b.com cost accounting
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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.
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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
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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.
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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
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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.
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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.
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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 :-
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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 :-
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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
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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.
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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.
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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.
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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.
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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
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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
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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.
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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.
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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
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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
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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
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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.
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(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:
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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:
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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
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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
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(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;
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(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
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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:
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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.
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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.
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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.
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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
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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;
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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,
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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 :
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(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:
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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 =
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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
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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;
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(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.
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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:
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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
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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
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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?
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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)
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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
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(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?
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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.
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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
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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.
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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:
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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)
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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 (-).
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(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.
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(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.
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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
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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.
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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:
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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:
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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.
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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:
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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:
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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.
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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:
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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.
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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
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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.
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(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
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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:
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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
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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:
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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.
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(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.
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(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:
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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.
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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
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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
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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:
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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.
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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:
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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.
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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.
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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.
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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.
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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.
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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
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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 ?
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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
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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
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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
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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
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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:
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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:
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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.
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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.
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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:
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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
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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:
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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:
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. 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
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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.
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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)
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(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)
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(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)
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(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)
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(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)
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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
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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.
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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
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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:
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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.
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(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:
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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.
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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:
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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.
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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.
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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.
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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:
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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:
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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.
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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:
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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:
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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
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_ 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
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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:
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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)
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(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)
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(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)
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(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).
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(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)
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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.
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(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
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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.
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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
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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;
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(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
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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.
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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:
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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:
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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
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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:
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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.
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