost per unit = Total cost of the batch / Number of units produced in the batch.

Batch costing is applicable in the production of medicines, biscuits, garments spare

parts and components.

30. Cost Control

Chartered Institute of Management Accountants (C.I.M.A) London defines Cost

Control as...

"The regulation by executive action of the cost of operating an undertaking

particularly where such action is guided by cost accounting ".

In simple words Cost Control is the executive action of keeping costs with in

prescribed limits. Cost control measures involve the following three steps

(i) Setting of standards.

(ii) Comparison of actual costs with pre-determined costs, (in) Analysis of

deviations from the standards.

(iv) Taking corrective actions.

Cost Reduction

Chartered Institute of Management Accountants (CIMA) London defines Cost

reduction as "The achievement of real and permanent reduction in the unit cost

of goods manufactured or services rendered without impairing their suitability for

the use intended".

In simple words cost reduction means the real and permanent reduction in the unit

cost of goods manufactured or services rendered without reducing their value and

quality.

It is a creative function of the management and should be carried on continuously. It

challenges the set standards and leads to a new reduced standard future.

Halsey Premium Plan :-

9

Halsey Plan originated by F.A. HALSEY (An American engineer) recognises the

individual efficiency and pays bonus on the basis of time saved.

Main features:-

1. For each job or operation standard time is fixed.

2. Time rate is guranteed and the worker receives the guranteed wages irespective

of whether he completes the job within the time allowed.

3. The worker is paid a bonus of 50% of the time saved. Formula.E = RT+P(S-T)xR

Where, E = Earnings of the employee. R = Rate per hour.

P = Premium percentage (It is always 50% of time saved)

S = Standard Time.

T=Actual Time.

Rowan Premium Plan

Rowan Plan was introduced by D. Rowan in 1901. Under this system, standard time

for doing a job is fixed and the worker is given wages for actual time he takes to

complete the job at an agreed rate of wage per hour.

Mainfeature:-

1. It gurantees time wages to workers.

2. It provides incentives to efficient workers.

3. Labour cost per unit of output is reduced because of increased production.

Formula, E = RT+

Where, E = Earnings of the employee. R = Rate per hour. S = Standard Time. T

= Actual Time.

Perpetual Inventory :-

Perpetual Inventory system is defined by ICMA-London as "a system of fecords

maintained by the controlling department which reflects the physical movement

of stocks and tli eir current balance

In simple words, it is a technique of controlling stocks through maintaining a set of

records to get information on a continuous basis.

Perpetual Imventory system is comprised of: Bin Card : a quantitative record of

receipts, issues and closing balance of the items of stores, ii). Stores Ledger: records

10

not only the physical movement of stocks but also their values. I iii). Continuous

Stock Taking: is the regular physical verification of stocks.

Continuous Stock Taking:-

Continuous Stock Taking means continuous physical verification of stores. It is

done through a programme of continuous stock taking. It insures the accuracy of

stock and exercises preventive control on stocks, Discrepency in stock, if there is

any, is resolved and records are made up to date.

36. Social Responsibility Cost: CIMA defines this as 'tangible and intangible costs

and losses sustained by third parties or the general public as a result of economic

activity, e.g. pollution by industrial effluent."

Distinguish between Costing, Cost Accounting and Cost Accountancy:

Following are the differences between costing, cost accounting and cost

accountancy:

Points Costing Cost Accounting Cost Accountancy

Function Its function is to

ascertain the cost of a

product or a service.

Its function is recording,

classifying allocating and

reporting various costs in

curred in the operation of

an enterprise.

Its function is to

formulate costing

principles methods

and techniques which

ar to be adopted by a

business.

Objective Its object is to provide

cost information for

further managerial

action.

Its objects is to provide

details of costs of a

product or a service in

order to enable the

management to compare

the actual costs with

predetermined costs.

Its object is to provide

the theoretical and

practical fram-work

within which cost

accountant functions

Point of time

of

functioning

It begins where cost

accountancy ends.

It begins where costing

ends.

It is the starting point

of costing process.

11

Persons

involved

The persons involved

here are the cost clerks.

The persons inolved here

are cost accountants.

The persons involved

are the different

experts in the

field of cost and

management

accountancy.

Scope Scope of costing is

narrow.

Scope of cost accounting

is broader.

Scope of cost

accountancy is the

broadest. It is the

theory and practice of

cost accountants.

Q.3. What are the primary functions of cost accounts? Name the industries for

which the maintenance of cost records has been made compulsory.

Following are the primary functions of cost accounting

1. Cost Book-keeping:

Cost accounting records costs of production or services' and classifies them.

2. Cost Ascertainment:

Cost accounting ascertains the cost of a product or a service by allocation and

apportioning recorded costs to cost centres and cost units. Cost is ascertained in

respect of a unit of a product or a process or a job or a service.

3. Analysis of Costs:

Cost Accounting analyses different elements of costs, their inter-relationship and

their behaviour. It also analyses the various determinants of costs and focuses the

areas ol inefficiencies and wastages.

4. Cost Reporting:

Cost accounting furnishes cost reports to the management. Such reports highlight

the of cost and their analysis and contains recommendations to the management for

suitable action were necessary.

12

Management Control

Cost accounting creates important cost data and cost information and furnishes

the management for exercising control on costs:

4 Cost Reduction:

Through cost analysis and cost study, cost accounting discovers the areas and

causes stages and inefficiencies and suggests remedial measures for reducing

them to the minimum possible limit. '. Preparation of Standards and Budgets :

Cost accounting develops standards andprepares budgets in order to exercise

control a-costs and performance, It facilitates the comparison between budgeted

cost and actual costs. It . r ains the causes of differences between the two and fixes

the responsibility for remedial measures.

5. Insaiinment of Profitability:

It matches costs with revenues and determines the profit, ass ification of Costs for

Managerial Decision:

It classifies costs into fixed and variable, controllable and non-controllable, etc. and

suggests solutions in particular situations.

Supply of Cost Information for Managerial Decision :

Through cost reports, it provides cost data and cost information for the purpose of

planning, control and decision making by the management. It provides a base on

which the processes of and decision making depend. It also provides various

techniques such as 'marginalng, differential costing and standard costing through

which the problems relating to production, distribution can be solved.

Just tries where Cost Accounting is Necessary:

Government of India have framed cost accounting (record) rules for maintenance of

records for various industries. Thus up to 1st April, 1998,43 industries have been

brought under : run ew of cost accounting (record) rules. Following are the names

of some of the industries:

1. Cement; 2. Cycles; 3. Costic soda; 4. Rubber; 5. Tyres; 6. Tubes; 7. Room Air . :

-c::ioners; 8. Refrigerators; 9. Automobile batteries; 10. Electric lamps, fans,

motors; 11. Motor 12. Tractors; 13. Aluminium; H.Vanaspati; 15.Bulkdrugs; 16.

Sugar; 17. Infant milk food; lite goods; 19. Paper; 20. Rayon; 21. Dyes; 22.

13

Polyester; 23. Nylon; 24. Cotton textiles; 25. Sfcel tubes and pipes; 26.

Engineering; 27. Chemicals; 28.Mini steel plants; 29. Fertilisers; 30. Milk :: 31

Footware; 32. Cosmetics; 33. Soaps and detergents etc.

Q.4. What are the limitations of financial accounting? How far has cost

accounting e««tributed in removing the defects of financial accounting?

Explain. [GU.-1997]

- rations of Financial Accounting:

Following are the limitations of financial accounting:

I Past data:

Financial accounting provides only past data because it records only those

transactions : have already taken place. It is a postmortem analysis of information

which is not useful to re -anagerial decision making processes.

Cost accounting provides on the other hand, present and projectedfuture cost data

which forms the basis of managerial decision.

2. Aggregate result of business:

Financial records provide total costs and total performances of the business as a

whole. On the contrary, cost accounting provides cost data for every product,

process, operation, etc. separately through the process of unit costing, batch

costing, process costing, etc.

3. Financial Accounting is static in nature:

Financial accounting is static in nature and does not incorporate changes taking

place within the business. But cost accounting is dynamic in nature and records all

changes taking place within the business.

4. Inadequate information for price fixation:

Financial accounting does not provide adequate information for price fixation as it

does not record expenses product wise, department or process wise.

Cost accounting on the other hand provides detailed information about costs

relating to each product, process, department, etc. which helps the management in

fixation of price.

14

5. No classification of expenses:

Financial accounting does not classify expenses into direct and indirect, fixed and

variable, controllable and uncontrollable, etc. as a result, cost control measures

cannot be taken.

Cost accounting helps the management in this matter by providing different

classification of costs.

6. No Control over costs:

Financial accounting fails to exercise any control over material, labour,

overheads, etc. As a result, avoidable wastages of materials, tabour, etc. cannot be

checked.

Cost accounting provides different techniques in order to check wastages in

respect of materials, labout and overheads. This technique is setting of different

stock levels, bin cards, stores ledger, perpetual inventory system, ABC analysis,

time recording and time booking, wage incentives, etc.

7. No data for comparison and decision making:

Financial accounting does not provide cost data which mayfacilitate the

comparison between two periods, two jobs, two operations, etc. Thus it does not

help in decision making.

Cost accounting produces data which can form a basis for comparison and

decision making. This is done through the technique of standard costing, budgeting,

marginal costing, differential costing etc.

Thus financial accounting is unable to provide adequate information required by

the management; So the need was felt for introducing cost accounting.

8. No analysis of losses:

Financial Accounting does not analyse the causes of losses arising from materials,

labour and equipments.

Cost accounting focuses the different causes of losses arising from defective raw

materials, wastage of materials, idle time, unutilised plant capacity, etc. Thus

financial accounting does not help in cost reduction and cost efficiency while cost

15

accounting is primarily engaged in the function of cost reduction and cost

efficiency.

9. Fails to ascertain break-even point.

Financial Accounting does not help in ascertaining break-even point but cost

accounting helps in ascertaining break-even point by adopting the technique of

marginal costing.

Q.5. What is meant by cost accounting? In what essential respects does Cost

Accounting differ from financial Accounting? [GU.1987]

Or, State and explain the main differences between financial accounting and

cost accounting.

[G.U.1998]

Mr. Wheldon defines cost Accounting as Classifying, recording and appropriate

allocation of expenditure for the determination of the costs ofproducts or services,

the relation these costs with sales volume and ascertainment of profitability. "

From the above, it is observed that Cost Accounting is that part of accounting which

fortifies, measures, reports and analyses the various elements of direct and indirect

costs associated :h manufacturing and providing goods and services. It provides the

management with accurate and ::mely information for product costing, planning,

controlling and decision making.

Thus cost accounting consists of costing and accounting principles for determining

costs. Differences between Cost Accounting and Financial Accounting :

ow ing are the differences between cost accounting and Financial accounting.:

Basis Financial Accounting Cost Accounting

1. Purpose It provides financial information

about the business to the owners

and other external users through

financial statements.

It provides cost information

of an enterprise to the

management for planning,

control and decisionmaking.

2. Form of

Accounts

Financial accounting is based on

GAAP in order to make the

statements uniform and

Cost accounting, has no

definite structure. It is

designed to cater to the

16

understandable to all. So it has a

single unified structure.

specific needs of the

management. It is utility

based and not GAAP based.

JL Recording It records all commercial

transactions including expenses in

a subjective manner.

It records only those

expenses which constitute the

cost of production in an

objective manner

1 Analysis of

profit

It discloses profit or loss for the

entire business as a whole through

income statements

It shows profitability or

otherwise of each product,

process, operation through

reponsibility accounting.

5. Control It lays emphasis on the recording

aspect of transactions without any

emphasis on control aspect.

It gives emphasis on control

aspect through the use of

various control techniques

such as budgetary control,

standard costing marginal

costing, etc.

1 Nature of

"formation

Financial accounting is concerned

about past records. So the accounts

are called historical accounts and

the

Cost accounting is concerned

with both past and future

costs but it lays more

emphasis on future

information is called post- mortem

information or actual.

costs. So it is future oriented.

7. Price Fixing Financial accounting does not help

in price fixing policy.

Cost accounting provids

sufficient data for fixing

pricing policy.

8. Nature of

Recorded

figures.

It records actual costs. It records actual as well as

estinialed costs.

17

Q.6. Why are cost accounts necessary?[GU. 1990, 1996, 1998] Or What are

the various objectives of cost accounting?

Cost accounting serves various purposes which justifyits introduction in a business

unit. Following are the purposes for which Cost accounting is needed :

(i) Product costing;

(ii) Planning and control; (iii)Cost reduction; and (iv)Decision-making.

Product Costing:

Product costing means the ascertainment of cost per unit by accumulating

manufacturing and other costs. It helps in :

(a) Determination of selling price.

(b) Analysis and classification of cost of production,'

(c) Submission of quotations.

(d) Valuation of inventory in order to facilitate the preparation of final accounts.

Planning and Control:

Cost accounting creates useful cost data and information for planning and control

by the management. The following tools of planning and control are provided by

cost accounting:

(a) Determination of standard costs on the basis of cost data and other cost

information as provided by cost accounting;

(b) Preparation of Budgets;

(c) Comparison of actual performance with budgeted performance; and

(d) Fixation of responsibilities and adoption of remedial measures.

Cost Reduction:

Cost data and other cost information are analysed; the causes of wastages and

inefficiencies are determined and suitable action is taken to eliminate them. I bus

the cost of production and selling prices can be reduced. Again productivity of the

labour force can be increased by imparting adequate training and unnecessary

production processes can be abolished by careful study of the production processes.

All these lead to cost reduction.

18

Decision Making :

Cost accounting provides useful cost data and costing techniques for decision

making purpose and determining business policy. Management can use the

techniques of standard costing marginal costing, differential costing, responsibility

centre costing for selecting the best one out of many alternatives in certain

situations such as:

(i) To make or buy decision;

(ii) Whether or not price should be reduced for increased sale;

(iii) Whether or not a new product should he introduced,

(iv) Whether or not an investment should be made in any asset;

(v) Whether or not the factory should be shut down, etc.

"How do cost accounting records help in planning and control of operations of

business enterprise? [G. U. 1989,1992 and 1995]

Cost accounting records help the management in planning and control of operations

of a lNeaness enterprise fit the following manner:

Cmt A ccounting in Planning:

Planning, decision making and control are the three basic functions of the

management. of these basic functions, cost accounting techniques help the

management by providing,, Bcessiry information in proper time.

Planning means thinking in advance, Planning requires the management to decide

in _ce as to what to do, how to do it, when to do it and who to do it.

So planning involves selection of a project and to determine its objectives in

advance. It JS the selection of a course of action where there are alternatives.

Moreover, planning requires the preparation of budgets and selection of a definite

course J achieve the objectives of the budgets. This is done by applying various cost

accounting : such as budgeting, marginal costing, differential costing, etc.

Budgeting involves capital reduction budget, sales budget, expenditure budget,

flexible budget, etc. nunting in Decision Making:

In order to materialise a plan, several alternative courses of action are available,

gement has to decide the best alternative course of action in a set situation. In the

19

process of best alternative, cost accounting helps the management by providing all

relevant cost —.31 : n about the various alternatives. Cmu -i 11 minting to the

control of operations:

Controlling of operations means keeping the cost and the performance of the

operations z set standard and budget. It is done by comparing the actual costs and

performances with standard costs and budgeted performances by analysing the

causes of deviations and by abagsuitable remedial measures thereon.

Cost accounting exercises different techniques for the proper use of materials,

tabour "head facilities and thereby reduces wastage to the minimum.

Measurement of performance:

Cost accounting provides pre-determined costs or standard costs and budgets are

prepared . r-asis of such costs. Actual performances are compared with the standard

costs or budgeted ariations of actual performances from the standard or budgeted

performances are ascertained sed. Responsibilities for such variances are fixed and

remedial measures thereon are taken to raise the future actual performances to tire

level of set standards. Thus cost accounting mportant tools to the management for

enforcing control on the operations of the business.

QJL Enumerate the advantages of cost accounting.

Smmages of cost Accounting:

Financial Accounting suffers from some deficiencies and cost Accounting attempts

to rran: i rese deficiencies. Advantages of costing arise from the removal of

deficiencies of Financial Accounting. The extent of advantages that will be obtained

from cost accounting will depend on the efficiency with which cost system is

installed and also the extent to which the management is prepared to accept the

system.

The principal advantages of cost accounting are stated below:

1. Disclosure of profitable and unprofitable activities :

A costing system reveals profitable and unprofitable activities and steps can be

taken to eliminate or reduce those activities from which loss arises.

2. Basis for fixing selling price

20

Cost accounting provides cost-data. It helps the management in fixing the selling

price in advance.

3. Measurement of performance:

Cost accounting provides cost-data for each element of cost. It

facilitates.comparison of costs of a product between two periods and efficiencies or

inefficiencies can be ascertained.

4. Cost Control:

Cost accounting provides budgets and standards which are techniques of cost

control. By applying these techniques the management can control cost.

5. Aid in decision making:

It supplies suitable cost-data and other related information for managerial decision

making such as introduction of a new product line, replacement of an old machinery

with an automatic plant, make or buy decision, etc.

6. Minimum wastage and losses :

Cost accounting system locates areas and causes of losses and wastages in respect

of materials, idle time, unutilised capacities and suitable action can be taken to

eliminate or reduce them to the minimum.

7. Cost reduction measures:

It helps the management in introducing cost reduction measures such as elimination

of unnecessary process, introduction of improved technology and process, various

labour incentive schemes for improving labour productivity.

8. Basis for formulating policies:

Cost accounting provides cost data product wise, process wise or department wise

at different levels of capacity and other relevant cost information to the

management in order to formulate production policy, labour policy, sales policy and

investment policy. Thus it helps the management in fixing quotation, contract or

tender price, adopting labour incentive programme, etc.

9. Inventory Control :

Costing system enforces control on inventory and reduces wastages and losses in

the form of over stocking. It helps in the valuation of inventory for preparing

interim accounts.

21

Q. 9. Discuss the nature, scope and limitations of Cost Accounting : (a) The

nature, (b)Scope and

(c) Limitations of cost Accounting

The nature of cost accounting can be understood from its characteristics of cost

accounting.

(a) Nature/Characteristics of Cost Accounting :

Following are the characteristics of cost accounting: ist Accounting is a Science :

Cost accounting is an empirical science, It has its own principles and rules..

Empirical Science:

Rules of cost accounting are conditioned by the operations, personnel and policy of

the undertaking with respect to which its techniques are to be applied .

Dynamic Nature:

The principles, rules and techniques of cost accounting are not static but dynamic,

They ge with passage of time and situation, Social Science:

Its principles cannot be verified and proved by controlled experiments like exact

science , Mathematics, Physics, Chemistry, etc.) because it is a social science.

5. Behavioural Science:

As it is operated by human beings with feelings arid emotions, it is also called a

behavioural science.

is an Art requiring skill:

It is also an art. So the application of its principles requires skills, efforts and

practice on re part of cost accountant.

(b) Scope of Cost Accounting:

The scope of cost accounting covers five aspects:

(i) Cost ascertainment or costing;

(ii) CostAccounting

(iii) Cost presentation;

(iv) Cost control, and

(v) Cost audit stA scertainment:

One of the important aspects of cost accounting is cost finding or cost

ascertainment. It - ascertaining the cost of a product or a service or a job.

22

The measurement of production at different stages is made by adopting certain

methods - r res of costing such as single or output costing, job costing, contract

costing, process costing, etc.

Cost Accounting :

Cost accounting is the process of accounting for costs. It implies the application of

ring and costing principles, methods and techniques in the ascertainment of costs

and the savings and/or excesses as compared with previous experiences or with

standards. 09 Cost Presentation:

Cost presentation refers to the reporting of cost data to the various levels of

management? team in their managerial decisions. It involves the presentation of

cost data to the right personnel k re right nine in the right form.

Cost Control :

Cost control means the guidance and regulation of actual cost of operating, an

undertaking, at guiding the actuals towards the line of targets. It regulates the

actuals ifthey deviate or vary from the targets. This guidance and regulation is done

by an executive action. Thus cost can be controlled by standard costing, budgetary

control, proper presentation and reporting of cost data.

(v) Cost Audit:

Cost audit is the verification of the correctness of the cost accounts. It is a check on

the adherence of the cost accounting plan. It ascertains the efficiency of the system

of cost ascertainment.

(c) Limitations of Cost Accounting:

Following are the limitations of cost accounting.

1. Lack of Uniform procedure :

There are different procedures for ascertaining costs. Thus costs of a product

determined by different procedures will be different.

However, this limitation can be avoided by adapting the procedure to the needs of

the organisation and such procedure should be constantly updated according to the

changing situations.

23

2. Flexibility in conventions and estimates:

Cost accounting classifies costs into different elements, issues of materials at

different prices, apportions overheads, allocates joint costs, divides overheads into

fixed and variable, etc. basing on different conventions and estimates which are

very often arbitrary. As a result determination of cost may not be correct.

However, this shortcoming can be overcome by introducing a sound costing system

and by clearly defining cost centres, cost units and responsibility centres.

3. Expensive System :

Introduction and functioning, of an elaborate costing system is expensive and it is

not suitable to small organisations.

This limitation can be overcome by introducing a flexible'costing system suitable to

serve the needs of an Organisation big or small and expenses can be reduced

accordingly.

4. Unhelpful in Inflationary situation:

Cost accounting fails in inflationary situation because it provides futuristic data

based on the current situations.

5. Cost data for a specific purpose :

Cost accounting provides cost data for a definite purpose. Such cost information

cannot be applied to other purposes without suitably adjusting to the changing

situations and purposes.

6. Arbitrary Nature:

Many of the costing procedures are arbitrary in nature. However, such procedures

can be rationalised by constant research and analysis.

Q.10. "Cost accounting has become an essential tool of management" On the

basis of this statement explain how cost accounts help the management for

successful operation of a manufacturing unit. [GU.1991]

Or, "Cost accounting has become an essential tool of management" Give your

comments on this statement. [GU.1997]

Or, State how, in your opinion, the work of the cost accountants contributes to

the successful operation of a manufacturing concern? [GU.1990,1996]

24

Or, Discuss the importance of cost accounting to the management in discharge

of their functions. [GU.2002]

Planning, controlling and decision making are the three important functions of

management, n each of these functions, cost accounting helps the management by

providing necessary cost data nd other cost information for its successful

functioning. Thus the importance of cost accounting to

e management may be considered under the following headings: I An aid to

planni.ng:

Planning means thinking in advance. It means that the management is to decide a

definite : roject, to determine a course of action and to monitor its functioning. This

is done by setting standards, paring budgets, comparing the actual performance with

the set standards and budgeted performance d taking remedial measures thereon. In

all these sphere of activities, cost accounting provides - -cessary cost data and

useful techniques such as marginal costing, standard costing, budgetary control, etc.

V A n Aid to Decision making process:

In order to materialise a plan, several alternative courses are available. Management

to decide the best alternative course of action in a set situation. In the process of

selecting the alternative, cost accounting provides the management with all relevant

cost information about the -rious alternatives to enable it (management) to arrive at

a rational and reasoned decision. Cost nation provided by cost accounting relates to

the following problems@

(a) Whether or not to invest in a definite project;

(b) Whether or not to shut down a plant;

(c) To decide the level of utilisation of plant capacity;

(d) To fix the price of a product; etc. 'aid to the control of operation:

Controlling of operations means keeping the costs and the performances of

operations n the set standards and budgets. It is done by comparing the -actual costs

and performances with : standard costs and budgeted performances by analysing the

causes of deviations and by taking edial measures thereon.

Thus cost accounting helps the management in its functions of planning, decision

making and controlling operations. This is done by cost accounting through

25

recording, classifying, analysin, md reporting of actual costs and by forecasting,

comparing and standardising cost data. .

In the words of Blocker and Weltmer, the aim of "costing is to serve management in

xt cution ofpolicies and in the comparison of actual and estimated results in order

that the value of each policy be appraised and changed to meet future conditions."

Following are the ways by which cost accounting helps the management;

(i) By classifying and subdividing costs;

(ii) By controlling manterials, labour and overheads;

(iii) By supplying information to management for deciding business policies;

(iv) By doudgiting;

(v) By setting standards for measuring efficiencs.

(vi) By best use of resources through cost reduction

(vii) By cost auditing; and

(viii) By indentifyig special factors affecting costs.

Q. 11. Explain the relationship between Cost Accounting and Financial

Accounting. State the steps involved in installing a costing system for a

manufacturing enterprise.

[GU.- 1993]

Or, Discuss the points of similarities and dissimilarities between cost

accounting, and financial accounting. [GU.-2001 & 2003]

Financial Accounting and cost accounting represents two parts of the accounting

information system. Therefore, there are certain similarities and dissimilarities

between the two. Similarities:

1. Monetary Transactions:

In both the systems, business transactions are recorded in monetary terms.

2. Double Entry System :

Both the systems are based on double entry system of book-keeping.

3. Application of GAAP:

The considerations which make Generally Accepted Accounting Principles (GAAP)

useful in financial accounting are equally relevant in cost accounting also.

26

4. Classification and Tabulation of information:

In both the sets of books, transactions are collected, classified and tabulated and

information is supplied to the management for their use.

5. Operating Information:

Operating information is useful in financial as well as in cost accounting. Thus

financial accounting has significant influence on cost accounting.

Both the systems are supplementary to each other because financial accounting

provides information broadly while cost accounting uses it in order to solve specific

problems.

6. Source of Information :

In both the systems, the sources of information are same such as vouchers, invoices;

etc. Therefore, cost accounting system cannot be installed without proper financial

accounting system. Thus a firm develops cost accounting system which is suited to

its financial accounting system.

Differences :

Inspite of similarities, the two systems have some dissimilarities relating to

structure or format of presenting information. These dissimilarities are discussed

below :

1. Structure of accounting:

Financial Accounting has an uniform structure as it provides information to outside

parties.

Cost accounting provides information to insiders i.e. to management. So the

structure is ' flexible and is tailored to the needs of management. Therefore, it has

utility based structure and not uniform structure.

2. Nature of Information :

Financial accounting classifies, records, presents, and interprets the financial

information for the purpose of preparing financial statements in aggregareform..

Cost accounting classifies, records, presents and interprets in a significant manner

the material, labour and overhead costs in detailedform.

27

Users of Information :

The users of financial accounting statements are mainly external to the business

u' such as shareholders, creditors, financial analysis, Government authorities,

stock. about unions, researchers, etc.

The information generated by cost accounting systems is used by members of

sment at different levels. 4L Accounting system:

Financial accounting classifies, records, summarises, monetary aspect of

transactions : accounting records monetary and non- monetary aspects also such

as number of ws, quantitative information etc. f Measurement:

Financial accounting uses monetary unitfor recording, classifying, summarising

- -erpreting financial transactions.

Cost accounting uses any measurement unit that suits a situation. Such as

machine - HI'hour,productunit,etc. tmm of emphasis:

In financial accounting the major emphasis is given on cost classification which is '.

pe of transactions such as salaries, wages, rent etc.

In cost accounting, major emphasis is on functions, activities, products, processes

imumalplanning and control, of data:

Financial accounting is concerned with historical costs i.e. information about the

pastmCost accounting is concerned with both present and future costs and financial

mm s as a guide to cost accounting. However, cost accounting is more future

oriented

us it provides data for budgeting and planning, yfoecrives:

Obj ecti ves of financial accounting are ascertainment ofoperational results

andfinancialObjectives of cost accounting are cost determination, cost control, cost

reduction and J cost reports for managerial decision-making.

What are the features of a good Cost Accounting system?

In ideal system of costing- should achieve the objectives of a costing system and

brings L--UCS to the business. Following are the characteristics of such a system:

The system should be devised to suit the nature, conditions, requirements of the

ilicity:

28

The system should be simple and understandable to all. The information should be

Ed i n a right format at the right time to the right person to make it meaningful.

ibility:

The system should be flexible to accommodate changes in conditions and

circumstances.

4. Economical:

The system should be economical taking into account the requirements of the

business.

5. Comparability:

Information it provides must be comparable with pastfigures or with the figures of

other departments. It should provide a reliable basis for performance evaluation.

6. Timeliness:

It must provide timely information to enable management to take suitable decision

for cost control and decision-making.

7. Organisational Set-up:

The system must correspond to organisational set-up so that it cm be introduced

with minimum changes.

8. Uniformity:

All forms orformats should be uniform in size and quality. Different colours

should be used to improve efficiency. Printed forms should be suitably designed for

collection and dissemination of cost data.

9. Minimum Clerical work:

. Filling of the forms by foremen and workers should involve as little clerical work

as possible. Every original entry should be supported by the examiner's signature.

10. Efficient Material Control:

Materials constitute a significant proportion of total cost. Hence an efficient system

of recording materials is the pre-requisite of an ideal cost accounting system. There

should be a good method for pricing materials issued to production.

29

11. Adequate wage procedure :

An well-defined wage system helps control over labour costs. There should be a

good procedure for time recording, preparation of wage sheets and payment of

wages.

12. Departmentalisation of Expenses :

There should be a good system of collection or apportionment and absorption of

overheads for correct ascertainment of costs.

Q. 13. Mention the steps which should be taken to install cost accounting

system in a manufacturing entity. [GU. 1 998j

Or Explain the steps which should be taken to install a cost accounting system

in an Organisation. [GU.2001]

Following are the steps to be taken to install cost accounting system in a

manufacturing entity/ Organisation:

1. Objective:

The objective to be achieved through the cost accounting system should be laid

down. If the objective is the cost determination only, then the system will be simple

but it would have to be elaborated if the objective is to have information which

would help the management in planning, control and decisionmaking.

2 Study of Existing Organisation and Routine:

Study should be made with reference to the following:

(a) Nature of business or operation or process carried;

(b) Extent of responsibility or authority of various functionals;

(c) Factory lay-out with particular reference to the manufacturing department;

(d) Treatment of wastage of materials;

(e) Time recording, computing and paying wages,

(f) System of issuing orders for production;

(g) Classification of expenses into fixed, semi-variable and variable overheads.

Structure of cost Accounts:

The system of cost accounting should be tailored to the manufacturing process.

30

Determination of cost rates:

It requires a thorough study of the factory conditions and decisions have to be made

yarding:

(a) Classification of costs into direct and indirect;

(b) Grouping of indirect costs into production, selling and distribution; (e)

Treatment of wastes;

(d) Method of pricing issues;

(e) Method of recovering overheads; and

(f) Calculation of overhead rates.

A complete cost accounting code should be drawn up so that expenses can be

quickly . sified as to both source and cause.

Introduction of system:

A system can function effectively only when the co-operation of all the officials is

obtained. -efore, before the introduction of the system, the implications of the

system should be explained to

Organising the cost office:

It is better to have the cost office situated adjacent to the factory so that delays in

routing documents or in clearing up discrepancies can be avoided. The duties of the

cost office fall into the lowing four categories:

(a) Stores Accounts:

Posting of receipts of materials and issues of stores in the stores ledger and

preparing material extracts.

(b) Labour Accounting:

Evaluation of Time Sheet and Job Cards, preparing labour extracts and preparation

of Pay Rolls.

(c) Cost Accounts:

Posting of all cost accounts viz. Job Account, Process Account, Service Account.

(d) Cost control:

Posting cost control accounts from data supplied from above three sections.

31

(e) Relation with other Departments:

Costing department should function independently. It should report directly to the

top management.

7. Authority and Responsibility:

Authority and responsibility should be clearly defined to make the system

successful. There should not be any ambiguity.

Q. 14. Explain the different techniques of costing.

Following are the different techniques of costing:

1. Uniform costing:

It is the use of standard principles, practices and methods of cost accounting within

a class of industry. Different undertakings in the same industry use same principles

and techniques for determining costs for the purpose of comparison and control.

2. Marginal Costing:

It is a technique of cost ascertainment which consists of variable costs only. It arises

due to change in the volume of production of a type of product. Costs are classified

into fixed and variable and fixed costs are accounted for in the profits of the period

in which fixed expenses arise. This technique is applied to ascertain the effect of

change in volume, product-mix, etc. on profit.

3. Direct Costing:

Under this technique, all direct costs consisting of all variable costs and some fixed

costs are charged to products, operations, processes, etc. Here indirect costs are

excluded and are written off against the profit of the period in which they arise.

Inclusion of some portion of the identifiable fixed costs into direct costing makes it

different from marginal costing.

4. Absorption Costing:

This technique charges all costs i.e. variable and fixed costs to operations,

processes, products. It does not make any distinction between fixed and variable

costs,

5. Historical Costing:

32

Under this technique, costs are ascertained after they are incurred. It ascertains

costs which were actually incurred in the past.

6. Standard Costing:

Standard costs are predetermined costs. Such costs are determined in conformity

with most efficient operation and use of resources. This technique compares actual

costs with standard costs. If there are variances, they are analysed and probable

causes are identified for remedial measures to be taken by the management.

Q.15. State the differences between historical costing and standard costing.

Following are the differnences between Historical Costing and Standard Costing

Basis Historical Costing Standard costing

1. Nature of cost Historical costing is concerned with

the calculation of costs after they

have been incurred.

Standard costing is concerned

with the determination of

costs before they are

incurred.

2. Type of

operation

Historical costing records only past

operations.

Standard costing sets

standards for future

production for the purpose of

cost control.

3. Nature of

function

Historical costing is concerned with

the 'ascertainment of cost of a

product or a

It is concerned with the

measurement of the

efficiencies

4. Usefulness of

information

service.

It is not much useful for managerial

decision because it is not timely

available

of the operations or

processes.

It is very useful to the

management for cost control.

Q. 16. State the differences between estimated costing and standard costing.

Following are the differences between Estimated Costing and Standard Costing:

Basis Estimated Costing Standard costing

1. Basis of It is concerned with the It is concerned with the

33

costing determination of the cost of a

product in advance basing on

estimates. The estimates are again

based on past experience and

expected future changes.'

determination of the cost of a

product based on proper

standards. Such standards are

scientifically set for each

element of cost.

2 Objective It tries to show the likely cost of a

product or service.

It attempts to show what

should be the cost in a given

situation.

3Accuracy Estimated costs are less accurate. Standard cost is more

accurate.

4. Relationship Estimated costs are pre-determined

costs but are not standard costs.

Standard costs are also

predetermined costs but are

not estimated costs.

J 1". Point out the differences between Absorption Costing and Marginal

Costing.

Following are the differences between Absorption Costing and Marginal Costing.

Basis Absorption Costing Marginal Costing

Constituents

of cost

All costs, both fixed and variable

are included for determining the

cost per unit.

Only variable costs are

considered for ascertaining

cost. Fixed expenses are

excluded from costs and are

recovered from contribution.

2. Relation

between cost

and volume

Cost per unit varies with the level

of output.

Here marginal cost per unit

remains same at all levels of

output.

.". Profit

.determination

Difference between sales and

total costs is profit.

Difference between sales and

marginal cost is contribution

and the difference between

contribution and fixed cost is

either profit or loss.

34

4.Treatment of

:T\ed costs and •

alaationof stock

A portion of the fixed cost is

carried forward to the next period

because the closing stock of

finished goods and work-in-

progress is valued at cost of

production including fiixed cost.

Stock of work-in-progress and

fmishea goods are valued at

marginal cost which does not

include fixed cost. Fixed cost is

not carried forward.

5. Absorption

erheads

In absorption costing,y?

xe</expenses are apportioned

arbitrarily.Thus there may

be.over-absorption or under

absorlition.

Since Variable costs are

charged to the products as a

result, there is no over or under

absorption.

6. Classification

of costs

Cost are classified on functional

basis such as production cost,

administrative cost, etc.

Costs are classified according

to behaviour of costs such as

fixed costs, variable costs, etc.

7. Cost volume It does not establish cost-volume-

profit

relationship Relationship as costs

are not classified into fixed and

variable.

It establishes cost-voluine-

profit relationship as costs are

classified into fixed and

variable.

8. Control It is not much helpful in taking

managerial decision e.g.

acceptance or rejection of an

export order.

It is much helpful in taking

managerial decisions because

of the role of contribution.

Q. 18. State the differences between Marginal Costing and Differential Costing.

Following are the differences between Marginal Costing and Differential Costing.

Basis Marginal Costing Differential Costing

1. Scope It has narrower scope because it

is confined to short term tactical

decisions

It has wider scope because it is

a technique of long-term

decision making. However it

becomes relevant even for

35

short term decisions where

fixed costs change.

2. Constituents -

of cost.

Marginal cost is prime cost plus

variable over heads.

Differential cost is a cost

arisingfrom increase or

decrease in total cost due to

increase or decrease in

production.

3. Presentation Cost information is presented to

management- by contribution

approach.

Here cost information is

presented under both

absorption and marginal

costing techniques.

4. Criteria for

decision making

Contribution and Profit volume

ratio ' are the main criteria of

performance evaluation and

decision making.

A comparison of differential

cost with incremental revenue

is the basis of policy decision.

5. Part of

accounting

system

Marginal costs may be

incorporated in the accounting

system through preparing a cost

sheet by contribution approach.

Differential costs do not find

any place in accounting

records because they are based

on assumptions and

arithmetical calculations for

planning.

Q. 19. Point out the difference between Marginal Costing and Direct Costing.

Marginal costing and direct coasting differ from each other in one main respect. In

the case of marginal costing, only variable costs are charged to individual products.

But in the case of direct costing, not only the variable costs but also some direct

fixed costs (i.e. those fixed costs which can be directly or conveniently charged to

individual products) are chargeable to individual products.

Q.20. Write Short Notes on : 1. Administrative Cost:

36

They are the costs which are incurred in carrying the administrative function of the

Organisation. Examples: cost of policy formulation and its implementation.

2. Selling Cost:

Selling costs are the costs which are incurred for the selling function ofthe products

or services. Example- cost of activities which are undertaken to create demand for

products and securing orders such as advertisement expenses, show-room expenses,

etc.

3. Distribution Cost:

Distribution costs are those costs which are incurred for distributing goods among

the . Jbtomers such as expenses relating to delivery van, carriage outward, packing

expenses, etc.

4. Research and Development cost:

Research costs are those costs which are incurred for searching for new products,

new anufacturing processes, improvement of existing products with new and

compact designs, etc.

Development c'osts are those costs which are incurred for putting research results

on . mmercial basis. As for example, cost of the pilot project for manufacturing

products on trial basis.

5 Product Cost:

Product cost is the aggregate of costs which are associated with an unit ofproduct.

ch costs consist of both direct and indirect expenses when absorption costing

system is adopted " : include only direct costs when marginal costing system is

adopted.

Product costs are related to the goods produced or purchased for resale and they are

rially identified as a part of inventory cost and such inventory costs become

expenses when the • entory is sold out. Thus product costs usually include costs of

direct material, direct tabour and i - tory overheads and are used for valuation of

inventory.

Direct Costs:

Direct costs are those costs which can be identified easily and indisputably with

aduct or a cost unit or a cost centre. Thus the costs of direct material, direct labour

37

and direct . :penses can be easily identified with a particular product, or cost unit or

cost centre and are charged that product or cost unit or cost centre. As they can be

identified, they are called traceable costs or cated costs. Example: cost of raw

materials, cost of ]about and cost of other direct expenses. " Indirect Costs:

Indirect costs are common costs. They cannot be identified with a particular

product, - a cost unit or a cost centre. So they cannot be allocated but can be

apportioned to products . - cost units or cost centres. All overhead costs are indirect

costs. They include costs of indirect materials, indirect labour and indirect

expenses. I iriable Costs:

Variable costs are those costs which tend to vary in total in direct proportion to the

me of output or level of activity. This variance in costs occurs within a given range

and a d of time. Though variable costs fluctuate in total amount with the changes in

the level of :>. they tend to remain constant per unit within the given range and

period of time. Thus . re is a linear relationship between the volume and variable

costs.

Examples: direct material costs, direct labour costs and other direct expenses such

as

Fixed Cost:

Fixed costs are those costs which tend to remain unaffected by changes in the level .

tivity or volume of output within a specified range of activity or output during a

given d of time. Such costs remain constant in total whether the activity increases or

decreases as production increases within a given range and the vice-verse. Hence

the relationship between volume and fixed cost is ail inverse one.

Thus fixed costs tend to remain constant for all levels of activity within a given

range and even if the level of activity comes down to nil, some of the fixed costs

will continue to be incurred.

Examples: Rent of factory premises, insurance, salary to some of the senior

executives, depreciation on assets, etc. continue to remain constant regardless of the

level of activity within a range during a given period.

38

10. Semi-variable Costs/Mixed Costs/Semi-fixed Costs:

Semi-variable costs are those costs which are neither perfectly variable nor

absolutely fixed in relation to changes in volume. They fall between two extremes

and are partly fixed and partly variable. They consist of both fixed cost and

variable cost. The fixed component represents the cost of providing capacity where

as the variable component represents the cost of using that capacity. The first part is

not affected by the changes in volume while the latter part is affected by the

changes in volume or activity. Thus semi-variable costs vary in same direction as

volume but not in direct proportion thereto.

Examples of semi variable costs are telephone, power, repairs, maintenance costs,

etc. A telephone bill involves two elements of costs-fixed charge for rent and

variable cost for number of calls made.

11. Controllable costs: Definition:

According to R.N. Anthony and GA. Welsh "An item of cost iv controllable if the

amount of cost incurred in (or assigned to) a responsibility centre is significantly

influenced by the actions of the manager of the responsibility centre. Otherwise it

is non-controllable." Meaning:

From the above defin ition it is observed that a cost is a controllable one if that

cost can be influenced and regulated during a given period by the actions of a

particular individual who is the in-charge of the responsibility or cost centre.

Otherwise the particular cost is noncontrollable. Characteristics:

Following'are the characteristics of controllable costs:

(i) Such costs are in relation to a particular responsibility centre;

(ii) The manager of that centre has significant but not complete influence on their

controllability;

(iii) They are relevant for a particular period; and

(iv) It remains with the lower of- intermediate level of management.

Examples:

Controllable expenses include direct material and direct tabourand some of the

overhead expenses. They can be generally influenced by the actions of the shop

39

level management. However, there are some expenses which are direct in nature but

not controllable by the action of lower level management e.g. the salary of an

engineer or a supervisor in case of contract costing.

12. Uncontrollable Costs:

Uncontrollable costs are the costs which are beyond the control of a given

individual during a given period of time. It means that they are not affected by the

actions of the lower level management.

Example: Allocated expenses to a responsibility centre regarding rent, senior

executive's depreciation, etc. are uncontrollable costs. JJL. Relative Cost:

The distinction between controllability and uncontro liability of costs is not very

sharp ; it is a relative concept. It depends on the level of management, span of time

and variability - f expenses.

Fast or Historical Costs :

Past or historical costs are the costs that had occurred in the past and are generally

ned in the financial accounts. Such costs are available only when the production of

a . J ar thing or the delivery of a particular service has already been done.

These costs report past events and there is a time la-, between the event and its

reporting, n e lag has made the information outdated and hence it is irrelevant for

decision making. However,

Stats act as a guide for future course of action. Following are the characteristics of

such costs:

(i) They are recorded force;

(ii) They can be verified because they are always supported by the evidence of their

lappenings.

(iii) They are objective because they are related to actual past events. 'r:determind

or standard costs:

Predetermined costs are estimated costs which are computed in advance of

production basis of specifications of all factors which affect costs. While computing

such costs, one consider previous periods costs and the factors which may affect

such costs in future. When . -:;:ermined costs are determined on scientific basis,

they are called standard costs. Thus "the ward costs are Predetermined costs which

40

determine what each product or service should cost : some given circumstances,"

said Brown and Howard.

Actual costs are compared with the predetermined costs and reasons (if variance are

sed, responsibility is fixed and remedial measures are taken. So it is considered as a

technique : "cost control.

Budgeted Costs:

Budgeted costs are estimated expenditure for different phases of business

operations as budgets for manufacturing expenses, administrative expenses, sales,

research and

pment expenditure, etc., Budgets are prepared for different segments of operation

and are iceived into a master budget for a future period of time. These budgets

specify certain targets in quantity and cost which are to be achieved by the

management. Continuous comparison of costs with budgeted costs is made in order

to determine variations so that the management can rrective measures. // is an

important tool of cost planning and control. It is also usedfor measuring

departmental performances. Standard costs:

According to the Chartered Institute of Management Accountants, London,

"Standard is a predetermined cost based on technical estimate for materials, tabour

and overheads . ^elected period of time for a prescribed set of working condition "

It is a cost which is determined in advance ofproduction of a product or a service. it

is a'should be cost' in a given situation in a-given period.

Standard cost is an instrument for converting budgeted cost into actual operations.

treated as a measure for the evaluation of operational performances through

variance analysis.

18. Marginal Costs:

According to the terminology of Cost Accountancy of the Institute of Cost and

Management Accountants, London; Marginal cost represents "the amount of any

given volume of output by which aggregate costs are changed if the volume of

output is increased by one unit. " It means that when there is an increase in output

by one unit, there is an increase in total cost. This increase in total cost is the

aggregate of variable costs or prime cost-plus variable overheads. Therefore,

41

marginal cost is the total of the variable costs only. Fixed costs are ignored in

determining the marginal cost of a product. It is different from direct cost which

may include some expenditures of fixed nature. Marginal costs are considered in

determining the cost of finished products, work-in-progress, etc. It is also useful in

profit planning and decision making.

19. Absorption Cost:

Absorption cost is the aggregate of variable costs andfixed costs which are charged

to operations, processes and/or products. It means that while determining the cost

of a product or service, not only the variable costs are considered but also a

proportionate amount of fixed costs is also assigned to an operation, a process

and/or a product.

Fixed costs are period costs. They are assigned to products or services produced or

created during a given period. Such assigned costs are called absorbed costs.

Therefore, the cost of a product or service represents the absorption costs.

20. Differential Cost/Incremental Cost:

Differential or Incremental cost is the additional cost due to a change in the level of

activity or pattern or method of production. Thus it is a cost which will be incurred

if the management chooses one course of action as opposed to another. Hence it is

a decision cost and is the difference in cost between two alternatives. It relates to a.

specific time period. Examples: the difference in cost between buying a component

from outside and making it in the company is the differential cost. If a new machine

is purchased for replacing an existing one, the difference in cost of the products

produced by both the machines is the differential cost. It is relevant for decision

making purposes.

21. Cost Centre:

ICMA defined a cost centre as "A location, a person or an item of equipment (or a

group of these) in respect of which costs may be ascertained and related to cost

units."

Thus it is the smallest organisational segment or area of activity to accumulate

costs. A cost centre is an individual activity or a group of similar activities for

which costs are accumulated.

42

Types of cost Centres:

Cost Centres are classified into the following three types:

1. Personal and Impersonal Cost Centres:

Personal cost centre is one which consists of a person or a group of persons and

costs are analysed and accumulated according to the person or a group of persons.

Example-works manager, sales manager, purchase manager, store keeper and a

group of salesmen, etc.

Impersonal cost centre consists of a location or an item of equipment. Example-a

region of sales, a department, etc. represents a cost centre relating to location. Again

a machine or a group of machines represent a cost centre relating to an item of

equipment.

2. Operation and Process Cost Centre: Operation cost centre:

An operation cost centre is a cost centre which may consist of those persons and/or

m achines that carry out an operation. Example-all machines and/or operators who

perform the same reration are combined into one cost centre in order to ascertain

the cost of each operation irrsepective f ocation in the factory. rVi >cess Cost

Centre:

Process cost centre consists of a specific process or a continuous sequence of

operations, nplea chemical industry represents a process cost centre. Product and

Service cost Centre: duct Cost Centre:

A product cost centre is one where actual production process is carried out.

Manufacturing s relating to the product are charged to the production centre.

Example-Conversion of raw materials " I finished product, etc. Usually such a

centre corresponds to a production department. I .-vice Cost Centre:

A service cost centre is one which renders services to either a production cost centre

or mother service cost centre. They are ancillary to product cost centres and help in

the smooth function production and other service cost centres. Example-

maintenance department is a service cost tre which provides service to both the

product cost centres and service cost centres. Again a house is a service cost centre

which generates and supplies powers both to the product cost .. .res and other

service cost centres.

43

22. Cost Unit:

A cost unit is a unit of product or a unit of service or a unit of time to which costs

are ascertained by means of allocating, apportionment and absorption.

ICMA defined cost unit as "A quantitative unit of product or service in relation to

ch costs are ascertained."

Thus it is a device for the purpose of breaking up or splitting of costs into smaller

isions attributable to products or services.

Example: a ton in coal, 1,000 bricks in brick kilns, one barrel in case of petroleum,

a bed in case of a hospital, passenger kilometre in case transport, 8 hours day in

case of wages, etc.

In short, a cost unit is a unit of a quantity of product or service or time or a

combination lese in relation to which costs are expressed or ascertained.

A cost unit must be clearly defined or selected before the process of cost finding is

~ It must be appropriate to the needs of a business.

Cost units are not uniform. They differ from industry to industry.

Examples of cost unit in different industries are as follows:

Name of the Industry Product Cost Unit

Aircraft Plane 1 plane

Automobiles Motor Car/Motor vehicle 1 car/1

vehicle

Brick kilns Bricks 1000 bricks

Brewery Bear/wine 1 Barrel

Building Construction Builing 1 Building

Bicycle Cycle 1 Cycle

Cement Cement 1 tonne

Cable Cable 1 metre

Confectionery . Biscuit 1kg.

Cotton Textiles Yarn 1kg.

Cosmetic Telcom powder 1 tin

Furniture Table/chair 1 table/ chair

Gas Gas 1 cubic Metre

44

Hospital Service 1 bed day/ 1 out patient

Ice-cream Ice cream 1 gallon

Nuts and Bolts Nuts and Bolts 1 gross

Oil Oil 1 tonne/litre

Paper Paper 1 Ream

Power Power 1 kilowat-hour

Pherinaceuticals Tablets 1000 tablets

Sugar Sugar 1 tonne/kg.

23. Profit Centre:

Profit centre is a segment of activity of a business to which both'revenues and costs

are assigned and the profit of that segment of activity is measured. It is created to

delegate responsibility to an individual and to measure his performance. Example-

Department in a departmental store, Branch, etc.

In a profit centre, both inputs and outputs are capable of measurement in financial

terms and efficiency of the manager can be effectively assessed. Differences

between a Cost Centre and a Profit-Centre:

There are certain differences between a cost centre and a profit centre which are

mentioned below:

I . Cost cetitre is the smallest unit of activity or the smallest area of responsibility in

respect of which costs are collected.

Profit centre is that segment of activity of a business which is responsible for

expenses and revenues.

2. Cost centres are created in order to account costs conveniently and to control

them. Profit centres are created to delegate responsibilities to individuals who have

special knowledge. Thus it is a process of decentralising of operations.

3. Cost centres are not autonomous but profit centres are autonomous.

4. A cost centre does not have any target costs though its object is to minimise

costs. A profit-centre has a profit target and can adopt independent policies to

achieve it.

5. There may be a number of cost centres in a profit centre-such as production cost

centre, service cost centre, etc.

45

A profit-centre may be a division within a company or a subsidiary company within

a group of companies.

24. Cost Control:

Cost control is the executive action of keeping costs within prescribed limits.

Chartered Institute of Management Accountants (CIMA) London defines cost

control as "The regulation by executive action of the cost of operating an

undertaking particularly where such action is guided by cost accounting. "

It is a conscious attempt by the management to regulate the cost of a product or

service on the basis of predetermined costs. It aims at reducing inefficiencies and

wastages. It is done by setting standards or predetermined costs and efforts are

taken to control the costs within the pre determined costs.

Thus cost control is exercised through setting up standards and comparing the

actual -mance with the set standards. Deviations from standards as disclosed by the

comparison are jna!> sed and corrective action is taken to ensure that the future

performance should comply with the sandards.

In short, cost control measures involve the following, three steps:

(i) Pre-determination of costs or setting standards;

(it) Comparison of actual costs with pre-determined costs;

(in)Analysis of deviations from the standards or pre-determined costs and corrective

actions thereon. 25. Cost Reduction:

Cost reduction means the real and permanent reduction in the unit cost of goods

manufactured or services rendered their value and qualit).

Chartered Institute of Management Accountants (CIMA) London defines cost

reduction he achievement of real and permanent reduction in the unit cost of goods

manufactured rendered without imparing their suitability for the use intended."

The above definition shows that the term 'cost reduction 'has the following

characteristics: (i) Cost reduction must be real and should come through increased

productivity; (it) Cost reduction must be permanent. Temporary reduction in costs

due to windfalls, ge in tax rate, change in market prices do not fall in the purview of

cost reduction.

46

(in) Cost reduction must not adversely affect the suitability of the products or

services "br:he intended.use;

Thus cost reduction arises through the elimination of wasteful and inessential

elements

(i) The design of the product; and

(ii) The techniques and practices used in connection with production of goods and

dering of services.

So it is a genuine savings in manufacturing, administration and selling and

distribution. It is a creative function of the management and should be carried pn

continuously. So it - enges the set standards and leads to a new reduced standard

in.future. 2t. Cost Efficiency:

Cost efficiency means the maximum efficiency achieved in the manufacture of

goods or endering of a service. It is achieved through the process of cost reduction.

Again, cost reduction is achieved by eliminating all inefficiencies and wastes in the

process i-.ufacturing a product or in rendering a service without impairing its

suitability for the use intended. It is a creative function of the management and a

continuous process. It is a genuine saving in the manufacturing, administration and

selling and distribution : -•. -ure of a product or a service.

1 Costs are ascertained by 'Cost Centres' or by 'Cost units' or by both"

Explain the statement with suitable examples. [G.U.2002]

Costing is the process of determining the costs of products, services or activities. In

the such determination of costs of a unit of a product or a service, the organisation

is divided small units which are known as cost centres. I.C.M.A (Institute of Cost

and Management tants of London) defines a cost centre as a location, a person or an

item of equipment (or a of them) for which cost may be ascertained and used for the

purpose of cost control. Thus according to the definition, a cost centre may be an

area such as a department, a sales area or a person or a group of persons such as a

foreman, a salesman, a group of customers or an item of equipment or a group of

equipments such as a lathe machine, delivery van; etc. Costs are accumulated and

allocated for such cost centres for the purpose of cost ascertainment and cost

47

control. Direct costs are allocated while indirect costs are apportioned to such cost

centres to compute the cost of production of a cost centre. The accumulated cost of

a cost centre is divided by the number of units of products produced or the units of

services rendered under the cost centre and the resultant figure is the cost per unit of

product or service. Cost Unit:

The ascertainment of unit cost of production is related to a unit of measurement. A

cost unit is "A unit of quantity of product or setvice or time in relation to which

costs unit may be ascertained or expressed. " I.C.M.A.

Cost units are not uniform and differ from industry to industry. Thus in case of

collieries, a tonne of coal is a unit, in case of a brick making industries, 1,000 bricks

is a cost unit, etc. Thus costs are determined and expressed for a cost unit.

Sometimes, a cost centre may itself be a cost unit and the accumulated cost of a

centre is the cost of a cost unit; as for example, construction of a building, a bridge,

etc. Examples:

(i) Where Cost Centre and cost units are different:

In case of brick kilns (Brick works), the whole of the brick kiln is considered as a

cost centre and all costs relating, the brick making process are collected and

accumulated to the certre. In brick works, per 1,000 bricks is considered as a cost

unit and the total cost of the bricks made are divided by the number of the bricks

made and multipl ied by 1000 in order to compute the unit cost of bricks i.e., the

cost of 1,000 bricks. Such is the case with conferees, textiles industries, etc.

(ii) Where Cost Centre and Cost Unit are same:

In case of construction industries, the construction of a building or a bridge is a cost

centre. All costs related to the building or bridge, etc are accumulated to this cost

centre. As the building itself is a cost unit, the cost of the cost centre will be the unit

cost in such industries. Thus in the process of cost ascertainment, determination of

cost centre and cost unit are important and both should be clearly defined ind

suitable to the nature of industry and its product or services. Common Costs:

Common costs are those costs which are incurred for more than one product, job,

territory or any other specific costing object.

48

The National Association of Accountants defines it as "The cos(ofseivices employed

in the creation of two or more outputs which is not allocable to these outputs on a

clearly justified basis. " There is no clear relation between the costs incurred and

the products made. Uniform Costs:

Uniform costing signifies common costing principles and procedures adopted by a

number of firms.

Replacement Cost:

It is the cost of replacing an asset at current market values.

Total Cost:

It is the sum of all costs associated to a particular unit, process, department, batch,

etc. It includes the cost of material, tabour and expenses.

B. ELEMENTS OF COST AND COST SHEET

;nt, batch, etc.

Ttart no. I

Laments

mf Cost

Showing Elements of Cost Elements of Cost.

(i) Material (ii) Labour (iii) Expenses (iv) Overheads.

es of Elements

=> Direct Indirect

Direct Indirect

Direct Indirect

=> Factory Administrative Sellingand Distribution

Chart no-2 Showing Features of Elements of Cost

(a) Direct

Material

(b)

Direct

Labour

(e) Direct (d) Factory (e) General Office

and administrative

Overheads

(f) Selling &

Distribution

Overheads. Expenses Overheads

(i) Easily id- (i) Easily (i) Easily (i) Incurred (i) Usually a small (i) Indirect

costs

entified with identifie

d

identified in the factory amount incurred after

and allocated with and with and or productive (ii) Methods of goods are

ready

to Costing allocated allocated process. absorption are for sale.

49

units or cost to

costing

to

relevant

(ii) Incurred in mostly arbitrary. (ii) Large in

amount

centres. units or costing shaping, and (iii) Difficult to (iii) Methods

of

(ii) Usually cost

centres

units constructing fix standards of allocation and

varies directly (ii)

Usually

(ii) May

be

material into performance. absorption are

with the vol- varies variable

or

a finished (iv) Generally

fixed

well-reasoned.

ume of output directly , fixed. product. (iv) Easy to

fix up

(iii)Sinificant with the (iii)

Impor-

(iii) Maybe standards of

or large in volume tance

varies

fixed, variable performance.

amount. of output from

industry

and Semi (v) Can be

identified

(ii)

Signific-

to

industry.

variable with products

ant or

large

(iv) Difficu- more easily.

in

amount.

lt in

allocation and

absorption.

(v) Usually

a large amounl

(vi) Methods

of absorption

quite scien-

tific.

(vii) Easy

fixation

of standards.

On the On the On file 0/iflie On file Oh the On

Hie

On the Onfde On the

basis of basis of basis of basis of basis of basis of basis

of

basis of basis of basis of

function association

with

product

Elements Traceabil

ity

behaviour

/Volume

Controllabilit

y

Time Normality Principle Maanageria

l decision

i.

Production

i. Product i.Materials i. Direct i Variable i.

Controllable

i.

Histor

ical

i. Normal

Cost

i. Capital

Cost

i. Marginal

cost Cost ii. Labour Costs Cost Cost Cost ii. Abnormal ii. Revenue cost

ii.Commer- ii. Period iii. Overh ii.

Indirect

ii. Fixed ii. Uncontro- ii.

Pre-

Cost Cost ii. Out of

50

deter-

cial Costs Cost heads Cost Cost llable Cost mincd

Cost

Pocket Cost

iii

Administr.

iii.

Committed

iii.

Dfferential

ative Costs fixed Cost Cost

iv. Selling iv. Discretio- iv. Imputed

Cost nary fixed

Cos

Cost

v. Distribu- v. Step Cost v. Sunk

Cost

tion Costs vi. Semi- vi.

Opportunity

vi.Distribu variable

Costs

Cost

tion Costs /Mixed Cost vii.

Replace-

vii.

Research

/Semi-fixed ment Cost

and Deveo. Costs viii

Avoidable

Ipmcnt

Costs

&

Unavoida.

ble Cost

51

Elements of Costs and Cost Sheet

Q. 1. What do you mean by elements of costs? Explain different elements of

total cost with citable illustrations. [GU. 1994 & 1998]

A cost is composed of three elements-material, labour and expenses. Each of these

ree elements can be direct or indirect i.e. direct materials, direct labour, direct

expenses and indirect eterials, indirect labour and indirect expenses. Aggregate of

three direct elements i.e. direct materials, rect labour and direct expenses constitute

direct expenditure and the aggregate indirect materials, rect labour and indirect

expenses constitute the indirect expenditure which is also known as : •• erheads. '

ining of "Direct" and "Indirect"

The term 'Direct 'means that which can be conveniently identified with and

allocated to entres, or processes or cost units. Examples: cost of materials which

forms a part of finished product.

The term 'Indirect' means that which cannot be conveniently identified with and .

ated to cost centres or cost units but which can be apportioned to or absorbed by

cost es or cost units. Example Cost of consumablestores, salary of a forman, rent,

etc. Each elements of cost isexplained in brief as follows : Direct Material:

Direct materials are those materials which can be identified with the product and

ch can be conveniently, measured and directly charged to the products. They enter

into the ^reduction and form a part of the finished product. Example - timber in

furniture making,clay in brick ng. leather in shoe making, etc. •.. r Materials

include the following:

(1) All raw materials such asjute in the manufacture of jute products; pig iron in

foundry, etc. (ii) All, materials specifically purchased for a specific job, or process

or order, etc. such : i n bookbinding, starch powder for dressing yearn, etc.

(Hi) All parts or components purchased or produced such as tyres for cycle,

batteries for nnsistor radios, etc.

(iv)Primary packing materials like cartons, card-board boxes, wrappings, etc. which

are protect the finished products or for easy handing within the factory. ect

Materials:

52

Indirect materials are those materials which cannot be identified or traced as part n

'duct They are known as on cost materials or expense materials. Example- fuel,

lubricating : snail tools for general use; materials for repairs and maintence of fixed

assets, sundry stores of a ue used in the factory, etc.

Grouping of materials into direct and indirect sometimes become a matter of

convenience. - - ~iaterials of small value which" form a part of a product and

should be termed as direct but they termed as indirect for the sake of simplicity. As

for example, thread used forms a part of the . d shirt hence should be classified as

direct materials but in order to save time and expense it is as indirect material so

also in case of nails in shoe making or furniture makilig, etc. ages/labour:

It refers to all labour expended in altering the construction, composition,

conformation or amdition of a product manufactured by a concern. In case of a

service industry, it is the cost of _. raid to workers who directly carry out the

service. Thus it is that Tabour which can be conveniently identified with or

attributed wholly to a particular job, product or proctss or which is expended for

converting raw materials into finished goods. Direct labour include the following:

(i) Labour engaged on the actual production of a product or engaged on carrying

out of an operation or process e.g. wages paid to carpenters working in a furniture

shop, etc.

(ii) Labour engaged in aiding manufacture, maintenance or transportation of

materials e.g. wages paid to driver.

(iii)Cost of any person specially required for a job e.g. wages paid to supervisors, in

spectors, etc. in case of contract costing. Indirect Labour:

Indirect wages represent the cost of Labour employed in the works or factory which

is ancillary to production. Therefore, such wages cannot be identified with a job,

process or operation. Example: wages to supervisor, foreman, idle time wages,

overtime wages nightshift wages, wages to store-keeper, watcher, etc. Direct

Expenses:

Direct expenses are those'expenses which are neither direct material cost nor direct

wages but are directly identifiable with a job, process or operation. They are

known as chargeable expenses, prime cost expenses, process expenses or

53

productive expenses. Such expenses like direct material and direct labour are not

incurred in the process of execution of a job or process, etc. They are expenses

leading to a job or contract and exhausts when the job or contract is completed.

Examples-

(i) Hire charge of a special concrete mixer required for civil engineering job; " (ii)

Cost of special pattern, drawing or layout, building plan;

(iii) Cost of a last prepared for a pair of shoes on order. (iv)Travelling or other

expenses for procuring a contract,

(v) Maintenance expense of special tools required for a job. Indirect Expenses:

They refer to expenses which cannot be charged to a product directly and which are

neither an indirect material or indirect wages. Example: Rent, Rates, taxes,

insurance depreciation, lighting, etc.

The aggregate of indirect expenses are called overheads which are subdivided into

(i) Manufacturing or factory overheads,

(ii) Administrative overheads;

(iii) Selling overheads;

(iv) Distribution overheads; and

(v) Research and development overheads.

Q.2 "All controllable costs are direct costs and not all direct costs are

controllable." Explain the statement with the help of suitable examples.

[G.U.1999]

Direct costs:

Direct costs are those costs which can be identified logically and practically to a

product or a cost unit or a cost centre. It means that, direct costs are those costs

which can be conveniently identified with or attributed to a product or a cost unit or

a cost centre.

Thus direct costs include direct materials, direct labour and direct expenses which

are traceable to products or cost centres or cost units. As for example, cost of raw

materials, cost of direct labour and cost of other direct expenses.

54

Controllable Costs:

According to R.N. Anthony and GA Welsh, "An item of cost is controllable if the

amount of cost incurred in (or assigned to) a responsibility centre is significantly

influenced by the actions of the manager of the responsibility centre otherwise it

is noncontrollable."

An organisation is divided into a number of responsibility centres and each centre is

assigned to an individual for its management. If the costs incurred in a particular

responsibility /cost centre can be influenced by the actions of the manager of the

centre then such costs are known as controllable costs otherwise the particular cost

is non-controllable.

From the above discussion it appears that the controllability or non-controllability

of costs rests with the lower and the intermediate level of management and not with

top level-management. Controllable costs have the following characteristics:-

(i) Costs are relating to a particular responsibility Centre;

(ii) The manager of that responsibility centre has significant but not complete

influence er their controllability; that means he cannot reduce them into zero.

(iii) They are relevant for a particular period because in the long-run all costs are

control

able; and

(iv) Controllability remajns with the lower or intermediate level of management.

From the above discussion,' it appears that controllable costs must be direct costs

such as ect materials, direct labour and direct expenses which can be controlled or

regulated by the actions the manager of a responsibility centre. He can take action

for control and reduction of such costs reducing wastage, idle time and by

eliminating unnecessary operations or improving thereon.

However, there are certain costs which are direct in nature but cannot be influenced

by e actions of the manager of that centre in a given period. Such costs are

uncontrollable during that p. nod even if they are direct in nature. As for example,

wages for the driver of a lorry engaged in a ' a rticular contract, wages of the

engineer engaged in a contract are direct in nature but uncontrollable. Thus all

controllable costs are direct but all direct costs are not controllable.

55

Enumerate the Characteristics of fixed and variable costs with suitable

illustrations.

[GU.- 1998]

Comparative Characteristics or Features of Costs

Costs Type: matures

4 4

(A) Fixed Cost Variable Costs Semi-variable or

(a) Committed Semi-fixed Costs

(b) Programmed or Mixed Costs.

/Managed

(i) Remain fixed during a given period.

(ii) Not affected by change in output or activity.

(iii) Inverse or opposite relationship between per unit fixed cost and

(i) Vary in the same direction as the change in Output.

(ii) Vary directly in one-to-one ratio

(i) Have both fixed and variable cost elements!

(ii) Partial movement in the direction of volume of output in less than one-to-one

ratio.

(iii) Marginal cost olume of output. comes down

Characteristices or Features of Costs Fixed Costs

Fixed costs are those which are associated with inputs that do not fluctuate in

response to changes in the total activity or output of the firm, within the relevant

range in a given period of time.

It means that fixed costs are certain expenses which are fixed in nature irrespective

of volume of output or activity within a certain range in a given period of time. If

the production or activity exceeds the given range, fixed costs also fluctuate. Again

they are to be analysed in relation to a given period of time. If the period of time

changes the fixed costs also vary. Thus fixed costs are to be studied in relation to

range and period and within this range and period, the volume of activity or output

is irrelevant.

56

Characteristics of Fired Costs:

Following are the chiet characteristics.of fixed costs: /. Fixed costs tend to remain

constant:

Fixed Costs tends to remain constant irrespective of volume ofproduction.

Example-Rent of the building; salary of the manager remains constant irrespective

of production during a month.

2. Effect on per unit fixed cost:

Fixed costs per unit of output increase with the decrease in the volume of'output or

production and decrease with the increase in the volume of output within a given

range. Example - if the fixed costs in a nionth are Rs. 10,000 and the actual

production is 10,000 units while the capacity is 20,000 units; the fixed cost is per

unit Re. 1. If the production is increased to 20,000 units, the fixed costs per unit will

be Re.0.50. On the other hand, if the actual production is reduced to 5,000 units, the

fixed costs per unit will be Rs. 2. It is because the fixed costs are time costs within

the capacity range of20,000 units and not production costs.

3. Nature:

Fixed costs are time costs or capacity costs. They are fixed within a capacity or

range and within a given period. They are not a result of the performance of activity

within the range so they are not influenced by the volume of output.

Example: It productive capacity is 20,000 units during a month the fixed cost within

this period and range will remain unchanged even if the production comes down to

nil. However, if there is a change either in time or in capacity, the fixed costs will

vary. As for example, fixed costs for a period of two months will become double as

they relate to time e.g. salary, rent etc. If the capacity increases from 20,000 to

30,000 units the fixed cost will tend to increase due to costs incurred for additional

supervisor's salary, rent for additional space, depreciation for new machines, etc.

4. Controllability:

Fixed costs are not controllable within a short period because only few items are

within the short-run managment control. However, all fixed costs are controllable

over the life span of the enterprise.

57

5. Chargeability:

Fixed costs are overheads and not production costs. They are chargeable against

contribution and not against sales.

Variable Costs:

Variable Costs are those costs which are assumed to fluctuate in direct proportion

to traduction activity/sales activity/some other measure of volume. It means that

they vary directly in total with the chance in the volume of output or sales,

There is a direct relationship between costs and volume. It means that variable

costs vary in total but remain constant per unit. Example the output of a factory is

1,000 units and the v ariable cost is Rs. 10,000; variable cost per unit comes to Rs.

10. But if the production is increased

1 12,000 units, the total cost will be in direct proportion to output Rs. 20,000 but the

unit cost will remain constant at Rs. 10.

Variable costs consist of direct materials, direct wages and direct expenses and are

known as production costs. Characteristics: I. Activity costs:

Variable costs tend to vary directly with output or activity because they are activity

costs.

2 Indifferent to time: .

Variable costs are related to output and not to the passage of time. As for

exarnple, the production in a month is 1,000 units and the variable costs are Rs.

10,000 and in another month e production becomes double i.e. 2000 units the total

variable cost will also become double i.e. Rs.

2 .000 though the period is same i.e. one month. Thus time has no influence on

variable costs. Pattern of variable costs :

The pattern of variable costs remain constant within a relevant range of

operations. ever the pattern may change beyond the range. 4. Controllability:

Variable costs are generally subject to short term management control. Example-.

hange in the mix of raw material, labour force is a short-term management decision

which affects viable costs. \ Sature:

Variable costs are production costs and are charged against sales.

58

4. Explain the division of costs on the basis of functions.

Costs are primarily divided into direct costs and indirect costs. Direct costs consist

of ct materials, direct wages and direct expenses. The sum of these three direct

expenses is knows as Prime Cost.

Indirect costs consist of indirect materials, indirect wages and indirect expenses.

The . ~i of these three indirect expenses is known as overhead. Overhead is

incurred over and above t.~e prime cost.

According to functions, overhead costs are again sub-divided into production or

factory

A orks or manufacturing overhead, administration or office overhead and selling and

distribution erhead or marketing cost. Thus the total cost incidental to production,

administration and selling and tribution may be analysed as follows.-

Prime Cost/Direct Cost/First Cost/ = Direct materials cost + direct labour

Basic Cost/Flat Cost cost + direct expenses.

2. Factory Cost/ Works Cost = Prime cost + Factory overheads.

3. Cost of Production/Office Cost. = Factory cost + Office overheads.

4. Total Cost or Cost of Sales = Cost ofProduction + Selling and distri

bution overheads.

5. Selling Price/Sales = Total Cost+Profit (or total cost-loss) Division of costs may

be shown in a statement form :

1. Direct Material Consumod : XXXX (Opening stock of raw materials+raw

materials purchased

-Closing stock of raw materials) XXXX

2. Direct Labour Cost XXXX

3. Direct Expenses XXXX Prime Cost or Direct Cost or First Cost or Basic Cost

or Flat Cost XXXX

Add.- Factory overheads...................................... XXX

Factory Cost or Works Cost XXX

Add.-Office overheads . . XXX

Cost of Production or Office Cost. XXX

Add.-Selling and distribution Costs = XXX

59

Total Cost or Cost of Sales = XXXX

Add. Profit (or less loss) XXX

Selling PricelSates = XXXX

Q. 5. What is a Cost Sheet? What are its advantages? Cost Sheet or Statement

of Cost.

Cost-sheet or statement of cost is a statement prepared at a given interval of time

showing the various elements of costs of a product or a service or a job in total as

well as per unit of output produced during the period. Costs are shown in an

analytical and in detailed form. It is presented in a columnar form. Sometimes it

may contain'total cost or per unit cost of the previous year or for a future budgeted

period. Following is a specimen form of a cost sheet or a statement of cost:

Specimen of Cost sheet or statement of Costs. Units.............

Particulars Total Cost Cost Per unit

Direct Materials ............. .............

Direct wages labour ............. .............

Direct Expenses ............. .............

PRIME COST ..........................

Add: Factory/Works overheads ............. .............

WORKS COST ..........................

Add: Administrative/Office overheads ............. .............

COSTOFPRODUCITON ..........,...............

Add: Selling and distribution overheads............. .............

TOTAL COST OR COST OF SALES Uses/advantages of Cost Sheet.\

1. Cost Revelation (disclosure):

It discloses the total cost and the cost per unit of output produced during a given

period.

2. Break-up of Costs:

It discloses the break-up or components of the total cost.

3. Cost Contribution of each element:

It discloses the extent to which each expenditure contributes to the total cost of a

product.'

60

4. Price Fixation -

It helps the management in fixing the selling price more accurately.

5. Price Regulation:

Selling prices can be regulated more easily and accurately on the basis of cost data.

6. Cost Estimate/Quotation:

Estimates can be made more accurately and easily on the basis of cost data.

7. Cost Comparison:

It facilitates the comparison of current cost with the cost of the previous period or

with the predetermined standard costs and variances can be ascertained.

8. Fixation of Production Policy

It helps the management in framing production policy and taking action for cost

reduction and cost control.

61

Unit-II

A. MATERIAL COST AND CONTROL

A. MATERIAL COST AND CONTROL

Part I: Theoretical questions

Q. 1. What is meant by Inventory/Material Control? Explain different methods

of inventory/ a terial control [GU.1999]

Weaning:

term inventory is defined by the Institute of Charterd Accountants of India as

"Tangible property

(i) for sale by ordinary course of business or

(ii) at a process of production for such sale; or

(iii) for consumption in the production of goods or servicesfor sale, including,

maintenance rplies and consumables other than machinery spares"

Thus the term inventory or stock comprises raw materials, work-in progress,

finished products, -ponents going into production, consumable stores and tools and

implements. entory Control:

Inventory control may be defined as "Systematic control and regulation of

purchase, rage and usage of materials in such a way so as to maintain an even

flow ofproduction and -1 ihe same time avoiding excessive investment in

inventories. Efficient material control cuts losses and wastes of materials that

otherwise pass unnoticed."

Again Official Terminology defines inventory control as "The systematic

regulation of stock Inels"

It is a system which aims at controlling investment in inventories. So it involves:

(i) Inventory planning: and

(ii) Decision making with regard to

(a) quantity and time of purchase;

(b) fixation of stock level;

(c) maintenance of stores records; and

62

(d) continuous stock-taking. ' thods of Inventory Control:

The following are the common techniques/methods of inventory control:

(i) The ABC plan and VED analysis;

(ii) Fixation of various levels or level setting;

(iii) Economic order quantity;

I Perpetual inventory system and continuous verification;

(v) Inventory turnover ratio and their review and

(vi) Inventory cost reports,

(i). ABC Analysis :

In this technique, materials are classified according to their value and costly and

more valuable materials are given greater attention and stricter control while less

costly materials are given minimum attention. Under this system materials are

classified into three groups viz. Group-A, Group-B and Group-C.

Group A: These are high-value items but consist of only a small percentage of the

total items handled. Because of high cost, there should be tightest control upon such

materials and they should be under the responsibil ity of the most experienced

person.

Group B: These are medium-value items and consist of a medium percentage of

total items handled. Such materials should be under normal control procedures.

Group C: They are low-value materials and constitute a very large percentage of

the total items of materials handled. Such materials should be under the simple and

economic method of control,

(ii). Fixation of Various Levels or Level Setting:

In order to have proper control on materials, certain stock levels are fixed up for

every item of stores so that stocks and purchases can be effectively controlled.

These are:

(a) Maximum Level- It represents the maximum quantity of an item of material

above which stock cannot be held at any time. It helps in avoiding over-stocking.

(b) Minimum Level- It represents the minimum quantity of an item of material that

can be held at any time. It helps in avoiding Stock-out.

63

(c) Danger Level- It is a level at which normal issues of the materials are stopped

and issues of materials are made only under specific instructions. It helps for special

arrangement of materials.

(d) Ordering Level/Re-order Level- It is the point at which indents are placed for

replenishing stocks.

(iii) Economic Order Quantity:

It is the quantity of materials that is to be ordered in one time. The quantity is fixed

in such a manner as to minimise the cost of carrying and ordering the stock. The

object is to have the lowest total cost which consists of carrying cost and stock out

cost.

(iv) Perpetual Inventory System and Continuous Verification:

ICWA, U.K. has defined it as "a system of records maintained by the controlling

department which reflects the physical movement ofstocks and their current

balance. A perpetual inventory is usually checked by a programme of continuous

stock taking. The former means the system of records wheres the latter means the

physical checking of those records."

Bin Cards and Stores Ledger help the management in maintaining this system. They

make a record of the physical movements of the stocks on the receipts and issues of

the materials and also show the balance of stores after every receipt and issue of

materials.

Continuous verification verifies the balance of stocks as shown by the Bill Cards

and Stores Ledger with the actual balance of stocks as ascertained through physical

verification.

(v) Inventory Turnover - Ratio and its Review:

Inventory Turnover Ratio is atechnique of exercising material control. It is

calculated as follows: Cost of Material consumed during the period Cost of Average

Inventory held during the Period

Average stock is the average of opening and closing stock. Inventory or Stock

Turnover Ratio can be calculated in days also:

Days during the period Inventory Turnover Ratio Turn over Ratios show the

turnover of different kinds of materials. Comparison of these ratios shows the

64

movement of different items of materials. A low ratio indicates slow moving stock.

On the ilier hand, a high ratio indicates the fast moving stock. In case of low ratio,

stock gets accumulated esulting in locking up of capital. On the contrary, a fast ratio

indicates fast moving of stock resulting least locking up of capital. In the former

case, capital investment is high while in the later case, . apital investment is low. If

the Turnover Ratio is zero, it indicates that the item has not been used at i during

the period and should be immediately disposed of otherwise, there will a loss. Thus

the malysis of turnover ratios of different items will help the management to avoid

unnecessary blockage :f capital.

iv) Inventory Cost Reports:

It is a report containing information relating to quantity of materials purchasecfand

used and I cks in hand. It is sent to different levels of management who can use the

report for the purpose of r -terial control.

Material control is divided into three aspects viz:- Purchases Control, Stores

Control and nsumption Control.

The Purchase Control is to ensure the efficiency of the purchasing department; The

Stores ntrol, to ensure the efficiency of the stores department and the Consumption

Control is to ensure the efficiency of the departmental foreman.

2 Write short note on ABC Plan and VED Analysis:

ABC Plan and VED Analysis:

The system involves analysis which is known as ABC Analysis i.e. Always Better

Control nalysis. It is originated in the General Electric Company in America. It is

based on the segregation naterials for the purpose of selective control. It is used

when a concern has a large number of ns and each item is of different value,

Materials are divided into three categories: A, B and C. . gories A contains

materials which constitute a smaller percentage of the total items of materials e

stores but constitute a large percentage of the total value of materials consumed. On

the rtherhand Category 'C contains materials which constitute a very large

percentage of the total - _:erials in the stores but constitute a small percentage of the

total value of materials consumed.

65

sen these two extremes will fall the materials whose percentage of number in

relation to total lumber of stores and the percentage of value in relation to the total

value of materials consumed and .. ■ materials are included in category 'B'. This

can be illustrated by the following:

Category Number of items (percent) Inventory Value (Percent)

A 20 70

B 30 20

C 50 10

Total 100 100

The items included in category 'A' involve the largest investment and therefore,

inventory control on such items should be most regorous and intensive. Most

sophisticated inventory control techniques are useually applied to these items.

'C category items of inventory which involve relatively small amount of investment

although the number of items is fairly large. Therefore, these items of stores warrant

the minimum attention.

'B' category items stand mid-way. It deserves less attention than 'A' but more than

that in C. Therefore, it can be controlled by less sophisticated techniques.

Thus ABC analysis is a technique of material control in descending order based on

money value of consumption i.e. stringent control on 'A' category, less stringent

control on 'B' category and very little control on 'C category items of stores. VED:

VED means Vital, Essential and Desirable. This analysis is used primarily for the

control of spare parts. Spare parts are divided into three groups- Vital, Essential

and Desircible.

The spares whose absence even for a short period will stop production for quite

sometime and the cost of such stoppage of production is very high are known as

Vital spares. This type of spare parts will invite maximum attention.

The spares the absence of which cannot be tolerated for more tnan a few hours or a

day and the cost of loss of production is very high and which are.essential for the

continuance of Production are known as essential spares. They invite less rigorous

attention than that in vital spates.

66

Desirable spares are those spares which are needed but whose absence for a short

period will not stop production. They invite less attention.

Q.3. Discuss the advantages of ABC analysis. Or Explain the role of ABC

analysis in material management. [GU.1991 & 2004]

Following are the advantages/role of ABC analysis:

(i) Scientific method of Material control:

It is helpful in developing a scientific method of controlling inventories based on

the quantum of capital investment in different types of inventories.

(ii) Stricter Control on costlier items:

A closer and stricter control is exercised on those items which represent a

significant portion ofthe uses value of materials. Thus costly materials attract

stricter and sophisticated control. 'A group materials comprise such materials and

managerial staff and not ordinary staff exercises control on such materials. Where

as 'B' group and 'C group materials are subject to normal control exercised by

ordinary staff.

(iii) Minimum possible in vestment in in ventory:

Investment in inventory is reduced to the minimum possible level because only a

reasonable quantity of costly materials is purchased.

(iv) Minimum storage and carrying cost of stores:

Storage cost and carrying cost are minimised because a reasonable quantity of

materials is maintained in the store.

(v) Saving in managerial time:

Expensive managerial time is saved as it is confined to expensive items of materials

only.

(vi) Maintenance of high stock-turn-over rate:

Scientific and selective control enables the management to maintain a high stock

turn-over rate.

(vii) Maintenance of enough stock of 'C group items:

It enables the management to maintain enough safety stock for 'C group items of

materials.

67

Q.4. What are the objectives/importance/functions of material control?

[G.U.1991,1993, 2002]

Following are the objectives of material control: ii To ensure the availability of

adequate materials:

Material control ensures the availability of minimum quantity of each item of

materials in store for smooth functioning of production. Thus it helps the

management in avoiding over-stocking of materials.

U) Optimum use of resources:

Material control reduces capital investment in inventory to the minimum by

avoiding overstocking.

Thus resources saved can be otherwise fruitfully used.

ii) Reasonable price of acquisition :

Material control helps in purchasing of a right quantity of material at a right time at

the right price from right sources. Thus materials are acquired at opportune time at

reasonable prices.

tv) Minimum wastage:

It minimises wastage and prevents theft and pilferage of materials by using various

techniques

in purchasing, storing and issuing materials.

Avoidance of spoilage and obsolescence:

By using the techniques of stock levels and stock turnover, the risk of spoilage and

obsolescence can be avoided.

i) Production planning:

Bin cards and stores ledgers provide information about each type of material in

stores at any point of time. Thus it helps the management in production planning.

ii) Reduction in carrying cost:

It reduces the carrying cost of stock because it maintains only the required amount

of stocks of each item of store. ii) Reduction in buying cost:

It reduces buying cost of materials by using the technique of economic order

quantity,

68

Discuss about the measures that are to be undertaken for effective material

control

[G.U.1993,2005]

Discuss the essentials of material control mr, Discuss the principles of material

control

Following are the measures to be undertaken by an organisation for enforcing an

effective material control:

Departmental Co-ordination and co-operation.,

There should be proper co-ordination and co-operation among the departments

which are involved in respect of the receipt, inspection, storage, issue, use and

accounting of materials.

Planning of Materials:

There should be proper planning and scheduling of material requirements. Si)

Classification and Codification of Materials:

There should be proper classification and codification of materials.

(iv) Inspection of Materials:

There should be proper inspection of materials when they are received.

(v) Proper Storage of Materials:

There should be proper storage of materials in order to avoid loss of materials due

to damage deterioration, evaporation, pilferage, theft, etc.

(vi) Use of Standard Forms:

Standard forms should be used for requistion, orders, issue, and transfers of

materials.

(vii) Proper system of Issue of Materials:

There should be a good method which should be followed for issue of materials to

different jobs, work orders, etc.

(viii) Perpetual In ventory system:

Perpetual Inventory system should be operated for proper control of materials and

ready information of stock position of different items.

(ix) Internal check:

69

A system of internal check system should be introduced in respect of receipt,

storage, issue and accounting of materials.

(x) Level setting:

Different levels of stock such as maximum, minimum, reorder, etc. of each item of

material should be set.

(xi) Ordering Quantity:

Ordering quantity of each type of material should be fixed in order to minimise the

material cost.

(xii) Fixation of Proper Issue Price:

Issue price of the materials should be carefully choosen as it affects the cost of a

job, process, etc.

(xiii) Record of Use of Materials:

There should be a proper record of use of materials during production in order to

minimise wastage of materials.

(xiv) Reporting System:

There should be proper reporting of purchases, return, issue and use of materials to

all relevevant levels of management to ensure proper planning of production and

control.

Q.6. What is meant by Perpetual Inventory? What are the advantages of

keeping perpetual inventory system ? [G. U.2004]

Perpetual Inventory system is a system of recording stock showing its change on

every receipt and issue of materials, on the balance of stock.

ICWA, U.K. has defined it as "A system of records maintained by the controlling

department which reflects the physical movement of stocks and their balance. A

perpetual inventory is usually checked by a programme of continuous stock

taking. However, both are not synonymous. Perpetual inventory means the system

of records whereas continuous stock taking means the physical checking of those

records with actual stocks."

Perpetual Inventory system is comprised of

(i) Bin Card,

(ii) Stores Ledger and

70

(iii) Continuous Stock Taking.

A Bin Card is a quantitive record of receipts, issues and closing balances of the

items of stores, each item is accompanied by a separate Bin Card and each

transaction of receipt and issue of .uerials is a posted to the Bin Card.

A Stores Ledger records not only the physical movements of stocks but also their

values. Continuous stock taking is the regular physical verification of stocks. It

ensures the I. curacy of the perpetual inventory records i.e. Bin Cards and Stores

Ledger. It is done through a jramme so that all the items of stocks are verified in a

year. Discrepancies found in physical - - tlcation of stock are adjusted in stock

records by preparing a debit note or a credit note. Debit note .sed in case of surplus

of stocks and a credit not is used in case of deficiency of stocks, h antages:

Following are the advantages of perpetual inventory system: Avoidance of Physical

Stock Taking:

It obviates the need for physical stock taking of all items of stocks at the end of the

year and as t suit, dislocation of production in stock taking is avoided. Quick

preparation ofProfit and Loss Account: The inventory of various items of stocks

can be easily ascertained from the bin cards and s: res ledger and a Profit and Loss

Account can be prepared quickly. Reliable check on stores:

A detailed and more reliable check on the stores can be exercised. Reliability of

stock figures:

Stock figures become reliable because of continuous stock taking. Moral Check on

Staff.

This method exercises a moral check on the staff and makes them disciplined and

careful about re:r duties.

Planning of production: It provides constant information about the stores position

and production can be planned accordingly and thus the stoppage of production can

be avoided. Perpetual Internal check on stores: Bin Cards and the Stores Ledger

act as a cross check on each other. As a result, a system of . rnal check is always in

operation.

ii) Control over Investment in Stock:

71

Investment on stock can be reduced to the minimum by considering the actual

operational .. jirements of stores i.e. by comparing the actual stock with the

minimum and maximum levels of saxks.

". What are the disadvantages of Perpetual Inventory System: Expensive:

The system is costly because it requires continuous checking of the records of

inventories by a .. .alised group of persons.

2.Difference between book value and actual value may exist:

Though the system shows the book balance of every item of stores, yet it does not

guarantee that the actual or physical balance of an item of stock will tally with the

book balance because a the items are not daily verified.

Q.8. Discuss the role or function of Perpetual Inventory System/Continuous

Stock-taking. Meaning:

Perpetual Inventory System means a System which indicates at all times the balance

of each item of store in hand. It is done by determining the balance of stock after

every receipt and issue of store. It is further supported by continuous physical

verification of stock with book balance of each item. Role or Function:

The role of perpetual inventory involves the following three functions: (i)

Maintenance of Bin Card; (ii) Maintenance of Stores Ledger:

(iii) Reconciliation of Bin Card and Stores Ledger; and (iv) Continuous Stock-

taking. Bin Card:

A Bin Card is made for each item of material and every receipt and issue of

material recorded therein and the balance is determined after each receipt and issue

of material. Thus it provides information regarding the balance of each item of

materials in store at all times.

Stores Ledger:

A Store Ledger is maintained for each item of materials in store by the cost

accounting department. Every receipt and every issue of each item of materials is

recorded both in quantity and in value and the balance of materials in hand in

quantity and in value is determined after each receipt, and issue of the material.

Thus it provides information regarding each item of materials in store, an\ time both

72

in quantity and in value. It also provides a check on the accuracy of Bin Cards.

Reconciliation of Bin Card and Stores Ledger Balances:

The balances of stores in hand, revealed by both] the Bin Card and the Stoics

Ledger should agree as both record the same transactions. However by comparison

between the two balances if any discrepancy is found, the causes of such

discrepancy should be ascertained and the differences should be adjusted. In this

way, the correct balances of stores in hand are established.

Continuous Stock- Taking:

Under continuous stock-taking, physical stock-taking of various items of stores are

conducted, throughout the year by specialised staff or internal audit staff. Physical

stock-taking is done in rotation and three to five items are verified everyday. Stock

verification is done by way of actual counting, weighing, or measuring. The actual

stock as the case may be and the result of verification recorded in Bin Cards.

Physical balances of stocks are compared with the book balances of stocks shown

by the Bin Cards and the stores ledger. Discrepancies, if any, between the two

balances, explanation for such discrepancies and necessary adjustments are

recorded in stores records (i.e. inbin cards and stores ledgers) in order to ascertain

the correct balances of stores.

The object of perpetual inventory is to enforce strict control on stores in order to

prevent theft pilferage and to minimise wastage. Moreover, it helps the management

to avoid unnecessary blockade of capital investment in stores. Again, it facilitates

smooth functioning of production as per schedule

Q. 9. State the distinctions between Perpetual Inventory System and

Continuous Stock-Taking.

Following are the differences between Perpetual Inventory System and Continuous

Stocktaking

Genus and Species:

Perpetual inventory System signifies a complete process of inventory control while

continuous i ck-taking is a part of the perpetual inventory system.

2 System of records and physical checking:

73

Perpetual inventoty means the system of recording stores in quantity and value

while continuous .k-taking means physical verification of those records with actual

stocks.

Dependence:

The effectiveness of perpetual inventory system depends largely upon the

continuous stocktaking le continuous stock-taking can be carried out independent of

perpetual inventory system.

10. Discuss and examine the meaning and significance of EOQ (Economic

Order Quantity)

[GU.1993J

Economic Ordering Quantity or Re-ordering Quantity may be defined as the most

favourable the optimum quantity which can ideally be purchased each time most

economically. It is the size of quantity of a material that will result in the minimum

total annual cost of the item of material. It tributes towards maintaining the material

at the optimum level at a minimum cost.

The total cost of a material consists of:

(i) Total acquisition cost,

(ii) Total ordering cost, and

(iii) Total carrying cost.

Acquisition cost is the buying cost of materials. It Usually remains unaffected

irrespective of - uantity of materials ordered at one tjme unless quantity discounts

are available.

Ordering cost consists of: (a) Clerical cost of preparing an order (b) Postal charges

and s t phone bill for placing an order (c) Cost of stationery and other consumables

required by purchasing •kpartment and (d) processing and receiving cost.

The above costs increase in direct proportion to the number of orders placed i.e.

they vary with re number of orders.ing cost consist of:

(i) Loss in the form of interest on investment on inventory (interest cost)

(ii) Cost of storage space;

(iii) Loss arising out of breakage, obsolescence, deterioration, Pilferage, etc;

74

(iv) Cost of insurance; and

(v) Cost of operating the stores-salaries etc.

Greater the quantity of stock, larger is the carrying cost. Thus ordering cost and

carrying cost -"- f opposing nature. If efforts are made to reduce one, the other one

will go up. So a balance is between these two types of costs and the Economic

Order Quantity is fixed at a point where -jregate cost is minimum. Thus economic

order quantity minimises the total cost associated with the inventory management.

The following is the mathematical formula for the determination of EOQ:

Where Q stands for the quantity to be ordered;

'C stands for annual consumption of materials; stands for the cost of placing an

order and stands for carrying Cost I.e. interest cost, storing cost, etc.

Significance:

(i) It gives the maximum economy in purchasing raw materials and reduces the total

cost of material

(ii) It helps the management in avoiding the risk of over-stocking and under-

stocking of material.

(iii) Loss through deterioration of quality, breakage, pilferage arising from

overstocking and loss from the stoppage of work due to shortage of material can be

avoided.

(iv) Capital blockage through over-stocking of materials can be avoided and thus

loss of interest on capital can be avoided.

Q.ll. Explain what is meant by Maximum Level, the Minimum Level and Re-

ordering Level in the maintenance of stock in an organisation. What are the

factors that govern the fixing of these levels? [G.U.-1992]

Or, Explain what is meant by Maximum Level, Minimum Level and Reorder

Level in the maintenance of stock in an organisation. [G.U.-1992 & 2005]

Maximum Level:

Maximum Level represents the maximum quantity of an item of material which can

be held at any time. Stock is not allowed to exceed this level. Its object is to avoid:

(a) Over-stocking of material and consequent loss of material due to wastage,

deterioration in quality and obsolescence.

75

(b) Blockade of capital unnecessarily; and

(c) Unnecessary storage cost.

Following factors are considered in determining maximum stock level: ' (a) Rate

of consumption of materials;

(b) Lead period (i.e. time required to obtain new supplies);

(c) Availability of finance,

(d) Storage cost;

(e) Possibility of loss due to evaporation, deterioration in quality;

(f) Extent of price fluctuation;

(g) Amount of risk arising from change in specification and obsolescence

(h) Seasonal considerations (i.e. seasonal nature of supply of materials'.

(i) Economic order quantity, and

(j) Rules framed by Government for importing raw materials (i.e. government

restrictions).

Formula for calculating Maximum Stock Level:

Maximum Stock level= Re-ordering level + Re-ordering Quantity-(Minimum

Consumption x Minimum Reordering Period)

Minimum Stock:

It is the level below which stocks are not allowed to fall. So it is a quantity of

material which the organisation must maintain all times. The quantity is fixed in

such a way that production may not be held up due to shortage of material. So this

level of stock is known as buffer stock or safety stock. As soon as the stock reaches

this stage, it indicates the possibility of stoppage of production unless a quick

arrangement is made for further purchase of materials.

The following factors are to be considered in fixing up this level of stock:

(i) Rate ofconsumption of the material during the lead time;

(ii) Lead time i.e. the time lag between the indenting and receiving of the material.

It is the time A hich is required to replenish the supply;

(iii) Nature of material: A minimum level is not required where a special material is

required in order to execute a specific order of a customer.

76

Formula:

Minimum Stock Level = Re-order level - (Normal Consumption x Normal Re-order

Period)

Re-order Level/Ordering Level:

Re-order level is the point at which the purchase requisition for fresh supplies is

initiated by the -tores department. This level is fixed somewhere between the

maximum and minimum levels. The difference of the quantity of the material

between the Reordering Level and the Minimum Level will be such as will be

sufficient to meet the production requirements till the fresh supply of materials is -

eceived. Thus it helps the management to avoid the risk of overstocking and under-

stocking. However, . it covers emergencies such as delay in supply or abnormal

uses of the material.

The following factors are considered in order to fix the Reorder level:

(i) Minimum Stock Level

(ii) Average Consumption and

(iii) Average Lead Period or

(i) Maximum Consumption and

(ii) Maximum Lead Period. Formula:

Reorder Level = Minimum Stock Level + (Average Consumption x Average Lead

Period.)

Or = Maximum Consumption x Maximum Re-order Period/Lead period (Wheldon)

Average Stock Level:

Average stock level is the level which represents a level of stock falling between

the maximum and the minimum levels of stock. It is calculated by applying the

following formula: Average Stock Level = Minimum stock Level + 1/2 of Re-

order quantity

.Or = 1/2 of (Minimum stock Level + Maximum Stock Level)

Danger Stock Level:

Danger Level is the level at which normal issue of materials is stopped except the

issue of materials under a specific instruction and an emergency purchase has to be

arranged so that production nay not be stopped altogether. This level is particularly

77

fixed to control materials during the period of emergency so that the urgent and

priority orders are not held up.

Formula:

Danger Level=Average Consumption x Maximum Re-order Period for emergency

purchases.

Q. 12. Define Re-order Level and explain its relation to Maximum and

Mininum Stock Levels. What factors are to be considered in fixing reordering

levels and quantities?

[GU.1990, 1992 & 1997]

Reorder Level:

Re-order level is the point at which purchase requisition for fresh supplies is

initiated by the stores department. This level falls in between the maximum and the

minimum levels. The difference of the quantity of the material between the

reordering level and the minimum level will be such as will be sufficient to meet the

production requirements till the fresh supply of materials is received.

According to wheldon, it is that level of inventory which should be equal to the

maximum consumption during the lead time. Formula for determining Re-order

Level is:

Reorder Level = Minimum Stock Level + (Average Consumption per unit of time

(perda-y) * Average Lead Period) Or, = Maximum Consumption per unit of time

(per day) x Maximum Lead Period (according to Wheldon) Relationship of Re-

order Level to Minimum and Maximum Stock Levels:

Minimum stock Level, Reorder Stock Level and Maximum Stock Level are inter-

related.

(i) Minimum Stock Level:

It represents the minimum quantity of materials which must be maintained in hand

at all time. It is a safety stock. It is determined by applying the following formula:

Minimum Stock Level = Re-order Level - (Normal Consumption per unit of time

(per day) x Normal Lead Period)

78

(ii) Maximum Stock Level:

It represents the maximum quantity of an item of material which can be heldin

stock at any time and the stock should not be allowed to exceed that quantity. It is

determined by the following formula:

Maximum Stock Level= Reorder Level+ Reorder quantity- (Minimum '

consumption per unit of time (perday) x Minimum lead period)

From the above definitions, it is obvious that both the Minimum and Maximum

Stock Levels depend on Re-order Level and consumption during the lead period.

Minimum Stock Level is the difference between the quantity of material at Re-order

Level minus consumption of materials during the lead period. Consumption during

lead period changes due to change in the actual rate of consumption per unit of time

or change in actual lead period. Thus change in actual consumption changes the

Minimum stock level. Higher is the consumption, lower is the Minimum stock level

or vice-versa.

Maximum Stock Level depends on the Reorder stock Level Re-order quantity and

the Minimum Consumption during minimum Lead Period. If actual consumption is

more than the assumed minimum, then the Maximum Stock Level will be less than

the assumed one.

Thus both Minimum Stock and Maximum Stock Levels are dependent on Re-order

level. Factors for Fixing Re-order Level and Reorder Quantity:

Following factors are to be considered in fixing the Re-order Level:

(i) Maximum rate of consumption per unit of time (per day) and (ii) Delivery time

or lead period required for receiving the goods ordered. Or,

(i) Minimum Stock level;

(ii) Average/Normal rate of consumption per unit of time (per day), (in) Average

lead period required for receiving goods ordered.

(iv) Allowances for excess consumption or unexpected delay in receving the goods

ordered.

79

Factors to be considered for Re-order Quantity/Ordering Quantity or Economic

Order Quantity.

Economic Order Quantity is the quantity of material to be ordered in one time. It is

that level of inventory order which minimises the total cost associated with the

inventory management. It means that the total cost comprising the acquisition cost,

ordering cost and'carrying cost is the minimum at that quantity of material which is

to be ordered. As acquisition cost per unit remains same irrespective r'quantity of

materials purchased the ordering cost and the carrying cost are to be considered

primarily and the reordering quantity is so fixed as will minimise these two costs

i.e. the ordering cost and carrying cost.

The following factors are to be considered:

(i) Annual consumption,

(ii) Ordering cost; and

(iii) Carrying cost.

Q. 13. Describe fully the procedure adopted by Purchase and Stores

Departments for efficient purchasing of materials up to the stage of receipt

into Store. [G. U. 1990]

Purchase Procedure:

Diagram showing Various Stages of Purchase Procedure.

Production or stores Department.

Purchase Requisition

Purchase Officer.

Enquiry Tenders Quotation Purchase Order.

Stores

Goods

Received Notes

Supplier

Accounts Department

Invoice & Payment

Following is the procedure followed by the Purchase Department for purchase of

materials, .(i) Purchase Requisition or Indenting for Materials;

80

(ii) Exploring the sources of supply and choosing the supplier;

(iii) Placing the purchase order;

(iv) Receiving and Inspecting of materials and

(v) Checking and passing of bills for payment.

Purchase Requisition or Indenting for Materials:

The store-keeper prepares a Purchase Requisition for the purchase of materials

when the stock level comes to an ordering level. It is a formal request to the

purchase department for purchasing materials. It is prepared by the store-keeper for

regular stock items. However, for any special material, it is prepared by the

departmental head or the works manager. It is prepared in triplicate; the original

copy is sent to the purchase department, the duplicate is left with the stores

department and the third copy is sent to the authorising departmental head.

Exploring the sources of supply and choosing the supplier.-

On the receipt of the purchase requisition, the Purchases Department selects a

source of supply of materials. Usually the department maintains a list of suppliers

with it. The department issues tenders to them and invites quotations from them for

the supply of the materials. A supplier is selected on the basis of the following

factors:

(i) Manufacturing and financial capacity.

(ii) Reliability,

(iii) Price quoted,

(iv) Terms of payment and delivery, etc.

When other factors are same, the purchase price should be the lowest and the party

should be reliable.

Materials may also be purchased by open tender method. Placing the Purchase

Order.

After choosing the suppl ier, the Purchase Department prepares a purchase order for

the supply of materials. It is prepared in three to five copies and is sent to the

following parties:

(i) The original copy to the supplier,

(ii) One copy to the Receiving Department:

81

(iii) One copy to the person who initiated the purchase requisition; (i v) One copy to

the Accounting Department; and

(v) The last copy is to be retained by the Purchase Department for future reference.

The Purchase Department has to take the follow up measures till the materials are

received.

Receiving and Inspecting of Materials:

The work of receiving and inspecting of materials is done by a separate Receipts

and Inspection Department in case of big organisations while in case of a small

organisation, it is done by the store keeper.

Receiving and Inspecting of materials includes the following functions:

(i) Maintenance of purchase order files;

(ii) Receiving, unloading and unpacking of materials and signing of challan. One

copy of the challan is sent to the supplier as a proof of the receipt of materials;

(iii) Checking the quality, quantity and physical condition of the materials received

i.e. comparing the purchase order with the delivery challan.

(iv) If goods are rejected, the reason thereof be stated;

(v) After inspection, materials received should be recorded in Stores/Goods

ReceivedNote which will be prepared in five copies. These notes are to be sent to

the following departments:

(a) Purchase Department,

(b) Accounts Department,

(e) The department which initiated the requisition;

(d) The store-keeper, and

(e) The fifth copy to be retained by the Inspection Department.

On this note, purchases are verified and payment is made to the supplier.

Checking and passing of Bills for Payment:

When the supplier's invoice is received, it is sent to the Stores Accounting Section.

This section checks the authenticity and the arithmetical accuracy of the invoice by

comparing the invoice with the Goods Received Note and the Purchase order.

Thereafter, the Account Section certifies and passes the Invoice for payment and on

this basis the cashier makes payment according to the agreed terms.

82

Q. 14. Discus the procedure to be followed in a manufacturing Organisation

while receiving the material and issuing the same to the factory. [G.U. 2002

(Marks-12)]

Or, What do you mean by 'Bin Card' and Stores Ledger? How are stores

recorded there in?

Or, Give a Specimen of (i) Bin card and (ii) Stores Ledger, [G. U.2002 (Marks-

12)]

Receipts and issues of materials required for a manufacturing Organisation are

recorded in two documents viz, 'Bin Card' and 'Stores Ledger'. Bin Card. Meaning:

Various item of materials received by the store-keeper are kept in their respective

bins i.e. racks, self, etc. Each item of material is kept in a separate bin and each bin

has a separate, card attached to it known as 'Bin Card'. A separate record for each

type of materials is maintained in the attached Bin Card, written up by the store-

keeper. Contents:

The Bin Card contains a record of receipts, issues and balance of material in terms

of quantity. It also provides information about 'goods ordered' and 'goods

reserved'for a particular job or rder. In addition, the card gives the description of

the material, its code number, bin number and stock levels (minimum level,

maximum level, reordering level and re-ordering quantity).

ABC Company Limited BIN CARD

Bin Card No...................... Bin No........................

Name of the Article:............ Maximum Level:

CodeNo:........................ Minimum Level:

Stores ledger Folio............ Re-ording Level :

Re-ordering Quantity

Date Receipts Issues Balance Checking Goods on order

Goods

Received

Note No.

Quantit

y

Stores

Requisitio

n Note

No.

Quantit

y

Quantity Date of

cheking

Remark

s

No.

and

date of

order

Quantity Date of

Goods

Receive

d

ABC Company Limited STORES LEDGER

Name of the Article:........... Maximum Level:

83

CodeNo:.......... Minimum Level:

Bin Card No.......... Re-ording Level :

Receipts Issues Balance

Dat

e

GRN

o.

Quanti

ty

Rat

e

Amo

unt

R.S.N

o.

Quanti

ty

Rat

e

Amou

nt

Quanti

ty

Rat

e

Amou

nt

Remar

ks

Writing up of Bin Card :

A bin card has three columns viz, Receipts, issues and Balance(as showing in the

above specimen) and entries for the receipts and issues should be made in their

respective columns on the basis of supporting documents before any materials

physically put in the bin or removed from the bin \.e."Touch the Bin before you

touch the item."

In the Bin Card, receipts are entered in the Receipts column on the basis of the

'Goods Receipts Note' and issues are entered in the Issue column on the basis of

Stores Requisition Note'. Receipts are debited, and issues are credited in the Bin

Card in terms of quantity. The balance is ascertained after each transaction and is

entered in the balance column.

Double Bin System:

Some concerns divide the bin in two parts-smaller part of the bin stores the quantity

equal to the minimum quantity which is to be held always and the other part stores

remaining quantity. Quantity in the smaller part is only used in case of emergency.

Normally stores are issued from the larger part and the physical verification is made

only for the larger part.

Purpose :

Bin Card shows the physical movement of, stores and shows the balance of stores in

hand of each item at any point of time.

Stores Ledgers

Stores Ledger is maintained by the costing department and is written up on the basis

of documentary evidences such as Goods Received Notes and Stores Requisition

Notes. It is identical with die Bin Card except that receipts and issues are shown at

84

money values. Every receipt or issue of materials is entered in the Receipt Column

or Issu.e Column in terms of.quantity and their money values and after every

transaction balances are ascertained in terms of quantity and money values which

are entered in the Balance Column.

In addition to Receipts, Issue and Balance Columns, a Stores Ledger contains the

description of the materials its Bin No. and Code No. and the Stock Levels.

Purpose/object :

It contains a continuous record of Stores Receipts. Issues and Balance in hand in

terms of quantity and their money values.

It exercises a check on the work of store keeper.

It facilitates the pricing of materials issued to production.

Q. 15. (a) what are the advantages of 'Bin Card and 'Stores Ledger'? (b)

Compare 'Bin Card' with Stores Ledger.'

Advantages of Bin Card:

Following are the advantages of Bin Card: /. Movement of Materials:

It indicates the flow of a material i.e. the receipts and issues of materials.

2. Material in hand at any points of time:

It indicates at a glance the quantity of a material in stock at any point of time.

3. Arrangement for fresh supply can be made :

It contains the ordering level and helps the store-keeper to initiate purchase

requisition for fresh supply of meterial when the stock in hand of that material

reaches the ordering level.

4. Useful for physical verification :

It is useful for physical verification of stock.

5. Remedial measures for discrepancy:

When any discrepancy arises between the balance shown by the Bin Card and the

balance shown by physical verification and the causes for such discrepancy are

known, the management can take remedial measures for controlling such

discrepancy.

85

6. Facilitates continuous stock-taking :

It facilitates continuous stock-taking and helps in maintaining perpetual inventory.

7. Facilitates the preparation of interim final accounts:

It facilitates the preparation of Interim Profit and Loss Account at any time without

actual stocktaking.

8. Acts as check on the entries in the Stores ledger.

It acts as a check on the accurancy of the entries in the stores ledger. Advantages of

stores ledger.

Following are the advantages of a Stores Ledger. /. Flow of Materials both in

quantity and in money value:

It shows the flow of a material in terms of quantity and in terms of money values.

2. Balance of materials both in quantity and money value:

It shows at a glance, at any point of time the balance of a material in terms of

quantity and money value.

3. Assessment of production Cost.

It provides the cost of materials used in the production of a product or a job. -

Check on the entries of the Bin Card.

It exercises a check on the entries made in the Bin Card. shows the value of Closing

Stock.

It shows the value of closing stock and the amount of capital invested therein.

I erification of Actual stock with Stock levels:

It enables the cost accountant to verify whether the stocks are kept with in the

prescribed level nd whether the purchase requisitions are made in time.

7. Facilitates Continuous Stock-Taking :

It facilitates continuous stock-taking and helps in perpetual inventory.

I Facilitates the Preparation Interim Final Accounts:

It facilitates the preparation of Interim Profit and Loss Account at any point of time

without actual stock-taking.

86

Differences between Bin Card and Stores Ledger.

Following are the differences between Bin Card and Stores ledger:

Basis Bin Card Stores Ledger

1. Contents It is a quantitative record of a

material.

It is a record of both quantity and

value of a material.

2. Sequence It is the first record of stores. It is the second record of stores.

3. Place of

Recording

It is kept in the storeroom. It is kept in the cost accounts

department.

4. Recording

person.

It is written up by the store-keeper. It is recorded by the stores

accountant.

5. Type of

Recording

It is a memorandum record and not

an accounting record.

It is an accounting record kept on

double entry principle.

6. Time of

Recording

An entry in the Bin Card is

normally made just before a

transaction takes . place.

An entry in the Stores Ledger is

always made only after the

transaction has taken place.

7. Posting In a Bin Card, each transaction is

individually posted.

In the Stores Ledger,

transactions can be sumarised

and periodically posted in total.

8. Transfers Inter-Job and Inter-departmental

transfers of materiels are not

recorded here.

Inter-Job and Inter-departmental

transfers of materiels are

recorded here

9. Role It is the basis of placing purchase

requisitions and purchase orders.

It is the basis for preparation of

Profit and Loss Account as it

provides inventory value.

87

Q.16. Illustrate normal wastage and abnormal wastage in cost account. Also

explain how does it affect the cost of production and the necessity to minimise

the same.

[GU.2001 (10 Marks)]

Or, How are wastages treated in cost accounts? [G U. 2000]

Or, How are material wastages and material scraps treated in Cost Accounts.

[GU. 2004]

"Waste or wastage is that portion of the basic raw materials lost in processing

having no recovery value."

So it arises in course of production and has no value.

Visible Waste:

A visible waste is physically present and which can be seen and handled. As for

example, saw dust in a wood working, ash in cooking industry, gas smoke etc,

Invisible waste:

An invisible waste is one which cannot be seen and handled. As for example waste

due to drying, evaporation, etc.

Types of wastes:

Wastes are of two types- Normal wastes and Abnormal wastes

Normal Wastes:

Normal waste is that which is likely to arise normally due to the inherent nature of

the material. It s natural or incidental to production. Example- Liquid materials lose

their weight due to evaporation, loss coal may occur due to loading and unloading,

loss due to breaking the bulk into small pieces, etc. Such waste is unavoidable.

However, it can be reduced to some extent by enforcing strict control but it cannot

be totally eliminated.

Normal waste can be estimated in advance on the basis of past experience or data.

Accounting Treatments:

An waste has practically no value. Hence, its treatment in cost accounting is

relatively simple i -.J its effect is the reduction in quantity of output and it has effect

on the calculation of cost per unit jfsuch output also.

88

From the input, normal waste is deducted and the normal output is determined. The

total cost of e input is spreaded over the normal output to determine the cost per

unit of output.

Thus the cost of normal waste is recovered from the sale proceeds of the good units

of the : Jtput and its cost is included in the cost of production.

Example :-

Total cost of input i.e. Material, Units Amount

labour and overhead 10,000 , 27,000

Less : Normal waste@ 10% (a'ssurnned) 1,000

Cost of normal output 9,000 27,000

.-. Cost per unit of output = =?3

If normal waste relates to loss of materials due to storage, handling, drying, etc., in

that case, it recovered by inflating the price of materials issued to production. It

means that the materials will be .ed at a higher price than its cost price in order to

cover the cost of normal wastage.

Example:

If500 handred eft. of timber is purchased @ ^ 200 per eft. and if 5% of the timber is

expected be lost due to seasoning, the inflated issue price per eft. of the seasoned

timber would be:

__Cost__ ' 500x^200 _ 1,00,000

(Input-Normal wasts) 500-5% of 500 475

Cost of input to be charged per cft.= ? 210 approx.

Alternative method of treatment of normal wastage is to consider such loss as a

factory head and in that case, materials will be issued at actual cost, n trolling of

Normal Waste:

Following measures may be taken for controlling normal wastage: Setting up

standard of Waste:

Standard for normal waste is to be set up on the basis of experience, quality of

materials and I ufacturing process.

89

Reporting.,

Actual wastage is compared with standard waste and difference is ascertained for

remedial -easures. Regular wastage report is to be sent to the management showing

the causes for such *astage.

Corrective Measures:

Causes of difference between the standard and actual waste are to be analysed and

corrective 2.A.20

Cost and Management Acconting measures are taken therefor Abnormal Waste or

Wastage.

Abnormal wastage is that waste which is in excess of normal waste and which

arises from abnormal causes, such as inefficacy in operation, sub-standard

materials, carelessness, etc. The value of such abnormal wastage is calculated as

follows:

Normal Cost of Normal Output

Normal Output

x Units of Abnormal Waste

Particulars Units Amount

Total cost of input i.e. material, labour and overhead 10,000 27,000

Less: Nomal waste @ 10% (assumed) 1,000 —

Costof Normal Output 9,000 27,000

Less :Costof Abnonnal waste

100 units (assumed) 100 300

27,000 Normal output 9,000 units

Cost of Actual output •8900 26,700

Treatment in Accounts:

Abnormal waste should not affect the cost of production as it is caused by abnormal

or unexpected conditions. Such loss represents the cost of material, labour and

overhead. It is transferred to the Costing Profit and Loss Account and should not be

added to the cost of production. It is necessary to facilitate the comparison of costs

of different periods.

90

Controlling of Abnormal Wastage:

All cases of abnormal waste should be thoroughly investigated and responsibility

should be fixed for such abnormal losses. As abnormal losses can be avoided,

remedial measures should be taken up for avoiding such losses. Persons engaged in

purchases, storage, production and inspection should be asked to maintain standard

and preventive action should be taken in order to avoid loss due to fire, accident,

mishandling, etc.

Q.17. Write short notes on:

(i) Obsolesence of Materials; [GU-2004]

(ii) Normal Loss of Materials

(iii) Abnormal Loss of Materials;

(iv) Scrap; [GU-2004 & 2005]

(v) Spoilage.

(i) Obsolescence of Materials: Meaning and causes:

Obsolete materials refer to those materials which are no longer required for

production. It is because there is a change in the design of the finished product for

which such materials have been used or there is a fall in the demand for such

finished product due to change in fashion or due to the emergence of substitute

cheaper materials.

Accounting:

Losses arising from obsolescence are treated as abnonnal losses and are debited to

the Costing

Profit and Loss Account. The cost of obsolate materials less scrap velue becomes

the net loss to be transferred to the Costing Profit and Loss Account.

91

Material Losses:

Material losses are those losses which arise due to evaporation, leakage, breaking

the bulk, careless handling, poor quality, obsolescence, inefficiency in operation,

theft, accident, fire, etc. Example- Show-dust in wood working plant; ash in

coocking industry, etc. Material losses are of two types:

(i) Normal Loss; and

(ii) Abnormal Loss.

Normal Loss of Materials:

Normal loss of materials is that loss which arises due to inherent nature of the

material and it is unavoidable. It cannot be eliminated. However, it can be reduced

to some extent by proper control. Example- loss due to leakage in case of liquid

materials, loss due to loading and unloading of coals; etc.

Accounting Treatment:

It is treated as cost of production and is recovered from good units of usable

materials by ilating their prices per unit.

Alternatively, it can be treated as a factory overhead,

Abnormal Loss:

Abnormal loss of materials is that loss which is in excess of the normal loss. It

arises due to abnormal causes such as defective planning, inefficiency in operation,

theft, fire, etc. It is avoidable by - reventive action, proper control and planning. A

tcounting Treatment:

Cost of abnormal loss of materials is excluded from the cost of production. It is

transferred to sting Profit and Loss Account.

Scrap:

Scrap is the incidental residue from certain type of manufacture, usually of small

amount and \ value recoverable without further processing. It means the residue,

remnants or fragments of

certain materials left from certain types of manufacture. Such residue or discarded

materials have A recovery value without further processing. It is common in

92

operations like turning, boring, punching, % i ng, moulding, etc. Examples saw-dust

and tail-ends in the timber industry; dead heads and bottom

. ds in foundries, cuttings, piece and splits in leather industry, off-cuts of sheet

metal, small pieces of

:'oth,etc.

Scrap has the following characteristics:-

(i) It is incidentally produced from the manufacturing process;

(ii) It is always physically available;

(iii) It can be used as a material by some other industry;

(iv) It has small recovery value; and

(v) No further processing is necessary to realise its recovery value, b raps are of

following types :

(i) Legitimate scrap -which arises due to nature of operation e.g. turning, boring,

etc.

(ii) Administrative scrap- arising from administrative action such as change in

method of production;

(iii) Defective Scrap- arising from the use of inferior quality of material or bad

workmanship, etc.

Accounting treatment: 1. As Income:

If realisable value of normal scrap is insignificant, it can be credited to the Profit

and loss Account as an other income and is not shown in the cost sheet. It is

applicable in case of legitimate scraps and administrative scraps.

2. As deduction from Cost of Materials or from Factory overhead:

The sale value of scrap may be shown as a deduction from the cost of materials

consumed or from factory overhead.

3. As deduction from Job Cost:

Scrap may be assigned as a cost when it is related to a job and is credited to the

related job.

4. As Inter-job Transfer:

Where scarp can be used in another job, it can be credited to the job where it arises

and debited to the job where it is transferred.

93

5. As Normal loss:

When the actual scrap is within the predetermined quantity, it is treated as normal

loss.

6. As A bnormal loss:

When the actual scrap exceeds pre-determined quantity it is treated as an abnormal

loss. The cost of such excess scrap is transferred to the Costing Profit and Loss

Account alter deducting its sale Price. (P) 01

7. Defective scrap as Abnormal Loss:

In case of defective scrap, the difference between its cost and sale proceeds is

transferred to the Costing Profit and Loss Account as it is an abnormal loss, (v)

Spoilage:

Spoilage refers to production that does not meet with quality standard and which is

so damaged in the course or that it cannot be rectified with further processing. So it

is treated as 'Junk goods' and Q 19. Fill

is sold for a disposable value. However, materials used in the spoiled units can be

used as material by _

the same or another process or product. —

Cost of spoilage is the cost of material, labour and overhead incurred on the spoiled

goods up to the point of rejection. It has a realisable value, So, the entire cost of

spoilage is not a loss. Therefore, the loss on spoilage is the difference between the

cost and its realisable value.

Spoilage arises due to substandard materials, poor workmanship, bad supervision,

etc.

Loss on spoilage may be of two types- normal loss and abnormal loss. Accounting

Treatment:

(a) Normal Loss:

Normal spoilage loss is due to the inherent nature of the process of production and

is included

viii) W

in the cost of production and is born by goods units of output.

94

(b) Abnormal Loss:

Abnormal spoilage is not due to inherent nature of the production process. It arises

from inefficient operating conditions. The loss on abnormal spoilage is transferred

to the Costing Profit and Loss

95

Unit-II B. LABOUR

Part I: Theoretical questions

Q.l. Define direct labour and indirect labour.

Or,

Distinguish between direct Labour and indirect labour with suitable examples.

How are they treated in cost accounting? [GU. 1997]

Direct Labour.

Direct labour is that labour which is directly engaged in the production of goods or

services and hich can be conveniently allocated to goods, products or services units.

ICM A defines direct labour costs as "The cost of remuneration for employees',

efforts and kills applied directly to a product or saleable service." It has the

following features:

(i) It is a part of prime cost;

(ii) It is attributed to finished goods;

(iii) It is identified with the total cost of production;

(iv) It varies with change in output; and

(v) It is controllable.

camples of Direct Labour

(i) Labour engaged in making the bricks in a kiln.

(ii) A carpenter working on the manufacture of a table woodworks.

(iii) A skilled worker in the factory producing a component part.

(iv) A machineman working on a printing machine in a printing press.

(v) Amason erecting a wall.

(vi) Labour extracting, coal, petroleum ete.

direct Labour-:

Indirect labour is that labour which is not directly engaged in the production of

goods and ices but which indirectly helps the direct labours engaged in production.

The remuneration paid ndirect labour is termed as Indirect Wages.

96

ICMA defines indirect labour cost as "wage cost other than direct wage cost."

Following are the important features of indirect labour:

(i) It is secondary in importance as compared to direct labour;

(ii) Its cost cannot be allocated bvut can only be apportioned;

(iii) It does not vary with the change in production:

(iv) It cannot be controlled;

(v) Its cost is treated as overheads;

(vi) It cannot be identified with the finished product.

Examples of Indirect Labour:

(i) Shop labour that helps production in a general way, such as cleaner, foreman,

crane operators

(ii) Labour employed on maintenance work.

(iii) Labour employed in service departments like sale and security, power house,

internal transport service etc.

(iv) Storekeeping workers and other such personnel.

Distinction between Direct Labour and Indirect Labour:

Direct Labour Indirect Labour

1. It can be conveniently identified with

finished product.

It cannot be identified with finished

product or cost centre.

2. It can be conveniently al located to

cost . centre or Cost unit.

It cannot be conveniently allocated to a

cost centre or cost unit.

3. It is a part of prime cost. It is a part of overheads.

4. It is primary in the production process. It is secondary in the production process.

5. It can be easily ascertained. It is difficult to ascertain.

6. It varies with change in output. It remains fixed irrespective of chance in

output,

7. It can be easily controlled. It cannot be easily controlled.

Treatment in Cost accounting: Direct Labour:

Wages paid to direct Labour is called direct wages and are included in the prime

cost. It is because it is directly associated with the product or process. Indirect

Labour:

97

Wages paid to indirect labour are called the indirect wages. They cannot be

conveniently allocated to products or cost centres. They are therefore apportioned

to different products or cost centres. They constitute overheads e.g. factory

overhead, office or administrative overhead, selling overheads, distribution

overhead, etc.

Q.2. (a) What do you understand by 'labour turnover'? State its effect on cost

of production, (b) Enumerate the causes of labour turnover and suggest steps

to be taken for reducing labour turn-over. [GU.1988,1991 and 1995]

or, Gives the meaning of Labour turn-over. [G U.2004]

Meaning:

Labour Turnover may be defined as the rate of change in the composition of

labour force during a specified period i.e. the ratio of replacement of workers

during a given period to the average number of workers in employment in the

concern during the same period.

The average number of workers in employment in an organisation is the average of

the total number of workers in employment at the beginning of the given period and

the total number of workers at the end of the period. In other words the average

number of workers in a given period will be:

Number of workers L at the begining of the given period

in employment Number of workers in employment ] le given period J L at

the end of given peirod ]

The Replacement of workers means, the number of workers who have been

employed in the place of workers who have left during the period. Expression of

labour Turnover:

Labour Turnover is usually expressed as a rate or percentage in order to facilitate

comparison between two periods and between two undertakings. Higherthe

percentage of labour turnover higher is the instability in the labour force. It means

the frequent changes in the labour force because of new workers engaged in place

of workers who have left. It is an undesirable phenomenon. Measurement of

Labour Turnover.

There are three methods to measure labour turnover

98

(i) Separation Method;

(ii) Replacement Method/Net labour turnover method;

(iii) Flux or Separation Cum Replacement method. Separation Method:

Under this method, labour turnover is measured by ascertaining, the percentage of

the workers left the organisation to the average number of workers in employment

during that period. Formula is given below:

Number of workers left during a perid

Average Number of workers during the same period

Number of workers at the beginning + Number of workers at the end Average

Number or workers =-

This method has the defect that it does not take into account the surplus labour force

which is discharged. Thus it may show a high percentage of turn over.

Replacement Method:

Under this method, labour turn over is measured by ascertaining the percentage of

number of orkers replaced to the average number of workers in employment in a

given period. The formula is is given below:

Labour Turnover1

Number of workers Replaced in a given period

Average Number of workers in empoloyment in the same period

This method takes into account the surplus labour and gives a correct labour

turnover for an . . sanding factory. It is because, it does not consider all additions to

labour force but takes into account 1 y the workers who have been employed in the

place of the workers who have left the organisation during that period. So it is the

most reliable definition of labour turnover.

Flux or Separation cum-Replacement Method:

Under this method, both separation and replacement are taken into account while

ascertaining - e percentage of labour turnover. The formula is given below:

Labour Turnover Number of Seperation (Employee leaving)+Number of

Replacements (new employee)

Average Number of employeesin employment during the period

99

This method is not applicable in an expanding concern because new workers may

be employed • en if no worker is replaced. In that case the labour turnover will be

high even if no worker leaves be Organisation. Thus it may show high labour

turnover which is not a fact.

Effect of labour Turnover on cost:

Effect of labour turnover is low productivity and increased cost of production. This

is due to the following reasons:

1. Fall in production:

Frequent changes in labour force interrupt the continuous flow of production. It

results in the fall in production and increase in overhead cost per unit.

2. Low productivity:

New workers may be less efficient in the beginning. So the low productivity will

increase overhead cost per unit.

3. Selection and Training Cost:

Selection and training of new workers will increase cos.t of production.

4. More Scraps and Defective Goods:

New workers are unfamiliar with the process of work and as a result, there will be

more scraps, rejects and defective products which will increase the cost of

production.

5. More Depreciation, Break-down of Tools and Machinery

New workers are inexperienced workers. So they may not be able to handle

machinery and tools properly. It may lead to more depreciation and breakage of

machinery and tools. Thus cost of production will go up.

6. More Compensation:

New workers are inexperienced workers so they are prone to accident. It will lead to

higher compensation and higher of production cost. Cause of Labour Turnover:

Causes of labour turnover may be classified into

(a) Personal causes;

(b) Unavoidable causes; and

(c) Avoidable causes. Personal Causes:

Workers may leave the organisation purely on personal reasons which'may be:

100

(i) Domestic troubles and family responsibilities;

(ii) Retirement and death;

(iii) Acc idents wh ich may make the workers permanently incapable to work;

(iv) Women workers due to marriage;

(v) Dislike for job or the place of work;

(vi) Workers finding better jobs in some other places;

(vii) Workers having roming nature;

(viii) Moral turpitude.

In the above the labour turnover is unavoidable and the employer cannot do

anything to reduce the labour turnover.

Unavoidable Causes:

Following are the circumstances where the management has to ask the workers

leave the organisation:

(i) Insubordination or inefficiency or irregularity.

(ii) Continued leave of absence;

(iii) Shortage of work;

(iv) Conviction in a criminal case,

Avoidable Causes:

Following are the avoidable causes which the management can prevent:

(i) Low wages;

(ii) Unsatisfactory working conditions:

(iii) Job dissatisfaction because of wrong placement;

(iv) Inadequate facilities such as accommdation, medical benefits, etc;

(v) Lack of promotion opportunities;

(vi) Unfair methods of promotion:

(vii) Lack of job satisfaction and training facilities;

(viii) Unsympathetic attitude of management.

Steps/Measures to Reduce Labour Turnover:

The management may take the following steps to reduce high percentage of labour

turnover:

101

(i) Scientific recruitment, selection and training of workers i.e. suitable labour

policy.

(ii) Provision of better working conditions;

(iii) Provision of better wages, allowances and other monetary benefits;

(iv) Provision of maximum fringe benefits i.e. non-monetary benefits;

(v) Introduction of fair promotion policy;

(vi) Provision of social security measures;

(vii) Better motivation of workers.

(viii) Cordial management labour relations;

(ix) Ensuringjob satisfaction and job security;

(x) Measures to reduce labour disputes;

(xi) Inviting suggestions from workers.

1.3. What are the different costs of Labour turnover?

The cost of labour turnover can be divided under two heads:

(i) Preventive costs and

(ii) Replacement costs.

Preventive Costs:

Preventive costs are incurred by a firm to keep the workers satisfied so that they

may not leave . firm.These costs include:

(i) Cost of personal administration,

(ii) Cost of medical services;

(iii) Cost of welfare services e.g. canteen facility, sport facilities; education

facilities, etc.

(iv) Cost of gratuity and pension schemes and other security measures and

retirement benefits.

(v) Cost of higher wages, bonuses, perquisites, etc.

Replacement Costs:

Replacement costs are associated with recruitment; training and their absorption in

new works, ej includes the following:

(i) Cost of recruitment, training and induction:

(ii) Loss of output due to interruption and inefficiency of the new workers;

102

(iii) Cost of tools and machine breakage;

(iv) Cost of breakage and defective work;

(v) Cost of additional supervision over new workers;

(vi) Cost of additional compensation due to frequent accidents;

(vii) Loss of profit due to loss of production and increased overhead.

Treatment of labour Turnover Cost:

Labour turnover costs are usually treated as factory overhead.

Preventive costs are distributed among the departments on the basis of number of

workers in each department.

The Replacement Costs are shared by the departments which are affected by the

labour turnover on the basis of number of workers replaced i.e. the new workers

employed in place of the workers who left.

Q.4. What do you mean by idle time? Distinguish between normal idle time

and abnormal idle time. How would you deal with each one of them in cost

accounts? Give your answer with suitable examples. [GU.1989]

Idle Time may be defined as the time during which no production is obtained

although wages are paid for that period. In other words, it means payment made to

a worker for a period during which he remains idle and does not work.

. Idle time is represented by the difference between the time as per the attendance

record and the time booked to different jobs. Example- According to attendance

record a worker is supposed to put in the factory 8 hours but the worker's job card

shows that he has spent only 7 hours on jobs. The difference of 1 hour (8-7 hours) is

the idle Time. Classification of Idle Time:

From the point of view of treatment in cost, idle time may be classified into two

categories. Viz. Normal Idle Time and Abnormal Idle Time. Normal Idle Time:

Normal Idle Time refers to the idle time which occurs normally or regularly. It is

an implied condition of production and cannot be avoided. It occurs mainly due to

unavoidable causes. However efforts may be made to reduce it to the minimum.

Following are the causes of normal idle time:-

(i) Time taken in going from the factory gate to the departmentwhere he works.

103

(ii) Time taken in picking up the work for the day; i.e. setting up of tools,

equipments, etc.

(iii) Time taken by workers in moving from one job to another;

(iv) Time taken by workers for tea, lunch and personal needs;

(v) Time lost when production is interrupted for machine maintenance.

(vi) Time lost due to waiting for jobs, instructions, etc. Accounting Treatment.

As cost of normal idle time is an unavoidable cost, it should be included in cost

ofproduction. It can be dealt with any one of the fol lowing ways, (i) As a factory

expense:-

Cost of normal idle time can be treated as an item of factory expense and re-corded

as an indirect charge.

Example: If an worker is engaged for 8 hours @ Rs. 5 per hour; he will receive Rs.

40 for the day. From the job card it is found that he has worked for 7 hours for the

day. In such a case one hour's wage Rs. 5 will be the cost.of normal idle time. It

may be debited to factory expenses and may be charged to production, (ii) As an

inflated rate of wage: '

Alternatively, the cost of Rs. 5 may be charged to production at an inflated rate of

labour. Such rate inflated the cost of normal time.

In the above example, wages of Rs. 40 are paid for 8 hours though the worker has

worked for 7 hours. This Rs. 40 is to be divided by 7 hours in order to determine the

effective hourly rate i.e. Rs. 40/ 7 hours or Rs. 5.71. This alternative method is more

popular. A bnormal Idle Time:

Abnormal idle time refers to the idle time which arises unusually or abnormally. It

may be due to avoidable or unavoidable causes. Following are the causes of

abnormal idle time: Avoidable Causes:

(i) Time wasted due to break-down of machinery which may arise on account of

inefficiency of works manager.

(ii) Time wasted due to failure of power supply.

(iii) Time wasted due to shortage of materials which may arise due to inefficiency

of the purchase department:

104

(iii) Time wasted due to unnecessary waiting for tools, instructions, etc. which

may arise due to lack of proper planning. Unavoidable Causes:

(i) Time Wasted due to fire, flood, etc. i.e. due to natural calamities;

(ii) Time wasted due to Strikes and lock outs due to labour disputes and political

reasons;

(iii) Fall in demand for products due to depression and other reasions;

(iv) Time wasted for major accidents, political cause, social unrests. -.atment in

Accounts:

Cost of abnormal idle time is an abnormal loss hence it should not form a part of

cost of oduction. It should be debited to the Costing Profit and Loss Account. The

objective is to make the

iparision of cost of production of different periods meaningful. Q.5. What do you

mean by Controllable Idle Time and Uncontrollable Idle Time? What are

accounting treatment? What are their accounting treatments?

Controllable idle time refers to that (normal or abnormal) idle time which can be

controlled for the management. Generally, the following are treated as controllable

idle time : 1. Normal idle time resulting from productive causes; such as:

(a) Time taken by the workers in waiting for instructions

(b) Time lost by the workers in waiting for materials;

(c) Time lost by workers in waiting, for tools;

(d) Time lost by workers in waiting for work;

(e) Failure of power supply due to internal causes;

(f) Minor break-down of machinery;

(g) Minor accident to workers.

Cost and Management Acconting

2. Abnormal idle time due to administrative causes like bad planning by the

management. Uncontrollable Idle Time:

Uncontrollable idle time refers to that idle time which cannot be controlled (i.e.

avoided or reduced) by the management. Usually the following are treated as

uncontrollable idle time:

1. Normal idle time resulting from productive causes, such as:

105

(a) Time taken by the workers to reach their departments from the factory gate at

the time of arrival at the factory, and the time taken by the workers to reach the

factory gate from their departments at the time of departure from the factory:

(b) Time taken by the workers in setting up of tools, implements and machines,

(c) Time taken by the workers in attending to their personal needs;

(d) Time taken by the workers in moving from one job to another;

(e) Time taken by the workers for tea and lunch;

(f) Time lost when machines are stopped for making necessary adjustments.

2. Abnormal Idle Time resulting from:

A: Adininistrative causes such as:

(a) Deliberate under-utilisation of the productive capacity;

(b) Curtailment of production during depression: B : Economic causes such as:

(a) Fall in demand for products

(b) Non-availability of materials in the market. C: Other causes such as :

(a) Fire, floods, storm; earthquake, etc.

(b) Strikes and lock outs;

(c) Power failure due to external causes;

(d) Major break-down of machinery.

Accounting Treatment:

If the idele time is normal and controllable, the cost of such idle time should be

treated as general factory overhead and should be apportioned to the various jobs

on an equitable basis. If it can be allocated to a department, it should be included in

the departmental overhead.

If it is normal but uncontrollable, it may be merged with the wages of the

workers. In that case, the wages rate of the workers gets inflated.

If it is abnormal and uncontrollable arising from strike, lock-outs, natural

calamities, it should be charged direct to the Costing Profit and Loss Account.

Q.6. What are the measures for controlling idle time? Mention some of them.

The cost of idle time increases cost of production or reduces profit. Therefore, it

should be controlled as far as possible. Though it cannot be wholly eliminated, yet

it can be reduced to a certain extent by adopting the following measures:

106

(i) Use of idle time cards.

Use of idle time cards for recording idle time with reasons thereof- it facilitates the

management to take proper steps to remove the causes of idle time.

(ii) Effective supervision over the workers by the foreman.

(iii) Planning and control of production;

(iv) Timely provision of materials, tools and implements.

(v) Timely provision of necessary instructions to the workers;

(vi) Proper maintenance of power plant and machineries

(vii) Careful watch over the labour utilisation statements in order to avoid the

concealment of idle time.

(viii) Setting up and enforcement of standards for normal idle time.

Q. 7. Explain in brief the measures applied for control of Labour costs. [GU.

2002]

Labour cost control refers to the control of labour costs per unit of production

through proper employment and efficient utilisation of labour force and not with the

reduction of wage rates. It involves the following:

(i) Efficient system for recruitment, training and placement of workers on jobs;

(ii) Healthy working conditions,

(iii) Proper recording oftime put in by the workers;

(iv) Satisfactory methods of labour remuneration; and

(v) Regular accounting for payment of wages. Following are the measures for

labour cost control:

(i) Production Planning.

Production planning includes product and process planning, programming, routing

and direction •r efficient utilisation of labour force.

I ii) Scientific Selection and Systematic training:

The requirements of the job should be assessed and workers should be selected

considering eir abilities to fulfil the requirements of the jobs for which they are to

be recruited- right man to the :ght job. Workers should also be properly trained in

order to increase their productivity which will "educe costs.

107

(iii) Job Evaluation:

Job evaluation means the determination of the relative worth of each job in order to

fix the -enumeration of each job. It is done by job analysis. It will lead to rational

wage system and labour i scontentment

' iv) Time and Motion Study. -

Time study means the measurement of time taken by the workers to do an element

of an aeration. It is the study of the speed of movement made by the workers while

performing an element fan operation. It leads to the determination of standard time,

production planning and wage planning.

Motion study means the science of eliminating wasteful process out of production

process. Its ^iect is to eliminate unnecessary motions and to simplify the method of

doing a work. It saves time -iergy and cost.

v) Setting up of Standards:

Standards can be set for labour cost and the actual cost can be compared with the

standard st and variances can be ascertained. Causes of variance are analysed and

suitable action can be taken against such causes.

i) Labour Budget:

Labour Budget means a plan of the number and types of workers needed for the

production of a job and the labour cost involved for that. It is a technique of control

for labour costs as it leads to the maximum utilisation of tabour force.

(vii) Proper wage Policy :

Proper wage policy means an wage plan which is designed to encourage the

workers to put in their best to achieve increased production.

(viii) Labour Performance Report.

Labour cost can be controlled with the help of labour utilisation and efficiency

reports which is to be received periodically from various departments.

Q.8. What do you mean by incentive wage plan/premium and bonus plan?

Mention its advantages and disadvantages.

Incentive plan/scheme or Bonus plan/scheme is a compromise, between Time Rate

System and the Piece Rate System. Under the incentive scheme, the gains or losses

108

arising from efficiency or inefficiency of the workers are shared by both the

employer and the employees.

Under time rate system, all the gains or losses resultingfrom the efficiency or

inefficiency of workers go to the employer. While under the piece rate system, all

the gains or losses resulting from the efficiency or inefficiency of workers go to

employees, But under the incentive systems, such gains and losses are shared by

both the parties. So the system is in between the time rate system and piece rate

system. This system provides incentives to the workers to earn more. Objectives:

The main objectives of the system are:

(i) To induce the workers to increase their efficiency.

(ii) To provide additional remuneration to more efficient workers.

(iii) To keep labour force contented and thereby to reduce labour turnover,

(iv) To keep the moral of the workers high.

(v) To have increased production.

(vi) To reduce fixed overhead cost per unit of production.

Suitability of the System:

This system is suitable in the following cases:

(i) In industries where proper time and motion study is undertaken and proper

standard of time and output can be fixed.

(ii) In industries where overhead charges are considerable and which can be

reduced only through increased production.

Advantages:

Incentive wages schemes have certain advantages which are as mentioned below:

(i) Assured time/day rate of wages:

The workers are assured of their time/day rates of wages whether they attain the

standard or not.

(ii) Inefficiency is not penalised:

Inefficiency of an worker is not penalised, as the worker is assured of his time/day

rates of wages whether they attain the standard or not. .

(iii) Efficiency is rewarded.

Efficient workers are rewarded by way of bonus in addition to their time wages.

109

iv) Promotion of efficiency

Additional incentive is given by way of bonus to more efficient workers leading to

improvement n productivity and efficiency.

v) Scope for more earnings:

Opportunity is provided to workers to increase their earnings by increasing

production.

(vi) Keeps labour force contented:

It keeps the labour force contented and thereby reduces labour turnover.

vii) Reduction of cost per unit:

Increased production under the system reduces the overhead cost as well as the cost

per unit if output. Disadvantages:

Following are the disadvantages of the system:

i) Difficulties in Setting Standard and Rate:

There are difficulties in setting standard of performance and rate of wages resulting

into scontentment and frequent labout dispute.

ii) Difficulties in withdrawing scheme:

It is difficult to withdraw the scheme once introduced when it becomes necessary.

iii) Objections from trade unions:

Trade unions object to introduce such a scheme leading to strikes and lock-outs.

iv) Complicated system:

Some incentive schemes are too complicated to introduce.

Deterioration of quality of work:

It may lead to more output at the cost of quality.

J.9. Mention different incentive schemes of payment of wages and explain

Halsey and Rowan Premium Bonus Schemes.

Following are the various incentive wages premium/bonus plans:

(i) Halsey Bonus Schemes;

(ii) Halsey-Weir Schemes;

(iii) Rowan Bonus Scheme;

(iv) Gantts Task and Bonus Scheme;

(v) Emerson's Efficiency Scheme;

110

(vi) Bedaux point Scheme.

(vii) Barth Variable Sharing Scheme: and

(viii) Accelarating Premium Bonus Scheme.

Balsey Premium Scheme:

Under this scheme/method, standard time fordoing a job is fixed and the worker is

given wages - the actual time he takes to complete the job at an agreed rate of wage

per hour. In addition, a :us equal to 50% of the wages of the time he saved is also

given to the worker.

Example: Suppose the standard time for a job is fixed at 10 hours and hourly rate is

Rs. 5. If i .vorker completes the job in 8 Hours, the worker will get wages for 8

hours i.e. Rs. 40. As he has . ed 2 hours (10-8) of time he will get, 50% of wages for

the 2 hours he saved as bonus : 50% of - rsxRs. 5) or Rs. 5. It means the worker will

get in total Rs. 45 i.e. wages 8hrsxRs. 5 + Bonus 1 of (2xRs.5).

Advantages: I.Simplicity:

It is simple to understand and easy to operate.

2. Guarantee of time wages:

It guarantees time wages to workers.

3. Sharing of Gains:

Wages of time saved are shared by the employer and employees, resulting into a

reduction in labour cost per unit.

4. Rewarding ofEfjtciency:

It rewards efficiency i.e. more effective wages for more efficient workers.

5. Reduction in fixed Cost per unit:

It reduces fixed overhead cost per unit.

Disadvantage :

1. Quality of work suffers:

Quality of work suffers because workers work in a hurry neglecting the quality of

the work.

2. Criticism by workers:

Workers criticise this method on the ground that the employer gets a share of the

gain.

111

3. No penalty for inefficient workers:

Underthis system, inefficient workers are not punished because their time wages are

guaranteed. Rowan Premium Bonus Scheme:

Under the system, standard time for doing a job is fixed and the worker is given

wages for the actual time he takes to complete the job at an agreed rate of wage

per hour. In addition, a bonus for the time saved as calculated according to the

following formula is also given to him:

(Time worked- hourly Rate) x T^^Allowed

Example: Suppose the standard time for a iob is fixed at 10 hours and hourly rate is

Rs. 5. If the worker completes the job in 8 hours the worker will get wages for 8

hours i.e. Rs. 40. As he has savec 2 hours (10-8) of time he will get a bonus of Rs. 8

as calculated below.

i.e. (Time worked x hourly Rate) x ^Time^a^

= (8xRs.5)x = Rs. 40x^p Rs. 8

.-. Total wages = 8xRs.5 + Bonus Rs. 8

= Rs. 48.

Advantages:

1. It guarantees time wages to workers.

2. It provides incentive to efficient workers and as such efficiency of the workers

increases.

3. Labour cost per unit of output is reduced because of increased production in a

given period.

4. Quality of work suffers less as in case of Halsy Scheme because the workers are

not induced to rush through the work.

5. Fixed overhead cost per unit is reduced through increased production.

Disadvantages:

1. Workers do not get full benefit of increased productivity because the gains are

shared between employer and employee.

2. It is inequitable because efficient and not so efficient get the same time wages.

3. Incentive is low to a very high efficient worker because a worker gets lesser

bonus for greater saving of time after saving 50% of the standard time.

112

4. It is too complicated to administer.

Q.10. What are the different methods of payment of wages? Explain the

relative importance of Time Rate and Piece Rate System.

Chart 1:

Chart Showing different types of time rate and piece rate system.

(a) Time Rate System (b) Piece Rate Syvteni

(i) Flat Time Rate. (i) Straight Piece Rate System.

(ii) High Day Rate. (ii) Taylors Differential Piece Rate System.

(iii) Measured Day Rate. (in) Merricks Multiple Piece Rate System.

(iv) Graduateed Time Rate. (iv) Gant's Task and Bonus Plan.

(v) Differential Time Rate.

Chart 2: Chart Showing dijferent Metliods of Payment of Wages.

A.. Time

Rates

B. Piece Rates. C. Combination of

Time Rate and

Piece Rates.

D. Premium

Bonus

Schemes.

E. Other

incentive

Schemes.

F. Group

Bonus

Scheme.

Time Rate at

binary

Levels Time

Rate a high

Wages Leval

Graduated

Time Rate.

-1

Differential

":me Rates.

(i) Straight Piece

Rate.

(ii) Piece Rate 5

with graduated

Time Rate.

(iii) Differential

Piece Rates.

(a) Totylor's

Differential

Piece Rate

System.

(b) Multiple

Piece Rates or

Merricks

Differential

System.

(i)Emersons

Efficiency Plan.

(ii) GanttTask and

Bonus scheme

(iii) Bedaux

Scheme or Point

Scheme.

(iv) Haynes

System

(v) Accel arated

Premium Schemes

(i) Halsey

Scheme

(ii) Halsey

Weir Scheme.

(in) Rowan

Scheme.

(i)

Indirect

monetary

incentive

.

$

(a) Profit

Sharing

(ii) Non-

Monetar

y

incentive

s.

(b)Co.

Partnershi

p

ere are two principal wage payment systems—

(a) Time Rate; and

113

(b) Piece Rate.

Other methods of labour remuneration such as premium or bonus plans and profit

sharing

schemes are used with either of the two principal methods of wages payment.

Time Rate system:

Time Rate is a system of labour remuneration where workers get wages on the

basis of time spent in thefactory irrespective of the amount of work done. As for

example, if an worker is paid @ Rs. 5 per hour and if he has spent 48 hours in a

week in the factory he would get Rs. 240 (48hrsxRs.5) for the week.

There are five types of time rate systems

(a) Flat Time Rate;

(b) High Day Rate;

(c) Measured Day Rate;

(d) Graduated Time Rate; and . (e) Differential Time Rate.

Advantages of Time Rate System:

Following are the advantages of Time Rate System:

1. Simplicity:

It is simple to understand and operate.

2. Assured Wage

The workers are assured of certain amount of wages on the basis of time spent in

the factory.

3. Contented Labour Force:

Labour force generally remains contented leading to good employer-employee

relations'hip.

4. Stress on Quality:

For precision and quality work, it is suitable because it is quality rather than speed

is essential for such work. Disadvantages:

1. No Provision for improvement ofLabour Efficiency:

It does not provide any incentive to improve efficiency because the labour

remuneration is not linked with efficiency.

2. Increased cost of Production:

114

Under the system, workers tend to adopt go slow tactics. It results in lower

production resulting into higher cost of production.

3. Efficiency is not rewarded:

Efficient workers are not rewarded for their efforts. Thus they suffer from

frustration leading to labour turnover.

4. Increase in Idle time:

Under the system, idle time may tend to increase.

5. Invites Strict Supervision:

For proper functioning of the system, strict supervision is necessary leading to

higher cost of overhead.

Application of the System:

Fol lowing are the situations under which the system is suitable

1. Where the work demands a high degree of skill but quantity of production is less

important e.g. tool making, watch making and other artistic goods.

2. Where the speed of production is beyond the control or energy of the workers i.e.

automatic production, chemical reaction.

3. Where output of a worker cannot be measured e.g. work of supervisor, cleaner,

sweeper, night watchman, etc.

4. Where close supervision of work is possible e.g. carpentry, printing, etc.

5. Where work is not repetitive e.g. jobing type industries.

6. Where the worker does a work in his own interest e.g. construction of

accommodation.

7. Where incentive scheme is difficult to introduce e.g. clerical work, etc.

8. Where work delays are frequent and beyond the control of workers.

Piece Rate System or Payment by Results:

Under the system, the volume of work done formsihe basis for determination of

wages payable to workers. A fixed rate is paid for each unit produced or a job

done or an operation performed and payment is made according to the quantity of

work done without considering the time .he worker has taken to perform the work.

As for example, a worker has produced 10 units in a day nd if he is paid @ Rs. 5

115

per unit; his remuneration will be Rs. 50 (10xRs.5). There are four variants : the

system leaving the different fixation of piece rates:

(a) Straight Piece Rate System:

(b) Taylor's Differerential Piece Rate System.

(c) Merricks Multiple Piece Rate System; and

(d) Gant's Task and Bonus Plan. Following are the advantages: -Rewardfor

Efficiency:

Workers are paid according to their merits. Thus efficiency is rewarded, . Better

Methods of Production:

Workers will adopt better methods of production in order to increase output leading

to increased " >duction. Reduction in Cost of Production:

An increased production will reduce fixed cost per unit. Thus the cost of production

will be -sduced.

• Less Idle time:

Idle time will be less as it is not paid for. I Cost ascertainment becomes simplified:

Cost of production will be easily ascertained because labour cost will be known.

L ess Supervision:

Less supervision over workers is required because the workers will work for self

interest. Motivation to work: Less efficient workers are automatically motivated to

become efficient. 3 usis for Standard Costing and Production Control:

It forms the basis of standard costing and production control.

The quality of output may suffer because the workers will try to produce more in

order to earn

2. More wastage of materials:

Workers may not use materials efficiently when they try to produce more leading to

increased cost of production.

3. Harmful impact on health:

Workers may take overstrain to increase production. It will adversely affect their

health.

4. Discontentment infixing rate:

116

Fixation of piece-rate on the basis of standard time may become sometimes

difficult.

5. Discontentment among slow workers:

It will create discontentment among slow workers bacause they cannot earn more.

6. Ignoring quality-goods producers:

Workers who are of the habit of producing quality goods will suffer because quality

is not rewarded.

Application of the system:

This method of remunerating workers is suitable underthe following situations:

1. Where the work is of repetitive nature;

2. Where the quantity of output can be measured;

3. Where quality of goods can be controlled;

4. Where equitable piece rate can be fixed;

5. Where materials, tools, etc. are suficiently available;

6. Where time cards are maintained to enforce punctuality.

Q. 11. State the essential features of Taylor's system of payment of wages by

result. [GU. 1997]

Taylor's differential piece rate system or Taylor's system ofpayment of wages by

results is a system where a large reward would be given to the workers who would

complete the work within or less than the standard time and much less wages to

those who would not complete the job within the standard time. Thus piece rate

underthe system would vary according to the level c: efficiency. The principle of

this system is to penalise a-slow worker by paying him a low piece rate for low

production and to reward an efficient worker by giving him a higher piece rate for

higher production.

Features:

The system has the following features: Fixation of standard :

A standard time for a standard output is fixed after careful time and motion study.

2. Determination of efficiency:

The level of efficiency of each worker is determined on the basis of standared time

as given below:

117

Standard Time Allowed for a Job x ] qq Actual Time Taken by the Worker

Again, on the basis of output, the level of efficiency of an worker is determined as

follows:

Actual Output Produced during the Standard Time

Standerd Output Prescribed for the Period

3. Determination of Two Piece Rates:

Two piece rates viz; (i) a low piece rate for efficiency below 100% and (ii) a high

piece rate for efficiency of 100% and above are fixed. Usually the piece rate for

efficiency below 100% is 83% c the ordinery piece rate and:

The piece rate for efficeincy of 100% or above is 125% of the ordinery piece rate

plus an -Jditional incentive of 50% of the ordinary piece rate i.e. 125%+ 50% or

175% of the ordinery piece rate.

4. No Guarunteed wage;

No minimum time wages are guaranteed to workers.

5. High Disparity:

There is a wide disparity between the low piece rate and high piece rate of wages. It

encourages -elow average workers to improve their efficiency or leave the

organisation. Advantages:

1. It attracts efficient workers;

2. It increases output;

3. Its incidence is to reduce cost of production because it reduces the fixed over-

head per unit.

4. It compells the inefficient workers to leave the Organisation automatically.

Disadvantages:

1. It creates discontenment among the workers.

2. It does not guarantee any minimum wage.

3. Workers just below the standard are penalised heavily. Suitability of the system:

Following the situations where the system can be applied:.

1. The work is of repetitive in nature;

2. Where the workers can be retained in a job for a long period;

3. Where individual output can be identified; and

118

4. Where standard time and standard output can be set.

Q.12.Write short notes on:

(i) Time and Motion Study [GU.2002]

(ii) Job Evaluation [GU.2003]

(iii) Merit Rating and

(iv) Job Analysis.

Time and Motion Study: [GU.2002]

Motion Study:

Motion study consists in dividing work into most possible fundamental elements

and :tidying the elements both separately and in relation to one another. From

these studies, wasteful m Dtions are eliminated and necessary motions are made

less tiring. It is a labour-saving device.

Workers are studied at their jobs and all their movements and motions are noted.

Each movement known as therbling (backwards). Time spent on each therbling

involved in an operation is collected. motions are studied and necessary motions for

performing the operation are ascertained and "nessary motions are suggested to be

avoided.

Advantages:

1. It increases labour efficiency through effective use of men and machines.

2. It simplifies the operations for a job;

3. It reduces time and labour fatigue. Time Study:

It is the art of observing and recording of the time required to do each detailed

element ofan industrial operation.

A job is divided into a number of operations and each operation is studied

separately and the time needed for its completion is ascertained. It is done after

motion study. It uses average worker and allows time for fatigue and personal time

while determining time for an element of an operation.

It involves three steps:

(i) Analysis of an work,

(ii) Standardisation of methods; and

119

(iii) Making the time study of standard methods.

Time study involves the careful study of the time in which the work ought to be

done.

Advantages:

1. It helps in fixing standard time for a job,

2. Wage-rate and bonus plan are fixed on the basis of standard time.

3. Efficiency of workers is increased.

4. Labour requirement of a job can be determined.

5. It helps in minimising idle time.

Job Evaluation: [GU.2003]

Job evaluation is a systematic technique for determining the relative worth of

various jobs within an organisation for establishing an wage structure. It

evaluates jobs in terms of their characteristics and more difficult a job, more it is

worth. All the characteristics are given points according to their importance and

total points are recorded to determine the money value of ajob.

Advantages:

1. It helps in the development of a rational wage-structure.

2. It brings about a co-ordial relationship between the management and the workers

because the wage structure is scientific.

3. It bringsa match between the needs of ajob and skills of workers.

4. It classifies jobs and simplifies operations.

5. It brings an uniformity in wage-structure.

Merit Rating:

Merit rating aims at evaluating the workers who actually perform the jobs in

order to suitably reward them on the basis of their merits. It assesses abilities of

workers and finds out differences among them. Following personal qualities are

considered for merit rating:

(i). Knowledge, skill and experience of the work; ' (ii) Aptitude for the work;

(iii) Quality and quantity of work done.

(iv) Punctuality, co-operation and discipline; (v)Relyability, integrity, adjustability;

120

(vi) Supervisory qualities like leadership, initiative, self-confidence and sense of

judgement.

Each quality is assigned a point value and total points are counted to assess the abi

lity or merit of a worker.

Advantages:

1. Evaluation of subordinates possible:

It helps the supervisor in evaluating the performance of his subordinates.

2. Detection of defects of workers possible:

It points out the defects of workers for remedial measures like training, motivation,

etc.

3. Justification of differential wage rates:

It justifies the differential wage rate for the same job.

4. Development of self-confidence:

It develops the sensce of confidence among the workers.

5. Incentive for efficiency:

It provides an incentive for improvement of performance of the workers.

6. Tool for rating workers:

It is the most effective tool for rating workers and reward them accordingly.

Limitations/Disadvantages: I. Blending tendency of workers.

There is a blending tendency in merit rating. It means that if an worker is good in

one factor; he s deemed to be good in other factors also.

2 Possibilities of variation in rating:

There is variation in merit rating because different members may judge the workers

differently. j

A Excellent workers may suffer.

There is a tendency to rate the employees keeping them in an average group. Thus

excellent orkers may suffer. Job Analysis:

Job analysis is defined as the process ofdetermining by observing and study and

reporting -ertlnent information relating to the nature ofa specific job. It is the

determination of the tasks h ich comprise the job and the skills, knowledge and

121

responsibilities required of the worker for the .ccessful performance and which

differentiates the job from all others.

Thus, it is a complete study of the job and to determine the factors required for its

performance. >hows the conditions under which the performance of the job is

carried on and necessary qualities the worker to do the job.

Information relating to a job can be sub-divided into the following two groups:

(i) Information relating to a job i.e. requirements of a job or job description.

(ii) Information relatitig to the job-holder i.e. the qualities of a worker to do the

job. : i vantages:

Fixation of suitable rate:

It helps in fixing suitable rates for different jobs on the basis of the characteristics of

each job. . \o. personal biasedness:

There is no personal biasedness for establishing rates for a job. // helps in

recruitment of right persons:

It helps in recruitment selection and placement of a right worker for a right job. -

Helps in Training and Development:

It assists in training and development programmes of workers. Basis for

assignment of jobs:

It provides the basis for assignment of new jobs to workers and helps in the

settlement of . rutes of workers.

Q.13. What is Overtime? How is it treated in cost accounting? Overtime:

Overtime is the work done by a worker over and above the normal working hours

in a day or during a week. Under Factory Act, if an worker works for more than 9

hours a day or more than 48 hours in a week, there is overtime work done by him.

It is resorted to complete an urgent or delayed work or to make up any shortfal I in

production or to increase production to meet the increased demand. Disadvantages

or Undesirability:

Following are the disadvantages of overtime: /. Less productivity:

A workers does overtime during the late hours of the day when he is fatigued and

tired so there is less production.

2. Adverse affect on quality and health:

122

It affects the quality of work and the state of health of an worker.

3. Higher rate and additional overhead:

Overtime rate is higher than the normal rate and it involves additional overheads.

4. Grows tendency to go slow:

It develops a tendency among the workers to go slow during normal hours.

5. Grows discontentment among workers:

There is a scope for biasedness in choosing workers. Hence there is a possibility of

creating discontentment among the workers.

6. Accounting Treatment :

Overtime payment comprises two elements:

(i) Normal rate of wages; and

(ii) Additional wages or overtime premium.

Normal Rate of wages:

1. Normal rate of wages of a direct worker is treated as a direct wages and is chargd

to the job.

2. Treatment of additional wages or overtime premium depends on the causes of

overtime as stated below:

(a) If the cause is to complete an urgent work at the request of a customer, it is

treated as a direct wages and is charged to the job.

(b) If the cause is the preasure of work or the seasonal nature of production or

power failure, accident, etc. it is treated as a factory overhead and is apportioned

among the jobs.

(c) If it is a regular feature in the factory due to labour shortage, it is treated as

direct wages and is charged to the jobs.

(b) If it is due to bad planning, fault of management, abnormal causes like fire,

floods, etc., it is treated as-abnormal loss and is charged to the Costing Profit and

Loss Account.

123

Unit- II C. OVERHEAD COST

Part I: Theoretical Questions

1. What do you understand by 'Overhead Cost'? Explain briefly the meaning

of the terms 'Fixed', 'Semi-Fixed' and 'Variable 'overhead costs giving one

example of each overhead. [GU.2003]

According to Wheldon, overhead may be defined as "The cost of indirect

materials, indirect ihour and such other expenses, including services as cannot

conveniently be charged direct to specific cost units. Alternatively overheads are

all expenses other than direct expenses. "

According to ICM A, overheads are "The aggregate of indirect material cost,

indirect wages and indirect expenses." Features:

They are aggregate of indirect materials cost, indirect wages and indirect expenses.

1 They are indirect costs and cannot be conveniently identified with any particular

cost centre or cost unit.

They are incurred for the concern as a whole and not for any particular product or a

job. So they are to be apportioned to products or jobs. - They are incurred in all

departments e.g. for production, administration, selling and distribution, etc. 5.

Benefits of indirect cost cannot be measured.

Fixed Overhead Costs:

Fixed overhead costs are those costs which do not vary with the change in the

volume of utput, but remain fixed within certain limits. These overheads remain

fixed or constant for all volumes production within the installed capacity of the

concern for a given period of time. Examples-Rent r factory and office premises,

factory and general manager's salary, etc.

Features/Characteristics:

They remain fixed during a period regardless of the change in the volume of

production within the installed capacity.

Fixed overheads are incurred even if there is no production.

Fixed overheads change only when production exceeds the installed capacity.

They vary per unit when the volume of output varies.

124

Fixed expense remain fixed for a given period. Therefore they are also called period

costs. Fixed costs are generally uncontrollable. They are not influenced by the

action of any specified executive.

They arise out of some policy decisions of the top management. As for example,

advertisement and publicity expenses.

fixed Overlteads/Semi-variable Overhead Costs:

Semi fixed or Semi-variable overheads are those overheads which remain fixed up

to a certain level of production and tend to vary beyond that level. These overheads

vary but not in direct proportic to the variation in the volume of output. Thus they

are partly fixed and partly variable; so they are called semi-variable costs also.

Examples- telephone charges, repairs and maintenance charges c transport vehicles,

etc. Telephone charges remain fixed upto a certain number of calls and thereafte-

charges increase with the increase in number of calls and so on.

If the fixed part of an item of this type of overhead is more than the variable part, it

may be called semi-fixed overhead. On the other hand, if the variable part of this

type of overhead is more than the fixed part, it is called semi-variable overhead.

Example:

A manufacturing company has a monthly installed capacity of producing 1,000

units of a produc: It has produced 500 units, 600 units and 700 units during the

months of January, February and March It has incurred indirect expenses of Rs.

2000; Rs. 2,200 and Rs. 2,400 respectively. Variable portic of the indirect expenses

for one hundred units (600-500) amounts to Rs. 200 (Rs. 2,200-Rs, 2,000

Therefore, out of Rs. 2000; semi variable expenses for 500 units, amounts to RsfnTf

x 500 i.e. Rs .200 100

1,000 and the fixed portion stands at Rs. 1000 (Rs. 2,000 - Rs. 1000). Therefore, for

600 units the fixec portion remains at Rs. 1000 but variable portion rises to Rs.

1,200 (Rs.2,200 Rs. 1,000).

Features of Semi-Fixed Expenses:

1. They do not vary in direct proportion to the change to the level of production but

they also d not remain constant.

125

2. They comprise a certain amount of fixed overhead and a certain amount of

variable overheac

3. Fixed portion remains constant and the variable portion varies in direct

proportion to the change in the volume of output.

4. Fixed-portion of these overheads is combined with fixed overheads and the

variable portion i s combined with variable overheads.

Variable Overhead:

Variable overheads are those overheads which vary directly with variation in the

volume of production. They increase when the volume of production increases and

decrease when the volume of production decreases.

Example:

These costs per unit tend to remain relatively constant with changes in production

level though the total amount fluctuates with fluctuations in the volume of output.

Examples- indirect material, indirect labour, spoilage, tools, lubricants. Though

variable overheads vary with output, they seldom show perfect variability. They

simply tend to vary rather than vary directly in proportion to output. Thus there are

three types of variable expenses:

(i)A 100% variable overhead cost i.e. for all ranges of production the variable

overhead cost per unit remains constant;

(ii) Variable expenses per unit of production are lower in lower range of output but

gradual!) increases as production goes up; and

(iii) Variable expenses per unit of production are more in lower range of production

but gradual lv decrease with the increase in production.

This type of classification is called the behavioural classification of overheads.

Q.2. What are the needs of classification of overheads into fixed and variable?

Following are the needs of classification of overheads into fixed, semi-fixed and

variable:

(i) Fixation of selling price-

It helps in determining the price policy of a concern. Sometimes, different prices

are charged for the same article in different markets in order to meet varying

degrees of competition. But in no situation the selling price should be less than the

126

prime cost plus variable overheads. It is very useful in determining the price of a

product in case of depression or in case of export of a product.

(ii) Framing flexible budget:

A flexible budget can be prepared for different levels of output if overheads are

divided between fixed and variable.

(iii) Effective Cost Control:

Variable expenses can be controlled by the lower level of management while

control of fixed expenses is left with the top management.

(iv) Management Decision:

It helps the management in taking decision regarding the utilisation of plant

capacity by exploring export market by price reduction, etc.

(v) Marginal costing and Break-even chart:

For the technique of marginal costing, preparation of break-even chart and study of

cost-volume profit relationship, division of overhead costs into fixed and variable is

essential.

(vi) Method of absorption overhead:

Absorption of overheads among the various products and jobs is done by two

different rates of absorption:

(a) A fixed overhead rate for the absorption of fixed overheads and

(b) A variable overhead rate for the absorption of variable overheads.

Q. 3. Classify the 'overheads' and mention the sources of documents for

collection of various overheads. [G.U.2002]

Chart showing classification of Overheads

VEIementwise

Classification

B. Functional

Classification

C. Behavioural

Classification

&

D. On the basis

of normality

E! On the basis of

controllability

i Indirect 1 .Factory overhead 1 .Fixed overhead 1 .Normal overheads 1. Controllable

Matterial 2.Administrative 2. Variable overhead 2. Abnormal overheads

1 Indirect Labour overheads 3. Semi-Variable overheads 2.Uncontrollable

]. Indirect 3. Selling overheads overheads overheads

\ erheads 4. Distribution

overheads

5. Rescrach and

Development

Expenses

Overheads can be classified into live groups; II. Elementwise classification;

127

II. Functional classification;

III. Behaviourwise classification; /. Elementwise Classification:

According to ICMA, London, this classification is applied more for factory

overheads than for classifying overheads in general. Here the overheads are

classified according to the nature and source of expenditure. These expenses are

broken up into.

(a) Indirect materials such as, stores used for maintenance of machinery and stores

used for service department

(b) Indirect labour such as maintenance workers, workers for handling materials,

supervisors, instructors.etc.

(c) Indirect expense such as rent, rates, insurance, manager's salary, canteen,

welfare expenses power, fuel etc.

11. Functional Classification:

Under this method, overheads are classified according to the major functional

division of an organisation. On the basis of major functions of an organisation,

overheads can be classified into four groups:

(a) Factory Overhead;

(b) Administrative Overheads;

(c) Selling Overheads;

(d) Distribution Overheads; and

(e) Research and Development Expenses.

Factory Overheads:

It is the indirect expenses of operating the manufacturing divisions of a concern. It

covers all indirect expenditure incurred from the receipt of the order till its

completion and despatch to the customers or to the warehouse. Examples cost of

small tools, power, wages for foreman, repairs b factory, factory rent, etc.

Administrative Overheads:

It is the indirect expenditure incurred in formulating policy, directing the

organision, operating the operations. They are expenses for policy formulation,

128

direction, control and administration. Examples-office rent, light, salaries of office

staff and directors, etc.

Selling Overhead:

It consists of those indirect costs which are associated with the marketing and

selling excluding distributing activities. Generally it covers the expenses required

for creating and stimulating demands, securing and retaining customers. In short,

they are expenses required for sales promotion and customers retention. Examples

are salesmen's salaries and commission, show-room expenses, advertisement,

packing expenses, etc.

Distribution Overhead.

It comprises all expenditure incurred in handling the products from the time they

are placed in the warehouse till they reach their destination. In other words, they are

the expenses incurred for the distribution division for the execution of orders.

Examples are house rent and warehouse staff salaries, delivery van expenses,

transport charges, etc.

Research and Development Expenses:

Research cost is the cost of searching for new and improved products, new

application of materials and new application of improved methods.

Development cost is the cost incurred for the implementation of the decision to

produce a new product or to introduce an improved method to manufacture a

product.

Behavioural Classification:

This classification of overhead is based on their tendency to vary with the

production or sales volume or activity level. Some expenses vary directly with the

rise or fall in output whereas some remain constant inspite of change in the level of

activity of the concern and there are some other items which are constant only upto

a certain level and then change their character to become variable or which vary

with the volume of output but vary less than proportionately.

In short, this classification is based on the reaction of the expenditure to the

changes in the volume oj output. Based on this behaviour of expenses, overhead

expenses may be classified into :

129

(i) Fixed overheads:

(ii) Variable overheads; and

(iii) Semi-fixed or Semi-variable overheads.

It is to be noted that this classification is not absolute but it is one of convenience

because all costs are variable in the long run. It is important fpr cost control and

decision-making.

Fixed Overheads Cost and Variable Overheads : Semi-fixed or Semi-variable

overhead :-

These are the expenses which contain both fixed and variable elements. They are

partly affected by the fluctuation in the level of activity. They are partly fixed and

partly variable. They remain fixed up to a certain level and beyond that they tend to

vary. Variable part of such cost is combined with i ariable overhead and the fixed

part with fixed overhead. Examples- telephone charges, salesmen's salary with fixed

salary plus commission beyond a certain level of sales, etc.

Q.4. Define the term 'Cost Allocation'and 'Cost Apportionment'and bring out

the distinction between the two with examples. [G. U. - 1998]

Or, Give the meaning of Apportionment of overheads. Cost Allocation:

G.U.2004]

'Cost allocation 'is the process of identification of overheads with cost centres. An

expenses which is directly identifiable with a specific cost centre is allocated to that

centre. Thus it means the i -signment, allotment or charging the whole item of a cost

to a department or to a contre or to a cost -nit. Similarly, the wages of the foreman

of the production department should be charged to that Traduction department.

Thus the term 'Cost allocation' means the allotment of the whole item without

division to a ^articular department or cost centre.

Cost Apportionment:

'Cost apportionment' is the allotment of proportions of overhead items to cost

centres or cost units. Thus it is the assignment or allotment of one portion of an

overhead expense to a department or cost centre. Examples are Rent and Rates

Depreciation. Repairs and Maintenance Lighting, Labour Welfare Expenses, etc.

130

Distinction between Cost Allocation and Cost Apportionment:

1. Cost allocation refers to charging of the whole item of an overhead to a particular

department or a cost centre, e.g. salary of the foreman of a production department to

be charged to that production department.

Cost apportionment refers to the charging of a share or a proportion of an item of

overhead to a department or a cost centre. Example- division of house rent between

production departments and service departments.

2. Cost allocation is done in case of those overheads which can be conveniently

identified with a department or cost centre. So they can be wholly allocated to that

department or cost centre. Cost apportionment is done in case of those overheads

which cannot be conveniently identified with any particular department or cost

centre and so cannot be charged wholly to any department or cost centre.

3. Cost allocation is a direct process while cost apportionment is an indirect process

which needs a suitable basis for division of the cost.

4. Overheads are first allocated if possible. If they cannot be allocated, then they are

apportioned.

5. Overheads which can be directly identified are charged to that department but

where the department has sub-divisions or the cost centre has sub-centres, such

allocated expenses are required to be apportioned further among those sub-division,

or sub-centres.

Q.5.What are the cardinal principles of apportionment of overheads? Explain

them with examples.

The Apportionment of overheads to various departments or cost centres involves

the selection of suitable base for apportionment. The selection of proper base is

made on certain criteria which are called the Principles of Overheads

Apportionment. Following are the useful principles:

Service use or Benefit Principle:

Under this principle, overhead costs should be apportioned among the various

departments or cost cenres according to the service or benefits received by each

department or cost centre from that overhead. However, the benefit should be such

131

as would be conveniently measurable. As for example, rent of a building can be

apportioned on the basis of area of the building occupied by each department.

2. A bility to Pay Principle:

Under this principle, overhead cost should be distributed on the basis of ability of

each department i.e. sales abi 1 ity or the amount of profit of each department. Thus

products making higher profits are to bear higher share of overhead expenses. This

method is inequitable as the efficient department are unduely burdened for the

benefit of inefficient departments. Example- general administratior expenses are

apportioned on this principle (on net sales basis).

3. Efficiency Principle:

Under this principle,' production targets are fixed for each department and the

overheads are apportioned among the various departments on the basis of targeted

production. If a departmen exceeds the target overhead cost per unit is reduced and

if a department fails to achieve the target overhead cost per unit is increased

showing inefficiency,'

Where service rendered by an overhead to various departments cannot be measured

exactly, the survey principle applies. Under this principle, an objective survey is

made of the various factois which have an effect on the incurring of an overhead in

different departments and on the basis of the results of the survey, the overhead

costs are apportioned among the departments.

As for example, a foreman serves two departments and on survey it is found that

70% of his time is engaged in one department and the balance 30% in the other

department. In this case 70% of his salary is apportioned to the former department

and 30% to the latter department.

Q.6. Discuss the various basis for apportionment of overheads to cost centres.

[GU.2000]

Overheads which are common to two or more departments or cost centres are

required to be apportioned among those departments on some equitable basis. The

bases should be practicable and economical and should ensure maximum possible

accuracy. Following are the bases:

132

1. Capital Value-

In this method, capital values of certain assets are used as the basis for the

apportionment of certain expenses. Examples-'rates, taxes, depreciation,

maintenance, insurance in respect of plant, machinery building, etc.

2. Floor area or cubic space:

This basis is adopted for the apportionment of certain expenses like lighting heating

rent, rates, taxes, maintenance of building air conditioning, etc. ,

3. Number of workers employed basis:

Under this method, the total number of workers working in each department is

taken as the basis for apportioning overhead expenses amongst the departments.

Where the expediture depends more on the number of employees than on wages

bill, the numbers of the employees working in different departments are taken as the

basis for apportioning such overhead expenses among the departments. Examples-

labour welfare and recreation expenses, medical expenses, labour time-keeping

expenses, etc.

4. Direct wages:

Overhead expenses which are linked up with the amount of direct wages are

apportioned on the basis of direct wages of each department or cost centre,

5. Direct labour hour basis:

Where manual labour is the most important factor of production, overheads are

apportioned among the various departments or cost centres in proportion to the total

number of labour hours worked in each department or cost centre. Examples

salaries of supervisors and administrative expenses.

6. Machine hour basis:

Where machines are the most dominant factor of production, expenses connected

with the working of machines are apportioned among the various departments or

cost centres on the basis of :otal number of machine hours worked in each

department or cost centre. Examples depreciation, -epairs and maintenance of

machines, consumable stores like oil, cotton waste, rags, lighting heating, power,

supervision charges, etc.

133

7. Value of materials passing through cost centres:

Expenses associated with materials are apportioned on the basis of value of

materials passing through each centre should be the basis for such apportionment.

Example-material handling expenses, store keeper's wages, etc.

8. Light points, number of watts, Kilowatt hours :

This basis is followed for the apportionment of lighting and power charges.

9. Technical Estimates:

The expense for which any conventional basis of apportionment is not suitable,

technical estimate basis is adopted for apportionment of such expenses and this

estimate is made by technical experts. Example- internal transport cost, works

manager's salary, technical director's fees, steam cost, etc.

Q.7. What is meant by absorption of overheads? Explain briefly the different

methods of absorption of overheads. [GU.200T]

Write a short note on overhead absorption [GU.2002]

Or, What is absortion of overheads? Explain the methods of absorption of

overheads. [GU.20041

Absorption means the distribution of the overhead expenses allotted to a

particular department over the units produced in that department. It means

charging each unit of production with its share of overhead expenses to ascertain

the total cost of each unit. The charge is made to each job in order to recover the

indirect cost and such charging of overhead to units of production is known as

absorption of overhead.

Overhead absorption is accompanied by absorption rates. Following are the

different rates of absorption:

Actual Overhead Rate:

This rate is obtained by dividing the actual quantum (quantity or value) by the total

number produced. Usually it is calculated monthly.

Actual Overhead Rate =

134

2. Pre-deterinined Overhead Rate :

Pre-determined rate is determined in advance of the actual production and is

computed by dividing the budgeted overhead for the accounting year by the

budgeted base for the period i.e.

Budgeted Overhead Expenses for the Period Pre determined Overhead Rate =-

Budgeted Base for the Period-

3. Blanket Overhead Rate or Single Rate:

When a single overhead rate is computed for the factory as a whole, it is known as

single or blanket overhead rate. It is calculated as under:

Overhead Cost for entire factory Blanket Rate - Total quantum of the base selected

4. Multiple Overhead Rate:

When different overhead rates are computed for each production department,

service department cost centre, each product or product line, each production factor;

they are known as multiple rates. It is calculated as under:

Overhead Cost allotated and apportoned to each cost centre Overhead Rate

=Corresponding Base-

5. Normal Overhead Rate:

Under this method, overhead rate is a predetermined rate calculated with a reference

to normal capacity. It is determined as under:

Normal Overhead

Normal Overhead Rate = Base at Normal Capacity

6. Supplementary Overhead Rates :

These rates are used to carry out adjustment between overhead absorbed and

overhead incurred. They are used in addition to some other rates. It is calculated as

follows:

Actual Overhead incurred-Absorbed Overhead Supplementary Overhead Rate =-

Base (hours or units)-

Q.8. What are the different methods of absorption of Factory Overheads?

Which of them is considered the best and why?

Chart Showing various methods of absorption of the factory Overheads.

135

A. Production unit Method

C Hourly Rate Method.

1. Direct Labour Hour Rate.

2. Machine Hour Rate.

B. Percentage Method.

1. Percentage on direct materials.

2. Percentage on direct wages.

3. Percentage on Prime Cost.

Various methods used for the absorption of factory overheads may be conveniently

grouped under three groups:

I. Production unit method,

II. Percentage methods:

(a) Percentage on direct materials cost

(b) Percentage on direct wages; and

(c) Percentage on Prime cost.

III. Hourly Rate methods:

(a) Direct labour hour rate and

(b) Machine hour rate. These methods are discussed below:

Production Unit Method.

It is an actual or pre-determined rate of overhead absorption. It is calculated by

dividing the total erhead cost by the number of units produced or expected to be

produced. This is also known as ost Unit Rate' method.

It is simple and direct and is usefull if there is only one product or if products can

be expressed in . :nmon measuring unit.

II (a) Percentage on Direct Material Cost:

Under th is method, a percentage of the factory overheads to the value of direct

materials consunied production is calculated in order to absorb factory overhead.

Amount of Fctory Overhead (Budgeted) Factory Overhead Rate =Expected Direct

Material Cost

136

Example:

Suppose anticipated direct material cost is Rs. 2,00,000 and budgeted

production/factory overheads are Rs. 50,000, then the factory overhead rate will be

25% That is 25% of material cost.

Suitability:

This method is suitable:

(i) Where output is uniform, i.e. where only one kind of article is produced;

(ii) Where the prices of materials are stable; and

(iii) Where the proportion of overhead to the material cost is significant. Merits:

(i) The method is simple and easy to operate;

(ii) It is suitable where prices of materials are fairly stable and materials used per

hour are constant.

Demerits:

(i) Overhead expenses tend to remain fairly stable but material prices are subject to

constant fluctuations and this leads to high or low charges in respect of overheads.

This vitiates the comparison of costs from period to period.

(ii) This method does not take time factor into account though most of the

overheads are related to time element. Thus a job using costly materials bears

higher proportion of overhead than the proportion of overheads borne by a cheaper

materials although both the jobs might take the same amount of time. This leads to

a distorted result.

(iii) Overheads attributable to jobs tend to vary in accordance with the time spent on

them rather than the value of materials used by them because overheads accrue on

time basis.

(iv) No distinction is drawn between the jobs done by skilled labourers and

unskilled labourers or by hand workers and by machine workers though the work

performed by unskilled workers and machine workers require less factory expenses

per unit.

137

(b) Percentage on Direct wages:

Under this method, a percentage of the factory overheads to the value of direct

wages incurred in the production is calculated in order to absorb the factory

overheads. Formula is given below:

Amount of Factory overhead (Budgeted) " Factory Overhead Rate =-Expected

Direct Labour Cost

Example:

Suppose the anticipated direct tabour cost is Rs. 1,00,000 and budgeted production

or factory overheads are Rs. 50,000, then the factory overhead rate will be

Suitability:

This method is suitable:

(i) Where direct labour constitutes a major proportion of the total cost of

production;

(ii) Where production is uniform;

(iii) Where skill of labour i.e. grades and sex composition do not differ widely;

(iv) Where wage rates do not fluctuate widely; and

(v) Where the ratio between skilled and unskilled labour remain constant.

Merits:

1. This method is simple to understand and easy to operate.

2. It gives automatic consideration to time factor as wages are directly related to

time. So it gives satisfactory results.

3. Labour rates are more stable than material prices.

4. Variable factory overhead costs are likely to vary with numbers of worker

employed. Hence the charge to production is related to the amount of wages paid. .

Demerits:

1. Where the work is done by both skilled and unskilled workers, this method is not

suitable because thejobs done by skilled workers will bear greater burden than the

burden borne by the unskilled workers.

2. Where piece rate system of wages payment is adopted, it is unsuitable because

time factor is ignored.

3. This method is not suitable where a large part of work is done by machines.

138

4. This method does not make any distinction between fixed and variable overheads

and the works done by machine workers and hand workers.

(c) Percentage on Prime Cost:

Under the method, a percentage of factory overheads to the value of prime cost

incurred in the Droduction is calculated in order to absorb the factory overheads.

Formula is given below:

Advantages:

This method is simple and easy to operate. Data required for the computation rs

easily available from the records.

3. It is good where standard articles are produced.

4. It takes into account both the direct material costs and the direct labour costs.

Disadvantages:

It does not give due consideration to the time factor where the cost of direct

material is predominant in the Prime Cost.

No distinction is made between thejobs done by the skilled workers and unskilled

workers, jobs done by machine workers and hand workers and between fixed

overheads and variable overheads.

II. Hourly Rate Methods: Direct Labour-hour Rate:

Under this method, factory overheads are absorbed on the basis of direct labout

hours worked The overhead rate is obtained by dividing the factory overheads by

the number of direct labour hours worked as shown below:

Budgeted Production / Factory Overheadnn Factory Overhead Rate =-Budgeted

Direct Labour Hours-x 100

Examples: If in a particular period, the budgeted production overhead expenses are

Rs, 1,00,000 and the direct labour hours are 2,00,000 hrs.

The factory overhead rate will be =

2,00,000 hours Suitability:

This method is suitable where:

(i) Labour constitutes the major factor of production

(ii) It is desired to consider the time factor;

139

(iii) Different grades of labour and different methods of wage payments are adopted

because it is based on tabour hours and not on labour wages.

Merits:

1 .It gives consideration to time factor. 2.It is not affected by the methods of wages

payment.

Demerits:

1. It does not consider other factors of production; so it may give distorted results;

e.g. absorption of material and machine handling expenses; shop up-keep expenses,

etc.

2. It is not suitable where machines are used in production predominantly;

3. Required data is not available where piece rate syatem is adopted.

(b) Machine Hour Rate:

It is the cost of running a machine per hour. It is the most scientific method of

overhead absorption where machines are predominantly used in production. ICMA

defines it as "An actual or predetermined rate of cost of apportionment of

overhead absorption, which is calculated by dividing the cost to be apportioned or

absorbed by the number of hours for which a machine or machines are operated

or expected to be operated. " Formula is:

Machine Hour Rate= Overhead to be absorbed Machine Hour Kate Machine

Hours

Merits:

1. It is a scientific method of overhead absorption.

2. It provides useful data for estimating quotation price.

3. It helps in knowing the existence and extent of idle time of machines.

4. It takes into account the time factor. Hence it gives accurate results.

5. It helps in computing the efficiency and cost of operating different machines.

6. It helps the management in choosing between labour and machine.

Demerits:

1. It is not suitable where manual labour is pre-dominant in production.

140

2. It involves the maintenance of additional records for noting the number of

machine hours operated.

3. It is difficult to estimate the rate where production programmed is not available

in advance.

4. It dose not consider the expenses not related to the operation of machines.

Among all the methods machine hour rate is most suitable where production is

made predominantly by the use of machines because it is scientific and gives

consideration to time factor. However, the Labour Hour Rate is suitable where

labour is pre-dominant in production process.

Q.9. What are the different methods of accounting, absorption and control of

administrative or of office Overheads? [G. U.2000]

Or, Explain the various techniques you would follow to control administrative

overhead [GU.2004, GU.2005]

There are three methods of accounting for administration overhead: LBy

apportionment to manufacturing and selling and distribution divisions;

II. By transfer to Costing Profit and Loss Account; or,

III. By addition as a separate item of cost.

1 .Apportionment to Manufacturing and Selling and Distribution Divisions: Under

this method an organisation has two basic functions:

(a) Manufacturing function and

(b) Selling and distribution function.

Administration expenses are incurred for manufacturing and selling and distribution

functions. So they are to be charged partly to manufacturing and partly to selling

and distribution functions on some realistic basis and the administration overheads

are thus merged to manufacturing and selling ind distribution overheads.

ccounting treatment: i When expenses are incurred:

Administration Overhead Control A/c Dr.

To General Ledger Adjustment A/c When expenses are distributed: Works

Overhead Control A/c Dr.

Selling and Distribution Overhead Control A/c Dr.

141

To Administration Overhead Control A/c Expenses are divided on some suitable

basis which should be rational and equitable.

efferent basis of apportionment are-

(a) Floor area;

(b) Capital value;

(c) Number of employees;

(d) Number of items handled;

(e) Number of letters typed and despatched; etc.

advantages.

Manufacturing and selling and distribution functions are the basic functions while

administrative function is auxiliary to these basic functions. Therefore, these

overheads are to be merged with the manufacturing overheads and the selling and

distribution overheads.

2. Manufacturing and selling and distribution expenses are subject to better control.

So merging administration expenses with other overheads facilitates control.

Disadvantages:

I. Distribution of administrative overheads to manufacturing and selling and

distribution departme: is difficult because equitable bases are sometimes not

available.

2. Administrative function is an important function and not an auxiliary function.

So such distribut i among other departments is not logical.

3. Merging of administrative overheads with other overheads may not help in the

control of sue expenses

Transfer to Costing Profit and Loss Account:

Underthis method, administrative division is considered as an independent division

and not ar auxiliary division. Administrative overheads are not directly related to

manufacturing and sale> activities of a concern. They are mainly fixed and based

on time and are not affected by units produced or sold. So it is better to transfer

such expenses direct to the Costing Profit and Loss Account.

Accounting Treatment is shown below:

1. When expenses are incurred:

142

Administrative Overhead Control A/c Dr.

To General Ledger Adjustment A/c

2. When expenses are transferred:

Costing Profit and Loss A/c Dr.

To Administrative Overhead Control A/c

Merits:

1. Underthis method, administration function is treated as an independent function

and overhead expenses of this department have no direct relationship with other

overheads. So their transfer to Costing Profit and Loss Account isjustified.

2. Merging of Administration Overhead with Production and Selling and

Distribution Overheads cannot be done equitably because the basis of division is

arbitrary. So it is better to transfer them into Costing Profit and Loss Account.

Demerits:

1. Exclusion of administration cost from total cost understates the cost of

production.

2. It is an important function of a concern; so its expenses should constitute a

component of cost of production.

Addition as a Separate Item of Cost:

In this method, administrative function is considered as a distinct function and its

overheads should be borne by the products or jobs sold. So under this method,

administrative overheads are added as a separate item of cost to the number of units

sold. Stock of finished goods,and work-in-progress should not bear the burden of

administrative overheads. Such overheads are classified and collected under

suitable cost accounting numbers. Various

departments are identified as cost centres and expenses are allocated to these cost

centres wherever possible and other overheads are apportioned to these cost centres

on some suitable basis. Rate of absorption is calculated on the basis of:

I. Factory costs;

II. Factory overheads;

III. Sales value:

IV. Units sold; and

143

V. Units purchased VI.Gross Profit on Sales; VII. Conversion Cost.

Control of Administrative Overheads:

Administrative overheads are mostly fixed in nature. They are incurred on account

of general administration policy of an Organisation. Thus they are non-controllable

by the lower level of management. However, the top management can exercise any

one of the following techniques for theircontrol:

I. Control through Classification and Analysis:

II. Control through Budgets and

III. Control through Standards.

Control through Classification and Analysis:

Overheads incurred against each type of function are collected for each department

and is compared periodically with the corresponding expenditure of the previous

year. It helps in formulating a policy for control of expenditure. So comparison and

analysis of expenditure is a technique of control.

Control through Budgets:

Budgets are fixed for each item of overheads for each administrative department

and actuals are compared with the budgeted amount. Responsibility can be fixed for

the variance, if any and -emedial measures can be taken.

Control through Standards:

Standard Costs may be set for each item of administrative overhead and actual can

be coippared ith the standard overlicads. Thus efficiency of each department can be

ascertained.

Q.10. Define 'Selling Overheads' and 'Distribution Overheads.' Give four

examples of each. Distinguish between selling and distribution expenses.

Discuss how you would exercise control over selling and distribution

overheads. [G U. 1998]

ICMA has used marketing cost as a broader concept to include three components,

viz; selling, : ablicity and distribution costs.

Marketing cost is the cost incurred in publicising and presenting to customers the

products of an dertaking in a suitably attractive forms based on relevant research

144

work, securing of orders and - E i ivery of the goods to customers. In certain cases,

after sales service and order processing may also - included.

I ling Overheads:

ICMA defines Selling Overheads as "That portion of the marketing cost which may

be incurred securing orders." It includes all costs incurred in selling products to

existing customers, in retaining customers and in promoting sales to potential

customers. It has three components:

(i) Direct Selling Expenses:

These expenses are incurred in securing customers, market research and retaining

customers Examples- Salary to sales manager and salesmen, showroom expenses,

Sales Department expenses, after sales service cost, meeting expenses, expenses for

quotations, etc.

(ii) Sales Promotion Expenses (Costs):

These expenses are incurred for creating demand for the products of a company.

Examples Advertisement expenses, distribution of samples and free gifts, exhibition

expenses, etc.

(iii) Financial Expenses (cost):

These expenses include actual or notional interest on working capital, credit

collection expenses, legal expenses, bad debts etc.

Distribution Cost:

ICMA defines it as that portion of the marketing cost which are incurred in

warehousing saleable products and in delivering goods to the customers. It

includes transportation cost. . warehousing cost, packing and cost of containers.

Examples- Freight, delivery van expenses, depreciation of delivery van, carriage

outward; etc.

Godown rent, lighting, heating, insurance, wages of godown-keeper, etc.

Cost of packing materials, cost of tools used in packing, etc. Distinction between

Selling and Distribution Expenses:

145

1. Selling overheads are incurred for promoting sales whereas distribution

overheads are incurred in moving the finished goods from the godown of the

factory to the customer's place.

2. The object of selling overhead is to create demand and retain the customers

whereas the object of distribution overhead is to deliver the goods safely to the

required place.

3. Selling overheads are mostly fixed whereas distribution overheads are mostly

variable in nature.

Control ofSellittg and Distribution Overheads (Costs):

There are three methods of controlling selling and distribution overheads. They are:

I. Analysis of expenses and Comparison with past performances.

II. Budgetary Control; and

III. Standard Costs.

I. Analysis of Expenses and Comparison with Past performance:

Under, this method, selling and distribution overheads are analysed on the basis of

nature, product territory, etc, and each item is compared with the corresponding

item of the previous year. Alternatively, overheads can be expressed as a percentage

of sales and compared with similar percentage of the previous year.

II. Budgetary Control:

Under this method, a sales forecast is made and on this basis a Sales Budget is

prepared. Selling and distribution overheads budget is prepared on the basis of Sales

Budget. The overheads are classified into fixed, semi fixed and variable for the

preparation of such budgets. Actual overheads are compared with the budgeted

overheads and differences are ascertained to take remedial measures where

necessary.

III. Standard Costs:

Standard Costs are set for overheads and actuals are compared with such standards

to ascertain the variance. If there is any adverse variance, it is reported to the top

management for taking remedial measures.

Q.ll. What are the different methods of absorption of selling and distribution

overheads.

146

Absorption of selling and distribution overheads is done in any of the following

three methods;

I. Estimated rate per unit or article;

II.A percentage on sales value or selling price; and

III. A percentage on factory cost.

i. Estimated Rate Per Unit or Article:

Underthis method, an estimated selling and distribution overhead rate per unit or

article is determined for each sales territory by dividing the total selling and

distribution overheads by total number of units or articles to be sold in that territory.

Fixed selling and distribution overheads will be charged to each unit or article at

that absorption rate. It is suitable if one article or uniform articles are sold in that

territory.

II. Percentage on Sales Value or Selling Price:

Under this method, a percentage of selling and distribution overheads to the

estimated sales value is calculated in order to absorb selling and distribution

overheads. Selling and distribution overheads are charged to each unit or article

sold at that territory in that percentage rate of absorption.

This method is suitable where more than one product are sold in that territory and

the selling price is stable.

III. Percentage on Factory Cost:

Under this method, a percentage of selling and distribution overheads to the

estimated factory cost of a territory is ascertained to absorb the overheads. Selling

and distribution overheads are charged to each unit or article sold in that territory at

that percentage rate of absorption.

This method is adopted as it is easy to operate though there is no relation between

selling and distribution overheads and factory cost. However, it is subject to

criticism because factory cost may ary without any change in the selling and

distribution costs.

Q. 12. What do you mean by over-absorption and under-absorption of

overheads? Give examples.

Give the accounting treatment of them. [GU.2000]

147

Or, Explain brifly the implications of over absorption of overhead in costing.

[GU.2005]

Absorptionof overheads means charging the overheads to cost units for the purpose

of their vecovery from production. Overheads may be absorbed in the costs either at

the actual overhead absorption rate or at the pre-absorption overhead rate.

When the actual rates are used, overheads are fully absorbed in the costs and there

will be no :ifference between the overhead actually incurred and the overhead

actually absorbed. However, hen predetermined rates are used, the overheads

absorbed may not be equal to the overhead actually c urred. This may give rise to

under or over-absorption of overheads. Over absorption = Actual expenses

expenses absored Under Absorption = Actual expenses> expenses absored Under

or over absorption of overheads is defined by I.C.M.A as " The difference between

the 'tint of overhead absorbed and amount of overhead incurred".

Under-absorption:

When the overheads absorbed by the finished products are less than the actual

overheads incurred, it is known as under-absorption of overheads. As for example,

the predetermined rate of overhead absorption is Re. 1 and the estimated production

is fixed at 10,000 units in a period. If 9,00( units are produced in that period and

actual overhead is Rs. 9,500. The amount of overhead chargec to production @ Re.l

on 9,000 units will be 9000 x Re.l or Rs. 9.000. Therefor, there will be a difference

of Rs. 500 (Actual Rs. 9,500-Absorbed -Rs.9,000) which is unabsorbed overhead. It

is a case of under absorption. Over-absorption:

When the overheads absorbed by the finished products at a predetermined rate are

more than the actual overheads incurred, it is known as over-absorption of

overheads and the difference between the two is over-absorbed overheads.

Example-In the above case if the production during the period is 10,000 units, in

that case the amount absorbed at the predetermined rate of Re.l will be Rs. 10,000

(10,000 x Re.l) while the actual overhead is Rs. 9,500. Thus the difference between

the two is Rs. 500 (Absorbed Rs. 10,000 Actual Rs.9,500) which is over-absorbed

overhead.

Reasons of under or over-absortion of overheads:

148

Following are the reasons of such under or over-absorption of overheads:

(i) Wrong estimation of factory overheads;

(ii) Change in the method of production;

(iii) Change in the production capacity unexpectedly;

(iv) Change in production volume;

(v) Seasonal change in production and

(vi) Under absorption because of under utilization of the available capacity.

Accounting Treatment of under or over-absorption:

Accounting treatment of under or over absorption depends upon the extent of such

under or over-absorption and the circumstances under which it arises.

Following are the three methods of under or over-absorption of overheads:

I. Use of supplementary rates;

II. Writing off to Costing Profit and Loss Account; and

III. Carry over to the next year's Overhead Account.

I. Use of supplimentary Overhead Rate:

Supplimentary Overhead Rate is a rate which is obtained by dividing the amount of

under or over-absorbed overhead by the total base selected. There are two

supplementary rates i.e. positive and negative supplementary rates. In case of under

- absorption, overhead is adjusted by adding it back through a positive

supplimentary rate. In case of over-absorption, the over-absorbed overhead is

deducted through a negative supplitnentary rate.

This method is used when the under or over absorbed overhead is a considerable

amount. It may also be used if the management likes to maintain actual historical

costs for future comparison. It is useful to determine actual cost of production. The

amount of under or over absorbed overheads is adjusted in work-in progress,

finished stock and cost of sales at the end of an accounting year in proportion to

direct labour hours or machine hours, etc.

II. Writing off to Costing profit and Loss Account:

According to this method, the amount of under or over-absorbed overhead is

transferred to the Costing Profit and Loss Account at the end of the accounting year.

149

This method is adopted where the amount of under or over absorbed overheads is

small. Again under-absorption due to idle facilities is also written off to Costing

Profit and Loss Account. But if it is due to abnormal causes such as strike, lock-

outs, etc, it should not be transferred to the Costing Profit and Loss Account; rather

it should be carried forward to the next accounting year.

The demerit of this method is that it distorts the cost of production affecting the

valuation of stock and profit of the year.

III. Carrying Forward to the Next year's Overheads Account:

Under this method, under or over-absorbed of overheids of one year is carried

forward to the ext year in order to determine the overhead absorption rate of the

next year. It is done by transferring le amount to a Suspense or Overhead Reserve

Account. It is justified if the business cycle is more an one year and in new business

where the initial production is low. It is criticised on the ground that . erheads

incurred in one year should, absorbed in that year and should not affect the cost of

production * another year.

Q.13. What is machine hour rate? How is it calculated?

Machine hour rate is the cost of running a machine per hour. This method of

absorption of . erheads is used in industries where the use of machines is

predominant in production and where erheads primarily consist of indirect expenses

in running and operating machines.

Machine Hour Rate is obtained by dividing the total running expenses of a machine

incurred i aring a particular period by the number of hours the machine is estimated

to work during that period. - allowing are the steps involved in calculating a

machine hour rate 1.To allocate and apportion the factory overheads to all the

production departments. To charge the departmental overheads to a machine or a

group of machines. Those overheads which can be allocated directly to the machine

or machines such as. depreciation, power, maintenance are to be charged specially

to the machine. Where a comprehensive machine hour rate is desired, direct wages

and other expenses for operating the machine are also included. Expenses are

classified into fixed and variable.

150

Fixed charges are estimated for every machine and the total fixed chares are divided

by the number of hours the machine runs to determine the standing charges per

hour. • Each variable expenses is divided by the number of running hours in order

to determine the expense per hour.

The total of fixed expenses per hour and the amount of each variable expense per

hour will give the Machine Hour Rate. Sometimes, a supplementary rate is used

when the charge for all other overheads costs is not luded in the machine hour rate.

X. Necessary adjustment is made to the total number of machine hours by

deducting cleaning warming and setting up time in order to determine the effective

machine hours worked.

Q.14. State the basis of apportionment of the following service department

expenses:

(a) Maintenance Department Expenses;

(b) Hospital Expenses;

(c) Personnel Department Expenses;

(d) Canteen Services;

(e) Stores Department Expenses;

(f) Transport Department Cost;

(g) Power House Expenses. IGU. 19881

Expenses Basis of Apportionment

(a) Maintenance Department Value and number of machines or machine hours

(b) Hospital Expenses Number of beds in each departments and according

to number of out patients

(c) Personal Department Number of employees in each department.

(d) Canteen Services Number of employees in each department or wages

in each department.

(e) Stores Department

expenses

Weight of materials or number ol material

requisitions.

(f) Transport Department Cost According to weight or volume of materials

handled.

151

(g) Power House Expenses Kilowat hours.

Q.15. What are the advantages of departmentalisation of Overhead expenses

(GU. 2005)

Ans: Departmentalisition of overhead expenses refers to the apportionment

overheads between production and service departments and the allocation of all

service departments overheads to the production department.

ADVANTAGES

1. Greater Accuracy in Cost Ascertainment: Departmentalisation of overhead

expenses ensures greater accuracy in ascertaining the cost of each job or product.

The services rendered b\ the various service cost centres in a concern are different

and the nature of production in each producing centre is also not uniform. Some

products may require more hand labour while some others may be , fabricated with

the help of specialised machines of considerable value. Therefore, for proper

allocation and apportionment of overheads, departmentalisation of overheads is

very useful. Further for accurate costing of each function or operation overhead

absorption rates should be determined seperately for each Cost Centre. This is

possible only with the help of departmentalusation.

2. Control over costs: Departmentalisation serves the purpose of control over

overhead costs Effective control may be exercised by comparing the departmental

costs with budget or past figures and taking necessary action for deviation.

3. Work-in-Progress: If overhead is not departmentalised the cost of work-in-

progress ma\ not be correctly worked out. It is necessary that the work-in progress

should be charged with the overheads of only those depairtments through which it

has passed and not the overheads of the entire concern.

4. Estimating and forecasting: Departmentalisation of overheads ensures proper

estmating and forecasting. This is because of greater accuracy in cost ascertainment

and cost control. The impact of management decisions on costs can be studied and

forecasting may prove accurate.

5. Responsibility Accounting: With the help of departmentalisation responsibility

accounting can be effectively introduced for control purposes. Personal budgets can

152

be formed for each departmental incharge and responsibility can be fixed to achieve

the target.

Q.16. Examine the propriety of including 'Inerest on Capital' as an element of

cost.

(or) What are the arguments for and those against for inclusion of interest on

capital in cost Accounts.

(or) Mention the treatment in costing of interest on capital. (GU. 2005)

Interest is the reward for capital, it may or may not be actually paid for capital

employed. A question frequently arises as to whether interst on capital should be

included as a charge in costs or it should be excluded from costs and treated as an

item of appropriation of profit. Economists and business men argue in favour of its

inclusion in cost while accountants argue against its inclusion in costs.

ARGUMENTS FOR INCLUSION

1. Profits will be overstated if interest is not included in cost.

2. Interest is paid on the borrowed capital and is included in accounts; therefore,

interest on owned capital should also be included in costs on the same ground.

3. Wages are the reward of labour and interest is a reward for capital. Since we

include wages in costs, so should interest be included.

4. In case of replacement of labour by machinery, a true comparison of the costs of

old and new methods cannot be made unless the interest is included in costs.

5. While comparing different jobs requiring different amount of capital or requiring

different periods of completion, it is essential to take interest element into

consideration.

6. If interst element is ignored, then the true cost of maintaining heavy stock of

materials and finished stock cannot be properly estimated.

ARGUMENTS AGAINST INCLUSION.

1. It is difficult to determine the amount of capital employed as well as a fair rate of

interest to be charged.

2. Interest being a matter of pure finance, should be treated as an appropriation of

profis and hence should be excluded from costs.

153

3. Interest being a reward for capital, is an economic concept and should be

excluded from cost accounts.

4. Comparison can be made by including interest on capital but without introducing

it into cost accounts. Inclusion of interest in cost accounts creates unnecessary

complication.

5. If interest is included, it will inflate the value of work-in-progress and finished

stock in hand which will imply an anticipation of income to that extent.

Therefore, it may be concluded that theoretically speaking, in priciple inclusion of

interest is und but on the ground of expedeincy and practical difficulties, it should

be excluded from cost accounts.

I. Objective Type Questions :

1". State whether the following statements are true or false:

1. Fixed overhead cost per unit remains fixed when output level changes. (False).

2. Re-apportionment of service department's costs is known as secondary

distribution of overhead. (True)

3. Overhead are also known as indirect expenses. (False)

4. Increased mechanisation results in greater amount of fixed costs. (True)

5. When under or over-absorbed overhead is a significant amount. It should be

transferred to Costing Profit and Loss Account. (False)

6. Apportionment of overhead on reciprocal basis is known as step ladder method.

(False)

7. Overhead absorption rates should be calculated on the basis of maximum

capacity. (False)

8. Basis of apportionment of depreciation of plants is values of plants in each

departments. (True)

9. When building is owned, rental value of the building should be included in cost.

(False)

10. Cost of after sales services is a part of selling and distribution overhead. (True)

154

11. Direct labour hour rate of absorption of overhead is suitable where most of the

production is done by using machine. (False)

12. The time factor is ignored when the cost of material is used as the basis for

absorption of overhead. (True)

13. Predetermined rate of absorption of overhead helps in quick preparation of

estimates and quoting price. (True)

14. Machine hour rate method pf absorption should be used in only those cost

centres in which work is dominantly done by machines. (True)

15. Allocation and apportionment of overheads to production and service

departments is known as Departmentalization. (True)

16. Overhead is the same as indirect cost. (True)

17. Overhead comprises indirect materials, indirect labour and chargeable expenses.

Ans: False. r8. Direct materials may also be treated as an item of overhead if

tracing them to cost unit is difficult. (True)

19. Production overhead is the same as manufacturing overhead. (True)

20. Variable overheads vary with time rather than volume. (False)

21. Variable cost per unit remains constant regardless of the volume of output.

(True)

22. As more and more .units are produced-within the installed capacity. Fixed cost

per unit goes on increasing. (False)

23. Fixed cost is not affected by the volume of output. (True)

24. Allocation and apportionment convey the same meaning. (False)

25. Assignment of items of overhead to departments by allocation and

apportionment is known as departmentalisation of overhead '.(True)

26. Departmentalisation facilitates cost control. (True)

27. Allotment of overhead to both production and service departments by allocation

and apportionment is known as primary distribution. (True)

28. Primary distribution is effected on the basis of service rendered by production

departments to service departments. (False)

29. Re- distribution of service department's costs to production departments is

known as secondary distribution. (True)

155

30. Step method is the process of distribution of service department costs amongst

the service departments on a reciprocal basis. (False)

31. Simultaneous equations method facilitates ascertainment of cost of each of the

two service departments on the basis of reciprocal services rendered. (True)

32 Allotment of overhead to cost units is known as 'absorption'. (True)

33. Overhead absorption is also called 'recovery' or 'application' of overhead. (True)

34. Blanket rate is a single rate of absorption computed for the entire factory.

(True)

35. Blanket rate is best suited to a factory having a number of production

departments. (False)

36. Adoption of multiple absorption rates ensures a greater degree of accuracy.

(True)

37. Adoption of pre-determined rates of recovery results in under or over absorption

of overheads. (True)

38. When the actual overheads are more than the absorbed overheads, the difference

is known as 'over- absorption'. (False)

39 Material cost percentage method of absorption is best suited to a concern

producing only one type of article and material prices do not fluctuate quite often.

(True)

40 Wages cost percentage method of absorption does not distinguish between a job

done by manual labour and that by a machine. (True)

41 Labour hour rate of absorption is most suited to a department in which work is

done by manual method. (True)

42 Machine hour rate method of absorption is computed on the basis of number of

hours a machine works during the accounting period. (True)

43 If the amount of under or over absorption is insignificant, the same may be

ignored, (False)

44 Under absorption of overhead results in under statement of cost. (True)

45. Computation of a supplementary rate becomes necessary when under absorption

is due to bad planning. (True)

156

46. Carrying forward amount of under or over absorbed overhead to next year is

opposed to accounting principles. (True)

47 Idle time and idle facility mean the same. (False)

48. Practical capacity is the same as normal capacity. (False)

49. Idle capacity is the difference between capacity based on sales expectancy and

practical capacity. (True)

50. Capacity considerations influence the computation of overhead absorption rates.

(True)

51. When direct wages of machine operators are included in machine hour rate , is

known as comprehensive machine hour rate. (True)

fill in the blanks in the following sentences with the appropriate word or

words.

Overhead is the-of indirect material and indirect wages and indirect expenses.

2. Allocation is the-of whole items of overhead to cost units or cost centres,

(allotment)

3. Apportionment is the-of items of cost to cost centre or sot units. (allotment

ofproportion)

4. Under/Over absorption of overhead arises only when overhead absorption is

based on (Predetermined rates)

5. Selling overhead is the cost of seeking to create and stimulate-. (demand)

6. Under absorption of overhead due to faulty management should be charged to

(CostingP&L A/o)

7. Under overhead absorption is minimum when overhead rate is based on-.

8. In comprehensive machine hour rate. Wages of machine operator are -

9. Factory rent should be apportioned to various departments on basis of - (normal

capacity) (included) (area occupied)

10. When actual overheads are less than absorbed overheads, the difference

between the two is called-. (over- absorption)

11. Machine hour rate of absorption of overhead is suitable where most of the

production is done by-. (using machine)

12. The total of all indirect cost is termed as-. (overhead)

157

13. Allocation and apportionment of overheads to production and service

departments is known as (primary distribution)

14. When costs of service departments charged to production departments is known

as secondan (distribution)

15. Apportionment of overhead expenses to the cost centres and cost units is known

as absorption (of overhead)

16. When a serv ice department renders services to other service departments but

does not receive services of the other services departments, then method is applied,

(step ladder)

17. Overhead is also called-. (indirect cost)

18. On the basis of behavior, overhead is classified as-. (fixed and variable)

19. Variable overheads are so called because they vary-. (with volume)

20. Fixed overheads remain the same in total for any level of output within the-

(installed capacity)

21. Allocation and apportionment of overhead to production and service

departments is known as -. (departmentalization)..

22. Assignment of whole item of cost to a single cost unit or cost centre is known

as-

(allocation).

23. Spreading over costs or revenue over two or more cost units or cost centres is

known as (apportionment)

24. Re-apportionment of service department costs to production departments is

known as condary (distribution)

ed capacity i s is known as is- (allocation)

xiown as is known a

Allotment of overhead to cost unit is known as - . (absorption)

A single rate of overhead absorption for the entire factory is known as-. (blanket

rate)

A number of separate rates of overhead for each department is known as-rate .

28. The (multiple ) overhead incurred and overhead absorbed is known as under

or over absorbed overhead, (difference between)

158

The problem of over or under absorption of overhead arises only when overhead is

recovered by adopting the-. (predetermined rate).

One of the main reasons giving rise to under or over absorption of overhead is-of

overhead, (wrong estimation)

When work is accomplished mostly by machines,-is the most appropriate method of

absorption, (machine hour rate)

The amount of under or over absorbed overhead may be — rate based on normal

capacity, (rninimizedby)

The difference between practical capacity and actual capacity based on sales

expectancy is known as-. (idle capacity)

Supplementary rate becomes necessary when the amount of under or over

absorption is -. (significant)

Over absorption has the effect of over-cost of a product.(stating)

Choose the correct alternative Overhead is included

(a) in prime cost

(b) in total cost

(c) in costing profit and loss account. Ans. (b) An overhead expense relating to

more than one cost centre is

(a) allocated (b)apportioned

(c) taken to the costing profit and loss account. Ans. (b)

Machine hour rate method of absorplion is applied where

(a) the use of machine is predominan

(b) the use of labour is predominan

(c) the use of material is predominant Ans. (a) Selling and distribution expenses

are

(a) variable .

(b) fixed

(c) semi variable Ans. (c) Fixed overhead varies in different levels

(a) per unit

159

(b) in total

(c) in both per unit and total. Ans (a)

160

Unit - III

STANDARD COSTING AND VARIANCE ANALYSIS

Part I: Theoretical Questions

Q.l. What is meant by Standard Costing.? (G.U.1988,1992, 2001]

or, Define and Explain Standard Costing. (GU.1996]

or, Write Short note on Standard Costing. [GU. 2003, 2006]

ICMA, London, defines Standard Costing «s "The preparation and the use

ofstandared costs, their comparison with actual costs and analysis of variances to

their causes and points of incidence."

Thus when standard costs are used, the technique is known as Standard Costing.

Standard costs have been defined by Lucey as "A pre-determined calculation of

how much cost should be under specified working conditions.".

According to Brown and Howard, Standard Costing is "A technique of cost

accounting which compares the standard cost of each product and service with

the actual cost to determine the efficiency of the operation so that any remedial

action can be taken immediately." Thus standard costing involves the following

steps:

1. The setting up of standard costs for different elements of costs i.e. material,

labour and overheads.

2. Ascertaining of actual costs.

3. Comparing the standards with actual costs to determine the differences known as

variances.

4. Analysing variances for ascertaining the reasons for differences.

5. Reporting of these variances and analysis thereof to management for appropriate

action where necessary.

Q.2. What are the advantages of Standard Costing? [G.U.1988,1992]

or, Discuss the advantages of Standard Costing from the management points of

view. [GU.2001]

Following are the various advantages of standard costing:

I. Effective Cost Control

161

Standards set act as yardsticks against which actuals are compared. Thus it

facilitates effective cost control and provides information for cost reduction.

2. Helping in formulating Policies and Planning

It provides a valuable guidance to the management in their function of formulating

policies, in determing pricing and planning.

3. Provides Incentives: .

Standards provide incentives and motivate workers to work with greater efforts for

appropriate rewards.

4. Determination of causes for inefficiency

Measurement and analysis of variances help in detecting mistakes and

inefficiencies. It enables the management to investigate their causes.

5. Delegation ofAutharity:

It delegates authority and establishes responsibility of each executive for his

performance.

6. Facilitates Co-ordination

It enforces co-ordination between different departments by establishing standards

for the performance of each department.

7. Cost Consciousness: It infuses the cost consciousness among the labour force

and thus productivity is improved.

8. Valuation of Closing Stock : It simplifies the valuation of closing stock because

it is valued at standar»d'cost.

9. Standardising of Business Activities : It sets standards for various business

activities. Thus it enables the use of standard materials,

standard methods of production,etc.

W. Management by exception :

Reporting of variances is based on the principle of Management by Exception. Only

variances beyond a pre-detcrmined limit may be considered by the management for

corrective action.

ii. Prompt preparation of Profit and Loss Account:

This will help the management for prompt preparation Profit and Loss Account for

a short periodl

162

Q.3. Define Standard and Standard cost

Standard: The term standard may be used to refer to the pre-deterniined rate or

any pre-determined amount against which performance is judged. As for

example, for an outpi of 1000 units, standard material cost is Rs. 5,000. Therefore,

the standard rate per unit is Rs. 5. Pre-determined rate is fixed on the basis of past

experience, study and analysis of prevaili conditions and expected future changes.

Standard Cost: Standard cost is a preditermined cost which determines in advance

what ea product or service should cost under given circumstances. It is determined

on the basis of techni estimate of for materials, labour and overheads for a selected

period of time and for a prescribed set of working conditions.

CIMA Loandon defines standard cost as "a pre determined cost which is

calculated from management standard of efficient operations and the relevant

necessary expenditure.

Brown and Howard defined the standard cost as "Pre-determined cost which ea

product or service should incur under given circumstances. "

Thus it is a pre-determined calculation of how much should be costs of a product or

a servei under specified working conditions.

mvolves the assessment of the value of cost elements such as material, labour,

overheads, etc.

Q.4. What are the purposes or objects of Standard Costing? [GU.1992J

Standard costing has the following purposes/objects:

Promoting and Measuring efficiencies by using standards as yardsticks against

actual performances.

Controlling and reducing costs by comparing actuals with standards and taking

actions against the persons responsible for variances.

Simplifying the costing procedure as cost of a product or service is calculated on

the basis of standards.

Valuing inventories on the basis of standards.

Fixing selling price and quotations on the basis of standards.

163

5. What are the limitations of Standard Costing ?

Following are the limitations of standards costing: It is difficult to establish

standards in practice.

Standards require constant revisions in view of changing costs. Revision involves

cost and creates problems.

Inaccurate and unreliable standards cause misleading results.

Installation of standard costing is a costly affair.

It is expensive and unsuitable in job-order industries, manufacturing non-standard

products. It is unsuitable for service industries.

Q. 6. Indicate the industries where Standard Costing system is suitably

applied.

[GU.1988,1992)

Application of Standard Costing Standard Costing can be applied in all industries

but it is more useful in those industries *hich produce standardised products and

which are repetitive in nature. Examples of such industries are:

Cement. Textile. Fertilisers, Sugar, Steel, etc.

In job-order industries, it is not worth while to develop and employ a full system of

standard costing because each job undertaken may be different from another and

setting standards for each ob may prove to be difficult and expensive.

Q.7. Explain the factors considered in establishment of Standard Costs. [GU.

2000]

For establishment of a standafd costing system, the following steps are necessary:

I. Establishment of cost centre;

II. Classification of accounts;

III. Types of standards

IV. Organisation for standard costing; and Setting up of standards.

V. Establishment of Cost Centre:

A cost centre is a location or a person or an item of equipment for which cost may

be ascertained and which may be used for the purpose of cost control.

164

II. Classification afAccounts:

Costs are required to be classified under a suitable accounting heading. It facilitates

quick identification and collection of expenses, their analysis and prompt reporting.

A code number is given for each class of cost.

III. Types of Standards :

There are three types of standards; viz, Current standard, Basic standard and

Normal standard

(a) Current Standard:

Current standard is a standard which is related to current conditions. It is

established to use it over a short period of time. It may be fixed on the basis of (i)

ideal standard or

(ii)| expected standard.

(i) Ideal Standard:

It is a standard which can be used in most favourable conditions, e.g: a standard

degree c high efficiency. It is not likely to be achieved because appropriate

conditions may :not prevail. It a target which is normally aimed at to be achieved.

(ii) Expected Standard:

This is the standard which is expected during a future specified budget period. It

is fixec taking into consideration of the present conditions and circumstances

prevailing within a particular industry after giving due concessions for human error

and changes in situations. It is realistic a attainable and is used for fixing efficiency

standard.

(b) Basic Standard:

It is a standard which is established to use for a long period unaltered. It is

revised o: when there are changes in the specification of materials and technology.

It is a tool for contro costs and framing forward plannings. It helps in the study of

trend of variances over a long pen

(c) Normal Standard:

165

It is the average standard covering one trade cycle. It is based on the basis of

average estima.; I performance over a future period of time. It is attainable only in

anticipated normal condition-conditions are changed, it is unattainable. IV.

Organisation for Standard Costing:

The success of standard costing depends upon the setting up of proper standards.

The standa: i are set by a committee consisting of

(i) Production manager;

(ii) Purchase manager;

(iii) Sales manager;

(iv) Personnel manager; and

(v) Cost accountant.

They review and revise the standards in view of the changing situations.

Setting up of standards:

The standards for direct material, direct wages, and overheads are fixed after

detailed :scussion.

Direct Material:

Standard direct material cost for each product should be established. This will

involve the following: i) determination of standard quantity of material i)

determination of standard price per unit of material.

The standard price of each material will be fixed by the cost accountant after

consulting with .* e purchase manager. Rates of materials are fixed after

considering the following: i) Prices of materials in stock; i) Materials already

contracted for;

iii) Future trends of prices;

iv) Discounts to be received, if any.

Direct Labour Cost:

Determination of standard direct labour cost will involve the determination of-*

i) Standard time and

ii) Standard rate. uxdard time:

166

Standard time should be fixed for each grade of labour and for each operation

involved with the of work study by the engineer and time and motion study

techniques. indard Rates:

Standard rates of pay for each grade of workers are to be determined after taking

into sideration of the prevailing rates, expected change in rates, system of wage

payment of labour. Variable Overhead:

It is, therefore, required to calculate the standard variable overhead per unit or per

hour so that unit cost can be multipled by the budgeted production to ascertain the

total budgeted cost during . period. Due consideration should be given for past

records and future trends of prices. Fixed overhead:

Fixed overhead are tend to remain same irrespective of variation in the volume of

output. It is essary to determine

(i) total fixed overhead for the period; and

i ii) budgeted production in units or standard hours for the period.

It is possible to estimate the standard fixed overhead cost per unit or per hour by

dividing the tal fixed overhead by budgeted total production units or hours as the

case may be.

Q.8. Explain the significance of Variance analysis [G.U,1992]

Or Explain Variance Analysis. [GU.1996]

Or "The usefulness of variance analysis largely depends: on how standard sts

are established". Elucidate the statement. [G.U.2005]

I. Establishment of Cost Centre:

A cost centre is a location or a person or an item of equipment for which cost may

be ascertained and which may be used for the purpose of cost control.

II. Classification afAccounts:

Costs are required to be classified under a suitable accounting heading. It facilitates

quick identification and collection of expenses, their analysis and prompt reporting.

A code number is given for each class of cost.

III. Types of Standards :

There are three types of standards; viz, Current standard, Basic standard and

Normal standard

167

(a) Current Standard:

Current standard is a standard which is related to current conditions. It is

established to use it over a short period of time. It may be fixed on the basis of (i)

ideal standard or (ii) expected standard.

(i) Ideal Standard:

It is a standard which can be used in most favourable conditions, e.g: a standard

degree c high efficiency. It is not likely to be achieved because appropriate

conditions may :not prevail. It a target which is normally aimed at to be achieved.

(ii) Expected Standard:

This is the standard which is expected during a future specified budget period. It

is fixec taking into consideration of the present conditions and circumstances

prevailing within a particular industry after giving due concessions for human error

and changes in situations. It is realistic a attainable and is used for fixing efficiency

standard.

(b) Basic Standard:

It is a standard which is established to use for a long period unaltered. It is

revised o: when there are changes in the specification of materials and technology.

It is a tool for contro costs and framing forward plannings. It helps in the study of

trend of variances over a long pen

(c) Normal Standard:

It is the average standard covering one trade cycle. It is based on the basis of

average estima.; I performance over a future period of time. It is attainable only in

anticipated normal condition-conditions are changed, it is unattainable.

IV. Organisation for Standard Costing:

The success of standard costing depends upon the setting up of proper standards.

The standa: i are set by a committee consisting of

(i) Production manager;

(ii) Purchase manager;

(iii) Sales manager;

(iv) Personnel manager; and

(v) Cost accountant.

168

They review and revise the standards in view of the changing situations.

Setting up of standards:

The standards for direct material, direct wages, and overheads are fixed after

detailed :scussion.

Direct Material:

Standard direct material cost for each product should be established. This will

involve the following: i) determination of standard quantity of material i i)

determination of standard price per unit of material.

The standard price of each material will be fixed by the cost accountant after

consulting with .* e purchase manager. Rates of materials are fixed after

considering the following: i) Prices of materials in stock; j i) Materials already

contracted for;

iii) Future trends of prices;

iv) Discounts to be received, if any.

Direct Labour Cost:

Determination of standard direct labour cost will involve the determination of

i) Standard time and

ii) Standard rate.

uxdard time:

Standard time should be fixed for each grade of labour and for each operation

involved with the of work study by the engineer and time and motion study

techniques.

indard Rates:

Standard rates of pay for each grade of workers are to be determined after taking

into sideration of the prevailing rates, expected change in rates, system of wage

payment of labour.

Variable Overhead:

It is, therefore, required to calculate the standard variable overhead per unit or per

hour so that unit cost can be multipled by the budgeted production to ascertain the

total budgeted cost during period. Due consideration should be given for past

records and future trends of prices.

169

Fixed overhead:

Fixed overhead are tend to remain same irrespective of variation in the volume of

output. It is essary to determine

(i) total fixed overhead for the period; and

i ii) budgeted production in units or standard hours for the period.

It is possible to estimate the standard fixed overhead cost per unit or per hour by

dividing the tal fixed overhead by budgeted total production units or hours as the

case may be.

Q.8. Explain the significance of Variance analysis [G.U,1992]

Or Explain Variance Analysis. [GU.1996]

Or "The usefulness of variance analysis largely depends: on how standard sts

are established". Elucidate the statement. [G.U.2005]

Meaning of Variance:

ICMA defines variance as "The difference between a standard cost and

comparable actual cost incurredd during a given period. The purpose qF

variance is, to enable the management to have control oyer cost."

Variance may be favourable or unfavourable. Again it may be controllable or

uncontrollable.

Favourable Variance:

When actual cost is less than the standard cost or actual result is better than the

standard, the difference is known as favourable variance. It is asign of efficiency.

Unfavourable Variance:

When actual cost exceeds standard cost or actual result is less than the standard, it is

known as unfavourable or adverse variance. It is a sign of inefficiency or wastage.

The terms favourable or unfavourable variances indicate a trend of variance from

standard cost. This trend will give a correct indication if the standards are

accurately set and timely revised with the changed situations, otherwise this will

give distorted results and will lead to wrong manager;. decision.

170

Analysis of Variances:

Meaning:

According to ICMA, variance analysis is defined as "Theprocess ofcomputing the

amount of difference disclosing the cause of'vciriance between the actual costs

and the standard costs. Thus variance analysis involves:

(i) computation of individual variances; and

(ii) determination of the cause of each variance.

Significance/importance/Objective:

The objective of the introduction of standard costing is to achieve cost control and

reduction. This objective can be attained by the management by adopting the

technique of'Managenia by exception."

If standards are properly set, variance analysis would serve as an useful tool in the

implementatior of the technique of Management by exception in that it keeps the

managment informed about the erratic and out of the behaviour of the business.

The basic rule of'Management by Exception' is that the management should

concenttaie of operations and segments of the enterprise that deviate from the

target performance and no: to spend much time on the review of satisfactory

performances. Further, both the favourab and unfavourable variances deserve

attention. An unfavourable variance suggests a condition that may require

correction. A favourable variance may suggest an opportunity that tk

management may exploit.

Variance analysis assigns responsibility for variation from standards and enables

the management to take corrective measures.

Variances may be controllable and uncontrollable. Controllable variances arise

from can. which are within the control of responsible individuals.

Standard Costing and Variance Analysis

Uncontrollable variances arise from the causes which are beyond the control of

responsible ndividuals.

171

Thus responsibility for controltable variances can be fixed to individuals and

corrective -tions can be taken by the management. As for example, excessive use

of materials in production and more than standard hours taken in production, etc.

Uncontrollable variances cannotbe assigned to individuals and hence corrective

actio cannot be by the management. As for example, increase in the price of

materials, increase in wages rates, etc.

Significance of variance analysis lies in the careful analysis of the controllable

variances id their report to the management for corrective action. Thus variance

analysis facilitates e implementation of the principle of Management by Exception.

J.9. What are the various circumstances under which material price and

material wastage ariance are likely to arise? [GU,2003]

Material Price Variance:

Material Price Variance represents the differences between the standard price and

the actual chase price for the actual quantity of materials used in production.

Material Price Variance= (Standard unit price-Actual unit price) x Actual quantity

of materials

I Circumstances:

Material price variance arises underthe following circumstances: i) Change in price.

i i) Quality of material being different from that of standard;

iii) Failure to obtain quantity discount which results in higher prices;

iv) Changes in the inward transport charges, handling and store-keeping;

' iterial Usage Variance:

Materia! Usage variance represents the difference between the standard quantity

specified for actual production and the actual quantity used at standard purchase

price. rmulais:

laterial usage Variance= (Standard Quantity Specified for Actual Production-Actual

Quantity •;d) x Standard Price Per Unit.

'rcumstances:

ollowing are the circumstances for Material Usages Variance: i) Use of different

grades of materials; i Change in product design;

iii) Change in labour performance;

172

iv) Carelessness in handling of materials; •) Pilferage;

i) Use of non-standard materials; i) Defective production requiring further materials

for rectification.

Q.10. What are different types of standards? Explain them in short.

Standards are of three types :

(i) Current Standard

(ii) Basic Standard

(iii) Normal Standard

(i) Current Standard: Current standard is a standard which is related to current

conditions a: I is established for use over a short period oftime. The standard may

be fixed on the basis of ide< standard or expected standard.

(a) Ideal Standard: This is the standard which can be attained under the most

favorab ; conditions which are possibly obtainable. It is based on high degree of

efficiency. So it is rathe impossible to attain. This standard is based on certain

assumptions such as most desirar . conditions of performance, no wastage of

materials or time or inefficiencies in manufactur process. So this standard is not

likely to be achieved as these assumptions may not prevai practice.

The utility of this standard is that though the target is not achievable, yet it can be

aimed. This standard is criticised on the ground that unfavourable differences

between the standard and actual will be very large and variances may remain a

permanent feature. It will result frustration of employees because such a standard is

never attainable.

(b) Expected or Attainable Standard: It is a standard which is anticipated during a

fut. budget period. While fixing such a standarded, present conditions and

circumstances prevaiI within a particular industry are taken into consideration.

However, expected changes in pres. circumstances and conditions are also to be

taken into consideration. Again, a reasonable al Iowa r. is also to be considered for

unavoidable wastages. So this standard is more realistic than : ideal standard

because it is based on realities. It is suitable to the management from control p of

view because variances are calculated from attainable standard.

173

Basic Standard: It is a standard which is established for use unaltered overa long

period of tin: It is set for a long period for helping forward planning. Basic standard

is established for a base a and remains unchanged for a long period of time though

maturial prices, labour rates and ot expenses change. As basic standard remains

unchanged and is not adjusted to current mar-. conditions, deviations of actual costs

from basic standards will not be of any use to the managen. for practical purposes.

So it can not be used as as a tool of control. However, variances from SL . standard

can be used for studying trends in manufacturing concerns.

Comparison between current standard and Basic standard

Points Current Standards Basic Standards

Nature-Dynamic) Static

It relates to current conditions and is revised when conditions change

It relates to base year's conditions an d not revised when conditions change

Period

It is for a short period

It is for a long period

Revision

It needs constant revision when conditions change

It does not need revision when conditi change

rend Variances cannot show trend Variances over long period show a

trend.

Consideration

inflation

It considers inflation and

adjusts standard accordingly

It does not consider inflation

formal Standard: It is the average standard which t le firm anticipates to attain over a

future

xriod of time. Usually such a standard covers a period of one trade cycle. Such

standards are established on the basis of average estimated performance over cycle.

It is not possible for a firm "-: follow normal standard because it is not possible to

forecast performances correctly for a long period of time. Such standards are

attainable under anticipated normal conditions and are not mainable if anticipated

174

normal conditions change over a future period of time. Thus the standard :«:-es not

serve the purpose of cost control.

11. What is estimated cost? Distinguish between standard cost and estimated

cost.

Estimated costs are predetermined costs. Standard costs are also estimated costs but

there are .enain differences between the two and they are as stated below:

I Basis: Estimatd costs are based on historical accounting. It is an estimate of what

the cost be. Thus it is a reasonable estimate of cost for future. It is a guess work.

Standard costing determines what should be the cost. It is based on scientific

analysis and i ".gineering studies. Thus it is a rational cost.

Tool of control: Estimated costs cannot be used to determine efficiency. It merely

determines v.e expected costs which are almost nearer to actual costs.

Standard costs are used as device to measure efficiency by comparing actual costs

with standard costs.

Objectives/Purpose: The purpose of determining estimated costs is to find out

selling price ulvance in order to produce a product or not and to prepare financial

budgets. Such costs do it helps in controlling costs.

Standard costs help in controlling costs through analysis of variances of each

element of costs.

"hey suggest remedial measures where necessary.

Mature : Estimated costs are revised with changes in conditions in order to make

them talistic. So they are dynamic in nature.

Standard cost are not easily changed even if small changes take place in

conditions. So :hey are static in nature.

I se : Estimated costs are used by a concern which use historical costing. So it is a

part of historical Accounting. On the other hand, standard costing is used by

concerns which use .zandard costing system. So it is a part of cost accounting

process.

12. What is material mix variance?

175

Material mix variance : It is that portion of the material use which arises due to

the iifference between standard dnd the actual composition of a mixture. It means

that there has been actual in a dual ratio of materials used from the standard ratio

set. It is calculated as the difference between the standard price of standard mix

and the standard price of actual mix.

If the material mix used in production is of higher price in larger quantity than the

standard mix :ost of actual material mix the cost of actual mateiral mix will be

more. On the other hand, the use of cheaper materials in a larger proportions will

mean lower material cost than the standard cosl

Material Mix variances are calculated under two situations: (i) When Actual weight

of Mix and standard weight of mix do not differ: variance arises a u to the

difference in price between standard price per unit and the actual price per unit of

the

Formula: Material Mix variance: (Standard unit price x Standard quantity-(Actual

unit price x actual quanta

(ii) Where the actual weight of mix is different from the standard mix; variance

arises due change in the composition of material and the difference between the unit

price of standard m and actual mix.

Formula: (Standard unit price x Standard quantity) - (Actual unit price x Actual

quantity Q.13. What is material yield variance?

Material Yield Variance or Material sub- use variance : It is that protion of the

mater usage variance which is due to the difference between the standard yield

specified and th actual yield obtained. The variance measures the actual loss or

saving of materials. This variar. is very important in case of process industries.

Where a certain percentage of loss of materials is inevitable: If the actual loss of

materia differs from the standard loss of materials, yield variance will arise. This

variance is also know n sub-variance. This loss may arise in the following two

situations.

(i) When standard and actual loss do not differ, the yield variance is calculated in

the follow manner.

Yield variance = Standard rate per unit of yield x (Actual yield - Standard yield)

176

Standard Cost of Standard Mix

Standard Rate =

Net Standard Output (i.e.gross output-Standard Loss)

(ii) When actual mix differs from standard mix, the formula for calculation of yield

variance almost same but a revised standard mix is to be calculated to adjust the

standard mix in proport: to the actual mix and the standard rate is to be calculated

from the revised standard

Standard Cost of Revised Standard Mix

Formula for standard rate :

Yied variance: Standard Rate (Actual Yied- Revised Standard Yied)

Importance: If the actual yield is more than the standard yield, it is a sign of

efficiency. A Ic yield indicates more consumption of materials arising from low

quality of materials or defecti. t method of production or carelessness in handling

materials.

Q.14. What is material Cost variance? What are its components? Explain them

in shor

Material variance: Direct material variances are known as material variances. Mate

cost variance is the difference between the standard cost of materials that should

have be.

Standard Costing and Variance Analysis

Rerred for manufacturing the actual output and the cost of materials that has been

actually cirred.

Material cost variance consists of:

(a) Material price variance and

(b) Material usage variance

Material usage variance consists of:

(i) Material mix variance

(ii) Material yield variance.

Material cost variance: Material cost variance is the difference between standard

material cost md actual material cost. It arises due to

(i) Change in price of materials

177

(ii) Variation in use of quantity of materials

Material price variance : Material price variance is that part of material cost

variance . h is due to the differnece between the standard price specified and the

actual price Material price variance arises due to change in basic prices of

materials and for adverse . e. the responsibility is fixed on purchase manager for

explaining the variance. . :erial price variance = Actual quantity (standard price -

Actual price)

b i Material usage variance: It is that part of material cost which arises due to the

difference been standard quantity specified and actual quantity of materials used.

It is calculated as

Mows.

Material usage variance = Standard price (standard quantity-Actual quantity)

It arises due to negligence in use of materials, pilferage, low quality of materials or

defective production method Responsibility for usage variance is fixed on

production manager and remedial - easures can be taken.

Material usage variance is sub-divided into

i) Material usage variance

iii) Material yield variance.

.Material mix variance: It is that part of material variance which arises due to

changes in ndard and actual composition of mix. It results from variation in

material mix proportion. the material of a higher price is used more than standard

proportion, then material price will be ' re and vice versa will result in less material

cost.

Material use variance = (Standard price x Standard quantity)-(Actual price xActual

quantity) Change may be in proportion of mix and in price. Material yield

variance : Materials yield variance arises from the difference between actual eld

and standard yield. It is that portion of the direct material usage variance which is

due to - difference between the standard yield specified and the actual yied

obtained. It is due to : ss or savings of materials.

Q.15. What is labour variance? What are its difference Components?

178

Labour variance is the difference between standard labour cost and actual labour

cost. It arises due to difference in rate and /or efficiency of labour. Labour variance

is known as labour : o st variance.

Labour cost variance : Labour cost variance is the difference between the

standard cost of labour allowed for actual output achieved and the actual cost of

labour employed. It is also known as wages variance. It is calculated as follows :

Labour cost variance = Standard cost of labour -Actual Cost of labour.

It consists of (i) Labour Rate variance.

(ii) Labour Efficiency variance. Labour Rate Variance : It is that protion of the

labour cost variance which arises due to tht difference between standard labour

rate specified and the actual labour rate paid. It is calculated as follows:

Labour Rate variance = Actual time taken (Standard Rate -Actual Rate)

The responsibility for rate variance lies with cost centre. Usually rate is determined

by marke: demand and supply and none is nomially held responsible.

The variance will be favourable if actual rate is less than standard rate and it will be

unfavourable if the actual rate is higher than the standard rate.

Labour efficiency variance : It is that part of labour cost variance which arises

due to tm difference between standard labour hours specified and the actual

labour hours paid j including idle time. This variance helps in controlling

efficiency of workers. It is calculated as follows :

Total Labour Efficiency Variance = Standard Wage Rate

(Standard time for actual output-Actual time paid Fire Actual time paid for includes

abnormal idle time. Labour efficiency variance may arise from

(i) Lack of proper supervision

(ii) Defective machinery

(iii) Inefficient traincing of labour

(iv) Increase in labour turn over

(v) Bad working conditions.

179

If actual time taken for doing a work is more than the specified standard time, the

variance w be unfavourable. On the otherhand, if actual time taken for ajob is less

than the standard time.tfi . variance is favourable.

Idle time variance : It is the standard cost of actual time paid to workers for

which they ha not worked due to abnormal reasons such as power failure, break

down of machinery or n supply of materials etc. Idle time variance is deducted

from gross efficiency variance and : . resultant figure is net efficiency variance.

Labour mix variance: It is a part of labour efficiency variance. It arises due to

change in ti:-. actual gang composition than the standard gang composition. The

change in labour compositi may be caused by the shortage of certain grade of

labour which is compensated by the employment of another grade of labour. It is

calculated in two ways :

(i) When standard labour mix is equal to actual labour mix, it is calculated in the

following a Labour mix variance = Standard cost of standard labour mix -

Standard cost of actual mix

When standard and actual time of labour mix are different, it is calculated in the

following manner:

Revised Standard Labour Cost) i time Revised Standard Labour

(Standard Cost of Actual Labour Mix.)

hour yield Variance/Labour sub-efficiency : It arises due to the standard output

specified mdactual output obtained. It is calculated as follows :

Labour yield variance = Standard Labour Cost per unit of output* (Actual yield-

Standard yieldfor Actual time)

If actual yield is more than the standard yield, the variance is favourable. If it is less

than the :dard yield, the variance is unfavourable.

16. Explain overhead variances.

Overhead variances: overhead is the aggregate of indirect material, indirect labour

and indirect . senses. They are know as indirect cost and are absobed by cost units

on some suitable basis. Under standard costing, overhead rates are predetermined

in. terms of either labour hours (per ur) or production units (per unit) of output. The

actual labour hours or actual output units produced re multiplied by standard

180

overhead cost rate to determine the standard overhead cost that ought to a\ e been

incurred. The standard cost is compared with actual overhead cost to find out the

riance, if any, for taking corrective actions. Thus overhead variance is the difference

between e standard cost of overhead allowed for actual output and the actual

overhead incurred. Overhead cost variance is calculated in the following manner:

Overhead cost variance = Actual output ^Standard overhead Rate per unit -

Actual

overhead cost.

Since overheads are divided into (i) Variable overhead and (ii) Fixed overhead,

overhead variances ire of two types.

(i) Variable overhead variance

(ii) Fixed overhead variance.

(i) Variable overheads are of two types

(a) Variable overhead expenditure variance

(b) Variable overhead efficiency variance.

(a) Variable overhead expenditure variance : It is the difference between the

standard variable overheadfor actual hours and the actual variable overhead

incurred. It is calculated as follows.

Variable overhead expenditure variance =

Actual hours x Standard variable overhead Rate per hour -Actual variable

overheads.

(b) Variable overhead efficiency variance: It is the difference between the

standard hours allowed for actual production and the actual hours taken

multiplied with the standard variable overhead rate.

It is calculated as follows :

Variable overhead efficiency variance = Standard variable overhead rate

(Standard Hours for Actual output-Actual Hours).

Fixed overhead variance: It is that portion of total overhead cost variance which

is du-: to the difference between the standard cost offixed overhead allowed for

the actual outp achieved and the actual fixed over cost incurred.

181

The formula for calculation of this variance is: Fixed overhead variance : Actual

output x Standard Fixed overhead Rate per unit-Actu

Fixed overhead

Or

Standard Hours produced x Standard Fixed overhead Rate per hour-Actual Fixed

overhead. This variance is further analysed as under.

(i) Expenditure variance :

It is that portion of the fixed overhead variance which is due to the difference

betwet budgetedfixed overheads and the actual fixed overheads incurred during a

particular perk d It is calculated as follows:

Expenditure variance = Budget fixed overheads - Actual Fixed overheads.

(ii) Volume variance:

It is that portion of fixed overhead variance which arises due to the difference

between tht standard cost offixed overhead allowed for the actual output and

budgeted fixed overhca. for the period during which the actual output has been

achieved. The variance shows over c i under absorptions of fixed overheads during

a particular period. If the actual output is more than the budgeted output, there is

over-recovery of fixed overheads and volume variance is favourab I. and vice versa

if the actual output is less than the budgeted output. This is because fixed expense-

are not expected to change with the change in output. Volume variance is calculated

as follows

Volume variance:

Actual output x Standard Rate - Budgeted fixed overheads

Volume variance is further subdivided (a) Capacity variance:

It is that portion of the volume variance which is due to working at a higher or

lower caput.

than the budgeted capacity i.e. under or over utilisation of plant capacity or less or

more hours than budgeted hours.

It is calculated as follows:

Capacity variance:

182

Standard Rate (Revised Budgeted units - Budgeted units) Or

Standard Rate (Revised Budgeted Hours - Budgeted Hours) (ii) Calendar variance

:

It is that portion of the volume variance which is due to the difference between

the number c working days in the budget period and the number of actual

working days in the period h which the budget is applicable. If actual working

days are more than the standard working days, the variance will be favourable and

vice verse if the working days are less the standard days. It is calculated as

Calendar variance:

Increase or decrease in production due to more or less working days at the budgeted

capacity x Standard Rate per unit.' Efficiency variance:

It is that portion of the volume variance which is due to the difference between the

budgeted efficiency of production and the actual efficiency achieved. This is due

to the efficiency of workers and plant. It is calculated as :

Standard Rate per hour = (Actual production in units - Standard production in units

)

Or

Standard Rate per hour = (Standard Hours'produced - Actual Hours)

Q.17. Make a comparesion between Standard Costing and Marginal Costing

Standard costing is a system of accounting in which all expenses (fixed and

variable) are considerd for determination of standard cost for a prescribed set of

working conditions.

On the other hand, marginal costing is a technique in which only variable expenses

are taken to ascertain the marginal cost. Both standard costing and marginal costing

are completly independend of each other and both may be installed jointly. Such

joint installation may be named Marginal Standard Costing or Standard Marginal

Costing System. Variances are calculated in the same way as in standared costing

system with the only differnece that volume variances are absent because fixed

expenses are charged in totals in each peirod. in marginal costing.

Q.18. Fill in the blanks :

1) Standared cost is a-cost, (predetermined)

183

2) Standard costing-the variations of actual costs from standard costs, (determines)

3) Under standard costing-cost of each element of cost is ascertained, (standard)

4) Variance analysis helps the management in-performances, (controlling)

5) Material cost variance is the-between the standard cost of materials allowed for

the output achieved and the actual cost of materials used, (difference)

Three types of standards are-.(current standard, basic standard and normal

standard)

The limitations of-have led to the development of standard costing system.

(historical costing systems)

Basic standard is established for use-over a long period of time, (without alteration)

19) The deviation of actual cost or profit or sales from standards is known as-.

(variance)

110) Management by exception is exercising control over-. (unfavorable items)

111) At the end of the period under review the actual cost is compared with the

predetermined standard cost and the eventual difference is known as the-variance,

(cost)

112) Control in standard costing is achieved by-. (variance analysis)

113) Standard costing is more widely applied in-industries, (process and

engineering)

(4) Labour cost variance is the difference between standard cost of labour and-.

(actual cost of labour)

(5) Idle time varianpe is -. (idle time sstandard rate)

(16) Volume variance is divided into-.

(capacity variance, calendar variance and efficiency variance)

(17) Standards set provide yardsticks against which-are compared, (actualcosts)

(18) The technique of standard costing may not be applicable in case of (small

concerns)

(19) Total material cost variance (standard cost of materials-actual cost of

materials)

(20) Material usage variance = Material Mix variance (Materialyield variance)

(21) Material price variance = actual usage (-).

184

(standard unit price-actual unit price)

(22) Material usage variance = standard price (-). (standard usage-actual usage)

(23) Material mix variance= standard cost of standard mix-.

(standard cost actual mix)

(24) Total labour cost variance=-. (standard cost of labour -actual cost of labour)

(25) Volume variance= standard rate (actual output--). (bugetedoutput)

(26) A favourable variance will arise when atual revenues are-than expected,

(more)

Q.19. State whether the following statements are true or false.

(1) Standard cost and estimated cost are same. (False)

(2) Standard costing is not used in the concerns where non-standard products are

produced.(Tn/e)

(3) Standard costing is a yard stick for measuring efficiency.(Me)

(4) In budgetary control, emphasis is given on targets of expenditure while as in

standard costing emphasis is given on achieving standards. (True)

(5) Material price variance = Standard quantity (standard price - Actual price)

(False)

(6) Expenditure variance = (Budgeted fixed overhead - standard fixed overhead)

(False)

(7) Pre-determined costs are established in advance of production. (True)

(8) Standard costs are pre-determined costs. (True)

(9) Estimated costs are also pre-determined. (True)

(10) In historical costing emphasis is given on 'what the cost should be'. (False)

(11) Standard costing is a of control technique. (True)

(12) Standard costing without variance analysis is of no value. (True)

(13) Standard costing is a method of cost ascertainment. (False)

(14) Standard costing is associated with variance analysis. (True)

(15) Budgetary control and standard costing are similar in nature. (False)

(16) Standard costing can be introduced in any concern even if there is no well-

defined organizational structure. (False)

185

(17) Fixation of standard cost for materials involves setting standards for both

quantity and price. (True)

(18) Standard time is determined by time and motion study. (True)

(19) In order to control cost, a company should use either standard costing or

budgetary control but not both of these techniques. (False)

(20) Standard cost shows the standards set for different elements of cost. (True)

(21) Standard costing is a yardstick of performance measurement. (True)

(22) Standard costing facilitates introduction of wage incentives. (True)

(23) Standard costing is an expensive technique. (True)

(24) Introduction of standard costing helps prevent occurrences of variances. (True)

(25) The term 'variance' includes not merely cost variance but profit variance also.

(True)

(26) Variance costing gives information regarding cost variance. (True)

(27) Material usage variance is the same as material quantity variance. (True)

(28) Material mix variance is a part of material usage variance. (True)

(29) Changes in basic wage rate do not cause wages rate variance. (False)

(30) Excessive labour turnover is one of the reasons for labour efficiency variance.

(True)

(31) Idle time variance is always unfavourable. (True)

(32) Labour mix variance is a sub-variance of labour efficiency variance. (True)

(33) Overhead cost variance is only under or over-absorbed production overhead.

(True)

(34) Production overhead capacity variance is a sub-division of fixed production

overhead volume variance. (False)

(35) Production overhead budget variance is a sub-variance of production overhead

cost variance. (True)

(36) Production overhead calendar variance is the variance accumulated during the

calendar year. (False)

(37) Relevant costs are historical in nature. (False)

(38) Historical costs are not relevant for decision making. (True)

Q. 20. Choose the correct alternative :

186

(a) Standard costing involves the

(i) fixation of estimated cost

(ii) determination of standard cost

(iii) Setting of budgeted cost

(b) The difference between actual cost and standard cost is known as.

(i) Variance

(ii) Profit

(iii) Differental cost

(c) Standard costing helps in

(i) Measurement of efficiency

(ii) Reducing losses

(iii) Controlling prices

(d) Standard costing can not be used

(i) Where management is inefficient

(ii) Where workers are slow

(iii) where non standard products are produced

(e) Basic standard is established for a

(i) Short period

(ii) Current period

(iii) Indefinite period

187

Unit-IV INTRODUCTION

Syllabus:

Meaning and definition of Management Accounting Nature, Scope and Objective of

Management Accounting Tools and Techniques of Mangements Accounting Role

in decision making. Relationship between Management Accounting and Financial

Accounting

1. Mention any three limitations of Financial Accounting.

Three limitations of financial accounting are:

(i) Hestorical Nature: Financial accounting records past transactions and provides

formation of historical nature such information is not much useful for future

planning.

(ii) Not useful in price fixation : It does not help the managemental in fixing price

of a - roduct or submitting a quotation for an order.

(iii) Information about total and not in details: It provides information of the firm

as a hole and not productwise or departmentwise.

Q. 2. Mention three objectives of Management Accounting.

Three objectives of management accounting are :

it Providing information to the management for planning and policy formulation.

Management accounting provides necessary information to the management for

planning and policy formulation.

ii) Helping in controlloingperformance: Management accounting formulates

standards and prepares budget for controlling the performance of the employees.

(iii) Helping in decesion making process. Management accounting submits reports

on the evaluation of various alternatives and suggests the most suitable one for

maximinsing profit.

Q. 3. Mention any three functions of Management Accounting

Three functions of management accounting are :

(i) Planning and forecasting: It helps the management in planning and fore casting

throught analitical reports.

(ii) Modification of data: It modifies accounting data and makes them useful for

analysis and interpretation.

188

(iii) Helping in Managerial control: Management accounting helps the managerial

in controlling the affairs of the business by providing staundares budgets and

reports

Q. 4. Mention three limitations of Management Accounting.

Three limitations of management accounting are:

(i) Based on financial accounting. It is based on financial accounting. If the

financial data are wrong, management accounting report will also be wrong.

(ii) Lack of knowlege: The use of management accounting requires knowledge of a

number c I related subjects. The degree X)f correctness of management, report

depends on the degree c: knowledge of the accountant.

(iii) Intutive decision: Management may not always follows the analylical report of

the management accounting. It may be guided by its intuition.

Q. 5. Mention three tools of Management Accounting

Three tools of management accounting are :

(i) Analysis offinancial statements : Analysis and interpretation of financial

statements is an important tool of management account.

(ii) Budgetary control: The use of budget in controlling the functions of various

levels of management is another tool of management.

(iii) Marginal costing: The technique of merginal costing helps the managment in

decision makin; process.

Q. 6. Mention three needs of Management Accounting?

Three needs of management accounting are:

(i) Proper planning: Management accounting supply vital information for planning

operations.

(ii) Measurement ofperformance: Management accounting measures the

performance of the management and suggests improvement measures.

(iii) Controlling the affairs of the business tools of management accounting are

very useful fc -controlling perpose of the business.

Q. 7. What are the characteristics of Management Accounting? What is the

nature of Management Accounting?

The characteristics of management accounting are:

189

(i) It provides accounting information : Management accounting is based on

accountir. information. It provides accounting information in simplified and

condensed form for decesic-making purpose.

(ii) It shows cause and effect analysis of different activities by establishing and

interpreti r g relationship between different accounting data.

(iii) It used special techniques and concepts to ascertain the effects of various

alternatives avai lab le to the management.

(iv) It helps the management in taking important decesions by submitting reports

basec on analysis and interpretation of financial data.

(v) It uses no formal norms in its funcitions of assisting the management in

decesior. making process.

(vi) It provides vital information but does not take any decesion by it self.

(vii) It is concerned with forecasting, planning and budgeting.

Q. 8. What is the need and importance of Management Accounting?

In complex industrial world, management accounting has became an integral part of

anagement because of its guidance and advice to the various levels of managent.

Following are e areas in which it helps the management in its decesion making

process.

i) To Increase efficiency in performance: It helps the management in planning and

excuting rudgets and thereby contributes to imporvement in functional efficiency of

the management.

ii) To make proper planning : It helps the management in proper planning its

activities for ichieving its desired goals.

iii) To measure performance: It measures the performance of the management by

using various ols. It also measures the efficacy of policy decisions taken earlier.

iv) To help the management in maximising profits. It analyses the the prospective

results of various ternatives and suggest the most suitable one for maximising

profits.

v) It helps the management in providing better customer services.

190

Q. 9. What is Management Accounting ?

Explain the nature or characteristics of Management Accounting.

Definition:

According to the Management Accounting Practices Committee set up by the

National ..counting Association of the U.S.A. "Management Accounting is the

process of identification, measurement, analysis, preparation, interpretation and

communication of both financial and operating information used by management

to plan, evaluate and control within an organisation and to assure appropriate

use of an accountability for its resources "

In short, management accountin is the presentation of accounting information in

such a way as assist the management in creation and operation of policy.

Thus management accounting is that part of accounting which facilitates the

management rrocess of decision making. Hence it has the following characteristics

or nature: Characteristics or nature ofManagement Accounting

1. Decision Making System:

It provides information to the management which assists it in the creation of policy

and day-to-day operations of the undertaking.

2. Systematic Approach to Planning and Control:

It provides information to the management for a system of setting standards, plans

or targets and reporting variances between planned and actual performances for

corrective actions.

3. Futuristic in nature:

It helps the management to evaluate future through the use of standard costs and

budgets.

4. Providing Data:

It provides accounting data for projection and planning future.

5. Providing Tools and Techniques:

It provides various tools and techniques for control of business operations,

improvement of overall efficiency in using economic resources and maximisation

of profit.

191

6. Cause and Effect Relationship:

It shows cause and effect relationship through variance analysis technique and

enables the management in taking remadial measures.

Q. lO.Define the term Management Accounting. [GU.1992]

Or, What do you mean by Management Accounting? [GU.1999] Definition of

Management Accounting :

Anglo-American Council on Productivity defines Management Accounting in the

followin terms- "Management Accounting is the presentation of accounting

information in such c way as to assist the management in the creation ofpolicy

and the day-to-day operation of at undertaking."

According to the above definition, management accounting is concerned with the

presentatk r of accounting information to the management in such a manner as will

enable the managementii formulating and executing the policy decisions. Here the

emphasis is given on the manner c presentation of information to the management.

J.Betty defines Management Accounting as follows: "Management Accounting is

the tern used to describe the accounting methods, systems and techniques which,

coupled with specia. knowledge and ability assist management in its task of

maximising profits and minimising losses."

It is a wider definition and includes the accounting methods, systems, techniques

for recording collecting and presenting accounting information for managerial use

for the purpose of earning maximum profits.

A comprehensive definition of Management Accounting is given by the

Manageme-Accounting Practice Committee set up by the National Accounting

Association of the U.S.A. as:

"Management Accounting is the process of identification, measurement,

accumulation analysis, preparation, interpretation and communication of both

financial and operating information used by management to plan, evaluate and

control within an organisation ami to assure appropriate use of and

accountability for its resources. Thus management accounting is thus the process

of:-

192

1. Identification - recognition and evaluation of business transactions and other

economic events for appropriate accounting action.J

2. Measurement -estimating of business transactions and'other economic events.

3. Accumulation- for correctly recording and classifying business transactions and

other economic events.

4. Analysis- to determine resources for business activity and to find out their

relationship with other economic events and circumstances.

5. Preparation and interpretation- to coordinate accounting and planning data to

identify a need of information and to present the required data in a logical manner

with necessar comments.

6. Communication- to report pertinent information to management and others for in

ternal and external uses.

In short management accounting is used for (i) planning; (ii) organising; (iii)

evaluating; (h controlling and (v) fixing accountability.

Q. 11. State the objectives of Management Accounting. [GU.1988,1989,1995

and 1997] Or, "The managerial objectives of accounting are to provide data

to help the management in planning, decision making, coordinating and

controlling operations" Discuss the statement with suitable example.

[GU.1998]

Or, Discuss the management accounting as a tool in:

(i) Decision making; and

(ii) Exercising Control. [GU.2003] Or: Describe the uses of accounting

information for managerial decision making purposes (GU.2006)

The essence of management process is decision making for specific objectives and

the decision making system is said to be efficient when such objectives are

realised with minimum use of resources.

According to Welsch, Glenn A. The process of decision making involves two basic

management functions viz; planning and control. Management Accounting

accumulates, measures and reports relevant information in such a way that

planning and controlfunctions ire facilitated.

193

For successful planning and efficient control, the fol lowing management functions

are involved:

I. Planning and Policy formulation;

II. Organisation;

III. Co-ordination;

IV. Controlling

V. Motivation;

VI. Decision making; and

VII. Analysing and reporting. Objectives of management accounting. I. Planning

and Policy Formulation:

Planning is a statement what should be dotie, and how it should be done, and

when it should be done. It is the design of a desiredfuture state of an entity and of

the effective ways of bringing it about. (According to Welsch)

In other words, planning involves:

(i) Establishment of enterprise's objectives;

(ii) Determination of operational goals;

(iii) Developing strategies to achieve the goals; and

(iv) Formulation of budgets or profit plans.

Management accounting provides adequate accounting information to the

management to assist them in the performance of the above functions.

Organisation:

Organisation is the establishment of relationship among the different individuals

in a concern. It involves the delegation of authority and the fixing of

responsibility.

Management accounting helps the management in establishing cost centres,

preparing budgets, preparing cost control accounts and fixing responsibility for

different functions.

Co-ordination:

Co-ordination among the different departments is essential for successful

materialisation ofgoals. It is done through enforcing each department to stick to

194

its budgeted performance and the management accountant assists the

management in this respect by providing it with budget appraisal reports.

IV. Controlling:

Control fol lows planning. It is the process to ensure that the plans are being

attained It is a feed back system. It tells:

(a) how effectively and efficiently the objectives, goals and plans are

accomplished;

(b) what went wrong; and

(c) what can be done to perform the planned activities in future.

Therefore, control implies the measurement and evaluation of performance. It

involves the following functions:

1. Comparison of actual performance against predetermined budgets and standards;

2. An analysis of the variances from budgets and standards in order to determine the

underlying causes and their reporting to responsible managers;

3. Initiation of an action that may correct the deficiencies indicated;

4. Follow-up to appraise the effectiveness of the corrective action; and

5. The feed back of the information to the planning process to improve future

planning and control activities.

Example: Production, sales and finance budgets are integrated in the master budget

and they are inter-linked. If production budget falls below the schedule, it will

affect the sales budget. So periodical comparison between the actual and the

budgeted performance should be made and the variance is to be reported to the

responsible manager for immediate corrective action. This is done by the

management accountant by submitting periodical budget appraisal report.

V. Motivation:

Management accounting is a motivational device. It is oriented towards persons.

Budgets are formulated by responsible managers and authority is delegated to them

for the accomplishment of such budgets. Performance reports prepared by the

management accountant focuses on the actual performance of the concerned

persons and incentives are offered or penalty is awarded on performance

appraisal. Thus it functions as a motivating device.

195

VI. Decision Making:

Where management is confronted with alternatives for the attainment of budgeted

goals. management accounting appraises alternative proposals and suggests the

better one. This is done through flexible budgeting, marginal costing and capital

budgeting techniques.

VII. Analysing and Reporting:

Management accounting is selective in reporting performance data to various

management levels. Managers at operating level need elaborate information on

their performances and the management accounting feeds them with necessary

reports.

On the other hand, the attention of top management is needed in exceptional items

and management accounting monitors the performance reports, prepares condensed

reports for the sideration of the top management. It facilitates the to apply the

principle of management by exception.

Thus, monitoring, analysing and reporting of essential information needed at

different levels management is an essential part of management accounting.

Q. 12. How does management accounting differ from financial accounting?

[GU.1999] Or, Why is the management Accounting a separate dicipline other

than financial accounting (GU.2006)

Or. Relationship between Management Accounting and Financial Accountin?

Financial accounting and management accounting arc closely related because the

management -. v. ounting draws out a major part of the accounting information

from financial accounting and difies the same for managerial use. Financial

accounting is concerned with recording and . assifying the business transactions and

preparing periodical financial statements for the purpose ascertaining operational

results and financial position. They are used for external use. On the her hand,

management accounting is to provide necessary information for management

planning

J control. They are used internally.

Inspite of their inter-relationship, there exists some points of differences between

the two which are as stated below:

196

Objective:

Financial accounti ng is attached more with reporting the results and position of

the business the persons and authorities other than the management- creditors,

investors, Government, etc.

Management accounting is concerned more with generating information for the

use of rural management in decision making process such as planning, control,

etc. Coverage of Information:

Financial accounting studies the business transactions and events of the enterprise

as a le. It does not trace the path of events within the enterprise. So, it shows the

performance and sition of the enterprise as a whole.

On the other hand, management accounting takes the organisation in its various

segments attempts to trace the impact and effect of the business transactions and

events through ese divisions and subdivisions such as on cost, inventories, process,

products etc. v\ature:

Financial accounting is historical in nature and transactions are recorded long

after they e taken place.

Management accounting analyses the events as they take place and project them

for Mure.

Therefore, financial accounting is concerned with the past and static in nature

whereas management accounting is concerned with future and dynamic in nature.

4. Precision:

Financial accounting is historical in nature hence is actual andprecise.

Management accounting reflects the future hence it is mere estimation, so it

requires i nodical adjustments.

5. Periodicity Reporting:

Periodicity in reporting financial accounts is much wider than that in the

management accounting e.g. annual statements.

In management accounting, weekly, fortnightly, even monthly reporting is used.

6. Accounting Principles:

197

Financial accounting has to be governed by the generally accepted accounting

principles and legal provisions since it has to cater to the information needs of the

outsiders.

Management accounting need not worry about such conventional and legal

constraints. It is free to formulate its own rules, procedures and forms since it is

used for internal use.

7. Legal Compulsion:

Financial accounting is compulsory in case of a joint stock company and is

necessary for other forms of business organisation for tax purposes.

On the otherhand management accounting is optional and its forms and contents

depend upon the outlook of the management.

8. Contents:

Financial accounting contains only the monetary information. Whereas

management accounting contains both monetary and non-monetary information

such as cost of materials and quantities of materials, amount of wages and number

of workers; etc.

9. Publication and Audit:

Financial statements are published for the benefit of public and are subject to

audit especially in case of companies.

On the otherhand, management accounting is preparedfor internal use of the

management So it is not required to be published or audited.

Q.13. Discuss the scope of management accounting. [GU.1989, 1995, 1997]

Management accounting includes financial accounting and extends to the operation

of i system of cost accountancy, budgetary control and statistical data. It meets the

legal and convention a requirements regarding the presentation of financial

statements such as profit and loss Accour Balance Sheet. Fund flow statementbut

gives more emphasis on the establishment and operatic -of internal control.

The scope-of management accounting inter-alia includes:

1. Installation and operation of Financial Accounting CostAccounting, Tax

Accounting an Information System:

198

It requires the installation and operation of financial accounting for the preparati.

financial statements in order to ascertain operational results and financial position.

It introduces and operates cost accounting in order to determine the cost of

production different products and services and to bring about cost control and cost

reduction. Its function als includes tax administration and the establishment of an

efficient information system to facilita:. a continuous flow.of information to

different levels of management.

2. Compilation and Preservation of Essential Data:

The management accountant presents the past data with suitable modifications in

siu ay as to reflect the trends of events. He analyses the past events and assesses

the anticipated h mges in relevant areas and provides effective assistance to the

planning process. Providing Means of Communication:

It provides a means of communicating management plans to various levels of

ganisation. It also co-ordinates their activities, defines their roles and assists the

management in i.recting their activities to the common goal.

Providing a system of Feed-Back Reports:

It provides a system by which feed-backs of departmental activities can be

reported to . management. The difference between the actual performance and the

budgeted performance different departments is ascertained and relevant information

is provided to the management :h a suggestion for taking corrective measures in

desired cases.

Analysis and Interpretation:

Accounting data are analysed and interpreted and are made understandable*and

use-ble to the management in order to enable it to fix responsibilities and to bring

about necessary anges in the organisation. "Assisting Management in Decision

Making:

It analyses different alternatives for a course of action and ranks the proposals on

the basis : their suitabilities. It helps the management in decision making process..

Providing Method of Evaluation of Performance:

It provides methods and techniques for evaluating the performance of

management gainst the declared objectives.

199

Modification of Techniques:

It modifies and sharpens the effectiveness of the existing techniques of analysis in

aerto increase the profitability of the enterprise.

- Budgeting and Forecasting:

Budgeting and forecasting measures and expresses the plans, policies and goals of

an enterprise for a definite period. Management accountant helps the departmental

heads in preparing K ir respective budgets and their execution.

9. Inventory Controlling:

Its function involves exercising control over inventory through fixing different

levels of Ktks, perpetual inventory, etc. It is essential in managing liquidity and

profitability.

Q. H.Discuss the functions of Management Accounting. [GU.,1989, 1995, 1997]

Or, Management accounting is the presentation of accounting data in such a

way as to assist the management in the creation of policy and in the day-to-day

operation of an undertaking." Explain the statement bringing out essential

services of management accounting. [GU.1991 & 1996]

Or, Discuss the services of the management accountant.

"Management Accounting is concerned with information which is useful to

management."

Explain the above statement highlighting the nature of information referred to.

Management accounting is closely associated with the process of management

control. Management control is the process of arranging resources and using them

effectively in the accomplishment of an organisation's objectives. The

basicfunction of management accounting is to assist the management in

performing its functions effectively. Thus management accounting function

includes all activities associated with collecting, processing, interpreting and

presenting data to the management in the process of decision making i.e. in

planning, coordination and in control. It includes the following functions:-

200

1. Planning and forecasting:

Management fixes various targets to be achieved by the business in future.

Planning and forecasting are essential. They can help greatly in this process

through various techniques such as budgeting, standard costing, marginal costing,

fund flow statement, profitability trend analysis, etc. Thus /'/ helps the management

in short-term and long-term forecasts and planning the future operation of the

business.

2. Modification of Data:

Financial accounting as such is not suitable for managerial decision making and

control purposes. Management accounting modifies the available financial and

cost accounting data by re-arranging them in such a way that they become easily

understandable and useful to the management.

Example: if sales data are required, they can be classified according to product,

area or season wise or type of customer wise.

3. Financial Analysis and Interpretation:

Accounting data are analysed and interpreted meaningfully for effective planning

and decisic -making. Interpretation is the most important function of the

management accounting. Financial data are expressed in technical terms and the top

management very often does not understanc them in the ir raw form. Management

accounting selects the useful data, analyses it andpresent the interpretation

before the management in a non-technical manner along with comment* and

suggestions. Thus analysis and interpretation of data are considered as backbone

management accounting.

4. Communication:

Management accounting is the important medium of communication. Different

levels management, such as top, middle and lower levels, need different types of

information and tr . management accounting provides them with necessary

information as and when they nee d

5. Facilitating Management Control:

Management accounting provides to the management various techniquesfor the

purpv of controlling performance. As for example, standards of various

201

departments and individu?. are set up. Actual performances are compared with

standards and deviations are calculated. The . deviations are analysed, causes are

found out and responsibilities are fixed. This analysis rep -known as performance

report is presented to the management for its controlling purpose.

6. Use of qualitative Information:

Financial data alone are not sufficient for decision making purposes. Qualitative

data ha strategic impact on decision making process and management accounting

provides relevant smalitative information to the management to use it along with

quantitative information uken from financial accounting. As for example- in

making sales budget, not only the past "ormance is considered but also the quality

of the sales personnel is also equally taken into : :-nsideration.

Thus management accounting provides to the management engineering records,

case stud-special service, productivity reports, etc. for its consideration.

Decision Making:

Management accounting analyses and ranks different proposals on the basis of

their ofitability and submits the appraisal report to the management for

investment decision, h as it ensures the efficient use of scarce resources of an

enterprise.

I Co-ordination:

Co-ordination is an important part of management control. Management

accountant mcts as a coordinator among the different functional departments. It

is done through budgeting and performance appraisal reports. Thus it facilitates the

management to direct all departmental ... ivities towards the common goal.

J. 15. How does management accounting differ from Cost accounting?

[G.U.2003]

Management accounting and cost accounting are two branches of accounting. Both

present accounting information to the management in such a way that facilitates

prudent planning, correct :;cision making and effective controlling of day-today

operations. Both cost accounting andman-_ aement accounting are internal to the

organisation and both assist the management in their managerial function. In many

202

areas both are overlapping in their functions; still the two systems can be :

rferentiated on the following grounds:

1. Object:

Primary objective of cost accounting is the ascertainment, allocation and

distribution of costs.

While the purpose of management accounting is to provide information to the

management for the purpose ofplanning, coordinating and controlling of

business activities.

Thus cost accounting is concerned with the accounting aspects of costs and

management counting is concerned with the impact and effect aspects of costs.

2. Nature of Information:

Cost accounting is based on past and present facts and figures.

While management accounting is based on future projects and plans based on

present and past cost data. So cost accounting is historical in its approach while

management accounting futuristic in its approach.

3. Principles:

Certain principles and procedures are followed in cost accounting. While no such

principles and procedures are beingfollowed in management accounting. Here

information is prepared and presented as is needed by the management.

4. Nature of Data used:

In cost accounting, only quantitative data is used.

While in management accounting, both quantitative and qualitative data are used.

5. Scope:

The scope of cost accounting is comparatively narrow and primarily concerned

with cost ascertainment.

While the scope of management accounting is very wide. It includes financial

accounting, cost accounting, budgeting, tax planning, etc.

6. Use of Information:

Cost accounting is concerned mostly in short-term planning.

203

While management accounting is concerned equally with short-term and long-term

planning. It uses sophisticated technique like sensitivity analysis, probability

structures in planning and forecasting process.

7. Functional Area:

Cost accounting is concerned with assisting the management in its function but

does not evaluate the performance of the management.

While management accounting is concerned both with assisting the management

in its function as well as evaluating the performance of the management of an

institution.

8. Installation:

Cost accounting can be installed without management accounting. While

management accounting cannot be installed without a proper cost accounting

system. Hence cost accounting is independent but management accounting is

dependent on cost accounting.

Q.16. Explain the limitations of financial accounting. How do you propose to

overcome them? [GU.1991]

Or, Describe fully the limitations of financial accounting and point out how

management accounting helps in removing them. [GU.1990]

Or, Management Accounting is expected to overcome the limitations of

financial accounting. Give your comments. [GU.2000]

Or, Is it not possible to achieve the objectives of management accounting

through normal financial accounting? [GU.1988]

Financial accounting is mainly concerned with the preparation of financial

statements like Profit and Loss Account and Balance Sheet to know the operational

results-profit or loss anc financial position respectively. This information is

complex and is given in technical language and not very much useful to the

management. Moreover, the growth and complexities of modern busines has

extended the area of limitations so far as its managerial uses are concerned. Some of

tht limitations are given below:

1. Historical Nature:

204

Financial accounting is historical in nature in the sense that it records what has

happein during a given period. It is not concerned with future uncertainties.

Management accounting uses financial data to determine the impact of the data on

th, future course of action through trend analysis, probability structures, ratio

analysis, etc. Th financial accounting as such is not so useful to managerial decision

making but it becomes usefu I:

he management after suitable modifications to the data.

2. Information about the Enterprise as a whole:

Financial accounting provides information about the enterprise as a whole e.g.

total expenses, total revenues, etc. It does not provide information in details such as

product wise, process wise, department wise information etc.

But management needs information in details. Management accounting provides

information in details such as product wise, process-wise, activity-wise, etc;

through the technique of standard . sting, responsibility accounting, budgetary

control, ratio analysis, performance appraisal reports, etc.

3. Price Fixation:

Financial accounting is not helpful in price fixing because costs are obtained after

they are incurred.

Management accounting assists the management in removing this limitation with

the help of projected and estimated costs through standard costing, marginal

costing, budgetary . antral techniques. -'. Cost Control:

Cost control under financial accounting is not possible because costs are known

only - fter the end ofthey ear. As costs are already incurred, they cannot be

controlled.

Management accounting can assist the management in cost control and cost

reduction I providing an yardstickfor measuring efficiency in the use of

resources. It is done through ponsibility accounting, standard costing, budgetary

control, performance appraisal report, stc. by comparing the actual cost with

standard cost and actual performance'with budgeted performance.

Policy Appraisal:

205

Financial accounting has no techniquefor performance appraisal. Profitability is

the only Jstick in financial accounting.

Management accounting can appraise the policies and programmes through its

various techniques such as budgeting, ratio analysis, performance appraisal, etc.

Evaluation of management cies and functions is one of the basic functions of

managementaccounting.

Decision Making:

Financial accounting cannot provide relevant information necessary to take

strategic tecision relating to introduction of a new product, replacement of labour

by machine, selection of - posal out of many alternatives, expansion or contraction

of production, etc. But Management accounting provides useful information for

such strategic decisions. It : ne through project appraisal and ranking on the basis

of profitability, focusing on weak areas lanagement supervision, etc.

Q tantitative Information:

Financial accounting records only quantitative information and ignores qualitative

trrmation. But decision making process is materially influenced by both

quantitative and qualitative rmation.

On the other hand, management accounting provides information of both

quantitative malitative information which helps it in decision making process.

Q. 17. Give the meaning of management accounting tools. [G.U.200]

The tools of management accounting refers to certain techniques, procedures,

methods, a. which are used by the management accountants for the purpose of

modification with a view assisting management in their decision making, planning

and control of business activities.

Following are the important tools used in management accounting:

(i) Financial planning,

(ii) Analysis of financial statements,

(iii) Budgetary control,

(iv) Standard costing and marginal costing;

(v) Decision accounting;

(vi) Ratio accounting,

206

(vii) Control accounting; and

(viii) Management information system.

Q. 18. Describe the tools and techniques of management accounting needed for

man.

The various tools and techniques used in management accounting for assisting

management in decision making are discussed below: i. Financial Planning:

Financial planning involves determining both long-term and short-termfinancial

object, of an enterprise, formulating financial policies and developing financial

procedures to achieve objectives. Thus management has to take strategic decisions

like-fund raising, fund allocati capital structuring, etc. Management accounting

provides techniques for such finaiK planning.

2. Analysis of Financial Statements:

Analysis and interpretation of financial statements are an attempt to determine

significance and meaning of financial statements so that a forecast may be made

of prospects for future earning ability to pay debts and probability of a sound

dividend policy. Technique: used are comparative financial statements, ratios, funds

flow statement, trend analysis, etc.

3. Historical Cost Accounting:

Financial accounting records actual costs which are used in operating a standard

cos; system and determining variance.

4. Standard Costing:

It is an important tool of cost control. It involves the preparation of standard costs,

comparison with the actual costs and analysis of the differences. It is also necessary

for performa: .. appraisal.

5. Budgetary Control:

It is a system where budgets are used as a tool for planning and control. Function

budgets are prepared on the basis of actual data and future possibilities. They are

compared v. the actual performance and differences are analysed for corrective

actions.

6. Marginal Costing:

207

It is a method of costing which is concerned with the changes in costs resulting

from nges in volume of production. It is concerned with variable costs. It is used in

utilising idle pacify in maximising profits or minimising loss.

' Decision Accounting:

Decision making is the primary function of the top management. It involves a

choice from tious alternatives. Decision accounting assesses the profitability of

various proposals. It ! itates the correct selection of a proposal.

Revaluation/Replacement Accounting:

Preserving of capital is an important object of management. Profits are to be

calculated in wuch way that capital is preserved in real terms. Revaluation

accounting is used to denote the .thod employed for overcoming the problems

connected with fixed assets replacement in a . iod of rising prices. It ensures proper

utilisation of funds in capital assets.

Control Accounting:

It refers to different systems of control devices such as standard costing,

budgetary ; ntrol, internal check, internal audit etc. Management accounting

evaluates departmental . formance through these devices and submits reports to

the relevant levels of management taking appropriate actions where necessary.

Q.19. "Management Accounting is an integral part of the system of

management

Control" Explain the various constituents of management control and point

out the functions of management accountant in relation thereto. [G.U.2001]

A) Constituents of Management Control: Management function is concerned with

decision making. Decision making involves planning and control. Control is the

process to ensure that the plans are being attained. It is a feed \k system. It tells

how effectively and efficiently objectives, goals and plans are accomplished, hat

went wrong and what can be done to assure that planned activities will be

performed.

208

Thus control implies the measurement and evaluation of performance. Control

function nol ves the following constituents:

1. Comparison of actual performance against predetermined budgets and standards;

2. An analysis of the variances from budgets and standards in order to determine

the underlying causes;

3. Initiation of action that may correct the deficiencies indicated;

4. Follow-up to appraise the effectiveness of the corrective action; and

5. Feed back of the information to the planning process to improve future planning

and control activities.

As control can be effected by individuals, performance report should clearly

indicate to the manager what activities were controllable by him and what were not.

For effective control, performance should be effectively evaluated and should be

compared gainst budgets and standards. Management accounting should be

selective in reporting performance ata to various levels of management. It is done

by providing detailed performance and control -eports. The maxim is "Management

by exception"

B) Functions of Management Accountant: A management accountant has the

following functions in relation to control:

1. Planning for control:

Management accountant establishes, coordinates and administrates an integrated

for the control of operation. Such a plan provides cost standards, expense budget,

sales fore., a capital investment programme, profit planning and a system to carry

out the plan.

2. Reporting:

He measures the performance against given plans and standards and interprets the

rest and reports them to the different levels of management.

3. Evaluation:

He evaluates various policies and programmes and reports the soundness or

otherwise them.

4. Tax Administration:

He submits different reports to the governments and administers tax problems.

209

5. Appraisal of External Effects:

He assesses the effects of various economic and fiscal policies of the government

ai evaluates the impact of other external factors in the attainment of objectives.

6. Protection of Assets:

He protects the assets of the firm through internal control, auditing and other

measure

Q. 20. State the application of computer in management decision making

process. (Or) Discuss the role of computer in managerial decision making

process. (GU.2006)

A)Computer and its Functions:

A computer is an electronic data processing device. It can read, write, compute,

compare store and process large volume of data with high speed, accuracy and

reliabilitity and works on i:. instructions given to it. Once the data and instructions

are fed into the memory (CPU), it obe; instructions and performs actions on the data

and produces results. Therefore a computer ha three devices :-

(i) Input device

(ii) Processing device (CPU); and

(iii) Output device.

Input device :

They help the user to feed the instructions and data into the computer. They include

- Key Board, Punch Card Reader, Paper Tape Reader, Speech Recognition System,

Floppy Disk, Mouse

Processing device :-

Processing device (Central Processing Unit or CPU) does the computing function

and i: includes addition, substraction, division, multiplication and summarisation,

etc. This device processes the data according to the instructions of the user.

Output device :-

Output device produces the results. Output devices are used for the processed value

results from the computer. This device includes visual display unit, Printers,

Plotters, Microfilm recorders, etc.

210

Thus a computer records, stores, processes, and produces the desired information

for the managerial persons at different levels at different times as per their

requirements. Decision and Decision Making :-

Decision making is the selection of one course of action from two or more

alternative courses of actions on the basis of certain criteria.

According to Mac Farland "A decision is an act of choice wherein an executive

forms a conclusion about what must be done in a given situation. A decision

represents a course of behaviour choosen from a number of possible alternative.

" According to George Terry "Decision making is the selection based on some

criteria from two or more alternatives. " Function of Management :-

The primary function of management is to reddress the problems of control, co-

ordination and communication. In these spheres a rnanager is to take crucial

decisions having far reaching effects. For a sound decision, the management needs

correct and full information. It is only a sound Management Information System

(MIS) which can provide timely adequate and accurate information.

B) Role of Comuper in Managerial Decision Making :-

In this MIS, computer plays a pivotal role because all information about the

business can be fed, stored, processed and required information can be obtained

quickly and accurately as and when needed. A computer functions like a storehouse

of processed information for immediate needs and future reference. Thus different

levels of management can use computer for various pes of information as and when

they require for the purpose of their decision making.

C) Different Levels of Management and Their Information Needs :-

The function of management has been decentralised at:

(a) Lower Level;

(b) Middle Level; and

(c) Top Level

A Manager at each level has a specified area of function where he has to take

prompt on. Therefore he needs accurate and quick information relating to his sphare

of activities so at he can take prompt corrective action. In this sphere also computer

provides services because applies not onty accurate but also quick information. A

211

short description of the functions of erent levels of management are given below.

Lower Level Management or Supervising Level:

Managers at this level deal with day to day operations or activities. These activities

include entory control, pay roll, processing sales transactions, keeping track of

employees, work hours, . These are routine work and repetitive nature. They need

feed back reports for the purpose of :rol and co-ordination. Somtimes they need

these reports to compare the variance from the dgeted targets and for corrective

actions there of. Computer provides them all necessary r:: nnation promptly without

delay.

Middle Level Management :-

Managers at this level are required to co-ordinate, control and monitor various

activities in an organisation. They act as a liason between lower management and

top management .Compu_r helps them in providing various control reports, feed

back reports for their action and on v. i transmission to top - level management.

Top - Level Management :-

Managers at this level are concerned with general direction of the company and k i

term planning of the organisation. They have to take decision on various strategic

decisions anc that purpose they need adequate and reliable information about the

affairs. They get this informa: from the data base of the computer. So the use of

computer is very much useful to the top - le management for its decision making

process.

Q. 21. Define the following Terms: Or Write short notes on :

I. Management Accounting.

2. Marginal Costing.

3. Break Even Point.

4. Margin of Safety.

5. Break Even Chart.

6. C.V.P. Analysis.

7. Contribution.

212

8. Variance/Analysis of Variance.

9. Standard Costing.

10. Capital Budgeting.

11. Pay-back Period Method.

12. Internal Rate of Return.

13. Budgetary Control.

14. Flexible Budget.

15. Zero Base Budgets.

16. Cash Budget.

17. Master Budget.

18. Fund Flow Statement.

19. Cash Flow Statement.

20. Current Ratio.

21. Liquidratio.

22. R.O.I./Net Worth Ratio.

23. Stock Turnover Ratio.

24. Solvency Ratio.

25. Debt Equity Ratio.

1. Management Accounting:

Anglo-America Council On Productivity defines Management Accounting in the

following terms:-

"Management Accounting is the presentation of accounting information in such

a ,way as to assist management in the creation of policy and the day to day

operation of an undertaking ".

In simple words, Management Accounting includes financial accounting and

extends tc the operation of a system of cost accounting, budgetary control and

statistical data. It not onl\ meets the legal and conventional requirements regarding

the presentation of financial statements such as Profit and loss Account, Balance

Sheet 'Fund Flow Statement' but also gives more emphasis on the establishment and

operation of internal control.

2. Marginal Costing:

213

CIMA defines Marginal Costing as " The ascertainment of marginal cost and of

the effect on profit of changes in volume or type of output by differentiating

between fixed cost and variable cost. "

The theory of Marginal Costing is based on the assumption that some elements of

costs end to vary directly with variation in the volume of output while the others do

not. That is why only ariable costs form part of product cost and fixed costs as

period cost are transferred to Marginal 3rofit and Loss Account. Thus, Marginal

Cost is the aggregate of all direct costs and variable : \ erheads of one additional

unit of output. It is a change in cost due to a change in output. Break Event Point:

CIMA defines Break- Even Point, as "The level of activity at which there is

neither rofit nor loss. It can be ascertained by using a break even chart or by

calculations. "

Break Even Point is a neutral point where there is neither profit nor loss. It is a

level ' activity where costs are equal to revenue or contribution is equal to fixed

costs.

Break even point can be calculated by using the following formula:-

(i) Break Even Point = Fixed Expenses/ Unit Contribution

(ii) Units)

(iii) Break Even Point=Fixed Expenses/ Unit Contribution x Unit Selling Price

(iv( Sales)

(iii) Break Even Point = Fixed Expenses/P.V.Ratio

(iv) Sales) Margin of safety:

Margin of Safety is the difference between the actual sales and the sales at break-

- n point. Therefore, the margin of safety is also the excess of production over the

break-even roint of output.

The soundness of a business may be gauged by the size of the margin of safety. A

high -gin of safety shows that the break-even point is much below the actual sales

so that even if ere is a fall in sales, there will still be a profit. A low margin of

safety, on the other hand, is an ator of the weak position of the business and even a

small reduction in sale or production will ersely affect the profit position of the

business.

214

Margin of Safety = Actual Sales - Break Even Sales

OR

Margin of Safety = [Profit / P. V.Ratio]

Break Even Chart:

Break Even Chart is the graphical representation of the marginal costing showing

inter itionship between Cost, Volume and Profit.

DR. VANCE is of the opinion that " It is a graph showing the amounts of fixed,

and Me costs and the sales revenue at different volumes of operation. It shows at

what .me the firm first covers all costs with revenue of break even. CIMA has

defined break even rt as "A Chart which shows the profitability or otherwise of an

undertaking at various . Is of activity and as a result, indicates the point at which

neither profit nor loss is made. " Cost Volume Profit Analysis fC. VP. Analysis]:

G VP. analysis is the study of inter relationship of three basic factors of business .

ations-COST, VOLUME and PROFIT. These three factors are inter-connected in

such a ier that they act and react on one another because of cause and effect

relationship een them.

The C.V.P analysis helps the management in the process ofprofit planning. The

outpu: of a concern must be increased in order to increase profit.

In the words of HEISER " The most significant single factor in profit planning of an

average business is the relationship between the volume of business, costs and

profit".

7. Contribution:

Contribution is the excess of sales value over marginal cost of the product. This

difference between sales and variable cost contributes towards fixed cost and profit.

Excess contribution over fixed cost represents profit and vice-versa represents

loss. P.V. rtaio can b: improved by any one of the following ways-

(i) By reducing variable costs.

(ii) By increasing selling price

(iii) By selling more profitable products. Formula for c'ontribution.

Sales- Variable Cost = Contribution

or Fixed Cost + Profit = Contribution or Fixed Cost - Loss = Contribution

215

8. Variance/Variance Analysis:

I.C.M.A defines Variance as "he difference between standard cost and tht

comparable actual cost incurred during a given period. The purpose of variance

is to enablt the management to have control over cost".

Favorable Variance:- When actual cost is less than the standard cost, it is known as

favourable variance. It is a sign of efficiency.

Variance Analysis:- Variance Analysis is defined by I.C.M.A. as "The process of

computing the amount of and isolating the causes of variance between the actual

costs cm. the standard costs ".

Thus it is the process of analysing variances by sub-dividing the total variance in

such a way that the management can assign responsibility for any off standard

performance.

The variance analysis is an important tool of cost control and cost reduction and

i: generates an atmosphere of cost consciousness in the organisation. Variance

Analysis invole

(i) Computation of individual variances and

(ii) Determination of the cause of each variance.

9. Standard Costing:

I.C.M.A. LONDON defines Standard Costing as "The preparation and the use of

standard costs, their comparison with actual costs and analysis of variances to

their caus and points of incidence."

According to WHELDON "Standard Costing is a method of ascertaining the cos:

whereby statistics are prepared to show (a) the standard cost (b) the actual cost

and (c) the differences between these costs, which is termed the variance."

Standard costing involves the following steps:

(i) Setting up of standard cost for different elements of cost.

(ii) Ascertaining actual costs.

(iii) Comparing the standards with actual costs to determine the difference shown

as variance.

(iv) Analysis of variance.

216

(v) Reporting of these variances and analysis there of to management for

appropriate action.

10. Capital Budgeting:

Charles T. Horngreen has defined Capital Budgeting, as "Capital Budgeting is long

term planning for making andfinancing proposed capital outlays. " It means

acquiring inputs with long-term return.

Capital budgeting concept implies the planning for capitals. It is a decision, which

involves the current outlay of cash resources in return for an anticipated flow of

future benefits.

In simple words, it implies decisions on (i) addition (ii) disposition (iii)

modification and (iv) replacement of fixed assets.

11. Pay Bach Period Method:

Pay back period method is a method, which represents the period in which the

total investment on a permanent asset pays back itself. It measures the period of

time in which the original cost of the project will be recovered from the additional

earnings of the project itself.

This is the easiest method to be used for evaluation of capital expenditures. This

method is also called Pay Out and Pay Off method.

In simple words, it is a quantitative method for apprising a capital expenditure

decision.

PBP =-

Annual Cash Inflow.

12. Internal Rate of Return [I.R.R]:

Internal Rate of Return can be defined as that rate of discount at which the present

value of cash inflows is equal to the present value of cash outflows. Since the

discount rate is determined internally, so this method is known as Internal Rate of

Return Method.

13. Budgetary Control:

ICMA defined Budgetary Control as The "Establishment of budgets relating the

responsibilities of executives to the requirements of a policy and the continuous

217

comparison of actual with budgeted results to secure by individual action the

objective of that policy or to provide a basis for its revision. "

14. Flexible Budget:

CIMA defines a flexible budget as "A budget which, by recognising the difference

in behaviours between fixed and variable costs in relation to fluctuations in

output, turnover or other variable factors such as number of employees, is

designed to change appropriately with such fluctuations. " It gives different

budgeted costs for different levels of activity. In this case, expenses are divided

between fixed, semi-fixed and variable and its usefulness depends on accurate

classification of expenditures. Such budgets are not rigid. They are adapted to the

change in the levels of activity.

CIMA has defined it as "A methodof budgeting whereby all activities are

revaluedeach time a budget is set. Discrete levels of each activity are valued and a

combination is choosen to match funds available ".

16. Cash Budget :

Cash Budget is a forecast of cash position for a period. It is a detailed budget of

cash receipts and cash expenditure incorporating both revenue and capital items. "//

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 " Thus it is an estimate of

anticipated receipts and payments of cash during a budget period. However, cash

adjustments and accruals are not shown in the cash budget.

17. Master Budget:

CIMA (Chartered Institute of Management Accountants) London has defined a

master budget as "The summary budget incorporating the functional budgets,

which is finally approved, adopted and employed. "

When the functional budgets have been prepared, a summary of all these budgets is

made and that summary budget is known as Master Budget. It shows the over all

plan of the business for the next period. It also shows the important accounting

ratios and gross and net profit figures.

18. Fund Flow Statement:

218

This statement shows the changes in the financial position between two periods. In

this statement, the word 'Fund' implies working capital. It shows the sources from

which funds have been recieved and the uses to which such funds are put. It helps

the management in policy formulation and performance appraisal.

19. Cash Flow Statement:

A Cash Flow Statement is a statement which shows the financial changes on cash

basis. It shows the cases of changes in cash position of a business enterprise

between the dates of two Balance Sheets.

20. Current Ratio:

Current Ratio is the relationship between Current Assets and Current Liabilities. It

measures the general liquidity of a firm in a short period. Current assets are those

assets which are converted into cash within a short period of time usually within

one year, they normally include cash and bank balances, marketable securities,

debtors, bills receivables, inventory, prepaid expenses and accrued incomes.

21. Liquid Ratio:

It is a ratio between quick assets and current liabilities. The term liquidity means

the ability of a firm to pay its short term obligations as and when they become

due. This ratio gives a stringent measure of liquidity because comperatively less

liquid assets such as inventories, prepaid expenses are excluded from the definiition

of quick assets. This liquid assets or Quick Assets include- Cash and bank balances,

short term marketable securities, debtors and bills receivable. Sometimes current

libilities do not include Bank overdraft which may be renewed from time to time.

In that case current liabilities (- )Bank overdraft is called liquid liabilities. It is

calculated as under:

Liquid Assets

Liquid Ratio/ Acid Test ratio/Quick Ratio =

22. Return On Investment and Return On Capital:

Return on Investment is a primary ratio to measure the profitability ofafirm. It

indicates the rate of return on the resources that are invested in a firm. Thus it

measures the degree of efficiency to which resources have been utilised. It

219

facilitates inter-firm comparison and helps the prospective investors in their

investment decision.

Return on Investment (ROI) is calculated with the following formula:

Return On Investment =. m x 100

23. Stock Turnover Ratio :

This ratio indicates the number of times the stock has been turned over during a

period and evaluates the efficiency with which a firm is able to manage its

inventory. It is calculated as follows:

Sales or Cost of Goods Sold

Inventory Turnover Ratio =Average Inventory-

24. Solvancy Ratio:

This ratio indicates the relationship between total outside liabilities and total

assets of-a firm. It shows the quantum of assets available per rupee of liability.

Thus it measures the margin of safety for the creditors. It is calculated as :

Total Liabilities_

Solvency Ratio - Total Assgts (Excluding fictitious Assets)

25. Debt Equity Ratio:

Debt Equity Ratio shows the relationship between External Equities and

Internal Equities. It indicates the relative proportion of debts and equity in

financing the assets of the firm. It is also known as External-Internal Equities

Ratio.

External equities or Debts mean outside funds such as - loans, debentures,

creditors and other short term 1 iabi 1 ities.

Internal Equities or shareholders' fund mean Share Capital both equity and

preference shares and Reserves and Surpluses.

The debt-equity ratio is calculated as :

External Equities I Debts

Debt-Equity Ratio =

Q.22. Write a brief note on Management audit. Definition:

220

Management audit signifies the audit of management process and functions which

covers all the areas of management like planning, organisation co-ordination and

control.

According to the "American Institute of Management" Management audit is a

diagnostic process for analysing, goals, plans, policies and activities in every

phase of operation to turn over unsuspected weaknesses and to develop ideas for

improvement in the areas that has escaped management attention.

Thus it is a critical review of an organisational structure and administration and

to make recommendations for adjustment and improvement.

Objective:

Management audit has the following objectives:

1. To increase profitability:

Its object is to increase profitability by improving organizational efficiency.

2. Pinpointing irregularities:

It pinpoints the irregularities in the process of management and shows weaknesses

in the chain of administration and policy formulation and suggests remedial

measures.

3. Identification of Objectives:

It helps in the identification of the objectives of the various levels of management

and suggests measures for co-ordination.

4. Appraisal of Policies:

Management audit makes a comprehensive appraisal of management policies and

its functions and suggests impfovementel measures where they are found necessary.

Q. 23. What are the preliminaries for installation of Management Accounting

System?

The following are the steps necessary for installation of management accounting

system :

(i) OperationalManualr: An operational manual should be prepared and adopted. It

will explain the duties and responsibilities of various management levels in the

organisation. It will help communication process.

221

(ii) Preparation of Forms and Returns : Various forms and returns are to be

prepared for collection and presentation of information for management needs.

(iii) Requisite Staffing: Requisite staff should be recruted for making the system

effective.

(iv) Classifying Accounts and Integrating the System : Accounts are classified to

facilitate collection and analysis of data. Both the financial accounting and cost

accounting should be integrated.

(v) Introduction of Standard Costing: Techniques of standard costing are to be

introduced for setting up standards and recording the performance and determining

variances. It is necessary for taking remedial measures.

(vi) Setting up Budgetary Control System: Budgetary control system is to be

introduced to plan the activities of various departments. It is necessary for the

preparation of functional budgets and integrating them into master budget which

determines the organisational goal.

(vii) Setting up Operational Research Techniques : Operational research

techniques are necessary to cope with the changing needs of business in ever

changing political and social environment.

Q. 24. Mention four functions and four duties of a Management Accountant?

Four fuounction of Management Accountaint are:

(i) Planning for control: He plans for control of operations through budgetary

control system and by introducing standard costing.

(ii) Reporting: He submits performance reports to the management for taking

remedial measures where necessary. .

(iii) Evaluation of policies and programmes: He evaluaties the efficacy of business

policies and programmes and reports there on to the management.

(iv) Tax Administration: He supervises over compliance of laws and tax liability.

Four duties ofManagement Accountant:

(i) Collection of information : He collects information from various sources, both

inside and outside the business.

222

(ii) Evaluation of information: He evaluaties the information collected and

relevant information is modified for using it in planning, controlling and reporting

purpose.

(iii) Interpretation of information: He interprets the facts about the business in

monetary terms and prepares his suggestions on policy matters.

(iv) Reporting of information: He suppl ies information to various levels of

management through reporting for decision making purpose.

Objective Type Questions:

Q. 25. Fill in the blanks :

(1) Management accounting is the presentation of_information to the management.

(accounting)

(2) Mangement accounting uses no_norms in its function, (fixed)

(3) Management accounting provides_but does not take decision, (provides)

(4) Management accounting is concerned not with the past, but with the-. (future)

(5) Management accounting_accounting information to make it usefull. (modifies)

(6) Mangement accounting is a_of management, (tool)

(7) Provision of accounting information is known as_. (reporting)

UNIT - V FINANCIAL STATEMENT ANALYSIS A. Financial Statement

analysis Syllabus:

Concept and Nature of Financial Statements : Limitations of Financial Statements,

Need of analysis, Tools and Taehiniques, Ratio analysis:Type, uses, significance

and limitations, liquidity, profitablility and Long term Solvency ratios. Statment of

Changes in financial position (Fund Flow Statement) Cash flow Statement as per

AS-3 (Simple Application)

Q. 1 What do you mean by a financial statement? What are its different types?

Meaning:

'A financial Statement' is a summarised statement of financial data relating to a

business unit. Such financial data are organised systematically, presented

logically in the statement in order to convey some financial aspects of a business

firm.

Definition of Financial Statement:

223

According to John N. Myer, 'The financial statement provides a summary of the

accounts of a business enterprise the Balance Sheet reflacting the assets,

liabilities and capital as on a certain date and an Income Statement showing the

results of operations during a certain period.

In the words of Anthony, financial statements essentially are interim reports,

presented annually and reflect a division of the life of an enterprise into more or

less an arbitrary accounting period - more frequently a year.' Types of financial

Statements :

Financial Statements primarily comprise two basic statements:

(i) The Position Statement or the Balance Sheet; and

(ii) The Income Statement or the Profit and Loss Account.

According to GAAP, finacial statements include the following:

(i) A Balance Sheet/Position Statments;

(ii) An Income Statement/Profit and Loss Account;

(iii) A statement of changes in Owner's Accounts; (Retained earnings) and (iv) A

statement of changes in financial position i.e. Fund Flow and Cash Flow statements.

1. Position Statement or Balance Sheet:

A Position Statement or a Balance Sheet is a tabular statement of summary of

balances (debit and credit) carried forward after an actual and constructive closing

of books of accounts and kept according to principles of accounting. It shows the

sources of funds and their applications. Funds are procured from owners and

creditors and application of such funds are made in the acquisition of assets. It

shows the financial position at a point of time i.e., the financial strength or

weakness of an enterprise.

2. Income Statement or Profit and Loss Account:

It is a statement containing the activities of a firm for a particular period. It is

prepared to determine the operational results of a concern for the particular period.

It shows the revenues earned and expenses incurred for earning those revenues. The

excess of revenues over the expenses is termed as profit while the excess of

expenses over revenues is termed as loss.

224

It may consist of manufacturing and/or Trading Account and the Profit and Loss

Account in order to show the cost of production and/or gross profit and net profit

respectively.

3. Statement of Changes In Owned Equity or Retained Earnings :

The term "Owner's Equity" means the claims of the owners of a business or

contributories of a company against the assets of the firm.

The term 'Equity" has two elements :

(i) Paid up capital i.e., the amount of money paid by the shareholders against the

shares: and

(ii) Ratainedearnings i.e., the reserves and surplus representing undistributed

profits.

4. Statement of Changes in Financial Position:

Basic financial statements are Profit and Loss Account and Balance Sheet. These

statement-show the net effect on the operations and the financial position of a

business respectively. The Balance Sheet shows the financial position of a business

at a point of time. Thus it gives a static view of the sources of funds of a business

and their various uses at a particular point of time. The Profit and Loss Account

shows the resources provided by business in a given period. There an many

transactions which do not operate through the Profit and Loss Account.

Therefore, f i a better understanding of financial statements, another statement

called the Statement Changes in Financial Position has to be prepared. It shows

the changes in assets and liabil it t of a firm from one point of time to another point

of time. Its objective is to show the movement fund (working capital) during a

particular period. This movement of fund can be shown in a statement which can be

prepared in any of the two forms

1. Fund Flow Statement and

2. Cash Flow Statement.

Fund Flow Statement:

This statement shows the changes in the financial position between two periods. In

th statementthe word'Fund' implies working capital. It shows the sources from

225

which funds ha been recieved and the uses to which such funds are put. It helps the

management in policy formulation and performance appraisal.

Cash Flow Statement:

A Cash Flow Statement is a statement which shows the financial changes on cash

basis. It shows the cases of changes in cash position of a business enterprise

between the dates of two Balance Sheets.

It focuses attention on cash changes only.

Q.2 State the nature of financial statements:

Nature of Financial Statements:

Financial Statements are prepared on the basis of recorded facts. Such recorded

facts are the transactions which have monetary valuel These statements are based

on historical costs and are prepared for the purpose of presenting a periodical view

of the financial position at a point of time and operational results for a given period.

The American Institute of Certified Public Accountants states the nature of financial

statements as given below:

"Financial statements reflect a combination of recordedfacts, accounting

conventions and personal judgements."

According to the American Accounting Association (AAA), "Every corporate

statement should be based on the accounting pinciples which are sufficiently

uniform, objective and well understood to justify opinions as to the condition and

progress of the business enterprises. " The following points explain the nature of

financial statements:

1. Recorded Facts:

Recorded facts are those facts which have been recorded in financial books.

Financial statements contain only the recorded facts but ignores unrecorded facts.

These facts are recorded at cost price and as a result, financial statements containing

such recorded facts show financial position on historical cost basis and does not

show its financial position on current economic condition..

Certain facts which may affect the financial position such as purchase and sale

contracts, claim for refund and guarantees are not recorded in the books of account

hence are not shown in the financial statements. They are shown only as foot notes

226

in the Balance Sheet. Non-recording of qualitative aspect of certain events also

fairly affect the financial statements.

"2. Accounting Conventions:

While preparing the financial Statements certain accounting conventions

arefollowed which are known as Modified Accounting Principles. Asfor

examples, Conservation, Prudence, Materiality, etc. to make the financial

statements realistic, uniform and comparable. However these modifying principles

allow the scope ofselecting alternatives which affect the qualitative aspect of the

financial statements. More over, the principle of valuation of various assets such

as, cost less depreciation in case of fixed assets, cost or net realisable value

whichever in lower in case of valuing current assets etc. make the financial

statements unrealistic to a certain extent.

3. Postulates:

Postulates are certain assumptions which are used for recording transactions. Some

of the postulates are going concern assumption, realisation principle, money

measurement etc. These postulates are used to make the financial statement

objective. But these are true if the firm is a running one, the money value remain

static and the revenues are realised immediately in full. These assumptions are

found very often incorrect. As a result, the financial statements prepared on the

basis of these principles do not show the real picture in terms of current money

values of the assets.

4. Personal Judgement:

Inspite of the existance of accounting principles and accounting standards, personal

judgement of the accountant plays an important role in the preparation of financial

statements. As for example -accountant uses his discretion in choosing the method

and rate of depreciation, in choosing the method of valuation of inventories, in

writing off intangible assets or in treating the expenditure on research and

development. Such use of personal judgement in such matters largely affect the

thruthfulness and fairness of financial statements.

5. Accounting Standards:

227

Financial Statements prepared on the basis of accounting principles as mentioned

above suffer from certain defects and infirmities. In order to remove these defects

and infirmities in financial statements, Accounting Standards have been introduced

and their mendatory use has been suggested. These accounting standards will go a

long way to make such statements uniform, comparable and reliable to a great

extent.

Q. 3 State the objectives of financial statements.

The financial statements are important sources of information relating to a business

enterprise disclosing its operational results of a given period, financial position at a

point of time, changes in the retained earnings position and the sources of inflows

and outflows of cash and funds during a given period.

Objectives of Financial Statements :

The objective of the preparation of financial statements can be broadly divided into:

(i) Statutory objectives; and

(ii) Non-statutory objectives.

Statutory Objectives:

The companies Act requires the preparation and presentation of financial statements

as per sections210and211.

Section 210(1) states that:

at every annual meeting, the directors shall lay before the company:

(a) A Balance Sheet at the end of the period, and

(b) A Profit and Loss Account for the period.

Section 211 requires that the Balance Sheet shall give true and fair view of the

financial position and the Profit and Loss Acount shall give the true and fair view of

profit or loss of the company.

Non-Statutory Objectives :

The basic objective of the financial statements is to assist various interested parties

in decision making.

228

The various other objectives are: (According to Accounting principles Board (APB)

Statement No. 4).

1. To provide reliable financial information about economic resources and

obligations of a business enterprise.

2. To provide reliable information about changes in net resources (resources-

obligations) of an enterprise that results from the profit directed activities.

3. To provide financial information that assits in estimating the earning potential of

the enterprise;

4. To provide other needed information about changes in ecoomic resources and

obligations.

5. To disclose, to the extent possible, other information relating to the financial

statements that is relevant to the needs of the users of these statements.

The above information is needed by:

(i) Financial Institutions for assessing the financial position and earning capacity

of a firm before granting a loan.

(ii) Stock Exchanges for the purpose of lising of shares.

(iii) Credit Rating Agencies for the purpose of determining and granting rating of

a company.

(iv) Government and Government Agencies for legal and control purposes.

(v) Courts for settling disputes.

(vi) News Papers and Journals for analysing and reporting the state of affairs.

(vii) The Investors i.e, shareholders, debentureholders, underwriters etc. to assess

the company.

Q. 4 State the limitation of financial statements : (GU.2006)

Financial accounting is based on certain accounting assumptions, principles,

conventions, etc. known as GAAP and these assumptions and principles may not

always work or come true. As a result, financial statements sufferfrom certain

inherent limitations.

Therefore, financial information provided by the financial statements may give a

misleading view unless such information is analysed and interpreted with due care

229

and caution. Following are some of the limitations the financial statements

suffer.from :

1. Assumption of Constant Money value:

Financial transactions are measured and recorded in terms of money and the

financial statements contain the information in monetary units. It is assumed that

the money value remains stable but in fact, it is constantly changing. So figures

contained in the financial statements do not show the real picture. It may result in

overstatement of profit in case of inflation and understatement )f profit in case

deflation.

2. Historical Costs:

Financial transactions are recorded at cost. So the fixed assets are shown in the

financial atements at cost less depreciation to date. It does not take into

consideration the realisable values : replacement values. So the effect of price level

changes is not reflected in the financial statements.

3. Periodicity Principle:

Financial statements are prepared periodically assuming that the business will run

indefinitely These statements are interim reports and do not show the real picture

which will be known only at the time of liquidation when the assets will be finally

realised. Thus these statements show onK interim financial position and interim

financial results.

4. Application of Personal Judgement:

In the preparation of financial statements, the accountant has to apply his personal j

udgements in many areas such as -method and rate of depreciation mode of

valuation of investments, etc.. This subjective element may distort the financial

results.

5. Arbitrary Allocation of Expenditure:

Cost allocation over a number of years may not be done rationally. Such allocation

may be done arbitrarily and it may distort the operational results and financial

position.

6. Use of Alternatives:

230

Financial transactions may be recorded in the books of account in alternative

methods which may materially affect the operational results and position, as a

result, they may not be comparable. As for example- different methods are available

for providing depreciation, valuation of inventories, etc.

7. Non-inclusion of Qualitative Information:

Financial statements contain quantitative information only and qualitative

information is altogether avoided. Thus they do not reveal human resource position

of the organisation.

8. Matching Priniciple:

Matching of expenses with revenues is a defective method of determining profit

because only actual costs and not imputed costs are considered under this principle.

9. Prudence Principle:

Financial statements are prepared on prudence principle under which future loses

are considered but future incomes are ignored. Thus they understate profits and

financial position.

10. Aggregate Information:

Financial statements show expenses and revenues in aggregate and do not reflect

product wise or service- wise cost hehaviour. Thus cost determination of a product

or service is not feasible. More -over, it does not provide a mechanism for cost

control.

Conclusion:

It is to be noted that financial statements contain some figures and they are dumb

and they do not speak themselves. It is the analyst who will make them speak. So

the skill and the power of judgement of the analyst is very important in

interpreting the financial statements so that the imformation contained therein

become useful in decision making process.

Q.5. What is financial statement analysis ? What are its objectives?

Financial statements analysis is the process of determining financial strengths

and weaknesses of the firm by establishing strategic relationship between the

items of Balance Sheet, Profit and Loss Account and other operative data.

231

According to R.W. Metcalfand PL. Titard, analysing of financial statements is 'A

process evaluating the relationship between component parts of a financial

statement to obtain a stter understanding of a firm's position and performance".

According to Myers, "// is largely a study of relationship among the various

financial objctors as a business is disclosed by a single set of statements, and a

study of the trend of hese factors as shown in a series of statements."

So in financial statement analysis, an effort is made to present the elements of the

statements in a more understandable manner and it is done by establishing the

relationship between the relating elements and underlying the significance of such

relationship.

A. Analysis :

Thus financial statements analysis serves two important functions:

1. Examination of past activities of business firm (operating and financial

activities); and

2. Providing a base for planning and forecasting future course of action on the basis

of interpretations and comments.

The word 'analysis' includes:

(a) Breaking financial statements into simpler ones;

(b) Re-grouping the elements;

(c) Re-arranging the figures given in the statements;

(d) Finding out ratios and percentages underlying the significance of such figures.

So establishing the relationship amongthe factors is the main function of the

analysis.

B. Interpretation :

Interpretation means explaining the meaning and significance of the simplified data.

In interpretation, an analyst is to form an opinion from the meaning of the

simplified data as regards the financial position, operational performance, solvency,

earning capacity, growth potential of the enterprise.

However, the term financial statement analysis cover both analysis and

interpretation because interpretation is not posible withoutanalysis and without

interpretation analysis has no value.

232

So it is a bridge between recording and reporting activity and the activity of

interpreting the recorded activity.

Objectives of Financial Statements Analysis:

Financial Statements are used by different groups having different objectives. These

objectives can be summarised as follows:

1. To judge the financial health of a firm:

In order to make an opinion on this matter, the analyst should study the following

facts:

(a) Sources and appl ications of funds;

(b) Total assets and total liabilities;

(c) Long term liabilities and fixed assets;

(d) Current liabilities and current assets;

(e) Working capital position; etc.

2. To Judge the Solvency (Payment ability) :

To judge the solvency or payment ability of a firm an analyst should judge the

following

(a) Periodical cash inflows and outflows;

(b) Operating income and interest charge;

(c) Cash profit, Interest income, tax, dividend, etc.

3. To Examine the Quality of Security Against Debt Obligationss:

4. To judge the earning capacity of the firm.

Here he is to consider - gross profit, net profit, operating profit, cash profit, return

on investment and overall profitability.

5. To examine any additional requirements of funds either through loan,

debentures or issue of shares.

6. To decide about the future prospects of the firm.

7. To measure the effeciency of operations;

8. To have a comperative study (inter-firm comparison and inter-period

comparison);

9. To decide upon matters like-amalgamation, absorption, merger, etc; and to

determine the purchase consideration.

233

Q.6: Write short notes on different users of financial statements and their

information needs.

Financial statements are the end products of financial accounting and are used by

differer: groups for their decision making purpose. Following are the parties who

are interested in the affairs of the business and its financial statements for the

protection of their varied interests:

1. Management:

Financial statements are primarily used by the management in order to assess the

efficiency of different cost centres, profitability, operational efficiency, financial

soundness and future planning and control.

2. Creditors and Financiers:

Creditors and financiers are interested in the short term and long term financial

position of the business enterprise. Financial statements enable them to determine

the creditworthiness of the firm by making out different ratios such as1, profitability

ratios, solvency ratios, liquidity ratios and turnover ratios.

3. Investors:

Investors are interested in the profitability and long term solvency of the firm. They

can determine investment worthiness, potential growth and future prospect of the

firm by making out relevant ratios out of the information contained in the

statements. It helps them in arriving at a rational investment policy.

4. Shareholders:

Shareholders are interested in the growth of the business. They determine

profitability, and the future prospect of the enterprise. They are interested in the

Rate of Return (ROI), quantum of dividend, capital appreciation in the value of

shares. All these can be gethered from the financial statements. Moreover, from the

study of the financial statements they can decide the dividend policy of the firm.

5. Workers and employees:

Financial statements are useful to the employees in determing the quantum of

bonusand in fixing wage structure. They are interested in the solvency, profitability

and paying capacity of the firm. Financial Statement help them in assessing the

earning and paying capacity of the firm.

234

6. Government:

Financial statements help the government to assess the tax liability of the firm. The

government is also capable of assessing the economic development sectorwise and

regionwise out of the financial statements. More over, the study of the statements

helps the Govt, to determine the price and aid policy.

7. Stock Exchange:

Stock exchanges deal in the purchase and sale of securities. Financial statements of

different companies help them to assess the financial position of a firm and is used

in determining the price of securities of these companies.

8. Trade Associations:

Trade associations are meant for providing service and security to their members.

Financial statements help them in providing service securities, bonus and other

financial benifits to their members. They may develop standard ratios out of

financial information contained in the financial statements and design uniform

accounting system in those organisations.

9. Economists and Researchers:

Financial Statements provide imporant information regarding financial health of the

industry, rate of economic growth, etc. On the basis of study, they suggest effective

measures to accelerate the economic grouwth.

10. Consumers:

Consumers are interested in getting the goods at reduced price. They want to know

the control measures to reduce the cost of production. They are also interested in

assured supply of quality goods which is possible if the firm has growth potential.

Conclusion: The comparison is made on horizontal basis when financial

statements of two or more periods of the same firm is made. It is on vertical basis

when the financial statements of two or more firms of same period are compared.

Related figures are compared and the changes are found out. Such changes in

figures of important items such as sales, gross profit, net profit, operating expenses,

etc. show the progress or regress of the firm and its efficiency, solvency, earning

capacity, etc. It shows a definite trend in above respect.

235

Q. 7: Explain the different methods of financial statement analysis.

Or

Explain the different tools/techniques of financial statements analysis.

There a number of methods/tools/techniques for analysing financial statements but

no single tool is self sufficient for decision making purpose. So generally a

combination of techniques are used in financial analysis. Following are the different

methods/tools/techniques generally used:

1. Comperative statements;

2. Common size statements;

3. Trend analysis;

4. Ratio analysis;

5. Fund flow analysis;

6. Cash flow analysis;

7. Cost-voulme - profit or Break - even analysis; and

8. Working capital analysis.

1. Comperative Statements:

Comperative study of financial statements is a comparison of the financial

statements c: the business with the previous years' financial statements and with the

performance of the other competetive enterprises. The purpose is to discover

strength and weakness of the firm and to suggest remedial measures. It shows the

structural balance of revenue and financial (position statements. It also shows the

changes in the composition of items and their respective load.

2. Common Size Statements:

In common size statements - Balance Sheet and Income Statement are shown in

analytical percentages. The figures are shown in percentages of total assets, total

liabilities and total sales The total assets are taken as 100 and different assets are

expressed in percentages of total assets. Similarly, total liability is taken as 100 and

each type of liabilities is shown as percentage of tota. liability. Total liability also

includes capital and it is also expressed as a percentage of total liability Each item

of Revenue Account such as individual expenses and incomes is also expressed as a

percentage of sales which is also taken as 100.

236

Assets, liabilities and sales are considered as base items and all other items are

expressed as percentages of base items. So the statements are known as 100%

statements.

3. Trend Analysis:

Trend analysis means forecasting of future posibi I ities in respect ofprofitability,

solvenc and growth. In this case, financial statements of serveral years are

considered. A base year is selected which is a normal year. Each item in the

statements is compared with the same item of the base year. Base year item is

considerd as 100 and the same item appearing in the financial statements in

different years will be expressed in percentage of the base year. It will show the

growth or decline in comparison to the base year. The changes in percentage value

of the item will give a trend which will show an upward or downward trend and an

opinion can be formed on the basis of such trend.

4. Ratio A nalysis:

Ratio is the relation of amount (a) to another (b), expressed as the ratio (a) to (b). it

is a simple arithmetical expression of the relationship of one number to another.

Ratio Analysis is a technique of analysis and interpretation of financial statements.

It is a process of identifying the strength and weaknesses of a firm by properly

identifying the relationship between the items of the Balance Sheet and the Profit

and Loss Account. Thus ratios give quantitative relationship and analysis is done to

make a quatitative judgement out of that quantitative relationship. The judgement

may be on liquidity, solvency, profitability, performance and capital structure.

5. Fund Flow Analysis:

Fund flow statement is a statement showing the changes in the financial position

between the dates of two balance sheets. It describes the sources from which

additional funds, are derived and the uses to which the sources were put.

Fund flow statement analysis is a technical devise to analyse the changes to the

financial condition of a business enterprise between two dates. It traces the changes

to original transactions and shows light on the financial strategy of the business

unit. It enables a person to make a proper interpretation of the changes and forecast

prediction. It judges the validity and effect of the financial strategy of the business.

237

6. Cash Flow Analysis:

Cash flow statement is a statement which describes the inflows and outflows of

cash and cash equivalents in an enterprise during a specified period of time. It

shows the effects of various transactins on cash and its equivalents and takes into

account thereceipts and payments of cash. A cash flow statement sumarises the

causes of changes in cash position of a firm between the two balance sheet dates.

According to AS-3 (Revised) a company should prepare and present a cash flow

statement for each period for which financial statements are prepared. Cash flow

statement is of vital importance to the financial management. It is an essential tool

of financial analysis for short-term planning. It shows the sources from which cash

funds are received and the uses to which they are put and also shows whether the

firm is capable of meeting of its short-term obligations.

7. Cost-Volume-Profit/Break Even Analysis:

Cost-Volume-Profit analysis implies the study of three basic factors of business

operations-cost, volume and profit. These three factors are inter related in such a

manner that they act and react on each other because of cause and effect

relationship between them. The cost of production determines its selling price,

which in turn the volume of sales which directly affects the volume of production

and the volume of production in turn affects cost. Thus cost-volume -profit analysis

shows the impact on net profit of:

(a) Changes in selling price;

(b) Changes in volume of sales;

(c) Changes in variable cost; and

(d) Changes in fixed costs.

Thus it helps the management in determining the effect of a probable change in any

one factor on the remaining factors. It is used in profit planning, performance

evaluation, price policy, etc.

8. Working Capital Analysis:

Working Capital is that part of business finance which helps in meeting working

expenses and day-to-day operations. Usually it consists of current assets and current

238

liabilities. The difference between the current assets and current liabilities is termed

as working capital.

Working capital analysis is the interpretation of the components of current assets

and current liabilities. Analysis statement shows whether working capital is

adequate or not in meeting day-to-day expenses and operational needs. It shows the

relative importance and qualitative aspect of each component of working capital. It

also shows the ability or otherwise of the short-term financial needs.

Q.8. What is Ratio Analysis? Mention four different ratios and explain their

utility to the management. [GU.1987]

Meaning of Ratio:

A ratio is a simple arithmetical expression of relationship of one number to another.

It is a numerical or quantitative relationship between two items or variables. Thus

ratio may be defined formally as "the indicated quotient of two mathematical

expressions " According to Kohlar, "A ratio is the relation of the amount 'a'to

another 'b', expressed as the ratio of a to b or a:b

Example: A firm has Rs 1,00,000 as current assets and Rs 50,000 as current

liabilities. So the ratio of current assets to current liabilities is 1,00,000:50,000 or

2:1 or 2.

A financial ratio is the relationship between two accounting figures expressed

mathematically. The ratio can be expressed mathematically as 2 x 100 or 200%.

Ratio Analysis:

Ratio Analysis is a technique of analysis and interpretation of financial

statements. It is a process of identifying the strength and weaknesses of a firm by

properly estabilishing the relationship between items of the Balance sheet and

Profit and Loss Account. It is undertaken by the management of a firm or by

parties outside the firm, viz; creditors, owners, investors, others, etc. The nature of

such analysis will differ depending on the purpose of the analyst. Mere calculation

of ratios does not serve any purpose unless they are analysed and interpreted

keeping in mind the objective of analysis.

Thus ratios give quantitative relationship and analysis is done to make a

qualitatiw judgment out of that quantitative relationship. Example - A firm has ?

239

1,50,000 as current assets and Rs. 50,000 as current liabilities. The ratio between

them is 3:1 or 3. It indicates a quantitative relationship between current assets and

current liabilities. This relationship is an index or yardstick which permits a

qualitative judgment to be formed about the firm's ability to meet the current

obligations. It measures the firm's liquidity. A standard current ratio is 2:1 and the

firm has the ratio of 3:1. It indicates that the firm has enough liquid resources to

meet its current obligations. So the firm is solvent in the short-run. Thus a

quantitative relationship is used toform a qualitative judgment about the short-

term solvency of the firm through the process of ratio analysis.

Following are the four ratios selected to determine the short-term and long-term

solvency of a firm:

(i) Current Ratio;

(ii) Liquid Ratio

(iii) Inventory Turnover Ratio

(iv) Debtors or Receivables Turn-over Ratio.

Current Ratio:

Current Ratio may be defined as a relationship between current assets and current

liabilities of a firm.

Current Ratio =

Current Assets Current Liabilities

Current assets include inventories, Trade debtors, bills receivable, cash in hand and

cash at bank, short term marketable securities, etc and current liabilities include

Trade creditors, bills payable, Outstanding liabilities and bank overdraft, etc.

It measures the general liquidity of a firm. Higher the ratio greater is the ability of

the firm to meet its short-term obligations and better is the short-term solvency.

Quick Ratio/Liquid Ratio

Quick Ratio is the relationship between quick assets and current liabilities. Quick

assets comprise-cash in hand, cash at bank, debtors, bills receivable, marketable

securities and short-term investments. It is a more rigorious test of liquidity than

current ratio because it stresses on the quality of current assets than their quantity.

So it excludes inventories which are not easily convertible into cash within a short

240

period when required to meet the short-term obligations. The standard ratio is 1:1.

Higher the ratio better is the short-term solvency. Thus it measures the quality of

assets and is called a test of liquidity. However, it should not be used blindly; rather

it should be used as a complementary to the current ratio.

Inventory Turn-Over Ratio:

Inventory Turn-over Ratio is a ratio between cost of goods sold to average

inventory. It would indicate whether the inventory has been efficiently used or not.

Its purpose is to see whether only the required minimum funds have been locked up

in the inventory. It shows how rapidly the inventory is turning to sales. Generally a

high inventory turnover is indicative of good turnover management and a low

turnover ratio indicates excessive inventory levels. Excessive inventory levels

indicate a poor demand for goods, unnecessary tie-up of funds, increased cost, and

decreased profits. Again, it may lead to obsolete stocks.

On the other hand, a very high level of inventory turn-over may be the result of a

very low level of inventory which may result in frequent stock outs and the firm

may be living from hand to mouth. It also may be due to small lot-sizes of

replenishment which may increase costs.

Thus inventory turn-over should not be too high or too low.

Costs of goods sold The formula of Stock Turn- Over Ratio is: Average

inventory/Stock

Debtors'Turn Over:

Debtors Turn Over Ratio is determined by dividing credit sales by average debtors.

The liquidity position of a firm depends on the quality of debtors to a great extent. It

indicates the number of time on the average that debtors turn over each year.

Generally higher the debtors turn over, more efficient is the management of credits.

Average debtors means the average of opening and closing debtors. Debtors turn

over may be expressed through the Debtors Collection Period. It shows the aging

of debts and measures the quality of debtors in an aggregate way. The formula of

average collection period is

241

Number of working days in a year Debtors Turn Over

Shorter the average collection period, the better is the quality of debtors as a short

collection period indicates the prompt payment by debtors. Average Collection

Period should be compared against the firm's credit terms and policy to judge its

credit and collection efficiency.

An excessively long collection period implies a very liberal and inefficient credit

and collection performance. On the other hand, too low a collection period implies a

restrictive credit and collection policy resulting in loss of marginal sales.

Cost and Management Accounting

Q.9. Write a brief note on the importance of ratio analysis to different

categories of users of financial statements. [GU. 2001]

or Explain in brief the importance of Ratio Analysis as a tool of management.

[GU.2000]

Ratio analysis is used as a device to analyse and interprete the financial strengths

and weaknesses of a firm. Ratios are known as symptoms which are analysed and

interpreted to determine the financial health of a firm. It is used by management,

shareholders, creditors, employees, government, and tax authorities.

Use to the Management:

Ratios are used by management for the following purposes:

(i). In Decision Making:

It throws light on the degree of efficiency of the management and utilisation of the

assets and helps the management in decision making.

(ii). In Forecasting and Planning:

Ratios scrutinise past results and indicate trends which help the management in

forecasting and planning.

(iii). In Measuring Financial Solvency:

Ratios show short term and long term liquidity position and the management can

take corrective actions where necessary for improving liquidity position.

(iv). In Communication:

Ratios are a means of communication and play a vital role in informing the position

and progress of the business.

242

(v). Control:

It helps in making effective control of the business. Standard ratios are used to

measure performance and suggest measures for correction where necessary.

(vi). Intra-firm Comparison:

Intra-firm comparison is possible through ratio analysis and efficiency and progress

of the business can be compared with those of other firms.

(Vii). Evaluation of Efficiency:

Ratios measure the general efficiency of a business and effectiveness of the

financial policies.

2. Use to the Shareholders:

Ratios help the shareholders to evaluate the security of their investments and return

thereon by using solvency ratios and profitability ratios. They can evaluate the

soundness of the financial policy and managerial efficiency through the use of

activity ratios and can judge the likely effect on the price of their shares in the stock

market.

3. Use to the Investors:

Investors are interested in the operational efficiency, earning capacities and the

financial health of the business. Ratios regarding profitability, debt equity, fixed

assets to net worth and assets turnover are some measures useful for the investors in

making decisions regarding the type of securities and industry in which they should

invest.

4. Use to the Creditors:

Creditors can reasonably assure themselves about the solvency and liquidity

position of the business by using ratio analysis. Trade creditors use short-term

solvency ratios like-current ratio, liquid ratio, etc to determine short-term solvency

while long term creditors use long-term solvency ratios such as debt-equity ratio,

fixed assets to long-term fund ratio, solvency ratio, etc. to determine long-term

solvency. Thus ratio analysis throws light on the repayment policy and the

capability of an enterprise.

243

5. Use to the Employees:

Employees are interested in the financial position and profitability of a concern as

this information is closely related to the security of their jobs and fringe benefits.

Solvency ratios and profitability ratios help them in forming an opinion on them.

6. Use to the Government:

Government is interested in the financial health of a business. Ratio analysis reflects

the policy of the management and its consistency or otherwise over the overall

regional and national economic policies. Ratios help the Government in

understanding the cost structure and the pricing policy of the firm and help the

Government in price control where necessary.

7. Use to the Tax Authorities:

Ratios help the tax authorities in assessing true profit of a firm and in reaching the

Best Judgment Assessment decision.

8. Use to the Financial Analyst:

Ratio analysis is an important technique to the financial analysts to study the

financial statements to compare the progress and position of various firms with each

other and vis-a-vis the industry.

Q.10. Explain the following ratios and their role in interpreting the financial

statements. [GU.1988]

(a) Debt-Equity Ratio [GU. 1988,1991, 2002, 2006];

(b) Capital Gearing Ratio [GU.1988,1994];

(c) Financial Leverage Ratio;

(d) Return on Shareholders Investment or Net Worth Ratio;

(e) Proprietory or Equity Ratio;

(f) Working Capital Turn-Over Ratio;

(g) Fixed Asset to Net Worth Ratio; and

(h) Total Coverage Ratio.

Debt-Equity Ratio:

Debt-equity ratio is the relation between borrowed capital and owners' capital and is

a measure of the long-term solvency of a firm. Long - Term Debts

244

Formula : Debt-Equity Rat.O = shareholdres'Funds/Equity

Long-term debts are the debts which are exclusive of current liabilities.

Shareholders' equity includes equity share capital as well as preference share

capital, reserves and undistributed profits minus undistributed loss and deferred

expenditure. Shareholders' equity so defined is equal to net worth and the ratio is

also called Debt to Net worth Ratio. This ratio is also calculated in the following

way:

Total Debts

Debts-Equ.ty Ratio =

Role:

Total debts includes current liabilities also. This ratio is considered better than the

earlier one because current creditors have also claim on the total assets of the firm.

This ratio appraises the financial structure of a firm and is very important from the

creditors* point of view. It reflects the relative contributions of the creditors and

owners of the business in financing. A high ratio shows a large share of financing

by the creditors relatively to the owners and a larger claim against the assets of the

firm. On the otherhand, a lower ratio indicates a larger share of financing by the

owners.

A high proportion of debt financing may make the management irresponsible and

speculative. Thus such a ratio indicates a greater risk to the creditors. Again it

shows a capital structure which will lead to inflexibility in the operations of the firm

and the firm's borrowing capacity will be limited and will face difficulties in raising

funds in the future.

However, the shareholders will get financial leverage in the prosperity period and

the firm will trade on equity.

Thus there should be a reasonable proportion between the two types of funds.

Capital Gearing Ratio:

Capital gearing ratio is the relationship between equity share capital including

undistributed profits and reseves minus undistributed loss and deferred expenditure

to preference share capital and other fixed interest bearing loans.

Equity Share Capital + Re serves + Surplus

245

Capital Gearing Ratio-Reference Share Capital+Longterm Interest Bearing

Loans'

Role:

It is used to analyse the capital structure or leverage of a company and refers to the

proportion between fixed interest or dividend bearing funds and non-fixed interest

or dividend bearing funds.

Fixed interest bearing funds include the funds provided by the preference

shareholders, debentureholders and financial institutions and non-fixed interest

bearing funds are provided by the equity shareholders.

The proportion between the owners' funds and non-owners' funds is known as

leverage. If the ratio is high, the capital gearing ratio is high (i.e. more than one)

and if the ratio is low, the gearing is said to be low (i.e. less than one). The extent to

which the capital is geared shows the speed with which the enterprise is

accelerating towards the corporate goal. High gearing means high speed and low

gearing means low speed. Further high gearing means trading on their equity and

low gearing means trading on thick equity.

Highly geared capital structure may indicate under capitalisation and under

capitalisation means that capital is disproportionate to the need's measured by the

volume of activity. On the otherhand, lowly geared capital structure means over-

capitalisation. Thus this ratio is important to the company as* well as to the

investors; so it should be carefully planned.

Financial Leverage Ratio:

The use of long-term fixed interest bearing debt and preference share capital along

with equity share capital is called Financial Leverage or Trading on Equity. When

owner's capital is used as a base to raise loans, it is called trading on equity. The

long-term fixed interest bearing capital is employed by a firm to earn more from the

use of these resources than their cost and the extra profit remaining after the

payment of interest thereon goes to the equity shareholders. Thus it increases the

return on equity. This leverage depends on the capacity of the funds to earn more

than the interest payable on such loans. However, if the earning is less than the cost

of loan, it will decrease the return on equity. Following is the ratio:

246

Earning before Interest and Tax_

rinancial Leverage Ratio Merest and.Tax-( Interest and Preference Dividend)

Return On Shareholders' Investment or Net Worth Ratio:

Return on Shareholders' Investment popularly known as ROI is the relationship

between net profit after interest and tax and proprietors' fund. It measures the profit

earning capacity of the business. Following is the method of calculating the ratio.

Net Profit after Interest and Tax ...

Return on Shareholders' Investment (ROI) =

Proprietors' Fund includes Equity and Preference share capital plus reserves and

surplus and Net Profits is the profit after deducting interest on debenture and loans

and Income tax.

It is used for measuring the over-all efficiency of the firm and indicates the extent to

which the goal of earning maximum profit is achieved. It reveals to the

management and prospective investors how well the resources of the firm are being

used.

It facilities inter-firm comparison of earnings and helps the investors in determining

the most attractive firm for investment.

Again when calculated over a number of years, it shows the trend of growth or

decay in the profitability and efficiency of the firm.

Proprietory or Equity Ratio:

It is a variant of Debt-Equity Ratio. It shows the relationship between the

shareholders fund and the total assets of the firm. It shows the proportion of

financing by the owners' fund and indicates the long-term solvency of the firm. It

also shows the net asset backing per rupee of shareholders' fund. Higher the ratio,

greater is the solvency. Formula for the calculation of Proprietory Ratio is:

Shareholders' Fundus Proprietory Ratio =

Shareholders' fund comprises Equity and Preference share capital plus reserves and

surplus. This ratio shows the general strength of the firm. Higher the ratio, the better

secured is the position of creditors.

Working Capital Turnover Ratio:

247

It is a ratio between cost of sales/ sales and average working capital. Working

capital means the difference between current assets and current liabilities and

average working capital means average of both opening and closing working

capitals. The ratio is calculated as follows:

Cost of Sales I Sales

Working Capital Turnover Ratio = Opening Working Capital + Closing Working

Capital

This ratio indicates the velocity of net working capital as it shows the number of

times the working capital is turned over in the course of a year. It measures the

degree of efficiency in the utilisation of working capital. Higher the ratio, the better

is the performance.

It can also be used for trend analysis and comparative study among different firms

in the same industry and for the different periods of the same firm.

It also shows the liquidity of the firm as it shows the rate at which inventories are

converted into sales and then to cash. A very high ratio indicates overtrading and a

very low ratio indicates under trading. Both are equally bad.

Fixed Assets to Net Worth Ratio:

It is the relationship between the fixed assets and the shareholders' fund. It is

calculated as follows:

Fixed Assets after depreciation Fixed Assets to Networth

Ratio=Shareholders'Funds-

It indicates the extent to which the shareholders' funds are sunked into the fixed

assets. It also shows the portion of the shareholders funds utilised in financing

current assets. Usually 60°/o to 65% of the shareholders' funds to be invested in the

fixed assets and the rest is to be utilised as working capital. Higher the ratio, more

the firm depends on outside sources for working capital which is not a satisfactory

affair. Total Coverage Ratio:

It is the ratio between earnings before interest and tax and total fixed charges. The

ratio is calculated as:

Earning Before Interest and Tax Total Coverage Ratio = Total Fixed Charges

248

Total fixed charges include interest and preference dividend. It shows the number of

times fixed charges are covered by earnings before tax. It is a measure of the firm's

ability to pay the fixed charges out of net profit before interest and tax. Higher the

coverage, the better is the ability

It helps the investors in determining the ability to pay the interest and preference

dividend in time. So it is a measure of creditworthiness of a firm.

Q.ll. Discuss the advantages of Ratio Analysis.

Following advantages can be attributed to the technique of ratio analysis:

Advantages of Ratio Analysis

1. Helps in Assessment of Financial Health of a Business:

It helps toanalyse and understand the financial health and trend of a business. It

makes it possible to forecast the future state of affairs.

2. Helps in Control:

It serves as a useful tool in management control process by making a comparison

between the performance of the business and the performance of similar type of

businesses.

3. Plays Important Role in CostAccounting etc.

It plays a significant role in cost accounting, financial accounting, budgetary control

and auditing.

4. Helps in Fixation of Responsibilities:

It helps in the identification, tracing andplacing, fixing of the responsibilities of

managerial persons at different levels.

5. Helps in Financial Management:

It accelerates the institutional isation and specialisation of financial management.

Q.12. Mention the limitations of accounting ratios/Ratio Analysis: [GU. 2005]

Usefulness of ratios depends on the abilities and intentions of the persons who

handle them. It will be affected considerably by the biasesof such persons. Again

even if the persons handling ratios are not biased, inadequacy of their knowledge

about compiling and using ratios will render this tool defective and ineffective.

In addition to these drawbacks of the persons handing the ratios, they also suffer

from the following limitations:

249

1. One Ratio in Isolation:

One particular ratio in isolation is not sufficient to review the whole business. A

group of ratios are to be considered simultaneously to arrive at any meaningful and

worthwhile opinion about the affairs of the business.

2. Book Values not the Real Values:

Ratios are calculatedon the basis of money values or book values of the items. They

do not take into account the real values of various items involved. Thus the

technique is not realistic in approach.

3. Historical Values:

Historical values, (specially in case of balance sheet ratios) are considered in

working out the various ratios. Effect of changes in price levels of various items are

ignored and to that extent Ihe comparisons and evaluations of performance through

ratios become unrealistic and unreliable.

4. Standardfor Comparison:

Ratios of a company or finn will connote some meaning only when they are

compared with ;ome standards but it is difficult to find out a proper standard basis

of comparison. The standard varies from firm to firm, period to period and situation

to situation.

5. Company Differences:

Situations of two companies are never same. Similarly, the factors influencing the

performance of a company in one year may change in another year. Thus, the

comparison of the ratios of two companies becomes difficult and meaningless when

they are operating in different situations.

6. Uncapable to bring out Real position:

Since the ratios are calculated on the basis of financial statements which are

themselves greatly affected by the firm's accounting policies. If there is any change

in accounting policies, the ratios may not be able to bring out the real position of the

firm.

7. Ratios are only Symptoms:

Ratios are at best only symptoms. They may indicate what is to be investigated.

Only a careful investigation will bring out the correct position.

250

8. Ignores Non-financial Factors:

They fail to bring out the significance of non-financial factors which may have

considerable bearings on the operating results and the financial position of an

enterprise. Such factors may be public image of the enterprise, the calibre of its

management, efficiency and loyalty of the workers, etc.

9. Window-Dressing:

It is not possible to discover false figures in the financial statements. Unscrupulous

management generally resorts to window-dressing in the preparation of such

statements. So ratios constituted on such false figures may give misleading results.

Thus ratios, though useful, should be used with due caution and after verifying the

authenticity of accounting figures and considering other relevant information.

Q.13: What are the different classes of accounting ratios ? Explain briefly each

class, or Classify the accounting ratios and explain briefly the different classes.

Ratios are an impotant tool for decision making process for different users. As

different users have varied interests which are some times conflicting to each other,

ratios are classified tc serve the different interests of the users. Following is the

chart of classification of ratios:

Ratios

1. Traditional

Classification or

Classification by

Statements.

2. Functional

Classification or

Classification

According to Tests.

3. Significance

Ratios or

Ratios According

to Importance.

4.

Classification

b> Users.

1. Balance Sheet

Ratios or, Financial

Ratios.

2. Profit and Loss

Account Ratios.

or, Operating Ratios.

3. Composite/Mixed

Ratios or, Inter-

Statement Ratios.

1. Liquidity Ratios.

2. Liberage Ratios.

3. Activity Ratios

4. Profitability

Ratios.

1. Primary Ratios.

2. Secondary

Ratios.

1 .Ratios for

Managers.

2.Ratios for

Creditors

3. Ratios for

Share holders.

251

I. Traditional Classification or Classification By Statements:

Ratios according to financial statements are given in the following chart:

Traditional Classification or Classification by Statements:

A

Balance Sheet Ratios

or

Financial Ratios

B

Profit and Loss Account Ratios

or

Operation Ratios

C

Composite /Mixed

or

Inter-Statement Ratios

1. Currernt Ratio. 1. Gross Profit Ratio. 1. Stock Turnover Ratio.

2. Liquid Ratio (Acid

Test

2. Operating Ratio. 2. Debtors Turnover Ratio.

or quick Ratio).

3. Absolute Liquidity

Ratio

3. Operating Profit Ratio. 3. Payables Turnover Ratio.

4. Debt Equity Ratio. 4. Net Profit Ratio.

y

4. Fixed Assets Turnover

Ratio.

5. Proprietory Ratio 5. Expense Ratio. '5. Return on Equity.

6. Capital Gearing

Ratio.

6. Interest Coverage Ratio. 6. Return on Shareholders'

Fund.

7. Assets-

Proprietorship

7. Return on Capital

Employed.

Ratio.

8. Capital Inventory to 8. Capital Turnover Ratio.

working Capital Ratio.

9. Ratio of Current

Assets

9. Working Capital Turnover

to Fixed Assets. Ratio.

10. Return on Total

Resources.

11. Total Assets Turnover.

A. Balance Sheet or Financial Position Ratios:

252

Balance Sheet or Financial Position Ratios espress the relationship between two

balance sheet items such as Current Ratio-comprising current assets and current

liabilities and so on takes both items from the same balance sheet.

B. Profit and Loss Account Ratios or Operating Ratios:

These ratios show the relationship between two items taken from the same Profit

and Loss Account. Examples- the ratio of Gross Profit to Sales, the ratio ofNet

Profit to Sales, etc.

C. Composite /Mixed or Inter-Statement Ratios:

These ratios show the relationship between a Profit and Loss Account item and a

Balance Sheet item. Examples - Stock Turnover Ratio (the ratio of cost of sales to

Average Stock) Total Assets to Sales ratio, etc.

II. Functional Classification or Classification According to Tests: Ratios

according to Functional Classification or classification according to tests are given

in the following chart:

Functional Classification Or Classification According to Tests

Liquidity Ratios Longterm

Solvency

Activity Ratios Profitability Ratios

253

A.l. Current Ratio

2. Liquid Ratio

(Acid Test or

Quick Ratio)

3. Absolute

Liquid or, Cash

Ratio.

4. Internal

Measure

B.l. Debtors

Turnover Ratio

2. Creditors

Turnover Ratio.

3. Inventory

Turnover Ratio.

1. Debt Equity

Ratio

2. Debt to Total

Capital Ratio.

3. Interest

Coverage Ratio.

4.Cash Flow to

Debts

Ratio. 5. Capital

Gearing Ratio

1. Inventory

Turnove Ratio.

2. Debtors

Turnover Ratio.

3. Fixed Assets

Turn over Ratio.

4. Total Assets

Turnc ver Ratio

5. Working

Capital Turnover

Ratio.

6. Payables

Turnovei Ratio

7. Capital

Employed

Turnover Ratio.

A. In relation to Sales

- 1. Gross Profit Ratio.

2. Operating Ratio.

3. Operating Profit Ratio -

4. Net Profit Ratio.

5. Expense Ratio.

B.In relation to Investment

1. Return on Investments

2. Return on Capital.

3. Return on Equity

Capital.

4. Return on Total

Resources.

5. Earnings per Share.

6. Price Earning Ratio.

Liquidity Ratios:

Liquidity ratios are those ratios which measure short-term solvency or financial

position. The\ show whether the firm is capable of paying short-term or current

obligations. They also show efficiency in respect of utilisation of liquid resources.

These ratios include Liquid Ratio, Acid Test Ratio, Debtors Turnover Ratio, Stock

Turnover Ratio, etc.

Long-term Solvency or Leverage Ratios:

These are ratios which convey the firm's ability to meet the longterm obligations.

They include Debt-Equity Ratio, Interest Coverage Ratio, Leverage Ratio, etc.

These ratios measure the contributions or financing by owners as compared to

financing by outsiders.

Activity Ratios:

254

Activity Ratios are those ratios which measure the efficiency of resources utilised.

They include Inventory Turnover Ratio, Debtors Turnover Ratio, Total Assets

Turnover Ratio, etc.

Profitability Ratios:

These ratios measure the results of business operations or over all performence of

the firm. They include Gross Profit Ratio, Operating Ratio, Net Profit Ratio, Return

on Capital Employed, etc.

Significance Ratios or Ratios According to Importance:

These ratios are classified on the basis of their importance. These ratios are divided

into:

1. Primary Ratios; and

2. Secondary Ratios.

They are used for inter-firm comparison. Some of the primary ratios are- Return on

Capital Employed, Return on Investment (ROI), etc. Other ratios which support the

primary ratios are called the Secondary Ratios. They include Operating Profit to

Sales Ratio, Sales to Total assets Ratio, Gross Profit Ratio, etc.

Classification by Users:

Classification by Users Ratios are given in the following chart:

Classification by Users

A. Ratios for

Management

B. Ratios for Creditors C. Ratios for Shareholders

1. Operating Ratio

2. Debtors Turnover

Ratio

3. Stock Turnover Ratio

4. Return on Capital

1. Current Ratio

2. Solvency Ratio

3. Fixed Assets Ratio

4. Creditors Turnover

Ratio

1. Yield Ratio

2. Proprietory Ratio

3. Dividend Ratio

4. Capital Gearing Ratio

5. Return on Capital Fund

Ratio

These ratios serve the varied interests of different groups of users. They show the

operational performance, liquidity position for creditors, return on capital

employed, dividend policy, capital structure, etc for shareholders. They provide

useful information for their decision making purposes.

255

Q.14. Explain the Profitability Ratios:

A. Profitability Ratios:

Profitability Ratios are those ratios which measure the earning capacity of a firm.

Mea surement of profit is the function of the financial accountant while the

measurement of profitability is the function of the financial analyst. Accounting

ratios are used as a tool for the measurement of the profitability of a firm.

The word profitability means the ability of a firm to earn profit. This ability to earn

profit is related with two variables- Sales and Investments therefore profitability of

a firm is measured in relation with sales and investments. Relationship between

profit and sales is shown by computing the Profit Margin Ratios where as the

relationship between profit and investments is shown by computing the Rate of

Return Ratios.

Profitability Ratios Relating to Sales:

1. Gross Profit Ratio.

2. Operating Ratio.

3. Net Profit Ratio.

4. Expense Ratio;

5. Cash Profit Ratio; and

6. Cash Profit to Sales Ratio.

1. Gross Profit Ratio :

Gross Profit is the difference between sales and cost of sales. It gives the margin to

meet the administrative and selling expenses and to contribute something towards

the net profit. Therefore higher is the gross profit greater is the net profit and such a

situation satisfies the interests of all the parties. Gross Profit is the ratio between

Gross Profit and Sales expressed in percentage. It is calculated as follows:

Gross Profit Ration

Sale

Role of Gross Profit Ratio:

It shows the efficiency of a firm in respect of cost of production, cost control and

sales. Inter firm comparison of gross profit is a measure of profitability. Any

256

abnormal change in gross profit ratio may be due to changes in cost of production

or in the changes in selling price or in both.

2. Operating Ratio:

Operating Ratio establishes the relationship between the cost of goods sold and

other operating expenses in one side and the Sales on the other side, expressed in

percentage. Operating cost comprises (Cost of goods sold + Administrative

Expenses + Selling and Distribution Expenses >. Again cost of Goods sold means -

(opening Stock + Purchases + Direct Expenses - Value of Closing Stock). It is

calculated as under:

Cost of Good Sold + Operating Expenses

Operating Ratio = x 100

Role:

It indicates the percentage of net sales which is consumed by operating cost. The

remaining percentage of net sales is known as Operating Profit. This Operating

Profit is to cover Interest. Income Tax, Dividend and Reserve. It measures the

operating efficiency of a firm. Therefore lower is the operating ratio higher is the

operating profit.

3. Operating Profit Ratio :

Operating Profit measures profitability. It arises out of operating activities.

Operating profit is the difference between the Net Sales and Operating Cost (Cost

of goods sold + Adminitrative Expenses + Selling and Distribution Expenses).

Again operating profit may be calculated as follows: Operating Profit = Net profit +

Non -Operating Expenses - Non-Operating Income. Operating Profit Ratio is

Calculated as under:

Operating Profit Operating Profit Ratio = NeTsale X

Role:

It measures profitability of a firm and efficiency in operation i.e. activities.

4. Net Profit Ratio :

Net Profit Ratio establishes the relationship between Net Profit and Net Sales. As it

measures the overall efficiency of the firm, net profit should include Operating

257

Profit +Non-operating Income -Non-operating Expenses and takes Tax i.e.

Operating Profit + Non-operating Net Income Tax. It is calculated as under:

Net Profit after Tax

Net Profit Ratio = x 100

Role :

It measures overall efficiency of the firm. It is the most important factor which

affect the decision making process of the investors. It also measures a firm's

capacity of facing adverse situation and increases the creditworthiness of the firm. It

indicates the firm's efficiency to use the firm's resources.

5. Expense Ratio:

Expense Ratio establishes the relationship between various classes of expenses to

sales. It is calculated for each class of expenses to sales. It is calculated as follows :

Factory Expenses d) Factory Expenses Ratio =-NeTsales- x 100

Administrative Expenses i n) Administrative Expenses Ratio

Selling or Distribution Expenses

in) Selling and Distribution Expenses Ratio = NeTsales

x 100

i iv) Particular Expense Ratio =

(v) Cost of Goods Sold Ratio =

Role:

It shows the percentage of sales that an expense or a group of expenses consume. It

helps the management in its efforts to control or reduce the particular expenses or a

group of expenses.

6. Cash Profit Ratio :

It establishes a relationship between quantum of cash generated through profit and

net sales. Cash Profit is Calculated as:

Net Profit+Non Cash Expenses-Non Cash Income Cash Profit Ratio =

Role:

258

It shows the percentage of cash generated out of sales. Thus it shows net inflow of

cash "rom sales. It measures the firm's ability to pay its obligations, raises

creditworthiness and helps investors in investment decision.

7. Cash Profit to Sales Ratio :

It shows the relationship between Cash Profit and Cash Sales and is calculated as

under Cash Profit

Cash Profit to Sales Ratio =

Role:

It is important in financial planning, in framing credit policy and in determining the

size c I cash budget.

B. Ratios In Relation To Investments :

Following ratios are concerned with the profitability relating to investments:

1. Return on Investment;

2. Return on Capital;

3. Return on Equity Capital;

4. Earning Per Share; and

5. Price Earning Ratio.

1. Return On Investment and Return On Capital (R.O.I):

Return on Investment is a primary ratio to measure the profitability of a firm. It

indicate; the rate of return on the resources that are invested in a firm. Thus it

measures the degree c efficiency to which resources have been utilised. It facilitates

inter-firm comparison and helps the prospective investors in their investment

decision.

Investments have two concepts:

(a) Investment in assets;

(b) I nvestment as Cap ital Employed.

Return on Investment (ROI) is calculated with the following formula:

Net Profit after Tax

Return On Investment Investment may be:

Investment

(a) Total Assets .

259

(b) Fixed Assets

. (c) Tangible Assets.

Capital Employed:

Capital Employed means:

(a) Total Capital Employed;

(b) Net Capital Employed;

(c) Average Capital Employed;

(d) Average Net Capital Employed;

(e) Shareholders' Equity;

(f) Net Worth or Proprietors' Fund.

Out of above concepts Return on Total Assets, Return on Net Assets, Total Capital

Employed, Average Capital Employed and Average Net Capital Employed are

generally considered. Formulas:

Net Profit after Tax + Interest ...

(l) Return On Total Assets =

Net Prqflt after Tax + Interest ...

(n) Return On Net Assets =.

(m) Return On Total Capital Employed =

Pr ofit before Interest

(iv) Return On Average Captial Employed =

Operating Capital + Closing Capital Average Capital =

(v) Return On Average net Capital Employed =

Net Capital = Fixed Assets + Working Capital; and

Operating Net Capital +ClosingNet Capital Average Net Capital =

PROFITABILITY ANALYSIS FROM EQUITY SHAREHOLDERS' POINT

OF VIEW:

Q.15: Write short notes on the ratios required by shareholders to consider the

profitability of their company.

The following ratios are made out to determine the productivity of shareholders'

fund and earing power per share :

1. Return on Shareholders' Fund or Net worth :

260

This ratio reflects the return on shareholders' fund. Share holder's Fund includes-

Equity Share Capital, Preference share Capital, Capital Reserve, Securities

Premium, General Reserve, Profit and Loss Account Credit balance-(Losses and

ficticious assets like Discount on issue of shares and debentures; cost of issue of

shares and debentures, etc.). It is calculated as follows:

Return on Shareholders Fund =

It is the basis for any decision on investment in equities. It facilitates inter firm

comparison and helps in trend of profitability analysis. So it is the primary ratio to

investors.

2. Return on Equity Capital:

It determines the return on equity share capital invested in a firm. Net profit after

tax and preference dividend is available to the equity shareholders. Thus such

available profit is the return on Equity Capital. It is calculated as under:

Net Profit after Tax-Preference Divided

Return on Equity Share Capital =

This ratio is very important to the equity shareholders because on the basis of this

dividend on equity shares is declared. It also affects the share market price in the

Stock Exchange.

3. Return Per Equity Share or Earning Per Share (EPS) :

Earning per share measures the productivity per equity share capital. It shows the

profit available per share. It is calculated as follows:

Return Per Equity Share or Earning Per Equity Share (EPS)

Net Profit after Tax - Preference Divided Number of Equity Shares

Role:

It is a good measure of profitability. When it is compared with the EPS of other

firms, it shows the comparative earning power of a firm. It helps in the profitability

trend analysis which shows the growth in earnings of the firm. It affects share

market price in Stock Exchanges. It is an important ratio to a prospective investor in

equity shares in his decision making process.

4. Dividend Per Share (D.P.S):

261

It is the amount of dividend declared per equity share. It is the actual income earned

by the equity shareholders. It is declared as a percentage on the paid up value of a

share. It is calculated as follows:

Total Amount of Dividend Declared

Dividend Per Share = Number of Shares

Role :

It is very important on the part of an equity shareholder because it is the actual

income received by a shareholder.

5. Price Earning Ratio (PER) :

It shows the relationship between market price per equity share and earning per

share. It is calculated to estimate the appreciation in the value of a share. It is used

to decide whether or not to buy a share. It is also used in security analysis because

the share price behaviour in the stock market is affected by this ratio. In short, it is

used in the valuation of the market price of a share. It is calculate as follows :

Price Earning Ratio (PER) =

Some Additional Ratios:

The following Ratios are also useful to Equity Shareholders.

1. Dividend Payout Ratio:

It establishes the relationship between earnings to equity shareholders and dividend

paid to them. It also shows the proportion of the earnings which is retained as

reserve. It is calculated as follow s

Amount of Dividend to Equity Shareholders Declared

Dividend Payout Ratio =

2. Earnings Yield (EY) :

It establishes the relationship between earning per share and market value per share.

It is calculated as followed:

Earnings Yie.d(EY)=

This shows the Yield on the worth of each share.

3. Dividend Yield (DY) :

It is a ratio between dividend per share and the market value per share. It is

calculated as follows:

262

It shows the yield of an investment and affects the share market price.

Q.16. What is Liquidity Ratio ? Write short notes on Liquidity Ratios.

Meaning:

Liquidity Ratios indicate the firm's ability to pay its current liabilities as and when

they become due. As short term obligations are usually met out of cash realised

from current assets, the current assets should be either liquid or near liquid. So

sufficiency of current assets should be assessed by comparing them with current

liabilities. To measure the liquidity of a firm, the following ratios are to be

calculated :

1. Current Ratio

2. Liquidity Ratio

3. Absolute Liquidity Ratio

4. Net Working Capital Ratio .

5. Overdue Liquidity Ratio

1. Current Ratio:

Current Ratio is the relationship between Current Assets and Current Liabilities. It

measures the general liquidity of a firm in a short period. Current Assets are those

assets which are converted into cash within a short period of time usually within

one year, they normally include cash and bank balances, marketable securities,

debtors, bills receivables, inventory, prepaid expenses and accrued incomes.

Current Liabilities are those liabilities which include-trade creditors, bills payable,

outstanding liabilities, income received in advance, dividend payable, contingent

liabilities, bank overdraft, provision for income tax and other unclaimed liabilities.

It is calculated as:

Significance:

This ratio measures the short term solvency or liquidity of a firm. It shows

availability of current assets per rupee of current liabilities.Higher is the ratio

greater is the amount of current assets per rupee of current liabilities. This gives a

safe margin for the short term creditors.

However, there is a conflict between profitability and liquidity. Higher is the ratio

greater is the liquidity but lower is the profit because more capital is blocked in

263

inventories, debtors and cash,. Therefore a balance between profitability and

liquidity is to be found out.

An ideal ratio is generally taken as 2:1

Usually current ratio shows a firm's short term financial strength and credit

worthiness.

2. Liquid Ratio or A cid Test Ratio or Quick Ratio:

It is a ratio between quick assets and current liabilities. The term liquidity means the

ability of a firm to pay its short term obligations as and when they become due. This

ratio gives a stringent

measure of liquidity because comperatively less liquid assets such as inventories,

prepaid expen>v are excluded from the definiition of quick assets. This liquid assets

or Quick Assets include- Cas and bank balances, short term marketable securities,

debtors and bills receivable. Sometimes currer libilities do not include Bank

overdraft which may be renewed from time to time. In that case current liabilities (-

)Bank overdraft is called liquid liabilities. It is calculated as under:

Liquid Ratio/Acid Test ratio/Quick Ratio = ctZu UaTlLs

or

Liquid Assets

Liquid Liabilities

cr

Current Assets - (Inventories + Prepaid Expenses) Current Liabilities

Current Assets - (Inventories + Prepaid Expenses) Current Liabilities - Bank

Overdraft

Significance:

It is a more rigorous and penetrating test of the liquidity position of a firm and gives

a bette' picture of liquidity.

An ideal ratio is usually considered at 1:1. 3. Absolute Liquid Ratio:

Absolute Liquid Ratio shows the relationship between Absolute Liquid Assets to

Curren: liabilities. It is also known as Super Quick Ratio or Super Acid Test Ratio.

Absolute liquid assets include-Cash and Bank balances and Marketable Securities

only and Current liabilities exclude bank overdraft. The ratio is calculated as:

264

Cash and Bank Balances + Marketable Securities Current Liabilities - Bank

Overdraft

Absolute Liquid Ratio Significance:

It shows the ability of a firm to pay its liquid liabilities out of its liquid assets .

An ideal ratio is usually 0.5 : 1.

4. Net Working Capital Ratio:

Net Working Capital is not a ratio. It is the difference between the Current Assets

and Current Liabilities. Greater is the working capital greater is the liquidity of the

firm. This ratio computed between Net Working Capital and Net Assets and is

calculated as :

Net Working capital ratio =

Net Assets

Significance :

It signifies the proportion of working capital to net assets. It means the amount of

capital invested in working capital .

5. Overdue Liability Ratio :

It is a relationship between overdue liabilities and the resources to meet them

immediately

The resources include only Cash and Bank Balances and Marketable Securities. It is

calculated as:

Cash and Bank Balances + Marketable Security

Overdue Liability Ratio =-overdue Liabilities-

An ideal ratio is 1.5:1. Significance :

It shows in ability of a firm to pay its overdue liabilities .

In order to test the liquidity of a firm, the following ratios are also considered.

(a) Inventory Turnover Ratio,

(b) Debtors Turnover Ratio, and

(c) Creditors Turnover Ratio,

Q.17. What do you mean by Leverage Ratios or longterm solvency or Capital

Structure Ratios? Write brief note on each of them. Meaning:

265

Leverage or Capital Structure Ratios are the ratios which show the firm's ability in

the payment of interest and repayment of principal to the firm's long term creditors.

In short, they show the long term solvency position of a firm.

In Leverage ratios there are two categories of ratios viz: (i) Structural Ratios; and

(ii) Coverage Ratios.

Structural Ratio:

Structural Ratios are based on the relationship between borrowed funds and owners

fund or own capital and includes-Debt-equity Ratio, Debt Assets Ratio; Equity

Assets Ratio, etc.

Coverage Ratios :

Coverage Ratios are based on the relationship between earnings and different

charges and includes. Interest Coverage Ratio, Dividend Coverage Ratio, Total

Fixed Charges Coverage Ratio, etc.

I. Structural Ratios:

1. Debt Equity Ratio :

Debt Equity Ratio shows the relationship between External Equities and Internal

Equities. It indicates the relative proportion of debts and equity in financing the

assets of the firm. It is also known as External-Internal Equities Ratio.

External equities or Debts mean outside funds such as - loans, debentures, creditors

and other short term liabilities.

Internal Equities or shareholders' fund means - Share Capital both equity and

preference shares and Reserves and surpluses.

The debt-equity ratio is calculated as :

External Equities I Debts

Debt - Equity Ratio =

There is another approach for Debt-Equity Ratio where the ratio is established

between Long Term Debt and Shareholders Fund and is calculated as:

Long Term Debts

Debt - Equ.ty Ratio =

The difference between the two ratios is that in the second approach current

liabilities are excluded.

266

The first approach is considered better because a part of the current liabilities

remains in the business permanently and functions like a long-term debt.

Such part of the permanent current liability is used in financial assets and has a

claim in the assets at the time of liquidation.

Significance:

It measures the extent to which debt financing has been used in the business and

shows the proportionate claims of the owners and outsiders against the assets of the

firm.

The purpose of the ratio is to get an idea of the cushion available to outsiders on the

liquidation of the firm.

Usually an ideal ratio is 1:1. In certain business, it may go up to 2:1. Lower is the

ratio better it is for the creditors. Moreover it increases the creditworthiness of the

firm. On the other hand, a high ratio indicates that a larger share of financing has

been made by the creditors in relation to owners and it involves greater risk of the

creditors. Moreover it leads to inflexibility in the operations of the firm because of

the interference of the creditors. Such a situation reduces the credit worthiness of

the firm.

A high Debt-Equity Ratio indicates that the firm is resorting to trading on equity. It

means that equity shareholders will earn a higher rate of return on their shares by

paying a lower return on debts. Therefore, the general proposition in this respect is

"other's money should be in reasonable proportion to the owners capital and the

owners should have sufficient stake in the fortunes of the enterprise."

2. Capital Gearing Ratio / Gearing Ratio :

Capital Gearing Ratio is a ratio between Capital having variable cost and capital

having fixed cost. Capital having variable cost refers to equity shareholders' fund

because return on equity shareholders is not fixed; it varies on the availability of

profit and the policy of management.

Capital having fixed cost refers to Preference Share Capital, Debentures, Bonds and

other long term loans because dividend on Preference Share Capital and interest on

long term loans are fixed in nature. It is calculated as :

Equity Shareholders Fund

267

Capital Gearing Ratio = Rxed lmrest Bearing Fmds

Equity Share Capital + Reserve and Surplus_

Preference Share Capital + Debentures + Bonds + Long Term Loans Capital

Gearing Ratio is a variation of Debt-Equity Ratio but it is more important financial

leverage ratio from the point of view of solvency and creditworthness of a firm.

A firm is said to be highly geared if its fixed charge bearing long term funds are

more than Equity Shareholders Fund. A highly geared capital ratio is good if the

firm can earn a higher rate of return than the rate of fixed charge on loan capital but

it involves a risk from the solvency point of view. It is also not good if the firm

follows a steady rate of dividend. Therefore a Capial Gearing Ratio should be a

balanced one.

3. Debt-Assets Ratio:

This ratio is established between Total Debts and Total Assets. It is calculated as

follows:

Total Debts

Debt'Assets Ratio =

Total Assets (Excluding Fictitious Assets)

Long Term Liabilities + Current Liabilities 0r

Total Assets (Excluding Fictitious

Assets)

Significance:

This ratio indicates the proportion of total assets of a firm is financed by the

outsiders or creditors. This ratio indicate the solvency or otherwise of a firm. Lower

the ratio better it is from the point of view of the creditors. It is the substitute of

Proprietory Ratio.

4. Equity-Assets Ratio/Proprietory Ratio/Equity Ratio/Networth to Total Assets

Ratio :

This ratio establishes the relationship between shareholders Fund and Total Assets.

It indicates the proportion of assets financed by Shareholders' Fund. It is calculated

as :

Shareholders Funds

Equity-Assets Ratio =

268

Equity Share Capital + Preference Share Capital + Reserves and Surplus or

Total Assets (Excluding Fictitious Assets)

Total Assets mean the realisable value of assets.

Significance:

This ratio indicates the degree of solvancy of the firm to the creditors. Higher the

ratio better it is and better is the long term solvency of the firm. It also indicates the

extent to whichthe assets of the company can be lost without affecting the interest

of the creditors.

5. Solvancy Ratio:

This ratio indicates the relationship between total outside liabilities and total assets

of a firm. It shows the quantum of assets available per rupee of liability, thus it

measures the margin of safety for the creditors, it is calculated as :

Total Liabilities(outside)

Solvency Ratio - (Excluding Fictitious Assets)

An ideal ratio is 1 : 2.

Significance:

In measures the proportion of total assets financed by creditors funds. So it

measures the degree of solvency of a firm because if assets are far more than

liabilities, creditos are more assured of repayment of their money at the time of

liquidation.

6. Fixed Assets to networth Ratio:

This ratio indicates the extent to which the shareholders fund has been utilised in

acquiring fixed assets. It is good if fixed assets are acquired out of the shareholders

fund and there remains a part there of after such aquisition for financing current

assets. It is calculated as :

Fixed Assets

Fixed Assets To Networth Ratio = shareholders Fjmd

Significance:

It indicates how judiciously shareholders fund has been utilised in acquiring fixed

assets and current assets. Normally the ratio is 0.60 :1. i.e. 60% of shareholders

fund may be used in acquiring fixed assets and 40% in current assets.

269

7. Fixed Assets Ratio/Fixed Assets to Long Term Fund Ratio :

This ratio indicates the relationship between Fixed Assets and Long Term Funds. It

shows the extent to which the long term funds are used in aquiring fixed assets and

current assets. It is conrtacted as:

Fixed Assets

Fixed Assets Ratio or Fixed Assets to Long Term Fund Ratio =

Long term funds include - Share Capital + Reserves and Surplus + Debenture +

Bonds + Other long terms loans. Signicance:

It measures the soundness of investment policy of a firm.

An ideal ratio is 60 :100.

8. Ratio of Current Assets to Proprietors' Funds:

This ratio indicates the extent of Proprietors' Funds used in acquiring or financing

current assets. As current assets constitute the gross working capital if a part of the

shareholders fund is used in such assets it signifies a sound investment policy. It is

complementary to fixed Assets Ratio. An ideal ratio should be 40 :100 or so. It is

calculated as :

CxifyQvxt Assets

Ratio of Current Assets To Proprietors' Funds =

Shareholders Fund includes - Share Capital + Reseves and Surpluses.

9. Funded Debts to Total Capitalisation Ratio:

This ratio establishes the relationship between the long term funds raised from

outsiders and the total long term funds available in the business.

Funded Debts include - Debentures + Mortgaged Loans + Bonds + Other long term

Loans Total Capitalisation includes - Shareholders Funds + Funded Debts.

Funded Debts to Total Capitalisation Ratio =

An ideal ratio is 50% to 55% and not beyond. Significance:

It indicates the proportion of funded debts to total capital. It measures the part of

total capitalisation financed by outsiders. Lowerthe ratio batter it is from the point

of view of outside long term creditors. It also indicates the margin of own capital

left for the availability of long term creditors.

II. Coverage Ratios:

270

1. Interest Coverage ratio or Debt Service Ratio :

This ratio measures the capacity of a firm to discharge their interest liability on

borrowed capital. It shows how many times the interest charge is covered by profit.

It establishes the relationship between Interest Charge and the profit available to

cover the interest. Here 'Profit' means profit before Interest and Tax. The ratio is

calculated as :

Net Profit Before Interest and Tax

■ Interest Coverage Ratio/Debt Service Ratio =-

0 Interest

Significance:

It measures the firm's ability to pay the interest charge out of profits. It i: an

important criteria for granting loan to the firm. Higher the ratio better is the

creditworthiness. On the other hand, a low ratio implies that creditors are not

assured of their interest.

2. Fixed Charges Coverage Ratio/Total Coverage ratio :

It is a ratio between total fixed charges and profit before interest and tax. It is also

known as Total Coverage Ratio because perference dividend is also added to the

total interest charges. It is calculated as:

Net Profit Before Interest and Tax

Fixed charge Coverage Ratio or Total Coverage Ratio =-

3. Preference Dividend Coverage Ratio :

This is a ratio between Net Profit After Tax and Preference .Dividend. It is

calculated as :

Net Pr qfit After Interest and Tax

Preference Dividend Coverage Ratio =

Significance:

It shows how many times preference dividend is covered by profit after tax. It

shows the degree of certainty of payment of preference dividend.

4. Cash Profit to Interest Coverage Ratio:

271

. This ratio shows the relationship between Interest Charge and Cash Profit. It is a

more redical measure of capacity of a firm to pay its interest charges because

interest is to be paid out of cash inflow to the firm. It is caculated as :

Net Profit Before Interest and Tax + Depreciation

Cash Profit to Interest Coverage ratio =

Significance:

It measures the financial strength to pay the interest charge. Higher the ratio better it

is. It proves the solvency of the firm to pay its interest charges.

Q.18. What is Leverage? What are the different types of leverages?

The dictionary meaning of the term 'Leverage' is 'An increased means of

accomplishing some purpose.' It means that it allows a person to accompish certain

objectives which are otherwise impossible to perform. Example - lifting a heavy

object with the help of a lever.

In financial terms it means a firm's ability to use fixed cost assets or funds to

increase the return on owner's investment.

According to James Home "Liverage is the employment of an asset or a source of

fund for which the firm has to pay a fixed cost or fixed return." Such fixed cost

bearing funds has an influence on the earnings available to equity shareholders.

Where return on capital employed is higher than the cost of capital, the difference

between the two goes to the equity shareholders and it increases the earnings of the

equity shareholders. Leverages are of two types :

1. Financial Leverage; and

2. Operating Leverage.

1. Financial Leverage:

A Financial Leverage means the use of long term fixed interest bearing debt and

preference share capital along with equity share capital. Long term fixed interest

bearing debt has a fixed cos payable irrespective of profit except preference

dvidend. If this fund is utilised to earn a higher ral of return than its cost, the extra

amount of return goes to the equity shareholders. As a result, equir shareholders get

a higher rate of return than the original return earned on their own capital. It called

Trading on Equity or favourable Financial leverage. However, if the return on

272

capital emplo\ e is lesser than the cost of fixed interest bearing debts and preference

dividend, it will reduce t earnings of the equity shareholders and such a situation is

called Unfavourable Leverage.

When a firm uses larger amount of debt in relation to its capital stock, such a firm is

said to by trading on its Equity. On the other hand, if the amount of debt is

comparatively low in relation t capital stock, the firm is said to be trading on Thick

Equity.

Significance:

If the return on capital employed is higher than the cost of debts, earnings per

equity share v. go up. On the ther hand, if the return on capital employed is lesser

than the cost of debts, earning per equity share will go down.Thus the impact of

financial leverage will fall on the earnings equity shares.

Advantages :

Following are the advantages of financial leverage:

1. Planning of Capital Structure:

It helps in planning the capital structure of a firm. The financial manager makes a

balancf between fixed cost funds and equity capital basing on a balance between

profit and risk.

2. Profit Planing:

It helps a firm in profit planning. A firm can increase return on equity share capital

by increas ing the quantum of fixed cost debt when the return on capital; employed

is higher than cost of deb:

3. Operating Leverage :

Operating Leverage means the greater percentage change in operating revenue than

the percentage change in sales. As fixed cost remains the same, net operating

income fluctuates whe-there is a small variation in revenue. Thus the fixed cost acts

as a fulcrum of a leverage. As f -example - when there is an increase in sales, there

will be an increase in operating reven... because fixed cost remains the same.

273

The degree of operating leverage depends on the amount of fixed element on the

cost stru. ture and operating leverage can be determind by means of a Break-Even

or Cost-Volume Pre' Analysis.

The degree of leverage can be calculated as follows :

Contribution

Operating leverage = operating Profit

Contribution = Sales - Variable Cost

Operating Profit = Sales - Variable Cost - Fixed Cost.

Fixed Cost

Break Even Point =

PIV Ratio

P/V. Ratio =

When production and sales move above the Break-Even Point, the firm enters into

highly profitable range of activities.

If a firm does not have fixed costs there will be no operating leverage. The

percentage change in sales will be equal to the percentage change in profit. If there

is a fixed cost the percentage change in profit will be more than the percentage

change in sales volume. Thus the degree of operating leverage will be computed as

follows:

Percentage Change in Profit

Degree Operating leverage = change in Sales

Q. 19. Write a very brief notes on 'Elements of financial statement'

[GU.2008J

Ans. Financial Statements contain the following elements:

1. Trading and Profit and Loss Account- containing all revenue incomes, revenue

expenses and Losses showing gross profit, gross loss and net profit or net loss;

2. Balance Sheet- containing all assets and liabilities both long tern and short tern

and capital;

3. Fun flow Statement shows the changes in working capital;

4. Cash Flow Statement shows the changes in cash or cash equivalents.

20. Objective type Questions :

274

State whether each of the following statements is true or false :

(a) Financial statements of a business enterprize include fund flow statement.

(True)

(b) Ratio analysis establishes relationship between financial statements .(True)

(c) Ratio analysis is a tool for analysing the financial statement of any

enterprise.fTr«^)

(d) Profit and Loss Account shows the operating performance of an enterprise for a

period of t\me.(True)

(e) Financial analysis helps an analysist to arrive at a decision.(True)

(f) The term financial analysis includes both analysis and interpretation/True)

(g) Financial Statements are the end products of accounting process. (True)

(h) Financial statement are primarily directed towards the needs of owner.(True)

(i) Facts and figures presented in financial statements are free from personal

judgements of)

Recorded facts are based on market pnce.(False)

(k) Financial statements provide all information about the business- both

quantitative and qual itative .(False)

(1) Financial Statements provide aggregate information about the business .(True)

(m) Financial statements are prepared on certain assumptions and conventions

(True) (n) Financial statements are interim reports (True)

(o) The purpose of financial reporting is to inform the management only about the

progress of the business. (False)

(p) Solvency ratios help the providers of longterm loan in assessing the firm's

ability to meet its obligations to longterm creditors. (True)

(q) Ratio is always expressed as a quotient of one number divided by another

number. (False)

(r) Ratios facilitate inter period comparison of performance. (True)

(s) Ratio explains the quantitative and qualitative aspects of business. (False)

(t) Quick assets include all current assets. (False)

(u) Price earning ratio shows the relationship between net earning per share to the

mar-price of a share. (True)

275

(v) Current Ratio is a better indicator than quick ratio about short term solvency

Twm,(False)

(w) Debt-equity is also called leverage Ratio. (True)

(x) Investment Ratio shows liquidity and profitability of the enterprise. (True)

(y) The amount of gross assets is equal to capital employed. (False)

(z) Return on Investment ratio measures profitability of a business. (True)

21. Fill in the blanks :

1) Financial statements are basic of information to interested parties, (sources)

2) The shareholders of a company are called-(members)

3) Preparation of Income statment is based on-basis, (accrual)

4) The statement which shows assets and liabiities of a company is known as-

(Balances ht)

5) Profit and Loss Account is also known as-statment. (Income)

6) Financial statments reflect a combination of recorded facts, accounting principles

and personal-(Judgements)

7) Financial Statements include-and-.

(Profit and Loss Account, Balanceshec

8. Analysis simply means_data, (simplifying data)

9. Interpretation means_data.(explaining)

10. Comparative analysis is also known as_analysis.( of horizontal)

11. Common size analysis is also known as_analyses. (Vertical)

12. The analysis of actual movement of money inflow and outflow, in an

Organisation is called analysis (Cash flow)

13. Analysis shows the direction of movement upwards or downward. (Trend)

14. Analysis identifies the direction of changes and trends in different indicators

of performance of an.organisation. (Comparative statement)

15. Analysis provides an insight into the structure of financial statements.

(Common size

(16) -is useful in evaluating the credit policy. (Average collection period)

(17) The-ratios tests long term solvency of the business.(Solvency)

(18) Lenders and suppliers are interested in the average-period, (payment)

276

(19) ratio measures the activity of a firm regarding inventory. (Inventor turnover

(20) -ratio more conservatively measures the short term liquid position of a firm.

(Quick,

(21) Ratio is an arithmetical relationship of one number to-—. (another number)

(22) Operation ratio is —- (Operating cost/Net sales)

(23) Rule of thumb of current ratio is-(2:1)

(24) Capital employed is-(Net Assets)

(25) Debt equity ratio is a relationship between-and shareholders' fund.

(Long Term Debt.)

22. Choose the correct alternative :

(1) Profit and Loss account shows.

(a) results of operation.

(b) liquidity position.

(c) both of them..

Ans. (a)

(2) Balancesheet shows

(a) Performance of the business.

(b) Financial position of the business.

(c) both of them.

Ans.(b)

(3) Financial facts are recoreded at

(a) Cost price

(b) market price

(c) replacement cost.

Ans. (a)

(4) Financial statements are

(a) interim reports of the business.

(b) final reports of the business.

(c) none of the above two.

Ans. (a)

277

(5) Accounting conventionsfollowed in preparation and presentation of financial

statements make financial statments.

(a) Comparable

(b) non comparble.

(c) None of the above two

Ans. (a)

(6) Financial statements are

(a) summarised reports of recorded facts.

(b) detailed reports of recorded facts.

(c) none of the above two.

Ans. (a)

(7) Financial Statements of a business enterprise inclube:

(a) Profit and Loss Account and Balance Sheet only.

(b) Cash Flow Statement only.

(c) All the above.

Ans. (c)

(8) The most commonly used tools for financial analysis are :

(a) Horizontal and vertical analysis.

(b) Ratio analysis.

(c)All the above.

Ans. (c)

(9) Annual report is issued by a company to its :

(a) Directors

(b) Auditors

(c) Shareholders. Ans. (c) (lO)Balancesheet provides information about financial

position of the enterprize.

(a) at a point in time

(b) over a period of time

(c) for a period of time. Ans. (a)

(11) Comparative statements are also known as...

(a) Dynamic analysis

278

(b) Horizontal analysis

(c) Vertical analysis Ans. (b)

(12) Upward or down ward movement of operations is shown by

(a) Trend analysis

(b) Comparative analysis

(c) Commonsize statement analysis. Ans. (a)

(13)Solvency of a firm is tested by :

(a) Current ratio.

(b) Debt Equity ratio.

(c) Quick ratio. Ans. (b)

(14) Quick Assets consist of:

(a) All current assets.

(b) Liquid assets;

(c) Only Cash in hand and at bank. Ans. (b)

(15) Rigorous test for liquidity position of a firm is tested by :

(a) Current Ratio.

(b) Liquid Ratio.

(c) Solvency Ratio. . Ans. (b)

(16) Rule of thumb of Acid Test Ratio is :

(a) 2:1

(b) 1:1

(c) 0.5:1 . Ans. (b)

(17)The measure of speed with which various accounts are converted into sales or

cash is:

(a) Activity ratios;

(b) Liquidity Ratios

(c) Debt Ratios. Ans. (a)

(18) The groups of ratios which primarily measures risk are :

(a) Liquidity, Activity and common stock.

(b) Liquidity, activity and profitability;

(c) Activity, debt and profitability. Ans. (c)

279

(19) Two basic measures of liquidity are :

(a) Inventory Turnover and Current Ratio.

(b) Current Ratio and Average Collection period;

(c) Current Ratio and Liquid ratio. Ans. (c)

(20) Efficiency of the use of resources is tested by :

(a) Return on investment.

(b) Return on shareholders fund

(c) Dividend payout ratio. Ans. (a)

280

Unit-V B. FUND FLOW STATEMENT

Q.l. What is Fund? Explain. (GU.2006)

The term 'fund' has been defined in a number of ways, viz. in broader sense, in

narrower sense and in a popular and generally accepted sense.

Meaning in Broader Sense:

The term 'funds' refer to all financial resources or purchasing or spending powers

of economic values possessed by a firm at a particular time. So it refers to the

money values in whatever form it may exit, e.g. resources in the form of man,

material, money, etc.

Meaning in Narrower Sense:

In narrower sense, the term 'fund' refers to cash and bank balances and the

statement pared on this basis is called a 'Cash Flow Statement'. In this case, the

flow consists of receipts and payments of cash and transactions affecting cash

position.

Meaning in Popular Sense:

In popular and generally accepted sense, the term 'Fund' is used to denote the excess

of . urrent assets over current liabilities. In other words, the terms 'working

capital'and 'funds'are taken to be synonymous (same meaning).

The working capital concept of funds have emerged out of the fact that the total

business esources (funds) are invested partly in fixed assets which exist in the form

of permanent capital id partly retained in liquid or near liquid form as working

capital. As business transactions generally result in either increase or decrease in

working capital, this concept of fund is usually accepted in fund flow statement.

Q.2. What do you mean by the term'Flow of Fund'? (GU.2006)

The term 'flow' means movement and it includes both inflow and outflow.

Therefore, the t rm 'flow offunds 'means transfer of economic value from one asset

of equity to another. A 'low of fund takes place when any transaction makes a

change in the amount offunds ailahle before the, happening of the transaction. If

the effect of a transaction results in any crease of the working capital, it is called a

source of fund or inflow of fund. On the otherhand, if te effect of a transaction

results in any decrease in working capital, it is known as an application fund or

281

outflow of fund. If a transaction does not affect the amount of working capital, it is

said at there is no flow of fund. Therefore, according to the working capital concept

of funds, the term '.ow offunds refers to the movement offunds in the working

capital. Thus flow of funds rises when a transaction affects a current account and a

non-current account i,e. a fund . count and a non-fund account simultanously.

However, there will be no flow of funds if a ransaction affects fund accounts only

or non-fund accounts only.

Examples:

I. Flow of funds

(i) Affecting current assets and non-current assets:

(a) Purchase of furniture in cash affecting a payment of cash and an increase of a n;

current asset-furniture. It is an outflow of cash.

(b) Sale of an old machinery in cash affecting a decrease in non-current asset- a

machine and an increase in current asset - cash. It is an flow of fund.

(ii) Affecting one non-current asset and another current liability:

Sale of machinery on credit affecting a decrease in non-current asset-machinery and

. increase in current liability- a creditor for machinery; etc.

An increase in current liability will decrease net working capital.

II. No flow offunds:

(a) Affecting one current asset and another current liability- Payment of creditors;

(b) Affecting one non-current asset and another non current liability-purchase of a

plant agar;

issue of debentures.

The above transactions do not affect net working capital.

Q.3. What is a Fund Flow Statement? [GU. 1998] Or,

Write short note on Fund Flow Statement. [GU. 1989,1990,1994, 2003] Or

Elaborate the concept of 'Fund Flow Statement'. [GU. 2002

Fund Flow Statement is a statement snowing the changes in the financial position

betvs. the dates of two balance sheets. It describes the sources from which

additional funds were deri a and the uses to which these sources were put.

282

Foulke defines it as "a technical device designed to analyse the changes to the

fine cial condition of a business enterprise between two dates. "

Thus a Fund Flow Statement is a statement which attempts to explain the changes

o\-e two periods in the balance sheet items by tracing them to the original

transactions. Tr* objective of analysis of such a statement is to throw light on the

financial strategy ofthe busine i unit and enables one to make proper

interpretation of the changes and forecast predict ic Thus it is a technique to judge

the validity and effect of financial strategy of a business enterpri s< It is

usedparticularly in situations where inspite of profitable operations, the firm is in

the grip : liquidity crisis which arises because the liquid profits are blocked in fixed

assets.

Usually it is prepared in a statement form showing sources of funds on the left hand

side and application of such funds on the right hand side.

Q.4.Describe the procedure you would adopt in preparing a fund flow

statement from the final accounts of a large public company. [GU. 2001]

Following is the procedure and steps for preparing a Fund Flow Statement: Step-l:

Schedule of changes in Working Capital:

A schedule of changes in Working Capital is to be prepared which shows the

differences between current assets and current liabilities between the dates of two

Balance Sheets. This schedule is balanced by the amount of increase or decrease in

working capital over the period. An increase in working capital is shown as a use of

fund while a decrease in working capital is shown as a source of fund in a Fund

Flow Statement. It should.be noted that while taking the figures of both current

assets and current liabilities, provision, if any, against such items should be adjusted

-efore calculating the changes in working capital. A fund flow statement should

always be ccompanied by a statement (or schedule) of changes in working capital

and the net change should ~e same in both the statements.

In case, a current asset in the current period is more than that (current asset) in the

previous iod, the effect is the increase in working capital and that increase is to be

written in the increase jmn and vice-versa is the decrease in the working capital.

Again, if a current liability in the rent period is more than that (current liability) in

283

the previous period the effect is the decrease in working capital and that decrease is

to be written in the decrease column and vice-versa is the . rease in working capital.

The total increase and total decrease are compared and the difference net increase or

net decrease in working capital. A specimen form of the statement is given tow:

of fund while a loss in operations is treated as a use of fund. However, the income

state contains certain items which do not affect working capital. These items are

write offs and paae entries such as loss on sale of an asset, depreciation, preliminary

expenses, deferred expense-which do not involve any flow of fund, hence they do

not affect the working capital. Such ite— affect non-fund accounts and are adjusted

to funds from operation. Thus the adjusted net pr: a source of fund while the

adjusted net loss is treated as a use of fund.

Step-HI: Consideration of changes in Non-fund Accounts:

Changes in non-fund accounts between two periods are to be considered. If there

increase in non-fund assets such as plant, land and buildings, furniture, long-term

investments.. over the period, it indicates the acquisition of assets and involves an

outflow or use of funds. 0 otherhand, if there is a decrease, in non-fund assets over

the period, it indicates sale of asse: involves an inflow of funds or a source of funds.

Losses or gains on such a sale is adjust;: operational net profit or net loss as

discussed earlier.

If there is an increase in non-fund liability such as - increase in share capital,

debenture, long term loans etc. over the period, it indicates an inflow of funds. On

the other hand, if there decrease in such non-fund liabilities, it indicates an outflow

or use of funds. Any profit c -involving non-fund liability may be treated as a

source or a use of fund respectively.

Step-IV: Treatment of some Special Items:

(a) Provision for taxation and proposed dividend may be treated as current liabilit

ic may be included in the Schedule of working Capital.

(b) Payment of Tax and payment of dividend may be treated as appropriations of p

-and are adjusted to operating profits. Again, on actual payment, they are treated as

uses of fur

Step-V: Preparation of Fund Flow Statement:

284

A statement of sources and application of funds is prepared in a summary form w

hen various sources of funds are shown on theTeft hand side and various uses of

funds are shov. -the right hand side if the statement is prepared in T-Form.

Following is a specimen of s_. statement:

Funds Flow Statement (for the year ended..............)

Sources Application

Funds from Operation Funds lost in Operation

Issue of Share Capital Redemption of Preference

Share Capital

Issue of Debenture Redemption of Debentures

Raising of Long-term Loans Repayment of Long-term

Loans

Sale ofNon-Current (fixed)

Assets

Purchase ofNon-Current

(fixed)

Assets

Non-Trading Receipts such as

dividends,

Purchase oflong-term

Investments

interest, etc. Non-Trading Payments

Sale of Long Term Investments Payment of Dividend

Net decreas in Working Capital Net Increase in Working

Capital

Q.5. What for is a Fund Flow Statements prepared? [GU.2001]

Or, What utilities can be derived from Fund Flow Statement? [GU.2002] Or,

Examine the uses and significance of the fund flow statement to the

management. [GU.2003]

Significance and Uses of Fund Flow Statement:

A Fund Flow Statement is an essential tool for financial analysis and is important to

management, equity holders and credit granting institutions. It shows a summary of

sources from •vhich funds have been obtained and uses to which such funds have

been put. Fund flow analysis helps one in judging the financial strategy of a

business and in ascertaining the soundness of that strategy.

285

Fund flow analysis is particularly useful in long range planning where projections

of available iquid resources are to be made. Management can come to know about

the adequacy or otherwise [Working capital to meet future requirements.

Importance of Fund Flow Statement and its analysis are summarised as follows:

/. Analysis of Financial Operations:

Fund flow statement shows enough materials for analysis of financial operations. It

shows )t only the changes in the financial position but also the causes of such

changes and their ffect on the liquidity position ofthe concern. It is very useful in

explaining the liquidity crisis of . profitable concern.

Z Formulation of a Realistic Dividend Policy:

A projected fund flow statement helps the management in persuing realistic

dividend policy ~ased on expected cash flows.

\ Resource Allocation:

A projected fund flow statement helps the management in the allocation of

resources in a rational way.

4. A Future Guide:

It acts as a future guide to the management as it projects its future needs and

sources of imds. Management can take timely action jn raising additional funds or

utilising surplus funds according to the needs of emerging situations.

I Appraising the use of Working Capital:

It helps in explaining how efficiently the firm has used its working capital and it

may also J ggest to the management how to improve, the position of working

capital.

i Credit-worthiness of a Firm:

It shows the overall creditworthiness and paying capacity of a firm which is very

important - a credit granting institution.

'. Long-term Managerial Decisions:

It helps the management in planning for the retirement of long-term debts,

replacement of E \id assets, expansion of operations, etc.

V.B.285

Cost and Management Acconting

286

Q.6. Write short note on:

(i) Working Capital [GU. 20C 2

Working Capital:

Working Capital is a capital which is used for day-to-day operational purposes of a

business It is the capital which generate cash flows and results into profit or loss. So

it is the revenue ear -1 capital of a firm. It keeps the business operations moving

uninterrupted.

The concept of working capital has two connotations.

(i) Gross Concept and

(ii) Net Concept. Gross Concept:

Gross Concept refers to the sum-total of all current assets of an enterprise emplo\ e:

business operations. This is a going concern concept because the finance manager is

conce-with the management of assets with a view to bringing about productivity

from other assets.

Net Concept:

Net concept refers to the excess of current assets over current liabilities. It is a

quality definition of working capital. It highlights the character of the source from

which the funds been procured to support that portion of the current assets which is

in excess of current asse

Q.7. How would you treat the following transactions while preparing the

fund flov> statement ?

(i) Investment;

(ii) Proposed Dividend;

(iii) Provision for Taxation

(iv) Interim Dividend;

(v) Bad Debts.

(vi) Provision for Bad Debts/ Reserve for Doubtful Debts.

Investment:

It is an application of fund. Investment may be short-term or long-term. If it is a

short-investment, it is included in the schedule of changes in working capital as an

287

item increase working capital. If it is a long-term investment, it is shown as an

application of fund in the F Flow Statement.

Proposed Dividend:

Proposed dividend can be treated in the fund flow statement in two ways: (i) When

proposed dividend is treated as a current liability: it will appear in the schec of

working capital as an item decreasing the working capital. Subsequent payment of

dividend does not affect working capital as it involves two fund accounts, viz.

proposed dividend account _ cash account.

(ii) When proposed dividend is taken as an appropriation of profits: an account is

r repared for proposed dividend and the same is debited to the Profit and Loss

Account to find out :he funds from operations. Subsequent payment will reduce

working capital.

Provision for Taxation:

It may be considered as a current liability in the schedule of changes in Working

Capital showing as an item decreasing working capital. In that case, no separate

account is required to be pened. When tax is paid, it will not appear as an

application of funds in the Funds Flow Statement since such payment does not

affect working capital. Payment of tax would affect two current accounts.

Again provision for Taxation may be treated as an appropriation of profits. In that

case, it will not appear in the schedule of Changes in Working Capital. An account

is needed to be prepared showing opening balance on the right side and closing

balance on the left hand side and the amount of tax paid is on the left side. The

balancing figure of the account shows the provision made during the year and is

transferred to the Profit and Loss Account in order to ascertain fund from

operations. Payments of tax is shown as a item of outflow of fund in the Fund Flow

Statement. Interim Dividend:

Interim Dividend is shown on the debit side of the Adjusted Profit and Loss

Account in order to show the fund from operations. Again, payment of interim

dividend is shown as an outflow of fund in the Fund Flow Statement. However, if

288

the balance of profit is after deducting interim dividend, in that case, it will not

come in the Adjusted Profit and Loss Account.

Bad Debts:

Bad debt is shown as a deduction from Sundry Debtors in the Schedule of Working

Capital. It is an item which decreases working capital.

Provision for Bad Debts/Reserve for Doubtful Debts:

It can be treated any of the following three methods:

(i) Opening provision should be deducted from opening debtors and closing

provision from closing debtors and good debtors should be ascertained and then the

debtors would be shown in the Schedule of Working Capital. No further treatment

is necessary.

(ii) Opening and closing debtors will be shown at gross figures in the current assets

and both opening and closing provisions will be shown under current liabilities. No

further treatment is necessary.

(iii) If excess provision has been created, it may be treated as an appropriation of

profit and should be debited to the Adjusted Profit and Loss Account for calculation

of Fund from operation. No further treatment is necessary.

Q, 8. How would you calculate funds from operations ? Show your answer

giving imaginary figures. [GU.2002]

Fund from operation is ascertained by preparing an Adjusted Profit and Loss

Account. Profit and Loss Account contains both fund transactions and non-fund

transactions. Non-fund transactions do not affect the working capital. They are

merely write offs, paper entries and appropriations of profits. Such non-fund

transactions do not affect working capital. They affect non-fund long term

liabilities, equities, etc. There are some fictitious assets which are charged to the

Profit anc Account but they do not affect the working capital. Similarly,

appropriations of profits s. . transfer to reserve fund, provision for income tax,

proposed dividend, transfer to sinking fur do not affect working capital. Again,

289

depreciation is an allocation of fixed assets to the Pre f Loss Account as a

productive expense but does not involve any outflow of cash.

Thus non-fund transactions affecting non-fund accounts affect the net profit though

th e not affect the working capital. In order to ascertain the true fundfrom

operations, the iter such nature which reduce net profit should be debited to the

Adjusted Profit and Loss Accotm and the items which increase the net profit are

credited in the Adjusted Profit and Lorn Account. The Adjusted Profit and Loss

Account will start with the opening balance of net prof the credit side and the

closing balance of profit on the debit side. The balancing figure appears or rc credit

side which presents the amount of fund from operation.

Proforma Adjusted Profit and Loss Account

To Depreciation of Fixed Asset 20,000 By Balance b/d (opening) 20000

To Amortisation of Fictitious By Profit on Sale of

Machinery

2,000

and Intangible Assets: By Dividend Received 1,000

Goodwill 5,000 By Funds from Operation 1,68,00:

Patent 1,000

Prel im i nerv Expenses

4,000

10,000

To Appropriation of Retained

Earnings:

Transfer to General Reserve 5,000

Transfer to Sinking Fund . 5,000

To Loss on Sale of Furniture 1,000

To Dividend paid 20,000

To Proposed Dividend 20,000

(If not taken as a current liability)

To Provision for Taxation 10,000

(If not taken as current liability)

To Closing Balance 1,00,000

1,91,000 1,91,000

290

Q.9. Explain the limitations of Fund Flow Statement:

Fund Flow statement has many uses. However, it has also some limitations as

mentioned below:

1. It is not substitute of an income statement or balance sheet. It provides only some

additional information regarding changes in working capital.

2. It shows changes between two periods but does not show continuous changes.

3. It is not an original statement as it is based on data taken from Balance sheet and

Profit and Loss Account.

4. It is historic in nature because it is based on financial statements. So projected

Fund Flow Statement may not be accurate.

5. It does not correctly show the cash position because cash is only one of the many

items comprising current assets.

Q.10. Distinguish between a Fund Flow Statement and Balance Sheet.

Balance Sheet is a position statement. It shows the resources of an undertaking and

the application of those resources on a particular date. Hence it shows the financial

position on a particular date. So it is static in nature.

Fund Flow Statement shows changes in the financial position between two dates.

Balance Sheet is the end results of all accounts. On the otherhand, Fund Flow

Statement is a post balance sheet exercise. So following differences are observed

between the two.

Fund Flow Statement Balance Sheet

1. It is a statement of changes in

financial position between two

Balance sheet dates. So it is dynamic

in nature.

1. It is a statement of financial position

on a particular date. Hence it is static

innature.

291

2. It shows the sources and application

of funds in a given period of time.

2. It shows the resources of an

undertaking and application of those

resources on a given date.

3. It is a tool of managment for

financial analysis and is very much

helpfull in decision making purposes.

3. It is not so much helpful in decision

making purpose ot the management.

4. Generally some more statements

such as Schedule of Changes in

Working capital, Adjusted Profit and

Loss Account, etc are to be prepared

before preparing the Fund Flow

Statement.

4. Here, Profit and Loss Account and

Profit and Loss Appropration Accounts

are to be prepared before preparing a

Balance Sheet.

5. Items of fund flow statement are

usually taken from the Profit and Loss

Account and Balance Sheet.

5. Items of Balance sheet are usually

taken from the Ledger Account balances

from ledgers.

Q.U. Is depreciation a fund? Explain.

Meaning of Depreciation:

Depreciation is a gradual and permanent decrease in the value of a fixed asset

owing to vear and tear, passage of time, innovation, obsolescence, etc.

Depreciation is the capital cost of an asset which is allocated over the life of the

asset, Ii a book entry which has the effect of reducing the book value of the asset

and the profit ot current year. Like other expenses it has no effect on working

capital since it does not affect a outflow of cash. So depreciation is the accountant's

way of matching costs of fixed assets with the benefits derived from those assets.

Hence depreciation is not a source of fund. Fund flow occ u when fixed assets are

acquired and at that time it is an application of fund and not a source of fur i

Depreciation simply spreads that outflow oyer the life of the assets for the purpose

of measurl -

[ the results of operations. However, depreciation can indirectly influence the flow

offund* affecting the firm's tax liability. Under Income Tax rules, depreciation is

a tax deduct ir item and net profit of the firm is reduced by the amount of

292

depreciation allowed undt i Income Tax rules. Thus there will be less tax and to

that extent there will be less outflow of cas

Again because of depreciation, net profit will be less and lesser amount of dividend

will be paid. Thus there will be savings in the out flow of cash.

Further, if a firm shows net loss after charging the amount of depreciation, the firm

is n required to pay any tax and dividend and in that case, there will be savings in

outflow. So in th case, it does not even indirectly affect the sources of fund. If the

firm charges huge depreciati and reduces net profit, it may save outflow of cash

through lesser payment of dividend.

Thus depreciation is not a direct source of fund. However, it affects the outflow of

fund--the extent tax liability and payment of dividend becomes less. So in that

sense, it may be treated as a source of fund.

FUND FLOW STATEMENT Part II: Practical Problems

The Balance sheets of Monish Enterprise as an January 1 and December 31,

1999 were given below:

Liabilities 1.1.99 31.12.99 Assets 1.1.99 31.12.99

Capital 1,50,000 1,78,000 Computer 1,55,000 1,75,000

Loan from Bank. 50,000 60,000 Inventory of

Loan from Richa 15,000 --- miscellaneous items 10,000 5,000

Account payables 50,000 . 54,000 Accounts

Receivables

65,000 80,000

Cash 35,000 32,000

2,65,000 2,92,000 2,65,000 2,92,000

293

UNIT - V C. CASH FLOW STATEMENT

Part -I Theoretical Questions :

Q. 1 : What is Cash Flow Statement?

Cash Flow Statement is a statement of inflows and outflows of cash and its

equivalents that take place in an enterprise during a specified period of time. Such

cash flows are classified by operating, investing and financing activities.

The word inflows means receipts of cash and its equivalents and the 'outflows'

means payments of cash and its equivalents.

Thus the statement concentrates to the transactions that have a direct impact on cash

and explains the changes in cash position between two periods. ,

In Short, a cash flow statement'shows the sources of cash receipts and the purposes

for cash payments in classified form. Thus it is like a Receipts and Payments

Account in a summary form.

Q. 2 : What is the classification of activities of an undertaking for the

preparation of a 'Cash Flow Statement' ?

According to AS - 3 (Revised), cash flows shown in the cash flow statement are

classified as follows:

1. Cash Flows by Operating Activities;

2. Cash flows by investing activities; and

3. Cash flows by financing activities.

1. Cash Flows by Operating Activities:

Cash flows by operating activities mean the flows of cash and its equivalents caused

by the principal revenue producing activities and its other activities which are not

investing and financing activities. It shows the extent to which the operation of an

enterprise can generate cash flows to maintain the operating capacity of an

enterprise, to pay dividend, to repay loans and make new investments without

taking outside finance.

Examples - Cash receipts from sale of goods or rendering services, cash receipts

from royalties and commission, cash payments to suppliers for goods and services,

cash payments for employees and cash payments for administrative expenses.

2. Cash Flow by Investing Activities:

294

Cash flows by investing activities mean the flow of cash caused by the activities

relating to acquisition and disposal of long tern assets (land, building, plant and

machinery, etc.) and other investments not included in cash equivalents. Such cash

flows represent the extent to which expenditures have been made for resources,

intended to generate future income and cash flows.

Examples: Cash payment relating to acquisition of fixed assets - land and buildings,

cash payments for capitalised research and developments of projects; cash receipts

from disposal of fixed assets; cash payments for acquiring shares, and debentures

cash receipts from sale of shares a debentures, etc.

3. Cash flows by Financing Activities:

Cash flows by financing activities mean the flows of cash caused by the activities

than result in changes in the size and composition of:

(i) The owners capital (including preference share capital in case of a company);

and

(ii) The borrowings of an enterprise (debentures, long-term loans from banks and

other financial institutions with or without security).

It shows the claims on future cash flows by the providers of funds.

Examples:

(i) Cash proceeds from issue of shares.

(ii) Cash proceeds from issuing debentures, loan bonds and other long-and short-

term borrowings.

(iii) Cash repayment on redemption of preference shares and debentures; and ,(iv)

Cash repayment of loans and bonds.

Other Items:

In addition to the above three types of activities, As - 3 (revised) also deals with

certa other items as discussed below:

(i) Interest and Dividend:

These items are treated under two heads:

(a) In ease of a financial enterprise: Cash flows arising from interest and dividend

received should be classified as cash flows from operating activities.

However Dividend Paid should be classified as cash flows from financing activities.

295

(b) In case of other enterprises: Cash flows arising from interest and dividends paid

should classify as cash flows from financing activities.

However, interest and dividend received should be classified as cash flows from

investing activities.

Thus cash flows from interest and dividend paid or received should each be dis

closed separately.

Tax from Income:

Cash flows arising from taxes on income should be separately disclosed. They

should be classified as cash flows from operating activities unless they can be

specifically identified with financing or investing activities.

Example: Tax on trading income is a cash flow from operating activities while tax

paid on capital gain arising from sale of a building is a cash flow from investing

activity.

Extra-ordinary Items:

Cash flows associated with extra-ordinary items should be classified as arising from

operating, investing or financing activities as the case may be and should be

disclosed separately under respective head.

Foreign Currency:

Cash flows from foreign currency should be shown separately in the Cash Flow

Statement.

Son-cash Transactions:

Transactions which do not involve inflow or outflow of cash or cash equivalents are

excluded from Cash Flow Statement.

Examples: Acquisition of a fixed asset on credit, conversion of convertible

debentures into shares, issue of bonus shares, depreciation, etc.

Q. 3 : Define the following Terms as given in AS - 3 (Revised).

(i) Cash:

Cash comprises cash in hand and demand deposits with banks.

(ii) Cash Equivalents:

296

Cash Equivalents are short-term highly liquid investments that are readily convert

ible into known amounts of cash and which are subject to an insignificant risk of

changes in value.

(iii) Cash Flow:

Cash Flows are the inflows and outflows of cash and cash equivalents.

(iv) Operating Activities:

Operating activities are the principahevenue producing activities of an enterprise

and other activities that are not investing and financing activities.

(v) Investing Activities:

Investing Activities are the acquisition and disposal of long-term assets and other

investments not included is cash equivalents.

(vi) Financing Activities:

Financing activities are the activities that result in changes in the size, composition

of the owners' capital (including preference share capital in the case of a company)

and borrowings of the enterprise.

Q. 4 : What are the objectivities of cash Flow Statement ?

Following are the objectives of preparing a Cash Flow Statement:

1. To judge the ability ofgenerating Cash and Cash Equivalents.

Cash Flow Statement reflects the ability of an enterprise to generate cash and cash

equivalents during a given period of time.

2. To Assess the Timing and Certainty of Cash Flows:

It shows the timing and certainty of cash flows generated in an enterprise.

3. To Assess the needs of utilising the Cash Flows :

It shows the need for utilising the cash generated from cash flows in various

sources.

4. To Assess the historical process ofgenerating cash flow:

It shows the historical process of generating cash flows from different activities of

an enterprise such as operating, investing and financing activities. The above

information helps the internal and external users of the financial statements to lake

strategic decisions about the affairs of the enterprise such as:

(a) Solvency position for the payment of debts, and interest thereon.

297

(b) Liquidity position for payment of dividend and tax.

(c) Availability of cash resources for the maintence of operating activities and for

investment and expansion of the enterprise.

Q. 5 : What are the benefits of Cash Flow information?

Benefits of cash flow statement:

1. It provides information about Changes in Net Assets:

Cash Flow Statement provides information about the changes of assets of an enterp

during a period. It enables the users to evaluate the net assets and the financial

structure.

2. It Provides Information about the Amounts and Timings of Cash Flows:

Cash Flow Statement shows the amounts of inflows and outflows of cash and their

ings. It enables the management to adopt the operations to the changing

circumstances and enah . the enterprise to avail of the opportunities accordingly.

3: It provides Information about the Generation and Utilisation of cash and

equivalent^ Cash Flow shows the ability of an enterprise to generate cash and its

equivalents a various needs for utilising such cash.

4. It makes Operating Reports Comparable :

Cash Flow Statement enhances the comparability of the reporting of operating

performance of different organisations. It is because Cash Flows are not effected by

accounting pr: ciples which may be different in different organisations. Operating

reports may not be comparat when different organisations follow different

accounting practices.

5. It checks the Accuracy of Past Assessment of Future Cash Flows:

Cash flow is used as an indicator of the amount, timing and certainty of Cash Flow;

which may be compared with the past assessment of future cash flows.

6. It Examines the Relationship Between Profitability and Net Cash Flow:

It helps the users to examine the relationship between profitability as shown by the

Pre" and Loss Account and the net cash flows. This statement shows where form

cash has come whet. cash has gone.

298

7. It shows the Liquidity and and Solvency Position:

Cash Flow Statement shows the ability of an enterprise in respect of financing its

norma operations, meeting its debt obligations in time and paying dividend to its

shareholders. Thus focuses on the liquidity and solvency position of an enterprise.

Q. 6 : Describe the advantages and Limitations of Cash Flow Statement.

Advantages :

1. Better Comparability of Financial Performance:

Cash Flow Statement enhances the comparability of performance of different enter

prises because it is based on cash flows, which make the statements free from

personal bias. Or the other hand, financial performance reports by financial

statements may be affected by person., bias of the accountant because different

accountants may follow different methods for the treatment of same types of

transactions.

2. Reliability of operational Results:

Cash Flow Statement shows the cash in flows generated from business operations.

Th s picture of cash flows from business operation is more reliable than the picture

as shown by the 3rofit and Loss Account because the amount of profit can be

changed due to change in the amount f depreciation, which is subject to

management decision. Thus the cash flow statement is not subject to managerial

decision while profit as shown by the Profit and Loss Account may be rfected by

managerial decisions.

3. Verification of Cash Budget:

It checks the accuracy of past assessment of future cash flows. It is done by

comparing the Cash Budget with Cash Flows during a given period and shows to

what extent Cash Budget has been followed in practice.

4. Basis for preparing future Cash Budget:

Cash flow is used as an indicator of the amount, timing and certainty of future cash

flows. This indicator is used in preparing cash budget for subsequent periods.

299

5. Solvency Position:

Cash Flow Statement shows the ability or otherwise of the enterprise in meeting

debt obligations, tax liability, dividend obligation and in performing operational

activities.

6. Information about Investing and Financing Activity:

Cash Flow Statement provides information about its activities in respect of

investment and finance and generation and uses of cash therefrom separately. Thus

it enables the users to evaluate changes in net asset and capital structure.

7. Relationship between Profit and Net Cash Flow:

Cash Flow Statement prepared in indirect method enlists the difference between net

profit before tax and the net cash flows generated from operations. Thus it shows

the relationship between Net profit and Net Cash flow.

Limitations:

1. Non - Cash Charges are ignored:

Cash Flow Statement ignores the non-cash charges, which are necessary for judg

ing the profitabi 1 ity of an enterprise.

2. Ignores the principles of Accrual:

Cash Flow Statement does not take into account the accrual concept which is one of

the important principle required for the preparation of Profit and Loss Account.

Hence, the result of operation differs.

Q.7: State the distinctions between Fund Flow and Cash Flow Statements.

Following are the distinctions between Fund Flow and Cash Flow statements:

Basis Fund Flow Statement Cash Flow Statement

1.Scope Fund Flow Statement deals with

the changes in working capital

position between two points of

time. So it is based on the wider

concept i.e. working capital.

Cash Flow Statement deals with the

changes in cash position only

between two points of time. So it is

based on the narrower concept of

funds i.e. cash and its equivalents

constituting a part of Funds.

300

2. Inclusion of

opening and clos

-ing balance of

cash.

Fund flow statement does not

contain any opening and closing

balance of cash.

Cash flow statement includes be;

opening and closing balances of cas:-

and its equivalents.

3. Contents and

their Effect

It records sources of funds in the

left hand side and application of

such funds on the right hand side.

If sources of funds exceed the

applica -tions of funds the result

is an increase in working capital

and the vice-versa is the decrease

in working capital.

Cash flow statement shows inflow s

a : outflows of cash and its

equivalents. 1 . difference between

the total inflows an . the total

outflows is the net increas, cash and

the vice-versa is the decree : in cash.

4.Schedule of

Changes in

work-working

capital

5. Objective

Schedule of changes in working

capital is usually prepared with

Fund Flow Statement. Thus it

does not reveal the item-wise

changes of current assets and

current liabilities

Fund Flow Statement shows the

firm's ability to meet it's longterm

liabilities

No such statement is prepared alon.

with Cash Flow Statement. The

statement itself shows the changes

all assets and liabilities in a

summarised form.

Cash Flow Statement shows the finr

• ability to meet its short-term

obligatic: -

5. Basis of

Accouning

Fund flow Statement is based on

accrual basis of accounting

Cash Flow Statement is based on cas

H basis of accounting.

7. Classification

of sources and

application

Fund Flow Statement does not

classify the activities into

operating, investing and

financing activities.

Cash Flow Statement classifies the

activities into operating, investing

aiv financing activivities for

recording cash flows.

8. Causes of

Changes

It explains the reason of changes

in working capital.

It explains the reason of changes in

cash and its equivalents.

9. Obligation

under SEBI

Preparation of Fund Flow

Statement is not obligatory as per

Preparation of Cash Flow Statement

is obligatory as per SEBI guidelines.

301

SEBI guideline:

Q. 8 : What are the uses of and significance of cash Flow Statement ?

Significance and uses of a Cash Flow Statement are as stated below:

1. Evaluation of Cash Position:

Cash Flow Statement showing inflows and outflows of cash and its equivalents over

a given period of time which enables a firm to evaluate its cash position at any point

of time within tfi. given period.

2. Planning and Coordinating Financial Operations:

A projected cash flow statement can be prepared on the basis of the Cash Flow

Statement in order to know future cash inflows and cash requirements and cash

position. This information will enable the firm to plan and co-ordinate its

operations, debt payments and investments a; :

ange funds when it becomes necessary.'

Evaluation of Performance:

Cash Flow Statement when compared with Cash Budget enables the firm to

determine . variances between the projected and actual performance and remedial

measures may be taken mprove the operational performance.

Liquidity Position:

Analysis of Cash Flow Statements covering a number of years along with those of

other rms will reveal the trend of liquidity position of the firm - improving or

deteriorating, over the ears.

Planning for Repayments of Long-term Loans and Capital Budgeting:

Cash Flow Statement shows the quantum, timing and certainties of inflows and

outflows cash which helps the management in planning the payment of long-term

loans and making estment in fixed assets.

Revealing the causes ofpoor Cash Position in the year of Substantial Profits:

Cash Flow Statement shows the generation and utilisation of cash and thereby it

reveals c causes of poor cash position even in the year when a firm earns a

substantial profit. Cash sition becomes poor when outflows for a period exceed the

inflows of cash.

302

Revealing Abilities in Meeting Short-term obligations:

As Cash Flow Statement shows the quantum and timing of inflows and outflows of

cash 1 ring a given period of time, the firm can assess its ability to pay its short-

term obligations in time - d arrange funds or reschedule its debt payments where it

becomes necessary.

9. Format of Cash Flow Statement (Direct Method) & (Indirect Method).

PRESENTATION AND PREPARATION OF CASH FLOW STATEMENT

AS PER THE RECOMMENDATION OF ICAI IN ACCOUNTING

STANDARD (AS 3).

The Institute of Chartered Accounts of India has recommended, rather revised, its

Ac-anting Standard (AS 3) which makes the Cash Flow Statement more informative

to its users by iding the cash flow statement into groups/headings viz., (a) Operating

activities, (b) Investing Ktivities and (c) Financing activities.

In short, it takes the following forms:

A. DIRECT METHOD :

Cash Flow Statement

(a) Cash Flow from Operating Activities :

Collection from Customers Less: Cash paid to creditors

Cash paid to employees

Cash paid for other operating Expenses

Cash Generated from Operation Less: Income Tax Paid

Cash flow before extraordinary items

Extraordinary' Receipts Net Cash from Operating Activities

(b) Cash Flow from Investing Activities

Sale of Fixed Assets Sale of Investments Interest Received Dividend Received

Less: Purchase of Fixed Assets Purchase of Investments Loans given, etc..

Net Cash from Investing Activities

(c) Cash Flow from Financing Activities:

Proceeds from fresh issue of shares Receipts from long-term loans, etc.

303

Less: Loan paid

Redemption of Preference Shares Interest paid Dividend paid

Buy- back of equity shares etc. Net Increase (Decrease) in Cash or Cash equivalent

Add: Cash at the (beginning)

Cash at the (closing)__

INDIRECT METHOD

Cash Flow Statement

(a) Cash Flow from Operating Activities

Operating Profit (by preparing adjusted P & L A/c) Add: Increase in Current

Liabilities, or Decreases in Current Assets

Less: Increase in Current Assets, or Decrease in Current Liabilities Cash generated

from operations Less : Income tax paid Cash flow before extraordinary item

Add: Extraordinary receipts

Net Cash from Operating Activities

C. Cash Flow Statement V.C.9

(b) Cash Flow from Investing Activities (shown as Above) :

(c)

Add:

Cash Flow from Financing Activities :

Proceeds from fresh issue, or, Long-term loan taken

Net increase or Decrease in Cash Equivalent Cash at the

beginning

Cash at the closing

Q. JO. Give a note on Cash Flow Statement as per AS- 3. [GU.2008]

As.3 deals with the change in financjal position. This standard shows the sources

and application of funds in a summary form.

Definition of Cash Flow Statement as per AS-3.

A statement of changes in financial position summarises for the period covered by it

the change in the financial position including the sources from which the funds are

obtained by the enterprise and the specific uses to which such funds are applied."

The term 'funds' refers to cash or cash equivalents or to working capital.

304

The statement of changes in financial position provides a meaningful link between

the balance sheet at the beginning and at the end of a period and the Profit and Loss

Account for that period.

The information in the statement of changes in financial position is generally

identifiable in the Balance Sheet, Profit and Loss Account and the related notes on

account.

Funds provided form regular operations of an enterprise or applied to such

operations are usually shown separately in the statement of changes in Financial

Position. This can be done by two alternative method:

I. Adj ustment Method and

II. Direct Method of revenues and expenses.

i. Adjustment Method:

In case of adjustment method, net profit is adjusted with those items shown in the

Profit and Loss Account for which there is no flow of fund. Under this system non-

cash expenses are added to Net Profit and non-cash income are deducted from Net

Profit.

ii. Direct Method of Revenues and Expenses:

In direct method of Revenues and Expenses, from Revenues of the period, the cost

and expenses of that period are deducted and the resulting amount is described as

Funds from Operation.

Unusual movements of funds, if material, are separetely disclosed in the statement

of changes.

Other sources and application of funds which are usually listed separately in the

statement changes in financial position include:

1. Proceeds from issue of shares for cash or for other consideration;

2. Redemption of preference share capital;

3. Borrowings by way of term loan;

Syllabus:

Concept of Cost- Volume Profit

Relationship

305

Break Even Analysis, Marginal Costing as tools of pricing decisions and levels of

activity planning, Meaning of Budget and Budgetary Control Types of Budgets-

Fixed and Flexible Master Budget Zero Based Budgeting Performance Budgeting

Standard Costing Vs Budgetary Control

(Simple application)

Part I: Theoretical Questions

Q.l. Explain the concept of 'Cost-Volume-Profit Relationship. [G.U.2002]

or, What do you understand by the term 'Cost-Volume-Profit Analysis' ? In

what way is it helpful in Management Accounting ? [GU.2000]

Meaning of Cost-Volume-Profit:

Cost-Volume-Profit Analysis/relationship (CVP Analysis) implies the study of

interrelationship of three basic factors of business operations- cost, volume and

profit. These three factors are inter-connected in such a manner that they act and

react on one another because of cause and effect relationship between them. The

cost of production determines its selling price, which in turn determines the level of

profit; the selling price affects volume of sales, which directly affects the volume of

production and volume of production in turn influences cost. In brief, changes in the

volume of production results in changes in cost and profit. It means that the . most

important factor influencing the earning of profit is the volume of output. CVP

Analysis shows the impact on net profit of:

(i) Changes in selling price;

(ii) Changes in volume of sales;

(iii) Changes in variable costs; and

(iv) Changes in fixed costs.

CVP Analysis helps the management in determining the effect of a probable

change in any one of these factors on the remaining factors.

Objectives of Cost Volume-profit-analysis/ Usefulness to Management

Accounting /Objectives:

Cost-Volume-Profit Analysis shows the relationship between cost, volume and

profit. If volunc is increased, the cost per unit will decrease and profit per unit will

increase if the selling pr . remains the same. Thus there is a direct relationship

306

between volume and profit but there is ar inverse relationship between volume and

cost. Thus the analysis of this relationship has become ar useful tool for the Cost

and Management Accountant for profit planning, cost control, evaluatic

performances and decision making. Thus it is useful to the management in

following matters:

1. Profit Planning:

It helps the management to forecast profit fairly accurately on the basis of relation >

between profit and cost in one hand and volume of output on the otherhand.

2. Setting up Flexible Budget:

It helps the management in setting up flexible budgets which indicate costs at

various Ie\. of activity. If the volume of output changes, sales value and variable

costs also change. Sc necessary to budget the volume of output first for establishing

budgets for sales and variable c

3. Evaluation of Performance:

It assists the management to evaluate the performance for the purpose of control.

Standa of performance i.e. increase or decrease in the level of performance, brings

about change > volume of output. Changes in the volume of output affects costs

which in turn affect prof: evaluation of performance and its control is important for

profit planning.

4. Fixation of Price Policy:

It also helps the management in formulating price policy because it shows the effec:

different price structure on different costs and profits. Pricing policy establishes and

fixes volume of output especially at the time of depression.

5. Determination of the amount of overhead charge on production:

This analysis helps the management in determining the amount of overhead costs t

charged to the production costs at various levels of operation at a pre-determined

rate.

Q.2. What are the specific cost and non-specific cost factors to be considered

in the 'make or buy' decisions. [GU.2002]

When a concern has idle facilities such as idle capacity, idle workers, etc. it can

utilise its i. facilities in the manufacture of a component which is necessary in the

307

manufacture of its prod uc Again such a component is available in the market and

can be bought and used in the product such a situation, management has to decide

whether it should make or buy the component.

In such a situation, costs are divided into specific costs and non-specific costs.

Specific costs:

Specific costs are those costs which are affected by managerial decisions. The costs

has be incurred whatever alternative decision management takes. These are mostly

variable cost They are future costs and will vary under different alternatives.

Non-specific Costs:

On the other hand, non-specific costs are historical costs. They are either incurred

or committed to be incurred. They are not affected by managerial decisions. They

remain constant under different alternatives. So they are irrelevant to the decision

making process and are ignored. They are usually fixed overheads.

In 'Buying Decisions', Purchase price of a component, transportation, insurance,

ordering costs represent the specific costs. On the otherhand, in-case of'Make

Decisions', expenses on materials, labour and variable overheads are specific cost

factors. Aggregate of two cost factors will be compared and savings in cost will be

determined. Thus management decisions will depend on the comparative analysis of

specific cost factor and the alternative which involves the lesser amount of specific

costs will be choosen. Non-specific cost factors in this case involves fixed expenses

such as rent, salary, lighting, etc. They are not affected by managerial decision.

They are committed expenses and will remain constant under different alternative

decisions. Therefore, they are not considered in the decision makingpf "Make or

Buy."

Additional Factors:

In addition to the above, following specific factors are also to be considered.

(i) Quality of the goods to be bought;

(ii) Continuity of supply;

(iii) Effect on labour relations;

(iv) Availability of suppliers for selection; etc.

308

Q.3. What is Absorption Costing ? Mention its advantages and disadvantages.

[GU. 1989] Meaning of Absorption Costing:

Absorption costing is a conventional technique of ascertaining cost. All costs both

variable and fixed are charged to an operation, process or product. Thus the cost of

a unit is made up of both direct costs and indirect or overhead costs. So the cost per

unit will change with the change in the level of output. As it consists of all costs, it

is also known as Full Costing Technique. As for example, the total costs of

producing 1,000 units of a product are - Material Rs 10,000; Labour- Rs 2.000;

Overheads - fixed- Rs 1,000; variable - Rs 1,500. According to official

Terminology issued by the institute of Cost and Management Accountants, England

Absorption Costing is "The practice of charging all Cost, both variable and fixed, to

operations processes or products". Therefore cost per unit is Rs 14.50. i.e.

Rs. 10,000+Rs.2,000+l ,000+Rs. 1500 1000 units

Advantages:

(i) Actual cost of production:

It recognises both variable and fixed expenses as cost elements and shows the actual

cost of production. Thus it ensures the recovery of full costs from production.

(ii) Correct Profit:

Underthis method profits can be correctly calculated as all costs are included in cost

of production.

(iii) Conforming to Accrual and Matching Concepts:

It enables to match costs with revenues of a period.

(iv) Revealing inefficiency:

It reveals inefficiency, if any, in the utilisation of plant capacity.

(v) Fixing Responsibility:

It facilitates in fixing responsibilities of the managers for their inefficiencies.

(vi) Determination of Gross Profit and Net Profit:

It helps in the determination of gross profit and net profit in an Income Statement.

Disadvantages:

(i) Difficulties in Comparison and Control of Costs:

309

Absorption costing depends upon the level of output and as a result, unit cost

changes . the change in the level of output. As for example, as fixed expenses

remain same for all the le -of output up to the plant capacity greater is the volume of

production lesser will be the cost per u-Therefore, the comparison of unit cost at

two levels of output is not possible; hence control of cl S: is not feasible.

(ii) Not helpful in Managerial Decisions:

Managerial decision regarding selection of suitable product-mix or buying or

manufactur-decision, or acceptance of export orders or choice of alternatives cannot

be possible under absorp-costing.

(iii) Carry-Forward of Fixed Costs and Overstatement of Profit:

Total fixed costs are not matched against the revenue of the period because the

value closing stock includes a portion of fixed cost. Thus there is an overstatement

of profit.

(iv) Inclusion of Fixed Expenses in Cost Unjustified:

Fixed costs are period costs. Hence they should not be included in production cost.

(v) Arbitrary Apportionment of Fixed Overheads:

Fixed costs are apportioned over the cost centres arbitrarily. It affects the

ascertainment: correct unit cost.

(vi) Flexible Budget not Possible:

Under absorption costing there is no distinction between fixed costs and variable

co> Hence the preparation of a flexible budget is not possible without such

distinction. Q.4. What is Marginal Costing ? What are its advantages and

limitations ? Marginal Cost:

CIMA defines marginal cost as "The amount at any given volume of output by

whk aggregate costs are changed if the volume of output is increased or

decreased by one unit

This unit may be a single article or a batch of articles or an order.

It means that marginal cost is the incremental or decremental cost due to an

increase o decrease in the number'of units produced. Thus marginal cost consists

of variable cost or. and relates to change in output in a particular circumstance.

310

Marginal Costing:

CIMA defines marginal costing as "The ascertainment of marginal cost and of the

effect on profit of changes in volume or type of output by differentiating between

fixed costs and variable costs."

In this type of costing, only variable costs are charged to cost units (operations,

processes or products) and the fixed costs attributable to the relevant period are

written off in full against the contribution of that period. Thus only the variable

costs form the part of product cost because only variable costs change due to

increase or decrease in output and fixed costs remain the same within the capacity.

The theory of marginal costing is based on the assumption that some elements of

costs tend to vary directly with variation in the volume of output and while others

do not. That is. why only variable costs form part of product cost and fixed costs as

period costs are transferred to Marginal Profit and Loss Account. Asa result, the

product cost will be a constant ratio, whereas the fixed costs will be constant

amount regardless of level of output within the capacity.

Under this technique, therefore, all costs are classified into two groups: fixed and

variable and for this purpose, fixed and variable elements are also separated from

semi-variable or semifixed costs and are included into the respective groups i.e.

fixed and variable costs groups. Thus marginal cost is the aggregate of variable

costs.

As for example, if the cost of direct materials is Rs 5,000; direct labour is Rs 2000;

variable overhead is 1000 and fixed overhead Rs 2,000 for producing 1,000 units;

the marginal cost per unit will be:

It is referred to as Marginal Costing in U.K. where as it is termed as Direct Costing

in the U.S.A. though there are some differences between them.

It is to be noted that marginal costing is one of the techniques of ascertaining cost of

production of goods manufactured or services rendered. It is not a method of

costing but it could be used in conjunctions with any method of costing such as job

or process costing. It can also be used with other techniques of costing such as

standard costing and budgetary control. It is also known by other names such as

direct costing, variable costing, attributable costing, out of pocket costing, etc.

311

Features of Marginal Costing:

Following are the features of marginal costing: (i) It is a technique of costing used

to ascertain the marginal cost and to know the inipact of variable cost on the volume

of output.

(ii) All costs are classified into fixed and variable costs on the basis of variability.

Even sem variable costs are segregated into fixed and variable costs.

(iii) Variable costs alone are charged to production while fixed costs are recovered

contribution.

(iv) Stock of work-in-progress and finished goods are valued on the basis of

marginal cost.

(v) Selling price is based on marginal cost plus contribution.

(vi) Profit is calculated by deducting both marginal cost and fixed cost from sales.

(vii) Break-even analysis and cost-volume profit analysis are integral part of this

technique.

(viii) Profitability of a product or a department is based on contribution made

available by eac product or department.

Advantages:

Following are the advantages of marginal costing:

1. Avoids complication of absorption of fixed costs:

It avoids the complication of over and under absorption of fixed cost as fixed costs

arc excluded from cost of production.

2. Data for decision making:

It provides useful data for managerial decision making.

3. Facilitates comparison of costs:

It facilitates the comparison of costs of different periods and costs at different levels

because fixed costs are not carried forward from period to period.

4. Impact of sales volume on profit:

Impact of changes in sales volume on profit is shown under this system.

5. Flexibility in use:

It is flexible and can be used along with other techniques such as standard costing,

budgetary control, etc.

312

6. Relationship:

It establishes a relationship between costs, sales and volume of output and

facilitates breakeven analysis.

7. Tool ofprofit planning:

It is a useful tool of profit planning as it shows profit at different levels of output.

8. Tool of cost control:

It is a tool of cost control as it concentrates on variable costs only which are

controllable in the short run.

9. Better Results:

It gives better results when used with Standard Costing.

10. Better Presentation:

The graphs and statements prepared under Marginal Costing are better understood

by management executives.

Limitations:

1. Difficulties in classification of costs into fixed and variable:

Classification of costs into fixed and variable involves technical difficulties because

no variable cost is completely variable and no fixed cost is completely fixed.

2. Ignoring of fixed costs altogether from cost ofproduction:

It ignores fixed costs though the impact of fixed cost on production has increased

significantly with the development of technology and it forms a significant portion

of the total cost.

3. Under statement of Profit:

Closing stock is under-valued and profit is understated.

4. Ineffective tool of control:

It does not provide an yardstick to exercise control.

5. Comparison of cost offobs notfeasible:

Cost comparison of two jobs cannot be made though marginal cost may be the same

because the jobs may take different amount of time.

6. Unsuitable in case of contracts and ship-building:

313

It is unsuitable to contracts or ship building industries where the value of work-in-

progress is very high because in incomplete stage itmay show loss whereas in

complete stage it may show very high profit.

7. Misleading Selling Price:

It is misleading to fix selling price considering only variable costs and ignoring

fixed costs as it may results in a loss.

8. Difficulties in Apportionment of Variable Costs:

It avoids apportionment of fixed costs but cannot avoid the apportionment of

variable costs which are sometimes difficult to apportion.

Q. 5. Explain briefly the technique of marginal costing. In what ways is this

technique useful in management accounting ? [GU.1998]

or, Discuss the concept and characteristics of Marginal costing as a technique

of Management Accounting. [GU.2004]

What it is:

Marginal Costing is a technique of ascertaining cost.' Under this technique, all costs

are classified into two groups viz. fixed and variable. Even the fixed and variable

elements are also separated from semi variable costs and are included in the

respective group. This division of expenses into fixed and variable is essential

because only variable costs are charged to production under this technique. Fixed

expenses are excluded from cost because they are treated as period costs and not the

cost of production. They are recovered out of contribution.

Characteristics of Marginal cost:

Fixed Unit Cost:

The primary characteristics of marginal cost is that unit cost remains the same in a

given condition regardless of the level of output and the total variable cost changes

directly with the change in the level of output. Thus marginal cost consists of the

variable costs only and as a result, the product cost will be a constant ratio

regardless of changes in the level of output or activity.

Income Statement:

314

Under this technique, difference between selling price and marginal cost is termed

as contribution and difference between contribution and fixed expenses is termed as

profit or loss.

Usefulness to Management Accounting:

Marginal costing technique is a valuable technique to the management in taking

manage- a decisions. It is very useful in determining business policy, important

decisions, profit planning cost control.

Decision Making:

Marginal costing helps the management in various important decision making

regarding the following matters:

(i) Introduction of a product;

(ii) Whether to make or buy;

(iii) Selection of most profitable product or sales mix,

(iv) Price reduction in competition or depression,

(v) Utilisation of spare capacity;

(vi) Selection of capital projects;

(vii) Determination of most profitable level of activity; etc.

In formulating the business policy and decision making, the management uses

various toe ; offered by marginal costing such as contribution, break-even chart,

profit-volume graphs, bre. event point, cost-volume-profit ratio, etc.

In marginal costing technique, only the variable costs and not the fixed costs are

conside-as production costs and contribution being the difference between the sales

and variable costs the primary factor for taking decisions on the above matters. The

contribution may be the aggree.r contribution or per unit contribution or

contribution per factor of production or contribution p limiting factor.

Profit Planning:

Profit planning is the planning of future operations to attain a defined profit goal

i.e.: desired amount of profit or to maintain a specified level of profit. Marginal

costing provides the necessary date for profit planning and decision making. It

facilitates the cost-volume profit relationsh:: by separating the fixed and variable

315

costs in the income statement. It helps the management planning and evaluating

profit from:

(a) a change in volume;

(b) a change in sales mix;

(c) a change in pricing of products;

(d) a make or buy decision

(e) selection of most profitable products, customers, territories, etc.

Evaluation of Performance:

Different products, departments, markets and sales division have different earnin_

potentialities. Marginal cost analysis is a very useful technique for evaluating the

performance of each sector of a concern. This evaluation is possible because of the

distinction made between fixed and variable expenses. The evaluation of

performance is based on the respective contribution made by each sector and higher

the contribution, better is the performance considering fixed expenses remaining

constant.

Cost Control:

Marginal costing provides continuing opportunities to the management to review

costs in relation to the level of sales and revenue. This opportunity for review arises

from division of costs into fixed and variable. Fixed costs can be controlled by the

top management and that to a limited extent. In marginal costing, the management

focuses the points which are controllable at lower level of management by the use

of standards, budgets, responsibility reports, etc. Marginal costing provides, through

the reports, all the data to the management for their interpretation and suitable

action against the person responsible.

Thus marginal costing is an effective tool for the controlling variable costs.

Again it also facilitates the control of fixed costs by the management through the

comparison of fixed costs with contribution. In marginal costing, fixed costs are

separately shown in the Income Statement and its role in the determination of net

316

profit can be ascertained easily by matching fixed costs against contribution. Thus

marginal costing helps the management in the control of fixed costs also.

Q.6. Explain the main concept of marginal costing in decision making process.

[GU.1991] Meaning of Marginal Costing:

Marginal costing is a technique of ascertaining cost in a particular situation.

According to this technique, variable costs are charged to the cost units as

production cost and the fixed costs which are attributable to the relevant period are

written off in full against the contribution for that period in order to ascertain profit.

Fixed costs are considered as period costs and remain constant at all levels of output

within the capacity. Profit is ascertained by deducting fixed costs from contribution

where contribution is the excess of sales over variable/marginal cost. Basic

Concept:

Fixed costs are time costs and remain constant in a particular condition irrespective

of level of output. So the quantum of aggregate contribution directly affects the

quantum of profit. It means that greater is the amount of contribution, greater is the

net profit. This is the basic concept of marginal costing.

All managerial decisions are aimed at maximising profit or minimising loss in the

short period where such loss is unavoidable. As profits depend on the quantum of

aggregate contribution being fixed costs remaining the same, all managerial

decisions are aimed at maximising contribution through:

i. Diversification of products;

ii. Fixation of selling prices;

iii. Selection of profitable product-mix;

iv. Adjustment of operations to limiting factor;

v. Alternative method of manufacture;

vi. Make or buy decision;

vii. Planning of activity level;

viii. Effect of change in selling price;

ix. Closing down, out sourcing or suspending activities;

x Selection of optimum volume and selling price, using

Break-even Chart;

317

xi Application of Cost-Volume Profit Ratio;

xii Working extra shin.

Diversification of Products and Exploring New Territory:

Sometimes a concern may propose to introduce a new product to the existing

product utilise its idle facilities or to capture a new market or for any other purpose,

a decision istak; the profitability of the new product. If the product is capable of

contributing something to fixed cos and profit after meeting its variable costs, the

product will be manufactured because fixed cosa remains constant.

ii. Fixation of Selling Price:

Product pricing is necessary under:

(i) Normal circumstances;

(ii) In times ofcompetion or trade depression

(iii) In accepting additional orders for utilisation of spare capacity;

(iv) In exporting.

Under normal circumstances products are priced in order to cover all the costs -

fixed ar . variable and to earn a margin of profit.

However, in all other situations mentioned above, product pricing is made in order

to cc .. the variable costs and to contribute towards fixed costs and profit. Marginal

costing helps the management in fixing prices above the variable costs which will

contribute something to fixed cos and profit as fixed costs are considered not as

production costs.

iii. Selection of Profitable Product-mix:

In the absence of any limiting factor, contribution of each mix will be considered

and the m which will give the highest contribution will be the most profitable

product-mix. However, iff . changes in the product-mix involves changes in fixed

cost, the relative profitability of the mixes w be assessed on the basis of net

profitability and not on the basis of contribution.

IV. Adjustment of operation to limiting factor:

Where there is a limiting factor, the selection of the profitable product will be on

the basis c contribution per unit of limiting factor. Higherthe contribution per unit

of limiting factor, more profitable is the product.

318

V. Alternative Method of Manufacture:

Where fixed costs remain constant, the basis of selection of the method of

manufacture will be the relative contribution available from each method. The

method which gives the largest contribution is to be selected.

VI. Make or Buy Decision:

A company may have unused capacity which may be utilised for making

component parts or similar items instead of buying them from market. It is termed

as "Make or Buy Decision." If the marginal cost of the manufactured items is less

than the purchase price, it will be more profitable to manufacture them in the

factory because it will contribute something towards the fixed cost and profit.

However, if production involves additional fixed costs, such fixed cost should be

added to the production cost for the purpose of its comparing with the purchase

price. If production cost is higher than the purchase price then purchase decision

will be taken.

VII. Planning of Activity Level:

As fixed expenses remain same at all levels of output, contribution available from

each level of output is to be ascertained and the level which gives the largest

contribution will be the most profitable level of activity.

VIII Effect of Change in Selling Price:

When a company faces competition or desires to expand the market, it becomes

necessary for the concern to reduce selling price. The effect of such change in price

on profit is to be considered by determining contribution per unit. Normally

reduction in selling price reduces contribution unless there is an increase in the

volume of output sold.

IX. Closing Down, Outsourcing or Suspending Activities:

Closing down, outsourcing or suspension of activities may be warrented by

unprofitable operation, trade depression, or other circumstances. If a product or a

division or a plant earns negative contribution, (variable expenses exceed sales), it

will be desirable to shut it down and get the work done by outsourcing.

X. Selection of Optimum Volume and Selling Price using Break even Chart:

319

Sales value and costs at different volumes of sales are ascertained and are plotted in

a graphic paper in order to determine the volume and selling price at which profit

would be the greatest. Thus the point at which the margin of profit is the greatest is

the optimum volume and the selling price at this volume is the optimum selling

price. Usually greater is the volume of sales, the unit selling price will be lower but

the aggregate contribution would be larger and it is the aggregate contribution

which will be deciding the optimum volume of sales and optimum selling price.

XI. Application of Cost-Volume-Profit Ratio:

Cost-volume-profit analysis is the study of the effects on future profit of changes in

fixed costs, variable costs, sales price, quantity and mix. Thus the principal factors

are: Fixed cost, Variable cost. Sales price, Sales Volume and Sales mix. Out of

these, sales volume is the dominant factor as it changes frequently and is outside the

perview of management control. So change in the volume of sale may affect profit

more than other factors and the relation between three variables such as sales

revenue, costs and profits influences management decision in the short period.

Profit volume ratio indicates the relationship between the contribution per unit and

selling price per unit. This ratio helps the management in taking decision in various

management problems such as:

(i) Determination of break-even and margin of safety;

(ii) Determination of variable cost and profit at any volume of sales;

(iii) Determination of sales volume for a desired amount of profit;

(iv) Fixing selling price;

(v) Selection of most profitable line;

(vi) Determination of additional sales required to maintain the present profit level in

case of price reduction;

(vii) Determination of the sales-mix to maximise profit.

319.A.12

Cost and Management Accounting

Q.7. What is meant by Break-even Chart ? What are its utility ? [GU.1987]

Meaning of Break even Chart:

320

Break-even chart is the graphical representation of the marginal costing showing

ink relationship between cost, volume and profit. It shows the break-even point

(i.e. no profit loss point of sale) and also indicates the estimated cost and estimated

profit or loss at vari volumes of activity.

Thus the Break-even Chart has been defined by CIMA as "A Chart which shows

tht profitability or otherwise of an undertaking at various levels of activity and as

a res. indicates the point at which neither profit nor loss is made. "

It shows the following information at various levels of activity:

(i) Variable costs; fixed costs and total costs;

(ii) Sales value;

(iii) Profit or loss;

(iv) Break-even point i.e. the point at which the total cost is just equal to sales;

(v) Margin of Safety.

It is a chart which shows the inter-action of volume, selling price, variable costs and

fixe costs at different levels. It also shows the relevant variables and their impact

upon per simultaneously. This is why break-even graph is also called a profit

planning chart.

Assumptions for Break-even Chart Construction:

Following assumptions are required to be made in the construction of a break-even

chart:

(i) Fixed costs will tend to remain constant.

(ii) The price of variable cost factors will remain unchanged;

(iii) Semi-variable costs can be segregated into variable and fixed elements;

(iv) Product specifications and methods of manufacturing and selling will remain

unchanged;

(v) Operating efficiency will not increase or decrease;

(vi) There will not be any change in pricing policy;

(vii) The number of units of sales and the number of units produced will be the

same i.e. there will be no opening or closing stock; and

(viii) Product-mix will remain unchanged.

Utilities/Advantages:

321

1. Simple to Understand:

It is simple to compile and easy to understand for the management because it

presents cost-volume-profit structure in a simpler way than in Profit and Loss

Account, cost schedules, operating statements, etc. The management can easily

grasp the significance of the information representee in the chart.

2. Guide to:

It is a useful tool to guide the management in studying the relationship between

cost, volume and profit. It shows the effect on profit of changes in: (a) Selling price

(b) Variable costs;

(c) Fixed costs; and

(d) Volume of sales

Thus the management can take important decisions.

3.Shows Profit earning Capacity:

It shows the strength and profit earning capacity of the business through Margin of

Safety and Angle of Incidence. Thus management can take decision in respect of (a)

Activity level; (b) Cost reduction; (c) Price fixation (d) Product substitution and (e)

Product-mix.

4. Effect of alternative Product-mix:

It shows the effect on profit of alternative product-mix so that management can

select the most profitable product-mix.

5. Helps in forecast and profit planning:

It helps the management in forecasting costs and planning profits.

6. A tool of cost control:

It is a tool for cost control because it shows the relative importance of fixed costs

and the variable costs.

7. Price fixation:

It helps the management in determining the sale price in order to attain a desired

profit.

Limitations/Disadvantages:

1. Static conditions may not always remain same:

322

Break-even point shows a static picture and may become out of date because

conditions may not remain unchanged. Selling price, fixed costs, variable cost per

unit may not remain constant it different levels of activity.

2. Single Break-even chart may be ineffective:

The effect of various product-mixes on profit cannot be studied from a single

Break-even Chart.

1 does not consider the capital employed:

Break-even chart does not generally take into consideration capital employed which

is one f the vital factors in many policy decisions. Thus decision taken on the basis

of only break-even : hart may not be safe and reliable.

4. Separation of semi variable cost may not be always possible:

Break-even chart requires the separation of semi-variable costs into fixed and

variable which cannot be made accurately.

5. Equality of production and sales may not hold good:

Break-even Chart assumes that production and sales are always to be co-ordinated

at the same volume arid sales always concide with production. However, the

assumption that whatever produced is sold and that revenue from sales increases in

direct proportion to output, does not hold good in practice.

Q. 8. What do you understand by Break-even Point? How is it computed ?

[G.U.2002] [GU.1988, 1994

Meaning of Break-even Point:

CIMA defines Break-even Point as "The level of activity at which there is neither

pn nor loss. It can be ascertained by using a break-even chart or by calculation. "

It is a level of activity where costs are equal to revenues. So it is a no-profit no loss

stage activity where fixed cost is equal to contribution. Any contraction of output

sold would mean and any expansion of output sold mean profit. Calculation of

Break-Even Point: Break-even point is calculated by the following formula:

Totcil Fixed Expenses Break-even point (in units) = Selling Price Per Unit-

Variable Cost Per Unit

Break-even Point (in sales)= X Selling Price Per Unit

or

323

_ Fixed Cost P/V Ratio

Contribution Per Unit ™ P/V. Ratio = Selling Price Per Unit xl0

°

Q.9. What is contribution ? [GU.2002]

Or Discuss the role of contribution in marginal costing and its relevance to

decision relating to the fixation of selling price. [GU. 1992] Contribution:

Contribution is the excess of sales value over marginal cost ofproduct. This

difference between sales and variable cost contributestowards fixed costs and profit.

Excess of contribution over fixed cost represents profit and vice-versa represents

loss.

Example: Suppose the selling price per unit is Rs 15 and variable cost per unit is Rs

10; total fixed cost is Rs 100,000 and number of units sold is 30,000 units.

Contribution and profit is determined as follows:

Contribution = (Sales Per unit - Variable. Cost Per unit) x Units Sold

= (Rs 15-Rs 10)x 30,000

= Rs 1,50,000 Profit = Contribution - Fixed costs

= Rs 150,000-? 1,00,000

= Rs 50,000.

Role of Contribution:

In marginal costing, only variable costs are charged to production and fixed costs

being time costs are not charged to production. Selling price minus variable costs is

called contribution which contributes to fixed expenses and profit. It means

contribution minus fixed expenses represents profit.

All business decisions are aimed at maximising profits. As fixed expenses remain

constant at all levels of production under a given condition, the quantum of

aggregate contribution will decide the quantum of profit. That is, larger the

contribution, larger will be the amount of profit. Therefore, all managerial decisions

are aimed at attaining the maximum amount of contribution which will maximise

profit.

Incase of Depression:

In certain situations, especially at the time of depression, it may not be possible to

earn profit in that period. In such a situation, managerial decisions are aimed at

324

reducing losses to the minimum by pricing the products just above the marginal cost

so that contribution available from such sale may contribute to the part recovery of

fixed expenses and loss can be reduced by that extent. It is because fixed expenses

can not be avoided in a short period and has to be born by the firm as a loss.

In case of competition:

Again in times of keen competion, reduction in product price may become

necessary, la such a situation, price reduction may be accompanied by the increase

in the volume of sale. As i result, the total contribution may remain the same though

per unit contribution becomes less and the total profit may remain unaffected.

Incase of existing idle capacity:

When there are idle facilities, those idle facilities can be utilised by producing

addition a output for export purpose at a price usually lower than the home-market

price. Contribution help us in fixing export price at a level higher than the marginal

cost because fixed costs are not invoK e at this additional production. As a result,

additional contribution available therefrom increases the total profit.

Thus contribution plays an important role through price fixing in:

(i) Maximising profits;

(ii) Maintaining the existing level of profit, and

(iii) Minimising losses.

Q.10. Write short notes on:

(i) Break-Even Analysis; and

(ii) Margin of Safety. Or How can Break-Even Analysis be decision making

Break Even Analysis:

The study of Cost Volume Analysis is often referred to as Break Even Analysis. It

is most widely known form of Cost-Volume-Profit Analysis. It is used in two

senses, viz, (i) Narr> sense and (ii) Broad sense.

In narrow sense it refers to a technique of determining the level of operations

where to:, revenues equal total expenses i.e. point of no profit no loss.

In broad sense it referes to the study of relationship between cost, volume and

profit a different levels of sales or production.

325

It is a method of presenting to the management the effect of changes in volume of

proti: The analysis of break even data will reveal to the management the effect of

alternative decisis on cost, volume and profits.

Break-even Analysis is based on the following assumptions:

(i) All elements of costs can be segregated into fixed and variable components;

(ii) Variable cost remains constant per unit of output at all levels of output;

(iii) Fixed costs remain constant in total at all levels of output;

(iv) Selling price per unit remains constant at all levels of output.

(v) Volume of production is the only factor that influences cost;

(vi) There will be no change in general price level;

(vii) There is only one product;

(viii) There is synchronisation between productions and sales i.e. whatever output

produi. e: is assumed to be sold.

Margin of Safety:

Margin of safety is the difference between the actual sales and the sales at break

even point. One of the assumptions of marginal costing is that output produced is

assumed to be sold. Therefore, the margin of safety is also the excess of production

over the break even point of output.

At break even point of sale, revenues and expenses are just equal. Therefore, sales

beyond break even point produce profit. Contribution from sales over break even

point is 100% profit because there are no fixed expenses left to charge against

contribution.

If the margin of safety is large, it is the indicator of the strength of the business. It is

because even if there is a substantial fall in sales or production, there will still be

some profit. On the other hand, if the margin of safety is small, there will be a loss

even there is a small fall in production or sale. Therefore, management takes all

efforts to increase the margin of safety so that more profit may be earned.

Formula:

MS = Acti

Actual Sales -BEP sales.

or

MS

326

Profit

P/V ratio

Formulas:

Or

Fixed Cost P/V Ratio

5. Desired Sales to Earn a Profit (In Units) =

Fixed Cost + Desired Profit Contribution Per Unit

6. Desired Sales in volume or ? =

Fixed Cost.+ Desired Profit P/V / Ratio

Fixed Cost + Desired Profit Contribution Per Unit

x Selling price per unit

7. Profit Volume Ratio or P/V Ratio =

Contribution Per Unit

Sales Per Unit

8. Margin of Safety = Actual Sales-B.E.P. Sales

Q. 11. Indicate the managerial utility of "Contribution" and "Margin of

safety".

[G.U-2008]

Managerial Utility of contribution:

The concept of contribution is an important tool to the management in making their

decision in respect of the following matters:

(i) Determination ofBreak-event point:

Contribution per unit of a product helps the management in determining the number

of units

Fixed Expenses

to be sold for reaching break event point of sale i.e. Conyribution per Unit

(ii) Fixation of Selling price:

Contribution helps the management in fixing selling price per unit. It is done by

adding estimated contribution per unit to the estimated variable cost per unit.'

(iii) Profit Maximization:

It helps the management in maximizing profits by choosing different product-mix

where contribution per unit is higher.

(iv) Selection of Production Method:

327

It helps the management in selecting a suitable alternative production method out of

various alternatives. It is done by choosing the method which gives the highest

contribution per limiting factor.

(v) Make or buy decision :

It helps the management in taking decision whether a product is to be manufactured

or bought from market.

Managerial Utility of "Margin of Safety": Margin of safety helps the

management in the matters:

(i) Profit Planning:

It helps the management in profit planning because contribution from margin of

safety is the profit. Hence larger is the margin of safety larger will be the profit.

(ii) Soundness of Business:

Sales after break-even point show an angle of incidence which is the difference

between the total sales and total cost. Larger is the angle higher will be the profit.

(iii) Risk Absorbing Capacity:

When a business organization attains margin of safety level, it can face temporary

unfavourable situations that may take place in the business before showing a loss.

(iv) Diversification of Products:

When a business reaches a margin of safety, it acquires a risk-bearing capacity.

Hence, the management can take the risk of diversifying its products as well as

market.

Q.12. Fill in the blanks :

(1) Marginal Cost is the_in the aggrigate costs due to change in the

volume of output. (Change)

(2) Marginal Costing is a_of ascertaining marginal costs, (technique)

(3) In marginal costing, only_costs are changed to production on. (variable)

(4) In marginal costing, unit cost remains_at all levels of production, (constant)

(5) The difference between sales and variable costs is known as_. (contribution)

(6) The cost volume profit analysis,_the relationship between cost, volume and

profit. (studies)

(7) The angle between the sales line and the total cost line forms after breakeven

point is known as_of incidence, (angle)

(8) Marginal costing is_to the management for cost control, (helpful)

(9) The process of choosing between alternatives is known as_. (decision making)

328

(10) Profit planning is possible with_costing, (marginal)

(11) The items of cost that cannot be influenced by an individuals are known as

cost.

(uncontrollabe )

112) Marginal costing is a tool of managerial_. (decision)

(13) Marginal costing helps in price fixation more in period of_. (depression)

14) Prime cost plus variable overhead is known as_. (marginal cost)

15) Selling goods_marginal cost can be followed only for a short period, (below)

16) Fixed cost is also known as_. (period cost)

17) Make or buy decisions made by comparing_with outside purchase price.

(variable cost)

18) Absorption costing is also known as (total costing)

19) Key factor is taken into consideration to judge the_of different products

whenever there is any shortage, (profitability)

20) If P/V ratio is 40% it means_is 60% of sales, (variable cost)

21) The CVP ratio is the analysis of relationship of_. (cost volume and profit)

22) Marginal costing technique can be combined with_. (standardcosting)

23) The system most useful for making decision of the make and buy and similar

other ones, is called_costing, (marginal)

24) P/V ratio is also known as_ratio, (contribution)

25) If contribution is greater than fixed cost, the excess is known as_. (profit)

26) In a year in which the closing stock of finished goods is larger than the opening

stock,— costing will show a higher profit compared to that under marginal costing,

(absorption)

27) Fixed cost and profit will be equal to . (contribution)

28) At the break-even point, total sales revenue will be equal to. (total cost)

29) Margin of safety expressed as per percentage is known as.(margin of safety

ratio)

50) Wider the angle of incidence_rate of profit, (higher)

Q.13. State whether the following statements are true or false :

(1) C VP analysis is a study of the inter-relationship of the variables in cost, volume

and profit. (True).

(2) CVP analysis is a study of changes in the amount of profit on cost, sales

quantity an sales mix. (False)

329

(3) At break-even point, contribution will be equal to profit. (True).

(4) In CVP analysis, marginal costing is the same as profit. (True).

(5) Profit/volume ratio is the ratio of profit to volume. (False)

(6) P/V can be improved only by making profits. (False)

(7) P/V'ratio is a special use in profit planning. (True)

(8) Margin of safety can be improved by lowering fixed costs. (True)

(9) Margin of safety cannot be improved by increasing the selling price. (False)

(10) Angle of incidence indicates the profit earning capacity of a concern. (True)

(11) The principal aim of absorption costing is to attempt to ensure that all overhead

cos: _ covered by the revenues received. (True).

(12) Marginal costingand d irect costi ng are sam e. (False)

(13) Marginal costing is based on the destinction between fixed and variable

costs.(True)

(14) In marginal costing, under recovery or over recovery of fixed overheads bound

to arise. (False)

(15) Marginal cost is the aggregate of prime cost plus variable costs. (True)

(16) In marginal costing, closing finished stock is valued at variable cost. (True)

(17) In marginal costing, profit is the difference between sales and marginal cost.

(False)

(18) In marginal costing, a portion of fixed over head is carried forward. (True)

(19) Marginal costing is based on the distinction between fixed and variance

costs.(True)

(20) Marginal costing is a method of costing like job and process costing. (False)

(21) In marginal costing, under and over-absorption of fixed overheads is bound to

arise/Fa A

(22) Marginal costing cannot be used in conjunction with standard costing. (False)

(23) Marginal cost is a technique of costing. (True)

(24) Marginal cost and marginal costing mean the same meaning. (False)

(25) At break-even point total cost is exactly equal to sales. (True)

(26) The profit volume ratio explains the relationship between the contribution and

sales.(7rwc

(27) Contribution is the aggregate of fixed cost and profit. (True)

(28) . Marginal cost comprises prime cost plus variable overhead. (True)

330

(29) In marginal costing technique is used, only variable costs are charged to

products. (True)

(30) Absorption costing fails to establish relationship between cost, volume and

profit. (Truej

(31) Differential costing can be used in absorption costing as well as marginal

costing. (False)

(32) Under marginal costing, closing inventories are always valued at marginal cost.

(True)

(33) In marginal costing, managerial decisions are guided by contribution margin

than by profit. (True)

(34) Variable cost per unit is constant for any level of activities. (True)

(35) Absorption costing is more suitable for decision making than marginal costing.

(False)

(36) Inventory values under absorption costing are higher than those under marginal

costing. (True)

(37) Profit in marginal costing will be more when production is more than sales.

(False).

(38) Contribution margin is the guiding factor of managerial decisions. (True)

(39) There will be a loss in marginal costing when there is production but no sales.

(True)

(40) Marginal costing does not provide suitable information to the management

fortactical decisions. (False).

(41) There will be difference in profits under absorption costing and marginal

costing when production is equal to sales. (False).

(42) Marginal costing is a technique of cost control. (True).

(43) In the long run, all cost are variable. (True).

(44) Differential cost analysis can be made only in marginal costing and not in

absorption costing. (False).

(45) Difference cost analysis is incorporated in the cost books. (False).

(46) In differential cost analysis decisions are taken by comparing the incremental

revenue with differential costs. (True).

(47) Both marginal costing and differential cost analysis are used for decision

making. (True).

331

(48) Cost-volume profit relationship is a more comprehensive term than break-even

analysis. (True)

(49) A fixed cost is fixed per unit. (False)

(50) Differential costing can be used in absorption costing as well as marginal

cost\ng.(False) Q.14. Choose the correct alternative :

(i) In marginal costing, profit is

(a) Sales-variable cost.

(b) Contibution- fixed overhead Ans: (b)

(ii) At break even point of sale.

(a) total revenue is equal to total cost

(b) total revenue is more than total cost. Ans : (a)

(iii) Margin of safety is

(a) Excess of actual sale over breakeven sale

(b) Excess of breakeven sale over action sale. Ans: (a)

(iv) Before break even point,

(a) Sales curve runs above the total cost curve

(b) sales curve meets the total cost curve. Ans: (b)

(v) Marginal costing is

(a) a method of costing

(b) a technique of ascertaining cost of production. Ans: (b)

(vi) For decision making purpose, which is more suitable to the management.

(a) Marginal costing

(b) Absorption costing. Ans : (a)

332

Unit - VI

B. BUDGET AND BUDGETARY CONTROL

Syllabus:

Meaning of Budget and Budgetary Control

Types of Budgets- Fixed and Flexible, Master Budget, Zero-based Budgeting.

Performance Budgeting

Standard Costing vs. Budgetary Control (Simple Application)

Part I: Theoretical Questions

Q. 1. Mention the three cardinal features of budgetary control.

The three cordinal features of budgetary control are :

(i) Planning: to plan for future activities

(ii) Co-ordination: to co-ordinate the activities of all the departments to a common

goal.

(iii) Control: to measure performance against budgets and provide remedial

measures.

Q. 2. Mention any three objectives of budgetary control.

Three objectives are:

(i) Planning for future by setting up various budgets.

(ii) Co-ordinating the activities of all the departments towards the common goal.

(iii) Controlling the affairs of the firm by evaluating the performance of

management by comparing it with budgets.

Q. 3. Mention any six characteristics of good budgeting. Characteristics of

budgeting are:

(i) Involvement of all persons: Persons at different levels of management should be

involved in the preparation of budget.

(ii) Fixation of authority and responsibility: Authority should be delegated to the

executive persons and responsibility of all should be fixed.

(iii) Realistic targets: Targets of the budget should be realistic

(iv) Support of the management: The management should whole hartedly support

the budget.

333

(v) Education to the employees: Employees should be properly educated about the

utility of budget.

(vi) Communication system: There should be a proper communication system.

(vii) Flexibility in budget: Budget should be flexible and based on situation.

Q.4 . Classifly budgets on the basis of time, function and flexibility and

describe them brief.

Budgets are classified according to their nature. The following are the types of bud.;

-which are commonly used.

A. Classification of budgets according to time.

(i) Long term budgets

(ii) Short term budgets

(iii) Current budgets

B. Classification of budget on the basis functions.

(i) Operating budgets

(ii) Financial budgets

(iii) Master budget

C. Classification on the basis of flexibility

(i) Fixed budget

(ii) Flexible budget

A. Classification according to time :

(i) Long term budget: A long term budget is preparedfor a period of three to five

yean It is done for expansion or modernisation of the undertaking, introduction of a

new product or a new project or undertaking heavy advertisement or capital

expenditure. It is useful: industries where gestation period is long i.e. machinery,

electricity com.

(ii) Short term budget: These budgets are general ly preparedfor one or two years.

Th e are in the form of monetary units. These budgets are generally prepared by

consumer industries like Sugar, Cotton textile etc. industries.

(iii) Current budgets : Such budgets are prepared for a week or for a month or for

so:- . months. These budgets relate to the current activities of the business.

According to I.C. London, 'current budget is a budget which is established for use

334

over a short period of time and is related to current conditions'. They are prepared

for control purposes-to watch progress of actual performance against targets and to

suggest early corrective measures where necessary.

B. Classification on the basis of Function/

(i) Operating budgets:

Operating budgets relate to the different activities or operation of a firm. The

commonly used operating budgets are :

(a) Sales Budget

(b) Production Budget.

(c) Plant utilization budget

(d) Material budget.

(e) Direct labour budget.

(f) Manufacturing overhead budget.

(g) Administration Cost budget.

(h) Selling and Distribution Expenses budget.

(ii) Financial Budget:

Financial budgets are concerned with cash receipts and disbursements, working

capital expenditure etc. Commonly used financial budgets are :

(a) Cash budget

(b) Working Capital budget.

(c) Capital Expenditure budget.

(d) Income Statement budget.

(iii) Master budget:

Master budget is a budget where various functional budgets are integrated into one

budget known as master budget. So it is a summary budget of a firm incorporating

its functional budgets ICWA, London. C. Classification or the basis of flexibility.

(a) Fixed budget

(b) Flexible budget.

Q.5. What are estimates, forecast and budget? Compare budget with forcast?

Estimate: An estimate is predetermination of future events either on the basis of

simple guess work or following scientific principle.

335

Forecast : Forecast is an assessment of probable future events. Budget is based on

the implimentation of a forecast and is related to planned events. Forecasting

precedes preparation of budget as it is an essential part of the budgeting process. So

it can be said that budgetary process is test of forecasting skill than anything elso :

To establish a realistic budget, it is necessary to forcast a wide range of factors like

sales volume, sale'price, availability of material and its price etc. So instead of

adding or deducting certain percentage to last year's budget, a proper forecasting

should be made and the budget should be prepared on the basis of such forecast.

Budget: Budget is a detailed statement of forecast resulting from joint action of a

number of planned operations conducted with normal efficiency.

Comparision between budget andforecast

Point of

Destiction

Budget Forecast

Nature Budget relates to planned events. It

means that policy and programme are

to be followed in future under

planned conditions

Forecast is concerned with

probable events which are likely

to hapen under anticipated

conditions during a specified

period to time

Period

covered

It is planned seperately for each

accounting period

It may cover a long period

Area

covered

It comprises the whole business unit.

Sectional budgets are integrated to

master budget

It may cover a limited function or

a definite activity of the business

such as sale.

A tool of Budget is a tool of control. It repres- It does not provide a tool of

control as

control ents actions which can be shaped

according to conditions

forecast is a statment of future

events.

Sequence Process of budget starts where

forecast ends. It converts forcast into

a budget.

The function of forecast ends with

the forecast of future events.

Object of It is made in respect of those areas . It is made in several other spheres

336

budget which are related to business. which may not be connected with

business process.

Q.6. Define Budget and Budgetary Control. [GU.1988, 1990, 1993, 2003,2006]

Budget:

ICMA defined Budget as "A plan quantified in monetary terms, preparedand

approxw, prior to a defined period of time, usually showing planned income to be

generated and/or expenditure to be incurred during that period and the capital to

be employed to attain a given objective."

According to R. Terry, Budget is "An estimate of future needs arranged according

to an orderly basis, covering some or all the activities of an enterprise for a definite

period ot time."

According to the above definitions, a budget is a quantitative expression of a plan

of action prepared in advance of the period to which it relates. It may be prepared

for an entire organisation or a segment of it or in respect of a definite managerial

function. It is a means of translating overall-objectives of a business into detailed

feasible action.

Examples- Production budget, sales budget, cash budget, plant utilisation budget,

etc.

A budget is expressed in relation to time, function or behaviour.

In short, budget is a plan of expected achievement based on the most efficient

operating standards in effect or in prospect at the time it is established, against

which actual accomplishment is regularly compared.

Budgetary Control: [GU. 1988,1990,1991,1993,2002 & 2003]

ICMA defined Budgetary Control as The "Establishment of budgets relating the

responsibilities of executives to the requirements of a policy and the continuous

comparison of actuals with budgeted results to secure by individual action the

objective of that policy or to provide a basis for its revision. "

The analysis of the above definition reveals the following points:

(i) Establishment of budgets;

(ii) Executive responsibility;

(iii) Measurement ofactual performance;

337

(iv) Comparison of actual performance with budgeted performance to establish

deviation;

(v) Analysis of the causes of variations and reporting

(vi) Remedial measures.

(vii) Revision.

Establishment of Budgets:

Budgets are fixed for each function and functional budgets are co-ordinated to each

other so that an overall budget for the organisation may be prepared. Examples-

cash budget, purchase budget, sales budget, capital budget, etc.

Executive Responsibility:

Executive responsibilities are specified forthe achivement of the specific target in

the budget. It is necessary for the attainment of the objectives of the organisation as

a whole.

Measurement of Actual Performance:

The performance of each executive is required to be measured periodically against

the budgeted targets.

Comparison:

Actual performance or data are compared with the budgeted targets and variances

are to be determined.

Analysis of the Causes of Variations:

Causes of variations are to be analysed and responsibilities are to be fixed.

Remedial Measures:

Remedial measures based on the causes of variances are to be taken so that they do

not recur in future. For these remedial measures, reporting of variances along with

their causes to the management become essential.

Revision:

Budgets should be revised from time to time in the light of changed circumstances.

Q.7. State the objectives or functions of Budgetary Control.

Or, Examine the role of Budgetary Control in the field of planning, co-

ordination and control. [GU.2001]

Or, Examplify the application of Budgetary control. [GU.2005]

338

Budgetary control improves planning, aids in co-ordination and helps in

having comprehensive control." Discuss. [GU.1997]

Following are the objectives of budgetary control:

I. Planning;

II. Co-ordination;

III. Communication;

IV. Motivation;

V. Control and

VI. Evaluation.

1 Planning:

Budgetary control involves the preparation of a detailed operational plan to achieve

the expected results of a business/Budgets will force the management at all levels to

plan in time all the activities they will perform during a future period. So it provides

a mechanism through which the managerial activities will be guided to achieve the

desired objectives of the business. Hence the budgetary control system improves

planning as it involves the achievements of set goals.

2. Co-ordination:

Budgetary control co-ordinates the efforts of the various sections of the business to

achieve the business goals of a given period. It forces the executives to think in

terms of a group and gives a direction to the business as a whole. Thus it brings

about matching efforts of the concerned department in the implementation of a well

thought out plan of action and is termed as an important tool for the materialisation

of a firm's business policy. As for example, a sales budget can be implemented only

with the co-operated and co-ordinated efforts of purchase department, production

department, finance department and sales department. So Budgetary control

increases the cooperation and co-ordination among the different departmental

managers.

3 Communication:

Budgetary control involves communication of the goal, programmes and policies to

be pursued by the management. This communication is made to the management of

all levels for the proper implementation of the plans and programmes within the

339

prescribed time. It spells out the role of each managerial person in the

implementation ofthe plans and policies. Thus budget is a means of communication

of business goal and policy.

4. Motivation:

Budgetary control motivates managers for the achievement of the business goals as

laid down in the budget. As the budgetary control system contains the incentive

schemes for efficiencies and penal action for inefficiencies, it motivates the

employees to improve their performance. Moreover, every employee's role is well

integrated in the total plan of action and the success of the plan demands every

concerned person's planned performance. So one's inefficiency will be detected,

responsiblility can be fixed and action may be taken.

5. Control:

Control consists of the action necessary to ensure that the performance of the

organisation conforms to the plans and objectives. Control of performance is

possible when the actuals are compared with the pre-determined standards laid

down in the budget. It is a technique of determining the efficiencies or

inefficiencies ofthe functional managers. It will make the departmental managers

careful and vigilant in the discharge of their responsibilities. So the budgetary

control ensures comprehensive control over the activities ofthe different

departments of an organisation.

6. Evaluation:

Comparison of the actual perfonnance with the budgeted standards would reveal the

deviations from the standards. Such deviations are analysed and causes are

determined. The corrective actions are taken up where necessary. It acts as guidance

for revision where necessary in the preparation of future budgets.

Q. 8. State the advantages/merit of Budgetary Control in an organisation.

[GU. 1988, 1990, 2003]

Following are the advantages of budgetary control:

1. Forward looking:

Budgeting compels the managers to think ahead. It means that the management

anticipates the changing conditions and prepares itself for the same.

340

2. Budget Preparation:

It helps the management in the process of planning and fixing targets, and

allocating responsibilities for the implementation of budgets. It increases

productivity, reduces wastes and controls costs.

3. Maximisation of Profits:

Budgetary control aims at the maximisation of profit through careful planning and

controlling

4. Evaluation of performance:

It reveals the efficiency or inefficiency of workers and helps the management in

adopting suitable labour policy.

5. Setting of standards:

It provides a yardstick against which the actual results can be compared.

6. Remedial Measures:

It helps the management in taking remedial measures where necessary.

7. Makes the management conscious:

It makes all levels of management to be careful and conscious in the discharge of

their duties and responsibilities. Thus it motivates the workers for better

performance.

8. Assigns Responsibility:

It assists in the delegation of authority and assignment of responsibility.

9. Introduction of Incentive Schemes:

It enables the management to introduce incentive schemes in the remuneration of

labour.

10. Introduction of Cost-Consciousness:

It infuses cost-consciousness among the employees of an organisation.

11. Co-ordination:

It brings about co-operation and co-ordination among the departmertts in the

achieve mentofset goals.

Q. 9. State the limitations of budgetary Control

Budgetary Control as a management control device suffers from the following

limitations:

341

1. Budgets are futuristic which may not be perfectly accurate :

Budgets are set future targets. It may not be possible to achieve those targets and as

such it may not be perfectly accurate due to uncertainty of future assumed

conditions.

2. Frequent Changes of Budgets become Costly in case of Rapidly Changing

situations:

Under frequent changing conditions, preparation of revised budgets to adapt the

changing conditions become a costly affair and nearly impossible.

3. Rigidity nature of budgetary Control may restrain managerial initiative and

inovation:

Budgets may serve as a constraints to the managerial initiative and inovative

character because every executive tries to achieve the budgeted targets without

caring for own initiative and inovative ideas.

4. Correlation and Co-ordination of Various Budgets is Expensive:

Maintaining correlation and co-ordination among the various budgets is an

expensive matter which may not be possible to afford by small firms. Hence, the

system may not be employed by small firms.

5. It may Develop conflicts among the functional executives:

Budgetary control may lead to conflicts among the functional executives regarding

allocation ofresources,shirking of responsibilities and blaming others for pitfalls.

6. It may invite ignoring of human behavioural aspect and antagonism among

the management and employees:

Badly handled budgetary control system with undue preasure and lac of regard to

behavioural aspect may invite antagonism and dis-satisfaction among the

employees of a firm.

Q. 10. Write

short notes on: Master Budget; Zero Based Budget Key Factor;

Selling and Distribution Budget.

(ii) (iii) (iv)

[GU. 1990, 2000]

Master Budget:

342

CIMA (Chartered Institute of Management Accountants) London has defined a

master budget as "The summary budget incorporating the functional budgets, which

is finally approved, adopted and employed. "

When the functional budgets have been prepared, a summary of all these budgets is

made and that summary budget is known as Master Budget. It shows the over all

plan of the business for the next period. It also shows the important accounting

ratios and gross and net profit figures.

It presents in a capsule form the high-lights of the budget forecast. The master

budget is prepared by the Budget Committee on the basis of co-ordinated functional

budgets and it becomes the target for the company for the budget period. The

master budget summarises the functional budgets in order to produce a Budgeted

Profit and Loss Account and a Budgeted Balance Sheet as at the end of a budgeted

period. Advantages :

(i) It shows all the functional budgets in one report.

(ii) The accuracy of functional budgets is checked.

(iii) It gives an overall estimated profit position of an organisation.

(iv) It shows a Forecast Balance Sheet.

Peter. A. Pyher defines zero base budget as "A planning and budgeting process

which requires each manager to justify his entire budget request in detail from

scratch (hence zero base) and shifts the burden of proof to each manger to justify

why he should spent money at all. The approach required that all activities be

analysed in 'Decision Package' which are evaluated by a systematic analysis and

ranked in order of importance."

CIMA has defined it as "A method of budgeting whereby all activities are revalued

each time a budget is set. Discrete levels of each activity are valued and a

combination choosen to match funds available

While preparing a budget for the next period, very often current year's budget is

taken as the base or the starting point and the budget is developed on the basis of

incremental changes from the base year's figures. But in case of Zero Base Budget,

it is prepared as if it is being prepared for a new company for the first time. Zero is

taken as a base as the name goes and taking zero as a base, a budget is developed on

343

the basis of likely activities for the future period. The budget for the year has to be

justified according to the present situation. The budgeting manager has to justify

why he wants to spend. The preference of spending on various activities will

depend on their justification and the priority for spending will be drawn. It will have

to be proved that the activity is essential and the amounts asked for are really

reasonable considering the volume of activity.

Use: It is very useful where it is difficult to use flexible budgeting. It can be

successfully applied to government expenditure, research and development, data

processing, quality control, marketing, transportation, legal staff, personal office,

etc. Advantages:

1. Promotes Operational Efficiency:

Zero base budgets is not based on incremental approach but on justification of the

activities and the requirement of funds. Thus it promotes operational efficiency.

2. Judicious Allocation of Funds:

Funds are allocated on the justification of activities and priorities, and the

implementation thereof is set accordingly.

3. Alternative Use:

It considers every time the alternative ways of performing a job.

4. Emphasis on Analysis of performance:

It makes the management analyse its performance and review its activities

accordingly.

5. Optimum Utilisation of Resources:

In zero base budgeting, current and proposed expenditures are evalued and

priorities are fixed accordingly. Thus resources are used efficiently.

6. Useful in Service Sector:

It is very much useful in the areas where output is not related to production i.e.

service sector. Limitations:

1. Cost-benefit Analysis not Possible:

Computation of cost-benefit analysis is not possible when it is used in non-financial

matters.

2. Difficulties in Budget Preparation:

344

Formulation and ranking of priorities in activities are difficult to perform.

3. Lack of Flexibility:

It has no scope for adjustment when there are unexpected changes in situation.

4. Costly:

It involves a lot of time and cost.

5. Unsuitable for Production Units:

It is unsuitable for production sectors Steps Involved in Zero Base Budgeting:

Following are the steps involved in preparing zero base budgets: (i) Each function

or activity of an organisation is to be identified. It is called decision

packing. Each decision packing is a separate and identifiable activity; 00 These

packages are linked with corporate objectives;

(iii) Each decision package is evaluated in order to ensure that it is cost effective;

(iv) Comparison of each activity with possible alternatives

(v) Decision packages are to be ranked on the basis of benefit analysis;

(vi) Resources are to be allocated on the basis of ranking of activities with resources

avail able to the organisation. Decision packages are self contained proposals for

seeking funds. Each package will clearly explain the activity, need for the item, the

amount involved, the benefit of implementing the proposal, the loss that may be

incurred if it is not done.

Key factor:

Key factor is a factor which governs the quantity that is to be manufactured or sold

particular time or over a period. It is the governing factor which is considered as a

major constraii to all operational activities. This factor is to be considered whether

budgets are capable of attainme-or not. So this factor is to be located before a

budget is prepared. It influences almost all budg ICM A defined the key factor as

"A factor which at any time or over a period may limit tr. activity of an entity, often

one where there is a shortage or difficulty of supply."

This factor is not static. It may vary from time to time due to internal or external

facte r is of temporary nature and in the long run it can be overcome by suitable

actions of manageme As for example, shortage of fund, shortage of material, quality

of labour and materials, etc.

345

Selling and Distribution Budget:

This budget is a forecast of the selling and distribution of products or services durin.

budget period. It is related to Sales Budget. All expenses related to selling and

distributions various products as indicated in the Sales Budget are included in it.

Expenses are related to sale volume of each product and a budget is prepared for

each item of selling and distribution expend

Selling and distribution overheads are divided into fixed and variable category with

referen c. to sales volume and a separate budget is prepared for variable and fixed

overheads. Common iter are salesmen's salaries, commission, travelling expenses,

wages, rent, other expenses relating -distribution, etc.

Q. 11. Are you in agreement with the view that budgeting should better be

called profit planning and control ? Elaborate. [G.U.1999]

One of the principal objective of budgetary control is to plan and control the income

expenditure of an organisation. With that object in view different functional budgets

are prepare: These budgets show the estimated revenues from sales and estimated

expenditure on productic administration, sales and distribution. A budgeted income

statement js prepared. It summarises af individual functional budgets. This budget

determines the estimated profit before tax during a period.

Budgetary control enforces control on the departmental heads for the

implementation budgets. It helps in fixing and allocating responsibilities to the

individuals and assign duties to the persons who are entrusted with the

implementation of the budgets. It helps the management in coordinating the

activities of the different departments for the achievement of the common goal of

the business i.e. maximisation of profits.

Thus if the functional budgets are properly implemented, the estimated profits as

shown ir the income statement will be realised and that will be the maximum profit

that a business organisation can earn during a budget period.

However, if the actual profit is lesser that the projected profit as shown in the

income state-' ment, it reveals that some functional budgets have not been properly

implemented or the budgets have failed due to internal or external factors. Causes

of the deviations will be analysed and reported to the management. Management

346

will adopt remedial measures where possible in order to prevent the derailment of

the budgets in future. Thus control over the implementation of the functional

budgets implies an automatic control on profit planning.

So budgeting means profit planning and control.

Q.12. Distinguish between budget and standard.

Following are the differences between budget and standard:

Basis Budget Standard

1.

Objective

Objective of budgeting is profit

planning. It also shows inflows

and outflows of cash.

Standards are developed usually for

expenses only. So they provide an

yardstick for measurement of

expenses.

2. Function Budget projects volume of

business and level of costs

which acts as ceiling

Standards emphasises cost levels to

which costs should be reduced. Thus

they pro vide minimum targets of

performance.

3.

Coverage

Budgets present forcasted Profit

and , Loss Account and Balance

sheet. It is a total concept.

Standard is a unit concept such as

standard for labour, material, etc.

4. Type of

Variance

Budget shows total variance.

•

Standard shows a unit or function

variance and causes of variance can

be ascertained

5.Scope Budget is more related to

planning, co-ordination and

control.

Standard is more related to control.

Q. 13. Define fixed budget and flexible budget. What are the advantages of

flexible budget? Distinguish between the two.

Fixed Budget

ICMA defines a fixed budget as "A budget which is designed to remain unchanged

irrespective of volume of output or turn over attained."

347

It is drawn for one level of activity and one set of conditions. Therefore, it is a rigid

budget and does not take into consideration any change in expenditure arising out of

changes in the level of activity.

Example: A master budget for a single output level say 20,000 unit level of sale,

etc. It is not a useful tool of control.

Flexible Budget:

CIMA defines a flexible budget as "A budget which, by recognising the difference

in behaviours between fixed and variable costs in relation to fluctuations in output,

turnover or other variable factors such as number of employees, is designed to

change appropriately with such fluctuations. " It gives different budgeted costs for

different levels of activity. In this case expenses are divided between fixed, semi-

fixed and variable and its usefulness depends on accurate classification of

expenditures. Such budgets are not rigid. They are adapted to the change in the

levels of activity. The industries where they are used:

1. Where the level of activity during the year varies from period to period;

2. Where the industry is subject to seasonal variations in demand.

3. Where the business is a new one and is difficult to forecast demand;

4. Where the industry suffers from the shortage of a factor of production.

5. Where the industry is influenced by changes in fashion.

6. Where there are general changes in sales.

7. Where the industry introduces a new product or makes changes in the design of

the produc:

8. Where the industries are engaged in making order or job business like ship

building, etc.

Utilities/Advantages: [GU.-2006]

1. Effective Tool of Budgetary Control:

It changes with the changes in the level of activity. So it is useful for budgetary

control.

2. Measurement of Performance:

The performance of a department can be judged with the reference to the level of

acti\ -achieved.

348

3. Cost Ascertainment:

Cost of production can be ascertained at different levels of activity.

4. Price Fixation:

It is useful in price fixation.

5. Co-ordination:

It results in the co-ordination of all the departments. Comparison: Following are the

differences between fixed and fluctuating budget:

Basis Fixed Budget Flexible Budget

1. Flexibility It is rigid and does not change

with the level of activity.

It is flexible and is adaptable with

the changes in the level of activity.

2. Condition It assumes that the conditions

will remain unchanged.

It assumes the changes in conditions.

3.

Classificatio

n of Costs

It does not require

classification of costs into

fixed, semi-fixed and variable.

Its success depends on the correct

classification of costs between fixed,

semi-fixed and variable.

4.

Comparison

Comparison between actual

performance and budgeted

performance is not possible.

Here comparison of actual

performance with budgeted

performance is possible.

5.

Forecasting

Accurate forecast of results is

not possible.

Here forecast of results at different

levels is possible.

6. Number of

Budgets

Required

Here only one budget is

prepared.

Here a series of budgets are prepared

for different levels of activity.

7. Cost

Ascertainme

nt

Cost ascertainment is not

possible if there is a change in

conditions.

Cost ascertainment is possible even

if there are changes in conditions.

8. Tool for

Cost Control

It has a limited use as a tool of

cost control.

It is effectively used as a tool of cost

control.

9. Price

Fixation

Price fixation is not possible if

volume of output changes

Here price fixation is possible for all

levels of production.

349

Q.14. Define Responsibility Accounting and State its significance. [G.U.-

2006]

[Madurai Kamraj M.Com. April 1989] (Or) Narrate the principles of

Responsibility Accounting. (Or) Discuss the advantages of Responsibility

Accounting.

(Or) Define Responsibility Accounting and Explain different responsibility

centres. (Or) Define the following terms:- (i) Cost Centre (ii) Investment

Centre (iii) Profit Centre.

(Or) "Responsibility Accounting consists in accumulation and reporting of

costs by levels of responsibility within an organisation" offer your obsevation

on the above statementment"

[M.Com. Delhi 1982]

Meaning: Responsibity Accounting is a system of cost control in terms of persons

who are responsible for the incurence of such costs. Here persons are made

responsible for the control of the costs which they incur.

In this case, responsibility is assigned to the persons and proper authority is given to

them so that they are able to keep up their performance. In case the performance is

not according to the predetermined standards, then the persons who are assigned

this duty will be personally responsible for it. Thus, in Responsibility Acounting,

the emphasis is given on man rather than on system.

In short, under this system, an organisation is divided into cost centres. These cost

centres are put under certain persons and adequate authority is delegated to them for

completing the work assigned to them. A system of management and reporting is

used to assess the performance of cost centres.

Some athoretative definitions are given below :

1. According to ICMA "Responsibility Accounting is a system of management

accounting under which accountability is established according to the

resposibility delegated to various levels of management and reporting system

instituted to give adequate feedback in terms of the delegated authority. Under

this system, divisions or units ofan organisation under a specified authority in a

350

person are developed as responsibility centres and evaluated individually for their

performance. "

2. According to ANTHONY AND REECE "Responsibility is that type of

management acocuntingthat collects and reports both planned and actual accounting

information in terms of responsibility centres."

3. According to ANDERSON "This concept encompasses an accounting system

in which the information and data are gathered and reported in a manner closely

related to the responsibility structure of the enterprise. "

According to the Institute of Cost and Works Accountants of India (ICWAI):

ResponsibilityAccounting is "A system of Management Accounting under which

accoutability is estabished according to the responsibility delegated to various

levels of management and a management information and reporting system

instituted to give adequate feed-back in terms of the delegated responsibility.

Under the system, divisions or units of an orgnisation under a specified authority

in a person are developed as responsibility centres and evaluated individually for

their performance. "

According to Charles T. Horngreen, Responsibility Accounting is "A system

ofaccounti that recognises various responsibility centres throughtout the

organisation and reflects th\ plans and action of each of the centres by assigning

particular revenues and costs to the 11. having the pertinent responsibility. It is

also called Profitability Accounting and Activity Accounting."

PRINCIPLES OF RESPONSIBILITY ACCOUNTING

Reaponsibility Accounting is based on the following principles :-

1. Fixing targets:

Targets should be fixed on budgets or standards according to the responsiblity.

2. Evaluation of performance:

Actual results should be compared with the budgets or standards for ascertaining

the variance?

3. Reporting :

After analysing the variances, reports should be submitted to the top management.

4. Corrective Action:

351

Next step is taking corrective actions and communicating these to the persons

concerned.

5. Setting up of Various Responsibility Centres:

The following types of responsibility centres can be established for management

controi purposes:-

(i) Cost Centre or expenses centre: According to CIMA, "a cost centre is a

production or service or location or function or activity or item of equipment whose

costs may be attributed to cost units. "

(ii) Revenue centre: According to CIMA, a Revenue centre is "a centre devoted to

raising revenue with no responsibility for production e.g. a sales centre. "

(iii) Profit centre: According to CIMA, a Profit centre is "a part of business

accountable for costs and revenues. "

(iv) Investment Centre : According to CIMA, an Investment Centre is "a profit

centre whose performance is measured by its return on capital employed. "

(v) Contribution Centre: According to C.I.M.A a contribution centre is "aprofit

centre whose expenditure is reported on a marginal or direct cost basis. "

Motivating Employees: The objective of Responsibility Accounting should be

motivating employees.

v_U antages of responsibility accounting or significance of responsibility

accounting Sound Cost Control System:

Knponsibility Accounting helps in the process of introduction of an impressive cost

control Control System:

p ststm is the prerequisite for the application of Responsibility Accounting.

Budgeting for fcomparison of actual performances against the budgets set.

3. Delegation of authority:

This system helps the management to make an effective delegation of authority and

responsibility.

4. Management by Exception :

It saves time of management by preparing reports relating to departmental work on

the principles of exception.

5. Motivating Managerial Executive:

352

This system motivates managerial executives by increasing their interests since they

are asked to explain the reasons of deviation of actuals from the budgeted figures.

Q. 15 : State the essential features of Responsibility Accounting.

Following are the essential features of Responsibility Accounting:

1. Determination of Costs and Revenue of each Cost Centre:

This system is based upon information relating to inputs and outputs or costs and

revenues. So it requires the determination of costs and revenues relating to a cost

centre incharge of a person.

2. Effective Information System:

There must be an effective information system for the purpose of control. This

information should be relating to the planned and actual costs at regular intervals.

3. Identification of Responsibility Centres:

Responsibility Centres should be clearly identified. These centres should be the

sphere of authority in an organisation. It is an unit of organisation which should be

separable and identifiable for the purpose of operation and measurement of

performance.

4. Existance ofRelationship between the Organisation at Structure and

Accounting System: Relationship between the organisational structure and

responsibility accounting system should be clear and non-overlapping. It means the

responsibility accounting system should be suitable to the organisational structure

so that performance of each centre can be independently judged.

5. Assignment of Cotrollable Costs to the Cost Centre :

Costs are to be divided between controllable costs and uncontrollable costs. Only

controllable costs are assigned to cost centres because individual efforts can control

such costs.

6. Transperent Pricing Policy:

There should be a clear price policy in respect of inter-division transfer of goods

and services.

7. Performance Reporting:

There should be a proper reporting system for conveying deviations of actuals from

budgeted targets for corrective actions at the earliest.

353

8. Mangem'ent By Exception :

Responsibility Accounting provides a tool for cost control through management by

exceptions.

9. Human Aspect of Responsibility Accounting:

It evaluates the performance of the person incharge of the cost centre, provides

feedback so that the future operation can be improved. Thus it motivates people to

work.

Q. 16. What are the preliminaries for the adoption of a system of Budgetary

Control? (Installation of budgetary control)

The following are the core requisites or steps for installation of a budgetary system.

(i) Organisation for budgetary control: A proper organisation is essential for the

success!. preparation, implemention and administration of budgets. The

organisation consists of

Chief Executive

Budget Officer

Budget Committee 4,

Departmental managers The chief executive will be in overall charge of budgetary

system. He constitutes the budget committee and the budget offices is the convenor

or of the budget Committe. He co-ordinates the different departmental budgets.

(ii) Budget centre: Budget centre is a part of the organisation for which budget is

prepared. All parts of the organisation should be covered by budget centres.

(iii) Budget Manual: CIMA England defines budget manual a document schedule

or booklet which setsout interalia, the responsibilities of the persons engaged in the

routine works and preparing the forms and maintaining records.

Requirementfor budgetary control: It-is a written document which guides the

executives ir preparing various budgets. Objectives of the organisation are written

in the Budget Manual and budgets are prepared for different departmental heads in

keeping in view the objectives of the organisations. Resposibility and functions of

each executive in regared to budgeting are written in the budget namual. Steps and

354

methodsof preparation of budgets and the method of reporting performance aganst

the budgets are also written in the manual. Thuse it is a written document which

gives everything relating to preparation and execution of various budgets.

(iv) Budget officer: The chief executive appoints a person as budget officer. He

scrutinises the budgets prepared by differental heads and makes changes where

necessary. He compares the actual performance with budget and communicates the

variance to the functional head for remedial measures. He is the co-ordinator among

different departments and monitor the gathered information.

(v) Budget Committee: This committee is made of the departmental heads of the

important and departments. The committee is responsible for the preparation and

execution of budgets. Budget officer is the co-ordinator of the committee.

(vi) Budget period: Budget period is the period for which a budget is prepared and

executed. The budget period depends on (i) Type of business and (ii) Demand

aspect.

(a) Shorperiodbudget For example, for seasonal industries (i.e. food or clothing)

the budget period shall be a short one.

(b) Long period budgets are prepared for capital expenditure, modernisation,

expansion of the undertaking, etc.

(c) Functional budgets like sales budget are for one year.

(d) For control purpose, short term budgets- monthly or weekly budgets are

prepared. (vii) Determination of key factors : Key factor is a factor in the activities

of an undertaking which at a partcular point in time or over a period will limit the

volume of output. It is a governing factor which is a major constriaint for all

operational activities of the organisation. So this factor is to be considered in

determinig whether the budgets are capable of attaenment. Hence this factor is to be

determined before the preparation of budgets as it influences all budgets.

Key factor may be

(i) demand, (ii) Availability of raw materials or labour, (iii) plant capacity etc.

355

Q.17. What is performance budget ? Mention the steps necessary for the

execution of a Performance Budget ?

Performance Budget

Performance Budget is defined as a budget "based on functions, activities and

projects." It is a budgeting system in which input costs are related to the

performances i.e. end results. It provides for appraisal ofperformance as well as

follow up action. This type of budget focuses attention on the accomplishment,

general and relative importance of the work to be done and the service to be

rendered. It does not give much stress on the means of accomplishment such as

personnel, service, supply, equipment, etc. In this case, functions of various

organisational units will be split into programme of activities and estimates would

be presented for each programme. Sometimes such programmes will be sub-

devided into sub-programmes. It seeks to establish a relationship between inputs

and their direct outputs.

Steps for the Execution of a Performance Budget:

Following steps are necessary for the execution of the system of performance

Budget:

1. Establishment of Responsibility Centre:

Responsibility Centre where some operations are performed and some financial

transactions take place must be well defined.

2. Programme of Action :

Some definite programme of action should be assigned. This programme of action

should result in some physical units or some definite service. As for example - units

of goods to be produced or units of goods to be sold by a particular department i.e.

output target, etc.

3. Allocation of Expenditure:

For the execution of the programme of action some expenses are to be allocated.

These expenses are shown under different classification.

4. Evaluation of Performance:

Performance of each responsibility centre is evalued periodically under two stages:

356

(a) Actual performance is compared with physical targets in order to determine the

extent of deviation. However budgeted physical targets may be revised after making

due allowance for actual physical work performed.

(b) The actual expenditure is compared with the budgeted or adjusted budgeted

expenditure in order to determine the monetary variance.

5. Performance Reporting:

A performance report is to be prepared showing the variances and the causes of

variances. Example -

The following data relate to a company which had a profit plan approved for selling

5000 units per month at an average selling price of Rs. 10 per unit. The budgeted

variable cost of production was Rs. 4 per unit and fixed costs were budgeted at Rs.

20,000, planned income being Rs. 10,000 per month. Because of shortages of raw

material the plant could produce only 4,000 units and the cost of production was

increased by 0.50 paise per unit. Consequently the selling price was raised by Re.

1.00 per unit. To modify production processes in order to meet material shortage the

company incurred an expenditure of Rs.l 1,000 in Research and Development. Set

out a performance budget and a summary report.

Solution: Performance Budget For the Month of...................

Perticulars Budget Actual

Units Amount

per unit

Total

Amount

Units Amount

per unit

Total

Amount

Sales

Less: Variable

Cost

Contribution

Less: Fixed Cost

Profit

5,000

5,000

10.00

4.00

50,000

20,000

4,000

4,000

11.00

4.50

44,000

18,000

6.00 30,000

10,000

6.50 26,000

21,000

20,000 5,000

357

Q.18: What do you mean by a control ratio ? What are them.

Control Ratio are' certain ratio which are used to determine the performance

efficiency of a responsibility centre. They show the actual level of activitiy attained,

degree of efficiency attained and the actual capacity utilised during a budgeted

period. These ratio are :

1. Activity Ratio:

It is a measure of the level of activity attained over a period of time. This ratio

expresses the relationship between shandard hours required for actual production

and budgeted hours. The fonnula is:

S tan dard hows for actual output Activity Ratio =-

2. Capacity Ratio:

This ratio meansures the extent of utilisation of budgeted hours of activity, the

objective is to show whether or not the available hours are being fully utilised. The

formula is:

Capacity Ratio:

Actual Hours Worked

Budgeted hours 3. Efficiency Ratio or Productivity Ratio:

This ratio measure the level of efficiency attained by each responsibility centre in

the process of production. This ratio indicates the efficiency attained ip producing a

stated output.

The formula is:

Standard Hours for Actual Production Efficiency Ratio =

The results of the above ratios can be interpreted as under:

Result Interpretation

100% No deviation

Above 100% Favourable deviation

Below 100% Unfavourable deviation

4. Calander Ratio:

This ratio measures the relationship between the number of actual days worked and

the number of days budgeted during a period. The formula is

358

Actual working days in a period

Calander Ratio = 100

Number of working days in a Budget period

Example - i.Narang Ltd. produces two commodities Viz: Good and Batter in one of

its departments. Each unit takes 5 hours and TO hours as production time

respectively. 1000 units of Good and 600 units of Better were produced during the

month of March. Actual manhours spent in this production were 10,000 hours,

Yearly budgeted hours were 96,000 hours. Compute various control ratios.

Solution:

Yearly Budgeted Hours = 96,000 hours

Monthly Budgeted Hours = 8,000 hours

Standard Hours for Actual Output:, 1000x5 + 600x 10= 11,000 hours Actual Hours

Worked: 10,000 hours

. . _ , S tan dard hours for actual output 0 Activity Ratio

Example - 2: A factory produces two types of products - X and Y, Product X takes

5 hours and of Y were produced. The company employs 50 workers in the

production department. The budgeted hours are 1,02,000 for the year. Calculate -

Activity Ratio, Capacity Ratio and Efficiency Ratio.

0 Budgeted Hours for the Month = = 8,500

ii) Actual Hours Worked = 25 * 8 * 50 = 10,000 Hours

iii) Standard Hours for Actual Production : -Product X = 1000x5 = 5,000

Product Y = 600 xl0 = 6,000

Total =11,000 Hours

. . „ . S tan dard hours for actual output \ 1,000

a) Activity Ratio =-

b) Capacity Ratio = Actual Hours Worked x , qq = x 100 = 117.65%

Budgeted hours 5, sou

S tan dard Hours for Actual output 11,000

c) Efficiency Ratio = Totooo * 100= 110%

Example - 3: Calculate:

a) Efficiency Ratio;

359

b) Activity Ratio; and

c) Capacity Ratio from the following figures: Budgeted Production- 88 units

Standard hours per unit - 10 Actual production - 75 units

Actual Working hours - 600 [B. Com. Delhi]

Solution: i) Budgeted Hours = 88 * 10 = 880 Hours

ii) Actual Hours Worked =600 Hours

iii) Standard Hours for Actual Production = 75 units x 10 = 750 Hours

. . Standard Hours for Actual output

a) Efficiency Ratio = -Actual Hours Worked- 100

5 tan dard hours for actual output 750

b) Activity Ratio =-

c) Capacity Ratia(Utilisation)= Actual Hours Worked x 1QQ = |gxl00 = 68.18%

Budgeted hours

Q.19. Distinguish between Standard Costing and Budgetary Control.

In both the standard costing and the budgetary control, there are predetermined

standards and actual results are compared with standards to measures efficiency or

inefficiency. Both help the maragement in controlling costs. Still they differ in the

following respects

Basis Standard Costing Budgetary Control

1.

Concept

In standard costing, standards are

set for producing a product or for

producing a service. It is intensive

in nature involving detailed

analysis of variances. As for

example, standards are set for

different elements of cost.

In budgetary control, budgets are

prepared for a department or for a

concern as a whole. It is extensive

in nature requiring lesser depth of

analysis. As for example, budget for

selling and distribution expenses,

capital investment for a state as a

whole.

2. Basis Standard costs are fixed on the

basis of technical information

and acceptable level of

efficiency. They are planned costs

Budgets are fixed on the basis of

past records and future

expectations without giving

attention to the level of efficiency.

360

and are expected in future.

3.Coverag

e

Standard costs are set for

manufacturing functions and

sometimes for marketing and

adminstrative function.

Budgets are compiled for all

functions of the business such as

sales, purchases, expenditures,

incomes, finance, etc.

4.

Variance

Analysis

Variances are calculated for

different elements of costs such

as material, labour, etc. showing

the causes therefore.

Variances are calculated for

different departments for the

concern as a whole without showing

causes.

5. Cost

Control

Standard costs represent realistic

yardstic to measure efficiency.

They are more useful for cost

controL

Budgets usually represent the upper

limit of spending. They do not

consider the effectiveness of

expenditure in terms of output.

6.

Relation

7.

Applicati

on

Standard Cost is a projection of

cost accounts.

Standard costing cannot be used

partially. It will have to be used

wholly. As for example-

standards for all elements of

costs.

Budgets are the projections of

financial accounts. Budgetary

control system can be applied partly

or wholly. As for example- budgel

for sales and production

departments only.

Though they are independent of each other, they are complementary to each other.

If standard costing is operated along with a system of budgetary control, there will

be more accurate estimate and more effective control.