Annamalai University: Accounting For Managerial Decisions

023E2310
1 – 20
ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
Master of Commerce (M.Com.)

Third Semester
ACCOUNTING FOR MANAGERIAL DECISIONS

LESSONS: 1 – 20
Copyright Reserved
(For Private Circulation only)
MASTER OF COMMERCE (M.Com.)
THIRD SEMESTER
Editorial Board
Dr. K. Vijayarani
Dean
Faculty of Arts
Annamalai University
Annamalainagar
Members
Dr. R. Singaravel Dr. P. Vijayan
Director Director
Directorate of Distance Education Directorate of Academic Affairs
Annamalai University Annamalai University
Dr. K. Govindarajan Dr. R. Elangovan

Professor and Head Professor and Coordinator
Department of Commerce Commerce Wing, DDE
Internals
Dr. V. Sundar Dr. N. Periyasamy
Professor of Commerce Professor of Commerce
Commerce Wing, D.D.E. Department of Commerce
Externals
Dr. P. Natarajan Dr. Ganapathy
Professor of Commerce Professor of Commerce
Pondicherry University Alagappa University
Puducherry Karaikudi
Lesson Writer
Dr. M Thirunarayanasamy
Associate Professor and Head
(Deputed from Annamalai University)
Department of Commerce
M.G.R. Govt. Arts College
Sirkazhi
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THIRD SEMESTER
SYLLABUS
Unit – I:Introduction to Management Accounting

Management Accounting - Meaning - Characteristics - Scope - Functions -
Distinction between financial accounting and management accounting - Tools and
Techniques of management accounting. Financial Statements: Meaning - objective -
uses – limitations-Techniques of financial statement analysis - Ratio analysis -
Meaning - Advantages and Limitations - Classification of ratios.
Unit – II:Funds Flow and Cash Flow Statement
Funds flow statement: Meaning - concept of fund - flow of funds -- Importance
Limitations - Preparation of funds flow statement - Cash flow Statement -meaning -
importance - Limitation - Methods of Preparation of Cash Flow Statement.
Unit – III: Budgetary Control
Meaning -- Definition - Estimates - forecast - budget - difference between
forecast and essentials of successful budgeting control - Classification of budget -
Preparation of various budgets.
Unit – IV: Marginal Costing
Meaning - Definition - Features - Advantages - Limitations - Absorption costing
- Cost Volume Profit analysis - Break even Charts - Differential Costing.
Unit – V: Standard Costing and Variance Analysis
Standard Costing-Applicability – Advantages - Limitations - Variance Analysis
(Material- Labour - Overhead - Sales)
Text Books:
1. Maheswari S.N., 2017, Principles of Management Accounting., Sultan
Chand and Sons, New Delhi
2. Sharma Shashi R.K and Gupa K, 2016, Management Accounting,
Kalyani Publishers, New Delhi
3. Murthy A and Gurusamy S 2018, Management Accounting, Vijay
Nicole Imprints Private Ltd., Chennai.
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Supplementary Readings:
1. Kaplan and Afkinson, 2016, Advanced Management Accounting,
Prentice Hall of India, New Delhi
2. Solomon Raj, L and Arockiyasamy, A. 2016, Management Accounting,
Tata McGraw Hill Publishing Ltd., New Delhi
3. Pillai R.S.N and Bagavathi, V 2017, Management Accounting, S.Chand
and Co., New Delhi
4. Hingorani N.L and Ramanathan ED, y Grewal. T.S 2015, Management
Accounting, Sultan Chand and Sons, New Delhi
5. Ravi M, Kishore, 2017, Management Accounting, Taxmann publications
Pvt. Ltd., New Delhi
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THIRD SEMESTER
CONTENTS
Lesson Page
Title
No. No.
1. Nature and Scope of Management Accounting 1

2. Financial Statements 11
3. Ratio Analysis 26
4. Accounting Ratio- Practical Problems 41
5. Funds Flow Statement 64
6. Preparation Of Funds Flow Statement 79
7. Cash Flow Statement 97
8. Preparation of Cash Flow Statement as Per As 3 117
9. Budgetary Control 134
10. Preparation of Sales Budget 144
11. Preparation of Production and Purchase Budgets 150
12. Preparation of Cash and Flexible Budgets 159
13. Preparation of Different Types of Overhead Budgets 174
14. Marginal Costing 182
15. Marginal Costing -- Cost Volume Profit Analysis 189
16. Marginal Costing - Break-Even Chart (BEC) And Differential 214
Costing
17. Standard Costing 225
18. Variance Analysis – Material Variance 232
19. Variance Analysis – Labour and Overhead Variances 250
20. Variance Analysis – Sales Variances 269
Model Question Paper 277
Accounting Problems for class room reference 281
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LESSON – 1
NATURE AND SCOPE OF MANAGEMENT ACCOUNTING

OBJECTIVES
In this lesson, we discuss the meaning, characteristics, scope, functions,
distinction between cost and management accounting, tools and techniques of
management accounting. After going through this lesson you will able to
 know the meaning and characteristics of management accounting
 understand the various functions of management accounting
 study the tools and techniques of management accounting
 understand the distinction between cost and management accounting
CONTENTS
 Introduction
 Meaning and Definitions
 Characteristics of Management Accounting
 Scope of Management Accounting
 Functions of Management Accounting
 Distinction between Cost and Management Accounting
 Tools and Techniques of Management Accounting
INTRODUCTION
In this section, we attempt to make a brief study about meaning and definition
of management accounting
Meaning and Definitions
The increasing complexities of modern and commercial life have necessitated
that accounting presentation should play a dynamic role in modern management.
The very aim of traditional accounting is to report operational results i.e., profit or
loss of the organization. But this does not cater to the needs of decision-makers.
Moreover the accounting system does not aid management adequately; this does
not mean that the system is defective, but it is due to the inefficiency on the part of
those who handle it. The processes of management are directing, coordinating,
control and motivation which fault too achieves their objectives if they are not
supported by appropriate plan, fact and control. No doubt accounting system
contributes much too all these processes. If the accounting systems are to be
utilized for the benefit of the managerial needs, it should be so designed as to meet
the changing conditions of the business as well as the society.
The whole accounting system can be classified as 1) Financial Accounting 2)
Cost Accounting and 3) Management Accounting. Financial Accounting attempts to
report the operating result during a year as well as the position of assets and
liabilities on a particular date. This system helps the shareholders only ad not the
management.
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Cost accounting was introduced to avoid the shortcomings of financial

accounting. This is only to avoid the possible losses arising from the mishandling of
the financial data and not to boost up the performance strategy of the business. It
also attempts to assist the management by reporting the operating result at regular
intervals and at different levels of activities. Lastly, cost accounting is meant to
measure the responsibility of the actual performance against planned performance.
It is also true that “many important data for managerial use are beyond the ability
of accountancy to supply – for example, market demand, state of competition general
business conditions, engineering design, personnel information, legal regulations and
limitations”. So management accounting has been originated to fulfill managerial
needs by providing the said important data which normal accounting fails to supply.
Hence, it evaluates alternative courses of action such as Planning of profit, product
pricing, inventory control etc. The question of management will arise only when there
some problem. The improvement and smooth running of the existing system to avoid
the possible problems may call for management analysis.
The term “Management Accounting” is composed of two word management an
Accounting. A clear grasp of these two words is essential to understand
“Management Accounting”. Management is mainly a task of planning co-ordinating
and controlling the efforts of others towards a particular objective. Its main aim is
to achieve greatest efficiency in the utilization of available material, man-power,
machines and skill. To-day scientific management is the substitute for gusess-work
or-hit or-miss-method. The objects of scientific management are to study the
operating problems on the basis of face and to work out the best use and
application of human and material resources. Hence, we may call Management
Accounting as a science which will achieve these objectives.
Management Accounting is of recent origin. It was first coined by the British
Team of Accountants which visited the U.S.A. under the sponsorship of Anglo-
American Productivity council in 1950. Its main aim was to highlight the utility of
accounting as an effective management tool. It is used to explain the modern
concept of accounts as a tool of management in contrast to the conventional
accounts prepared mainly for information of proprietors. Now, the purview of
management accounting includes all techniques and controls such as financial
control, budgetary control, efficiency in operation through standard costing, cost-
volume-profit analysis, etc. It also includes planning for future variances between
the actual and standards, reporting to top management, formulation of policy etc.
Lastly, accounting information should be presented in such a way as to assist the
management to conduct day-to-day business most efficiently. Moreover the
published account of business concerns do not provide and information in a form
that suggests the line on which management policies and actions should proceed.
In short, all the requirements of modern management should be written in
management language. Management accounting is otherwise known as Managerial
Accounting, Control Accounting, Responsibility Accounting, Decision Accounting,
forward Accounting or Management Accountancy.
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Definitions
In this section, we attempt to make a brief study about definition of
Management Accounting
According to T.G. Rose
“Management Accountancy is the adoption and analysis of accounting
information, audits diagnosis and explanation in such a way as to assist
management”.
According to Crossman
“Management Accounting functions largely through operating reports based
upon standard costs and budgets compared with actual expenditure, through
internal auditing, and through special duties and reports pertaining to the probable
plans programmes”
From the above definitions we learn that Management Accountancy is the art
and science of directing accounting information to the person concerned in order to
release the business philosophy ie., presenting the accounting information in a
manner which aids the Management in taking management decisions. All the
definitions of Management Accounting bring out its mechanical concept but not the
spirit of the system. However, we can come to a conclusion that all accounting
operations which are oriented towards increasing the productivity of human,
material and other productivity of human, material and other productivity
resources of the enterprise constitute Management Accounting. Hence, all
accounting which directly or indirectly, by provide, effective tools to managers in
enterprises and government animations lead to increase in productivity is
Management Accounting.
Characteristics of Management Accounting
In this section, we attempt to make a brief study about salient characteristics
of management accounting.
1.Management accounting is of recent origin and there are no specific norms to
be followed for analysis. Every concern follows its own method of analysis depending
on the availability of data and the purpose of analysis. Hence, the analysis and
interpretation of data depends upon the calibre of the management accountant.
2. Management accounting considers financial, quantitative and qualitative
information for analysis. Financial and quantitative data are collected from
financial accounts, cost accounts, labour register, etc. Qualitative information such
as, industrial relations, competition, economic conditions, etc., are also considered
for analysis and decision making.
3.Financial accounting-gives only the financial results but the causes for such
results are not explained. Management accounting makes use of different
techniques such as ratio analysis, funds flow analysis, etc., which explain the
causes for such results and changes. Similar procedure is followed in the analysis
of other data also.
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4.Management accounting is concerned with forecasting. It thus helps in

planning for the future. Techniques such as budgetary control, standard costing,
etc., are based on forecasts.
5. Management accountant keeping in view the overall objectives of the
organisation In management accounting all the plans such as budgets, standards,
etc., are made and also deviations from the budgets or standards are checked and
corrective actions are taken wherever necessary.
Scope of Management Accounting
We present here a brief explanation about scope of Management Accounting.
The scope of Management Accounting is very wide and broad-based. Within its fold
it encompasses a searching analysis of all the aspects and branches of business
operations. Anyhow the areas included within the ambit of Management Accounting
may be listed as follows.
i) General Accounting (Financial Accounting)
ii) Cost Accounting
iii) Budgeting and forecasting
iv) Cost control procedure
v) Cost and Statistics
vi) Taxation
vii) Methods and procedures
viii) Audit
ix) Office services
x) Legal provisions
General or financial accounting
This include recording of external transactions covering receipts and
payments of cash, recording of inventory and sales and recognition of liabilities and
setting up of receivables. It also covers the preparation of regular financial
statements which are made up from ledger balances. Management cannot obtain
full control and co-ordination without proper system of accounting.
Cost Accounting
It is concerned with the application of cost to job, product, process and
operation. It acts as a supplement to financial accounting. It also helps in sharpening
the internal aspects of financial accounting. It plays a vital role in assisting the
management in the creation of policy and operation of business concerns.
Budgeting and forecasting
These envisage the preparation of fixed and flexible budgets, cash budgets,
profit and loss forecasts etc., in co-operation with operating and other departments.
They help the management a great-deal.
Cost control procedures
They are concerned with the establishment and operation o internal control
and the preparation of internal reports in order to convert the budget into operating
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services, Management is assisted by them by measuring actual results against

budgetary standard of performance.
Cost and statistics
These are concerned with the provision of statistical and analytical information
in the form of graphs, charts, diagram etc., to the various departments of the
business.
Taxation
This is concerned with the computation of income, filing of returns and
making of tax payments, in accordance with the provisions of the Income Tax Act.
Methods and procedures
Theses deal with reducing the cost and improving the efficiency of accounting
as also of office operations, including the preparation and issuance of accounting
and other manuals, where these will prove useful.
Audit
It needs devising system of internal control by establishing internal audit
coverage of all operating units.
Office services
These are concerned with the maintenance of data processing and other office
management services like communication, duplicator, printing, mailing, etc.
Legal provision
Several management decisions depend upon the provisions of various laws and
statutory provisions prevailing in the country. For example the decision to make a
fresh issue of shares depends upon the permission of controller of capital issues.
Like-wise the form of published accounts, the external audit, the authority to float
loans, sales, pay roll, income etc, depend upon various rules and regulations
passed from time to time.
It is very clear that management Accounting has a close relation with all those
areas explained above to have its scope wide and broad based.
Functions of Management Accounting
In this section, we discuss the general functions of management accounting.
These include all activities connected with collecting processing, interpreting and
presenting information to management. Management Accounting satisfies the
various needs of management for taking appropriate business decisions which may
be described as follows:
 Modification of data
 Analysis and interpretation of data
 Facilitating management control
 Formulation of business budgets
 Use of qualitative information
 Satisfaction of informational Needs for various levels of management
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i) Modification of Data
Management Accounting supplies accounting data required for decision
making purposes through a process of classification and combination which
enables to retain similarities of details without eliminating the dissimilarities e.g.
combination of purchases for different months and their break-up according to the
class of product, type of suppliers, days of purchase, territories etc.
ii) Analysis and Interpretation of Data
The data collected becomes more significant and meaningful only with analysis
and interpretation. For example, when the data or final accounts are analysed by
means of comparative statements, ratios and percentages, cash flow statements
and fund flow statements, it will facilitate new directions for its use by
management.
iii) Facilitating Management Control
Management Accounting enables all accounting efforts to be directed towards
control of a business concern. The important features in any system of control are
the standard for performance and measure of deviation there from. This is made
possible through budgetary control and standard costing which are integral parts of
Management Accounting.
iv) Formulation of Business Budgets
One of the primary functions of management is planning, which is
accomplished by Management Accounting through the process of budgeting. It
involves the setting up of objectives and the selection of the most appropriate
strategies by comparing them with reference to some discriminating criteria
Forecasting, probability and trends are some of the techniques used for this
purpose.
v) Use of Qualitative Information
Management Accounting draws upon sources, other than accounting for such
information as it is not capable of being readily convertible into monetary terms.
Statistical accompilations, engineering records and minutes of meeting are few
such sources of information.
vi) Satisfaction of Information Needs or Levels of Management
This serves management as a whole according to its requirements. This serves
top. Middle and lower level managerial needs to sub serve their respective needs.
For instance, it has a system of processing accounting data in a way that yields
concise information to cover the entire field of business activities at long intervals
for the top management technical data for specialized personnel regularly and
detailed figures relating to a particular sphere of activity at short intervals for those
at the lower rungs in the organizational set-up.
In short the list of Management Accounting is a profit of overall managerial
activity (not something grafted on to it from outside)guiding and serving
management as a body to derive the best return from its resources, both for itself
and for the super system in which it functions.
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Distinction between Financial and Management Accounting

In this section, we attempt to make a brief study about how management
accounting differ from financial accounting .
Financial accounting is concerned with recording, classifying, summarizing
and interpretation of monetary information in other words only monetary
transactions are recorded financial accounting. Management accounting is
concerned with accounting information which is useful to management here both
monetary and non-monetary information is considered.
Financial accounting is compulsory in certain cases and is a basic necessity
for all business concerns. The procedure to be followed for financial business
concerns is laid down by law, where it is compulsory. Management accounting is
not compulsory. It is optional. Management may make use of it or not.
The objective of financial accounting is to ascertain the profit or loss and
financial position, but it is independent other accounting system. The objective of
management accounting is to provide information for managerial decision making
for this purpose it is dependent on financial accounting for financial data.
Financial statements are prepared for a specified period, generally one year.
There is no fixed period for management accounting, depending on the
requirements, analysis can be done. Projected data for future are not considered in
financial accounting for analysis but it is considered in management accounting.
In financial accounting reports are prepared annually after the preparation of
final accounts. But in management accounting after completing a particular work
reports are prepared and submitted whenever required.
Audit of financial accounting records is compulsory in certain cases but no need
for audit of management accounts. Accuracy of data is ensured as actual figures and
financial information only are recorded. The results may not be accurate always
especially when they are future estimates and qualitative in nature.
Tools and Techniques of Management Accounting
We present here a brief explanation about different tools and techniques
applied in management accounting
Modern management is not satisfied with mere postmortem examination of
accounts and records. It seeks guidance from accounts in its management
functions. It is not an easy job to arrive at concrete management decisions unless it
is accentuated on some aids or media. Hence, some tools are necessary to reach the
target. Management Accounting employs tools and techniques in order to discharge
its duty of helping management in planning. Co-ordination control and appraisal of
activities, such techniques and tools are as follows.
 Analysis of Financial statements
 Ratio Analysis
 Cash Flow and Fund Flow Analysis
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 Statistical and Graphical Techniques.

 Costing Techniques.
 Standard Costing and Variance Analysis
 Budgetary Control
 Inventory Management
 Financial Planning and Control
 Evaluation of Capital Projects and Returns on investment
 Communications and Reporting
 Total and Marginal Cost Analysis including Even Charts and Profit-Volume
Analysis
The above analysis may show areas where immediate management action is
necessary and serve as the basis for formulation of regular plans for the future.
Fund flow Analysis may disclose important features on the basis on which working
capital requirements, stock holding. Cash requirements and cash may be modified
and revised. Ratio Analysis may throw up data for action spheres of profitability
and solvency of the business. Marginal lost Analysis assists in policy decisions in
respect of utilization of material sales mix, cost control, spare capacity, etc. Other
data from the above analysis may be used for drawing budgets and standard costs
for future periods.
REVISION POINTS
 Management accounting information plays an important role in planning
and controlling organizational activities.
 Traditionally, management accounting systems have tended to produce
primarily financial information for managers.
 However, with increased competition, the nature of the management
accounting systems has been extended to encompass both qualitative and
quantitative non-financial information, to help managers and other
stakeholders plan and control their operations.
 Thus, management accounting information systems are one of the main
decision-making support systems in modern organizations.
INDEX QUESTIONS
1. Explain the scope and characteristics of Management Accounting.
2. Explain the tools and techniques of Management Accounting.
3. Bring out the differences between ‘Management Accounting’ and ‘Financial
Accounting’.
SUMMARY
In this lesson, we have briefly touched upon the following points:
The term “Management Accounting” is composed of two words management an
Accounting. A clear grasp of these two words is essential to understand
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“Management Accounting”. Management is mainly a task of planning co-ordinating

and controlling the efforts of others towards a particular objective. Its main aim is
to achieve greatest efficiency in the utilization of available material, man-power,
machines and skill. To-day scientific management is the substitute for guess-work
or-hit or-miss-method Management Accountancy is the art and science of directing
accounting information to the person concerned in order to release the business
philosophy i.e., presenting the accounting information in a manner which aids the
Management in taking management decisions. There are five stages in the evolution
of management accounting and they are:
1) Financial recording
2) Cost ascertainment
3) Integration of cost and financial accounting
4) Business forecasting, Budgeting and standard costing
and
5) Budgetary control.
TERMINAL EXERCISES
1. What is management accounting?
2. Discuss the functions of management accounting.
3. What are the tools and techniques used to management accounting?
4. Differentiate cost accounting and management accounting?
5. Explain features and limitations of management accounting?
SUPPLEMENTARY MATERIALS
 Hilton (2005), Managerial Accounting: Creating Value in a Dynamic
Business Environment, 6thedition, McGraw-Hill
 Journal of Management Accounting Research-American accounting
Association
 International journal of accounting and information management
 The international management accounting (IMAS) project
ASSIGNMENT
1. Discuss the functions of management accounting.
2. Explain features and limitations of management accounting?
REFERENCES
1. S.N. Maheshwari Principles of Management Accounting,
2. T.S Reddy and Hariprasad Reddy Management Accounting.
3. M.C. Shukla and T.S. Grewal Management Accounting.
4. L. Cecil and L. Merwin Management Accounting.
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LEARNING ACTIVITIES
 To attend and participate management accounting training course is
Lecture based with interactive workshops
 To learn and update their knowledge or accounting and law
 To attending to introduction to management accounting course,
participants are expected to have a basic knowledge of accounting and
commercial law concepts, as well as English language proficiency
 To understand the role of management accounting from a resource
management viewpoint
KEY WORDS
Spare capacity, Duplicator, Appropriate plan, Analysis and interpretation and
Debtors Turnover’

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LESSON – 2
FINANCIAL STATEMENTS
OBJECTIVES
In first lesson, we discussed the meaning, characteristics, scope, functions,
distinction between financial and management accounting, tools and techniques of
management accounting. In this lesson, we discuss meaning, objectives, uses,
limitations and techniques of financial statements. After going through this lesson
you will able to
 know the meaning and objectives of financial statements
 understand the various uses and limitations of financial statements
 understand the various tools and techniques of financial statements
CONTENTS
 Introduction
 Meaning
 Types of financial statements
 Objectives of financial statements
 Uses of financial statements
o Useful for management
o Useful for the Financiers
o Useful for the Creditors
o Useful for Investors
 Limitations of financial statements
 Analysis and Interpretation of Financial Statements
 Types of Financial Analysis
o External Analysis
o Internal Analysis
o Horizontal Analysis
o Vertical Analysis
 Techniques of financial statements
o Comparative financial statements:
 Preparation of Comparative financial statements
o Common size statements
 Preparation of Common size financial statements
o Trend Analysis
o Ratio analysis
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o Funds flow analysis

 Cash flow analysis
o Networking capital analysis
INTRODUCTION
In this section, we attempt to make a brief study about meaning and of
financial statements
Meaning
Financial statements or reports are account balances arranged in effective and
meaningful order so that the facts and concepts they portray may a be readily
interpreted and used as bases for decisions by all those interested in the affairs of a
business concern. Management on the basis of information given by these reports,
may review the company’s progress to date and decide upon the courses of action
to be taken in future, creditors may choose to extend or maintain or restrict credit.
Shareholders may judge prospects for their investment and elect to sell or to
continue the ownership, laborers may judge the ability of the company to pay more
wages; and the customers may appraise the effectiveness of the economic unit from
which they buy goods or services.
The term ‘financial statement’ refers to two statements-the Balance sheet or
statement of financial position reflecting the assets, liabilities and capital on a
particular data and income statement or Profit and Loss Account, showing the
operational results during a certain period. Usually they are prepared at the end of
operational results during a certain period. Usually they are prepared at the end of
a given period for a business concern in the case of limited companies these include
Profit and Loss Appropriation Account. In big companies they have a third
statement which is called ‘package of financial statements’ and it includes schedule
relating to land, buildings, equipment, inventories, long term investments, accrued
liabilities, long-term debt, cost of goods manufactured, selling expenses, etc. These
schedules constitute the first step towards the analysis of certain data in the
Balance sheet and Income Statement. When adequate information cannot be given
merely by listing of financial statement items, explanatory footnotes are to be given
as an integral part of financial statements.
Types of Financial Statements
We present here a brief explanation about different types of financial
statements prepared by concerns carrying on business
1. Balance sheet
2. Income statement
3. Statement of retained earnings
Following are the basic financial statements prepared by the non trading
organizations.
Receipts and payments account
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Income and expenditure account

Balance sheet
Objectives of Financial Statements
We discuss in this section the general objectives of preparing the various
financial statements
1. Balance sheet is prepared to ascertain the financial status or financial
position
2. Trading account is prepared to ascertain the gross profit or loss
3. Profit &loss account is prepared to ascertain the net profit or loss
4. Statement of retained earnings is prepared to study the changes in the
balances of undistributed profits after making transfer to various reserves
5. Receipts and payments account is prepared to know total receipts and total
payments of during the period
6. Income and Expenditure account is prepared to know total revenue
receipts and total revenue payments of during the period
Uses of Financial Statements
Financial statements provide meaningful, useful and valuable information
periodically regarding financial position and future prospects of the business
concern. The usefulness of financial statements is discussed below:
Useful for management: Financial statements are of utmost help to the
management of a concern. Management will be able to take effective decisions only
when correct and reliable information is at its disposal. If information is not
available, management can neither plan nor fulfill the functions of operation and
control. Effective utilisation of capital employed, efficient use of assets,
improvement in financial position, etc., can be deciphered and understood from the
financial statements. It is commonly felt that financial statements are important
tools to the operation and control of business as the barometer, compass, and
charts are to the successful navigation of a ship.
Useful for the Financiers: Besides management, financial statements are also
of great importance to the financiers and lenders. Lenders need information
regarding customer's financial position, solvency, credit standing, profitability, etc.
Financial statements provide most of the information. Financial statements help
the bankers and lenders to decide whether to extend loans to the customers.
Useful for the Creditors: Trade creditors are another class for whom financial
statements are important. Trade credit implies extending facilities of deferred
payment for credit-purchases by seller to buyer. Traditionally, the seller used to
depend on trade references, while extending trade credit and financial statements
were rarely used. The seller used to depend on the business concept that “if the
customer has paid in the past at the due date, he will pay in future also”. But these
beliefs carry only half the truth. Extending credit is essential due to tough
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competition and at the same time supplier of trade credit feels that financial
position of the customers has to be examined before extending trade credit. It is
possible that customer is faithful and paying regularly but his financial position is
not sound. Sometimes, his financial position may be sound but he may be very
negligent in making payments at due dates. All these facts are revealed by financial
statements with the help of solvency ratios, cash and fund flow analysis, etc.
Useful for Investors: Present and prospective investors are interested in
studying financial statements to assess earning capacity, growth potential and
efficiency of management. The share holder would like to assess the present and
future prospects. In case of debenture holder as investor, his interest is limited to
the extent of knowing long-term solvency and coverage of interest in profits.
Financial statements provide such information readily to shareholders and
debenture holders.
Limitations of Financial Statements
In this section, we discuss the limitations of financial statements
1. Financial Statements are essentially interim reports and hence, cannot be
final because the actual gain or loss of a business can be determined only
after it has put down it shutters.
2. They tend to give an appearance of finality and accuracy, because they are
expressed in exact money amount. Any value to the amounts presented in
the statement depends upon the value standards of the person dealing
with them.
3. The Balance Sheet loses its function as an index of current economic
realities due to the fact that financial statements are compiled on the basis
of historical costs while there is a marked decline in the value of the
monetary unit and the resultant rise in prices. The problem has become
more important especially during the war and the post war period.
4. They do not give effect to many factors which have a bearing on financial
conditions and operating results because they cannot be stated in terms of
money and are qualitative in nature. Such factors are the reputation and
prestige of the business with the public, its credit rating the efficiency and
loyalty of its employees and integrity of management. Due to these
limitations it is said that financial statements do not show the financial
condition of a business rather they show the position of financial
accounting for a business.
Analysis and Interpretation of Financial Statements
In this section, we attempt to make a brief study of Analysis and interpretation
of financial statements. Analysis and interpretation of financial statements an
attempts to determine the significance and meaning of the financial statement data
so that a forecast can be made of the prospects for future earnings ability to pay
interest, debt maturities (current and long-term) and probability of a sound
dividend policy. To quote Myers “Financial statement analysis is largely study of the
15
relationship among the various financial factors in a business as disclosed by a

single set of statements and study of the trend of these factors as shown in a series
of statements. So financial analysis’ main function is the pinpointing of the
strengths and weaknesses of a business concern by regrouping and analysis of
figures contained in financial statements by making comparison of various
components and by examining their content. The financial manager uses this as
the basis to plain future financial requirements by means of forecasting and
budgeting procedures.
The analysis and interpretation of financial statements represents the last of
the four major steps of accounting viz.
1. Analysis of each transaction to determine the accounts to debited and
credited and the measurement and valuation of each transaction to
determine the amounts involved.
2. Recording of the information in the journals, summarization in ledgers and
preparation of a work sheet.
3. Preparation of financial statements.
4. Analysis and interpretation of financial statements results in the
presentation of information that assists business mangers, creditors and
investors. They require a clear understanding of monetary valuation of the
items.
The analyst must group what represent sound and unsound relationships
reflected by the financial statements. He should fully realize that financial,
administrative and operating policies of management or the absence of such
policies can be detected by studying the statements. Moreover, the process of
analysing financial statements involves the compilation and study of financial and
operating data and the preparation and on of measuring devices such as ratios,
trends and percentages. Thus, the date is more meaningful and it is placed in
better perspective when it is provided by means of measurement, its relationship
with other date was established and it is ranked in terms of its relative significance.
One can achieve this by comparisons made between related item in the same
statement for a given data or in period of time of statements for a series of years.
That as why the financial and operating data of one company should be compared
with statistics prepared for the industry.
Analysis and interpretation are interconnected because interpretation is
impossible without analysis and short or interpretation, analysis is useless.
Interpretation requires proper analysis. It is difficult to interpret financial
statements figures which consist not only of account balances, which usually are
the results of a number of debit and credit entries for a variety of transaction, but
also combinations of account balances, because the figures do not represent
homogeneous data. So this needs in analysis of the totals in statements into their
components so as to restore some sort of homogeneity to the statement data. For
example, through current liabilities, in a company’s balance sheet, are shown
16
separately from other liabilities it would be better from the point of view of the
financial manager to have information regarding debts due within a month or six
months or for long periods. This information has to be obtained by aging the
accounts as it is not available in statements. Interpretation further requires
comparison. The Financial statement has to be dissected into its constituents in
order to measure the relative magnitudes of the various entities. For example, if
current liabilities on a particular date are a t a certain figure and if it is desired to
know whether business would be in a position to meet these obligations, the value
of liabilities will be compared with that of assets such as cash, readily convertible
assets, etc., which are available to pay off liabilities.
Unlike in the earlier days, now accountants play a vital role in the analysis
and interpretation of financial and operating data due to the pressing demand for
analytical information by business executives, bankers and others. Now-a-day the
work of an accountant is incomplete if he has not analysed and interpreted the data
presented in the statements.
Types of Financial Analysis
In this section, we attempt to make a brief study of different types of financial
analysis
1. External Analysis
2. Internal Analysis
3. Horizontal Analysis
4. Vertical Analysis
External Analysis
This is made by those who do not have access to the detailed records of the
company. This group includes credit agencies, investors and governmental agencies
regulating a business in a nominal way. They depend almost entirely on published
financial statements. Now their position has been improved due to governmental
information regulations requiring business undertakings to make available detailed
information schedules and explanatory footnotes to the public through audited
accounts.
Internal Analysis
This is accomplished b those who have access to the books of accounts and all
other information related to business. The internal analyst analyses for managerial
purposes. It is the internal analysis and it is conducted by executives and
employees of the enterprise as well as governmental and court agencies which may
have major regulatory and other jurisdiction over the business.
Horizontal Analysis
When financial statements for a number of years are reviewed and analysed,
the analysis is called ‘horizontal analysis;. This is also known as ‘Dynamic Analysis’
as it is based on data from year to year rather than one data or period of time as a
whole.
17
Vertical Analysis
It is often used for referring to ratios developed on one date or for one
accounting period. It is also called ‘Static Analaysis’. This is not very helpful for a
proper analysis of the fir’s financial position and its interpretation as it does not
enable to study the data in perspective. But this can be provided by a study
conducted over a number of years, so that comparisons can be effected. Hence this
is not very useful.
Techniques of Financial Statements
The most important techniques of analysis and interpretation of financial
statements are listed in this section: (a)Comparative financial statements,
(b)Common measurement or size statements, (c)Trend analysis, (e)Ratio analysis,
(d)Cash flow analysis, (e)Funds flow analysis, (f)Net working capital analysis
Comparative financial statements:
Two years figures of a concern can be easily compared. Under the Companies
Act, companies must show the corresponding figures of the previous year in their
Profit and Loss Accountant and Balance Sheet. We can observe by this comparison
the increase or decrease in the various assets and liabilities and the proprietary
equity or capital. Similarly we can observe the progress of a business by the
comparison of income statements for two periods. It is more welcome to work out
the items in terms of percentage and enter these also in the statements as
comparison of absolute figures has no significance or sometimes in misleading.
These statements normally comprise comparative income statements (profit and
loss account), comparative balance sheets, and comparative statements of change
in total capital as well as in working capital. These statements help in making inter-
period and inter-firm comparisons and also highlight the trends in performance
efficiency, and financial position.
Preparation of Comparative financial statements
1. Comparative income statements (profit and loss account)
2. Comparative balance sheets
Preparation of Comparative income statements
Illustration – 1
You are required to prepare a comparative income statement Profit & Loss
Account
2020 2021 2020 2021
Rs Rs Rs Rs
To Cost of goods sold 6,000 7,500 By Net Sales 8,000 10,000
To Operating expenses:
Administrative 200 200
Selling 300 400
To Net Profit 1,500 1,900
8,000 10,000 8,000 10,000
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Solution
Comparative Income Statement
Particulars 2020 2021 Absolute Percentage
Increase + Increase +
Rs Rs
Decrease - Decrease -
Net sales 8,000 10,000 + 2,000 + 25%
Less: cost of goods sold 6,000 7,500 + 1,500 + 25%
Gross profit A 2,000 2,500 + 500 + 25%
Less: Operating expenses
Administrative cost 200 200 - -
Selling cost 300 400 + 100 + 33.33%
Total cost B 500 600 + 100 + 20%
Net profit (Gross profit- Total 1,500 1,900 + 400 +26.7%
cost)(A – B)
Preparation of Comparative Balance Sheet
Illustration – 2: From the following balance sheets relating to a trader, prepare
a comparative balance sheet.
Balance sheets as on 31.12.2020 and 31.12.2021

Liabilities 2020 2021 Assets 2020 2021
Capital & reserve 80,000 1,20,000 Current assets 60,000 85,000
Long term borrowings
40,000 40,000 Investments 20,000 15,000
from bank
Current liabilities and
30,000 40,000 Fixed assets 70,000 1,00,000
provisions
1,50,000 2,00,000 1,50,000 2,00,000
Comparative Balance Sheet

Particulars 2020 2021 Increase (+) Percentage
Decrease(-) of Increase/
Decrease
Assets Rs. Rs Rs.
Current Assets 60,000 85,000 + 25,000 + 41.67
Investments 20,000 15,000 -5,000 - 25.00
Fixed Assets 70,000 1,00,000 + 30,000 + 42.86
Total Assets 1,50,000 2,00,000 + 50,000 + 33.33
Liabilities and Capital
Current Liabilities 30,000 40,000 + 10,000 +33.33
Long term borrowings from
40,000 40,000 -
bank
Total Liabilities (a) 70.000 80,000 + 10 000 +14.29
Capital and Reserves (b) 80.000 1 20.000 + 40 000 + 50.00
Total Liabilities and capital (a+b) 1,50,000 2,00,000 + 50,000 +33.33
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Common size statements

Sometimes Financial statements when read with absolute figures are not
easily understandable. Hence, it is essential that figures reported in these
statements should be converted into percentage to some common base. Common
size statements indicate the relationship of various items with some common items,
(expressed as percentage of the common item). For example in a Balance Sheet the
total assets and liabilities is taken as 100 and all the figures are expressed as
percentage of total. Similarly, in a Profit and Loss Account sales figure is assumed
to be equal to 100 and all other figures are expressed as a percentage of the total.
The statements thus prepared are called common size statements. These
statements normally comprise Common size balance sheets, Common size income
statements (profit and loss account).
Preparation of Common size financial statements
1. Common size income statements (profit and loss account)
2. Common size balance sheets
Preparation of Common size income statements
Illustration – 3
From the following profit and loss accounts of “RANJITHA” Ltd for the year
ended 31st Dec 2020 and 2021.You are required to prepare a common – size income
statements.
Dr Profit and Loss Account Cr

2020 2021 2020 2021
Particulars Particulars
Rs Rs Rs Rs
To Cost of goods sales 1,200 1,500 By Net sales 1,600 2,000
Administration expenses 40 60
Selling expenses 60 60
To Net profit 300 380
1,600 2,000 1,600 2,000
Solution
Common – Size Income Statements

2020 2021
Percentage Percentage
Net sales 100 100
Less:Cost of sales 75 75
Gross profit
25 25
Less:Operating expenses
Administrative expenses 2.5 3
Selling expenses 3.75 3
Total cost 6.25 6
Net profit
18.75 19
(Gross profit – Total cost)
20
Preparation of Common size Balance sheet

Illustration – 4
From the following balance sheet of “MARADON” Ltd, prepare a common size
balance sheet as 31st Dec for 2020 and 2021.
Balance Sheet
2020 2021 2020 2021
Liabilities Assets
Rs Rs Rs Rs
Bills payable 500 750 Cash 500 700
Tax payable 1,000 1,500 Debtors 3,000 4,500
Creditors 1,500 2,000 Stock 1,000 2,000
15% Debentures 1,000 1,500 Land 1,000 1,200
10% preference capital 2,000 2,000 Building 2,500 2,250
Equity capital 3,000 3,250 Plant 2,000 1,800
Reserve 2,000 2,250 Furniture 1,000 800
11,000 13,250 11,000 13,250
Solution
Common Size Balance Sheet as on 31st December 2020 & 2021
Assets 2020 2021
% %
Current assets
Cash 4.54 5.28
Debtors 27.27 33.96
Stock 9.09 15.09
Total current assets 40.90 54.33
Fixed assets
Land 9.09 9.06
Building 22.73 16.98
Plant 18.19 13.59
Furniture 9.09 6.04
Total fixed assets 59.10 45.67
Total assets [Total current assets + Total fixed assets] 100 100
Liabilities
Current liabilities
Bills payable 4.54 5.66
Tax payable 9.09 11.32
Creditors 13.64 15.09
Total current liabilities 27.27 32.07
Long term liabilities
15% Debentures 9.09 11.32
Total long term liabilities 9.09 11.32
Total liabilities [current liabilities + long term liabilities] 36.36 43.39
Capital and Reserves
10% preference capital 18.18 15.09
Equity capital 27.28 24.53
Reserves 18.18 16.98
Total Share holder’s fund 63.64 56.51
Total liabilities and capital 100 100
[Current liabilities + Long term liabilities + Capital Reserve]
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Trend Analysis
It is essential to have statements for a number of years for analyzing the trend
of data shown in the financial statements. It also involves the calculation of
percentage relationship that each statement item bears to the same item in the
base year. Trend percentages disclose changes in the financial and operating data
between specific period and make it possible for the analyst to form an opinion as
to whether unfavorable or unfavorable tendencies are reflected by the data.
Illustration – 5
From the following data relating to the assets side of the Ranjitha Ltd, for the
period 31st Dec, 2018 to 31st Dec 2021.You are required to calculate the trend
percentage taking 2018 as the base year.
Assets 2018 2019 2020 2021
Cash 1,000 1,200 800 1,400
Debtors 2,000 2,500 3,250 4,000
Stock 3,000 4,000 3,500 5,000
Other current assets 500 750 1,250 1,500
Land 4,000 5,000 5,000 5,000
Building 8,000 10,000 12,000 15,000
Plant 10,000 10,000 12,000 15,000
Total 28,500 33,450 37,800 46,900
Solution:
Statement Showing Trend Percentage
2018 2019 2020 2021 Trend percentage
Rs. Rs. Rs. Rs. Base Year 2018
2018 2019 2020 2021
Cash 1,000 1,200 800 1,400 100 120 80 140
Debtors 2,000 2,500 3,250 4,000 100 125 163 200
Stock 3,000 4,000 3,500 5,000 100 133 117 167
Other current assets 500 750 1,250 1,500 100 150 250 300
Total currentassets 6,500 8,450 8,800 11,900 100 129 135 183
Fixed Assets
Land 4,000 5,000 5,000 5,000 100 125 125 125
Building 8,000 10,000 12,000 15,000 100 125 150 175
Plant 10,000 10,000 12,000 15,000 100 100 120 150
Total fixed assets 22,000 25,000 29,000 35,000 100 114 132 159
Ratio analysis
An analysis of financial statements based on ratios is known as ratio analysis.
A ratio is a mathematical relationship between two or more items taken from the
financial statements. Ratio analysis is the process of Computing determining, and
presenting the relationship of items. It also includes comparison and interpretation
of ratios and using them as basis for the future projections.
Funds flow analysis
Funds flow statement signifies the sources and applications of funds. The term
'funds' refers to working capital. Funds flow analysis clearly shows internal and
22
external sources of working capital and the way funds have been used. Funds flow
is derived from analysis of changes which have taken place in assets and equities
between two balance sheet dates.
Cash flow analysis
Cash flow analysis depicts the inflows and outflows of cash. Cash flow
statement is the device for such analysis. It highlights causes which bring changes
in cash position between two balance sheet dates.
Networking capital analysis
Networking capital statement or schedule of changes in working capital is
prepared to disclose net changes in working capitals on two specific dates (generally
two balance sheet dates). It is prepared from current assets and current liabilities
on the specified dates to show net increase or decrease in working capital.
REVISION POINTS
 Financial statements or reports are account balances arranged in effective
and meaningful order
 There are three types of financial statement in trading business i.e. 1.
Balance sheet 2. Income statement3. Statement of retained earnings.
 The basic financial statements prepared by the non trading organization 1.
Recepts and payment accounts 2. Income and expenditure account 3.
Balance sheet
 Analysis and Interpretation of financial statements
 Preparation of comparative financial statements
INDEX QUESTIONS
1. Briefly describe the uses and limitations of financial statements.
2. What do you understand by Analysis and Interpretation of financial
statements?
3. Discuss the different types of analysis of financial statements in detail.
4. Briefly explain the Techniques and tools of financial statement analysis.
5. You are required to prepare a comparative income statement from the
following profit and loss account of M Ltd.
Particulars 2020 2021 2020 2021

Particulars
Rs Rs Rs Rs
To Cost of goods sold 2,000 3,000 By Net sales 3,000 5,000
To Operating
expenses 100 300
Selling 850 1,500
To Net Profit
3,000 5,000 3,000 5,000
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6. You are required to prepare a comparative Balance Sheet from the

following Balance Sheet as on Dec 31st 2020 and 2021
Balance Sheet
Rs Rs Rs Rs
Bills payable 500 750 Cash 1,000 1,400
Creditors 1,500 2,000 Debtors 2,000 3,000
Bank o/d 1,000 1,500 Stock 2,000 3,000
6% debentures 1,000 1,500 Land 1,000 1,000
Preference capital 3,000 3,000 Buildings 3,000 2,700
Equity capital 4,000 4,000 Plant 3,000 2,700
Reserve 2,000 2,450 Furniture 1,000 1,400
13,000 15,200 13,000 15,200
7. You are required to prepare a common size income statement from the
following profit and loss account of R Ltd.
Particulars 2020 2021 2020 2021
Particulars
Rs Rs Rs Rs
To Cost of goods sold 600 750 By Net sales 800 1,000
Selling 30 40
To Net Profit 150 190
800 1,000 800 1,000
8. From the following Balance Sheets of MR Ltd., You are required to prepare
a common size balance sheet
Balance Sheet
Liabilities 2020 2021 2020 2021
Assets
Rs Rs Rs Rs
Bills payable 100 150 Cash 220 300
Creditors 140 190 Debtors 190 210
Equity capital 400 500 Stock 290 330
Reserve 160 200 Land 100 120
8 % debentures 200 160 Buildings 200 200
1,000 1,200 1,000 1,200
9. From the following data relating to the assets side of the RM Ltd, for the
period 31st Dec, 2018 to 31st Dec 2021.You are required to calculate the
trend percentage taking 2018 as the base year.
Assets 2018 2019 2020 2021
Cash 500 600 400 700
Stock 1,500 2,000 1,750 2,500
Land 2,000 2,500 2,500 3,000
Building 5,000 9,000 10,000 12,000
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SUMMARY
Financial Statements refer to a package of statements such as balance sheet,
income statement, funds flow statement, cash flow statement and statement of
retained earnings. These statements are prepared by a business concern at the end
of a given period to disclose its financial information, presenting a periodical review
or report on the progress of the business. Analysis and interpretation are closely
related. Interpretation is not possible without analysis and without interpretation
analysis has no value. Analysis is a process of evaluating the relationship between
component parts of a financial statement to obtain a better understanding of a
firm’s position and performance. Objectives of Financial Statement areto provide
reliable financial information about economic resources and obligations of a
business firm. To provide other needed information about changes in such
economic resources and obligations.
Financial statements are helps to creditors to determine the debt capacity of
the concern. Financial statements provide information to share holders and other
investors about present and future prospect of the concern. Financial Statements
required further detailed analysis and interpretation for better understand, they
can not speak themselves. They are based on personal judgment and opinions of
the accountants of each concern therefore the correct financial conditions are not
always disclosed by financial statements, various factor may affect personal views
and their validity.
TERMINAL EXERCISES
1. What are the limitations of financial statements?
2. Write short note on income statement
3. What are the types of financial statements?
4. What are the objectives of financial statements?
5. Explain analysis and interpretation of financial statements
Business Environment, 7th edition, McGraw-Hill
 Horngren, Datar & Foster, Cost Accounting – A Managerial Emphasis (any
edition)
 Management accounting e-journal –SSRNlibrary
 The journal of accounting And management
ASSIGNMENT
1. Explain the uses of financial statements?
2. Discuss the types of financial analysis?
3. How to prepare comparative financial statements-Explain?
25
REFERENCES
1. S.N. Maheshwari Principles of Management Accounting.
2. T.S. Reddy and Hariprasad Reddy Management Accounting.
LEARNING ACTIVITIES
 To appreciate historical and contemporary views of how management
accounting creates value for an organization
 To understand and apply a range of decision-making models that enable
managers to solve problems and evaluate performance
KEY WORDS
Analysis, Common-size statement, vertical analysis and Horizontal analysis

26
LESSON – 3
RATIO ANALYSIS
OBJECTIVES
In second lesson, we discussed the meaning, objectives, uses, limitations and
techniques of financial statements. In this lesson, we discuss meaning, definition,
advantages, disadvantages and kinds of ratios. After going through this lesson you
will able to
 know the meaning and definition of ratio and ratio analysis
 understand the various uses and limitations of accounting ratios
 understand the various kinds of ratios
CONTENTS
 Introduction
o Meaning
o Definition
 Advantages of Accounting Ratios
 Limitations of Accounting Ratios
 Ratio Analysis
 Steps in Ratio Analysis
o Collection of necessary data
o Computation of ratios:
o Comparison of ratios
o Analysis and interpretation of ratios
 Classification of Ratios
o Balance Sheet Ratios
o Revenue Statement or P& L Account or Profit ability ratios
o Composite Ratios
INTRODUCTION
of Ratio
Meaning
A ratio is a mathematical expression of relationship between two
interconnected figures. It is one number expressed in terms of another related
number. As commerce graduates you all know the methods of recording business
transactions in the books of accounts and the preparation of Profit and Loss
Account and Balance Sheet. It is also necessary to examine the art of interpretation
of accounts. It requires skill on judgement to know the meaning and relative
importance of figures: which are visible to all. Here we are going to see how
27
business enterprises measure their turnover, profitability, liquidity and leverage.

With the use of ratios we can measure a business concern's performance. Ratios
found in final accounts of a company may reveal much about its financial position
to its shareholders, creditors and management.
The shareholders, investors, creditors, financial institutions and financial
journalists are very much interested to read the accounting data. Most of the people
in the case of limited companies, who read the accounting data, are not intimately
connected in any way with the day to day running of the company. It is very
important to know how to read the accounts properly and to extract maximum
information from them. Hence, the principles to be examined by the interpreter are
1. Profitability, 2. Ownership,3. Solvency, 4. Trend, 5. Gearing and 6. Financial
strength. Any person reading and interpreting the accounts will place a different
emphasis on each of the above principles. The technique that is followed by
accountants to facilitate the discussion of the above principles is Accounting Ratio
or Ratio Analysis. This technique is highly developed in America. In 1919 Alexander
Wall presented this elaborate system of Ratio Analysis. He pointed out that in order
to get a complete picture it is essential to consider the relationships in financial
statements other than that of current assets to current liabilities relationship that
might be measured quantitatively and used as checks on current ratio. Since then,
comprehensive analysis by means of calculation of a series of ratios rapidly became
“all the rage”.
Definition
In this section, we attempt to make a brief study about definition of Ratio. A
ratio is a number expressed in terms of another number. It is a statistical
yardstick-a measure of the relationship between two figures. It is an expression
spelt out by dividing one figure with the other.
Ratio can be define as “The indicated quotient of two mathematical
expressions”
There are different ways of expression of the ratios namely “Proportion”,
“times” and “Percentage.”
Proportion / Quotient -i.e. what one number is to another number For example,
3,000 is, to 1,000, what 3 is to 1 (3: 1).
Rate gives the velocity or the number of times one number is, that other
number. For example, 3,000 are 3 times that of 1,000.
Percentage: when the relation between two numbers is expressed for one
hundredth it is called percentage. For example 3,000 / 1,000 x 100 = 300%
Advantages of Accounting Ratios
In this section, we discuss the advantages of accounting ratio
1. Accounting ratios are most commonly used for management control
purposes by comparing its oven performance with the performance of other
similar concerns.
28
2. It is one of the media to link the past and future.

3. They can play a significant role in cost accounting, financial accounting,
budgetary control and auditing.
4. Apart from management, it assists the general public to understand the
financial trend and financial health of the business. It is possible, from
ratio analysis, to have a general impression of the past performances of the
business and is possible to have forces about the uncertain future without
any difficulty.
5. Identification of financial responsibility is possible from critical ratio
analysis.
6. Ratio analysis is one of the factors which curb the development of
institution in financial management.
However, it is questioned whether accounting ratios will render valuable
services to all concerned. It all depends on the person who handles it.
Limitations of Accounting Ratios
Accounting ratios have the following limitations
1. The ratios thus drawn are based on the historical figures appearing in the
Balance sheet. Hence the performance of one enterprise based on the
historical data gives a wrong direction to the approach.
2. Assets and liabilities are not grouped under money value and real value
items in preparing different ratios.
3. One particular ratio is not sufficient to review the operation of the
business. It should be considered along with other related ratios.
4. Accounting and financial ratios will tend to interpret wrong direction, if
based on unauthentic data.
5. Accounting ratios, in practice are useful to understand the trend of a
particular unit not particular type of business as a whole. This can be done
by comparing the past results with that of the present Management and
financial policies which differ widely from concern to concern. But in
practice it is difficult to compare the performance of one Company with the
other. The study of ratio analysis gives us some guideline, because, a ratio
which is satisfactory for one particular enterprise may be reverse in the
case of another.
6. From the points discussed above it can be stated that ratio analysis can be
regarded ‘only as an aid to making judgement and not a substitute to
judgement’.
Ratio Analysis
In this section, we attempt to make a brief study of ratio analysis. Ratio
analysis is a tool of financial statement analysis, in the hands of management in
which, inferences are drawn based on the computation and analysis of different
29
ratios. It involves the collection of required information, calculation of ratios,

analysis and interpretation of ratios.
Steps in Ratio Analysis
Following are the different steps involved in ratio analysis:
Collection of necessary data: Before proceeding to compute ratios, it is
necessary to collect the data for comparison. The data may be available from the
financial statements, viz., income statement and balance sheet and other records.
Computation of ratios: Ratios are calculated for two, related figures. For
example, ’net profit and capital invested’, ‘current assets and current liabilities’
‘debtors and sales’, etc.
Comparison of ratios: Ratios will be meaningless, unless they are compared
and analysed. Comparison of ratios may be done with that of standard ratios, ratios
relating to preceding years; or with ratios of other departments or firms.
Analysis and interpretation of ratios: The ratios calculated must be thoroughly
scrutinized and based on the analysis inferences are drawn. For example, if the net
profit ratios for three consecutive years are 10%, 15% and 20%, it may be
concluded that, net profit percentage is showing an increasing trend.
Classification of Ratios
In this section, we attempt to make a brief study of different types of
accounting ratios. Ratios are classified in several ways. Different standpoints are
used for classifying ratios. There is no uniformity in classification by different
experts. Classifications may be based on Users, may be based on Relative
Importance, may be Purpose/Function and Statements
Accounting ratios may be broadly classified as follows
1. Balance Sheet Ratios
2. Revenue statement ratios
3. Balance Sheet and Revenue statement ratios
They may also be classified either according to Structural point of view of the
Functional point of view. Under the structural point of view we have.
1. Balance Sheet Ratios
2. P & L Account Ratios
3. Composite Ratios
When a ratio is among two or more balance sheets items it is called Balance Sheet
Ratios or Financial ratios. When a ratio is between two P & L Account items it is called
‘Profit and Loss Account Ratio or Operating Ratio’ and when a ratio is between Balance
Sheet item and a Profit and Loss Account item, it is called ‘Composite Ratio’.
Balance Sheet Ratios
1. Current or 2 to 1 Ratio
2. Acid Test or Quick Ratio or Liquid Ratio
30
3. Proprietary Ratio
4. Assets-Proprietorship Ratio
5. Debt-Equity Ratio
6. Capital Gearing Ratio
Revenue Statement or P& L Account or Profit ability ratios
1. Gross Profit Ratio 2. Net Profit Ratio
3. Expenses Ratio 4. Operating Ratio
5. Operating profit ratio 6. Stock Turnover Ratio
Composite Ratios
1. Return on proprietors’ Fund 2. Return on proprietors’ Equity
3. Return on Equity share capital 4. Return on capital employed
5. Return on Total Assets 6. Turnover of Fixed Assets
7. Turnover of Total Assets 8. Turnover of Working capital
9. Turnover of Debtors 10. Creditors velocity
Balance Sheet Ratios
1. Current Ratio
It is also known as ‘Working Capital Ratio’ and ‘2 to 1 ratio’. It expresses the
relation between current assets and current liabilities. Current assets include cash,
stock, debtors, bills of exchange and investments which are held by the business
for the purpose of immediate conversion into cash. Normally asset which will be
converted within a year i.e., within the two dates of balance sheets may be regarded
as current assets. In the cycle of business operation, these assets change their form
during the period covered from the last balance sheet. For example just before
acquisition of materials there is cash but after acquisition cash is converted into
stock and when cash sales are effected, stock is converted into cash.
Current assets include cash, bank, stock, debtors, bills receivables and
prepaid expenses. Current liabilities include sundry creditors, bills payable,
provision for taxation, outstanding expenses etc.
Current Ratio is obtained by dividing the total current assets by the total
current liabilities. It is calculated as
Current assets
Current liabilities
Significance of Current Ratio
Current Ratio measures the company’s ability to meet its short tern
obligations. As current assets are almost double the current liabilities, current ratio
is reasonably good. Standard ratio is 2 : 1 which is desirable, it indicates that
current assets are twice the current liabilities. But in actual practice 1: 1 ratio is
considered more suitable than 2: 1, because high ratio may be due to poor
investment policies, excessive stock etc. On the other hand low ratio (0.5: 1) may
31
signify that a shortage of working capital. High ratios indicate both under-trading
and over-capitalisation whereas low ratios indicate over-trading and under-
capitalisation of business. Current ratio varies from industry to industry and within
industry form company to company and within the same company from time to
time.
Acid Test or Quick Ratio or Liquid Ratio
Quick ratio is also called as “liquid ratio” of “Acid test ratio” or “Near money
ratio”. It is the acid test of a concern’s financial soundness. It is the relationship
between quick assets and quick liabilities. Quick ratio 1:1 is considered
satisfactory.
Liquid ratio assists in the study of the immediate cash position of a company.
It is a supplementary measure of liquidity and places more emphasis on immediate
conversion of assets into cash then does the current ratio. When used with the
current ratio, it gives a better picture of the company's ability to meet its short -
term liabilities out of short term assets. It also serves as a more rigorous test of
liquidity than the current ratio.
Liquid assets = Current assets other than stock and prepaid expenses
Liquid liabilities = Current liabilities other than bank overdraft
Liquid Ratio is obtained by dividing the total Liquid assets by the total Liquid
liabilities. It is calculated as
Liquid assets
Liquid liabilities
3. Proprietary Ratio
It is the ratio of the proprietors' funds to the total assets. It is otherwise known
as ‘Capital Ratio’, Equity Ratio’ and 'Worth Debt Ratio'. It indicates how much of
the total assets is owned by the proprieties. It is calculated as
Proprietors' funds
Total assets
The term equity comprises the long term and short term and the owner's
equity or share capital otherwise called external equities and internal equities. In
the case of external equities great importance is attached for the reason that if the
debenture holders and creditors are not paid promptly the company can be brought
to liquidation by them. On the other hand there is not much risk attached to
liabilities to the shareholders. The proprietors' funds include not only equity capital
but also preference capital plus General Reserve and P&L A/c (Cr) Balance. Total
assets include goodwill also. Some may exclude goodwill. But it is necessary to
indicate whether goodwill is taken for calculation or not.
Significance Proprietary Ratio
If the proprietors' funds are Rs. 20,00,000 and the total assets are
Rs.25,00,000 the capital ratio is
32
20,00,000 20
= = 0.8: 1
25,00,000 25
It is clear that out of every Rupee employed in the business, proprietors’
contribution is 80 paise while the creditors have contributed the remaining 20
paise.
This ratio helps to 'test the soundness of capital structure. When this ratio is
below what is normal in the industry in which the company is engaged, the
Company’s condition may be criticized as top heavy with debt. Lastly, the main
purpose of this ratio is to indicate the long term or future solvency position of the
business.
4. Assets proprietorship Ratio
This ratio is further analyzed into
1. Ratio of Fixed Assets to proprietors' funds
2. Ratio of Current Assets to proprietors' funds
3. Ratio of Fixed Assets to Current Assets.
The proprietor should provide the Fixed Assets and contribute some part of the
working capital if the business has been adequately financed in relation to its
capital structure. The main object of determining the ratio of fixed assets to
proprietors' funds is to find out the extent to which his funds are sunk into the
assets with low turnover. When his funds are less than the fixed assets, creditor's
obligation may be used to finance a part of the fixed assets.
This ratio is being calculated by dividing the depreciated book value of the
fixed assets by the amount of proprietors' fund. The formula is
Fixed Assets
Proprietor’s Fund
Example: Proprietors’ Fund Rs. 20,00,000
Fixed Assets Rs. 15,00,000
The ratio expressed as percentage would be
15 ,00 ,000
= 0.75
20 ,00 ,000
Similarly the ratio of current assets to proprietors' fund is obtained by dividing
the value of current assets by the amount of proprietors' fund. For Example, if the
value of current assets is Rs.20,00,000 and the proprietors' funds are Rs.
40,00,000 the ratio expressed in percentage.
Current Assets
Proprietor’s Fund
20,00,000
= 0.50 times
40,00,000
33
5. Debt Equity Ratio

This ratio relates to all recorded creditor’s claim on assets to the owners. It is
also known as External-Internal Equity ratio. It measures the Company’s
obligations to creditors in relation to fund provided by the owners.
It is calculated as
Debt
Equity
The second method is better one. Debt includes both long term and short term
loans in the form of Bills Payable mortgages, debentures, creditors, outstanding
and accrued expenses. Equity includes equity share capital preference share
capital, capital 'reserve etc. In short, it is proprietors’ funds.
Significance Debt Equity Ratio
Suppose the liabilities to outsiders are Rs. 5,00,000 and the proprietors' funds
are Rs. 20,00,000 then Debt Equity Ratio would be:
Debt
Equity
5 ,00 ,000
 0.20 times
25 ,00 ,000
This means that the value of assets could shrink 80 percent before creditors
prospects of repayment would in any way be impaired. Here the interpretation
depends entirely on the financial and business policy of the company. The purpose
tests ratios is to have an idea of the amount of capital subscribed to the company
by the share holders and the assets cushion' available to creditors on liquidation.
6. Capital Gearing Ratio
The term ‘Capital Gearing’ is used to denote the proportion between Equity
share capital on the one hand and Preference share capital and other kinds of fixed
interest bearing loans on the other. It is as significant and helpful for the smooth
and successful running of a business as the use of speed gears for a motor car or a
machine. Such relationship indicates whether capital structure is high geared or
low geared. or low geared.
Capital gearing ratio is calculated as
Equity capital
Fixed Interest Bearing Securities
As already seen Equity Capital includes all reserves and undistributed profits
which belong to the share-holders, fixed interest bearing securities include
preference shares, redeemable preference shares, debentures, public debts etc.
Significance Capital Gearing Ratio
It capital carrying fixed fate of interest is more than the equity share capital;
gearing is said to be ‘high’. For example the equity share capital of a company
34
Rs.10,00,000. General Reserves Rs. 2,00,000 the preference share capital Rs.
2,00,000and Debentures Rs. 4,00,000.
12 ,00 ,000
 12 : 6 or 2 : 1
6,00 ,000
Gearing is low because capital carry fixed ratio of interest is less than equity
capital. Suppose if Equity Capital is Rs. 2,00,000 and reserves Rs. 4,00,000 add
preference share capital and debentures amount to Rs. 12,00,000 the gearing is
said to be high as follows:
6 ,00 ,000 6
  6 : 12  1 : 2
12 ,00 ,000 12
From the above illustrations it is clear that low gearing means High Equity
capital and high gearing means low Equity Capital. When the company earns
good profit, shareholders stand to gain with high capital gearing, because the
debt capital is paid fixed interest and the balance of profits is available to the
equity share holders. On the other hand when a. company has low profit, the
payment of fixed interest may absorb all the profits leaving nothing for the
equity holders.
Hence, gearing ratio affects distribution policies, the building up of
reserves, stable dividend policy etc. It must be carefully planned as it affects the
company's capacity to maintain an even distribution policy during the difficult
trading periods. The purpose of this ratio is for the analysis of the capital
structure of a company. It is important both for the company and the
prospective investors.
Revenue Statement or P& L Account or Profit ability ratios
7. Gross Profit Ratio
This ratio is set up for comparison of the gross profit with net sales. This is
also called ‘Turnover Ratio’. This is invariably expressed as a percentage. This will
reveal the extent to which the business is managed profitably. This also serves as
an effective check on stock control. This ratio serves as a guide to the efficiency of
the production department. This ratio may be compared with the ratios in the
previous year and in similar, business. It is calculated as under.
Gross profits
x 100
Net sales
Example: Net Sales Rs. 10,00,000 and Gross profit Rs.2,00,000

2 ,00 ,0000
Percentage of gross profit on sale is x 100 – 20 %
10 ,00 ,000
Significance Gross Profit Ratio
This indicates the margin of profit on sale effected and whether the average
percentage of mark-up on the goods is maintained.
35
8. Net Profit Ratio

It is the ratio of operating profit to net sales. Higher the net profit ratio the
better it is for any concern. It is ascertained-by finding out the ratio between the
net profit to net sales. It is calculated as under.
Net profits
100
Net sales
Example:Net profit Rs.1,00,000 and Net sales Rs.16,00,000

1,00 ,000
100  6.25%
16 ,00 ,000
Significance Net Profit Ratio
This is an effective measure of profitability of a business. This is an indication
of the company's performance and its sales promotion. This shows what portions of
sales is left over after deduction of all expenses.
9. Expenses Ratio
Many expense ratios exist. It is useful to examine each of the individual
expense items as a percentage on sales. We can find out specific areas of
improvement or deterioration. Here Administrative expenses, selling expenses
material consumed etc., may be compared in relation to the turnover. Such
comparison with corresponding ratios of the previous year will afford valuable
information to effect economy. Expense ratios are calculated as follows.
Materials consumer
1. × 100
Sales
Finance expenses
2. × 100
Sales
Selling expenses
3. × 100
Sales
Administrative expenses
4. × 100
Sales
Non − operating expenses
5. × 100
Sales
10. Operating Ratio
This is ascertained by comparing the cost of goods sold and other operating
expenses with net sales. The ratio is calculated as
Cost of goods sold  Operating Expenses
100
Net Sales
A rise in the operating ratio indicates a decline in the efficiency

Net Profit Ratio + Operating Ratio = 100
Example: Cost of goods sold Rs 10, 40,000, Operating expenses Rs.
3,60,000and Net sales Rs 16,00,000
36
14,00,000
Operating ratio = = 0.88 ∶ 1
16,00,000
11. Operating profit ratio
This is ascertained by comparing the operating profit with net sales. The ratio
is calculated as
Operating profit
100
Net Sales
Operating profit :
Net Profit + Non operating expenses – Non operating income
Example: Net profit Rs 40,000, Non operating expenses Rs. 13,000, Non
operating income Rs 3,000 and Net sales Rs 10,00,000
Operating profit: Net Profit + Non operating expenses – Non operating income
= Rs. 40,000+ Rs. 13,000- Rs. 3,000 = Rs 50,000
50,000
100  5%
10,00,000
12. Stock Turnover Ratio
It is also known as ‘Inventory Ratio’ and it is prepared to ascertain the number
of times the stock is tuned during the period under review, It is the relationship
between inventory and cost of goods sold. As sales figures are at selling price and
the inventory at cost, the ratio is computed by dividing the cost of goods sold by the
average inventory: Average inventory means opening stock plus closing stock
divided by 2 and cost of sale; means opening stock plus purchases minus closing
stock or Sales less gross profit. The stock turnover ratio is calculated as:
Cost of goods sold
Average stock
Example: Cost of goods sold Rs.10,40,000, Opening stock Rs.3,00,000
Closing Stock Rs. 4,00,000
Cost of goods sold= Opening stock plus purchases minus closing stock
=Rs.10,40,000 + Rs.3,00,000 - Rs. 4,00,000= 9,40,000
Average inventory = Opening stock plus closing stock divided by 2
3 ,00 ,000  4 ,00 ,000
 3 ,50 ,000
2
Cost of goods sold
Stock turnover ratio:
Average stock
9 ,40 ,000
 2.68
3 ,50 ,000
37
Composite Ratios
13. Return on proprietors’ Fund
This ratio is also known as Return on Shareholders’ Equity. This ratio is the
ratio of net profit to Proprietors’ Equity. It also indicates the profitably of the
business. It is usually expressed as a percentage. It measures the business success
and managerial efficiency.
Net Pro it (after taxes &𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
× 100
Proprietors′ Equity
14. Return on shareholder’s investment
It is otherwise known as Return on proprietors' fund. It brings out the
relationship between the Proprietors’ Fund and Net Profit. This ratio measures the
profitability of the business. In other-words it indicates the rate of return earned on
the investment of owners’ funds. For the calculation of this ratio we should take the
simple average of such shareholders' investment as on the date of commencement
of the figures at the beginning and end of the year. This ratio is being calculated as
follows:
Net Pro it (after interest and taxes)
× 100
Proprietors ′ Fund
15. Return on Equity Share Capital
This is also known as Rate on Return on Equity Capital. This is considered in
the analysis of overall profitability. It brings out the relationship between the Equity
Share Capital and Net Profit after paying dividend to the preference shareholders. It
is usually expressed as a n percentage. This ratio is calculated as follows.
Net Pro it (after taxes &𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
× 100
Equity Share Capital
This shows what percentage of the earned profit after tax & preference
dividend bears to the amount of capital invested by equity shareholders for the risk
borne by them.
16. Return on Total Assets
It is otherwise known as Return on Gross capital employed or Total capital
employed. There is a relationship between the total assets and net profit before
charging preference divided as interest expenses. Total assets are contributed by
both preference shareholders and creditors. This ratio measures profitability of total
capital committed to the business. It also helps the management to find out its
success in enhancing the income of the shareholders through the use of borrowed
find. It is calculated as follows:
Net profit before preference divident andInteres t exp enses
100
Total Assets
For example, the rate of return on total assets is 20% and the rate of interest
on borrowed capital is 10%. The management has made a saving of 10% (20-10)
through the use of borrowed capital and thus benefited the equity holders.
38
17. Turnover of Fixed Assets

It is also called as Sales to Fixed Assets or Fixed Assets Turnover or Net Sales
to Fixed Ratio. It shows whether fixed assets are fully utilized. This ratio shows
any excess investment in fixed assets and the ratio of cost of goods manufactured
to fixed assets. A high ratio shows better use of fixed asset. It may be calculated
as
Cost of goods sold Net sales
or
Fixed assets Fixed assets
18. Turnover of Total Assets

It is also called total assets turnover Ratio. It is calculated by dividing the net
sales by total assets. The standard of this ratio is two times. A high ratio indicates
utilization over trading of fixed assets whereas a low ratio indicates excessive
investments i.e., a symptom of idle capacity. Some authors take cost of goods old
instead of sales. The turnover total assets ratio is arrived at as under:
Cost of goods sold Net sales
or
Total assets Total assets
19. Turnover of Working capital

It is otherwise known as sales to working capital or working capital turnover
ratio. It is calculated by dividing the net working capital by net sales. Whether
working capital is effectively used or not will be shown by the working capital
turnover Ratio. It is calculated as
Net working capital
Net sales
It shows whether the business is being operated on a small or large amount of

working capital in relation to sales. It helps us to test the efficiency with which the
working capital is utilized. A high ratio shows higher efficiency and low ratio
indicates inefficiency. Sales in respect of working capital should be normal. A low
turnover of working capital may be the outcome of an excess working capital, slow
turnover of inventories and a large cash balance. On the other hand, a high
working capital turnover may be the result of favorable turnover of stock and
receivables or may reflect and inadequate working capital.
20. Turnover of Debtors
It is also called ‘Debtors Turnover’ or ‘Debtors Turnover Period’. It indicates
the rate at which the money is being collected on account of credit sales. In other
words, the average collection period can be ascertained. This ratio is calculated
as.
Debtors  Bills receivable
 365 days
Credit Sales
This is mainly prepared to find how many days’ credit is outstanding by

debtors
39
21. Creditors’ velocity

It indicates the turnover of payables in the credit purchases. It is calculated by
divined sundry creditors and bills payable by credit purchases. The formula is as follows.
Creditors  Bills Payables
 365 days
Credit purchases
22. Earnings per share (EPS)
This is calculated by dividing the profit (minus preference dividend) by the
number of Equity share. The gives the income earned fro each equity share.
Net Pro it − Preference Dividend
The formula is EPS =
Number of Equity shares
23. Price Earning Ratio (PER)
Market perice per equity share
This is calculated as followsv Price Earning Ratio =
Earings per share
24. Pay out Ratio (POR)

It is also known as Dividend Pay out Ratio and it is the ratio of dividends per
share to EPS. It shows what portion of EPS has been used for paying dividend and
what has been retained for polishing back. It is calculated as follows.
Divident per equityshar e
Pay Out Ratio=
Earining per share
25. Dividend Yield Ratio
It indicates the effective return on investment. Which prospective investors
may hope to earn. It is calculated as follows.
Divident per share
100
Market price of equity share
REVISION POINTS
 Ratio analysis is the broad method by which financial data is converted
into simple mathematic ratios for comparison.
 Using ratio analysis, companies can be evaluated even across industries.
Trends of growth, increased performance, and deterioration within the firm
can be evaluated against itself, as well as across the industry
 In order to calculate the ratio analysis for a financial institution, obtain the
data from the financial statements. Typically, the balance sheet and
income statement will provide the data that you require for calculations
INDEX QUESTIONS
1. What is a Ratio? Explain it advantages and disadvantages.
2. Explain various steps in ratio analysis
3. Explain different kinds of Ratios
40
SUMMARY
In this lesson, we have briefly touched upon the following points: A ratio is a
mathematical expression of relationship between two interconnected figures. It is
one number expressed in terms of another related number. Ratio can be defined as
“The indicated quotient of two mathematical expressions.” It can be expression of
the ratios namely “Proportion”, “times” and “Percentage.”
Ratios play a significant role in cost accounting, financial accounting, budgetary
control and auditing and same time one particular ratio is not sufficient to review the
operation of the business. It should be considered along with other related ratios.
Accounting ratios may be broadly classified in to three groups namely Balance Sheet
Ratios, Revenue statement ratios and Balance Sheet and Revenue statement ratios
TERMINAL EXERCISES
1. What is ratio analysis?
2. What are the advantages of ratio analysis?
3. What are the Limitations of ratio analysis?
 Management accounting research-Elsevier
ASSIGNMENT
1. Explain the steps taken in Ratio analysis?
2. Explain the classification of ratios with illustration.
REFERENCES
1. S.N. Maheshwari Principles of Management Accounting.
2. T.S Reddy and Hariprasad Reddy Management Accounting.
LEARNING ACTIVITIES
 To assess the impact of different decisions, control systems and performance
evaluation methods within the social context of an organization
KEY WORDS
Gearing, Proportion, Financial responsibility, Statistical yardstick and
Interconnected

41
LESSON – 4
ACCOUNTING RATIO- PRACTICAL PROBLEMS

OBJECTIVES
In third lesson, we discussed the meaning, objectives, uses, limitations and
techniques of ratio analysis. In this lesson, we discuss how to work out different
types of ratios. After going through this lesson you will able to
 Know the method of applying formulas
 Understand how to calculate different types of ratios
CONTENTS
 Introduction
 Illustrations
INTRODUCTION
In this section, we attempt to make a brief study about method of applying
formulas and preparing different types of ratios.
Illustrations
In this section, we worked put some model problems
Illustration – 1
Total sales Rs. 1,00,000
Cost of goods sold Rs. 80,000
Calculate Gross profit ratio
Solution
A. Gross profit ratio
Gross profit
---------------- x 100
Sales
Sales - Cost of goods sold = Gross profit
Rs.
Sales 1,00,000
Les: Cost of goods sold 80,000
----------
Gross profit =>20,000
----------
20,000
-------------  100 = 20%
1,00,000
Gross profit ratio=20%
Illustration –2
Sales Rs. 1,00,000
Total expenses Rs. 60,000
Calculate Net profit ratio
42
Solution
Net profit ratio
Rs
Sales 1,00,000
Less: Total expenses 60,000
-----------
Net profit 40,000
-----------
Net profit 40,000
Net profit ratio = ------------- x 100 ------------- x100 = 40%
Sales 1,00,000
Illustration – 3
Sales Rs. 2,00,000
Operating expenses Rs.30,000
Gross profit ratio = 20%
Calculate operating ratio
Solution
Cost of goods sold + operating expenses
Operating ratio =------------------------------------------------------x100
Sales
Sales – Gross profit=Cost of goods sold
Sales = Rs. 2,00,000
Gross profit =2,00,000 x 20/100 =40,000
Cost of goods sold2,00,000 – 40,000 =1,60,000
1,60,000 + 30,000 1,90,000
= ------------------------- x 100 =------------- x= 95%
2,00,000 2,00,000
Operating ratio = 95%
Illustration –4
Cost of goods sold = Rs1,60,000
Opening Stock = Rs.25,000
Closing Stock = Rs.75,000
Find out stock turnover ratio.
Solution
Cost of goods sold
Stock turnover ratio = ------------------------
Average stock
Opening stock+Closing stock
Average stock = -----------------------------------------
2
Opening Stock = Rs 25,000
Closing Stock = Rs. 75,000
43
25,000 + 75,000 1,00, 000

=-------------------=---------------= 50, 000
2 2
Cost of goods sold
Stock turnover ratio=--------------------------
Average stock
1,60,000
= -----------------= 3.2 times
50,000
Stock turnover ratio = 3.2 times
Illustration –5
Calculate debtor turnover ratio from the following data
Rs
Total sales 1,00,000
Cash sales 20,000
Debtors as on 01.1.2021 10,000
Debtors as on 31.12.2021 15,000
Bills Receivables as on 01.01.2021 7,500
Bills Receivables as on 31.12.2021 15,500
Solution
Credit sales
Debtors turnover ratio = ------------------------------------
Average Account Receivable
Total sales - Cash sales= Credit sales
1,00,000 - 20,000 = 80,000
Opening Account Closing Account
Receivables + Receivables
Average Account Receivables= ----------------------------------------------
2
Opening Account receivables = 10,000+7,5000 = 17,500
Closing Account Receivables = 15,000+12,500 = 27,500
44,000
Average Account Receivables = --------------=22,000
2
80,000
Debtors turnover Ratio = -------------- =3.6 times
22,000
Debtors turnover ratio = 3.6 times
Illustration– 6
From the following information calculate creditor turnover Ratio:
Rs.
Credit Purchase during 2021 1,00,000
Creditors as on 01.01.2021 20,000
Creditors as on 31.12.2021 10,000
44
Bills Payables as on 01.01.2021 4,000

Bills Payables as on 31.12.2021 6,000
Solution
Credit Purchase
Creditors Turnover Ratio = ----------------------------------
Average Account Payable
Opening Account Payables = 20,000 + 4,000 = 24,000
Closing Account Payables = 10,000 +6,000 = 16,000
40,000
Average account payable =------------- = 20,000
2
1,00,000
Creditors turnover ratio = --------------= 5 times
20,000
Creditors turnover ratio = 5 times
Illustration – 7
The balance sheet of a company is given below:
Balance Sheet
Liabilities Rs Assets Rs
Equity share capital 10,00,000 Land & building 12,00,000
Preference share capital 4,00,000 Plant & machinery 10,00,000
Debenture 8,00,000 Stock 4,80,000
Reserve 6,00,000 Debtors 4,00,000
Creditors 3,00,000 Cash 1,10,000
Bank old 1,00,000 Prepaid expenses 10,000
32,00,000 32,00,000
Calculate Debt equity ratio.
Solution
External equities Debt
Debt equity ratio (i)-----------------------(or)-----------
Internal equities Equity
Internal equities = Preference share capital + Equity share capital
+Reserve + Surplus
Debt 12,00,000
Debt Equity Ratio=-------- = ----------------=0.6 times
Equity 20,00,000
Debt equity ratio = (0.6:1)
Illustration – 8
From the following details calculate current ratio and liquid ratio. Stock
Rs. 40,000, Debtors Rs 60,000, Bills receivables Rs 10,000, Cash in hand Rs
20,000, Prepaid expense Rs 10,000, Land Rs 50,000 , Plant Rs 12,000, Share
capital Rs 25,000, Creditors Rs1,00,000 Bills payables Rs 70,000, and Bank o/d
Rs. 30,000.
45
Solution
Current assets
Current ratio.= -----------------------
Current liabilities
Current assets
Rs
Stock 40,000
Debtors 60,000
Bills receivables 10,000
Cash in hand 20,000
Prepaid expenses 10,000
1,40,000
Current liabilities
Rs
Creditors 1,00,000
Bills payables 70,000
Bank OD 30,000
2,00,000
Current assets 1,40,000

Current Ratio =----------------------- = ------------=0.7
Current liabilities 2,00,000
Quick assets
Quick ratio = ----------------------
Quick liabilities
Quick assets
Current assets – (Stock and prepaid expenses)
1,40,000 – [ 40,000 + 10,000 ]
1,40,000 – 50,000
Quick assets =90,000
Quick liabilities
Current liabilities-Bank o/d
2,00,000-30,000=1,70,000
Quick assets 90,000
Quick ratio = -------------------=-------------= 0.529 times
Quick liabilities 1,70,000
Quick ratio = 0.529
Illustration– 9
Give below is the summarized balance sheet and profit and loss of Ranjitha
Ltd., as on 31.12.2021.You are required to calculate
 Current ratio  Return on capital employed
 Quick ratio  Debtors turnover ratio
46
 Fixed assets ratio  Debt collection period

 Debt equity ratio  Creditors turnover ratio
 Proprietary ratio  Debt payment period
 Stock turnover ratio  Net profit ratio
 Fixed assets turnover ratio  Operating ratio
Dr Profit and Loss Account Cr

Particulars Rs Particulars Rs
To Opening stock 9,95,000 By Sales 85,00,000
To Purchase 54,52,500 By Closing stock 14,90,000
To Direct expenses 1,42,500
To Gross Profit 34,00,000
99,90,000 99,90,000
To Administration expenses 15,00,000 By Gross profit 34,00,000
To Selling & distribution exp 3,00,000 By Non operating income 90,000
To Financial expenses 1,50,000
To Other non-operating exp. 40,000
To Net profit 15,00,000
34,90,000 34,90,000
Balance Sheet as on 31.12.2021
Issued Capital:20,000 20,00,000 Land and building 15,00,000
shares of Rs. 100 each
Reserves 9,00,000 Plant & machinery 8,00,000
Creditors 13,00,000 Stock 14,80,000
Profit and Loss Account 3,00,000 Debtors 7,10,000
6% Debentures 3,00,000 Cash at bank 3,10,000
48,00,000 48,00,000
Solution
1.Current Ratio
Current assets 25,00,000
= -----------------------= --------------- = 1.92 times
Current assets:
Rs.
Stock 14,80,000
Debtors 7,10,000
Cash at bank 3,10,000
25,00,000
Current liabilities: Creditors 13,00,000
47
2. Quick ratio
Quick assets 10,20,000
= ---------------------= ---------------- = 0.78 times
Current assets – (Stock and prepaid expenses) =Quick assets
25,00,000– 14,80,000=10,20,000
Fixed assets 23,00,000
3. Fixed assets ratio =-------------------=---------------=0.657 times
Long term funds 35,00,000
Long term debt 3,00,000
4. Debt equity ratio = ---------------------- = -------------- =0.0937 times
Share holders funds 32,00,000
Shareholders funds 32,00,000

5. Proprietary ratio =-------------------------- = ---------------- =0.667times
Total tangible assets 48,00,000
Cost of sales
6. Stock turnover ratio = ------------------
Average stock
Cost of sales= Sales -Gross profit
= 85,00,000-34,00,000
= 51,00,000
Opening stock + Closing stock
Average stock = ---------------------------------------
2
9,95,000+14,90,000
=---------------------------- = 12,42,500
2
51,00,000
Stock turnover ratio = --------------- = 4.10 times
12,42,500
Cost of sales or sales
7. Fixed assets turnover ratio = ---------------------------
Fixed assets
Cost of sales = 51,00,000
Fixed assets = Land and building + Plant and machinery
= 15,00,000 + 8,00,000
= 23,00,000
51,00,000
Fixed assets turnover ratio =---------------= 2.217
23,00,000
Sales
Fixed assets turnover ratio = ----------------
Fixed assets
48
85,00,000
= ---------------=3.696times
23,00,000
Profit before interest and Tax
8. Return on capital employed = ---------------------------------------X 100
Capital employed
Profit before interest and tax:
Net profit+ Non-Operating expenses + Interest – Non operating income
15,00,000+ 40,000 + 1,50,000 – 90,000 = 16,00,000
Capital employed:
Share capital + Profits + Reserves + Long term borrowings
=20,00,00 + 3,00,000 + 9,00,000 + 3,00,000=35,00,000
16,00,000
Return on capital employed = ---------------=0.457
35,00,000
Credit sales
9. Debtors turnover ratio = --------------------
Average debtors
85,00,000
= -------------------- =11.97
7,10,000
Debtors + Bills receivables
Debtors collection period =---------------------------------x 12 months
Credit sales
7,10,000
= ---------------x 12
85,00,000
Collection period in months 1 months
Debtors + Bills receivables
Collection period in number of days = -----------------------------------x365 days
Credit sales
7,10,000
= ----------------x365=30.48 days (or) 30 days
85,00,000
Credit purchase
10. Creditors turnover ratio =------------------------
Accounts payables
54,52,500
=----------------=4.194 times
13,00,000
Creditors payment period in number of months
Creditors + Bills payables
=-------------------------------------x 12 months
Credit purchase
13,00,000
= ----------------- x 12= 2.86 months
54,52,500
49
11. Net profit ratio

Net profit
=----------------x100
Sales
15,00,000
= ----------------x 100= 17.647%
85,00,000
Cost of sales+ Administration expenses + Selling expenses
12. Operating ratio = ----------------------------------------------------------------x100
Sales
Sales –Gross profit=Cost of sales
85,00,000 – 34,00,000= 51,00,000
51,00,000 + 15,00,000 + 3,00,000
Operating ratio=---------------------------------------------- x 100
85,00,000
69,00,000
= -----------------x100 = 81.176%
85,00, 000
Illustration – 10
Current liabilities = Rs. 50,000
Current ratio = 2.5
Quick ratio = 1.5
Calculate current assets, quick assets, quick liabilities and stock.
Solution
Current assets
Current ratio =----------------------- =2.5 times
Current liabilities
If current assets are 2.5 times, current liabilities are 1 time
Current assets 2.5
---------------------= -----
50,000 1
Calculation of current assets
Current assets = 2.5 times
Current liabilities = 1=50,000
Current assets = 2.5=?
Make a cross multiplication
2.5 x 50,000
= --------------------=Current assets = Rs. 1,25,000
1
Calculation of Quick assets
Quick ratio = 1.5
Quick assets
= ---------------------- =1.5 times
Quick liabilities
Current liabilities =1=50,000
Quick assets =1.5=?
50
1.5 x50,000
-----------------
1
Quick assets =Rs 75,000
Calculation of stock
Current assets-Quick assets =Stock
1,25,000-75,000 =50,000
Stock =Rs 50,000
Illustration – 11
Current ratio = 2.5 times
Quick ratio = 1.75 times
Closing stock = Rs 1,50,000
Calculate current assets, current liabilities and quick assets.
Solution
Current assets
Current ratio = -----------------------=2.5
Current liabilities
Quick ratio = 1.75
Quick assets
----------------------=1.75
Quick liabilities
Closing stock=Rs. 1,50,000
Calculation of current assets
Current assets-Quick assets =Closing stock
2.5 -1.75 = 0.75
Closing stock =0.75=1,50,000
Current assets =2.5=?
2.5 x 1,50,000
= ------------------ =5,00,000
0.75
Current assets =Rs. 5,00,000
Calculation of current liabilities
Closing stock = 0.75 = 1,50,000
Current liabilities = 1 =?
1 x 1,50,000
= --------------------=2,00,000
0.75
Current liabilities =Rs.2,00,000
Calculation of quick assets
Closing stock = 0.75 =1,50,000
Quick assets = 1.75 =?
1.75 x 1,50,000
--------------------------=3.50.000
0.75
Quick assets =Rs. 3,50,000
51
Note: when the absent of bank over draft current liabilities are to be taken as
quick liabilities.
Illustration – 12
From the following Particulars, Prepare the balance sheet of Christeena Ltd.,
which has only one class of share capital
Sales for the year Rs. 20,00,000
Gross Profit Ratio 25%
Current Assets Ratio 1.5
Quick Assets Ratio 1.25
Stock Turnover Ratio 15 times
Debt Collection Period 1.5 month
Turnover to fixed assets 1.5
Ratio of Reserves to share capital = 0.33 (or) 1/3
Fixed Assets to Net Worth = 0.83 (or) 5/6
Note:“Turnover” refers to cost of sales and “stock” refers to closing stock
Solution
Sales = Rs.20,00,000
Less: Gross Profit 25% =5,00,000
Cost of goods sold =15,00,000
Stock Turnover Ratio = 15 times
Cost of goods sold 15
-----------------------=15 (or)----------
Closing Stock 1
Cost of goods sold = 15
Closing stock = 1
Cost of goods sold = 15 =15,00,000
Closing stock = 1 =?
1x15,00,000
= -----------------------=1,00,000
15
Closing stock = Rs 1,00,000
Current Ratio = 1.
Current Assets = 1.5
Current liabilities = 1
Quick Ratio = 1.25
Quick Assets = 1.25
Quick liabilities = 1
Current Assets -Quick Assets=Stock
1.5 -1.25=0.25
Closing Stock =0.25 =1,00,000
Current Assets =1.25 =?
1.5  1,00,000
= ---------------------=6,00,000
0.25
Current Assets=Rs.6,00,000
52
Closing Stock =0.25 =1,00,000

Current liabilities = 1 =?
1x1,00,000
=--- ----------------- =4,00,000
0.25
Current liabilities = Rs 4,00,000
Closing stock = 0.25 = 1,00,000
Quick Assets = 1.25 =?
1.25x1,00,000
= --------------------- =5,00,000
0.25
Quick Assets =Rs.5,00,000
Closing stock = 0.25 =1,00,000
Quick Liabilities = 1 =?
1 x1,00,000
= --------------------=4,00,000
0.25
Quick liabilities = Rs 4,00,000
Debt Collection Period =1.5 months
1.5
Debtors = Salesx-------
12
1.5
20,00,000x-------=2,50,000
12
Debtors =Rs.2,50,000
Turnover to Fixed Assets = 1.5
Cost of goods sold 1.5
-------------------------- = 1.5 (or)-------
Fixed Assets 1
Cost of goods sold = 1.5 =15,00,000
Fixed Assets = 1 =?
1x15,00,000
= -----------------------=10,00,000
1.5
Fixed Assets =Rs.10,00,000
5
Fixed Assets to Net Worth = 0.83(or)------
6
Fixed Assets = 5 = 10,00,000
Net Worth = 6 =?
6x10,00,000
= ------------------- =12,00,000
5
53
Net worth = Rs 1,20,000

Ratio of Reserves & Surplus to share capital= 0.33 (or) 1/3
Reserve & surplus 0.33 1
------------------------- =0.33(or) -------(or)----
Share capital 1 3
Reserve & surplus = 1
Share Capital = 3
Share capital+Reserve & surplus=Net Worth
3 + 1 =4
Net Worth = 4 = 12,00,000
Share Capital = 3 =?
3x12,00,000
= ----------------------- =9,00,000
4
Share capital = Rs 9,00,000
Net Worth = 4 =12,00,000
Reserves & Surplus = 1 = ?
1x12,00,000
= ---------------------- =3,00,000
4
Reserve & Surplus =Rs 3,00,000
Total Current Assets = Rs. 6,00,000
Less:-
Closing StockRs.1,00,000
Debtors Rs.2,50,000
---------------3,50,000
Cash and Bank 2,50,000
-------------
Cash and Bank=Rs 2,50,000
Balance Sheet
Issued Capital 9,00,000 Fixed Assets 10,00,000
Reserves & Surplus 3,00,000 Current Assets:
Current liabilities 4,00,000 Stock 1,00,000
Debtors 2,50,000
Cash and Bank 2,50,000
16,00,000 16,00,000
Illustration – 13
With the help of the following ratios of Anand Ltd., draw the Balance Sheet for
the year 2020
Current Ratio = 2.5 times
Liquid Ratio = 1.5 times
Net Current Assets = Rs. 3,00,000
54
Stock Turnover Ratio (cost sales/closing stock) = 6 times

Gross Profit Ratio = 20%
Fixed Assets Turnover Ratio (on cost) = 2 times
Fixed Assets to Share Holders Net Worth = 0.80 time
Debt Collection Period = 2 months
Reserves and surplus to capital = 0.50 time
Solution
Net Current Assets = Working capital
Current Assets- Current liabilities = Net Current Assets (working capital)
Current Ratio = 2.5
Current Assets 2.5
= ----------------------------=2.5(or) -------
Current liabilities 1
Current Assets - Current Liabilities = Working capital
2.5 - 1 = 1.5
Working capital = 1.5 =3,00,000
Current Assets= 2.5 =?
2.5 x 3,00,000
= ----------------------=5,00,000
1.5
Current Assets = Rs.5,00,000
Working Capital = 1.5 = 3,00,000
Current Liabilities = 1 =?
1x3,00,000
= --------------------=2,00,000
1.5
Current Liabilities = Rs.2,00,000
Liquidity Ratio = 1.5
Liquid Assets 1.5
=---------------------=1.5 (or)------
Liquid liabilities 1
Working Capital = 1.5 =3,00,000
Liquid Assets = 1.5 =?
1.5x3,00,000
= ---------------------------=3,00,000
1.5
Liquid Assets = Rs.3,00,000
Working Capital = 1.5 =3,00,000
Liquid Liabilities = 1 =?
1 x 3,00,000
= -------------------=2,00,000
1.5
Liquid liabilities = Rs.2,00,000
Current Assets -Liquid Assets=Stock
5,00,000 -3,00,000 = 2,00,000
Stock Turnover Ratio = 6 times
55
---------------------------=6(or) -----
Closing Stock 1
Closing Stock = 1 =2,00,000
Cost of goods sold = 6=?
6x2,00,000
=-------------------=12,00,000
1
Cost of goods sold = Rs.12,00,000
Cost of goods sold = 80% =12,00,000
Sales = 100% =?
100% x12,00,000
= ---------------------------=15,00,000
80%
Sales = Rs 15,00,000
Gross Profit 15,00,000x 20/100 = 3,00,000
Debt Collection Period
Salesx2/12
15,00,000x 2/12=2,50,000
Debtors = Rs2,50,000
Fixed Assets Turnover Ratio(on cost) = 2
------------------------- = 2 (or)-------
Fixed Assets 1
Cost of goods sold = 2 =12,00,000
Fixed Assets = 1 =?
1x12,00,000
= ----------------------
2
Fixed Assets= Rs6,00,000
Fixed Assets to share holders Net Worth = 0.80
Fixed Assets 0.80
------------------------------= 0.80 (or)----------
Share Holders Net Worth 1
Fixed Assets = 0.80 = 6,00,000
Net Worth = 1 =?
1x6,00,000
= -------------------- =7,50,000
0.80
Net Worth = Rs.7,50,000
Reserve and Surplus to capital = 0.50
Reserve and surplus 0.50
---------------------------- =0.50(or)---------------
Capital 1
Capital + Reserve & Surplus = Net Worth
1 + 0.50 =1.50
Net Worth = 1.50 = 7,50,000
56
Capital = 1 = ?
1x7,50,000
= --------------------- =5,00,000
1.50
Capital = Rs.5,00,000
Net Worth = 1.50 = 7,50,000
Reserve & Surplus = 0.50 =?
0.50x7,50,000
= -------------------------- =2,50,000
1.50
Reserve & surplus =Rs 2,50,000
Current Assets 5,00,000
Less: Stock 2,00,000
Debtors 2,50,000
4,50,000
-----------
Cash 50,000
-----------
Balance Sheet
Issued Capital 5,00,000 Fixed Assets 6,00,000
Reserves & Surplus 2,50,000 Current Assets:
Long term Loan(Balancing Figure) 1,50,000 Stock 2,00,000
Current liabilities 2,00,000 Debtors 2,50,000
Cash and Bank 50,000
11,00,000 11,00,000
Illustration – 14
With the following ratio and further information given below prepare a Trading
Account, Profit and Loss Account and Balance Sheet of Neenu Ltd.,
Gross Profit Ratio = 25%
Net Profit / sales = 20%
Stock turnover Ratio = 10 times
Net Profit / Capital = 1/5
Capital to total liabilities = 1/2
Fixed Assets / Capital = 5/4
Fixed Assets / Total current assets = 5/7
Fixed Assets = Rs.10,00,000
Closing stock = Rs.1,00,000
Solution
Fixed assets Rs.10,00,000
Fixed Assets / Capital=5/4
Fixed Assets
--------------------
Capital
57
Fixed Assets = 5 times =10,00,000

Capital =4 times=?
4 x10,00,000
= --------------------=8,00,000
5
Capital=Rs.8,00,000
Here Capital =Proprietary fund
Fixed Assets 5
------------------------ = -------
Total current assets 7
Fixed Assets = 5 times=10,00,000
Total current assets = 7 times=?
7x10,00,000
= -----------------------=Rs.14,00,000
5
Total Current Assets=Rs.14,00,000
1
Net Profit / Capital =-------
5
Capital = 5 times=8,00,00
Net Profit = 1 time =?
1 x8,00,000
= ---------------------=1,60,000
5
Net Profit=Rs.1,60,000
Net / Sales= 20%
Net profit = 20% = 1,60,000
Sales = 100% =?
100x1,60,000
= -----------------------= 8,00,000
20
Sales = 8,00,000
Less: Gross Profit
8,00,000x25/100 = 2,00,000
------------
Cost of goods sold 6,00,000
-----------
Stock turnover Ratio = 10 times
-------------------------=---------
Average Stock 1
Cost of goods sold = 10 times =6,00,000
Average Stock= 1 time =?
1x6,00,000
= ---------------------=60,000
10
58
Average Stock = Rs60,000

Opening Stock+Closing Stock
-------------------------------------------------=Average Stock
2
Opening stock+1,00,000
----------------------------------------=60,000
2
Opening Stock+1,00,000 = 60,000x 2
Opening Stock+1,00,000 = Rs.1,20,000
Opening Stock=1,20,000-1,00,000
Opening Stock=Rs.20,000
Total Current Assets = 14,00,000
Less: Closing Stock = 1,00,000
-------------
Debtors+Cash and Bank 13,00,000
-------------
Proprietary fund = 8,00,000
Less: Net profit = 1,60,000
-------------
Share Capital 6,40,000
-------------
Capital to total liabilities = 1/2
Capital 1
----------------------=---------
Total liabilities 2
Capital = 1 time =8,00,000
Total liabilities = 2 times = ?
2 x8,00,000
=--- -----------------=16,00,000
1
Total liabilities =Rs.16,00,000
Dr Trading Account Cr
To Opening Stock 20,000 By Sales 8,00,000
To Purchase(balancing figure) 6,80,000 By Closing stock 1,00,000
To Gross Profit 2,00,000
9,00,000 9,00,000
Dr Profit & Loss A/C Cr
To Sundry Expenses 40,000 By Gross Profit 2,00,000
(balancing figure)
To Net Profit 1,60,000
2,00,000 2,00,000
59
Balance Sheet
Share capital 6,40,000 Fixed Assets 10,00,000
+ Reserve & Surplus1,60,000 8,00,000
Current liabilities 16,00,000 Current Assets:
Stock 1,00,000
Other current Assets 13,00,000
24,00,000 24,00,000
REVISION POINTS
 Ratio analysis is an important tool for analyzing the company's financial
performance.
 Ratio analysis is the broad method by which financial data is converted
into simple mathematic ratios for comparison.
 Using ratio analysis, companies can be evaluated even across industries.
Trends of growth, increased performance, and deterioration within the firm
can be evaluated against itself, as well as across the industry
 In order to calculate the ratio analysis for a financial institution, obtain the
data from the financial statements. Typically, the balance sheet and
income statement will provide the data that you require for calculations
INDEX QUESTIONS
1. Calculate stock turnover ratio
Gross Profit ratio 20%
Gross profit Rs20,000
Opening StockRs 125,000
Closing Stock Rs 37,500
2. You are required to calculate debtor turnover ratio from the following data
Rs
Total sales 2,00,000
Cash sales 40,000
Debtors as on 01.1.2021 20,000
Debtors as on 31.12.2021 30,000
Bills Receivable as on 01.01.2021 15,000
Bills Receivable as on 31.12.2021 31,500
3. From the following you are required to calculate creditor turnover Ratio:
Rs
Credit Purchase during 2021 5,00,000
Creditors on 01.01.2021 20,000
Creditors on 31.12.2021 30,000
Bills Payable 01.01.2021 20,000
Bills Payable 31.12.2021 15,000
60
4. Calculate average payment period

Rs.
Total purchase 7,62,000
Purchase return 62,000
Cash purchase 1,00,000
Creditors as on Jan 1 22,000
Bills payable as on Jan 1 10,000
Creditors as on 31st Dec 50,000
Bills payable as on 31st Dec 20,000
Reserve for discount on creditors 5,000
5. Calculate average payment period
Rs
Total purchase 1,00,000
Purchase return 10,000
Creditors as on 31st Dec. 30,000
Bills payable as on 31st Dec 10,000
Reserve for discount on Creditors 2,000
6. From the following calculate working capital turnover ratio:
Rs
Current Asset 3,00,000
Sales 7,00,000
Gross profit 1,00,000
7. Calculate fixed assets turnover ratio
Rs
Sales 10,00,000
Gross profit ratio 25%
Land & building 1,90,000
Plant & machinery 40,000
Furniture & fitting 20,000
8. Calculate proprietary ratio.
Rs
Preference share capital 3,00,000
Equity share capital 7,00,000
Reserves 2,00,000
Surplus ( profit and loss a/c) 3,00,000
Plant & machinery 2,00,000
Furniture 2,00,000
Stock 1,25,000
Debtors 40,000
Bills receivable 35,000
Good will 2,00,000
61
9. Calculate Return on total resources and turnover to total assets.

Rs
Plant & machinery 1,50,000
Stock 3,00,000
Debtors 1,60,000
Cash 60 000
10,70,000
Net sales Rs 7,00,000
Less: Net profit Rs 2,50,000
4,50,000
10. Calculate debt equity ratio.
Balance Sheet
Equity Share capital 5,00,000 Land & building 5,00,000
Preference share capital 2,00,000 Plant & machinery 4,00,000
Debenture 6,00,000 Stock 3,00,000
Reserve 1,00,000 Debtors 3,00,000
Creditors 2,00,000 Cash 1,00,000
16,00,000 16,00,000
11. Calculate capital gearing ratio, and debt equity ratio
Rs.
Equity share capital 50,000
10% preference share capital 50,000
8% Debenture 20,000
10% Public debts (10 years) 10,000
Bank over draft 20,000
Creditors 30,000
Outstanding expenses 4,000
Proposed dividend 75,000
Provision for taxation 10,000
Profit & loss a/ c 10,000
2,89,000
12. Calculate current assets, current liabilities, Quick assets, Quick liabilities
and Stock
Current ratio .5 times
Liquidity ratio .5 times
Working capital Rs. 4,50,000
Bank o/d s. 60,000
13. The following are the Profit and Loss Account and Balance Sheet of
RanjiMara Ltd., Redraft them for the purpose of analysis and calculate:
1.Gross profit ratio, 2.Net profit ratio, 3. Operating profit ratio, 4.
Operating ratio, 5.Return on capital employed, 6. Debtors turnover ratio,
62
7.Creditors turnover ratio, 8. Stock turnover ratio, 9. Fixed assets turnover

ratio, 10.Current ratio, 11.Quick ratio, 12. Debt equity ratio, 13.
Proprietary ratio, 14. Fixed assets ratio, 15. Capital gearing ratio
Dr Trading and Profit & Loss Account Cr
To Opening stock By Sales 5,00,000
Raw materials 25,000
Finished goods 50,000
To Purchase of raw 1,50,000 By Closing stock:
materials Raw materials 75,000
Finished goods 50,000
To Direct wages 1,00,000 By Profit on sale 25,000
ofInvestments
To Manufacturing expenses 50,000
To Administration expenses 25,000
To Selling expenses 15,000
To Distribution expenses 10,000
To Loss on sale of plant 27,500
To Interest on debentures 5,000
6,50,000 6,50,000
Balance Sheet
Equity share capital 50,000 Fixed assets 1,25,000
10% Preference share capita 50,000 Stock of raw materials 75,000
Retained earnings 50,000 Stock of finished goods 50,000
5% Debentures 1,00,000 Sundry debtors 50,000

Sundry creditors 50,000 Bank balance 25,000
Bills payable 25,000
3,25,000 3,25,000
14. From the following information, you are required to prepare a Balance Sheet:
i) Current ratio 1.75 times
ii) Liquid ratio 1.25 times
iii) Stock Turnover Ratio (cost of sales/closing stock) 9 times
iv) Gross Profit ratio 25%
v) Debt collection Period1 ½ months
vi) Reserves and surplus to capital0.2 times
vii) Turnover to fixed assets (based on cost of sales)1.2 times
viii) Capital gearing ratio0.6 times
ix) Fixed assets to net worth 1.25 times
x) Sales for the year Rs. 24,00,000
63
SUMMARY
In this lesson, we worked out different types of accounting ratios
TERMINAL EXERCISES
1. What is Gross profit ratio?
2. What is liquidity ratio?
3. What are the financial ratios?
4. What are profitability ratios?
edition)
ASSIGNMENT
1. What are the methods of applying formulas in Accounting Ratios- Explain?
2. Explain Liquidity ratios, financial ratios,profitabity ratios with illustration
REFERENCES
1. S.N. MaheshwariPrinciples of Management Accounting
2. T.S Reddy and Hariprasad ReddyManagement Accounting
3. M.C. Shukla and T.S. Grewal Management Accounting
4. L. Cecil and L. Merwin Management Accounting
LEARNING ACTIVITIES
 To attend and participatemanagement accounting training course is
 To work independently and to take responsibility for the learning process
 To work within teams and to co-operate with team members.
 To learn andupdate their knowledge or accounting and law
KEY WORDS
Turnover, Liquid ratio, Capital gearing ratio and Debt equity ratio

64
LESSON – 5
FUNDS FLOW STATEMENT

OBJECTIVES
In fourth lesson, we discussed the method of applying different ratios. In this
lesson, we discuss the meaning, concept of fund, flow of fund, importance and
limitation of funds flow statement. After going through this lesson you will able to
 know the concept of fund and flow of fund
 understand the importance and limitation of funds flow statement
 understand the method of finding the changes in working capital and
calculation of funds from operation
CONTENTS
 Introduction
o The Concept of ‘Funds’
o Definitions of fund
 Flow of Funds
 Funds Flow Statement
 Importance of Funds Flow Statement
 Limitations of Funds Flow Analysis
 Working Capital
o Meaning
o Concepts of working capital
o Current assets
o Current liabilities
o Examples for current assets and current liabilities
 Preparation of Funds Flow Statement
o Schedule of Changes in Working Capital
 Method of preparation of Schedule of changes in working
capital
 Column of Statement showing changes in the workingcapital
 Principle for preparation of funds flow statement
 Specimen of the Working Capital Statement
o Statement of Sources and Application of Funds
 Application and sources of fund
 Format for Funds Flow Statement
 Funds from Operations
65
o Calculation of funds from operation

 Taking only operating incomes and expenses
 Taking only Non operating incomes and Non operating
expenses
 Statement showing funds from operations under considering
only non operating incomes and non operating expenses
 Funds from operation can be calculated by preparing adjusted
profit and loss account
 Treatment of Some Special Items
o Treatment and Tax and Dividend
o Tax and Dividend given in different ways
o Investments
o Reconciliation of Profits
o On the assets side of the given balance sheet
o On the Liability side of the given Balance Sheets
 Hidden Information
o Provision for tax account
o Proposed dividend account
o Fixed asset account
o Provision for Depreciation Account
o Investments Account
INTRODUCTION
of Fund and Flow of Fund. Numerous transactions of financial nature take place in
a business firm over a period of time. It is necessary to consolidate and summaried
the transactions to obtain a comprehensive idea about the nature, effect,
consequences and result of the transactions. It is customary to prepare an Income
Statement and a Balance Sheet at the end of a period to provide a summarised
version of all the financial transactions of a period. The income statement is
prepared to ascertain the profitability of the business. It gives the operating profit
or loss and the net profit or loss during the accounting period.
The balance sheet is a static statement as it gives the amount of assets and
liabilities on a particular date. It is prepared to ascertain the financial position of the
business as on the particular date. Due to various reasons assets and liabilities may
changed, balance sheet does not explain the reasons for the changes in the assets and
liabilities between two dates. At end of a particular period a statement is prepared to
study the movement of assets and liabilities is known as Funds flow statement
66
The Concept of ‘Funds’

In this section, we attempt to make a brief study about meaning of Fund. The
term “Funds” is a highly disputed one - conveying different meanings to different
people. It’s meaning spans from ‘Total resources of a concern’ to ‘Cash and near
Cash items’.
As cash is the easiest form of expressing economic value and is readily
convertible into goods and services we think of funds as cash. It business were
operated strictly on cash basis, it would be very easy to trace the commitments and
recovry over a period of time.
It is quite certain that all resources are not obtained on the basis of cash
transaction. Management has discretion to obtain credit. For example, if a business
obtained trade credit from a supplier, someone else funds will be employed until
repayment is made. If credit is similarly granted to customers, its funds are in effect
used by someone else. By these management decisions the economics’ values have
been shifted. Hence, the concept of funds should be interpreted to denote the
changed in Current Assets and current liabilities, i.e., working capital.
All financial aspects of all important transaction between the business and
outsiders, whether they affect cash or working capital will be interpreted as fund.
Definitions of fund
In this section, we attempt to make a brief study about definition of Fund.
According to Paul C. Hastings “The total amount of funds used in a firm's operations
is equal to the total assets employed in an enterprise”. This view Supports, the
broadest meaning of ‘Funds’ as total resources.
According to International Accounting Standard (IAS) - 7, the term ‘Fund’
generally refers to Cash, to Cash equivalents or to working capital”. This view leans
towards the narrower meaning of ‘Funds’.
Flow of Funds
In this section, we attempt to make a brief study about meaning of flow of
fund. The term ‘flow’ means ‘movement’. Hence, ‘flow of funds’ denotes ‘movement
of funds’, i.e., inflow and outflow of funds. The flow of fund can be said to have
taken place only when the net working capital is affected, as the term “funds” has
been used in a specia1 sense to mean net working capital. Inflow of fund increases
the fund available and outflow of fund decreases the fund.The flow of funds in a
business may be visualised as a continuous process.
Funds Flow Statement
We present here a brief explanation about Funds flow statement. Fund is
interpreted as ‘working capital’ in the context of funds flow statement. Thus, ‘Funds
flow’ is ‘change in working capital’. Flow of funds implies any changes in working
capital. Funds flow statement is the statement prepared to show movement of
funds, i.e., change in working capital during the given period. This statement
measures and presents in an analytical manner the summarised version of the
numerous flows of funds for a specified period. It shows the different sources and
67
applications of fund and the net effect, that is, the net increase or decrease in the
fund. It gives the reasons for inflows and outflows of funds or working capital
during the period under review.
Importance of Funds Flow Statement
We discuss in this section the general the importance of funds flow statement.
Everybody knows that working capital is the life blood of any business. The
availability of the correct amount of funds and its proper use in a business can
hardly be emphasized. Funds flow statement is one of the tools for managing this
working capital. This statement helps in the planning, deployment and controlling
of funds year after year. The following are the importance or uses of funds flow
statement.
1. It provides a detailed analysis and understanding of changes in the
distribution of financial resources between two balance sheet dates.
2. Funds flow statement gives the various sources through which funds were
raised during the year and the applications of the same.
3. Credit granting institutions require the business concerns to show how the
funds granted will be utilised. Funds flow statement will serve this purpose.
4. Funds flow statement gives indication of any weakness or strength in the
general financial position of a firm.
5. Funds flow statement study the change in the components of working
capital give an insight into the efficiency of working capital management.
6. It throws light on the financial consequences of business operations and
also it compared with the relevant budgets to assess the usage of funds as
per plans.
7. This can help in the formulation of sound policy for liquidity and short
term solvency of the firm.
8. A part of the working capital is generally financed out of long term sources
to have adequate margin between current assets and current liabilities.
This can be analysed with the help of funds flow analysis.
9. Comparison of projected funds flow statement with the actual figures will
help in the determination of effectiveness and efficiency in the
implementation of financial plans.
10. Funds flow analysis facilitated to rearrangement of capital structure,
formulating long term financial plans and policies, etc.
Limitations of Funds Flow Analysis
Though funds flow analysis is an important tool of financial analysis, it has
the following limitations:
1. This statement only an examination of the balance sheet at the end of the
period will show the resultant effect of these changes. It cannot replace the
68
usual financial statements. In fact, the statement is intended to supplement

and not to supplant, the convential financial statements either in whole or part.
2. Funds flow statement is based on past data, it may not represent the
current conditions of the firm. It is just reflect what has happened already.
3. Funds flow statement is just rearranged information gathered from balance
sheet, income statement and other relevant financial records. Hence, the
accuracy of information in the funds flow statement depends on the
accuracy of information in the financial statements and other records.
4. It is not generally considered as a sophisticated technique of financial analysis.
5. Funds Flow Statement does not reveal shifts among the items making up of
current liabilities. It would not tell whether any loss of working capital has
unduly impaired the financial position.
6. Transactions causing changes among non-current items are completely
omitted in the funds flow statement. Thus, there are chances of ignoring
strategic decisions involving non-current items.
Working Capital
In this section, we attempt to make a brief study of working capital, current
assets and current liabilities. Funds flow statement is based on the working capital
concept of funds and flow of funds implies any changes in working capital. Hence,
before study the method of preparation of funds flow statement better to know the
concept of working capital.
Meaning
Capital required for financing day to day operations of the business such as
purchase of materials, payment of wages, payment of rent, etc., is called working
capital. Financing day to day operations of the business is equally important as
financing long term requirements of a business concern. Sufficient resources must
be kept in the liquid form, i.e., as short term assets to make the regular payments.
Hence, the amount invested in short term assets is called working capital.
Concepts of working capital
There are many concepts of working capital namely; ‘Gross working capital’ is
the total of current assets. ‘Circulating Capital’ is the amount revolving in the cycle
of ‘Cash - Inventories - Receivables and Cash’. ‘Net working Capital’ is the excess of
Current Assets over Current liabilities. Funds Flow statement is generally prepared
and interpreted on the basis of 'Net Working Capital’. Net working capital can be
computed as the difference between Current Assets and Current liabilities.
Current assets
Current assets include cash and other assets that are acquired with the
intention of converting them into cash, or consumed, within one year or within the
normal operating cycle. The time spends for the conversion should not exceed one
year or the operating cycle of the business.
69
Current liabilities
All those liabilities which are payable in cash in the normal course of business
within a period of one year or within the operating cycle are called current
liabilities. Here also, the intention of contracting the liability must be to pay it off in
the normal course. Current liabilities are payable out of income of the business or
out of current assets or by creation of additional current liabilities
Examples for current assets and current liabilities
List of Current assets List of Current liabilities
Cash in hand Accounts payable
Cash at bank Creditors
Short-term investments Bills payable
Advances recoverable Income received in advance
Accounts Receivable: Outstanding expenses
Debtors Bank overdraft
Bills Receivable Cash credit
Stock of Short term loans
Raw materials Provision for doubtful debts
Work-in-process Provision for discount on
Finished goods debtors
Spares Notes payable
Accrued income Tax payable
Prepaid expenses Dividend payable
Reserve for discount on creditors
Preparation of Funds Flow Statement
In this section, we discuss the methods of preparing funds flow statement
The Funds Flow Analysis involves preparation of
1. Schedule of changes in working capital and
2. Statement of Sources and Application of Funds
Schedule of Changes in Working Capital
In this section, we attempt to make a brief study of schedule of changes in
working capital. Schedule of changes in working capital is the statement showing
the net increase or decrease in working capital along with changes in the various
individual current assets and current liabilities contributing to such increase or
decrease at two different points of time. It is prepared with the help of only current
assets and Current liabilities.
(a) Method of preparation of Schedule of changes in working capital
This statement consists four columns:
First column for current assets and current liabilities at the beginning
Second column for current assets and current liabilities at the end
Third column for Increase in working capital
Fourth column for decrease in working capital
70
(b) Column of Statement showing changes in the working capital

Particulars Current assets and Current assets and Increase in Decrease in
current liabilities at current liabilities at working capital working capital
the beginning the end
Here, we should compare each current asset in the previous year with that in
the current year. Similarly, we should compare each current liability in the
previous year with that in the current year. The difference is recorded for every
current asset and liability. We should repeat this until all accounts in respect of
current assets and current liabilities in the two balance sheets are gone through
and differences are properly recorded. The two column showing the changes in.
current assets and current liabilities are balanced. The balancing figure represents
either an increase or decrease in the working capital. We should also remember
that schedule of changes in working capital is prepared only from accounts
declared in the Balance sheets. There is no effect of additional information given in
the problem because such additional information will affect the statement of
sources and application of funds.
(c) Principle for preparation of funds flow statement
(i) Increase in current assets increases the working capital
(ii) Decrease in current assets decreases the working capital
(iii) Increase in current liabilities decreases the working capital
(iv) Decrease in current liabilities increases the working capital
(d) The following is a specimen of the Working Capital Statement Schedule of
Changes in Working Capital
Particulars Year Year Changes in working
Rs Rs capital
Increase Decrease
Rs Rs
Current Assets:
Cash xxx xxx xxx -
Bank Balance xxx xxx xxx -
Stock xxx xxx - xxx
Sundry debtors xxx xxx xxx -
Trading investments xxx xxx - xxx
Prepaid expenses xxx xxx xxx
Total (A) xxxx xxxx
Current Liabilities:
Creditors xxx xxx - xxx
Bills payable xxx xxx xxx
Outstanding expenses xxx xxx xxx
Short term loans xxx xxx xxx
Bank overdraft xxx xxx xxx
71
Total (B) xxxx xxxx xxx xxx

Working capital (A - B)
Net Increase in working capital xxx
Net Increase decrease in working capital xxxx
xxxx xxxx
Note:
If current assets increase shown in changes in working capital increase column
If current assets decrease shown in changes in working capital decrease column
If current liability increase shown in changes in working capital decrease column
If current liability decrease shown in changes in working capital increase column
Statement of Sources and Application of Funds
We present here a brief explanation about the method of preparing the
statement of sources and application. Statement showing sources and applications
of funds gives a list of various sources raised during the year which amounts to
increase of working capital and the purpose for which these sources have been
used, which amount to reduction of working capital. Prepare the statement showing
sources and applications of fund taking all the sources and applications as
calculated. The net increase or decrease of working capital as shown in this
statement will be equal to what is shown by the schedule of changes in working
capital.
(a) Application and sources of fund
Transactions resulting in increase of funds or working capital are called
sources of fund. On the contrary, transactions causing decrease of funds or
working capital are called applications of fund.
(b) Format for Funds Flow Statement
Funds Flow Statement can be prepared in two different formats namely
1) T format,
2) Statement form
Funds Flow Statement in T format
Sources Rs. Applications Rs.
Issue of shares xxx Redemption of preference shares xxx
(including premium) Redemption of debentures xxx
Issue of debentures xxx Repayment of long term loans xxx
Issue of bonds xxx Purchase of fixed assets xxx
Long term borrowings xxx Payment of dividend xxx
Sale of fixed assets xxx Payment of interim dividend xxx
Payment of tax xxx
Funds from operations Funds lost in operations(operating
xxx xxx
(operating profit) loss)
72
-
Total sources xxx Total applications xxx
Decrease in working capital xxx Increase in working capital xxx

Total xxx Total xxx
Funds Flow Statement in a statement form
Sources of funds Rs.
Issue of shares (including premium) xxx
Issue of debentures xxx
Issue of bonds xxx
Long term borrowings xxx
Sale of fixed assets xxx
Funds from operations (operating profit) xxx
Total sources (A) xxx
Application of funds
Redemption of preference shares xxx
Redemption of debentures xxx
Repayment of long term loans xxx
Purchase of fixed assets xxx
Payment of dividend xxx
Payment of interim dividend xxx
Payment of tax xxx
Funds lost in operations xxx
Total Applications (B) xxx
Net increase/ decrease in working capital (A-B) xxx
Funds from Operations
In this section, we attempt to make a brief study on calculation of Funds from
operation. Funds from operations are an internal source of fund. It is the fund from
operating activities of the business. When goods are sold by a concern, It brings in
funds in the form of cash debtors or bills receivable. To earn revenues, the business
concern has to spend on various expenses, which require outflow of fund in the
form of cash, creditors, bills payable etc. Funds from operations are the difference
between total inflow of fund due to operating activities and total outflow of fund due
to operating activities. Profit and. loss account includes non-fund items and non -
operating items. Non-fund items are items that do not involve flow of funds. Non-
operating items are items not related to normal operating activities. Both these
must be adjusted to find out the funds from operations.
Calculation of funds from operation
(a) Method No 1 Taking only operating incomes and expenses
Under this method non operating expenses & loss and non operating incomes
& gains to be excluded, operating expenses & loss and operating incomes & gains
alone to be taken into consideration
Gross profit xxx
Add: Operating incomes and gains xxx
73
xxx
Less: Operating expenses and losses xxx
Funds from operation +xxx
Funds lost from operation -xxx
(b) Method No 2 Taking only Non operating incomes and Non operating expenses
Net profit xxx
Add: Non operating expenses and losses xxx
xxx
Less: operating incomes and gains xxx
Funds from operation +xxx
Funds lost from operation -xxx
(c)Statement showing funds from operations under considering only non operating
incomes and non operating expenses
Net profit earned during the year or Closing balance of P&L xxxx
A/c/ P&L Appropriation A/ c
Add: Non fund and non-operating items which are already debited
to Profit& Loss A/c or P&L Appropriation A/c
1 Depreciation /Provision for depreciation on fixed assets xxx
2 Loss on sale of fixed assets & investments xxx
3 Loss on revaluation of fixed assets xxx
4 Intangible assets written off:
Goodwill written off xxx
Patents written off xxx
Trade marks written off xxx
Copy rights written off xxx
5 Fictitious assets written off:
Preliminary expenses written off xxx
Discount on issue of shares/ debentures written off xxx
6 Transfer to reserves:
Transfer to general reserve xxx
Transfer to sinking fund xxx
Transfer to contingency reserve xxx
7 Dividends:
Interim dividend
Proposed dividend (if taken as - non-current liability) xxx
8 Provision for taxation (if taken as non- current liability) xxx
9 Loss on redemption of debentures others xxx
10 Other xxx
Total xxxx
xxxx
Less: Non fund and non-operating items which are already
credited to Profit& Loss A/c or P&L Appropriation A/c
1 Dividend received xxx
2 Interest received xxx
3 Rent received xxx
4 Commission received xxx
5 Profit on sale of fixed assets and investments
6 Profit on revaluation of fixed assets xxx
7 Excess provisions transferred to P&L AI c xxx
8 Refund of income tax xxx
74
9 Others xxx
10 Opening balance of P&L A/ c / P&L Appropriation A/ c xxx xxx
Funds From Operations + xxx
Funds Lost in operations - xxx
xxxx
(d) Funds from operation can be calculated by preparing adjusted profit and loss
account
Dr Adjusted Profit and Loss Account Cr
By opening balance of Profit & xxx
Loss A/c or P&L Appropriation
A/c
To Depreciation /Provision for xxx xxx
By Dividend received
depreciation on fixed assets
To Loss on sale of fixed assets xxx xxx
By Interest received
& investments
To Loss on revaluation of fixed xxx xxx
Rent received
assets
To Intangible assets written off: By Commission received xxx
Goodwill written off xxx By Profit on sale of fixed assets
and investments
Patents written off xxx By Profit on revaluation of fixed xxx
assets
xxx By Excess provisions
Trade marks written off xxx
transferred to P&L AI c
Copy rights written off xxx By Refund of income tax xxx
To Fictitious assets written off: By Others xxx
Preliminary expenses written xxx
off
Discount on issue of shares/ xxx By Funds From Operations xxx
debentures written off (Balance)
To Transfer to reserves:
Transfer to general reserve xxx
Transfer to sinking fund xxx
Transfer to contingency reserve xxx
To Dividends:
Interim dividend
Proposed dividend (if taken as -
xxx
non-current liability)
To Provision for taxation (if
xxx
taken as non-current liability)
To Loss on redemption of
xxx
debentures others
To Other xxx
ToClosing balance of P&L A/c/ xxx
P&L Appropriation A/ c
To Funds lost From Operations xxx
(Balance)
xxxxx xxxxx
75
Treatment of Some Special Items

We present here a brief explanation about how to treat some special item while
preparing funds flow statements.
Treatment and Tax and Dividend
a) It is preferable to treat them as non current items if nothing is specified.
b) If ‘tax payable’ or ‘dividend payable’ is given on the balance sheet liabilities
side, they are to be taken as current liabilities.
Provision for tax and proposed dividend are non current. Once tax is assessed
or dividend is declared, it becomes a liability to be paid off immediately.
Tax and Dividend given in different ways
a) If provision for tax and dividend are given in the adjustments alone and nothing
is given in the balance sheets, the given amount is debited to adjusted profit
and loss account. It is also shown as application in funds flow statement. It is
presumed that provision is made and payment is also made immediately.
b) If provision for tax and proposed dividend are given in the balance sheets
alone and nothing is mentioned in the adjustments:
The opening balance of these items can be assumed to have been paid in
cash during the current year. The opening balances are shown as
application of funds. The closing balances are debited to the adjusted profit
and loss account as provisions made in the current year.
c) If provision for tax and proposed dividend are given in the balance sheet as
well as in adjustments:
It is necessary to prepare separate ledger accounts for them. From those
accounts, the tax paid and dividend paid are shown as applications of
funds. The provisions made are shown in the debit side of adjusted profit
and loss account.
d) Interim dividend should be treated separately from proposed dividend.
Investments
‘Trading investments’ or ‘current investments’ or ‘Short-term investments’
should be taken as current assets. Non trading investments and income thereon
should be treated as non current items. If nothing is mentioned, ‘Investments’ may
be treated as ‘Non Current’.
Reconciliation of Profits
When ‘Reported Income’ or net profit for the current year is given along with
opening and closing balance sheets, it is better to reconcile the profits. Dividend
paid may be found as balancing figure.
Net profit + Opening balance of Profit and Loss - Transfer to reserve - closing
balance of Profit and Loss = Dividend.
On the assets side of the given balance sheet
Any decrease in intangible and fictitious assets like goodwill, patents,
preliminary expenses, and discount on shares. etc should be assumed as
76
‘amortisation’ and should be debited to adjusted profit and loss account, if they
were previously debited to profit and loss account.
Any decrease in investments can be taken as sale and increase may be
assumed as purchase.
Any increase in fixed assets is usually due to purchase. Decrease in fixed
assets can be due to sale or depreciation.
On the Liability side of the given Balance Sheets
a) Increase in share capital is due to fresh issue of shares. Increase in share
premium is due to premium collected on new issue made.
b) Decrease in redeemable preference shares or debentures is because of
redemption carried out.
c) Increase in loans is ‘loans borrowed’ and decrease in loans is ‘loans repaid’.
Hidden Information
We present here a brief explanation about how to find some hidden items
through preparation of some accounts. The meaning of changes in many items on
the assets side or liability side may be obvious. However a lot of information is
‘Hidden’ and it should be ‘Dugout’ as ‘Balancing Figures’ by preparing relevant
accounts. The following are some of the examples for bringing out hidden
information.
1. Provision for tax account: It may yield tax paid or provision made in the
current year as balancing figure.
2. Proposed dividend account: Proposed dividend account is prepared on the
same lines as ‘provision for tax’ account shown above may reveal either
‘Dividend Paid’ or current year's proposed dividend as balancing figure.
3. Fixed asset account: Asset purchased or asset sold or depreciation or profit
or loss on sale may be found as balancing figure by preparing a fixed asset
account.
4. Provision for Depreciation Account: In this account current year's
depreciation or depreciation on asset sold can be found as Hidden
information.
5. Investments Account: Sale or purchase of long term investments can be
found from Investments account. It is possible to find either profit or loss
on sale on such investments also.
REVISION POINTS
 The term "funds" has more than one meaning. In its narrow sense, the
term funds is used to mean cash
 In funds flow statement, however cash is not used as a basis, because it
concentrates only on changes in a single asset, cash. Instead, and the term
funds is used in the broader sense of working capital, as it focuses on
changes in broader category of working capital.
77
 Net working capital is the excess of current assets over current liabilities.
In funds flow statement, the term funds is used to mean net working
capital, as it is closely related to the operating cycle of the business.
 There are many concept of working capital namely Gross working capital,
Net working capital.
 The methods of preparing fund flow statement
1) schedule of changes in working capital
2) Statement of sources and application of funds
INDEX QUESTIONS
1. What do you understand by the terms ‘Funds’, Flow of Funds’, ‘working
capital’, and ‘Funds from operation’?
2. Explain the importance and limitations of funds flow statement
SUMMARY
At end of a particular period a statement is prepared to study the movement of
assets and liabilities is known as Funds flow statement. The term “Funds” is a
highly disputed one - conveying different meanings to different people. The concept
of funds should be interpreted to denote the changed in Current Assets and current
liabilities, i.e., working capital.
The term ‘flow’ means ‘movement’. Hence, ‘flow of funds’ denotes ‘movement
of funds’, i.e., inflow and outflow of funds. Funds flow statement helps many
ways to management. Though funds flow analysis is an important tool of
financial analysis, it has various limitations also. Capital required for financing
day to day operations of the business such as purchase of materials, payment of
wages, payment of rent, etc., is called working capital. Funds Flow statement is
generally prepared and interpreted on the basis of ‘Net Working Capital’. Net
working capital can be computed as the difference between Current Assets and
Current liabilities. Schedule of changes in working capital is the statement
showing the net increase or decrease in working capital. It is prepared with the
help of only current assets and Current liabilities. Funds flow statement is a
statement showing sources and applications of funds gives a list of various
sources raised during the year which amounts to increase of working capital and
the purpose for which these sources have been used, which amount to reduction
of working capital.
TERMINAL EXERCISES
1. What is the concept of funds?
2. What is fund flow statement
3. What is the importance of fund flow statements?
4. What are the limitations of fund flow analysis?
5. What is working capital?
78
edition)
 Management accounting e-journal –SSRN library
ASSIGNMENT
1. Explain the principles for preparation of fund flow statements with
examples.
2. How to calculate fund from operation Explain.
REFERENCES
1. S.N. Maheshwari Principles of Management Accounting
2. T.S Reddy and Hariprasad Reddy Management Accounting
LEARNING ACTIVITIES
KEY WORDS
Funds, Current assets and Current liabilities, movement of funds, Trading
investments and Circulating Capital

79
LESSON – 6
PREPARATION OF FUNDS FLOW STATEMENT

OBJECTIVES
In fifth lesson, we discussed the meaning, concept of fund, flow of fund,
importance and limitation of funds flow statement. In this lesson, we worked out
some practical problems of Funds flow statement. After going through this lesson
you will able to
 Learn how to prepare schedule of changes in working capital
 Understand how to prepare Funds flow statement
 Understand the method of calculation of funds from operation
CONTENTS
 Preparation of Scheduled of Changes in Working Capital
 Calculations of funds from operations
 Preparation of Funds Flow Statement
Preparation of Scheduled of Changes in Working Capital

In this section, for your understanding, we worked out some problems relating
to preparation of schedule changes in the working capital.
Illustration – 1
From the following particulars, prepare a schedule showing changes in the
working capital.
Particulars 2020 2021

Current Assets Rs. Rs.
Cash in hand 3,000 1,000
Cash at bank 4,000 5,000
Debtors 13,000 10,000
Bills receivable 5,000 9,000
Prepaid expenses 7,000 1,000
Stock 30,000 20,000
Short term investments 9,000 10,000
Current Liabilities
Creditors 8,000 5,000
Bills payable 3,000 4,000
Outstanding expenses 7,000 2,000
Income received in advance 1',000 3,000
80
Solution
Schedule of changes in working capital
Particulars Changes in working
2020 2021
Capital
Rs. Rs. Increase Decrease
Current Assets
Cash in hand 3,000 1,000 - 2,000
Cash at bank 4,000 5,000 1,000 -
Debtors 13,000 10,000 - 3,000
Bills receivable 5,000 9,000 4,000 -
Prepaid expenses 7,000 1,000 - 6,000
Stock 30,000 20,000 - 10,000
Short term investments 9,000 10,000 1,000 -
Total current assets(A) 71,000 56,000
Current Liabilities
Creditors 8,000 5,000 3,000 -
Bills payable 3,000 4,000 - 1,000
Outstanding expenses 7,000 2,000 5,000
Income received in advance 1,000 3,000 2,000
Total current liabilities(B) 19,000 14,000
14,000 24,000
Working capital(A-B) 52,000 42,000
Decrease in working capital 10,000 10,000 ---
24,000 24,000
52,000 52,000 24,000 24,000
Illustration 2:
The following are the summarized Balance Sheets of MaraRanji Ltd. as at 31 st
December 2020 and 2021. Prepare scheduled of changes in working capital

BALANCE SHEETS AS ON 31-12---
Rs. Rs. Rs. Rs.
Equity shares 1,00,000 1,00,000 Fixed Assets 95, 000 1,20,000
Preference shares -- 50,000 Investments 10,000
General reserve 30,000 40,000 Current assets
P&L A/c 25,000 70,000 Stock 40,000 60,000
Current liabilities Debtors 20,000 40,000
Creditors 20,000 10,000 BIR 5,000 2,000
Prepaid
Overdraft 3,000 -- 5,000 18,000
expenses
Bills payable --- 2,000 Cash 20,000 10,000
Taxation provision 7,000 12,000 Advances 10,000 40,000
Proposed dividend 10,000 16,000
1,95,000 3,00,000 1,95,000 3,00,000
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Solution
Particulars 2020 2021 Changes in working Capital
Current Assets
Stock 40,000 60,000 20,000 ---
Debtors 20,000 40,000 20,000 --
BIR 5,000 2,000 --- 3,000
Prepaid expenses 5,000 18,000 13,000 --
Cash 20,000 10,000 --- 10,000
Advances 10,000 40,000 30,000
Total current assets(A) 1,00,000 1,70,000
Current Liabilities
Creditors 20,000 10,000 10,000 --
Overdraft 3,000 -- 3,000 --
Bills payable --- 2,000 2,000
Taxation provision 7,000 12,000 -- 5,000
Proposed dividend 10,000 16,000 -- 6,000
Total Current liabilities 40,000 40,000
Working capital(A-B) 60,000 1,30,000 96,000
23,000
Decrease in working capital 70,000 70,000
96,000 96,000
Note: Taxation provision and proposed dividend have been treated as current
liabilities
Calculation of Funds from Operations
to calculation the funds from operations.
Illustration – 3
From the following details calculate the funds from operations
Particulars Rs
Salaries 5,000
Rent 3,000
Depreciation on plant 5,000
Provision for tax 4,000
Loss on sale of plant 2,000
Opening balance of P & L Appropriation A/ c 25,000
Transfer to general reserve 1,000
Goodwill written off 2,000
Dividend Received 5,000
Refund of tax 3,000
Profit on sale of building 5,000
Closing balance of P&L Appropriation A/ c 60,000
Discount of issue of debentures 2,000
Provision for bad debts 1,000
Preliminary expenses written off 3,000
82
Solution
Dr Adjusted profit and loss account Cr
Particulars Rs. Particulars Rs.
By Opening balance of
To Depreciation on plant 5,000 25,000
P & L A /c
To Provision for tax 4,000 By Dividend received 5,000
To Loss on sale of plant 2,000 By Refund of tax 3,000
To Tran. to general reserve 1,000 By Profit on sale of building 5,000
To Goodwill written off 2,000
By Funds From Operations
To Discount on issue of debentures 2,000 47,000
( balance)
To Preliminary expenses
written off 3,000
To Proposed dividend 6,000
To Closing balance of
60,000
P & L A/c
85,000 85,000
Illustration 4
From the following Profit and Loss A/ c, calculate funds from operations
Profit and Loss A/ c
To Rent 10,000 By Gross Profit 9,86,000
To Salary 25,000
To Depreciation 3,000
To Discount on
issue of shares 10,000
To Preliminary expense
written off 6,000
9,86,000 9,86,000
Solution
Calculation of funds from operations:
Particulars Rs Rs
Net profit earned during the year 9,27,000
Add: Non-operating and non-fund items which are already
debited to P & L A/c:
Depreciation 3,000
Discount on issue of shares 10,000
Preliminary expenses written off 6,000 24,000
9,51,000
Less: Non-operating & non-fund items already credited to ---
P&L A/c
Funds from operations 9,51,000
Preparation of Funds Flow Statement
to funds flow statement
83
Illustration – 5
Prepare (a) a statement of changes in working capital and (b) a statement of
sources and application of funds from the following data:
Balance Sheets
2020 2021
Liabilities 2021 Rs. Assets 2020 Rs.
Rs. Rs.
Equity capital 5,000 5,300 Cash 2,000 2,500
Long-term debt 1,400 1,300 Debtors 2,400 2,700
Profit & Loss a/ c 2,800 3,700 Stock 3,100 3,200
Provision for Other current
2,100 2,500 800 700
depreciation assets
Creditors 2,000 2,100 Fixed assets 5,000 5,800
13,300 14,900 13,300 14,900
Additional information
(i) Fixed Assets Rs.1 ,200 were purchased for cash
(ii)Fixed Assets (Cost Rs 400-Depreciation Rs.150) were sold at book value.
(iii) Depreciation for 2021 Rs.550 was debited to P&L A/ c.
Solution
Current Assets
Cash 2,000 2,500 500 --
Debtors 2,400 2,700 300 --
Stock 3,100 3,200 100 --
Other current assets 800 700 -- 100
Total current assets(A) 8,300 9,100
Current Liabilities
Creditors 2,000 2,100 -- 100
Total current liabilities(B) 2,000 2,100 -- --
Working capital(A-B) 6,300 7,000 900 200
Decrease in working capital 700 -- 700
900 900
Funds flow statement
Particulars Rs. Rs.
Sources of funds:
Issue of shares (5,300-5,000) 300
Sale of fixed assets 250
Funds from operations 1,450 2,000
Applications of funds:
Purchase of fixed assets 1,200
Long term debt paid (1,400-1,300 100 1,300
Increase in working capital 700
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Working Notes
By Opening balance of P&L A/c
To Provision for depreciation 550 2,800
To Closing balance of By Funds From Operations

3,700 1,450
P&L A/c (balance)
4,250 4,250
Dr Fixed Assets account Cr

To Balance b/d 5,000 By Cash ( Sale) 250
To Cash (Balance-Purchased) 1,200 By Provision for depreciation 150
By Balance c/d 5,800
6,200 6,200
Dr Provision for depreciation account Cr
To Fixed assets 150 By Balance b/d 2,100
By Profit and loss a/c
To Balance c/d 2,500 550
( Provision made)
2,650 2,650
Illustration – 6
The balance sheets of Himani Co. Ltd., as at 31st December 2020 and 2021
are given below
2020 2021
Assets (Rs.) (Rs.)
Freehold land 1,00,000 1,00,000
Plant at cost 1,04,000 1,00,000
Furniture at cost 7,000 9,000
Investment at cost 60,000 80,000
Debtors 30,000 70,000
Stock 60,000 65,000
Cash 30,000 45,000
Total 3,91,000 4,69,000
Liabilities
Share capital 1,00,000 1,50,000
Share premium - .5,000
General reserve 50,000 60,000
Profit & Loss A/c 10,000 17,000
6% Debentures 70,000 50,000
Provision for depreciation on plant 50,000 56,000
Provision for depreciation on furniture 5,000 6,000
Provision for taxation 20,000 30,000
Sundry creditors 86,000 95,000
Total 3,91,000 4,69,000
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A plant purchased for Rs 4,000 (depreciation Rs.2,000) was sold for

cashRs.800 on 30th September 2021. On 30th June 2021, an item of furniture
was purchased for Rs.2,000. These were the only transactions concerning fixed
assets during 2021. Depreciation on plant was provided at 8% on cost (the sold
item is not taken into consideration) and on furniture at 12 ½ % on average
cost. A dividend of 22 ½% on original shares was paid. Prepare a schedule of
changes in working capital and also a statement of sources and application of
funds during 2021.
Solution

Current Assets
Debtors 30,000 70,000 40,000 --
Stock 60,000 65,000 5,000 --
Cash 30,000 45,000 15,000 --
Current Liabilities
Sundry creditors 86,000 95,000 --- 9,000
Total current liabilities(B) 86,000 95,000 60,000 9,000
Working capital(A-B) 34,000 85,000
Decrease in working capital 51,000 --- --- 51,000
60,000 60,000
Particulars Rs. Rs.

Sources of funds:
Sale of plant 800
Issue of shares 50,000
Share premium 5,000
Funds from operations 79,700 1,35,500
Applications of funds:
Purchase of furniture (9 ,000-7 ,000) 2,000
Purchase of investment (80,000-60,000) 20,000
Redemption of debentures (70,000-50,000) 20,000
Tax paid 20,000
Dividend paid 22,500 84,500
Increase in working capital 51,000
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Working Note
To Provision for depreciation on 8,000 By Opening balance of P&L 10,000
plant A/c
1,200 By Funds From Operations 79,700
To Loss on sale of plant
(balance)
To Provision for dep. 1,000
{(7,000 +9,000)/2)*12 ½%
To Transfer to general reserve 10,000
To Provision for tax 30,000
To Dividend 22,500
(1,00,000 x 22 ½%)
To Closing balance of P&L A/c 17,000
89,700 89,700
Dr Plant Account Cr
To Balance b/d 1,04,000 By Cash ( Sale) 800
By Provision for depreciation 2,000
By Profit and loss A/c 1,200
By Balance c/d 1,00,000
1,04,000 1,04,000
Dr Provision for depreciation account Cr
To Plant A/c 2,000 By Balance b/d 50,000
By Profit and loss a/c
To Balance c/d 56,000 8,000
( Provision made)
58,000 58,000
Illustration – 7
The following are the comparative Balance sheets of Sree Lakshmi Ltd for the
year ending 31st March 2020 and 2021.
2020 2021 2020 2021
Liabilities Assets
Rs. Rs. Rs. Rs.
Share capital 1,00,000 1,00,000 Fixed Assets 1,00,000 1,10,000
Profit & loss A/c 80,000 90,000 Stock 80,000 90,000
Bank loan 60,000 75,000 Debtors 90,000 1,20,000
Current liabilities 65,000 80,000 Cash at Bank 40,000 40,000
Provision for taxation 20,000 25,000 Preliminary expenses 15,000 10,000
3,25,000 3,70,000 3,25,000 3,70,000
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Adjustments:
i) Depreciation charged on fixed assets Rs. 15,000 during the year 2021
ii) Tax paid during the year Rs. 7,000
iii) Interim dividend paid during the year 2021 Rs. 10,000
Solution
Statement of changes in working capital
Current Assets
Stock 80,000 90,000 10,000 -
Debtors 90,000 1,20,000 30,000 -
Cash 40,000 40,000 - -
Current Liabilities
Current Liabilities 65,000 80,000 - 15,000
Total current liabilities(B) 65,000 80,000
Working capital(A-B) 1,45,000 1,70,000 40,000 15,000
Increase in working capital 25,000 25,000
40,000 40,000
Sources Rs Applications Rs.
Bank loan 15,000 Tax paid during year 7,000
Funds from operation 52,000 Interim dividend paid 10,000
Purchase of fixed assets 25,000
Increasing in working capital 25,000
67,000 67,000

To Depreciation on fixed assets 15,000 By Balance b/d 80,000
To Interim dividend 10,000
To Preliminary expenses 5,000 By Funds from 52,000
write off operation
(Balancing figure)
To Balance c/d 90,000
1,32,000 1,32,000
Dr Fixed Assets account Cr
To Balance b/d 1,00,000 By Depreciation 15,000
To Bank (Balancing figure) 25,000 By Balance c/d 1,10,000
1,25,000 1,25,000
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Dr Provision for Taxation A/c Cr

To Bank 7,000 By Balance b/d 20,000
To Balance c/d 25,000 By Profit and loss A/c 12,000
(Balancing figure)
32,000 32,000
Illustration – 8
The following are the comparative Balance sheets of Steffy Ltd for the year
ending 31st March 2020 and 2021.
2020 2021 2020 2021

Liabilities Assets
Rs. Rs. Rs. Rs.
Share Capital 4,00,000 5,00,000 Land and 4,00,000 3,80,000

Building
General Reserve 1,00,000 1,20,000 Machinery 3,00,000 3,38,000
Retained earnings 61,000 61,200 Stock 2,00,000 148,000
Bank loan 1,40,000 - Debtors 1,60,000 1,28,400
(long term)
Creditors 3,00,000 2,70,400 Cash 1,000 1,200
Provision for Tax 60,000 70,000 Bank - 16,000
Good will - 10,000
10,61,000 10,21,600 10,61,000 10,21,600
Adjustments:
i) Dividend of 11.5% was paid.
ii) Assets of another company were purchased for a consideration of
Rs.1,00,000 Payable in shares. The following assets were purchased.
iii) Stock Rs. 40,000 Machinery Rs 50,000.
iv) Deprecation written off on machinery 24,000.
v) Income Tax provided during the year Rs. 66,000.
vi) Loss on sale of machinery Rs. 400 was written off to general reserve.
vii) Further machinery was purchased for cash Rs. 16,000.
Prepare a funds flow statement
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Solution:
Statement of changes in working capital
Working Capital
2020 2021
Particulars Increase Decrease
Rs. Rs.
Rs. Rs.
Current Assets
Sock 2,00,000 1,48,000 - 52,000
Debtors 1,60,000 1,28,400 - 31,600
Cash 1,000 1,200 200 -
Bank - 16,000 16,000 -
Current liabilities
Creditors 3,00,000 2,70,400 29,600 -
45,800 83,600
Decrease in working capital 37,800
83,600 83,600
Sources Rs Applications Rs.
Issue of shares for stock 40,000 Dividend paid 46,000
Sale of machinery 3,600 Repayment of bank loan 1,40,000
Funds from operation 1,76,600 Tax paid 56,000
Decrease in working Capital 37,800 Purchase of machinery 16,000
2,58,000 2,58,000

To Dividend paid 46,000 By Balance b/d 61,000
To Depreciation on machinery 24,000
To Provision for tax 66,000 By Funds from operation 1,76,600
(Balancing Figure)
To Transfer to General Reserve 20,400
To Depreciation on land and 20,000
Building
2,37,600 2,37,600
Dr Machinery A/c Cr
To Balance b/d 3,00,000 By Bank (Sales) 3,600
(Balancing figure
To Share capital 50,000 By Depreciation 24,000
To Bank 16,000 By General reserve 1,400
3,66,000 3,66,000
90
Dr Good Will A/c Cr

To Balance b/d Nil By Balance c/d 10,000
To Share Capital 10,000
10,000 10,000
Dr Share Capital A/c Cr
By Balance b/d 4,00,000
By Stock 40,000
By Machinery 50,000
To Balance c/d 5,00,000 By Good will 10,000
5,00,000 5,00,000
Dr General Reserve A/c Cr
To Machinery (Loss on sale) 400 By Balance b/d 1,00,000
To Balance c/d 1,20,000 By P&L A/c (Balancing figure) 20,400
1,20,400 1,20,400
Dr Provision for Tax A/c Cr
To Bank (Tax paid) (Balancing 56,000 By Balance b/d 60,000
figure)
To Balance c/d 70,000 By P&LA/c 66,000
1,26,000 1,26,000
Illustration – 9
Balance sheets of Ranjitha Ltd for the year ending 31st December 2020 and
2021 are given below. Prepare a funds flow statements.
2020 2021 2020 2021

Liabilities Assets
Rs. Rs. Rs. Rs.
Equity share capital 4,00,000 5,00,000 Building 3,50,000 4,00,000
10% Redeemable pref. 2,00,000 - Machinery 3,00,000 3,20,000
share capital
Capital redemption reserve - 1,00,000 Furniture 20,000 18,000
Reserve fund 2,00,000 1,20,000 Investment 1,00,000 1,50,000
Stock 3,00,000 2,50,000
Share premium 30,000 30,000 Debtors 1,40,000 2,00,000
Profit and loss A/c 1,20,000 1,80,000 Cash 20,000 32,000
12% Debentures 2,00,000 3,00,000
Creditors 80,000 1,40,000
12,30,000 13,70,000 12,30,000 13,70,000
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Adjustments
The following transactions took place during the year 2021.
i) Preference Shares were redeemed at 10% premium.
ii) Investment (book value Rs.40,000) were sold for Rs. 70,000.
iii) Depreciation provided on Building, machinery and furniture were Rs.
20,000, 80,000 and Rs. 2,000 respectively.
iv) Dividend Rs. 50,000, and Income taxRs.45,000 were paid during the
current year.
v) Provision for depreciation on 31.12.2020 Rs. 2,00,000 and on 31-12-2021
Rs. 2,50,000 on machinery a/c
Solution
Statement of Changes in working capital
Working capital
Particulars 2020 2021 Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets
Stock 3,00,000 2,50,000 - 50,000
Debtors 1,40,000 2,00,000 60,000 -
Cash 20,000 32,000 12,000 -
Current liabilities
Creditors 80,000 1,40,000 - 60,000
72,000 1,10,000
Decrease in working capital 38,000 -
1,10,000 1,10,000
Fund flow statement
Sources Rs. Applications Rs.
Issue of equity shares 1,00,000 Redemption of 10% Preference 2,20,000
shares at premium
Issue of 12% Debentures 1,00,000 Dividend paid 50,000
Sale of Investment 70,000 Income tax paid 45,000
Funds from operation 2,67,000 Purchase of machinery 1,00,000
Decrease in working capital 38,000 Purchase of building 70,000
Investment purchased 90,000
5,75,000 5,75,000
Dr Adjusted profit and loss A/c Cr

To Transfer to General reserve 20,000 By Balance b/d 1,20,000
To Premium on redemption of 20,000 By Profit on sale of investment 30,000
Preference shares (Adj 2)
To Provision for depreciation: By Funds from operation 2,67,000
on Building 20,000 (Balancing figure)
on machinery 80,000
on furniture 2,000
To Dividend paid 50,000
To Income Tax paid 45,000
To Balance c/d 1,80,000
4,17,000 4,17,000
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Dr Redeemable Preference Share Capital A/c Cr

To Bank A/c 2,00,000 By Balance b/d 2,00,000
To Balance c/d Nil
2,00,000 2,00,000
Dr Investment A/c Cr
To Balance b/d 1,00,000 By Bank 40,000
1,90,000 1,90,000
Dr Investment A/c Cr
4,20,000 4,20,000
Dr Furniture A/c Cr
To Balance b/d 20,000 By Depreciation 2,000
20,000 20,000
Dr Machinery A/c Cr
To Balance b/d 5,00,000 By Discarded 30,000
(3,00,000 + 2,00,000)
To Bank A/c (balance) 1,00,000 By Balance c/d 5,70,000
(320000 + 250000)
6,00,000 6,00,000
Dr Provision for Depreciation on Machinery A/c Cr

To Machinery A/c 30,000 By Balance b/d 2,00,000
(Balance-discarded)
To Balance c/d 250,000 By Adjusted P&L A/c 80,000
2,80,000 2,80,000
Note:Transfer to General Reserve
Rs
Opening Balance 2,00,000
Less: Transfer to capital redemption reserve 1,00,000
Balance shouldbe 1,00,000
Where as closing balance of General reserve 1,20,000
Increase in general reserve is to be treated as transfer
20,000
from current year profit(debited in adj P&L a/c)
REVISION POINTS
 Net working capital is the excess of current assets over current liabilities.
In funds flow statement, the term funds is used to mean net working
capital, as it is closely related to the operating cycle of the business.
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 There are many concept of working capital namely Gross working capital,
Net working capital.
 The methods of preparing fund flow statement 1) schedule of changes in
working capital 2) Statement of sources and application of funds
INDEX QUESTIONS
1. From the following details prepare a schedule of changes in working capital
Bank loan (short period) 70,000 -
Creditors 1,50,000 1,35,200
Bank - 8,000
Cash 500 600
Debtors 80,000 64,200
Stock 1,00,000 74,000
Share capital 2,00,000 2,50,000
P&L Ale 30,500 30,600
Buildings 2,00,000 1,90,000
2. The balance sheets of Ashwathy Co. Ltd. at the end of 2020 and 2021are
given below. You are required to prepare statement of changes in working
capital
Balance Sheets
Accounts
20,000 25,000 Cash 20,000 10,000
payable
Marketable
Notes payable 20,000 5,000 10,000 -
securities
Other current
10,000 15,000 Inventory 60,000 1,00,000
liabilities
6% Bond’s - 30,000 Receivables 30,000 40,000
Common steel 50,00050,000 Gross block 1,00,000 1,40,000
Retained Less: Accum-
80,000 1,10,000 (40,000) (55,000)
earnings depreciation.
1,80,000 2,35,000 1,80,000 2,35,000
3. From the following calculate funds from operations. Goodwill written off
Rs.5,000; General reserve provided Rs.3,000; Dividend paid Rs.7,000;
Preliminary expenses written off Rs.2,500; Profit on sale of machinery
Rs.1,000, Net profit for the year Rs.8,000
Calculate funds from operations from the following P&L A/c
To Expenses paid 3,00,000 By Gross profit 4,50,000
To Depreciation 70,000 By Gain on sale of land 60,000
To Loss on sale of machine 4,000
To Discount 200
To Goodwill 20,000
94

5,10,000 5,10,000
4. From the following Balance Sheets of NMR Ltd., prepare a Funds Flow
Statement.
Balance Sheets
Rs. Rs. Rs. Rs.
Equity share 300,000 4,00,000 Goodwill 1,15,000 90,000
capital
Pref. sharecapital 1,50,000 1,00,000 Building 2,00,000 1,70,000
General reserve 40,000 70,000 Plant 80,000 2,00,000
P & L A/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed dividend 42,000 50,000 Stock 77,000 1,09,000
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 in bank 10,000 8,000
taxation
6,77,000 8,17,000 6,77,000 8,17,000
Additional Information:
i) Depreciation: Plant – Rs. 10,000 and buildings Rs. 20,000 charged in
1993.
ii) An interim dividend of Rs. 20,000 had been paid in 2021.
iii) Income tax Rs. 35,000 was paid during 2021.
5. Ranjitha Ltd. supplies you the following Balance on 31st December 2020
and 2021. You are required to prepare a funds flow statement
Balance Sheets
2020 2021 2020 2021
Liabilities Assets
Rs. Rs. Rs. Rs.
Share Capital 70,000 74,000 Bank 9,000 7,800
Balance
Bounds 12,000 6,000 Accounts 14,900 17,700
Receivable
Account’s Payable 10,360 11,840 Inventories 49,200 42,700
Provision for 700 800 Land 20,000 30,000
doubtful debts
Reserves and 10,040 10,560 Goodwill 10,000 5,000
Surplus
1,03,100 1,03,200 1,03,100 1,03,200
Following additional information has also been supplied to you:

i) Dividends amounting to Rs. 3,500 were paid during the year 2021.
ii) Land was purchased for Rs.10,000.
95
iii) Rs.5,000 were written off on Goodwill during the year.

iv) Bonds of Rs.6,000 were paid during the course of the year.
6. Prepare a fund Flow statement from the following particulars
st 2020 2021
Balance sheet as on 31 December
Rs. Rs.
Cash 40,000 44,400
Accounts Receivable 10,000 20,700
Inventories 15,000 15,000
Land 4,000 4,000
Buildings 20,000 16,000
Equipment 15,000 17,000
Accumulated depreciation (5,000) (2,800)
Patents 1,000 900
1,00,000 1,15,200
Current liabilities 30,000 32,000
Bonds payable 22,000 22,000
Bonds payable discount (2,000) (1,800)
Capital stock 35,000 43,500
Retained earnings 15,000 19,500
1,00,000 1,15,200
7. Income for the period Rs. 10,000
8. A Building that cost Rs.4,000 and which had book value o Rs.1,000 is sold
for Rs. 1,400.
9. The depreciation charge for the period was Rs.800
10. There was Rs.5,000 issue of common stock.
11. Cash dividend of Rs. 2,000 and Rs.3,500 stock dividend were declared.
12. Tax paid Rs. 1,000.
SUMMARY
In this lesson, we have briefly touched upon the preparation of schedule of changes
in working capital, calculation of funds from operation and Funds flow statement
TERMINAL EXERCISES
1. What is working capital?
2. What is concept of working capital?
3. What is concept of working capital?
4. Write short notes on Current assets.
5. Write short notes on current liabilities.
96

ASSIGNMENT
1. Explain the principles for preparation of fund flow statements with
examples.
2. How to calculate fund from operation Explain.
REFERENCES
4. L. Cecil and L. Merwin Management Accounting,
LEARNING ACTIVITIES
 To assess the impact of different decisions, control systems and
performance evaluation methods within the social context of an
organization
KEY WORDS
General Reserve, Premium on redemption of Preference shares, and Share
premium

97
LESSON – 7
CASH FLOW STATEMENT

OBJECTIVES
In sixth lesson, we worked out some practical problems of funds flow
statement. In this lesson, we discuss the meaning, concept of cash, flow of cash,
importance and limitation of cash flow statement. After going through this lesson
you will able to
 know the concept of cash and flow of cash
 understand the importance and limitation of cash flow statement
 understand the method of calculation of cash from operation
CONTENTS
 Introduction
o Meaning
 Importance or Uses of Cash Flow Statement
 Limitations of the Cash Flow Statement
 Preparation of Cash Flow Statement
o Cash Inflows and Cash Outflows
 Difference between Fund Flow Statement and Cash Flow Statement
 Formats of Cash Flow Statement
 Illustrations
INTRODUCTION
In this section, we attempt to make a brief study about meaning of funds flow
statement. Cash management is an important function in any organisation. A
business concern must have sufficient cash to carryout its day today activities at
the same time, excess cash with the business firm is not desirable, therefore it is
necessary for business concerns to ascertain the cash position periodically and to
analyse the movement of cash.
Meaning
To analyse the movement of cash, business concerns prepared a statement which
is called as cash flow statement. This statement gives the reasons for change in cash
position between two. Cash here refers to cash and cash equivalents. Cash Flow
statement is only a summarized statement containing actual receipts and payment
during the period. This statement will commence with the opening cash and bank
balances and to this are added the amounts of cash received such as issue of shares,
issue of debentures, receipts from debtors and sale of assets. From the total, the
following items are deducted representing payments to creditors, payment of liabilities,
payment of expenses, purchases of assets and payment of taxation and dividends. The
balance will represent the closing cash and bank balances if the figures of purchases
sales and creditors are not available, it is usual in prepare the statement in the same
98
way as the Sources and Application of Funds. Individual increase or decrease in each
of the current assets and current liabilities is shown in the statement. Moreover, the
movement of various assets and liabilities are shown in this statement.
Importance or uses of Cash Flow Statement
We present here a brief explanation of importance of cash flow statement.
Cash flow statement is an important tool of financial management in short tern
financial analysis. The following are the important uses of cash flow analysis and
the resultant cash flow statement.
1. Cash flow statement helps to prepare cash budget. The cash flows in the
recent past indicate the quantum and direction of such flows and form the
basis for preparing monthly or quarterly budgets for cash or even the
annual cash budget for the ensuing year.
2. Cash flow statement explains how cash is raised through various sources
and how these are used for different purposes and it is an efficient tool of
short term financial analysis.
3. Cash flow statement gives a clear view of the cash position and the various
sources and applications of cash. It is possible for the financial manager to raise
and invest cash efficiently and to retain sufficient cash for day today operations.
4. Cash flow statement helps to find surplus cash and it can be profitably invested
and interruption of business activities for want of cash can be avoided.
5. Cash flow statement enables comparison among various concerns,
various departments and comparison of figures relating to different years.
6. Cash flow statement can act as a guide for coordinating the inflows and
outflows of cash. The ‘Matching’ of the future cash receipts with payments
results in effective cash management.
7. This statement provides a clear insight into the cash flows. On this base
the firm can tank some financial policies like dividend policy, cash
discount, credit terms, etc.
8. It reveals the liquidity position of the firm
9. Cash flow statement helps to take some financial decisions like repayment
of overdraft or loans, payment of bonus, advertising campaigns,
investments outside the firm, etc
Limitations of the Cash Flow Statement
We discuss in this section the general limitations of cash flow statement.
1. Cash flow statement takes into consideration only the revenues received in
cash and expenses paid in cash. Hence, cash from operation does not
represent the true profitability of the business.
2. Cash flow statement cannot give a complete picture of liquidity of a
business because it considered only cash and cash equivalents and it does
99
not considered other current assets likely to be realised within a short

period such as debtors, bills receivable and short term advances etc.
3. Cash flow statement discloses inflows and outflows of cash alone. Thus its
scope is very limited compared to funds flow statement which reveals the
changes in working capital or the income statement which displays the
overall financial position.
4. Cash flow statement is prepared in addition to income statement and
balance sheet. Hence, it helps to management in decision making along
with income statement and balance sheet of the concern.
Preparation of Cash Flow Statement
In this section, we attempt to make a brief survey of how to prepare cash flow
statement. Cash flow statement is prepared on the same lines as the funds flow
statement but strictly restricted to sources and uses of cash. Preparation of the
statement isbased on the opening and closing balance sheets, profit and loss account
and other relevant information. Cash flow statement starts with the cash and bank
balances at the commencement of the period. If there is bank overdraft and cash
balance, the net cash balance or net bank overdraft becomes the starting point.
The different ‘sources’ of cash are added to the opening balance and the
‘applications’ of cash are subtracted. The balance represents cash and bank balances at
the end of the accounting period. If a negative balance is obtained, it represents the bank
overdraft at the end of the period. The closing balance or overdraft thus arrived at should
be the same as shown in the closing balance sheet for the accounting period.
Cash inflows and cash outflows
In this section, we discuss the ash inflows and outflows.
Cash inflows or Sources
Transactions that bring in cash or increase the cash position are called
sources of cash. There are two types of sources namely internal sources and
external sources
(i) Internal sources
Cash from operation
(ii) External sources
1. Issue of shares for cash
2. Issue of debentures for cash
3. Issue of bonds for cash
4. Sale of fixed assets for cash
5. Sale of long-term investments for cash
6. Loans borrowed and the amount received in cash.
Cash outflows or application
Transactions that involve cash outlay or decrease the cash position are called
applications of cash. Examples of applications of cash are as follows:
100
1. Redemption of preference shares, debentures and bonds in cash.

2. Purchase of fixed assets and long term investments for cash.
3. Cash outflow due to operation.
4. Loans repaid in cash.
Not cash flow
The following cash movements are not to be taken as cash flow because the
total cash position remains unaltered
1. Cash is withdrawn from bank or deposited into bank
2. Investments are made in short term securities
3. Short term investments are realized
Difference between Fund Flow Statement and Cash Flow Statement
In this section, we attempt to make a brief study on how funds flow statement
is differ from cash flow statement.
1. Cash Flow Statement shows the causes for the changes in cash. whereas the
Fund Flow Statement shows the causes of changes in net Working Capital
2. Fund Flow Statement is not started with the opening and closing balances
of cash, but there is opening and closing balances in Cash Flow Statement
3. Fund Flow Statement is concerned with the changes in Working Capital
between two Balance Sheet dates but Cash Flow Statement depicts only
the changes in cash position
4. Fund Flow Statement is useful for long-term financing but Cash Flow
Statement is useful only for short-term financing.
5. Fund Flow Statement is based on accrual basis of accounting but Cash
Flow Statement is based on cash basis of accounting.
6. Fund Flow Statement deals with all the components of Working Capital
whereas Cash Flow Statement deals only with cash
Formats of Cash Flow Statement
In this section, we attempt to make a brief about different types of formats.
Cash Flow Statement can be prepared in two different formats namely
i) T format ii) Statement form
Cash Flow Statement in T format
Inflows Rs. Out flows Rs.
Opening Balances: Redemption of debentures xxx
Cash xx
Bank balance xx
Issue of shares xxx Repayment of long term loans xxx
(including premium) Purchase of fixed assets xxx
Issue of debentures xxx Payment of dividend xxx
101
Inflows Rs. Out flows Rs.

Issue of bonds xxx Payment of interim dividend xxx
Long term borrowings xxx Payment of tax xxx
Sale of fixed assets xxx Cash lost in operations xxx
Cash from operations xxx Closing Balance
Cash xxx
Bank balance xxx
Total xxx Total xxx
Cash Flow Statement in the form of statement
Particulars Rs.
Opening Balances:
Cash xx
Bank balance xx
Sources of cash
Issue of shares (including premium) xxx
Issue of debentures xxx
Issue of bonds xxx
Long term borrowings xxx
Sale of fixed assets xxx
Cash from operations xxx xxx
Total cash available (A) xxx
Application of cash
Redemption of debentures xxx
Repayment of long term loans xxx
Purchase of fixed assets xxx
Payment of dividend xxx
Payment of interim dividend xxx
Payment of tax xxx xxx
Closing Balance:
Cash
Bank balance
Calculation of cash from operation
Funds from operation Xxx
Add: Increase in current liabilities xx
Decrease in current assets xx Xxx
Xxx
Less: Decrease in current liabilities xx
Increase in current assets xx Xxx
Cash from operation Xxx
102
Single form combining Statement of funds and cash from operations

Particulars Rs. Rs.
Net profit earned during the year or Closing balance of xxx
P&L A/c/ P&L Appropriation A/ c
Add: Non fund and non-operating items which are already
debited to Profit& Loss A/c or P&L Appropriation A/c
1 Depreciation /Provision for depreciation on fixed assets Xxx
2 Loss on sale of fixed assets & investments Xxx
3 Loss on revaluation of fixed assets Xxx
4 Intangible assets written off:
Goodwill written off Xxx
Patents written off Xxx
Trade marks written off Xxx
Copy rights written off Xxx
5 Fictitious assets written off:
Preliminary expenses written off Xxx
Discount on issue of shares/ debentures written off Xxx
6 Transfer to reserves:
Transfer to general reserve Xxx
Transfer to sinking fund Xxx
Transfer to contingency reserve Xxx
7 Dividends:
Interim dividend
Proposed dividend (if taken as - non-current liability) Xxx
8 Provision for taxation (if taken as non- current liability) Xxx
9 Loss on redemption of debentures others Xxx
10 Other Xxx
11 Increase in current liabilities Xxx
12 Decrease in current assets Xxx xxx
xxx
Less: Non fund and non-operating items which are already
credited to Profit& Loss A/c or P&L Appropriation A/c
1 Dividend received Xxx
2 Interest received Xxx
3 Rent received Xxx
4 Commission received Xxx
5 Profit on sale of fixed assets and investments
6 Profit on revaluation of fixed assets Xxx
7 Excess provisions transferred to P&L AI c Xxx
8 Refund of income tax Xxx
9 Others Xxx
10 Decrease in current liabilities Xxx
11 Increase in current assets Xxx
12 Opening balance of P&L A/ c / P&L Appropriation A/ c Xxx xxx
Cash from operation + xxx
Cash lost from operation - xxx
103
Illustrations
In this section, we worked out some problems for your understanding.
Calculation of cash from operations
Illustration – 1
From the following balances, you are required to calculate cash from
operations.
Particulars 31.12.2020 31.12.2021

Rs. Rs.
Debtors 50,000 47,000
Creditors 20,000 25,000
Prepaid expenses 800 700
Accrued income 600 750
Income received in advance 300 250
Profit made during the year - 1,30,000
Solution:
Calculation of cash from operation
Particulars Rs. Rs.

Profit made during the year 1,30,000
Add: Increase in current liabilities and Decrease in
current assets
Debtors (50,000 - 47,000) 3,000
Creditors (25,000 - 20,000) 5,000
Outstanding expenses(1,200-1,000) 200
Prepaid expenses(800 - 700) 100 8,300
Decrease in current liabilities and
Increase in current assets:
Bills receivable (12,500 - 10,000) 2,500
Bills payable (8,000 - 6,000) 2,000
Accrued income (750 - 600) 150
Income received in advance (300-250) 50 4,700
Cash from operations 1,33,600
Illustration – 2
Maradon Ltd. earned profit of Rs. 2.00,000 after charging or crediting the
following items to its P & L A/c during 31-3-2020.The following additional details is
available
(a) Profit on sale of investmentsRs4,000
(b) Loss on sale of buildingsRs9,000
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(c) Depreciation on fixed assetsRs7,000

(d) Amortization of goodwillRs2,000
The following additional details are available 1-1-2020 31-12-2020

Creditors 12,000 16,000
Debtors 40,000 60,000
Accrued incomes 5,000 8,000
Income received in advance 2,000 1,000
Calculate the cash from operations for the year ending 31-3-2020.
Solution
Calculation of cash from operations
Particulars Rs Rs
Net profit as per profit and loss account 2,00,000
Add: Non cash and non trade items debited toP& L A/c
Loss on sale of buildings 9,000
Depreciation on fixed assets 7,000
Amortization of goodwill 2,000 18,000
2,18,000
Less: Non trading income credited to P & L A/c
Profit on sale of investments 4,000
2,14,000
Add: Increase in current liabilities and Decrease in current
assets
Bills payable ( 8,000-5,000) 3,000
Creditors ( 16,000-12,000) 4,000
Bills receivable ( 20,000-18,000) 2,000 9,000
2,23,000
Less: Decrease in current liabilities and Increase in current
assets
Outstanding expenses( 2,000-1,000) 1,000
Income received in advance( 2,000-1,000) 1,000
Debtors ( 60,000-40,000) 20,000
Prepaid expenses( 3,000-2,000) 1,000
Accrued income ( 8,000-5,000) 3,000 26,000
Cash from operation 1,97,000
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Preparation of cash flow statement

The following problems deals with preparation of cash flow statements.
Illustration – 3
From the Balance Sheets of Maradon and Ranjitha as on 31.12.2020 and
31.12.2021, prepare cash flow statement:
Balance Sheets
Creditors 40,000 44,000 Cash 10,000 7,000
Mrs. Y loan 25,000 -- Debtors 30,000 50,000
Capital 1,25,000 1,53,000 Stock 35,000 25,000
Loan from
40,000 50,000 Machinery 80,000 55,000
Indian bank
Land 75,000 1,10,000
2,30,000 2,47,000 2,30,000 2,47,000
During the year machine costing Rs.10,000 (accumulated depreciation
Rs.3,000) was sold for Rs.5,000. The provision for depreciation against machinery as on
2020 was Rs.25,000 and on 2021 was Rs.40,000. Net profit for 2021 was Rs.45,000.
Solution
Cash flow statement
Sources Rs Application Rs
Opening cash balance 10,000 Purchase of land 35,000
Sale of machinery 5,000 Mrs.Y’s loan repaid 25,000
Loan from Indian ban 10,000 Drawings 17,000
Cash from operations 59,000 Closing cash balance 7,000
84,000 84,000
Calculation of Funds from operation
Net profit as per P&L account 45,000
Add: Non Operating and Non cash Expenses:
Loss on sale of machinery 2,000
Depreciation 18,000 20,000
65,000
Less: Non trade incomes --
Funds from operation 65,000
Calculation of cash from operations:
Particulars Rs. Rs.
Funds from operations 65,000
Add: Increase in current liabilities and Decrease in current assets:
Creditors (44,000-40,000) 4,000
Stock (35,000-25,000) 10,000 14,000
79,000
Less: Decrease in current liabilities Increase in current assets:
Debtors (50,000-30,000) 10,000
Cash from operations 69,000
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Dr Machinery A/c Cr
To Balance b/d 1,05,000 By Cash (sale) 5,000
(80,000+25,000) By Provision for depreciation 3,000
By P/L a/c (Loss on sale) 2,000
(55,000+40,000)
1,05,000 1,05,000
Dr Provision for Depreciation A/c Cr

By Balance b/d 25,000
To Machinery A/c 3,000
To Balance c/d 40,000 By P/L a/c 18,000
( 55,000+40,000)
43,000 43,000
Dr Capital A/c Cr
To Drawings( Balance) 17,000 By Balance b/d 1,25,000
To Balance c/d 1,53,000 By Net profit 45,000
1,70,000 1,70,000
Illustration – 4
The comparative Balance sheets of Swetha Ltd are given below

Share capital 1,00,000 1,00,000 Fixed Assets 1,00,000 1,10,000
Profit & loss a/c 80,000 90,000 Stock 80,000 90,000
Bank loan 60,000 75,000 Debtors 90,000 1,20,000
Current liabilities 65,000 80,000 Cash at Bank 40,000 40,000
Provision for taxation 20,000 25,000 Preliminary 15,000 10,000
expenses
3,25,000 3,70,000 3,25,000 3,70,000
Adjustments
i) Fixed Assets depreciated Rs. 15,000 during to the year 2021
ii) Taxes paid during the year Rs. 7,000
iii) Interim dividend paid during 2021 Rs. 10,000
Prepare cash flow statement
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Solution
Cash flow statement
Inflow Outflow
Opening cash balance 40,000
Bank loan 15,000 Tax paid during year 7,000
Cash from operation 27,000 Interim dividend paid 10,000
Fixed assets purchase 25,000
Closing cash balance 40,000
82,000 82,000
Working Notes
Dr. Adjusted profit and loss a/c Cr.
To Depreciation on fixed assets 15,000 By Balance b/d 80,000
To Interim dividend 10,000 By Funds from operation 52,000
To preliminary expenses write off 5,000 (Balancing figure)
1,32,000 1,32,000
Dr. Fixed Assets a/c Cr.

1,25,000 1,25,000
Dr. Provision for Taxation a/c Cr.

To Bank 7,000 By Balance b/d 20,000
To Balance c/d 25,000 By profit and loss a/c 12,000
(Balancing figure)
32,000 32,000
Calculation of cash from operations: Rs. Rs.

Add: Increase in current liabilities and Decrease in. current
assets:
Increase in current liabilities 15,000
67,000
Less: Decrease in current liabilities Increase in current assets:
Increase in stock 10,000
Increase in debtors 30,000 40,000
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Illustration – 5
From the following balance sheet of MR Ltd. on 31st December 2020 and 2021
you are requires to prepare cash flow statement.
Balance sheets
Rs. Rs. Rs. Rs.
Share capital 1,00,000 1,50,000 Good will 12,000 10,000
General Reserve 15,000 20,000 Building 40,000 50,000
Profit and loss a/c 16,000 13,000 Plant 37,000 80,000
Debentures 50,000 75,000 Stock 30,000 23,500
Sundry Creditors 8,000 5,000 Land 10,000 35,000
Bills payable 1,000 1,500 Investment 10,000 12,000
Provision for Taxation 16,000 18,000 Bills receivable 2,000 3,000
Provision for doubtful 2000 1,000 Debtors 18,000 19,000
debts
Cash 6,000 15,000
Bank 43,000 36,000
2,08,000 2,83,500 2,08,000 2,83,500
The following additional information has also been given

1. Building purchased during the year 2021 for Rs. 10,000.
2. Plant purchased for Rs. 50,000 by Issue of shares to another company.
3. Land Rs. 25,000 purchased during the year by Issued of debentures.
4. Depreciation charged on plant Rs. 7,000.
Solution
Cash flow statement

Inflow Rs. Outflow Rs.
Opening Cash 6,000 Building purchased (Adj) 10,000
Opening Bank balance 43,000 Investment purchased 2,000
Cash from operation (WN1) 14,000 Closing cash 15,000
Closing bank balance 36,000
63,000 63,000
Working Notes
Dr. Adjusted profit & loss a/c Cr.
To Depreciation on plant 7,000 By Balance b/d 16,000
To Good will write off 2,000
To General Reserve 5,000 By Funds from operation 11,000
(Balance)
27,000 27,000
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Dr. Building a/c Cr.

To Balance b/d 40,000 By Balance c/d 50,000
To Bank a/c 10,000
50,000 50,000
Dr. Plant a/c Cr.
To Balance b/d 37,000 By depreciation a/c 7,000
To share capital a/c 50,000 By Balance c/d 80,000
87,000 87,000
Dr. Land a/c Cr.
To Balance b/d 10,000 By balance c/d 35,000
To Debentures a/c 25,000
35,000 35,000
Dr. Share Capital a/c Cr.

To Balance c/d 1,50,000 By Balance b/d 1,00,000
By plant a/c 50,000
1,50,000 1,50,000
Dr. Debenture a/c Cr.
To Balance c/d 75,000 By Balance b/d 50,000
By Land a/c 25,000
75,000 75,000
Add: Increase in current liabilities and Decrease in. current
assets:
Decrease in stock 6,500
Increase in bills payable 500
Increase in provision for taxation 2,000 9,000
20,000
Less: Decrease in current liabilities Increase in current
assets:
Increase in bills receivable 1,000
Increase in debtors 1,000
Decrease in creditors 3,000
Decrease in provision for doubtful debts 1,000 6,000
Illustration – 6
From the following balance sheet of RM Ltd. on 31st December 2020 and 2021
you are requires to prepare cash flow statement.
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Balance sheets
Rs. Rs. Rs. Rs.
Share capital 2,00,000 2,50,000 Good will ---- 5,000
General Reserve 50,000 60,000 Building 2,00,000 1,90,000
Profit and loss a/c 30,500 30,600 Plant 1,50,000 1,69,000
Long term loan 70,000 --- Stock 1,00,000 74,000
Sundry Creditors 1,50,000 1,35,200 Debtors 80,000 67,200
Provision for 30,000 35,000 Cash 500 600
Taxation
Bank -- 5,000
5,30,500 5,10,800 5,30,500 5,10,800
Adjustments
i) Dividend of Rs 23,000 was paid.
ii) Assets of another company were purchased for a consideration of Rs
50,000 Payable in shares. The following assets were purchased.
iii) Stock Rs. 20,000 Plant Rs 25,000.
iv) Deprecation written off on Plant 12,000.
v) Income Tax provided during the year Rs. 33,000.
vi) Loss on sale of machinery Rs. 200 was written off to general reserve.
vii) Further machinery was Plant for cash Rs. 8,000.
Prepare a Cash flow statement
Solution
Cash flow statement
Inflows Rs Outflows Rs.
Opening Cash 500 Dividend paid 23,000
Opening Bank -- Repayment of bank loan 70,000
Sale of machinery 1,800 Tax paid 28,000
Cash from operation 1,35,300 Purchase of machinery 8,000
Closing cash 600
Closing Bank 8,000
1,37,600 1,37,600

To Dividend paid 23,000 By Balance b/d 30,500
To Depreciation on machinery 12,000 By Funds from operation 88,300
To Provision for tax 33,000 (Balancing Figure)
To Transfer to General 10,200
Reserve
To Depreciation on land and 10,000
Building
1,18,800 1,18,800
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Dr Machinery A/c Cr
(Balancing figure
To Bank 8,000 By General reserve 700
1,83,000 1,83,000
Dr Good Will A/c Cr
To Balance b/d Nil By Balance c/d 5,000
To Share Capital 5,000
5,000 5,000
Dr Share Capital A/c Cr
By Balance b/d 2,00,000
By Stock 20,000
By Machinery 25,000
To Balancec/d 2,50,000 By Good will 5,000
2,50,000 2,50,000
Dr General Reserve A/c Cr

To Machinery (Loss on sale) 200 By Balance b/d 50,000
To Balance c/d 60,000 By P&L A/c (Balaning figure) 10,200
60,200 60,200
figure)
ToBalance c/d 35,000 By P&LA/c 33,000
63,000 63,000

Add: Increase in current liabilities and Decrease in.
current assets:
Decrease in Debtors 15,800 61,800
1,50,100
Less: Decrease in current liabilities Increase in current
assets:
Decrease in creditors 14,800 14,800
Cash from operations 1,35,300
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REVISION POINTS
 Cash here refers to cash and equivalents
 Cash flow statement is only a summarized statement containing actual
receipts and payment during the accounting period
 A cash flow statement reveals the liquidity position of the firm
 Cash flow statement which classifies cash flows during the period from
operating, investing and ... An enterprise should prepare a cash flow statement.
 Cash flow statement provides information on a firm's liquidity and solvency
and its ability to change cash flows in future circumstances.
INDEX QUESTIONS
1. Explain the importance and limitation of cash flow statement
2. How does cash flow statement differ from funds flow statement?
3. From the following Balance Sheets of Vijay Company Ltd Calculate cash
from operations
31.12.2020 31.12.2021
Liabilities Rs. Rs.
Share Capital 1,50,000 1,00,000
Profit & Loss 80,000 50,000
6% Debentures 60;000 50,000
Creditors 40,000 30,000
Total 3,85,000 2,70,000
Assets
Fixed assets 1,50,000 1,00,000
Goodwill 40,000 50,000
Stock 80,000 30,000
Debtors 80,000 50,000
Bank 15,000 10,000
Total 3,85,000 2,70,000
4. Ranjitha Corporation made a profit of Rs.2,50,000 after considering the
following. You are required to determine cash from operations
Rs.
a) Depreciation on fixed assets 5,000
b) Provision for tax 10,000
c) Loss on sale of machine 500
d) Transfer to general reserve 10,000
e) Provision for doubtful debts 1,500
f) Profit on sale of fixed assets 2,500
g) Amortisation of development cost 6,000
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Assets and liabilities 31-12-2020 31-12-2021

Rs Rs
Creditors 30,000 35,000
Debtors 40,000 45,000
5. Following are the comparative balance sheets of Maradon Company Ltd.
Rs. Rs. Rs. Rs.
Share capital 70,000 74,000 Bank Balance 9,000 -
Accounts
Debentures 12,000 6,000 14,900 17,700
receivable
Accounts payable 10,360 11,840 Stock in trade 49,200 42,700
Provision for
700 .800 Buildings 20,000 40,600
doubtful debts
Bank overdraft - 2,800 Goodwill 10,000 5,000
P & LA/c 10,040 10,560
1,03,100 1,06,000 1,03,100 1,06,000
(a) Buildings were acquired for Rs.20,600
(b) Amount provided for amortization of goodwill totalled Rs.5,000
(c) Dividends paid totalled Rs.3,500
(d) Debenture loan repaid was Rs.6,000
(e) Explain how the overdraft of Rs.2,800 as on 31st Dec. 2021 arisen has
6. From the following balance sheets of Ranjitha Ltd. for 2020 and 2021,
prepare cash flow statement
Rs. Rs. Rs. Rs.
Equity shares 2,00,000 3,00,000 Goodwill 50,000 40,000
8% Pref. shares 1,00,000 50,000 Buildings 1,00,000 75,000
Trade
Capital reserve - 25,000 10,000 35,000
investments
Profit & Loss
18,000 27,000 Sundry debtors 60,000 90,000
account
Proposed
28,000 39,000 Stock 85,000 78,000
dividend
Bills payable 10,000 6,000 Cash in hand 7,000 6.000
Liabilities for
8,000 6,000 Cash at bank 10,000 22,000
expenses
Provision for Preliminary
28,000 32,000 10,000 7,000
Taxation expenses
4,37,000 5,62,000 4,37,000 5,62,000
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i) In 2009, Rs.18,000 depreciation has been written off to plant account

and no depreciation has been charged on buildings.
ii) A piece of building has been sold out and the balance has been
revalued, profit on revaluation and sale being transferred to capital
reserve. There is no other entry in capital reserve account.
iii) A plant was sold for Rs.12,000 (WDV Rs.15,000)
iv) Rs. 2,100 dividend has been received, but it includes Rs.600 pre-
acquisition dividend
v) An interim dividend of Rs.I0,000 has been paid in 2009
7. The following are the Balance Sheets of a Company for the last two years :

Rs. Rs. Rs. Rs.
Sundry
39,500 41,135 Cash at Bank 2,500 2,700
Creditors
Bills Payable 33,780 11,525 Debtors 85,175 72,625
Bank Overdraft 59,510 - Advances 2,315 735
Taxation
40,000 50,000 Stock 1,11,040 97,370
Reserve
Land and
Capital Reserve 50,000 50,000 1,48,500 1,44,250
Buildings
Profit & Loss Plant and
39,690 41,220 1,12,950 1,16,200
A/c Machinery
Share Capital 2,00,000 2,60,000 Goodwill - 20,000
4,62,480 4,53,880 4,62,480 4,53,880
8. The following additional information is obtained from the General Ledger:

i) During the year ended 31st December 2021, an interim dividend of Rs.
26,000 was paid.
ii) The assets of another company were purchased for Rs. 60,000 payable
in fully paid shares of the company. The assets consisted of stock Rs.
21,640; machinery Rs. 18,360 and goodwill Rs. 20,000. In addition,
sundry purchases of plant were made totaling Rs. 5,650.
iii) Tax liability in respect of 2003 was settled at Rs. 45,000.
iv) The net profit for the year before tax was Rs. 82,530.
SUMMARY
Cash plays a very important role in the entire economic life of a business.
Cash Flow Statement is a statement like Fund Flow Statement. A Cash Flow
Statement concentrates to transactions that have a direct impact on cash. It deals
with the inflow and outflow of cash between two Balance Sheet dates. That is, it
115
explains the changes in cash position between the two periods. Cash Flow means
inflow and outflow of cash during accounting period. From the beginning of the
year up to the end of the year cash is received from various sources and spent on
various heads. Incoming and outgoing of cash is termed as cash flow. The term
cash here stands for cash and bank balances.
Cash Flow Statement facilitates to prepare sound financial policies. It also
helps to evaluate the current cash position. A projected Cash Flow Statement can
be prepared in order to know the future cash position of a concern so as to enable a
firm to plan and coordinate its financial operations properly. A Cash Flow
Statement cannot be equated with the income statement. An income statement
takes into account both cash and non-cash items. Hence Cash Fund does not mean
net income of the business. A Cash Flow Statement only reveals the inflow and
outflow of cash. The cash balance disclosed by this statement may not depict the
true liquid position. There are controversies over a number of items like cheques,
stamps, postal orders etc. to be included in cash. Cash Flow Statement can be
prepared on the same pattern on which a Fund Flow Statement is prepared.
TERMINAL EXERCISES
1. What is cash flow statement?
2. What is the limitation of cash flow statement?
3. Explain the importance of cash flow statement?
4. Discuss the Difference between fund flow statement and cash flow statement
5. How to prepare cash from operation? Give format?
edition)
ASSIGNMENT
1. Discuss the Difference between fund flow statement and cash flow
statement
REFERENCES
116
LEARNING ACTIVITIES
organization
KEY WORDS
Cash from operation, inflows and outflows

117
LESSON – 8
PREPARATION OF CASH FLOW STATEMENTAS PERAS 3

OBJECTIVES
In seventh lesson, we discussed the meaning, concept of cash flow statement
and we worked out some practical problems of cash flow statement. In this lesson,
we discuss how to prepare cash flow statement according to AS 3. After going
through this lesson you will able to
 understand how to calculate of cash from operation as per AS3
 understand how to prepare cash flow statement as per AS3
CONTENTS
 Introduction
 Meaning of Cash Flow Statement
 Classification of Cash Flows
 Presentation of Cash Flow Statement
 Procedure for Preparation of Cash Flow Statement under As 3
o Cash flows from Operating Activities
o Cash flows from Investing Activities
o Cash flows from financing Activities
 Treatment of Certain Items in the Cash Flow Statement as Per As 3
o Extraordinary items
o Interest and dividends
o Taxes on income
o Acquisitions and disposals of subsidiaries and other business units
o Non cash transactions
o Other Disclosures
 Illustrations
INTRODUCTION
In this section, we attempt to make a brief study about meaning of cash flow
statement according toAS3. A funds flow statement showed flows of working capital
which included items like stock of goods and prepaid expenses which did not
contribute to the short term ability of the enterprise to pay its debts. Flows were not
classified under the heads of operating, financial and investing activities. There was no
standard format of the statement. There was the need of a cash flow statement in a
standard format classifying flows from different activities. In June 1995 the Securities
and Exchange Board of India (SEBI) amended clause 32 of the Listing Agreement
requiring every listed company to give along with its Balance Sheet and Profit and Loss
Account, a Cash Flow Statement prepared in the prescribed format, showing
separately cash flows from operating activities, investing activities and financing
activities. In March 199'/ the Institute of Chartered Accountants of India issued AS-l
(Revised); Cash Flow Statement. The revised accounting standard supersedes AS-3:
118
Changes in Financial Position, issued in June 1981. Cash Flow Statement has
replaced Statement of Changes in Financial Position.
Meaning of Cash Flow Statement
Cash Flow Statement reports the inflows and outflows of cash and its
equivalents of an organisation during a particular period. It reports the cash
receipts and payments classified according to the firm’s major activities - Operating,
Investing and Financing. It shows the net cash inflow or net cash outflow for each
activity and for the overall business of the firm. It reports from where cash has
come and how it has been utilised. It explains the causes for the change in the cash
balance by reconciling the opening balance of the period with the closing balance.
Classification of Cash Flows
In this section, we attempt to make a brief study about the classification of
cash flows. According to AS3 a cash flow statement aims to determine the effects of
cash of different type of cash inflows and outflows. In this process, all cash flows
are classified into three categories:
(a) Cash flows from Operating Activities
(b) Cash flows from Investing Activities
(c) Cash flows from Financing Activities
Presentation of Cash Flow Statement
We present here a brief explanation about different presentation of cash flow
statement. The cash flow statement should report cash flows during the period
classified by operating, investing and financing activities. An enterprise presents its
cash flows from operating, investing and financing activities in a manner which is
most appropriate to its business. Classification by activity provides information that
allows users to assess the impact of those activities on the financial position of the
enterprise and the amount of its cash and cash equivalents. This information may
also be used to evaluate the relationships among those activities
Format of cash flow statement Rs
Cash from Operating activities xx
Cash from Investing activities xx
Cash flows from Financing activities xx
Net increase or decrease in cash & cash equivalents xx
Add: Cash & cash equivalents at the beginning of period xx
Cash & cash equivalents at the end of period xx
Procedure for Preparation of Cash Flow Statement under as 3
Preparation of cash flow statement involves the following steps:
i) Find out the opening and closing balances of cash and cash equivalents.
ii) Find out the net cash flows from operating, investing and financing
activities separately.
iii) Add or deduct the net cash flows to the opening balance of cash. The
resultant figure will be the closing balance of cash and cash equivalents.
119
Opening and closing balances of cash and cash equivalents can be taken from
the balance 'sheet at the beginning and at the end of the relevant period or the cash
book. It is necessary to calculate the net cash flows from operating, investing and
financing activities from the information available in the financial statements and
accounting records.
Cash flows from Operating Activities
We present here a brief explanation about different cash flows from operating
activities. The amount of cash flows arising from operating activities is a key
indicator of the extent to which the operations of the enterprise have generated
sufficient cash flows to maintain the operating capability of the enterprise, pay
dividends, repay loans and make new investments without recourse to external
sources of financing. Information about the specific components of historical
operating cash flows is useful, in conjunction with other information, in forecasting
future operating cash flows.
Cash flows from operating activities are primarily derived from the principal
revenue· producing activities of the enterprise. Therefore, they generally result from
the transactions and other events that enter into the determination of net profit or
loss. Examples of cash flows from operating activities are:
i) Cash receipts from the sale of goods and the rendering of services;
ii) Cash receipts from royalties, fees, commissions and other revenue;
iii) Cash payments to suppliers for goods and services;
iv) Cash payments to and on behalf of employees;
v) Cash receipts and cash payments of an insurance enterprise for premiums
and claims, annuities and other policy benefits;
vi) Cash payments or refunds of income taxes unless they can be specifically
identified with financing and investing activities; and
vii) Cash receipts and payments relating to future contracts option contracts and
swap contracts when the contracts are held for dealing or trading purposes.
The following statement shows the method of calculation of cash flow from
cash flows operating activities
Cash inflows from operating activities:

Cash receipts from: Rs. Rs.
1. Sale of goods xxx
2. Debtors (collection) xxx
3. Rendering of services xxx
4. Royalties, fees, commission and other revenue xxx
5. Premium, annuities for an insurance enterprise xxx
6. Refund of income tax xxx
7. Futures, forward, options and swap contracts xxx xxx
120
Less: Cash outflows due to operating activities: xxx

Cash payments:
1. To suppliers for goods and services xxx
2. To and on behalf of employees xxx
3. Towards claims, annuities and other policy payments for an
xxx
insurance enterprise
4. Income tax paid xxx
5. To futures, forward, options and swap contracts xxx xxx
Operating cash flows before extra-ordinary items xxx
Add/Less: Cash flows from extra-ordinary items xxx
Cash flows from operating activities xxx
Some transactions, such as the sale of an item of plant, may give rise to a gain
or loss which is included in the determination of net profit or loss. However, the
cash flows relating to such transactions are cash flows investing activities. An
enterprise may hold securities and loans for dealing or trading purposes, in which
case they are similar to inventory acquired specifically for resale. Therefore, cash
flows arising from the purchase and sale of dealing or trading securities are
securities are classified as operating activities. Similarly, cash advances and loans
made by financial enterprises are usually classified as operating activities since
they relate to the main revenue producing activity of that enterprise,
Cash flows from Investing Activities
We present here a brief explanation about different cash flows from investing
activities. The separate disclosure of cash flows arising from investing activities is
important because the cash flows represent the extent to which expenditures have
been made for resources intended to generate future income and cash flows.
Examples of cash flows arising from investing activities are
i) Cash payments to acquire fixed assets and intangibles assets. These payments
include those relating to capitalised research and development costs and self-
constructed fixed assets
ii) Cash receipts from disposal of fixed assets (including intangibles);
iii) Cash payments to acquire shares, warrants or debt instruments of other
enterprises and interests in joint ventures (other than payments for those
instruments considered to be cash equivalents and those held for dealing or
trading purposes.)
iv) Cash receipts from disposal of shares, warrants or debt instruments of other
enterprises and interests in joint ventures (other than receipts from those
instruments considered to be cash equivalents and those held for dealing or
trading purposes.)
v) Cash advances and loans made to third parties (other than advances and
loans made by a financial enterprise);
vi) Cash receipts from the repayment of advances and loans made to third parties
(other than advances and loans of a financial enterprise);
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vii) Cash payments for future contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities; and
viii) Cash receipts from future contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities;
When a contract is accounted for as a hedge of an identifiable position, the
cash flows of the contract are classified in the same manner as the cash flows of the
position being hedged.
cash flows investing activities
Cash inflows from investing activities Rs. Rs.

1. Sale proceeds of fixed assets (including intangibles) xxx
2. Sale proceeds of investments xxx
3. Pre-acquisition dividend received xxx
4. Interest and dividend on investments xxx
5. Repayment of loans and advances by third parties xxx
(for an enterprise other than financial enterprise)
6. Receipts from futures, forward, option and swap
xxx xxx
contracts
(other than contracts held for trading ordealing
purposes or the receipts of which are classified as
financing activities)
Less: Cash outflows due to investing activities:
1. Purchase of fixed assets (including intangibles) xxx
2. Research & Development costs capitalized infixed
xxx
assets
3. Costs on self-constructed fixed assets xxx
4. Purchase of investments xxx
(Payments to acquire shares, warrants or debt
instruments of other enterprises other than those held
for or dealing purposes and those payments of which
are treated as cash equivalents)
5. Cash loans and advances made to third parties xxx

(for an enterprise other than financial enterprise)
6. Cash payments for futures, forward, option and
xxx xxx
swap contracts
(other than contracts held fortrading or dealing
purposes or the payments of which are classified as
financing activities)
Cash flow from investing activities xxx
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Cash flows from financing Activities

We present here a brief explanation about different cash flows from financing
activities. The separate disclosure of cash flows arising from financing activities is
important because it is useful in predicting claims on future cash flows by
providers of funds (both capital and borrowings) to the enterprise. Examples of cash
flows arising from financing activities are:
1) Cash proceeds from issuing shares or other similar instruments;
2) Cash proceeds from issuing debentures, loans, notes, bonds, and other short
or long-term borrowings and
3) Cash repayments of amounts borrowed
cash flows financing activities
Cash inflows from financing activities: Rs. Rs.

1. Issue of shares for cash xxx
2. Issues of debentures, bonds, notes for cash xxx
3. Cash received from loans borrowed xxx
4. Additional capital introduced by owners xxx xxx
Less: Cash outflows due to financing activities
1. Repayments of loans xxx
2. Redemption of debentures xxx
3. Redemption of preference shares xxx
4. Dividend paid xxx
5. Drawings in cash by owners incase of sole traders xxx xxx
Cash flow from financing activities xxx
Treatment of certain items in the Cash Flow Statement as per as 3
In this section, we attempt to make a brief study of how to treat various items
while preparing cash flow statement as per As 3
Extraordinary items
The cash flows associated with extraordinary items are disclosed separately as
arising from operating, investing or financing activities in the cash flow statement.
This is done to enable users to understand their nature and effect on the present
and future cash flows of the enterprise.
Interest and dividends
i) In the case of financial enterprise:
Interest paid and interest and dividends received should be classified as cash
flows arising from operating activities.
ii) In the other than financial enterprise:
a) Interest paid should be classified as cash flows from financing activities
b)Interest and dividends received should be classified as cash flows from
investing activities
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iii) Dividends paid:

Dividends paid should be classified as cash flows from financing activities for
all enterprises.
Taxes on income
Cash flows arising from taxes on income should be separately disclosed and
should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
Acquisitions and disposals of subsidiaries and other business units
The aggregate cash flows arising from acquisitions and from disposals of
subsidiaries or other business units .should be presented separately and classified
as investing activities. The cash flow effects of disposals are not deducted from
those of acquisitions.
Non cash transactions
Investing and financing transactions that do not require the use of cash or
cash equivalents should be excluded from a cash flow statement. Such transactions
should be disclosed elsewhere in the financial statements in a way that provides all
the relevant information about these investing and financing activities.
Other Disclosures
An enterprise should disclose, together with a commentary by management,
the amount of significant cash and cash equivalent balances held by the enterprise
that are not available for use by it.
Illustrations
In this section, we worked out some problems for your understanding.
Illustration – 1
The current assets and current liabilities of the business for the years ending
31st December 2020 and 2021 are as under
i) Profit for the year 2020 is Rs.10,000 after providing depreciation of Rs.10,000.
ii) The current assets and current liabilities of the business for the years
ending 31 st December 2020 and 2021 are as under:
31.12.20 31.12.21
Rs. Rs.
Sundry debtors 10,000 12,000
Provision for bad debts 1,000 1,200
Sundry creditors 8,000 9,000
Short-term investments 10,000 12,000
Accrued income 3,000 4,000
Income received in advance 2,000 1,000
Calculate cash from operating activities
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Solution
Particulars Rs. Rs.
Cash Flow from operating activities:
Net profit before tax and extra-ordinary items 10,000
Add: Adjustments for non-cash and non- operating expenses:
Depreciation 10,000
20,000
Less: Non-operating income ---
Operating cash flow before tax and working capital changes 20,000
Working capital changes:
Provision for bad debts(1,200-1,000) 200
Bills payable(6,000-5,000) 1,000
Sundry creditors(9,000-8,000) 1,000
Outstanding expenses(1,500-1,000) 500
Bills receivable(4,000-3,000) 1,000
Prepaid expenses(2,000-1,000) 1,000 4,700
24,700
Less: Decrease in current liabilities and Increase in current assets
Income received in advance(2,000-1,000) 1,000
Sundry debtors(12,000-10,000) 2,000
Inventories(8,000-5,000) 3,000
Accrued income(4,000-3,000) 1,000 7,000
Operating cash flow before income tax and extra-ordinary items 17,700
Less: Income tax paid ---
17,700
Cash flows from operating activities before extra-ordinary items 17,700
Add: Cash flows from extra-ordinary items --
Net cash flows from operating activities 17,700
Illustration – 2
From the following Balance Sheets of Vijay Company Ltd. find cash from
operating activities
31-12-2020 31-12-2021
Rs. Rs.
Liabilities
Share Capital 80,000 85,000
Profit & Loss (Appropriation A/ c) 13,000 22,000
Provision for depreciation 1,000 2,500
Creditors 9,500 5,000
Mortgage - 5,000
Total 1,03,500 1,19,500
Assets
Building 50,000 50,000
Plant 24,000 34,000
Stock 9,000 7,000
Debtors 16,500 19,500
1,03,500 1,19,500
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Solution
Rs
Cash Flow from operating activities:
Net profit before tax and extra-ordinary items (22,000-13,000) 9,000
Add: Adjustments for non-cash and non-operating
expenses
Provision for depreciation (2,500-1,000) 1,500
10,500
Operating cash flow before tax and working capital 10,500
changes
current assets:
Stock (9,000-7,000) 2,000
12,500
Less: Decrease in current liabilities and Increase in
current assets:
Creditors(9,500 -5,000) 4,500
Debtors(19,500-16,500) 3,000 7,500
Operating cash flow before income tax and extra- 5,000
ordinary items
Less: Income tax paid --
Cash flows from operating activities before extra- 5,000
ordinary items
Add/Less: Cash flows from extra-ordinary items ---
Illustration – 3
Maradon Corporation made a profit of Rs.3,70,250 ·after considering the
following. You are required to determine cash from operating activities. Assume
that income tax of Rs.50,000 is paid.
Rs.
a) Depreciation on fixed assets 7,500
b) Provision for tax 50,000
c) Loss on sale of machine 600
d) Transfer to general reserve 20,000
e) Provision for doubtful debts 1,200
f) Profit on sale of fixed assets 2,500
g) Amortisation of development cost 5,000
Rs Rs
31.12.2020 31.12.2021
Creditors 20,000 25,000
Debtors 36,000 39,000
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Solution
Cash Flow from operating activities: Rs. Rs.
Net profit before tax and extra-ordinary items
(3,70,250+50,000+20,000) 4,40,250
Add: Adjustments for non-cash and non-operating
expenses:
Depreciation on fixed assets 7,500
Loss on sale of machine 600
Provision for doubtful debts 1,200
Amortisation of development cost 5,000 14,300
4,54,550
Less: Non-operating income
Profit on sale of fixed assets 2,500
Operating cash flow before tax and working capital
4,52,050
changes
current assets:
Creditors (25,000-20,000) 5,000
Bills receivable (12,000-10,500) 1,500 6,500
4,58,550
Less: Decrease in current liabilities and Increase in
current assets:
Bills payable (15,000-13,000) 2,000
Soutstanding expenses (7,000-6,000) 1,000
Debtors (39,000-36,000) 3,000
Prepaid expenses (1,700-1,600) 100 6,100
Operating cash flow 'before income tax and extra-
4,52,450
ordinary items
Less: Income tax paid 50,000
Cash flows from operating activities before extra-
4,02,450
ordinary items
Add/Less: Cash flows from extra-ordinary items -
Net cash flows from operating activities 4,02,450
Illustration– 5
Statement of financial position of Abibharathi Ltd., is presented below
Liabilities Assets 2020 2021
Rs. Rs. Rs. Rs.
Share capital 18,000 19,000 Cash 6,000 4,000
Creditors 6,400 7,600 Debtors 15,500 19,000
Profit & loss A/c 2,900 3,500 Buildings 5,000 6,200
Patent rights 800 900
27,300 30,100 27,300 30,100
You are required to prepare a statement of flow of cash
127
Solution
I: Cash Flow from operating activities: Rs Rs
Net profit before extra-ordinary items. (3,500-2,900) 600
Add: Adjustments for non-cash and non-operating expenses: --
600
Operating cash flow before tax and working capital changes 600
Creditors (7,600-6,400) 1,200
1,800
Less: Decrease in current liabilities and Increase in current assets:
Debtors (19,000-15,500) 3,500
Operating cash flow before income tax and extra-ordinary items -1,700
Less: Income tax paid --
Cash flows from operating activities before extra-ordinary items -1,700
Add/less cash flows from extra ordinary item --
Net cash flows used in operating activities -1,700
II Cash Flow from investing activities
Cash inflows -
Cash outflows:
Purchase of buildings 1,200
Purchase of patents 100
III Net cash flows used in investing activities 1,300
Cash Flow from financing activities
Cash inflows:
Shares issued 1,000
Cash outflows: ---
Net cash flows from financing activities 1,000
Net decrease in cash and cash equivalent (2,000)
Add: Cash & cash equivalents at beginning 6,000
Cash and cash equivalents at the end of year 4,000
Illustration – 6
The following are the balance sheets of RRM Co. Ltd. as on 31.12.20 and
31.12.21
Rs. Rs. Rs. Rs.
Share capital 1,00,000 1,25,000 Building 1,00,000 95,000
General reserve 25,000 30,000 Machinery 75,000 85,500
P&L A/c 15,250 15,300 Stock 50,000 37,000
Bank loan 35,000 - Debtors 40,000 31,100
Creditors 75,000 67,600 Cash 250 300
Provision for tax 15,000 17,500 Bank - 4,000
Investment - 2,500
2,65,250 2,55,400 2,65,250 2,55,400
Additional information:
1. Dividend of Rs.11, 000 was paid
2. Machinery was purchased for Rs.15,000
3. Income tax\paid during the year Rs.16,500
128
Prepare cash flow statement.

Solution
I: Cash Flow from operating activities: Rs Rs
Net profit before extra-ordinary' items (15,300-15,250) 50
Add: Adjustments for non-cash and non- operating items:
Depreciation on machinery 4,500
Depreciation on buildings(1,00,000-95,000) 5,000
Transfer to general reserve(30,000-25,000) 5,000
Dividend provided 11,000
Income tax provided 19,000 44,500
44,550
Less: Non-operating income --
assets:
Decrease in debtors(40,000-31,100) 8,900
Decrease in stock(50,000-37,000) 13,000 21,900
66,450
assets:
Creditors(75,000-67,600) 7,400
59,050
Less: Income tax paid 16,500
Cash flow from operating activities before extra-ordinary 42,550
items
Add/Less: Cash flows from extra-ordinary items --
II: Cash flow from investing activities:
Cash inflows:
Cash outflows:
Purchase of investments -2,500
Purchase of machinery 15,000
Net cash used in investing activities (17,500)
III: Cash flow from financing activities:
Cash inflows:
Issue of shares 25,000
Cash outflows:
Repayment of bank loan25,000
Dividend paid11,000 46,000
Net cash used in financing activities (21,000)
Net increase in cash & cash equivalents 4,050
Add: Cash and cash equivalents at the beginning of the 250
year
Cash and cash equivalents at the end 4,300
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Illustration – 7
From the following balance sheet of Ranjitha Ltd. on 31st December 2020 and
2021 you are requires to prepare cash flow statement.
Balance sheets
Rs. Rs. Rs. Rs.
Share capital 2,00,000 2,50,000 Good will ---- 5,000
General Reserve 50,000 60,000 Building 2,00,000 1,90,000
Profit and loss a/c 30,500 30,600 Plant 1,50,000 1,69,000
Long term loan 70,000 --- Stock 1,00,000 74,000
Sundry Creditors 1,50,000 1,35,200 Debtors 80,000 64,200
Provision for Taxation 30,000 35,000 Cash 500 600
Bank -- 5,000
5,30,500 5,10,800 5,30,500 5,10,800
Adjustments:
1. Dividend of Rs 23,000 was paid.
2. Assets of another company were purchased for a consideration of Rs
50,000 Payable in shares. The following assets were purchased.
3. Stock Rs. 20,000 Plant Rs 25,000.
4. Deprecation written off on Plant 12,000.
5. Income Tax provided during the year Rs. 33,000.
6. Loss on sale of machinery Rs. 200 was written off to general reserve.
7. Further machinery was Plant for cash Rs. 8,000.
Prepare a Cash flow statement as per AS 3
Solution:
I: Cash Flow from operating activities: Rs. Rs.
Net profit before tax extra-ordinary' items 66,300
Add: Adjustments for non-cash and non- operating items:
Depreciation 22,000
88,300
Less: Non-operating income --
assets:
Decrease in debtors 15,800
assets:
Creditors (14,800)
Less: Income tax paid (28,000)
130
Cash flow from operating activities before extra-ordinary items 1,07,300

Add/Less: Cash flows from extra-ordinary items --
Net cash flows from operating activities 1,07,300
II: Cash flow from investing activities:
Cash inflows:
Sale of machinery 1,800
Cash outflows:
Purchase of machinery (8,000)
Net cash used in investing activities (17,500)
III: Cash flow from financing activities:
Cash inflows:
Cash outflows:
Repayment of bank loan (70,000)
Dividend paid (23,000)
Net cash used in financing activities (93,000)
Net increase in cash & cash equivalents 8,100
Add: Cash and cash equivalents at the beginning of the year 500
Cash and cash equivalents at the end 8,600

To Profit and loss A/c 100 By Profit before tax and 66,300
( 30,500-30,600) extraordinary items
To proposed dividend 23,000
To Transfer to General Reserve 10,200
66,300 66,300
Dr Machinery A/c Cr
(Balancing figure
To Bank 8,000 By General reserve 700
1,83,000 1,83,000
figure)
To Balance c/d 35,000 By P&LA/c 33,000
63,000 63,000
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REVISION POINTS
 Cash flow statement which classifies cash flows during the period from
operating, investing and ... An enterprise should prepare a cash flow
statement.
 Cash flow statement provides information on a firm's liquidity and solvency
and its ability to change cash flows in future circumstances.
 Cash flow statement provides additional information for evaluating changes
in assets, liabilities and equity.
 Cash flow statement improves the comparability of different firms'
operating performance by eliminating the effects of different accounting
methods .
 Cash flow statement indicate the amount, timing and probability of future
cash flows
INDEX QUESTIONS
1. From the following balances you are required to calculate cash from
operating activities:
1.1.2021 31.12.2021
Rs. Rs.
Debtors 50,000 47,000
Creditors 20,000 25,000
Accrued income 600 750
Profit made during the year - 1,30,000
2. The comparative Balance Sheets of a firm for the two years were as follows
31.12.2020 31.12.2021
Rs. Rs.
Liabilities :
Loan from wife - 20,000
Creditors 25,000 52,000
Bank overdraft 43,000 60,000
Capital 66,000 34,000
1,46,000 1,74,000
Assets:
Cash 11,000 15,000
Debtors 40,000 35,000
132
Stock 25,000 30,000

Machinery 20,000 14,000
Buildings 50,000 80,000
1,46,000 1,74,000
Additional Information
i) Net loss for the year amounted to Rs. 13,000
ii) During the year a machine costing Rs. 5,000 (accumulated depreciation
Rs. 2,000) was sold for Rs. 2,500.
iii) The provision for depreciation against machinery as on 31-12-2020 was
Rs. 6,000 on 31-12-2021 Rs. 7,000.
3. Following are the Balance Sheets of a partnership firm
Liabilities Rs Rs Assets Rs Rs
Creditors 36,000 41,000 Cash 4,000 3,600
Loan from - 20,000 Debtors 35,000 38,400
partner
Loan from bank 30,000 25,000 Stock 25,000 22,000
Capital 1,48,000 1,49,000 Land 20,000 30,000
Building 50,000 55,000
Machinery 80,000 86,000
2,14,000 2,35,000 2,14,000 2,35,000
During the year partners withdrew Rs. 26,000 for domestic expenses. The
provision for depreciation against machinery as on 1-1-20 was Rs. 27,000
and on 31-12-20 Rs. 36,000. Prepare a cash flow statement.
4. From the following Balance Sheets of Kumar Ltd. as on Dec. 31-12-2020
and 2021. You are required to prepare Cash flow statement for the year
ended Dec. 31-2021.
Liabilities Rs Rs Assets Rs Rs
Share capital 1,00,000 1,00,000 Cash 600 200
General 14,000 18,000 Bank 6,000 15,000
Reserve
Profit & Loss 16,000 13,000 Debtors 18,000 19,000
A/c
Bills payable 1,200 800 Stock 30,000 23,400
Pant 37,000 36,000
Provision for 16,000 18,000 Building 40,000 36,000
taxation
Provision for 400 600 Investments 10,000 11,000
doubtful debts
Good will 12,000 12,000
133
1,55,000 1,55,800 1,55,000 1,55,800

i.Depreciation on plant Rs. 4,000.
ii. Provision for taxation of Rs. 19,000 was made during the year 2021.
SUMMARY
In this lesson, we have briefly touched upon the following points. Cash Flow
Statement reports the inflows and outflows of cash and its equivalents of an
organisation during a particular period. It is prepared in the prescribed format,
showing separately cash flows from operating activities, investing activities and
financing activities. Cash Flow Statement revised accounting standard supersedes
AS-3: Changes in Financial Position, issued in June 1981. Cash Flow Statement
has replaced Statement of Changes in Financial Position.
TERMINAL EXERCISES
1. Explain the importance of cash flow statement?
2. Discuss the Difference between fund flow statement and cash flow statement
 Horngren, Datar & Foster, Cost Accounting – A Managerial Emphasis (any ed.)
ASSIGNMENT
1. Explain the classification of cash flows?
2. Explain the procedure for preparation of cash flow statement under A3?
REFERENCES
1. S.N. Maheshwari Principles of management Accounting
LEARNING ACTIVITIES
accounting creates value for an organisation
evaluation methods within the social context of an organisation
KEY WORDS
Account standard and proposed dividend

134
LESSON – 9
BUDGETARY CONTROL
OBJECTIVES
In eighth lesson, we discuss how to prepare cash flow statement according to
AS 3. In this lesson, we discuss the meaning of budget, budgeting budgetary
control, advantages, limitations, essentials of budgetary control. After going
through this lesson you will able to
 understand meaning of budget, budgeting budgetary control.
 understand the advantages, limitations, essentials of budgetary control
 know the meaning of Budget committee, Budget Centres, Budget Manual
and Budget Period
 know the various types of budgets
CONTENTS
 Introduction
o Meaning of Budget
o Definition of Budget
o Budgeting
o Budgeting – Definition
o Budgetary control
o Budgetary control – Definition
 Advantages of budgetary control
 Limitations of Budgetary Control System
 Estimates
 Forecasts
 Difference between Forecast and Budget
 Budget Committee, Budget Centres, Budget Manual and Budget Period
 Essentials of Budgetary Control
 Classification of Budget
INTRODUCTION
The management of business activities on scientific basis is essential for
optimising the use of resources with a view to achieving ultimate objectives of
running an enterprise. The principles of scientific management suggest the
systematized approach to the problems of production, marketing, personnel,
finance, etc. According to it, every activity affecting the overall business objectives
should be pre-planned and nothing should be left to chances. The management
should be clear about the approach to be followed to accomplish a particular task
and there must exist a system for taking corrective action wherever things go wrong
135
or beyond the expectations of the management. Managerial control becomes

essential in case of public limited companies and government undertakings which
are run by hired managerial personnel with little interest in the results of such
enterprises. The proprietors have, therefore, to think of a device which may
encourage the management to work with greater care and caution to serve the
interests of all by optimising the use of investments in the form of man, money and
materials. Budgeting is one such device which helps the management to
understand the business programmes in their right perspective and take steps to
achieve business objectives.
Meaning of Budget
In this section, we attempt to make a brief study about meaning of budget. We
know about central and state governments’ budgets which are presented in the
parliament and state assemblies every year; it deals with the expected revenues and
expenditure for a year of time. In the field of commerce, business firms prepare
different types of budgets such as sales budget, production budget, cash budget,
etc. A budget is a formal business plan for some future period.
Definition of Budget
In this section, we attempt to make a brief study about definition of budget
1. Charles T. Homgren states, “A budget is a formal quantitative expression of
management plan.”
2. Brown Howard viewed that “a budget is a pre-determined statement of
management policy during a given period which provides a standard for
comparison with the results actually achieved.”
3. According to the Institute of Cost and Works Accountant, England a budget
is “a financial or quantitative statement prior to a defined period of time, of
a policy to be perused for that period to attain a given objective.” From
these definitions, the salient features of a budget may be noted as under:
a. A budget is a document in writing.
b. It pertains to a policy which is to be executed during budget period.
c. It relate to a defined period in future.
d. A budget is expressed in terms of physical quantities, money values or
both.
e. Some specific objectives are. to be achieved through the establishment
of budgets.
f. Budgets provide a basis or standard for comparison with actual
performance for control purposes.
Budgeting
In this section, we attempt to make a brief study about meaning of budgeting.
Budgeting refers to the process of preparing the budgets. It involves a detailed
136
study of business environment clearly grasping the management objectives, the

available resources of the enterprise and capacity of the enterprise.
Budgeting – Definition
In this section, we attempt to make a brief study about definition of budgeting
1. J.Batty: “The entire process of preparing the budgets is known as budgeting”.
2. Rowland and Harr: “Budgeting may be said to be the act of building budgets”.
Budgetary control
We present here a brief explanation about budgetary control. Control may be
defined as “comparing operating results with the plans, and taking corrective action
when results deviate from the plans”. The budgetary control is concerned with the
management of business activities with the help of budgets. In this way, budgets
serve as a control device. Budgetary control is the process of preparation of budgets
for various activities and comparing the budgeted figures for arriving at deviations if
any, which are to be eliminated in future.
Budgetary control – Definition
In this section, we attempt to make a brief study about definition of budgetary
control. The Institute of Cost and Works Accountants, England, has defined
budgetary control as “the establishment of departmental budgets relating to the
responsibilities of executives to the requirements of a policy, and the continuous
comparison of actual with budgeted results, either to secure by individual action
the objectives of that policy or to provide a firm basis for its revision.”
In the opinion of Brown and Howard, “Budgetary control is a system of
controlling costs which includes the preparation of budgets, coordinating the
departments and establishing responsibilities, comparing actual performance with
the budgeted and acting upon results to achieve maximum efficiency.”
Advantages of Budgetary Control
In this section, we discuss the advantages of budgetary control. Budgetary
control has assumed a special significance in almost every organization. There is
hardly any enterprise and government department in which budget is not done. The
budgetary control system enables the management to enhance over-all efficiency for
the achievements of organizational objectives. It contributes in the developments of
an undertaking in the following manner.
1. With a prior knowledge of work to be done the management can develop an
appropriate strategy for the achievements of the targets set out in the budgets.
2. Budgeting develops a sense of responsibility among the employees who are
required to do a particular work in a given period of time. The powers can
be delegated without much fear of its being misused.
3. Budgetary control provides for the preparation of variance report which
contains a comparatives study of actual and budgeted figures with
variances. An adverse variance, i.e. actual performance falling short of
budgeted performance, is brought to the knowledge of top management
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which finally takes corrective action to avoid such a situation in the next
budget period. In this manner control becomes more effective.
4. Budgeting helps in the coordination of business activities without which
an. enterprise cannot run in perfect harmony. For example, production
budget is drawn in accordance with the expected sales as set out in Sales
budget. Similarly, purchase budget is prepared according to quantity
production as shown in production budget.
5. Budget serves as a medium of written communication. It ensures better
understanding and harmonious relation between top management,
managers and workers.
6. Delays in the implementation of the business programmes is avoided by
the preparation and implementation of budgets well in time.
7. Overheads budget sets limit to expenditure on various items. Any expenditure
beyond the limit specified can be incurred only with the prior sanction of the
competent authority. Thus there is opportunity to scrutinize the expenditure
before it is actually incurred. Thus over-spending of overheads can be checked
and scarce financial resources put to proper use.
8. Budgets, if properly drawn economise the use of resources. For example, if
the budget for inventories is rightly drawn up, it will reduce the
requirements of the money to be tied up in inventories.
9. Budgets suggest the arrangement the facilities well in advance for
maintaining the operational efficiency of any enterprise. For instance, Cash
budget clearly indicates the deficit/surplus cash position at different
timings and accordingly additional working capital may be procured or
surplus cash invested for effective working of the organization.
10. Budgetary controls provide a basis for rewarding the employees who
perform better. It is generally not used as a punitive measure.
11. A sound budgetary control system can contribute in the set up the
standard costing which can act a complementary to budgeting.
Limitations of Budgetary Control System
In this section, we discuss the limitations of budgetary control. Budgets and
budgetary control system is, undoubtedly, very important for running an enterprise
on scientific basis for optimizing their use of available resources and achieving
organisational objectives. However, the system suffers from certain limitations and
the management should keep them in view while adopting and implementing the
system. The main limitations are as under:
Budgets are Estimates
The figures contained in a budget are simply an estimate about future.
Budgets are prepared on the basis of certain assumptions about future. It is likely
that the assumptions might not hold good. In that case, the whole budget will have
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to be recast. The revision of budgets in accordance with the changes in business

conditions is a must for the success of budgeting.
Wrong Budgets may be Prepared
The success of budgetary control system largely depends upon the accuracy
with which the budgets are prepared. If the forecasting is done on the basis of
inadequate information or subjective considerations of management, then the
wrong budgets will be formulated. Wrong budgeting leads to wrong strategies
which leads to wastage of resources and thus the very purpose of budgeting is
forfeited.
Mismanagement
Budgetary control becomes effective only when the managers who are responsible
for implementing the budgets are efficient and duty conscious. Budgeting itself is no
guarantee for success in business if the management is inefficient or indifferent to the
budgetary control system. There can be no substitute for better management.
Employees Resistance
Sometimes, the employees are charged with the responsibility of operating the
budgets and achieve the desired results oppose budgeting due to their inefficient
character which is exposed when they fail to achieve the targets. Many a times, the
resistance to budgeting is just psychological. The top management can lessen the
workers’ resistance to budgeting by the preparation of realistic budgets with the
consent and cooperation of all those who are concerned with the implementation of
budgeting in the organisation.
Rigidity
Generally, the management prepares the budgets for next year by making
some changes here and there in the existing budgets. This method of budget
preparation introduces an element of rigidity in budgeting which can be eliminated
by introducing the system of zero base budgeting in which a fresh thought is given
to the whole issue of budgeting.
Costly Affair
The system involves cost in terms of money, time and energy. Efforts should be
made to reduce the cost by developing an appropriate and simple method of
budgeting and control system.
Estimates
We present here a brief explanation about estimates. An ‘estimate’ is
predetermination of future events either on the basis of guesswork or following
scientific procedures.
Forecasts
We present here a brief explanation about forecast. Forecast is an assessment
of possible future events. “Budget” is planning of future events. Forecasting
precedes budgeting. Effective budgeting is based on efficient forecasting. In order to
prepare a budget it is essential to forecast various important variables like sales,
selling prices, availability of materials, prices of materials, wage rates etc.
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Difference between Forecast and Budget

We discuss in this section the how forecast differ from budget. Both budgets
and forecasts are foreseeing the future events. Still, there are number of differences
between budgets and forecasts as mentioned below:
i. Forecasts are mostly concerned with expected or probable events but
Budgets are conceded with planned events.
ii. Generally forecasting is done for a long duration of time but budgets are for
a shorter, specific duration of time
iii. Result of forecasting is planning but result of planning is budgeting
iv. Forecasting is a mere estimation but budget is a target fixed for a period.
v. Forecasting does not act as a tool of measurement but budgets are the
targets against which actual are compared.
vi. Forecasting refers to events over which there is no control but purpose of
budget is to control the activities.
Budget Committee, Budget Centres, Budget Manual and Budget Period
In this section, we attempt to make a brief study about meaning of budget
committee, budget centres, budget manual and budget period
Budget Committee: In a small concern the accountant is made responsible to
prepare the budgets and implement the budgetary control system. In larger
ordanisations, a budget committee is set up to help the budget controller to prepare
budgets and implement the budgetary control. The heads of various departments
are usually members of the committee. The main function of the budget committee
is to prepare, review and finalises budgets.
Budget Centres: These are the specific segments of the organisation for which
budgets are prepared. The budget centre may be a department, or any system of
the enterprise. Establishment of budget centres is essential for covering all parts of
the organisation and for effective cost control. The evaluation of performance of
different parts of the organisation becomes easier when different centres are
established covering all the activities.
Budget Manual: It is a document which spells out the responsibilities of
various executives concerned with the budgets. It also specifies the relationship
among them to avoid conflicts.
Budget Period: It is the length of the period for which a budget is prepared.
The length of the budget period depends on the type of budget, nature of the
product, availability of finance, economic cycle, length of the trade cycle, etc.
Essentials of Budgetary Control
We present here a brief explanation about the essentials of budgetary control.
1. Deciding the Budget Centre: A budget centre is the section of the
organization with respect to which the budgets are prepared. A budget
centre may be in the form of a product, a department or a branch of the
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company and so on. The budget centre should be clearly defined and
established.
2. Deciding the Budget Period: A budget period is the period of time in which
the budget will be prepared and operated. The selection of budget period
should be made very carefully. A too long budget period makes the correct
estimation more difficult while a too short budget period may prove to be
more costly. The selection of budget period may depend upon the nature of
operations and the purpose of preparing the budget. As such, in case of
industries engaged in generation and distribution of electricity, transport
operations, etc., where capital expenditure is too high, budgets may be
prepared even for a period of 5 to 10 years. While in case of industries
engaged in manufacturing of motor vehicles or radios, etc., where the
customer demand may change more frequently, the budget period may be
shorter. Similarly, a sales budget may be prepared for a period of 5 years,
whereas the short-term cash budget may be prepared on a weekly or even
daily basis.
3. Establishment of Accounting Records: There should be an efficient and a
proper system of accounting so that the information and data required for
the efficient implementation of the budgetary control system could be made
available on time.
4. Organisation for Budgetary Control: A properly prepared organisation chart
clearly informs the duties and responsibilities of each level of executive. A
budgetary control organisation is headed by a senior executive as a budget
controller or budget officer. In small or medium-sized organisations,
budger officer performs all types of works of budgetary control system.
However, in case of large organisations, the officer may have a budget
committee under him, which may consist of the chief executive and head s of main
departments. The role of a budget committee may only be advisory and its decision
may become a binding only if accepted by the chief executive. The functions
performed by a budget committee can be broadly stated as follows:
 To receive and scrutinise the functional budgets
 To revise the functional budgets, if necessary
 To approve the revised budgets·
 To receive the budget reports and comparative statements
 To locate the responsibilities and recommend the corrective and remedial
action
Classification of Budget
We present here a brief explanation about the classification of budget.
Budgeting in an undertaking may be done for a particular segment or it may cover
all the activities depending upon the need and resources of the enterprise. The large
scale business enterprises prepare different types of budgets covering almost all
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activities where control is desired. In order to understand the nature of budgets, it

is desirable to know their classification which is usually done on time, functions
and flexibility basis.
According to time, budgets can be of three types viz., (i) Long-term budgets, (ii)
Short-term budgets, and (iii) Current budgets. Long-term budgets are concerned
with planning activities for a long-period -a period of 5 to 10 or more years whereas
short-period budgets cover a period of 1 to 2 years. Current budgets relate to the
current period with in a short period of 1 year. An yearly budget is generally broken
on monthly, quarterly or half-yearly basis for effective implementation of the same
According to functional classification, a budget relates to a particular activity
which can be a selling, production, purchasing or any other activity. The budgets
prepared according to functions are known as functional budgets. The popular
functional budgets prepared in a large scale enterprise are,
1. Sales budget 2. Production budget 3. Purchase budget
4. Capital expenditure budget 5. Overhead cost budgets 6. Cash budget
Research and development budget
On the basis of flexibility, budgets are grouped into two categories, namely
i) Fixed budgets and (ii) Flexible or Variable budgets.
A fixed budget is one which rigidly specifies the targets for a particular level of
activity. The targets are not revised during the budget period irrespective of the fact
that the actual level of activity attained in much different from the budgeted figure.
Consequently the variances are violent and it becomes difficult to isolate the
reasons for variances due to change in the level of activity. Fixed or static budgets
can serve the purpose only if the budgets can be prepared with high degree of
accuracy and budget period is short because the forecast for short period can be
made with reasonable degree of accuracy. On the other hand, a flexible budget is
one which permits the change in accordance with the changes in the level of
activity. According to flexible budgeting, budgets for different levels of activity are
prepared and the management enjoys the benefit of adopting anyone of them
according to changes in the attainment of the level of activity. Thus, the flexible
budget has a series of fixed budgets for different levels of activity. It is always
preferable to prepare flexible budget particularly when the economic conditions
frequently change and it is difficult to forecast with any fair degree of accuracy.
REVISION POINTS
 An estimate of costs, revenues, and resources over a specified period,
reflecting a reading of future financial conditions and goals.
 The establishment of budgets relating the responsibilities of executives to
the requirements of a policy.
 Continuous comparison of the actual performance with that of the budget
so as to know the variations from budget and placing the responsibility of
executives for failure to achieve the desires results as given in the budget.
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 Budgetary control is defined by the Institute of Cost and Management

Accountants (CIMA) as: "The establishment of budgets relating the
responsibilities of executives to the requirements of a policy, and the
continuous comparison of actual with budgeted results, either to secure by
individual action the objective of that policy, or to provide a basis for its
revision".
INDEX QUESTIONS
1. What is “Budget”? What are its essential features?
2. Distinguish between forecasts and budgets.
3. What are essential requisites for budgetary control?
4. What are the merits and limitations of budgetary control?
SUMMARY
In this lesson, we have briefly touched upon the following points. Budget is a
formal quantitative expression of management plan. The process of preparing the
budgets is known as budgeting. Budgetary control is a system of controlling costs
which includes the preparation of budgets, coordinating the departments and
establishing responsibilities, comparing actual performance with the budgeted and
acting upon results to achieve maximum efficiency. Budgetary control provides for
the preparation of variance report which contains a comparatives study of actual
and budgeted figures with variances. It helps to avoid the delays in the
implementation of the business programmes. Budgetary control system suffers
from certain limitations and the management should keep them in view while
adopting and implementing the system.
Estimate is predetermination of future events; Forecast is an assessment of
possible future events. Budget is planning of future events. Both budgets and
forecasts are foreseeing the future events. Still, there are number of differences
between them.
In larger organisations, a budget committee formed to prepare budgets and
implement the budgetary control. Specific segments for preparation of budgets are
known as budget centre. Budget manual is a document which spells out the
responsibilities of various executives concerned with the budgets. The length of the
period for which a budget is prepared is known as budget period. Budgeting in an
undertaking may be done for a particular segment or it may cover all the activities
depending upon the need and resources of the enterprise. It can be classified on the
basis of time, functions and flexibility.
TERMINAL EXERCISES
1. What is the meaning of budget?
2. What is budgeting?
3. What is budgetary control?
4. What are the essentials of budgetary control?
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edition)
ASSIGNMENT
1. Explain the advantages of budgetary control?
2. What are the limitations of budgetary control system?
3. Explain the classification of budget.
REFERENCES
LEARNING ACTIVITIES
KEY WORDS
Budget committee, Budget Centres, Budget Manual and Budget Period

144
LESSON – 10
PREPARATION OF SALES BUDGET

OBJECTIVES
In ninth lesson, we discuss the meaning of budget, budgeting budgetary
control, advantages, limitations, essentials of budgetary control discuss. In this
lesson, we discuss how to prepare sales budget. After going through this lesson you
will able to
 Know how to prepare Sales Budget
CONTENTS
 Introduction
 Sales Budget- Meaning
 Preparation of Sales Budget
INTRODUCTION
The preparation of realistic budgets is essential for success in budgeting.
Budgets are prepared after having set the objectives, goals and strategies for the
achievement of over-all business objectives. In this section, we will study as to how
Sales budget is prepared. The forecasting of sales is not an easy job. It requires a
lot of skill and knowledge in the techniques of sales forecasting, collection of
relevant facts and figure and an understanding of business environment in which
the firm is placed. The techniques of sales forecasting for new products are different
from those used for established products.
Sales Budget- Meaning
In this section, we attempt to make a brief study about meaning of sales
budget. A sales budget is a statement expressed in physical quantities or/and
values of anticipated sales during a specified period of time. Sales forecasting is the
basic step in the preparation of a sales budget. It is done by sales department
under the charge of a sales manager in consultation and cooperation with the
Budget Controller.
The sales data for the last few years are compiled in a form what is known as
'Time Series' which is statistically dealt to fit a trend line and extrapolate the sales
figures for future. This technique is quite simple and widely used by business firms
for the purpose of sales forecasting. However, it can be profitably used only if the
Time Series do not show violent fluctuations and corrections are rightly made for
seasonal and stochastic variations. The sales force i.e. salesmen, selling agents and
sales managers, being in actual field of selling activity, can contribute a lot in
correct forecasting of sales by sending their assessment of sales to head office for
the budget period. The management should accept the estimated figures as
reported by sales personnel only after due allowance for subjectivity of field staff.
Preparation of Sales Budget
In this section, we prepared few sales budgets for your understanding
145
Illustration – 1
Ranjitha Ltd produces two products, Vikram and Veda. There are two sales
divisions, North and South.Budgeted sales for the year ended 31st December 2020
are as follows.
Division Products Units Price per unit ( Rs).

North Vikram 25,000 10
Veda 15,000 5
South Vikram 24,000 10
Veda 30,000 5
Actual sales for the said period were:
Product North South

Alpha 28,000 units of Rs. 10 each 25,000 units of Rs. 10 each
Beta 18,000 units of Rs. 5 each 33,000 units of Rs. 5 each
On the basis of assessments of the salesmen the following are the observations
of sales division for the year ending 31stDecember 2021.
North Zone Vikram Budgeted increase of 40% on 2020 budget.
Veda Budgeted increase of 10% on 2020 budget
South Zone Vikram Budgeted increase of 12% on 2020 budget
Veda Budgeted increase of 15% on 2020 budget
It was further decided that because of the increase sales campaign in North an
additional sales of 5,000 units product will result. Prepare a sales budget for the
year 2021.
Solution
Sales Budget
Budgeted sales Budgeted sales for Actual sales for
for 2021 2020 2020
Products
Division
Selling
Selling
Selling
Price
Price
Price
Total Total Total

Qty. Qty. Qty.
Rs. Rs. Rs. Rs. Rs. Rs.

Vikra
North 38,125 10 3,81,250 25,000 10 2,50,000 28,000 10 2,80,000
m
Veda 18,375 5 91,875 15,000 5 75,000 18,000 5 90,000
Total 56,500 4,73,125 40,000 3,25,000 46,000 3,70,000
Vikra
South 26,880 10 2,68,800 24,000 10 2,40,000 25,000 10 2,50,000
m
Veda 34,500 5 1,72,500 30,000 5 1,50,000 33,000 5 1,65,000
Total 61,380 4,41,300 54,000 3,90,000 58,000 4,15,000
Vikra
Total 65,005 6,50,050 49,000 4,90,000 53,000 5,30,000
m
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(Summary) Veda 52,875 2,64,375 45,000 2,25,000 51,000 2,55,000

Total 1,17,880 9,144,25 94,000 7,15,000 1,04,000 7,85,000
Working Note:
North zone
Budgeted sales of Vikram for 2009 25,000 units
Add: Increase of 40% on 2009 10,000 units
Total sales 35,000 units
Budgeted sales of Veda for 2009 15,000 units
Add: Increase of 10% on 2009 budget 1,500 units
South zone
Budgeted sales of VIKRAM for 2009 24,000 units
Add: Increase of 12 % on 2009 budget 2,880 units
Budgeted sales of Veda for 2009 30,000 units
Add: Increase of 15 % on 2009 budget 4,500 units
The proposed sales campaign in North division
will increase additional sales of 5,000 units. It is
shared between Vikram and Veda in the ratio of
budgeted sales (2009) i,e 25,000 : 15,000 (5 : 3)
Vikram = 5,000 x 5 / 8 = 3,125 units
Veda = 5,000 x 3/8 = 1,875 units
Total budgeted sales in north zone for the year 2009
Vikram = 35,000 units + 3,125 units = 38,125 units
Veda = 16,500 units + 1,875 units = 18,375 units
Illustration – 2
Ajith Kumar Ltd manufactures two products Thala and AK and sells them
through two divisions East and West. For the purpose of submission of sales
budget to the budget committee the following information has been made available.
Budgeted sales for the current year were :
Product East West
Thala 400 at Rs.9 600 at Rs.9
AK 300 at Rs. 21 500 at Rs. 21
Actual sales for the current year were:
Product East West

Thala 500 at Rs.9 700 at Rs.9
AK 200 at Rs. 21 400 at Rs. 21
Adequate market studies reveal that product Thala is popular but under
priced, it is observed that if price of Thala is increased by Re. 1 it will find a ready
market. On the other hand, AK is over-priced to customers to market could absorb
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more if sales price of AK be reduced by Re. 1. The management has agreed to give
effect to the above price changes. From the information based on these price
changes and reports from salesmen, the following estimates have been prepared by
divisional managers.
Product East West

Thala + 10 % +5%
AK + 20 % + 10 %
With the help of an intensive advertisement campaign, the following additional
sales above the estimated sales of divisional managers are possible.
Product East West

Thala 60 70
AK 40 50
You are required to prepare Budget for Sales incorporating the above estimates
and also show the budgeted and actual sales of the current year.
Solution
Sales Budget
Budgeted sales for Budgeted sales for Actual sales for
future period current period current period
Division
Product
Selling
Selling
Selling
Value
Value
Value
Price
Price
Price
Unit
Unit
Unit

East Thala 500 10 5,000 400 9 3,600 500 9 4,500
AK 400 20 8,000 300 21 6300 200 21 4,200
Total 900 13,000 700 9,000 700 8,700
West Thala 700 10 7,000 600 9 5,400 700 9 6,300
AK 600 20 12,000 500 21 10,500 400 21 8,400
Total 1,300 19,000 1,100 15,900 1,100 14,700
Total THALA 1,200 10 12,000 1,000 9 9,000 1,200 9 10,800
AK 1,000 20 20,000 800 21 16,800 600 12 12,600
Total 2,200 32,000 1,800 25,800 1,800 23,400
East + West = Total
Thala 500 + 700 = 1,200
AK 400 + 600 = 1,000
Working Note:
East
Budgeted sales of Product Thala 400 units
Add: Increase in sales over current budget is 10% 40 units
Add: Increase in sales due to advertisement 60 units
Estimated sales of Thala 500 units
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Budgeted sales of Product AK 300 units

Add: Increase in sales over current budget is 20 % 60 units
Estimated sales of AK 400 units
West
Budgeted sales of Product Thala 600 units
Add: Increase in sales over current year budget is5 % 30 units
Estimated sales of Thala 700 units
Budgeted sales of Product AK 500 units
Add: Increase in sales over current year budget is 10 % 50 units
Add: Increase in the sales due to advertisement 50 units
Estimated sale of AK 600 units
REVISION POINTS
 A sales budget is a detailed schedule showing the expected sales for the budget
period; typically, it is expressed in both Rupees and units of production.
 Sales budget= Opening stock +Purchases-Closing stock
INDEX QUESTIONS
1. Novel Products Ltd. sells two products A and B in the North and South
zones of the market. The following were the actual sales for the year ended
31-12-2020.
North Zone South Zone
Product Units Price Units Price
Rs. Rs
A 20,000 20 30,000 20
B 25,000 30 40,000 30
For the year 2021, it is expected that sales of A and B will increase by 20%
in the normal process. A special advertising campaign is expected to fetch
an additional 25% in the sales of product A in both zones. The selling price
of A is unchanged but the price of B is to be increased by Rs. 2 per unit
which is expected to have no Special effect on sales.
Prepare a sales budget for the year 2021 along with the actual results of
the year 2020.
2. Kumar Ltd sells two products R and P which are manufactured in one plant.
During the year 2020 it plans to sell the following quantities of each product.
Sales Budget units

First quarter Second quarter Third quarter Fourth quarter
Product R 90,000 2,50,000 3,00,000 80,000
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Product P 80,000 75,000 60,000 90,000

Each of these two products is sold on a seasonal basis. The company plans
to sell product 'R' throughout the year at a price of Rs. 10 per unit and
product 'P' at a price of Rs. 20 per unit. A study of the post experience
reveals that company has lost 3% of its billed revenue each year because of
returns, (constituting 2% of loss of revenue) allowances and bad debts (1 %
loss). Prepare a sales budget incorporating the above information.
SUMMARY
In this lesson, we have briefly touched upon the following points: In the budgeting
process, sales are a starting point, as sale a key factor in many cases. This is probably
the most difficult functional budget to prepare. The problem with preparation of sales
budget lies in correct forecasting and estimation of sales quantity, and this will be
more complicated, if the sales budget is to be done for a new product.
TERMINAL EXERCISES
1. What is sales budget?
ASSIGNMENT
1. How to prepare sales budget? Explain.
REFERENCES
LEARNING ACTIVITIES
KEY WORDS
Violent fluctuations and forecasting of sales

150
LESSON – 11
PREPARATION OF PRODUCTION AND PURCHASE BUDGETS

OBJECTIVES
After going through this lesson you will able to
 understand the meaning of production, production cost budget and
purchase budgets
 Know how to prepare production, production cost budget and purchase
budgets
CONTENTS
 Production Budget
 Format of the production budget
 Production Cost Budget
 Purchase budgets
 Format of Purchase budget
INTRODUCTION
In tenth lesson, we discuss the meaning of sales budget and methods of
preparation of sales budget. In this lesson, we discuss the meaning of production,
production cost budget and purchase budgets and also discuss methods of
preparation of Production, production cost budget and purchase budgets
Production Budget
In this section, we attempt to make a brief study about meaning of production
budget. The production budget deals with the amount of goods to be produced
during the budget period. Sales budget is the forerunner of production budget. It
suggests the quantities which should be produced in order to maintain sales and
delivery schedules. Other considerations in the preparation of a production budget
are the opening and desired closing inventories, installed plant capacity and
existing utilization, availability of necessary production inputs, production cycle
and production policy of management. An analysis of the above factors will suggest
the amount of goods that can be produced within the factory. If the calculated
production is less than the budgeted sales, then the firm will not be in a position to
maintain the sales budget and earn sufficient profits for which potential exists.
Format of the Production Budget
In this section, we explain format of the production budget
Estimated sales xxx
Add: Desired closing stock xxx
xxx
Less: Estimated opening stock xxx
Desired Production xxx
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Illustration – 1
From the following information you are required to prepare a production
budget for the half year ending 30th June 2020
Product Budgeted sales (Unit) Opening stock (Units) Desired closing stock
(Units)
A 3,000 500 1,000
B 2,000 100 600
C 2,500 500 1,500
D 4,000 1,000 500
Solution
Preparation of Production Budget
Particulars Product Product Product Product
A B C D
Estimated sales 3,000 2,000 2,500 4,000
Add: Desired closing stock 1,000 600 1,500 500
4,000 2,600 4,000 4,500
Less: Estimated opening stock 500 100 500 1,000
Desired Production 3,500 2,500 3,500 3,500
Illustration 2 M/s. Priyanka Ltd. plans to sell 20,000 units in the first
quarter, 30,000 units in the second quarter, 40,000 units in the third quarter,
50,000 units in the fourth quarter 40,000 units in the first quarter of the next year.
At end of each quarter the company plans to have an inventory equal to one fifth of
the sales of the next quarter. Calculate number of units must be manufactured in
each quarter of the current year.
Production Budget
Particulars First Second Third quarter Fourth
quarter quarter quarter
Estimated sales in units 20,000 30,000 40,000 50,000
Add: Desired closing stock 6,000 8,000 10,000 8,000
26,000 38,000 50,000 58,000
Less: Estimated opening stock 4,000 6,000 8,000 10,000
Production 22,000 32,000 42,000 48,000
Production Cost Budget
We present here a brief explanation about production cost budget. The
production cost budget is prepared to know the estimated expenditure on the
budgeted production as set out in production budget. The production cost consists
of the cost of raw materials, labour and production overhead costs. Therefore, the
Production Cost Budget includes the cost of each of these components on the
budgeted production.
Illustration – 3
From the following particulars prepare a production budget and production
cost budget for the period of six months ending 30th June 2021.
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a. No. of units to be sold for different months are as follows

Months Units
January 2,200
February 2,400
March 2,800
April 3,000
May 4,000
June 3,200
July 3,600
b. Finished units equal to half the sales for the next month will be the stock at
the end of each month (including previous year December 2020).
c. Budgeted production and production cost for the year ending 31-12-2021 are;
 Production = Rs. 44,000 (units)
 Direct material per unit= Rs. 6
 Direct labour per unit= Rs. 15
 Total factory overhead apportioned to product = Rs. 1,76,000
Solution
Note:
Finished units equal to half the sales for the next month will be the stock at
end of each month (including previous year December 2020). Assume the opening
stock of each month is the closing stock of the previous month. December closing
stock is ½ of January sales. July month sales are given for the purpose of
calculation of closing stock for the month of June.
Production Budget
th
For 6 months ending 30 June 2021 (In units)
Jan Feb March April May June
Estimated sales 2,200 2,400 2,800 3,000 4,000 3,200
Add Desired closing stock 1,200 1,400 1,500 2,000 1,600 1,800
3,400 3,800 4,300 5,000 5,600 5,000
Less Estimated opening stock 1,100 1,200 1,400 1,500 2,000 1,600
Budgeted Production 2,300 2,600 2,900 3,500 3,600 3,400
Total production for 6 months ending 30th June.
2,300 + 2,600 + 2,900 + 3,500 + 3,600 + 3,400 = 18,300 units
Working Note
Total Factory overhead for the year = Rs. 1,76,000
Total Production for the year = Rs44,000 units
Factory over head per unit= Total factory overhead / Total production
=1,76,000 / 44,000 =Rs. 4
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Production Cost Budget
Particulars No. of Units Cost per unit Total cost

Direct material 18,300 6 1,09,800
Direct wages 18,300 15 2,74,500
Factory over head 18,300 4 73,200
Total production cost 4,57,500
Purchase Budgets
We present here a brief explanation about raw materials purchase budget .The
raw materials purchase budget represents the physical quantities of different types
of raw materials and other components which must be purchased during a given
time period for the maintenance of production schedules. It also shows the money
values required to purchase the budgeted raw materials. The quantities which must
be purchased are arrived at only after the consideration of the opening and closing
inventories of raw materials. The purchases to be made are also governed by the
storage capacity and availability of necessary finances
Format of Purchase Budget
In this section, we present the format of purchase budget
Estimated Raw materials consumed xxx
Add: Desired closing stock of raw materials xxx
xxx
Less: Estimated opening stock of raw materials xxx
Estimated Purchase xxx
Illustration– 4
From the following figures, prepare a material purchase budget for the month
of January 2021.
Material A Material B
Estimated material consumption 24,000 8,800
Estimated opening stock 3,200 1,200
Estimated closing stock 4,000 1,600
Solution
Material Purchase Budget
Add: Estimated closing stock 4,000 1,600
28,000 10,400
Less: Estimated opening stock 3,200 1,200
Estimated Purchase 24,800 9,200
Illustration – 5
Draw a material procurement budget from the following information.
Estimated sales of a product 10,000 Units. Each unit of the product requirement 2
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units of material R and 3 units of material M. Estimate opening balances at the

commencement of the next year.
Finished product 2,000 units
Material R 4,000 units
Material M 6,000 units
The desirable closing balances at the end of the next year.
Material R 5,000 units
Solution
Particulars Finished Product
( Units)
Estimated sales 10,000
Add: Desired closing stock 5,000
15,000
Less: Estimated opening stock 2,000
Desired Production 13,000
Particulars Material R Material M
(13,000 x 2 = 26,000)
(13,000 x 3 = 39,000)
31,000 45,000
Estimated Purchase 27,000 39,000
Illustration – 6
Draw a material procurement budget (quantitative budget) from the following
information.
Estimated sales of a product 40,000 Units. Each unit of the product
requirement 3 units of material A and 5 units of material B.
Estimate opening balances at the commencement of the next year.
Material A 12,000 units
Material B 20,000 units
Materials on order
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Material on order
Solution
Particulars Finished Product
( Units)
Estimated sales 40,000
Add: Desired closing stock 7,000
47,000
Less: Estimated opening stock 5,000
Desired Production 42,000
Particulars Material A Material B
Estimated material consumption 1,26,000 2,10,000
(42,000 x 3 =1,26,000)
(42,000 x 5 = 2,10,000)
A= (15,000 + 8,000)
B=(25,000+ 10,000)
1,49,000 2,45,000
A= (12,000 + 7,000)
B=(20,000+ 11,000)
Estimated Purchase 1,30,000 2,14,000
Note: Material on order are treated as stocks
REVISION POINTS
 Production budget deals with the amount of goods to be produced during
the budget period
 Purchase = Sales + Closing Stock - Opening Stock
INDEX QUESTIONS
1. Vijay Ltd. plans to sell 12,000 units in the first quarter, 26,000 units in the
second quarter, 38,000 units in the third quarter, 48,000 units in the
fourth quarter 37,000 units in the first quarter of the next year. At end of
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each quarter the company plans to have an inventory equal to 20% of the
sales of the next quarter. Calculate number of units must be manufactured
in each quarter of the current year.
2. From the following particulars prepare a production budget and production
cost budget for the period of six months ending 30th June 2020
a) No. of units to be sold for different months are as follows
Months Units
January 1,000
February 2,000
March 2,500
April 2,800
May 3,800
June 3,000
July 3,200
b) Finish ed units equal to half the sales for the next month will be the
stock at the end of each month (including previous year December
2019).
c) Budge ted production and production cost for the year ending 31-12-
2020 are;
i) Production= Rs. 11,000 (units)
ii) Direct material per unit= Rs. 4
iii) Direct labour per unit= Rs. 6
iv) Total factory overhead apportioned to product = Rs. 55,000
3. Draw a material procurement budget from the following information
requirement 3 units of material P and 4 units of material M.
Material P 5,000 units
Material P 6,000 units
4. Draw a material procurement budget from the following information.
requirement 5 units of material X and 4 units of material Y.
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Material X 10,000 units
Material Y 18,000 units
Materials on order
Material on order
Material X6,000 units
Material Y8,000 units
SUMMARY
In this lesson, we have briefly touched upon the following points
The production budget deals with the amount of goods to be produced during
the budget period. It can be prepared by adding closing finished goods with sales
and deducting opening stocks. The production cost budget is prepared to know the
estimated expenditure on the budgeted production as set out in production budget.
The raw materials purchase budget represents the physical quantities of different
types of raw materials and other components which must be purchased during a
given time period for the maintenance of production schedules
TERMINAL EXERCISES
1. What is production budget?
2. Give a format of production budget?
3. What is production cost budget?
4. Explain the term purchase budget?
5. Give a format of purchase budget with example.
ASSIGNMENT
1. Give a format of production budget?
2. Give a format of purchase budget with example.
158
REFERENCES
LEARNING ACTIVITIES
organization
KEY WORDS
Material consumed and Material on order

159
LESSON – 12
PREPARATION OF CASH AND FLEXIBLE BUDGETS

OBJECTIVES
 understand the meaning of cash budget and flexible budgets
 Know how to prepare cash budget and flexible budgets
CONTENTS
 Cash Budget - Meaning
 Cash inflows and outflows
 Methods of preparation of Cash Budget
o Receipt and Payment Method
o Adjusted Profit and Loss Method
o Balance Sheet Method
 Flexible Budgets
INTRODUCTION
In eleventh lesson, we discussed the meaning of production budgets,
production cost budget and purchase budgets and also discussed methods of
preparation of production budgets, production cost budget and purchase budgets.
In this lesson, we discuss the meaning of cash budget and flexible budget and also
discuss methods of preparation of cash budget and flexible budgets.
Cash Budget - Meaning
In this section, we attempt to make a brief study about meaning of cash
budget. A cash budget deals with the expected cash inflows and cash outflows
during a specified period of time for which the budget is prepared. The budget
officer forecasts the cash flows and cash requirements during budget period which
must syncronize with the periods of other functional budgets as most of the
information for cash budget are derived from other budgets. The cash budget
enables the management to arrange the deficit cash balance well in time for
maintaining operational efficiency of the enterprise. Similarly, surplus cash balance
as shown in the budget at the end of any period can be invested in temporary
investments. Thus cash planning in an enterprise is effective only when cash
budget is in operation. This budget is prepared by adding expected incomes with
opening cash balance and deducting desired payments. The difference of cash
receipts and cash payments for a period is either positive or negative, which is
carried to next period.
Cash Inflows and Outflows
We present here a brief list of cash inflows and cash outflows. The possible
sources of cash inflows are: (a) cash sales, (b) realisation from debtors, (c) issue of
shares and debentures, (d) raising loans, (e) sales of investments: (f) sale of any
fixed asset.
160
The cash-outflow results due to(i) purchase of raw materials, (ii) payment of
wages, (iii) disbursement of overheads, (iv) purchases of fixed assets and
investments, (v) redemption of debentures and loans, (vi) payment of dividend, (vii)
discharge of tax obligations, etc.
Methods of Preparation of Cash Budget
We present here a brief explanation about different methods of preparation of
cash budget. A cash budget may be prepared by using anyone of the following
methods:
(1) Receipt and Payment method,
(2) Adjusted Profit and Loss method,
(3) Balance Sheet method.
Receipt and Payment Method
According to this method, Cash Budget includes all the cash receipts
whether they are on revenue account or capital account. Similarly all expected
capital and revenue expenditures are brought in a cash budget. The accruals i.e.
income earned but not received and expenditure due but not paid are excluded
from the cash budget. Thus a cash budget is a sort of cash account which records
cash receipts and cash payments and shows expected cash balance at the end of
the budget period. The management can forecast payments on account of capital
expenditure, tax, dividend, etc. The difference of cash receipts and cash payments
for a period is either positive or negative, which is carried to next period.
Adjusted Profit and Loss Method
Under this method the profit as shown in the Profit and Loss Account prepared
in the conventional manner forms the basis for cash forecast. The profit is adjusted
by adding back to it the non-cash items such as depreciation, outstanding
expenses, other provisions etc. The other items which increase the total cash
inflows are the increase in share capital, debenture and loans, current liabilities
(creditors) and decrease in fixed assets, debtors and stock etc. Out of the total
cash-inflows calculated as above, the items which results in cash outflow are
subtracted to arrive at the cash position at the end of the period. The items which
reduce the cash position are accrued incomes, advance payments, dividend
payment, redemption of debentures and loans, decrease in creditors, payment for
fixed assets, increase in debtors and stock etc.
Balance Sheet Method
Under-this method a projected Balance Sheet is prepared in which cash
balance is not an estimated item but a difference between total projected assets and
total estimated liabilities. In other words, the excess of projected assets over
projected liabilities represents cash balance. If the liabilities are more than the
assets, the balance shows the overdraft.
161
Illustration – 1
A firm expects to have Rs. 30,000 as opening balance on 1stMay 2020 and
requires you to prepare an estimate of the cash position for 3 months May to July
2020. The following information is supplied to you.
Factory Office Selling

Sales Purchases Wages
Month Expenses Expenses Expenses
March 40,000 24,000 6,000 3,000 4,000 3,000

April 46,000 28,000 6,500 3,500 4,000 3,500
May 50,000 32,000 6,500 4,000 4,000 3,500
June 72,000 36,000 7,000 4,400 4,000 4,000
July 84,000 40,000 7,250 4,250 4,000 4,000
Other Information
i. 25 % of the sales is for cash, remaining will be collected in the month
following that of sales.
ii. Suppliers supply goods on two months credit.
iii. Delay in payment of wages and all others expenses is: One month
iv. Income taxRs. 10,000 is due and to be paid in July.
v. Preference share dividend of 10% on Rs. 1,00,000 is to be paid in May.
Solution
Working Note 1
25 % of the sales are cash sales; remaining 75% of the sales are credit and will
be collected in the month following that of sales.
Sales in March Sales in April Sales in May Sales in June Sales in July
40,000 Rs. 46,000 Rs. 50,000 Rs. 72,000 Rs. 84,000
25 % 75% 25 % 75% 25 % 75% 25 % 75% 25 % 75%
cash credit cash credit cash credit cash credit cash credit
sales sales sales sales sales sales sales sales sales sales
10,000 30,000 11,500 34,500 12,500 37,500 18,000 54,000 21,000 63,000
Collection from
30,000 34,500 37,500 54,000
debtors
Working Note2
Credit period allowed by the suppliers two month.
March April May June July Aug Sep

Purchase 24,000 28,000 32,000 36,000 40,000 - -
Amount paid on - - 24,000 28,000 32,000 36,000 40,000
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Working Note 3
Delay in payment of wages and all other expenses is one month.
Expenses March April May June July August
Wages 6,000 6,500 6,500 7,000 7,250
Factory expenses 3,000 3,500 4,000 4,400 4,250
Office expenses 4,000 4,000 4,000 4,000 4,000
Selling expenses 3,000 3,500 3,500 4,000 4,000
To be paid on 6,000 6,500 6,500 7,000 7,250
3,000 3,500 4,000 4,400 4,250
4,000 4,000 4,000 4,000 4,000
3,000 3,500 3,500 4,000 4,000
Cash Budget for Three Months from May to July
Particulars May June July
Rs. Rs. Rs.
Opening cash balance 30,000 25,000 35,000
Add Receipts
Cash sales 12,500 18,000 21,000
Collection from debtors 34,500 37,500 54,000
Total receipts (A) 77,000 81,000 1,10,000
Less Payments
Payments to creditors 24,000 28,000 32,000
Wages 6,500 6,500 7,000
Factory expenses 3,500 4,000 4,400
Office expenses 4,000 4,000 4,000
Selling expenses 3,500 3,500 4,000
Income tax - - 10,000
Preference dividend 10,000 - -
Total payments (B) 51,500 46,000 61,400
Closing cash balance (A - B) 25,500 35,000 48,600
Illustration – 2
Prepare a cash budget for the months for May, June and July 2021 on the
basis of the following information. Income and Expenditure forecasts
Credit Credit Wages Manufacturing Office Selling
Month sales purchases Expenses Expenses Expenses
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8.500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,5000
August 60,000 34,000 8,000 3,000 1,500 4,000
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i. Cash balance on 1st May 2021 Rs.8,000/-

ii. Plant costing Rs.16,000/- is due for delivery in July: Payable 10% on
delivery, the balance after 3 months.
iii. Advance tax of Rs.8,000/- each is payable in March and June
iv. Period of credit allowed (i) by suppliers two months and (ii) to customers
one month
v. Lag in payment of manufacturing expenses ½ month
vi. Lag in payment of office and selling expenses 1 month
Solution
Cash Budget for 3 Months from May To July
Particulars May June July
Rs Rs Rs
Opening cash balance 8,000 13,750 12,250
Add Receipts
Collection from debtors 62,000 64,000 58,000
(A) 70,000 77,750 70,250
Less Payments
Payments to creditors 36,000 38,000 33,000
Wages 10,000 8,500 9.500
Manufacturing expenses 3,750 4,000 3,750
Office expenses 1,500 2,500 2,000
Selling expenses 5,000 4,500 3,500
Capital expenses (plant) - - 1,600
Advance tax - 8,000 -
(B) 56,250 65,500 53,350
Closing cash balance (A - B) 13,750 12,250 16,900
Illustration – 3
From the following budgeted figures prepare a cash budget for three months to
June 30.
Months Sales Rs. Materials Rs. Wages Rs. Overheads Rs.

January 60,000 40,000 11,000 6,200
February 56,000 48,000 11,600 6,600
March 64,000 50,000 12,000 6,800
April 80,000 56,000 12,400 7,200
May 84,000 62,000 13,000 8,600
June 76,000 50,000 14,000 8,000
Expected cash balance on 1st April - Rs. 20,000
Other Information
i. Materials and overheads are to be paid during the month following the
month of supply.
ii. Wages are to be paid during the month in which they are incurred.
164
iii. Terms of Sales: The terms of credit sales are payments by the end of the
month following the month of sales, ½ of the sales are paid when due the
other half to be paid during the next month, 5% salary commission is to be
paid within the month following actual sales.
iv. Preference dividend of Rs. 30,000 is to be paid on 1st July.
v. Share call money of Rs. 25,000 is due on 1st April and 1st June.
vi. Plant and Machinery worth Rs. 10,000 is to be installed in the month of
January and the payment is to made in the month of June.
Solution
Cash Budget for 3 Months from April to June
Particulars April May June
Rs Rs Rs
Opening cash balance 20,000 32,600 - 5,600
(Bank o/d)
Add Receipts
Collection from Debtors 60,000 72,000 82,000
Share call money 25,000 - 25,000
(A) 1,05,000 1,04,600 1,01,400
Less payments
Payments for material 50,000 56,000 62,000
Wages 12,400 13,000 14,000
Overhead 6,800 7,200 8,600
Sales commission 3,200 4,000 4,200
Preference Dividend - 30,000 -
Capital Expenses (Plant) - - 10,000
(B) 72,000 1,10,200 98,800
Closing cash balance (A – B) 32,600 - 5,600 2,600
(BankO/D)
Illustration – 4
The following data is made available to you to prepare a cash budget under the
adjusted profit and loss method.
st
Balance Sheet as on 31 March 2021
Liabilities Rs. Assets Rs.
Share capital 2,00,000 Building 1,25,000
Debentures 75,000 Machinery 75,000
Reserves 35,000 Furniture & fixtures 55,000
Profit & Loss a/c 20,000 Debtors 25,000
Creditors 60,000 Bills receivables 20,000
Bill Payables 20,000 Closing stock 45,000
Bank balances 65,000
4,10,000 4,10,000
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Projected Trading and Profit and Loss Account for the year ending 31st March 2021
To Opening stock 35,000 By Sales 4,20,000
To Purchase 2,20,000 By Closing stock 85,000
To Carriage 12,000
To Gross profit c/d 2,38,000
5,05,000 5,05,000
To Establishment 1,00,000 By Gross Profit b/d 2,38,000
To Discount 12,000 By Commission 12,000
To Administrative exp. 38,000 By Interest 10,000
To Distribution exp. 22,000
To Depreciation on 16,000
machinery
To Advertisement 18,000
To Net profit c/d 54,000
2,60,000 2,60,000
To Dividend 22,000 By Balance of profit from 20,000
last year
To Balance c/d 52,000 By Net profit b/d 54,000
74,000 74,000
The closing balance of certain items as on 31st March 2022 is also given as
additional information.
Share capital Rs. 2,40,000
Debentures Rs. 90,000
Building Rs. 1,40,000
Machinery Rs. 80,000
Bills payables Rs. 25,000
Solution
Cash Budget
Particulars Rs. Rs.
Cash balance as on 1st April, 2022 65,000
Add: Additions
Net profit of the year 54,000
Depreciation 16,000
Issue of share capital 40,000
Issue of debentures 15,000
Increase in B/P 5,000
1,30,000
Cash available 1,95,000
Less: Deduction
Dividend 22,000
Purchase of building 15,000
Purchase of machinery 5,000
Increase in stock 40,000 82,000
Closing balance as on 31st March, 2022 1,13,000

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Flexible Budgets
In this section, we attempt to make a brief study about meaning of flexible
budgets. Fixed budgets are prepared for a specific level of activity. Such budgets are
based on the assumption that the future can be forecast with certainty and there is
no significant difference between actual performance and budgeted data. In actual
practice, the assumption of accurate forecasting does not hold good, particularly
when the future is distant and economic environment full of uncertainties.
Consequently the actual level of activity attained is different from the budgeted one
and the comparison between budgeted and actual data will be unrealistic as it will
throw no light on the variations arising due to the change in the actual level of
activity. In order to remove rigidity and introduce flexibility in budgeting flexible
budgets are prepared. A flexible budget also known as variable or sliding scale
budget is one which permits adaptability in accordance with the changes in the
level of production. It is prepared for varying levels of production activity and thus
provides a realistic basis for comparing performance of different
departments/products.
The preparation of a flexible budget is not difficult. Actually there is no
difference between the preparation of a fixed budget and flexible budget except that
in the later case costs and other data are estimated for varying levels of activity. In
other words, a flexible budget consists of a series of fixed budgets. The element of
fixed cost in the total cost makes a lot of the targets for the consideration of
decision-makers. In case of a manufacturing concern the target may be to achieve a
certain rate of profit on capital employed (ROI) but the targets for non-profit making
government organisation will depend upon the nature of work they carry out. For
example, the over-all objective of expenditure on literacy programme may be fixed
as increasing the literacy rate from 50 per cent to 60 per cent during the budget
period. Similarly, the objective of expenditure may be set as an increase in the ratt;
of employment, bringing additional land under cultivation of a particular crop,
extension of areas under forests, etc. But the targets have to be interpreted in
physical terms so that the effectiveness of expenditure is judged from the
comparison of actuals with the budgeted figures.
Illustration – 5
The following are budgeted expenses for the production of 10,000 units
Per unit (Rs)
Material 60
Labour 30
Variable overheads 25
Fixed overheads (Rs. 1,50,000) 15
Variable expenses (direct) 5
Selling expenses (10% fixed) 5
Administration expenses (Rs. 50,000 fixed) 5
Distribution expenses (20% fixed) 5
Total 150
Prepare a budget for the production of 8,000 units and 6,000 units.
167
Solution
Flexible Budget
10,000 units 8,000 units 6,000 units
Particulars Per Total Per Total Per Tota
unit Rs. unit Rs. unit Rs.l
Variable Cost
Material 60 6,00,000 60 4,80,000 60 3,60,000
Labour 30 3,00,000 30 2,40,000 30 1,80,000
Variable OH 25 2,50,000 25 2,00,000 25 1,50,000
Variable expenses 5 50,000 5 40,000 5 30,000
Semi Variable Cost
Selling Expenses:
Variable (90%) 4.50 45,000 4.50 36,000 4.50 27,000
Fixed (10%) 0.50 5,000 0.625 5,000 0.833 5,000
Distribution Expenses:
Variable (80%) 4 40,000 4 32,000 4 24,000
Fixed 20% 1 10,000 1.25 10,000 1.667 10,000
Fixed Cost
Fixed over head 15 1,50,000 18.75 1,50,000 25 1,50,000
Administration expenses 5 50,000 6.25 50,000 8.333 50,000
Total 150 15,00,000 155.375 12,43,000 164.333 9,86,000
Illustration – 6
On the basis of the following particulars draw up a flexible budget for overhead
expenses and determine the overhead rates at 70%, 80% and 90% plant capacity.
Particulars Plant Capacity
70%Rs. 80%Rs. 90%Rs.
Variable Overhead: Indirect Labour - 36,000 -
Indirect Material - 12,000 -
Semi Variable Overheads: Power (30% fixed) - 60,000 -
Repairs (40% fixed) - 6,000 -
Fixed Overheads: Depreciation - 33,000 -
Insurance - 9,000 -
Salaries - 30,000 -
Total Overhead expenses 1,86,000
Estimated direct labour hours 1,24,000
Solution
Flexible Budget
Particulars 70% Capacity 80% Capacity 90% Capacity
Variable Cost: Indirect Labour 31,500 36,000 40,500
Indirect Material 10,500 12,000 13,500
Semi Variable Cost: Power Variable 36,750 42,000 47,250
Fixed 18,000 18,000 18,000
Repairs Variable 3,150 3,600 4,050
Fixed 2,400 2,400 2,400
Fixed Overheads: Depreciation 33,000 33,000 33,000
Insurance 9,000 9,000 9,000
Salaries 30,000 30,000 30,000
Total 1,74,300 1,86,000 1,97,700
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Estimated Labour hours at 80% capacity= 1,24,000 hours

Labour hour for 1%1,24,000 / 80= 1,550
Labour hour for 70% = 1550 x 70= 1,08,500 hours
Labour hour for 90%=1550 x 90= 1,39,500 hours
Over head rate
Over head rate = Total overhead / Labour hours
70% Capacity= Rs. 1,74,300 / 1,08,500 hours = 1.606 per hour
80% Capacity= Rs. 1,86,000/ 1,24,000 hours= 1.5 per hour
90% Capacity= Rs. 1,97,700 /1,39,500 hours = 1.417 per hour
Illustration – 7
The following are information relating to the productive activities of Ranjitha.
Ltd., for three months ended 31 December, 2021.
Fixed Expenses Rs.
Management Salaries 2,10,000
Rent and Taxes 1,40,000
Depreciation of Machinery 1,75,000
Sundry Office Expenses 2,22,500
7,47,500
Semi-Variable Expenses at 50% capacity :
Plant Maintenance 62,500
Indirect Labour 2,47,500
Salesmen's Salaries 72,500
Sundry Expenses 65,000
4,47,500
Variable Expenses at 50% capacity
Materials 6,00,000
Labour 6,40,000
Salesmen's Commission 95,000
Total 13,35,000
It is further noted that semi-variable expenses remain constant between 40%
and 70% capacity, increase by 10% of the above figures between 70% and 85%
capacity and increase by 15% of the above figures between 85% and 100% capacity.
Fixed expenses remain constant whatever the level of activity may be. Sales at 60%
capacity are Rs. 25,50,000 at 80% capacity Rs. 34,00,000 and 100%capacity .Rs.
42,50,000.Assuming that all items produced are sold, prepare a flexible budget at
60%, 80% and 100% production capacity.
Solution:
Working Note 1 : Variable cost for 50% capacity
Materials50% capacity = Rs. 6,00,000
6,00,000
Material for 1% =  = 12,000
50
Material for 60% = 12,000 x 60 = 7,20,000
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Material for 80% = 12,000 x 80 = 9.60,000

Material for 100% = 12,000 x 100 = 12,00,000
In this manner we calculate all other variable cost for different levels of activities
Semi Variable Cost
Working Note 4
Semi variable expenses remain constant between 40% and 70% capacity
Semi Variable cost for 50% capacity
Total semi variable cost for 50% is 4,47,500. It is increase by 10% between
70% and 85% levels.
Plant and maintenance for 50% = 62,500
Add: 10% Increase(62,500 x 10/100 ) = 6,25068,750
Working Note 6
Total semi variable cost for 50% is 4,47,500.It is increase by 15% between 85%
and 100% levels.
Plant and maintenance for 50% = 62,500
Add: 15% Increase (62,500 x15/100 )= 9,375 71,875
In this manner we calculate all other semi variable cost for different levels of activities
Note
Fixed expenses remain constant whatever the level of activity may be.
Flexible Budget
Capacity level
Particulars
50% 60% 80% 100%
Variable cost Rs Rs Rs Rs
Material 6,00,000 7,20,000 9.60,000 12,00,000
Labour 6,40,000 7,68,000 10,24,000 12,80,000
Salesman's commission 95,000 1,14,000 1,52,000 1,90,000
Total variable cost (A) 13,35,000 16,02,000 21,36,000 26,70,000
Semi-variable cost
Plant maintenance 62,500 62,500 68,750 71,875
Indirect Labour 2,47,500 2,47,500 2,72,250 2,84,625
Salesmen's salaries 72,500 72,500 79,750 83,375
Sundry expenses 65,000 65,000 71,500 74,750
Total semi variables cost (B) 4,47,500 4,47,500 4,92,250 5,14,625
Fixed cost
Management salary 2,10,000 2,10,000 2,10,000 2,10,000
Rent & Taxes 1,40,000 1,40,000 1,40,000 1,40,000
Depreciation 1,75,000 1,75,000 1,75,000 1,75,000
Office expenses 2,22,500 2,22,500 2,22,500 2,22,500
Total fixed cost (C) 7,47,500 7,47,500 7,47,500 7,47,500
Total cost
Variable cost 13,35,000 16,02,000 21,36,000 26,70,000
Semi variable cost 4,47,500 4,47,500 4,92,250 5,14,625
Fixed cost 7,47,500 7,47,500 7,47,500 7,47,500
Total cost (A + B + C) 25,30,000 27,97,000 33,75,750 39,32,125
Sales 21,25,000 25,50,000 34,00,000 42,50,000
Less: Total cost 25,30,000 27,97,000 33,75,750 39,32,125
- 4,05,000 - 2,47,000 24,250 3,17,875
(Loss) (Loss) (Profit) (Profit)
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REVISION POINTS
 A cash budget deals with expected cash inflows and cash out flows during
a specified period of time for which the budget is prepared.
 Cash inflows are cash sales, collection from debtors , issue of shares and
debenture, sale of investments, etc….
 Cash outflows are purchase of raw materials, cash paid to creditors,
payment of various expenses….
INDEX QUESTIONS
1. A firm expects to have Rs. 20,700 as opening balance on 1st May 2021 and
requires you to prepare an estimate of the cash position for 3 months May
to July 2021. The following information is supplied to you.
Factory Office Selling
Sales Purchases Wages
Month Expenses Expenses Expenses
March 27,600 16,560 4,140 2,070 2,760 2,070
April 31,740 19,320 4,485 2,415 2,760 2,415
May 34,500 22,080 4,485 2,760 2,760 2,415
June 49,680 24,840 4,830 3,036 2,760 2,760
July 57,960 27,600 5,003 2,933 2,760 2,760
Other Information:
i) 25 % of the sales is for cash, remaining will be collected in the month
following that of sales.
ii) Suppliers supply goods on two months credit.
iii) Delay in payment of wages and all others expenses is: One month
iv) Income tax Rs. 6,900 is due and to be paid in July.
v) Preference share dividend of 10% on Rs. 69,000 is to be paid in May.
2. Prepare a cash budget for the months for May, June and July 2021 on the
basis of the following information.
(a) Income and Expenditure forecasts
Credit Credit Wages Manufacturing Office Selling
Month sales purchases Expenses Expenses Expenses
March 43,800 26,280 6,570 2,920 1,460 2,920
April 45,260 27,740 5,840 2,190 1,095 3,650
May 46,720 24,090 7,300 3,285 1,825 3,285
June 42,340 25,550 6,205 2,555 1,460 2,555
July 40,880 28,470 6,935 2,920 730 3,285
August 43,800 24,820 5,840 2,190 1,095 2,920
(b) Cash balance on 1st May 2021 Rs. 5,840
(c) Plant costing Rs. 11,680 is due for delivery in July : Payable 10% on
delivery, the balance after 3 months.
(d) Advance tax of Rs. 5,840 each is payable in March and June
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(e) Period of credit allowed (i) by suppliers two months and (ii) to customers
one month
(f) Lag in payment of manufacturing expenses ½ month
(g) Lag in payment of office and selling expenses 1 month
3. The following are budgeted expenses for the production of 10,000 units
Per unit (Rs)
Material 36
Labour 18
Variable overheads 14
Fixed overheads (Rs.90,000) 9
Variable expenses (direct) 4
Selling expenses (10% fixed) 3
Administration expenses (Rs. 30,000 fixed) 3
Distribution expenses (20% fixed) 3
Total 90
Prepare a budget for the production of 8,000 units and 6,000 units
4. On the basis of the following particulars draw up a flexible budget for
overhead expenses and determine the overhead rates at 70%, 80% and
90% plant capacity.
Plant Capacity
Particulars
70% Rs. 80% Rs. 90% Rs.
Variable Overhead:
Indirect Labour - 28,800 -
Semi Variable Overheads:
Power (30% fixed) - 48,000 -
Fixed Overheads:
Depreciation - 26,400 -
Insurance - 7,200 -
Salaries - 24,000 -
Estimated direct labour hours 99,200
5. The cost details of an article at a capacity level of 5,000 units is given
under A below. For a variation of 25% in capacity above or below this level,
the individual expenses vary as indicated under B below:
A B
Particulars
Rs.
Material Cost 12,500 (100% Varying)
Labour Cost 7,500 (100% Varying)
Power 625 (80% Varying)
Repairs and Maintenance 1,000 (75% Varying)
Stores 500 (100% Varying)
Inspection 250 (20% Varying)
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Depreciation 5,000 (100% Varying)

Adm. Overheads 2,500 (25% Varying)
Selling Overheads 1,500 (25% Varying)
Total 31,375
Cost per unitRs.6.275.Find the unit cost of the product at production levels
of 4,000 units and 6,000 units.
6. The following are information relating to the productive activities of G. Ltd.,
for three months ended 31 December, 2021.
Fixed Expenses : Rs.
Management Salaries 1,05,000
Rent and Taxes 70,000
Depreciation of Machinery 87,500
Sundry Office Expenses 1,11,250
3,73,750
Semi-Variable Expenses at 50% capacity :
Plant Maintenance 31,250
Indirect Labour 1,23,750
Salesmen's Salaries 36,250
Sundry Expenses 32,500
2,23,750
Variable Expenses at 50% capacity :
Materials 3,00,000
Labour 3,20,000
Salesmen's Commission 47,500
Total 6,67,500
It is further noted that semi-variable expenses remain constant between
40% and 70% capacity, increase by 10% of the above figures between 70%
and 85% capacity and increase by 15% of the above figures between 85%
and 100% capacity. Fixed expenses remain constant whatever the level of
activity may be. Sales at 60% capacity are Rs. 12,75,000 at 80% capacity
Rs. 17,00,000and 100% capacity Rs. 21,25,000.Assuming that all items
produced are sold, prepare a flexible budget at 60%, 80% and 100%
production capacity.
SUMMARY
In this lesson, we have briefly touched upon the following points: A cash
budget deals with the expected cash inflows and cash outflows during a specified
period of time for which the budget is prepared. It can be prepared by three
different ways namely 1. Receipt and Payment method, 2. Adjusted Profit and Loss
method and 3. Balance Sheet method. A flexible budget also known as variable or
sliding scale budget is one which permits adaptability in accordance with the
changes in the level of production. It is prepared for varying levels of production
activity and thus provides a realistic basis for comparing performance of different
departments/product.
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TERMINAL EXERCISES
1. What is meaning of cash budget?
2. Explain the term cash outflows and cash inflows?
3. What are the methods of preparation of cash budget?
4. What is flexible budget?
 The international management accounting (IMAS) projects
ASSIGNMENT
1. What are the methods of preparation of cash budget? Explain with example.
2. What is flexible budget? Explain with example
REFERENCES
1. S.N. Maheshwari Principles of management Accounting
LEARNING ACTIVITIES
KEY WORDS
Semi variable cost, Flexible budget and Level of activity

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LESSON – 13
PREPARATION OF DIFFERENT TYPES OF OVERHEAD BUDGETS

OBJECTIVES
After going through this lesson you will able to:
 understand the meaning of different types of overhead budgets and Zero
base budget
 Know how to prepare overhead budgets
CONTENTS
 Labour Cost Budget
 Manufacturing Overheads Budget
 Research and Development Budget
 Cost of Goods Sold Budget
 Administration Cost Budget
 Selling and Distribution Cost Budget
 Capital Expenditure Budget
 Zero-Base Budgeting
o Benefits from ZBB
o Problems with ZBB
INTRODUCTION
In 12th lesson, we discussed the meaning of cash budget and flexible budget
and also discussed methods of preparation of cash budget and flexible budgets. In
this lesson, we discuss the meaning of different types of overhead budgets and Zero
base budget (ZBB).
Labour Cost Budget
In this section, we attempt to make a brief study about meaning labour cost
budget. Labour cost budget represents the total amount of money which will be
needed for payment to workers, direct as well as indirect, during the production
budget period. It can be prepared only if the total number of labour hours to produce
the budgeted quantity and the rate per hour are known. The nature of production
suggests the kind of labour required and the work study tells the total labour hours
required to achieve budgeted production. Labour rates can be collected from the
personnel department. That should, however, be modified in the light of the likely
changes in wage-rates. Total labour cost is arrived at by multiplying together the
labour hours and the wage rate. A comparison of the existing labour force in terms of
hours and the budgeted labour hours will disclose whether additional labour will be
required or some existing labour will be rendered surplus.
Manufacturing Overheads Budget
In this section, we attempt to make a brief study about meaning
manufacturing overhead budget. This budget presents a forecast of indirect
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expenses which are linked with manufacturing. All expenses of manufacturing such
as salaries of office personnel including works manager's salary, factory rent,
depreciation, insurance, light and fuel, stationery, etc., are included in this budget.
The total manufacturing expenses are classified into fixed and variable
components. They can further be grouped into controllable and un-controllable
categories with a view to exercise better control over them. The budget officer
finalises the budget in consultation with the production manager.
Illustration – 1:
Prepare a Manufacturing overhead budget from the following data: Budgeted
output for the quarter ending 31-3-2020 is 500 units. Budget fixed overhead
apportioned to the division Rs 48,000 for the year 2020. Variable overhead is
estimated to be Rs 80,000 for an annual output of 8,000 units. Semi variable
estimated for the year is Rs 30,000 (40% fixed and 60% variable)
Solution
Manufacturing overhead budget
Particulars Rs Rs
Fixed overhead(48,000 x 3/12) 12,000
Variable overhead (80,000/8,000) x 500 5,000
Semi variable overhead
Fixed (30,000x 40% x 3/12) 3,000
Variable ( 30,000x 60 % =(24,000/ 8,000) x 500 1,125 4,125
Total Manufacturing overhead 21,125
Research and Development Budget
We present here a brief explanation about Research and Development Budget.
Generally, large scale business enterprises set up research and development wing
within their organisations to carry on research for developing new products and/or
improving upon the existing ones with a view to minimising cost and earn maximum
profits. Such enterprises prepare Research and Development Budget which depends
upon the existing projects in hands and the new projects to be undertaken within the
budget period. This budget has no direct-linkage with sales, production or other
operating budgets. The management decides the nature of research to be carried
within the firm and also the expenditure to be incurred thereon. It also decides about
the treatment to be given to the research and development expenditure i.e. what part of
expenditure to be capitalised and what portion be treated as an ordinary business
expenditure. The Research and Development Budget helps the management to carry
on the research activities on a continuous basis for the benefit of the organisation
Cost of Goods Sold Budget
We discuss in this section about cost of goods sold budget. Cost of Goods Sold
Budget is prepared to depict budgeted cost of goods meant for sales. This budget is
prepared by adjusting cost of production by opening or closing stocks of finished
goods. This budget may also be prepared product wise.
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Administration Cost Budget

In this section, we attempt to make a brief study about meaning administration
cost budget. This budget shows estimated expenditure of administration offices and
management remunerations during the budget period. There may be several
department or budget centres which are responsible for the preparation of its own
budgets. These petty budgets are incorporated in the Administration Cost Budget. In
this budget also expenditure may be classified into fixed and variable overheads
which are estimated on the basis of past records and future plans.
Selling and Distribution Cost Budget
In this section, we attempt to make a brief study about meaning selling and
distribution cost budget. This budget is the forecast of all expenses incurred in
selling and distribution function during the budget-period. This budget is closely
connected with Sales Budget because it is based on the volume of sales projected
for the budget-period. But there may be certain expenses which may cover future
budget period, for example an advertising campaign may be launched in the year
may have influence our sales in forthcoming year or years. This budget is normally
prepared by the sales manager and selling office manager, distribution manager
and advertising or publicity manager. Advertising is nowadays a costly item in the
selling and distribution cost budgets.
Illustration – 2
You are required to construct a selling overhead budget from the details given below
Rs
Establishment expenses of sales department 15,000
Other expenses of sales department 6,000
Advertisement 4,500
Salaries to counter salesmen 15,000
Commission to counter salesmen at 2% on their sales
Commission to traveling salesmen at 5% on their sales
and out of pocket expenses at 3 % on their sales
The following are the likely sales rang for a year
Sales at Counter Sales by Traveling salesmen
Rs Rs
1,50,000 15,000
2,00,000 20,000
2,50,000 25,000
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Solution
Selling Overhead Budget
Estimated Sales
Rs Rs Rs
1,65,000 2,20,000 2,75,000
Fixed selling overhead:
Establishment expenses of sales department 15,000 15,000 15,000
Other expenses of sales department 6,000 6,000 6,000
Advertisement 4,500 4,500 4,500
Salaries to counter salesmen 15,000 15,000 15,000
Total 40,500 40,500 40,500
Variable Overhead:
Commission to counter salesmen at 2% on their sales 3,000 4,000 5,000
Commission to traveling salesmen at 5% on their sales 750 1,000 1,250
Traveling salesmen’s of pocket expenses at 3 % on 450 600 750
their sales
Total Variable overhead 4,200 5,600 7,000
Total Selling overhead 44,700 46,100 47,500
Capital Expenditure Budget
In this section, we attempt to make a brief study about meaning capital
expenditure budget. It is closely connected with the production budget which will
show how much machine capacity is needed and when. This enable one to
determine what new machines have to be installed and at what time. This also goes
for buildings and other assets of fixed nature. Of course, much of the capital
expenditure may be avoided by getting some work done by outsiders. For instance,
the whole work, of packing can be contracted out. Such giving out of contracts in
fact has an effect upon the whole of the production budget. Capital Expenditure
Budget may be short term or long term budgets. In this budget the availability of
capital fund is a limiting factor. It is desirable that capital expenditure budget must
be coordinated with each budget because in the cash budget, provision for cash
required for capital expenditure has to be made. In the factory overhead budget
also, there should be provision for repairs maintenance, insurance and deprecation
on new capital asset.
Zero-Base Budgeting (ZBB)
We present here a brief explanation about ZBB. Traditional method of
budgeting known as incremented based budgeting is based on past year's
programmes and performance which is generally regarded as satisfactory for
developing future budgets. In this type of budgeting, the targets set in the past year
are not questioned and some additions are made in the last year's budget itself to
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incorporate the necessary additional expenditure on on-going and new business

activities to be carried out in the budget period. This is a very simple method which
calls for few alterations and additions without going into the details of the whole
budgeting process in the light of changed circumstances. The traditional method of
budgeting is not workable where management is conscious of innovative changes in
the present business and administrative policies for achieving maximum over-all
efficiency of the origination.
Zero-base Budgeting pre-supposes the non-existence of any budget in the past
and evaluates the budget activities in terms of benefits and costs in the light of
prevailing business environment and likely changes in future. It is synonymous
with budgeting from scratch-from zero, requiring Justification of everything
irrespective of trends or past levels of expenditure. In. other words, Zero-base
budgeting implies constructing a budget without any reference to what has gone
before. It is essentially an exercise of reappraisal of purpose, .methods and
resources. The budget so prepared is likely to be more realistic to serve the best
interests of an organisation. Zero-base budgeting has been defined by Peter A.
Phyrr as under:
"A. planning and budgeting process which requires each manager to Justify
his entire budget request in detail right-from the scratch (hence the term zero-base)
and shifts the burden of proof to each manager to justify why he should spend any
money at all. The approach in turm requires an in depth analysis of all the 'decision
packages' to be evaluated on systematic and rational lines and also ranked in order
of importance."
Benefits From ZBB
In this section, we discuss the benefits accrue to an organisation which
implements Zero-Base Budgeting on the right basis
1. Continuous reviewing' of on-going schemes ensures effective utilization of
limited funds in the best possible projects and manner.
2. The programmes or activities which have outlived their utility are pruned
and thus the organisation can be saved from unproductive expenditure.
3. Ranking of projects and programmes on cost-benefit analysis basis secures
an efficient allocation of funds.
4. It facilitates the accommodation of high priority projects by reducing
existing activities.
5. ZBB helps in the management of projects, programmes and activities
according to availability of funds. If the cuts in budgets become imperative
due to shortage of funds, the BCR for different programmes will be a
correct guide in such a decision-making. Instead of introducing ad hoc
cuts in budgets, the activities making up to the quantum of funds available
will be choosen.
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6. It provides an in-built system for reviewing actual costs and performance

against budget.
7. It improves communication all round, particularly top management's
awareness of what is contained in each budget center’s proposal.
8. It promotes innovative ideas in terms of alternative ways of performing an
activity and alternative levels of efforts.
Problems with ZBB
In this section, we discuss the limitations of ZBB. Like any other technique of
planning, the Zero-base budgeting is not an unmixed blessing. Following problems
may be encountered in the implementation of ZBB in any organisation or
government department.
i. Zero-base budgeting is a costly affair as it involves too much energy, time
and money in the collection and analysis of data regarding alternative
projects, programmes and activities. It can freeze an organisation in a
paper work blizzard for several months in a year.
ii. The evaluation of legal necessity or technical feasibility of Decision
Packages is itself a highly difficult and technical job which might not be
done rightly in the absence technically qualified personnel for the purpose.
It cannot be said that a Zero-base budget is always realistic and in the best
interest of the organisation.
iii. ZBB requires measurements on performance levels and cost effectiveness
that might not be readily available.
iv. There is every possibility that "Pet" projects might be ranked arbitrarily as
there is no way of avoiding 'pet projects' being given a high ranking.
REVISION POINTS
 Labour cost budget represents the total amount of money which will be
needed for payment of workers, direct as well as indirect, during the
production budget period
 Manufacturing overhead budget presents a forecast of indirect expenses
which are linked with manufacturing.
 Research and development budget represents The large scale organization
to carry on research for developing new products and improving upon the
existing ones with a view to minimizing cost and earn maximum profits.
 Cost of goods sold budget is prepared by adjusting cost o production by
opening stocks of finished goods.
INDEX QUESTIONS
1. Explain different types of overhead budgets
2. What is Z.B.B? What are its advantages and limitations?
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SUMMARY
Labour cost budget represents the total amount of money which will be needed
for payment to workers, direct as well as indirect, during the production budget
period. Manufacturing expenses budget presents a forecast of indirect expenses
which are linked with manufacturing. Research and Development Budget depends
upon the existing projects in hands and the new projects to be undertaken within
the budget period. This budget has no direct-linkage with sales, production or other
operating budgets.
Administration Cost Budget shows estimated expenditure of administration
offices and management remunerations during the budget period. Selling and
Distribution Cost Budget is the forecast of all expenses incurred in selling and
distribution function during the budget-period. Capital Expenditure Budget may be
short term or long term budgets. In this budget the availability of capital fund is a
limiting factor. Zero-base Budgeting pre-supposes the non-existence of any budget
in the past and evaluates the budget activities in terms of benefits and costs in the
light of prevailing business environment and likely changes in future.
TERMINAL EXERCISES
1. What you meant by labour cost budget?
2. What you mean by manufacturing overhead budget?
3. What are the benefits of ZBB?
4. Write short note on:
a. Zero- base budgeting
b. Cost of goods sold budget
c. Selling and distribution cost budget
d. Capital expenditure budgeting
edition)
ASSIGNMENT
1. Explain different types of Budgeting;
2. What are the benefits of ZBB?
3. Write short note on:
a. Zero- base budgeting
b. Cost of goods sold budget
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c. Selling and distribution cost budget

d. Capital expenditure budgeting
e. Research and development budget
REFERENCES
LEARNING ACTIVITIES
evaluation methods within the social context of an organisation
KEY WORDS
Zero base, limiting factors and blizzard

182
LESSON – 14
MARGINAL COSTING
OBJECTIVES
In 13th lesson, we discussed the meaning of different types of overhead budgets
and Zero base budget (ZBB). In this lesson, we discuss the meaning of marginal
costing, features, advantages, limitations of marginal costing and absorption
costing. After going through this lesson you will able to
 understand the meaning of marginal costing and absorption costing.
 understand features, advantages, limitations of marginal costing
CONTENTS
 Introduction
o Meaning of marginal costing
o Marginal costing -Definition
 Fixed cost and variable cost
 Features of marginal costing
 Advantages of marginal costing
 Limitations of marginal costing
 Absorption costing
INTRODUCTION
of marginal costing
Meaning of Marginal Costing
We present here a brief explanation about meaning of marginal costing. In
order to understand the marginal costing technique, it is essential to clearly
understand the meaning of marginal cost. Marginal cost means the cost of the
marginal or last unit produced. It is also defined as the cost of one more or one less
unit produced. In this connection a unit may mean a single commodity, one dozen,
a gross or any other packet of goods. For example, if a manufacturing firm
produces X unit as a cost of Rs. 300 and the production of X + 1 units cost Rs. 320,
then the cost of the additional one unit is Rs. 20 which is the marginal cost.
Similarly, if the cost of production of X-1 units comes down to Rs. 280, then the
cost of the marginal unit which was being produced is Rs. 20 (Rs. 300 - 280). It
would be observed that marginal cost varies directly with production and marginal
cost per unit remains the same. Marginal cost consists of prime cost i.e., cost of
materials, labour and all variable overheads. It does not contain any element of
fixed cost which is kept separate under marginal cost technique. Marginal costing
may be defined as the technique of presenting cost data wherein variable costs and
fixed costs are shown separately for managerial decision-making. It should be
clearly understood that marginal costing is not a method of costing or process
costing like job costing but it is simply a method or technique of the analysis of
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costing information for the guidance of the management which try to find out the
effect on profit due to changes in the volume of output. Marginal Costing is a
popular term in Great Britain. In U.S.A., the term Direct Costing is used in place of
marginal costing. In fact, Marginal Costing and Direct Costing are the two different
names of the same technique. Like marginal cost, the direct cost also consists of
prime cost and variable overheads. Since marginal or direct costing is concerned
with variable costs, it would be better if these terms are replaced by Variable cost.
Marginal costing -Definition
In this section, we attempt to make a brief study about definition of marginal
costing. Marginal costing is not a method of costing like job costing or process
costing. It is a specials technique very useful in the process of decision - making for
the management.
The Institute of Cost and Works Accountant of England has defined marginal
costing as “the ascertainment by differentiating between fixed costs and variable
cost of marginal cost and of the effect upon the profit of changes in the volume type
of output” Thus, the technique of marginal costing are:
1. Differentiation between fixed costs and variable costs;
2. Ascertainment of marginal cost and
3. Finding out the effect on profit due to changes in volume or type of output.
Fixed Cost and Variable Cost
We discuss in this section the meaning of fixed cost and variable cost. Total
cost involved in a production may be divided broadly into two categories namely-
Variable cost and fixed cost. Variable cost varies directly with changes in the
volume of production whereas fixed cost remains the same for all levels of
production. Raw material and labour costs vary according to level of production
and as such fall in the category of variable cost. If wood required for the production
of one table is 2 cft., then the production of 10 tables will require 20 cfts of wood.
Similarly, wage-cost for 10 tables will be Rs. 250 if one table cost Rs. 25 as wages.
Thus the tendency of variable cost is to change according to changes in the volume
of production. Variable cost is also known as product cost as it is related to volume
of output.
On the other hand, fixed cost remains unchanged whether we produce one
table or 10 tables. Every production involves some amount of fixed cost which is
not influence by the variations in the level of production. Fixed cost remains fixed
at the same level regardless of changes in the volume of output and varies per unit
inversely with the changes in the level of output. Hence fixed cost is known as
period cost because it accrues with the passage of time irrespective of the volume of
output. Rent of building, insurance premium, local taxes, etc., are some of the
examples of fixed cost. A manufacturing firm will have to pay rent of the building,
insurance premium and local taxes irrespective of the level of production. Semi
variable cost is one which is partly fixed and partly variable. The classification of
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total cost into variable and fixed components is significant for managerial decision-
making.
Hence, marginal costing is equal to total costs less fixed costs i.e., direct
materials, direct labour, direct expenses and variable overhead. Thus, marginal
cost is variable Cost (which forms part of product costs and does not include fixed
costs). Fixed cost is not included in the cost of production because they bear
relation to certain period of time and also vary per unit of production. In short the
whole marginal costing is built on the foundation of this classification of overheads
into fixed and variable expenses.
Features of Marginal Costing
A full fledged system of marginal costing is characterized by the following
features:
1. A technique, not a system of costing: Marginal costing is a technique of
analysis and presentation of cost rather than a system of costing. It can be
applied with any existing method of costing.
2. Fixed costs are treated as period cost: Fixed costs do not form part of cost
of production. They are written off during the period in which they are
incurred.
3. Profitability judged by contribution: The relative. Profitability of a product or
department is judged by the marginal contribution.
4. Separation of costs into Fixed and variable components: All costs are
classified it to fixed and variable costs in computing the cost of production.
5. Valuation of Stock: the stock of finished goods and work-in progress are
valued at variable costs excluding selling and distribution variable costs.
6. Cost-Volume-profit relationship: Break even technique is fully employed to
reveal the state of profitability at various level of activity.
7. Basis for price fixation: Prices are based on marginal costs plus profits.
Contribution is the excess of selling price over the marginal costs of sales.
8. Method of reporting and recording: Marginal costs are not incorporated in
accounting reports. They are incorporated in flexible budgets so that after
the expiry of budget period, estimated costs at the beginning may be
compared with the actual costs incurred at the end.
9. Instrument of control and decision making: Marginal costs are used as an
instrument of control and decision making by management, for improving
the efficiency of the concern.
Advantages of Marginal Costing
In this section, we discuss the advantages of marginal costing.
1. Simplicity: The system of marginal costing is very simple and easy to
understand by all managers.
185
2. Profit Planning: Marginal costing helps, profit planning by focusing

attention of contribution, which represent the difference between sales
value and variable costs.
3. Cost control: The marginal cost technique officers a fundamental basis for
the effective control of costs by presenting a vivid picture of the entire
variable costs. The classification of costs into fixed and variable enables to
prepare flexible budgets and control the costs effectively through
responsibility identification.
4. Production planning; Marginal costs remain the same per unit of
production irrespective of the value of production. Hence, it helps the
management in future production.
5. Stock valuation: Marginal costing facilitates stock valuation very much
since no portion of fixed costs is carried forward to the next accounting
period.
6. Simplification of overhead treatment: The system of marginal costing
simplifies the overhead recovery system. It does away with the need for
allocation, appointment and absorption of flexed overheads. Hence, under
over-absorption of overheads cannot arise at all.
7. Decision making: The technique of marginal costing is a valuable aid to
management of decision making in many key area such as:
a. The price at which a product should be sold.
b. Unification of surplus capacity.
c. Submission of quotation and tenders.
d. Determination of volume of output.
e. Make or buy a component.
f. Replacement of machinery
g. Determining optimum product or sales mix.
h. Operate the plant or shut it down etc.
i. Acceptance of export orders.
j. Suspension or permanent closure of a business.
8. Performance appraisal:When there are several profit generating divisions in
a company, marginal costing helps to ascertain the contribution of each
division to the total profit of the company income and expenditure can
easily be matched.
Limitations of Marginal Costing
In this section, we discuss the limitations of marginal costing.
1. Difficulty in analysis: considerable difficulty neither is always experienced
analyzing overheads into their fixed and variable component, and no
variable cost is completely variable nor is a fixed cost completely fixed.
186
2. Lopsided emphasis: Marginal costing has a tendency to attach more

importance to the selling function, which has the effect of relegating the
production function to a comparatively unimportant position.
3. Difficulty in Application: The technique of marginal costing cannot be
adequately applied kin the case of industries in which large stocks have to
carried by way of work- in-progress.
4. Limited scope: As marginal costing distinguishes between the treatment of
fixed and variable components as parts of fixed costs, it is difficult to adopt
the technique in capital intensive industries where fixed are very high.
5. In appropriate basics for pricing: Selling price cannot reasonably be fixed on
the basis of contribution alone, since there is a danger of too many sales
being effect at marginal costing resulting either in loss to the business or
inadequate profit.
6. As fixed costs are due to increasing automation the costing system cannot
be effective and dependable.
7. As marginal costing is suitable only for taking short-term decisions it is not
useful in the long-run.
8. The exclusion of fixed overhead from the inventories affects the profit and
loss account and products unrealistic and conservative Balance Sheet.
9. As marginal costing does not provide any standard for the evaluation of
performance it does not ensure effective control than a system of budgetary
control and stand costing and variable overheads alone are required.
Absorption Costing
We present here a brief explanation about absorption costing. The traditional
technique ascertaining the cost of production is the Absorption Costing Technique
according to which total cost involved in a production is aggregated without any
regard to its constituents. Since Absorption Costing technique does not make any
distinction between variable and fixed costs and takes into account total cost, it is
also known by the names of Full Cost or Total Cost technique. This is the very old
method which had been used by manufacturing firms for product costing and profit
reporting. Modern firms are not only concerned with ascertaining cost per unit for
price fixation but they are also conscious of cost control and cost reduction for
overcoming the keen competition successfully and enhance over-all profitability of
their concerns. The traditional or Absorption Costing sometimes fails to guide the
management properly in decision-making. Therefore, marginal costing technique is
now increasingly been used in the formulation of production and price policies.
Under marginal costing, fixed costs are separated from the total cost in the analysis
of cost data for decision-making.
REVISION POINTS
 Marginal cost means he cost of the marginal or last unit produced.
 Variable cost varies directly with changes in the volume of production.
187
 Fixed cost remains the same for all levels of production.

 The additional technique ascertaining the cost of production is the
absorption costing technique according to which total cost involved in a
production is aggregated without any regard to its constituents.
INDEX QUESTIONS
1. What is marginal costing? Explain its advantages and limitations of
marginal costing.
2. Explain absorption costing. How does it differ from marginal costing?
SUMMARY
Marginal cost means the cost of the marginal or last unit produced. It is also
defined as the cost of one more or one less unit produced. Marginal costing is equal
to total costs less fixed costs. Variable cost varies directly with changes in the
volume of production whereas fixed cost remains the same for all levels of
production. Marginal costing is a technique of analysis and presentation of cost
rather than a system of costing. It can be applied with any existing method of
costing.
Marginal costing helps, profit planning by focusing attention of contribution,
which represent the difference between sales value and variable costs. It also offer
fundamental basis for the effective control of costs by presenting a vivid picture of
the entire variable costs. Considerable difficulty neither is always experienced
analyzing overheads into their fixed and variable component, and no variable cost is
completely variable nor is a fixed cost completely fixed. Absorption costing
technique does not make any distinction between variable and fixed costs and takes
into account total cost, it is traditional technique ascertaining the cost of
production, in this technique total cost involved in a production is aggregated
without any regard to its constituents
TERMINAL EXERCISES
1. What is marginal costing?
2. What is absorption costing?
3. What you meant by fixed cost and variable cost?
4. What are the features of marginal costing?
ASSIGNMENT
1. What are the features of marginal costing?
2. Explain the advantages of marginal costing?
188
3. Explains the limitations of marginal costing?

REFERENCES
LEARNING ACTIVITIES
KEY WORDS
Absorption costing, Product cost and period cost

189
LESSON – 15
MARGINAL COSTING -- COST VOLUME PROFIT ANALYSIS

OBJECTIVES
In earlier lessons, we have gone through the concept of marginal costing,
advantages and limitation of marginal costing etc. Now, we shall discuss in detail
cost relations with volume and distribution system of an economic entity.
CONTENTS
 Introduction
 Objectives of Cost Volume Profit Analysis
 Limitations of Cost Volume Profit Analysis
 Important Concepts
o Contribution
o Profit Volume Ratio (P/V Ratio)
o Break even Point (BEP)
o Break even ratio
o Composite P/V Ratio
o Composite BEP
o Margin of Safety
o Margin of Safety Ratio
o Fixed Cost
o Expected Sales
o Expected Profit
 Illustrations
INTRODUCTION
In this section, we attempt to make a brief study about meaning of cost volume
profit analysis. We know that marginal costs vary directly with volume of production or
output whereas fixed cost remains unaltered regardless of the volume of output within
the scale of production already fixed by the management. When cost behaviour is
studied in relation to income, it shows the cost-volume profit relationship. As a result
of changes in sales volume, variable cost changes as per change in volume, selling
price remains constant, and fixed cost indeed remains fixed; consequently there is a
change in profit. A manager constantly strives to relate these elements (cost, volume
and profit) to maximize profit. Apart from profit projection, the concept of cost volume
profit (CVP) is relevant to all decision making areas. CVP is a management accounting
tool that expresses relationships among sales volume, costs and profits. Cost volume
profit analysis can answer a number of analytical questions, such as:
 What is the break-even revenue of an organisation?
 How much revenue does an organisation need to achieve a budgeted profit?
190
 What level of price change affects the achievement of budgeted profit?

 What is the effect of cost changes on the profitability of an operation?
Objectives of Cost Volume Profit Analysis
In this section, we attempt to make a brief study about objectives the cost
volume profit analysis
1. In order to forecast profit accurately, it is essential to ascertain the
relationship between costs and profits on the one hand and volume on the
other.
2. Cost volume profit analysis is helpful in setting up flexible budget which
indicate costs at various levels of activities.
3. Cost volume profit analysis helps in evaluation of performance for
control.
Such analysis may assist the management in formulating pricing policies by
projecting the effect of different price structures on cost and profits.
Limitations of Cost Volume Profit Analysis
In this section, we discuss the limitations of Cost volume profit analysis. The
main limitations of CVP analysis are as follows:
1. It is assumed that the production facilities anticipated for cost volume
profit analysis do not undergo any change. Such analysis gives misleading
results if expansion or reduction of capacity takes place.
2. Where a variety of products with varying margins of profit are
manufactured, it is difficult to forecast, with reasonable accuracy, the
volume of sales-mix which would optimize the profit.
3. The analysis will be correct only if input price and selling prices remain
fairly constant (which is hardly found in practice). Thus, if cost reductions
programmes are undertaken or selling price are changed, the relationship
between cost and profit will not be accurately depicted.
4. In cost volume profit analysis, it is assumed that variable costs are
perfectly and completely variable at all levels of activity and the fixed cost
remains constant throughout the range of volume being considered.
However, such conditions may not arise in practical situations.
5. It is assumed that changes in the opening and closing inventories are not
significant; however, sometimes the changes may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period
cost. Therefore, closing stock carried over to the next financial year does
not contain any component of fixed cost. The inventory therefore should be
valued at full cost in reality.
Important Concepts
In this section, we attempt to make a brief study of different concepts used in
this lesson
191
Contribution
Contribution is the difference between sales and variable cost. In other words,
contribution is the excess of selling price over variable cost. Contribution is the
amount available for meeting fixed expenses and the balance is profit.
Calculation of contribution
1. Sales – Variable cost = Contribution
2. Fixed cost + Profit = Contribution
3. Fixed cost – Loss = Contribution
Profit Volume Ratio (P/V Ratio)
This is the ratio of contribution to sales. It is an important ratio analysing the
relationship between sales and contribution. A high P/V ratio indicates high
profitability and low P/V ratio indicates low profitability. This ratio helps in
comparison of profitability of various products. Since high P/V ratio indicates high
profits, the objective of every organisation should be to improve or increase the P/V
ratio. Profit Volume Ratiois calculated by the following formula:
Contribution
1. 100
Sales
When two sales and two profits are given
Change in profit
2. 100
Change in Sales
Break even Point (BEP)
Break even point is the level of activity or sales volume at which the total
revenue is equal to the total expenses. At the break even point, a business man
neither earns any profit nor incurs any loss. Break even point also called “No profit,
no loss point” or “Zero profit & zero loss point.” Break Even Point is calculated by
the following formula:
Break even point in units
Fixed cos t
B.E.P =
Contribution per unit
Break even point in Sales Value
Fixed cos t
B.E.P = Sales (or)
Contribution
Fixed cos t
B.E.P =
P /V Ratio
B.E.P =Actual Sales – Margin of Safety
Break even ratio
Break even ratio is the percentage of break even sales to actual sales
Break even sales
Break even ratio =  100
Actual Sales
192
Composite P/V Ratio

In case of concerns dealing in several products, composite P/V ratio can be
calculated taking the total contribution and sales revenue.
Total Contribution
Composite P/V Ratio = 100
Total sales
Composite BEP
For a concerns dealing in several products, a composite BEP can be calculated
considering the total cost and total revenue of all such products.
Total Fixed Cost
Composite BEP =  Total Sales (or)
Total Contribution
Total Fixed Cost

Composite BEP =
Composite P /V ratio
Margin of Safety
Margin of safety is the difference between actual sales and break even sales.
Margin of safety is calculated in rupees, units or even in percentage form. Margin of
safety indicates the value/volume of sales which directly contribute to profit, as
fixed costs have already been recovered at break even point. Margin of safety is
calculated by the following formula:
1. Margin of Safety in units
Pr ofit
Margin of safety =
2. Margin of Safety in Sales Volume
Pr ofit
Margin of safety = Sales
Contribution
(or)
Pr ofit
Margin of safety =
P /V ratio
(or)
Margin of safety = Actual sales – B.E.P
Margin of Safety Ratio
When margin of safety is expressed as a percentage to the actual sales it is
called margin of safety ratio
M arg in of safety
Margin of safety ratio = 100
Actual Sales
Fixed Cost
Cost remains unchanged for any level of activities is known as fixed cost. It
can be calculated by the following formula
Fixed Cost = Sales x P/V ratio – Profit
Fixed Cost = Sales x P/V ratio + Loss
193
Expected Sales
It refers to calculation of sale for the given amount of profit. It can be
calculated by the following formula
Fixed cos t  Expected profit
Expected Sales in units =
Contribution per units

Expected Sales in volume =
P /V ratio
Fixed cos t  Expected Loss

P /V ratio
Expected Profit
It refers to calculation of profit for the given amount of sales. It can be
calculated by the following formula
Sales x P/V ratio – Fixed cost
Illustrations
In this section we worked out some modal problems for your understanding
Illustration – 1
You are given the following data for the year 2020. Total sales Rs. 10,00,000,
Variable cost Rs. 6,00,000 and fixed cost Rs.3,00,000. Calculate
1. Contribution
2. P/ V ratio
3. BEP
4. Margin of safety
5. Sales required to earn a profit Rs 2,00,000
6. Profit when sales amount to Rs 12,00,000
Solution
Particular Rs
Sales 10,00,000
Less: Variable Cost 6,00,000
Contribution 4,00,000
Less: Fixed cost 3,00,000
Profit 1,00,000
7. Contribution Rs 4,00,000
Contribution 4,00,000
8. P/V ratio= 100 = 100 = 40 %
Sales 10,00,000
Fixed cos t 3,00,000

9. B.E.P = = =Rs 7,50,000
P /V Ratio 40%
Pr ofit 1,00 ,000

10. Margin of safety = = = Rs 2,50,000
P / V ratio 40%
194
11. Sales required to earn a profit of Rs 2,00,000

P /V ratio
3,00,000  2,00,000
= = Rs. 12,50,000
40%
12. Profit when sales amount to Rs 12,00,000
Expected Profit =Sales x P/V ratio – Fixed cost
=12,00,000 x 40% - 3,00,000
=4,80,000 – 3,00,000=Rs. 1,80,000
Illustration –2
From the following information relating to Surya and Sons Ltd., you are
required to find out
a)Contribution b)P/ V ratio c)BEP
d)Margin of safety e)Volume of sales to earn a profit Rs 6,000
f)Profit when sales amount to Rs 20,000
Total sales Rs. 15,000, Variable cost Rs. 7,500 and fixed cost Rs 4,500
Solution
Rs
Sales 15,000
Less: Variable Cost 7,500
Contribution 7,500
Less: Fixed cost 4,500
Profit 3,000
a) Contribution Rs 7,500
Contribution 7 ,500
b) P/V ratio= x 100 = x 100 =50 %
Sales 15,000
Fixed cos t 4,500
c) B.E.P= = =Rs 9,000
P / V Ratio 50%
Pr ofit 3,000
d) Margin of safety = = = Rs 6,000
P /V ratio 50%
e) Sales required to earn a profit of Rs 6,000
Expected Sales in volume=
P /V ratio
4,500  6 ,000
= = Rs 21,000
50%
f) VI.Profit when sales amount to Rs 20,000
Expected Profit=Sales x P/V ratio – Fixed cost
=20,000 x 50% - 4,500
=10,000 – 4,500=Rs 5,500
195
Illustration – 3
From the following data calculate:
a) P/V ratio; (b) Variable cost and (c) Profit.
Rs
Sales 80,000
Fixed expenses 15,000
Break even point 50,000
Solution
(a) Calculation of P/V ratio
Fixed cos t
Break even point =
P /V Ratio
15 ,000
50,000 =
P /V ratio
15 ,000
P/V ratio =  30 ( or ) 30%
50 ,000
(b) Calculation of variable cost
Contribution = Sales xP/V ratio
80,000 x 30% = Rs 24,000
Variable cost = Sales – Contribution
80,000 – 24,000 = 56,000
(c) Calculation of profit
Profit = Contribution – Fixed cost
24,000 – 15,000 = Rs 9,000
Illustration –4
From the following information, calculate
1.BEP
2. Number of units that must be sold to earn a profit of Rs 60,000 per year.
3. Number of units that must be sold to earn a net income of 10 % on sales
Sales price Rs 20 per unit
Variable Cost Rs 14 per unit
Fixed cost Rs 79,200
Solution
Contribution per unit = Sales price per unit – Variable cost per unit
= 20 – 14 =6
Contribution 6
P/V ratio= x 100 = 100 =30 %
Sales 20
Fixed cos t 79 ,200
1) B.E.Pin units= = =13,200 units
Contributi on per unit 6
Fixed cos t 79 ,200
B.E.P in rupees= = =Rs 2,64,000
P /V ratio 30%
2) Number of units that must be sold to earn a profit of Rs 60,000 per year
196

Expected Sales in Units =
Contribution per units
79,200  60,000
= = 23,200 units
6
P / V ratio
79,200  60,000
= = Rs 4,64,000
30%
3) Number of units that must be sold to earn a net income of 10 % on sales
Sales = Variable cost + Fixed cost + Profit
If ‘x’ is number of units:20x = 14x +Rs 79,200 + 2x
20x = 16x + 79,200
20x-16x = 79,200
4x = 79,200
x = 79,200 / 4 = 19,800 units
Illustration – 5
The sales turnover and profit during two years were as follows
Year Sales Profit
Rs (Rs)
2020 1,40,000 15,000
2021 1,60,000 20,000
You are required to find out

a)P/ V ratio
b)BEP
c)Margin of safety
d)Volume of sales to earn a profit Rs 40,000
e)Profit when sales amount to Rs 1,20,000
Solution
Note:When sales and profit of two years are given, the P/V ratio is obtained by
using the “Change formula”
Change in profit
a) P/V ratio = 100
Change in Sales
Change in Sales = 1,20,000 – 1,40,000= 20,000
Change in Profit = 15,000 – 20,000 = 5,000
Change in profit 5 ,000
P/V ratio= x 100 = 100  25%
Change in Sales 20 ,000
b) Calculation of BEP
Fixed cos t
Break even point =
P /V ratio
197
Fixed cost =( Sales x P/V ratio)Contribution – Profit

=( 1,40,000 x 25% ) – 15,000
=35,000 – 15,000 = Rs 20,000
Note: The same fixed cost can be obtained using 2002 sales also
20 ,000
Break even point =  Rs 80 ,000
25%
c) Sales required to earn profit of Rs 40,000
Required sales =
P /V ratio
20 ,000  40 ,000
= = Rs 2,40,000
25 %
d) Profit when sales amount to Rs 1,20,000
Expected Profit =Sales x P/V ratio – Fixed cost
=1,20,000 x 25% -20,000
=30,000 – 20,000=Rs 10,000
Illustration – 6
The sales turnover and profit during two half year periods were as follows
First half of the Second half of
year the year
Rs. Rs.
Sales 45,000 50,000
Total cost 40,000 43,000
Assuming that there is no change in price and variable cost and that the fixed
expenses are incurred equally in the two half year periods, You are required to find
out
a)P/ V ratio b)BEP c)Percentage of margin of safety
Solution
Note:When sales and profit of two years are given, the P/V ratio is obtained by
using the “Change formula”
Change in profit
a) P/V ratio = 100
Change in Sales
Change in Sales = 45,000 – 50,000= 5,000
Sales – Total cost = Profit
First half year45,000 – 40,000 = 5,000
Second half year 50,000 – 43,000 = 7,000
Change in Profit = 5,000 – 7,000=2,000
Change in profit
P/V ratio= 100
Change in Sales
2 ,000
= x 100  40%
5 ,000
198
b) Calculation of BEP
Fixed cos t
Break even point =
P /V ratio
Fixed cost =( Sales x P/V ratio)Contribution – Profit
=( 45,000  40% ) – 5,000
=18,000 – 5,000 = Rs 13,000
Note: Total fixed cost for the full year 13,000 x 2 = Rs 26,000
26 ,000
Break even point =  Rs. 65 ,000
40%
c) Calculation of percentage of margin of safety
Total profit
Margin of safety =
P /V ratio
Total profit 5,000 + 7,000 = 12,000
12,000
Margin of safety =  Rs 30,000
40%
Total m arg in of safety
Percentage of margin of safety= x 100
Total sales
30 ,000
= 100  31.58 %
95 ,000
Illustration – 7
The P/V ratio of a firm dealing in precision instrument is 50% and the margin
of safety is 40%. You are required to work out the B.E.P, and the net profit if sales
volume is Rs 50,00,000
Contribution
P/V ratio= 100
Sales
Contribution
50%= 100
50 ,00 ,000
50
Contribution = 50,00,000  = Rs 25,00,000
100
Margin of safety = 50,00,000  40 % = 20,00,000
a) Break even sales
Total sales – margin of safety = Break even sales
50,00,000 – 20,00,000 = Rs 30,00,000
b) Fixed cost
Fixed cos t Fixed cos t
B.E.P = = 30,00,000 =
P /V Ratio 50 %
50
Fixed cost = 30,00,000   Rs 15 ,00,000
100
c) Profit
Contribution – Fixed cost = Profit
25,00,000 – 15,00,000 = Rs 10,00,000
199
Illustration – 8
An analysis of Ranjitha Company led to the following information
Cost element Variable cost Fixed Cost

( % of Sales) Rs.
Direct material 32.8
Direct labour 28.4
Factory overheads 12.6 1,89,900
Distribution overheads 4.1 58,400
Administrative overheads 1.1 66,700
Budgeted sales are Rs 18,50,000. You are required to determine
i) the break even sales volume
ii) the profit at the budget sales volume
iii) the profit if actual sales(a) drop by 10%( b) Increased by 5% from budgeted
sales.
Solution
Total variable cost
Cost element Variable cost
( % of Sales)
Direct material 32.8
Direct labour 28.4
Factory overheads 12.6
Distribution overheads 4.1
Administrative overheads 1.1
Total 79.0%
Total Fixed cost

Factory overheads 1,89,900
Distribution overheads 58,400
Administrative overheads 66,700
Total 3,15,000
Sales – Variable cost = Contribution
100– 79 = 21
Contribution 21
P/V ratio = 100 = 100  21%
Sales 100
Fixed cos t 3 ,15 ,000
a) B.E.P = = 15 ,00 ,000
P /V Ratio 21%
b) Profit at the budgeted sales of Rs 18,50,000
Sales x P/V ratio – Fixed cost
18,50,000 x 21% – 3,15,000
3,88,500 – 3,15,000 = 73,500
200
c) Profit if actual sales drop by 10%

Actual sales(18,50,000 – 1,85,000)16,65,000
Less: Variable cost 16,65,000 x79 %13,15,350
Contribution3,49,650
Less: Fixed cost3,15,000
Profit34,650
d) Profit if actual sales increased by 5 %
Actual sales(18,50,000 +92,500)19,42,500
Less: Variable cost 19,42,500 x79 %15,34,575
Contribution4,07,925
Less: Fixed cost3,15,000
Profit92,975
Illustration – 9
Maradon Ltd manufacturers and sells four types of products under the four brand
names, R,P,C, H respectively. The total budgeted sales (100%) are 60,000 per month.
The sales mix in value comprises of 33 1/3%, 41 2/3%, 16 2/3% and 8 1/3 of R,P,C,H.
The operating cost are
I. Variable cost
A.60% of the selling price
B.68% of the selling price
C.80% of the selling price
D.40% of the selling price
II.Fixed cost is Rs.14,700 per month.
Calculate the break-even point for the products on an overall basis. It has
been proposed to change the sales mix as follows, the total sales per month remain
at Rs.60,000
Product R =25%
Product P =40%
Product C =30%
Product H =5%
Assuming that if the proposal is implemented calculate the breakeven point.
Solution
Particulars Product R Product P Product C Product H Total
Sales mix 33 1/3% 41 2/3% 15 2/3% 8 1/3% 100%
Sales 20,000 25,000 10,000 5,000 60,000
Less: Variable cost 12,000 17,000 8,000 2,000 39,000
Contribution 8,000 8,000 2,000 3,000 21,000
201
Overall contribution
Overall P/ V Ratio= 100
Overall sales
21,000
= 100  35 %
60 ,000
Break Even Point on over all basis
Fixed cos t
Overall B.E.P =
Overall P /V ratio
14 ,700
= = Rs.42,000
35 %
Note: Variable cost R = 20,000x60/100 =Rs.12,000
P = 25,000x68/100 =Rs.17,000
C = 10,000x80/100 =Rs.8,000
H =5,000x40/100=Rs.2,000
New proposal
Particulars Product R Product P Product C Product H Total
Sales mix 25% 40% 30% 5% 100%
Sales 15,000 24,000 18,000 3,000 60,000
Less: Variable cost 9,000 16,320 14,400 1,200 40,920
Contribution 6,000 7,680 3,600 1,800 19,080
Overall contribution
Overall P/ V Ratio= 100
Overall sales
19 ,080
= 100  31.80 %
60 ,000
Break Even Point on over all bases
Fixed cos t 14 ,700
Overall B.E.P = = = Rs 46.226
Overall P /V ratio 31.80 %
Decision Making Problems
1. Make or buy Decision
Illustration10
A Love manufacturing company finds that the cost of making a part in its own
workshop is Rs. 1,200.The same part is available in the market for Rs.1,120 with
an assurance of continuous supply. The cost data to make the part are:
Rs
Material 400
Direct labour 500
Variable cost 100
Fixed cost 200
Total 1,200
a.Should the part be made or bought?
b. Will your answer be different if the market price is Rs. 920
202
Solution
Rs
Material 400
Direct labour 500
Variable cost 100
Total marginal cost 1,000
Total marginal cost amounting to Rs.1,000 but market rate Rs.
1,120.Therefore, the company can manufacture the part. The production of every
part will generate a contribution of Rs.120 [1,000 – 1,120]. When the market price
is reduced to Rs. 920 the company should not manufacture the part. Because the
part is available at low price than production cost available in the market.
2. Accepting Additional Order and Foreign Order
The customers those want to buy large volume demand products at less than
the market price. Therefore it is to decide whether to accept the order or reject.
Decisions regarding foreign order should be made after, considering the following
factors:
1) The excess capacity of the plan to meet the new demand.
2) The price being offered by the new market.
3) The impact of sale of goods in the new market on the present market for the
goods
Illustration – 11
A company producing 72,000 units of “Alpha” product working at 60%
capacity receives an order from a foreign dealer for 35,000 units at Rs.100 per unit.
The local market price is Rs.180 per unit.
Cost data Rs
Material 40
Skilled labour 20
Unskilled labour 20
Variable over head 20
Fixed over head 40
Total cost per unit 140
Advice the management whether to accept the order or not
1) What would be your advice if the order had come from the local merchant?
2) If there is any temporary fall in demand how the minimum price to be
charged?
Solution
First, it is to be examined whether the firm has capacity to produce 35,000
units or not.
Total capacity of the firm = 100%
Capacity utilized = 60%
203
Balance of capacity = 40%

Production at60% capacity = 72,000 units
Production at 40% capacity = ?
40x72,000
= -------------------=48,000 units
60
The firm can produce 48,000 units, but an order had come for 35,000 units
only. Therefore, the company can produce 35,000 units.
Computation of contribution for foreign order:
Foreign order price isRs.100 per unit.
Less: Variable cost:
Material Rs. 40
Unskilled labour Rs. 20
Variable OH Rs. 20 80 per unit
---------------
Contribution Rs. 20 per unit
---------------
1. The firm can produce 35,000 units for a contribution of Rs.20 per unit
Therefore, the foreign order should be accepted this order will generate an
additional contribution Rs.7,00,000 [35,000xRs.20] Fixed cost have already
been met in the local market.
2. The order from a local merchant should not be accepted at a price of
Rs.100 per unit, which is less than the local price Rs.180.This price will
affect the relationship with other customers. And there will be a general
tendency a reduction in the price.
3. If there is a temporary fall in demand the selling price should be reduced
equal to total variable cost and should not reduced below the variable
cost.The company can reduce the price up to Rs.80 (equal to variable cost)
3) Maintaining the Desired Level of Profit
To sustain the market, companies have to reduce prices of its product due to
any competition and government regulations, etc. But, the company wants to
maintain a present level of profit. Marginal costing technique can be used to
ascertain number of units have to be sold to maintain the same level of profit. The
following procedure can be followed:-
1. First, contribution per unit to be calculated.
New selling price - Variable cost = Contribution
2. Secondly, add desired profit with fixed cost.
3. Thirdly, divide the total fixed cost and desired profit by contribution per unit.
Illustration –12
Beta company produces packing containers. Due to competition the company
proposed to reduce the selling price. To maintain the present profit indicate the
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number of units to be sold at the proposed reduction in selling price 5%, 10% and
15%.The following additional information is available.
Rs
Present sales[ 5,000 units] 5,00,000
Variable cost[5,000 units] 3,00,000
Fixed cost 1,50,000
Profit 50,000
Solution
Rs. 5,00,000
Selling price per unit = -------------------=Rs. 100
5,000 units
Rs. 3,00,000
Variable cost per unit =-------------------=Rs. 60
5,000 units
Present level profit= Rs. 50,000
New selling price
1. When selling price is reduced by 5%Old selling price Rs.100
Less:5% reducing in selling price(100x5/100) Rs.5
-------------
New selling price 95
-------------
2. When selling price is reduced by 10%Old price Rs.100
Less: 10% reducing in selling price (100 x 10/100) Rs.10
------------
------------
3. When selling price is reduced by 15%Old price Rs.100
Less:15% reducing in selling price(100 x 15/100) Rs.15
-----------
------------
Contribution per unit At 5% At 10% At 15%
Reduction reduction reduction
Selling price (Rs) 95 90 85
Less:Variable cost (Rs) 60 60 60
-----------------------------------------------------
Contribution per unit 35 30 25
----------------------------------------------------
Units to be sold to earn present level profit
Fixed cost + present level profit
------------------------------------------
205
At selling price reduce by 5%

1,50,000+50,000
---------------------------------- =5,714 units
35
When selling price is reduced by 10%

1,50,000+50,000
--------------------------------- =6,667 units
30
When selling price is reduced by 15%

1,50,000+50,000
------------------------------------ = 8,000 units
25
Key Factor or Limiting Factor

It is also, known as “Governing Factor” or “Scarce Factor”. A key factor is one
which restricts production are profit of a business. It may arise due to the shortage
of material, labour, capital, plant capacity, or sales etc. Normally selection of the
product based on the highest contribution per unit it is, considered as key factor.
The steps to be followed are:-
1. First ascertain contribution per unit
2. Secondly, divide contribution per unit with the given key factor to get key
factor contribution.
3. Thirdly rank the product on the basis of the key factor contribution.
Illustration – 13
The following particulars are obtained from costing records of a factory:
Product X Product y
(Rs.) (Rs.)
Selling price 400 1,000
Material [Rs.40 per Kg] 80 320
Labour [Rs.20 per hour] 100 200
Variable over head 40 80
Total fixed overhead 30,000
Comment on the profitability of each product when.
a) Raw material is in short supply.
b) Production capacity is limited,
c) Sales quantity is limited,
d) Sales value is limited,
e) Only 2000 kg of raw material is available for both type of product in total and
maximum sales quantity of each product is 600 units.
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Solution
Calculation of No of kgs. of raw material required to produced one unit of product
Material cost
= ---------------------
Price per Kg
80
For X =----------= 2 Kg
40
320
For Y =------- = 8 Kg
40
Calculation of labour hours:-
Labour cost
= ---------------------
Rate per hour
100
For X =---------= 5 hrs
20
200
For Y =----------=10 hrs
20
Contribution
Formula :------------------
Key factor
Product X Product Y
(Rs.) (Rs.) (Rs.) (Rs.)
Selling price per unit 400 1,000
Less: Marginal cost
Material 80 320
Labour 100 200
Variable OH 40 220 80 600
Contribution 180 400
I. When Raw material is in short supply
Contribution Contribution
= --------------------- (or) ---------------------
Key factor Raw material
Rs. 180
Product X = ----------=Rs. 90 contribution per Kgs
2 Kgs
Rs. 400
Product Y = ---------=Rs. 50contribution per Kg
8 Kgs
207
When raw material is in short supply, contribution per kg of product X is

higher and X is recommended to be manufacture.
II. When production capacity is limited:
Production capacity = Labour hour
Contribution
-----------------
Key factor
Rs. 180
Product X------------- = Rs. 36 contribution per hour
5 hours
Rs. 400
Product Y=------------ =Rs. 40 contribution per hour
10 hours
When production capacity is limited contribution per hour of product Y is
higher and Y is recommended to manufacture.
III. Sales quantity is limited [Sales units limited]
Contribution per unit of product X=Rs. 180
Contribution per unit of product Y=Rs. 400
When sales quantity is limited, contribution per unit of product Y is higher
and Y is recommended to manufacture.
VI. When sales value is limited [total sales amount limited]
Contribution
P/ V Ratio= ------------------x 100
Sales
180 400
X =---------x100 = 45% Y= ----------x100= 40%
400 1,000
When sales value is limited the P/V Ratio of product X is higher and the
product X is more profitable
V. When 2,000 Kg of Raw material only is available;
When raw material is in short supply, product X has more profit. Therefore,
the raw material should be used for production on maximum number of X units.
This will consume 1,200 Kg of Raw material (600 unitsx2 Kgs=1,200 Kgs)
Materials available2,000 Kgs
Less: Material required for X 1,200 Kgs
Balance of raw material800 Kgs
The balance of raw material should be utilized for the production of 100 units of Y.
Balance of raw material
=---------------------------------------------------------------
Material required for one unit of production of y
800 Kg
=------------------=100 units
8 Kg
When a raw material as well as sales quantity is limited, the raw materials
should first be used for maximum number of units of product X, i.e. for 600 units.
208
This will consume 1,200 kgs of material and the balance 800 kgs. Shall be utilized
for producing 100 units of product Y
Alternative Methods of Production
Much time management has to choose a course of action from among so many
alternatives, marginal costing is helpful in comparing the alternatives methods of
production machine work or hand work. The method which gives maximum
contribution is to be adopted keeping in mind the limiting factor.
Illustration – 14
Product A can be produced either by machine X or machine Y; machine X can
produce 200 units of A per hour, machine Y 300 units per hour. Total machine
hours available during the year are 5,000taking into account the following data
determine the profitable method of manufacturer.
Machine X Machine Y
(per unit) (per unit)
Marginal cost Rs.10 Rs.12
Selling price Rs.18 Rs.18
Fixed cost Rs.4 Rs.4
Profitability statement
Solution
Machine X MachineY
(Rs) (Rs)
Selling price 18 18
Less: Marginal cost 10 12
Contribution per unit 8 6
Output per unit 200 units 300 units
Contribution per unit Rs.1,600 Rs. 1,800
Machine hours per year 5,000 hour 5,000 hour
Actual contribution 80,00,000 90,00,000
(1,600 x 5,000) (1,800 x 5,000)
Hence production by machine Y is more profitable.
Selection of Suitable Product Mix or Sales Mix
Product mix is the ratio in which various product are produced and sold. Some
time the management wants to change the ratio of product mix, at the time
management wants to take decisions regarding which ratio of mixing gives
maximum contribution and profit.
 First we should calculate contribution per unit
 Secondly we should calculate total contribution of every product mix (No of
units x contribution per units.)
 Thirdly we should calculate total net product of every product mix (Total
contribution-fixed cost)
 Which product mix gives more profit that should select as profitable mix.
209
Illustration – 15
Present the following information to show to management:
1. The marginal product cost and contribution per unit
2. The total contribution and profit resulting from each of the following sales
mixtures.
3. The proposed sales mixed to earn a profit of Rs. 500 and Rs. 600 with total
sales of product “Hero” and “Zero” being 300 units.
Product Product
“Hero” “Zero”
Direct material (per unit) Rs.20 Rs.18
Direct wages (per unit) Rs.6 Rs.4
Sales price (per unit) Rs.40 Rs.30
Fixed cost Rs. 1,600
Variable expenses are allocated to products as 100% of direct wages
Sales mixtures
A. 200 units of Hero and 400 units of Zero
B. 300 units of Hero and 300 units of Zero
C. 400 units of Hero and 200 units of Zero
Recommenced which of the sales mixtures should be adopted.
Solution
1. First we should calculate contribution per unit
[Sales-Variable cost]
Product “Hero” Product “Zero”
Rs Rs
Selling price per unit 40 30
Less ; Marginal cost per unit
20 18
Direct material
6 4
Direct wages
6 32 4 26
Variable cost 100% of wages
Contribution 8 4
2.Secondly we should calculate total contribution of every mix [contribution per
unitx Number of units of the mix
MixA MixB MixC
Hero = 200 units Hero = 300 units Hero = 400 units
Zero=400 units Zero=300 units Zero=200 units
[No of units xcontribution per 200x8=1,600 300x8=2,400 400x8= 3,200
unit] 400x4=1,600 300x4=1,200 200x4=800
Total contribution(Rs ) 3,200 3,600 4,000
(-)Fixed cost (Rs ) 1,600 1,600 1,600
Profit(Rs ) 1,600 2,000 2,400
Mix C should be adopted as it gives the maximum contribution and profit.
210
Proposed mixes
The proposed sales mix to earn a profit of Rs. 500 with total sales of Hero and
Zero being 300 units.
Sales of Hero = ? units
Sales of Zero = ? units
---------------
Total sales of Hero and Zero = 300 units
----------------
Let X number units of Hero be sold
Sales of Zero = Total sales - Hero sales
= 300 units-X units
= Zero sales = [300 – X]
Note
Fixed cost +Profit = Contribution
Rs. 1,600 + Required Rs. 500 = Rs. 2,100
[No of units Hero sales x [No of unit Zero sales x Total

contribution per unit] + contribution per unit] =contribution
[ XxRs. 8 units ]+ [300-XxRs. 4]=Rs. 2,100
8X+ 4[300-X] = Rs. 2,100
8X+ Rs. 1,200-4X = Rs. 2,100
8X- 4X = Rs. 2,100-1,200
4X = Rs. 900
Rs. 900
X = --------------X=Hero =225units
4
Total sales = 300 units
(-) Hero sales = 225 units
--------------
Zero sales = 75 units
-------------
Prove:
Hero225xRs. 8 = 1,800
Zero75xRs. 4 = 300
------------
Total contribution = 2,100
(-) Fixed cost = 1,600
------------
Profit Rs. = 500
------------
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The proposed sales mixes to earn a profit of Rs. 600 with total sales of Hero
and Zero being 300 units.
Fixed cost + Profit = Contribution
Rs. 1,600 + Rs. 600 = Rs. 2,200
8X+ 4 (300 – X) = Rs. 2,200
8X+ Rs. 1,200-4X = Rs. 2,200
8X-4X = Rs. 2,200-Rs. 1,200
4X= Rs. 1,000
Rs. 1,000
X=-------------- Hero=X = 250 units
4
Total sales = 300 units
(-) Hero sales = 250 units
---------------
Zero sales = 50 units
---------------
Prove:
Hero 250 unitsxRs.8 = 2,000
Zero50 unitsxRs.4 = 200
-----------
Total contribution Rs. = 2,200
(-) Total fixed cost Rs. = 1,600
-------------
Net profit Rs. = 600
------------
REVISION POINTS
 Contribution = Sales-Variable cost
 Contribution = Fixed cost + Profit
 Contribution = Fixed cost – loss
 P/V Ratio= Contribution/ sales x 100
 P/V Ratio = Changes in profit/ Changes in Sales x 100
 BEP =Fixed cost/Contribution x Sales
 BEP = Fixed cost/ P/V Ratio
 MOS = Actual sales – BEP sales
 Fixed cost = Sales x P/V Ratio –Loss
 Fixed cost = Sales x P/V Ratio +Profit
INDEX QUESTIONS
1. Explain the merits and demerits of Cost volume profit analysis.
2. You are given the following data. Total sales Rs. 7,00,000, Variable cost Rs.
4,00,000 and fixed cost Rs.2,00,000. Calculate: Contribution, P/ V ratio,
BEP, Margin of safety , Sales required to earn a profit Rs 50,000 and Profit
when sales amount to Rs 5,00,000.
212
3. From the following data calculate:P/V ratio, Variable cost and Profit.
Rs
Sales 50,000
Fixed expenses 10,000
Break even point 40,000
4. The sales turnover and profit during two years were as follows
Year Sales Profit
Rs (Rs)
2001 70,000 7,500
2002 80,000 10,000
a)P/ V ratio
b)BEP
c)Margin of safety
e)Profit when sales amount to Rs 60,000
SUMMARY
When cost behaviour is studied in relation to income, it shows the cost-volume
profit relationship. As a result of changes in sales volume, variable cost changes as
per change in volume, selling price remains constant, and fixed cost indeed remains
fixed; consequently there is a change in profit. A manager constantly strives to
relate these elements (cost, volume and profit) to maximize profit. Cost volume
profit analysis is helpful in setting up flexible budget which indicate costs at
various levels of activities and helps to forecast profit accurately, it is essential to
ascertain the relationship between costs and profits on the one hand and volume
on the other.
Cost volume profit analysis has some limitations like analysis will be correct
only if input price and selling prices remain fairly constant. Closing stock carried
over to the next financial year does not contain any component of fixed cost.
Contribution is the difference between sales and variable cost. P/V ratio is the
ratio of contribution to sales. Break even point is the level of activity or sales
volume at which the total revenue is equal to the total expenses. Margin of safety is
the difference between actual sales and break even sales. Cost remains unchanged
for any level of activities is known as fixed cost.
TERMINAL EXERCISES
1. What is contribution?
2. What is profit volume ratio
3. What is BEP?
4. What is MOS?
213
5. What is expected sales?

6. What is expected profit?
ASSIGNMENT
1. Explains the imitations of cost volume profit analysis?
2. You are required to calcite 1. Contribution 2. P/v ratio 3. BEP 4. MOS
Sales Rs.2000000
Variable cost Rs.1200000
Fixed cost Rs.400000
REFERENCES
LEARNING ACTIVITIES
KEY WORDS
Contribution, Break even point and Margin of safety

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LESSON – 16
MARGINAL COSTING -BREAK-EVEN CHART (BEC) AND DIFFERENTIAL

COSTING
OBJECTIVES
 understand the meaning of break-even charts
 understand assumption, advantages and limitations of break-even charts
 know different kinds of break-even charts
 understand the meaning and method of finding incremental cost and
incremental revenue
CONTENTS
 Break-even Chart (BEC) - Meaning
o Definition
 Significance of Break-even Chart
 Assumptions of Break-even Chart
 Advantages of Break-Even Analysis and Chart
 Limitations of B.E.C
 Construction of Break-even Chart
 Types of Break even Charts
o Simple break even chart
o Contribution Break Even Chart
o Cash Break-Even Chart
o Profit Break Even Chart
o Control Break-Even Chart
 Differential costing
 Definition for Differential Cost
o Differential Cost
o Differential Costing
 Steps Involved in Differential Costing
 Illustration
INTRODUCTION
In 15th lesson, we discussed the meaning of cost- volume- profit analysis and
its calculation methods. In this lesson, we discuss the meaning of break-even
charts, advantages, limitations, kinds break-even charts and meaning of differential
costing.
215
Break-Even Chart (BEC) - Meaning

In this section, we attempt to make a brief study about meaning of break-even
charts. Graphical representation of break-even point (or cost Volume-profit) is
known as the break-even chart. It is a technique of break-even analysis. Break-even
chart shows the profitability or otherwise of an undertaking at various levels of
activity, and indicates the point at which neither profit nor loss is made.
Definition
In this section, we attempt to make a brief study about definition of break-even
charts
Dr. Vance is of the opinion that “it is a graph showing the amounts of fixed
variable costs and the sales revenue at different volumes of operation. It shows at
what volume the firm first covers all costs with revenue of break-even.”
Significance of Break-Even Chart
In this section, we attempt to make a brief study about significance of break-
even chart. Break-even chart is very useful for managerial decision; with the help of
BEC we can be known the followings
1. The variable costs, fixed costs and total costs.
2. Sales unit or value, Profit or loss and Margin of safety
3. Angle of incidence or the intersection of sales line with costs line can also
be known.
Assumptions of Break-Even Chart
In this section, we attempt to make a brief study about assumptions of break-
even chart
1. Selling price remains the same at different levels of activity.
2. Costs are divided into two namely fixed and variable costs.
3. Variable costs change according to the volume of production but price of
variable costs will be unchanged. Fixed costs remain the same and do not
change with level of activity.
4. There is no change in the product mix and in the level of efficiency.
5. No change in the policies of management and manufacturing process due
to non-static operating efficiency.
6. As the number of units produced and sold are the same
7. There is no closing or opening stock.
Advantages of Break-Even Analysis and Chart
In this section, we discuss the advantages of Break-even chart
1. It helps to determine total cost, variable cost and fixed cost.
2. It helps to study cost, volume, profit relationship and cost control
3. B.E. output or sales value and total profits can be determined.
4. It is very useful to the managerial decision-making.
216
5. It is useful for forecasting Profitability of different levels of activity, various

products or profit, i.e.
6. It is a very usefully technique to select the best products mix inter-firm
comparison is possible.
Limitations of B.E.C
In this section, we discuss the limitations of Break-even chart
1. Exact and accurate classification of cost into fixed and variable is not
possible. There fore B.E.C. is constructed under some unrealistic
assumptions
2. Variable cost per unit is constant and it varies in proportion to the volume.
Fixed costs vary beyond a certain level of output.
3. Detailed information cannot be known from the chart. To know all the
information about fixed cost, Variable cost and Selling price, a number of
charts must be drawn.
4. Constant selling price is not true and no importance is given to opening
and closing stocks.
5. B.E.C concerned with only one sales mix or product mix. It cannot be
studied the various product mix on profits
6. Capital amount, market aspects, effect of government policy etc are
important for decision-making, which are not considered in B.E.C
7. If the business conditions change during a period, the B.E.C. becomes out
of date as it assumes no change in business condition.
Construction of Break-Even Chart
We discuss in this section about how to construction of break-even chart
1. On the graph the ‘X’ axis (horizontal axis) shows the volume of
production and the 'Y' axis (Vertical axis) shows the cost and sales. A
graph has two sides which are known as “axes”. The horizontal side at
the bottom of the graph is the X-axis. The left hand vertical side is the
Y-axis. On the Y-axis, costs and revenues are exhibited. On the X-axis
one or more of production quantity, capacity in percentage form, sales
volume etc. is shown.
2. Draw both axes on the suitable graph paper on the basis of appropriate
scale.
3. Insert production quantity on X-axis and costs and sales revenues on Y-
axis.
4. Draw the fixed cost line on the graph. Even at zero production, the fixed
costs remain the same. At zero production, the fixed costs will be the loss.
5. The total cost line is drawn above the fixed cost line. For this purpose, the
variable cost is added to the fixed cost to arrive at the total cost and drawn
at each and every scale of production.
217
6. Sales revenue line is drawn commencing at zero and finishing at the last
point.
7. Then the sales line cuts the total cost line i.e., sales equals the total cost.
This is known as Break-Even Point. If dotted line is drawn from BEP to X-
axis, it indicates BEP (Units) and if it is drawn towards Y-axis, it indicates
BEP (Value).
8. The difference between the sales line and total cost line is marked as profit
and it is to the right of BEP. The angle at which sales line cuts the total
cost line is the angle of incidence.
9. The position to the left of the BEP on the graph indicates the loss which
goes up to the total amount of fixed costs which is the maximum loss at
the zero production.
10. Then the graph will indicate the BEP, profit or loss at different level of
output, margin of safety, contribution and the relationship between the
marginal cost, fixed cost and total cost.
Types of Break Even Charts
In this section, we attempt to make a brief study of different types of break
even charts. From the point of view of methods of preparation and purpose for
which the Chart is prepared, break even chart may be various types. Normally,
following types are most commonly used.
(1) Simple Break-Even Chart
(2) Contribution Break Even Chart
(3) Profit Break Even Chart
(4) Cash Break Even Chart
(5) Control Break Even Chart
Simple Break Even Chart
It is orthodox break even chart. Its preparation is simple. Normally cost and
revenue are shown on Y-axis, Quantity of sales, Value of sales, Sales as percentage
to capacity, Volume of production (units) Value of production (in rupees) and
Production as percentage to capacity are shown on X axis
Illustration – 1
D Ltd. has furnished the following details: Draw a break-even chart and
determine the brake even point.
Fixed cost Rs.40,000
Variable cost per unit Rs.10
Selling Price per unit Rs.20
Estimated sales 1,000, 2,000, 3,000,4,000, 5,000 and 6,000 units

218
Solution
No. of Units Variable Cost Fixed Cost Total Cost Sales contribution Profit/Loss
0 0 40,000 40,000 0 0 -40,000
1,000 10,000 40,000 50,000 20,000 10,000 -30,000
2,000 20,000 40,000 60,000 40,000 20,000 -20,000
3,000 30,000 40,000 70,000 60,000 30,000 -10,000
4,000 40,000 40,000 80,000 80,000 40,000 0
5,000 50,000 40,000 90,000 1,00,000 50,000 10,000
6,000 60,000 40,000 1,00,000 1,20,000 60,000 20,000
16.7.2 Contribution Break Even Chart

In the case of simple break even chart variable cost line is shown above the
fixed cost line. Some times fixed costs can be shown above the variable costs. In t
such a case the chart is known as contribution break even chart. The specially of
this chart is that contribution is indicated clearly in this chart by way of difference
between variable cost line and sales line.
Contribution Chart
219
Under this method, fixed cost line, sales line and contribution line are drawn.
Contribution line starts from the origin and slopes upward as level of output increases.
The point of intersection of contribution line and the fixed cost line is the break even point,
as at break even point contribution is equal to fixed cost. From the break even point
perpendicular is drawn to x axis to determine the break even output and a
perpendicular is drawn up to the sales line to determine the break even sales.
16.2.7.3 Cash Break-Even Chart
It also follows the conventional form of graph. The expenses are divided into
two viz. cash expenses and non-cash expenses such as depreciation. The cash fixed
cost and the total cash cost lines i. e. excluding depreciation etc, are drawn along
with the sales line. The meeting point of the sales line and the total cash cost line is
the cash break-even point.
Example
Capacity Variable Cost Cash Fixed Cost Total Cash Cost Sales Revenue
% Rs. Rs. Rs.
20 1,00,000 3,00,000 4,00,000 2,00,000
40 2,00,000 3,00,000 5,00,000 4,00,000
60 3,00,000 3,00,000 6,00,000 6,00,000
80 4,00,000 3,00,000 7,00,000 8,00,000
100 500,000 3,00,000 8,00,000 10,00,000
Profit Break Even Chart

It is a simplified and improved form of break-even graph. It is a pictorial
representation of cost-volume-profit relationship. All basic data, required for BE
chart, are required for the construction of the profit volume graph. In this chart, the
horizontal axis represents the sales volume and the vertical axis shows profit or
loss. The vertical slope line above the horizontal line represents the profit and below
the horizontal line shows loss. The diagonal line presents the total marginal
contribution of the business. The horizontal line at zero profit level represents the
220
break-even point where there are no profits or losses. The profit can be determined
at any given point of sale with the help of this profit volume chart.
Profit Chart
Y
60
Profit 40
fit
(in thousand Rs.)
o
Pr
20 B.E.P.
0
X
Loss
1 2 3 4 5 6
–20
ss
Lo
–40
Production in (in thousand units)
Under this method, sales in quantity or value are taken along the x axis and
the profits or losses at various levels on the y axis. The profits and losses at
different levels of sales are marked and the profit line is drawn. Profit line,
commences from a point in the ‘y’ axis for zero level of sales and slopes upwards
crossing x axis. The point at which the profit line intersects x axis (sales line) is the
break even sales in units or value. Profit is zero at the point on the x axis. At zero
level of sales, there is loss equal to fixed cost, Hence the point at which the profit
line starts from the y axis in the amount of fixed cost.
Control Break-Even Chart
Break-even chart may be prepared in conjunction with standard costing and
budgetary control system. Budgeted fixed costs, budgeted variable cost and
budgeted sales are also plotted, in addition to the actual fixed costs, actual variable
costs and actual sales. This graph is useful for comparing budgeted and actual
profits, B.E.P. and sales. It facilitates to study the significant deviations, more
particularly, the profit variance.
Differential Costing
Every decision to be taken involves two or more alternative courses of action.
The decision is based on the difference in effect of cost of the alternatives on future
performance. Only those future cost data are relevant which will differ between two
alternatives. Historical costs have no direct bearing on the decision. Differential
cost meets these two criteria. Thus, differential cost is the difference in total costs
of two or more alternatives or courses of action and relevant for decisions. Thus
differential costing is a technique in which difference between costs and difference
between incomes are compared for the purpose of analysis and decision making.
When the cost increases the difference is called incremental cost and when the cost
221
decreases the difference is called decremental cost. Differential cost is also known
as “Relevant cost” also particularly when a decision is under consideration.
Similarly, when the income or revenue increases the difference is called
incremental revenue and when the income or revenue decreases, the difference is
called, decremental revenue. The incremental or decremental cost includes both
fixed cost and variable cost. But marginal costing technique considers only the
change in variable costs. When change in fixed costs is also considered under
marginal costing, it is equivalent to differential costing technique.
Definition for Differential Cost
Differential Cost
I.C.M.A. defines differential cost as “the increases or decreases in total cost or
the changes in a specific element of costs that result from any variations in
operations” with reference to level of output, differential cost is the difference in
total costs for two levels of output.
Differential Costing
According to I.C.M.A. London “differential costing is a technique based on
reparation of adhoc information in which only cost and income differences between
two alternatives/courses of action are taken into consideration” The differential cost
analysis is useful in making many policy decisions such as:
1. The introduction of a new plant.
2. Make or buy decisions
3. Lease or buy decisions
4. Discontinuing a product, suspending or closing down a segment of the
business.
5. The profitability of a change in product mix.
6. Acceptance of an offer at a lower selling price.
7. Change in the methods of production.
8. The determination of the most profitable levels of production and price.
9. Submitting tenders.
10. The determination of price at which raw materials can be purchased.
11. Equipment replacement decisions.
12. The profitability or Otherwise of further processing.
13. The opening of a new sales area of territory.
Steps involved in Differential Costing
Under differential costing system a comparison is made between the cost it
differential and income differential between two or more situations and decision it
taken up about a particular course of action if incremental revenue is more than
me differential cost. The following are the steps involved in this process
1. Differential cost (Incremental / Decremental) is ascertained by comparing
total cost of each alternative with the cost before taking up the alternative.
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2. Incremental revenue is also calculated as the difference between the total

income before and after implementing the decision
3. Difference between incremental revenue and differential cost shows net
gain or net loss, termed as net increment.
4. Net revenue or net increment is related to incremental investment and rate
of return is calculated.
Generally, positive ‘Net increment’ is a green signal for undertaking a proposal,
unless the return is grossly insufficient in comparison with the cost of capital or
investment.
Illustrations
In this section we worked out some modal problems for your understanding
Illustration – 1
A company has capacity of producing 5,00,000 units of certain product per
annum. The sales department reports that the following prices are possible at
various levels of production.
Volume of production Selling price per unit (Rs)
60 % 2.00
70 % 1.80
80 % 1.60
90 % 1.40
100 % 1.25
The variable cost of manufacture between these level is Re.0.40 per unit and fixed
cost Rs.4,00,000. Prepare a statement showing incremental revenue and differential
cost at each level. At which volume of production will the profit be maximum?
Solution
Volume of Units Selling Sales Incremental Variable Fixed Total cost Incremental Net
production price values Revenues Cost Cost (Rs) (Rs) cost (Rs) increment
p.u (Rs) (Rs) (0.40 p.u) Rs
(Rs) (A) (Rs) (B) (A-B)
60% 3,00,000 2.00 6,00,000 - 1,20,000 4,00,000 5,20,000 - -

70 % 3,50,000 1.80 6,30,000 30,000 1,40,000 4,00,000 5,40,000 20,000 10,000
80 % 4,00,000 1.60 6,40,000 10,000 1,60,000 4,00,000 5,60,000 20,000 -10,000
90 % 4,50,000 1.40 6,30,000 10,000 1,80,000 4,00,000 5,80,000 20,000 -30,000
100 % 5,00,000 1.25 6,25,000 -5,000 2,00,000 4,00,000 6,00,000 20,000 -25,000
Decision
Profit will be maximum at 70 % volume of production i.e., 3,50,000 units
REVISION POINTS
 Graphical representation of break -even point (cost volume profit) is known
as the break even chart
 There are different types of break- even chart such as Simple break even
chart, Contribution break even chart, Profit break even chart, Cash break
even chart, Control break even chart.
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INDEX QUESTIONS
1. What is Break Even Chart? How it is useful?
2. What are the assumptions and limitations of Break Even Chart?
3. Briefly explain the different kinds of Break Even Chart
4. A company has capacity of producing 10,000 unitsat 50 % capacity of
certain product per annum. The sales department reports that the
following prices are possible at various levels of production.
Volume of production Selling price per unit (Rs)

60 % 1.00
70 % 0.90
80 % 0.80
90 % 0.70
100 % 0.65
The variable cost of manufacture between these level is Re.0.20 per unit
and fixed cost Rs 30,000. Prepare a statement showing incremental revenue
and differential cost at each level. At which volume of production will the
profit be maximum?
SUMMARY
Break-even point is known as “no profit, no loss point”. Chart shows the
profitability at various levels of activity, and indicates the point at which neither
profit nor loss is made is known as break-even chart. In simple words the graphical
representation of break-even point is known as the break-even chart. It will show
the variable costs, fixed costs, total costs, Profit or loss margin of safety and angle
of incidence. Break-even chart is help to management in different ways. Differential
costing is a technique in which difference between costs and difference between
incomes are compared for the purpose of analysis and decision making.
TERMINAL EXERCISES
1. What you mean break even chart?
2. What you meant by differential costing?
3. What is the significance of break even chart?
4. What are the limitations of break even chart?
edition)
224
ASSIGNMENT
1. Explain the advantages of break even chart?
2. Explain the various types of break even chart with example?
3. Explain the steps involved in differential costing?
REFERENCES
LEARNING ACTIVITIES
KEY WORDS
Graphical representation and Angle of incidence

225
LESSON – 17
STANDARD COSTING
OBJECTIVES
In 16th lesson, we discussed the meaning of break-even charts, advantages,
limitations, kinds of break-even charts and meaning of differential costing. In this
lesson, we discuss the meaning of standard costing, applicability, advantages and
limitations of standard costing. After going through this lesson you will able to
 understand the meaning of standard costing
 understand applicability, advantages and limitations of standard costing
CONTENTS
 Introduction
o Definition
 Technique of standard costing
 Objectives of Standard Costing
 Establishment of a Standard Costing System
 Applicability of Standard Costing
 Types of Standards
o Ideal Standard
o Basic Standard
o Normal Standards
o Expected Standard
 Advantages of Standard Costing
 Limitations of Standard Costing
 Determination of Standards
 Determination of Standard Hour
INTRODUCTION
In this section, we attempt to make a brief study about meaning of standard
costing. Standard costing is one of the tools of cost control. It is an extension of
budgetary control. Standard cost is defined as pre-determined cost based on
normal conditions of production and standard costing as a system of costing which
involves specification of standard cost for each element of cost comparison of actual
costs with the standards, determination of variances i.e., the deviation of actual
costs from the standard costs, identification of causes for adverse variances and
presentation of relevant cost information to management for corrective action in
case of adverse variances. The standard costing is based on the principle- ‘What the
cost ought to be? From this standpoint the standard cost is different from the
estimated cost which provides an idea as to what the cost will be The standard cost
is predetermined after careful studies of production methods and techniques and
the most’ likely cost of inputs whereas the estimated cost is simply based on
personal estimation which generally is the average of the cost incurred in the past.
226
The very purpose of standard cost and estimated cost differ as the former is set
with the main purpose of cost control and cost reduction whereas the later is
estimated just for rough estimation of profit margins. It may be noted that the
standard costing is not a separate method of cost accounting but it is a technique
which is used to achieve certain objectives.
Definition
In this section, we attempt to make a brief study about definition of standard
costing.
I.C.M.A., England has defined Standard costs as “a predetermined cost which
is calculated from management’s standard of efficient operation and the relevant
necessary expenditure”.
It also has defined Standard costing as “the preparation and use of standard
costs their comparison with actual costs and the analysis of variances to their
causes and points of incidence”.
From the above definitions it is clear the Standard costs represent the
scientifically planned or predetermined costs based on technical estimate of
material, labour and overhead for a selected period of time and for a prescribed set
of working conditions. These standards can be established in respect of qualities
like material and labour.. Moreover these standards should be accepted by the
people who use it and they should be relatively permanent.
Technique of Standard Costing
We present here a brief explanation about different technique of standard
costing involves.
1. The ascertainment of standard costs.
2. The used of standard costs.
3. Their comparison of it with the actual and the measurement of variances.
4. The location of responsibility for the variance and the corrective action to
be taken.
5. The analaysis of variance for ascertaining the reasons for the same.
Objectives of Standard Costing
We discuss in this section the general objectives of standard costing
1. The control of all factors affecting production.
2. The disclosure of the effect of temporary increase of decrease in the volume
and sales on revenues.
3. The supply of prompt reports to the management showing the progress of
production and low expenditure to date. Compares the estimates so that
corrective actions may be taken in time.
Establishment of a Standard Costing System
We present here a brief explanation about establishment of a standard costing
system. he installation of standard costing system in a manufacturing concern
involves the following steps.
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1. Setting of standard costs

2. Setting up of standards
3. Classification of accounts
4. Establishment of costs centers
5. Standardisation of functions
Applicability of Standard Costing
In this section, we attempt to make a brief survey of applicability of standard
costing. The technique of standard costing can be applied to any class of
production or service. Anyhow it is appropriate in those cases where service or
production is of a repetitive character. It is implied that this technique is of
maximum value when it is used with a process costing system in process industries
like bricks, cement, fertilizer, paper, sugar, biscuits etc.
Types of Standards
The following are four types of standards which may be used in an organization.
1. Ideal Standard
2. Basic standard
3. Normal Standard
4. Expected Standard
Ideal Standard
Manufacturing concerns may try to reach this level of attainment which will
result only from ideal condition like maximum sales, low cost of labour and
materials etc. But ideal conditions exist rarely. So they are not realistic. They
discourage the employees with adverse variance.
Basic Standard
Here standards are fixed with reference to base year. For example, if the year
1980 is taken as 1:l1e base year, than the standards costs fixed for that year will be
compared with the actual costs of the year under consideration. The main
difference between the current standard and the basic standard is in the period of
time for which the standards are set for a short term, the basic fixed for quite a
long period requiring periodic revisions.
Normal Standards
Some times an average level of attainment is set as the target. This would iron
out the wide punctuations that may be caused by the seasonal and cyclical changes
in business.
Expected Standard
Business organisation hopes to attain some maximum possible efficiency
under the actual conditions which are prevailing in the business. Standards are set
for budget period on the basis of this expected level attainment. As they are based
on current conditions, they are fixed for a short term and revised frequently
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whenever changes take place in the working conditions. Hence they are also called
'current standard costs'
Advantages of Standard Costing
In this section, we discuss the advantages of standard costing
1. Standard costs help the management in fixation of prices and in laying
down production policies.
2. They help in readily showing up and than elimination of avoidable wastage
and losses;
3. They provide constant and uniform bases for management on the
operational efficiency of workers and other members of the staff.
4. Management, through the study of variances, needs to concentrate only
areas and problems which call for its attention ie, the system of
"management by exception" be precrised.
5. Delegation of authority becomes effective as the concerned men know that
they have to achieve and by what standard they will be judged.
6. The whole concern is injected with a dynamic forward looking mentality.
7. Performance of employees at all levels can be judged objectively. This
enables the concern to promote and reward the right person.
8. Standards function as a ‘yardstick’measure the actual performance and the
efficiency of labour and other factors.
9. Valuation of closing stock is facilitated by the standard cost of production.
10. As standards &re set for every- element of cost, the costing procedures are
simplified.
Limitations of Standard Costing
In this section, we discuss the disadvantages of standard costing
1. Setting the standards itself is a difficult task as it involves technical skill.
2. The fixation of inaccurate standards, especially those that are incapable of
achievement, adversely effects the morale of the employees and act as
hindrance to increased efficiency.
3. The system is pot suitable for the jobbing type of industries producing
articles according to customer's specifications. Even if it is installed, the
fixation of standard for each type of job becomes difficult and expensive.
4. It is necessary to distinguish between controllable and uncontrollable
variances in order to locate deviations and fix responsibilities.
5. The system may not be suitable even in the case of industries that are
liable to frequent technological changes affecting the conditions of
production. Even if it is installed, a constant revision of standards becomes
necessary.
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6. Small concerns cannot afford this system due to higher cost associated
with standard costing.
7. There is not unanimity regarding the circumstances to be taken as the
basis for setting standard costs. Even if there is unanimity, a revision of
standard is essential to suit to the changing circumstances. The revision of
standard becomes expensive. If they are not revised, they become
outmoded. Just as inaccurate standards are not reliable and harmful, so
are outmoded standards disadvantageous.
Determination of Standards
For any given product or unit the following standards must be determined.
1. Standard material cost
2. Standard labour costs
3. Standard direct costs
4. Standard variable over head costs
5. Standard fixed overhead costs
6. Standard Selling price and profit.
The Standard Direct Material cost is found by multiplying by quantity
materials to be purchased with the rate of price at which they are available.
Determination of Standard Labour costs involves fixation of (a) standard
labour grease (b) standard labour times i.e., standard hours through "Time Motion
and Fatigue Study" with the help of work study engineers and (c) standard wages
rates based on time rate, piece rate and premium plans.
Standard Direct (expenses) costs is any-expenditure other than direct material
and direct labour which is directly to be accrued on a specific cost unit. It is
charged directly to the particular cost standard (account) concerned.
Standard Overhead costs are classified as manufacturing, administration,
selling and distribution overhead. They are also classified as fixed, variable and
semi-variable so that correct estimate for each class may be prepared for the budget
period. Standard overhead rate in determined on the basis of the past records and
the future trends.
Determination of Standard Hour
We present here a brief explanation about determination of standard hour.
Time factor is common to all the operations. In standard costing ‘standard hour’ is
applied to the quantity of work or output which should be performed in one hour. A
standard hour may be defined as an hour which measures the amount of work that
should be performed in one hour under standard conditions. It has a practical
advantage in the measurement of ‘Efficiency Ratio and Activity Ratio’.
Efficiency ratio is the number of standard house equivalent to the work
produced, expressed as a percentages of the actual hours spent in producing that
work.
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Standard hours for actual production

Efficiency Ratio  100
Standard hours for budgeted production
Activity Ratio is the number of standard hours equivalent to the work
produced, expressed as a percentage of budgeted standard hours,
REVISION POINTS
 Standard costing is one of the tools of cost control.
 Various techniques of standard costing.
 Various objectives of standard costing.
 There are four standard such as Ideal standard, Basic standard, Normal
standard, Expected standard
INDEX QUESTIONS
1. Evaluate the advantages and limitations of standard costing system
2. Explain the different steps involved in the installation of standard costing
system
SUMMARY
In this lesson, we have briefly touched upon the following points.
Standard cost is defined as pre-determined cost based on normal conditions of
production and standard costing as a system of costing which involves specification
of standard cost for each element of cost comparison of actual costs with the
standards, determination of variances. The main objectives of standard costing are
control of all factors affecting production and disclosure of the effect of temporary
increase of decrease in the volume and sales on revenues. The technique of
standard costing can be applied to any class of production or service. The following
are four types of standards which may be used in an organization namely 1) Ideal
Standard, 2) Basic standard, 3) Normal Standard 4) Expected Standard. The main
limitation of standard costing is the fixation of inaccurate standards, especially
those that are incapable of achievement, adversely effects the morale of the
employees and act as hindrance to increased efficiency.
TERMINAL EXERCISES
1. Define standard costing?
2. Explain the various types of standard costing?
3. What are the objectives of standard?
4. Explain the limitations of standard costing?
5. Explain the how to determination of standard?
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ASSIGNMENT
1. Explain the various types of standard costing?
2. Explain the limitations of standard costing?
3. Explain the how to determination of standard?
REFERENCES
LEARNING ACTIVITIES
organization
KEY WORDS
Ideal standard and variances

232
LESSON – 18
VARIANCE ANALYSIS – MATERIAL VARIANCE

OBJECTIVES
 understand the meaning of variance analysis
 understand the method of calculation of variance
 know different types of material variances
CONTENTS
 Meaning of variance:
 Controllable and uncontrollable variances:
 Favourable and unfavourable variances
 Categories of Variances
o Material Variance
o Direct Material Cost Variance (DMCV)
o Direct Material Price Variance (DMPV)
o Direct Material Usage Variance (DMUV)
o Direct Material Mix Variance (DMMV)
o Direct Material Yield Variance (DMYV)
 Illustrations
INTRODUCTION
In 17th lesson, we discussed the meaning of standard costing, applicability,
advantages and limitations of standard costing. In this lesson, we discuss the
meaning of variance analysis and calculation of variance.
Meaning of Variance
In this section, we attempt to make a brief study about meaning of variance
analysis. Cost reduction through economic use of resources is the primary objective
of standard costing. Cost is controlled by means of comparing actual performances
with the standards set earlier. It helps identify how much more or less than the
standard has been spend. Here differences or variances are computed by comparing
actual sales, actual cost and actual profits with standard sales, standard cost and
standard profits. These variances may be either favourable or adverse to the entity.
Controllable and Uncontrollable Variances:
In this section, we attempt to make a brief study about meaning of controllable
and uncontrollable variances. According to the controllable nature variances may
be of two types: controllable and uncontrollable. If the person or section responsible
for the variance is identifiable, costs are considered controllable, otherwise not.
When raw materials and labour hours are spent more than standard, the person
responsible for the same can be identified. But when material prices and wage rates
233
are higher than the standard prices and rates, it is very difficult to hold and
individual responsible. Thus the variances arising out of external factors are
considered uncontrollable. This is why; variances should be classified as
controllable and uncontrollable to identify the person accountable for the same.
Favourable and Unfavourable Variances
In this section, we attempt to make a brief study about favourable and
unfavourable. The actual costs incurred in a period are compared with the relevant
standard cost and any deviation or difference is termed as variance. The variance
can be favourable and unfavourable. In case of cost variances, a favourable
variance means the actual cost incurred is less than the standard cost specified.
Favourable variance may also be called positive variance or credit variance.
In case of sales variances, when the actual sales are more than the standard
or budgeted sales it is termed favourable. Thus, in case of cost variances, the Cost
should be less than standard and in case of sales, the actual sales be more than
the standard for the variance to be termed as favourable.
Unfavourable variance, also called ‘Adverse’ or ‘Negative’ variance is the result
when the actual cost exceeds the standard cost. The same is the result when actual
sales are less than the budgeted sales. Adverse variances result in decrease of the
profit by increase in the total cost. It is essential to probe into the cause for
unfavourable variances deeply to identity any inefficiency, negligence, etc.
Categories of Variances
We present here a brief explanation about different categories of variances.
Variances can be broadly divided into two categories: (1) Cost variances d (2) Sales
variances.
Cost Variances: Total cost variance is the difference between standard cost for
the actual output and the actual total cost incurred. The total cost variance can be
subdivided as follows:
(a) Direct material variances
(b) Direct labour variances
(c) Overhead variances
Material Variance
In this section, we attempt to make a brief survey of different types of material
variances. The Material variance can be subdivided as follows:
i) Direct material cost variance (DMCV)
ii) Direct material price variance (DMPV)
iii) Direct material usage variance (DMUV)
iv) Direct material mix variance (DMMV)
v) Direct material yield variance (DMYV)
vi) Direct material sub-usage variance (DMSUV)
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Direct material cost variance (DMCV)

The variance between standard cost and actual cost of materials is known as
material cost variance. This variance arises mainly from two factors: one fr from
variation in its prices and the other from the variation in its uses. Relation among
the variances may be diagrammatically presented as below:
From the diagram it is evident that material cost variance refers to difference
between standard cost and actual
a cost of material. The same formula is applicable
to the measurement of labour and overhead cost variances. Now let us examine
how the standard cost and actual cost are determined.
Standard cost
We should bear in mind that all the components of standard
standa cost are not
based on estimates. It is composed of two factors. One is standard rate per unit of
production and the other is actual quantity of production. Hence standard cost is
neither a totally estimated one, nor an exclusively actual cost. In other way of
speaking, it refers to what should have been the cost to produce what have been
actually processed.
Here, Material cost variance = SC –AC
Where, SC = Standard cost of actual number of goods produced,
AC = Actual cost
Again, SC = SRxAQ
SRx
AC = ARxAQ
Where, SR = Standard rate of material cost per unit,
AR = Actual cost of material per unit,
AQ = Number of goods actually produced.
Causes of material cost variances
(a)Changes
a)Changes in price of direct raw materials,
(b)Failure to secure discount on purchase,
(c)Non-availability
availability of standard quality of raw materials,
(d)Excessive carriage inwards arising from purchases of small quantity of
goods per lot, and
(e)Failure to purchase materials in time.
Direct material price variance (DMPV)
As stated earlier material cost variance arises out of two major factors: one
from variations in prices and the other from changes in quantity of material
235
consumed. Material price variance is the difference between the standard price
specified and the actual price paid.
Material price variance = AQ (SP – AP)
In other words, the price variance is computed by multiplying the actual
quantity of goods used by the difference between standard price and actual price
per unit of raw material.
Reasons for material price variance
1. Efficient or inefficient buying
2. higher or lower freight and other charges
3. Changes in contract price
4. Fluctuations in market price
5. Bulk- Purchase or Hand –to- mouth purchase policy
Direct material usage variance (DMUV)
This is the difference between the standard quantity specified and the actual
quantity used. Material usage variance = SP (SQ – AQ)
Here, SQ = Quantity of materials which should have been used to produce the
units actually produced. Usually purchase manager is held responsible for
variations arising out of such circumstances. Some of the above factors might be
out of his control. In such cases he cannot be held accountable.
Causes of material usage variance
(a)Negligence in use of raw materials,
(b) Defect in production technique or employment of untrained and unskilled
workers,
(c)Pilferages of raw materials,
(d)Use of raw materials more than standard,
(e)Use of additional materials because of defective production.
Direct Material Mix Variance (DMMV)
Production of output may require mixture of raw materials of different
qualities and prices. The proportion at which they should be mixed is usually
predetermined. But the proportion of actual mix may differ from that of the
predetermined mix. This results in variation in the quantity of materials used.
Variation in cost due to change in the proportion of mix of materials is called
material usage variance. This cost may again be classified into two groups:
(a) Material Mix Variance and
(b) Material Yield Variance.
If material mix used in production is different from the standard mix, the
difference in cost is called material mix variance. The actual yield may also differ
from the standard output expected from the raw materials put in. The cost of this
236
difference is called material yield variance. Relation between the two is graphically
shown below.
Material Mix Variance= SP x ( RSQ – AQ)

Here RSQ means Revised Standard Quantity
S tan dard Quantity
RSQ = Total Actual Quanity
Total S tan dard Quantity
Direct material yield variance (DMYV)
This is that portion of the direct material usage variance which is due to the
difference between standard yield specified and actual yield obtained.
SC x ( SY-AY)
(or)
(Standard loss for actual input – Actual loss) x Average standard price
Total s tan dard cos t
Average standard price =
S tan dard output
Illustrations
In this section, we worked out some model problems for your understanding
Illustration – 1
Calculate material variances
Material Standard price per Standard Actual Price Actual Quantity
Kg.Rs quantity Rs.
A 5 10,000 7 12,000
B 9 5,000 6 6,000
Solution
Material Standard Actual
SQ SP SC AQ AP AC
( SQ x SP) ( AQ x AP)
A 10,000 5 50,000 12,000 7 84,000
B 5,000 9 45,000 6,000 6 36,000
Total 15,000 95,000 18,000 1,20,000
Direct Material Cost Variance (DMCV)
DMCV = SC – AC
Material A 50,000 - 84,000 = 34,000 (UF)
Material B 45,000 - 36,000 = 9,000 (F)
25,000 (UF)
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Direct Material Price Variance (DMPV)

DMPV=AQ  ( SP- AP)
Material A 12,000  (5-7) = 24,000 (UF)
Material B 6,000  (9-6) = 18,000 (F)
6,000 (UF)
Direct Material Usage Variance (DMUV)
DMUV=SP x ( SQ- AQ)
Material A 5  (10,000 -12,000) = 10,000 (UF)
Material B 9  (5,000 – 6,000 ) = 9,000 (UF)
19,000 (UF)
Check1 :DMCV=DMPV+DMUV
25,000(UF) = (6,000 UF + 19,000UF)
DMMV=SP x ( RSQ- AQ)
S tan dard Quantity
RSQ = x Total Actual Quanity
10 ,000
Material A = 18 ,000 = 12,000
15 ,000
5 ,000
Material B = 18 ,000 = 6,000
15 ,000
Material A 5  (12,000 -12,000) = 0
Material B 9  (6,000 – 6,000 ) = 0
0
Direct Material Sub – Usage Variance (DMSUV)
DMSUV=SP x (SQ- RSQ)
Material A 5  (10,000 -12,000) = 10,000 ( UF)
Material B 9  (5,000 – 6,000 ) = 9,000 (UF)
19,000 (UF)
Check 2:DMUV=DMMV+DMSUV
19,000(UF) = ( 0 + 19,000UF)
Illustration – 2
The standard material cost for 100 kg. of chemical D is made up of:
Chemical A - 30 kg. @ 4 per kg.
Chemical B - 40kg, @ Rs,5 per kg.
Chemical C - 80kg. @ Rs,6 per kg.
In a batch, 500 kg. of chemical D were produced from a mix of
Chemical A - 140 kg. at a cost of Rs,588
Chemical B - 220kg. at a cost of Rs.1 ,056
Chemical C - 440kg. at a cost of Rs,2,860
Calculate the various variances for 100 kgs. of chemical D.
238
Solution
Chemical A
Actual quantity for 100 Kgs of D
For 500 Kg of D140 kgs are used
For 100 kg how much required
140
100  28 kgs
500
Chemical B
Actual quantityfor 100 Kgs of D
220
100  44 kgs
500
Chemical C
Actual quantity for 100 Kgs of D
440
100 88 kgs
500
588
Actual price Chemical A =  4.2 per kgs
140
1,056
Actual price Chemical B =  4.8 per kgs
220
2 ,860
Actual price Chemical C =  6.5 per kgs
440
Chemicals Standard Actual
SQ SP SC AQ AP AC
A 30 4 120 28 4.2 117.60
B 40 5 200 44 4.8 211.20
C 80 6 480 88 6.5 572.00
Total 150 800 160 900.80
DMCV = SC – AC
Chemical A 120 - 117.60 = 2.40 (F)
Chemical B 200 - 211.20 = 11.20 (UF)
Chemical C 480 - 572 = 92.00 (UF)
100.80 (UF)
DMPV=AQ x ( SP- AP)
Chemical A 28 x (4-4.2) = 5.60 (UF)
Chemical B 44 x (5-4.8) = 8.80 (F)
Chemical C 88 x (6-6.5) = 44.00 (UF)
239
40.80 (UF)
DMUV=SP x ( SQ- AQ)
Chemical A 4 x (30 - 28) = 8 (F)
Chemical B 5 x (40 – 44 ) = 20 (UF)
Chemical C 6 x (80 - 88) = 48 (UF)
60 (UF)
100.80 (UF) = ( 40.80 UF + 60UF)
S tan dard Quantity
30
Material A = 160 = 32
150
40
Material B = 160 = 42.67
150
80
Material C = 160 = 85.33
150
Chemical A 4  (32 -28) = 16 ( F)
Chemical B 5  (42.67-44 ) = 6.65 ( UF)
Chemical C 6  (85.33-88) = 16.02 ( UF)
6.67 ( UF)
Direct Material Sub – Usage Variance (DMSUV)
DMSUV=SP x (SQ- RSQ)
Chemical A 4 x (30 -32) = 8.0 ( UF)
Chemical B 5 x (40 – 42.67 ) = 13.35 (UF)
Chemical C 6 x ( 80 – 85.33) = 31.98 (UF)
53.33 (UF)
60 (UF) = ( 6.67UF+ 53.33UF)
Illustration – 3
SQ SP Total AQ AP Total
A 500 6.00 3,000 400 6.00 2,400
B 400 3.75 1,500 500 3.60 1,800
C 300 3.00 900 400 2.80 1,120
1,200 1,300
Less: 10% Normal 120 220
loss
1080 5,400 1,080 5,320
240
Solution
DMCV = SC – AC
A 3,000 - 2,400 = 600 (F)
B 1,500 - 1,800 = 300 (UF)
C 900 - 1,120 = 220 (UF)
80 (F)
DMPV=AQ x ( SP- AP)
A 400 x (6-6) = 0
B 500 x (3.75-3.60) = 75 (F)
C 400 x (3-2.80) = 80 (F)
155 (F)
DMUV=SP x ( SQ- AQ)
A 6 x (500 -400) = 600 (F)
B 3.75 x (400- 500 ) = 375 (UF)
C 3 x (300- 400) = 300 (UF)
75 (UF)
Check1:DMCV=DMPV+DMUV
80 (F)=(155 F + 75UF)
S tan dard Quantity
500
Material A = 1300 = 541.67
1200
400
Material B = 1300 = 433.33
1200
300
Material C = 1300 = 325.00
1200
A 6  (341.67 -400) = 850 ( F)
B 3.75  (433.33- 500 ) = 250 ( UF)
C 3  (325-400) = 225 ( UF)
375 ( UF)
Direct Material Yield Variance (DMYV)
(Standard loss for actual input – Actual loss)x Average standard price
Standard loss for actual input 1,300  10% = 130
241
Average standard price 5,400/ 1,080 = Rs 50

DMYV(130- 220)  5= 450 (UF)
75 (UF) = (375 F+ 450 UF)
Illustration – 4
Standard material for 100 kgs chemical NO. 007 is given bellow
45 kg of material A @ Rs 2 per kg. Rs 90
40 kg of material B @ Rs 4 per kg. Rs 160
25 kg of material C @ Rs 6 per kg. Rs 150
110
Standard loss 10
----------
100
----------
Actual production 2,000 kg of chemical No.007Actual material usage is as follows
Material A 1,000Kgs @ Rs 1.90 per Kg .Rs 1,900
Material B 850Kgs @ Rs4.20 per Kg.Rs 2,570
Material C 450Kgs @ Rs6.50 per Kg.Rs 2,925
Solution
SQ for production of 100 units is given for production of 2000 units SQ will be
2,000
Material A x 45  900 Kgs
100
2,000
Material B x 40  800 Kgs
100
2,000
Material C x 25  500 Kgs
100
Std loss 10 kgs for input of 110 Kgs
Std loss for the input of 2200 kgs will be
10
x 2 ,200  200Kgs
110
Actual loss: Actual input – Actual output
2,300 – 2,000 = 300 Kgs
SQ SP SC AQ AP AC
A 900 2 1,800 1,000 1.90 1,900
B 800 4 3,200 850 4.20 3,570
C 500 6 3,000 450 6.50 2,925
Total 2,200 2,300
Less: Std loss 200 300
2,000 8,000 2,000 8,395
DMCV = SC – AC
242
A 1,800 - 1,900 = 100 (UF)

B 3,200 - 3,570 = 370 (UF)
C 3,000 - 2,925 = 75 (F)
395 (UF)
DMPV=AQ x ( SP- AP)
A 1,000 x (2-1.90) = 100 (F)
B 850 x (4-4.20) = 170 (UF)
C 450 x (6-6.50) = 225 (UF)
295 (UF)
DMUV=SP x ( SQ- AQ)
A 2 x (900-1,000) = 200 (UF)
B 4 X (800-850 ) = 200 (UF)
C 6 X (500-450) = 300 (F)
100 (UF)
395 (UF) = ( 295 UF + 100UF)
S tan dard Quantity
900
Material A = x 2300 = 940.91
2200
800
Material B = x 2300 = 836.36
2200
500
Material B = x 2300 = 522.73
2200
DMMV =SP x ( RSQ- AQ)
A 2 x (940.91- 900) = 118.18 (U F)
B 4 x (836.36-800 ) = 54.55 ( UF)
C 6 x (522.73-500) = 436.36 ( F)
263.83 ( UF)
Direct material yield variance (DMYV)
Std loss 10 kgs for input of 110 Kgs
Std loss for the actual input of 2300 kgs will be
10
x 2,300  209.09Kgs
110
243
Average standard price 8,000/ 2000 = Rs 4

DMYV (209.09- 300) x 4= 363.63 (UF)
100 (UF) = (263.63 F+ 363.63 UF)
Illustration –5
Standard material cost of a certain chemical mixture is
40 % material A @ Rs 25 per kg
60 % material B @ Rs 36 per kg.
Standard loss of10 % is expected in production
Actual material usage is as follows
Material A 150 Kgs @ Rs 27 per Kg
Material B 260 Kgs @ Rs 34 per Kg
The actual output was 360 Kgs
Calculate all material variances
Solution
Calculation of SQ
Material A 40%
Material B 60%
100%
Standard loss 10%
Actual Output 90%
Material A40 requiredfor production of 90
Material A required for production of 360 kgs will be
40
x 360 160
90
Material B 60 required for production of 90
Material B required for production of 360 kgs will be
60
x 360  240
90
SQ SP SC AQ AP AC
A 160 25 4,000 150 27 4,050
B 240 36 8,640 260 34 8,840
Total 400 410
Less: Std loss10% 40 50
360 12,640 360 12,890
410 – 360 = 50
244
DMCV = SC – AC
A 4,000 - 4,050 = 50 (UF)
B 8,640 - 8,840 = 200 (UF)
250 (UF)
DMPV=AQ x ( SP- AP)
A 150 x (25-27) = 300 (UF)
B 260 x (36-34) = 520 (F)
220 (F)
DMUV=SP x ( SQ- AQ)
A 25 x (160 -150) = 250 (F)
B 36 x (240- 260 ) = 720 (UF)
470 (UF)
250 (UF)=220(F) + 470(UF)
S tan dard Quantity
160
Material A =  410 = 164
400
240
Material B = 410 = 246
400
A 25  (164 – 150) = 350 ( F)
B 36  (246 –260) = 504 ( UF)
154 ( UF)
Standard loss for actual input 418 x 10% = 41
Average standard price 2,640/ 360 = Rs 35.11
DMYV(41- 50) x 35.11= 315.99 (or) 316 (UF)
470 (UF) = (154UF + 316 UF)
Illustration– 6
Standard material cost of a certain chemical mixture is
60 % material B @ Rs 3 per kg
Standard loss of 15 % is expected in production
Actual production is 1,700 kgs
The position of stocks and purchases for the period is as under
245
Material Opening Closing stock Purchase

stock
Quantity Total Cost
A 35 5 800 3,400
B 40 50 1,200 3,000
Calculation of SQ
Material A 40%
Material B 60%
100%
Standard loss 15%
Actual Output 85%
Material A40 required for production of 85
Material A required for production of 1,700 will be
40
x 1700  800
85
Material B 60 required for production of 85
Material B required for production of 1,700 will be
60
x 1,700 1,200
85
Calculation of AQ and AP
Qty Rate per Value Qty Rate per Value
unit unit
Opening Stock 35 4 140 40 3 120
Add: Purchase 800 3400 1,200 3,000
835 3540 1240 3120
Less: Closing Stock 5 4 20 50 3 150
830 3520 1190 2970
3520 2970
Actual price:A  4.24 B  2.50
830 1190
SQ SP SC AQ AP AC
A 800 4 3200 830 4.24 3527
B 1200 3 3600 1190 2.50 2975
Total 2000 2020
Less: Std loss15% 300 320
1700 6800 1700 6502
2020 – 1700 = 320
246

DMCV = SC – AC
A 3,200 - 3527 = 327 (UF)
B 3,600 - 2975 = 625 (F)
298 (F)
DMPV=AQ x ( SP- AP)
A 830 x (4-4.25) = 207.50 UF
B 1190 x (3-2.50) = 595 (F)
387.50 (F)
DMUV=SP x ( SQ- AQ)
A 4 x (800 -830) = 120 (UF)
B 3 x (1,200- 1,190 ) = 30 (F)
90 (UF)
Check1 : DMCV=DMPV+DMUV
298 (F)=(387.50 F + 90UF)
S tan dard Quantity
800
Material A = x 2020 = 808
2000
1,200
Material B = x 2020 = 1212
2000
A 4 X (808 -830) = 88 (UF)
B 3 X (1,212- 1190 ) = 66 ( F)
22 ( UF)
Standard loss for actual input 2020 x 15 % = 303
Average standard price 6800/ 1,700 = Rs 4
DMYV(303- 320) x 4 = 68 (UF)
90 (UF) = (22 UF + 68 UF)
247
REVISION POINTS
 Cost variance is the difference between standard cost for actual output and
the actual cost incurred.
 DMCV =Standard Cost –Actual Cost
 DMPV = Actual Quantity (Standard Price-Actual Price)
 DMUV = Standard Price (Standard Quantity- Actual Quantity)
 DMMV = Standard Price(Revised Standard Quantity- Actual Quantity)
 DMYV =Standard cost (standard Yield-Actual Yield)
INDEX QUESTIONS
1. Explain different types of variances.
2. What is the difference between controllable and uncontrollable variances?
3. The standard material cost for 500 kg. of chemical B is made up of:
Chemical A - 150 kg. @ Rs.2 per kg.
Chemical B – 200kg, @ Rs.3 per kg.
Chemical C – 400kg. @ Rs.5 per kg.
In a batch, 2000 kg. of chemical B were produced from a mix of
Chemical B - 800kg. at a cost of Rs.3,200
Calculate the various variances for 500 kgs. of chemical B.
4. Calculate material variances from the following data
Material SQ SP AQ AP
A 1000 5 800 6
B 800 4 1000 5
C 600 6 800 5
2400 2600
Less: 10% Normal loss 240 440
2160 2160
5. Standard material cost of a certain chemical mixture is
60 % material B @ Rs 6 per kg.
Standard loss of 10 % is expected in production
Actual material usage is as follows
Material A 300 Kgs @ Rs 7 per Kg
Material B 520 Kgs @ Rs 4 per Kg
The actual output was 500 Kgs
248
SUMMARY
In this lesson, we have briefly touched upon the following points: In this analysis
variances are computed by comparing actual sales, actual cost and actual profits with
standard sales, standard cost and standard profits. These variances may be either
favourable or adverse to the entity. If actual costs are less than standards, the
variances are favourable for they bring economy. Conversely, when actual sales are
less than standards, the situation is adverse to the business. These differences or
variances reveal the efficiencies of concerned production centres or people. Favourable
variances denote efficiency, while adverse ones signify incompetence.
If the person or section responsible for the variance is identifiable, costs are
considered controllable, otherwise not. Variances can be broadly divided into two
categories: (1) Cost variances d (2) Sales variances. The variance between standard cost
and actual cost of materials is known as material cost variance. Material usage variance
is the difference between the standard quantity specified and the actual quantity used.
TERMINAL EXERCISES
1. Explain the term Variance?
2. What is difference between controllable and uncontrollable variance?
3. What is difference between favorable and unfavorable variance?
4. What is material variance?
 Horngren, Datar & Foster, Cost Accounting–A Managerial Emphasis (any
edition)
ASSIGNMENT
1. What is difference between controllable and uncontrollable variance?
2. What is difference between favorable and unfavorable variance?
3. What is material variance? Explain with examples
REFERENCES
249
LEARNING ACTIVITIES
KEY WORDS
Variance, Favourable and Controllable

250
LESSON – 19
VARIANCE ANALYSIS – LABOUR AND OVERHEAD VARIANCES

OBJECTIVES
In 18th lesson, we discussed the meaning of variance analysis and calculation
of material variance. In this lesson, we discuss the meaning, different kinds of
labour and overhead variances and calculation of different types of labour and
overhead variance. After going through this lesson you will able to
 understand the meaning of labour and overhead variances
 know different types of labour and overhead variance
 understand the method of calculation of labour and overhead variance
CONTENTS
 Introduction
 Types of Labour Variances
 Direct Labour Cost variance (DLCV)
o Direct Labour Cost Variance (DLCV)
o Direct Labour Rate Variance (DLRV)
o Idle Time Variance
o Direct Labour Efficiency Variance (DLEV)
o Direct Labour Mix variance (DLMV) / Gang Composition Variance
o Direct labour yield variance (DLYV)
 Illustrations
 Overhead Variances
 Kinds of overhead variances
o Overhead cost Variance:
o Overhead Budget Variance (or) Overhead Expenses Variance
o Overhead volume variance
o Overhead Efficiency Variance
o Overhead capacity variance
o Calendar Variance
INTRODUCTION
In this section, we attempt to make a brief study about meaning of labour
variance. Labour variance arise because of (i) difference in actual rate and standard
rates of labour and (ii) the variation in actual time taken by workers and the standard
time allotted to them for performing a job. These are computed on the same pattern as
those of material variances. Labour variance can be very easily calculated by applying
the same techniques as used in calculation of material variance. One can find out the
various formulas for Direct labour variance by simply putting the word “time” in the
place of “Quantity” in the formula of meant for Direct material variance.
251
Types of Labour Variances

In this section, we attempt to make a brief survey of different types of labour
variances. The labour variance can be subdivided as follows:
1. Direct labour cost variance ( DLCV)
(or) Direct labour wage variance (DLWV)
2. Direct labour rate variance ( DLRV)
3. Direct labour efficiency variance (DLEV)
(or) Direct labour time variance (DLTV)
4. Direct labour mix variance ( DLMV) (or) Gang composition variance
5. Direct labour yield variance ( DLYV)
6. Direct labour sub-efficiency variance ( DLSEV)
7. Direct labour Idle time variance
Direct Labour Cost Variance (DLCV)
Difference between standard cost and actual cost of labour is called labour
cost variance. Computation of the variance requires determination of two items.
One, what should have been spent on labour to produce the units which have been
actually produced. The other is the amount which has been actually spent for the
purpose. The difference between the two may again be classified in these broad
categories. First, there may be difference between standard and actual wage rate;
secondly, workers may be paid for idle hours, and thirdly, the time during which
the work has been completed might be more or less than the time during which the
work should have been completed. The first one is known as labour rate variance,
the second one as idle time variance and the last one as labour efficiency variance.
Relations among the three are diagrammatically shown below.
Labour Cost Variance
SC – AC
Labour Rate Variance Idle time Variance Labour efficiency variance

AH paid* (SR – AR) SR x Idle time SR (SH – AH worked*)
Note (*)Students should be aware of the difference between AH paid for and AH
worked. The two may not be equal in some cases because for some hours the
workers may paid though they remained idle (i.e., they did not remain engaged in
work).For instance, they may remain idle for sudden power failure or machine
break-down. For measuring labour efficiency variance, impact of idle time, i.e., the
unproductive period, should be taken care of.
It refers to difference between standard cost and actual cost of labour.
Hence, Labour cost variance = SC – AC
Where, SC =SH xSR per unit of production
AC =AH paid x AR
SH = Actual output x Standard time per unit of output
252
Direct Labour Rate Variance (DLRV)

This variance arises out of difference between standard rate and actual rate of
wages. It may be computed with the following formula:
Labour rate variance = AH paid x (SR – AR)
Where, SR = Standard hourly rate of pay.
AR = Actual hourly rate of pay.
Causes of labour rate variance
a) Fluctuation in time rate or piece rate,
b) Employing workers of the quality other than that fixed in standards,
c) Variation in the use of overtime than specified earlier, and
d) Payment at higher rate for seasonal or other excessive works.
It is very difficult to hold an individual accountable for such variances for the
rate fixation is generally beyond the control of an individual.
Idle Time Variance
This variance arises when workers are paid for the hours, for which they have
not worked due to abnormal situation. It is always adverse to an entity. It is
calculated as below:
Idle time variance = SR x Idle hours
Workers cannot be held liable for this variance. Management should enquire
the causes of the abnormal circumstance like power failure, machine break-down
for an effective control.
Direct Labour Efficiency Variance (DLEV)
It arises because of the difference between standard labour hours fixed up and
the actual labour engaged. If workers take less time than the standard time to
complete a job, they may be considered efficient; if they take more time, they will be
treated inefficient. It is calculated as below:
Labour efficiency variance = SR x (SH – AH worked)
Causes of labour efficiency variance
(a) Deficiency in supervision,
(b) Use of faulty machines and tools,
(c) Inadequate training and defective instruction,
(d) Unhygenic working condition,
(e) Strained labour relations,
(f) Use of sub-standard materials, etc.
Direct Labour Mix variance (DLMV) / Gang Composition Variance
Skilled and semi-skilled workers may be required to be simultaneously
engaged in production. The proportion in which these people will be employed is
pre-planned. In practice, if the workers are employed in a proportion which differs
from the predetermined proportion, there will be a variation in both cost and yield.
Management are interested in identifying the factors responsible for the variation
253
and in measuring their respective effects in changes in costs. Such variances may
be computed in the line similar to what is applied for material mix variance
computation.
Labour Mix Variance = SR x (RST – AT)
Here RST means Revised Standard Time
S tan dard Time
RST = x Total Actual Time
Total S tan dard Time
Direct Labour Yield Variance (DLYV)
It is due to the difference in the standard output specified and actual output
obtained.
Average standard rate (Actual production – Standard production)
(or)
(Standard loss for actual input – Actual loss) x Average standard rate
Total standard cost
Average standard rate =
Standard output
Illustrations
In this section, we worked out some model problems for your understanding
Illustration – 1
Calculate labour variances
Labour Standard Time Standard Rate Actual Rate Actual Time
(Hours) (Rs) (Rs) (Hours)
Men 50 3 2 55
Women 40 2 3 35
Solution
Labour Standard Actual
ST SR SC AT AR AC
(ST x SR) (AT x AR)
Men 50 3 150 55 2 110
Women 40 2 80 35 3 105
Total 90 230 90 215
DLCV = SC – AC
Men 150 - 110 = 40 (F)
Women 80 - 105 = 25 (UF)
15 (F)
DLRV=AT x ( SR- AR)
Men 55 X (3-2) = 55 (F)
Women 35 X (2-3) = 35 (UF)
20 (F)
254

DLEV=SR x ( ST- AT)
Men 3 x (50-55) = 15 (UF)
Women 2 x (40-35) = 10 (F)
5 (UF)
Check1 :DLCV=DLRV+DLEV
15(F) = (20 F + 5UF)
Direct LabourMix Variance (DLMV)
DLMV =SR x ( RST- AT)
S tan dard Time
RST = x Total Actual time
50
Men = x 90 = 50
90
40
Women = x 90 = 40
90
DLMV=SR x ( RST- AT)
Men 3 x (50 -55) = 15 UF
Women 2 x (40 – 35 ) = 10 F
5 UF
Direct Labour Sub – Efficiency Variance (DLSEV)
DLSEV=SR x (ST- RST)
Men 3 x (50 -50) = 0
Women 2 x (40 – 40 ) = 0
0
Check 2:DLEV = DLMV + DLSEV
5 (UF) = (5UF + 0)
Illustration–2
The information regarding the composition and hourly wage rates of labour
force engaged on a job scheduled to be completed in 30 hours are as follows:
Category of Standard Actual
workers No. of Hourly wage No. of Workers Hourly wage rate
Workers rate per per worker
worker
Skilled 75 6 70 7
Semi skilled 45 4 30 5
Unskilled 60 3 80 2
Work was completed in 32 hours. Calculate labour variances
Solution
Calculation of standard Time (Std man hours)
No. of workers x standard time for the job
Skilled 75 x 30 = 2,250
Semi skilled 45 x 30 = 1,350
255
Unskilled 60 x 30 = 1,800
Calculation of Actual Time (Actual man hours)
No. of workers x Actual time for the job
Skilled 70 x 32=2,240
Semi skilled 30 x 32=960
Unskilled 80 x 32=2,560
workers ST SR SC AT AR AC
( ST x SR) ( AT x AR)
Skilled 2,250 6 13,500 2,240 7 15,680
Semi skilled 1,350 4 5,400 960 5 4,800
Unskilled 1,800 3 5,400 2,560 2 5,120
5,400 5,760
DLCV = SC – AC
Skilled 13,500 - 15,680 = 2,180 (UF)
Semi 5,400 - 4,800 = 600 (F)
skilled
Unskilled 5,400 - 5,120 = 280 (F)
1,300 (UF)
DLRV=AT x ( SR- AR)
Skilled 2240 X (6-7) = 2240 UF
Semi 960 X (4-5) = 960 UF
skilled
Unskilled 2560 X (3-2) = 2560 F
640 UF
DLEV=SR x ( ST- AT)
Skilled 6 x (2250-2240) = 60 F
Semi 4 x (1350- 960) = 1560 F
skilled
Unskilled 3 x (1800-2560) = 2280 UF
660 UF
1300(UF) = (640 UF + 660UF)
S tan dard Time
256
2 ,250
Skilled= x5 ,700 = 2,400
5 ,400
1,350
Semi skilled = x5 ,700 = 1,440
5 ,400
1,800
Unskilled = x5 ,700 = 1,920
5 ,400
Skilled 6 x (2,400 -2,240) = 960 F
Semi 4 x (1,440 -960 ) = 1,920 F
skilled
Unskilled 2 x (1,920-2,560) = 1,920 UF
960 F
Skilled 6 x (2,250- 2,400) 900 UF
Semiskilled 4 x (1,350- 1,440) 360 UF
Unskilled 2 x (1,800-1,920) 360 UF
1,620 UF
660 (UF) = (960F + 1,620UF)
Illustration – 3
From the following data, calculate labour variances
Budgeted labours for completing Job X
8 skilled workers at Rs 10 per hours for 20 hours
2 unskilled workers at Rs 8 per hours for 20 hours
Actual labours for completing Job X
Solution
Calculation of standard Time (Std man hours)
No. of workers x standard time for the job
Skilled 8 x 20 = 160
Unskilled12 x 30 = 240
Calculation of Actual Time (Actual man hours)
No. of workers x Actual time for the job
Skilled 12 x 20=240
Unskilled13 x 20=260
257

workers ST SR SC AT AR AC
( ST x SR) ( AT x AR)
Skilled 160 10 1,600 240 11 2,640
Unskilled 240 8 1,920 260 7 1,820
400 500
DLCV = SC – AC
Skilled 1,600 - 2,640 = 1,040 (UF)
Unskilled 1,920 - 1,820 = 100 (F)
940 (UF)
DLRV=AT x ( SR- AR)
Skilled 240 X (10-11) = 240 UF
Unskilled 260 X (8-7) = 260 F
20 F
DLEV=SR x ( ST- AT)
Skilled 10 x (160-240) = 800 UF
Unskilled 8 x (240-260) = 160 UF
960 UF
940(UF) = (20 F + 960UF)
S tan dard Time
160
Skilled = x500 = 200
400
240
Unskilled = x500 = 300
400
Skilled 10 x (200 -240) = 400 UF
Unskilled 8 x (300-260) = 320 F
80 UF
Skilled 10 x (160- 200) 400 UF
Unskilled 8 x (240-300) 480 UF
880 UF
960 (UF) = (80UF + 880UF)
258
Illustration – 4
A group of workers normally consists of 30 men, 15 women and 10 boys.They
are paid standard hourly rates as under.
Men Re.0.80
Women Re.0.60
Boys Re.0.40
In a normal working week of 40 hours, the group is expected to produce 2,000
units of output. During the week ended 31st December the group consisted of 40
men, 10 women, and 5 boys. The actual wages paid were art Re. 0.70, Re. 0.65 and
Re. 0.30 respective 4 hours were cost due to abnormal idle time and 1,600 units
were produced.
Calculate:
1. Wage variance
2. Wage Rate variance
3. Labour Efficiency variance
4. Group composition variance
5. Labour idle time variance
Solution
Standard hours for 2,000 units of standard output
Here standard hours refer to standard man hours.
No of man x No of hours= Man hours
Men = 30 men x 40 hours = 1,200 hours
Women = 15 women x 40 hours = 600 hours
Boys = 10 boys x 40 hours = 400 hours
The above standard hours for standard output of 2,000 units, but actual
outputs 1,600 units only. So we should calculate standard hours for actual output.
Men
Standard hours for 2,000 units =1,200 units
Standard hours for 1,600 units = ?
1,600x1,200
------------------=960 hours
2,000
Women
Standard hours for 2,000 units =600 units
Standard hours for 1,600 units =?
1,600x600
------------------=480 hours
2,000
Boys
Standard hours for 2,000 units =400 units
Standard hours for 1,600 units =?
259
1,600x400
------------------=320 hours
2,000
Standard hours for actual output of 1,600 units
Men = 960 hours
Women = 480 hours
Boys = 320 hours
Actual hours
No of man x No of hours = Man hours
Men = 40 men x 40 hours = 1,600 hours
Women= 10 women x 40 hours = 400 hours
Boys = 5 boys x 40 hours = 200 hours
Idle time is due to time lost abnormally on account of machine break down.
We should pay wages to workers for idle time also. Therefore, idle time is not
deducted from actual time.
Standard Actual
( for 1,600 units) ( for 1,600 units)
Hours Rate Cost Hours Rate Cost
Men 960 0.80 768 1,600 0.70 1,120
Women 480 0.60 288 400 0.65 260
Boys 320 0.40 128 200 0.30 60
1,760 1,184 2,200 1,440
Wages variance = Direct labour cost variance
DLCV = SC - AC
Men = 768 -1,120 = - 352 (A)
Women = 288 -260 = 28 (F)
Boys = 128 -60 = 68 (F)
------------
256 (A)
------------
Wage rate variance (or) Direct labour rate variance
DLRV =AHx(SR-AR)
Men 1,600x(0.80-0.70) = 160 (F)
Women = 400x(0.60-0.65) = 20 (A)
Boys = 200x(0.40-0.30) = 20 (F)
----------
200 (F)
-----------
260
Direct labour efficiency variance

DLEV = SRx(SH-AH)
Men = 0.80x(960-1,600 ) = 512 (A)
Women = 0.60x(480-400) = 48 (F)
Boys = 0.40x(320-200) = 48 (F)
----------
416 (A)
----------
Groups composition variance (or) Direct labour mix variance
DLMV = STx(RSH-AH)
Idle time
40 men x4 hours each =160 hours
10 women x4 hours each =40 hours
5 boys x4 hours each =20 hours
Actual hours -Idle hours = Actual hours worked
Men 1,600 hours-160 hours = 1,440 hours
Women400 hours- 40 hours = 360 hours
Boys 200 hours- 20 hours = 180 hours
--------------------
1,980 hours
---------------------
Total actual worked
RSQ = ---------------------------------x Standard hours
Total standard hours
1,980
Men =------------x960 =1,080 hours
1,760
1,980
Women =-----------x480=540 hours
1,760
1,980
Boys =----------x320=360 hours
1,760
DLMV= SRx(RSH-AH)
Men = 0.80x (1,080-1,440)=288 (A)
Women = 0.60x(540-360) =108 (F)
Boys = 0.40x(360-180) =72 (F)
----------
108 (A)
----------
261
Idle time variance

Idle time x SR
Men 160 hours x 0.80 = 128 (A)
Women40 hours x 0.60 =24 (A)
Boys 20 hours x 0.40 =8 (A)
----------
160 (A)
----------
Direct labour Revised Efficiency Variance
DLREV=SRx(SH-RSH)
Men = 0.80 x (960 - 1,080) = 96 (A)
Women = 0.60 x (480 - 540) = 36 (A)
Boys = 0.40 x (320 -360) = 16 (A)
------------
148 (A)
--------------
Verification
1.DLCV = DLRV + DLEV
256 (A) = 160 (F)+ 416 (A)
256 (A) = 256 (A)
2.DLEV = DLMV + DLREV + Idle time variance
416 (A) = 108 (A) + 148 (A) +160 (A)
416 (A) = 416 (A)
Overhead Variances
In this section, we attempt to make a brief study about meaning of overhead
variances. With the tremendous technological advances and accelerated
mechanisation share of overhead cost to total has increased amazingly.
Introduction of standard costing technique may help control this cost considerably.
For the purpose, total standard cost and the number of units or labour hours
expected to be produced over the budget period are estimated in advance. Then
standard overhead cost per unit is computed by dividing the former by the latter.
With a view to controlling overhead expenses, they are divided into two groups;
variable overhead and fixed overhead. The first one varies proportionately with the
volume of production, while the second one does not. Controlling the variable
overheads is not so difficult. But regulating the other is very intricate. Here the
critical factor is the capacity level at which the factory or the production centre is
expected to operate. Usually plant and machinery do not work at full capacity.
Hence, it is to be decided the level of capacity to be utilised and the units to be
produced in the period concerned. Standard overhead cost per unit of production is
to be determined with this information.
262
Kinds of Overhead Variances

We present here a brief explanation about different types of overhead variances
1. Overhead cost Variance
2. Overhead Budget Variance (or) Overhead Expenses Variance
3. Overhead volume variance
4. Overhead Efficiency Variance
5. Overhead capacity variance
6. Calendar Variance
Budgeted overhead
Calculation of Standard rate per unit:
Budgeted output
Calculation of Standard Production
Number of units produced in one hour x Actual hours worked
Calculation of Standard Overhead:
Actual production x Standard rate per unit
Overhead cost Variance
This is the difference between the standard overhead specified and the actual
overhead incurred.
Kinds of OH cost variance:
1. Fixed OH cost variance
2. Variable OH variance
OH Cost Variance
Standard OH - Actual OH
Fixed OH cost variance
Standard fixed OH - Actual fixed OH
Variable OH cost variance
Standard variable OH - Actual variable OH
Overhead Budget Variance (or) Overhead Expenses Variance
This is the difference between the budgeted expensed and the actual expenses
incurred.
Budgeted overhead - Actual overhead
Overhead volume variance
This variance arises on account of difference between Budgeted output actual
output
Standard Rate x (Actual production - Budgeted production)
Overhead Efficiency Variance
This is differences between the budgeted efficiency of production and the
actual efficiency attained.
Standard Rate x (Actual production - Standard production)
263
Overhead capacity variance

This variance araised on account of over (or) under utilization of plant or
equipment. This variance arises because, of the working above or below standard
capacity. It may be caused by idle time, strike and lock out, failure or power,
machine break down etc.
1. When there is no calendar variance
Standard Rate x (Standard production - Budgeted production)
2. When there is calendar variance
Standard Rate x (Standard production - Revised Budgeted production)
Calendar Variance
This is difference between the number of working days in the budget period
and the actual number of working days in the period to which the budget is
applied.It is a part of capacity variance.
Standard Rate x (Revised budgeted production - Budgeted production)
Illustration – 5
Items Budget Actual
No. of working days 20 25
Man hours per day 8,000 8,400
Output per man hour in units 1 0.90
Overhead cost Rs 1,60,000 Rs 1,68,000
Calculate overhead variances
Solution
Budgeted overhead
Calculation of Standard rate per hour:
Budgeted output
Budgeted output:
Output per man hour x Man hours per day x No. of working days
1 x 8,000 x 20 = 1,60,000 units
Rs 1,60 ,000
Calculation of Standard rate per unit: = Re 1
1,60 ,000 units
Budgeted output
Number of units produced in one hour =
Budgeted hours
1,60 ,000
=  1 unit
1,60 ,000
(Budgeted hours 8,000 hrs x 20 days = 1,60,000 )
Calculation of Standard Production:
Number of units produced in one unit x Actual hours worked
1 unit x 1,84,800 hours = 1,84,800 units
Actual hours worked ( 8,400 hours x 22 days)
Actual production ( 22 days x 8,400 man hours x 0.9 unit =1,66,320 units)
264

Actual production x Standard rate per hour
1,66,320 x 1 = 1,66,320 units
OH Cost Variance
Standard OH - Actual OH
1,66,320 – 1,68,000 = 1,680 (UF)
Overhead Budget Variance
1,60,000 – 1,68,000 = 8,000 (UF)
Overhead volume variance
Standard overhead - Budgeted overhead
1,66,320 – 1,60,000 = 6,320
Overhead Efficiency Variance
1 x( 1,66,320 – 1,84,800) = 18,840 ( UF)
Overhead capacity variance
Revised budgeted production
Production for 20 days is 1,60,000 units ( 8,000 units x 20 days)
1,60 ,000 units
Production for 22 days = x 22 days  1,76,000 units
20 days
Overhead capacity variance = 1 x (1,84,800 – 1,76,000) = 8,800 (F)
Calendar Variance
1 x (1,76,000 – 1,60,000) = 16,000 ( F)
Illustration – 6
Maris Ltd has furnished the following information for the month of July 2021
Items Budget Actual
Out put in units 30,000 32,500
Hours 30,000 33,000
Fixed overhead Rs 45,000 50,000
Variable overhead Rs 60,000 68,000
Working days 25 26
Solution
Budgeted overhead
Calculation of Standard total overhead rate per unit:
Budgeted output
1,05 ,000
=  Rs 3.50
30 ,000
265
60 ,000
Calculation of standard variable over head rate per unit=  Rs 2.00
30 ,000
45 ,000
Calculation of standard fixed over head rate per unit=  Rs 1.50
30 ,000
Actual production x Standard rate per hour
As per total overhead rate = (3.50 x 32,500 units) = Rs 1,13,750
As per variable overhead rate = (2.00 x 32,500 units) = Rs 65,000
As per fixed overhead rate = (1.50 x 32,500 units) = Rs 48,750
Budgeted output
Standard production per hour =
Budgeted hours
30 ,000
=  1 unit
30 ,000
Standard production in actual hours 1 x 33,000 = 33,000 units
I. OH Cost Variance
(a) Total OH Cost Variance
Standard total OH – Actual total OH
Rs 1,13,750 – 1,18,000 =4,250 (UF)
(b) Variable OH Cost Variance
Standard variable OH – Actual variable OH
Rs 65,000 – 68,000 =3000 (UF)
(c) Fixed OH Cost Variance
Standard fixed OH – Actual fixed OH
Rs 48,750 – 50,000 =1,250 (UF)
II. Overhead Budget Variance
Rs 45,000 – Rs 50,000 = Rs 5,000 (UF)
III. Overhead volume variance
Standard overhead - Budgeted overhead
Rs. 48,750 – 45,000 = Rs 3,750 ( F)
IV. Overhead Efficiency Variance
Fixed rate 1.50 x (32,500 – 33,000) = 750 (UF)
V. Overhead capacity variance
266
Revised budgeted production

Production for 25 days is 30,000 units
30 ,000 units
Production for 26 days = x 26 days  31,200 units
25 days
Overhead capacity variance = 1.50 x (33,000 – 31,200) = 2,700 (F)
VI. Calendar Variance
1.50x (31,200 – 30,000) = 1,800 ( UF)
REVISION POINTS
 Labour cost variance = Standard cost – Actual cost
 Labour rate Variance = Actual Hour paid (standard rate-Actual Rate )
 Labourvariance arise because of a) difference in actual rate and standard
rates of labour and 2) the variation in actual time taken by workers and the
standard time taken by workers and the standard time allotted to them for
performing a job.
INDEX QUESTIONS
1. The information regarding the composition and hourly wage rates of labour
force engaged on a job scheduled to be completed in 20 hours are as follows:
workers No. of Hourly wage No. of Workers Hourly wage
Workers rate per rate per worker
worker
Skilled 40 3 25 4
Semi skilled 30 2 35 1
Unskilled 35 2 50 0.75
Work was completed in 22 hours. Calculate labour variances
2. From the following data, calculate labour variances
Budgeted labours for completing Job No. 007
Actual labours for completing Job No.007
6 skilled workers at Rs 5.50 per hours for 30 hours
7 unskilled workers at Rs 3.50 per hours for 30 hours
267
3. Ranjitha Ltd has furnished the following information for the month of April
2021
Items Budget Actual
Out put in units 15,000 16,250
Hours 15,000 16,500
Fixed overhead Rs 22,500 25,000
Variable overhead Rs 30,000 34,000
Working days 25 26
SUMMARY
In this lesson, we have briefly touched upon the following points: Labour
variance arise because of (i) difference in actual rate and standard rates of labour
and (ii) the variation in actual time taken by workers and the standard time allotted
to them for performing a job. Difference between standard cost and actual cost of
labour is called labour cost variance. Labour rate variance is difference between
standard rate and actual rate of wages. When workers are paid for the hours, for
which they have not worked due to abnormal situation is known as idle time
variances. Labour efficiency variance is difference between standard labour hours
fixed up and the actual labour engaged. labour yield variance is the difference in
the standard output specified and actual output obtained.
With a view to controlling overhead expenses, they are divided into two groups;
variable overhead and fixed overhead. Overhead variances can be classified as
overhead cost variance, overhead budget variance, overhead expenses variance,
overhead volume variance, overhead efficiency variance, overhead capacity variance
and calendar Variance
TERMINAL EXERCISES
1. What is labour variance?
2. What are the types of labour variance?
3. What are the types of Overhead variance?
4. What is Overhead variance?
 Horngren, Datar & Foster, Cost Accounting–A Managerial Emphasis (any
edition)
ASSIGNMENT
1. What are the types of labour variance? Explain with example.
2. What are the types of Overhead variance? Explain with example.
268
REFERENCES
4. L. Cecil and L. Merwin“ Management Accounting
LEARNING ACTIVITIES
evaluation methods within the social context of an organization
KEY WORDS
Idle time, Semi skilled, Efficiency Variance and Revised budgeted production

269
LESSON – 20
VARIANCE ANALYSIS – SALES VARIANCES

OBJECTIVES
In 19th lesson, we discussed the meaning, different kinds of labour and
overhead variances and calculation of different types of labour and overhead
variance. In this lesson, we discuss the sales variance and calculation of different
types of sales variance. After going through this lesson you will able to
 understand the meaning of sales variances
 know different types of sales variance
 understand the method of calculation of sales variance on the basis of
sales value and profit
CONTENTS
 Introduction
 Methods of computing sales variances
o Sales variances based on Sales Value
 Sales value variance
 Sales Price Variance
 Sales volume variance
 Mix Variance
 Sales Quantity Variance:
o Sales variance based on Profit or Margin
 Sales Margin Value Variance (SMVV)
 Sales Margin Price Variance ( SMPV)
 Sales margin volume Variance (SMVV)
 Sales Margin Mix Variance
 Sales Margin Quantity Variance
 Illustrations
INTRODUCTION
In this section, we attempt to make a brief study about meaning of sales
variance. So far out discussion has confined only to cost variances and their
favourable and adverse impacts on the entity. But variations between actual sales
and standard sales also have similar impacts. Such variations may be classified
into two broad categories according to the causes of such variations. One arises
from the difference in standard and actual selling prices and the other from the
variations in the volume of sales. Major sales variances are listed below.
Methods of Computing Sales Variances
We present here a brief explanation about different methods of computing
sales variance. There are two methods of computing sales variances viz
1. Sales variances based on Sales Value
2. Sales variances based on Profit
270
Sales variances based on Sales Value

We discuss in this section different types of sales variances on the bases of
sales value.
Sales value variances
This is the difference between standard or budgeted sales and the actual sales.
Sales value Variance = Budgeted Sales – Actual Sales.
(BS-AS)
Where a budgeted Sales = Standard price x budgeted quantities
(SP x BQ)
Where a Actual Sales = Actual price x Actual quantities
(AP x AQ)
Sales Price Variance
This is that portion of the sales value variance which is due to the difference
between standard prices specified and the actual price charged.
Sales price variance = Actual Quantity Sold (Standard price – Actual price)
AQ (SP – AP)
Sales volume variance
It is difference between budgeted sales and the standard value of the actual
mix of sales.
Sales volume variance =
Standard Price (Budgeted Quantity - Actual Quantity)
(or)
Budgeted Sales - Standard Sales
Sales volume variance: This can be further sub-divided into i) Mix variance
and ii) Quantity variance.
Mix Variance: This is the portion of the sales value variance which is due to the
difference, between the standard and the actual inter-relationship of the qualities of
each product or product group of which sales are composed.
Mix Variance = SMV = SP x (RSQ-AQ)
Standard price x (Revised Standard Quantity – Actual Quantity)
Revised Standard Quantity
Total Quantity of Actual Mix
x S tan dard Quantityof each product
Total Quantity of Standard Mix
Sales Quantity Variance:It is the difference between the sales volume variance
and the sales mix variance, arising purely due to difference in the quantity sold.
Sale Quantity Variance:
Standard price x (Budgeted quantity - Revised Standard Quantity)
Sales variance based on Profit or Margin
We discuss in this section different types of sales variances on the bases of
Profit.
271
Sales Margin Value Variance (SMVV)

It is the difference between the actual margin from sales (Cost of sales) at
standard and budgeted margin.
Margin ( or) Value Variance = Budgeted profit – Actual profit
Sales Margin Price Variance ( SMPV)
This is that portion of total margin variance which is due to the difference
between the standard price of the quantity of the sales effected and the actual price
of those sales.
Price Variance = Actual Quantity of sales x( Standard rate of profit - –Actual
rate of profit)
Price Variance = AQ x ( SP-AP)
Sales margin volume Variance (SMVV)
This is that portion of total margin variance which is due to the difference
between the budgeted quantity and the actual quantity of sales. Margin Volume
Variance.
SMVV = Standard Margin per unit (Budgeted units – Actual units sold)
As already stated volume variance can be further subdivided into
(i) Mix variance and
(ii) Quantity variance.
Sales Margin Mix Variance
It is that portion of the sales margin variance which is due to the difference
between the actual and budgeted quantities of each product of which the sale
mixture is composed, valuing sales at the standard not selling prices and cost of
sales at standard.
Sales Margin Mix Variance:
Standard rate of profit x (Revised Standard Quantity – Actual Quantity)
Revised Standard Quantity:
Sales Margin Quantity Variance
It is the difference between sales margin volume variance and sales margin
mix variance.
Margin Quantity Variance:
Standard rate of profit x (Budgeted quantity - Revised Standard Quantity)
SP ( BQ- RSQ)
Illustrations
In this section we worked out some problems for your understanding
I. Sales variance based on turnover
272
Illustration – 1
From the following details calculate:
i) Sales value variance ii) Sales price variance iii) Sales volume variance
iv) Sales mix variance v) Sales quantity variance
Products Standard Actual
No. of Rate per Total No. of Rate per Total sales
units unit (Rs) sales units unit (Rs)
A 5,000 5 25,000 6,000 6 36,000
B 4,000 6 24,000 5,000 5 25,000
C 3,000 7 21,000 4,000 8 32,000
Solution
Total Sales Value variance (TSVV)
TSVV = Budgeted sales – Actual Sales
A 25,000 - 36,000 = 11,000 (F)
B 24,000 - 25,000 = 1,000 (F)
C 21,000 - 32,000 = 11,000 (F)
23,000 (F)
Sales Price Variance (SPV)
SPV = AQ x (SP –AP)
A 6,000 x (5-6) = 6,000 F
B 5,000 x (6-5) = 5,000 UF
C 4,000 x (7-8) = 4,000 F
5,000 F
Sales Volume Variance (SVV)
SVV = SP x (BQ –AQ)
A 5 x (5,000-6,000) = 5,000 F
B 6 x (4,000-5,000) = 6,000 UF
C 7 x (3,000-4,000) = 7,000 F
18,000 F
Sales Mix Variance (SMV)
SMV = SP x (RSQ –AQ)
A 5 x (6,250-6,000) = 1,250 UF
B 6 x (5,000-5,000) = 0
C 7 x (3,750-4,000) = 1,750 F
500 F
Note: Revised Standard Quantity
S tan dard Quantityof each product
273
15 ,000
A= 5 ,000  6 ,250
12 ,000
15 ,000
B= 4 ,000  5 ,000
12 ,000
15 ,000
C= 3 ,000  3 ,750
12 ,000
Sales Quantity Variance (SQV)
SQV = SP x (BQ –RSQ)
A 5 x (5,000-6,250) = 6,250 F
B 6 x (4,000-5,000) = 6,000 F
C 7 x (3,000-3,750) = 5,250 F
17,500 F
Verification 1 :SVV = SPV + + S VloV
23,000 (F) = 5,000 (F) + 18,000(F)
Verification 2 :SvloV = SMV + SQV
18,000 (F) = 500(F) + 17,500(F)
II. Sales variance based on Profit
Illustration –2
Modern Toys Ltd has budgeted the following sales for December 2020
Toy A 900 units at Rs 50 Per unit
Toy B 900 units at Rs 100 Per unit
Toy C 900 units at Rs 75 Per unit
As against this, the actual sales were:
Toy A 1,000 units at Rs 55 Per unit
Toy B 700 units at Rs 95 per unit
Toy C 1,100 units at Rs 78 per unit
The cost per unit of A,B and C was RS 45, Rs 85 and Rs 65 respectively.
Compute the different variances to explain the difference between the
budgeted and actual profit.
Solution
Products Standard Actual
No. of Profitper Total No. of Profit per Total
units unit Profit units unit Profit
(Rs) (Rs)
A 900 5 4,500 1,000 10 10,000
B 650 15 9,750 700 10 7,000
C 1,200 10 12,000 1,100 13 14,300
2,750 2,800
274
Working notes:
Standard profit per unit = Budgeted selling price per unit – Cost per unit
A:50– 45 = Rs 5
B:100– 85 = Rs 15
C:75 – 65 = Rs 10
Actual profit per unit = Actual selling price per unit – Cost per unit
A:55 – 45 = Rs 10
B:95 – 85 = Rs 10
C:78 – 65 = Rs 13
Sales Value variance (SVV)
SVV = Budgeted profit – Actual profit
A 4,500 - 10,000 = 5,500 (F)
B 9,750 - 7,000 = 2,750 (UF)
C 12,000 - 14,300 = 2,300 (F)
5,050 (F)
Sales Price Variance (SPV)
SPV = AQ x (Standard Profit –Actual Profit)
A 1,000 x (5-10) = 5,000 F
B 700 x (15-10) = 3,500 UF
C 1,100 x (10-13) = 3,300 F
4,800 F
Sales Volume Variance (SVV)
SVV = Standard Profit x (BQ –AQ)
A 5 x (900-1,000) = 500 F
B 15 x (650-700) = 750 F
C 10 x (1,200-1,100) = 1,000 UF
250 F
Sales Mix Variance (SMV)
SMV = Standard Profit x (RSQ –AQ)
A 5 x (916-1,000) = 420 F
B 15 x (662-700) = 570 F
C 10 x (1,222-1,100) = 1,220 UF
230 UF
Note:Revised Standard Quantity
2 ,800
A= x900  916.36  916
2 ,750
2 ,800
B= x 650  661.82  662
2 ,750
2 ,800
C= x1,200 1,221.82  1,222
2 ,750
275
Sales Quantity Variance (SQV)

SQV = Standard Profit x (BQ –RSQ)
A 5 x (900-916) = 80 F
B 15 x (650-662) = 180 F
C 10 x (1,200-1,222) = 220 F
480 F
Verification 1:SVV = SPV + + S VloV
5,050 (F) = 4,800 (F) + 250(F)
Verification 2:SvloV = SMV + SQV
250 (F) = 230(UF) + 480(F)
REVISION POINTS
 Sales variance is the Variances between actual sales and standard sales
 Sales volume variance = Budgeted sales –actual Sales
 Sales price variance = Actual Quantity (Standard price-Actual price)
 Sales Volume variance = Standard price (Budgeted Quantity-Actual
Quantity)
 Sales mix variance = Standard price (Revised Budgeted Quantity-Actual
Quantity)
INDEX QUESTIONS
1. Explain different types of sales variances
2. From the following particulars, calculate sales variances
Product Budgeted Sales Actual Sales
Quantity units Price (Rs) Quantity units Price (Rs)
A 1,000 20 1,300 21
B 2,000 15 2,300 14
Total 3,000 3,600
3. From the following particulars, calculate sales variances
Quantityunits Price (Rs) Quantity units Price (Rs)
M 400 10 440 11
N 500 20 480 19
O 100 50 180 45
Total 1,000 1,100
4. Calculate sales margin variance from the following
Quantity Selling Price Standard Quantity Selling Price
units per unit (Rs) cost per unit units per unit (Rs)
M 600 20 12 800 24
N 400 15 9 600 12
1,000 1,400
276
SUMMARY
In this lesson, we have briefly touched upon the following points: It refers to
the difference between actual and budgeted sales. Here we should be cautious
about the term value and price. Value means total sales value, i.e., quantity
multiplied by selling price per unit. Naturally the term price is used to mean price
per unit. Hence the value variance arises due to combined effects of variations in
budgeted and actual quantity sold and unit selling prices. If actual sales value
exceeds budgeted sales, the situation is considered favourable to the business.
Sales variance can be calculated on two different basis namely on sales value and
profit. The portion of the sales value variance which arises from the difference
between actual and budgeted selling prices per unit is known as sales price
variance. Sales value variance arises due to difference between actual and budgeted
quantity of sales.
TERMINAL EXERCISES
1. Explain Sales Variance?
2. What are the methods of computing sales variance?
ASSIGNMENT
1. Explain Sales Variance?
2. What are the methods of computing sales variance?
REFERENCES
LEARNING ACTIVITIES
KEY WORDS
Value variance and Quantity variance

277
MODEL QUESTION PAPER

THIRD SEMESTER
Section –A
Answer any FIVE questions.

All questions carry equal marks.
(5 ×3 = 15 Marks)
1) What is Management Accounting?

2) What is cash flow statement?
3) What is Sales budget?
4) What are the features of marginal costing?
5) Explain the objectives of standard costing?
Section –B
Answer any FIVE questions.

All questions carry equal marks.
(5 ×6 = 30 Marks)
6) Discuss the scope of the management accounting.

7) State the importance and limitation of financial statement.
8) What is Break Even chart? What are its advantages?
9) From the following balances, you are required to calculate Cash from
Operations:
31.12.2020 31.12.2021
Rs. Rs.
Debtors 50,000 47,000
Bills receivables 10,000 12,500
Creditors 20,000 25,000
Income accrued 600 750
Net profit made -- 1,30,000
278
10) Following are the details relating to the trading activities of Ranjitha Ltd.
Stock velocity 8 months
Debtor's velocity 3 months
Creditor's velocity 2 months
Gross Profit ratio 25%
Gross profit for the year Rs. 4,00,000; Bills Receivable Rs. 25,000 and Bills
payable Rs. 10,000. Closing stock of the year is Rs. 10,000 more than the
opening stock.
Find out(a) Sales (b) Debtors (c) Closing stock and (d) Creditors
11) The Maradon Industries has prepared its annual sales forecast, expecting to
achieve sales of Rs. 30,00,000 next year. The Controller is uncertain about the
pattern of sales to be expected by month and asks you to prepare monthly
budgets of sales. The following sales data pertain to the year, which is
considered to be representative of a normal year:
Month Sales (Rs.) Month Sales (Rs.)
January 1,10,000 July 2,60,000
February 1,15,000 August 3,30,000
March 1,00,000 September 3,40,000
April 1,40,000 October 3,50,000
May 1,80,000 November 2,00,000
June 2,25,000 December 1,50,000
Prepare a monthly sales budget for the coming year on the basis of the above data
12) Calculate profit from the following particulars
Sales Rs 50,000
Variable cost Rs 30,000
Break even salesRs 37,500
13) Calculate material cost and price variance from the following particulars
Standard Actual
Quantity 500 kgs 550Kgs
Price Rs. 10 Rs. 9
Section - C
Answer any THREE questions.
All questions carry Equal marks.
(3 X 10 = 30 Marks)
14) Discuss the role of management accountant in a business concern. And

explain the characteristics of management accounting.
279
15) From the following Balance Sheets of NMR Ltd., prepare a Funds Flow
Statement.
Balance Sheets
Rs. Rs. Rs. Rs.
Equity share capital 300,000 4,00,000 Goodwill 1,15,000 90,000
Pref. sharecapital 1,50,000 1,00,000 Building 2,00,000 1,70,000
P & L A/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed dividend 42,000 50,000 Stock 77,000 1,09,000
Bills Payable 20,000 16,000 Cash in hand 15,000 10,000
Provision for taxation 40,000 50,000 Cash in bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000
i) Depreciation: Plant – Rs. 10,000 and buildings Rs. 20,000 charged in 2020.
ii) An interim dividend of Rs. 20,000 had been paid in 2021.
iii) Income tax Rs. 35,000 was paid during 2021.
16) On the basis of the following particulars draw up a flexible budget for overhead
expenses and determine the overhead rates at 70%, 80% and 90% plant
capacity.
Particulars Plant Capacity
70%Rs. 80%Rs. 90%Rs.
Variable Overhead:
Indirect Labour - 28,800 -
Semi Variable Overheads:
Power (30% fixed) - 48,000 -
Fixed Overheads:
Depreciation - 26,400 -
Insurance - 7,200 -
Salaries - 24,000 -
Estimated direct labour hours 99,200
280
17) The sales turnover and profit during two years were as follows
Year Sales Profit

Rs (Rs)
2001 70,000 7,500
2002 80,000 10,000
a)P/ V ratio
b)BEP
c)Margin of safety
e)Profit when sales amount to Rs 60,000
18) The standard material cost for 100 kg. of chemical D is made up of:
Chemical A - 30 kg. @ 4 per kg.
Chemical B - 40kg, @ Rs,5 per kg.
Chemical C - 80kg. @ Rs,6 per kg.
In a batch, 500 kg. of chemical D were produced from a mix of
Chemical B - 220kg. at a cost of Rs.1 ,056
Calculate the various material variances for 100 kgs. of chemical D. 


281
Problems on Management Accounting
SL. No. No. of Problems

1 Financial Statement Analysis 4
2 Ratio Analysis 6
3 Funds Flow Statement 6
4 Cash Flow Statement 4
Total 20
FINANCIAL STATEMENT ANALYSIS
Part - A
Problem No. 1: Preparation of Comparative Income Statement
The following are the income statements of Ranjitha Ltd., for the year ending
31st 2020 and 2021. You are required to prepare a comparative income statement
31-12-20 31-12-21
Rs. Rs.
Net Sales 10,00,000 12,00,000
Cost of goods sold 5,50,000 6,00,000
Operating expenses:
Administration 80,000 1,00,000
Selling 60,000 80,000
Non-operating expenses:
Interest 40,000 50,000
Income-tax 50,000 80,000
Problem No. 2: Preparation of comparative balance sheet:
Ranjitha & Priyanka Ltd., furnishes its balance sheet for the years 2020 and
2021 requests you to prepare a comparative balance sheet for those years.
Balance Sheets
Rs. Rs. Rs. Rs.
Equity Share 80,000 80,000 Land & 80,000 74,000
Capital Building
8% Debentures 80,000 90,000 Pant & 60,000 54,000
Machinery
Retained Earnings 40,000 49,000 Furniture 20,000 28,000
Sundry Creditors 50,000 70,000 Inventory 40,000 60,000
Bills Payable 10,000 15,000 Debtors 40,000 80,000
Cash 20,000 8,000
2,60,000 3,04,000 2,60,000 3,04,000
282
Problem No. 3: Preparation of common size income statement

The following income statements of Priyanka Co. Ltd. for the years 2020 and
2021. Prepare common size statement for the two years.
Trading and Profit and Loss Account
Particulars 2020 2021 Particulars 2020 2021
Rs. Rs. Rs. Rs.
To Cost of Sales 2,40,000 3,50,000 By Sales 4,00,000 5,00,000
To Gross Profit c/d 1,60,000 1,50,000
4,00,000 5,00,000 4,00,000 5,00,000
To Operating By Gross 1,60,000 1,50,000

Expenses Profit b/d
Administration 25,000 30,000 By Interest
Selling 15,000 20,000 on
Distribution 10,000 10,000 investments 20,000 50,000
To Non-operating
Expenses
Finance 20,000 20,000
Goodwill written off 10,000 ---
To Net profit 1,00,000 1,20,000
1,80,000 2,00,000 1,80,000 2,00,000
Problem No. 4: Preparation of common size balance sheets
Ranjitha & Maradon Ltd. furnishes the following Balance Sheets for the years
2020 and 2021. Prepare common size balance sheets.
Rs. Rs. Rs. Rs.
Share Capital 2,00,000 3,00,000 Buildings 4,00,000 4,00,000
Reserves 6,00,000 7,00,000 Machinery 6,00,000 10,00,000
10% Debentures 2,00,000 3,00,000 Stock 2,00,000 3,00,000
Creditors 3,00,000 5,00,000 Debtors 2,00,000 2,50,000
Bills payable 1,00,000 80,000 Cash at
Tax payable 1,00,000 1,20,000 bank 1,00,000 50,000
15,00,000 20,00,000 15,00,000 20,00,000
283
RATIO ANALYSIS
Part A
Problem No. 5: Calculation of different type of ratios from given income statement and
balance sheet
Priyanka enterprises present you the following income statement and request
you to calculate (1) Gross profit ratio, (2) Net Profit ratio, (3) Operating ratio,
(4) Operating profit ratio, (5) Expense ratio.
Income Statement
Particulars Rs. Rs.
Sales 8,60,000
Less: Sales Returns 60,000
Net Sales 8,00,000
Less: Cost of goods sold 3,50,000
Gross – Profit 4,50,000
Add: Non-operating income
Profit on sale of building 30,000
Income from investments 20,000 50,000
5,00,000
Less: Operating Expenses
Administration expenses 40,000
Selling expenses 60,000
Distribution expenses 20,000
Non-operating expenses
Finance expenses 30,000
Provision for income tax 30,000 2,00,000
3,00,000
Problem No: 6.
You are given the following information
Rs.
Cash 18,000
Debtors 1,42,000
Closing stock 1,80,000
Bills payable 27,000
Creditors 50,000
Outstanding expenses 15,000
Taxes payable 75,000
Calculate (a) Current ratio, (b) Liquidity ratio, (c) Absolute liquidity ratio
Ans: Current Ratio 2.038 times (2) Liquidity ratio 0.96 times (3) Absolute liquidity ratio
0.11 times
284
Problem No: 7.
Calculate the debtors turnover ratio and debt collection period
Rs.
Total sales for year 2021 1,00,000
Cash sales for the year 2021 20,000
Debtors as on 1-1-2021 10,000
Debtors as on 31-12-2021 15,000
Bills receivable as on 1-1-2021 7,500
Bills receivable as on 31-12-2021 12,500
Ans; Debtors turnover ratio 3.56 times
Problem No: 8.
Calculate: (1) Current Assets, (2) Current liabilities,
(3) Liquid Assets (4) Stock
Current ratio = 2.8:, Acid-test ratio = 1.5, Working Capital = Rs. 1,62,000
Ans: (1) Current Assets = Rs. 2,52,000, (2) Current liabilities = Rs.90,000
(3) Liquid Assets = Rs. 1,35,000 (4) Stock = Rs. 1,17,000
Part - B
Problem No: 9: Calculation of different types of ratios from income statement and
balance sheet
Given below is the summarized balance sheet and profit and loss of
Samynarayanan Surgar Mills Ltd. as on 31-12-2021. You are required to calculate.
(1) Current ratio (7) Fixed assets turnover ratio
(2) Quick ratio (8) Return on capital employed
(3) Fixed assets ratio (9) Debtors turnover ratio
(4) Debt equity ratio (10) Creditors turnover ratio
(5) Proprietary ratio (11) Gross profit ratio
(6) Stock turnover ratio (12) Operating ratio
(13) Net profit ratio
Balance Sheet as on 31-12-2021
Liabilities Rs. Assets Rs.
Issued Capital: Land & Building 30,000
4,000 shares of Rs. 10 each 40,000 Plant & Machinery 16,000
Reserves 18,000 Stock 29,600
Creditors 26,000 Debtors 14,200
Profit and Loss Account 6,000 Cash at Bank 6,200
6% Debenture 6,000
96,000 96,000
285
Profit and Loss Account

To Opening Stock 19,900 By sales 1,70,000
To Purchase 1,09,050 By Closing Stock 29,800
To Direct expenses 2,850
To Gross profit 68,000
1,99,800 1,99,800
To Administration expenses 30,000 By Gross profit b/d 68,000
To Selling & Distribution Exp. 6,000 By Non-operating
To Financial expenses 3,000 Income 1,800
To Other non-operating Exp. 800
To Net Profit 30,000
69,800 69,800
Ans:
(1) Current ratio 1.92 times (7) Fixed assets turnover ratio 2.21 or 3.69times
(2) Quick ratio 0.78 times (8)Return on capital employed 45.71%
(3) Fixed assets ratio 0.65 times (9)Debtors turnover ratio 11.97 times
(4) Debt equity ratio 0.094 times (10) Creditors turnover ratio 4.19 times
(5) Proprietary ratio 0.67 times (11) Gross profit ratio40%

(6) Stock turnover ratio 4.10 times(12) Operating ratio81.17%
(13) Net profit ratio 17.64%
Problem No. – 10: Preparation of balance sheets with the help of given ratios
With the help of the following ratios regarding Prasath & Co Ltd., draw the
Balance sheet of the company for the year 2021.
Current ratio 2.5 times
Liquidity ratio 1.5 times
Net working capital Rs. 3,00,000
Stock turnover ratio (cost of sales/closing stock) 6 times
Gross profit ratio 20%
Debt collection period 2 months
Fixed assets turnover ratio (on cost of sales) 2 times
Fixed assets to shareholders net worth 0.80 times
Reserves and surplus to capital 0.50 times
Ans:96,000
286
FUNDS FLOW STATEMENT

Part A
Problem No. – 11: Preparation of Scheduled or changes in working capital
31.12.2020 31.12.2021
Rs. Rs.
8% Debentures 40,000 40,000
Outstanding rent 8,000 12,000
Cash in Hand 4,000 8,000
Cash at bank 12,000 15,000
Accounts payable 20,000 26,000
Machinery 25,000 16,000
Accounts receivable 30,000 34,000
Prepaid commission 4,000 ---
Share premium 15,000 15,000
Equity share capital 50,000 50,000
You are asked to compile a working capital statement from the above details.
Problem – 12:
Calculate funds from operations from the following
To Administrative expense 25,000 By Gross profit 2,15,000
To Selling expenses 16,000 By Interest on investments 5,000
To depreciation 26,000 By Profit on sale of 4,000
To Loss on sale of building 6000 machinery
To discount on issue of 2,000
debentures
2,24,000 2,24,000
Problem No. – 13:From the following details calculate the funds from operations
Rs.
Salaries 5,000
Rent 3,000
Depreciation on plant 5,000
Provision for tax 4,000
Opening balance of P & L A/c 25,000
Transfer to General Reserve 1,000
Dividend Received 5,000
Closing Balance of P & L A/c 60,000
287
Discount on issue of debentures 2,000

Provision for bad debts 1,000
Refund of tax 3,000
Profit of sale of building 5,000
Ans: Funds from operations Rs. 47,000
Problem No. 14: Preparation of funds flow statement (without adjustment)

From the following Balance Sheets, prepare a statement showing flow of funds.
Liabilities 31-12-2020 31-12-2021 Assets 31-12-2020 31-12-2021
Rs. Rs. Rs. Rs.
Share Capital 2,00,000 2,50,000 Land 50,000 66,000
Retained earnings 10,000 23,000 Stock 80,000 90,000
Creditors 70,000 45,000 Debtors 1,20,000 1,15,000
Cash 30,000 47,000
2,80,000 3,18,000 2,80,000 3,18,000
Ans: Increase in working capital Rs. 2,000
Part B
Problem No. 15:Preparation of funds flow statement (with adjustment)
From the following Balance sheets of Maradon Ltd., prepare a Funds
Statement.
Rs. Rs. Rs. Rs.
Equity share capital 4,00,000 4,50,000 Good will 65,000 55,000
Pref. share capital 1,50,000 1,25,000 Buildings 2,00,000 1,70,000
General reserve 40,000 70,000 Motor car 50,000 35,000
P & L A/c 30,000 68,000 Furniture 1,00,000 95,000
Creditors 55,000 53,000 Plant 80,000 2,00,00
Bills payable 20,000 16,000 Investments 3,800 4,200
Provision for Debtors 1,60,000 2,00,000
taxation 82,000 1,00,000 Stock 77,000 1,09,000
Provision for Bills
doubtful debts 3,800 4,200 Receivable 20,000 30,000
Cash in hand 15,000 10,000
7,80,800 9,16,200 7,80,800 9,16,200
288
Addition information
a) Provide depreciation on plant Rs. 10,000
b) Buildings costing Rs. 20,000 was sold for Rs. 18,000
c) An interim dividend of Rs. 20,000 has been paid in 2021
d) Income tax Rs. 35,000 was paid during 2021
e) Investments costing Rs. 1,500 was sold during the year for Rs. 2,000
Problem No. – 16:
Following are the summarized Balance Sheets of RM Ltd., as on 31-12-2020
and 31-12-2021.
Rs. Rs. Rs. Rs.
Share capital 2,00,000 2,50,000 Land & 42,000 50,000
Building 2,00,000 1,90,000
General reserve 50,000 60,000 Machinery 1,50,000 1,69,000
P & L A/c 30,500 30,600 Sundry
Debtors 1,00,000 74,000
Bank loan (long- 70,000 --- Stock 80,000 64,200
term)
Sundry Creditors 1,50,000 1,35,200 Cash 500 600
Provision for taxation 30,000 35,000 Bank --- 8,000
Proposed dividend 42,000 50,000 Good will --- 5,000
5,72,000 5,60,800 5,72,000 5,60,800
1) Dividend was paid.
2) Assets of another company were purchased for a consideration of Rs. 50,000,
payable in shares. The following assets were purchased: Stock Rs. 20,000;
Machinery Rs. 25,000.
3) Depreciation written off machinery Rs. 12,000
4) Income tax paid during the year Rs. 33,000
5) Loss on sale of machinery Rs. 200 was written off to general reserve.
6) Further machinery purchased for cash Rs. 8,000
Prepare a Funds Flow Statement
Ans:Decrease in working capital Rs. 18,900, Funds from operations Rs. 1,40,300,
Total FPS Rs. 1,81,000.
289
CASH FLOW STATEMENT

Part A
Problem – 17: Calculation of cash from operations
From the following data you required to calculate the cash from operations:
Fund From the operations for the year 2021 Rs. 84,000. Current assets and
liabilities were as follows:
Rs. Rs.
Trade creditors 1,82,000 1,94,000
Trade debtors 2,75,000 3,15,000
Inventories 1,85,000 1,70,000
Trade investments 40,000 70,000
Problem – 18: Preparation of cash flow statement (with out adjustment)
From the following Balance Sheets of Ranjitha Ltd., you are required to
prepare a cash flow statement.
Rs. Rs. Rs. Rs.
Share capital 4,00,000 5,00,000 Cash 60,000 96,000
Trade Creditors 1,40,000 90,000 Debtors 2,40,000 2,30,000
Profit and Loss A/c 20,000 46,000 Stock 1,60,000 1,89,000
Land & Building 1,00,000 1,36,000
5,60,000 6,36,000 5,60,000 6,36,000
Ans: Cash operations Rs. 34,000, Total cash flow statement Rs. 1,60,000.
Problem – 19: Preparation of cash flow statement (with out adjustment)
Maradon Ltd., supplies you the following Balance on 31st December 2020 and
2021.
Balance Sheets
Rs. Rs. Rs. Rs.
Capital stock 70,000 74,000 Bank Balance 9,000 7,800
Debentures 12,000 6,000 Accounts 14,900 17,700
Receivable
Accounts payable 10,360 11,840 Inventories 49,200 42,700
Provision for doubtful 700 800 Land & Building 20,000 30,000
debts
Reserves and surplus 10,040 10,560 Good will 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
290
Following additional information has also been supplied you:

i) Cash dividends amounting to Rs. 3,500 and Stock dividend Rs. 4.000 were
paid during the year 2021.
ii) Land & Building was purchased for Rs. 12,500
iii) Rs. 5,000 were written off on Goodwill during the year.
iv) Debentures were redeemed at a premium of 10% in 2021.
v) You are required to prepare a Cash Flow Statement.
Ans:
Problem – 20:
The Balance sheets of Don Enterprises for the years 2020 and 2021 was as
follows.
Rs. Rs. Rs. Rs.
Share capital 2,00,000 2,50,000 Land & Building 80,000 80,000
Profit & Loss A/c 50,000 1,00,000 Investments 20,000 32,000
Capital Reserve --- 18,000 Plant 60,000 68,000
Bank Loan --- 20,000 Goodwill 40,000 30,000
Sundry Creditors 10,000 21,000 Stock 55,000 1,00,000
Provision for tax 15,000 18,000 Debtors 30,000 75,000
Proposed dividend 27,000 23,000 Bills receivable 10,000 50,000
Cash 7,000 15,000
3,02,000 4,50,000 3,02,000 4,50,000
i) Land and building were purchased at a cost of Rs. 20,000 through borrowing
from bank.
ii) Land and building sold during the year and profit on the sale was transferred
capital reserve.
iii) Investment costing Rs. 10,000 was sold at a loss Rs. 2,000.
iv) Investments were purchased and Rs. 3,000 by way of interest is received in
including Rs. 1,000 was used in writing down the book value of investments.
v) Stock of 2021 was valued at 10% above cost. It decided to value the stock at
cost.
You are required to prepare a cash flow statement.

291
SL. No. No. of Problems

1 Marginal Costing 8
2 Standard Costing and Variance Analysis 10
3 Budgets and Budgetary Control 8
Total 26
MARGINAL COSTING
Part-A Questions
1. From the following information calculate Contribution, P/ V Ratio, BEP,
Margin of safety
Total sales = Rs. 6,00,000
Selling price per unit = Rs. 100
Variable cost per unit = Rs. 60
Fixed cost = Rs.2,00,000
Ans: P/V Ratio = 40% ,BEP = Rs. 5,00,000,Margin of safety = Rs. 1,00,000
Problems related to Calculation of P/V Ratio, BEP,
Margin of safety, expected sales and Expected profit.
2. From the following data, calculate Contribution, P/ V Ratio, BEP, Margin of
safety. Amount of sales required to earn a profit of Rs. 50,000, and Profit when
sales are Rs. 6,00,000
No. of units sold : 20,000
Selling price per unit : Rs. 25
Trade discount : 4%
Direct material cost per unit : Rs. 8
Direct labour cost per unit : Rs. 5
Fixed overheads : Rs. 1,20,000
Variable overheads 60% on direct labour..
Ans : P/ V Ratio = 33.33% , BEP = Rs. 3,60,000, MOS = 1,20,000,
Expected sales = Rs. 5,10,000, Expected Profit = Rs. 80,000
3. TheP/ V Ratio of a firm dealing in precision instrument is 50% and margin of
safety 40%. You are required to work out the BEP, and the net profit when
sales volume is Rs. 50,00,000.
Aus :BEP = Rs 30,00,000, Net profit = Rs. 10,00,000
292
Part - B Questions
4. An analysis of Kanmani Co. Ltd, led to the following information
Varialble cost (% on sales) Fixed cost( Rs)

Direct material 32.8 -
Direct labour 28.4 -
Factory overheads 12.6 1,89,900
Distribution overheads 4.1 58,400
Administration 1.1 66,700
overheads
Budgets sales for the year Rs 18,50,000. you are required to calculate. (i) The
break-even sales. (ii) The profit at the budgets sales. (iii)The profit if actual sales
a. Drop by 10%
b. Increase by 5% from budgeted sales.
Ans : P/ V Ratio =21%, BEP = Rs. 15,00,000, Profit = Rs. 73,500, Profit when actual
sales drop by 10% = Rs. 34,650, Profit when actual sales increase by
5% = Rs. 92,925.
5. Assuming that the cost structure and selling price are remain. In periods I and
II, find out
1) P/V Ratio
2) BEP in amount
3) Profit when sales are Rs. 1,00,000
4) Sales required to earn a profit of Rs. 20,000
5) Margin of safety in II period
6) Margin of safety ratio for period II
7) Margin of safety ratio for both periods together.
Period Rs Rs
I 1,20,000 9,000
II 1,40,000 13,000
Ans: P/ V Ratio = 20%, Fixed cost=15,000, BEP = Rs. 75,000, Required Profit =
Rs 5,000, Required sales = Rs. 1,75,000; M.S. 65,000; MSR: 46.43%
and 42.31%
DECISION MAKING PROBLEMS

Problem related to Accepting Additional Order
6. The cost sheet of a product is given below:
Rs.
Direct Material 5.00
Direct wages 3.00
Factory Overhead:
Fixed Re. 0.50
Variable Re. 0.50 1.00
293
Administrative expenses 0.75

Selling or distribution overhead:
Fixed Re . 0.25
Variable Re . 0.50 0.75
Total cost per unit 10.50
Selling price per unit is Rs. 12.00
The above figures are for an output of 50,000 units. The capacity for the firm
is 65000. units. A foreign customer is desirous of buying 15,000 units at a price of
Rs. 10 per units.
Advise the manufacturer whether the order should be accepted what will be
you advise if the order were from a local merchant?
Ans: The order from foreign customer should be accepted. The order from local
customer should not be accepted.
Problem related to Key factor:

7. The following particulars are obtained from costing records of a factory:
Product A Product B
(per unit) (per unit)
Rs. Rs.
Selling Price 200 500
Material (Rs. 20 per kg.) 40 160
Labour (Rs. 10 per hour) 50 100
Variable overhead 20 40
Total fixed overhead Rs. 15,000.
Comment on the profitability of each product when:
1) Raw material is in short supply;
2) Production capacity is limited;
3) Sales quantity is limited;
4) Sales value is limited;
5) Only 1,000 kgs. of raw material is available for both type of products in total
and maximum sales quantity of each product is 300 units.
Ans: 1 – A is more profitable, 2 – B is more profitable, 3 – B is more profitable
4 – A is more profitable, 5 – A = 300 units; B = 50 units
Problem related to selection of suitable product mix:

8. Following information has been made available from the cost records of United
Automobiles Ltd. manufacting spare parts.
Direct Materials Per Unit
X Rs. 8
Y Rs. 6
Direct Wages
X 24 hours at 25 paise per hour
294
Y 16 hours at 25 paise per hour

Variable overheads 150% of Wages
Fixed overheads Rs. 750
Selling price
X Rs. 25
Y Rs. 20
The directors want to be acquainted with the desirability of adopting any one
of the following alternative sales mixes in the budget for the next period.
i)
250 units of X and 250 units of Y
ii)
400 units of Y
iii)
400 units of X and 100 units of Y
iv)150 units of X and 350 units of Y
State which of the alternative sales mixes you would recommend to the
management?
Ans: Alternative IV is profitable
STANDARD COSTING AND VARIANCE ANALYSIS

Problems related to Calculation of Material Variance
9. From the following information of production No. 777 calculate
1. Material cost variance 2. Material price variance
3. Material usage variance 4. Material mix variance
5. Material sub-usage variance
Material Standard SP Actual Quantity AP
Quantity
Kg Rs. Kg Rs.
X 20 5 24 4.00
Y 16 4 14 4.50
Z 12 3 10 3.25
48 48
Ans: DMCV = 8.50 (F), DMPV = 14.50 (F), DMUV = 6(A) DMMV = 6(A), DMSUV = Nil
10. From the following information compute material variances.
Standard Actual
Quantity Unit Price Total Quantity Unit Price Total
(Kilos) Rs. Rs. (Kilos) Rs. Rs.
Material A 10 2 20 5 3 15
Material B 20 3 60 10 6 60
Material C 20 6 120 15 5 75
Total 50 200 30 150

Ans: DMCV = 50 (F), DMPV= 20 (A), DMUV = 70 (F) DMMV = 10 (A),
DMSUV = 80(F)
295
11. Calculate material variance
Standard (for 10 units) Actual (for 100units)

Quantity Price Total Quantity Price Total
(Kilos) Rs. Rs. (Kilos) Rs. Rs.
A 50 6.00 300 400 6.00 2,400
B 40 3.75 150 500 3.60 1,800
C 30 3.00 90 400 2.80 1,120
Input 120 1300
Normal loss
Less:10% 12 220
Output 108 540 1080 5,320
Ans: DMCV =8 (F) , DMPV= 155 (F) , DMUV = 75 (A) DMMV = 375 (F)
12. The standard cost of a certain chemical mixture is
40% Material A at Rs. 25 per Kg.
60% Material B at Rs. 36 per Kg.
A standard loss of 10% is expected in production
During a period, there is used:
150 Kgs. Of Material A at Rs. 27 per kg.
260 kgs. of Material B at Rs. 34 per Kg.
The actual output was 360 Kgs.
Compute all material variance.
Ans: DMCV = 250 (A) , DMPV= 220 (F), DMUV = 470
(A) DMMV = 154 (A) DMYV = 316 (A)
13. Vinak Ltd. produces an article by blending two basic raw materials. It
operates a standard costing system and the following standards have been set
for raw materials:-
Material Standard Mix Standard price per kg
A 40% Rs.4
B 60% Rs. 3
The standard loss in processing is 15%,
During April 2021 the com. produced 1,700 kgs of finished output. The
position of stocks and purchases for the month of April 2021 is as under.
Material Stock on Stock on Purchases during
1-4-2021 1-4-2021 April 2021
Kgs. Kgs. Kgs. CostRs.
A 35 5 800 3,400
B 40 50 1,200 3,000
Calculate all material variances.
Ans: DMCV = 297.50 (F), DMPV= 387.50 (F), DMUV = 90 (A) DMMV = 22 (A)
DMYV =68 (A)
296
Problems related to Calculation of labour Variance

14. The information regarding the composition and hourly wage rates of labour
force engaged on a job scheduled to be completed in 30 hours are as following:
Standard Actual
Category of
workers No. of Hourly wage No. of Hourly wage
workers rate per workers workers rate per workers
Skilled 75 6 70 7
Semi-skilled 45 4 30 5
Un-skilled 60 3 80 2
The work was completed in 32 hours. Calculate labour variances.
Ans: DLCV = 1,300 (A) , DLRV= 640 (A), DLEV =660 (A) DLMV =960 (A) DLSEV = 1,620 (A)
Problems related to Calculation of Overhead Variance
15. Budgetd hours for month of March 2021, 180 hours Standard rate of article
produced per hour 50 units.
Budgeted fixed overheads Rs. 2,700
Actual production March 2021, 9,200 units
Actual hours for production 175 hours.
Actual fixed overheads Rs. 2,800
Calculate overhead cost variance, overhead budget variance, overhead volume
variance, overhead efficiency variance and overhead capacity variance.
Ans: OHCV = 40 (A), OHBV= 100 (A), OHVV =60 (F) OHEV =135 (F) OH
Capacity V =75 (A)
16. A factory has estimated its overheads for one year year atRs. 96,000. The
factory runs for 300 days in a year. It work for 8 hours a day. The tool
budgeted production for the year is 24,000 articles.
Actual data is also given to you as under for the month April 1988.
Actual overhead Rs. 8,500
Output 2,100, articles
Idle time 4 hours
Calculate: (1) Overhead cost variance (2) Overhead budget variance
(3) Overhead efficiency variance (4) Overhead volume variance, 5) Overhead
capacity variance (6) Idle time variance
Ans: OHCV = 100 (A), OHBV = 500 (A), OHVV = 400 (F) OHEV = 560 (F)
OH Capacity V =160 (A) Idle time V 160(A)
17. Calculate overhead variances.
Items Budget Actual

No. of working days 20 22
Man hours per day 8,000 8,400
Output per man hour in units 1 0.9
Overhead Cost Rs. 1,60,000 1,68,000
Ans: OHCV = 1,680 (A) , OHBV= 8000 (A), OHVV =6320 (F) OHEV =18,480 (A)
OHC calender V =16,000 (F)
297
Problems related to Calculation of Sales Variance

18. Joy Ltd. furnishes the following information relating to budgeted sales and
actual sales for June 2021.
Budget Price Actual Price
Product Sales Qty. Rs. Sales Qty. Rs.
Units Units
A 1200 15 880 18
B 800 20 880 20
C 2000 40 2640 38
Calculate sales Variances.
Ans: S Value V = 19,760 (F), Sale price V = 2640 (A), sales volume V 22,400 (F),
Sales mix V 11,000 (F), Sales sub volume V=11,400(F)
BUDGETS AND BUDGETARY CONTROL

Part - A Questions
Preparation of Production budget:
19. You are required to prepare a production budget for the half year ending June 2021
from the following information:
Product Budgeted sales quantity Actual stock on 31-12- Desired stock on
Units 2020 30-6-2021
Units Units
M 20,000 4,000 5,000
T 50,000 6,000 10,000
Ans : Production M 21,000 units T 54,000 units
20. Lakshmanan Ltd. plans to sell 1,10,000 units of a certain product line in the
first fiscal quarter. 1,20,000 units in the second quarter, 1,30,000 units in
the third quarter, 1,50,000 units in the fourth quarter and 1,40,000 units in
the fifth quarter. At the beginning of the first quarter of the current year,
there are 14,000 units of the product in stock. At the end of each quarter, the
company plans to have an inventory equal to one-fifth of the sales for the next
fiscal quarter. How many units must be manufactured in each quarter of the
current year?
Ans : Production 1Q 1,20,000 units,I1Q 1,22,000 units, II1Q 1,34,000 units
1VQ 1,48,000 units .
Preparation of Purchase Budget
21. The Sales Director of a manufacturing company reports that next year he
expects to sell 50,000 units of particular product. The production Manager
consults the Storekeeper and casts his figures as follows
Two kinds of raw materials A and B, are required for manufacturing the product.
Each unit of the product requires 2 units of A and 3 units of B. The estimated
opening balances at the commencement of the next year are:
Finished product: 10,000 units
Raw Materials A: 12,000 units ; B : 15,000 units
The desirable closing balance at the end of the next year
298
Are: Finished product 14,000 units, A : 13,000 units B : 16,000 units

Prepare Materials Purchase Budget for the next year.
Ans : Production 54,000 units Purchase material A 1,09,000 units and
material B 1,63,000.
Part - B Questions
22. Vijayalakshmi Engg. Co. manufacturers two products 'P' and 'R' An estimate of
the number of units expected to be sold in the first 7 months of 2021 is given
below: Prepare production budget and production cost budget, for the period
January to June 2021.
Production P (units) Production R (units)

Jan 1,400 500
Feb 1,400 600
March 1,200 800
April 1,000 1,000
May 800 1,200
June 800 1,200
July 900 1,000
It is anticipated that:
i) There will be no work-in-progress at the end of any month.
ii) Number of units equal to half the anticipated sales for the next month will be in
stock at the end of each month (including December 2020).
The budgeted production and production cost for the year ending 31-12-2021
are as following:
Production P Production R
Production (units) 12,000 11,000
Direct material cost per units (Rs.) 20 15
Direct wages per units (Rs.) 10 8
Other manufacturing charges apportion able to 48,000 33,000
each type of product for the year (Rs.)
i) A production budget showing the number of units to be manufactured each
month; and
ii) A summarised production cost budget for six months period-January to June
2021.
Ans: Total six months production P 6,350 units and R 5,550 units. Production cost
P Rs. 2,15,900 and R Rs. 1,44,300, Total cost Rs. 3,60,200.
299
23. Summarized below are the Income and Expenditure forecasts of Gemini Ltd.
for the months of March to August, 2021:
Month Sales Purchases Wages Manufacturing Office Selling

(all credit) (all credit) Expenses Expenses Expenses
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
You are given the following further information
i) Plant costing Rs. 16,000 is due for delivery in June. 10% paid on delivery and
balance will be paid after 3 months.
ii) Advance Tax of Rs. 8,000 is payable in March and June each.
iii) Period of credit allowed (i) by suppliers 2 months and (ii) to customers
1 month.
iv) Lag in payment of manufacturing expenses 1/2month.
v) Lag in payment of all other expenses 1 month.
You are required to prepare a cash budget for three months starting on 1st
May, 2021 when there was a cash balance of Rs. 8,000.
Ans: Closing cash May Rs. 15,750,June Rs. 12,750 and July Rs. 18,400.
24. Draw up a flexible budget for overhead expenses on the basis of the following
data and determine the overhead rates at 70%. 80% and 90% plant capacity.
At 70% At 80% At 90%
Capacity Capacity Capacity
Rs. Rs. Rs.
Variable Overheads:
Indirect labour — 12,000 —
Stores including spares — 4,000 —
Semi-Variable Overheads:
Power
(30% fixed, 70% variable) — 20,000 —
Repairs and
Maintenance — 2,000 —
(60% fixed, 40% variable)
Fixed Overheads:
Depreciation — 11,000 —
Insurance — 3,000 —
Salaries — 10,000 —
Total Overheads — 62,000
Estimated direct labour hours:
Total Overhead: 70% = 58,150; 80% = 62,000; 90% = 65,850
Ans: Direct labour hour rate 70 % = Re. 0.536, 80 % = Re 0.50,90% = Re 0.472
300
25. The cost of an article at a capacity level of 5,000 units is given under A below.
For a variation of 25% in capacity above or below this level, the individual
expenses very as indicated under B below.
A B
Rs.
Material Cost 25,000 (100% Varying)
Labour Cost 15,000 (100% Varying)
Power 1,250 (80% Varying)
Repairs and Maintenance 2,000 (75% Varying)
Stores 1,000 (100% Varying)
Inspection 500 (20% Varying)
Depreciation 10,000 (100% Varying)
Adm. Overheads 5,000 (25% Varying)
Selling Overheads 3,000 (25% Varying)
62,750
Cost per unit Rs. 12.55
Find the unit cost of the product at production levels of 4,000 units and 6,000
units.
Ans: Total cost for 4000units = Rs 51,630, for 5000 units =Rs 62,750 and for 6000
units Rs 73, 870. Cost per unit 12.91,12.55 and 12.32.
26. The expenses for budgeted production of 10,000 units in a factory are
furnished below:
Per Unit Rs.
Material 70
Labour 25
Variable Overheads 20
Fixed Overheads (Rs. 1,00,000) 10
Variable Expenses (Direct) 5
Selling Expenses(10% Fixed) 13
Distribution Expenses (20% Fixed) 7
Administration Expenses (Rs. 50,000) 5
Total Cost per unit 155
Prepare a budget for production of:
i) 8,000 units.
ii) 6,000 units
iii) indicate cost per unit at both the levels.
Assume that administration expenses are fixed for all levels of production.
Ans: Total cost for 10,000units = Rs. 15,50,000, for 8000 units =Rs. 12,75,400 and
for 6000 units Rs. 10,00,800. Cost per unit Rs. 155.00,Rs. 159.425 and
Rs. 166.80

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023E2310
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ANNAMALAI UNIVERSITY PRESS : 2022 – 23

Annamalai University: Accounting For Managerial Decisions

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023E2310

Master of Commerce (M.Com.)

ACCOUNTING FOR MANAGERIAL DECISIONS

Dr. K. Govindarajan Dr. R. Elangovan

MASTER OF COMMERCE (M.Com.)

Unit – I:Introduction to Management Accounting

MASTER OF COMMERCE (M.Com.)

1. Nature and Scope of Management Accounting 1

NATURE AND SCOPE OF MANAGEMENT ACCOUNTING

Cost accounting was introduced to avoid the shortcomings of financial

4.Management accounting is concerned with forecasting. It thus helps in

services, Management is assisted by them by measuring actual results against

Distinction between Financial and Management Accounting

 Statistical and Graphical Techniques.

“Management Accounting”. Management is mainly a task of planning co-ordinating

o Funds flow analysis

Income and expenditure account

relationship among the various financial factors in a business as disclosed by a

Balance sheets as on 31.12.2020 and 31.12.2021

Comparative Balance Sheet

Common size statements

Dr Profit and Loss Account Cr

Common – Size Income Statements

Preparation of Common size Balance sheet

Particulars 2020 2021 2020 2021

6. You are required to prepare a comparative Balance Sheet from the

business enterprises measure their turnover, profitability, liquidity and leverage.

2. It is one of the media to link the past and future.

ratios. It involves the collection of required information, calculation of ratios,

5. Debt Equity Ratio

Example: Net Sales Rs. 10,00,000 and Gross profit Rs.2,00,000

8. Net Profit Ratio

Example:Net profit Rs.1,00,000 and Net sales Rs.16,00,000

A rise in the operating ratio indicates a decline in the efficiency

17. Turnover of Fixed Assets

18. Turnover of Total Assets

19. Turnover of Working capital

It shows whether the business is being operated on a small or large amount of

This is mainly prepared to find how many days’ credit is outstanding by

21. Creditors’ velocity

24. Pay out Ratio (POR)

ACCOUNTING RATIO- PRACTICAL PROBLEMS

25,000 + 75,000 1,00, 000

Bills Payables as on 01.01.2021 4,000

Current assets 1,40,000

 Fixed assets ratio  Debt collection period

Dr Profit and Loss Account Cr

Shareholders funds 32,00,000

11. Net profit ratio

Closing Stock =0.25 =1,00,000

Net worth = Rs 1,20,000

Stock Turnover Ratio (cost sales/closing stock) = 6 times

Fixed Assets = 5 times =10,00,000

Average Stock = Rs60,000

4. Calculate average payment period

9. Calculate Return on total resources and turnover to total assets.

7.Creditors turnover ratio, 8. Stock turnover ratio, 9. Fixed assets turnover

5% Debentures 1,00,000 Sundry debtors 50,000

FUNDS FLOW STATEMENT

o Calculation of funds from operation

The Concept of ‘Funds’

usual financial statements. In fact, the statement is intended to supplement

(b) Column of Statement showing changes in the working capital