Professional Documents
Culture Documents
LESSON – 1
INTRODUCTION
The term “Management Accounting” is of recent origin. It was first coined by the British
Team of Accountants that visited the U.S.A. under the sponsorship of Anglo-American
Productivity Council in 195 with a view of highlighting utility of Accounting as an
“effective management tool”. It is used to describe the modern concept of accounts as a
tool of management in contrast to the conventional periodical accounts prepared mainly
for information of proprietors. The object is to expand the financial and statistical
information so as to throw light on all phases of the activities of the organisation.
All techniques which aim at appropriate control, such as financial control, budgeted
control, efficiency in operations through standard costing, cost-volume-profit theory etc,
are combined and brought within the purview of Management Accounting.
According to Kohler, Forward Accounting includes “Standard costs, budgeted costs and
revenues, estimates of cash requirements, break even charts and projected financial
statements and the various studies required for their estimation, also the internal
controls regulating and safeguarding future operating.”
Blending together into a coherent whole financial accounting, cost accounting and all
aspects of financial management”. He has used this term to include “the accounting
methods, systems and techniques which, coupled with special knowledge and ability,
assist manageme4nt in its task of maximizing profits or minimizing losses.” – James
Batty.
Thus all accounting which directly or indirectly providing effective tools to managers in
enterprises and government organizations lead to increase in productivity is
“Management Accounting.”
1. Forward Looking Principle – basis on the past and all other available data,
forecasting the future and recommending wherever appropriate, the course of
action for the future.
2. Target Setting Principle – fixation of an optimum target which is variously
known as standard, budget etc., and through continuous review ensuring that the
target is achieved or exceeded.
3. The Principle of Exception – instead of concentrating on voluminous masses of
data, Management Accounting concentrates on deviations from targets (which
are usually known as variances) and continuous and prompt analysis of the
causes of these deviations on which to base management action.
The scope of Management Accounting is wide and broad based. It encompasses within
its fold a searching analysis and branches of business operations. However, the
following facets of Management Accounting indicate the scope of the subject.
1. Financial Accounting.
2. Cost Accounting
3. Budgeting & Forecasting
4. Cost Control Procedure
5. Statistical Methods
6. Legal Provisions
7. Organisation & Methods
It is clear that Management Accounting has a vital relation with all those areas
explained above.
1. Modification of Data:
The data becomes more meaningful with the analysis and interpretation. For example,
when Profit and Loss account and Balance Sheet data are analyzed by means of
comparative statements, ratios and percentages, cash-flow-statements, it will open up
new directions for its use by management.
It serves management as a whole according to its requirements it serves top middle and
lower level managerial needs to subserve their respective needs. For instance it has a
system of processing accounting data in a way that yields concise information covering
the entire field of business activities at relatively 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 lower rungs of organizational
ladder.
The gist of Management Accounting can be expressed thus, it is a part of over all
managerial activity – not something grafted on to it from outside – guiding and servicing
management as a body, to derive the best return form its resources, both the itself and
for the super system within which it functions.
From the above discussions, one may come to the following conclusions about the
fundamental approach in Management Accounting.
Firstly, the Management Accounting functions is a managerial activity and it puts its
finger in very pie without itself making them it guides and aids setting of objectives,
planning coordinating, controlling etc. But it does not itself perform these functions.
Secondly it serves management as a whole – top middle and lower level – according to
its requirements. But in doing so it never fails in keeping in focus the macro-approach to
the business as a whole.
Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach is to split
all costs and benefits into two groups – measurable and non measurable. It is easy to
deal with measurable costs which are expressed in terms of money. But there are
several ventures such as office canteens where the cost-benefits may not be monetarily
measurable.
The terms financial accounting, and management accounting, are not prices description
of the activities they comprise. All accounting is financial in the sense that all accounting
systems are in monetary terms and management, of course, is responsible for the
content of financial accounting reports. Despite this close interrelation, there are some
fundamental differences between the two and they are:
The gradual growth of management accounting has brought with it a recognition of the
desirability of segregating the accounting function from other activities of a secretarial
and financial nature in order to make possible a more accurate accounting control over
multifarious, complex and sprawling business operations. As a natural corollary,
controller has come into being by way of a skilled business analyst who, due to his
training and experience, is the best qualified to keep the financial records of the
business and to interpret these for the guidance of the management.
It is not surprising, therefore, that controllership function has developed pari passu with
the development of management accounting so much so that there is a tendency to
record the two as synonymous. In a way, this is true because of controller in the United
States does all that management accounting is expected to accomplish, in fact,
controller is the pivot round which system of management accounting revolves.
Generally speaking, controllership function embraces within its broad sweep and wide
curves, all accounting functions including advice to management on course of action to
be taken in a given set of circumstances with the object of completely eliminating the
role of intuition in business affairs.
Concept:
The controllers’ Institute, as well as the National Industrial conference Board of the
United States, have spelt out the functions of the controller in still greater detail but the
seven-point concept of modern controllership is board enough to leave no phase of
policy or organization beyond the controller’s jurisdiction. Through the concept has been
laid down mainly from the functional point of view, it lifts the notion of controllership from
pedestrian paper-shuffling to a top-management attitude that aids decision – making, it
broadens controller’s outlook and provides him with specific goals.
Status of Controller:
There is no fixed place for the controller in the hierarchy of management. It is
sometimes said that the status of controller is not ensured simply by virtue of his holding
the office but depends, in no small measure, upon hi personality, mental equipment,
industrial background and his capacity to convince others of his ability as well as
integrity. Moreover, it would depend upon the terms of his appointment and, therefore, it
is bound to vary with every individual undertaking. The terms of appointment may be
fixed by the Board of Directors or may be included in the Articles of Association of the
Company.
Limitation:
It is also necessary that the limitation of Controller’s role imposed by the very nature of
his work, must be borne in mind. Though the Controller helps in bringing together all
phases of management, he does not pretend to solve the problems of production of
marketing, he knows their nature and so can discuss in detail with all levels of
management the financial implications of solutions they suggest.
LESSON – 4
FINANCIAL STATEMENTS:
According to the American Institute of Certified Public Accountants, “Financial
statements reflect a combination of recorded facts accounting conventions and personal
judgements and the judgements and conventions applied affect them materially.” This
statement makes clear that the accounting information as depicted by the financial
statements are influenced by three factors viz. recorded facts, accounting conventions
and personal judgements.
1. Shareholders
2. Debenture-holders
3. Creditors
4. Financial institutions and commercial banks
5. Prospective investors
6. Employees and trade unions
7. Tax authorities
8. Govt. departments
9. The company law board
10. Economists and investment analysis, etc.
IMPORTANCE OF FINANCIAL STATEMENTS
IMPORTANCE TO MANAGEMENT:
Financial statements help the management to understand the position, progress and
prospects of business results. By providing the management with the causes of
business results, they enable them to formulate appropriate policies and courses of
actions for the future. The management communicate only through these financial
statements their performance to various parties and justify their activities and thereby
their existence.
IMPORTANCE TO LENDERS/CREDITORS:
The financial statements serve as a useful guide for the present suppliers and probable
lenders of a company. It is through a critical examination of the financial statements that
these groups can come to know about the liquidity profitability and long-term solvency
position of a company. This would help them to decide about their future course of
action.
IMPORTANCE TO LABOUR:
Workers are entitled to bonus depending upon the size of profit as disclosed by audited
profit and loss account. Thus, P & L a/c becomes greatly important to the workers in
wage negotiations also the size of profits and profitability achieved are greatly relevant.
IMPORTANCE TO PUBLIC:
Business is a social entity. Various groups of the society, though not directly connected
with business, are interested in knowing the position, progress and prospects of a
business enterprise. They are financial analysts, lawyers, trade associations, trade
unions, financial press research scholars, and teachers, etc.
Importance of National Economy: The rise & growth of the corporate sector, to a
great extent, influences the economic progress of a country. Unscrupulous & fraudulent
corporate managements shatters the confidence of the general public in joint stock
companies which is essential for economic progress & retard economic growth of the
country. Financial Statements come to rescue of general public by providing information
by which they can examine & asses the real worth of the company & avoid being
cheated by unscrupulous persons.
(i) The materials used and (ii) The modus operandi of analysis
ON THE BASIS OF MATERIAL USED: According to this basis financial analysis can
be of two types.
(i) External Analysis: This analysis is done by those who are outsiders for the
business. The term outsiders includes investors, credit agencies, government and other
creditors who have no access to the internal records of the company.
(ii) Internal Analysis: This analysis is done by persons who have access to the books
of account and other information related to the business.
On the basis of modus operandi. According to this, financial analysis can also be two
types.
(i) Horizontal analysis: In case of this type of analysis, financial statements for a
number of years are reviewed and analyzed. The current year’s figures are compared
with the standard or base year. The analysis statement usually contains figures for two
or more years and the changes are shown recording each item from the base year
usually in the from of percentage. Such an analysis gives the management considerable
insight into levels and areas of strength and weakness. Since this type of analysis is
based on the data from year to year rather than on the date, it is also termed as
Dynamic Analysis.
(ii) Vertical analysis: In case of this type of analysis a study is made of the quantitative
relationship of the various terms in the financial statements on a particular date. For
example, the ratios of different items of costs for a particular period may be calculated
with the sales for that period such an analysis is useful in comparing the performance of
several companies in the same group, or divisions or departments in the same
company.
A financial analyst can adopt one or more of the following techniques/tools of financial
analysis.
Comparative Income Statement: The Income statement discloses net profit or Net
Loss on account of operations. A comparative Income Statement will show the absolute
figures for two or more periods, the absolute change from one period to another and if
desired the change in terms of percentages. Since, the figures for two or more period
are shown side by side, the reader can quickly ascertain whether sales have increased
or decreased, whether cost of sales has increased or decreased etc. Thus, only a
reading of data included in Comparative Income Statements will be helpful in deriving
meaningful conclusions.
ILLUSTRATION : From the following Profit and Loss Accounts and the Balance Sheet
of Swadeshi polytex Ltd. For the year ended 31st December, 1987 and 1988, you are
required to prepare a comparative Income Statement and Comparative Balance Sheet.
SOLUTION:
Swadeshi Polytex Limited
COMMON – SIZE INCOME STATEMENT
FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988
(Figures in Percentage)
1987 1988
Net Sales 100 100
Cost of Goods Sold 75 75
Gross Profit 25 25
Opening Expenses:
Administration Expenses 2.50 2
Selling Expenses 3.75 4
Total Operating Expenses 6.25 6
Operating Profit 18.75 19
Interpretation: The above statement shows that though in absolute terms, the cost of
goods sold has gone up, the percentage of its cost to sales remains constant at 75%,
this is the reason why the Gross Profit continues at 25% of sales. Similarly, in absolute
terms the amount of administration expenses remains the same but as a percentage to
sales it has come down by 5%. Selling expenses have increased by 25%. This all leads
to net increase in net profit by 25% (i.e., from 18.75% to 19%)
3. Trend Percentage: Trend Percentages are immensely helpful in making a
comparative study of the Financial statements for several years. The
method of calculating trend percentages involves the calculation of
percentage relationship that each item bears to the same item in the base
year. Any year may be taken as base year. It is usually the earliest year.
Any intervening year may also be taken as the base year. Each item of
base year is taken as 100 and on that basis the percentages for each of
the years are calculated. These percentages can also be taken as Index
Numbers showing relative changes in the financial data resulting with the
passage of time.
The method of trend percentages is useful analytical device for the management
since by substitution percentages for large amounts, the brevity and readability
are achieved. However, trend percentages are not calculated for all of the items
in the financial statements. They are usually calculated only for major items since
the purpose is to highlight important changes.
Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are the
other tools of Financial Analysis which have been discussed in detail as separate
chapters.
LESSON – 6
RATIO ANALYSIS
The term “ratio” simply means one number expressed in terms of another. It describes
in mathematical terms the quantitative relationship that exists between two numbers,
the terms “accounting ratio”. J. Batty points out, is used to describe significant
relationships between figures shown on a Balance Sheet, in a Profit and Loss Account,
in a Budgetary control System or in any other Part of the accounting organisation. Ratio
Analysis, simply defined, refers to the analysis and interpretation of financial statements
through ratios. Nowadays it is used by all business and industrial concerns in their
financial analysis. Ratio are considered to be the best guides for the efficient execution
of basic managerial functions like planning, forecasting, control etc.
Ratios are designed to show how one number is related to another. It is worked out by
dividing one number by another. Ratios are customarily presented either in the form of a
coefficient or a percentage or as a proportion. For example, the current Assets and
current Liabilities of a business on a particular date are Rs. 2.5 Lakhs and Rs. 1.25
lakhs respectively. The resulting ratio of current Assets and current Liabilities could be
expressed as (i.e. Rs. 2,00,000/1,25,000) or as 200 per cent. Alternatively in the form of
a proportion the same ratio may be expressed as 2:1, i.e. the current assets are two
times the current liabilities.
Ratios are invaluable aids to management and others who are interested in the analysis
and interpretation of financial statements. Absolute figures may be misleading unless
compared, one with another. Ratios provide the means of showing the relationship
which exists between figures. Though there is no special magic in ratio analysis, many
prefer to base conclusions on ratios as they find them highly useful for making
judgments more easily. However, the numerical relationships of the kind expressed by
ratio analysis are not an end in themselves, but are a means for understanding the
financial position of a business. Generally, simple ratios or ratios compiled from a single
year financial statements of a business concern may not serve the real purpose. Hence,
ratios are to be worked out from the financial statements of a number of years.
Ratios, by themselves, are meaningless. They derive their status partly from the
ingenuity and experience of the analyst who uses the available data in a systematic
manner. Besides, in order to reach valid conclusions, ratios have to be compared with
some standards that are established with a view to represent the financial position of
the business under review. However, it should be borne in mind that after computing the
ratios one cannot categorically say whether a particular ratio is god or bad as the
conclusions may vary from business to business. A single ideal ratio cannot be applied
for all types of business. Speedy compiling of ratios and their presentations in the
appropriate manner are essential. A complete record of ratios employed in advisable
and explanation of each, and actual ratios year by year should be included. This record
may be treated as a part of an Accounts Manual or a special Ratio Register may be
maintained.
CLASSIFICATION OF RATIOS:
Ratios can be classified into different categories depending upon the basis of
classification.
The traditional classification has been on the basis of the financial statement to which
the determinants of a ratio belong. On this basis of ratios could be classified as:
1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of the items of
the Profit and Loss account only e.g. Gross Profit ratio, stock turnover ratio, etc.
2. Balance sheet ratios, i.e., ratio calculated on the basis of figures of Balance
sheet only, e.g., current ratio, debt-equity etc.
3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profit and loss
account as well as the balance sheet, e.g. fixed assets turnover ratio, overall
profitability ratio etc.
However, the above basis of classification has been found to be guide and unsuitable
because analysis of Balance sheet and Balance sheet and income statement can not
be done in insalaion. The have to be studied together in order to determine the
profitability and solvency of the business. In order that ratios serve as a toll for financial
analysis, they are now classified as:
(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financial ratios,
(a) Liquidity Ratios (b) Stability Ratios.
LESSON – 7
PROFITABILITY RATIOS:
Profitability is an indication of the efficiency with which the operations of the business
are carried on. Poor operational performance may indicate poor sales and hence poor
profits. A lower profitability may arise due to the lack of control over the expenses.
Bankers, financial institutions and other creditors look at the profitability ratios indicator
whether or not the firm earns substantially more than it pays interest for the use of
borrowed funds and whether the ultimate repayment of their debt appears reasonably
certain. Owners are interested to know the profitability as it indicates the return which
they can on their investments. The following are the important profitability ratios:
The term capital employed has been given different meanings by different accountants.
Some of the popular meanings are as follows:
Share capital + Reserves & Surplus + Long Term loans + Non business assets +
Fictitious assets.
In Management accounting, the term capital employed is generally used in the meaning
given in the third point above.
The term “Operating profit” means “Profit before Interest & Tax.” The term “Interested”
means “Interested on long term borrowing”. Interest on short – term borrowings will be
deducted for computing operating profit. Non-term borrowing will be deducted for
computing operating profit. Non-trading incomes such as interested on Government
securities or non-trading losses or expenses such as loss on account of fire, etc., will
also be excluded.
The term Net Profit here means “Net Incomes after Interest & Tax” It is different from
the “Net Operating Profit” Which is used for computing the “Return on Total Capital
Employed” in the business. This because the shareholders are interested in Total
Income after Tax including Net Non-operating Income (i.e., Non-operating Income –
Non-operating Expenses)
4. Debt service coverage ratio: The interest coverage ratio, as explained above,
does not tell us anything about the ability of a company to make payment of
principle amounts also on time. For this purpose debt service coverage ratio is
calculated as follows:
Net Profit before interest & tax
Debt service coverage ratio = ---------------------------------------------------
Principal Payment Instalment
Interest + -----------------------------------------
1 – (Tax rate)
The principle payment instalment is adjusted for tax effects since such payment is not
deductible from net profit for tax purposes.
Net Profit Before Interest & Tax
5. Interest Coverage Ratio = -------------------------------------------------------
Interest Charges
Gross Profit
6. Gross Profit Ratio = ------------------------------------------------- x 100
Net Sales
Net Profit
7. Net Profit Ratio = ------------------------------------------------ x 100
Net Sales
Operating Profit
Operating Profit Ratio = -------------------------------------------- x 100
Net Sales
Operating Cost
9. Operating Ratio = --------------------------------- x 100
Net Sales
1. Fixed assets turnover ratio : This ratio indicates the extent to which the
investments in fixed assets contribute towards sales. If compares with a previous
period, it indicates whether the investment in fixed assets has been judicious or
not. The ratio is calculated as follows:
Net Sales
---------------------------------
Fixed Assets (NET)
Net Sales
----------------------------------
Working Capital
Working capital turnover ratio may take different forms for different purposes. Some of
them are being explained below:
The term Accounts Receivable include “Trade Debtors” and Bill Receivable”.
In case details regarding and closing receivable and credit sales are not available the
ratio may be calculated as follows:
Total Sales
---------------------------------------------
Accounts Receivable
Significance: Sales to Accounts Receivable Ratio indicates the efficiency of the staff
entrusted with collection of book debts. The higher the ratio, the better it is, Since it
Would indicate that debts are being collected more promptly. For measuring the
efficiency, it is necessary to set up a standard figure, a ratio lower then the standard will
indicate inefficiency.
The ratio helps in Cash Budgeting, since the flow of cash form customers can be
worked out on the basis of sales.
(ii) Debt collection Period ratio: The ratio indicates the extent to which the debts have
been collected in time. It gives the average debt collection period. The ratio is very
helpful to the lenders because it explains to them whether their borrowers are collecting
money within a reasonable time. An increase in the period will result in greater blockage
of funds in debtors. The ratio may be calculated by any of the following methods.
Accounts receivable
(c) -------------------------------------------------------------------
Average monthly or daily credit sales
In fact, the two ratios are interrelated Debtor’s turnover ratio can be obtained by dividing
the months (or days)
In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the number
of months (or days) in a year are divided by the debtors turnover, average debt
collection period is obtained (i.e., 12/6 – 2 months)
A longer collection period implies too liberal and inefficient credit collection
performance. However, in order to measure a firm’s credit and collection efficiency its
average collection period should be compared with the average of the industry. It should
be neither too liberal nor too restrictive. A restrictive policy will result in lower sales
which will reduce profits.
Credit Purchases
-------------------------------------------
Average accounts payable
The term Accounts payable include “Trade Creditors” and “Bills payable”
In case the details regarding credit purchases, opening closing accounts payable have
not been given, the ratio may be calculated as follows:
Total Purchases
----------------------------------
Account Payable
The ratio give the average credit period enjoyed from the creditors. It can be computed
by any one of the following methods:
Month’s or days in a year
(a) ---------------------------------------------------
Creditors’ turnover
Significance: Both the creditors turnover ratio and the debt payment period enjoyed
ratio indicate about the promptness or otherwise in making payment of credit
purchases. A higher “creditors turnover ratio” or a “lower credit period enjoyed ratio”.
Signifies that the creditors are being paid promptly, thus enhancing the credit
worthiness of company. However, a very favourable ratio to this effects also shows that
the business is not taking full advantage of credit facilities which can be allowed by the
creditors.
Stock Turnover Ratio: This ratio indicate whether investments in inventory is efficiently
used or not. It therefore, explains whether investment in inventories is within proper
limits or not. The ratio is calculated as follows:
Inventory ratio can be calculated regarding each constituent of inventory. It may thus be
calculated regarding raw materials, Work in progress & finished goods.
Cost of goods sold
1* --------------------------------------------------
Average stock of finished goods
Materials consumed
2** ----------------------------------------------
Average stock of raw materials
The method discussed above is as a matter of fact the best basis for computing the
stock Turnover Ratio. However, in the absence of complete information, the inventory
Turnover Ratio may also be computed on the following basis.
Net sales
-------------------------------------------------
Average inventory at selling Prices
The average inventory may also be calculated on the basis of the average of inventory
at the beginning and at the end of the accounting period.
Significance: As already stated, the inventory turnover ratio signifies the liquidity of the
inventory. A high inventory turnover ratio indicates brisk sales. The ratio is, therefore, a
measure to discover the possible trouble in the form of overstocking or overvaluation.
The stock position is known as the graveyard of the balance sheet. If the sales are quick
such as a position would not arise unless the stocks consists of unsalable items. A low
inventory turnover ratio results in blocking of funds in inventory becoming obsolete or
deteriorating in quality.
It is difficult to establish a standard ratio of inventory because it will differ from industry.
However, the following general guidelines can be given.
(i) The raw materials should not exceed 2-4 months’ consumption of the year.
(ii) The finished goods should not exceed 2-3 months’ sales
(iii) Work in progress should not exceed 15-30 days’ cost of sales.
PRECAUTIONS: While using the Inventory Ratio, care must be taken regarding the
following factors:
(i) Seasonable conditions: If the balance sheet is prepared at the time of slack
season, the average inventory will be much less (if calculated on the basis of inventory
at the beginning of the accounting period & inventory at close of the accounting period).
This may give a very high turnover ratio.
(ii) Supply conditions: In case of conditions of security inventory may have to be kept
in high quality for meeting the future requirements.
(iii) Price trends: In case of possibility of a rise in prices, a large inventory may be kept
by business. Reverse will be the case if there is a possibility of fall in prices.
(iv) Trend of volume of business: In case there is a trend of sales being sufficiently
higher than sales in the past, a higher amount of inventory may be kept.
LESSON – 9
FINANCIAL RATIOS
Financial Ratios indicate about the financial position of the company. Accompany is
deemed to be financially sound if it is in a position to carry on its business smoothly and
meetits obligions, both short – term as well as longterm, without strain. It is a sound
principle of finance that the short-term requirements of funds should be met out of short
term funds and long-term requirements should be met out of long-term funds. For
example if the payment for raw materials purchases are made through the issue
debentures it will create a permanent interest burden on the enterprise. Similarly, if fixed
assets are purchased out of funds provide by bank overdraft, the firm will come to grief
because such assets cannot be sold away when payment will be demanded by the
bank.
(1) LIQUIDITY RATIOS: These ratios are termed as “working capital” or “short-term
solvency ratios”. As enterprise must have adequate working-capital to run its day-to-day
operations. Inadequacy of working capital may bring the entire business operation to a
grinding halt because of inability of enterprise to pay for wages, materials & other
regular expenses.
CURRENT RATIOS: This ratio is an indicator of the firm’s commitment to meet its
short-term liabilities. It is expressed as follows:
Current assets
-----------------------------
Current Liabilities
Current assets mean assets that will either be used up or converted into cash within a
year’s of time or normal operating cycle of the business, whichever is longer. Current
liabilities means liabilities payable within a year or operating cycle, whichever is longer,
out of existing current assets or by creation of current liabilities. A list of items include in
current assets & current liabilities has already been given in the performs analysis
balance sheet in the preceding chapter.
Book debts outstanding for more than six months & loose tools should not be included
in current assets. Prepaid expenses should be taken as current assets.
An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency due
to the fact that if the current assets are reduced to half, i.e., 1 instead of 2, then also the
creditors will be able to get their payments in full. However a business having seasonal
trading activity may show a lower current ratio at a creation period of the year. A very
high current ratio is also not desirable since it means less efficient use of funds. This is
because a high current ratio means excessive dependence on long-term sources of
raising funds. Long-term liabilities are costlier than current liabilities & therefore, this will
result in considerably lowering down the profitability of the concern.
It is to be noted that the mere fact current ratio is quite high does not mean that the
company will be in position to meet adequately its short-term liabilities. In fact, the
current ratio should be seen in relation to the component of current assets & liquidity. If
a large portion of the current assets comprise obsolete stocks or debtors outstanding for
a long term, time, the company may fail even if the current ratio is higher then 2.
The current ratio can also be manipulated very easily. This may be done either by either
postponing certain pressing payments or postponing purchase of inventories or making
payment of certain current liabilities.
Significance: The current ratio is an index of the concern’s Financial stability since it
shows the extent of working capital which is the amount by which the current assets
exceed the current liabilities. As stated earlier, a higher current ratio would indicate
inadequate employment of funds while a poor current ratio is a danger signal to the
management. It shows that business is trading beyond its resources.
(II) QUICK RATIO: This ratio is also termed as “acid test ratio” or “liquidity ratio”. This
ratio is ascertained by comparing the liquid assets (i.e., assets which are immediately
convertible into cash without much loss) to current liabilities prepaid expenses and stock
are not taken as liquid assets. The ratio may be expressed as:
Liquid assets
---------------------------
Current liabilities
Some accountants prefer the term “Liquid Liabilities” for “Current Liabilities” or the
purpose of ascertaining this ratio. Liquid liabilities means liabilities which are payable
within a short period. The bank over-draft (if it becomes a permenant mode of financing)
& cash credit faculties will be excluded from current liabilities in such a case.
The ideal ratio is 1.
A comparison of the current ratio to quick ratio shall indicate the inventory hold-ups. For
example if two units have the same current ratio but different liquidity ratio, it indicates
over-stocking by the concern having low liquidity ratio as compared to the concern
which has a higher liquidity ratio.
Thus, debtors are excluded from liquid assets for the purpose of comparing super –
quick ratio. Current liabilities & liquid liabilities have the same meaning as explained
above. The ratio is the more measure of firms’ liquidity position. However, it is not
widely used in practice.
STABILITY RATIO: These ratios help in ascertaining long term solvency of a firm which
depends basically on three factors:
(i) Whether the firm has adequate resources to meet its long term funds requirements.
(ii) Whether the firm has used an appropriate debt-equity mix to raise long-term funds.
(iii) Whether the firm earns enough to pay interest & instalment of long-term loans in
time.
The capacity of the firm to meet the last requirement can be ascertained by computing
the various coverage ratios, already explained in the preceding pages. For the other two
requirements, the following ratios can be calculated.
(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raised adequate
long-term funds to meet its fixed assets requirements. It is expressed as follows:
Fixed assets
---------------------------
Long – Term funds
The ratio should not be more than 1. If it is less than 1, it shows that a part of the
working capital has been financed through long-term funds. This is desiarable to some
extent because a part of working capital termed as “Core Working Capital” is more or
less is a fixed nature. The ideal ratio is 67.
(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capital structure of
firm is made up or the debt-equity mix adopted by the firm. The following ratios fall in
the category.
(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportion
between fixed interest or dividend bearing funds & non-fixed interest or dividend bearing
funds in the total capacity employed in the business. The fixed interest or dividend
bearing funds include the funds provided by the debenture holders & preference
shareholders. Non-fixed interest or dividend bearing funds are the funds provided by the
equity shareholders. The amount, therefore, includes the Equity Share Capital & other
Reserves. A proper proportion between the two funds is necessary in order to keep the
cost of capital at the minimum.
Significance: The ratio indicates the preparation of owners’ stake in the business.
Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which the
firm depends upon outsiders for its existence. The ratio provides a margin of safety to
the creditors. It tells the owners the extent to which they can gain the benefits or
maintain control with a limited investment.
Significance: This ratio focuses the attention on the general financial strength of the
business enterprise. The ratio is of particular importance to the creditors who can find
out the proportion of shareholders funds in the total assets employed in the business. A
high proprietary ratio will indicate a relatively little danger to the creditor’s etc., in the
event of forced reorganization or winding up of the company. A low proprietary ratio
indicates greater risk to the creditors since in the event of losses a part of their money
may be lost besides loss to the properties of the business. The higher the rate, the
better it is. A ratio below 50 percent may be alarming for the creditors since they may
have to lose heavily in the event of company’s liquidation on account of heavy losses.
Thus “Ratio can assist management in its basic functions of forecasting planning
coordination, control and communication”.
For example non-financial charges though important for the business are not revealed
by the financial statements. If the management of the company changes, it may have
adverse effect on the future profitability of the company but this cannot be judged by
having a glance at the financial statements of the company.
Financial statements show only historical cost but not market value.
The comparision of one firm with another on the basis of ratio analysis without taking
into account the fact of companies having different accounting policies will be
misleading and meaningless.
3. Ratios alone are not adequate : Ratios are only indicators they cannot be taken
as final regarding good or bad financial position of the business Other things
have also to be seen.
4. Window dressing: The term window dressing means manipulations of accounts
in a way so as to conceal vital facts and present the financial statements in a way
to show a better position than what it actually is. On account of such a situation
presence of a particular ratio may not be a definite indicator of good or bad
management.
5. Problem of price level changes: Financial analysis based on accounting ratios
will give misleading results if the effects of changes in price level are not taken
into account.
6. No fixed standards: No fixed standards can be laid down for ideal ratios. For
example, current ratio is generally considered to be ideal if current assets are
twice the current liabilities. However, in case of these concerns which have
adequate arrangements with their bankers for providing funds when they require,
it may be perfectly ideal if current assets are equal to slightly more than current
liabilities.
7. Ratios area composite of many figures: Ratios are a composite of many
different figures. Some cover a time period, others are at an instant of time while
still others are only averages. A balance sheet figures shows the balance of the
account at one moment of one day. It certainly may not be representative of
typical balance during the year. It may, therefore, be conducted that ratio
analysis, if done mechanically, is not only misleading but also dangerous.
The computation of different accounting ratios & the analysis of the financial statements
on their basis can be very well understood with the help of the illustrations given in the
following pages:
COMPUTATION OF RATIOS
Illustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai Hind
Ltd., Redraft the for the purpose of analysis and calculate the following ratios:
Db. Cr.
Particulars
Opening stock of finished 1,00,000 Sales 10,00,000
goods
Opening stock of raw 50,000 Closing stock of raw 1,50,000
materials materials
Purchase of raw materials 3,00,000 Closing stock of finished 1,00,000
goods
Direct wages 2,00,000 Profit on sale of shares 50,000
13,00,000 13,00,000
BALANCE SHEET
Liabilities Rs. Assets Rs.
Share Capital: Fixed Assets 2,50,000
Equity Share Capital 1,00,000 Stock of raw materials 1,50,000
Preference share capital 1,00,000
Reserves 1,00,000 Stock of finished 1,00,000
Debentures 2,00,000 Sundry debtors 1,00,000
Sundry Creditors 1,00,000 Bank Balance 50,000
Bills Payable 50,000
6,50,000 6,50,000
SOLUTION:
INCOME STATEMENT
Sales Rs. 10,00,000
Ratios:
Gross Profit x 100 50,000 x 100
(i) Gross Profit Ratio ---------------------------- -------------------------- = 50%
Sales 10,00,000
(or)
(or)
ILLUSTRATION 2 : Following are the ratios to the trading activities of National Traders
Ltd.
Gross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/- closing
stock of the year is Rs. 10,000 above the opening stock. Bills receivable amount to Rs.
25,000 and Bills payable to Rs. 10,000.
Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry Creditors
SOLUTION :
(a) Sales:
Gross profit
Gross Profit Ratio = ------------------------- x 100
Sales
12,00,000
Average Stock = ------------------------- x 8 = Rs. 8,00,000
12
16,00,000 - 10,000
Therefore, Opening Stock = ---------------------------------
2
= 7,95,000
Total Creditor’s
Creditor’s Velocity i.e., = ------------------------------ x 12
Purchases
Creditor’s Velocity is 2 months, it means that Account Payable are 1/6th of the
Purchases for the year
The technique of Funds Flow Analysis is widely used by the financial analyst, credit
granting institutions and financial managers in performance of their jobs. It has become
a useful tool in their analytical kit. This is because the financial statements, i.e., “Income
Statement” and the “Balance Sheet” have a limited role to perform. Income statement
measures flow restricted to transactions that pertain to rendering of goods or services to
customers. The Balance Sheet is merely a static statement. It is a statement of assets
and liabilities which does not focus major financial transactions which have been behind
the balance sheet changes. One has to draw inferences after comparing the balance
sheets of two periods. For example, if the fixed assets worth Rs. 2,00,000 are
purchased during the current year by raising share capital of Rs. 2,00,000 the balance
sheet will simply show a higher capital figure and higher fixed assets figure. In case,
one compares the current year’s balance sheet with the previous year, then only one
can draw an inference that fixed assets were acquired by raising share capital of Rs.
2,00,000. Similarly, certain important transaction which might occur during the course of
the accounting year might not find any place in the balance sheet. For example, if a loan
of Rs. 2,00,000 was raised and paid in the accounting year the Balance sheet will not
depict this transaction. However, a financial analyst must know the purpose for which
the loan was utilized and the source from which it was raised. This will help him in
making a better estimate about the company’s financial position and policies.
The term “fund” generally refers to cash, to cash and cash equivalents, or to working
capital. Of these the last definition of the term is by far the most common definition of
“fund”.
There are also two concepts of working capital – gross and net concept. Gross working
capital refers to the firm’s investment in current asset while the term net working capital
means excess of current assets over current liabilities. It is in the latter sense in which
the term ‘funds’ is generally used.
Current Assets: The term ‘Current Assets’ includes assets which are acquired with the
intention of converting them into cash during the normal business operations of the
company.
Current Liabilities: The term ‘Current Liabilities’ is used principally to designate such
obligations whose liquidation is reasonably expected to require the use of assets
classified as current assets in the same balance sheet or the creation of other current
liabilities or those expected to be satisfied within a relatively short period of time usually
one year. However, this concept of current liabilities has now undergone a change. The
more modern version designates current liabilities as all obligations that will require
within the coming year or the operation cycle, whichever is longer. The use of existing
current assets or the creation of other current liabilities . in other words, the more fact
that an amount is due within a year does not make it current liability unless it is payable
out of existing current assets or by creation of current liabilities. For example
debentures due for redemption within a year of the balance sheet date will not be taken
as a current liability if they are to be paid out of the proceeds of a fresh issue of shares /
debentures or out of the proceeds realized on account of sale of debentures redemption
fund investments.
The term current liabilities also includes amounts set apart or provided for any known
liability of which the amount cannot be determined with substantial accuracy e.g.,
provision for taxation, pension etc., These liabilities are technically called provisions
rather than liabilities.
Meaning of “Flow of Funds” The term “Flow” means change and therefore, the term
“Flow of Funds” means “Change in Funds” or “Change in working capital”. In other
words, any increase or decrease in working capital means “Flow of Funds”.
Funds flow statement helps the financial analyst in having a more detailed analysis and
understanding of changes in the distribution of resources between two balance sheet
dates. In case such study is required regarding the future working capital position of the
company, a projected funds flow statement can be prepared. The uses of funds flow
statement can be put as follows.
• Why the liquid position of the business is becoming more and more unbalanced
inspite of business making more and more profits.
• How was it possible to distribute dividends in excess of current earnings or in the
presence of a new loss for the period?
• How the business could have good liquid position in spite of business making
losses or acquisition of fixed assets?
• Where have the profits gone?
Definite answers to these questions will help the financial analyst in advising his
employer / client regarding directing of funds to those channels which will be most
profitable for the business.
2. It answers intricate queries. The financial analyst can find out answers to a
number of intricate questions.
Sources of funds. The sources of funds can be both internal as well as external.
Internal Sources: Funds from operations is the internal source of funds. However,
following adjustments will be required in the figure of Net Profit for finding out real
funds from operations.
Add the following items as they do not result in outflow of funds:
1. Depreciation on fixed assets
2. Preliminary expenses or goodwill, etc., written off.
3. Contribution of debenture redemption find, transfer to general reserve, etc, if they
have been deducted before arriving at the figure of net profit.
4. Provision for taxation and proposed dividend are usually taken as appropriations
of profits only and not current liabilities for the purposes of Funds Flow
Statement. This is being discussed in detail later. Tax or dividends actually paid
are taken as applications of funds. Similarly, interim dividend paid is shown as an
applications of funds. All these items will be added back to net profit, if already
deducted, to find funds from operations.
5. Loss on sale of fixed assets.
1. Profit on sale of fixed assets since the full sale proceeds are taken as a separate
source of funds and inclusion here will result in duplications.
2. Profit on revaluation of fixed assets.
3. Non-operating incomes such as dividend received or accrued dividend, refund of
income tax, rent received or accrued rent. These items increase funds but they
are non-operating incomes. They will be shown under separate heads as
‘source of funds’ in the Funds Flow Statement.
In case the profit and Loss Account shows “Net Loss”, this should be taken as an item
which decreases the funds.
A funds flow statement depicts change in working capital. it will, therefore, be better for
the students to prepare first a Schedule of Changes in Working Capital before preparing
a funds flow statement.
While preparing a funds flow statement, current assets and current liabilities are to
be ignored. Alternation is to be given to changes in Fixed Assets and Fixed
Liabilities. The statement may be prepared in the following form.
FUNDS FLOW STATEMENT
Sources of funds: Rs. Application of Funds Rs.
Issue of Shares --- Redemption of Redeemable ---
Issue of Debentures --- Preference Shares ---
Long-term Borrowing --- Redemption of Debentures ---
Sale of Fixed Assets --- Payment of other long-term loans ---
Operating profit* --- Operating Loss* ---
Decrease in working capital --- Payment of dividend, tax, etc. ---
Increase in working capital* ----
The change in working capital disclosed by the ‘schedule of changes in working capital
will tally with the change disclosed by the ‘funds flow statement’.
Illustration 1:
From the following balance sheet of X Ltd. On 31st December 1985 and 1986, you are
required to prepare.
2. Purchase of Plant. This has been found out by preparing the Plant Account.
Plant Account
To balance b/d 37000 By Depreciation 4000
To bank 3000 By balance c/d 36000
3. Tax paid during the year has been found out by preparing a Provision for Tax
Account.
35000 35000
4. ‘Investment’ have been taken as a fixed asset presuming that they are long-term
investment.
LESSON – 11
A cash flow statement can be prepared on the same pattern on which a funds flow
statement is prepared. The change in the cash position from one period to another is
computed by taking into account “Sources” and “Application” of cash.
Following are the points of difference between a Cash Flow Analysis and a Funds
analysis.
1. A cash flow statement is concerned only with the change in cash position while a
funds flow analysis is concerned with changed in working capital position
between two balance sheet dates. Cash is only one of the constituents of
working capital besides several other constituents such as inventories, accounts
receivable, prepaid expenses.
2. A cash flow statement is merely a record of cash receipts and disbursements. Of
course, it is valuable in its own way but if fails to bring to light many important
changes involving he disposition of resources. While studying the short-term
solvency of a business one is interested not only in cash balance but also in the
assets which are easily convertible into cash.
3. Cash flow analysis is more useful to the management as a tool of financial
analysis in short period as compared to funds flow analysis. It has rightly been
said that shorter the period covered by the analysis, greater is the importance of
cash flow analysis. For example, if it is to be found out whether the business can
meet it obligations maturing after 10 years from now, a good estimate can be
made about firm’s capacity to meet its long-term obligations if changes in working
capital position on account of operations are observed. However, if the firm’s
capacity to meet a liability maturing after one months is to be seen, the realistic
approach would be to consider the projected change in the cash position rather
than an expected change in the working capital position.
4. Cash is part of working capital and, therefore, an improvement in cash position
results in improvement in the funds position but the reverse is not true. In other
words, “inflow of cash” results in ‘inflow of funds’ but inflow of funds may not
necessarily result in “inflow of cash”. Thus, a sound funds position does not
necessarily mean a sound position but a sound cash position generally means a
sound funds position.
5. Another distinction between a cash flow analysis and a funds flow analysis can
be made on the basis of the techniques of their preparation. An increase in a
current liability or decrease in a current asset results in decrease in working
capital and vice verse. While an increase in a current liability or decrease in a
current asset (other than cash) will result in increase in cash and vice versa.
Some people, as stated before, use of term “funds” in a very narrow sense of ‘cash’
only. In such an event the two terms ‘Funds’ and ‘Cash’ will have synonymous meaning.
UTILITY OF CASH FLOW ANALYSIS
1. Helps in efficient cash management
2. Helps in internal financial management
3. Discloses the movement of cash
4. Discloses success or failure of cash planning
Illustration 1
From the following balances you are required to calculate cash from operations:
Illustration 2:
Balance Sheets of A and B on 1.1.1988 and 31.12.1988 were as follows:
BALANCE SHEET
1.1.88 31.12.88 1.1.88 31.12.88
Liabilities Rs. Rs. Assets Rs. Rs.
Creditors 40,000 44,000 Cash 10,000 50,000
Mrs. A’s 25,000 .... Debtors 30,000 50,000
Loan
Loan from 40,000 50,000 Stock 35,000 25,000
Bank
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Building 35,000 60,000
During the year of a machine costing Rs. 10,000 (accumulated depreciation Rs. 3,000)
was sold for Rs. 5,000. The provision for depreciation against Machinery as on 1.1.1988
was Rs. 25,000 and on 31.12.1988 Rs. 40,000. Net profit for the year 1988 amounted to
Rs. 45,000. You are required to prepare Cash Flow Statement.
Solution
Cash Flow Statement
Cash balance as on 1.1.1988 Rs. 10,000
Add: Sources
Cash from Operations Rs. 59,000
Loan from Bank 10,000
Sale of Machines 5,000 74,000
8,400
Less: Applications:
Purchase of Land 10,000
Purchase of Building 25,000
Mrs. A’s Loan repaid 25,000
Drawings 17,000 77,000
Cash Balance as on December 31, 1988 7,000
Working Notes
1,05,000 1,05,000
43,000 43,000
LESSON 12
BUDGETS AND BUDGETARY CONTROL
Definitions
The Institute of Cost and Management Accountants, London, gives the following
definitions:
Realistic Budget: The quality of the budget is very important for the successful operation
of budgetary control. If should be realistic and operationally feasible. Flexible budget is
normally a good budget as it take into consideration the dynamics of the business. It
must be based on what is attainable, must suit the organizational facilities and
complexities and must be flexible to accommodate the changing environment of the
business.
1. Budgeting compels management to plan for the future. The budgeting process
forces management to look ahead and become more effective and efficient in
administering business operations. It instills into managers the habit of evaluating
carefully their problems and related variables before making any decisions.
2. Budgeting helps to coordinate, integrate, and balance the efforts of various
departments in the light of the overall objectives of the enterprise. This results in
goal congruency and harmony among the departments.
3. Budgeting facilitates control by providing definite expectations in the planning
phase that can be used as a frame of reference for judging the subsequent
performance. Undoubtedly, budgeted performance is a more relevant standard
for comparison than past performance is based on historical factors which are
constantly changing.
4. Budgeting improves the quality of communication. The enterprise’s objectives,
budgets goals, plans, authority and responsibility and procedures to implement
plans are clearly written and communicated through budgets to all individuals in
the enterprise. This results in better understanding and harmonious relating
among mangers and subordinates.
5. Budgeting helps to optimize the use of the firm’s resources, both capital and
human. It aids in directing the total efforts of the firm into the most profitable
channels.
6. Budgeting increase the morale and thereby the productivity of the employees by
seeking their meaningful participation in the formulation of plans and policies,
bringing about a harmony between individual goals and the enterprise’s
objectives, and by providing incentives for better performance.
7. Budgeting develops profit-mindedness and cost consciousness.
8. Budgeting permits the management to focus attention on significant matters
through budgetary reports. Thus, it facilitates management by exception and
thereby saves the management’s time and energy.
9. Budgeting measure efficiency and thereby enables self-evaluation by the
management, it also indicates the progress made in attaining the enterprise’s
objectives.
Management must consider the following limitations in using the budgeting system as a
device to solve managerial problems:
1. Budgeting is not an exact science, its success depends upon the precision of
estimates. Estimates are based on facts and managerial judgement. Managerial
judgement can suffer from subjectivity and personal biases. The efficacy of
budgeting thus depends upon the quality of managerial judgement.
2. A perfect system of budging cannot be organized in a short period. Business
conditions change rapidly. Therefore, the budging system should be continuously
adapted to changing circumstance. Budgeting has to be a continuous exercise, it
is a dynamic process. Management should not lose patience, it should go on
trying various techniques and procedures in developing and using the budgeting
system.
3. A skillfully prepared budget system will not by itself improve the management of
an enterprise unless it is properly implemented. For the success of the budgetary
system, it is essential that it is understood by all, and that the managers and
subordinates put in concerted effort for accomplishing the budget goals. All
persons in the enterprise must be fully involved in the preparation and execution
of budgets, otherwise budgeting will not be effective.
4. Budgeting is a management tool, a way of managing, not the management itself.
The presence of a budgetary system should not make management complacent.
To get the best results, management should use budgeting with intelligence and
foresight, along with other managerial techniques. Budgeting assets
management, it cannot replace management.
5. Budgeting will be ineffective and expensive if it is unnecessarily detailed and
complicated. A budget should be precise in format and simple to understand, it
should be flexible in application.
6. Budgeting will hide inefficiencies instead of revealing them if there is not
evaluation system. There should be continuous evaluation of the actual
performance. The standards should also be re-examined regularly.
5. Budget Period: There is no “right” period for any budget. Budget periods may be
short term and long term. If a business experiences seasonal fluctuations, the
budget period will probably extend over one seasonal cycle. If this cycle covers,
say two or three years, the long-term budget would cover the period, while the
short-term budgets would perhaps be preparation on a monthly basis for control
purpose. Short-term budgeting is usually costly to prepare and operate, while
long-term budgeting may be considerably affected by unforeseen conditions.
Budget periods frequently used in industry vary between one month and one
year, the latter probably being the most commonly used as it fits in with the
normally accepted accounting period. However, forecasts of much longer
periods than a year may be used in the case of capital expenditure budgets, for
example, which must be planned well in advance. A common practice in industry
is to have a series of budget periods. Thus, the sales budget may cover the next
five years, while production and cost budgets may cover only one year. These
yearly budgets will be broken down into quarterly or even monthly periods.
Where long-term budgets are operated it is usual to supplement them with short-
term ones.
6. The key factor. This is the factor whose influence must first be assessed in order
to ensure that functional budgets are reasonably capable of fulfillment. The key
factor-known variously as the “limiting” or “governing” or “principle budget” factor
is of vital importance. It may not be the same for each budget period, as the
circumstances may change. It determines priorities in functional budget. Among
the many key factors which may affect budgeting are the following:
a. Management
i. Lack of capital, restricting policy
ii. Lack of knowhow
iii. Inefficient executives
iv. Insufficient research into product design and methods.
LESSON – 13
Classification of Budgets
Though budgets can be classified according to various points of view the following
bases of classification are generally in vogue:
(1) Long-term Budgets (2) Short-term Budgets (3) Current Budgets: They cover a
period of a month or so and as shot-term budgets, they get adjusted to prevailing
circumstances. Sometimes, within the framework of a short-term budget, there
are quarterly plans which are prepared by recasting the budget for a still shorter
period on the basis of the performance of the immediate past. In a way, these
quarterly budgets are meant to be an elaboration of the annual budget.
(1) Sales Budget, (2) Production Budget, (3) Personnel Budget (4) Purchase
Budget : Correlated with sales forecast and production planning, it deals with
purchases that are required for planned production. purchase would include
both direct and indirect materials and goods. (5) Research Budget (6) Cash
Budget (7) Capital Budget (8) Master Budget (9) Plant utilization Budget (10)
Office and Administration Budget. This budget represents cost of all
administrative expenses, such as managing director’s salary, staff salaries
and expenses of office management like lighting and cleaning.
(1) Fixed Budget: This is budget in which targets are rigidly fixed. Such budgets
are usually prepared from one to three months in advance of the fiscal year to
which they are applicable. Thus, twelve months or more may elapse before
figures forecast for the December budget Are used to measure actual
performance. Many things may happen during this intervening period and
they mayh make the figures go widely out of the line with the actual figures.
Thought it is true that a fixed, or static budget as it is sometimes called, can
be revised whenever the necessity arises, it smacks of rigidity and artificially
so far as control over costs and expenses are concerned. Such budgets are
preferred only where sales can be forecast with the greatest of accuracy
which means, in turn, that the cost and expenses in relation to sales can be
quite accurately ascertained.
(2) Flexible Budget
LESSON – 14
SALES BUDGET
This is a forecast of total sales expressed and incorporated in quantities and / or money.
A sales budget may be prepared by expressing turnover under any one or combination
of the following:
A sales budget may be prepared with the help of any one or more of the following
methods.
(1) Analysis of past sales: Analysis of past sales for a number of years, say 5 to 10
years, viz. long-term trend, seasonal trend, cyclical trend, sundry other factors.
The long-term trend represents the movement of the fortunes of a business over
many years. The seasonal trend may affect many types of business and hence
this factor must be taken into account when studying figures for consecutive
months over a number of years. The cyclical trend represents the fluctuations in
the business activity due to the effect of the trade cycle. In order to study the
cyclical trend it is desirable to disregard the effects to the long-term and seasonal
trends. Sundry factors include, such as a strike in the industry or a serious fire or
flood. From such analysis it will be possible to suggest future trends. In analyzing
such sales, considerable help can be obtained from statistical reports produced
by the trade units and commercial intelligence units, government publications,
etc.
(2) Studying the impact of factors affecting sale: Any change in the company policy
or method should always be considered. For example, introduction of special
discounts special salesmen, a new design of the product, new or additional
advertising campaigns, improved deliveries, after-sales service should have
some market effect on a sales budget. While preparing such forecasts, the sales
manager must consider the opinion of divisional managers and other sales staff,
the budget officer and the accountant. It will be observed that the preparation of a
sales budget involves many factors and calls for a high degree of knowledge of
conditions, and if ability to deduce fro the known facts and various estimates the
probable course of sales budget is prepared first. If production is the key factor,
the production budget should be built up first and the sales budget must be
drawn up within up within the limits imposed by the production budget.
Illustration 1
AB Co. Ltd. manufactures two products, A and B, and sells them through two divisions –
North and South. For the purpose of submission of sales budget to the budget
committee, the following information has been made available.
Market studies reveal that the product A, is popular but under-period. It is observed that
if the price of A is increased by Re. 1 it will still find a ready market. On the other hand,
B is over-period to customers and the market could absorb more if the sales price of B
is reduce by Re. 1. The management has agreed to give effect to the above price
changes.
From the information relating to these price changes and reports from salesman, the
following estimates have been prepared by divisional managers. Percentage increase in
sales over current budget is:
Product North South
A +10% +5%
B +20% +10%
Additional sales above the estimated sales of divisional managers are:
Product North South
A 600 units 700 units’
B 400 units 500 units
Prepare a Sales Budget
Solution
Sales Budget
A B Co. Ltd.
For the Year : 19 x 7
Prepared by ......................
Checked by ......................
Submitted on ....................
Division Product Budget for Budget for Current Actual sales for
Future Period Period Unit Price Current Period
Unit Price Value Unit Price
Value Value
Qty Rs Rs. Qty Rs Rs. Qty Rs Rs.
. . .
Production Budget
Like the sales budget, the production budget is built up in terms of quantities and
money. The quantities are entered at the beginning and, when the remainder of the
budget have been built up and the cost of production calculated, the costs are entered
to compile a production cost budget. In preparing the production budget, consideration
should be given to the following:
(1) Principal budget factor, e.g., if sales be the budget factor then it should be the
sales budget; otherwise other budgets.
(2) Production planning and determination of optimum factory capacity.
(3) The opening stocks, and stocks required to be carried at the end of the period.
(4) The policy of the management regarding manufacture or purchase of
components.
(a) Products
(b) Manufacturing department
(c) Months, quarters, etc.
Purchase Budget
A purchase Budget gives the details of the purchase which must be made to meet the
needs of the business. It includes all items of purchase. Such as raw materials, indirect
materials and other equipments. The purchase budget for raw materials is the most
important and the following factors are required to be considered in preparing this
budget.
Collating the details given above with the information contained in the Materials Budget,
prepare the Purchase Budget of Ramesh Limited.
Solution
Ramesh Limited
Purchase Budget
(1983-84)
Particulars AB GH XY
kg. kg kg
Estimate Consumption 9,03,000 6,90,000 5,47,000
Add: Stock required on 30-06-84 17,000 20,000 33,000
Total requirements 9,20,000 7,10,000 5,80,000
Less: Estimated stock on
1st July 1983 20,000 10,000 30,000
Quantity to be purchased 9,00,000 7,00,000 5,50,000
Price per kg (Estimate Re. 1 50 p 40 p
Estimated cost of purchase
of materials (Rs) 9,00,000 3,50,000 2,20,000
Preparation of Cash Budget
A complete system of budgetary control makes the construction of cash budget easy. It
is one of the functional budgets which is prepared along with other budgets. There are
three recognized methods of preparing a cash budget.
Steps to be Adopted
Cash Receipts Forecast; Cash receipts from sales, debtors, income from sales of
assets and investments and probable borrowings should be forecast and brought into
cash budget. Any lag in payment by debtors or by others shall be considered for
ascertaining further cash inflows.
Cash requirements forecast: Total cash outflows are taken out from operating budgets
for the elements of cost, and from capital expenditure budget for the purchase of fixed
assets. Adjustments are to be made for any lag in payments.
Care must be taken to ensure that outstanding or accruals are excluded from the cash
budget since this method is based on the concept of actual cash flows.
Illustration 6
A newly started company Quick Co. Ltd., wishes to prepare cash budget from January.
Prepare a cash budget for the first six months from the following estimated revenue and
expenditure.
Month Total Sales Material Wages Production Selling and
Overheads distribution
Overheads
Rs. Rs. Rs. Rs. Rs.,
Jan. 20,000 20,000 4,000 3,200 800
Feb. 22,000 14,000 4,400 3,300 900
Mar. 24,000 14,000 4,600 3,300 800
Apr. 26,000 12,000 4,600 3,400 900
May. 28,000 12,000 4,800 3,500 900
June 30,000 16,000 4,800 3,600 1,000
Cash balance on 1st January was Rs. 10,000. A new machine is to be installed at Rs.
30,000 on credit, to be repaid by two equal installments in March and April.
Sales commission @ 5% on total sales is to be paid within the month following actual
sales. Rs. 10,000 being the amount of 2nd call may be received in March. Share
premium amounting to Rs. 2,000 is also obtainable with 2nd call.
Cash Budget
For the period January to June 1984
Details Jan. Feb. Mar. Apr. May. June
Rs. Rs. Rs, Rs, Rs, Rs.
A Balance b/d 10,000 18,000 29,000 20,000 6,100 8,800
B Receipts: 10,000 11,000 12,000 13,000 14,000 15,000
Cash Sales (50%)
Debtors - 10,000 11,000 12,000 13,000 14,000
Capital - - 10,000 - - -
Share premium - - 2,000 - - -
(A + B) Total 20,000 39,000 64,800 45,000 33,100 37,800
C Payments Material - - 20,000 14,000 14,000 12,000
Wages 2,000 4,200 4,500 4,600 4,700 4,800
Production Overheads - 800 900 800 900 900
Commission - 1,000 1,100 1,200 1,300 1,400
Machinery - - 15,000 15,000 - -
(C) Total 2,000 9,200 44,800 38,900 24,300 22,600
Balance
(A+B+C) 18,000 29,800 20,000 6,100 8,800 15,200
Flexible Budgets
In those industries where the pattern of demand is stable, a fixed budget may be
adequate, especially where the budget period is comparatively short. In such
businesses it is possible to forecast sales with a considerable degree of accuracy.
There are many undertakings where stable conditions are absent. In such concerns
fluctuations in output might lead to violent deviations fromd the budget. In such
concerns it is usual to adopt the flexible budgetary technique. A flexible budget is a
budget which is designed to change in accordance with the level of activity actually
attained. If flexible.
The owner of a car knows that the more he uses it per year the more it costs him to
operate it. He also knows that the more he uses his car the less its costs per running
metres. The reason for this lies in the nature of the expenses, some of which are fixed
while others are variable or semivariable. Insurance, taxes, registration, and garaging
are fixed costs; they remain the same whether the car is operated 1,000 or 2,000
kilometers. The costs of tyres, petrol oil, and repair are variable costs and depend
largely upon the kilometers driven. Obsolescence and depreciation result in a combined
type of cost that, although fluctuating to some degree upon the usage of the car, is
semi-variable for it does not vary directly with the usage. The cost of operating the car
per kilometer depends on the number of kilometers the car is used. The mileage
constitutes the basis for judging the activity of the automobile. If the owners prepares an
estimate of total cross and compares his actual expanses with the budget in keeping his
expenses within the allowed limits, unless he takes the mileage factor into account.
Originally, the flexible budget idea was applied principally to the control of departmental
factory overhead. In recent years, however, the idea has been applied to the entire
budget so that production budgets as well as selling and administrative budgets are
prepared on a flexible basis. The construction of a flexible budget is identical with that of
a fixed budget, except that a budget is calculated for each volume ranging from a
possible 60 per cent to 100 per cent of capacity. When actual figures are available
estimate previously determined for the level attained are compared with actual results,
and the differences are noted. This end-of period comparison is used to measure the
performance of each department head. It is this readymade method of comparison that
makes the flexible budget a valuable instrument for cost control. The flexible budget
assists in evaluating the effects of varying volumes of activity on profits and on cash
position.
Illustration 9
The following data are available in a manufacturing company for the half-year period
ending 30th June, 1984.
It is assumed that fixed expenses remain constant for all levels of production’ semi-
variable expenses remain constant between 45% and 65% of capacity, increasing by
10% between 65% and 80% of capacity and 20% between 89% and 100% of capacity.
Prepare a flexible budget for the half-year and forecast the profits at 60%, 75%, 90% of
capacity.
Solution
Operating capacity
B. Semi-variable exp:
Maintenance and repairs 2.5 2.5 2.75 3.00 3.00
Indirect labour 9.9 9.9 10.89 11.88 11.88
Sales Dept. salaries 2.9 2.9 3.19 3.48 3.48
Sundry Adm. expenses 2.6 2.6 2.86 3.12 3.12
C. Variable expenses:
Material 24.0 28.80 36.00 43.20 48.0
Labour 25.6 30.72 30.47 46.08 51.2
Other expenses 3.8 4.56 5.70 6.84 7.6
CAPITAL BUDGETING
Every business concern has to face the problem on capital expenditure decisions some
time or the other. Hence, planning for capital expenditure has become an integral part of
policy making, management and budgetary control. Capital expenditure is one which is
intended to benefit future periods and normally includes investment in fixed assets and
other development projects. It is essentially a long-term function, and such for a
decision to buy land, buildings or plant and machinery etc., would influence the activity
of the business for a considerable period of time. Hence, it is essential to keep a close
watch on capital expenditure at all times. Further, the advent of mechanization and
automation has resulted in management being confronted with ever more frequent and
difficult problems. Despite the fact that various techniques have been developed to
assist management in its task of decision-making more effectively, the ultimate decision
depends on the availability of relevant information which can be generated only by well-
established capital expenditure budgeting system. The other commonly used
nomenclatures for capital expenditure decision are “Capital Budgeting”, or “Capital
investment Decision”, or simply “Investment Decisions”.
Capital budgeting normally refers to long-term planning for proposed capital outlays and
their financing. It is the decision-making process by which firms evaluate the acquisition
of major fixed assets whose benefits would be spread over several time periods.
Succinctly, it involves current investment in which the benefits are expected to be
received beyond one year in the future. The use of one year as a line of demarcation is,
however, somewhat arbitrary. The main exercise in capital budgeting is to judge
whether or not an investment proposals provides a reasonable return to investors which
would be consistent with the investment objective of the business. Hence, capital
budgeting involves generation of investment proposals, estimating costs and benefits
(cash flows) for the investment proposals and evaluation of net benefits and selection
of projects based upon an acceptance criterion.
Control of capital expenditure is the next important objective of capital budgeting. This is
achieved by forecasting the long-term financial requirements and thereby enabling the
management to plan in advance to raise funds at the right time. The objective of
preparing capital budget is to plan and then compare the actual capital expenditure with
the budgeted figure for controlling costs.
3. Determining the required quantum and the right source of funds for investment.
The next important objective of capital budgeting is to determine the funds required for
long-term project and to see that such estimates fall in line with the company’s financial
policies. It also aims to compromise between the availability of funds and needs of the
capital projects.
The projects listed above are generally profit-oriented and therefore they may be
evaluated on the basis of their costs and benefits. But there are investments which are
undertaken by all business units and on which it would be difficult to measure returns,
such as the following:
(1) Safty precautions provision of safety devices and equipment may be demanded
by various legal requirements.
(2) Welfare projects: provision of sports facilities for employees may boost
employees morale. This cannot be evaluated financially.
(3) Service projects: provision of buildings and equipment for non manufacturing
departments may be essential, but the return from investment on them cannot be
evaluated.
(4) Research and development: This may be initiated to improve the company
methods or products. It would be very difficult to measure the return on R&D for a
considerable period of time.
(5) Educational projects: Provision of company training course may be instrumental
in improving the efficiency of employment but the returns from investment on
such programmes may be difficult to evaluate.
Future costs: Future costs are the projected or estimated costs. they are relevant for all
types of investment decision past cost, though not relevant for decision-making, are
useful to the extent that they furnish a starting point for future cost projections. While
calculating these costs, factors such as market conditions, economic conditions, political
situation, general trend in the price levels, probabilities relating to future production and
sales, economic life of the project, etc. are to be taken into account.
Opportunity costs: In simple terms, opportunity cost refers to the benefits of the best
alternative foregone. As the investment in a project involves commitment of the firm’s
investible funds it becomes relevant to consider the opportunity of getting some benefits
by employing the resources on some other alternative. For example, in an expansion
scheme the economic value of the space required rather than its book value is relevant.
In a replacement decision, the realizable value rather then the book value of the old
may be relevant as a reduction of the cost of replacement. This type of cost is relevant
for all types of investment decision. Imputed cost is a kind of opportunity cost. It is the
cost which is not actually incurred, but would be incurred in the absence of self-owned
factors, e.g. cost of retained earnings, rent on company owned facilities, etc.
Incremental or differential cost: It is the additional cost due to a change in the volume of
business or nature of business activity. Hence it is useful for decisions such as adding
new machinery, new – product, changing a distribution channel etc. sometimes this cost
is considered synonymous with marginal cost. But marginal cost has much limited
meaning as it refers to the cost of an added unit of output.
Interest cost : Accounting reports normally ignore the imputed interest on capital which
is relevant for decision-making purposes. Interest cost constitutes the minimum
acceptance criterion for capital investment projects undertaken for profit. A firm must at
least recover its money before it can realize a profit on its own investment.
Secondary costs and benefits: These costs and benefits are particularly relevant for the
capital expenditure decision in public enterprises. They are external to the project
implementing body and there for called external cost and benefits, or simply
“externalities”. These are the costs and benefits, which are imposed on other sectors-
government, society or the economy as a whole – during the construction and operation
of the project and for which nothing is paid or received. There are two types of
externalities, viz., technological and pecuniary. The smoke and dust pollution and noise
etc., are examples of technological externalities pecuniary externalities are such as
increasing rates of hire for factors of production, reduction in prices of substitute
projects, etc. secondary benefits are the increase in profits that can be attributed to the
increased activity of processors, merchants and others who handle the project’s output
or input. The major problems associated with these costs and benefits are their
identification and measurement. However, for easy identification they should be related
to the socioeconomic objectives assigned to the project. To measure these costs and
benefits, shadow prices or imputed prices should be used.
Forms and procedures: There should be a routine for controlling capital expenditure. A
procedure should be adopted for the various stages requesting for capital expenditures,
authorization, reporting the progress of such projects and audit. A well designed from
should be used for the above purposes for better control.
LESSON – 16
The final step in a the capital budgeting system involves evaluating the profitability of
the alternative project and selecting the best one. A firm may face a situation where
more investment proposals may be available than investible funds. Some proposals
may be good, some moderate, and many poor. Hence, a ranking procedure has to be
evolved so that the available funds can be allocated among different proposals in a
profitable manner. Essentially, the ranking procedure envisages relating of a stream of
future benefits to the cost of investments. Among the various methods, the following are
commonly used by many business concerns:
Payback period
Business units, while selecting investment projects, would consider the recover of cost
as the first and foremost concern, even though earning maximum profit is then ultimate
goal. Payback period normally refers to the time required for recouping the initial
investment in full with the help of the stream of annual cash flows generated by the
project. It is also called ‘pay-out or pay off period”, expressed, as:
C
Payback period (PB) = ------------
1
Where X represents cash flows during periods 0,1,2,.....P represents payback period.
The cash flows for the purpose of PB calculation, would be savings or earnings after
payment of taxes but before depreciation. To illustrate, if a cash outlay of Rs. 30,000 is
expected to yield a constant net cash flow (cash earnings minus cash expenses) of Rs.
12,000 P a for a period of 5 years, the PB is 2 ½ years (Rs. 30,000 + Rs. 12,000).
Selection criteria: Among the mutually exclusive or alternative projects whose PBs are
lower than the cut-off period, the project with the shorter PB would be selected. In case
there are budget constraints, the procedure would be to rank the projects in the
ascending order of PBs and select the first ‘X’ number of projects which the budget
provision permit. However, with a views to making the selection process more realistic,
a cut-off period or minimum payback ratio could be set up and all investment proposals
for which the PB is greater than this cut-off period be rejected. Payback ratio is the
inverse of the payback period. For a payback period of 4 years, the payback ratio is
1/4. Thus larger the payback ratio, better the project.
Illustration 1
From the following advise the management as to which project is preferable based on
payback period. The standard cut off period for the company is 5 years.
Project A Project B
Rs. Rs.
Capital cost 15,000 15,000
Cash flows (savings before depreciation, but after taxes)
Ist year 5,000 4,000
IInd year 5,000 4,000
IIIrd year 5,000 4,000
IVth year 2,000 3,000
Vth year 2,000 7,000
VIth year 2,000 9,000
21,000 31,000
Solution Project A Project B
Payback period = 3 years 4 years
(5,000 + 5,000 + 5,000 = 15,000) (Rs. 4,000 + 4,000 + 4,000 +
3,000 = 15,000)
The PBs of A and B are 3 years and 4 years respectively and thus project. A is
adjudged superior to project B in terms of PB criterion since it is also shorter than the
cut-off period.
Despite the simplicity and ease of operation, this method suffers from several
drawbacks.
Demerits
1. The PB is more a liquidity than a profitability concept, for it places accent only on
the recovery of cash outlay and stresses the importance of liquidity, that is
recovery at the cost of profitability.
2. It does not consider the earnings beyond the payback period. This may lead to
wrong selection of investment projects. Profitable projects with long gestation
periods or projects which generate high returns only after a certain period of time
may be rejected under this method.
3. The most serious limitation of this method is that it ignores the time value of
money.
Average Rate of return Method (ARR)
The average return is computed by adding all the earnings after depreciation, and
dividing them by the project’s economic life. Average investment is the simple average
of the values of assets at the beginning and end of the useful life of the asset which in
most cases, Would be zero. Though sometimes initial investment is used, average
investment is more logical.
Selection Criteria: The decision rule is that a project with the highest rate of return on
investment is selected on condition that such rate is above the standard rate set, or the
cut-off rate.
Illustration 2
Calculate the average rate of return for project ‘A’ and ‘B’ from the following information.
Project A Project B
Invested (Rs) 25,000 37,500
Expected life (in years) 4 5
Net earnings (after depreciation and taxes)
Years
1 2,500 3,750
2 1,875 3,750
3 1,875 2,500
4 1,250 1,250
5 -- 1,250
7,500 12,500
4 5
-Rs. 1,875 Rs. 2,500
Average investment Rs. 25,000 + 0 Rs. 37,500+0
2 2
-Rs. 12,500 Rs. 18,750
Average rate of Rs. 1,875x100 Rs. 2,500x100
Rs. 12,500 Rs. 18,750
return -15% 13.33%
Both the projects satisfy the minimum required rate of return. However, if the projects
are mutually exclusive or alternative i.e. only one project is to be selected, project A will
be selected as its ARR is higher than project B. if they are not mutually exclusive, and
there are no budget constraints, both the projects will be selected.
Merits:
Demerits
1. The most severe criticism of this method is that it ignores the time value of
money.
2. Normally, a host of variants are to be resolved relating to its components viz.,
earnings and investment cost. For example, it may be the gross, net or average
investment which is to be considered for computation. This may produce different
rates of any one proposal.
3. Another problem in connection with the method is regarding a reasonable rate of
return on investments. Some stipulate a minimum rate so that if projects do not
satisfy this rate, they are summarily excluded from consideration.
LESSON – 17
The discounted cash flow technique is an improvement on the pay-back period method.
It takes into account both the interest factor as well as the return after the pay-back
period. The method involves three stages.
i. Calculation of cash flows, i.e., both inflows and outflows (preferably after tax)
over the full life of the asset.
ii. Discounting the cash flows so calculated by a discount factor
iii. Aggregating of discounted cash inflows and comparing the total with the
discounted cash outflows.
iv. Discounted cash flow technique thus recognizes that Re 1 of today (the cash
outflow) is worth more than Re. 1 received at a future date (cash inflow)
Discounted cash floe methods for evaluating capital investment proposals are of three
types:
NPV Method
This is generally considered to be the best method for evaluating the capital investment
proposals. In case of this method cash inflows and cash outflows associated with each
project are first worked out. The present values of these cash inflows and outflows are
then calculated at the rate of return acceptable to the management. This rate of return is
considered as the cut-off rate and is generally determined on the basis of cost of capital
suitably adjusted to allow for the risk element involved in the project. Cash outflows
represent the investment and commitments of cash in the project at various points of
time. The working capital is taken as a cash outflow in the year the project starts
commercial production. profit after tax but before depreciation represents cash inflow.
The Net present value (NPV) is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
The equation for calculation NPV is case of conventional cash flows can be put as
follows:
R1 R2 R3 Rn
NPV = ------ + ------- + -------- + ---------
(1 + k) (1 + k)2 (1 + k)3 (1 + k)n
Incase of non-convential cash inflow (i.e. where there are a series of cash inflows as
well cash outflows ) the equation for calculating NPV is as follows:
R1 R2 R3 Rn
NPV = ------ + ------- + -------- + ---------
(1 + k) (1 + k)2 (1 + k)3 (1 + k)n
11 12 13 1n
10 ------ + ------- + -------- + ---------
(1 + k) (1 + k)2 (1 + k)3 (1 + k)n
Where NPV = Net present value, R = Cash Inflows at different time periods, K Cost of
Capital or Cut-off Rate, 1 = Cash outflows at different time periods.
Accept or reject criterion. The net present value can be used as an accept or reject’
criterion. In cash the NPV is positive (i.e., present value of the cash inflows is more than
present value of cash outflows) the project should be accepted.
Illustration
The Alpha Co. Ltd. is concidering the purchase of a new machine. The alternative
machines (A and B) have been suggested, each having an initial cost of Rs. 4,00,000
and requiring Rs. 20,000 as additional working capital at the end of 1 st year. Earning
after taxation are expected to be as follows:
Cash Inflows
Year Machine A Machine B
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
The company has a target of return of 10% and on this basis, you are required to
compare the profitability of the machines and state which alternative you consider
financially preferable.
Note: The following table gives the present value of Re.1 due in ‘n’ number of years.
Excess Present value Index : This is a refinement of the net present value method.
Instead of working out the net present value, a present value index is found out by
comparing the total of present value of future cash inflows and the total of the present
value of future cash outflows. This can be put in the form of following formula.
Excess present value Index provides ready comparison between investment proposals
of different magnitudes. For example, ‘A’ requiring an investment of Rs. 1,00,000 shows
excess present value of Rs. 20,000 while another project ‘B’ requiring an investment of
Rs. 10,000 shows an excess on present value of Rs. 5,000. If absolute figures of
present values are compared, Project ‘A’ may to be profitable.
However, if excess present value index method is followed project ‘B’ would prov e to
be profitable.
1,20,000
Present Value Index for project A = ------------------------ x 100 = 120%
1,00,000
15,000
Present Value Index for Project B = ------------------------- x 100 = 150%
10,000
LESSON – 18
Internal Rate of Return is that rate at which the sum of discounted cash inflows equals
the sum of discounted cash outflows. In other words, it is the rate which discounts the
cash flows to zero. It can be stated in the form of a ratio as follows:
Cash Inflows
------------------- = 1
Cash outflows
Thus, in case of this method the discount rate is not known but the cash outflows and
cash inflows are known. For example, if a sum of Rs. 800 invested in a project becomes
Rs. 1,000 at the end of a year, the rate of return comes to 25% calculated as follows:
R
1 = -------------
1+r
Where
I = Cash Outflow, i.e., initial Investment
R = Cash Inflow
r = Rate of return yoclded by the Investment (or IRR)
Thus:
1000
800 = ----------
1+r
Illustration
Cost of project Rs. 11,000
Cash inflow:
Year 1 6,000
Year 2 2,000
Year 3 1,000
Year 4 5,000
Solution:
I
F = --------------------
C
F= Factor to be located
I= Original investment
C= Average cash inflow per year
11,000
F = -------------------- = 3.14
3,500
The factor thus calculated will be located in. Table II on the line representing number of
years corresponding to estimated useful life of the asset. This would give the estimate
date of return to be applied for discounting the cash inflows for the internal rate of
return. The rate comes to 10%.
The present value at 10% comes to Rs. 272. The initial investment is Rs. 11,000.
Internal rate of Return may be taken approximately at 10%
In case more exactness is required another trial rate which is slightly higher than 10%
(since at this rate the present value is more than initial investment) may be taken.
Taking a rate of 12%, the following results would emerge.
The internal rate of return is this more than 10% but less than 12%. The exact rate may
be calculated as follows:
Difference in calculated
Present value and required
net cash only
Internal Rate of Return = ------------------------------------------- x Difference in rate
Difference in calculated
present values
11,272 - 11,000
= 10% + -------------------------------- x 2
11,272 – 10,844
272
= 10% + ------------- x 2 = 11.3%
428
The internal rate would, therefore, the between 10% and 12% calculated as follows:
272
= 10 + --------------------- x 2
272 + 156
= 10 + 1.3 = 11.3%
(i) Discounted cash flow technique take into account the time value of money
conceptually it is better than other techniques such as pay-back or accounting
rate of return.
(ii) The method takes into account directly the amount of expenses and revenues
over the project’s life. In case of other methods simply their averages are
taken.
(iii) The method automatically gives more weight to those money value which are
nearer to the present period than those which are father from it. While in case
of other methods, all money units are given the same weight which seems to
be unrealistic.
(iv) The method makes possible comparison of projects requiring different capital
outlays, having different lives and different timings of cash flows, at a
particular moment of time because of discounting of all cash flows.
Demerits: The following are the demerits of discounted cash flow method.
(1) The method is difficult to understand and work out as compared to other method
of ranking capital investment proposals.
(2) The method takes into account only the cash inflows on account of a capital
investment decision. As a matter of fact, the profitability or other wise of a capital
proposal can be judged. Only when the net income (and not the cash inflow) on
account of operations is considered.
(3) The method is based on the presumption that cash inflow can be invested at the
discounting rate in the new projects. However, this presumption does not always
hold goods because it all depends upon the available investment opportunities.
LESSON – 19
The concept of ‘marginal cost’ has been borrowed from economic theory. To the
economist, marginal cost is an incremental cost: he considers it as the addition to total
cost which results from the production of one more unit of output. That is, it does not
arise if the additional unit is not produced.
The Institute of Costs and Management Accountants, London, defines marginal cost as:
“The amount at any given volume of output by which aggregate cost are changed if the
volume of output is increased or decreased by one unit.” As referred to here, a unit may
indicate a single article, a batch of articles, an order a stage of production capacity, a
processor a department, i.e., it relates to the change in output in the particular
circumstances under consideration.
Under marginal costing, costs are mainly classified into fixed costs and variable costs.
the essential feature of marginal costing is that the product or marginal costs (i.e., those
costs which are dependent on the volume of activity, are separated from the period or
fixed costs, i.e., costs which remain unchanged with a change in the volume of activity.
Variability with the volume of output is the main criterion for the classification of costs
into product and period categories. Even the semi-variable costs have to be bifurcated
into their fixed and variable components based on the variability criterion. In this regard,
the absorption or conventional costing system differs from marginal costing. Under
absorption costing system all manufacturing costs, whether of fixed or variable nature
are treated as product costs. all companies which use marginal costing as an aid to
managerial decision-making mainly use the absorption costing system.
PROFORMA MARGINAL COST STATEMENT
profit --------------
From the marginal cost statement, the following equations may be derived:
These equations may be used for solving problems of different types involving cost-
volume – profit relationship.
Contribution is the difference net sales and marginal costs, and it is used to recover
fixed costs first. Any excess over fixed costs would be profits. When a business
manufacturers more than one product, the computation of profits realized on individual
products may be difficult due to the problem of apportionment of fixed costs to different
products., the rationale of contribution lies in the fact that fixed costs are done away with
under marginal costing. The concept of contribution helps to determine the breakeven
points, profitability of products, departments, etc., to select product-mix for profit
maximization, and to fix selling prices under different circumstances such as trade
depression, expert sales prices discrimination etc. contribution is the definite test to
ascertain whether a product or process is worthwhile to continue among different
products or processes.
The contribution could be used as a measure to solve the problem of key factor. A key
factor, otherwise called ‘limiting factor’, or ‘principal budget factor’, or ‘scarce factor’,
may be defined as the factor which, over a period, will limite the volume of output, or
which puts a limit on the efforts of the management to produce as many units of the
selected products as it would like to when manufacture and sale of a product are
confronted by the problem of key factor, the profitability of that particular product is then
ascertained by relating the key factor used for the manufacture of the product, and its
resulting contribution. Generally, sales would be the limiting factor but sometimes,
materials, labour, plant capacity, etc., may be the inhibiting, factor when the key factor
and contribution are given, the relative profitability may be calculated by employing the
formula given below:
Contribution
Profitability = ------------------------
Key factor
For example, when material is in short supply, profitability is determined by dividing the
contribution per unit by the quantity of materials used per unity when sales is the key
factor, profitability is measured by contribution sales ratio, and so on.
(a) Marginal costing is easy to understand. It can be combined with standard costing
and budgetary control and thereby make the control mechanism more effective.
(b) Elimination of fixed overhead from the cost of production prevents the effect of
varying charges per unit, and also prevents the carrying forward of a portion of
the fixed overheads of the current period to the subsequent period. As such cost
and profit are not initiated and cost comparisons becomes more meaningful.
(c) The problem of over or under absorption of overheads is avoided.
(d) A clear-cut division of costs into fixed and variable elements makes the flexible
budgetary control system more easy and effective and thereby facilitated greater
particle cost control.
(e) If helps profit planning through break – even charts and profit graphs
comparative profitability can easily be assessed and brought to the notice of the
management for decision-making.
(f) It is an effective tool for determining efficient sales or production policies, or for
taking pricing and tendering decisions, particularly when the business is at a low
ebb.
Managerial Uses of Managerial Costing:
From the advantages stated above, the following may be listed as specific
managerial uses:
(a) Cost Ascertainment: Marginal costing technique facilitates not only the recording
of costs but their reporting also. The classification of costs into fixed and variable
components makes the top of cost ascertainment more easy. The main problem
in this regard is only segregation of the semi-variable cost into fixed and variable
elements. However, this may be overcome by adopting any of the methods
already explained for the purpose.
(b) Cost control: Marginal cost statements can be understood more easily by the
management than those presented under absorption costing bifurcation of costs
into fixed and variable enables management to exercise control over production
cost and thereby effect efficiency. In fact, while variable costs are controllable at
the lower levels of management, fixed costs can be controlled at the top level.
Under this technique management can study the behaviour of costs at varying
conditions of output and sales and thereby exercise better control over costs.
Despite its superiority over absorption costing, the marginal costing technique has its
own limitations.
(a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a
major technical difficulty arises in drawing a sharp line of demarcation between
fixed and variable costs. the distinction between them holds good only in the
short run. In the long-run, however, all costs are variable.
(b) In marginal costing, greater importance is attached to the sales function thereby
relegating the production function largely to a secondary position. But, the real
efficiency of a business is to be assessed only by considering the selling and
production functions together.
(c) The elimination of fixed costs from the valuation of inventories is illogical since
fixed costs are also incurred in the manufacture of goods. Further, it results in the
understatement of the value of stock, which is neither the cost nor the market
price.
(d) Pricing decision cannot be based on contribution alone. Sometimes, the
contribution will be unrealistic when increased production and sale are effected,
either through extensive use of existing machinery or by replacing manuallabour
by machines. Another possibility is that there is danger of too many sales being
effected at marginal cost, resulting in denial to the business of inadequate profits.
(e) Although the problem of over or under absorption of fixed overheads can by
overcome to a certain extent, the same problem still persist with regard to
variable overheads.
(f) The application of this technique is limited in the case of industries in which
according to the nature of business, large stocks have to be carried by way of
work-in-progress (e.g. contracting firms)
(a) Profit Planning: A business concern exists with the objective of making profits,
and profits are the yardstick of its success profit planning is therefore a part of
operations planning. It is the basis of planning cash, capital expenditure, and
pricing. If growth and survival of a business are to be ensured, profit planning
becomes an absolute necessary. Marginal costing assists profit planning through
computation of contribution ratio. It enables planning of future operation in such a
way as to either maximize profits pre maintain specified levels of profit. Normally,
profits are affected by several factors, such as the volume of sales, marginal cost
per unit, total fixed costs, selling price and sales mix etc., Hence management
can achieve their profit goals by varying one or more of the above variables.
Basic marginal costing equations which are useful in profit planning are as
follows.
Profit volume ratio (p/w ratio). This is the ratio of contribution to sales. Symbolically it is
expressed as:
Contribution
C/S ratio or P/V ratio = --------------------------------- x 100 (1)
(as a percentage) Sales (S)
Contribution
Sales = -------------------------- (3)
P/V ratio
Brake Even point (BEP). This may be defined as that point of sales volume at which
total revenue is equal to total costs. it is a no-profit no-less point. It may be derived from
the equation (3). We may get
Contribution at BEP
BEP (in Rs.) -----------------------------
P/V ratio
At BEP, the contribution will be equal to fixed cost and therefore, the formula may be
restructured as follow:
Fixed Cost
BEP (in Rs.) = ---------------------------
P/V ratio
Margin of Safety (MS) : This represents the difference between salew or production at
the selected activity, and the break-even sales or production.
C
Sales at the selected activity = ----------------------
P-V ratio
F
BEP = ----------------------
P/V ratio
C F profit (p)
MS = ------------------------- ------------ ------------------- = ---------------------------
P/V ratio P/V ratio P/V ratio
Where C-F = P
Margin of safety is also presented in percentages as follows:
MS (Sales) x 100
-----------------------------------------
Sales at selected activity
Illustration 2
From the following information, calculate BEP and determine the net profit if sales are
25% above BEP
Solution
Rs.
Selling price per unit 50.00
Less: marginal cost per unit Rs.
Materials 20.00
Wages: 10.00
Variable overheads: 7.50 37.50
Contribution: 12.50
C 12.50
P/V ratio = ------------- x 100 = ---------------- x 100 = 25%
S 50
F Rs. 50,000
BEP = ---------------- = ----------------------- x 100 = 2,00,000
P/V ratio 25
Business concern may have plans either to expland or contract the level of activities
depending upon the conditions prevailing in the market. Such planning is to be
considered before events overtake the business. Marginal costing is very useful for
taking such decisions by enabling management to compare the contribution at different
levels of activities.
Illustration 5
Levels of Activity
Rs. Rs.
Material 72,000 20.00
Wages 21,600 6.00
Variable overheads 14,400 4.00
1,08,000 30.00
Fixed overheads 16,000
Total factory cost 1,24,000
Note: Factory overheads increase by Rs. 1,600 at each level of activity. Therefore,
variable overheads must be
Rs. 1,600
----------------- = Rs. 4 per unit. At 80% level of activity, Factory overheads
400 units
are Rs. 28,800 of which variable cost are Rs. 12,800 (Rs. 4 x 3,200), resulting in fixed
overheads of Rs. 16,000 (Rs. 28,800 – Rs. 12,800).
A company which has a variety of product lines can employ marginal costing in order to
determine the most profitable sales mix from a number of selected alternatives.
Illustration 6
The directors of AB Ltd. are considering the sales budget for the next budget period.
The following information has been made available form the cost records.
Product Z Product Y
(per unit) (per unit)
Directed materials Rs. 40 Rs. 50
Selling price Rs. 120 Rs. 200
Direct wages (a)
Rs. 2 per hour 10 hours 15 hours
You are required to present to the management a statement showing the marginal cost
of each product, and to recommend which of the following sales mix should be adopted.
Per unit
Product Z Product Y
Rs. Rs. Rs. Rs.
Selling price 120 200
Less: Materials
cost
Direct materials 40 50
Direct wages 20 30
Variable 20 80 30 110
overheads
40 90
Selection of Alternatives
Products
Z Y Total
Rs. Rs. Rs.
450 – 300 – Y 18,000 27,000 45,000
Contribution
(450 x Rs. 40)
+ (300 x Rs.
90)
Less: Fixed 20,000
over-heads
Profit 25,000
900 – Z
Contribution 36,000 36,000
(900 x Rs. 40)
Less fixed cost 20,000
Profit 16,000
(c) 600 – Y 54,000 54,000
Contribution
(600 x Rs. 90)
Less: fixed cost 20,000
Profit 34,000
Profit 22,000
(a) What will be the effect of changes in prices / costs and volume on profit?
(b) What minimum sales volume need be effected to avoid losses?
(c) What should be the level of activity to earn a target profit?
(d) Which product is the most profitable and which product or operation of a plant
should be discontinued? Etc
The break-even analysis is the most widely known from of the CVP analysis. The
study of CVP relationship is frequently referred to as break-even analysis. However,
some state that up to the point of activity where total revenue equals total expenses, the
study can be called as break-even analysis and beyond that point, it is the application of
CVP relationship.
Break-even Analysis can be used to show the effect of a change in any of the following
profit factors:
MANAGEMENT REPORTING
Meaning
The term ‘Report’ normally refers to a formal communication which moves upward, i.e.,
for factual communication by a lower to a higher level of authority in response to order
received from higher level. Reports provide means of checking the performance. A
person, who is issued with orders or instructions to do certain things should report back
what he has done in compliance thereof. Reports may be oral or written and also
routine or special.
Objects of Reporting
The primary object of management reporting is to obtain the required information about
the operating results of the organisation regularly in order to use them for future
planning and control. Another object is to secure understanding and approval of the
judgment by the people engaged in various aspects of the work of enterprise. The
second object is closely related to the first one and is important in terms of efficiency,
morale and motivation.
Reporting system enables management at all levels to keep itself abreast of past
performance as well as developments and it facilitates a check on individual operating
levels. Based on reports, management takes crucial decisions. Hence, the essentials of
good reporting system are as follows:
Models of Reporting
Reports may be presented in the form of written statements, graphs, abd or oral.
1. Written statements
a. Formal financial statements: These statements may deal with any one or
more of the following:
i. Actual against the budgeted figures.
ii. Comparative statements over a period of time
b. Tabulated statistics: This statement may deal with statistical analysis of a
particular type of expenditure over a period of time or sales of a product
over a period in different regions, etc.
c. Accounting ratios: The ratios may either form part of the formal financial
statement or be given in the form separate statement.
2. Graphic reports
The information may be presented by means of graphic reports which give a
better visual view of the data than the long array of figures given instatements.
Charts, diagrams and pictures are the usual form of graphic reports. They have
the advantage of facilitating quick grasp of significant trends by receivers of
information.
3. Oral reports
Oral reports are mostly presented at group meetings and conferences with
individuals.
Types of reports
Routine Reports
Reports which are submitted at periodical intervals on a regular basis covering routine
matters e.g., variance analysis, financial statements, budgetary control statements are
routine reports.
Special Reports
Operating Reports
These reports may be classified into control report information – cum-venture
measurement report.
Control Report
It is an important ingredient of control process and helps in controlling different activities
of an enterprise. It provides information properly collected and analyzed to different
levels of management.
Information Report
These reports provide information which are very much useful for future planning and
policy formulation.
Financial Reports
These report contain information about the financial position of the business. They may
be classified into Static Reports and Dynamic Reports. Static reports reveals the
financial position on a particular data e.g., balance sheet of a company. On the other
hand, the dynamic report reveals the movement of funds during a specified period e.g.
Fund flow statement, Cash flow statement.
MANAGEMENT ACCOUNTING
PART – B (5 x 14 = 70)
Answer any FIVE questions
All questions carry EQUAL marks
Each answer to a theory need not exceed Three pages.
10. What is budgetary control? What are the objectives and advantages of budgetary
control?
11. Discuss the different methods of ranking investment proposals.
12. What are the functions of management accounting?
13. X Ltd., furnishes you the following information:
Year 1998
I Half II Half
Sales Rs. 8,10,000 10,26,000
Profit 21,600 64,800
From the above you are required to compute the following assuming that the fixed
cost remains the same in both the periods:
i) P/V ratio
ii) Fixed cost
iii) The amount of profit or loss where sales are Rs. 6,48,000
iv) The amount of sales required to earn a profit of Rs. 1,08,000
v) From the balance sheets of A Ltd.; make out i) a statement of changes in the
working capital and ii) Fund Flow statement.
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