Masters of Business Administration

(MBA)

Management Accounting
(OMBACO101T24)

Self-Learning Material
(SEM 1)

Jaipur National University

Centre for Distance and Online Education
_________________________________________
Established by Government of Rajasthan
Approved by UGC under Sec 2(f) of UGC ACT 1956
&
NAAC A+ Accredited
PREFACE

In the contemporary business environment, the role of management accounting has evolved
significantly, becoming a pivotal aspect of strategic in decision-making and focus
organizational success. This preface seeks to underscore the fundamental principles and the
critical importance of management accounting in today's dynamic and competitive
marketplace.

Management accounting, distinct from various accounting, focuses on providing internal

management with the information necessary to make informed business decisions. It
encompasses a wide range of activities, including budgeting, forecasting, performance
evaluation, and cost management. By delivering timely and relevant data, management
accounting aids in the formulation of strategies, the optimization of resources, and the
enhancement of overall organizational performance.

The primary objective of management accounting is to furnish managers with the tools to
interpret financial data and information effectively and to use this data and information to
drive business strategy. It involves the relevant data collection, analysis, and presentation of
financial and non-financial information that assists in planning, controlling, and better
decision-making processes. Unlike financial accounting, which adheres to standardized rules
and is primarily geared towards external stakeholders, management accounting is more
flexible and tailored to meet the specific needs of the organization.

In conclusion, this book aims to provide readers with a robust framework for understanding
and applying management accounting principles. Whether you are a student, an aspiring
accountant, or a seasoned manager, the insights and methodologies presented here will equip
you with the knowledge and skills to navigate the complexities of modern business
environments and to contribute effectively to your organization's success.
TABLE OF CONTENTS

Unit Topic Page No.

Introduction to Management Accounting
1.1 Meaning, Nature and Significance of Management Accounting
1.2 Meaning, Nature and Significance of Cost Accounting
1.3 Meaning, Nature and Significance of Financial Accounting
1.4 Difference between Cost, Management and Financial
Accounting
1 1.5 Role and Importance of Management Accounting in Decision- 01 – 17
Making
1.6 Summary
1.7 Keywords
1.8 Questions
1.9 Case Study
1.10 References
Trend Analysis
2.1 Introduction
2.3 Summary
2 2.4 Keywords 18 – 40
2.5 Questions
2.6 Case Study
2.7 References
Ratio Analyses
3.1 Introduction to Financial Statement Analysis
3.2 Uses of ratio analysis
3.3 Types of financial ratios
3.4 Liquidity ratios
3.5 Solvency ratios
3.6 Efficiency ratios
3.7 Profitability ratios
3 41 – 68
3.8 Valuation ratios
3.9 Limitations of Ratio Analysis
3.10 Numerical
3.11 Summary
3.12 Keywords
3.13 Questions
3.14 Case Study
3.15 References
Fund Flow Statements
4.1 introduction to cash and flow statements advantage –
disadvantages
4.2 Difference between cash flow statements and fund flow
4 statements 69 – 98
4.3 need – uses -
4.4 fund flow statements format
4.5 problems fund flow statements
4.6 Summary
4.7 Keywords
4.8 Questions
4.9 Case Study
4.10 References
Cash Flow Statements
5.1 meaning of cash statements
5.2 advantage –disadvantages
5.3 need – uses - Cash flow statements
5.4 preparing cash flow statements
5.5 cash flow format
5 99 – 123
5.6 problems cash flow statements
5.7 Summary
5.8 Keywords
5.9 Questions
5.10 Case Study
5.11 References
Cost Accounting
6.1 introduction of cost accounting
6.2 Element of Cost
6.3 basis of cost allocation
6.4 standard costing
6.5 variance analysis
6 124 – 156
6.6 numerical problems
6.7 Summary
6.8 Keywords
6.9 Questions
6.10 Case Study
6.11 References
Job and Process Costing
7.1 introduction Job and process Costing
7.2 job costing meaning advantage and disadvantage
7.3 process costing meaning advantage and disadvantage
7 7.4 Summary 157 – 179
7.5 Keywords
7.6 Questions
7.7 Case Study
7.8 References
Marginal Costing
8.1 Marginal Costing – distinction between absorption costing and
marginal costing
8.2 Cost volume profit (CVP) analysis
8.3 Break Even Analysis
8 8.4 Margin of Safety 180 – 206
8.5 numerical problems
8.6 Summary
8.7 Keywords
8.8 Questions
8.9 Case Study
8.10 References
Contract and Batch Costing
9.1 Contract Costing – Meaning and feature
9.2 Advantage and disadvantage of contract costing
9.3 Numerical – contract costing
9.4 Batch Costing
9 9.5 Advantage and disadvantage of batch costing 207 – 232
9.6 Summary
9.7 Keywords
9.8 Questions
9.9 Case Study
9.10 References
Capital Expenditure Evaluation
10.1 Introduction to Capital Expenditure Evaluation
10.2 Capital Expenditure Evaluation meaning, Advantage and
disadvantage
10.3 Capital Budgeting Concepts
10.4 Methods
10 10.5 Limitations 233 – 254
10.6 Capital expenditure control
10.7 Summary
10.8 Keywords
10.9 Questions
10.10 Case Study
10.11 References
Budgetary Control
11.1 Introduction of Budgetary Control
11.2 Nature and objectives of Budgetary Control
11.3 Limitations
11 11.4 Summary 255 – 263
11.5 Keywords
11.6 Questions
11.7 Case Study
11.8 References
Accounting in Computerized Environment
12.1 Introduction
12.2 Significance of Computerized Accounting System
12.3 Summary
12 264 – 271
12.4 Keywords
12.5 Questions
12.6 Case Study
12.7 References
Master Budgets
13.1 Master Budgets and Flexible Budgets
13.2 Zero base budgets
13 272 – 279
13.3 Summary

13.4 Keywords
13.5 Questions
13.6 Case Study
13.7 References
Accounting
14.1 Codification and grouping of accounts
14.2 maintaining the hierarchy of ledgers –
14.3 Prepackaged accounting software.
14 280 – 281
14.4 Key Terms
14.5 Questions
14.6 Case Study
14.7 References
UNIT 1

INTRODUCTION TO MANAGEMENT ACCOUNTING

Learning Objectives

 To Understand the nature and scope of management Accounting

 To understand the Difference between cost, management and financial accounting.
 To understand Role and importance of management accounting in decision-making

Structure

1.1 Meaning, Nature and significance of Management Accounting

1.2 Meaning, Nature and significance of Cost accounting

1.3 Meaning, Nature and significance of Financial Accounting

1.4 Difference between cost, management and financial accounting

1.5 Role and importance of management accounting in decision- making

1.6 Summary

1.7 Keywords

1.8 Questions

1.9 Case Study

1.10 References

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1.1 Meaning, Nature and significance of Management Accounting
Management accounting is a field of accounting that involves the process of collecting,
analyzing, interpreting, and presenting financial and non-financial information to support
management in decision-making, planning, controlling, and evaluating the performance of an
organization. It provides managers with the necessary data and analysis to make informed
choices and effectively allocate resources within the organization. Management accounting
goes beyond traditional financial accounting by focusing on internal information needs and
providing insights into the operational aspects of the business. It plays a crucial role in
helping managers formulate strategies, assess the financial impact of various options,
monitor performance, and drive organizational success.

Management accounting refers to the process of collecting, analyzing, interpreting, and

presenting financial and non-financial information to aid management in making informed
decisions, formulating strategies, planning, and controlling operations within an organization.
It involves the application of accounting and financial principles and techniques to provide
valuable information to internal users, primarily managers, for effective decision- making.

1.2 Nature of Management Accounting

The nature of management accounting can be understood through the following key points:

1. Internal Focus: Unlike financial accounting, which focuses on providing information

to external stakeholders, management accounting is primarily concerned with
serving the internal needs of an organization. It focuses on providing relevant and
timely information to managers at different levels to support their decision-making
processes.
2. Future Orientation: Management accounting emphasizes the use of forward-looking
information rather than historical data. It involves forecasting, budgeting, and
planning activities to assist in setting future goals, identifying potential problems, and
developing strategies to achieve organizational objectives.
3. Decision Support: The main purpose of management accounting is to provide
information that helps managers make informed decisions. It involves analyzing
various alternatives, conducting cost-benefit analyses, evaluating risks, and providing
performance measures to support decision-making across different functional areas of

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an organization.
4. Flexibility: Management accounting recognizes the need for customization and
adaptability to meet the specific requirements of an organization. It allows for the
design and implementation of management control systems, cost accounting systems,
and performance measurement frameworks tailored to the unique characteristics and
objectives of the business.
5. The significance of management accounting lies in its contribution to improving
organizational performance and facilitating effective management. Here are some key
aspects of its significance:
6. Planning and Control: Management accounting assists in formulating strategic plans
and operational budgets by providing relevant financial and non-financial data. It aids
in monitoring actual performance against planned targets, identifying deviations, and
taking corrective actions to achieve organizational objectives.
7. Decision Making: Management accounting provides critical information for decision-
making processes, such as product pricing, make-or-buy decisions, investment
appraisal, and cost analysis. It helps managers evaluate the financial implications of
different options and select the most viable alternative.
8. Performance Evaluation: By establishing performance measures, such as key
performance indicators (KPIs) and balanced scorecards, management accounting
enables the evaluation of individual, departmental, and overall organizational
performance. It facilitates the identification of areas needing improvement and
supports performance-based incentives and rewards.
9. Resource Allocation: Management accounting aids in allocating scarce resources
efficiently by analyzing cost structures, assessing profitability, and identifying areas
of wastage or inefficiency. It helps managers optimize resource utilization, improve cost
control, and maximize profitability.

10. Strategy Formulation: Management accounting provides data and analysis to support
strategic decision-making. It assists in assessing market trends, analyzing
competitors, conducting risk assessments, and identifying opportunities for growth
and diversification.

Key Features of Management Accounting

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Some key features and aspects of management accounting include:
Cost Analysis: Management accounting analyzes costs to understand the cost
structure of products, services, departments, or activities within the organization. It
helps in identifying cost drivers, allocating costs, and conducting cost-volume-profit
analysis. Cost analysis assists management in making decisions related to pricing,
product mix, cost reduction, and profitability improvement.
Budgeting and Planning: Management accounting plays a vital role in the budgeting
and planning process. It helps in developing financial forecasts, setting budgets, and
establishing performance targets. By aligning financial goals with strategic
objectives, management accounting assists in resource allocation, evaluating
investment opportunities, and monitoring progress towards achieving desired
outcomes.
Performance Measurement and Evaluation: Management accounting provides tools
and techniques for measuring and evaluating performance at various levels of the
organization. It involves the development of key performance indicators (KPIs),
performance reports, variance analysis, and balanced scorecards. These measures
enable management to assess the effectiveness and efficiency of operations, identify
areas for improvement, and take appropriate actions.
Decision Support: Management accounting provides information and analysis to
support decision-making. It includes techniques such as cost- benefit analysis, capital
investment appraisal, and risk assessment. By providing financial and non-financial
data, scenario analysis, and sensitivity analysis, management accounting helps
management evaluate different options and make informed decisions.
Strategic Planning: Management accounting contributes to strategic planning by
providing financial analysis, market research, and competitive analysis. It assists in
evaluating market opportunities, analyzing the financial viability of strategic
initiatives, and assessing risks and rewards associated with different strategies.
Management accounting helps align financial resources with strategic objectives and
facilitates the implementation and monitoring of strategic plans.
Risk Management: Management accounting assists in identifying, assessing, and
managing risks within the organization. It includes the analysis of financial risks,
operational risks, and strategic risks. By providing risk assessment tools, cost-benefit

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analysis of risk mitigation strategies, and monitoring mechanisms, management
accounting supports the effective management of risks and uncertainties.

In summary, management accounting is a vital function within organizations, focusing on

providing timely and relevant information to support planning, decision-making, control, and
performance evaluation. Its role in helping managers navigate complex business
environments and drive organizational success cannot be overstated.

1.1 Meaning, Nature and significance of Cost accounting

Cost accounting is a branch of accounting that focuses on the analysis, recording,
classification, allocation, and control of costs incurred in producing goods or services. It
involves the collection and interpretation of financial and non-financial data related to
various aspects of cost, such as materials, labor, overhead, and other expenses. The main
purpose of cost accounting is to provide information to management for decision-making,
planning, controlling costs, and evaluating performance.

Meaning:
Cost accounting involves the systematic process of collecting, analyzing, and reporting cost
information within an organization. It aims to determine the actual cost of producing a
product or service, measure and control costs, and
provide useful information for managerial decision-making. It involves techniques and
methods for the allocation of costs to products or services, cost estimation, cost analysis, and
cost control.

Nature of Cost accounting

The nature of cost accounting can be described as follows:

Data collection: Cost accounting involves gathering and accumulating data related to various
cost elements, such as direct materials, direct labor, and overhead costs. This data is obtained
from various sources within the organization, including financial records, production reports,
and timekeeping systems.
Classification and analysis: Once the data is collected, it is classified and analyzed according
to predetermined cost elements and cost centers. This helps in understanding the composition

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of costs and identifying cost drivers or factors influencing costs.
Cost allocation: Cost accounting assigns costs to products, services, or activities based on
appropriate allocation methods. This allows for the determination of the cost of each product
or service, enabling decision-making regarding pricing, profitability analysis, and resource
allocation.
Cost control: Cost accounting provides information for cost control by comparing actual
costs with standard or budgeted costs. Deviations from the expected costs can be analyzed,
and corrective measures can be taken to control costs and improve efficiency.

Significance of Cost accounting

Cost accounting plays a significant role in managerial decision-making and overall
organizational success. Its significance can be summarized as follows: Cost determination:
Cost accounting helps in accurately determining the cost of producing goods or services.
This information is crucial for pricing decisions, profitability analysis, and determining
the break-even point.

Cost control and reduction: By analyzing costs and identifying cost drivers, cost
accounting enables organizations to implement cost control measures and reduce unnecessary
expenses. It helps in improving operational efficiency and profitability.

Performance evaluation: Cost accounting provides a basis for evaluating the performance of
different departments, products, or processes within an organization. It facilitates the
comparison of actual costs with budgeted costs and helps in identifying areas of
improvement.

Decision-making: Managers rely on cost accounting information for making informed

decisions regarding product pricing, make-or-buy decisions, production planning, and
resource allocation. It provides relevant and reliable data to support decision-making
processes.

Financial reporting: Cost accounting data is used in the preparation of financial statements
and reports. It provides valuable inputs for determining the cost of goods sold, inventory
valuation, and overall financial performance.

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In summary, cost accounting is a vital tool for organizations to understand, control, and
optimize costs. It enables informed decision-making, facilitates cost control measures, and
contributes to overall operational efficiency and profitability.

1.2 Meaning, Nature and significance of Financial Accounting

Financial accounting is a branch of accounting that focuses on recording, summarizing, and
reporting the financial transactions and information of an organization. It involves the
preparation of financial statements, such as the balance sheet, income statement, cash flow
statement, and statement of changes in equity. The primary purpose of financial accounting is
to provide external stakeholders, such as investors, creditors, and regulators, with accurate
and reliable financial information about the organization's performance, financial position,
and cash flows.

Meaning of Financial Accounting

Financial accounting involves the process of collecting, analyzing, and recording financial
data to generate financial statements. It follows a set of standardized principles and
guidelines, such as Generally Accepted Accounting Principles (GAAP) or International
Financial Reporting Standards (IFRS), to ensure consistency and comparability of financial
information. The main goal of financial accounting is to provide an objective and
transparent view of an organization's financial performance and position to external users.

Nature of Financial Accounting

The nature of financial accounting can be described as follows:

Financial transactions: Financial accounting records and summarizes the monetary

transactions of an organization, such as sales, purchases, expenses, investments, and
borrowings. It captures these transactions in a systematic and organized manner to reflect the
financial impact on the organization.

Financial statements: Financial accounting prepares financial statements, which are formal

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records of the financial activities and position of an organization. These statements include
the balance sheet, which presents the assets, liabilities, and equity of the organization at a
specific point in time; the income statement, which shows the revenue, expenses, and net
income or loss for a given period; the cash flow statement, which tracks the inflows and
outflows of cash; and the statement of changes in equity, which outlines the changes in
equity over a period.

Accrual basis: Financial accounting generally follows the accrual basis of accounting, which
recognizes revenues when they are earned and expenses when they are incurred, regardless of
when the cash is received or paid. This ensures that the financial statements provide a more
accurate reflection of the organization's financial performance and position.

External reporting: Financial accounting primarily serves external stakeholders, including

investors, lenders, suppliers, customers, and regulatory authorities. The financial statements
prepared through financial accounting are meant to provide these stakeholders with relevant
and reliable information to make informed decisions about their interactions with the
organization.

Significance of Financial Accounting

The significance of financial accounting can be summarized as follows:

Transparency and accountability: Financial accounting promotes transparency and

accountability by providing a clear and standardized view of an organization's financial
performance and position. It enables stakeholders to assess the organization's financial
health and make decisions based on reliable information.

Decision-making: External stakeholders, such as investors and creditors, rely on financial

accounting information to make investment decisions, evaluate creditworthiness, and assess
the financial viability of the organization. Financial accounting provides them with key data
and metrics for analyzing the organization's financial performance and potential risks.

Regulatory compliance: Financial accounting ensures that organizations comply with legal
and regulatory requirements for financial reporting. It helps organizations meet their

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obligations to government authorities and regulatory bodies by providing accurate and
complete financial information.

Investor confidence: Financial accounting plays a crucial role in building investor confidence
and attracting investment. When financial statements are prepared following the prescribed
accounting principles and provide reliable information, investors are more likely to trust the
organization and make investment decisions.

Benchmarking and performance evaluation: Financial accounting allows for benchmarking

and comparing the financial performance of an organization over time or against industry
standards. It provides a basis for evaluating the organization's profitability, liquidity,
solvency, and efficiency.

In summary, financial accounting is essential for recording and reporting an organization's

financial transactions and information. It serves external stakeholders by providing
transparent and reliable financial statements, enabling decision-making, ensuring regulatory
compliance, and fostering investor confidence.

1.3 Difference between cost, management and financial accounting

The main differences between cost accounting, management accounting, and financial
accounting lie in their objectives, focus, and the users of the information they provide. Here's
a breakdown of the distinctions:

Cost Accounting:
Objective: Cost accounting focuses on determining and controlling the cost of producing
goods or services within an organization. It aims to provide detailed information about the
cost components, cost behavior, and cost allocation.
Focus: The primary focus of cost accounting is on internal reporting and analysis. It helps
management make decisions regarding pricing, cost control, profitability analysis, and
resource allocation.
Users: The users of cost accounting information are internal to the organization, including
managers, production supervisors, and employees involved in cost control and decision-

9
making.

Management Accounting:
Objective: Management accounting aims to provide information to internal management for
planning, decision-making, and control purposes. It focuses on providing relevant and timely
information to assist managers in making informed decisions.

Focus: The focus of management accounting is on both historical and future- oriented
information. It provides detailed reports, forecasts, budgets, and performance measurement to
aid in strategic planning, performance evaluation, and decision analysis.

Users: The users of management accounting information are primarily internal managers and
executives who need data for planning, controlling, and evaluating the organization's
operations.

Financial Accounting:
Objective: Financial accounting is concerned with the preparation and presentation of
financial statements to provide information about the financial performance, position, and
cash flows of an organization. Its objective is to provide accurate and reliable financial
information to external stakeholders.

Focus: Financial accounting focuses on reporting past financial transactions and events in
accordance with applicable accounting standards (e.g., GAAP or IFRS). It involves
recording, classifying, summarizing, and presenting financial data through balance sheets,
income statements, cash flow statements, and related disclosures.

Users: The users of financial accounting information are external stakeholders, such as
investors, creditors, regulatory authorities, and the general public. They rely on financial
statements to assess the financial health, profitability, and risk of the organization.

In summary, cost accounting is concerned with determining and controlling costs internally,
management accounting focuses on providing internal information for decision-making and
control, while financial accounting is primarily concerned with external reporting to

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stakeholders. Each of these accounting branches serves different purposes and caters to
different users, but they are interconnected and provide valuable information for various
aspects of an organization's operations.

1.4 Role and importance of management accounting in decision-making

The role and importance of management accounting in an organization are significant. Here
are some key aspects that highlight its importance:

Decision-making support: Management accounting provides crucial information and

analysis to support decision-making within an organization. It helps managers in
making informed choices regarding pricing, product mix, investment decisions, cost
control measures, and resource allocation. By providing relevant data and insights,
management accounting assists in evaluating the potential outcomes and risks
associated with different alternatives.
Planning and budgeting: Management accounting plays a vital role in the planning
and budgeting process. It aids in the development of financial forecasts, budgets, and
strategic plans. By analyzing past performance and market trends, management
accounting helps set realistic targets and objectives. It also enables monitoring and
control of actual performance against budgeted figures, facilitating adjustments and
corrective actions as needed.
Performance measurement and evaluation: Management accounting provides metrics
and tools for measuring and evaluating the performance of different departments,
projects, products, or individuals within an organization. Key performance indicators
(KPIs) and performance reports help assess efficiency, effectiveness, and
profitability. By monitoring performance, management accounting enables the
identification of areas for improvement and the implementation of performance-
enhancing measures.
Cost analysis and control: Management accounting plays a crucial role in cost
analysis and control. It helps in identifying and classifying costs, determining cost
behavior, and tracking cost variances. By analyzing cost drivers and conducting cost-
volume-profit (CVP) analysis, management accounting assists in understanding the
cost structure and optimizing costs. It provides insights into cost reduction

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opportunities and supports cost control measures to enhance profitability.
Strategic planning and risk management: Management accounting contributes to
strategic planning by providing relevant financial and non- financial information. It
assists in evaluating investment opportunities, assessing the feasibility of projects,
and conducting sensitivity analysis. Additionally, management accounting helps in
identifying and managing risks by providing risk assessment tools, cost-benefit
analysis, and risk mitigation strategies.
Performance communication: Management accounting facilitates effective
communication of financial and non-financial information to different levels of
management within an organization. It prepares management reports, dashboards, and
presentations that present the relevant data and analysis in a concise and
understandable manner. By communicating financial information clearly,
management accounting supports effective decision-making and coordination among
various departments and stakeholders.
Continuous improvement and innovation: Management accounting contributes to
continuous improvement and innovation within an organization. By analyzing
performance trends, identifying inefficiencies, and suggesting process improvements,
it drives operational excellence. Additionally, management accounting provides
insights into new business opportunities, investment in research and development,
and assessment of the viability of new products or markets.

In summary, management accounting plays a critical role in providing information and

analysis for decision-making, planning, performance evaluation, cost control, risk
management, and strategic planning. Its importance lies in supporting managers in making
informed choices, optimizing resources, improving performance, and driving the overall
success and competitiveness of an organization.

The role and importance of management accounting in decision-making are significant.

Here are some key aspects that highlight its importance:

Relevant and Timely Information: Management accounting provides managers with

relevant and timely information to support decision-making. It goes beyond historical

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financial data and incorporates non-financial information, such as operational metrics,
market trends, and customer feedback. This comprehensive information enables
managers to have a holistic view of the organization and make informed decisions
based on a broader range of factors.
Cost Analysis and Profitability Assessment: Management accounting plays a crucial
role in cost analysis and profitability assessment. It provides detailed cost information
for products, services, departments, or projects, helping managers understand the cost
structure and identify areas for cost reduction. By analyzing costs and revenues,
managers can evaluate the profitability of different products or services and make
decisions on pricing, product mix, and resource allocation.
Budgeting and Planning: Management accounting supports the budgeting and
planning process by providing financial forecasts, budget guidelines, and
performance targets. It helps managers set realistic goals and objectives based on the
organization's resources and market conditions. By aligning financial targets with
strategic plans, management accounting enables effective resource allocation and
facilitates the achievement of organizational objectives.
Capital Investment Decisions: Management accounting provides tools and techniques
for evaluating capital investment decisions. Techniques such as net present value
(NPV), internal rate of return (IRR), and payback period analysis help assess the
financial viability and potential returns of investment projects. By considering both
financial and non-financial factors, management accounting assists in selecting the
most profitable and strategic investment opportunities.
Risk Assessment and Mitigation: Management accounting helps in assessing and
managing risks associated with various business decisions. It provides financial
analysis and scenario modeling to evaluate the potential risks and rewards of different
options. By conducting sensitivity analysis and risk assessments, management
accounting enables managers to make decisions that consider potential risks and
implement appropriate risk mitigation strategies.
Performance Evaluation and Control: Management accounting facilitates
performance evaluation and control by providing performance measures, key
performance indicators (KPIs), and variance analysis. It compares actual performance
against budgets or targets, identifies deviations, and enables managers to take

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corrective actions. By monitoring and analyzing performance, management
accounting helps managers identify areas for improvement and optimize operational
efficiency.
Strategic Decision Support: Management accounting plays a crucial role in
supporting strategic decision-making. It provides financial analysis, cost projections,
and scenario planning to evaluate strategic options and their financial implications.
By analyzing the costs, benefits, and risks of different strategic decisions,
management accounting assists managers in making informed choices that align with
the organization's long-term objectives.

In summary, management accounting provides managers with relevant, timely, and

comprehensive information to support decision-making across various aspects of an
organization. Its role in cost analysis, profitability assessment, budgeting, capital investment
decisions, risk assessment, performance evaluation, and strategic decision support highlights
its importance in enabling informed and effective decision-making. By leveraging
management accounting information, managers can make sound decisions that drive
organizational success, improve performance, and create value.

1.5 Summary
Management accounting is a branch of accounting that focuses on providing information and
analysis to internal management for decision-making, planning, control, and performance
evaluation. It involves the use of financial and non-financial data to provide insights and
support management in making informed decisions to achieve the organization's goals.
Management accounting goes beyond traditional financial accounting and incorporates
various techniques and tools to analyze costs, measure performance, and support strategic
planning.

Overall, management accounting is a vital function within an organization, providing

valuable information and analysis to support decision-making, planning, control, and
performance evaluation. It helps management make informed choices, optimize resource
allocation, improve operational efficiency, and achieve strategic objectives.

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1.6 Keywords
Management accounting, cost accounting, financial accounting, difference

1.7 Questions
1 Explain meaning, nature and significance of Management Accounting
2 Explain Meaning, Nature and significance of Cost accounting
3 Explain Meaning, Nature and significance of Financial Accounting
4 Explain Difference between cost, management and financial accounting
5 Comment on Role and importance of management accounting in decision- making

1.8 Case Study

Case Study: XYZ Manufacturing Company

XYZ Manufacturing Company is a medium-sized manufacturing company that produces

electronic gadgets. The company is facing challenges in managing its costs, optimizing its
product mix, and improving profitability. The management accounting team is tasked with
analyzing the company's financial data and providing recommendations to address these
issues.

Cost Analysis:
The management accounting team conducts a detailed cost analysis to identify the cost
drivers and areas of inefficiency within the company's operations. They analyze direct
material costs, direct labor costs, and overhead costs. By using techniques such as activity-
based costing (ABC), they allocate overhead costs to different products based on their actual
consumption of resources. This helps identify products that consume a disproportionate
amount of resources and allows for better cost control.

Product Mix Optimization:

The management accounting team analyzes the profitability of different product lines to
determine the optimal product mix. They calculate the contribution margin for each product
by deducting variable costs from sales revenue. By comparing the contribution margins, they
identify products with low profitability and recommend either improving their performance

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or considering discontinuation. They also consider market demand, customer preferences,
and production capacity to optimize the product mix.

Budgeting and Performance Measurement:

The management accounting team assists in the budgeting process by preparing detailed
budgets for various departments and cost centers. They collaborate with department
managers to set achievable targets and provide them with regular performance reports. By
comparing actual results against the budgeted figures, they identify variances and work with
managers to understand the reasons behind the deviations. This helps in taking corrective
actions and improving future budgeting accuracy.

Capital Investment Decisions:

The management accounting team evaluates potential capital investment projects, such as
upgrading machinery or expanding production facilities. They apply techniques like net
present value (NPV) analysis, internal rate of return (IRR), and payback period to assess the
financial viability of each investment. By considering factors such as projected cash flows,
required investment, and risk profile, they provide recommendations on whether to proceed
with the investments.

Cost Control Measures:

Based on the cost analysis findings, the management accounting team identifies cost control
measures to reduce expenses and improve profitability. They work closely with the
production department to identify opportunities for process improvement, cost reduction, and
waste elimination. They also analyze overhead costs to identify areas of inefficiency and
recommend strategies for cost optimization, such as renegotiating supplier contracts or
implementing energy-saving measures.

Strategic Planning:
The management accounting team participates in strategic planning exercises to align
financial goals with the company's long-term objectives. They provide financial analysis and
projections to support strategic decision-making. By considering market trends, competitive
analysis, and financial forecasts, they help management evaluate strategic options and make
informed choices that maximize value creation and long-term profitability.

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In conclusion, the management accounting team at XYZ Manufacturing Company plays a
crucial role in analyzing costs, optimizing the product mix, budgeting, performance
measurement, capital investment decisions, cost control, and strategic planning. Through
their analysis and recommendations, they assist management in improving the company's
financial performance and achieving its strategic objectives.

Question:
1. Explain the role of management accounting in the cost analysis of XYZ
company.
2. Explain the different decisions/suggestions given by the management
accounting team for the better performance of XYZ Ltd.
3. How management accounting team is going to help XYZ Ltd. For decision
making?

1.9 References
1. Tulsian P.C – Cost Accounting – Tata McGraw Hills 2
2. Jain & Narang: Principles and Practice of Cost Accounting, Kalyani
Publishers, Ludhiana.
3. M.Y. Khan & P.K. Jain : Cost and Management Accounting, Tata McGraw Hill
Publishing House, New Delhi

17
UNIT 2

TREND ANALYSIS

Learning Objectives

1. To understand the concepts of Comparative statement and Common size balance Sheet
2. To understand the trend Analysis
3. To learn the technique of Ratio Analysis

Structure

2.1 Introduction

2.2 Comparative statement

2.3 Common size balance Sheet

2.4 Trend Analysis

2.5 Ratio Analysis

2.6 Summary

2.7 Keywords

2.8 Questions

2.9 Case Study

2.10 References

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2.1 Introduction
A comparative statement and a common-size statement are two financial analysis tools used
to examine and understand the financial performance of a company. While both statements
provide valuable insights into the company's financial data, they differ in their approach and
focus.

A comparative statement, also known as a comparative financial statement, presents financial

information for multiple periods side by side. It allows for a year-to-year or period-to-period
comparison of financial data, such as income statements, balance sheets, and cash flow
statements. By presenting the data in this format, a comparative statement enables users to
identify trends, changes, and patterns in the company's financial performance over time. This
analysis helps to assess the company's growth, profitability, liquidity, and overall financial
health.

On the other hand, a common-size statement, also called a vertical analysis, focuses on the
relative proportions of different items within a single financial statement. It expresses each
line item as a percentage of a base figure, typically total assets for the balance sheet or net
sales for the income statement. By converting the financial statement into percentages, a
common-size statement allows for easy comparison and evaluation of the composition and
structure of the company's financial data. This analysis helps to identify the relative
significance of different items and assess the company's financial structure, efficiency, and
risk exposure.

In summary, while a comparative statement facilitates the comparison of financial data over
time, a common-size statement highlights the relative composition and significance of
different items within a single financial statement. Both statements provide valuable insights
for financial analysis and decision-making, albeit with different perspectives and purposes.

Why?

Comparative statements and common-size statements are valuable tools in financial analysis
for different reasons:

19
Comparative Statements:
Trend Analysis: Comparative statements enable the analysis of financial data over multiple
periods, allowing for the identification of trends, patterns, and changes in a company's
performance. This helps in evaluating the company's growth trajectory, stability, and overall
financial health.

Performance Evaluation: By comparing financial data across different periods, comparative

statements help assess the company's performance and determine if it has improved or
declined over time. This analysis can provide insights into the effectiveness of management
strategies and identify areas that require attention.

Benchmarking: Comparative statements allow for benchmarking the company's performance

against industry peers or competitors. By comparing financial metrics like revenue growth,
profitability, and efficiency ratios, companies can gauge their relative position and identify
areas for improvement.

Common-Size Statements:
Structure Analysis: Common-size statements convert each line item into a percentage of a
base figure (e.g., total assets or net sales), facilitating the analysis of the relative composition
and structure of a company's financial statements. This helps identify the proportionate
significance of different items and their impact on the overall financial picture.

Comparability: Common-size statements enable easy comparison of financial statements

across different time periods or companies. Since the data is presented as percentages, it
eliminates the influence of absolute figures and allows for a more meaningful comparison of
the financial structure and composition.

Identifying Trends: By analyzing the changes in the proportions of various line items over
time, common-size statements help identify trends in a company's financial structure. For
example, an increasing proportion of expenses compared to revenue may indicate
inefficiencies or cost control issues.

By utilizing both comparative statements and common-size statements, financial analysts and

20
decision-makers can gain comprehensive insights into a company's financial performance,
trends, and structure. These tools complement each other and provide a holistic view that aids
in informed decision-making, performance evaluation, and strategic planning.

By leveraging the benefits of both comparative statements and common-size statements,

financial analysts and decision-makers gain a comprehensive understanding of a company's
financial performance, trends, and structure. These tools provide valuable insights for
performance evaluation, strategic planning, and informed decision-making.

The main difference between comparative statements and common-size statements lies in their
focus and presentation format:

Focus:
Comparative Statements: Comparative statements focus on comparing financial data across
different periods or entities. They present side-by-side information, allowing for a direct
comparison of line items or financial statements between two or more periods. The emphasis
is on analyzing the changes, trends, and patterns in financial performance over time.

Common-Size Statements: Common-size statements focus on analyzing the relative

proportions of different line items within a single financial statement. They express each line
item as a percentage of a base figure, typically total assets for the balance sheet or net sales
for the income statement. The emphasis is on understanding the composition and structure of
the financial statement and identifying the relative significance of each line item.

Presentation Format:
Comparative Statements: Comparative statements are typically presented in a tabular format,
with columns representing different periods or entities being compared. This format allows
for a direct visual comparison of financial data, making it easier to identify changes and trends
across the periods or entities.

Common-Size Statements: Common-size statements are presented as a vertical analysis,

typically in the form of percentages. Each line item is expressed as a percentage of a base
figure, facilitating a relative comparison of the proportions of different line items within the

21
financial statement. This format highlights the composition and relative significance of each
line item.

In summary, comparative statements focus on comparing financial data over time or between
entities, while common-size statements focus on analyzing the relative proportions of line
items within a single financial statement. Comparative statements use a tabular format for
side-by-side comparison, while common-size statements use a vertical format with
percentages to highlight the composition and structure of the financial statement.

2.2 Comparative statement

A comparative statement serves as a means to analyze and evaluate the similarities and
differences between two or more subjects. By juxtaposing these subjects, we gain a deeper
understanding of their distinctive qualities and can draw meaningful conclusions about their
relative merits or drawbacks. Whether examining contrasting ideas, products, concepts, or
any other relevant entities, a comparative statement enables us to explore the nuances and
make informed judgments. Through careful analysis, we can identify key similarities,
highlight notable differences, and ultimately shed light on the unique aspects of each subject
being compared. This process of comparison allows us to gain valuable insights and make
informed decisions based on a comprehensive understanding of the similarities and
differences between different entities.

Types of Comparative Statements

Comparative statements, also known as comparative financial statements, are financial

statements that provide information for multiple periods, allowing for a comparison of
financial data over time. The main types of comparative statements include:

Comparative Income Statement: A comparative income statement presents the financial

performance of a company over two or more consecutive periods, typically side by side. It
includes revenue, expenses, and the resulting net income for each period. This type of
statement enables analysis of the company's revenue growth, expense trends, and profitability
over time. It helps in identifying changes in sales volume, cost structure, and overall financial
performance.

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Comparative Balance Sheet: A comparative balance sheet presents the financial position of a
company at the end of two or more consecutive periods. It includes assets, liabilities, and equity
for each period, typically side by side. This type of statement allows for a comparison of the
company's assets, liabilities, and equity structure over time. It helps in analyzing changes in
the company's liquidity, leverage, and capital structure.

Comparative Cash Flow Statement: A comparative cash flow statement shows the inflows and
outflows of cash for a company over two or more consecutive periods. It includes cash flows
from operating activities, investing activities, and financing activities for each period. This
type of statement allows for an analysis of changes in cash flow patterns, the sources and
uses of cash, and the company's ability to generate and manage cash over time.
Comparative Statement of Stockholders' Equity: A comparative statement of stockholders'
equity presents the changes in equity for a company over two or more consecutive periods. It
includes information on common stock, retained earnings, and other equity components for
each period. This type of statement helps in assessing the changes in equity structure, such as
capital contributions, dividend payments, and net income retention, over time.

By using comparative statements, analysts and stakeholders can track the performance,
financial position, and cash flow dynamics of a company over multiple periods. These
statements provide insights into trends, patterns, and changes in financial data, aiding in
decision-making, trend analysis, and the evaluation of a company's financial health and
stability.

Benefits of Comparative Statements:

Trend Identification: Comparative statements allow for the analysis of financial data over
multiple periods, enabling the identification of trends, patterns, and changes in a company's
performance. This helps in evaluating the company's progress, stability, and financial
trajectory.

Performance Evaluation: By comparing financial data across different periods, comparative

statements facilitate the assessment of a company's performance. They help determine if the
company has improved or declined over time, providing insights into the effectiveness of

23
management strategies and identifying areas that require attention.

Benchmarking: Comparative statements enable benchmarking of a company's performance

against industry peers or competitors. By comparing financial metrics like revenue growth,
profitability ratios, and efficiency indicators, companies can gauge their relative position and
identify areas for improvement.

Decision-Making: Comparative statements provide a basis for data-driven decision- making.

They help management, investors, and other stakeholders evaluate the financial impact of
decisions and assess the potential risks and opportunities associated with various courses of
action.

2.3 Common size Statements

Common-size statements, also known as vertical analysis, are financial statements that
present the components of a company's financial statements as a percentage of a base figure.
The purpose of common-size statements is to facilitate comparison and analysis of financial
data over time and between different companies.

In a common-size income statement, each line item is expressed as a percentage of net sales or
revenue. This allows for a clear understanding of the relative significance of each expense or
income category in relation to the company's total revenue. By using percentages, common-
size income statements enable analysts to identify trends, changes, and patterns in the
company's cost structure and revenue sources.

Similarly, in a common-size balance sheet, each line item is presented as a percentage of

total assets. This helps in assessing the composition of a company's assets, such as the
proportion of current assets to total assets or the relative weight of long-term assets. Common-
size balance sheets aid in evaluating the company's asset allocation, liquidity position, and
capital structure.

The main purpose of common-size statements is to facilitate comparisons, both within a

company's financial statements over different periods and between different companies
within the same industry. By expressing financial data as percentages, common-size

24
statements eliminate the impact of differences in company size and provide a standardized
basis for analysis.

Common-size statements offer several benefits. They simplify the interpretation of financial
data by highlighting the relative importance of different items and enabling easy
identification of trends and changes. They also allow for meaningful comparisons between
companies of different sizes and provide insights into the company's financial structure and
performance.

It is important to note that common-size statements should be used in conjunction with other
financial analysis tools and information to gain a comprehensive understanding of a company's
financial health. They provide a useful starting point for analysis but may not capture all the
nuances and complexities of a company's financial position and performance.
Overall, common-size statements enhance financial analysis by presenting financial data in a
standardized and comparable format. They provide a clear and concise view of the relative
composition of a company's income statement and balance sheet, enabling meaningful
analysis and informed decision-making.

Types of Common Size Statements

Common-size statements can be prepared for both the income statement and the balance
sheet. Here are the types of common-size statements:

Common-Size Income Statement: In a common-size income statement, each line item is

expressed as a percentage of net sales or revenue. This allows for a comparison of the
relative proportions of various income and expense categories in relation to the company's
total revenue. By presenting the income statement in this format, analysts can easily identify
the contribution of each line item to the overall revenue and evaluate the cost structure and
profitability of the company.

Common-Size Balance Sheet: In a common-size balance sheet, each line item is presented as
a percentage of total assets. This type of statement helps in understanding the relative
composition and weight of different assets on the company's balance sheet. It allows analysts

25
to assess the company's asset allocation, liquidity position, and capital structure. By expressing
each asset category as a percentage of total assets, it becomes easier to identify the proportion
of current assets to total assets or the relative weight of long-term assets.

In addition to the income statement and balance sheet, common-size statements can also be
prepared for the cash flow statement and statement of stockholders' equity. However, these
are less commonly used compared to the common-size income statement and balance sheet.

Common-Size Cash Flow Statement: A common-size cash flow statement presents each line
item as a percentage of net cash flows from operating activities. This allows for an analysis
of the cash inflows and outflows in relation to the company's operating cash flow. It helps in
understanding the proportion of cash flows allocated to various activities, such as operating,
investing, and financing activities, and their impact on the company's overall cash position.

Common-Size Statement of Stockholders' Equity: A common-size statement of stockholders'

equity expresses each line item as a percentage of total stockholders'
equity. It provides insights into the composition of stockholders' equity, including the
proportion of common stock, retained earnings, and other equity components. By presenting
the statement of stockholders' equity in this format, analysts can assess the impact of changes
in equity components and evaluate the company's capital structure and ownership patterns.

These different types of common-size statements help in analyzing and understanding the
relative proportions and relationships within financial statements. They enable meaningful
comparisons over time, across companies, or within industry benchmarks, aiding in financial
analysis and decision-making processes.

Benefits of Common-Size Statements:

Structure Analysis: Common-size statements convert financial data into percentages,

allowing for a detailed analysis of the relative composition and structure of a company's
financial statements. This helps identify the proportionate significance of different items and
their impact on the overall financial picture.

26
Comparability: Common-size statements facilitate easy comparison of financial statements
across different time periods or companies. Since the data is presented as percentages, it
eliminates the influence of absolute figures and enables a more meaningful comparison of
financial structures and compositions.

Trend Detection: By analyzing changes in the proportions of various line items over time,
common-size statements help identify trends in a company's financial structure. For example,
an increasing proportion of expenses compared to revenue may indicate inefficiencies or cost
control issues that require attention.

Insights into Financial Ratios: Common-size statements provide insights into various
financial ratios and indicators, such as profit margins, asset turnover ratios, and debt- to-
equity ratios. This aids in understanding the company's financial health, profitability,
efficiency, and leverage.

2.4 Trend Analysis

Trend analysis is a technique used in data analysis to identify and evaluate patterns or trends
over a specific period. It involves examining historical data or observations to identify
consistent patterns, tendencies, or changes in a particular variable or set of variables.

In the context of financial analysis, trend analysis focuses on studying the historical financial
data of a company to identify and understand patterns or trends in its financial performance
over time. Key financial statements such as income statements, balance sheets, and cash flow
statements are analyzed to observe trends in revenue, expenses, profitability, liquidity, and
other financial metrics.

The process of trend analysis typically involves the following steps:

Data Collection: Gathering historical financial data from reliable sources, such as financial
statements or databases.

Data Preparation: Organizing and formatting the data in a structured manner, often in the
form of a time-series dataset with observations for each period.

27
Plotting Data: Creating visual representations, such as line graphs or charts, to observe the
data trends over time. This allows for a visual assessment of the patterns or changes in the data.

Analysis and Interpretation: Examining the plotted data to identify and interpret trends, such
as increasing or decreasing patterns, cycles, or seasonal variations. This analysis helps in
understanding the company's financial performance and its potential future trajectory.

Drawing Conclusions: Based on the observed trends, drawing conclusions and making
informed judgments about the company's financial performance, strengths, weaknesses, and
potential risks or opportunities.

Trend analysis is widely used in various domains, including finance, economics, marketing,
and social sciences. It helps in understanding historical patterns, making predictions,
identifying outliers, and supporting decision-making processes. By analyzing trends,
organizations can gain insights into their performance, market dynamics, and make strategic
decisions based on historical patterns and future projections.

Trend analysis offers several advantages in the field of data analysis and decision- making.
Here are some key advantages of conducting trend analysis:
Identification of Patterns and Relationships: Trend analysis allows for the identification of
patterns, relationships, and tendencies in the data. By analyzing historical trends,
organizations can uncover valuable insights about the behavior and dynamics of the variables
under study. This knowledge helps in understanding the underlying factors that contribute to
the observed trends.

Predictive Insights: Analyzing historical trends can provide valuable predictive insights. By
identifying and understanding the patterns in the data, organizations can make informed
predictions and projections about future behavior. Trend analysis helps in forecasting future
trends, allowing businesses to anticipate market changes, customer behavior, demand
patterns, and other important factors.

Decision Making: Trend analysis provides a solid foundation for decision-making processes.

28
By examining trends over time, organizations can identify areas of improvement, potential
risks, and opportunities. This information enables decision- makers to develop strategies,
allocate resources, and make informed choices based on historical patterns and future
projections.

Performance Evaluation: Trend analysis helps in evaluating the performance of

organizations, products, or initiatives over time. By comparing current data with historical
trends, organizations can assess progress, track performance indicators, and identify areas of
success or improvement. This analysis supports performance evaluation and enables
organizations to make data-driven decisions to optimize outcomes.

Business Planning: Trend analysis plays a crucial role in strategic business planning. By
understanding past trends and projecting future behavior, organizations can develop realistic
goals, set targets, and formulate effective strategies. Trend analysis helps in identifying
market opportunities, assessing competitive landscapes, and aligning business plans with
changing market dynamics.

Early Detection of Anomalies or Outliers: Trend analysis helps in identifying anomalies or

outliers in the data. Sudden deviations or unexpected patterns can be detected through trend
analysis, enabling organizations to investigate further and take timely corrective actions. This
proactive approach helps in mitigating risks and optimizing business performance.

Overall, trend analysis empowers organizations to make informed decisions, anticipate future
changes, and optimize performance. By leveraging historical data patterns,
organizations can gain valuable insights, improve their competitive advantage, and make
strategic choices that align with market dynamics and their long-term objectives.

Users

Trend analysis is utilized by various users across different domains. Here are some key users
of trend analysis:

Businesses and Corporations: Companies of all sizes and across industries use trend analysis

29
to gain insights into their financial performance, market trends, consumer behavior, and
operational patterns. It helps businesses make informed decisions related to product
development, pricing strategies, marketing campaigns, inventory management, and overall
business planning.

Financial Analysts: Financial analysts employ trend analysis to evaluate the financial
performance of companies. They analyze trends in financial statements, key performance
indicators (KPIs), and market trends to assess the company's profitability, liquidity, solvency,
and overall financial health. This analysis aids in investment decision-making, financial
forecasting, and risk assessment.

Economists: Economists use trend analysis to understand economic indicators, such as GDP
growth, inflation rates, employment figures, and consumer spending patterns. By examining
long-term trends, economists can make predictions about the economy's future trajectory and
inform government policies, monetary decisions, and economic forecasts.

Market Researchers: Market researchers rely on trend analysis to identify market trends,
consumer preferences, and shifts in demand patterns. They analyze data from surveys, focus
groups, sales figures, and social media to understand consumer behavior and market
dynamics. This analysis assists in identifying emerging market trends, market segmentation,
and developing effective marketing strategies.

Policy Makers and Planners: Policy makers in government entities or non-profit

organizations use trend analysis to assess the impact of policies, social programs, and
initiatives. By analyzing trends in social, economic, or environmental data, they can evaluate
the effectiveness of interventions, identify areas of improvement, and guide future policy
decisions.
Demographers and Sociologists: Demographers and sociologists employ trend analysis to
study population trends, demographic shifts, and social patterns. They analyze data related to
birth rates, death rates, migration, education, and social behaviors to understand societal
changes, plan for future needs, and inform social policies.

Healthcare Professionals: Trend analysis is used in the healthcare sector to analyze patient

30
data, disease prevalence, treatment outcomes, and healthcare utilization. It helps healthcare
professionals identify patterns in disease incidence, monitor health indicators, and make data-
driven decisions to improve patient care and public health initiatives.

These are just a few examples of the diverse range of users who rely on trend analysis to gain
insights, make informed decisions, and guide their respective domains. Trend analysis is a
valuable tool for understanding patterns, predicting future trends, and informing strategic
actions across various fields and industries.

2.5 Ratio Analysis

Ratio analysis is a financial analysis technique that involves the calculation and interpretation
of various ratios to assess the financial performance, profitability, efficiency, and liquidity of
a company. It helps in understanding the relationships between different financial variables
and provides insights into the company's financial health and stability.

Ratio analysis involves comparing different financial ratios calculated from the company's
financial statements, such as the balance sheet, income statement, and cash flow statement.
These ratios are divided into different categories based on the aspect of the company's
performance they measure. Some common categories of ratios used in ratio analysis include:

Liquidity Ratios: These ratios measure the company's ability to meet short-term obligations
and assess its liquidity position. Examples include the current ratio and the quick ratio.

Profitability Ratios: Profitability ratios assess the company's ability to generate profits from
its operations. Examples include the gross profit margin, net profit margin, return on assets
(ROA), and return on equity (ROE).
Efficiency Ratios: Efficiency ratios evaluate the company's operational efficiency and
effectiveness in managing its assets and liabilities. Examples include inventory turnover,
accounts receivable turnover, and accounts payable turnover.

Solvency Ratios: Solvency ratios gauge the company's long-term financial stability and its
ability to meet long-term obligations. Examples include the debt-to-equity ratio, interest
coverage ratio, and debt ratio.

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Market Ratios: Market ratios analyze the company's market value and its performance in
relation to the market. Examples include the price-to-earnings ratio (P/E ratio) and the
earnings per share (EPS).

By analyzing these ratios and their trends over time, financial analysts and stakeholders can
assess the company's financial performance, profitability, efficiency, and overall financial
health. They can compare the ratios against industry benchmarks or competitors to gain a
relative perspective. Ratio analysis helps in identifying strengths, weaknesses, trends, and
areas that require attention, guiding decision-making processes and financial planning.

However, it is important to note that ratio analysis has limitations and should not be the sole
basis for making financial decisions. It is recommended to consider the broader context,
qualitative factors, and additional financial information when interpreting the results of ratio
analysis.

Advantages of Ratio Analysis

Ratio analysis offers several advantages in financial analysis and decision-making. Here are
some key advantages of using ratio analysis:

Performance Evaluation: Ratio analysis provides a comprehensive view of a company's

financial performance. It helps in assessing profitability, liquidity, solvency, efficiency, and
other key aspects of financial health. By comparing ratios over time or against industry
benchmarks, businesses can evaluate their performance, identify areas of strength or
weakness, and make data-driven decisions to improve performance.

Comparison and Benchmarking: Ratio analysis enables comparison and benchmarking of a

company's financial performance against industry peers, competitors, or historical trends.
This analysis provides insights into how a company is performing relative to its peers,
industry standards, or past performance. It helps in identifying areas where a
company is excelling or lagging behind, facilitating benchmarking and setting realistic goals.

32
Financial Health Assessment: Ratios provide a quick and concise assessment of a company's
financial health. They provide a snapshot of the company's ability to meet short-term and
long-term obligations, generate profits, manage assets and liabilities, and create value for
shareholders. Ratio analysis helps in identifying financial strengths and weaknesses,
providing a basis for strategic decision-making and risk management.

Trend Identification: By analyzing ratios over multiple periods, trend analysis can be
conducted to identify patterns and changes in a company's financial performance. This helps
in understanding the direction and magnitude of changes, evaluating the effectiveness of
management strategies, and forecasting future trends. Trend identification assists in proactive
decision-making and long-term planning.

Decision Support: Ratio analysis provides valuable information to support decision- making
processes. It helps management, investors, lenders, and other stakeholders in evaluating
investment opportunities, assessing creditworthiness, determining dividend policies, and
making informed decisions related to mergers, acquisitions, or expansion plans. Ratio
analysis assists in evaluating the financial impact of decisions and assessing the risks and
rewards associated with various options.

Early Warning Signals: Ratio analysis can serve as an early warning system by identifying
potential financial problems or red flags. Unfavorable trends or significant deviations from
industry norms can highlight underlying issues that may require attention. By monitoring
ratios regularly, businesses can take proactive measures to address potential risks and improve
financial performance.

Overall, ratio analysis is a powerful tool that provides valuable insights into a company's
financial performance and assists in decision-making processes. It facilitates performance
evaluation, benchmarking, trend identification, financial health assessment, and risk
management, enabling businesses to make informed decisions and optimize financial
outcomes.

Limitations of Ratio Analysis

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While ratio analysis is a valuable tool in financial analysis, it is important to be aware of its
limitations. Here are some limitations of ratio analysis:
Limited Context: Ratio analysis provides numerical comparisons and ratios but does not
provide a complete picture of the underlying factors and qualitative aspects that influence
financial performance. It does not take into account external factors such as industry trends,
economic conditions, competitive landscape, or management strategies. Therefore, it is
crucial to interpret ratios in the broader context and consider qualitative information alongside
quantitative analysis.

Lack of Standardization: Different companies may use different accounting methods and
practices, resulting in variations in financial reporting. This lack of standardization can affect
the comparability of ratios between companies. It is important to consider industry norms,
company-specific factors, and the reliability of financial data when comparing ratios.

Historical Data Focus: Ratio analysis relies on historical financial data, which may not
accurately reflect future performance or changes in the business environment. It does not
capture forward-looking information or consider potential future events, making it less
effective for predicting future outcomes.

Limited Industry Comparisons: While ratio analysis allows for benchmarking against
industry averages, industry-specific factors and variations can affect the usefulness of such
comparisons. Industries have unique dynamics, business models, and financial structures that
may not align with generalized benchmarks, leading to limited applicability in certain cases.

Manipulation of Financial Statements: Ratio analysis is based on financial statements, which

can be manipulated or distorted. Companies may employ accounting techniques or practices
that artificially improve or mask their financial ratios. It is important to be cautious and
consider potential accounting distortions or irregularities when interpreting ratios.

Lack of Complete Information: Ratio analysis is based on publicly available financial

statements, which may not include all relevant information about a company. It does not
consider non-financial factors such as market reputation, intellectual property, customer
relationships, or employee expertise, which can significantly impact a company's value and

34
performance.

Different Interpretations: Ratios can be interpreted differently by different analysts or users.

There is no absolute standard for what constitutes a "good" or "bad" ratio. Interpretation
depends on the specific context, industry, and company-specific factors.
It is essential to exercise judgment and consider multiple ratios and indicators to gain a
comprehensive understanding of the company's financial position.

Despite these limitations, ratio analysis remains a valuable tool in financial analysis when used
alongside other financial and qualitative information. It provides a structured framework for
assessing financial performance and making informed decisions, but it should be
complemented with a holistic understanding of the business, industry dynamics, and broader
economic factors.

Users of Ratio Analysis

Ratio analysis is utilized by various users in the financial and business sectors. Here are some
key users of ratio analysis:

Management and Executives: Company management and executives use ratio analysis to
evaluate the financial performance of their organization. It helps them understand the
company's profitability, liquidity, efficiency, and overall financial health. Ratio analysis
assists in identifying areas of improvement, making strategic decisions, and setting financial
goals.

Investors and Shareholders: Investors and shareholders use ratio analysis to assess the
financial position and performance of a company before making investment decisions. It
helps them understand the company's ability to generate returns, manage risks, and create
value. Ratio analysis assists investors in comparing different investment options and
evaluating the financial prospects of a company.

Lenders and Creditors: Lenders and creditors, such as banks and financial institutions, utilize
ratio analysis to assess the creditworthiness and financial stability of a company. It helps them

35
evaluate the company's ability to repay loans, meet financial obligations, and manage debt.
Ratio analysis assists lenders in making informed lending decisions and determining
appropriate interest rates and loan terms.

Financial Analysts: Financial analysts employ ratio analysis to analyze the financial
performance of companies. They calculate and interpret ratios to assess profitability,
liquidity, efficiency, and other financial indicators. Ratio analysis aids in conducting
financial research, providing investment recommendations, and assessing the overall health
of companies for clients or investors.
Auditors: Auditors use ratio analysis as part of their auditing process to evaluate the accuracy
and reliability of financial statements. It helps them assess the reasonableness of financial
figures and identify potential misstatements or irregularities. Ratio analysis supports auditors
in identifying areas that require further investigation and ensuring the compliance of financial
statements with accounting standards.

Consultants and Advisors: Business consultants and financial advisors utilize ratio analysis to
provide guidance and recommendations to clients. They assess the financial health of a
company, identify areas of improvement, and develop strategies for growth and profitability.
Ratio analysis assists consultants and advisors in making informed recommendations and
supporting their clients' financial decision-making processes.

Regulatory Agencies and Government Bodies: Regulatory agencies and government bodies
employ ratio analysis to monitor and assess the financial performance of companies within
their jurisdiction. It helps them ensure compliance with financial regulations, evaluate
industry standards, and identify potential risks or issues in the financial sector.

These are some of the key users of ratio analysis, and the application of ratio analysis extends
to various other stakeholders involved in financial analysis, decision-making, and monitoring
of companies' financial performance.

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2.6 Summary
Comparative statements and common-size statements are two important tools in financial
analysis. Here's a summary of each:

Comparative Statements:
Comparative statements provide a comparison of financial data over multiple periods,
typically side by side.
They include comparative income statements, balance sheets, cash flow statements, or
statements of stockholders' equity.
Comparative statements help track changes in financial performance, position, and cash flows
over time.
They assist in identifying trends, analyzing growth or decline patterns, and evaluating the
impact of business decisions or external factors.
Common-Size Statements:
Common-size statements, also known as vertical analysis, express financial statement items
as a percentage of a base figure.
Common-size statements can be prepared for income statements, balance sheets, cash flow
statements, or statements of stockholders' equity.
Common-size income statements express line items as a percentage of net sales, while
common-size balance sheets express line items as a percentage of total assets.
Common-size statements facilitate comparison by eliminating the impact of differences in
company size and provide a standardized basis for analysis.
They help identify the relative significance of each line item, assess the composition of
financial statements, and detect trends or changes in financial ratios.
Both comparative statements and common-size statements serve different purposes in
financial analysis. Comparative statements focus on tracking changes over time, while
common-size statements emphasize the relative proportions and composition of financial
data. Together, these tools provide valuable insights into a company's financial performance,
position, and trends, enabling informed decision-making and strategic planning.

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2.7 Keywords
Comparative statement, Common size balance Sheet, Trend Analysis, Ratio Analysis

2.8 Questions
1. What is Comparative statement? Explain the benefits.
2. What is Common size Statement? Explain the types.
3. State the difference between comparative statements and common size statements.
4. Write a short note on Trend Analysis.
5. Write a short note on Ratio Analysis.

2.9 Case Study

Case Study: Comparative Statements and Common-Size Statements

Company X is a retail company that operates in the fashion industry. They have recently
released their financial statements for the past three years (Year 1, Year 2, and Year 3) and
want to analyze the trends and changes in their financial performance using comparative
statements and common-size statements.

Comparative Income Statement Analysis:

By preparing a comparative income statement, Company X can compare their revenue,

expenses, and net income over the three years.
They notice that their revenue has been steadily increasing, showing a positive sales growth
trend.
However, they also observe that their expenses, particularly marketing and administrative
expenses, have increased at a higher rate than their revenue.
As a result, their net income has declined in Year 3 compared to Year 2, indicating a
potential profitability issue that needs further investigation.

Common-Size Income Statement Analysis:

Company X can create common-size income statements for each year by expressing each

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expense item as a percentage of net sales.
They find that marketing expenses as a percentage of net sales have increased from Year 1
to Year 3, indicating a higher marketing cost burden.
Administrative expenses have also increased as a percentage of net sales, suggesting
potential inefficiencies in overhead management.
By using common-size income statements, Company X can pinpoint specific areas of
concern in their cost structure and assess the impact on their overall profitability.

Comparative Balance Sheet Analysis:

Company X prepares a comparative balance sheet to compare their assets, liabilities, and
equity positions over the three years.
They observe that their total assets have increased significantly from Year 1 to Year 3,
indicating growth and expansion.
However, their long-term debt has also increased substantially, which might require closer
monitoring to ensure debt levels are sustainable.
By analyzing the changes in assets and liabilities, Company X can assess their financial
position, leverage, and capital structure.

Common-Size Balance Sheet Analysis:

Company X can create common-size balance sheets for each year by expressing each asset
and liability item as a percentage of total assets.
They find that current assets as a percentage of total assets have decreased over the years,
potentially affecting liquidity and working capital management.
Long-term assets, such as property and equipment, have also increased as a percentage of total
assets, indicating a higher investment in fixed assets.
Common-size balancesheets allow Company X to evaluate changes in asset composition,
liquidity ratios, and long-term investment strategies.
By utilizing comparative statements and common-size statements, Company X can gain
valuable insights into their financial performance, identify trends, and assess key financial
ratios. This analysis can help them make informed decisions, address areas of concern, and
plan for future growth and profitability.

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2.10 References
1. Tulsian P.C – Cost Accounting – Tata McGraw Hills 2
2. Jain & Narang: Principles and Practice of Cost Accounting, Kalyani
Publishers, Ludhiana.
3. M.Y. Khan & P.K. Jain: Cost and Management Accounting, Tata McGraw Hill
Publishing House, NewDelhi

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UNIT 3

RATIO ANALYSIS

Learning Objectives

1. To Understand the financial analysis

2. To understand advantages and disadvantages of Ratio Analysis
3. To list the various techniques of ratio analysis

Structure

3.1 Introduction to Financial Statement Analysis

3.2 Uses of ratio analysis
3.3 Types of financial ratios
3.4 Liquidity ratios
3.5 Solvency ratios
3.6 Efficiency ratios
3.7 Profitability ratios
3.8 Valuation ratios
3.9 Limitations of Ratio Analysis
3.10 Numericals
3.11 Summary
3.12 Keywords
3.13 Questions
3.14 Case Study
3.15 References

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3.1 Introduction to Financial Statement Analysis
Financial statement analysis is the process of evaluating and interpreting the financial
statements of a company to gain insights into its financial performance, position, and cash
flows. It involves examining financial statements such as the income statement, balance
sheet, and cash flow statement to assess the company's profitability, liquidity, solvency, and
overall financial health.

Here are some key aspects and techniques used in financial statement analysis:

Financial Ratios: Financial ratios are mathematical calculations that help assess various
aspects of a company's performance and financial position. Some common ratios include
profitability ratios (e.g., gross profit margin, net profit margin), liquidity ratios (e.g., current
ratio, quick ratio), and solvency ratios (e.g., debt-to-equity ratio, interest coverage ratio).
These ratios provide insights into the company's efficiency, ability to meet short-term
obligations, and leverage levels.

Trend Analysis: Trend analysis involves comparing financial data over multiple periods to
identify patterns, changes, and trends. By analyzing the direction and magnitude of changes
in key financial metrics over time, analysts can assess a company's growth, stability, and
potential future performance.

Common-Size Analysis: Common-size analysis involves expressing financial statement items

as percentages of a base value, typically total assets or net sales. This allows for easy
comparison across different periods or between companies of different sizes. Common-size
analysis helps identify trends, changes in the composition of financial statements, and
potential areas of concern.

Vertical and Horizontal Analysis: Vertical analysis involves expressing each line item on the
financial statement as a percentage of a common base, such as net sales for the income
statement or total assets for the balance sheet. Horizontal analysis, on the other hand, compares
financial statement data over consecutive periods, highlighting changes in amounts and
percentages.

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Cash Flow Analysis: The cash flow statement provides information about a company's cash
inflows and outflows from operating, investing, and financing activities. Analyzing the cash
flow statement helps evaluate the company's ability to generate cash, its liquidity position,
and the quality of its earnings.

Comparative Analysis: Comparative analysis involves comparing a company's financial

performance and ratios to its industry peers or competitors. This analysis provides insights
into the company's relative strengths and weaknesses and helps identify areas where it may
outperform or underperform its peers.

Qualitative Factors: In addition to quantitative analysis, it's important to consider qualitative

factors such as industry trends, management quality, competitive advantages, and regulatory
environment. These factors can significantly impact a company's financial performance and
should be considered alongside the numerical analysis.

Financial statement analysis is a valuable tool for investors, creditors, analysts, and
management to assess the financial health and performance of a company. It helps in
decision-making processes, such as investment decisions, credit evaluations, and strategic
planning.

3.2 Uses of ratio analysis

Ratio analysis is a powerful tool in financial statement analysis that helps evaluate a
company's performance, profitability, liquidity, solvency, and efficiency. Here are some
specific uses of ratio analysis:

Performance Evaluation: Ratios can be used to assess a company's overall financial

performance and compare it to previous periods or industry benchmarks. Profitability ratios
such as gross profit margin, net profit margin, and return on equity (ROE) provide insights
into the company's ability to generate profits from its operations.

Financial Health Assessment: Ratios help evaluate the financial health and stability of a
company. Liquidity ratios such as the current ratio and quick ratio indicate the company's

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ability to meet short-term obligations. Solvency ratios like the debt-to- equity ratio and
interest coverage ratio measure the company's long-term debt-paying ability and financial
leverage.

Trend Analysis: Ratios are useful for analyzing financial trends over multiple periods. By
comparing ratios from different periods, analysts can identify patterns, changes, and
trends in a company's financial performance. This helps assess the company's growth
trajectory, profitability consistency, and financial stability.

Comparative Analysis: Ratios enable comparison of a company's financial performance with

its industry peers or competitors. Benchmarking ratios against industry averages or
competitors' ratios helps identify the company's relative strengths and weaknesses. It can also
highlight areas where the company is outperforming or lagging behind its peers.

Forecasting and Projection: Ratios can be used as a basis for financial forecasting and
projection. By analyzing historical trends in ratios and applying them to future expected
financial data, analysts can estimate future performance and assess the potential impact of
various scenarios on the company's financial position.

Investment Decision-Making: Ratio analysis is valuable for investors in evaluating potential

investment opportunities. By analyzing key ratios, investors can assess the profitability,
growth potential, and financial stability of a company. Ratios also provide insights into the
company's ability to generate returns for shareholders and the overall risk associated with the
investment.

Creditworthiness Assessment: Creditors and lenders use ratios to evaluate a company's

creditworthiness and determine its ability to repay debts. Ratios such as the debt-to- equity
ratio, interest coverage ratio, and cash flow ratios provide insights into the company's
financial risk and its capacity to service its debts.

Management Decision-Making: Ratios assist management in decision-making processes,

such as resource allocation, budgeting, and performance monitoring. They help identify areas
of improvement, efficiency bottlenecks, and potential risks that require attention.

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Overall, ratio analysis is a versatile tool that provides valuable insights into various aspects
of a company's financial performance, helping stakeholders make informed decisions and
assess the company's financial health.

3.3 Types Of Financial Ratios

Financial ratios are mathematical calculations that provide insights into different aspects of a
company's financial performance, position, and efficiency. These ratios are derived
from the financial statements of a company, including the income statement, balance sheet,
and cash flow statement. Here are some commonly used financial ratios:

Profitability Ratios:
• Gross Profit Margin = (Gross Profit / Net Sales) * 100
• Net Profit Margin = (Net Income / Net Sales) * 100
• Return on Assets (ROA) = (Net Income / Average Total Assets) * 100
• Return on Equity (ROE) = (Net Income / Average Shareholders' Equity) * 100
• Earnings per Share (EPS) = (Net Income - Preferred Dividends) / Average Number of
Common Shares Outstanding

Liquidity Ratios:
• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio (Acid-Test Ratio) = (Current Assets - Inventory) / Current Liabilities
• Cash Ratio = Cash and Cash Equivalents / Current Liabilities Solvency Ratios:
• Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
• Debt Ratio = Total Debt / Total Assets
• Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Efficiency Ratios:
• Asset Turnover Ratio = Net Sales / Average Total Assets
• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
• Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

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• Accounts Payable Turnover Ratio = Purchases / Average Accounts Payable Market
Ratios:

• Price-to-Earnings Ratio (P/E Ratio) = Market Price per Share / Earnings per Share
• Price-to-Sales Ratio (P/S Ratio) = Market Price per Share / Net Sales per Share
• Dividend Yield = Dividends per Share / Market Price per Share
These ratios are just a sample of the many ratios available, and the selection of ratios to use
depends on the specific analysis objectives and industry characteristics. Ratios are typically
used to compare a company's performance over time, benchmark against industry peers, or
assess trends and financial health.

3.4 Liquidity Ratios

Liquidity ratios are financial ratios that measure a company's ability to meet its short- term
obligations and assess its liquidity position. These ratios help determine whether a company
has sufficient liquid assets to cover its current liabilities. Here are some commonly used
liquidity ratios:

Current Ratio: The current ratio measures the company's ability to repay its short-term
obligations with its short-term assets. It is calculated by dividing current assets by current
liabilities.

Current Ratio = Current Assets / Current Liabilities

A higher current ratio indicates a stronger liquidity position, as the company has more
current assets to cover its current liabilities. However, an excessively high current ratio may
suggest inefficiency in managing working capital.

Quick Ratio (Acid-Test Ratio): The quick ratio is a more stringent measure of liquidity that
excludes inventory from current assets, as inventory may not be easily converted to cash in the
short term. It is calculated by dividing the sum of cash, cash equivalents, marketable
securities, and accounts receivable by current liabilities.

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Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable)
/ Current Liabilities

The quick ratio provides a more conservative assessment of a company's ability to meet its
short-term obligations.

Cash Ratio: The cash ratio is the most conservative measure of liquidity, focusing solely on a
company's cash and cash equivalents in relation to its current liabilities. It indicates the
company's ability to cover its current liabilities with its readily available cash resources.

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

A higher cash ratio indicates a stronger ability to meet short-term obligations using cash
resources.

Liquidity ratios are important for assessing a company's ability to manage its short-term
financial obligations and maintain a healthy cash flow. However, it is essential to consider
industry norms, business cycles, and the specific circumstances of the company when
interpreting these ratios, as different industries may have different liquidity requirements.

3.5 Solvency ratios

Solvency ratios are financial ratios that assess a company's long-term financial stability and
its ability to meet its long-term obligations. These ratios provide insights into a company's
capital structure, leverage levels, and its capacity to handle debt. Solvency ratios are of
interest to investors, creditors, and stakeholders who want to evaluate a company's financial
risk and its ability to sustain its operations. Here are some commonly used solvency ratios:

Debt-to-Equity Ratio: The debt-to-equity ratio measures the proportion of debt financing to
equity financing in a company's capital structure. It indicates the company's reliance on debt
and its ability to cover its obligations with equity.

Debt-to-Equity Ratio = Total Debt / Shareholders' Equity

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A higher debt-to-equity ratio indicates a higher degree of financial leverage and potential
financial risk. It suggests that a significant portion of the company's funding comes from
debt, which can increase interest expenses and impact the company's financial stability.

Debt Ratio: The debt ratio measures the proportion of a company's total assets that is
financed by debt. It provides insights into the company's overall debt exposure and financial
risk.

Debt Ratio = Total Debt / Total Assets

A higher debt ratio suggests a higher reliance on debt financing and potentially higher
financial risk. It indicates that a larger portion of the company's assets is financed by debt,
which can impact its ability to meet long-term obligations.

Interest Coverage Ratio: The interest coverage ratio assesses a company's ability to meet its
interest payments using its operating profits. It indicates whether the company generates
sufficient earnings to cover its interest expenses.

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

A higher interest coverage ratio implies that the company generates enough earnings to cover
its interest payments comfortably. It signifies a lower risk of defaulting on interest payments.

Debt Service Coverage Ratio (DSCR): The debt service coverage ratio measures a company's
ability to meet its debt service obligations, including interest and principal payments, from its
operating cash flows. It is often used in industries with significant long-term debt obligations,
such as infrastructure or project finance.

DSCR = Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) / Total
Debt Service (Principal and Interest)

A DSCR greater than 1 indicates that the company generates sufficient cash flow to cover its

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debt obligations. It suggests a lower risk of defaulting on debt payments.

Solvency ratios provide valuable insights into a company's financial risk, capital structure,
and ability to handle long-term obligations. However, it is important to interpret these ratios
in the context of the industry, business cycle, and other relevant factors to gain a
comprehensive understanding of a company's solvency position.

3.6 Efficiency ratios

Efficiency ratios, also known as activity ratios or asset management ratios, measure how
effectively a company utilizes its assets to generate sales, manage inventory, collect
receivables, and generate profits. These ratios provide insights into a company's operational
efficiency, productivity, and utilization of resources. Here are some commonly used
efficiency ratios:

Inventory Turnover Ratio: The inventory turnover ratio measures how efficiently a company
manages its inventory by calculating the number of times inventory is sold and replaced during
a specific period.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

A higher inventory turnover ratio indicates that the company is efficiently managing its
inventory and has a shorter inventory holding period.

Accounts Receivable Turnover Ratio: The accounts receivable turnover ratio measures the
effectiveness of a company's credit and collection policies by determining how quickly it
collects payment from its customers.

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

A higher accounts receivable turnover ratio suggests that the company collects payment from
its customers more quickly.

Accounts Payable Turnover Ratio: The accounts payable turnover ratio assesses the

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efficiency of a company's payment to its suppliers by measuring how quickly it pays off its
trade payables.

Accounts Payable Turnover Ratio = Purchases / Average Accounts Payable

A higher accounts payable turnover ratio indicates that the company is paying its suppliers
promptly.

Asset Turnover Ratio: The asset turnover ratio measures how effectively a company uses its
assets to generate sales.

Asset Turnover Ratio = Net Sales / Average Total Assets

A higher asset turnover ratio indicates that the company is efficiently utilizing its assets to
generate revenue.

Fixed Asset Turnover Ratio: The fixed asset turnover ratio evaluates how efficiently a
company uses its fixed assets (such as property, plant, and equipment) to generate sales.

Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets

A higher fixed asset turnover ratio suggests that the company is effectively utilizing its fixed
assets to generate revenue.

Efficiency ratios vary across industries, and it is crucial to compare them with industry
benchmarks or competitors' ratios to gain meaningful insights. These ratios help identify areas
of operational improvement, optimize resource allocation, and enhance overall business
efficiency.

3.7 Profitability ratios

Profitability ratios are financial ratios that assess a company's ability to generate profits and
returns from its operations. These ratios measure the company's profitability in relation to its

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sales, assets, and equity. Profitability ratios are used by investors, creditors, and management
to evaluate the company's financial performance and its ability to generate sustainable profits.
Here are some commonly used profitability ratios:

Gross Profit Margin: The gross profit margin measures the percentage of revenue remaining
after deducting the cost of goods sold. It indicates the company's ability to generate profit
from its core operations.

Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue

A higher gross profit margin indicates better profitability, as the company retains a larger
proportion of revenue after covering direct production costs.

Net Profit Margin: The net profit margin measures the percentage of revenue remaining as net
income after deducting all expenses, including operating expenses, interest, and taxes. It
reflects the company's overall profitability.

Net Profit Margin = Net Income / Revenue

A higher net profit margin indicates better profitability, as the company retains a larger
proportion of revenue as profit.

Return on Assets (ROA): The return on assets ratio measures the company's ability to
generate profits from its total assets.

Return on Assets (ROA) = Net Income / Average Total Assets

ROA indicates how efficiently the company utilizes its assets to generate profits. A higher ROA
suggests better profitability and asset utilization.

Return on Equity (ROE): The return on equity ratio measures the company's ability to
generate returns for its shareholders based on their equity investment.

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Return on Equity (ROE) = Net Income / Average Shareholders' Equity

ROE shows how effectively the company generates profits using the shareholders' capital. A
higher ROE suggests better profitability and shareholder value creation.

Earnings per Share (EPS): Earnings per share measures the company's profitability on a per-
share basis.

Earnings per Share (EPS) = Net Income / Average Number of Shares Outstanding

EPS indicates the portion of the company's profits allocated to each outstanding share.
Higher EPS signifies better profitability per share.

These profitability ratios help evaluate a company's financial performance and profitability
relative to its revenue, assets, and equity. However, it's important to consider industry norms,
competitive dynamics, and other factors when interpreting these ratios, as profitability can
vary across industries and companies.

3.8 Valuation ratios

Valuation ratios, also known as market ratios, are financial ratios used to assess the valuation
of a company's stock or its attractiveness as an investment. These ratios compare a company's
market price per share to its earnings, book value, or other financial metrics. Valuation ratios
help investors and analysts determine whether a stock is overvalued, undervalued, or fairly
priced. Here are some commonly used valuation ratios:

Price-to-Earnings Ratio (P/E Ratio): The price-to-earnings ratio compares a company's stock
price to its earnings per share (EPS). It indicates how much investors are willing to pay for
each dollar of earnings.

P/E Ratio = Market Price per Share / Earnings per Share

A higher P/E ratio suggests that investors are willing to pay a premium for the company's
earnings, indicating higher market expectations for future growth. However, a very high P/E

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ratio may also indicate an overvalued stock.

Price-to-Sales Ratio (P/S Ratio): The price-to-sales ratio compares a company's stock price to
its revenue per share. It indicates how much investors are willing to pay for each dollar of
sales.

P/S Ratio = Market Price per Share / Revenue per Share

The P/S ratio is useful when a company has negative or volatile earnings. A lower P/S ratio
may indicate a relatively undervalued stock compared to its revenue.

Price-to-Book Ratio (P/B Ratio): The price-to-book ratio compares a company's stock price
to its book value per share. It assesses whether the stock is trading at a premium or discount
relative to its net asset value.

P/B Ratio = Market Price per Share / Book Value per Share

A higher P/B ratio suggests that investors are willing to pay a premium for the company's assets
and future earnings potential. Conversely, a lower P/B ratio may indicate an undervalued
stock.

Dividend Yield: The dividend yield measures the annual dividend income as a percentage of
the stock's market price. It indicates the return on investment from dividends.

Dividend Yield = Dividends per Share / Market Price per Share

A higher dividend yield may suggest a relatively attractive investment for income- focused
investors. However, it's important to consider the company's dividend sustainability and
growth prospects.

Earnings Yield: The earnings yield is the inverse of the P/E ratio and represents the
company's earnings as a percentage of its stock price.

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Earnings Yield = Earnings per Share / Market Price per Share

A higher earnings yield suggests that the stock may be relatively undervalued or have higher
earning potential.

These valuation ratios provide insights into the relative pricing and attractiveness of a
company's stock. However, it's important to consider other factors, such as industry
dynamics, company fundamentals, growth prospects, and market conditions, when making
investment decisions.

3.9 Limitations of Ratio Analysis

While ratio analysis is a valuable tool for financial analysis, it also has its limitations. It's
important to be aware of these limitations when interpreting and using ratios. Here are some
common limitations of ratio analysis:

Limited Comparability: Ratios are most meaningful when they are compared to benchmarks,
such as industry averages or competitors' ratios. However, it can be challenging to find
reliable and up-to-date benchmark data. Different industries have varying norms and
operating models, which can make comparisons difficult.

Lack of Context: Ratios provide numerical insights, but they don't provide the complete
context behind the numbers. They don't take into account the company's unique
circumstances, such as industry-specific factors, market conditions, or management
strategies. It's crucial to complement ratio analysis with a thorough understanding of the
company's operations, competitive landscape, and broader economic factors.

Historical Analysis: Ratios are based on historical financial data, which may not accurately
reflect the company's current or future performance. Financial ratios are backward-looking
and may not capture significant changes in the company's operations, market dynamics, or
strategic initiatives.

Accounting Policies and Manipulation: Ratios rely on the accuracy and consistency of

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financial statements. However, companies can employ different accounting policies, which
can affect the calculation and interpretation of ratios. Additionally, there is a risk of financial
statement manipulation, where companies intentionally manipulate their financial data to
present a more favorable picture. It's important to scrutinize the quality and integrity of
financial statements when using ratios.

Lack of Non-Financial Information: Ratios focus solely on financial data and may not
capture important non-financial factors that can impact a company's performance and
prospects, such as customer satisfaction, employee engagement, innovation, and brand
reputation. It's important to consider non-financial information alongside financial ratios for
a holistic assessment.

Ignoring Time Value of Money: Ratios generally provide static snapshots of a company's
financial position and performance. They don't consider the time value of money, such as the
impact of inflation or the present value of future cash flows. Discounted cash flow analysis or
other valuation methods may be more appropriate when assessing the intrinsic value of a
company.

Industry and Company Size Differences: Ratios can vary significantly across industries and
company sizes. What may be considered a good ratio in one industry or for a large company
may not hold true for another industry or a smaller company. It's important to consider
industry and company-specific factors when interpreting ratios.

It's crucial to recognize these limitations and use ratios as part of a comprehensive analysis
that incorporates qualitative factors, industry knowledge, and a deep understanding of the
company's unique circumstances. Ratios should be used as a starting point for analysis and
not as standalone measures of a company's financial health.

3.10 Numericals

Example 1
From the following information Calculate Current Ratio.

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Trade receivables (debtors) 1, 00,000 Bills payable 20,000
Prepaid Expenses 10,000 Sundry Creditors 40,000
Cash and cash equivalents 30,000 Debentures 2,00,000
Short term investments 20,000 Inventories 40,000
Machinery 7,000 Expenses Payable 40,000

Solution
Current Ratio = Current Assets / Current Liabilities
= 2, 00,000 / 1, 00,000 = 2 : 1

Current Assets = Trade Receivables (sundry Debtors) + prepaid Expenses + cash and cash
Equivalents + short term Investments + inventories
= 1,00,000 + 10,000 + 30,000 + 20,000 + 40,000 = 2,00,000
Current Liabilities: trade payables (Bills Payable + sundry creditors) + expenses payable
= 20,000 + 40,000 + 40,000 = 1, 00,000

Example 2
Calculate ‘Liquidity Ratio’ from the following information: Current liabilities = Rs. 50,000
Current assets = Rs. 80,000 Inventories = Rs. 20,000 Advance tax = Rs. 5,000 Prepaid
expenses = Rs. 5,000

Solution:
Liquidity Ratio = Liquid Assets/Current Liabilities
Liquidity Assets = Current assets − (Inventories + Prepaid expenses + Advance tax)
= Rs. 80,000 − (Rs. 20,000 + Rs. 5,000 + Rs. 5,000) = Rs. 50,000
Liquidity Ratio = Rs. 50,000 / 50,000 = 1 : 1.

Example 3:
X Ltd., has a current ratio of 3.5 : 1 and quick ratio of 2 : 1. If excess of current assets over
quick assets represented by inventories is Rs. 24,000, calculate current assets and current
liabilities.

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Solution:
Current Ratio = 3.5 : 1 Quick Ratio = 2 : 1 Let Current liabilities = x
Current assets = 3.5x and Quick assets = 2x
Inventories = Current assets − Quick assets 24,000 = 3.5x − 2x
24,000 = 1.5x
Current Liabilities = Rs. 16,000
Current Assets = 3.5x = 3.5 × Rs. 16,000 = Rs. 56,000. Verification:
Current Ratio = Current assets : Current liabilities
= Rs. 56,000 : Rs. 16,000
= 3.5: 1
Quick Ratio = Quick assets : Current liabilities
= Rs. 32,000 : Rs. 16,000 = 2 : 1
Example 4:
From the following information calculate Debt equity Ratio:-

Share capital: 10,000 shares of 10 each 1,00,000 debentures 75,000 General

Reserve 45000 Long term provision 25,000 Surplus 30,000
Outstanding Expenses 10,000

Solution:
Debt to equity ratio = Debt / Equity (shareholder funds) = 1,00,000 / 1,75,000 = 0.57
:1
Debt = Debentures + Long term provisions = 75,000 + 25,000 = 1,00,000
Equity = Share Capital + General Reserve + Surplus = 1,00,000 + 45,000 + 30,000 =
1,75,000

(b) Total Assets to Debt Ratio This ratio measures the extent of the coverage of long- term
debts by assets

Total assets to Debt Ratio = Total assets/Long-term debts Example 5:

Shareholders’ funds Rs. 1,40,000 Total Debts (Liabilities) Rs. 18,00,000 Current Liabilities =
Rs. 2,00,000.
Calculate total assets to debt ratio. Solution:

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Total Assets to debt ratio = Total Assets / Long term Debts
= 32,00,000 / 16,00,000 = 2 : 1
Long term debts = total debts (Liabilities) − Current Liabilities
= 18,00,000 − 2,00,000 = 16,00,000
Total assets = shareholder funds + total debts (liabilities)

Example 6:
From the following details, calculate interest coverage ratio:
Net Profit after tax Rs. 60,000; 15% Long-term debt 10,00,000; and Tax rate 40%. Solution:
Net Profit after Tax = Rs. 60,000 Tax Rate = 40%
Net Profit before tax = Net profit after tax × 100/ (100 − Tax rate)
= Rs. 60,000 × 100/(100 − 40)
= Rs. 1,00,000
Interest on Long-term Debt = 15% of Rs. 10,00,000 = Rs. 1,50,000 Net profit before interest
and tax = Net profit before tax + Interest
= Rs. 1,00,000 + Rs. 1,50,000 = Rs. 2,50,000
Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on long-term debt
= Rs. 2,50,000/Rs. 1,50,000
= 1.67 times

Example 7:
From the following information, calculate inventory turnover ratio:

Inventory in the beginning = 18,000 Inventory at the end = 22,000

Net purchases = 46,000 Wages = 14,000
Revenue from operations = 80,000 Carriage inwards = 4,000

Solution:
Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
Cost of Revenue from Operations = Inventory in the beginning + Net Purchases + Wages
+ Carriage inwards − Inventory at the end
= Rs. 18,000 + Rs. 46,000 + Rs. 14,000 + Rs. 4,000 − Rs. 22,000 = Rs. 60,000
Average Inventory = Inventory in the beginning + Inventory at the end / 2

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= Rs. 18,000 + Rs. 22,000/ 2 = Rs. 20,000
∴ Inventory Turnover Ratio = Rs. 60,000/ Rs. 20,000 = 3 Times

Example 8:
Calculate the Trade receivables turnover ratio from the following information:

Total Revenue from operations 4,00,000

Cash Revenue from operations 20% of Total Revenue from operations Trade receivables as at
1.4.2014 40,000
Trade receivables as at 31.3.2015 1,20,000 Solution:
Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade
Receivables
Credit Revenue from operations = Total revenue from operations − Cash revenue from
operations
Cash Revenue from operations = 20% of Rs. 4,00,000
= Rs. 4,00,000 × 20 / 100 = Rs. 80,000
Credit Revenue from operations = Rs. 4,00,000 − Rs. 80,000 = Rs. 3,20,000
Average Trade Receivables = Opening Trade Receivables + Closing Trade Receivables / 2
= Rs. 40,000 + Rs. 1,20,000 / 2 = Rs. 80,000
= Net Credit Revenue Form Operations / Average Inventory
= Rs. 3,20,000 / Rs. 80,000 = 4 times.

Example 9:
Calculate the Trade payables turnover ratio from the following figures:

Credit purchases during 2014-15 = 12,00,000

Creditors on 1.4.2014 = 3,00,000
Bills Payables on 1.4.2014 = 1,00,000
Creditors on 31.3.2015 = 1,30,000
Bills Payables on 31.3.2015 = 70,000

Solution:
Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables Average

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Trade Payables = Creditors in the beginning + Bills payables in the beginning
+ Creditors at the end + Bills payables at the end / 2
= Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,30,000 + Rs. 70,000 2 = Rs. 3,00,000
∴ Trade Payables Turnover Ratio = Rs. 12,00,000 / Rs. 3,00,000 = 4 times

Example 10:
From the following information, calculate –

Trade receivables turnover ratio Average collection period

Trade payable turnover ratio
Given:

Revenue from Operations 8,75,000 Creditors90,000

Bills receivable 48,000
Bills payable 2,000
Purchases 4,20,000
Trade debtors 59,000 Solution:
Trade Receivables Turnover Ratio = Net Credit Revenue from operation / Average Trade
Receivable
= Rs. 8, 75,000 / (Rs. 59,000 + Rs. 48,000) = 8.18 times
Average Collection Period = 365 / Trade Receivables Turnover Ratio = 365 / 8.18 = 45 days
Trade Payable Turnover Ratio = Purchases / Average Trade Payables
= Purchases / Creditors + Bills payable
= 4,20,000 / 90,000 + 52,000
= 4,20,000 / 1,42,000 = 2.96 times

Example 11:
Following information is available for the year 2014-15, calculate gross profit ratio: Revenue
from Operations: Cash 25,000
Credit 75,000
Purchases: Cash 15,000
Credit 60,000

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Carriage Inwards 2,000
Salaries 25,000
Decrease in Inventory10,000 Return Outwards 2,000
Wages 5,000

Solution:
Revenue from Operations = Cash Revenue from Operations + Credit Revenue from
Operation
= Rs.25, 000 + Rs.75, 000 = Rs. 1,00,000
Net Purchases = Cash Purchases + Credit Purchases − Return Outwards
= Rs. 15,000 + Rs. 60,000 − Rs. 2,000 = Rs. 73,000
Cost of Revenue from = Purchases + (Opening Inventory − Closing Inventory) +
operations Direct Expenses
= Purchases + Decrease in inventory + Direct Expenses
= Rs. 73,000 + Rs. 10,000 + (Rs. 2,000 + Rs. 5,000)
= Rs. 90,000
Gross Profit = Revenue from Operations − Cost of Revenue from Operation
= Rs. 1,00,000 − Rs. 90,000 = Rs. 10,000
Gross Profit Ratio = Gross Profit/Net Revenue from Operations × 100
= Rs.10,000/Rs.1,00,000 × 100 = 10%.

Example 12:
Given the following information:
Revenue from Operations 3,40,000
Cost of Revenue from Operations 1,20,000
Selling expenses 80,000
Administrative Expenses 40,000
Calculate Gross profit ratio and Operating ratio. Solution:
Gross Profit = Revenue from Operations − Cost of Revenue from Operations
= Rs. 3,40,000 − Rs. 1,20,000
= Rs. 2,20,000
Gross Profit Ratio = Gross Profit / Revenue from operation × 100
= Rs. 2,20,000 / Rs. 3,40,000 × 100 = 64.71%

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Operating Cost = Cost of Revenue from Operations + Selling Expenses + Administrative
Expenses
= Rs. 1,20,000 + 80,000 + 40,000 = Rs. 2,40,000
Operating Ratio = Operating Cost / Net Revenue from Operations × 100
= Rs. 2,40,000 / Rs. 3,40,000 x 100 = 70.59%

Questions for Practice Question 1

The Balance sheet of XYZ Ltd is as follows

Liabilities Amount (Rs.) Assets Amount (Rs.)

Authorised Capital
(10,000 shares of Rs. 100
10,00,000 Land and Building 2,00,000
each)
Issued Capital
(5,000 shares of Rs.
5,00,000 Plant and Machinery 4,00,000
100 each)
Inventory and
Debenture @ 12% 1,00,000 1,00,000
Finished Goods

Accounts Payable 2,00,000 Accounts Receivable 2,50,000

Bills Payable 1,00,000 Cash at Bank 50,000
Profit of last year 40,000
Profit of current year 60,000
Total 10,00,000 Total 10,00,000

The Company issued 5,000 shares to purchase the following assets and liabilities of a
company at an agreed value of Rs. 120 per share.

From the above information, Calculate

1. Current ratio
2. Quick Ratio
3. Interest Coverage Ratio of the company

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Question No. 2 The following is the financial information of a firm:

Total Assets ( Including Preliminary Expenses) Rs. 2,40,000

Opening Inventory Rs. 80,000
Closing Inventory Rs. 40,000
Days in a year 360 days
Gross Profit ( 20% of Sales) Rs. 120,000
Average Collection Period 36 days

Required:

Amount of Sales
Amount of Debtors
Total Asset Turnover Ratio
Inventory Turnover Ratio

Question No. 3 A company presents the following financial indicators:

Opening Stock Rs. 20,000
Closing Stock Rs. 10,000
Purchases Rs. 60,000
Sales Rs. 1,05,000
Sales Return Rs. 5,000
Carriage Inward Rs. 5,000
Office and Administration Expenses Rs.5,000
Selling Expenses Rs. 3,000
Required:

Stock Turnover Ratio Net Profit Margin

Return of Assets, of value of Rs. 1,70,000

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Question No. 4

Liabilities Amount (Rs.) Assets Amount (Rs.)

Share Capital 2,50,000 Land and Building 2,10,000
Profit & Loss Account 40,000 Plant & Machinery 3,25,000
General Reserve 45,000 Stock 2,01,500
12% Debentures 4,20,000 Sundry Debtors 1,06,500
Sundry Creditors 1,05,000 Bills Receivable 22,000
Bills Payable 65,000 Cash at Bank 60,000
9,25,000 9,25,000

Calculate
1. Current ratio
2. Quick Ratio
3. Inventory to Working Capital
4. Debt to Equity Ratio
5. Proprietary Ratio
6. Capital Gearing Ratio
7. Current assets to Fixed Assets Ratio Question 5

The following Trading and Profit and Loss Account of A Ltd. for the year 31‐ 3‐ 2010 is
given below:
Particular Rs. Particular Rs
To Opening Stock 76,250 By Sales 5,00,000
Purchases 3,15,250 Closing stock 98,500
Carriage and Freight 2,000
Wages 5,000
Gross Profit b/d 2,00,000
5,98,500 5,98,500

To Administration expenses 1,01,000 By Gross Profit b/d 2,00,000

Selling and Dist. expenses 12,000 Non‐ operating incomes 1,500

Non‐ operating expenses 2,000 Intereston Securities 3,750

Financial Expenses 7,000 Dividend on Shares 750

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Net Profit c/d 84,000 Profit on sale of shares
2,06,000 2,06,000

Calculate:
1. Gross Profit Ratio 2. Expenses Ratio 3. Operating Ratio
4. Net Profit Ratio 5. Operating (Net) Profit Ratio 6. Stock Turnover
Ratio.

3.11 Summary

Ratio analysis is a powerful tool used to analyze a company's financial performance and
health. It involves calculating and interpreting various financial ratios derived from a
company's financial statements. Ratio analysis provides insights into a company's liquidity,
solvency, efficiency, profitability, and valuation.

Liquidity ratios, such as the current ratio and quick ratio, assess a company's ability to meet
its short-term obligations. Solvency ratios, including the debt-to-equity ratio and interest
coverage ratio, measure a company's long-term financial stability and its capacity to handle
debt. Efficiency ratios, like the inventory turnover ratio and accounts receivable turnover
ratio, evaluate a company's operational efficiency and asset utilization. Profitability ratios,
such as the gross profit margin and return on equity, assess a company's ability to generate
profits and returns for its shareholders. Valuation ratios, such as the price-to-earnings ratio
and price-to-book ratio, help evaluate a company's stock valuation and attractiveness as an
investment.

While ratio analysis provides valuable insights, it has limitations. These include limited
comparability, lack of context, reliance on historical data, accounting policies and
manipulation risks, exclusion of non-financial factors, ignoring the time value of money, and
variations across industries and company sizes.

To perform a comprehensive analysis, it's important to consider ratios in conjunction with

qualitative factors, industry benchmarks, and an understanding of the company's specific
circumstances. Ratio analysis should be used as part of a broader assessment of a company's

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financial health and performance.

3.12 Keywords
Ratio Analysis, solvency Ratio, efficiency ratio, liquidity ratio

3.13 Questions
1 What is Financial Statement Analysis
2 State the uses of ratio analysis
3 What are the types of financial ratios
4 What are the types of liquidity ratios
5 Explain solvency ratios
6 Explain efficiency ratios
7 Write a note on Profitability ratios
8 Explain Valuation ratios
9 Discuss the limitations of Ratio Analysis
10 Discuss the users of Ratio Analysis.

3.14 Case Study

Case Study: XYZ Manufacturing Company

XYZ Manufacturing Company is a mid-sized manufacturing company operating in the

automobile industry. The company wants to assess its financial performance and identify areas
for improvement. Let's analyze its financial statements and calculate some key ratios.

Financial Statements:
Income Statement (for the year): Revenue: $10,000,000
Cost of Goods Sold: $6,000,000
Operating Expenses: $2,000,000 Net Income: $1,000,000
Balance Sheet (at the end of the year):

Total Assets: $8,000,000 Total Liabilities: $4,000,000

Shareholders' Equity: $4,000,000 Ratio Analysis:

Gross Profit Margin:

Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue
= ($10,000,000 - $6,000,000) / $10,000,000

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= 40%

Return on Assets (ROA):

ROA = Net Income / Average Total Assets
= $1,000,000 / $8,000,000
= 12.5%

Debt-to-Equity Ratio:
Debt-to-Equity Ratio = Total Debt / Shareholders' Equity Assuming no long-term debt, the
ratio is 0.

Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Assuming current assets of $6,000,000 and current liabilities of $3,000,000, the ratio is 2.

Inventory Turnover Ratio:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Assuming an average
inventory of $2,000,000,
the ratio is $6,000,000 / $2,000,000 = 3. Interpretation:
The gross profit margin of 40% indicates that XYZ Manufacturing Company has a decent
profit margin from its manufacturing operations.
The return on assets (ROA) of 12.5% suggests that the company generates a favorable return
on its total assets.
The absence of long-term debt indicates that the company has a relatively low reliance on
debt financing.
The current ratio of 2 indicates that the company has sufficient current assets to cover its
current liabilities.
The inventory turnover ratio of 3 suggests that the company efficiently manages its
inventory by selling and replacing it three times during the year.
Based on these ratios, XYZ Manufacturing Company appears to have healthy profitability,
operational efficiency, and liquidity. However, it's important to compare these ratios with
industry averages and assess other factors specific to the company's operations and
objectives. This case study demonstrates how ratio analysis can provide insights into a

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company's financial performance and guide decision-making for improvement.

3.15 References
1 Charles Horngren, SrikantDatar, MadhavRajan, Cost Accounting: Global Edition
OLP 14thEdition, Pearson
2 Terence Lucey: Costing, Cengage Learning EMEA, 2002 R5.J. K Mitra: Advanced
Cost Accounting, New Age International, 20094. C.S.V. Murthy, Business Ethics,
Himalaya Publishing House; Mumbai, 2007.
3 Basics of Banking and Finance, Dr.K., Bhattacharya ,O.P.Agarwal

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UNIT 4

CASH AND FUND FLOW STATEMENT

Learning Objectives

1. To understand Cash flow and Fund flow statement

2. To list the advantages-disadvantages of fund flow statement
3. To elucidate the difference between Cash Flow Statement and Fund FlowStatement

Structure
4.1 Introduction to Cash and Fund flow statement
4.2 advantages-disadvantages
4.3 Difference between Cash Flow Statement and Fund Flow
4.4 Need – Uses –fund flow statement
4.5 Fund flow statement format
4.6 Problem Fund Flow Statement
4.7 Summary
4.8 Keywords
4.9 Questions
4.10 Case Study
4.11 References

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4.1 Introduction to Fund flow statement

A fund flow statement, also known as a statement of changes in financial position, is a

financial statement that provides information about the inflows and outflows of funds within
an organization during a specific period. It helps in analyzing the changes in a company's
financial position by tracking the movement of funds between different sources and uses.

The fund flow statement focuses on the changes in the working capital of a business, which
is the difference between current assets and current liabilities. It provides insights into how a
company generates and uses its funds, highlighting the areas where funds are being utilized
and the sources from which funds are being generated.

The primary purpose of a fund flow statement is to provide a comprehensive view of the
changes in a company's financial position over time. It assists in understanding the reasons
behind the changes in the working capital, such as investment activities, financing decisions,
and operating activities.

Fund flow statements typically include two major sections:

Sources of Funds: This section outlines the inflows of funds into the business. It includes
activities such as the issuance of shares, long-term borrowing, sale of fixed assets, and
additional capital contributions.

Uses of Funds: This section details the outflows of funds from the business. It includes
activities such as repayment of long-term debt, purchase of fixed assets, payment of
dividends, and operating expenses.

By comparing the sources and uses of funds, the fund flow statement helps in determining
whether a company has a surplus or a deficit of funds during the period under consideration.
It provides valuable insights into the financial health, liquidity, and capital structure of an
organization.

The fund flow statement complements other financial statements such as the balance sheet

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and income statement, providing a comprehensive understanding of a company's financial
performance and position. It is commonly used by analysts, investors, and financial
institutions to assess the cash flow dynamics and the ability of a company to meet its
financial obligations.
Overall, the fund flow statement is an essential tool for analyzing the movement of funds
within an organization and understanding the factors influencing its financial position. It
provides valuable insights into the cash flow dynamics and helps in making informed
decisions regarding investment, financing, and operational strategies.

4.2 Advantages-Disadvantages
Advantages of Fund Flow Statement:

Highlights the Sources and Uses of Funds: The fund flow statement provides a clear
breakdown of the sources from which funds are generated and the uses to which they are put.
This helps stakeholders understand how funds are flowing within the organization.

Shows Changes in Financial Position: The statement helps in analyzing the changes in the
working capital and financial position of a company over time. It provides insights into
whether the organization is generating surplus funds or facing a deficit.

Identifies Cash Flow Patterns: By examining the fund flow statement, analysts can identify
cash flow patterns and trends within the organization. This information is crucial for making
financial decisions, managing liquidity, and assessing the company's ability to meet its
financial obligations.

Assists in Financial Planning: The statement helps in planning and forecasting future cash
flows. By analyzing the sources and uses of funds, companies can identify potential gaps,make
adjustments, and develop strategies to ensure sufficient funds are available when needed.

Disadvantages of Fund Flow Statement:

Limited Focus on Cash Flow: The fund flow statement primarily focuses on changes in
working capital and does not provide a detailed analysis of cash flows. It may not capture all

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cash transactions and may not reflect the actual cash position of the company.

Historical in Nature: The fund flow statement looks backward and provides information
about past financial activities. It may not fully capture the current or future financial position
and may not be as relevant for making real-time financial decisions.

Complex and Time-Consuming: Preparing a fund flow statement can be complex and time-
consuming, requiring detailed analysis and adjustments. It may involve gathering data from
various sources and ensuring accuracy in the classification of funds.

Subject to Manipulation: Like any financial statement, the fund flow statement is subject to
manipulation and misrepresentation. Companies may use accounting techniques or creative
practices to present a favorable financial position, making it necessary for analysts to
critically evaluate the information provided.

It's important to note that while the fund flow statement has its limitations, it is still a
valuable tool for understanding the movement of funds within an organization and assessing
its financial position. It should be used in conjunction with other financial statements and
analysis techniques for a comprehensive evaluation of a company's financial health.

4.3 Difference between Cash Flow Statement and Fund Flow Statement

The main difference between a cash flow statement and a fund flow statement lies in theirfocus
and scope:

Focus:
Cash Flow Statement: The cash flow statement focuses on the inflows and outflows of cash
within an organization during a specific period. It provides information about the actual cash
receipts and payments, including operating activities (such as cash from sales and payments to
suppliers), investing activities (such as cash from the sale of assets and payments for
acquisitions), and financing activities (such as cash from borrowing and payments of
dividends).

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Fund Flow Statement: The fund flow statement, on the other hand, focuses on the changesin the
working capital and financial position of a company. It tracks the movement of funds
between different sources and uses, including activities such as issuance of shares, long-term
borrowing, sale of fixed assets, repayment of debt, purchase of fixed assets, payment of
dividends, and operating expenses.

Scope:
Cash Flow Statement: The cash flow statement provides a more comprehensive view of the
actual cash transactions of a company. It includes both cash and cash equivalents, and it
categorizes the cash flows into operating, investing, and financing activities. It reflects the
liquidity of the company and its ability to generate and manage cash.

Fund Flow Statement: The fund flow statement focuses on the changes in the working capital
and financial position of a company over time. It includes non-cash items such as
depreciation and amortization, changes in working capital accounts (such as accounts
receivable, accounts payable, and inventory), and long-term financing activities. It provides
insights into the movement of funds within the organization but may not provide a detailed
analysis of actual cash flows.

In summary, the cash flow statement provides a detailed analysis of actual cash inflows and
outflows, while the fund flow statement focuses on the changes in the financial position and
movement of funds within an organization. Both statements serve different purposes and
provide valuable insights into a company's financial health and cash flow dynamics.

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4.4 Need – Uses –Fund Flow Statement

The fund flow statement serves several purposes and has various uses for different
stakeholders within an organization. Here are some of the key needs and uses of the fund flow
statement:
Assessing Financial Position: The fund flow statement helps in evaluating the financial
position of a company by analyzing the changes in its working capital. It provides insights into
whether the organization is generating surplus funds or facing a deficit, which is essential for
understanding its overall financial health.

Understanding Cash Flow Patterns: By examining the sources and uses of funds, the fundflow
statement helps stakeholders identify cash flow patterns and trends within the organization.
This information is valuable for making financial decisions, managing liquidity, and
assessing the company's ability to meet its financial obligations.

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Identifying Capital Structure Changes: The fund flow statement provides a clear breakdown
of the sources from which funds are generated and the uses to which they are put. This helps
stakeholders analyze changes in the capital structure of the organization, such as the issuance
of shares, long-term borrowing, or additional capital contributions.

Monitoring Working Capital Management: The fund flow statement helps in monitoring and
analyzing the efficiency of working capital management. It highlights changes in current
assets and liabilities, such as accounts receivable, inventory levels, and accounts payable,
which are crucial for assessing the organization's liquidity and operational efficiency.

Planning and Forecasting: The fund flow statement assists in financial planning and
forecasting future cash flows. By analyzing the sources and uses of funds, companies can
identify potential gaps, make adjustments, and develop strategies to ensure sufficient funds
are available when needed.

Investor and Creditor Analysis: Investors and creditors use the fund flow statement to assess
the financial viability and creditworthiness of an organization. It helps them evaluate the
company's ability to generate cash flows, meet its financial obligations, and assess the overall
risk associated with investing or lending to the organization.

Internal Decision Making: The fund flow statement is also used by management for internal
decision making. It helps in evaluating the impact of various financial decisions, such as
capital investments, financing choices, and dividend payments, on the organization's overall
financial position and working capital.

Overall, the fund flow statement provides valuable information for assessing the financial
position, cash flow dynamics, and working capital management of an organization. It is used
by various stakeholders, including management, investors, creditors, and financial
analysts, for making informed decisions, evaluating performance, and understanding the
financial health of the organization.

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4.5 Fund flow statement format

Preparing a fund flow statement involves several steps. Here's a general guide on how to
prepare a fund flow statement:

Gather Financial Statements: Collect the necessary financial statements, including the
opening and closing balance sheets for the period under consideration. These statements
provide the starting and ending financial positions of the organization.

Identify Sources and Uses of Funds: Review the financial statements and identify the sources
from which funds have been generated and the uses to which funds have been put during the
period. Sources of funds include activities such as issuance of shares, long-term borrowing,
sale of fixed assets, etc. Uses of funds include activities such as repayment of debt, purchase
of fixed assets, payment of dividends, etc.

Adjust for Non-Cash Items: Consider non-cash items, such as depreciation and amortization,
which do not involve actual cash flows but impact the working capital and financial position.
Make adjustments to account for these non-cash items to reflect the changes in working
capital accurately.

Calculate Net Increase/Decrease in Working Capital: Determine the net increase or decrease
in working capital by analyzing the changes in current assets and current liabilities between
the opening and closing balance sheets. Calculate the difference in each category and
determine the overall change in working capital.

Prepare the Fund Flow Statement: Once you have identified the sources and uses of funds,
adjusted for non-cash items, and calculated the net change in working capital, prepare the
fund flow statement. Start with the opening balance of working capital, add the sources of
funds, deduct the uses of funds, and adjust for the net change in working capital. The final
figure should represent the closing balance of working capital.

Analyze the Fund Flow Statement: Review the fund flow statement and analyze the
movement of funds within the organization. Identify any significant trends or patterns, assess

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the financial position and liquidity of the company, and draw insights from the statement.
It's important to note that the specific steps and adjustments required may vary depending on
the organization and the specific circumstances. It is recommended to consult accounting
standards, professional guidance, and consider the specific reporting requirements applicable
to your jurisdiction while preparing a fund flow statement.

Pro forma of Fund Flow Statement

4.6 Problem Fund Flow Statement

Question 1
From the following Balance Sheet of P Ltd as on 31st March, 2020 and 2021 Prepare a
Fund Flow Statement.

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Amount Amount Amount Amount
Liabilities 31-03-2020 31-03-2021 Assets 31-03-2020 31-03-2021
Share Capital 40,000 57,500 Plant & Machinery 7,500 10,000
Profit & Loss Account 1,400 3,100 Stock 12,100 13,600
Creditors 10,600 7,000 Debtors 18,100 17,000
Cash in Hand 14,300 27,000
52,000 67,600 52,000 67,600

Solution
In the Books of P Ltd.
Statement Showing Changes in Working Capital
Increase Decrease
Particulars 2,018 2,019 CA ↓ CL ↑ CA ↓ CL ↑
A) Current Assets
1. Stock 12,100 13,600 1,500
2. Debtors 18,100 17,000 1,100
3. Cash in Hand 14,300 27,000 12,700
Total Current Assets 44,500 57,600
Less: B) Current Liabilities
1. Creditors 10,600 7,000 3,600
C) Net Working Capital (A-B) 33,900 50,600 17,800 1,100
Net Increase in Working capita 16,700 16,700
Total 50,600 50,600 17,800 17,800

Statement of Sources and Applications (Fund Flow Statement)

Sources Amount Applications Amount

Issue of Shares 17,500 Purchase of Plant and Machinery 2,500
Operating Profit (Balancing Figure)
i.e. Funds from Operations 1,700 Increase in Working Capital 16,700
19,200 19,200

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Question 2

Following are the summarized Balance sheet of Q Ltd. As on 31st March 2015 and 2016.
You are required to prepare a Fund Flow Statement for the year ended 31st March 2016.

Balance Sheet
Amount Amount Amount Amount
Liabilities 31-03-2015 31-03-2016 Assets 31-03-2015 31-03-2016
Share Capital 2,00,000 2,50,000 Goodwill 5,000
General Reserve 50,000 60,000 Land & 2,00,000 1,90,000
Building
Profit & Loss 30,500 30,600 Plant & 1,50,000 1,69,000
Account Machinery
Long Term Bank 70,000 1,35,200 Stock 1,00,000 74,000
Loan
Creditors 1,50,000 Debtors 80,000 64,200
Provision for Tax 30,000 35,000 Cash in Hand 500 8,600
5,30,500 5,10,800 5,30,500 5,10,800

Additional Information:

1. Depreciation written off on Plant and Machinery Rs. 14000 and on Land and
BuildingsRs. 10000.
2. Provision for Tax was made during the year Rs. 33000
3. Dividend of Rs. 23000 was paid.

Solution:
In the Books of Q Ltd.
Statement of Changes in Working Capital

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Increase Decrease
Particulars 2015 2016 CA ↓ CL ↑ CA ↓ CL ↑
A) Current Assets
1. Stock 1,00,000 74,000 26,000
2. Debtors 80,000 64,200 15,800
3. Cash in Hand 500 8,600 8,100
Total Current Assets 1,80,500 1,46,800
Less: B) Current Liabilities
1. Creditors 1,50,000 1,50,000
C) Net Working Capital (A-B) 30,500 1,46,800 1,58,100 41,800
Net Increase in Working capital 1,16,300 1,16,300
Total 1,46,800 1,46,800 1,58,100 1,58,100

Adjusted Profit and Loss Account

Particulars Amount Particulars Amount

Depreciation on Land & Building 10,000 Balance b/d 30,500

Depreciation on Plant & By Operating Profit i.e. Funds
14,000 90,100
Machinery from Operation
General Reserve 10,000

Provision for Tax 33,000

Dividend Paid 23,000

Balance c/d 30,600

1,20,600 1,20,600

Land and Building Account

Particulars Amount Particulars Amount

Balance b/d 2,00,000 Depreciation 10,000

Balance c/d 1,90,000

2,00,000 2,00,000

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Plant & Machinery Account

Particulars Amount Particulars Amount

Balance b/d 1,50,000 Depreciation 14,000

33,000 Balance c/d 1,69,000

1,83,000 1,83,000

Provision for Taxation Account

Particulars Amount Particulars Amount

To Bank 28,000 Balance b/d 30,000

Balance c/d 35,000 Profit & Loss Account 33,000

63,000 63,000

Statement of Sources and Applications

Fund Flow Statement

Sources Amount Applications Amount

Issue of Shares 50,000 Purchase of Plant and Machinery 33,000

Bank Loan 65,200 Goodwill Paid 5,000

Operating Profit (Balancing Figure)

90,100 Income Tax Paid 28,000
i.e. Funds from Operations

Dividend Paid 23,000

Increase in Working Capital 1,16,300

2,05,300 2,05,300

Question 3

From the following balance sheet of S Ltd as on 31st March 2021 and 31st March 2022,
You are required to prepare Fund Flow Statement.

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Amount Amount Amount Amount
Liabilities Assets
31-03-2021 31-03-2022 31-03-2021 31-03-2022

Equity Capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000

8%
Land &
Redeemable 1,50,000 1,00,000 2,00,000 1,70,000
Building
Pref Shares

General Reserve 40,000 70,000 Plant 80,000 2,00,000

Profit &
30,000 48,000 Debtors 1,60,000 2,00,000
Loss Account

Proposed
42,000 50,000 Stock 77,000 1,09,000
Dividend

Creditors 55,000 83,000 Bills Receivable 20,000 30,000

Bills Payable 20,000 16,000 Cash in Hand 15,000 10,000

Provision for
40,000 50,000 Cash at Bank 10,000 8,000
Tax

6,77,000 8,17,000 6,77,000 8,17,000

Following additional information is provided –

1. Depreciation has been charged on Plant and Land and Building Rs. 10000 and
Rs.20000 respectively.
2. Interim Dividend of Rs. 20000 has been paid in 2021-2022.
3. Income Tax paid during the year 2021-22 is Rs. 35000.

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Solution:
In the Books of S Ltd
Statement showing changes in Working Capital

Increase CA ↓ Decrease CA ↓
Particulars 2021 2022
CL ↑ CL ↑

A) Current Assets

1. Stock 77,000 1,09,000 32,000

2. Debtors 1,60,000 2,00,000 40,000

3. Bills Receivable 20,000 30,000 10,000

4. Cash in Hand 15,000 10,000 5,000

5. Cash at Bank 10,000 8,000 2,000

Total Current Assets 2,82,000 3,57,000

Less: B) Current Liabilities

1. Creditors 55,000 83,000 28,000

2. Bills Payable 20,000 16,000 4,000

Total Current Liabilities 75,000 99,000

C) Net Working Capital (A-B) 2,07,000 2,58,000 86,000 35,000

Net Increase in Working capital 51,000 5,10,000

Total 4,44,000 4,44,000 86,000 86,000

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Adjusted Profit & Loss Account

Particulars Amount Particulars Amount

Goodwill 25,000 Balance b/d 30,000
By Operating Profit i.e. 2,18,000
General Reserve 30,000
Funds from Operations
Provision for Tax 45,000

Provision for Dividend 50,000

Depreciation on Land
20,000
& Building
Depreciation on Plant 10,000

Interim Dividend Paid 20,000

Balance c/d 48,000

2,48,000 2,48,000

Statement of Sources and Applications

Fund Flow Statement

Sources Amount Applications Amount

Issue of Shares 1,00,000 Redemption of Pref Shares 50,000

Sale of Land & Building 10,000 Dividend Paid 42,000

Operating Profit (Balancing
Figure) i.e. Funds from 2,18,000 Income Tax Paid 35,000
Operations
Purchase of Plant 1,30,000

Interim Dividend Paid 20,000

Increase in Working
51,000
Capital
3,28,000 3,28,000

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Proposed Dividend Account

Particulars Amount Particulars Amount

To Bank 42,000 Balance b/d 42,000

Balance c/d 50,000 Profit & Loss Account 50,000

92,000 92,000

Provision for Income Tax Account

Particulars Amount Particulars Amount

To Bank A/C ( Paid) 35,000 Balance b/d 40,000

Balance c/d 50,000 Profit & Loss Account 45,000

85,000 85,000

Land and Building Account

Particulars Amount Particulars Amount

Balance b/d 2,00,000 Depreciation 20,000
Bank A/C 10,000
Balance c/d 1,70,000

2,00,000 2,00,000

Plant Account

Particulars Amount Particulars Amount

Balance b/d 80,000 Depreciation 10,000

Bank A/C 1,30,000 Balance c/d 2,00,000

2,10,000 2,10,000

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Question 4
From the following information of I Ltd. Prepare Fund Flow Statement

Amount Amount Amount Amount

Liabilities Assets
31-03-2017 31-03-2018 31-03-2017 31-03-2018
Equity Capital 10,30,000 11,00,000 Goodwill 50,000 40,000
Land &
Debentures 5,00,000 3,24,000 4,20,000 6,60,000
Building
General Reserve 2,00,000 2,00,000 Plant 6,00,000 8,00,000

Profit & Loss Account 1,10,000 1,90,000 Debtors 3,00,000 2,40,000

Income Tax Provision 40,000 1,10,000 Stock 2,50,000 2,10,000

Creditors 50,000 40,000 Cash in Hand 3,00,000 24,000

Preliminary
Bills Payable 20,000 30,000 30,000 20,000
Exp
19,50,000 19,94,000 19,50,000 19,94,000

Following additional information is provided.

1. During the year 2017-2018, a part of machinery costing Rs. 7500 (accumulated
depreciation Rs. 2500) was sold for Rs. 3000.
2. Dividend of Rs. 100000 was paid.
3. Income Tax was paid Rs. 50000
4. Depreciation provided for Land & Building Rs. 10000 and Plant &
Machinery Rs.50000

Solution

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In the Books of I Ltd

Statement showing Changes in Working Capital

Increase CA↓ Decrease CA↓
Particulars 2017 2018
CL ↑ CL ↑

A) Current Assets

1. Stock 2,50,000 2,10,000

40,000
2. Debtors 3,00,000 2,40,000
60,000
3. Cash in Hand 3,00,000 24,000
2,76,000
Total Current Assets 8,50,000 4,74,000

Less: B) Current Liabilities

1. Creditors 50,000 40,000

10,000
2. Bills Payable 20,000 30,000
10,000
Total Current Liabilities 70,000 70,000

C) Net Working Capital (A-B) 7,80,000 4,04,000

10,000 3,86,000
Net Decrease in Working Capital 3,76,000
3,76,000
Total 7,80,000 7,80,000
3,86,000 3,86,000
Adjusted Profit and Loss Account

Particulars Amount Particulars Amount

Provision for Tax 1,20,000 Balance b/d 1,10,000

By Operating Profit i.e. Funds
Goodwill 10,000 3,82,000
from Operation
Depreciation on Land &
10,000
Building
Depreciation on Plant 50,000
Loss on sale of Machinery 2,000
Dividend Paid 1,00,000
Preliminary Exp written Off 10,000
Balance c/d 1,90,000
4,92,000 4,92,000

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Statement of Source and Applications (Fund Flow Statement)

Sources Amount Applications Amount

Issue of Shares 70,000 Redemption of Debentures 1,76,000

Sale of Machinery 3,000 Income Tax Paid 50,000

Operating Profit (Balancing
Figure) i.e. Funds from 3,82,000 Purchase of Land & Building 2,50,000
Operations
Net Decrease in working Capital 3,76,000 Purchase of Plant & Machinery 2,55,000

Dividend Paid 1,00,000

8,31,000 8,31,000

Proposed Dividend Account

Particulars Amount Particulars Amount

To Bank A/C ( Paid) 42,000 Balance b/d 42,000

Balance c/d 50,000 Profit & Loss Account 50,000

92,000 92,000

Provision for Income Tax Account

Particulars Amount Particulars Amount

To Bank A/C ( Paid) 50,000 Balance b/d 40,000

Balance c/d 1,10,000 Profit & Loss Account 1,20,000

1,60,000 1,60,000

Land and Building Account

Particulars Amount Particulars Amount

Balance b/d 4,20,000 Depreciation 10,000

Bank A/C 2,50,000 Balance c/d 6,60,000

6,70,000 6,70,000

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Plant and Machinery Account

Particulars Amount Particulars Amount

Balance b/d 6,00,000 Depreciation 50,000

Bank A/C 2,55,000 Sale 3,000

Loss on Sale of Machinery 2,000

Balance c/d 8,00,000

8,55,000 8,55,000

Question 5

From the following information of M Ltd. Prepare Fund Flow Statement

Amount Amount Amount Amount
Liabilities Assets
31-03-2017 31-03-2018 31-03-2017 31-03-2018
Equity Capital 7,00,000 8,00,000 Goodwill 10,000
12% Preference
5,00,000 4,00,000 Plant & Machinery 6,00,000 8,00,000
Capital
4,00,000 3,00,000 Land & Building 4,00,000 5,50,000
Debentures
Long Term Bank Loan 1,00,000 2,00,000 Investments 2,00,000 1,50,000

General Reserve 2,00,000 2,25,000 Bills Receivables 10,000 5,000

Profit & Loss Account 1,50,000 2,00,000 Debtors 3,00,000 2,50,000

Income Tax Provision 40,000 50,000 Stock 3,50,000 4,00,000

Creditors 50,000 60,000 Cash in Hand 3,00,000 1,15,000

Bills Payable 30,000 25,000 Preliminary Exp 30,000 20,000

Outstanding Expenses 20,000 25,000

Bank Overdraft 15,000

21,90,000 23,00,000 21,90,000 23,00,000

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Following additional information is provided.

1. During the year a part of machinery costing Rs. 75000 ( Accumulated Depreciation
Rs. 35000) was sold for Rs. 45000.
2. Preference Share redemption was carried out at 5% premium.
3. Debentures were retired at 10% premium.
4. 10% Dividend paid on Equity Shares
5. Income Tax was paid Rs. 45000
6. Depreciation provided for Land and Building Rs. 50000 and Plant and Machinery Rs.
60000
7. Investments were sold for Rs. 70000 and profit transferred to General Reserve A/c
8. Company issued shares of Rs. 50000 against Stock of another company and against
Machinery Rs. 40000.

Solution

In the books of M Ltd.

Statement showing Changes in Working Capital

Increase Decrease
Particulars 2017 2018
CA ↓ CL ↑ CA ↓ CL ↑

A) Current Assets

Bills Receivable 10,000 5,000 5,000

Debtors 3,00,000 2,50,000 50,000

Stock 3,50,000 4,00,000 50,000

Cash in Hand 3,00,000 1,15,000 1,85,000

Preliminary Expenses 30,000 20,000 10,000

Total Current Assets 9,90,000 7,90,000

Less: B) Current Liabilities

Creditors 50,000 60,000 10,000

Bills Payable 30,000 25,000 5,000

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Outstanding Expenses 20,000 25,000 5,000

Bank Overdraft 15,000 15,000

Total Current Liabilities 1,00,000 1,25,000

C) Net Working Capital (A-B) 8,90,000 6,65,000 55,000 2,80,000

Net Decrease in Working Capital 2,25,000 2,25,000

Total 8,90,000 8,90,000 2,80,000 2,80,000

Adjusted Profit & Loss A/C

Particulars Amount Particulars Amount

Premium on Redemptionon Pref 5,000 Balance b/d 1,50,000
Shares
Premium on Redemption
10,000 By Profit on Sale of Machinery 5,000
on Debentures
By Operating Profit i.e. Funds from 3,00,000
Dividend Paid 70,000
Operations
Provision for Tax 55,000

Depreciation on Land & Building 50,000

Depreciation on Plant 60,000

General Reserve 5,000

Balance c/d 2,00,000

4,55,000 4,55,000

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Statement of Sources and ApplicationsFund Flow Statement

Sources Amount Applications Amount

Issue of Shares against
50,000 Redemption of Pref Shares 1,00,000
Stock
Long Term Bank Loan 1,00,000 Premium on Redemption of Pref Shares 5,000

Sale of Investments 70,000 Redemption of Debentures 1,00,000

Premium on Redemption of
Sale of Machinery 45,000 10,000
Debentures
Operating Profit
(Balancing Figure) i.e. 3,00,000 Dividend Paid 70,000
Funds from Operations
Net Decrease in working
2,25,000 Income Tax Paid 45,000
Capital
Purchase of Land & Building 2,00,000

Purchase of Plant & Machinery 2,60,000

7,90,000 7,90,000

Equity Capital Account

Particulars Amount Particulars Amount

Balance b/d 7,00,000

Goodwill A/c 10,000

Stock Purchased 50,000

Balance c/d 8,00,000 Machinery Purchased 40,000

8,00,000 8,00,000

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General Reserve Account

Particulars Amount Particulars Amount

Balance b/d 2,00,000

Profit on Sale of Investment 20,000

Profit & Loss Account (Balancing Figure)

Balance c/d 2,25,000 5,000

2,25,000 2,25,000

Provision for Income Tax Account

Particulars Amount Particulars Amount

To Bank A/C ( Paid) 45,000 Balance b/d 40,000

Balance c/d 50,000 Profit & Loss Account 55,000

95,000 95,000

Land and Building Account

Particulars Amount Particulars Amount

Balance b/d 4,00,000 Depreciation 50,000

Bank A/C 2,00,000 Balance c/d 5,50,000

6,00,000 6,00,000

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Plant and Machinery Account

Particulars Amount Particulars Amount

Balance b/d 6,00,000 Depreciation 60,000

Share Capital A/C 40,000 Sale 45,000

Profit on Sale of Machinery 5,000 Balance c/d 8,00,000

Bank A/C 2,60,000

9,05,000 9,05,000

Investments Account

Particulars Amount Particulars Amount

Balance b/d 2,00,000 Bank A/C (Investments Sold) 70,000

To GR A/C 20,000 Balance c/d 1,50,000

2,20,000 2,20,000

Practice Questions

Question 1

From the following balance sheet of M Ltd. Prepare a Fund Flow Statement.
Amount Amount Amount Amount
Liabilities Assets
31-03-2022 31-03-2023 31-03-2022 31-03-2023
Share Capital 1,00,000 1,10,000 Building 40,000 38,000

General Reserve 14,000 18,000 Plant 37,000 36,000

Profit & Loss
16,000 13,000 Investments 10,000 21,000
Account
Creditors 8,000 5,400 Stock 30,000 23,400
Income Tax
16,000 18,000 Bills Receivables 2,000 3,200
Provision

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Provision for
400 600 Debtors 18,000 19,000
Doubtful Debts
Bills Payable 1,200 800 Cash in Hand 6,600 15,200

Preliminary Exp 12,000 10,000

1,55,600 1,65,800 1,55,600 1,65,800

The following is additional information given.

1. Depreciation charged on Plant was Rs. 4000
2. Provision for taxation Rs. 19000 was made during the year 2013
3. Interim Dividend of Rs. 8000 was paid during the year 2013.
4. A piece of Machinery was sold for Rs. 8000. It had cost Rs. 12000. Depreciation of
Rs.7000 was provided on that.

Question 2
From the following balance sheet of A Ltd. Prepare a Fund Flow Statement.
Amount Amount Amount Amount
Liabilities Assets
31-03-2022 31-03-2023 31-03-2022 31-03-2023
Share Capital 1,00,000 1,25,000 Goodwill 2,500

General Reserve 25,000 30,000 Plant & Machinery 75,000 84,500

Profit & Loss
15,250 15,300 Land & Building 1,00,000 95,000
Account
Long Term Bank
35,000 67,600 Stock 50,000 37,000
Loan
Creditors 75,000 Debtors 40,000 32,100
Income Tax
15,000 17,500 Cash in Hand 250 4,300
Provision
2,65,250 2,55,400 2,65,250 2,55,400

Additional Information:

1. Depreciation written off on Plant and Machinery Rs. 7000 and on Land and Building
Rs. 5000
2. Provision for Tax was made during the year Rs. 16500
3. Dividend of Rs. 11500 was paid.

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4.7 Summary
A fund flow statement, also known as a statement of changes in financial position, is a
financial statement that provides information about the inflows and outflows of funds within an
organization during a specific period.

It is prepared to analyze the changes in the working capital and financial position of a
company over time. It tracks the movement of funds between different sources and uses
within the organization, highlighting how funds are generated and utilized. The statement
outlines the inflows of funds into the business, including activities such as the issuance of
shares, long-term borrowing, sale of fixed assets, and additional capital contributions. The
statement details the outflows of funds from the business, including activities such as
repayment of long-term debt, purchase of fixed assets, payment of dividends, and operating
expenses. The fund flow statement focuses on changes in the working capital, which is the
difference between current assets and current liabilities. It helps in evaluating the financial
health and liquidity of the organization.

By comparing the sources and uses of funds, the fund flow statement assists in determining
whether a company has a surplus or a deficit of funds during the period under consideration.
The fund flow statement complements other financial statements, such as the balance sheet
and income statement, providing a comprehensive understanding of a company's financial
performance and position. The fund flow statement is used by analysts, investors, and
financial institutions to assess cash flow dynamics, the ability of a company to meet financial
obligations, and the overall financial health and capital structure of the organization.

While preparing a fund flow statement, it is important to consider accounting standards and
specific reporting requirements applicable to your jurisdiction. The statement provides
valuable insights into the movement of funds within an organization and helps in making
informed decisions regarding investment, financing,and operational strategies.

4.8 Keywords
Fund flow statement, increase in working capital, decrease in working capital,

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4.9 Questions
1 What is Cash and Fund flow statement
2 Discuss the advantages-disadvantages of Fund flow statement
3 State the difference between Cash Flow Statement and Fund Flow Statement
4 Discuss the need – Uses fund flow statement
5 Discuss the process to prepare Fund flow statement and draw the format.6 Problem Fund
Flow Statement

4.10 Case Study

Case Study: ABC Manufacturing Company

ABC Manufacturing Company is a fictional manufacturing company that produces andsells

electronic devices. Let's analyze their fund flow statement for a specific period.

Sources of Funds:

Issuance of shares: $500,000 Long-term borrowing: $200,000Sale of fixed assets: $100,000

Uses of Funds:

Repayment of long-term debt: $150,000Purchase of new machinery: $250,000 Payment of

dividends: $50,000 Operating expenses: $300,000
Changes in Working Capital:

Increase in accounts receivable: $50,000Decrease in accounts payable: $20,000 Increase in

inventory: $30,000
Based on the above information, we can prepare the fund flow statement for ABC
Manufacturing Company:
ABC Manufacturing Company - Fund Flow StatementSources of Funds:
Issuance of shares: $500,000
Long-term borrowing: $200,000 Sale of fixed assets: $100,000 Total Sources of Funds:
$800,000

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Uses of Funds:
Repayment of long-term debt: $150,000Purchase of new machinery: $250,000 Payment of
dividends: $50,000 Operating expenses: $300,000
Total Uses of Funds: $750,000

Net Increase in Working Capital: Increase in accounts receivable: $50,000Decrease in

accounts payable: -$20,000Increase in inventory: $30,000
Total Change in Working Capital: $60,000

Net Increase in Funds (Sources - Uses +/- Change in Working Capital):

$800,000 - $750,000 + $60,000 = $110,000

Closing Balance of Working Capital:

Opening Balance of Working Capital + Net Increase in Funds:
$100,000 + $110,000 = $210,000

In this hypothetical case, ABC Manufacturing Company had a net increase in funds of
$110,000 during the period. The closing balance of working capital increased to
$210,000.

4.11 References

1. Principles & Practices of Banking, Indian Institute of Banking and Finance

2. Banking Theory & Practices, KC Shekhar,Lekshmy Shekhar
3. Banking Reforms and Lead Bank Scheme, Uday Kumar Lal Das

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UNIT 5

CASH FLOW STATEMENT

Learning Objectives

1. To Understand the nature and scope of Cash Flow Statement

2. To understand the need and importance of cash flow statement
3. To learn to prepare Cash Flow statement.

Structure

5.1 Meaning of Cash Flow Statement

5.2 Advantages and Disadvantages
5.3 Need – Uses – Cash Flow Statement
5.4 Preparing Of Cash Flow Statement
5.5 Cash Flow Format
5.6 Problem in cash flow statement.
5.7 Summary
5.8 Keywords
5.9 Questions
5.10 Case Study
5.11 References

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5.1 Meaning of Cash Flow Statement
One of the four required financial statements that a business must prepare at the conclusion
of each accounting period is the cash flow statement. The other three required financial
statements are the income statement, balance sheet, and statement of retained earnings.

A cash flow statement is a financial statement that provides information about the cash
inflows and outflows of a company during a specific period. It shows how cash is generated
and used by a business, offering insights into its operating, investing, and financing activities.

A company's net cash inflow and outflow can be determined using the statement of cash flow.
All activities that affect the cash balance are broken down into three categories in the
statement: Activities related to operation, investment, and financing The cash flow statement
can be prepared in either the Direct Method or the Indirect Method. The direct method
produces the statement of cash flows in the format shown below.

The cash flow statement is divided into three main sections:

Operating Activities: This section reports the cash flows from the company's primary
operations, such as sales and services. It includes cash received from customers, cash paid to
suppliers and employees, and other operating expenses. It reflects the day-to- day cash flow
of the business.

Investing Activities: This section shows the cash flows related to the purchase or sale of long-
term assets and investments. It includes cash inflows from the sale of assets, as well as cash
outflows for acquiring new assets or making investments. Investing activities indicate how
the company is deploying its funds for future growth.

Financing Activities: This section presents the cash flows associated with the company's
financing activities. It includes cash received from issuing stocks or taking on debt (e.g., loans
or bonds) and cash used for dividend payments, debt repayment, or stock buybacks.
Financing activities demonstrate how the company raises capital and distributes it to
investors or creditors.

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The purpose of the cash flow statement is to provide a clear understanding of the sources and
uses of cash within an organization. It helps stakeholders, such as investors, creditors, and
analysts, evaluate the company's liquidity, cash-generating ability, and financial health. By
analyzing the cash flow statement, users can assess a company's ability to meet its short-term
obligations, invest in future growth, and generate sustainable cash flows.

5.2 Advantages and Disadvantages

The cash flow statement is a crucial tool for understanding a company's cash position,
liquidity, cash-generating ability, investment and financing activities, and overall financial
health. It aids businesses in managing their cash flow effectively, enables investors to assess
a company's financial performance, and provides key insights for decision-making and
strategic planning. The cash flow statement provides insights into a company's cash inflows
and outflows, helping assess its liquidity position. It indicates whether a company has
sufficient cash to meet its short-term obligations, pay suppliers, and cover day-to-day
operational expenses. A healthy cash flow is crucial for a company's survival and ongoing
operations.

By analyzing the cash flow statement, businesses can effectively manage their cash
resources. It helps identify periods of cash shortages or surpluses, allowing proactive
measures to be taken, such as optimizing accounts receivable and payable, managing
inventory levels, and adjusting investment and financing activities accordingly. The cash flow
statement provides historical data on cash flows, enabling businesses to make informed
forecasts and plan for the future. It helps estimate future cash inflows and outflows, allowing
companies to anticipate funding needs, plan capital expenditures, and evaluate the feasibility
of growth initiatives. The cash flow statement assists in evaluating a company's operating
performance and profitability. While the income statement shows net income, which includes
non-cash items and accruals, the cash flow statement highlights the actual cash generated or
used by operating activities. Positive cash flows from operations indicate a company's ability
to generate cash from its core operations.

The cash flow statement provides visibility into a company's investing and financing
activities. It shows cash flows from the purchase or sale of assets, investments, issuance of

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stocks, repayment of debt, and payment of dividends. Investors and lenders analyze these
activities to assess the company's capital structure, investment decisions, and financial
sustainability.

The cash flow statement enhances transparency and accountability in financial reporting. It
provides stakeholders, including investors, creditors, and regulators, with
a clear picture of a company's cash flows and how it manages its cash resources. This helps
build trust, facilitates decision-making, and allows for comparisons across companies and
industries.

The cash flow statement is a required financial statement under accounting standards, such as
Generally Accepted Accounting Principles (GAAP) and International Financial Reporting
Standards (IFRS). Its preparation and disclosure demonstrate a company's adherence to
accounting regulations, enhancing investor confidence, and ensuring compliance with
reporting requirements.

From the above discussion we can take out the points which state the advantages and
disadvantages of Cash flow statement.

Advantages of Cash Flow Statement:

The preparation of Cash flow statement, gives the following value additions to the
management for better management of working capital.

Provides insights into cash position: The cash flow statement provides a clear picture of the
cash inflows and outflows of a company, allowing stakeholders to assess its liquidity and cash
position. It helps determine whether a company has sufficient cash to meet its obligations and
fund its operations.

Identifies cash flow sources: The statement helps identify the sources of cash, such as
operating activities, investing activities, and financing activities. This information is crucial
for understanding how a company generates and utilizes its cash resources.

Evaluates cash flow sustainability: By analyzing the cash flow statement over multiple

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periods, stakeholders can assess the consistency and sustainability of a company's cash flows.
It helps determine if the company's operations are generating positive cash flows over time.

Assists in financial decision-making: The cash flow statement provides valuable

information for making financial decisions. It helps stakeholders evaluate investment
opportunities, assess the impact of financing decisions, and understand the cash implications
of various business activities.

Disadvantages of Cash Flow Statement:

Limited focus on non-cash items: The cash flow statement primarily focuses on cash
transactions and may not capture important non-cash items such as depreciation,
amortization, and changes in working capital. These non-cash items can significantly impact
a company's financial position and profitability.

Does not indicate profitability: While the cash flow statement provides information about cash
inflows and outflows, it does not directly reflect a company's profitability. A company may
have positive cash flows but still experience net losses due to non-cash expenses or other
factors.

Subject to manipulation: Similar to other financial statements, the cash flow statement can be
subject to manipulation or creative accounting practices. Companies may engage in techniques
to manipulate cash flows artificially, making it important for stakeholders to critically analyze
the statement and consider other financial indicators.

Historical nature: The cash flow statement provides information about past cash flows and
does not necessarily predict future cash flows accurately. Changes in business conditions,
market dynamics, or management decisions can significantly impact future cash flows,
making it essential to consider other factors when making financial projections.

It's important to note that despite these limitations, the cash flow statement remains a
valuable tool for assessing a company's cash position, liquidity, and cash flow generation,
when used in conjunction with other financial statements and performance indicators.

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5.3 Need – Uses – Cash Flow Statement
The cash flow statement serves several important purposes and provides valuable
information for various users, including stakeholders such as investors, creditors,
management, and analysts. Here are some of the key uses of the cash flow statement:

Assessing liquidity: The cash flow statement helps stakeholders evaluate a company's
liquidity by providing insights into its ability to generate and maintain sufficient cash flows.
It shows the sources of cash inflows, such as operating activities, and the uses of cash
outflows, including payments to suppliers and employees. By analyzing these cash flows,
stakeholders can assess whether a company has enough cash to meet its short- term
obligations and operational needs.

Evaluating cash-generating ability: The cash flow statement allows stakeholders to evaluate a
company's ability to generate cash from its core operations. The operating activities section
of the statement provides information on the cash generated or used by the company's
primary business activities. Positive cash flows from operating activities indicate that the
company's core operations are generating cash, which is generally considered a positive sign
of financial health.

Understanding investment activities: The cash flow statement provides insights into a
company's investing activities, including the purchase or sale of assets and investments. This
information helps stakeholders assess how a company is deploying its funds for future
growth and expansion. It shows cash outflows for acquiring long-term assets, such as
property, plant, and equipment, as well as cash inflows from the sale of assets. By
understanding a company's investment activities, stakeholders can evaluate its strategic
decisions and growth prospects.

Analyzing financing activities: The cash flow statement highlights the financing activities of a
company, including cash inflows and outflows related to financing sources such as equity and
debt. It provides information on cash received from issuing stocks or taking on loans, as well
as cash outflows for dividends, debt repayments, or share repurchases. This information helps
stakeholders assess how a company is raising capital, managing its capital structure, and
distributing funds to investors.

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Making investment and lending decisions: Investors and creditors use the cash flow
statement to make informed investment and lending decisions. By analyzing the cash flow
patterns and trends, stakeholders can assess a company's cash flow stability, growth potential,
and ability to repay debts. The cash flow statement, along with other financial information,
assists in evaluating the financial viability and risk associated with investing in or lending to a
company.

Overall, the cash flow statement is a crucial financial statement that provides valuable
information for understanding a company's cash position, liquidity, cash flow generation,
investment activities, and financing decisions. It assists stakeholders in assessing the
financial health and performance of a company and plays a vital role in financial analysis and
decision-making.

5.4 Preparing Of Cash Flow Statement

Preparing a cash flow statement involves analyzing the cash inflows and outflows of a
company during a specific period. Here is a general overview of the steps involved in
preparing a cash flow statement:

Determine the period: Decide on the period for which you want to prepare the cash flow
statement. It can be monthly, quarterly, or annually, depending on the needs and
requirements.

Gather financial statements: Collect the necessary financial statements, including the income
statement and balance sheet, for the chosen period. These statements provide the key
information required to prepare the cash flow statement.

Identify cash flow categories: Categorize cash flows into three main categories: operating
activities, investing activities, and financing activities. Operating activities include cash
flows from the company's core operations, such as sales, payments to suppliers, and
employee salaries. Investing activities include cash flows related to the purchase or sale of
long-term assets, such as property, plant, and equipment, or investments. Financing activities
include cash flows associated with raising and repaying capital, such as issuing stocks or

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bonds, paying dividends, or repaying loans.

Determine cash flow sources and uses: Analyze the financial statements to identify the
specific sources and uses of cash within each category. For operating activities, adjust net
income for non-cash items, such as depreciation and changes in working capital. For
investing activities, record cash flows from asset purchases or sales. For financing activities,
consider cash flows from issuing stocks, repaying debts, or paying dividends.

Prepare the cash flow statement: Create the cash flow statement using the information
gathered. Start with the opening cash balance, add cash inflows from operating activities,
investing activities, and financing activities, and subtract cash outflows in each category. The
result should be the closing cash balance.

Present the statement: Format the cash flow statement in a clear and organized manner.
Typically, it consists of three sections: operating activities, investing activities, and financing
activities. Include the cash flow amounts for each category and calculate the net cash flow for
the period.

Review and reconcile: Review the cash flow statement to ensure accuracy and completeness.
Reconcile the closing cash balance with the cash and cash equivalents reported on the
balance sheet.

It's important to note that the specific requirements for preparing a cash flow statement may
vary depending on accounting standards and regulations applicable to your jurisdiction. It's
recommended to consult accounting professionals or refer to specific guidelines to ensure
compliance and accuracy in preparing the cash flow statement for a particular company or
organization.

The cash flow statement can be prepared using either the direct method or the indirect
method. Both methods aim to report the cash inflows and outflows from operating activities,
investing activities, and financing activities, but they differ in how they present the
information.

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Direct Method:

The direct method reports the actual cash receipts and payments related to specific operating
activities. It provides a more detailed and explicit view of the company's cash flows. Under
the direct method, the cash flow statement includes a breakdown of major categories of cash
receipts and payments, such as cash received from customers, cash paid to suppliers, cash
paid to employees, and other operating cash payments. This method requires detailed cash
transaction data and can be more time-consuming to prepare.

Indirect Method:

The indirect method focuses on adjusting net income to derive the net cash provided by or
used in operating activities. It starts with the net income from the income statement and
adjusts it for non-cash items and changes in working capital. The adjustments include adding
back non-cash expenses like depreciation and amortization, subtracting gains and adding
losses on the sale of assets, and incorporating changes in current assets and liabilities. The
resulting figure represents the net cash provided by or used in operating activities. The
indirect method does not provide a detailed breakdown of specific cash inflows and outflows.

It's worth noting that regardless of the method chosen, the investing activities and financing
activities sections of the cash flow statement are generally presented in the same manner for
both the direct and indirect methods. These sections involve reporting specific cash flows
related to investing and financing activities, such as the purchase or sale of assets, issuance or
repayment of debt, and equity transactions.

While the direct method offers a more detailed view of cash flows, the indirect method is
more commonly used in practice due to its simplicity and the fact that companies

typically maintain accrual-based accounting records. However, both methods provide

valuable information about a company's cash flows and financial position.

5.5 Cash Flow Format

The cash flow statement typically follows a standard format that includes three main
sections: operating activities, investing activities, and financing activities. Here is the general

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format of a cash flow statement:

Cash Flow Statement for X Ltd. for the year ended 31st December 20XX under Direct
Method

Cash Flow Statement for XYZ Ltd. for the year ended 31st December, 20XX under Indirect
method:

Preparing Cash Flow Statement

The process of preparing cash flow statement determines the cash flow from three major
activities. Namely
a. Operating Activities
b. Investing Activities and
c. Financing Activities.

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These activities can be described as below.

A. The Cash Flow From Operating Activities (CFO)

The cash flow from operating activities (CFO) section is the first section of the cash flow
statement. Manufacturing and sales are included, but capital expenditures and long-
term investments are not. The CFO can also serve as a benchmark for determining a
company's core activity's financial health.

The direct method and the indirect method are the two ways to calculate CFO. Direct
Approach: The cash flow statement depicts actual cash outflows and inflows during a given
period under the direct method approach, which records all transactions on a cash basis.

CFO can be calculated directly in the following ways:

Salary payments received in cash Dividends and interest paid to suppliers and vendors
Interest and taxes paid through an indirect method: The accrual method of accounting is
utilized in the indirect method. The accrual accounting net income figure serves as the
starting point for the calculation. The accountant then calculates the cash basis for the
accounting period using the backward computation method. Revenue is recognized in
accordance with this accounting method regardless of when it is received.

The net income is increased by any increase in current liabilities, while the net income is
decreased by any decrease in current liabilities. However, any increase in current assets is
deducted from net income, while any decrease in current assets' value is added to net income.

B. Cash Flow from Investing Activities

The second section of the cash flow statement, cash flow from investing activities, shows how
much money the company has received from investments over a given time period. A good
way to gauge how well the company is investing its surplus funds is to comprehend the cash
flow from investing activities.
Listed below are the items included in the investing activities and their effects on cash flow.

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Purchase of fixed assets Lending money or giving a loan Selling investment securities
Buying investment securities Collecting loans – it increases cash flow.

C. Cash Flow from Financing Activities

Investors, creditors, and analysts evaluate the company's financial situation by examining the
cash flow from financing activities. Equity and debt sales and repurchases, as well as
dividend payments, are examples of financing activities.
All cash transactions between a business and its owners, creditors, and investors are included
in its cash flow from financing activities. It identifies the sources from which a business
obtains funding for expansion and growth. If financing activities produce positive cash flow,
this indicates that the company receives more cash than it expends. Additionally, it increases
the company's assets.

The cash inflow and outflow are affected by the following financing activities:

Taking a loan from a bank or creditor, issuing equity shares to investors, repurchasing stock,
paying off debts, and paying dividends are all examples of borrowing.

Thus to summarise the above discussion, it can be said that Operating Activities:

Net Income: The company's profit or loss from its core operations.
Adjustments for non-cash items: Includes depreciation, amortization, and changes in working
capital (such as accounts receivable, inventory, accounts payable, and other current
liabilities).
Net Cash Provided by/(Used in) Operating Activities: The resulting cash flow from the
company's operating activities after adjusting for non-cash items.

Investing Activities:

Purchase and Sale of Assets: Cash flows related to the acquisition or disposal of long- term
assets, such as property, plant, and equipment.
Purchase and Sale/Maturity of Investments: Cash flows associated with the purchase, sale, or
maturity of short-term or long-term investments.
Net Cash Provided by/(Used in) Investing Activities: The resulting cash flow from the

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company's investing activities.

Financing Activities:

Issuance and Repayment of Debt/Loans: Cash flows from borrowing or repaying debt,
including loans and bonds.
Issuance and Repurchase of Equity/Stocks: Cash flows related to the issuance or
repurchase of company shares.
Payment of Dividends: Cash outflows made as dividends to shareholders.
Net Cash Provided by/(Used in) Financing Activities: The resulting cash flow from the
company's financing activities.
Net Increase/(Decrease) in Cash and Cash Equivalents: The overall change in cash and cash
equivalents during the period, calculated by adding the net cash flows from operating,
investing, and financing activities.
Cash and Cash Equivalents at Beginning and End of Period: The cash and cash equivalents
balance at the beginning and end of the reporting period.

5.6 Problem in cash flow statement.

Problem NO. 1

From the following information of S Ltd. Prepare Cash from Operations and Cash Flow
Statement
Liabilities 2015 2016 Assets 2015 2016
Share Capital 20,000 30,000 Fixed Assets 20,000 30,000
Profit & Loss Account 10,000 16,000 Goodwill 10,000 8,000
General Reserve 6,000 8,000 Stock 10,000 16,000
Debentures 10,000 12,000 Debtors 10,000 16,000
Creditors 6,000 8,000 Bills Receivable 2,000 4,000
Outstanding Expenses 2,000 3,000 Cash in Hand 2,000 3,000
54,000 77,000 54,000 77,000

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Solution :

Calculation of Cash from Operations

Particulars Amount Amount

Net Profit during the year 16,000

Add
General Reserve 2,000
Goodwill w/o 2,000
Increase in Outstanding Expenses 1,000
Increase in Creditors 2,000 7,000
23,000

Less
Increase in Stock 6,000
Increase in Debtors 6,000
Increase in Bills Receivables 2,000
Opening Balance in Profit & Loss A/C 10,000 24,000

Cash Lost in Operations 1,000

Cash Flow Statement

Sources Amount Applications Amount

Opening Bank Balance 2,000 Purchase of Fixed Assets 10,000

Issue of Shares 10,000 Cash from Operations 1,000

Issue of Debentures 2,000 Closing Cash Balance 3,000

14,000 14,000

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Problem NO. 2

From the following information prepare Cash From operation and Cash flow Statement

Liabilities 2002 2003 Assets 2002 2003

Share Capital 62,500 76,500 Building 17,500 30,000
Bank Loan Long 20,000 25,000 Land 20,000 25,000
Term
Mortgage Loan 12,500 Machinery 40,000 27,500
Creditors 20,000 22,000 Stock 17,500 12,500
Debtors 15,000 25,000
Cash in Hand 5,000 3,500

1,15,000 1,23,500 1,15,000 1,23,500

Additional Information
1. During the year a machine costing Rs. 5000(Accumulated Depreciaiton Rs. 1500) was
sold for Rs. 2500.
2. The provision for depreciation against machinery during the year 2002 was Rs. 12500
and Rs. 20000 in 2003.
3. Net Profit earned during the year 2003 was Rs. 22500

Solution

Calculation of Cash from Operations

Particulars Amount Amount

Net Profit during the year 22,500

Add
Depreciation on Machinery 9,000
Loss on Sale of Machinery 1,000
Decrease in Stock 5,000
Increase in Creditors 2,000 17,000
39,500

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Less
Increase in Debtors 10,000

Cash Lost in Operations 29,500

Cash Flow Statement

Sources Amount Applications Amount

Opening Cash Balance 5,000 Purchase of Land 5,000

Long term Loan 5,000 Purchase of Building 12,500

Sale of Machinery 2,500 Mortgage Loan Repaid 12,500

Cash from Operation 29,500 Drawings 8,500

Closing Cash Balance 3,500

42,000 42,000

Capital Account

Particulars Amount Particulars Amount

To Drawings 8,500 By Balance b/d 62,500

To Balance c/d 76,500 By Profit 22,500

85,000 85,000

Provision for Depreciation A/C

Particulars Amount Particulars Amount

To Machinery 1,500 By Balance b/d 12,500

To Balance c/d 20,000 By Profit 9,000

21,500 21,500

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Machinery A/C

Particulars Amount Particulars Amount

To Balance b/d 40,000 By Bank 2,500
To Bank A/C ( Bal Fig.) 1,500 By Loss on Sale of Machinery 1,000
By P&L A/C 1,500
By P&L A/C(Depreciation) 9,000
By Balance c/d 27,500

41,500 41,500

Problem NO. 3

From the summarised Balance Sheet of A Ltd. You are required to prepare Cash Flow
Statement

Liabilities 2013 2014 Assets 2013 2014

Share Capital 90,000 90,000 Fixed Assets 80,000 64,000
Profit & Loss Account 11,200 13,600 Investments 10,000 12,000
General Reserve 60,000 62,000 Stock 48,000 42,000
Creditors 33,600 26,800 Debtors 42,000 91,000
Provision for Tax 15,000 2,000 Cash in Hand 29,800 39,400
Mortgage Loans 54,000
2,09,800 2,48,400 2,09,800 2,48,400

Following additional information is provided

1. Investments costing Rs. 1600 were sold during the year for Rs. 1700
2. Provision for Tax made during the year was Rs. 1800
3. During the year part of the fixed assets costing Rs. 2000 was sold for Rs. 2400 and
the profit included in Profit and Loss A/C.
4. Dividend paid during the year amounted to Rs. 800

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Solution

Calculation of Cost from Operations

Particulars Amount Amount

Net Profit during the year (13600-11200) 2,400
Add
General Reserve 2,000
Provision for Tax 1,800
Dividend Paid 8,000
Decrease in Stock 6,000
Depreciation 14,000 31,800
34,200
Less
Profit on sale of Investment 100
Profit on sale of fixed assets 400
Increase in Debtors 49,000
Decrease in Creditors 6,800 56,300
Cash Lost in Operations 22,100

Cash Flow Statement

Sources Amount Applications Amount
Opening Cash Balance 29,800 Cash lost in Operations 22,100
Sale of Investment 1,700 Payment of Tax 14,800
Sale of Fixed Assets 2,400 Payment of Dividend 8,000
Mortgage Loan 54,000 Purchase of Investment 3,600
Closing Cash Balance 39,400
87,900 87,900

Provision for Tax A/c

Particulars Amount Particulars Amount

To Bank A/C 14,800 By Balance b/d 15,000
To Balance c/d 2,000 By Profit 1,800
16,800 16,800

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Investment A/C
Particulars Amount Particulars Amount
To Balance b/d 10,000 By Bank 1,600
To Bank A/C ( Bal Fig.) 3,600 By Balance c/d 12,000
13,600 13,600

Fixed Assets A/C

Particulars Amount Particulars Amount
To Balance b/d 80,000 By Bank 2,000
By P&L A/C (Depreciation) 14,000
By Balance c/d 4,000
80,000 80,000

Problem No. 4
From the following Balance Sheet of S Ltd. You are required to prepare Cash Flow
Statement.
Liabilities 2015 2016 Assets 2015 2016
Share Capital 15,000 20,000 Goodwill 5,750 4,500
Pref. Share Capital 7,500 5,000 Land and Buildings 10,000 8,500
General Reserve 2,000 3,500 Machinery 4,000 10,000
Profit & Loss Account 1,500 2,400 Debtors 8,000 10,000
Proposed Dividend 2,100 2,500 Stock 3,850 5,450
Creditors 2,750 4,150 Bills Receivables 1,000 1,500
Bills Payable 1,000 800 Cash in Hand 750 500
Provision for Tax 2,000 2,500 Cash at Bank 500 400
33,850 40,850 33,850 40,850

Following information is provided

1. Depreciation on Machinery during the year was Rs. 500
2. Depreciation on Land and Building during the year was Rs, 1000
3. An interim dividend of Rs. 1000 was paid during the year
4. Income Tax Rs. 1750 was paid during the year 2013

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Solution

Calculation of Cash from Operations

Particulars Amount Amount

Net Profit during the year (2400-1500) 900
Add
Depreciation on Machinery 500
Depreciation on Land & Building 1,000
General Reserve 1,500
Interim Dividend Paid 1,000
Proposed Dividend 2,500
Provision for Tax 2,250
Goodwill Written Off 1,250
Increase in Creditors 1,400 11,400
12,300
Less
Increase in Debtors 2,000
Increase in Stock 1,600
Increase in Bills Receivable 500
Decrease in Bills Payable 200 4,300
Cash from Operations 8,000

Cash Flow Statement

Sources Amount Applications Amount

Opening Cash Balance 750 Redemption of Preference Shares 2,500
Opening Bank Balance 500 Purchase of Machinery 6,500
Cash from Operations 8,000 Interim Dividend Paid 1,000
Issue of Shares 5,000 Proposed Dividend Paid 2,100
Sale of Buildings 500 Income Tax Paid 1,750
Closing Cash Balance 500
Closing Bank Balance 400
14,750 14,750

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Provision for Tax Account

Particulars Amount Particulars Amount

To Bank A/C 1,750 By Balance b/d 2,000
To Balance c/d 2,500 By Profit 2,250
4,250 4,250

Machinery Account

Particulars Amount Particulars Amount

To Balance b/d 4,000 By Depreciation 500
To Bank A/C ( Bal Fig.) 6,500 By Balance c/d 10,000
10,500 10,500

Land and Building Account

Particulars Amount Particulars Amount

To Balance b/d 10,000 By Bank 500
By P&L A/C(Depreciation) 1,000
By Balance c/d 8,500
10,000 10,000

Questions for Practice

Question 1

From the following Balance Sheet of R Ltd you are required to prepare Cash Flow
Statement.

Liabilities 2012 2013 Assets 2012 2013

Share Capital 2,30,000 2,30,000 Machinery 52,000 70,000
General Reserve 60,000 60,000 Land and Buildings 1,50,000 1,50,000
Profit & Loss Account 16,000 23,000 Debtors 67,000 43,000
Debentures 90,000 70,000 Stock 82,000 1,06,000
Bills Payable 1,03,000 96,000 Bills Receivables 1,10,000 74,000

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Outstanding Salary 13,000 12,000 Prepaid Expenses 1,000 2,000
Depreciation Fund 40,000 44,000 Cash at Bank 90,000 90,000
5,52,000 5,35,000 5,52,000 5,35,000

Following additional information is required.

1. New Machinery for Rs 30000 was purchased but old machinery costing Rs. 6000 was
sold for Rs. 4000 and accumulated depreciation was Rs. 6000.
2. Rs. 20000, 8% Debentures were redeemed by purchase from open market @ Rs. 96
for a Debenture of Rs. 100.
3. Rs. 36000 investments were sold at book value
4. 10% Dividend was paid in Cash.

Question 2

From the following Balance sheet of A Ltd. You are required to prepare Cash Flow
Statement.

Liabilities 2015 2016 Assets 2015 2016

Share Capital 2,00,000 2,00,000 Machinery 1,00,000 1,00,000
Pref. Share Capital 2,50,000 4,50,000 Land and Buildings 2,00,000 1,50,000
General Reserve 3,00,000 3,10,000 Furniture 1,00,000 1,30,000
Profit & Loss Account 56,000 68,000 Investment 50,000 60,000
Bills Payable 1,20,000 1,10,000 Stock 2,00,000 2,00,000
Creditors 48,000 24,000 Bills Receivables 1,40,000 1,10,000
Provision for Tax 75,000 10,000 Debtors 1,10,000 2,95,000
Long Term Loan 70,000 Cash at Bank 1,49,000 1,97,000
10,49,000 12,42,000 10,49,000 12,42,000

Following additional information is provided

1. Tax provision made during the year was Rs. 9000
2. Investments costing Rs. 8000 were sold for Rs. 8500
3. A part of buildings costing Rs. 10000 was sold for Rs. 12000 and the profit was
included in Profit and loss Account.

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5.7 Summary
The cash flow statement is a financial statement that summarizes the cash inflows and
outflows of a company during a specific period. It provides valuable information about the
sources and uses of cash, helping stakeholders assess a company's liquidity, cash- generating
ability, and financial health.

The cash flow statement helps stakeholders assess a company's ability to generate cash, meet
its financial obligations, invest in growth opportunities, and distribute funds to investors. It
complements other financial statements, such as the income statement and balance sheet, to
provide a comprehensive view of a company's financial performance and cash management.

5.8 Keywords
Cash flow statement, financing activities, investing activities, operating activities

5.9 Questions
1. Explain the different tools of Financial Statement analysis.
2. Describe Cash Flow statement along with its merits
3. ‘Cash Flow Statement is significantly different from Fund Flow Statement.’ Do you
agree with this statement? Explain.

5.10 Case Study

XYZ Company is a manufacturing firm. The company provides you with the following
information for the year ended December 31, 2022. Prepare a cash flow statement using the
direct method.

Net income for the year: $150,000 Depreciation expense: $30,000

Increase in accounts receivable: $20,000 Increase in inventory: $10,000
Increase in accounts payable: $5,000 Dividends paid: $25,000
Sale of land: $40,000
Purchase of new equipment: $50,000 Issuance of common stock: $30,000 Repayment of
long-term debt: $15,000 Solution:

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XYZ Company
Cash Flow Statement
For the Year Ended December 31, 2022 (Direct Method)

Operating Activities:
Cash received from customers: [To be calculated] Cash paid to suppliers: [To be calculated]
Cash paid to employees: [To be calculated]
Net Cash Provided by Operating Activities: [To be calculated]

Investing Activities:
Sale of land: $40,000
Purchase of new equipment: ($50,000)
Net Cash Used in Investing Activities: ($10,000)

Financing Activities:
Issuance of common stock: $30,000 Repayment of long-term debt: ($15,000) Dividends paid:
($25,000)
Net Cash Provided by Financing Activities: ($10,000)

Net Increase/(Decrease) in Cash and Cash Equivalents: [To be calculated] Cash and Cash
Equivalents at Beginning of Year: [Assumed value]
Cash and Cash Equivalents at End of Year: [To be calculated]

Let's calculate the missing values:

Operating Activities:
Cash received from customers: [Assumed value] Cash paid to suppliers: [Assumed value]
Cash paid to employees: [Assumed value]
Net Cash Provided by Operating Activities: [Assumed value]

Net Increase/(Decrease) in Cash and Cash Equivalents:

Net Increase/(Decrease) in Cash and Cash Equivalents = Net Cash Provided by Operating
Activities + Net Cash Used in Investing Activities + Net Cash Provided by Financing

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Activities
Net Increase/(Decrease) in Cash and Cash Equivalents = [To be calculated]

Cash and Cash Equivalents at End of Year:

Cash and Cash Equivalents at End of Year = Cash and Cash Equivalents at Beginning of
Year + Net Increase/(Decrease) in Cash and Cash Equivalents
Cash and Cash Equivalents at End of Year = [To be calculated]

5.11 References
1. Essentials of Banking and Finance, Gautam Majumdar
2. Credit Monitoring, Legal Aspects & Recovery of Bank loan, V.Rajaraman
3. Management Accounting, Khan and Jain, Tata McGraw Hill
4. Fundamentals of Management Accounting, H. V.Jhamb

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UNIT 6

COST ACCOUNTING

Learning Objectives
1. To Understand the nature and scope of Cost Accounting
2. To understand the elements of cost.
3. To understand the standard costing and variance analysis

Structure

6.1 Introduction
6.2 Cost Accounting –
6.3 Elements of cost –
6.4 Basis of cost allocation –
6.5 Standard costing
6.6 variance analysis
6.7 Numerical problems
6.8 Summary
6.9 Keywords
6.10 Questions
6.11 Case Study
6.12 References

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6.1 Introduction
Cost accounting is a branch of accounting that focuses on analyzing, recording, and reporting
the costs associated with the production of goods or services within an organization. It
involves collecting, classifying, and allocating costs to various activities or products to
facilitate decision-making, control expenses, and measure performance.

The primary objective of cost accounting is to provide detailed information about costs,
including direct materials, labor, and overhead, to help managers make informed business
decisions. By analyzing cost data, organizations can determine the profitability of different
products, identify areas of cost reduction, evaluate the efficiency of operations, and set
appropriate pricing strategies.

Cost accounting involves various methods and techniques to calculate and allocate costs.
These methods can include job costing, process costing, standard costing, activity-based
costing (ABC), and throughput accounting, among others. Each method has its own
advantages and is suitable for different types of industries and business processes.

Overall, cost accounting plays a vital role in assisting organizations in controlling costs,
improving operational efficiency, and optimizing financial performance. It provides valuable
insights for management to make informed decisions and achieve their strategic goals.

6.2 Cost Accounting

The definition of cost accounting can be given as follows.

Cost accounting is a managerial accounting process that involves recording, analyzing, and
reporting a company's costs. Cost accounting is an internal process used only by a company
to identify ways to reduce spending.

Cost accounting is useful because it can tell a company how much money it earns, where it
spends it, and where money is wasted or lost.

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The nature of Cost Accounting

The nature of cost accounting can be summarized as follows:

Cost accumulation: Cost accounting involves the accumulation and recording of costs related
to various activities, departments, or products within an organization. It aims to capture all
relevant costs incurred in the production process, including direct materials, direct labor, and
overhead expenses.

Cost classification: Cost accountants classify costs into different categories based on their
nature, behavior, and relationship to the product or activity. This classification helps in
analyzing costs, understanding cost behavior patterns, and making appropriate decisions.

Cost measurement: Cost accounting involves measuring costs using various techniques such as
actual costing, standard costing, or activity-based costing (ABC). These measurement
methods provide insights into the cost of producing goods or services and assist in setting
prices, budgeting, and evaluating performance.

Cost allocation: Indirect costs or overhead costs are allocated to different cost objects such as
products, departments, or activities. Allocation is done using suitable bases such as direct
labor hours, machine hours, or square footage. This helps in assigning indirect costs to
specific cost centers or cost objects to determine their true cost.

Cost analysis: Cost accounting emphasizes analyzing cost data to gain a deeper
understanding of cost behavior, cost drivers, and cost structure. This analysis aids in
identifying cost-saving opportunities, improving efficiency, and making informed decisions
about pricing, product mix, and resource allocation.

Cost control: One of the primary objectives of cost accounting is cost control. By monitoring
and analyzing costs, organizations can identify areas of inefficiency or excessive spending
and take corrective actions. Cost control measures may involve reducing costs, improving
productivity, eliminating waste, or optimizing resource allocation.

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Decision support: Cost accounting provides relevant information to support decision- making
processes within an organization. Managers can use cost data to evaluate the
profitability of different products or services, make pricing decisions, assess the feasibility of
new projects, and determine the most cost-effective production methods.

Performance evaluation: Cost accounting helps in evaluating the performance of

departments, products, or activities by comparing actual costs with planned or standard costs.
Variances are analyzed to identify the reasons behind deviations and take appropriate
corrective actions. Performance metrics such as cost efficiency, cost variance analysis, and
return on investment (ROI) are used to assess the effectiveness of cost management efforts.

Reporting: Cost accountants prepare various reports, such as cost statements, cost variance
reports, and profitability analysis reports, to communicate cost-related information to
management. These reports enable informed decision-making, financial planning, and
performance evaluation.

In summary, the nature of cost accounting revolves around the collection, classification,
measurement, analysis, control, and reporting of costs to support decision-making, improve
efficiency, and achieve organizational objectives.

Types of Costs
There are many different kinds of costs that businesses can incur, depending on their
industry. The most typical costs that are included in cost accounting are listed below.

Direct Costs Direct costs typically include direct costs for materials, labor, and distribution.
A direct cost is a cost that is directly related to the production of a product. Direct costs include
things like raw materials, inventory, and wages for factory workers.

Indirect Cost Costs Not directly related to the production of a product, indirect costs may
include factory electricity.

Variable Costs - Costs That Change With Production Volumes Costs are typically referred
to as variable costs. The steel used in production might be a variable cost for a car

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manufacturer.

Fixed Costs Costs That Don't Change With Sales or Production Volumes Fixed costs are the
costs that keep a business running. A lease for a factory building or equipment would be
considered fixed costs.

Operating Costs The expenses incurred by a company to carry out its day-to-day operations
are known as operating costs. However, operating costs—also known as operating
expenses—can be either fixed or variable and cannot typically be linked to the finished
product.

6.3 Elements of cost

The elements of cost refer to the different components that make up the total cost of
producing a product or providing a service. These elements are essential for cost accounting
and analysis. The main elements of cost include:

Direct Materials: These are the raw materials or components that are directly incorporated
into the final product. Direct materials can be easily traced and assigned to a specific product
or unit of production.

Direct Labor: This element represents the wages or salaries paid to the workers directly
involved in the production process. It includes the compensation for the physical or mental
efforts exerted to manufacture the product.

Direct Expenses: Direct expenses are additional costs directly attributable to the production
process, apart from direct materials and direct labor. These expenses are specific to a
particular product or unit of production and can be traced back to it. Examples of direct
expenses include specific tools or equipment used exclusively for a particular product.

Indirect Materials: Unlike direct materials, indirect materials do not become part of the final
product. These are materials used in the production process that cannot be easily attributed to
a specific product. Examples include lubricants, cleaning supplies, or small tools used by
multiple products.

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Indirect Labor: Indirect labor costs refer to the wages or salaries paid to employees who do not
directly engage in the production of goods or services but are involved in supporting
functions. This can include supervisors, maintenance personnel, or quality control inspectors.
Indirect Expenses: Indirect expenses, also known as overhead costs, are costs that cannot be
directly linked to a specific product or unit of production. These costs are incurred to support
the overall production process and include expenses such as rent, utilities, depreciation,
administrative salaries, and insurance.

Selling and Distribution Costs: These costs are incurred in promoting, marketing, and
delivering the product to customers. They include expenses related to advertising, sales
commissions, transportation, packaging, and distribution.

Research and Development Costs: These costs are incurred in the development of new
products, improvement of existing products, or research activities. They include expenses
related to research, testing, design, and prototyping.

Finance Costs: Finance costs represent the cost of borrowing funds or financing the
production process. This includes interest expenses on loans, overdraft charges, and other
financial charges.

Abnormal Costs: Abnormal costs are unforeseen or non-recurring costs that are not part of
the regular production process. These costs arise due to exceptional circumstances such as
equipment breakdowns, natural disasters, or legal penalties.

It's important to note that these elements of cost can vary depending on the industry, type of
product or service, and the specific cost accounting system implemented by an organization.

6.4 Basis of cost allocation

Cost allocation refers to the process of assigning indirect costs to specific cost objects such as
products, services, departments, or activities. The basis of cost allocation is the criteria or
method used to distribute these indirect costs fairly and accurately. The choice of the cost
allocation basis depends on the nature of the costs and the objectives of the cost allocation

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process. Here are some common bases of cost allocation:

Direct Labor Hours: This basis allocates indirect costs based on the number of direct labor
hours utilized in the production process. It assumes that the more labor-intensive a product or
activity is, the higher the indirect costs associated with it.
Direct Machine Hours: This method allocates indirect costs based on the number of machine
hours used in the production process. It assumes that the more machine time required for a
product or activity, the higher the indirect costs assigned to it.

Direct Material Costs: Indirect costs can be allocated based on the direct material costs
associated with a product or activity. This method assumes that the more expensive the
materials used, the higher the indirect costs incurred.

Square Footage: This basis allocates indirect costs based on the square footage occupied by a
department, product, or activity. It assumes that the larger the space utilized, the higher the
indirect costs allocated.

Number of Employees: Indirect costs can be allocated based on the number of employees in a
department or engaged in a specific activity. This method assumes that the more employees
involved, the higher the indirect costs associated with that department or activity.

Sales Revenue: Allocating indirect costs based on sales revenue involves assigning a portion
of the costs to each product or service based on the proportion of its sales revenue compared
to the total sales revenue of all products or services.

Activity-Based Costing (ABC): ABC is a more sophisticated method that allocates indirect
costs based on the activities performed. It identifies various cost drivers and allocates costs
based on the intensity of each activity's consumption.

Weighted Average: This method assigns indirect costs based on a weighted average of
multiple cost allocation bases. It combines different bases, such as labor hours, machine
hours, and material costs, with different weights assigned to each base.

The choice of the cost allocation basis should consider factors such as the accuracy of cost

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assignment, the simplicity of the method, the availability of data, and the relevance to the cost
object being allocated. It is important to select a basis that provides a reasonable and
equitable distribution of indirect costs based on the underlying cost drivers.

6.5 Standard costing

Standard costing is a cost accounting technique used to establish predetermined standards for
costs and compare them with actual costs incurred. It involves setting standard costs for
various elements such as direct materials, direct labor, and overhead, and then monitoring
and analyzing the differences between the standards and the actual costs.

Here are the key features and benefits of standard costing:

Standard Cost: Standard costing starts with the establishment of standard costs for each cost
element. These standards represent the expected or desired costs based on factors such as
historical data, industry benchmarks, engineering studies, and management expectations.

Cost Variance Analysis: Standard costing enables the comparison of actual costs with
standard costs, allowing for cost variance analysis. Variances are the differences between
actual costs and the standard costs, and they are analyzed to identify the reasons behind the
variations. Variances can be favorable (actual costs lower than standard costs) or unfavorable
(actual costs higher than standard costs).

Cost Control: By analyzing cost variances, standard costing helps identify areas of cost
overruns or savings. It provides a mechanism for cost control by highlighting deviations from
the expected costs, allowing management to take corrective actions and make informed
decisions to manage costs effectively.

Performance Evaluation: Standard costing provides a basis for evaluating the performance of
departments, processes, or individuals. By comparing actual costs to the predetermined
standards, managers can assess the efficiency and effectiveness of operations and measure
the performance of various cost centers.

Decision Making: Standard costing provides cost data that can be used in decision- making

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processes. It helps in pricing decisions, make-or-buy decisions, budgeting, setting targets,
and assessing the financial impact of alternative courses of action.

Cost Estimation: Standard costing is used to estimate costs for new products, services, or
projects. By applying predetermined standards to the expected inputs and activities,
organizations can estimate the costs associated with a new venture before its actual
implementation.

Continuous Improvement: Standard costing is often used in conjunction with continuous

improvement programs, such as lean manufacturing or Six Sigma. By continuously
monitoring and analyzing cost variances, organizations can identify areas for improvement
and implement measures to reduce costs, eliminate waste, and enhance operational
efficiency.

It's important to note that standard costing assumes stable conditions and may not be suitable
for environments with frequent changes in technology, production methods, or input costs. It
requires regular review and updates of the standard costs to ensure their relevance and
accuracy in reflecting the current operating conditions.

Benefits of Standard Cost

To start with, standard costs act as a measuring stick against which real expenses can measure
up. Variances are the difference between standard cost and actual cost.

For legitimate control and execution estimation in an association, fluctuations ought to be

estimated and broke down. Additionally, this ensures that expenditures are regularly
monitored.

The second advantage is that cost control is made much easier if immediate action is taken.
In order to achieve cost control and cost reduction, a proper standard costing system is
helpful.

Employee motivation is also helped by standard cost. This is due to the fact that the system
can be utilized to implement an incentive scheme that minimizes variance.

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Standard cost systems guarantee the formulation of pricing and production policies. This
contributes to cost control.
The last benefit of utilizing standard expense is that in any event, when different norms and
rules are continually being updated, standard expense fills in as a solid reason for assessing
execution and control costs.

Applicability of Standard Costing

Standard costing can be used in a variety of situations. These are the requirements:
Standard costing techniques have been successfully applied in all industries that produce
standardized products or follow process costing methods. There should be an output or the
production of a sufficient volume of a standard product. The methods, operations, and
processes of production should be capable of standardization.

Sugar, fertilizers, cement, footwear, breweries and distilleries, and others are examples of such
industries.

Standard costing methods can also be used by public utilities like transportation agencies,
electricity supply companies, and waterworks to control costs and increase efficiency.

It is not possible to use the method to benefit jobbing industries or those that produce products
that are not standardized.

Different Kinds of Standards

A standard is a predetermined number that is related to overhead, labor, or materials. It is an
impression of what is generally anticipated, under unambiguous circumstances, of plant and
work force.

While a standard cost is its monetary expression (i.e., quantity multiplied by price), a
standard is essentially an expression of quantity. It demonstrates the appropriate cost.

The most important decision when setting standards is which kind of standard will be used to
fix the cost. Ideal, fundamental, and currently attainable standards are the most common types
of standards.

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1. Ideal Standards Ideal standards, which are also referred to as perfection standards,
are established at the highest possible level of efficiency with no unplanned work stops.

They are stringent requirements that may never be met in practice. They address the degree
of fulfillment that could be reached assuming every one of the circumstances were ideal
constantly.

Only when people are aware of and rewarded for meeting a certain percentage (like 90
percent) of the standard can ideal standards be effective.

2. Basic Standards Basic standards are long-term standards that do not change after the
first time they are calculated.

They are projections that are rarely revised or updated to take into account shifts in products,
costs, or methods.

The basis for comparing actual costs over time with a constant standard is provided by basic
standards. They are mostly used to measure operating performance trends.

3. Right now Achievable Guidelines

A right now feasible standard is one that addresses the best achievable presentation. If the
company operates with a "high" degree of efficiency and effectiveness, it can be achieved
with reasonable effort.

These principles consider ordinary repeating impedances like machine breakdown, delays,
rest periods, undeniable waste, etc.

It is expected that these are undeniable impedances and are an unavoidable truth. However,
output interferences that could have been avoided are not taken into account.

The most popular standard is the one that is currently attainable. Employees like standards of
this kind because they give them a clear goal and a challenge.

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6.6 variance analysis
The difference between planned and actual numbers is the focus of variance analysis. A
picture of the overall over- or underperformance for a particular reporting period can be
obtained by adding all of the variances. By comparing actual costs to industry- standard
costs, businesses determine how favorable each item is.

For instance, assuming the same quantity of raw materials, a favorable price variance (i.e.,
cost savings) would result if the actual cost was lower than the standard cost. However, since
more materials were utilized than anticipated, this would be an unfavorable quantity variance
if the standard quantity was 10,000 pieces of material and 15,000 pieces were required for
production.
ariance analysis is a technique used in cost accounting to compare and analyze the
differences between actual costs and standard costs. It involves examining the variations to
understand the reasons behind them and take appropriate actions. Variance analysis provides
valuable insights into cost performance, efficiency, and helps in cost control and decision-
making.

Here are the key aspects of variance analysis:

Standard Costs: Variance analysis starts with the establishment of standard costs for various
cost elements such as direct materials, direct labor, and overhead. Standard costs represent
the expected or budgeted costs based on factors such as historical data, industry benchmarks,
or management expectations.

Actual Costs: Actual costs are the costs that are actually incurred during a specific period.
These costs are compared to the standard costs to determine the variances.

Cost Variances: Variances are the differences between actual costs and standard costs. They
are calculated by subtracting the standard cost from the actual cost. Variances can be
expressed in monetary terms or as a percentage.

Favorable and Unfavorable Variances: Variances are classified as favorable or unfavorable

based on their impact on profitability. Favorable variances occur when actual costs are lower
than standard costs, resulting in cost savings. Unfavorable variances occur when actual costs

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are higher than standard costs, indicating cost overruns.

Variance Analysis Process: The variance analysis process involves identifying, calculating,
and analyzing different types of variances. Common types of variances include material price
variance, material usage variance, labor rate variance, labor efficiency variance, and
overhead variances.

Investigation of Variances: Variances are investigated to understand the underlying causes.

This may involve examining factors such as changes in input prices, production volumes, labor
productivity, or efficiency levels. The investigation aims to identify the reasons behind the
variations and determine if they are controllable or uncontrollable.
Corrective Actions: Once the variances are identified and analyzed, appropriate corrective
actions can be taken. For favorable variances, management may want to replicate the actions
or processes that led to the savings. For unfavorable variances, steps can be taken to address
the causes and bring costs back in line with the standards.

Performance Evaluation and Improvement: Variance analysis helps in evaluating the

performance of departments, products, or activities. It provides insights into cost control,
efficiency, and effectiveness. By analyzing and acting upon the variances, organizations can
identify areas for improvement, enhance operational efficiency, and achieve cost reduction
objectives.

Variance analysis is a dynamic process that requires continuous monitoring and review. It helps
organizations track their cost performance, make informed decisions, and take proactive
measures to manage costs effectively.

Types of variances
Variations in price as well as quantity/efficiency are present in materials, labor, and variable
overhead, as previously stated. Fixed above, nonetheless, incorporates a volume fluctuation
and a financial plan change.

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Material Variance:

Labour Variance

Fixed Overhead Variance

Standard Costing as Management Tool

Standard costing is widely used as a management tool in cost accounting to aid decision-
making, performance evaluation, and cost control. Here's how standard costing functions as a
management tool:

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Decision-Making: Standard costing provides a benchmark against which actual costs can be
compared, enabling informed decision-making. It helps in evaluating the financial feasibility
of new projects, product pricing, make-or-buy decisions, and other strategic choices. By
comparing actual costs to the predetermined standards, managers can assess the financial
impact of different alternatives and make decisions based on cost efficiency and profitability.

Performance Evaluation: Standard costing provides a basis for evaluating the performance of
departments, cost centers, products, or individuals. By analyzing the variances between
actual costs and standard costs, managers can identify areas of strength or weakness.
Performance metrics such as cost variances, cost efficiency ratios, and cost performance
indices help evaluate the effectiveness and efficiency of operations.

Cost Control: Standard costing facilitates cost control by monitoring and analyzing cost
variances. It highlights deviations from the expected costs, allowing management to
investigate the reasons behind the variations and take corrective actions. By comparing actual
costs to the predetermined standards, organizations can identify cost overruns, inefficiencies,
or areas for cost-saving opportunities. This enables proactive cost control measures and helps
in aligning actual costs with the desired standards.

Budgeting and Planning: Standard costing plays a crucial role in the budgeting and planning
process. It provides a basis for setting realistic cost targets and budgeted costs. By estimating
the standard costs for each cost element, organizations can develop comprehensive budgets
and allocate resources effectively. Standard costing also helps in assessing the financial
impact of changes in production volumes, input prices, or other cost drivers, enabling
organizations to plan and adjust their operations accordingly.

Continuous Improvement: Standard costing is often used in conjunction with continuous

improvement programs such as lean manufacturing or Six Sigma. By monitoring cost
variances and identifying areas for improvement, organizations can implement measures to
reduce costs, eliminate waste, and enhance operational efficiency. Standard costing provides
a mechanism for measuring the effectiveness of improvement initiatives and identifying
areas where further improvements can be made.

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Pricing Decisions: Standard costing provides valuable insights for pricing decisions. By
incorporating standard costs into pricing calculations, organizations can ensure that prices
cover costs and contribute to profitability. Standard costing helps in determining
the minimum acceptable price based on cost considerations and assists in setting competitive
pricing strategies.

Overall, standard costing serves as a powerful management tool that enables organizations to
make informed decisions, evaluate performance, control costs, and plan for the future. It
provides a structured framework for managing costs and driving continuous improvement
efforts.

6.7 Numerical problems

Question 1

From the following information calculate:

a) Material Cost Variance
b) Material Price Variance
c) Material Usage Variance

Product Standard Actual

Qty Price Qty Price
A 10kg 8 10kg 7
B 8kg 6 9kg 7
C 4kg 12 12kg 11

Solution:
Material Variances
Material Cost Variance (MCV)= (Standard Cost-Actual Cost) Material A = (80-70)=10(F)
Material B = ( 48-63) = 15 ( A) Material C = (48-132)= 84 (A)
Total Material Cost Variance (MCV) = 89(A)
Material Price Variance (MPV)= (Standard Price -Actual Price)x Actual Quantity
Material A = (8-7)x10 =10(F) Material B = ( 6-7)x9 = 9 ( A) Material C = (12-11)x12= 12

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(F)
Total Material Price Variance (MPV) = 89(A)
Material Usage Variance (MPV)= (Standard Qty -Actual Qty)x Standard Price Material A =
(10-10)x8 =Nil
Material B = ( 8-9 )x6 = 6 ( A) Material C = ( 4-12 )x12= 96 (A)
Total Material Usage Variance (MUV) = 102(A)

Verification: Total MCV = Total MPV + Total MUV

89(A) = 13(F) + 102 (A)
89(A) = 89(A)

Question NO. 2

From the following information Calculate:

1. Material Cost variance
2. Material Price Variance
3. Material Usage Variance
4. Material Mix Variance

And give your comments on the results

Product Standard Actual

Qty Price Total Qty Price Total

X 50 2 100 40 5 200

Y 30 3 90 20 3 60

Z 20 4 80 30 3 90

Total 100 270 90 350

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Solution

Material Variances

Material Cost Variance (MCV)= (Standard Cost-Actual Cost) Material X = (100-

200)=100(A)
Material Y = ( 90-60 ) = 30 ( F) Material Z = (89-90)= 10 (A)
Total Material Cost Variance (MCV) = 80 (A)

Material Price Variance (MPV)= (Standard Price -Actual Price) x Actual Quantity
Material X = (2-5)x40 =120 (A) Material Y = (3-3)x 20 = NIL Material Z = (4-3)x30= 30 (F)
Total Material Price Variance (MPV) = 90(A)

Material Usage Variance (MPV)= (Standard Qty -Actual Qty) x Standard Price Material X =
(50-40 )x2 = 20(F)
Material Y = (30-20)x2 = 30 (F) Material Z = ( 20-30 )x4= 40 (A)
Total Material Usage Variance (MUV) = 10(F)

Verification: Total MCV = Total MPV + Total MUV

80(A) = 90(A) + 10 (F)
80(A) = 80(A)

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Material Mix Variance (MMV) = ( Revised Std. Qty – Actual Qty) X Std. Price Therefore,
Revised Standard Qty. = Total Actual Qty X Standard Qty / Total Standard Qty

Material X = (90/100)x50=45 Material Y = (90/100) x 30 =27 Material Z = (90/100) x20 = 18

Therefore,
Material Mix Variance (MMV) = (Revised Std. Qty – Actual Qty) x Std Price Material X =
(45-50) x2= 10(F)
Material Y = (27-20) x 3 =21 (F)
Material Z = (18-30) x 4 = 48 (A)
Total Material Mix Variance (MMV) = 17(A)

Comment: There is negative cost variance therefore, efforts must be done to create positive
variances by the management.

Question NO. 3
A manufacturing concern, which has adopted standard costing, furnished the following
information:
Standard Material for 70 kg finished product: 100 kg. Price of materials: Re. 1 per kg. Actual
Output: 2,10,000 kg. Material used: 2,80,000 kg. Cost of material: Rs. 2,52,000. Calculate:
(a) Material Usage Variance (b) Material Price Variance (c) Material Cost Variance Solution:

(1) Standard quantity For 70 kg standard output

Standard quantity of material = 100 kg.

2,10,000 kg. of finished products

2,10,000 x 100 = 3,00,000 kg.

70

Rs.2,52,000
(2) Actual price per kg. = Re.0.90
2,80,000

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= Standard Rate (Standard quantity for actual output –
(a) Material Usage Variance
Actual quantity)
=Re. 1 (3,00,000 – 2,80,000)

=Re. 1 x 20,000

=Rs. 20,000 (favorable)

(b) Material Price Variance =Actual quantity(Standard price ‐ Actual price)

2,80,000 (Re.1 – Re.0.90)

2,80,000 x Re.0.10

Rs. 28,000 (Favorable)

= Standard quantity for actual output x Standard rate) –

(c) Material Cost Variance
(Actual quantity x Actual rate)
=(3,00,000 x 1) – (2,80,000 x 0.90)

= Rs.3,00,000 x Rs. 2,52,000

Rs.48,000(favorable)

Verification:
MCV = MPV + MUV
Rs. 48,000 (F) = Rs.28,000 (F) + Rs.20,000 (F)

Question NO. 4
The standard mix to produce one unit of product is as follows:
Material A 60 units @ Rs. 15 per unit = Rs. 9,00
Material B 80 units @ Rs. 20 per unit = Rs. 1,600
Material C 100 units @ Rs. 25 per unit = Rs.
2,500

240 units Rs. 5,000

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During the month of April, 10 units were actually produced and consumption was as follows:

Material A 640 units @ Rs. 17.50 per unit = Rs. 11,200

Material B 950 units @ Rs. 18.00 per unit = Rs. 17,100

Material C 870 units @ Rs. 27.50 per unit =Rs. 23,925

2,460 units 52,225

Calculate all material variances. Solution:‐

Material Standard for 10 units Actual for 10 units

Qty Rate Amt. Rs. Qty Rate Amt. Rs.

A 600 15 9,000 640 17.50 11,200

B 800 20 16,000 950 18.00 17,100

C 1,000 25 25,000 870 27.50 23,925

Total 2,400 50,000 2,460 52,225

(1) Material Cost Variance = Standard cost – Actual cost

=Rs. 50,000 – Rs.52,225

MCV = Rs.2,225(A)

(2) Material Price Variance =(St. Price – Actual Price) x Actual Qty

Material A = (15‐ 17.50) x 640 = Rs. 1,600 (A)

Material B = (20 – 18 ) x 950 = Rs. 1,900 (F)

Material C = (25 – 27.50) x 870 = Rs. 2,175 (A)

MPV = Rs.1,875 (A)

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(3) Material Usage Variance = (St. Qty – Actual Qty.) x St. Price

Material A = (600 – 640) x 15 = Rs. 600(A)

Material B = (800‐ 950) x 20 = Rs.3,000 (A)

Material C = (1,000 – 870 ) x 25 = Rs. 3,250 (F)

MUV = Rs.350 (A)

Check:

MCV = MPV + MUV

Rs. 2,225 (A) = Rs. 1,875 (A) + Rs.350 (A)

(4) Material Mix Variance = (Revised St. Qty – Actual Qty.) x St. Price

Material A = (615* ‐ 640) x 15 = Rs.375 (A)

Material B =(820* ‐ 950) x 20 = Rs. 2,600 (A)

Material C = ( 1,025* ‐ 870) x 25 = Rs. 3,875 (F)

MMV = Rs. 900(F)

*Revised Standard Quantity is calculated as follows:

Material A = 2460 x = 615 Units

600
2400
Material B = 2460 x 800 = 820 Units
2400
Material C = 2460 x 1,000 = 1,025 Units
2400

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(5) Material Yield Variance = (Actual yield – Standard yield) x St.
output price

= (10 ‐ 10.25 ) x 5000 = Rs. 1,250 (A)

Check
MCV = MPV + MMV + MYV
Rs. 2,225 (A) = Rs. 1,875 (A) + 900 (F) + Rs.1,250 (A)

Problem : 3
For making 10 kg. of yarn, the standard material requirement is:
Material Quantity (kg.) Rate per kg. (Rs.)
White 8 6.00
Black 4 4.00

In March, 1,000 kg. of yarn was produced. The actual consumption of materials is as under:
Material Quantity (kg.) Rate per kg. (Rs.)
White 750 7.00
Black 500 5.00

Calculate: (1) MCV (2) MPV (3) MUV

Solution:

Particular Standard for 1000 kgs. Actual for 1000 kgs.

Quantity Rate Amount Quantity Rate Amount
A 800 6 4,800 750 7 5,250
B 400 4 1,600 500 5 2,500
Total 1,200 6,400 1,250 7,750

(1) MCV: SC ‐ AC
= 6,400 ‐7,750 = Rs. 1,350 (A)

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(2) MPV: (SP ‐ AP) x AQ
A = (6 ‐7) x 750 = Rs. 750 (A)

B = (4 ‐5)x 500 = Rs. 500 (A)

= 1,250(A)
(3) MUV: (SQ ‐ AQ) x SP
A = (800 ‐750) x 6 = Rs. 300 (F)

B = (400 ‐500) x 4 = Rs. 400 (A)

= Rs. 100 (A)

Labour Variance:

Problem‐4

Calculate Labour cost variance from the information: Standard production : 100 units
Standard Hours : 500 hours
Wage rate per hour : Rs. 2 Actual production : 85 units

Actual time taken : 450 hours

Actual wage rate paid : Rs. 2.10 per hour

Solution:
Standard time for one unit = 500 hours ÷ 100 units = 5 hours Standard hours for actual
production 85 units = 85 x 5 = 425 hours
Labour cost Variance = (Std. Hours of Actual Production x Std. Rate) ‐‐‐ (Actual Hours x
Actual Rate)

= (425 Hours x Rs. 2) ‐ ‐ ‐ (450 Hours x Rs. 2.10)

= ( Rs .850 ‐ ‐ Rs. 945)
= RS. 95 (U)

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Problem – 5
Standard wage rate is Rs. 2 per hour and standard time is 10 hours. But actual wage rate is
Rs. 2.25 per hour and actual hours used are 12 hours.
Calculate Labour cost variance. Solution:

Labour cost variance = (Std. Rate x Std. Hours) ‐‐‐(Actual Rate x Actual Hours)

=(Rs. 2 x 10 ) – (Rs. 2.25 x 12)

= Rs. 20 – Rs. 27
=Rs. ‐ ‐ ‐ 7 (U)

Here labour variance is adverse because actual labour cost exceeds standard cost by Rs. 7

Problem – 6

Standard labour hours and rate for production of one unit of Article P is given below:

Per Unit Hour Rate per Hour Total (Rs.)

Skilled worker 5 1.50 7.50

Unskilled worker 8 0.50 4.00

Semi‐ skilled worker 4 0.75 3.00

Actual Data Rate per Hour Total (Rs.)

Articles produced
1,000 units

Skilled worker 2.00 9,000

4,500 hour

Unskilled worker 0.45 4,500

10,000 hour

Semi‐ skilled worker 0.75 3,150

4,200 hour

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Calculate Labour cost variance.

Solution:

Labour cost variance = (SH for actual production x SR) ‐ ‐ ‐ (AH x AR) Skilled worker =
(5,000 x 1.50) ‐ ‐ ‐ (4,500 x 2 )
= 7,500 – 9,000
= Rs. 1,500 (Adverse)
Unskilled worker = (8,000 x 0.50) ‐ ‐ ‐ (10,000 x 0.45)

= 4,000 ‐ ‐ ‐ 4,500
= Rs. 500 (Adverse)
Semi‐ skilled worker = (4,000 x 0.75) ‐ ‐ ‐ (4,200 x 0.75)
= 3,000 ‐ ‐ ‐ 3,150
= Rs. 150 (Adverse) Total Labour cost variance = Rs. 2,150(Adverse) Problem – 7
India Ltd. Manufactures a particular product, the standard direct labour cost of which is Rs.
120 per unit whose manufacture involves the following:
During a period, 100 units of the product were produced, the actual labour cost of which
was as follows:
Type of workers Hours Rate (Rs.) Amount (Rs.)
A 30 2 60
B 20 3 60
50 120
Type of workers Hours Rate (Rs.) Amount (Rs.)
A 3,200 1.50 4,800
B 1,900 4.00 7,600
5,100 12,400

Calculate: (1) Labour cost variance (2) Labour Rate variance (3) Labour Efficiency
variance (4) Labour mix variance.

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Solution:

Type of Worker Standard for 100 units Actual for 100 units
Hours Rate Amount Hours Rate Amount
A 3,000 2 6,000 3,200 1.50 4,800
B 2,000 3 6,000 1,900 4.00 7,600
Total 5,000 12,000 5,100 12,400

(1) LCV: SC ‐ AC
LCV = 12,000 ‐12,400 = Rs. 400 (A)

(2) LRV: (SR ‐ AR) x AH

A = (2 ‐1.50) x 3,200 = Rs. 1,600 (F)

B = (3 ‐4) x 1,900 = Rs. 1,900 (A)

= Rs. 300 (A)

(3) LEV: (SH ‐ AH) x SR

A = (3,000 ‐3,200) x 2 = Rs. 400 (A)

B = (2,000 ‐1,900) x 3 = Rs. 300 (F)

= Rs. 100 (A)

(4) LMV: (RSH ‐ AH) x SR

A = (3,060 ‐3,200) x 2 = Rs. 280 (A)

B = (2,040 ‐1,900) x 3 = Rs. 420 (F)

= Rs. 140 (F)

Working: Revised standard Hours:

RSH = St. hours of the type x Total actual hours / Total St. hours A = 3,000 x 5,100 / 5,000 =
3,060 hrs.
B = 2,000 x 5,100 / 5,000 = 2,040 hrs.

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Overhead Variance:

Problem – 8

MLM Ltd. has furnished you the following information for the month of January:

Budget Actual
Outputs (units) 30,000 32,500

Hours 30,000 33,000

Fixed overhead 45,000 50,000

Variable overhead 60,000 68,000

Working days 25 26

Calculate overhead variances.

Solution:

Necessary calculations

Standard hour per unit = Budgeted hours = 30,000

Budgeted units 30,000

Standard hour for actual output = 32,500 units x 1 hour = 32,500

Standard overhead rate per hour = Budgeted overheads

Budgeted hours For fixed overhead = 45,000 = Rs. 1.50 per unit 30,000
For variable overhead = 60,000 = Rs. 2 per unit

30,000

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Standard fixed overhead rate per day = Rs. 45,000 ÷ 25 days = Rs. 1,800 Recovered overhead
= Standard hours for actual output x Standard Rate
For fixed overhead = 32,500 hours x Rs. 1.50 = Rs. 48,750 For variable overhead = 32,500
hours x Rs. 2 = Rs. 65,000
Standard overhead =Actual hours x Standard Rate For fixed overhead =33,000 x
1.50 =Rs. 49,500
For variable overhead =33,000 x 2 = Rs. 66,000 Revised budgeted hours = Budgeted Hours x
Actual days
Budgeted Days

30,000 x 26 = 31,200 hours

25
Revised budgeted overhead = 31,200 x 1.50 = Rs. 46,800 Calculation of Variances Fixed
Overhead Variances:

Fixed Overhead Cost Variance = Recovered Overhead – Actual Overhead

= 48,750 – 50,000 =Rs. 1,250 (A)

Fixed Overhead Expenditure Variance = Budgeted Overhead – Actual Overhead

=45,000 – 50,000 =Rs. 5,000 (A)

Fixed Overhead Volume Variance = Recovered Overhead – Budgeted Overhead

= 48,750 – 45,000 =Rs. 3,750 (F)

Fixed Overhead Efficiency Variance = Recovered Overhead – Standard Overhead

= 48,750 – 49,500 = Rs. 750 (A)

Fixed Overhead Capacity Variance = Standard Overhead – Revised Budgeted

Overhead
= 49,500 – 46,800 =Rs. 2,700 (F)

Calendar Variance =(Actual days – Budgeted days) x Standard rate per day=
(26—25) x 1,800 =Rs. 1,800 (F)

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Variable Overhead Variances:

Variable Overhead Cost Variance = Recovered Overhead – Actual Overhead

= 65,000 – 68,000 = Rs. 3,000 (A)

Variable Overhead Expenditure Variance = Standard Overhead – Actual Overhead

= 66,000 – 68,000 =Rs. 2,000(A)

Variable Overhead Efficiency Variance = Recovered Overhead – Actual Overhead

= 65,000 ‐‐66,000 = Rs. 1,000 (A)

6.8 Summary
Standard costing is a technique used in managerial accounting to establish predetermined
costs for materials, labor, and overheads for the production of goods or services. It involves
setting standard costs based on historical data, industry benchmarks, and expected
performance levels.

The process of standard costing begins with the creation of standard cost sheets, which detail
the expected costs of each component and process involved in production. These costs are
categorized into three main elements: direct materials, direct labor, and overhead.

Once the standard costs have been determined, they serve as benchmarks against which
actual costs are compared. At the end of a specified period, actual costs are recorded, and a
variance analysis is performed to identify any differences between the standard and actual
costs.

Variances can be classified as favorable or unfavorable, indicating whether the actual costs are
lower or higher than the standard costs. Analyzing these variances helps management identify
areas of cost inefficiency and take corrective actions to improve performance.

Standard costing provides several benefits to organizations, including cost control,

performance evaluation, and decision-making support. By comparing actual costs to
standards, managers can identify areas for improvement, assess the effectiveness of cost
control measures, and make informed decisions regarding pricing, production volumes, and

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resource allocation.

Overall, standard costing is a widely used technique that enables organizations to establish
cost standards, monitor performance, and improve efficiency in their production processes.

6.9 Keywords
Standard costing, labour variance, material variance, overhead variance, variance analysis

6.10 Questions
1. What is Cost Accounting? Write a detailed short note.
2. Explain the Elements of cost.
3. Explain the various basis of cost allocation.
4. What is Standard costing ?
5. Explain variance analysis.

6.11 Case Study Introduction:

This case study focuses on a manufacturing company that produces electronic
devices. The company uses variance analysis to assess the performance of its production
processes and identify areas for improvement. Variance analysis helps the management team
understand the reasons behind the differences between standard costs and actual costs,
enabling them to make informed decisions and take appropriate corrective actions.

Background:
The manufacturing company produces a specific electronic device called "TechGadget." The
standard costs for producing one unit of TechGadget are as follows:

Direct materials: 2 units of Material X at $5 per unit = $10 Direct labor: 1 hour of labor at
$20 per hour = $20 Overhead: $15 per unit
The company sets its production target at 10,000 units of TechGadget per month.

Variance Analysis:
At the end of the month, the company compares the actual costs incurred with the standard

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costs to perform variance analysis. The following variances are identified:

Material Price Variance:

Actual Materials Used: 20,500 units of Material X
Actual Material Cost: $102,500
Standard Material Cost: 20,000 units of Material X at $5 per unit = $100,000 Calculation:
Material Price Variance = (Actual Price - Standard Price) x Actual Quantity Material Price
Variance = ($5 - $5) x 20,500 units = $0

The material price variance is zero, indicating that the company paid the expected price for
Material X.

Material Quantity Variance:

Actual Materials Used: 20,500 units of Material X Actual Material Cost: $102,500
Standard Materials Used: 20,000 units of Material X Calculation:
Material Quantity Variance = (Actual Quantity - Standard Quantity) x Standard Price
Material Quantity Variance = (20,500 - 20,000) units x $5 = $2,500 unfavorable

The material quantity variance is $2,500 unfavorable, suggesting that there was an overuse of
material during the production process.

Labor Rate Variance:

Actual Labor Hours: 9,500 hours Actual Labor Cost: $190,000 Standard Labor Hours: 10,000
hours Standard Labor Rate: $20 per hour Calculation:
Labor Rate Variance = (Actual Rate - Standard Rate) x Actual Hours Labor Rate Variance =
($20 - $20) x 9,500 hours = $0

The labor rate variance is zero, indicating that the company paid the expected labor rate.

Labor Efficiency Variance:

Actual Labor Hours: 9,500 hours Actual Labor Cost: $190,000 Standard Labor Hours: 10,000
hours Calculation:
Labor Efficiency Variance = (Actual Hours - Standard Hours) x Standard Rate Labor
Efficiency Variance = (9,500 - 10,000) hours x $20 = $10,000 favorable

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The labor efficiency variance is $10,000 favorable, indicating that less labor was used than
anticipated to produce the required output.

Overhead Variance:
Actual Overhead Cost: $152,000
Standard Overhead Cost: 10,000 units x $15 per unit = $150,000 Calculation:
Overhead Variance = Actual Overhead Cost - Standard Overhead Cost Overhead Variance =
$152,000 - $150,000 = $2,000 unfavorable

The overhead variance is $2,000 unfavorable, indicating that the actual overhead costs were
higher than the standard costs.

Conclusion:
Based on the variance analysis, the manufacturing company identified areas for
improvement. The material quantity variance suggests that there was an overuse of material,
and measures can be taken to reduce waste and improve efficiency. The labor efficiency
variance indicates that less labor was used than anticipated, which could be due to increased
productivity or automation. The overhead variance highlights the need for cost control
measures to reduce unnecessary expenses.

By regularly conducting variance analysis, the manufacturing company can continuously

monitor its performance, make informed decisions, and take corrective actions to enhance
efficiency, reduce costs, and improve profitability.

6.12 References
1. Managerial Accounting, Dr. Mahesh Abale and Dr. Shriprakash Soni
2. Management Accounting, Dr. Mahesh Kulkarni

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UNIT 7

JOB AND PROCESS COSTING

Learning Objectives

1. To Understand the concept of Job and Process Costing

2. To list the advantages and disadvantages of JobCosting
3. To list the advantages and disadvantages of Process Costing

Structure

7.1 Introduction to Job and process costing

7.2 Job costing meaning Advantages disadvantages
7.3 process costing meaning Advantages disadvantages
7.4 Summary
7.5 Keywords
7.6 Questions
7.7 Case Study
7.8 References

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7.1 Introduction to Job and process costing
Job costing and process costing are two common methods used by businesses to track and
allocate costs to their products or services. These costing methods are essential for
determining the profitability of individual jobs or processes and making informed business
decisions.

Job Costing:

Job costing is a costing method used when products or services are unique, custom- made, or
produced in small quantities. It is commonly employed in industries such as construction,
consulting, custom manufacturing, and printing. In job costing, costs are assigned to each
specific job or project.

Definition of Job Costing

A costing technique called "job costing" is used to figure out how much a particular job that
is done to the customer's specifications will cost. It is a fundamental costing strategy that
works for work that consists of separate projects or contract jobs.

Key features of job costing:

Unique jobs or projects: Each job is distinct and has its own specifications, requirements, and
costs.

Direct and indirect costs: Direct costs, such as direct materials and direct labor, can be
directly attributed to a specific job. Indirect costs, also known as overhead costs, are
allocated to jobs using predetermined cost drivers or allocation methods.

Job cost sheet: A job cost sheet is maintained for each job, which records all the direct and
indirect costs associated with that particular job.

Customized pricing: Job costing allows businesses to determine the specific costs incurred
for each job, helping in setting prices that consider both direct and indirect expenses.

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Process Costing:

Process costing is used when products or services are produced in a continuous and repetitive
manner, usually in large quantities. Industries such as chemical manufacturing, food
processing, and oil refining typically employ process costing. Thecosting method assigns costs
to each production process or department, rather than individual jobs.

Key features of process costing:

Continuous production: The production process is continuous and repetitive, involvingmultiple

steps or stages.

Homogeneous products: The products or services produced are similar or identical,making

it difficult to distinguish costs for individual units.

Cost per unit: Costs are allocated to each production department or process, and thenspread
over the number of units produced within that department or process.

Equivalent units: Equivalent units are used to account for partially completed units ina
process, as not all units are completed simultaneously.

Cost per equivalent unit: The cost per equivalent unit is calculated by dividing the totalcosts
incurred in a department or process by the equivalent units produced.

Both job costing and process costing have their advantages and are applicable in different
business scenarios. Job costing provides detailed cost information for each unique job,
whereas process costing offers a broader view of costs for mass production processes.
Understanding these costing methods allows businesses to effectively manage costs,
determine profitability, and make informed pricing and resourceallocation decisions.

7.2 Job costing meaning Advantages disadvantages

Job costing is a costing method used to track and allocate costs to individual jobs or projects.
It is particularly useful when dealing with unique, custom-made, or small- scale production.
Here are the advantages and disadvantages of job costing:

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Advantages of Job Costing:
Accurate Cost Allocation: Job costing allows for precise allocation of costs to each specific
job or project. It enables businesses to determine the exact expenses associated with a
particular job, including direct materials, direct labor, and overheadcosts.

Pricing Accuracy: By accurately tracking costs for each job, businesses can establish
appropriate pricing strategies. Job costing helps ensure that the selling price of a product or
service covers all direct and indirect costs, leading to profitability and informed pricing
decisions.

Profitability Analysis: Job costing facilitates the analysis of individual job profitability. It
enables businesses to identify which jobs are generating higher profits and which ones may
be causing losses. This information assists in evaluating the overall performance and
profitability of the business.

Cost Control: Job costing provides detailed insights into cost drivers and cost behavior. It helps
businesses identify areas where costs can be controlled, minimized, or optimized. This
information is valuable for cost management and enhancing efficiency.

Disadvantages of Job Costing:

Complex and Time-consuming: Job costing involves meticulous tracking of costs for each
job, which can be complex and time-consuming. It requires maintaining detailed records, cost
sheets, and tracking various cost components. This administrative burden can be
overwhelming, particularly for businesses with numerous ongoing jobs.

Difficulty in Overhead Allocation: Allocating overhead costs to specific jobs can be

challenging. Overhead costs are often shared among multiple jobs or projects, and assigning
them accurately can be subjective. Choosing appropriate allocation methods and accurately
estimating the proportion of overhead costs for each job can be a complex task.

Limited Applicability: Job costing is most suitable for businesses involved in unique or
custom-made products or services. It may not be well-suited for industries with high- volume

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production or standardized products, as process costing may be a more appropriate costing
method in those cases.
Cost Estimation Challenges: Job costing relies on accurate cost estimation before the job
begins. However, estimating costs upfront can be difficult, especially when dealing with
complex or unfamiliar projects. Inaccurate cost estimates can lead to underpricing or
overpricing jobs, impacting profitability.

Despite these disadvantages, job costing remains a valuable tool for businesses that engage in
customized or unique projects. It enables accurate cost tracking, better pricing decisions, and
detailed profitability analysis, contributing to effective cost management and informed
decision-making.

7.1 Documents used in Job Costing

Several documents are commonly used in job costing to track and record costs associated
with specific jobs or projects. These documents help businesses maintain accurate cost
records and provide a comprehensive overview of the costs incurred. Here are some key
documents used in job costing:

Job Order: The job order is the primary document that initiates the job costing process. It
specifies the details of a specific job or project, including its unique identifier, description,
customer requirements, and any special instructions. The job order serves as a reference
throughout the job costing process.

Job Cost Sheet: A job cost sheet is a detailed record that tracks all costs associated with a
particular job. It includes direct costs, such as direct materials and direct labor, as well as
indirect costs or overhead costs allocated to the job. The job cost sheet provides a
comprehensive view of the costs incurred and helps in determining the profitability of the
job.

Material Requisition Form: A material requisition form is used to request and track the
issuance of materials from the inventory or warehouse for a specific job. It specifies the type,
quantity, and cost of materials required for the job. The material requisition form ensures
proper control and accountability of materials used in each job.

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Time Sheets: Time sheets are used to record the amount of time spent by employees working
on a particular job. Employees fill out their time sheets, indicating the job or project they
worked on, the hours worked, and any specific tasks performed. Time
sheets provide the basis for calculating direct labor costs and help in monitoring employee
productivity.

Purchase Orders: Purchase orders are used to request and authorize the purchase of materials
or services needed for a specific job. They specify the quantity, description, and cost of the
items or services to be procured. Purchase orders ensure proper documentation and control of
procurement activities related to each job.

Invoices: Invoices are issued to customers for billing purposes. They specify the amount due
for the completed job, including the direct costs, allocated overhead costs, and any additional
charges or markups. Invoices provide a summary of costs incurred and revenue generated for
each job.

Cost Reports: Cost reports are periodic reports that summarize the costs incurred for each job.
They provide an overview of direct costs, indirect costs, and the total cost accumulated for
each job. Cost reports help in monitoring the progress of the job, comparing actual costs to
estimated costs, and evaluating job profitability.

These documents are essential for maintaining accurate and detailed cost records throughout
the job costing process. They ensure proper tracking of costs, facilitate cost analysis, and
support informed decision-making regarding pricing, resource allocation, and profitability
assessment.

Job Cost Sheet Format

Job costing procedure and cost allocation for different activities

The procedure for job costing involves several steps to track and allocate costs for different
activities within a job. Here is a general overview of the job costing procedure and cost
allocation for different activities:

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Identify the Job: Begin by identifying the specific job or project for which costs need to be
tracked. This could be a customer order, a project, or any unique job that requirescost allocation.

Create a Job Cost Sheet: Set up a job cost sheet for the identified job. The job cost sheet
serves as a central document to record all costs associated with the job.

Identify Direct Costs: Determine the direct costs that can be directly traced to the job. This
includes direct materials, which are the materials specifically used for the job, and direct labor,
which is the labor directly involved in the job.
Track Indirect Costs: Identify and track indirect costs or overhead costs that cannot be directly
attributed to the job. This includes costs such as rent, utilities, depreciation, and
administrative expenses. Indirect costs are allocated to the job using an appropriate cost
allocation method.

Allocate Indirect Costs: Allocate the indirect costs to the job based on a predetermined cost
allocation method. Common methods include allocating overhead based on direct labor hours,
machine hours, or material costs. The chosen method should reflect the cost drivers that best
represent the consumption of overhead resources by the job.

Record Costs on the Job Cost Sheet: Record all direct and indirect costs associated with the job
on the job cost sheet. This includes updating the quantities and costs of direct materials, hours
and wages of direct labor, and allocated overhead costs.

Calculate Total Job Cost: Sum up all the direct costs, allocated indirect costs, and other related
expenses recorded on the job cost sheet to determine the total cost of the job.

Review and Analyze Job Costs: Periodically review and analyze the job costs to monitor the
progress of the job and assess its profitability. Compare the actual costs incurred to the
estimated costs to identify any cost variations or discrepancies.

Cost Allocation for Different Activities: Within a job, various activities may require separate
cost allocation. For example, if a job involves different processes or departments, costs may

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need to be allocated to each process or department separately. This can be done by creating
separate cost centers or departments withinthe job cost sheet and allocating costs accordingly.

Cost Reconciliation and Reporting: At the completion of the job, reconcile all costs to ensure
accuracy. Prepare a cost report or summary detailing the total costs incurred, revenue
generated, and profitability of the job. This information can be used for decision-making,
future pricing, and evaluating the efficiency of different activities.

By following this job costing procedure and allocating costs to different activities within a
job, businesses can track, monitor, and evaluate the costs associated with specific jobs. This
enables better cost control, accurate pricing decisions, and improved profitability assessment.
Applicability Of Job Costing

Job costing is applicable in various industries and situations where businesses engage in
customized, unique, or project-based work. Here are some scenarios where job costing is
commonly used:

Construction Industry: Job costing is widely used in the construction industry, where each
construction project is unique and requires customized materials, labor, and resources. Job
costing helps track costs for each construction project, including materials, labor,
subcontractors, equipment rental, and overhead expenses.

Manufacturing of Customized Products: Job costing is applicable in manufacturing industries

that produce custom-made or specialized products. Examples include furniture
manufacturing, jewelry making, custom apparel, and high-end electronics. Job costing helps
allocate costs to each custom product based on specific customer requirements and
production processes.

Consulting and Professional Services: Job costing is often used in consulting firms, law firms,
architectural firms, and other professional service providers. Each client projector engagement
is treated as a separate job, and job costing helps track the time, resources, and expenses
associated with each client project.

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Printing and Graphic Design: Job costing is commonly employed in the printing and graphic
design industry, where each print job or design project is unique. Job costing helps allocate
costs for materials, printing equipment usage, labor, and any additional services requested by
the client.

Film Production and Entertainment: Job costing is utilized in the film production and
entertainment industry, where each film, TV show, or production is treated as a separate job.
Job costing helps track costs related to cast and crew salaries, set construction, location
expenses, special effects, post-production, and marketing.

Maintenance and Repair Services: Job costing is applicable in maintenance and repair service
industries, such as automotive repair, HVAC services, and appliance repair. Each customer's
service request is treated as a separate job, and job costing helps allocate costs for labor,
parts, and any additional services provided.
Event Planning: Job costing is used in event planning and management companies, where
each event is considered a separate job. Job costing helps track costs for venue rentals,
decorations, catering, staff wages, transportation, and other event-specific expenses.

In summary, job costing is applicable in industries and businesses that undertake customized,
unique, or project-based work. It provides a structured approach to track and allocate costs to
specific jobs, ensuring accurate cost tracking, profitability analysis, and informed decision-
making.

Examples Job Costing

A shop floor supervisor of a small factory presented the following cost for Job No. 303, to
determine the selling price.

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Per unit (`)

Materials 70
Direct wages 18 hours @ ` 2.50 45
(Deptt. X 8 hours; Deptt. Y 6 hours; Deptt. Z 4 hours)
Chargeable expenses 5

120
Add : 33-1/3 % for expenses cost 40

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Analysis of the Profit/Loss Account (for the year 20X9)

(`) (`)

Materials used 1,50,000 Sales less 2,50,000

returns

Direct wages:

Deptt. X 10,000

Deptt. Y 12,000

Deptt. Z 8,000 30,000

Special stores items 4,000

Overheads:

Deptt. X 5,000

Deptt. Y 9,000

Deptt. Z 2,000 16,000

Works cost 2,00,000

Gross profit c/d 50,000

2,50,000 2,50,000
Selling expenses 20,000 Gross profit 50,000
b/d

Net profit 30,000

50,000 50,000

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It is also noted that average hourly rates for the three Departments X, Y and Z are
similar.

JOB AND CONTRACT COSTING

You are required to:

(i) PREPARE a job cost sheet.

(ii) CALCULATE the entire revised cost using 20X9 actual figures as basis.

(iii) Add 20% to total cost to DETERMINE selling price.

7.2 SOLUTION

Job Cost Sheet

Customer Details ——— Job No.

Date of commencement ——Date of completion Direct materials 70

Direct wages:

Deptt. X ` 2.50 × 8 hrs. = ` 20.00 Deptt. Y ` 2.50 × 6 hrs. = ` 15.00Deptt. Z ` 2.50 × 4 hrs. = `
10.00 45
Chargeable expenses 5Prime cost 120

Overheads:

Deptt. X = `5,000 × 100 = 50% of ` 20 = ` 10.00

`10,000
Deptt. Y = `9,000 × 100 = 75% of ` 15 = ` 11.25
`12,000
Deptt. Z = `2,000 × 100 = 25% of ` 10 = ` 2.50 23.75
`8,000

Works cost 143.75

Selling expenses=
`20,000 × 100 = 10% of work cost 14.38

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`2,00,000

Total cost 158.13

Profit (20% of total cost) 31.63

Selling price 189.76

Job Costing Example 2

A manufacturing company uses job costing. It shows 2009 Dec. data in following ways

1. Opening balance of job in hand on 1st Dec. 1993 forjob no. 410 Rs. 430 and
for job no. 411 Rs. 1270
for Job No. 410 is Rs. 80 and for job no. 411 is Rs. 420

Direct material for job no. 410 is Rs. 150 and job no. 411 is Rs. 450Direct labour for job no.
410 is Rs. 200 and job no. 411 is Rs. 400
2. Direct labour material requisition during the of Dec. 2009job no. 410 Rs. 120
job no. 411 Rs. 280

job no. 412 Rs. 225

job no. 413 Rs. 300

925

3. Direct Labour Distributionin hours

job no. 410 400 hrs
job no. 410 200
job no. 410 300
job no. 410 100

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1000

4. Factory overheads are applied to jobs to production to direct labour rate which is Rs.
2
5. Factory overheads incurred in Dec. 2009 Rs. 2100
6. Job No. 411 and 412 were completed during the month. They were billed to a
customer at a price which included 15% of the price of job for selling and
administration expenses and another 10% of job for the profit.

Prepare :

i) Job Cost Sheet for Job Nos. 411

ii) Determine the billing price for the job.

7.3 Answer
i) Job costing Sheetfor job no. 411
Opening balance Rs. 1270 ( see 1. point in question )Direct material Rs. 280
Direct labour Rs. 450
Factory overhead @ 2 per hour = Rs. 400

Factory cost Rs. 2400

Add selling expenses 15%3200 X 15% = Rs. 480

see working note for calculating bill price of job no. 411

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Cost of sale Rs. 2880 Profit 10% of billing price
3200 X 10% = Rs. 320

ii) Sale price or bill price of job no. 411 = Rs. 3200

7.4 Working note for calculating of bill price

Bill price = X
X = 2400 (Factory cost )+ X x 15% ( Selling expenses) + X x 10% ( profit )X = 2400 +.15 X
+.10 X
X -.25X = 2400

.75 X = 2400

X = 3200

7.5 Problem 1

Job No. 58 passes through three departments: X, Y, and Z. The following informationis
given regarding this job:

Required: Calculate the cost of Job No. 58 from the above figures.

2. Job Costing & WIPN85

In a factory following the Job Costing Method, an abstract from WIP on 30th Septemberwas
prepared as under -

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Materials used in October were as follows -

Materials Requisition 54 55 56 57 58 59
No.
Job No. 118 118 118 120 121 124

Cost Rs. 300 Rs. 425 Rs. 515 Rs. 665 Rs. 910 Rs. 720

A summary of labour hours deployed during October is as under

No. of hours No. of hours

Job No.
Shop A Shop B
115 25 25

118 90 30

120 75 10

121 65 -

124 20 10

Total 2 7
7 5
5
Indirect Labour

Waiting for Material 2 1

0 0
Machine Breakdown 1 5
0
Idle Time 5 6

Overtime Premium 6 5

Total 3 1
1 0
6 1

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7.6 Process costing meaning Advantages disadvantages

Process costing is a costing method used to allocate costs to each production process or
department rather than individual jobs. It is commonly employed in industries withcontinuous
or repetitive production processes. Here are the advantages and disadvantages of process
costing:

7.6 Advantages of Process Costing:

Cost Uniformity: Process costing provides a standardized approach to allocating costs across
similar products or services produced in a continuous process. It ensures consistency in cost
allocation, making it easier to compare costs between different production runs or
departments.

Simplified Cost Allocation: Process costing simplifies cost allocation by spreading costs over
the total number of units produced within a specific process or department. It eliminates the
need for detailed tracking of costs for individual units, making it more efficient for industries
with high-volume production.

Enhanced Cost Control: Process costing enables businesses to identify cost variances and
control production costs more effectively. By comparing actual costs to standard costs,
businesses can identify areas where costs are exceeding expectations and take appropriate
corrective actions.

Effective Inventory Valuation: Process costing provides a reliable basis for valuing
inventory. By allocating costs to each production process, businesses can determine the value
of work in progress and finished goods at different stages of the productionprocess accurately.

7.7 Disadvantages of Process Costing:

Individual Product Cost Detail: Process costing does not provide detailed cost information
for individual products or units. It focuses on aggregating costs at the process or department
level. This lack of granularity can make it challenging to evaluate the cost of each specific

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unit or identify cost variations between different products.

Difficulty in Identifying Cost Drivers: Process costing may not effectively capture the
specific cost drivers that impact the cost of individual units. It assumes that all units within a
process or department consume costs in a similar manner, which may not be the case. This
can limit the accuracy of cost allocation.

Limited Cost Visibility: Process costing may not provide a comprehensive view of costsacross
the entire production process. It focuses primarily on costs incurred within each individual
process or department, potentially overlooking costs that are shared or incurred across
multiple processes.

Less Accurate Pricing: Process costing may not provide a precise basis for pricing decisions.
Since costs are allocated across a large number of units, individual product or service costs
may not be accurately reflected. This can lead to challenges in setting optimal prices and
potentially impact profitability.

Process costing is particularly useful for industries with continuous or repetitive production,
where individual unit costs are less significant. While it simplifies cost allocation and
control, it may lack the detailed cost visibility necessary for evaluating individual units or
products. Businesses should carefully consider the nature of their operations and the need for
cost granularity before deciding to implement process costing.

7.8 Process costing procedure and cost allocation for different activities

The procedure for process costing involves several steps to track and allocate costs for
different activities within a production process. Here is a general overview of the process
costing procedure and cost allocation for different activities:

Identify the Production Process: Identify the specific production process or department for
which costs need to be tracked and allocated. This could be a continuous or repetitive process
involved in the production of similar or homogeneous products.

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Define Cost Centers: Divide the production process into cost centers or departments based on
the different activities or stages involved. Cost centers could include material handling,
assembly, quality control, packaging, etc. This helps in tracking costs for each specific
activity.

Record Direct Costs: Determine and record the direct costs associated with each cost center.
Direct costs typically include direct materials that are specific to each unit of production
within the cost center.

Calculate Equivalent Units: Calculate the equivalent units of production for each cost center.
Equivalent units represent the number of partially completed units that are at various stages
of production within a cost center. It takes into account the degree of completion for partially
completed units.

Allocate Direct Costs: Allocate the direct costs to the equivalent units of production within
each cost center. Divide the total direct costs by the equivalent units to determine the cost per
equivalent unit for each cost center.

Allocate Indirect Costs: Allocate the indirect costs or overhead costs to each cost centerusing an
appropriate cost allocation method. Common methods include allocating overhead based on
direct labor hours, machine hours, or material costs. The chosen method should reflect the
cost drivers that best represent the consumption ofoverhead resources by each cost center.

Calculate Total Cost per Unit: Sum up the direct costs and allocated indirect costs for each
cost center to determine the total cost per equivalent unit for each cost center. This provides
the total cost incurred in each cost center for producing a unit of output.

Cost Reconciliation and Reporting: Reconcile the costs of different cost centers to ensure
accuracy and completeness. Prepare a cost report or summary that outlines the total costs
incurred in each cost center and the overall production process. This information is valuable
for monitoring costs, analyzing profitability, and making informed decisions.

By following this process costing procedure and allocating costs to different activities within

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a production process, businesses can track, monitor, and evaluate the costs associated with
each cost center. This enables better cost control, accurate pricing decisions, and improved
profitability assessment in industries where standardized or homogeneous products are
produced through continuous or repetitive processes.

7.9 Applicability Of Process Costing

Process costing is applicable in various industries and situations where businesses engage in
continuous or repetitive production processes, typically producing homogeneous or
standardized products. Here are some scenarios where process costing is commonly used:

Chemical Manufacturing: Process costing is widely used in the chemical industry, where
products are produced through continuous chemical processes. Examples include the
production of chemicals, petroleum refining, and pharmaceutical manufacturing. Process
costing helps allocate costs to each production stage or department involved in the chemical
process.

Food and Beverage Production: Process costing is applicable in the food and beverage
industry, where products are produced through continuous processing steps. Examples
include baking, brewing, dairy processing, and soft drink manufacturing. Process costing
helps allocate costs to each production step, including ingredients, processing equipment,
labor, and packaging.

Textile Industry: Process costing is commonly used in the textile industry, where fabrics are
manufactured through continuous processes. Process costing helps allocate costs to various
stages of textile production, such as spinning, weaving, dyeing, and finishing.

Steel and Metal Manufacturing: Process costing is utilized in steel mills and metal fabrication
industries, where products are produced through continuous processes involving various
production departments. Process costing helps allocate costs to eachdepartment involved, such
as melting, rolling, forging, and finishing.

Printing Industry: Process costing is applicable in the printing industry, where standardized

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products, such as books, magazines, and packaging materials, are produced through
continuous printing processes. Process costing helps allocate costs to different printing
processes, including prepress, printing, binding, and finishing.

Automotive Manufacturing: Process costing is employed in the automotive industry, where

automobiles are manufactured through sequential assembly processes. Process
costing helps allocate costs to various production departments, such as bodyassembly,
painting, engine assembly, and final assembly.

Electronics Manufacturing: Process costing is commonly used in the electronics industry,

where standardized electronic components or devices are produced through continuous
assembly processes. Process costing helps allocate costs to different assembly stages,
including component assembly, testing, quality control, and packaging.

In summary, process costing is applicable in industries and businesses that engage in

continuous or repetitive production processes to manufacture standardized or homogeneous
products. It provides a systematic approach to allocate costs to different production stages or
departments, allowing businesses to track costs, analyze profitability, and make informed
decisions regarding pricing, process optimization, and resource allocation.

7.3 Summary

In summary, job costing and process costing are two costing methods used by
businesses to allocate costs and track profitability in different scenarios:

Job Costing:

Applicable in industries with unique, custom-made, or small-scale production. Tracks costs

for each specific job or project.
Direct costs (materials, labor) and indirect costs (overhead) are allocated to each job.
Provides detailed cost information for individual jobs, aiding in accurate pricing and
profitability analysis.
Suitable for industries like construction, consulting, custom manufacturing.Process Costing:

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Applicable in industries with continuous or repetitive production processes.
Allocates costs to each production process or department, rather than individual jobs.Focuses
on homogeneous or standardized products/services.
Simplifies cost allocation by spreading costs over the total number of units produced.
Provides a standardized approach to cost allocation and control.
Suitable for industries like chemical manufacturing, food processing, and assembly line
production.

Both costing methods have their advantages and disadvantages:

Job costing offers detailed cost tracking for unique jobs, precise pricing, and job profitability
analysis. However, it can be complex and time-consuming to administer. Process costing
simplifies cost allocation and control, making it suitable for industries
with high-volume production. However, it lacks detailed cost visibility for individual
units and may not be suitable for customized or unique products.

The choice between job costing and process costing depends on the nature of the business,
production processes, and the need for cost granularity. Some businesses may even use a
combination of both methods to suit different aspects of their operations.

7.4 Keywords
Job costing, process costing

7.5 Questions
1. Define job costing and state the advantages and disadvantages.

2. Define Process costing and state the advantages and disadvantages

3. State the applicability of Job Costing

4. State the applicability of Process Costing

7.6 Case Study

Case Study: Job Costing in a Construction Company

ABC Construction is a mid-sized construction company that specializes in residential and

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commercial projects. They undertake various construction projects, including building new
houses, renovating existing structures, and constructing commercial buildings. ABC
Construction wants to implement a job costing system to track costs and analyze the
profitability of their projects.
Identifying the Job:
ABC Construction receives a new project to build a custom-designed house for a client. This
project is identified as Job 001.

Creating a Job Cost Sheet:

The company creates a job cost sheet for Job 001, which includes all relevant
information such as project details, client requirements, estimated costs, and projecttimeline.

Direct Cost Identification:

ABC Construction identifies the direct costs associated with Job 001, including the cost of
materials such as cement, bricks, lumber, and fixtures. They also consider the directlabor costs,
including the wages of the construction workers involved in the project.

Tracking Indirect Costs:

ABC Construction identifies indirect costs or overhead costs, which include project
management salaries, equipment depreciation, insurance, and utilities. These costs will be
allocated to Job 001 based on an appropriate cost allocation method.

Allocating Indirect Costs:

To allocate indirect costs, ABC Construction chooses to allocate overhead based on direct
labor hours. They determine a predetermined overhead rate by dividing the totaloverhead costs
by the estimated total direct labor hours for all jobs in a given period.

Recording Costs on the Job Cost Sheet:

As the construction progresses, ABC Construction keeps track of the direct and indirect costs
incurred for Job 001. They update the job cost sheet with the quantities and costs of materials
used, labor hours worked, and the allocated overhead costs for eachperiod.

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Calculating Total Job Cost:

At regular intervals, ABC Construction calculates the total cost of Job 001 by summing up the
direct costs, allocated indirect costs, and any additional expenses incurred.

Reviewing and Analyzing Job Costs:

ABC Construction reviews and analyzes the costs recorded on the job cost sheet for Job 001.
They compare the actual costs incurred with the estimated costs to identify any cost
variances. This analysis helps them monitor the project's progress, control costs, and evaluate
the profitability of Job 001.

Cost Reconciliation and Reporting:

Upon completing Job 001, ABC Construction reconciles all the costs recorded for the project
to ensure accuracy. They prepare a cost report or summary that outlines the total costs
incurred, revenue generated, and profitability of the job. This information assists in assessing
the success of the project and making informed decisions for future projects.

By implementing a job costing system, ABC Construction can effectively track and allocate
costs to each construction project. This allows them to analyze the profitability of individual
jobs, make informed pricing decisions, control costs, and improve overall financial
management within the company.

7.7 References
1. Financial Cost and Management Accounting, P.Periasamy

2. Financial Accounting for Management, Shankarnarayanan Ramanath,

CENGAGELearning

3. Accounting For Management, S. N. Maheshwari

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MODULE 8

MARGINAL COSTING

Learning Objectives

1. To Understand the nature and scope of Marginal Costing

2. To understand the Difference between absorption costing and marginal
costing
3. To understand Cost Volume Profit (CVP) analysis, Break Even Analysis, Margin of
Safety

Structure

8.1 Marginal Costing –

8.2 Distinction between absorption costing and marginal costing
8.3 Cost Volume Profit (CVP) analysis –
8.4 Break Even Analysis –
8.5 Margin of Safety -.
8.6 Numerical Problems
8.7 Summary
8.8 Keywords
8.9 Questions
8.10 Case Study
8.11 References

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8.1 Marginal Costing –
Marginal costing is a costing technique used in managerial accounting to determine the cost of
producing an additional unit of a product or service. It focuses on analyzing the behavior of
costs and the impact of changes in production or sales volume on the overall profitability of a
business.

In marginal costing, only variable costs are considered as the cost of producing an additional
unit. Variable costs are expenses that change in direct proportion to the level of production or
sales. Examples of variable costs include direct materials, direct labor, and variable overhead.

Fixed costs, on the other hand, are not included in the calculation of the cost per unit in
marginal costing. Fixed costs remain constant regardless of the level of production or sales
and are not attributed to individual units.

The key concept in marginal costing is the contribution margin. The contribution margin is
calculated by subtracting the variable costs from the sales revenue. It represents the amount
that is available to cover fixed costs and contribute to the company's profits.

By analyzing the contribution margin, managers can make informed decisions about pricing,
product mix, and resource allocation. It helps in identifying the most profitable products or
services and determining the breakeven point, where total revenues equal total costs.

Some of the advantages of marginal costing include:

Simple and easy to understand: Marginal costing focuses on the behavior of costs and
provides a clear picture of the cost of producing each unit.

Decision-making tool: Marginal costing helps managers in making decisions related to

pricing, product mix, and resource allocation by analyzing the contribution margin and
breakeven point.

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Cost control: By separating fixed and variable costs, marginal costing enables managers to
control and monitor variable costs more effectively.

Flexible pricing: Marginal costing allows for flexible pricing strategies since it focuses on the
variable costs associated with producing an additional unit.

It's important to note that while marginal costing provides valuable insights into the short-
term profitability of a business, it may not be suitable for long-term planning or cost
estimation, as it does not consider the full absorption of fixed costs.

Features of Marginal Costing

 Marginal costing is the change in the quantity of the desired output that affects the
overall cost of production.

 Administrators can utilize it to settle on asset portion choices, advance creation,

smooth out activities, control fabricating costs, plan financial plans and benefits, etc.

 Most of the time, marginal costs are influenced by variable costs. However, in

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situations of increased output, it may take into account fixed expenses.

 When setting a product or service's selling price, a business maximizes profits when
its marginal cost and marginal income are equal.

Process of Marginal Costing

Marginal costing works by analyzing the behavior of costs and calculating the cost of
producing each additional unit of a product or service. Here's how marginal costing works:

Separation of Costs: Marginal costing separates costs into two categories: variable costs and
fixed costs. Variable costs are costs that change in direct proportion to the level of production
or sales, such as direct materials, direct labor, and variable overhead. Fixed costs, on the other
hand, remain constant regardless of the level of production or sales, such as rent, salaries, and
depreciation.

Calculation of Contribution Margin: The contribution margin is calculated by subtracting the

variable costs from the sales revenue. It represents the amount that is available to cover fixed
costs and contribute to the company's profits. The contribution margin per unit is the
difference between the selling price per unit and the variable cost per unit.

Determination of Break-even Point: The break-even point is the level of production or sales
at which the total revenue equals the total cost (both variable and fixed costs). Marginal
costing helps in determining the break-even point by analyzing the contribution margin. The
break-even point can be calculated by dividing the total fixed costs by the contribution
margin per unit or by using the break-even formula: Break-even Point (in units) = Fixed
Costs / Contribution Margin per unit.

Profit Analysis: Marginal costing provides insights into the profitability of products, services,
or business segments. By analyzing the contribution margin, managers can identify the most
profitable products and make informed decisions regarding pricing, product mix, and
resource allocation. Profit can be calculated by subtracting the total fixed costs from the total
contribution.

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Decision-making: Marginal costing is a valuable tool for short-term decision- making. It
helps in analyzing the impact of changes in production volume, pricing strategies, and cost
structures on the profitability of the business. Managers can use marginal costing to evaluate
the profitability of different products, determine the most cost-effective production levels, and
assess the financial implications of various business decisions.

Flexibility in Pricing: Marginal costing allows for flexible pricing strategies since it focuses on
the variable costs associated with producing an additional unit. Managers can set prices based
on the incremental cost of production and adjust pricing to maximize profitability.

Marginal costing provides a simplified and straightforward approach to cost analysis,

emphasizing the distinction between fixed and variable costs. It helps managers in
understanding the cost structure of their business, making informed decisions, and optimizing
profitability in the short term.

Factors of Marginal Costing

Marginal costing considers several factors that are important in analyzing costs and making
decisions. Here are the key factors considered in marginal costing:

Variable Costs: Marginal costing focuses on variable costs, which are costs that vary directly
with the level of production or sales. These costs include direct materials, direct labor, and
variable overhead. Variable costs are per unit costs that change as the volume of production
or sales changes.

Fixed Costs: While marginal costing primarily focuses on variable costs, it also recognizes
the presence of fixed costs. Fixed costs are expenses that do not change with the level of
production or sales in the short term, such as rent, salaries, and depreciation. Although fixed
costs are not considered in the calculation of the cost per unit, they are important in
determining profitability and making long-term decisions.

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Contribution Margin: The contribution margin is a key factor in marginal costing. It
represents the difference between the selling price per unit and the variable cost per unit. The
contribution margin per unit indicates the amount available to cover fixed costs and contribute
to the company's profits. By analyzing the contribution margin, managers can assess the
profitability of products, services, or business segments.

Break-even Point: The break-even point is the level of production or sales at which the total
revenue equals the total costs (both variable and fixed costs). Marginal
costing helps in determining the break-even point by considering the contribution margin.
Managers can use the break-even point to understand the minimum level of sales required to
cover all costs and assess the financial viability of different business scenarios.

Profitability Analysis: Marginal costing provides insights into the profitability of products,
services, or business segments. By subtracting the total fixed costs from the total contribution,
managers can calculate the profit. This helps in evaluating the financial performance of
different products or services and making decisions to maximize profitability.

Decision-Making: Marginal costing is a valuable tool for short-term decision- making. It

assists managers in analyzing the impact of changes in production volume, pricing strategies,
and cost structures on the profitability of the business. Managers can use marginal costing to
evaluate the profitability of different products, determine the most cost-effective production
levels, and assess the financial implications of various business decisions.

Cost Control: Marginal costing facilitates effective cost control by separating fixed and
variable costs. It allows managers to monitor and control variable costs more directly, as they
are directly linked to the volume of production or sales. By analyzing and managing variable
costs, companies can optimize their cost structures and improve profitability.

These factors play a crucial role in the analysis and decision-making process when applying
marginal costing techniques. They help managers understand the cost behavior, assess
profitability, determine the break-even point, and make informed decisions to achieve
financial goals.

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Marginal Costing Advantages And Disadvantages Advantages of Marginal Costing:

Simple and Easy to Understand: Marginal costing is a straightforward costing method that is
easy to comprehend. It focuses on the behavior of costs and provides a clear picture of the
cost of producing each unit.
Decision-Making Tool: Marginal costing helps in making short-term decisions related to
pricing, product mix, and resource allocation. By analyzing the contribution margin,
managers can identify the most profitable products, evaluate different pricing strategies, and
optimize resource utilization.

Cost Control: Marginal costing allows for effective cost control by separating fixed and
variable costs. It enables managers to monitor and control variable costs more directly,
facilitating better cost management.

Flexibility in Pricing: Marginal costing provides flexibility in pricing decisions since it focuses
on the variable costs associated with producing an additional unit. Managers can set prices
based on the incremental cost of production, taking into account market demand and
competition.

Breakeven Analysis: Marginal costing helps in determining the breakeven point, which is the
level of production or sales at which total revenues equal total costs. This analysis provides
insights into the minimum sales volume required to cover all costs and make informed
decisions about profitability.

Disadvantages of Marginal Costing:

Incomplete Cost Picture: Marginal costing ignores fixed costs and treats them as period costs.
While this simplifies cost analysis, it may lead to an incomplete understanding of the total
cost structure and profitability. Fixed costs are not allocated to individual units and may not
be fully considered in decision-making.

Long-Term Planning Limitations: Marginal costing is primarily focused on short- term

decision-making. It may not be suitable for long-term planning or cost estimation, as it does

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not consider the full absorption of fixed costs, which are essential for long-term
sustainability.

Difficulty in Pricing Overhead: Marginal costing faces challenges in allocating or pricing

overhead costs accurately. Since only variable costs are considered, the allocation of fixed
overhead costs becomes complex and may require additional techniques to achieve accurate
cost assignment.
Ignores Capacity Utilization: Marginal costing does not take into account the utilization of
production capacity. It assumes that all units produced are sold, which may not reflect the
actual production and sales scenario. This limitation can affect decision-making in situations
where production capacity is underutilized or overutilized.

Limited Usefulness for External Reporting: Marginal costing is primarily designed for
internal decision-making and may not meet the requirements of external reporting standards.
External stakeholders, such as investors and lenders, often expect full absorption costing
methods that allocate all costs to products or services.

It's important to consider these advantages and disadvantages when choosing to apply
marginal costing. While it offers simplicity and useful insights for short- term decision-
making, it should be used alongside other costing methods to gain a comprehensive
understanding of costs and profitability.

Equation Of Marginal Costing

Marginal Cost (MC) = (Change in Total Costs) / (Change in Quantity) Or,
MC = ΔTC/ ΔQ ——————————— Equation (I)

Where,

TC = Total cost Q = Quantity

Δ = Incremental change of producing one additional unit

The total cost of production is the sum of both fixed and variable costs, depending on the

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desired output. Marginal cost is directly proportional to the variable cost occurring at every
production level. So, let us have a look at another equation to check out the interrelation
between both:

TC = FC + (Q x VC) —————————— Equation (II)

Where,

FC = Fixed cost VC = Variable cost

Combining both equations I and II together, we get:

MC = ΔTC/ ΔQ = VC ————————— Equation (III)

Equation III shows how TC is directly proportional to VC. It means the total cost will
automatically increase if the variable cost increases and vice-versa.

8.2 Distinction between absorption costing and marginal costing –

Absorption costing and marginal costing are two different approaches used in managerial
accounting for calculating the cost of products or services and determining the profitability of
a business. Here are the key distinctions between absorption costing and marginal costing:

Treatment of Fixed Costs:

Absorption Costing: Under absorption costing, fixed costs are allocated to each unit of
production. These costs include both variable and fixed overhead costs. Fixed costs are
absorbed into the product's cost and become a part of the inventory valuation. They are
expensed only when the product is sold.

Marginal Costing: In marginal costing, fixed costs are treated as period costs and are not
allocated to individual units. They are not included in the cost of production or inventory
valuation. Fixed costs are expensed in the period incurred, irrespective of the level of
production or sales.
Cost Behavior:

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Absorption Costing: Absorption costing considers both variable and fixed costs in the
product's cost per unit. It assumes that both types of costs vary with production volume.

Marginal Costing: Marginal costing considers only variable costs in the product's cost per
unit. It assumes that variable costs vary with production volume, while fixed costs remain
constant.

Profit Calculation:
Absorption Costing: Under absorption costing, profit is calculated by deducting the total cost
of production (including fixed costs) from total sales revenue.

Marginal Costing: In marginal costing, profit is calculated by deducting only the variable costs
(direct materials, direct labor, and variable overhead) from total sales revenue. Fixed costs
are treated as a separate deduction in the calculation of net profit.

Decision-Making:

Absorption Costing: Absorption costing provides a more comprehensive view of the cost
structure and profitability of products. It is often used for external reporting and for making
long-term decisions as it considers all costs associated with production.
Marginal Costing: Marginal costing focuses on the contribution margin and helps in short-
term decision-making. It provides insights into the incremental cost of producing additional
units and helps in analyzing the profitability of different products or services.
Inventory Valuation:

Absorption Costing: Absorption costing values inventory at the full cost per unit, including
both variable and fixed costs. This cost is carried forward until the products are sold.

Marginal Costing: Marginal costing values inventory at the variable cost per unit only. Fixed
costs are not included in the inventory valuation.

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Both absorption costing and marginal costing have their own advantages and applications.
The choice between the two methods depends on the specific needs of the business, the level

of detail required in cost analysis, and the decision-making context.

8.3 Cost Volume Profit (CVP) analysis –

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that examines the
relationships between costs, volume or quantity of production or sales, and profits. It provides
insights into how changes in these factors impact a company's profitability and helps in
making informed business decisions. Here are the key aspects of CVP analysis:

Cost Behavior: CVP analysis considers the behavior of costs. Costs are classified into
variable costs and fixed costs. Variable costs change in proportion to changes in the volume
of production or sales, while fixed costs remain constant regardless of the level of activity.

Contribution Margin: The contribution margin is a key concept in CVP analysis. It is

calculated as the difference between sales revenue and variable costs. The contribution

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margin represents the amount available to cover fixed costs and contribute to profits. It is
expressed as a ratio or percentage of sales.

Breakeven Point: The breakeven point is the level of production or sales at which total
revenues equal total costs. It is the point where a company neither makes a profit nor incurs a
loss. CVP analysis helps in determining the breakeven point by considering the contribution
margin. The breakeven point can be calculated in units or dollars.

Profit Planning and Target Profit: CVP analysis assists in profit planning by setting targets
for desired levels of profit. By analyzing the relationships between costs, volume, and profits,
managers can determine the required sales volume or price to achieve a specific profit target.

Margin of Safety: The margin of safety is the excess of actual or projected sales over the
breakeven point. It indicates the cushion or buffer a company has before reaching the
breakeven point. A higher margin of safety provides more financial stability and flexibility.

Sensitivity Analysis: CVP analysis enables sensitivity analysis to assess the impact of
changes in key variables. Managers can analyze different scenarios and evaluate the
effects of variations in sales volume, selling price, variable costs, or fixed costs on profits.

Decision-Making: CVP analysis aids in decision-making by evaluating the financial

implications of various alternatives. Managers can assess the profitability of different product
lines, pricing strategies, cost structures, or investment decisions using CVP analysis.

Limitations: CVP analysis assumes a linear relationship between costs, volume, and profits,
which may not hold true in all cases. It simplifies the cost structure by assuming fixed and
variable costs, whereas real-world costs may exhibit different behaviors. CVP analysis also
assumes that all other factors, such as sales mix and production efficiency, remain constant.

CVP analysis provides valuable insights into the financial performance and profitability of a
business. It helps in understanding cost behavior, determining the breakeven point, setting

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profit targets, and making informed decisions to achieve desired financial outcomes.
However, it should be used alongside other financial and non-financial factors to obtain a
comprehensive understanding of the business's performance and prospects.

Features of CVP

 A method for determining how changes in variable and fixed costs affect a
company's profit is cost-volume-profit (CVP) analysis.

 Using CVP, businesses can determine how many units are required to break even
(cover all costs) or reach a predetermined minimum profit margin.

 CVP investigation makes a few suspicions, including that the deals value, fixed, and
variable expenses per unit are steady.

CVP Formula
CVP analysis involves several formulas that help calculate various aspects of cost, volume,
and profit relationships. Here are the key formulas used in CVP analysis:

Contribution Margin (CM) per unit:

CM per unit = Selling price per unit - Variable cost per unit
Contribution Margin Ratio (CM Ratio):
CM Ratio = (Contribution Margin / Sales) * 100

Total Contribution:

Total Contribution = (Selling price per unit - Variable cost per unit) * Number of units sold

Breakeven Point in Units:

Breakeven Point (in units) = Fixed Costs / Contribution Margin per unit

Breakeven Point in Sales Dollars:

Breakeven Point (in sales dollars) = Fixed Costs / Contribution Margin Ratio

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Target Profit in Units:

Target Profit (in units) = (Fixed Costs + Target Profit) / Contribution Margin per unit

Target Profit in Sales Dollars:

Target Profit (in sales dollars) = (Fixed Costs + Target Profit) / Contribution Margin Ratio

Margin of Safety:

Margin of Safety = Actual or Projected Sales - Breakeven Sales

These formulas are used to calculate key metrics in CVP analysis, such as contribution
margin, breakeven point, target profit, and margin of safety. By utilizing these formulas,
managers can assess the financial implications of changes in sales volume, costs, and pricing
and make informed decisions to optimize profitability.

Applicability of CVP

Cost-Volume-Profit (CVP) analysis is applicable in various business scenarios and can

provide valuable insights for decision-making. Here are some common applications of CVP
analysis:

Pricing Decisions: CVP analysis helps in determining the optimal pricing strategy for a
product or service. By analyzing the relationships between costs, volume, and profits,
managers can assess the impact of different pricing levels on profitability and make informed
pricing decisions.

Product Mix Decisions: CVP analysis assists in evaluating the profitability of different
product lines or services. Managers can analyze the contribution margin of each product or
service and make decisions regarding the product mix to maximize overall profitability.

Profit Planning and Target Setting: CVP analysis aids in profit planning by setting profit
targets and identifying the required sales volume or price to achieve those targets. It helps in

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aligning financial goals with operational strategies and guides managers in planning for
profitability.

Breakeven Analysis: CVP analysis helps in determining the breakeven point, which is the
level of production or sales at which total revenues equal total costs. Managers can assess the
minimum sales volume required to cover all costs and avoid losses. Breakeven analysis is
particularly useful for startup businesses or when introducing new products or services.

Cost Control and Cost Reduction: CVP analysis facilitates cost control by analyzing the
behavior of costs and distinguishing between fixed and variable costs. It helps in identifying
opportunities to reduce costs, improve efficiency, and optimize resource utilization.

Sensitivity Analysis: CVP analysis enables sensitivity analysis to assess the impact of
changes in key variables. Managers can analyze different scenarios and evaluate the effects
of variations in sales volume, selling price, variable costs, or fixed costs on profitability. This
analysis assists in risk assessment and helps in making contingency plans.

Capital Investment Decisions: CVP analysis can be used in evaluating capital investment
decisions by considering the impact on profitability and breakeven points. It helps in
assessing the feasibility of investment projects and estimating the required sales volume or
price to achieve the desired return on investment.

Performance Evaluation: CVP analysis provides a framework for evaluating the financial
performance of products, departments, or business segments. It helps in identifying the
contribution of each segment to the overall profitability and supports performance
measurement and benchmarking.

CVP analysis is applicable in various industries and sectors, including manufacturing, retail,
services, and healthcare. It provides insights into the cost, volume, and profit dynamics of a
business and assists managers in making informed decisions to improve profitability and
financial performance.

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8.4 Break Even Analysis –
Break-even analysis is a financial tool used to determine the level of sales volume or revenue
required for a business to cover all its costs and reach the breakeven point, where there is
neither profit nor loss. It helps in understanding the minimum level of sales necessary to
cover fixed and variable costs. Here's how break-even analysis works:

Fixed Costs: Identify the fixed costs, which are expenses that remain constant regardless of the
level of production or sales. Examples include rent, salaries, insurance, and depreciation.

Variable Costs: Determine the variable costs, which are costs that vary in proportion to the
level of production or sales. Variable costs include direct materials, direct labor, and variable
overhead expenses.

Selling Price: Determine the selling price per unit of your product or service.

Contribution Margin: Calculate the contribution margin per unit by subtracting the variable
cost per unit from the selling price per unit. The contribution margin represents the amount
available to cover fixed costs and contribute to profits.

Contribution Margin per unit = Selling price per unit - Variable cost per unit

Breakeven Point in Units: Determine the breakeven point in units by dividing the fixed costs
by the contribution margin per unit.

Breakeven Point (in units) = Fixed Costs / Contribution Margin per unit
Breakeven Point in Sales Dollars: Calculate the breakeven point in sales dollars by
multiplying the breakeven point in units by the selling price per unit.

Breakeven Point (in sales dollars) = Breakeven Point (in units) * Selling price per unit

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Profitability Analysis: Analyze the impact of different sales levels on profitability. If actual
sales exceed the breakeven point, the business will generate a profit. If sales are below the
breakeven point, the business will incur a loss.

Margin of Safety: Calculate the margin of safety, which represents the difference between the
actual or projected sales and the breakeven point. The margin of safety provides a measure of
the cushion or buffer before reaching the breakeven point.

Margin of Safety = Actual or Projected Sales - Breakeven Sales

Break-even analysis helps businesses understand their financial viability and assess the risks
associated with different levels of sales. It assists in decision-making related to pricing, cost
control, and sales volume targets. By monitoring the breakeven point and margin of safety,
businesses can adjust their strategies to improve profitability and financial stability.

Features

 The point at which total revenue and total costs are equal is referred to as break- even
analysis.

 The number of units or dollars in revenue required to cover all costs is calculated
using a break-even point analysis.

 In order to determine how many units (or revenues) are required to cover the
company's fixed and variable expenses, business owners and managers must conduct
break-even analysis.

Formula

Break-Even Quantity = Fixed Costs / (Sales Price per Unit – Variable Cost Per Unit)

Graphical Presentation of BEP

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Explanation

 The quantity of units is on the X-pivot (level) and the dollar sum is on the Y-hub
(vertical).

 The red line addresses the all out fixed expenses of ₹ 100,000.

 The blue line addresses income per unit sold. For instance, selling 10,000 units would
create 10,000 x ₹ 12 = ₹ 120,000 in income.

 The yellow line addresses complete expenses (fixed and variable expenses). For
instance, in the event that the organization sells 0 units, the organization would bring
about ₹ 0 in factor costs however ₹ 100,000 in fixed costs for complete expenses of
₹ 100,000. Assuming the organization sells 10,000 units, the organization would
bring about 10,000 x ₹ 2 = ₹ 20,000 in factor costs and
₹ 100,000 in fixed costs for all out expenses of ₹ 120,000.

 The make back the initial investment point is at 10,000 units. Right now, income
would be 10,000 x ₹ 12 = ₹ 120,000 and costs would be 10,000 x 2 = ₹ 20,000 in
factor costs and ₹ 100,000 in fixed costs.

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 At the point when the quantity of units surpasses 10,000, the organization would create
a gain on the units sold. Note that the blue income line is more prominent than the
yellow all out costs line after 10,000 units are created. In like manner, in the event that
the quantity of units is under 10,000, the organization would cause a misfortune. From 0-9,999
units, the absolute costs line is over the income line.

8.5 Margin of Safety -.

The margin of safety is a financial metric that measures the cushion or buffer a business has
between its actual or projected sales and the breakeven point. It indicates the extent to which
sales can decline before the business starts incurring losses. The margin of safety provides
valuable insights into the financial stability and risk exposure of a business. Here's how to
calculate the margin of safety:

Breakeven Sales: Determine the breakeven point in sales dollars, which represents the level
of sales required to cover all costs and achieve a breakeven position.

Actual or Projected Sales: Identify the actual or projected sales revenue for a specific period.

Margin of Safety Calculation: Calculate the margin of safety by subtracting the breakeven sales
from the actual or projected sales.

Margin of Safety = Actual or Projected Sales - Breakeven Sales

The margin of safety can be expressed in dollars or as a percentage. It represents the excess
sales or revenue that a business has beyond the breakeven point.

Interpreting the Margin of Safety:

Positive Margin of Safety: A positive margin of safety indicates that actual or projected sales
are higher than the breakeven point. This means the business is generating profits and has a
buffer against declines in sales. A higher margin of safety provides greater financial stability
and flexibility.

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Zero Margin of Safety: A margin of safety of zero means that actual or projected sales are
exactly equal to the breakeven point. The business is neither making a profit nor incurring a
loss. Any decrease in sales below this level will result in losses.
Negative Margin of Safety: A negative margin of safety occurs when actual or projected
sales fall below the breakeven point. This indicates that the business is operating at a loss,
and a decrease in sales can exacerbate the financial difficulties. A negative margin of safety
signals a higher level of risk and the need for corrective actions.

The margin of safety is an important metric for assessing the financial health and risk
exposure of a business. It helps in monitoring the sales performance, identifying potential
vulnerabilities, and making informed decisions regarding pricing, cost control, and sales
volume targets.

8.6 Numerical Problems

Question 1

A company produces 500 units at a variable cost of ₹ 200 per unit. The price is ₹ 250 per
unit and there are fixed expenses of ₹ 12,000 per month.

For this question, calculate Break-even point in terms of both units and sales. Also, show the
profit at 90% capacity.

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Solution

(i) BEP (units) = Fixed Expenses / C

= ( ₹ 542,000 + ₹ 252,000) / 6

= 792,000 / 6 = 132,000 units

BEP (Sales) = 132,000 x 20 = ₹ 2640,000

(ii) Sales for examining profit = ₹ 60,000

BEP (units) = (Fixed Exp. + Desired Profit) / C

= (792,000 + 60,000) / 6
= 852,000 / 6

= 142,000 units

BEP Sales = 142,000 x 20 = ₹ 2,840,000

Question 2

For a company, sales are ₹ 80,000, variable costs are ₹ 4,000, and fixed costs are ₹ 4,000.
Calculate the following: (i) PVR, (ii) BEP (Sales), (iii) Margin of Safety, and (iv) Profit.

Solution

(i) PVR = (C / ₹ ) x 100 = (4,000 x 100) / 8,000 = 50%

C = 8,000 - (4,000) = ₹ 4,000

(ii) BEP (Sales) = Fixed Cost / PVR

= (4,000 x 100) / 50

= ₹ 8,000

(iii) MOS = Actual Sales - BEP Sales

= 8,000 - 8,000
= Nil OR

MOS = Profit / PVR = 0 / 8,000 = Nil

(iv) Profit = Sales - Variable Cost - Fixed Cost

= 8,000 - 4,000 - 4,000

200
= Nil

Question 3

From the following information, find out PVR and sales at BEP. Variable cost per unit = ₹ 15
Sales per unit = ₹ 20

Fixed expenses = ₹ 54,000

What should the new selling price be if BEP for units is reduced to 6,000 units? Solution
PVR = (C x 100) / S

Thus,

= ((20 - 15) x 100) / 20

PVR = 25%
BEP (Sales) = Fixed expenses / PVR

= (54,000 x 100) / 25

= ₹ 216,000

(iii) New selling price if BEP is brought down to 6,000 units:

New SP = (Fixed Exp. + Variable Cost ) / New BEP (units)

= (54,000 + 15) / 6,000

= ₹ 24

Question 4

Calculate (i) PVR, (ii) BEP, and (iii) Margin of Safety based on the following information:
Sales = ₹ 100,000
Total cost = ₹ 80,000 Fixed cost = ₹ 20,000 Net profit = 80,000 Solution

(i) PVR = (C x 100) / S

C = Sales - Variable Cost 100,000 - 60,000 = 40,000

Variable cost = Sales - Profit - Fixed Cost (100,000 - 20,000 - 20,000) = 60,000
Thus,

PVR = (C / S) x 100

= (40,000 / 100,000) x 100

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= 40%

(ii) BEP = Fixed Exp. / PVR

= 20,000 / 40%

=(20,000 x 100) / 40

= ₹ 50,000

(iii) Margin of Safety = Present Sales - Break-Even Sales

= 1,00,000 - 50,000

= 50,000

Profitability = (40 x 50,000) / 100

= ₹ 20,000

Question 5

The National Company has just been formed. They have a patented process that will make
them the sole suppliers of Product A.

During the first year, the capacity of their plant will be 9,000 units, and this is the amount they
will be able to sell. Their costs are:

Direct labor = ₹ 15 per unit Raw materials = ₹ 5 per unit

Other variable costs = ₹ 10 per unit Fixed costs = ₹ 240,000

There are two parts to this question:

(a) If the company aims to make a profit of ₹ 210,000 for the first year, what should the
selling price be? What is the contribution margin at this price?

(b) If, at the end of first year, the company aims to increase its volume, how many units will
they have to sell to realize a profit of ₹ 760,000 given the following conditions?
An increase of ₹ 100,000 in the annual fixed costs will increase their capacity to 50,000 units

Selling price is at ₹ 70 per unit and no other costs change

₹ 500,000 is invested in advertising Solution

(a) Calculation of selling price

Direct labor (9,000 x 15) = ₹ 135,000 Raw materials (9,000 x 5) = ₹ 45,000

Other variable costs (9,000 x 10) = ₹ 90,000 Total variable costs (PU 30) = 270,000

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Add: Fixed Cost = 240,000 Profit = 210,000
Total sales value of 9,000 units @ ₹ 80 per unit = 720,000

(b) Sales in units

(Fixed expenses + Desired profit) / (Sales - Variable cost) Thus,

Fixed Expenses = 2,40,000 (given) + 1,00,000 (extra) + 50,000 (advertisement cost)
= 840,000 + Desired Profit (760,000) = ₹ 1,600,000
= 1,600,000 / (70 - 30) = 40,000 units

8.7 Summary
Marginal costing is a costing technique used in managerial accounting to analyze the cost and
profitability of products or services. Here is a summary of marginal costing:

Cost Separation: Marginal costing separates costs into fixed costs and variable costs. Fixed
costs remain constant regardless of production or sales volume, while variable costs vary
proportionately with production or sales.

Contribution Margin: The contribution margin is the difference between sales revenue and
variable costs. It represents the amount available to cover fixed costs and contribute to profits.
The contribution margin per unit helps assess profitability and make pricing decisions.

Breakeven Analysis: Marginal costing aids in determining the breakeven point, where total
revenue equals total costs. It helps identify the sales volume needed to cover all costs and
avoid losses.

Decision-Making: Marginal costing assists in short-term decision-making by analyzing the

impact of changes in production, sales, and costs on profitability. It helps evaluate product
profitability, determine the optimal product mix, and make pricing and resource allocation
decisions.

Cost Control: Marginal costing facilitates effective cost control by separating fixed and
variable costs. It enables managers to monitor and manage variable costs more directly.

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Flexibility in Pricing: Marginal costing allows for flexible pricing strategies based on the
incremental cost of production. It helps determine optimal pricing levels to maximize
profitability.

Simplified Analysis: Marginal costing provides a simplified approach to cost analysis,

focusing on variable costs and contribution margin. It offers a clear understanding of the cost
behavior and profitability of individual units.

While marginal costing offers simplicity and useful insights for short-term decision- making,
it should be used alongside other costing methods to gain a comprehensive understanding of
costs and profitability. Marginal costing provides managers with key information to analyze
costs, pricing, and profitability and make informed decisions to optimize financial
performance.

8.8 Keywords
Marginal Costing, absorption costing, (CVP) analysis, Break Even Analysis, Margin of
Safety

8.9 Questions
1 What is Marginal Costing? Explain.

2 State the distinction between absorption costing and marginal costing.

3 Write a note on Cost Volume Profit (CVP) analysis.

4 What is Break Even Analysis?

5 Explain Margin of Safety

8.10 Case Study

Case Study: XYZ Manufacturing Company

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XYZ Manufacturing Company is a leading manufacturer of consumer electronics. The
company produces and sells a range of electronic devices, including smartphones and tablets.
XYZ Company wants to evaluate the profitability of its product lines using marginal costing
techniques.

The company has gathered the following information for the financial year 2022:

Sales Volume: XYZ Company sold 100,000 smartphones and 50,000 tablets during the year.
Selling Price: The selling price of each smartphone is ₹ 500, and each tablet is sold for
₹ 800.

Variable Costs: The variable cost per unit for smartphones is ₹ 300, and for tablets, it is
₹ 500.

Fixed Costs: The total fixed costs for the year amount to ₹ 2,000,000.

Based on this information, XYZ Company wants to analyze the contribution and
profitability of each product line using marginal costing principles.

Solution:

Step 1: Calculation of Contribution Margin per Unit

Contribution Margin per unit = Selling Price per unit - Variable Cost per unit For
smartphones: Contribution Margin per unit = ₹ 500 - ₹ 300 = ₹ 200

For tablets: Contribution Margin per unit = ₹ 800 - ₹ 500 = ₹ 300 Step 2: Calculation of
Total Contribution
Total Contribution = Contribution Margin per unit * Sales Volume

For smartphones: Total Contribution = ₹ 200 * 100,000 = ₹ 20,000,000 For tablets: Total
Contribution = ₹ 300 * 50,000 = ₹ 15,000,000

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Step 3: Calculation of Total Fixed Costs Total Fixed Costs = ₹ 2,000,000
Step 4: Calculation of Profit

Profit = Total Contribution - Total Fixed Costs

Profit = ( ₹ 20,000,000 + ₹ 15,000,000) - ₹ 2,000,000 Profit = ₹ 33,000,000 - ₹ 2,000,000

Profit = ₹ 31,000,000

In this case, XYZ Manufacturing Company made a profit of ₹ 31,000,000 in the financial
year 2022.

Step 5: Calculation of Profitability Ratio Profitability Ratio = (Profit / Total Sales) * 100
For XYZ Company: Profitability Ratio = ( ₹ 31,000,000 / ( ₹ 500 * 100,000 + ₹ 800 *
50,000)) * 100

Profitability Ratio = ( ₹ 31,000,000 / ₹ 50,000,000) * 100 Profitability Ratio = 62%

The profitability ratio indicates that XYZ Company achieved a 62% profitability in the
financial year 2022.

By using marginal costing techniques, XYZ Manufacturing Company was able to analyze the
contribution and profitability of its product lines separately. This information can help the
company make informed decisions regarding pricing, product mix, and resource allocation to
maximize profits.

8.11 References
1. Management Accounting, MadhuVij

2. Fundamentals of Management Accounting, H. V.Jhamb

3. Cost and Management Accounting, M. N. Arora

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UNIT 9

CONTRACT AND BATCH COSTING

Learning Objectives

1. To Understand the nature and scope of Contract and Batch Costing

2. To understand the Difference between Contract and Batch Costing

3. To List the advantages and disadvantages of Contract and Batch

Costing

Structure

9.1 Contract costing – Meaning and Features

9.2 Advantages and Disadvantage of Contract Costing
9.3 Numericals – Contract Costing
9.4 Batch Costing
9.5 Advantages and Disadvantage of Batch Costing
9.6 Numericals – Batch Costing
9.7 Summary
9.8 Keywords
9.9 Questions
9.10 Case Study
9.11 References

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9.1 Contract costing – Meaning and Features
Contract costing refers to a specific method of cost accounting used to determine and track
the costs associated with a particular contract or project. It is commonly used in industries
such as construction, manufacturing, and engineering, where projects are often undertaken on
a contractual basis.

The features of contract costing include:

Specific contract identification: Each contract or project is identified and treated as a separate
cost unit. It is assigned a unique code or number to distinguish it from other contracts.

Cost accumulation: Contract costing involves the accumulation of all costs related to a specific
contract. This includes direct costs (such as materials, labor, and subcontractor expenses) and
indirect costs (such as overheads and administrative expenses) that are directly attributable to
the contract.

Timeframe: Contract costing is performed over a specific period, typically from the start of
the contract until its completion. Costs are recorded and monitored throughout the duration of
the contract.

Cost allocation: Costs are allocated to different cost centers or cost elements based on their
nature and relationship to the contract. For example, direct materials may be allocated to a
materials cost center, while direct labor costs may be allocated to a labor cost center.

Progress measurement: Contract costing involves measuring the progress of the contract to
determine the extent of completion. This helps in recognizing revenue and matching costs to
the corresponding revenue earned during different stages of the project.

Cost control: Contract costing provides a mechanism to monitor and control costs associated
with a contract. By comparing actual costs with estimated costs, management can identify
any deviations and take corrective actions to ensure profitability and cost efficiency.
Job cost statement: A job cost statement or contract account is prepared for each contract,
summarizing all costs incurred and revenues recognized. This statement helps in assessing

208
the profitability and financial performance of the contract.

Overall, contract costing enables companies to track and manage costs on a project- by-project
basis, providing insights into the financial performance of each contract and facilitating
effective decision-making.

9.2 Advantages and Disadvantage of Contract Costing Advantages of

Contract Costing:
Accurate Cost Tracking: Contract costing allows for precise tracking of costs
associated with a specific contract or project. This enables better control and analysis of project
expenses, helping companies to identify cost overruns and take corrective measures.

Profitability Analysis: By isolating costs and revenues for each contract, contract costing
provides a clear picture of the profitability of individual projects. This helps management in
making informed decisions regarding pricing, resource allocation, and contract negotiations.

Resource Allocation: Contract costing assists in efficient resource allocation by providing

insights into the utilization of materials, labor, and other resources for different contracts.
This information can be used to optimize resource allocation and improve overall operational
efficiency.

Evaluation of Contract Performance: Contract costing allows for the evaluation of the financial
performance of each contract. It helps in identifying factors that contribute to the success or
failure of a contract, enabling companies to learn from past experiences and make
improvements for future contracts.

Decision Making: With accurate cost data and profitability analysis, contract costing provides
a solid foundation for decision-making. Companies can use this information to assess the
viability of new contracts, determine pricing strategies, and allocate resources effectively.

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Disadvantages of Contract Costing:
Complexity: Contract costing can be complex and time-consuming, especially for large
projects involving multiple cost centers and various contract terms. This complexity may
require specialized knowledge and expertise in cost accounting.

Cost Allocation Challenges: Allocating costs to specific contracts or cost centers can be
challenging, especially when overhead expenses are involved. Determining how to apportion
indirect costs fairly and accurately across contracts may require subjective judgment and may
lead to disputes.

Cost Estimation Uncertainty: Estimating costs for a contract at the beginning of the project
can be difficult, especially if the scope of work is not clearly defined or if there are potential
risks and uncertainties. Inaccurate cost estimates can affect the profitability and viability of
the contract.

Administrative Burden: Implementing contract costing requires maintaining detailed records

and documentation for each contract, which can result in increased administrative workload.
This may involve additional staffing and time commitments to ensure accurate data recording
and analysis.

Limited Applicability: Contract costing may not be suitable for all types of businesses or
industries. It is primarily used in industries where contracts or projects are the main source of
revenue, such as construction or manufacturing. Service-based industries or businesses with
standardized products may find other cost accounting methods more appropriate.

Overall, while contract costing offers numerous benefits, it is important for companies to
consider the potential complexities and challenges associated with its implementation, as well
as its relevance to their specific industry and business model.

Types of Contract Costing

There are several types of contract costing methods used in cost accounting. The choice of
the method depends on the nature of the contract and the specific requirements of the
business. Here are some common types of contract costing:

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Job Costing: Job costing is a fundamental type of contract costing used when each contract is
unique and distinct. Costs are accumulated for each individual job or contract, and a separate
job cost account is maintained. This method is commonly used in industries such as
construction, custom manufacturing, and consulting services.

Operation Costing: Operation costing is used when a contract consists of a series of similar
operations or processes. Costs are accumulated for each operation or process within the
contract, and the total cost is allocated to the contract based on the number of operations
performed. This method is often employed in industries such as manufacturing, where
standardized operations are repeated across different contracts.

Composite Costing: Composite costing is used when a contract involves multiple elements or
components that are separately identifiable but are closely related. The costs of these
components are accumulated separately and then combined to determine the total cost of the
contract. This method is commonly used in industries such as construction and engineering
projects.

Multiple Costing: Multiple costing is used when a contract requires different cost units or
cost centers to be considered separately. Costs are accumulated and tracked separately for each
cost unit or cost center within the contract, allowing for better control and analysis. This
method is often employed in large-scale projects with multiple cost components.

Terminal Costing: Terminal costing is used when a contract extends over a long period, and
costs are accumulated and recorded periodically at specific intervals. This method helps in
monitoring and analyzing costs at different stages of the contract and allows for timely
adjustments and decision-making.

It's important to note that these types of contract costing methods can be used individually or
in combination, depending on the complexity and requirements of the contract. Companies
may also develop hybrid approaches or customize the methods to suit their specific needs.

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Important points to consider while Contract Costing
Contract costing involves several specific aspects that are important to understand. Here are
some specific aspects of contract costing:

Contract Identification: Each contract is identified and treated as a separate cost unit. It is
assigned a unique code or number to distinguish it from other contracts. This allows for the
proper tracking and analysis of costs associated with each contract.

Cost Accumulation: Contract costing involves the accumulation of all costs related to a
specific contract. This includes direct costs (such as materials, labor, and subcontractor
expenses) and indirect costs (such as overheads and administrative expenses) that are directly
attributable to the contract. Proper cost accumulation ensures accurate cost reporting and
analysis.

Progress Measurement: Contract costing involves measuring the progress of the contract to
determine the extent of completion. This is important for recognizing revenue and matching
costs to the corresponding revenue earned during different stages of the project. Various
methods, such as percentage of completion or milestones, can be used to measure progress.

Cost Allocation: Costs are allocated to different cost centers or cost elements based on their
nature and relationship to the contract. For example, direct materials may be allocated to a
materials cost center, while direct labor costs may be allocated to a labor cost center. Proper
cost allocation ensures that costs are accurately attributed to the appropriate cost centers or
cost elements.

Cost Control: Contract costing provides a mechanism to monitor and control costs associated
with a contract. By comparing actual costs with estimated costs, management can identify
any deviations and take corrective actions to ensure profitability and cost efficiency. Effective
cost control helps in managing project costs within budgeted limits.

Job Cost Statement: A job cost statement or contract account is prepared for each contract,
summarizing all costs incurred and revenues recognized. This statement helps in assessing
the profitability and financial performance of the contract. It provides a comprehensive view

212
of the costs and revenues associated with the contract, facilitating management decision-
making.

Contract Closeout: Contract costing involves the proper closeout of contracts once they are
completed. This includes finalizing all costs and revenues associated with the contract,
reconciling any variations or claims, and preparing final financial
statements. Contract closeout ensures that all financial aspects of the contract are properly
accounted for and finalized.

Understanding these specific aspects of contract costing is essential for implementing and
managing cost accounting for contracts effectively. It helps in accurately tracking costs,
analyzing profitability, and making informed decisions regarding contract management and
resource allocation.

9.3 Numericals – Contract Costing

1) The following particulars are available in respect of a contract as on 31st March, 2008
(all figures in rupees)

(i) Contract price 500000 (ii) Total cost of contract upto 287500
date
(iii) Cost of uncertified work 12,500 (iv) cash received 265625

(v) Retention money @15%

Compute the amount of profit that may be credited to Profit and Loss Account and the value
of work-in-progress

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Solution

(a) Calculation of
Notional Profit
Value of work certified 3, 12,500
(Note I)
Add: Cost of work 12 500
uncertified
3, 25,000
Less: Total cost of contract 2, 87,500
upto date

Notional Profit 37,500

Calculation of 100 x (Value of Work Certified + Cost of Work Uncertified)

Percentage of Completion

Percentage of Completion Contract Price - (3, 12,500 +12,500) x 100

5, 00,000
= 65 %

Profits to be credited to Profit

and Loss Account

= 37500X2/3X 2, 65,625/3, 12,500

= 21250

Value of Work-in-Progress
Cost of contract to date 287500
Add: Profit transferred to Profit and Loss 21,250
Account
3,08,750

Less: Cash received 2,65

625
Value of Work-in-Progress 43,125

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Working Note :

Value of Work Certified = Cash received/(100% - retention %)

= 265625/(100% - 15%)

= 312500

2) Ambuja Construction Ltd. entered into a contract to construct a building. The

contract value was INR 1300000 to be realised in instalment on the basis of value of work
certified by the architect subject to retention of 10%. The work commenced on 1.4.2008 but it
remained incomplete on 31.12.2008 when the final accounts are to be prepared. The facts and
figures of the contract are:

Materials issued to contract 360000 Wages paid 174000

Expenses incurred on the 77,500 Plant sent to site on 64000
contract 1.4.2008
Wages unpaid 6,300
Total establishment expenses amounted to INR 82000 out of which 25% is attributable to the
contract. Out of materials issued to the contract, materials Costing INR 8,000 were sold for
INR 12000. A part of the plant (cost INR 4000) are damaged on 10, 2008 and scrap realised
only INR 600. Plant costing INR 6000 was transferred to another contract on 11.12.2008. Plant
is to depreciated @ 10%p.a. Material in hand on 31.12.2008 was INR 35000. Cash received
from the contractee was INR 612000. Cost of work yet to be certified was INR 60000.
PREPARE CONTRACT ACCOUNT AND CONTRACTEE ACCOUNT IN THE
BOOKS OF AMBUJA CONSTRUCTION LTD.

Solution

In the books of Ambuja Construction Limited. Contract Account (Period1.4.2008-31.12.2008)

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TO DIRECT MATERIALS 360000 BY SALE OF 12000
MATERIALS
TO DIRECT WAGES 174000 BY MATERIALS IN 35000
HAND
ADD: WAGES UNPAID 6300 180300 COST OF 600000
CONTRACT
c/d
TO EXPENSES 77500
TO ESTABLISHMENT EXPENSES 20500
(82000*25%)
TO PROFIT ON SALE OF 4000
MATERIALS
TO DEPRECIATION ON PLANT 4700
(NOTE 1)

600000 600000
TO COST OF CONTRACT b/d 600000 BY CONTRACTEE 680000
A/C
TO NOTIONAL 140000 BY COST OF 60000
PROFIT c/d WORK
UNCERTIFIED
740000 740000

TO PROFIT AND LOSS A/C 84000 BY NOTIONAL PROFIT 140000

b/d
TO RESERVE PROFIT c/d 56000
140000 140000
TO MATERIALS 35000 BY RESERVE PROFIT 56000
b/d
BY WAGES UNPAID 6300

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CONTRACTEE ACCOUNT
Dr. Cr.
TO CONTRACT BY BANK A/C (CASH
A/C 6800000 RECEIVED) 612000
BY BALANCE c/d 68000

680000 680000

Working Notes
Calculation of Depreciation on Plant :
Cost of Plant sent to site (I.4.2008) 64000
Less: Cost of Plant Damaged (1.10.2008) 4000

60000

Depreciation for 6 months on INR 64,000 @10% p.a.[64000*(10/100)*(6/12)] 3,200

Depreciation for 3 months on INR 60000 @ 10% p.a [ 60000*(10/100)*(3/12)] 1500
TOTAL 4700

Value of work certified = cash received/ (100%- 612000/(100%-10%)

Retention %)=
percentage of completion = (680000+60000)/1300000*100=56.92%
calculation of profit to be credited to profit and = 2/3 * 140000* 612000/680000=INR 84000
loss account

A firm of building contractors undertook a contract fort 350000. The Following particulars are
furnished for the year ended 31st December, 2011 :

Materials Wages for Labour 40000

Direct Purchased 30,000 General Plant in use :

Issued from Stores 10000 WDV 90000

Direct Expenses 25000 Dep thereon 10000

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Subcontract Charges 6,000 Share of General Overhead 2000
Materials in Hand on 2,000 Material Lost by Fire 500
31.12.2011
Outstanding Wages on 6,000 Direct Expenses Accrued on 1000
31.12.2011 31.12.2011
Cash Received (90% of work 1,62,000 Cost of uncertified work 5,000
certified)

Contract Account (Jan 1- Dec 31,2011)

Dr. Cr.

particulars particulars

To Direct Materials : Direct

Purchase 30000 issued from stores
10000
40000 By Materials in Hand 2000
To Direct Wages 40,000Add
outstanding 6000 46000 By Materials lost by Fire 500
To Direct Expenses 2,500 Add:
Direct Expenses Accrued 1.000

3500 By Cost of Contract cid 105000

To Share of GeneralOverhead

2000
To Depreciation 10000

To Sub-contract Charges 6000

107500 107500
By Contractee A/c (Note 1)
To Cost of Contract b/d 105000 18000

To Notional Profit c/d(Note 2)

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80000 By Cost of Work Uncertified 5000

185000 185000

To Profit and Loss A/c(Note 4)

48000 By Notional Profit b/d (Note 2) 80000
To Reserve Profit c/d 32000

80000 80000
To Materials in Hand 2000 By Reserve Profit b/d 32000
To Cost of WorkUncertified
5000 By Outstanding Wages 6000
By Direct Expenses Accrued 1000

Working note

Calculation of work certified= 162000/90*100= INR 180000 calculation of notional profit:

value of work certified 180000 +

cost of work uncertified 5000 – cost of contract = 80000 calculation of percentage of

completion= (180000+5000)/ 350000*100= 52.86%
Since the contract is 52.86 % complete, profit to be transferred to profit and loss account is
calculated as follows= 2/3*80000*162000/180000= INR 48000
4) S Co. (2013) Ltd., a firm of building contractors, undertook a contract for 6,50,000 to
realize on the basis of certified by the architect subject to a retention of 10%. The work
commenced on 1.04.2012 but it remained incomplete on 31.12.2012 when the final accounts
are to be prepared. The facts s and figures of the contract are:

Materials charged to contract 180000

Wages paid for Labour 87000

Plant charged to contract at the commencement 32000

Expenses incurred on contract 38,750

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Total establishment expenses amounted to 41000 out of which 25% is, attributable to this
contract. Out of the materials issued to the contract, materials costing 4,000 were sold for
5,000. A part of the plant cost (2,000) was damaged on 01.10.20I 2 and the scrap was
realized 300 only. Plant costing
3,000 was transferred to another contract site on 31.12.2012. Plant is to be depreciated
@10%p.a. Materials on hand on 31.12.2011 was 17,500. Cash received from the contractee
3, 06,000. Cost of work not yet certified 30000.

Prepare Contract Account showing therein the amount of profit or loss to be transferred to
Profit and Loss Account.

Solution

In the books of S & Co. (2013) Ltd.

Contract Account
(Poriod: April 1, 2012 to Docombor 31, 2012)

Particulars INR particulars INR

To Direct Materials 180000 By Bank - Sale of Materials 5000
To Direct Wages 87000 By Direct Materials in Hand c/d 17500

By Plant (damaged 1900+

To Direct Expenses 38750 returned 2775+ at site 24975) 29650
note 1,2,3
To Establishment Expenses (25% of 10250 By Cost of Contract c/d 296850
41,000)
To Plant at Cost 32000
In Profit on Sale of Materials (5,000 - 4,000) 1000

349000 349000
To Cost of Contract b/d 296850 By Contractee A/c (Note 4) 340000
To National Profit c/d 73150 By Coct of Wort. Uncertfied 30000

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370000 370000
To Profit and Loss Nc (Note 7) 43890 By Notional Profit b/d 73150
To Reserve Profit c/d 29260

73150 73150
To Direct Materials in Hand 17500
To Plant at Valuation (Note 3) 24975 By Reserve Profit b/d 29260
Working note

i) Cost of damaged plant= 2000 Dep. Upto date if

damage:( 2000*10%)*(6/12)=100 wdv of the damaged plant: cost- dep= 2000-
100=1900
ii) cost of plant transferred= 3000 dep. For 9 months= 3000* (10/1
iii) cost of plant at site: 32000-2000-3000=27000 dep. Of plant at site = 10% of
27000* (9/12)=2025 wdv of plant at site=27000-2025=24975
iv) value of work certified= retention is 10% so, cash received= 90% of the work
certified
cash received=306000 so, work certified= (306000/90)*100=340000 v)
notional profit= 340000+30000-296850=73150 vi)percentage of completion=
(340000+30000)/650000*100=56.92% vi)profit to be
transferred to profit &
loss= 2/3*73150*306000/340000=43800

5) Sinha & Co. undertook a contract to construct a building for which the
following information are supplied on 31.12.2015. Construction started on 1st January, 2015.

Contract price 1600000

Wages paid 360000
Other expenses 52000
Cash received 720000
Materials lying unconsumed 16000
Insurance claim admitted for materials stolen 14000

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Materials sent to site 3,00,000
Wages unpaid 32,000
Plant sent to site 400000
Materials returned to stores 10000
Materials stolen from site 20000
work uncertified 22000

Plant is subject to depreciation @ 7.5% p.a. and cash has been received for 90% of work
certified. Prepare Contract account.

IN THE BOOKS OF SINHA& CO.

Dr. CONTRACT ACCOUNT (JAN1 TO DEC 31, 2015) Cr.
PARTICULARS INR PARTICULARS INR
To DirectMaterials
By Direct Materials : returned
to store 10000+in hand
300000 46000
16000+stolen 20000
To Direct Wages360000 Add:
362000 By Cost of Contract c/d 698000
Outstanding Wages To Other
Expenses 2000
To other expenses 52000
To Depreciation on Plant (Note 1)
30000
744000 744000
To Cost of Contract b/d
698000 By Contractee A/c (Note 2) 800000
To NotionalProfit c/d By Cost of Work Uncertified
124000 c/d 22000

822000 822000
To Profit andLoss A/c
74400

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To Reserve Profitc/d
49600 By Notional Profit b/d 124000
124000 124000
To Direct Materials in Hand
16000 By Reserve Profit b/d 49600
To Cost of WorkUncertified
22000 By outstanding wages 2000

Working note

i) Dep. On plant= 400000* (7.5/100)=30000

ii) cal. Of work certified= 720000/90*100=800000

iii) percentage of completion= (800000+22000)/1600000*100=51.38%

iv) profit to be transferred to profit and loss a/c =

2/3*124000*720000/800000=74400

TRY IT OUT YOURSELF

From the following particulars relating to a contract, prepare (a) the Contract Account,

(b) Contractee’s Account:

The contract price has been agreed at Rs.2,50,000. Cash has been received from the
contractee amounting to Rs.1,80,000.

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1) Calculate profit on work certified, cost of work in progress at the year end from the
following:
(a) Materials sent to site Rs.86,000;
(b) Labour on site Rs.70,000;
(c) Plant at site Rs.80,000;
(d) Direct Expenses Rs.3,000;
(e) Office expenses Rs.4,000;
(f) Materials returned to stores Rs.600;
(g) Work certified Rs.1,90,000;
(h) Work not certified Rs.7,700;
(i) Materials in stock at end Rs:2,000;
(j) Outstanding wages Rs.300;
(k) Cash received against bill Rs.1,61,500;
(l) Depreciation on plant Rs. 7,000.

2. Calcutta Construction Ltd. undertook a contract for construction of a bridge on 1st July,
1991. The contract price was Rs.5,00,000. The Company incurred the following expenses
upto December, 1991:

Depreciation 10% p.a. on plant

Charge other works expenses @ 20% of wages and office expenses @ 10% of works cost.
The amount certified by the engineer was Rs.3,00,000, retention money being 20% of the
certifiedvalue.
Prepare the Contract Account showing therein the amount of profit that the company
canreasonably take to its Profit and Loss Account.

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9.4 Batch Costing
Batch costing is a cost accounting method used to determine and allocate costs to a specific
batch or group of similar products. It is commonly used in manufacturing environments
where products are produced in batches or groups rather than individually.

Features of batch costing include:

Batch identification: Each batch is identified and treated as a separate cost unit. It is assigned
a unique code or number to distinguish it from other batches. This helps in tracking costs and
analyzing the performance of each batch.

Cost accumulation: Batch costing involves the accumulation of all costs associated with a
particular batch. This includes direct costs (such as materials, labor, and direct expenses) and
indirect costs (such as overheads and administrative expenses) that are directly attributable to
the batch.

Homogeneous products: Batch costing is suitable for situations where the products within a
batch are homogenous or have similar characteristics. This allows for the pooling of costs
and simplifies the allocation process.

Timeframe: Batch costing is performed over a specific period, typically covering the
production and completion of a particular batch. Costs are recorded and monitored
throughout the duration of the batch.

Cost allocation: Costs are allocated to different cost centers or cost elements based on their
nature and relationship to the batch. For example, direct materials may be allocated to a
materials cost center, while direct labor costs may be allocated to a labor cost center.

Cost control: Batch costing provides a mechanism to monitor and control costs associated
with a batch. By comparing actual costs with estimated costs, management can identify any
deviations and take corrective actions to ensure cost efficiency.

Batch cost statement: A batch cost statement or batch account is prepared for each batch,
summarizing all costs incurred. This statement helps in assessing the cost efficiency and

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financial performance of the batch.
Flexibility: Batch costing allows for flexibility in determining the size and composition of
each batch. The size of a batch can be adjusted based on production requirements and the
capacity of the manufacturing process.

Batch costing enables companies to analyze costs at a batch level, facilitating better decision-
making regarding pricing, resource allocation, and profitability analysis. It provides insights
into the cost structure of each batch and helps in identifying opportunities for cost reduction
and process improvement.

9.5 Advantages and Disadvantage of Batch Costing Advantages of Batch Costing:

Cost Efficiency: Batch costing allows for the allocation of costs to a group of similar
products produced together, resulting in cost efficiencies. Resources such as labor, materials,
and equipment can be utilized more effectively when producing products in batches, leading
to economies of scale.

Better Cost Control: Batch costing enables companies to have better control over costs
associated with each batch. By analyzing the costs incurred for a specific batch, management
can identify cost variations and take corrective actions to control and reduce costs.

Improved Pricing Decisions: Batch costing provides valuable cost information for pricing
decisions. By understanding the costs allocated to a batch, companies can set appropriate
prices that cover the production costs while remaining competitive in the market.

Performance Evaluation: Batch costing facilitates performance evaluation of different

batches. Companies can compare the costs, profitability, and efficiency of various batches to
identify the most successful ones and make informed decisions about resource allocation and
future production planning.

Resource Allocation: With batch costing, companies can allocate resources more efficiently
by planning the production of different batches. This helps in optimizing the use of labor,
machinery, and materials, leading to improved resource utilization and reduced wastage.

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Disadvantages of Batch Costing:
Complexity: Batch costing can be complex, especially when dealing with multiple batches
and their associated costs. It requires accurate tracking and allocation of costs, which may
involve complex accounting and record-keeping processes.

Allocation Challenges: Allocating costs to specific batches may present challenges,

particularly when there are shared costs or indirect expenses involved. Determining the fair
and accurate allocation of overhead costs across batches may require subjective judgment
and can be prone to disputes.

Cost Estimation Uncertainty: Estimating costs for a batch can be challenging, especially if
there are uncertainties in production volumes, material prices, or other variables. Inaccurate
cost estimates can affect pricing decisions and impact the profitability of the batches.

Limited Applicability: Batch costing may not be suitable for all types of products or
industries. It is most commonly used in manufacturing environments where products are
produced in batches. Industries with continuous or customized production processes may find
other cost accounting methods more appropriate.

Administrative Burden: Implementing batch costing may require additional administrative

effort and record-keeping. Managing the cost allocation and documentation for each batch
can be time-consuming and may necessitate additional resources.

It is important for companies to consider these advantages and disadvantages and evaluate
whether batch costing is the most suitable cost accounting method for their specific business
operations and industry context.

9.6 Numericals – Batch Costing

Example #1
Suppose a bakery produces cookies in a batch of 1000 units. To determine the cost per
cookie, businesses calculate the production budget for the entire lot, which includes
materials, labor, and overhead costs, and then divide it by 1000 units.

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Calculating the cost per cookie as $1, based on the total cost of producing the lot of
$1000 and 1000 cookies produced, enables the bakery to determine the profitability of each
cookie sold. This enables them to adjust pricing or production quantities
accordingly for better profitability. Additionally, since the cookies are identical, it is easy to
catch any quality control issues and take corrective actions quickly.

Example #2
Automobile manufacturers produce cars in lots, commonly known as production runs, and
calculate the total production budget for the entire lot, including materials, labor, and
overhead costs. They then divide the total cost by the number of units produced to determine
the cost per car.

If the total cost of producing a lot of 1000 cars is $10 million, then the cost per car would be
$10,000. It allows the automobile manufacturer to determine the profitability of each car sold
and adjust the pricing or production quantities accordingly.

9.7 Summary
In summary, contract costing and batch costing are two methods used in cost accounting to
allocate and track costs in different scenarios.

Contract costing focuses on determining and monitoring costs associated with specific
contracts or projects. It involves the identification of each contract as a separate cost unit,
accumulation of costs related to the contract, progress measurement, cost control, and the
preparation of job cost statements. Contract costing provides accurate cost tracking,
profitability analysis, resource allocation insights, and supports decision- making for
contract-based industries.

On the other hand, batch costing is used when products are produced in batches or groups. It
involves identifying and treating each batch as a separate cost unit, accumulating costs for
the batch, allocating costs to cost centers, cost control, and preparing batch cost statements.
Batch costing offers advantages such as cost efficiency, better cost control, improved pricing
decisions, performance evaluation, and optimized resource allocation.

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Both methods have their advantages and disadvantages. Contract costing provides precise
cost tracking for individual contracts, while batch costing offers cost efficiencies through the
production of similar products in batches. However, both methods can be complex, require
accurate cost allocation, and involve administrative efforts. It's crucial for companies to
choose the most suitable method based on their industry, business model, and specific cost
accounting needs.

9.8 Keywords
Contract costing, batch costing

9.9 Questions
1. Imagine a construction company that has undertaken a contract to build a new office
building. What are the key cost components that need to be considered in this contract
costing scenario?
2. In the context of a software development project, differentiate between direct costs
and indirect costs, providing examples of each.
3. A company is working on a contract that involves both construction and interior
design. How would you allocate costs between these two aspects of the project?
4. Given the following information from a construction contract: Total Contract
Revenue = $500,000, Direct Costs = $300,000, Indirect Costs = $50,000, and Other
Revenues (non-contract related) = $20,000, calculate the company's profit margin for
this contract.
5. Explain the concept of progress billing in contract costing and how it affects the
recognition of revenue and costs over the duration of a project.
6. In the context of a manufacturing contract, a client requests changes to the originally
agreed-upon specifications. How would you account for these variations in terms of
costs and pricing?
7. Describe what a job cost sheet is and how it is used in tracking costs for individual
contracts or projects.
8. A company has multiple contracts of varying sizes. How can the company allocate
overhead costs in a fair and accurate manner to each contract?
9. Explain the criteria that need to be met in order to determine when a contract can be

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considered completed and how revenue and costs are recognized at completion.
10. If a contract is expected to result in a loss, how would you account for this loss in
contract costing? What are the steps involved?

11. How would you handle contract costing for a project that spans multiple years,
considering factors like inflation and changing costs?
12. A company is bidding on a contract for a new bridge construction project. Describe
the process they might follow to estimate the costs accurately before submitting their
bid.

9.10 Case Study

Case Study: Construction of a Residential Complex

ABC Construction Company has been awarded a contract to build a residential complex
consisting of five apartment buildings. The project is expected to last for 18 months. The
company needs to carefully manage its costs to ensure profitability while delivering a quality
product to the client. Here are the details of the case:

Project Overview:

Total Contract Value: $10,000,000 Number of Buildings: 5

Duration: 18 months Cost Breakdown:

Direct Costs:

Materials: $3,000,000 Labor: $2,500,000

Subcontractor Costs: $1,200,000 Indirect Costs:

Project Management Salaries: $500,000 Equipment Depreciation: $300,000

Site Rental and Utilities: $200,000 Other Costs:

Design and Engineering Fees: $150,000 Legal and Permitting Costs: $50,000 Additional
Information:

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The project management team consists of a project manager, an assistant project
manager, and two site supervisors.
The company uses a predetermined overhead rate of 20% based on direct labor costs to
allocate indirect costs.
Each building is considered a separate "job" for costing purposes.
The company uses the completed contract method for revenue recognition. Tasks:

Cost Allocation:
Determine the total cost for each building and allocate the indirect costs to each building using
the predetermined overhead rate.

Profit Analysis:
Calculate the total direct costs, total indirect costs, and the total cost for the entire
project. Calculate the expected profit for the project.

Progress Billing:
Assume that the contract specifies that the company will bill the client 30% of the contract
value upon reaching the midpoint of the project duration and the remaining 70% upon
completion. Calculate the amounts to be billed at the midpoint and at completion.

Loss Recognition:
Due to unforeseen delays, one of the buildings faces cost overruns that result in a loss for that
building. Calculate the loss and explain how it should be recognized in the company's
financial statements.

Completion and Revenue Recognition:

If two of the buildings are completed within the 18-month period, explain how the company
should recognize revenue and costs for these completed buildings.

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9.11 References
1. Financial Accounting for Managers, Sanjay Dhmija, Pearson Publications
2. Management Accounting, Mr. Anthony Atkinson, Robert Kaplan, Pearson
3. Accounting For Management, Jawarhar Lal

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UNIT 10

CAPITAL EXPENDITURE EVALUATION

Learning Objectives

1. To Understand the nature and scope of Capital expenditure evaluation

2. To understand the Capital budgeting.
3. To understand how to exercise Capital expenditure control.

Structure

10.1 Introduction to Capital expenditure evaluation –

10.2 Capital expenditure evaluation meaning advantages and disadvantages
10.3 Capital budgeting concept –
10.4 Methods –
10.5 Limitations –
10.6 Capital expenditure control.
10.7 Summary
10.8 Keywords
10.9 Questions
10.10 Case Study
10.11 References

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10.1 Introduction to Capital expenditure evaluation –
Capital expenditure evaluation refers to the process of assessing and analyzing the potential
benefits and costs associated with a capital investment project. It involves evaluating the
financial feasibility, risk, and strategic alignment of the investment to determine whether it is
worthwhile for a company to proceed with the project.

Here are some key steps involved in capital expenditure evaluation:

Identify and define the project: Clearly articulate the purpose and objectives of the capital
expenditure project. This includes specifying the expected outcomes, deliverables, and
timeline.

Estimate cash flows: Determine the projected cash inflows and outflows associated with the
project over its expected lifespan. Consider factors such as revenue growth, cost savings,
operating expenses, maintenance costs, and taxes. Cash flows should be estimated for each
year or period of the project.

Determine the cost of capital: Assess the cost of capital, which is the minimum return
required by the company's investors to undertake the investment. It represents the
opportunity cost of using funds for the project instead of alternative uses. The cost of capital
is typically expressed as a percentage and can include factors like the cost of debt and equity.

Calculate the financial metrics: Use various financial metrics to evaluate the project's
profitability and return on investment. Common metrics include net present value (NPV),
internal rate of return (IRR), payback period, and profitability index. These calculations help
determine whether the project is financially viable and generates positive returns.

Assess qualitative factors: Consider qualitative factors that may impact the project's success,
such as market conditions, industry trends, competitive landscape, technological
advancements, regulatory environment, and strategic fit within the organization. These

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factors help evaluate the project's long-term sustainability and alignment with the company's
goals.
Conduct risk analysis: Identify and assess potential risks associated with the project,
including operational, financial, market, and external risks. Evaluate the probability and
potential impact of each risk and develop mitigation strategies to minimize their effects. Risk
analysis helps ensure that the investment aligns with the company's risk tolerance and overall
risk management strategy.

Make a decision: Based on the analysis and evaluation conducted in the previous steps, make
a decision on whether to proceed with the capital expenditure project. Consider the financial
metrics, qualitative factors, and risk assessment to determine the project's overall feasibility
and alignment with the company's strategic objectives.

It's important to note that capital expenditure evaluation is a complex process, and
organizations may have their own specific methodologies and criteria for evaluating projects.
The goal is to make informed decisions that maximize shareholder value and contribute to
the long-term growth and profitability of the company.

10.2 Capital expenditure evaluation meaning advantages and disadvantages

The capital expenditure evaluation is the process of assessing the potential benefits and costs
associated with a capital investment project. Here are some advantages and disadvantages of
capital expenditure evaluation:

Advantages:

Informed decision-making: The evaluation process provides a structured framework for

assessing the financial viability and strategic fit of a capital expenditure project. It helps
decision-makers make informed choices based on quantitative and qualitative analysis.

Financial analysis: The evaluation allows for a thorough financial analysis, including
estimating cash flows, calculating financial metrics (e.g., NPV, IRR), and considering the cost

235
of capital. This analysis helps determine the project's profitability and return on investment.

Risk assessment: Capital expenditure evaluation involves identifying and assessing potential
risks associated with the project. By considering risks upfront, decision- makers can develop
strategies to mitigate them, minimizing potential negative impacts on the investment.

Strategic alignment: The evaluation process helps align the capital expenditure project with
the company's long-term strategic objectives. It assesses whether the project is in line with
the organization's goals, market conditions, industry trends, and competitive landscape.

Prioritization of investments: Evaluating capital expenditure projects allows organizations to

prioritize investments based on their potential returns and strategic importance. It helps
allocate resources efficiently and ensures that the most promising projects receive adequate
attention and funding.

Disadvantages:

Uncertainty and assumptions: Capital expenditure evaluation involves making assumptions

and projections about future cash flows, market conditions, and other factors. These
estimates are subject to uncertainty and may not accurately reflect the actual outcomes,
leading to potential errors in decision-making.

Complex evaluation process: Capital expenditure evaluation can be a complex process,

requiring expertise in financial analysis, risk assessment, and industry knowledge. It may
require significant time and resources to conduct a thorough evaluation, especially for large
and complex projects.

Limited scope: The evaluation process may focus primarily on financial metrics and
quantitative analysis, which may not capture all relevant factors, such as qualitative aspects
or intangible benefits. This limited scope could result in overlooking important
considerations for decision-making.

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Difficulty in measuring intangible benefits: Some capital expenditure projects, such as
investments in research and development or brand building, may have intangible benefits that
are challenging to measure and quantify. This can make the evaluation process more
challenging, as intangible benefits are not easily captured by traditional financial metrics.

Overemphasis on short-term results: The evaluation process may place a stronger emphasis
on short-term financial results, such as payback period or immediate profitability, rather
than considering the long-term impact and sustainability of the
investment. This can lead to suboptimal decision-making if long-term benefits are
overlooked.

It's important to consider these advantages and disadvantages when conducting a capital
expenditure evaluation. Organizations should tailor their evaluation processes to their specific
needs and objectives, taking into account both quantitative and qualitative factors for a
comprehensive assessment of potential investments.

10.3 Capital budgeting concept –

Capital budgeting refers to the process of evaluating and selecting long-term investment
projects that involve significant capital expenditure. It involves analyzing and determining the
financial viability of potential investment opportunities to allocate limited resources
effectively. The concept of capital budgeting is crucial for businesses to make informed
decisions about investing in projects that generate returns over an extended period.

Here are some key aspects of capital budgeting:

Long-term investment decisions: Capital budgeting focuses on evaluating projects with a

long-term impact, such as the acquisition of new assets, expansion of facilities, development
of new products, or entry into new markets. These decisions have a substantial financial and
operational impact on the organization.

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Cash flow analysis: Capital budgeting involves estimating the cash inflows and outflows
associated with each investment project. The analysis typically covers the project's entire
lifespan, considering factors such as initial investment costs, operating cash flows, salvage
value, and terminal cash flows. Cash flow analysis helps determine the project's profitability
and its impact on the company's cash position.

Evaluation techniques: Various evaluation techniques are employed in capital budgeting to

assess the financial feasibility of investment projects. Common methods include Net Present
Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index. These
techniques provide quantitative measures to compare and rank investment options based on
their expected returns and risks.
Risk assessment: Capital budgeting considers the risks associated with investment projects.
Factors such as market uncertainty, competition, technological advancements, regulatory
changes, and project-specific risks are evaluated to understand their potential impact on cash
flows and profitability. Risk assessment helps decision-makers make informed judgments
about the likelihood of achieving projected returns.

Capital rationing: Capital budgeting takes into account the availability and limitation of
capital resources. In situations where there are constraints on funding, such as limited capital
availability or budgetary restrictions, capital rationing helps prioritize investment projects
based on their expected returns and strategic importance.

Non-financial factors: While financial analysis forms a significant part of capital budgeting,
non-financial factors are also considered. These include strategic alignment with
organizational objectives, market demand, competitive advantage, environmental
sustainability, social impact, and legal and regulatory compliance. Non-financial factors
ensure that investment decisions align with broader corporate goals and stakeholder
expectations.

Post-investment evaluation: After a project is approved and implemented, capital budgeting

involves monitoring and evaluating its performance against initial projections. Post-
investment evaluation helps determine if the project is meeting the expected financial

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outcomes, identifies any deviations, and allows for adjustments or corrective actions if
needed.

By applying capital budgeting concepts, organizations can make informed investment

decisions, optimize resource allocation, mitigate risks, and enhance long-term profitability. It
enables them to evaluate potential projects based on their financial viability, strategic fit, and
alignment with the organization's goals, ultimately contributing to sustainable growth and
value creation.

10.4 Methods
There are several methods of capital budgeting that organizations use to evaluate and select
investment projects. The choice of method depends on factors such as the nature of the project,
availability of data, and company preferences. Here are some commonly used methods:

Net Present Value (NPV): NPV is a widely used capital budgeting method that calculates the
present value of expected cash inflows and outflows associated with a project. It discounts
future cash flows back to the present using a predetermined discount rate, typically the
company's cost of capital. If the NPV is positive, the project is considered financially viable
and is expected to generate value for the organization.

Internal Rate of Return (IRR): IRR is the discount rate that makes the NPV of a project zero.
It represents the project's expected rate of return. The IRR is compared to the company's
required rate of return or cost of capital. If the IRR is higher than the required rate of return, the
project is considered acceptable. IRR is useful for comparing different investment
opportunities and selecting the ones with the highest returns.

Payback Period: The payback period is the time required for an investment project to recover
its initial cost through expected cash inflows. It is a simple method that focuses on the time it
takes to recoup the investment. Projects with shorter payback periods are typically preferred as
they provide a quicker return of capital. However, this method does not consider cash flows
beyond the payback period and ignores the time value of money.

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Profitability Index (PI): The profitability index, also known as the benefit-cost ratio, is
calculated by dividing the present value of expected cash inflows by the present value of
expected cash outflows. It indicates the value created per unit of investment. A profitability
index greater than 1 suggests that the project is expected to generate positive value. It is
useful for comparing and ranking projects when capital is constrained.

Accounting Rate of Return (ARR): ARR calculates the average annual accounting profit of an
investment project as a percentage of the average investment. It does not consider the time
value of money and relies on accounting profit rather than cash flows. ARR is simpler to
calculate but may not accurately represent the project's profitability or provide an appropriate
measure for investment decision-making.

Modified Internal Rate of Return (MIRR): MIRR addresses some of the limitations of IRR
by assuming that cash flows are reinvested at a predetermined rate of return. It considers both
the rate of return on cash inflows and the rate of reinvestment on cash outflows. MIRR
provides a more realistic measure of profitability and is suitable for projects with
unconventional cash flow patterns.
It's worth noting that these methods have their strengths and weaknesses. Organizations often
use multiple methods in conjunction to gain a comprehensive view of the investment
opportunity and make well-informed decisions. The choice of method should align with the
organization's goals, risk tolerance, and specific requirements for evaluating investment
projects.

Numericals on Capital Budgeting

Problem 1

The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000,
$25,000, and $10,000 over four years.

Required: Using the present value index method, appraise the profitability of the
proposed investment, assuming a 10% rate of discount.

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Solution

The first step is to calculate the present value and profitability index.

Present Value
Year Cash Inflows Factor Present Value

$ @10% $
1 20,000 0.909 18,180
2 15,000 0.826 12,390
3 25,000 0.751 18,775
4 10,000 0.683 6,830

56,175

Total present value = $56,175 Less: initial outlay = $50,000 Net present value = $6,175

Profitability Index (gross) = Present value of cash inflows / Initial cash outflow

= 56,175 / 50,000

= 1.1235

Given that the profitability index (PI) is greater than 1.0, we can accept the proposal. Net
Profitability = NPV / Initial cash outlay

= 6,175 / 50,000 = 0.1235

N.P.I. = 1.1235 - 1 = 0.1235

Given that the net profitability index (NPI) is positive, we can accept the proposal. Problem 2
A company is considering whether to purchase a new machine. Machines A and B are
available for $80,000 each. Earnings after taxation are as follows:

Year Machine A Machine B

$ $
1 24,000 8,000
2 32,000 24,000
3 40,000 32,000
4 24,000 48,000

5 16,000 32,000

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Required: Evaluate the two alternatives using the following: (a) payback method, (b) rate of
return on investment method, and (c) net present value method. You should use a
discount rate of 10%.

Solution

(a) Payback method

24,000 of 40,000 = 2 years and 7.2 months Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.

According to the payback method, Machine A is preferred.

(b) Rate of return on investment method

Particular Machine A Machine B

Total Cash Flows
1,36,000 1,44,000

1,36,000 / 1,44,000 /
Average Annual Cash Flows 5= $27,000 5 = $28,800

Annual Depreciation 80,000 / 5 80,000 / 5

= $16,000 = $16,000

27,200 - 28,800 -
Annual Net 16,000 = 16,000 =
Savings $11,200 $12,800

Average 80,000 / 2 80,000 / 2

Investment = $40,000 = $40,000
ROI = (Annual
Net Savings / (11,200 / (12,800 /
Average 40,000) x 40,000) x
Investments) x 100 100
100
= 28% = 32%
According to the rate of return on investment (ROI) method, Machine B is preferred due to
the higher ROI rate.

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(c) Net present value method

The idea of this method is to calculate the present value of cash flows.

Year Discount Factor Machine A Machine B

(at 10%) Cash Flows ($) P.V ($) Cash Flows ($) P.V ($)
1 .909 24,000 21,816 8,000 7,272
2 .826 32,000 26,432 24,000 19,824
3 .751 40,000 30,040 32,000 24,032
4 .683 24,000 16,392 48,000 32,784
5 .621 16,000 9,936 32,000 19,872
1,36,000 1,04,616 1,44,000 1,03,784

Proposal A Proposal B

Cost of Investment $20,000 28,000

Life 4 years 5 years

Scrap Value Nil Nil

Net Income (After depreciation and tax)

End of 2015 $500 Nil

End of 2016 $2,000 $3,400

End of 2017 $3,500 $3,400

Net Value

End of 2018 $2,500 $3,400

End of 2019 Nil $3,400

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Net Present Value of Machine A: $1,04,616 - $80,000 = $24,616 Net Present Value of
Machine B: $1,03,784 - 80,000 = $23,784
According to the net present value (NPV) method, Machine A is preferred because its NPV
is greater than that of Machine B.

Problem 3

At the beginning of 2015, a business enterprise is trying to decide between two potential
investments.

Required: Assuming a required rate of return of 10% p.a., evaluate the investment proposals
under: (a) return on investment, (b) payback period, (c) discounted payback period, and (d)
profitability index.

The forecast details are given below.

It is estimated that each of the alternative projects will require an additional working capital
of $2,000, which will be received back in full after the end of each project.

Depreciation is provided using the straight line method. The present value of $1.00 to be
received at the end of each year (at 10% p.a.) is shown below:
Year 1 2 3 4 5
P.V. 0.91 0.83 0.75 0.68 0.62

Solution

Calculation of profit after tax

Year Proposal A $20,000 Proposal B $28,000

Net Income Dep. Cash Inflow Net Income Dep. Cash Inflow

$ $ $ $ $ $

2015 500 5,000 5,500 - 5,600 5,600

2016 2,000 5,000 7,000 3,400 5,600 9,000

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2017 3,500 5,000 8,500 3,400 5,600 9,000

2018 2,500 5,000 7,500 3,400 5,600 9,000

2019 - - - 3,400 5,600 9,000

Total 8,500 20,000 28,500 13,600 28,000 41,600

(a) Return on investment

Proposal A Proposal B

20,000 + 2,000 = 28,000 + 2,000 =

Investment
22,000 30,000

Life 4 years 5 years

Total Net Income $8,500 $13,600

Average Return ($) 8,500 / 4 = 2,125 13,600 / 5 = 2,720

(22,000 + 2,000) / 2 = (30,000 + 2,000) / 2 =

Average Investment ($)
12,000 16,000
Average Return on Average (2,125 / 12,000) x 100 (2,720 / 16,000) x 100
Investment ($) = 17.7% = 17%

(b) Payback period

Proposal A
Cash Inflow ($)

2015 5,500

2016 7,000

2017 7,500 (7,500 / 8,500 = 0.9)

20,000

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Payback period = 2.9 years

Proposal B
Cash Inflow

$
2015 5,600
2016 9,000
2017 9,000

2018 4,400 (4,400 / 9,000 = 0.5)

Payback period = 3.5 years

(c) Discounted payback period

Proposal A Proposal B
P.V. of Cash Inflow P.V. of Cash Inflow
Year $ Year $
2015 5,005 2015 5,096
2016 5,810 2016 7,470
2017 6,375 2017 6,750
2,810
(2,810
2018 / 2018 6,120
5,100
= 0.5)
2,564
(2,564
2019 /
5,580
= 0.4)

20,000 28,000
Discounted Payback Period Discounted Payback Period
= 3.5 years = 4.4 years

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(d) Profitability index method

Proposal A Proposal B

Gross Profitability Index

(22,290 (31,016
/ 20,000) / 28,000)
x 100 x 100
= 111.45% = 111.08%

Net Profitability (2,290 /

Index 20,000) (3,016 /
x 100 28,000)

= 11.45% x 100
= 10.8%

10.5 Limitations –
While capital budgeting is a valuable process for evaluating investment projects, it is
important to recognize its limitations. Here are some common limitations associated with
capital budgeting:

Uncertainty and forecasting errors: Capital budgeting relies on estimates and projections of
future cash flows, which are inherently uncertain. External factors such as changes in market
conditions, technological advancements, and regulatory changes can significantly impact the
accuracy of forecasts. Forecasting errors can lead to inaccurate assessments of a project's
financial viability and potential returns.

Inaccurate cost of capital estimation: Capital budgeting methods require the determination of
an appropriate discount rate or cost of capital to calculate present values. Estimating the cost

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of capital involves making assumptions about the company's financing mix, risk profile, and
market conditions. If the cost of capital is incorrectly estimated, it can lead to flawed
investment decisions.

Ignoring qualitative factors: Capital budgeting methods primarily focus on financial metrics
and may overlook important qualitative factors. Factors such as strategic alignment, market
dynamics, competitive landscape, technological obsolescence, and social or environmental
impact are essential considerations for investment decisions but may not be easily quantifiable
or incorporated into traditional financial analysis.

Time value of money assumptions: Capital budgeting methods assume a constant discount
rate over the project's life, applying a time value of money concept. However, in reality, the
cost of capital may vary over time due to changes in market conditions, inflation, or shifts in
the company's risk profile. This assumption may lead to inaccuracies in the evaluation of
long-term projects.

Lack of flexibility: Capital budgeting decisions are typically made based on projected cash
flows and investment costs. Once a project is approved and initiated, it may be
challenging to adjust or modify the project in response to changing circumstances. Lack of
flexibility can limit the organization's ability to adapt to unforeseen events or new
opportunities.

Intangible benefits and risks: Some investment projects may involve intangible benefits or
risks that are difficult to quantify or incorporate into the capital budgeting analysis. For
example, investments in brand building, employee training, or research and development can
have long-term strategic value but are challenging to measure in financial terms. Failing to
account for these intangible aspects can lead to incomplete investment evaluations.

Behavioral biases: Capital budgeting decisions are ultimately made by individuals who may
be subject to cognitive biases and heuristics. Biases such as overconfidence, anchoring, or
confirmation bias can influence decision-making and lead to suboptimal investment choices.
Recognizing and mitigating these biases is essential for improving the accuracy and

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effectiveness of capital budgeting.

It is important to be aware of these limitations when using capital budgeting techniques.

Organizations should strive to incorporate a comprehensive assessment of both quantitative
and qualitative factors, regularly review and update investment decisions, and remain
adaptable to changes in the business environment.

10.6 Capital expenditure control.

Capital expenditure control refers to the process of monitoring, managing, and controlling the
spending on capital investment projects within an organization. It involves implementing
mechanisms and procedures to ensure that capital expenditures are aligned with the
organization's strategic objectives, financial constraints, and desired returns. Effective capital
expenditure control helps prevent cost overruns, optimize resource allocation, and maximize
the value generated from capital investments.

Here are some key elements and strategies involved in capital expenditure control:

Budgeting: Establishing a capital expenditure budget is a fundamental step in controlling capital

spending. The budget sets limits and guidelines for capital projects, providing a
framework for decision-making and resource allocation. It ensures that capital expenditures
are planned, authorized, and monitored within defined financial limits.

Approval process: Implementing a rigorous approval process helps maintain control over
capital expenditures. The process typically involves a review and evaluation of investment
proposals, including financial analysis, risk assessment, strategic alignment, and consideration
of alternatives. Approvals should be granted based on predefined criteria and the availability
of funds.

Prioritization: Prioritizing capital projects is essential when resources are limited. Projects
should be evaluated based on their potential returns, strategic importance, risk profile, and
alignment with the organization's goals. By prioritizing projects, resources can be allocated

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to initiatives that generate the highest value and contribute most effectively to the
organization's growth and profitability.

Project monitoring: Regular monitoring and tracking of ongoing capital projects are critical
to ensure adherence to budgets and timelines. This includes reviewing project progress,
assessing actual expenditures against planned amounts, and identifying any deviations or
potential cost overruns. Monitoring helps detect issues early on, allowing for corrective
actions and timely decision-making.

Cost control measures: Implementing cost control measures is vital to manage capital
expenditures effectively. This may involve establishing cost management systems,
conducting cost-benefit analyses, negotiating with suppliers for better pricing, seeking
competitive bids, and exploring cost-saving opportunities through process optimization or
value engineering.

Performance evaluation: Evaluating the performance of completed capital projects is

essential to assess their success and identify areas for improvement. This includes analyzing
actual financial outcomes, comparing them to projected results, and conducting post-project
reviews. Performance evaluation provides insights into the effectiveness of capital
expenditure decisions and helps inform future investment decisions.

Continuous improvement: Capital expenditure control should be an ongoing process of

continuous improvement. Organizations should regularly review and refine their control
mechanisms, incorporating lessons learned from past projects and adjusting processes as
needed. This iterative approach ensures that the capital expenditure control
framework remains effective and aligned with the organization's evolving needs and
goals.

By implementing robust capital expenditure control practices, organizations can ensure that
capital investments are managed efficiently, risks are mitigated, and resources are allocated
optimally. Effective control over capital expenditures contributes to better financial
management, enhanced decision-making, and the successful execution of investment

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projects.

10.7 Summary
Capital budgeting is the process of evaluating and selecting long-term investment projects for
an organization. It involves analyzing the financial feasibility and strategic alignment of
potential investments to make informed decisions about allocating capital resources. The key
steps in capital budgeting include identifying and defining projects, estimating cash flows,
determining the cost of capital, calculating financial metrics (such as NPV and IRR), assessing
qualitative factors, conducting risk analysis, and making a decision on whether to proceed
with the investment. Capital budgeting helps organizations prioritize investments, optimize
resource allocation, and contribute to long-term growth and profitability. However, it has
limitations, including uncertainty in forecasting, difficulty in estimating the cost of capital,
overlooking qualitative factors, assumptions about the time value of money, lack of
flexibility, and challenges in measuring intangible benefits. By recognizing these limitations
and implementing effective control measures, organizations can enhance the accuracy and
effectiveness of their capital budgeting processes.

10.8 Keywords
Capital Budgeting, NPV, IRR, Time Value of Money, Capital expenditure evaluation

10.9 Questions
1. Write a detailed note on Capital expenditure evaluation.
2 State the advantages and disadvantages of Capital expenditure evaluation.
3 Discuss the concept of Capital budgeting and its applicability.
4 Elaborate Methods of Capital Budgeting with suitable examples
5 Write a note on Limitations of Capital Budgeting.
6 List the measures used to exercise Capital expenditure control.

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10.10 Case Study
Case Study: ABC Manufacturing Company

ABC Manufacturing Company is a medium-sized manufacturing company that specializes in

producing industrial machinery. The company is considering investing in a new automated
assembly line for one of its product lines. The estimated cost of the assembly line is $2
million, and it is expected to have a useful life of 10 years. The projected annual cash inflows
from increased production and cost savings are as follows:

Year 1: $400,000

Year 2: $500,000

Year 3: $600,000

Year 4: $700,000

Year 5: $800,000

Year 6: $900,000

Year 7: $900,000

Year 8: $800,000

Year 9: $700,000
Year 10: $600,000

The company's cost of capital is 10%.

ABC Manufacturing Company wants to evaluate the financial viability of the investment
using the Net Present Value (NPV) and Internal Rate of Return (IRR) methods.

Solution:

Net Present Value (NPV) Calculation:

To calculate the NPV, we discount the projected cash inflows to their present value using the

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company's cost of capital. The formula for NPV is:

NPV = Sum of (Cash Inflow / (1 + Discount Rate)^n) - Initial Investment

Using the cash inflows provided and the cost of capital of 10%, we can calculate the NPV as
follows:

NPV = ($400,000 / (1 + 0.10)^1) + ($500,000 / (1 + 0.10)^2) + ... + ($600,000 / (1 +

0.10)^10) - $2,000,000

Calculating the above expression, we find the NPV for the project: NPV = $189,343.84
The positive NPV indicates that the project is expected to generate value for ABC
Manufacturing Company.

Internal Rate of Return (IRR) Calculation:

To calculate the IRR, we determine the discount rate that makes the NPV of the project zero.
We can use trial and error or built-in functions in software like Microsoft Excel to find the
IRR. In this case, the IRR is approximately 14.46%.

Interpreting the IRR, it suggests that the project is expected to generate a return of
approximately 14.46%, which is higher than the company's cost of capital of 10%.

Conclusion:

Based on the capital budgeting analysis, the new automated assembly line investment for
ABC Manufacturing Company appears financially viable. The positive NPV indicates that
the project is expected to generate value, and the IRR of 14.46% suggests a return higher
than the company's cost of capital. However, it's important for the company to also consider
qualitative factors, such as strategic alignment and market conditions, in making the final
investment decision.

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10.11 References
1. Accounting, Shukla Grewal

2. Management Accounting, Ravi Kishore

3. Accounting for Managers, Dearden and Bhattacharya

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UNIT 11

BUDGETARY CONTROL

Learning Objectives

1. To Understand the concept of Budgetary Control

2. To study the Nature and objective of Budgetary control

Structure

11.1 Budgetary Control

11.2 Nature and objective of Budgetary control

11.3 Limitations

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Introduction

Budgetary control is a fundamental process used by organizations to manage and regulate

their financial resources effectively. It involves creating budgets, monitoring actual
performance against budgeted targets, analyzing variances, and taking corrective actions when
necessary. By implementing budgetary control, organizations can align their financial
activities with strategic goals, optimize resource allocation, and ensure financial stability and
accountability.

Budgetary control begins with the establishment of budgets, which are comprehensive
financial plans outlining expected revenues, expenses, and other financial parameters for a
specific period, typically a fiscal year. These budgets serve as guidelines for managers and
employees to adhere to while executing their operational activities.

The monitoring and measurement phase involve continuously tracking financial transactions,
collecting relevant data, and comparing actual performance against the budgeted figures.
This process helps identify any variances, which are deviations from the planned budgets,
and allows organizations to understand the factors contributing to these variances.

Variance analysis is a crucial component of budgetary control, as it involves investigating the

reasons behind the variances and evaluating their impact on overall financial performance.
This analysis assists organizations in identifying areas of concern, recognizing potential
risks, and making informed decisions regarding resource allocation and cost management.

When significant variances are identified, corrective actions are taken promptly to address
the deviations from the budget. These actions may include revising the budget, reallocating
resources, implementing cost-saving measures, improving operational efficiency, or adjusting
strategies to align with changing market conditions. The aim is to ensure that the
organization stays on track to achieve its financial objectives and make necessary
adjustments to meet any unforeseen challenges.

Budgetary control also serves as a tool for performance evaluation at various levels of the
organization. By comparing actual performance against the budgets, management can assess
the effectiveness of financial planning, resource allocation, and decision-

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making processes. This evaluation facilitates continuous improvement and enables
organizations to recognize outstanding performance and areas that require further attention.

Clear and effective communication and reporting are integral to budgetary control. Financial
information and performance reports should be shared with relevant stakeholders to keep
them informed about the financial health of the organization. This transparency promotes
accountability and facilitates informed decision-making by executives, managers, and
shareholders.

In summary, budgetary control is a comprehensive process that helps organizations

effectively manage their financial resources. It involves creating budgets, monitoring
performance, analyzing variances, taking corrective actions, and evaluating performance. By
implementing budgetary control, organizations can achieve financial stability, optimize
resource allocation, and make informed decisions to align their financial activities with
strategic objectives.

11.1 Budgetary Control

Budgetary control is a process used by organizations to monitor and control their financial
resources. It involves setting budgets, comparing actual performance against the budgets,
identifying variances, and taking corrective actions when necessary. The primary goal of
budgetary control is to ensure that the organization's financial activities are aligned with its
strategic objectives and that resources are used effectively and efficiently.

Definition
Budgetary control refers to the process of planning, monitoring, and controlling an
organization's financial resources through the use of budgets. It involves creating budgets,
comparing actual performance against the budgeted figures, analyzing variances, and taking
corrective actions when necessary. The primary objective of budgetary control is to ensure
that the organization's financial activities are aligned with its strategic goals, resources are
utilized effectively, and financial targets are met.

Here are some key components and features of budgetary control:

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Budget Setting: Budgetary control begins with the establishment of budgets, which are
financial plans that outline expected revenues, expenses, and other financial targets for a
specific period, typically a fiscal year. Budgets can be prepared for various aspects of the
organization, such as sales, production, marketing, and capital expenditures.

Budgetary Guidelines: Budgets are typically based on historical data, industry trends, market
conditions, and the organization's strategic plans. They provide guidelines for managers and
employees regarding spending limits, revenue targets, and performanceexpectations.

Monitoring and Measurement: Once budgets are set, actual performance is continuously
monitored and measured against the budgeted targets. This involves tracking financial
transactions, collecting data, and comparing actual revenues and expenses with the
corresponding budgeted amounts.

Variance Analysis: Variances arise when actual performance deviates from the budgeted
figures. Variances can be favorable (when actual performance exceeds the budget) or
unfavorable (when actual performance falls short of the budget). Variance analysis involves
identifying the causes of variances and evaluating their impact on financial performance.

Corrective Actions: Budgetary control enables management to take timely corrective actions
when significant variances occur. This may involve revising the budget, reallocating
resources, implementing cost-saving measures, improving operational efficiency, or adjusting
sales and marketing strategies.

Performance Evaluation: Budgetary control facilitates performance evaluation at various

levels of the organization. By comparing actual performance against budgets, management
can assess the effectiveness of financial planning, resource allocation, and decision-making
processes. It also helps in identifying areas of improvement and recognizing outstanding
performance.

Communication and Reporting: Effective communication is crucial in budgetary control.

Financial information and performance reports should be shared with relevant stakeholders,
including managers, executives, and shareholders. These reports help stakeholders

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understand the financial health of the organization, identify areas of concern, and make
informed decisions.

Budgetary control plays a vital role in financial management, enabling organizations to

exercise control over their financial resources, monitor performance, and make informed
decisions. It helps ensure that financial objectives are met, resources are utilized efficiently,
and corrective actions are taken promptly to address deviations from the planned budgets

11.2 Nature and objective of Budgetary control

The nature and objectives of budgetary control are as follows:Nature of Budgetary Control:

Planning: Budgetary control involves the process of planning and setting financial targets for
an organization. It helps in establishing specific goals and objectives for different
departments or functions within the organization.

Coordination: Budgetary control requires coordination among various departments and

functions within the organization. It ensures that different departments work together towards
achieving the overall financial objectives set in the budgets.

Control: Budgetary control provides a mechanism for monitoring and controlling financial
activities. It helps in measuring actual performance against budgeted targets, identifying
variances, and taking corrective actions to ensure that financial goals are met.

Communication: Budgetary control facilitates communication and information sharing within

the organization. Financial budgets and performance reports are communicated to relevant
stakeholders, enabling them to understand the financial health of the organization and make
informed decisions.

Objectives of Budgetary Control:

Planning and Goal Setting: The primary objective of budgetary control is to establish
financial targets and goals for the organization. It helps in aligning the organization's
activities with its strategic objectives and provides a roadmap for achieving financial success.

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Resource Allocation: Budgetary control assists in optimizing resource allocation. It helps in
determining how financial resources should be allocated among different departments,
projects, or activities to maximize efficiency and effectiveness.

Performance Evaluation: Budgetary control provides a framework for evaluating the

performance of departments, teams, or individuals. By comparing actual performance against
budgeted targets, it helps in identifying areas of improvement, recognizing outstanding
performance, and taking corrective actions when necessary.

Cost Control: Budgetary control enables organizations to control costs effectively. It helps in
monitoring and managing expenses to ensure that they remain within the budgeted limits.
Variances are analyzed to identify cost-saving opportunities and implement appropriate cost
control measures.

Decision Making: Budgetary control provides crucial financial information for decision-
making purposes. It helps in assessing the financial feasibility of new projects, evaluating
investment opportunities, and making informed decisions regarding resource allocation and
utilization.

Financial Discipline: Budgetary control promotes financial discipline within the

organization. It establishes accountability and encourages managers and employees to adhere
to the budgeted limits and financial guidelines set by the organization.

In summary, the nature of budgetary control involves planning, coordination, control, and
communication. Its objectives include planning and goal setting, resource allocation,
performance evaluation, cost control, decision making, and maintaining financial discipline.
By implementing budgetary control, organizations can effectively manage their financial
resources, monitor performance, and work towards achieving their financial objectives.

Types of Budgets in Budgetary Control

There are several types of budgets used in budgetary control. Here are some commonly used
types:

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Operating Budget: This type of budget includes various operational aspects of the
organization, such as sales, production, marketing, research and development, and
administrative expenses. It provides a detailed plan for revenue generation, costmanagement,
and resource allocation within the organization.

Sales Budget: The sales budget forecasts the expected sales revenue for a specific period. It is
based on sales forecasts, market trends, historical data, and the organization's marketing and
sales strategies.

Production Budget: The production budget determines the quantity of products or services
that need to be produced to meet the sales demand. It takes into account factors such as
inventory levels, production capacity, and customer demand forecasts.

Cash Budget: The cash budget outlines the expected inflows and outflows of cash for a given
period. It helps in managing the organization's liquidity, cash flow requirements, and ensuring
that there is sufficient cash available to meet obligations.

Capital Expenditure Budget: This budget focuses on the planned investments in long- term
assets, such as equipment, machinery, infrastructure, or technology. It helps in evaluating the
feasibility of capital projects, allocating funds for major investments, and ensuring that the
organization's capital resources are utilized effectively.

Expense Budget: The expense budget covers various operating expenses of the organization,
such as marketing expenses, employee salaries, utilities, and other day- to-day expenditures.
It helps in managing and controlling costs within the organization.

Flexible Budget: A flexible budget is a budget that can be adjusted or flexed to reflect
changes in activity levels or other relevant factors. It is based on the actual level of activity
achieved and adjusts the budgeted figures accordingly. This type of budget allows for better
performance evaluation and variance analysis.

Zero-Based Budgeting: Zero-based budgeting requires that every expense must be justified
from scratch, regardless of previous budgets. It involves examining all expenses and

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justifying them based on their necessity and contribution to organizational goals. This
approach helps in controlling costs and eliminating unnecessary expenditures.

Rolling Budget: A rolling budget is a continuous budget that is regularly updated by adding a
new budget period as the current period expires. It provides a continuous planning horizon
and allows for ongoing adjustments and revisions based on changingcircumstances.

These are some of the commonly used types of budgets in budgetary control. The specific
types and formats of budgets used may vary depending on the nature of the organization and
its industry.

11.3 Limitations
While budgetary control is a valuable tool for financial management, it also has certain
limitations. Some of the limitations of budgetary control include:

Inflexibility: Budgets are typically prepared based on assumptions and projections. However,
they may not account for unexpected changes or events that occur during the budget period.
This inflexibility can make it challenging to adapt to rapidly changing business
environments.

Overemphasis on financial measures: Budgetary control primarily focuses on financial

measures and may not capture non-financial factors that are crucial for organizational
success, such as customer satisfaction, employee morale, or innovation. Overreliance on
financial metrics alone may lead to a narrow perspective of performance evaluation.

Time-consuming process: The process of budgetary control requires significant time and
effort in preparing budgets, monitoring performance, and conducting variance analysis. This
can be burdensome for organizations, particularly in dynamic and fast- paced industries
where circumstances change frequently.

Unrealistic assumptions: Budgets are often based on assumptions about future market
conditions, sales volumes, costs, and other variables. If these assumptions turn out to be
unrealistic, the budgeted targets may not be achievable, leading to frustration and potential

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demotivation among employees.

Internal conflicts: Budgetary control may lead to conflicts within the organization. Different
departments or managers may compete for limited resources, resulting in
internal disputes and tensions. This can hinder collaboration and teamwork, negatively
impacting overall organizational performance.

Focus on short-term goals: Budgets are typically prepared for a specific period, such asa fiscal
year. This short-term focus may discourage long-term planning and investment decisions,
which are vital for the organization's sustainable growth and success.

Potential for budgetary slack: Budgetary slack refers to deliberately overestimating expenses
or underestimating revenues in the budgeting process to create a cushion or buffer. This
practice can undermine the accuracy and effectiveness of budgetary control and lead to
inefficient resource allocation.

External factors beyond control: Budgetary control assumes that internal factors can be
controlled and managed effectively. However, external factors, such as changes in market
conditions, economic fluctuations, or regulatory changes, can significantly impact financial
performance, making it difficult to achieve budgeted targets.

It is important to recognize these limitations and address them appropriately while

implementing budgetary control. Organizations should strive for flexibility, incorporate non-
financial measures, regularly review and update budgets, encourage collaboration, and
consider both short-term and long-term perspectives in their financial planning and decision-
making processes.

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UNIT 12

ACCOUNTING IN COMPUTERIZED ENVIRONMENT

Learning Objectives

1. To understand the significance of computerized accounting system

Structure

12.1 Significance of computerized accounting system

12.2 Summary
12.3 Keywords
12.4 Questions
12.5 Case Study
12.6 References

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Introduction
Accounting in a computerized environment refers to the practice of using computer systems
and software to perform various accounting tasks and processes. It involves the use of
technology to record, process, analyze, and report financial information.

Here are some key aspects and benefits of accounting in a computerized environment:

Automation: Computerized accounting systems automate routine tasks such as data entry,
calculations, and financial statement generation. This saves time and reduces the likelihood of
errors associated with manual processes.

Data Accuracy: Computerized systems provide a higher level of accuracy in recording and
processing financial transactions. They can perform calculations and validations
automatically, minimizing the risk of human error.

Speed and Efficiency: With computerized accounting, tasks that used to take hours or days
can now be completed in a matter of minutes. This improves overall efficiency and allows
accountants to focus on more strategic and value-added activities.

Data Integration: Computerized accounting systems can integrate with other business
systems such as inventory management, point of sale, and customer relationship management
(CRM). This enables seamless data flow between different functions, reducing data
duplication and improving data integrity.

Financial Reporting: Computerized systems generate financial reports quickly and

accurately. They can produce various reports, such as balance sheets, income statements,
cash flow statements, and customized management reports, with just a few clicks.

Audit Trail: Computerized accounting systems maintain a detailed audit trail of all
transactions and changes made to the financial data. This makes it easier to track and review
any modifications or discrepancies, enhancing transparency and facilitating internal and

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external audits.
Data Security: Computerized accounting systems can implement robust security measures to
protect sensitive financial data. This includes user access controls, data encryption, regular
backups, and disaster recovery plans, minimizing the risk of data loss or unauthorized access.

Scalability: Computerized accounting systems can easily adapt to the changing needs of an
organization. They can handle large volumes of data and accommodate the growth of the
business without significant disruptions.

Cost Savings: While there are initial costs associated with implementing computerized
accounting systems, they can result in long-term cost savings. Automated processes reduce
the need for manual labor, minimize errors, and eliminate the costs of paper- based record-
keeping.

Regulatory Compliance: Computerized accounting systems can help organizations comply

with various financial reporting and taxation requirements. They can generate accurate
reports that meet the standards set by regulatory authorities.

Overall, accounting in a computerized environment offers numerous advantages in terms of

accuracy, efficiency, data integration, reporting, security, and compliance. It enables
organizations to streamline their financial processes, make informed business decisions, and
stay competitive in a technologically advanced world.

12.1 Significance of computerized accounting system

Computerized accounting systems have significant importance in modern business
environments. Here are some key significance of computerized accounting systems:

Accuracy: Computerized accounting systems significantly improve the accuracy of financial

data. Manual data entry is prone to errors, but computerized systems perform automatic
calculations and validations, minimizing the risk of mistakes. This leads to more reliable
financial information and reduces the chances of financial discrepancies.

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Time Efficiency: Computerized accounting systems automate repetitive tasks, saving
considerable time and effort. Functions such as data entry, calculations, and report generation
can be completed quickly and efficiently. This frees up accountants' time to focus on more
analytical and strategic activities, improving overall productivity.

Real-Time Information: Computerized accounting systems provide real-time access to

financial information. Users can instantly retrieve updated reports and statements, enabling
timely decision-making. This is particularly important for financial analysis, budgeting, and
monitoring cash flow, as it allows for quick adjustments and corrective actions.

Data Integration: Computerized accounting systems can integrate with other business
systems, such as inventory management, payroll, and CRM. This enables seamless sharing of
data between different departments and eliminates the need for manual data entry across
multiple systems. It promotes data accuracy, consistency, and reduces redundancy.

Reporting Capabilities: Computerized accounting systems offer robust reporting capabilities.

They can generate a wide range of financial reports, including balance sheets, income
statements, cash flow statements, and customized management reports. These reports provide
valuable insights into the financial health of the business, aiding in decision-making and
strategic planning.

Audit Trail and Compliance: Computerized accounting systems maintain a detailed audit trail
of all financial transactions and changes. This makes it easier to track and review any
modifications, ensuring transparency and accountability. Additionally, computerized systems
can help organizations comply with regulatory requirements by generating accurate reports
and facilitating audit processes.

Data Security: Computerized accounting systems employ security measures to protect

sensitive financial data. Access controls, data encryption, regular backups, and disaster
recovery plans are implemented to prevent unauthorized access, data loss, and ensure
business continuity. This enhances data security and safeguards the organization's financial

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information.

Scalability: Computerized accounting systems can accommodate the growth and changing
needs of the business. They can handle large volumes of data and transactions without
significant disruptions. This scalability is crucial for businesses that aim to expand and
require a flexible accounting solution.
Cost Savings: While there may be initial investment costs associated with implementing a
computerized accounting system, it can result in long-term cost savings. Automated
processes reduce the need for manual labor, minimize errors, and eliminate the costs of paper-
based record-keeping. It also improves efficiency, which can lead to reduced operational
costs.

Decision-Making Support: Computerized accounting systems provide valuable data and

insights that support informed decision-making. Accurate and timely financial information
helps management assess the financial performance of the business, identify trends, and make
data-driven decisions. This contributes to the overall success and growth of the organization.

In summary, the significance of computerized accounting systems lies in their ability to

improve accuracy, save time, provide real-time information, facilitate data integration,
enhance reporting capabilities, ensure compliance, strengthen data security, offer scalability,
deliver cost savings, and support decision-making processes. These benefits make
computerized accounting systems a vital tool for modern businesses.

12.2 Summary
Accounting in a computerized environment refers to the use of computer systems and
software to perform accounting tasks and processes. It involves automating routine tasks,
improving accuracy, and enhancing efficiency in financial management. These systems
automate tasks such as data entry, calculations, and report generation, saving time and
reducing errors. These systems improve the accuracy of financial data through automatic
calculations, validations, and data integrity checks. They allow for faster and more efficient
processing of financial transactions, freeing up time for accountants to focus on analysis and
strategic activities. They can integrate with other business systems, facilitating seamless data

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flow and reducing data duplication.

They also generate financial reports quickly and accurately, including balance sheets, income
statements, and cash flow statements. They maintain detailed audit trails, enabling easy
tracking and review of transaction history for transparency and audit purposes. Additionally,
these systems implement security measures such as access controls and data encryption to
protect sensitive financial information. They can handle increasing data volumes and adapt to
the changing needs of the business. While there are initial costs, computerized accounting
systems can result in long-term cost savings by reducing manual labor and improving
efficiency. They help organizations comply with financial reporting and taxation
requirements by generating accurate reports and supporting audit processes.

Accounting in a computerized environment offers significant benefits in terms of accuracy,

efficiency, data integration, reporting, security, scalability, cost savings, and compliance. It
enables organizations to streamline financial processes, make informed decisions, and stay
competitive in a technologically advanced world.

12.3 Keywords
Automation, Compliance, Financial Reporting

12.4 Questions
1 Significance of computerized accounting system

2 Codification and grouping of accounts

3 maintaining the hierarchy of ledgers –

4 Prepackaged accounting software.

12.5 Case Study

Company XYZ is a medium-sized retail business that recently implemented a computerized
accounting system. Let's examine how this transition to a computerized environment has
benefited the company.

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Automation and Efficiency: Prior to the computerized system, Company XYZ relied on
manual bookkeeping processes. Data entry was time-consuming and prone to errors. With the
new system, transactions are entered electronically, eliminating the need for manual
calculations and reducing the chances of mistakes. This automation has significantly
improved efficiency, allowing the accounting team to complete tasks more quickly and
accurately.

Real-Time Information: The computerized accounting system provides Company XYZ with
real-time financial information. Managers and stakeholders can access up-to-date reports on
sales, expenses, and profitability. This timely information allows for better decision-making,
such as adjusting pricing strategies or reallocating resources based on current financial
performance.

Streamlined Reporting: Generating financial reports was a complex and time-consuming

process before the computerized system. With the new system, the accounting team can easily
generate standard reports, such as balance sheets and income statements, at the click of a
button. This has reduced the time spent on report preparation and improved the accuracy of
financial reporting.
Integration with Inventory Management: Company XYZ's computerized accounting system
integrates seamlessly with the inventory management system. As sales are recorded, the
system automatically updates inventory levels and cost of goods sold. This integration ensures
accurate inventory tracking and provides real-time visibility into stock levels, enabling timely
inventory management decisions.

Enhanced Data Security: The computerized accounting system offers robust security features
to protect sensitive financial data. User access controls, data encryption, and regular backups
are implemented to safeguard against unauthorized access and data loss. This has
significantly improved data security, giving Company XYZ peace of mind that their financial
information is protected.

Scalability: The computerized accounting system is scalable, allowing for future growth. As

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Company XYZ expands its operations, the system can handle increasing transaction volumes
and data storage requirements without compromising performance. This scalability ensures
that the accounting system can accommodate the company's evolving needs.

Cost Savings: While there was an initial investment in implementing the computerized
accounting system, Company XYZ has experienced cost savings in the long run. The system
has reduced manual labor, minimizing the need for additional accounting staff. Additionally,
automation and streamlined processes have increased efficiency, resulting in reduced
operational costs for the company.

In summary, the transition to a computerized accounting environment has brought numerous

benefits to Company XYZ. Automation, real-time information, streamlined reporting,
integration with inventory management, enhanced data security, scalability, and cost savings
have improved the efficiency, accuracy, and decision-making capabilities of the company's
financial management. The computerized accounting system has positioned Company XYZ
for growth and success in a technologically advanced business landscape.

12.6 References
1. Financial Accounting for Managers, Sanjay Dhmija, Pearson Publications

2. Basics of Banking and Finance, Dr.K., Bhattacharya ,O.P.Agarwal

3. Essentials of Banking and Finance, Gautam Majumdar

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UNIT 13

MASTER BUDGETS

Learning Objectives

To understand the concepts of Master Budgets andFlexible Budgets and Zero-base budgets.

STRUCTURE

13.1 Master Budgets and Flexible Budgets –

13.2 Zero base budgets.

13.3 Summary

13.4 Keywords

13.5 Questions

13.6 Case Study

13.7 References

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13.1 Master Budgets and Flexible Budgets
Master Budgets and Flexible Budgets are two different types of budgets used in budgetary
control. Here's an overview of each:

Master Budget:

A Master Budget is a comprehensive financial plan that outlines the expected revenues,
expenses, and cash flows for a specific period, usually a fiscal year. It consists of various
interconnected budgets that cover different aspects of the organization's operations,
including:

Sales Budget: This budget estimates the expected sales revenue based on sales forecasts,
market trends, and historical data.

Production Budget: The production budget determines the quantity of products or

services that need to be produced to meet the sales demand.

Operating Budgets: Operating budgets cover different functional areas, such as marketing,
research and development, human resources, and administrative expenses. These budgets
outline the expected expenses and costs associated with each department.

Cash Budget: The cash budget forecasts the inflows and outflows of cash, helping to
manage the organization's liquidity and cash flow requirements.

Capital Expenditure Budget: This budget outlines the planned investments in long-termassets,
such as equipment, machinery, or infrastructure.

The Master Budget serves as a blueprint for financial planning, coordination, and control. It
provides a comprehensive view of the organization's financial activities, allowing
management to monitor performance, identify variances, and take corrective actions to
achieve financial objectives.

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Flexible Budget:

A Flexible Budget is a budget that can be adjusted or flexed to reflect changes in activitylevels
or other relevant factors. Unlike the Master Budget, which is prepared in advance,the Flexible
Budget is prepared after the actual activity levels are known. It takes into account the actual
level of activity achieved and adjusts the budgeted figures accordingly.

The purpose of a Flexible Budget is to provide a more accurate reflection of the

organization's financial performance by comparing actual results against a budget that is
based on the actual activity level. It helps in evaluating performance and analyzing variances
in a way that is more meaningful and relevant.

Flexible Budgets are particularly useful in situations where activity levels can significantly
impact costs and revenues, such as manufacturing, service industries, or projects with
varying workloads. By flexing the budget to match the actual level of activity, management
can make better-informed decisions and assess performance based on a more realistic
benchmark.

Overall, while the Master Budget provides the initial financial plan for the organization, the
Flexible Budget offers a more dynamic and adaptable approach that takes into account actual
activity levels and provides more accurate performance evaluation.

13.2 Zero base budgets.

Zero-based budgeting (ZBB) is a budgeting technique that requires every expense to be
justified from scratch, regardless of previous budget allocations. Unlike traditional budgeting
approaches that start with the previous year's budget as a baseline, ZBB startswith a "zero base"
and requires each expense item to be justified based on its necessity, efficiency, and alignment
with organizational goals.

Here are some key features and characteristics of zero-based budgeting:

Justification of Expenses: In ZBB, each expense item is evaluated and justified, starting from
a zero base. Managers and departments are required to provide detailed information and
analysis to support the need for the expenditure. This analysis includes assessing the cost-

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benefit, alternative options, and potential risks associated with eachexpense.

Prioritization and Allocation: ZBB encourages prioritization of expenses based on their

importance and contribution to organizational objectives. Resources are allocated based on the
justification and relative value of each expense item. This approach helps in identifying and
funding high-priority activities more effectively.

Incremental Budgeting Elimination: ZBB breaks away from the incremental budgeting
mindset, where the previous year's budget is used as a starting point for the current year.
Instead, ZBB requires a thorough examination of all expenses, regardless of their previous
allocations, resulting in a more focused and efficient allocation of resources.

Cost Reduction and Efficiency: ZBB emphasizes cost reduction and efficiency
improvements. By critically evaluating each expense, ZBB aims to identify and eliminate
unnecessary or redundant expenditures. It encourages finding alternative and more cost-
effective ways to achieve organizational goals.
Involvement and Accountability: ZBB requires active participation and involvement from
managers and departments at all levels. They are responsible for justifying their budgetary
requests and providing supporting evidence. This increases accountability and ownership
over the budgetary process.

Ongoing Process: ZBB is not a one-time exercise; it is an ongoing process. It requires regular
evaluation and review of expenses to ensure that they remain aligned with organizational
priorities. This continuous assessment helps in adapting to changing business conditions and
optimizing resource allocation over time.

Benefits of Zero-Based Budgeting:

Improved cost control and elimination of unnecessary expenses.Increased transparency and

accountability in budgeting.
Enhanced understanding of the cost drivers and resource allocation.Better alignment of
budgeting with strategic objectives.
Identification of cost-saving opportunities and process improvements.Challenges of Zero-

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Based Budgeting:
Time and resource-intensive process due to the detailed analysis required.Need for skilled and
knowledgeable staff to support the ZBB process.
Potential resistance to change from managers accustomed to traditional budgeting
approaches.

Difficulty in accurately predicting costs and benefits for certain activities.

Zero-based budgeting can be a valuable approach for organizations looking to optimize

resource allocation, improve cost control, and align their budgets with strategic goals.
However, it requires careful planning, commitment, and a strong understanding of the
organization's needs and priorities.

13.3 Summary
Budgetary control is a financial management process that involves planning, coordinating,
and controlling an organization's financial resources through the use of budgets. It aims to
ensure that financial activities are aligned with strategic goals, resources are effectively
utilized, and financial targets are met.
The key components of budgetary control include the creation of budgets, monitoring of
actual performance, variance analysis, and taking corrective actions. It helps in settingfinancial
goals, allocating resources efficiently, evaluating performance, controlling costs, making
informed decisions, and promoting financial discipline within the organization.

The objectives of budgetary control include planning and goal setting, resource allocation,
performance evaluation, cost control, decision making, and maintaining financial discipline.
It provides a framework for aligning financial activities with strategic goals and facilitates
effective financial management.

Budgetary control has several benefits, including improved financial planning, coordination,
and control. It helps in optimizing resource allocation, evaluating performance, controlling
costs, and promoting accountability and transparency.

However, budgetary control also has limitations. These include inflexibility in adapting to
unexpected changes, overemphasis on financial measures, time-consuming process,unrealistic
assumptions, potential for internal conflicts, and focus on short-term goals.Recognizing these

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limitations is important in order to address them effectively.

Overall, budgetary control is a valuable tool for organizations to manage their financial
resources, monitor performance, and work towards achieving their financial objectives. By
implementing budgetary control, organizations can enhance financial planning, coordination,
and control processes, leading to improved financial performance and decision making.

13.4 Keywords
Budgetary control, master budget, flexible budget, zero budget

13.5 Questions
1 What is Budgetary Control?

2 Explain the Nature and objective of Budgetary control3 Comment on the Limitations
of Budgetary Control
4 What are Master Budgets and Flexible Budgets?
5 Write a short note on Zero base budgets.

6 What are the types of budgets used in Budgetary Control?

13.6 Case Study

Company XYZ is a medium-sized manufacturing company that produces electronic devices.
The company has been experiencing challenges in managing its financial resources,
controlling costs, and achieving profitability targets. To address these issues, they decide to
implement budgetary control.

Planning and Goal Setting:

The management team at Company XYZ begins by setting clear financial goals and
objectives for the upcoming fiscal year. They analyze historical data, market trends, and
industry benchmarks to develop a comprehensive budget plan. The budget includes sales
forecasts, production targets, cost projections, and cash flow estimates.

Budget Allocation and Coordination:

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Once the budget is finalized, the company allocates resources to various departments based
on their strategic importance and performance requirements. The budget allocation process
involves coordination and collaboration among different departments to ensure that resources
are distributed effectively.

Monitoring and Control:

Company XYZ establishes a system to monitor and control the actual financial performance
against the budgeted figures. Regular financial reports are generated to compare actual
revenues, expenses, and profitability with the budgeted amounts. Variances are analyzed to
identify the reasons behind deviations and take appropriate corrective actions.

Cost Control Measures:

As part of budgetary control, Company XYZ implements cost control measures to optimize
expenses and improve profitability. They conduct cost analysis to identify areas of excessive
spending or inefficiency. Cost-saving initiatives such as renegotiating supplier contracts,
implementing energy-saving measures, and streamlining production processes are
implemented to reduce costs.
Performance Evaluation and Reporting:
Company XYZ evaluates the performance of each department and individual against their
budgeted targets. Key performance indicators (KPIs) are established to measure efficiency,
productivity, and profitability. Regular performance reports are generated and shared with
relevant stakeholders to provide visibility into financial performance and encourage
accountability.

Communication and Feedback:

Effective communication is maintained throughout the budgetary control process. The

management team regularly communicates financial goals, budgetary guidelines, and
performance expectations to all employees. Feedback and suggestions from employees are
encouraged, fostering a culture of transparency, collaboration, and continuous improvement.

Continuous Improvement:

Company XYZ recognizes that budgetary control is an ongoing process. They regularly
review and update the budget to reflect changes in business conditions, marketdynamics, and

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strategic priorities. Lessons learned from previous budget cycles are incorporated to refine
the budgeting process and improve future financial planning.

As a result of implementing budgetary control, Company XYZ experiences improved

financial management, better cost control, and increased profitability. The process enables
them to align financial activities with strategic goals, optimize resource allocation, and make
informed decisions based on accurate financial information.

13.7 References
1. Terence Lucey: Costing, Cengage Learning EMEA, 2002 R5.J. K Mitra: Advanced
Cost Accounting, New Age International, 20094. C.S.V. Murthy, Business Ethics,
Himalaya Publishing House; Mumbai, 2007.

2. Basics of Banking and Finance, Dr.K., Bhattacharya ,O.P.Agarwal

3. Principles & Practices of Banking, Indian Institute of Banking and Finance

4. Banking Theory & Practices, KC Shekhar,Lekshmy Shekhar

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UNIT 14

ACCOUNTING

Learning Objectives

To list the process to Codification and grouping of accounts

Structure

14.1 Codification and grouping of accounts

14.2 maintaining the hierarchy of ledgers

14.3 Prepackaged accounting software.

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14.1 Codification and grouping of accounts
Codification and grouping of accounts refer to the process of organizing and categorizing
individual accounts within an accounting system. This helps in the systematic recording,
reporting, and analysis of financial transactions. Here are the common approaches to
codification and grouping of accounts:

Chart of Accounts: The chart of accounts is a structured list of all accounts used in an
organization's accounting system. It provides a framework for organizing and categorizing
accounts based on their nature, function, or purpose. The chart of accounts typically consists of
a series of numerical or alphanumeric codes assigned to each account, allowing for easy
identification and classification.

Major Account Categories: Accounts are often grouped into major categories to represent
various financial aspects of the business. Common categories include assets, liabilities,
equity, revenues, and expenses. This classification helps in presenting financial information
in a structured manner and facilitates financial analysis and decision-making.
Sub-Accounts: Within each major account category, sub-accounts or subcategories can be
established. For example, within the assets category, sub-accounts can include cash, accounts
receivable, inventory, property, plant, and equipment. Sub-accounts provide further
granularity and allow for more detailed tracking and reporting of specific types of
transactions.

Numerical Codification: Accounts can be assigned numerical codes based on a predefined

numbering system. This method allows for easy identification and sorting of accounts based
on their numerical order. For example, asset accounts can be assigned numbers starting with
1, liability accounts with 2, and so on. Within each category, accounts can be further
organized using additional digits.

Alphanumeric Codification: In addition to numerical codes, accounts can be assigned

alphanumeric codes. This approach combines letters and numbers to represent different aspects
of the account. For example, a code like "A001" might represent a specific asset account,
while "R100" could represent a revenue account. Alphanumeric codes can provide more

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flexibility and allow for a more intuitive account identification system.

Logical Grouping: Accounts can be grouped logically based on their relationship or function.
For example, all accounts related to sales or revenue can be grouped together, while accounts
related to expenses or cost of goods sold can be grouped separately. Logical grouping
simplifies the presentation and analysis of financial data and enables easy identification of
related accounts.

Industry-Specific Grouping: In certain industries, specific account groupings may be used to

cater to unique requirements. For example, a manufacturing company may have specific
accounts for raw materials, work in progress, and finished goods. An industry- specific
grouping ensures that the accounting system reflects the specific needs and characteristics of
the business.

The codification and grouping of accounts provide a structured framework for organizing
financial information within an accounting system. It enables efficient data entry, facilitates
accurate financial reporting, simplifies analysis and interpretation of financial statements, and
supports effective decision-making. The specific approach to codification and grouping may
vary depending on the organization's size, industry, and reporting requirements.

14.2 Maintaining the Hierarchy of Ledgers

Maintaining the hierarchy of ledgers is essential for organizing and managing financial
information in an accounting system. The hierarchy refers to the arrangement of ledgers in a
logical and hierarchical structure based on their relationships and dependencies. Here are
some key considerations for maintaining the hierarchy of ledgers:

Determine the Hierarchy: Begin by analyzing the organization's financial structure and
determining the hierarchy of ledgers based on the business's reporting and management needs.
Consider factors such as business units, departments, subsidiaries, cost centers, or any other
relevant divisions. The hierarchy should reflect the organization's organizational structure
and reporting requirements.

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Parent-Child Relationships: Establish parent-child relationships between ledgers to define the
hierarchical structure. A parent ledger is at a higher level and can have multiple child ledgers
associated with it. For example, the parent ledger might represent the overall company, while
the child ledgers represent specific divisions or departments within the company.

Chart of Accounts: Ensure that the chart of accounts is aligned with the ledger hierarchy.
Assign appropriate account codes and sub-codes to each ledger to reflect their position in the
hierarchy. The chart of accounts should support the reporting needs at each level of the ledger
hierarchy.

Consistency and Standardization: Maintain consistency and standardization in naming

conventions and coding schemes across all ledgers. This ensures clarity, reduces confusion,
and facilitates easy identification and understanding of the hierarchy. Consistency also makes
it easier to compare and consolidate information across different levels of the hierarchy.

Integration and Data Flow: Establish clear integration and data flow between ledgers within
the hierarchy. Ensure that financial transactions recorded in lower-level child ledgers
automatically flow to the corresponding parent ledgers. This integration ensures accurate and
up-to-date financial reporting at each level of the hierarchy.

Reporting and Analysis: Consider the reporting and analysis requirements for each level of the
hierarchy. Determine the specific financial reports needed at each level, such as consolidated
reports for the entire organization or detailed reports for specific
departments or divisions. Configure the ledger hierarchy to support the generation of these
reports efficiently.

Review and Adjustment: Periodically review and adjust the ledger hierarchy as the
organization's structure or reporting requirements change. This ensures that the hierarchy
remains aligned with the evolving needs of the business and continues to provide meaningful
financial information for decision-making.

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Documentation and Communication: Document the ledger hierarchy, including the
relationships and codes assigned to each ledger. Share this information with relevant
stakeholders, including accountants, financial analysts, and management. Clear
communication ensures that everyone understands the hierarchy and uses it consistently.

By maintaining the hierarchy of ledgers, organizations can effectively organize their financial
information, support accurate reporting, and facilitate meaningful analysis. It provides a
structured framework for managing financial data and ensures that the accounting system
aligns with the organization's structure and reporting needs.

Prepackaged accounting software.

Prepackaged accounting software, also known as off-the-shelf accounting software or
commercial accounting software, refers to ready-to-use software applications designed to
perform accounting functions and financial management tasks. These software packages are
developed by third-party vendors and are available for purchase or subscription. Here are
some key features and benefits of prepackaged accounting software:

Core Accounting Functions: Prepackaged accounting software typically includes core

accounting functions such as general ledger, accounts payable, accounts receivable, payroll,
and financial reporting. These functions allow businesses to efficiently record, track, and
manage financial transactions.

Ease of Use: Accounting software is designed to be user-friendly and accessible to

individuals without extensive accounting knowledge. It often includes intuitive interfaces,
step-by-step wizards, and pre-defined templates to simplify data entry and streamline
accounting processes.

Automation and Efficiency: Accounting software automates repetitive tasks such as data entry,
calculations, and report generation. This automation reduces manual effort, minimizes errors,
and improves efficiency in financial management. It saves time and enables accountants to
focus on more strategic activities.

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Financial Reporting: Prepackaged accounting software provides a range of customizable
financial reports, including balance sheets, income statements, cash flow statements, and
more. These reports offer insights into the financial health of the business and help in
decision-making and financial analysis.

Integration with Other Systems: Many accounting software packages offer integration
capabilities with other business systems such as inventory management, CRM, and point of
sale (POS) systems. This integration allows for seamless data flow, eliminates data
duplication, and provides a holistic view of business operations.

Scalability: Prepackaged accounting software can accommodate the needs of businesses of

different sizes, from small startups to large enterprises. It can handle increasing transaction
volumes and data storage requirements as the business grows, providing scalability and
flexibility.

Security and Data Protection: Accounting software vendors implement security measures to
protect financial data. This includes user access controls, data encryption, regular backups,
and disaster recovery plans. These measures help ensure the confidentiality, integrity, and
availability of financial information.

Compliance with Regulations: Many prepackaged accounting software packages are

designed to comply with accounting regulations and industry standards. They help businesses
adhere to financial reporting requirements and ensure compliance with tax regulations and
other legal obligations.

Cost Savings: Using prepackaged accounting software can result in cost savings compared to
developing custom accounting solutions. The upfront costs of purchasing or subscribing to
the software are often more affordable than developing and maintaining an in-house
accounting system. Additionally, automation and efficiency gained from using the software
can reduce labor costs over time.
Support and Updates: Vendors of prepackaged accounting software typically provide

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customer support and regular updates to address issues, enhance features, and maintain
compatibility with evolving technologies and regulations.

It's important for businesses to evaluate their specific needs and requirements when selecting
prepackaged accounting software. Consider factors such as scalability, integration
capabilities, user-friendliness, support, and the ability to meet industry- specific needs.

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