UNIT I

INTRODUCTION TO
MANAGEMENT ACCOUNTING
WHAT IS 'ACCOUNTING'
Accounting is the systematic and comprehensive recording of financial transactions pertaining to a business, and it
also refers to the process of summarizing, analyzing and reporting these transactions to oversight agencies and tax
collection entities. Accounting is one of the key functions for almost any business; it may be handled by a
bookkeeper and accountant at small firms or by sizable finance departments with dozens of employees at large
companies.

THREE BRANCHES OF ACCOUNTING

Before discussing what are the three branches of Accounting? let me tell you the definition. According to
Wikipedia, Accounting usually generates financial statements which reveal in money terms the economic resources
under the control of management; selecting information which is appropriate and representing it faithfully.
Today, it is referred to as “the language of business” since it is the vehicle for reporting financial information
pertaining to a business entity to numerous different categories of people.
According to Wikipedia, branches of accounting are: Financial, Management, Cost, Tax, Forensic and Public
Sector.
Following are the Main Three Branches of Accounting

1. Financial accounting: It is intended for outsiders (persons apart from owners and managers). There are
several uses of Financial accountancy. It is worried about the recording of business transactions and the
periodic preparation of income statement,
balance sheet and cash flow statement from these types of records. In this way, it is perfect for determining
profit or loss made during a given period and financial position by the end of the given period as well as the
sources and uses of cash for the year. Financial accountancy is controlled by both local and international
standards.
2. Management accounting: It is focused on the interpretation of accounting information to help the
management in future planning, decision making, control, etc. Management accountancy, for that reason,
serves the information requirements of the insiders, e.g., owners, managers and employees. Within the
division of management accountancy you will find nearly enormous quantities of tools, methods, techniques
and approaches floating around.
3. Cost accounting: It is a useful tool you utilize to cut back and eliminate costs in a business. This has been
developed to determine the costs incurred for carrying out different business activities and to assist the
management to exercise strict cost control. Considering that managers are making decisions just for their own
firm, there’s no need for the information to be comparable to similar information from other businesses.
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 Rather, information should be suitable for a specific environment.

MANAGEMENT ACCOUNTING

Management Accounting is the process of analysis, interpretation and presentation of accounting information
collected with the help of financial accounting and cost accounting, in order to assist management in the process of
decision making, creation of policy and day to day operation of an organization. Thus, it is clear from the above that
the management accounting is based on financial accounting and cost
accounting.

OBJECTIVES

1) Measuring performance: Management accounting measures two types of performance. First is employee
performance and the second is efficiency measurement. The actual performance is measured with the standardized
performance and a report of deviation from the standard performance is reported to the management for the
effective decision making and also to indicate the effectiveness of the methods in use. Both types of performance
management are used to make corrective actions in order to improve performance.
2) Assess Risk: The aim of management accounting is to assess risk in order to maximize risk.
3) Allocation of Resources: is an important objective of Management Accounting.

4) Presentation of various financial statements to the Management.

FUNCTIONS OF MANAGEMENT ACCOUNTING

The management process implies the four basic functions of: (1) Planning. (2) Organising (3) Controlling, and (4)
Decision-making.
Management accounting plays a vital role in these managerial functions performed by managers.

(1) PLANNING:
Planning is formulating short term and long-term plans and actions to achieve a particular end. A budget is the
financial planning showing how resources are to be acquired and used over a specified time interval.

Management accounting is closely interwoven in planning both because it provides information for decision-making
and because the entire budgeting process is developed around accounting- related reports. Management accounting
helps managers in planning by providing reports which estimate the effects of alternative actions on an enterprise’s
ability to achieve desired goals. For example, if a business enterprise determines a target profit for a year, it should
also determine how to reach that target.

For example, what products are to be sold at what prices? The management accountant develops data that help
managers identify the more profitable products. Similarly, the effects of alternative prices and selling efforts (say,
what will profit be if we cut prices by 5% and increase volume by 15%, etc.) can easily be determined by the
management accountant. As part of the budgeting process, management accountants prepare budgeted (forecasted)
financial statements, often called proforma statements.

(2) ORGANIZING:
Organizing is a process of establishing an organizational framework and assigning responsibility to people working
in an organization for achieving business goals and objectives. The type of organizational structure differs from one
business enterprise to another. In the organising
process, departmentalization can be done by setting up divisions, departments, sections, branches.
Organizing requires clarity about each manager’s responsibility and lines of authority. The various departments and
units are interrelated in a hierarchy, with a formal communication structure in which information and instructions
are passed downwards to lower level management and upwards to top management level.
Management accounting helps managers in organising by providing reports and necessary information to regulate
and adjust operations and activities in the light of changing conditions. For example, the reports under management
accounting can be prepared on product lines on which basis managers can decide whether to add or eliminate a
product line in the current product mix. Similarly management accountant can provide sales report, production
report to the respective manager for taking suitable action about the sales and production position.

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(3) CONTROLLING:
Control is the process of monitoring, measuring, evaluating and correcting actual results to ensure that a business
enterprise’s goals and plans are achieved. Control is accomplished with the use of feedback. Feedback is
information that can be used to evaluate or correct the steps being taken to implement a plan. Feedback allows the
managers to decide to let the operations and activity continue as they are, take remedial actions to put some actions
back in harmony with the original plan and goals or do some rearranging and re-planning at midstream.
Management accounting helps in the control function by producing performance reports and control reports which
highlight variances between expected and actual performances. Such reports serve as a basis for taking necessary
corrective action to control operations. The use of performance and control reports follows the principle of
management by exception. In case of significant differences between budgeted and actual results, a manager will
usually investigate to determine what is going wrong and possibly, which subordinates or units might need help.

(4) DECISION-MAKING:
Decision-making is a process of choosing among competing alternatives. Decision-making is inherent in each of
three management functions described above, namely, planning, organising and controlling. A manager cannot plan
without making decisions and has to choose among competing objectives and methods to carry out the chosen
objectives. Similarly in organising, managers need to decide on an organization structure and on specific actions to
be taken on day-to-day operations. In control function managers have to decide whether variances are worth
investigating.
The decision-making process includes the following steps:

(i) Identifying a problem requiring managerial action.

(ii) Specifying the objective or goal to be achieved (e.g. maximising return on investment).
(iii) Listing the possible alternative courses of action.
(iv) Gathering the information about the consequences of each alternative.
(v) Making a decision, by selecting one of the alternatives.
Management accounting plays a critical role in step 4 of the decision-making process. Manage- ment accounting
system contains a storehouse of valuable information for predicting the results of various courses of action. The
management accounting can assist management in formally structuring decision problems as well as placing the
alternatives and their consequences in a form that will be easier for management to evaluate. While developing and
gathering information for decision making purposes, the management accountant should include qualitative
information also in his report to help managers better in their decision-making tasks
.

SCOPE OF MANAGEMENT ACCOUNTING

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Following is the scope of Management Accounting:

1) Financial Accounting
2) Cost Accounting
3) Revaluation accounting
4) Control Accounting
5) Marginal Costing
6) Budgetary Control
7) Financial Planning and
8) Break Even Analysis
9) Decision accounting:
10) Reporting
11) Taxation
12) Audit

VARIOUS TECHNIQUES USED TO DISCHARGE THE FUNCTION OF MANAGEMENT

ACCOUNTING

Following are the technique used to discharge the function of management accounting:

1) Marginal Costing
2) Budgetary Control
3) Standard Costing
4) Uniform Costing

FINANCIAL ACCOUNTING V/S COST ACCOUNTING

1) Financial Accounting protects the interests of the outsiders dealing with the organization e.g shareholders,
creditors etc. Whereas reports of Cost Accounting is used for the internal purpose by the management to enable
the same in discharging various functions in a proper manner.
2) Maintenance of Financial Accounting records and preparation of financial statements is a legal requirement
whereas Cost Accounting is not a legal requirement.
3) Financial Accounting is concerned about the calculation of profits and state of affairs of the organization as
whole whereas Cost accounting deals in cost ascertainment and calculation of profitability of
the individual products, departments etc.
4) Financial Accounting considers only transactions of historical financial nature whereas Cost Accounting
considers not only historical data but also future events.
5) Financial Accounting reports are prepared in the standard formats in accordance with GAAP whereas Cost
accounting information is reported in whatever form management wants
FINANCIAL ACCOUNTING V/S MANAGEMENT ACCOUNTING

1) Financial Accounting reports are used by outside parties such as creditors, shareholders, tax authorities etc.
whereas Management Accounting reports are used by managers inside the organization for planning,
directing, controlling and taking decisions.
2) In Financial Accounting, only historical financial transactions are considered and do not consider non-financial
transactions whereas in Managerial Accounting emphasis is on decisions affecting the future, thus it may
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consider future data as well s non-financial factors.
3) Maintenance of financial accounting records and preparation of financial statements is a legal requirement
whereas Management Accounting is not at all legal requirement. Moreover, these systems have
their own reporting formats.
4) In Financial Accounting, precision of information is required whereas in Management Accounting timeliness
of information is required.
5) In Financial Accounting, only summarized data is prepared for the entire organization whereas in Management
Accounting detailed reports are prepared about products, departments, employees and customer.
6) Preparation of Financial Accounting is based of Generally Accepted Accounting Principles whereas
Management Accounting does not follow such principles to prepare reports.
7) Financial reports generated by the Financial Accounting are required to be accurate whereas accuracy is not the
prerequisite of management accounting.

COST ACCOUNTING VS. MANAGEMENT ACCOUNTING

1) The scope of management accounting is broader than that of cost accounting.

2) Both the accounting streams are not a legal requirement.
3) Cost accounting provides only cost information for managerial use whereas management accounting provides
all types of accounting information i.e., cost accounting as well as financial accounting information.
4) In Cost accounting, the main emphasis is on cost ascertainment and cost control whereas in management
accounting the main emphasis is on decision-making.
5) The various techniques used by cost accounting are standard costing, budgetary control, marginal costing
and cost-volume-profit analysis, uniform costing and inter-firm comparison,
etc. whereas management accounting also uses these techniques but also uses techniques like ratio analysis,
funds flow statement, statistical analysis etc.
6) Cost Accounting is a part of Management Accounting whereas Management accounting is an extension of
managerial aspects of cost accounting with the ultimate intention to protect the interests of the business.

IMPORTANCE OF MANAGEMENT ACCOUNTING

1. Helping Forecast the Future:
Forecasting aids decision-making and answering questions, such as: Should the company invest in more
equipment? Should it diversify into different markets? Should it buy another company? Management
accounting helps in answering these critical questions and forecasting the future trends in business.
2. Helping in Make-or-buy Decisions:

Is it cheaper to procure materials or a product from a third party or manufacture them in- house? Cost and
production availability are the deciding factors in this choice. Through management accounting, insights will
be developed which will enable decision-making at both operational and strategic levels.
3. Forecasting Cash Flows:
Predicting cash flows and the impact of cash flow on the business is essential. How much cost will the
company incur in the future? Where will its revenues come from and will the revenues increase or decrease
in the future? Management accounting involves designing of budgets and trend charts, and managers use this
information to decide how to allocate money and resources to generate the projected revenue growth.
4. Helping Understand Performance Variances:

Business performance discrepancies are variances between what was predicted and what is actually
achieved. Management accounting uses analytical techniques to help the management build on positive
variances and manage the negative ones.
5. Analyzing the Rate of Return:
Before embarking on a project that requires heavy investments, the company would need to analyze the
expected rate of return (ROR). If given two or more investment opportunities, how should the company
choose the most profitable one? In how many years would the company break even on a project? What are
the cash flows likely to be? These are all vital questions that can be answered through management
accounting.

LIMITATIONS OF MANAGEMENT ACCOUNTING

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 1) Management Accounting is based on financial and cost accounting, in which historical data is used to make
future decisions. Thus, strength and weakness of the managerial decisions are based on the strength
and weakness of the accounting records.

2) Management Accounting is useful only to those people who are in the decision making process.

3) Tools and techniques used in management accounting only provide information and not ready made
decision. Thus, it is only a supplementary service.
4) In Management Accounting, decision is based on the manager’s institution as management try to avoid
lengthy courses of scientific decision making.

5) Personal prejudices and bias affect the decisions as the interpretation of financial information is based on
personal judgment of the interpreter.

MANAGEMENT ACCOUNTANT

Introduction
Management accountants interpret financial information to make business decisions. Broadly, this role combines
accounting, finance and management with the techniques needed to drive successful businesses. They provide
business data and analysis to managers within organisations to assist in business decision-making and control. They
tend to be more involved with general management, working with managers to analyse cost and revenues: the focus
is on the analysis and reporting of a company’s financial position in order to provide insight into business
performance. Specifically, they provide the monthly management accounts, and budgets and forecasts to aid
business planning.
He aids managerial planning and commercial decision-making tasks by providing appropriate financial information
and undertaking related accounts administration. A challenging area of accountancy that rewards dedication,
leadership and expertise.

Alternative job titles for this role

 Lead accountant
 Enterprise accountant

What the job involves

 Work closely with general management on business decisions and plans
 Analyse cost and revenues
 Analyse, compose and communicate a company’s financial position
 Provide insights into business performance
 Provide the monthly management accounts, and budgets and forecasts to aid business planning
 Work on cost analysis and cost-reduction projects
 Work on competitor analysis, variance analysis, tender preparation and review, strategic planning, long- and
medium-term planning, as well as investor appraisal

ROLES OF MANAGEMENT ACCOUNTANT

The following points will highlight the seven roles of management accountant in decision- making process of the
organization. The seven roles are discussed below:

Role # 1. Stewardship Accounting:

Management accountant designs the frame-work of cost and financial accounts and prepares reports for routine
financial and operational decision-making.

Role # 2. Long-term and Short-Term Planning:

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Management accountant plays an important role in forecasting future business and economic events for making
future plans i.e., long-term plans, strategic management accounting, formulating corporate strategy, market study
etc.
Role # 3. Developing Management Information System (MIS):

The routine reports as well as reports for long-term decision-making are forwarded to managerial personnel at all
levels to take corrective action at the right time. The management accountant also uses these reports for taking
important decisions.

Role # 4. Maintaining Optimum Capital Structure:

Management accountant has a major role to play in raising of funds and their application. He has to decide about
maintaining a proper mix between debt and equity. Raising of funds through debt is cheaper because of tax benefits.
However, it is risky as because interest on debt has to be paid whether the firm earns adequate profits or not.
Management accountant has, therefore, to maintain an optimum capital structure and give due consideration to
various cost of capital theories, leverage and possibility of trading on equity.

Role # 5. Participating in Management Process:

The management accountant occupies a pivotal position in the organization. He performs a staff function and also
has line authority over the accountant and other employees in his office. He educates executives on the need for
control information and on the ways of using it. He shifts relevant information from the irrelevant and reports the
same in a clear form to the management and sometime to interested external parties.

Role # 6. Control:

The management accountant analyses accounts and prepares reports e.g., standard costs, budgets, variance analysis
and interpretation, cash and fund flow analysis, management of liquidity, performance evaluation and responsibility
accounting etc. for control.

Role # 7. Decision-Making:

Management accountant provides necessary information to management in taking short-term decision e.g., optimum
product mix, make-or-buy, lease or buy, pricing of product, discontinuing a product etc. and long-term decisions
e.g., capital budgeting, investment appraisal, project financing etc.
However, the job of management accountant is limited to provision of required information in a comprehensive as
well as reliable form to the management for decision-making purposes. But the actual decision-making
responsibility lies with the management. In other words, neither the management accountant nor the internal
accounting reports can make the decisions for the management.

FINANCIAL STATEMENT ANALYSIS

1. Financial Statement Analysis

1.1 INTRODUCTION

Financial statements are the summaries of the operating, financing and investment activities of business. It must give
useful information for investors and creditors in making investment, credit and other business decisions
Financial statements are developed to take wise decisions for company. Financial statement analysis compares ratios
and trends calculated from data found on financial statements. Financial ratios permit experts to compare output of
business to industry averages or to specific competitors. These comparisons assist recognize financial vigour and
flaws. The term 'financial analysis' also termed as 'analysis and interpretation of financial statements', denotes to the
process of determining financial strengths and limitations of the company by establishing strategic affiliation
between the items of the balance sheet, P&L A/c and other operative data. It is the combined name for the tools and
techniques that gives significant information to decision makers.
1.2 USES OF FINANCIAL ANALYSIS

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It facilitates investors and creditors to evaluate past performance and financial status and predict future performance.
The principal objective of financial reporting is to give information to present and potential investors and creditors
and others to make rational investment, credit and other decisions. Successful decision making requires assessment
of the past performance of companies and assessment of their future prospects. Major aim of a company's financial
analysis for a specific period is to consider the financial position of the company, where it views the company's
financial balance and debt performance. The obtained parameters are of great importance, since it is the vital for
growth, development and continued existence of companies, mainly because they determine the ability of its
financing. Financial analysis is also helpful to determinate the proprietary position of the company, which aims to
thoroughly analyse company's assets in terms of manifestations, to analyse the structure of assets, the
satisfactoriness of their goals and objectives, and to find out the degree of capacity utilization, efficiency of use and
speed of their skill. Financial analysis is valuable for firms to determinate the position of the company yield, based
on the determination of earnings power, and to analyse income statement or to analyse the structure of incomes and
expenditures, including analysis of the lower point of return and quantification of the business, financial and overall
business risks.
The scrutiny and explanation of financial statements is used to verify the financial status of the firm. Various tools
or methods are used to study the relationship between financial statements.

1.3 TOOLS OF FINANCIAL STATEMENT ANALYSIS

A. Comparative financial statements

B. Common size statements
C. Trend analysis
D. Ratio analysis
E. Funds flow analysis
F. Cash flow analysis

1.3.1 Comparative financial statements

Comparative study of financial statements is the comparison of the financial statements of the business
with the preceding year's financial statements. It facilitates detection of weak points and applying remedial
measures. Practically, two financial statements (balance sheet and income statement) are prepared in
comparative form for analysis purposes.

1. Comparative Balance Sheet: The comparative balance sheet demonstrates the different assets and
liabilities of the firm on different dates to make comparison of balances from one date to another.
The comparative balance sheet has two columns for the data of original balance sheets. A third
column is used to show change (increase/decrease) in figures. The fourth column may be added
for giving percentages of increase or decrease. While interpreting comparative Balance sheet the
interpreter is accepted to study the following aspects:
I. Current financial position and Liquidity position
II. Long-term financial position
III. Profitability of the concern
II. For studying current financial position or liquidity position of a concern, interpreter must
investigate the working capital in both the years. Working capital is the excess of current assets
over current liabilities.
III. For studying the long-term financial position of the concern, one should examine the changes in
fixed assets, long-term liabilities and capital.
IV. Another aspect to be understood in a comparative balance sheet is the profitability of the concern.
The study of increase or decrease in profit will help the interpreter to observe whether the
profitability has improved or not.

After studying various assets and liabilities, a judgment should be formed about the financial position of
the concern.

1.3.2 Common size statements

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 The common size statements (Balance Sheet and Income Statement) are revealed in analytical percentages.
The figures of these statements are shown as percentages of total assets, total liabilities and total sales
correspondingly.
Common size balance sheet

A statement where balance sheet items are expressed in the ratio of each asset to total assets and the ratio of
each liability is expressed in the ratio of total liabilities is called common size balance sheet. Thus the
common size statement may be prepared in the following way.

5. The total assets or liabilities are taken as 100.

6. The individual assets are expressed as a percentage of total assets i.e. 100 and different
liabilities are calculated in relation to total liabilities.

1.3.3 Trend analysis

Trend analysis appraises an organization's financial information over a period of time. Periods may be
measured in months, quarters, or years, depending on the circumstances. The objective is to compute and
analyse the amount change and percent change from one period to the next. For calculating the percentage
change between two periods, calculate the amount of the increase (or decrease) for the period by
subtracting the earlier year from the later year. If the difference is negative, the change is a decrease and if
the difference is positive, it is an increase. Divide the change by the earlier year's balance. The result is the
percentage change. To calculate the change over a longer period of time, select the base year. For each line
item, divide the amount in each non base year by the amount in the base year and multiply by 100.

Figure: Analysis Through Comparison.

1.3.4 Ratio analysis

Ratio Analysis is used to get a fast indication of a firm's financial performance in major areas. It is a
process of determining and interpreting numerical relationship based on financial statement. It is a
technique of interpretation of financial statement with the help of accounting ratios derived from the
balance sheet and profit and loss account. The ratios are categorized as Short-term Solvency Ratios, Debt
Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.

1.3.5 Funds flow analysis

Fund flow analysis is associated with more specific information as compared to the wide range of ratio
metrics. Fund flow analysis reveals information about the inflows and outflows of capital for a specific
period of time. Fund flow analysis may disclose why certain ratio valuations are relatively high or low in a
company by digging down into the actual movement of cash and assets into and out of a company. Fund
flow analysis involves creating fund flow statements that match capital inflows with outflows.

1.3.6 Cash flow analysis

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 Cash flow statement represents inflow and outflow of funds. It is important tool for short term analysis.

1.4 ADVANTAGES OF FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is an important business practice because it facilitates senior management to reassess a
corporation's balance sheet and income statement to estimate levels of monetary position and success. Financial
statement analysis may be essential for management to recognize levels of cash receipts and disbursements in
business operations. A statement of cash flows lists cash flows related to operating activities, investments and
financing transactions. A statement of owners' equity may facilitate an investor to recognize a company's
shareholders.
Major characteristics to improve the financial statements:

1. Intelligibility which indicates that the information contained in financial statements should be accessible in
such a way that users can comprehend it, so they could communicate the intended meaning. Will
statements be understandable or not depends on how they are compiled by accountants, and how they are
used by the users (decision makers), who should have the basic knowledge to interpret information and to
use them for adoption and implementation of certain business activities.
2. Comparability: To decide the trend of changes in financial situation and to determine productivity of
business enterprises, it is imperative through consistent adherence to evaluation and measurement of the
effects of business events from period to period. This characteristic should allow investors, creditors and
others to identify and appreciate financial statements of entities in the flow of time, and to compare the
financial
statements of different entities. At last, comparability of financial statements is provided if the users are
timely informed about the changes in accounting policy in the same or in different companies.
3. Timeliness: It entails that if company want that instruments of financial reporting had a great use value,
especially for decision-makers they must be submitted to a reasonable time.
4. Verifiability: This characteristic is a new attribute from 2010 Framework. The information is confirmable
in the sense that it should ensure credibility and objectivity. It necessitates that independent observers reach
the same or similar conclusions that is not biased or contains material errors and recognition of the chosen
method of assessment is applied free from material error and subjectivity

1.5 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

1. It is just study of temporary reports.

2. It checks just financial aspect of company's performance and position but it ignores non- monetary
characteristic of company.
3. It does not investigate the changes in price level of different items of financial statements.
4. Many accounting theories and conventions are used to prepare financial statement and these concepts and
conventions are established for analysis. So, analysis is totally affected with these accounting concepts.
5. Analysis of financial statements is just source but not conclusion or result because reviewer or evaluator,
who writes its analysis, may also affect the analysis. So, different interpretation by different person may
become its restraint.
2. FINANCIAL RATIO ANALYSIS

2.1 INTRODUCTION

Financial ratio analysis is performed by comparing two items in the financial statements. The resulting ratio can
be interpreted in a way that is not possible when interpreting the items separately.

Financial ratios can be classified into ratios that measure: profitability, liquidity, management efficiency, leverage,
and valuation & growth.

2.2 List of Financial Ratios

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Here is a list of various financial ratios. Take note that most of the ratios can also be expressed in percentage by
multiplying the decimal number by 100%. Each ratio is briefly described.
2.2.1 Profitability Ratios
Gross Profit Rate = Gross Profit ÷ Net Sales

Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus sales returns,
discounts, and allowances) minus cost of sales.

Return on Sales = Net Income ÷ Net Sales

Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from
dollar sales. Generally, the higher the ROS the better.

Return on Assets = Net Income ÷ Average Total Assets

In financial analysis, it is the measure of the return on investment. ROA is used in evaluating management's
efficiency in using assets to generate income.

Return on Stockholders' Equity = Net Income ÷ Average Stockholders' Equity Measures the
percentage of income derived for every dollar of owners' equity.

2.2.2 Liquidity Ratios

Current Ratio = Current Assets ÷ Current Liabilities

Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable
securities, current receivables, inventory, and prepayments).

Acid Test Ratio = Quick Assets ÷ Current Liabilities

Also known as "quick ratio", it measures the ability of a company to pay short-term obligations using the more
liquid types of current assets or "quick assets" (cash, marketable securities, and current receivables).

Cash Ratio = ( Cash + Marketable Securities ) ÷ Current Liabilities

Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable
securities are short-term debt instruments that are as good as cash.

Net Working Capital = Current Assets - Current Liabilities

Determines if a company can meet its current obligations with its current assets; and how much excess or deficiency
there is.
2.2.3 Management Efficiency Ratios

Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable

Measures the efficiency of extending credit and collecting the same. It indicates the average number of times in
a year a company collects its open accounts. A high ratio implies efficient credit and collection process.

Days Sales Outstanding = 360 Days ÷ Receivable Turnover

Also known as "receivable turnover in days", "collection period". It measures the average number of days it takes a
company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.

Inventory Turnover = Cost of Sales ÷ Average Inventory

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Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost
of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.

Days Inventory Outstanding = 360 Days ÷ Inventory Turnover

Also known as "inventory turnover in days". It represents the number of days inventory sits in the warehouse. In
other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the
shorter the DIO the better.

Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable

Represents the number of times a company pays its accounts payable during a period. A low ratio is favored
because it is better to delay payments as much as possible so that the money can be used for more productive
purposes.

Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover

Also known as "accounts payable turnover in days", "payment period". It measures the average number of days
spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained
above).

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding

Measures the number of days a company makes 1 complete operating cycle, i.e. purchase merchandise, sell
them, and collect the amount due. A shorter operating cycle means that the company generates sales and
collects cash faster.

Cash Conversion Cycle = Operating Cycle - Days Payable Outstanding

CCC measures how fast a company converts cash into more cash. It represents the number of days a company
pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the
CCC the better.

Total Asset Turnover = Net Sales ÷ Average Total Assets

Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA,
except that net sales is used instead of net income.

2.2.4 Leverage Ratios

Debt Ratio = Total Liabilities ÷ Total Assets

Measures the portion of company assets that is financed by debt (obligations to third parties). Debt ratio can
also be computed using the formula: 1 minus Equity Ratio.

Equity Ratio = Total Equity ÷ Total Assets

Determines the portion of total assets provided by equity (i.e. owners' contributions and the company's
accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio.

The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total equity.

Debt-Equity Ratio = Total Liabilities ÷ Total Equity

Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a
leveraged firm; less than 1 implies that it is a conservative one.

Times Interest Earned = EBIT ÷ Interest Expense

Measures the number of times interest expense is converted to income, and if the company can pay its interest
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expense using the profits generated. EBIT is earnings before interest and taxes.

2.2.5 Valuation and Growth Ratios

Earnings per Share = ( Net Income - Preferred Dividends ) ÷ Average Common Shares Outstanding
EPS shows the rate of earnings per share of common stock. Preferred dividends is deducted from net income to get
the earnings available to common stockholders.

Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share

Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate that the company is
under-priced. Conversely, investors expect high growth rate from companies with high P/E ratio.

Dividend Pay-out Ratio = Dividend per Share ÷ Earnings per Share

Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant
portion is retained for the next year's operations.

Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share

Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is
attractive to investors who are after dividends rather than long-term capital appreciation.

Book Value per Share = Common SHE ÷ Average Common Shares

Indicates the value of stock based on historical cost. The value of common shareholders' equity in the books of the
company is divided by the average common shares outstanding.
3. Fund Flow Analysis

3.1 Introduction to funds flow analysis

The notion of funds is described by several accountants in different way. The term funds have different meaning
according to interpretation of accountants and accounting approaches. Flow of fund means inward and outward
movement of funds of an enterprise. Basically, funds denote to working capital and flow means movement and
changes. In this regard, flow of funds encompasses movement in working capital items such as current assets and
current liabilities. Fund flow analysis is the analysis of flow of fund from current asset to fixed asset or current asset
to long term liabilities or vice-versa
Fund refers to working capital.

Funds flow statement is an assertion of sources and uses of funds. It describes changes in net working capital
between two balance sheet dates. Funds flow statement is prepared in three stages that include schedule of changing
in working capital, calculation of funds from operations and statement of fund flow. Net inflows generate surplus
cash for fund managers to spend which tend to create demand for stocks and bonds in their preferred sector. On the
contrary, net outflows decrease excess cash for fund managers that results in lower demand for stocks and bonds.
Consequently, investors can use fund flow information to decide where capital is being invested in terms of asset
class or geography. The funds flow statement is helpful in numerous ways such as it is helpful in knowing the
sources and uses of funds, suggests the ways in which working capital position can be improved, can be used in
planning a sound dividend policy and beneficial in forecasting the flow of funds and in projecting the working
capital requirements. It indicates various methods by which funds are obtained during a particular period and the
ways in which these funds are employed. In simple words, it is a statement of sources and application of funds. A
statement of sources and application of funds is a technical device designed to analyse the changes in the financial
condition of a business enterprise between two dates.
Fund flows can offer shareholders with huge information about where capital is being committed around the world.
In fund flow, there is all possible information of financial resources which have become available during an
accounting period and in the manner these resources are utilized. The statement analyses the changes between
opening and closing balance sheet of the period. The flow of fund in company may be conceived as a continuous
process. For every use of funds, there must be an offsetting source. In general, the assets of the firm represent the net
uses of funds, its liabilities and net worth represent net sources.
13
3.2 Various sources and use of funds:

To summarize, Fund flow statement is considered as an important tool for financial analysis and control. Fund flow
analysis serves as a valuable aid to financial manager or creditor in evaluating the use of funds by firm and in
explaining how these uses are financed. Future flow can also be evaluated through projected fund statement. This
offers the finance manager an efficient method to assess the growth of firm, its resulting financial needs and the best
way to finance these needs.

3.3 The following rules may be noted:

(a) Increase in a current asset item increases working capital.

(b) Decrease in current asset item decreases working capital.

(c) Increase in current liability item decreases working capital.

(d) Decrease in current liability item increases working capital.

The increase or decrease in the Working Capital should be equal to that shown in the Statement of Sources and
Applications of Funds.
3.4 Illustration:
4. Cash Flow Statement

4.1 INTRODUCTION

Accounting Standard-3 (AS-3), issued by The Institute of Chartered Accountants of India (ICAI) in June 1981,
which dealt with a statement showing ‘Changes in Financial Position’, (Fund Flow Statement), has been revised and
now deals with the preparation and presentation of Cash flow statement. The revised AS-3 has made it mandatory
for all listed companies to prepare and present a cash flow statement along with other financial statements on annual
basis.

A cash flow statement provides information about the historical changes in cash and cashequivalents of an
enterprise by classifying cash flows into operating, investing and financing activities. It requires that an enterprise
should prepare a cash flow statement and should present it for each accounting period for which financial statements
are presented. This chapter discusses this technique and explains the method of preparing a cash flow statement for
an accounting period.

4.2 Objectives of Cash Flow Statement

A Cash flow statement shows inflow and outflow of cash and cash equivalents from various activities of a company
during a specific period. The primary objective of cash flow statement is to provide useful information about cash
14
flows (inflows and outflows) of an enterprise during a particular period under various heads, i.e., operating
activities, investing activities and financing activities.

This information is useful in providing users of financial statements with a basis to assess the ability of the
enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise those cash flows. The
economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and
cash equivalents and the timing and certainty of their generation.

4.3 Benefits of Cash Flow Statement

Cash flow statement provides the following benefits :

1. A cash flow statement when used along with other financial statements provides information that enables
users to evaluate changes in net assets of an enterprise, its financial structure (including its liquidity and
solvency) and its ability to affect the amounts and timings of cash flows in order to adapt to changing
circumstances and opportunities.
2. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash
equivalents and enables users to develop models to assess and compare the present value of the future cash
flows of different enterprises.

3. It also enhances the comparability of the reporting of operating performance by different enterprises
because it eliminates the effects of using different accounting treatments for the same transactions and
events.

4. It also helps in balancing its cash inflow and cash outflow, keeping in response to changing condition. It is
also helpful in checking the accuracy of past assessments of future cash flows and in examining the
relationship between profitability and net cash flow and impact of changing prices.

4.4 Limitations of Cash Flow Statements-

Cash flow statement is used as a tool of financial statement analysis. Even though, cash flow statement suffers
from some limitations. Such limitations re listed below.
1. Cash flow statement shows only cash inflow and cash outflow. But, the cash balance disclosed by the statement
cannot reveals the true liquid position of the business.

2. Net Cash Flow disclosed by Cash Flow Statement does not necessarily mean net income of the business because
net income is determined by taking into account both cash and non-cash items.

3. It does not give complete picture of the financial position of the business concern.

4. The preparation of cash flow statement is only post-mortem analysis. There is no projection of cash in future in
this method.

5. It is not a substitute of Income Statement.

6. The accuracy of cash flow statement is based on the balance sheet. If balance sheet is wrong, the cash flow
statement is also wrong.

7. It is not prepared on the basic accounting concept of accrual basis. Hence, the accuracy of cash flow statement is
questionable.

8. It is not suitable for judging the profitability of a firm as non-cash items are not included in the calculation of
cash flow from operating activities.

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4.5 Classification of Activities for the Preparation of Cash Flow Statement
You know that various activities of an enterprise result into cash flows (inflows or receipts and outflows or
payments) which is the subject matter of a cash flow statement. As per AS-3, these activities are to be classified into
three categories:

(1) operating, (2) investing, and (3) financing activities so as to show separately the cash flows generated
(or used) by (in) these activities. This helps the users of cash flow statement to assess the impact of these
activities on the financial position of an enterprise and also on its cash and cash equivalents.

4.5.1 Cash from Operating Activities

Operating activities are the activities that constitute the primary or main activities of an enterprise. For
example, for a company manufacturing garments, operating activities are procurement of raw material,
incurrence of manufacturing expenses, sale of garments, etc. These are the principal revenue generating
activities (or the main activities) of the enterprise and these activities are not investing or financing
activities. The amount of cash from operations’ indicates the internal solvency level of the company, and
is regarded as the key indicator of the extent to which the operations of the enterprise have generated
sufficient cash flows to maintain the operating capability of the enterprise, paying dividends, making of
new investments and repaying of loans without recourse to external source of financing.

Cash flows from operating activities are primarily derived from the main activities of the enterprise.
They generally result from the transactions and other events that enter into the determination of net profit
or loss. Examples of cash flows from operating activities are:

Cash Inflows from operating activities

1. cash receipts from sale of goods and the rendering of services.

2. cash receipts from royalties, fees, commissions and other revenues.

a. Cash Outflows from operating activities

3. Cash payments to suppliers for goods and services.

4. Cash payments to and on behalf of the employees.

5. Cash payments to an insurance enterprise for premiums and claims, annuities, and other policy benefits.

6. Cash payments of income taxes unless they can be specifically identified with financing and
investing activities.

i. The net position is shown in case of operating cash flows.

An enterprise may hold securities and loans for dealing or for trading purposes. In either case they
represent Inventory specifically held for resale. Therefore, cash flows arising from the purchase and sale of
dealing or trading securities are classified as operating activities. Similarly, cash advances and loans made
by financial enterprises are usually classified as operating activities since they relate to main activity of that
enterprise.

4.5.2 Cash from Investing Activities

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As per AS-3, investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents. Investing activities relate to purchase and sale of long-term assets or fixed assets such
as machinery, furniture, land and building, etc. Transactions related to long-term investment are also investing
activities.

Separate disclosure of cash flows from investing activities is important because they represent the extent to which
expenditures have been made for resources intended to generate future income and cash flows. Examples of cash
flows arising from investing activities

Cash Outflows from investing activities

λ Cash payments to acquire fixed assets including intangibles and capitalised research and
development.

λ Cash payments to acquire shares, warrants or debt instruments of other enterprises

other than the instruments those held for trading purposes.

λ Cash advances and loans made to third party (other than advances and loans made
by a financial enterprise wherein it is operating activities).
Cash Inflows from Investing Activities

λ Cash receipt from disposal of fixed assets including intangibles.

λ Cash receipt from the repayment of advances or loans made to third parties (except in
case of financial enterprise).

λ Cash receipt from disposal of shares, warrants or debt instruments of other enterprises
except those held for trading purposes.

λ Interest received in cash from loans and advances.

λ Dividend received from investments in other enterprises.

4.5.3 Cash from Financing Activities

As the name suggests, financing activities relate to long-term funds or capital of an enterprise, e.g., cash
proceeds from issue of equity shares, debentures, raising long-term bank loans, repayment of bank loan, etc.
As per AS-3, financing activities are activities that result in changes in the size and composition of the
owners’ capital (including preference share capital in case of a company) and borrowings of the enterprise.
Separate disclosure of cash flows arising from financing activities is important because it is useful in
predicting claims on future cash flows by providers of funds (both capital and borrowings ) to the enterprise.
Examples of financing activities are:

Cash Inflows from financing activities

λ Cash proceeds from issuing shares (equity or/and preference).

λ Cash proceeds from issuing debentures, loans, bonds and other short/ long-term
borrowings.
Cash Outflows from financing activities

λ Cash repayments of amounts borrowed.

λ Interest paid on debentures and long-term loans and advances. λ

Dividends paid on equity and preference capital.

17
 It is important to mention here that a transaction may include cash flows that are classified differently. For
example, when the instalment paid in respect of a fixed asset acquired on deferred payment basis includes both
interest and loan, the interest element is classified under financing activities and the loan element is classified
under investing
activities. Moreover, same activity may be classified differently for different enterprises. For example, purchase
of shares is an operating activity for a share brokerage firm while it is investing activity in case of other
enterprises.

Cash Flow Statement

(A) Cash flows from operating activities Xxx

(B) Cash flows from investing activities Xxx

(C) Cash flows from financing activities Xxx

Net increase (decrease) in cash and cash Xxx

equivalents (A + B + C)

+ Cash and cash equivalents at the beginning Xxx

= Cash and cash equivalents at the end Xxxx

BUDGETS AND BUDGETORY CONTROL

Businesses need to plan for the future. In large businesses such planning is very formal while, for smaller
businesses, it will be less formal. Planning for the future falls into three time scales:
• Long-term: from about three years up to, sometimes, as far as twenty years ahead
• Medium-term: one to three years ahead
• Short-term: for the next year. Clearly, planning for these different time scales needs different approaches: the
further on in time, the less detailed are the plans. In the medium and longer term, a business will establish broad
business objectives. Such objectives do not have to be formally written down, although in a large business they are
likely to be. In smaller businesses, objectives will certainly be considered and discussed by the owners or managers.
Planning takes note of these broader business objectives and sets out how these are to be achieved in the form of
detailed plans known as budgets.

WHAT IS A BUDGET?
A budget is a financial plan for a business, prepared in advance. A budget may be set in money terms, eg a sales
budget of £500,000, or it can be expressed in terms of units, eg a purchases budget of 5,000 units to be bought.

18
Budgets can be income budgets for money received, eg a sales budget, or expenditure budgets for money spent, eg a
purchases budget. The budget we shall be focusing on in this chapter is the cash budget, which combines both
income and expenditure, estimating what will happen to the bank balance during the time period of the budget. Most
budgets are prepared for the next financial year (the budget period), and are usually broken down into shorter time
periods, commonly four-weekly or monthly. This enables budgetary control to be exercised over the budget: the
actual results can be monitored against the budget, and discrepancies between the two can be investigated and
corrective action taken where appropriate.

Characteristics of a budget

A good budget is characterized by the following:

1. Participation: involve as many people as possible in drawing up a budget.
2. Comprehensiveness: embrace the whole organization.
3. Standards: base it on established standards of performance.
4. Flexibility: allow for changing circumstances.
5. Feedback: constantly monitor performance.
6. Analysis of costs and revenues: this can be done on the basis of product lines, departments or cost
centers.

BENEFITS OF BUDGETS AND BUDGETARY CONTROL

Budgets provide benefits both for the business, and also for its managers and other staff:

1. The budget assists planning. By formalizing objectives through a budget, a business can ensure that its plans are
achievable. It will be able to decide what is needed to produce the output of goods and services, and to make sure
that everything will be available at the right time.

2. The budget communicates and co-ordinates. Because a budget is agreed by the business, all the relevant
managers and staff will be working towards the same end. When the budget is being set, any anticipated problems
should be resolved and any areas of potential confusion clarified. All departments should be in a position to play
their part in achieving the overall goals.

3. The budget helps with decision-making. By planning ahead through budgets, a business can make decisions on
how much output – in the form of goods or services – can be achieved. At the same time, the cost of the output can
be planned and changes can be made where appropriate.

4. The budget can be used to monitor and control. An important reason for producing a budget is that management
is able to use budgetary control to monitor and compare the actual results (see diagram below). This is so that action
can be taken to modify the operation of the business as time passes, or possibly to change the budget if it becomes
unachievable.

5. The budget can be used to motivate. A budget can be part of the techniques for motivating managers and other
staff to achieve the objectives of the business. The extent to which this happens will depend on how the budget is
agreed and set, and whether it is thought to be fair and
achievable. The budget may also be linked to rewards (for example, bonuses) where targets are met or exceeded.

LIMITATIONS OF BUDGETS AND BUDGETARY CONTROL

Whilst most businesses will benefit from the use of budgets, there are a number of limitations of budgets to be
aware of:

1. The benefit of the budget must exceed the cost. Budgeting is a fairly complex process and some businesses –
particularly small ones – may find that the task is too much of a burden in terms of time and other resources, with
only limited benefits. Nevertheless, many lenders – such as banks – often require the production of budgets as part
19
of the business plan. As a general rule, the benefit of producing the budget must exceed its cost.

2. Budget information may not be accurate. It is essential that the information going into budgets should be as
accurate as possible. Anybody can produce a budget, but the more inaccurate it is, the less use it is to the business as
a planning and control mechanism. Great care needs to be taken with estimates of sales – often the starting point of
the budgeting process – and costs. Budgetary control is used to compare the budget against what actually happened
– the budget may need to be changed if it becomes unachievable.

3. The budget may demotivate. Employees, who have had no part in agreeing and setting a budget which is
imposed upon them, will feel that they do not own it. As a consequence, the staff may be demotivated. Another
limitation is that employees may see budgets as either a ‘carrot’ or a ‘stick’, ie as a form of encouragement to
achieve the targets set, or as a form of punishment if targets are missed.

4. Budgets may lead to dysfunctional management. A limitation that can occur is that employees in one
department of the business may over-achieve against their budget and create problems elsewhere. For example, a
production department might achieve extra output that the sales department finds difficult to sell. To avoid such
dysfunctional management, budgets need to be set at realistic levels and linked and coordinated across all
departments within the business.

5. Budgets may be set at too low a level. Where the budget is too easy to achieve it will be of no benefit to the
business and may, in fact, lead to lower levels of output and higher costs than
before the budget was established. Budgets should be set at realistic levels, which make the best use of the resources
available.

WHAT BUDGETS ARE PREPARED?

Budgets are planned for specific sections of the business: these budgets can then be controlled by a budget holder,
who may be the manager or supervisor of the specific section. Such budgets include:
• purchases budget – what the business needs to buy to make/supply the goods it expects to sell
• sales (revenue) budget – what the business expects to sell
• production budget – how the business will make/supply the goods it expects to sell
• labour budget – the cost of employing the people who will make/supply the goods
• trade receivable budget – how much the business will receive from credit sales
• trade payable budget – how much the business will pay for credit purchases
• cash budget – how much money will be flowing in and out of the bank account
The end result of the budgeting process is often the production of a master budget, which takes the form of forecast
operating statements – forecast income statement – and forecast balance sheet. The master budget is the ‘master
plan’ which shows how all the other budgets ‘work together’.

BUDGETARY PLANNING
Many large businesses take a highly formal view of planning the budget and make use of:

• a budget manual, which provides a set of guidelines as to who is involved with the budgetary planning and
control process, and how the process is to be conducted
• a budget committee, which organizes the process of budgetary planning and control; this committee brings
together representatives from the main functions of the business – eg production, sales, administration – and is
headed by a budget coordinator whose job is to administer and oversee the activities of the committee.
In smaller businesses, the process of planning the budget may be rather more informal, with the owner or manager
overseeing and budgeting for all the business functions.

Whatever the size of the business it is important, though, that the planning process begins well before the start of the
budget period; this then gives time for budgets to be prepared, reviewed, redrafted, and reviewed again before
being finally agreed and submitted to the directors or

20
owners for approval. For example, the planning process for a budget which is to start on 1 January might
commence in the previous June, as follows:
• June Budget committee meets to plan next year’s budgets
• July First draft of budgets prepared
• August Review of draft budgets
• September Draft budgets amended in light of review
• October Further review and redrafting to final version
• November Budgets submitted to directors or owners for approval
• December Budgets for next year circulated to managers
• January Budget period commences
BUDGETARY CONTROL METHODS

a) Budget:

 A formal statement of the financial resources set aside for carrying out specific activities in a given period
of time.
 It helps to co-ordinate the activities of the organization. An example
would be an advertising budget or sales force budget.
b) Budgetary control:

 A control technique whereby actual results are compared with budgets.

 Any differences (variances) are made the responsibility of key individuals who can either exercise control
action or revise the original budgets.
Budgetary control and responsibility centres;
These enable managers to monitor organisational functions.
A responsibility centre can be defined as any functional unit headed by a manager who is responsible for the
activities of that unit.
There are four types of responsibility centres:

a) Revenue centres
Organisational units in which outputs are measured in monetary terms but are not directly compared to input
costs.
b) Expense centres
Units where inputs are measured in monetary terms but outputs are not.

c) Profit centres
Where performance is measured by the difference between revenues (outputs) and expenditure (inputs). Inter-
departmental sales are often made using "transfer prices".
d) Investment centres
Where outputs are compared with the assets employed in producing them, i.e. ROI.

BUDGET ORGANISATION AND ADMINISTRATION

In organising and administering a budget system the following characteristics may apply:

a) Budget centres: Units responsible for the preparation of budgets. A budget centre may encompass
several cost centres.
b) Budget committee: This may consist of senior members of the organisation, e.g. departmental heads and
21
executives (with the managing director as chairman). Every part of the organisation should be represented on the
committee, so there should be a representative from sales, production, marketing and so on. Functions of the budget
committee include:
Coordination of the preparation of budgets, including the issue of a manual Issuing of
timetables for preparation of budgets
Provision of information to assist budget preparations
Comparison of actual results with budget and investigation of variances.

c) Budget Officer: Controls the budget administration The job involves:

liaising between the budget committee and managers responsible for budget preparation dealing with
budgetary control problems
ensuring that deadlines are met
educating people about budgetary control.

d) Budget manual:
This document:
charts the organisation details the
budget procedures
contains account codes for items of expenditure and revenue timetables
the process
clearly defines the responsibility of persons involved in the budgeting system.
BUDGET PREPARATION
Firstly, determine the principal budget factor. This is also known as the key budget factor or limiting budget
factor and is the factor which will limit the activities of an undertaking. This limits output, e.g. sales, material
or labour.
a) Sales budget: this involves a realistic sales forecast. This is prepared in units of each product and also in sales
value. Methods of sales forecasting include:
sales force opinions
market research
statistical methods (correlation analysis and examination of trends) mathematical models.
In using these techniques consider:
company's pricing policy
general economic and political conditions
changes in the population
competition
consumers' income and tastes
advertising and other sales promotion techniques after
sales service
credit terms offered.

b) Production budget: expressed in quantitative terms only and is geared to the sales budget. The production
manager's duties include:
analysis of plant utilisation
work-in-progress budgets.
If requirements exceed capacity he may:
subcontract
plan for overtime
introduce shift work
hire or buy additional machinery
The materials purchases budget's both quantitative and financial.

c) Raw materials and purchasing budget: The

materials usage budget is in quantities.
The materials purchases budget is both quantitative and financial.

22
Factors influencing a) and b) include:
production requirements
planning stock levels
storage space
trends of material prices.
d) Labour budget: is both quantitative and financial. This is influenced by: production
requirements
man-hours available grades
of labour required
wage rates (union agreements) the
need for incentives.
e) Cash budget: a cash plan for a defined period of time. It summarises monthly receipts and payments. Hence,
it highlights monthly surpluses and deficits of actual cash. Its main uses are:
to maintain control over a firm's cash requirements, e.g. stock and debtors
to enable a firm to take precautionary measures and arrange in advance for investment and loan facilities
whenever cash surpluses or deficits arises
to show the feasibility of management's plans in cash terms
to illustrate the financial impact of changes in management policy, e.g. change of credit terms offered to
customers.
Receipts of cash may come from one of the following: cash sales
payments by debtors the
sale of fixed assets the
issue of new shares
the receipt of interest and dividends from investments.

Payments of cash may be for one or more of the following:

purchase of stocks
payments of wages or other expenses
purchase of capital items
payment of interest, dividends or taxation.
Question on cash budget

FIXED AND FLEXIBLE BUDGETING

FIXED BUDGETING:

The Chartered Institute of Management Accountants (UK) defines a fixed budget as the budget which is designed to
remain unchanged irrespective of the level of activity actually attained. It is based on a single level of activity. A
fixed budget performance report compares data from actual operations with the single level of activity reflected in
the budget. It is based on the assumption that the company will work at some specified level of activity and that a
stated production will be achieved. It suggests that the budget is not adjusted when production level changes.

However, in practice, fixed budgeting is rarely used. The main reason is that actual output is often significantly
different from the budgeted output. In such a case the budget cannot be used for the purpose of cost control. The
performance report may be misleading and will not contain very useful information. For example, if actual
production is 12,000 units in place of the
budgeted 10,000 units, the costs incurred cannot be compared with the budget which relates to different levels of
activity.

A fixed budget can be usefully employed when budgeted output is close enough to the actual output. It is also
important to note that budget levels should be determined on the basis of what is likely to happen in the future rather
than on the basis of what has happened in the past.
FLEXIBLE BUDGETING:
23
A flexible budget is defined in the terminology of cost accounting, issued by the Chartered In- stitute of
Management Accountants (UK) as “a budget which by recognising the difference between fixed, semi-fixed and
variable costs, is designed to change in relation to the level of activity attained.”

A flexible budget is a budget that is prepared for a range, i.e., for more than one level of activity. It is a set of
alternative budgets to different expected levels of activity. The flexible budget is also known by other names, such
as variable budget, dynamic budget, sliding scale budget, step budget, expenses formula budget and expenses
control budget. The underlying principle of a flexible budget is that every business is dynamic, ever-changing, and
never static.

Thus, a flexible budget might be developed that would apply to a “relevant range” of production, say 8,000 units to
12,000 units. Under this approach, if actual production slips to 9,000 units from a projected 10,000 units, the
manager has a specific tool (i.e., the flexible budget) that can be used to determine budgeted cost at 9,000 units of
output. The flexible budget provides a reliable basis for comparison because it is automatically geared to changes in
a production activity.
A flexible budget has the following important features:

1. It covers a range of activity (output).

2. It is flexible, i.e., easy to change with variation in production levels.
3. It facilitates performance measurement and evaluation.
The flexibility involved in this budget makes a very useful decision-making tool for management. Perhaps the most
important point in favour of flexible budgeting is that it provides the most accurate and reliable base for measuring
performance and efficiency of the departments and individuals working in the organization.
Steps in Flexible Budgeting:
The following steps (stages) are involved in developing a flexible budget:

1. Deciding the range of activity to which the budget is to be prepared.

2. Determining the cost behaviour patterns (fixed, variable, semi-variable) for each element of cost to be included
in the budget.
3. Selecting the activity levels (generally in terms of production) to prepare budgets at those levels.
4. Preparing the budget at each activity level selected by associating the activity level with corresponding costs.
The corresponding costs to be attached with each activity level are determined in terms of their behaviour, i.e.,
fixed, variable, semi-variable.
ADVANTAGES OF FLEXIBLE BUDGETING:
Flexible budgeting is budgeting that is automatically tailored to any level of activity. Welsch has listed three
specific uses of the flexible budget.
1. To facilitate development of the departmental expense budgets for inclusion in the profit plan.
2. To provide expense goals for the managers of responsibility centres during the period covered by the profit plan.
3. To provide adjusted budget allowances for comparison purposes (against actual expenses) in the monthly
performance reports.
In general, flexible budgeting has the following important advantages:

(1) Accurate Budgeting:

The use of flexible budgets may result in the preparation of more accurate budgets. Flexible budgeting techniques
require that consideration is to be given to the output factor in budget preparation. Since all costs do not behave in
the same manner (as some costs rise faster than others when production increase) a budget giving consideration to
the volume (output) factor is bound to be more accurate than one where volume is not considered.

(2) Accurate Performance Measurement:

The flexible budgeting technique incorporates changes in activity level and compares actual results with the budget
in terms of output achieved. This facilitates more meaningful comparison and evaluation between actual and
budgeted data as comparable data are compared. The deviations resulting from the comparison are reliable and
24
helpful to management in cost control and decision-making.
(3) Coordination:
Flexible budgeting results in coordination between all activities/departments of a business. Production is planned in
relation to expected sales; materials and labour are acquired to meet expected production requirements. Facilities are
provided to achieve budgetary goals, and funds are made available for the investments necessary to have higher
output.
(4) Control Tool:
Flexible budgeting is an effective management control tool. Business operations are conducted more efficiently and
losses are avoided or reduced. Comparison between the budgeted costs (at the actual production level) and actual
costs form the basis for analysing cost variances and fixing responsibility for the same. In fact, managers
themselves feel motivated in controlling costs for which they are responsible. The flexible budget provides cost
goals or targets based on scheduled activity or output before the decision point, i.e., before the cost is incurred. This
contributes to cost control throughout the organization.

Comparison Chart

BASIS FOR FIXED BUDGET FLEXIBLE BUDGET

COMPARISON
Meaning he budget designed to remain The budget designed to change with
constant, regardless of the activity the change in the activity levels is
level reached is Fixed Flexible Budget.
Budget.

Nature Static Dynamic

Activity Level Only one Multiple
Performance Evaluation Comparison between actual and It provides a good base for making a
budgeted levels cannot be done comparison between the actual and
accurately, if there is a budgeted levels.
distinction in their activity
levels.

Rigidity Fixed Budget cannot be Flexible budget can be easily

modified as per the actual modified in accordance with the
volume. activity level attained.
Estimates Based on assumption Realistic and Practical

PERFORMANCE BUDGETING/ PERFORMANCE BASED BUDGET

Meaning
Performance budget may be defined as a budget based on functions, activities and projects. Performance budgeting
may be described as a budgeting system, where under input costs are related to the end results, i.e., performance.
According to the National Institute of Bank Management, Mumbai, the PB is the process of analyzing, identifying,
simplifying, and crystallizing specific performance objectives of a job to be completed over a period, in the
framework of the organizational objectives, the purpose and objectives of the job.
It involves the evaluation of the performance of the organization in the context of both specific as well as overall
objectives of the organization.

Purpose of PB:

1. The performance budget is an instrument through which financial resources are allocated according to purposes
and objectives. The costs of various programmes proposed for achieving these objectives are clearly indicated.
2. It also presents data for measuring worth performance of the accomplishment of objectives set under each
programme. The focus of attention is not only on expenditure but also on achievement. Both are integral parts of
financial planning and expenditure authorization.

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Process of PB:
PB is a technique or a method employed by any agency/department. The first stage is to decide what its goal or
objective should be, the next stage is to decide on a set of programmes in order to achieve the goal and then to
implement the programme.
Final stage is to evaluate the actual performance of each segment and its contribution towards achievement of its
goal.

Operational Steps in PB:

(a) Formulation of objectives of the agency/department

(b) Identification of various programmes or projects, which will help the agency to achieve its objective
(c) Evaluation of the programmes in terms of benefits that they produce compared to the resources that they
consume
(d) Selection of the programmes on the basis of cost benefit analysis in order to utilize the funds in the optimal
manner
(e) Development of performance criteria for the various programmes (suitable work measurement units, norms,
yardsticks, standards, and other performance indicators)
(f) Preparation of long-term physical as well as financial plans
(g) Preparation of the annual budget
(h) Assessment of performance of each programme and by each responsibility unit and comparison of the same
with the budget
(i) Undertaking periodical review of programmes with a view to assess the strengths and weaknesses and make
modification, if necessary

Merits:
1. It improves legislative review by presenting a comprehensive view of the various departments and agencies of
the government. In fact this system ensures the advantages that are likely to accrue from an organic integration of
the process of planning and budgeting.
2. It helps to improve public relations by providing clearer information for a rational public appraisal of
responsible government.
3. It brings the financial (program funding) and physical (expected results) aspects together, interweaving them in a
lace, right from the beginning of the proposal to the final stage of the scheme. This was absent in the traditional
planning, programming and budgeting process.

Limitations:

1. The programme and activity classifications developed are sometimes too broad to reveal the significant activities
of the department to serve as a basis for budgetary decisions and management.
2. Due to its goal-oriented nature, PBB technique focuses on quantitative rather than a qualitative evaluation.
3. PBB without decentralized accounting and systematic reporting mechanisms would be ineffective.
However, despite its difficulties and limitations, PBB provides a meaningful basis for
administrative planning, executive coordination, legislative scrutiny and administrative accountability at all levels of
government. Most importantly, a progressive budget based on PBB would strengthen the democratic process and
evoke meaningful participation of the citizens in the implementation of the tasks set out in the budget.

ZERO BASE BUDGETING (ZBB)

Meaning and Definition

26
 Zero based budgeting in management accounting involves preparing the budget from the scratch with a zero-base. It
involves re-evaluating every line item of cash flow statement and justifying all the expenditure that is to be incurred
by the department.

Thus, zero-based budgeting definition goes as a method of budgeting whereby all the expenses for the new period
are calculated on the basis of actual expenses that are to be incurred and not on the incremental basis which
involves just increasing the expenses incurred in the previous year at some fixed rate. Under this method, every
activity needs to be justified, explaining the revenue that every cost will generate for the company.

Contrary to the traditional budgeting in which past trends or past sales/expenditure are expected to continue, zero-
based budgeting assumes that there are no balances to be carried forward or there are no expenses that are pre-
committed. In the literal sense, it is a method for building the budget with zero prior bases. Zero-based budgeting
lays emphasis on identifying a task and then funding these expenses irrespective of the current expenditure
structure.

Zero Based Budgeting Steps

1. Identification of a task
2. Finding ways and means of accomplishing the task
3. Evaluating these solutions and also evaluating alternatives of sources of funds
4. Setting the budgeted numbers and priorities.
Zero Based Budgeting Example

Let us take an example of a manufacturing department of a company ABC that spent Rs. 10 million last year. The
problem is to budget the expenditure for the current year. There are multiple ways of doing so:
1. The board of directors of the company decides to increase/decrease the expenditure of the department by 10 percent.
So the manufacturing department of ABC Ltd will get Rs. 11 million or Rs. 9 million depending on the
management’s decision.
2. The senior management of the company may decide to give the department the same amount as it got in the
previous year without hiring more people in the department, or increasing the production etc. This way, the
department ends up getting Rs. 10 million.
3. Another way is, as, against the traditional method, management may use zero-based budgeting in which the previous
year’s number of Rs. 10 million is not used for calculation. Zero-based budgeting application involves calculating
all the expenses of the department and justifying each of these. This reflects the actual requirement of the
manufacturing department of company ABC which may be Rs. 10.6 million.

Having understood zero-based budgeting calculation; some of the advantages of zero-based budgeting are stated
below:
ZERO BASED BUDGETING ADVANTAGES

1. Accuracy: Against the regular methods of budgeting that involve just making some arbitrary changes to the
previous year’s budget, zero-based budgeting makes every department relook each and every item of the cash flow
and compute their operation costs. This to some extent helps in cost reduction as it gives a clear picture of costs
against the desired performance.

2. Efficiency: This helps in efficient allocation of resources (department-wise) as it does not look at the historical
numbers but looks at the actual numbers

3. Reduction in redundant activities: It leads to the identification of opportunities and more cost- effective ways of
doing things by removing all the unproductive or redundant activities.
4. Budget inflation: Since every line item is to be justified, zero-based budget overcomes the weakness of incremental
budgeting of budget inflation.

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5. Coordination and Communication: It also improves co-ordination and communication within the department and
motivates employees by involving them in decision-making.
Although zero-based budgeting merits make it look like a lucrative method, it is important to know the
disadvantages listed as under:

ZERO BASED BUDGETING DISADVANTAGES

1. Time-Consuming: Zero-based budgeting is a very time-intensive exercise for a company or a government funded
entries to do every year as against incremental budgeting, which is a far easier method.

2. High Manpower Requirement: Making an entire budget from the scratch may require the involvement of a large
number of employees. Many departments may not have an adequate time and human resource for the same.

3. Lack of Expertise: Explaining every line item and every cost is a difficult task and requires training the managers.

CONCLUSION:
Zero-based budgeting aims at reflecting true expenses to be incurred by a department or a state [in the case of
budget making by the government]. Although time-consuming, this is a more appropriate way of budgeting. At the
end of the day, it is a company’s call as whether it wants to invest time and manpower in the budgeting exercise to
provide more accurate numbers or go for an easier method of incremental budgeting.
RESPONSIBILITY ACCOUNTING

Meaning and Definition of Responsibility Accounting:

The systems of costing like standard costing and budgetary control are useful to management for controlling the
costs. In those systems the emphasis is on the devices of control and not on those who use such devices.
Responsibility Accounting is a system of control where responsibility is assigned for the control of costs. The
persons are made responsible for the control of costs.

Proper authority is given to the persons so that they are able to keep up their performance. In case the performance
is not according to the predetermined standards then the persons who are assigned this duty will be personally
responsible for it. In responsibility accounting the emphasis is on men rather than on systems.

For example, if Mr. A, the manager of a department, prepares the cost budget of his department, then he will be
made responsible for keeping the budgets under control. A will be supplied with full information of costs incurred
by his department. In case the costs are more than the budgeted costs, then A will try to find out reasons and take
necessary corrective measures. A will be personally responsible for the performance of his department.

Charles, T. Horngreen:
“Responsibility accounting is a system of accounting that recognizes various responsibility centres throughout the
organisation and reflects the plans and actions of each of these centres by assigning particular revenues and costs to
the one having the pertinent responsibility. It is also called profitability accounting and activity accounting”.
According to this definition, the organisation is divided into various responsibility centres and each centre is
responsible for its costs. The performance of each responsibility centre is regularly measured.
Essential Features of Responsibility Accounting:

1. Inputs and Outputs or Costs and Revenues:

The implementation and maintenance of responsibility accounting system is based upon information relating to
inputs and outputs. The physical resources utilized in an organization; such as quantity of raw material used and
labour hours consumed, are termed as inputs. These inputs expressed in the monetary terms are known as costs.
Similarly outputs expressed in monetary terms are called revenues. Thus, responsibility accounting is based on cost
and revenue information.
2. Planned and Actual Information or Use of Budgeting:
Effective responsibility accounting requires both planned and actual financial information. It is not only the
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historical cost and revenue data but also the planned future data which is essential for the implementation of
responsibility accounting system. It is through budgets that responsibility for implementing the plans is
communicated to each level of management. The use of fixed budgets, flexible budgets and profit planning are all
incorporated into one overall system of responsibility accounting.
3. Identification of Responsibility Centres:
The whole concept of responsibility accounting is focused around identification of responsibility centres. The
responsibility centres represent the sphere of authority or decision points in an organization. In a small firm, one
individual or a small group of individuals, who are usually the owners may possibly manage or control the entire
organization.

However, for effective control, a large firm is, usually, divided into meaningful segments, departments or divisions.
These sub- units or divisions of organization are called responsibility centres. A responsibility centre is under the
control of an individual who is responsible for the control of activities of that sub-unit of the organization.

This responsibility centre may be a very small sub-unit of the organization, as an individual could be made
responsible for one machine used in manufacturing operations, or it may be very big division of the organization,
such as a divisional manager could be responsible for achieving a certain level of profit from the division and
investment under his control. However, the general guideline is that “the unit of the organisation should be separable
and identifiable for operating purposes and its performance measurement possible”.
For effective planning and control purposes, responsibility centres are, usually, classified under three
categories:
(i) cost centres;
(ii) profit centres; and
(iii) investment centres.
4. Relationship between Organisation Structure and Responsibility Accounting System:
A sound organisation structures with clear-cut lines of authority—responsibility relationships are a prerequisite for
establishing a successful responsibility accounting system. Further, responsibility accounting system must be so
designed as to suit the organization structure of the organization. It must be founded upon the existing authority-
responsibility relationships in the organization. In fact, responsibility accounting system should parallel the
organization structure and provide financial information to evaluate actual results of each individual responsible for
a function.
The following chart shows relationship between organization structure and responsibility centres:

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5. Assigning Costs to Individuals and Limiting their Efforts to Controllable Costs:
After identifying responsibility centres and establishing authority-responsibility relationships, responsibility
accounting system involves assigning of costs and revenues to individuals. Only those costs and revenues over
which an individual has a definite control can be assigned to him for evaluating his performance.
Responsibility accounting has an appeal because it distinguishes between controllable and uncontrollable costs.
Unlike traditional accounting where costs are classified and accumulated according to function such as
manufacturing cost or selling and distribution cost, etc. or
according to products, responsibility accounting classifies accumulated costs according to controllability.
‘Controllable costs’ are those costs which can be controlled or influenced by a specified person or a level of
management of an undertaking. Costs which cannot be so controlled or influenced by the action of a specified
individual of an undertaking are known as ‘uncontrollable costs’. The difference in controllable and uncontrollable
costs may only be in relation to a particular person or level of management.

The following guidelines recommended by the Committee of the American Accounting Association in regard
to assigning of costs may be followed:
(a) If the person has authority over both the acquisition and use of the services, he should be charged with the cost
of these services.
(b) If the person can significantly influence the amount of cost through his own action, he may be charged with
such costs.
(c) Even if the person cannot significantly influence the amount of cost through his own direct action, he may be
charged with those elements with which the management desires him to be concerned, so that he will help to
influence those who are responsible.
6. Transfer Pricing Policy:
In a large scale enterprise having decentralized divisions, there is a common practice of transferring goods and
services from one segment of the organisation to another. In such situations, there is a need to determine the price at
which the transfer should take place so that costs and revenues could be properly assigned.
The significance of the transfer price can well be judged from the fact that for the transferring division it will be a
source of revenue, whereas for the division to which transfer is made it will be an element of cost. Thus, there is a
need of having a proper transfer policy for the successful implementation of responsibility accounting system. There
are various transfer pricing methods in use, such as cost price, cost plus normal profit, incremental cost basis,
negotiated price, standard price, etc.
7. Performance Reporting:
As stated earlier, responsibility account is a control device. A control system to be effective should be such that
deviations from the plans must be reported at the earliest so as to take corrective action for the future. The deviations
can be known only when performance is reported.
Thus, responsibility accounting system is focused on performance reports also known as ‘responsibility reports’,
prepared for each responsibility unit. Unlike authority which flows from top to bottom, reporting flows from bottom
to top. These reports should be addressed to appropriate persons in respective responsibility centres.
The reports should contain information in comparative form as to show plans (budgets) and the actual performance
and should give details of variances which are related to that centre. The variances which are not controllable at a
particular responsibility centre should also be mentioned separately in the report. To be effective, the reports
should be clear and simple. Use of diagrams, charts, illustrations, graphs and tables may be made to make them
attractive and easily understandable.
A specimen of a performance report is given below:

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8. Participative Management:
The function of responsibility accounting system becomes more effective if participative or democratic style of
management is followed, wherein, the plans are laid or budgets/ standards are fixed according to the mutual consent
and the decisions reached after consulting the subordinates. It provides motivation to the workers by ensuring their
participation and self- imposed goals.
9. Management by Exception:
It is a well-accepted fact that at successive higher levels of management in the organisational chain less and less
time is devoted to control and more and more to planning. Thus, an effective responsibility accounting system must
provide for management by exception, i.e., it should focus attention of the management on significant deviations
and not burden them with all kinds of
routine matters, rather condensed reports requiring their attention must be sent to them particularly at higher levels
of management.
The following diagram explains the flow and reporting details at different levels of management:

10. Human Aspect of Responsibility Accounting:

‘The aim of responsibility accounting is not to place blame. Instead it is to evaluate the performance and provide
feedback so that future operations can be improved’. Goals and objectives are achieved through people and, hence,
responsibility accounting system should motivate people. It should be used in positive sense. It should not be taken
as a device to punish subordinates.
It should rather help in improving their performance. Subordinates sometimes dislike control because they take them
as restraints. The best responsibility accounting system enlightens employees about the positive side of control. To
ensure the success of responsibility accounting system, it must look into the human aspect also by considering needs
31
of subordinates, developing mutual interests, providing information about control measures and adjusting according
to requirements.

STEPS FOR ACHIEVING GOALS OF RESPONSIBILITY ACCOUNTING

1. The organisation is divided into various responsibility centres each responsibility centre is put under the charge
of a responsibility manager. The managers are responsible for the performance of their departments.

2. The targets of each responsibility centre are set in. The targets or goals are set in consultation with the manager
of the responsibility centre so that he may be able to give full information about his department. The goals of the
responsibility centres are properly communicated to them.
3. The actual performance of each responsibility centre is recorded and communicated to the executive concerned
and the actual performance is compared with goals set and it helps in assessing the work of these centres.

4. If the actual performance of a department is less than the standard set, then the variances are conveyed to the top
management. The names of those persons who were responsible for that performance are also conveyed so that
responsibility may be fixed.

5. Timely action is taken to take necessary corrective measures so that the work does not suffer in future. The
directions of the top level management are communicated to the concerned responsibility centre so that corrective
measures are initiated at the earliest.

6. The purpose of all these steps is to assign responsibility to different individuals so that the performance is
improved. In case the performance is not up to their targets set, then responsibility may be fixed for it.
Responsibility accounting will certainly act as control device and it will help in improving the overall performance
of the business.

RESPONSIBILITY CENTER: CONCEPT AND TYPES

Concept of Responsibility Centers:

Any organizational or functional unit headed by a manager who is responsible for the activities of that unit is called
a responsible center. The manager is responsible or accountable for the accomplishments of the tasks set in his unit.
The total organizational task is divided into sub-tasks, which are performed by different departments. In this sense,
all departments in an organization are responsibility centers.
All responsibility centers use resources [inputs or costs] to produce something [output or revenues].

Types of Responsibility Centres:

Responsibility centres can be classified by the scope of responsibility assigned and decision- making authority given
to individual managers.
The following are the four common types of responsibility centres:
1. Cost Centre:
A cost or expense centre is a segment of an organisation in which the managers are held re- sponsible for the cost
incurred in that segment but not for revenues. Responsibility in a cost centre is restricted to cost. For planning
purposes, the budget estimates are cost estimates; for control purposes, performance evaluation is guided by a cost
variance equal to the difference between the actual and budgeted costs for a given period. Cost centre managers
have control over some or all of the costs in their segment of business, but not over revenues. Cost centres are
widely used forms of responsibility centres.

In manufacturing organisations, the production and service departments are classified as cost centre. Also, a
marketing department, a sales region or a single sales representative can be defined as a cost centre. Cost centre may
vary in size from a small department with a few employees to an entire manufacturing plant. In addition, cost
centres may exist within other cost centres.
For example, a manager of a manufacturing plant organised as a cost centre may treat individual departments within
the plant as separate cost centres, with the department managers reporting directly to plant manager. Cost centre
managers are responsible for the costs that are controllable by them and their subordinates. However, which costs

32
should be charged to cost centres, is an important question in evaluating cost centre managers.
2. Revenue Centre:
A revenue centre is a segment of the organisation which is primarily responsible for generating sales revenue. A
revenue centre manager does not possess control over cost, investment in assets, but usually has control over some
of the expense of the marketing department. The performance of a revenue centre is evaluated by comparing the
actual revenue with budgeted revenue, and actual marketing expenses with budgeted marketing expenses. The
Marketing Manager of a product line, or an individual sales representative are examples of revenue centres.
3. Profit Centre:
A profit centre is a segment of an organisation whose manager is responsible for both revenues and costs. In a profit
centre, the manager has the responsibility and the authority to make decisions that affect both costs and revenues
(and thus profits) for the department or division. The main purpose of a profit centre is to earn profit. Profit centre
managers aim at both the production and marketing of a product.
The performance of the profit centre is evaluated in terms of whether the centre has achieved its budgeted profit. A
division of the company which produces and markets the products may be called a profit centre. Such a divisional
manager determines the selling price, marketing programmes and production policies.

In profit centres, managers are encouraged to take important decisions regarding the activities and operations of
their divisions. Profit centres are generally created in terms of product or process which has grown in size and has
profit responsibility. In some organizations, profit centres are given complete autonomy on sourcing supplies and
making sales.

Benefits of Creating Profit Centres:

The creation of profit centres in a diversified or divisionalized firm has many benefits:

(i) Better planning and decision making—Profit centres managers are independent in managing the activities and
are responsible for profit and success of their business units. This encourages them to make better planning,
profitable decisions and exercise control. It creates a sense of accountability among the profit centre managers.

(ii) Participation in organizational plans and policies— although profit centre managers are independent in the
management of their business units, they function within the umbrella of overall organization. They get
opportunities to participate in the discussion of plans and policies at the firm level. This widens their perspective
and inculcates the habit of taking an integrated and macro view of activities in place of a narrow division specific
view. In this process, profit centres managers can get trained to be the senior managers of their companies or other
firms in the future.
(iii) Beneficial competitive environment—All profit centres managers target success and profit by managing costs
and aiming higher revenues. This creates a competitive environment among the managers managing their respective
business units which is not only beneficial for them but also contributes in achieving the overall objectives of the
firm and in maximizing the firm profit.

4. Investment Centre:
An investment centre is responsible for both profits and investments. The investment centre manager has control
over revenues, expenses and the amounts invested in the centre’s assets. He also formulates the credit policy which
has a direct influence on debt collection, and the inventory policy which determines the investment in inventory.

The manager of an investment centre has more authority and responsibility than the manager of either a cost
33
centre or a profit centre. Besides controlling costs and revenues, he has investment responsibility too. ‘Investment
on asset’ responsibility means the authority to buy, sell and use divisional assets.
ADVANTAGES OF RESPONSIBILITY ACCOUNTING:

The advantages of responsibility accounting are:

1. It establishes a sound mechanism for control.

2. It forces the management to consider the organizational structure and examines who is responsible for
what and fix the delegation of power.
3. It encourages budgeting with which actual achievement can be compared.
4. It increases interest and awareness of the officers as they are called upon to explain about the deviations for
which they are responsible.
5. The exclusion of items which are beyond the scope of the individual’s responsibility simplifies the structure of
the reports and facilitates promptness in reporting.
LIMITATIONS OF RESPONSIBILITY ACCOUNTING:

Responsibility accounting suffers from the following-limitations:

1. The prerequisites for a successful responsibility accounting system are:

(a) A sound organizational structure where divisions can be identified clearly as responsibility centre.
(b) Proper delegation of work and responsibility.
(c) A proper system of reporting.
If these conditions are absent it is difficult to have a responsibility accounting system.

2. The traditional way of classification of expenses needs to be subjected to a further analysis which becomes
difficult.
3. In introducing the system certain managers may require additional classification particularly if the responsibility
reports are different from routine reports.

STANDARD COSTING AND VARIANCE ANALYSIS

INTRODUCTION

Standard costing is an important subtopic of cost accounting. Standard costs are usually associated with a
manufacturing company's costs of direct material, direct labor, and manufacturing overhead.
Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product,
many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of
goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers,
of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs
and the standard costs, and those differences are known as variances.
Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes
aware that manufacturing costs have differed from the standard (planned, expected) costs.
 If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells
management that if everything else stays constant the company's actual profit will be less than planned.
 If actual costs are less than standard costs the variance is favorable. A favorable variance tells management
that if everything else stays constant the actual profit will likely exceed the planned profit.
The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the
difference from the planned amounts.
MEANING OF STANDARD COSTING

It is a method of costing by which standard costs are employed. According to ICMA, London, Standard Costing is
“the preparation and use of standard costs, their comparison with actual cost and the analysis of variances to
34
their causes and points of incidence”.
According to Wheldon, it is a method of ascertaining the costs whereby statistics are prepared to show:

(i) The standard cost;

(ii) The actual cost;
(iii) The difference between these costs which is termed the variance.
But W. Bigg expresses:
“Standard Costing discloses the cost of deviations from standards and clarifies these as to their causes, so that
management is immediately informed of the sphere of operations in which remedial action is necessary.”
Thus, from the above, it becomes clear that Standard Costing involves:

(i) Ascertainment and use of Standard Costs;

(ii) Recording the actual costs;
(iii) Comparison of actual costs with standard costs in order to find out the variance;
(iv) Analysis of variance; and
(v) After analyzing the variance, appropriate action may be taken where necessary.

OBJECTIVES OF STANDARD COSTING

The objectives of Standard Costing for which it is implemented are:

(a) It helps to implement budgetary control system in operation;

(b) It helps to ascertain performance evaluation.
(c) It supplies the ways to utilise properly material, labour and also overhead which will be economic in
character.
(d) It also helps to motivate the employees of a firm to improve their performance by setting up a ‘standard’.
(e) It also helps the management to supply necessary data relating to cost element to submit quotations or to
fix up the selling price of a firm.
(f) It also helps the management to make proper valuations of inventory (viz., Work-in- progress, and finished
products).
(g) It acts as a control device to the management.
(h) It also helps the management to take various corrective decisions viz., fixation of price, make-or-buy
decisions etc. which will be more beneficial to the firm.

DEVELOPMENT OF STANDARD COSTING

Importance of Standard Costing cannot be ignored for the following and that is why the same is well-
developed in the present-day world:
(i) Compilation of Historical Cost is very expensive and difficult:
A manufacturing firm making large number of parts requires too much clerical work which is required in order to
compile the materials, labour and overhead charges to each and every cost of parts produced for ascertaining the
average cost of the product.
(ii) Historical Costs are inadequate:
In order to measure the manufacturing efficiency, historical costs are not practically adequate. It fails to explain the
reasons of increased cost or any change in cost structure.
(iii) Historical Costs are too old:
In many firms, costs are determined and selling prices are ascertained even before the production starts—which is
not desirable.
(iv) Historical Costs are not typical:

35
This is due to the wide fluctuation in market for which there is no relation between the selling price per unit and cost
price per unit.

ADVANTAGES OF STANDARD COSTING

The following advantages may be derived from Standard Costing:

(i) Standard Costing serves as a guide to the management in several management functions while formulating prices
and production policies etc.
(ii) More effective cost control is possible under standard costing if the same is reviewed and analyzed at regular
intervals for improvements and immediate action can be taken if deviations from standards are found out which,
ultimately, leads to cost reduction.
(iii) Analysis of variance and its measurement helps to detect inefficiencies and mistakes which enable the
management to investigate the reasons.
(iv) Since standard costs are predetermined costs they are very useful for planning and budgeting. It also helps to
estimate the effect of changes in Cost-Price-Volume relationship which also helps the management for decision-
making in future.
(v) As standard is fixed for each product, its components, materials, process operation etc. it improves the overall
production efficiency which also ultimately reduces cost and thereby increases profit.
(vi) Once the Standard Costing System is implemented it will lead to saving cost since most of the costing work
can be eliminated.
(vii) Delegation of authority and responsibility becomes effective by setting up standards for each cost centre as
the supervisors or executives of each cost centre will know the standard which they have to maintain.
(viii) This system also helps to prepare Profit and Loss Account promptly for short period in order to know the
trend of the business which helps the management to take decisions promptly.
(ix) Standard costing also is used for inventory valuation purposes. Stock can be valued at standard cost which can
reduce the fluctuation of profit for different methods of valuation for the same.
(x) Efficiency of labour is promoted.
(xi) This system creates cost-consciousness among all employees, executives and top management which increase
efficiency and productivity as well.

DISADVANTAGES OF STANDARD COSTING

The alleged disadvantages of Standard Costing are:

(i) Since Standard Costing involves high degree of technical skill, it is, therefore, costly. As such, small
organizations cannot, introduce the system due to their limited financial resources. But, once introduced, the benefits
achieved will be far in excess to its initial high costs.
(ii) The executives are liable for those variances that are found from actions which are actually controllable by
them. Thus, in order to fix up the responsibilities, it becomes necessary to segregate variances into non-controllable
and controllable portions although that is not an easy task.
(iii) Standards are always changing since conditions of the business are equally changing. So, standards are to be
revised in order to make them comparable with actual results. But revision of standards creates many problems,
particularly in inventory adjustment.
(iv) Standards are either too liberal or rigid since the same are based on average past results, attainable good
performance or theoretical maximum efficiency. So, if the standards are very high, it will adversely affect the
morale and motivation of the employees.

BUDGETARY CONTROL AND STANDARD COSTING: SIMILARITIES AND DIFFERENCES

Both Standard Costing and Budgetary Control are based on the principle that costs can be controlled along certain
lines of supervision and responsibility, that focuses on controlling cost by comparing actual performance with the
predefined parameter. However, the two systems are neither similar nor
interdependent. Similarities
Budgetary control and standard costing are comparable systems of cost accounting in that they are both
predetermined and forward-looking. The common objective is of controlling business operations by establishing
pre-determined targets.
36
 The modus operandi is also the same for both the systems where the actual performance is compared with the pre-
determined targets (standards or budgets) in order to ascertain variance. The causes of such variances are then
investigated and appropriate actions taken wherever necessary. However, there are few distinctions between these
two systems.
Differences
Standard Costing delineates the variances between actual cost and the standard cost, along with the reasons. On the
contrary, Budgetary Control, as the name suggest, refers to the creation of budgets, then comparing the actual output
with the budgeted one and taking corrective action immediately.
Comparison Chart
Basis of Difference Standard Costing Budgetory Control
Meaning The costing method, in which evaluation of Budgetary Control is the system in
performance and activity is done by making a which budgets are prepared and
comparison between actual and standard costs, continuous comparisons are made
is Standard Costing. between the actual and budgeted
figures to achieve the desired result.

Basis Determined on the basis of data related Budgets are prepared on the
to production. basis of management's plans.
Range All business concerns. It includes cost and financial
data.
Concept Unit Concept Total Concept
Scope Narrow Wide
Reporting of Yes No
Variances
Effect of temporary The short term changes will not The short term changes will
changes in conditions influence the standard costs. not influence the standard
costs.
Comparison Actual costs and standard cost of actual Actual figures and budgeted
output. figures
Applicability Manufacturing concerns All business concerns

STANDARD COSTING AND VARIANCE ANALYSIS

Standard costing is the establishment of cost standards for activities and their periodic analysis to determine the
reasons for any variances. Standard costing is a tool that helps management account in controlling costs.
For example, at the beginning of a year a company estimates that labor costs should be $2 per unit. Such standards
are established either by historical trend analysis of the cost or by an estimation by any engineer or management
scientist. After a period, say one month, the company compares the actual cost incurred per unit, say $2.05 to the
standard cost and determines whether it has succeeded in controlling cost or not.
This comparison of actual costs with standard costs is called variance analysis and it is vital for controlling costs and
identifying ways for improving efficiency and profitability. If actual cost exceeds the standard costs, it is an
unfavorable variance. On the other hand, if actual cost is less than the standard cost, it is a favorable variance.
Variance analysis is usually conducted for
 Direct material costs (price and quantity variances);
 Direct labor costs (wage rate and efficiency variances); and
 Overhead costs.
Analysis of variance in planned and actual sales and sales margin is also vital to ensure profitability.

DIRECT MATERIAL PRICE VARIANCE

37
Direct material price variance (also called the direct material spending/rate variance) is the product of actual
quantity of direct material used and the difference between standard price and actual price per unit of direct
material. It is calculated using the following formula:
DM Price Variance = ( SP − AP ) × AQ
Where,
SP is the standard unit price of direct material AP is the
actual price per unit of direct material AQ is the actual
quantity of direct material used
Analysis
Direct material price variance is calculated to determine the efficiency of purchasing department in obtaining direct
material at low cost. A positive value of direct material price variance is favorable which means that direct material
was purchased for lesser amount than the standard price. A negative value of direct material price variance is
unfavorable because more than estimated price per unit is paid.
However, a favorable direct material price variance is not always good; it should be analyzed together with direct
material quantity variance. It is quite possible that the purchasing department may purchase low quality raw material
to generate a favorable direct material price variance. Such a favorable material price variance will be offset by an
unfavorable direct material quantity variance due to wastage of low quality direct material.
Example
DIRECT MATERIAL YIELD VARIANCE

Direct material yield variance is the product of the standard price per unit of direct material and the difference
between standard quantity of direct material allowed for actual production and the standard mix quantity of direct
material. Standard mix quantity is the total quantity of two or

38
more types of direct materials which, if mixed in the standard ratio, would have been consumed on the actual
quantity of the product produced. Direct material yield variance can be calculated only for a product made from two
or more direct materials. The formula is:
DM Yield Variance = ( SQ − SM ) × SP
Where,
SQ is the standard quantity of direct material
SM is the standard mix quantity of material used
SP is the standard price per unit of direct material used
Standard mix quantity is calculated by multiplying standard mix percentage of a given material by total actual
quantity of the material used. For example, if three materials A, B and C are mixed in ratio 5:3:2 and actual
quantity of material used is 2.5 kg then,
Standard mix quantity of material A = 2.5 × 5 / (5 + 3 + 2) = 2.5 × 50% = 1.25 kg
A positive value of DM mix variance is favorable whereas as a negative value is unfavorable.

DIRECT LABOR RATE VARIANCE

Direct labor rate variance (also called direct labor price/spending variance or wage rate variance) is the product of
actual direct labor hours and the difference between the standard direct labor rate and actual direct labor rate. Direct
labor rate variance is similar to direct material price variance. The following formula is used to calculate direct labor
rate variance:
DL Rate Variance = ( SR − AR ) × AH

Where,
SR is the standard direct labor rate AR is
the actual direct labor rate AH are the
actual direct labor hours

Analysis

Direct labor rate variance determines the performance of human resource department in negotiating lower wage
rates with employees and labor unions. A positive value of direct labor rate variance is achieved when standard
direct labor rate exceeds actual direct labor rate. Thus positive values of direct labor rate variance are favorable and
negative values are unfavorable.
However, a positive value of direct labor rate variance may not always be good. When low skilled workers are
recruited at lower wage rate, the direct labor rate variance will be favorable however; such workers will be
inefficient and will generate a poor direct labor efficiency variance. Direct labor rate variance must be analyzed in
combination with direct labor efficiency variance.

DIRECT LABOR EFFICIENCY VARIANCE

Direct labor efficiency variance (also called direct labor quantity/usage variance) is the product of standard direct
labor rate and the difference between the standard direct labor hours allowed and actual direct labor hours used. The
basic concept of direct labor efficiency variance is similar to that of direct material quantity variance. The following
formula is used to calculate direct labor efficiency variance:
DL Efficiency Variance = ( SH − AH ) × SR
Where,
SH are the standard direct labor hours allowed
AH are the actual direct labor hours used
SR is the standard direct labor rate per hour
The standard direct labor hours allowed (SH) in the above formula is the product of standard direct labor hours
per unit and number of finished units actually produced.

39
Analysis
The purpose of calculating the direct labor efficiency variance is to measure the performance of production
department in utilizing the abilities of the workers. A positive value of direct labor efficiency variance is obtained
when the standard direct labor hours allowed exceeds the actual
direct labor hours used. Thus a positive value is favorable. Negative value of direct labor efficiency variance implies
that more direct labor hours have been used than actually needed.
It is necessary to analyze direct labor efficiency variance along with direct labor rate variance. It is quite possible
that unfavorable direct labor efficiency variance is simply the result of recruiting low skilled workers. In which case
direct labor rate variance will become favorable at the expense of direct labor efficiency.
MARGINAL COST

1. MARGINAL COST
Marginal cost is the change in the total cost when the quantity produced is incremented by one. That is, it is the cost
of producing one more unit of a good. For example, let us suppose:

Variable cost per unit = Rs 25

Fixed cost = Rs
1,00,000
Cost of 10,000 units = 25 × 10,000 = Rs 2,50,000
Total Cost of 10,000 units = Fixed Cost + Variable Cost
= 1,00,000 + 2,50,000
= Rs 3,50,000
Total cost of 10,001 units = 1,00,000 + 2,50,025
= Rs 3,50,025
Marginal Cost = 3,50,025 – 3,50,000
= Rs 25

1.1 MARGINAL COSTING

Marginal Costing is ascertainment of the marginal cost which varies directly with the volume of production by
differentiating between fixed costs and variable costs and finally ascertaining its effect on profit.

1.2 ASSUMPTIONS OF MARGINAL COSTING

- Total variable cost is directly proportion to the level of activity. However, variable cost per unit remains
constant at all the levels of activities.

- Per unit selling price remains constant at all levels of activities.

- All the items produced by the organisation are sold off.

1.3 FEATURES OF MARGINAL COSTING

 Marginal costing is used to know the impact of variable cost on the volume of production or output.

 Break-even analysis is an integral and important part of marginal costing.

 Contribution of each product or department is a foundation to know the profitability of the product or
department.

40
  Addition of variable cost and profit to contribution is equal to selling price.

 Marginal costing is the base of valuation of stock of finished product and work in progress.

 Fixed cost is recovered from contribution and variable cost is charged to production.

 Costs are classified on the basis of fixed and variable costs only. Semi-fixed

 prices are also converted either as fixed cost or as variable cost.

Ascertainment of Profit under Marginal Cost

‘Contribution’ is a fund that is equal to the selling price of a product less marginal cost. Contribution may be described
as follows:

Contribution = Selling Price – Marginal Cost

Contribution = Fixed Expenses + Profit
Contribution – Fixed Expenses = Profit

1.4 ADVANTAGES OF MARGINAL COSTING

 Easy to operate and simple to understand.

 Marginal costing is useful in profit planning; it is helpful to determine profitability at different level of
production and sale.

 It is useful in decision making about fixation of selling price, export decision and make or buy decision.

 Break even analysis and P/V ratio are useful techniques of marginal costing.

 Evaluation of different departments is possible through marginal costing.

 By avoiding arbitrary allocation of fixed cost, it provides control over variable cost.

 Fixed overhead recovery rate is easy.

 Under marginal costing, valuation of inventory done at marginal cost. Therefore, it is not possible to carry
forward illogical fixed overheads from one accounting period to the next period.
 Since fixed cost is not controllable in short period, it helps to concentrate in control over variable cost.

 When an additional unit of a product is manufactured, the extra cost incurred is the variable cost of
production. Fixed costs are unaffected and no extra fixed cost is incurred when output is increased. The
marginal cost of a product is its variable cost which is usually direct labour, direct material, direct expenses
and variable production overheads. Marginal costing is used to understand the impact of variable cost on
volume of production. As a result, this technique is also known as variable costing or direct costing.

 Marginal costing is the accounting system in which variable costs are charged to products and fixed costs
are considered as periodic costs and written off in full against contribution. Under marginal costing, the
contribution is the foundation to know the profitability of a product. The contribution is equal to the selling
price of a product less marginal cost. Fixed cost is recovered from contribution. Further, opening and
closing inventory are valued at marginal (variable) cost.
 Marginal costing is the principal costing technique used in decision making. The main reason for this is, the
marginal costing approach allows management to be focused on changes resulting from the decision in
concern.

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  If we consider the same example as above, marginal cost per unit of product A would be the addition of
direct material and direct labour which is $10,000 + $20,000 = $30,000 per unit of A. As each product
sells at $50,000, marginal costing system calculates a contribution of $20,000 on each unit sold of product
A. Fixed overhead of $10 million will be treated as a periodic cost, not as a cost related to the product.

2.ABSORPTION COSTING

Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other
words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and
fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full
absorption method.

Absorption costing is often contrasted with variable costing or direct costing. Under variable or direct costing,
the fixed manufacturing overhead costs are not allocated or assigned to (not absorbed by) the products
manufactured. Variable costing is often useful for management's decision-making. However, absorption
costing is required for external financial reporting and for income tax reporting.
2.1 COMPONENTS OF ABSORPTION COSTING

The key costs assigned to products under an absorption costing system are:

 Direct materials. Those materials that are included in a finished product.

 Direct labor. The factory labor costs required to construct a product.
 Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary with production
volume. Examples are supplies and electricity for production equipment.
 Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with
production volume. Examples are rent and insurance.

2.2 ABSORPTION COSTING PROBLEMS

 Since absorption costing requires the allocation of what may be a considerable amount of overhead
costs to products, a large proportion of a product's costs may not be directly traceable to the product.
Direct costing or constraint analysis do not require the allocation of overhead to a product, and so may
be more useful than absorption costing for incremental pricing decisions where you are more concerned
with only the costs required to build the next incremental unit of product.

 It is also possible that an entity could generate extra profits simply by manufacturing more products
that it does not sell. This situation arises because absorption costing requires fixed manufacturing
overhead to be allocated to the total number of units produced - if some of those units are not
subsequently sold, then the fixed overhead costs assigned to the excess units are never charged to
expense, thereby resulting in increased profits. A manager could falsely authorize excess production
to create these extra profits, but it burdens the entity with potentially obsolete inventory, and also
requires the investment of working capital in the extra inventory.

Total cost allocated to product A using absorption costing is the addition of direct material, direct labour and fixed
overhead cost which is $10,000 + $20,000 + $10,000 = $40,000 per unit of A. As each product sells at $50,000,
absorption costing system calculates a profit of $10,000 on each unit sold of product A.

2.3 DIFFERENCE BETWEEN MARGINAL COSTING AND ABSORPTION COSTING

The main difference between absorption costing and marginal costing lies in how the two techniques treat fixed
production overheads. Under marginal costing, fixed manufacturing overhead costs are not allocated to
products. This is contrasted with absorption costing, where fixed manufacturing overheads are absorbed by
products. Absorption costing is a procedure of tracing both variable costs and fixed costs of production to the
product whereas marginal costing traces only variable costs of production to the product while fixed costs of
production are considered periodic expenses.

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 λ Definition

 Absorption costing is a method of costing a product in which all fixed and variable production costs are
apportioned to products.
 Marginal costing is an accounting system in which variable costs are charged to products and fixed
costs are considered as periodic costs.

λ Inventory Valuation
λ Absorption Costing values inventory at full production cost. Fixed cost relating to closing stock is carried
forward to the next year. Similarly, fixed cost relating to an opening stock is charged to the current year
instead of the previous year. Thus, under absorption costing, all fixed cost is not charged against revenue of
the year in which they are incurred.
λ Marginal Costing values inventory at a total variable production cost. Therefore, there is no chance of
carrying forward unreasonable fixed overheads from one accounting period to the next. However, under
marginal costing, the value of inventory is understated.
λ Effect on Profit

 If inventory levels increase, absorption costing gives the higher profit.This is because fixed overheads
held in closing inventory are carried forward to the next accounting period instead of being written off
in the current accounting period.
 If inventory levels decrease, marginal costing gives the higher profit.This is because the fixed overhead
brought forward in opening inventory is released, thereby increasing the cost of sales and reducing profits.
 Treatment of Fixed Cost – Outcome

 Absorption Costing includes fixed production overheads in inventory values. However, fixed overheads
cannot be absorbed exactly due to difficulties in forecasting costs and volume of output. Therefore, there is
the possibility that overheads could be over or under absorbed. Overhead is over-absorbed when the
amount allocated to a product is higher than the actual amount and it is under absorbed when the amount
allocated to a product is lower than the actual amount.
 In Marginal Costing, fixed production overheads are not shared out among units of production. Actual
fixed overhead incurred is charged against contribution as a periodic cost.

 Usefulness of the Technique

 Absorption Costing is more complex to operate and it does not provide any useful information for
decision making like marginal costing. Cost data produced under absorption costing is not very useful for
decision making because product cost includes fixed overhead obscuring cost-volume-profit relationship.
However, absorption costing is required for external financial reporting and income tax reporting.
 Marginal Costing does not allocate fixed manufacturing overheads to a product. As a result, marginal
costing could be more useful for incremental pricing decisions where a company is more concerned about
additional cost required to build the next unit. Identification of variable costs and contribution enables
management to use cost information more easily for decision making.

(2) Presentation in Financial Statements

 Absorption Costing is acceptable under IAS 2, Inventories. Thus, absorption costing is required for
external financial reporting and income tax reporting.
 Marginal Costing is often useful for management’s decision making. Exclusion of fixed cost from
inventory affects profit. Therefore, true and fair view of financial statements may not be clearly transparent
under marginal costing

3. DIRECT COST
A direct cost is a price that can be completely attributed to the production of specific goods or services. Some costs,
such as depreciation or administrative expenses, are more difficult to assign to a specific product and therefore are
considered to be indirect costs. A direct cost can be considered a variable cost if it is inconsistent and changes
amounts often.

Direct costs are one of two general branches of product costs in accounting for manufactured goods. The other
branch, which contains all non-traceable expenses, is indirect costs. Examples of direct costs include

43
manufacturing supplies and commissions. Rent expense may only be a direct cost if only one cost object relates to
the facility being rented.
Because direct costs can be specifically traced to a product, direct costs to not need to be allocated to a product,
department or other cost object. Direct costs may be related to labor, materials, fuel or power consumption.
Direct costs usually benefit only one cost object. Items that are not direct costs are pooled and allocated based
on cost drivers.

4. DIFFERENTIAL COSTING

Differential costs are the increase or decrease in total costs that result from producing additional or fewer units or
from the adoption of an alternative course of action.

The alternative course of action may arise due to change in sales volume, alternative method of production,
change in product/sales mix, make or buy, refuse or accept decisions, addition of a new product, exploring a new
market, decision to drop a product line, etc.

Differential cost may be referred to as either incremental cost or decremental cost. When there is an increase in the
cost due to increase in the level of production, it is called incremental cost, and when there is decrease in the cost
due to decrease in the level of production, it is called decremental cost. A few definitions of differential cost are
given below.

According to the Institute of Cost and Management Accountant, London, differential cost may be defined as “the
increase or decrease in total cost or the change in specific elements of cost that result from any variation in
operations”.

For example, difference in costs may arise because of replacement of labour by machinery and difference in costs of
two alternative courses of action will be the differential cost.

It may be remembered that differential cost may be increase or decrease in costs. Suppose, present cost is Rs.2,
50,000 when the work is done by labour and the expected cost Rs.2, 25,000 when the work is done by machinery.

In this case, differential cost will be decrease in costs Rs.25,000 (i.e., Rs.2,50,000 – Rs.2,25,000) and the decision of
replacement of labour by machinery should be implemented by the firm because differential cost of Rs.25,000
(decrease in cost) will increase the profits of the firm by Rs.25,000.

If change in cost occurs due to change in level of activity, differential cost is referred to as incremental cost in case
of increase in output and decremental cost in case of decrease in output. However, in practice, no distinction is made
between differential cost and incremental or decremental cost and two terms are used to mean the same thing.
5. CVP ANALYSIS

CVP analysis is a method of cost accounting that is concerned with the impact varying levels of sales and product
costs will have on operating profit. CVP analysis is only reliable if costs are fixed within a specified production
level. All units produced are assumed to be sold and all costs must be variable or fixed in a CVP analysis. Another
assumption is all changes in expenses occur because of changes in activity level. Semi-variable expenses must be
split between expense classifications using the high-low method, scatter plot or statistical regression.

In analyzing CVP, a powerful function is to calculate the breakeven point in units for the firm. You can calculate
the breakeven point in dollars by multiplying the sales price for your product by the breakeven point in units.

Breakeven point in units is the number of units the firm has to produce and sell in order to make a profit of zero. In
other words, it is the number of units where total revenue is equal to total expenses.

If operating income equals zero, then the breakeven point in units has been reached. If the operating income is
positive, the business firm makes a profit. If the operating income is negative, the firm takes a loss.

44
If you are observant, you can see that the variables in this equation resemble the variables you have already used in
the cost-volume-profit equation.

One of the focuses of CVP analysis is breakeven analysis. Specifically, CVP analysis helps managers of firms
analyze what it will take in sales for their firm to break even. There are many issues involved; specifically, how
many units do they have to sell to break even, the impact of a change in fixed costs on the breakeven point, and the
impact of an increase in price on firm profit. CVP analysis shows how revenues, expenses, and profits change as
sales volume changes.

6. BREAK-EVEN ANALYSIS

The purpose of the break-even analysis formula is to calculate the amount of sales that equates revenues to expenses
and the amount of excess revenues, also known as profits, after
the fixed and variable costs are met. There are many different ways to use this concept. Let’s take a look at a
few of them as well as an example of how to calculate break-even point.
Formula

The break-even point formula is calculated by dividing the total fixed costs of production by the price per unit less
the variable costs to produce the product.

Since the price per unit minus the variable costs of product is the definition of the contribution margin per unit,
you can simply rephrase the equation by dividing the fixed costs by the contribution margin.

This computes the total number of units that must be sold in order for the company to generate enough revenues to
cover all of its expenses. Now we can find out the Break Even point of sales by multiplying the BEP in units by
selling price in units.

6.1 ASSUMPTIONS OF BREAK-EVEN ANALYSIS

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(v) The fixed costs remain constant over the volume under consideration.

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(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

6.2 PROFIT-VOLUME RATIO

The Profit/volume ratio, which is also called the ‘contribution ratio’ or ‘marginal ratio’, expresses the relation
of contribution to sales and can be expressed as under:

P/V Ratio = Contribution/Sales

Since Contribution = Sales – Variable Cost = Fixed Cost + Profit, P/V ratio can also be expressed as:

P/V Ratio = Sales – Variable cost/Sales i.e. S – V/S or, P/V

Ratio = Fixed Cost + Profit/Sales i.e. F + P/S
or, P/V Ratio = Change in profit or Contribution/Change in Sales

This ratio can also be shown in the form of percentage by multiplying by 100. Thus, if selling price of a product is
Rs. 20 and variable cost is Rs. 15 per unit, then

P/V Ratio = 20 – 15/20 × 100 = 5/20 × 100 = 25%

The P/V ratio, which establishes the relationship between contribution and sales, is of vital importance for studying
the profitability of operations of a business. It reveals the effect on profit of changes in the volume.

In the above example, for every Rs. 100 sales, Contribution of Rs. 25 is made towards meeting the fixed expenses
and then the profit comparison for P/V ratios can be made to find out which product, department or process is more
profitable. Higher the P/V ratio, more will be the profit and lower the P/V ratio, lesser will be the profit. Thus, every
management aims at increasing the P/V ratio.

The ratio can be increased by increasing the contribution. This can be done by:
(i) Increasing the selling price per unit

(ii) Reducing the variable or marginal cost.

(iii) Changing the sales mixture and selling more profitable products for which the P/V ratio is higher.
The concept of P/V ratio is also useful to calculate the break-even point, the profit at a given volume of sales, the
sales volume required to earn a given (or desired) profit and the volume of
sales required to maintain the present profits if the selling price is reduced by a specified percentage.

The formula for the sales volumes required to earn a given profit is:
P/V Ratio = Contribution/Sales

or, P/V Ratio = Fixed Cost + Profit/Sales

or, Sales = Fixed Cost + Profit/P/V ratio = F + P/P-V Ratio

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6.3 MARGIN OF SAFETY
Excess of sale at BEP is known as margin of safety. Therefore,

Margin of safety = Actual Sales − Sales at BEP

Margin of safety may be calculated with the help of the following formula:

Margin of Safety = Profit / Profit-Volume Ratio

6.4 LIMITING (KEY) FACTOR

In management accounting, limiting factors refer to the constraints in availability of production resources (e.g.
shortages in labor, machine hours or materials) that prevent a business from maximizing its sales.
6.5 ANGLE OF INCIDENCE

Angle of incidence is the angle between the total cost line and the total sales line. If the angle is large, the firm is
said to make profits at a high rate and vice-versa.

6.6 BREAK- EVEN CHART

Break-Even charts are being used in recent years by the managerial economists, company executives and
government agencies in order to find out the break-even point. In the break-even charts, the concepts like total
fixed cost, total variable cost, and the total cost and total revenue are shown separately. The break even chart shows
the extent of profit or loss to the firm at different levels of activity. The following Fig. 1 illustrates the typical
break-even chart;

In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis. Total revenue
(TR) curve is shown as linear, as it is assumed that the price is constant, irrespective of the output. This
assumption is appropriate only if the firm is operating under perfectly competitive conditions. Linearity of the
total cost (TC) curve results from the assumption of constant variable cost.

It should also be noted that the TR curve is drawn as a straight line through the origin (i.e., every unit of the output
contributes a constant amount to total revenue), while the TC curve is a straight line originating from the vertical
axis because total cost comprises constant / fixed cost plus variable cost which rise linearly. In the figure, В is the
47
break-even point at OQ level of output.

The corresponding chart plotted as production against amount appears as follows:

6.7 LIMITATIONS OF BREAK- EVEN ANALYSIS

1. In the break-even analysis, we keep everything constant. The selling price is assumed to be constant and the
cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with the help of past
functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small range of output.
It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological change, improvement in
the art of management, etc., which have been overlooked in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer from various
limitations of such data as neglect of imputed costs, arbitrary depreciation estimates and inappropriate allocation of
overheads. It can be sound and useful only if the firm in question maintains a good accounting system.
6. Selling costs are specially difficult to handle break-even analysis. This is because changes in selling costs are a
cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate income tax.

8. It usually assumes that the price of the output is given. In other words, it assumes a horizontal demand curve
that is realistic under the conditions of perfect competition.

9. Matching cost with output imposes another limitation on break-even analysis. Cost in a particular period
need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a breakeven point
is considered an approximation rather than a reality.

6.8 ADVANTAGES OF BREAK-EVEN ANALYSIS

1. Provides detailed and understandable information:

The break-even chart visualises the information clearly. The different elements of cost- direct materials,direct
labour,overheads-can be presented through an analytical break-even chart.

2. Profitability can be known:

Besides the level of no profit, no loss, the problem of managerial decision making regarding temporary or permanent
shut down of business or continuation at a loss can be solved by break even analysis.

3. Effect of changes of cost and sales prices can be demonstrated:

The effect of changes of fixed costs and variable costs at different levels of production on profits can be
demonstrated by the graph. The relatiinship of cost,volume and profit at different levels if activity and varying
selling prices is shown through the chart.

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4. Cost control:

It is a managerial tool for control and reduction of costs,elimination of wastage and achieving better efficiency. It
shows the relative importance of the fixed costs in the total cost of the product and if they are high, they can be
contolled.
5. Economy and efficiency can be effected:

The capacity can be utilised to the fullest possible extent and he economies of scale and capacity utilisation can be
affected. The efficiency of output is indicated by the angle of incidence formed at the intersection of the variable
cost line and sales line.

6. Forecasting and planning possible:

Break-even analysis is very helpful in forecasting,long term planning,growth and stability.

DECISIONS INVOLVING ALTERNATIVE CHOICES

1. CONCEPT OF RELEVANT COSTS

1.1 RELEVANT COSTS

In management accounting relevant cost are those costs which are important or relevant for the future business
plans. Relevant cost are often those cost which will be incurred if company decides to do something, in other words
all historical cost are not relevant cost because they have been already incurred and therefore a company will look
into future cost rather than historical cost to take any decision for future business projects

So for example if a company is planning to increase the production of its products it would want to see only relevant
cost associated with such decision. In this case if the company already has machinery needed to produce that good, it
will not look into the cost associated with that of machinery. Company will rather look into the cost associated with
raw material and labor needed to produce such goods and incremental benefits associated with such decision.

Relevant cost can be of significance importance when company has many alternative choices or projects and it is
not sure which project is beneficial than a detailed analysis of relevant cost can help the company in choosing that
project which will give maximum return to the company.

1.2 TYPES OF RELEVANT COSTS

The following are relevant Costs:

Differential cost: A differential cost is the difference in cost items under two or more decision alternatives
distinctively two different projects or situations. Where same thing with the same amount appears in all alternatives,
it is irrelevant. Differential costs must be compared to differential revenues.
Incremental or marginal cost: Relevant costing is an incremental investigation which indicates that it considers
only relevant costs that is costs that vary between alternatives and ignores sunk costs that is costs which have been
incurred, which cannot be changed and therefore are inappropriate to the business situation. Incremental or marginal
cost is a cost linked with producing an additional unit.
Incremental cost must be compared with incremental revenues to take decision.

Opportunity cost: It is cost of opportunity foregone. Whenever an organization decides to go for a particular
project, it should not overlook opportunities for other projects. It should consider what alternative opportunities are
there and which the best of these alternative opportunities is.
Irrelevant costs: The reverse of a relevant cost is a sunk cost. A sunk cost is an expense that has already been
made, and so will not change on a go-forward basis. Sunk costs are past costs.
These cannot be changed with any future decision. Similarly, a cost which is identical in all decisions is
immaterial.

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 Types of Relevant Costs Types of Non-Relevant Costs

Future Cash Flows Sunk Cost

Cash expense that will be incurred in the future Sunk cost is expenditure which has already been
as a result of a decision is a relevant cost. incurred in the past. Sunk cost is irrelevant because it
does not affect the future cash flows of a business.

Avoidable Costs Committed Costs

Only those costs are relevant to a decision that can be Future costs that cannot be avoided are not
avoided if the decision is not implemented. relevant because they will be incurred
irrespective of the business decision bieng
considered.

Opportunity Costs Non-Cash Expenses

Cash inflow that will be sacrificed as a result of a Non-cash expenses such as depreciation are not
particular management decision is a relevant cost. relevant because they do not affect the cash flows of a
business.

Incremental Cost General Overheads

Where different alternatives are being considered, General and administrative overheads which are
relevant cost is the incremental or differential cost not affected by the decisions under consideration
between the various alternatives being considered. should be ignored.

1.3 ADVANTAGES AND LIMITATION

While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form it as
the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it should charge a
price that provides a sufficient profit margin above its total cost and not just the relevant cost.
Examples of application of relevant costing include:
 Competitive pricing decisions
 Make or buy decisions
 Further processing decisions

For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions, relevant
costing is not appropriate because most costs which may seem non-relevant in the short term become avoidable and
incremental when considered in the long term. However, even long term financial decisions such as investment
appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.

2. DECISION MAKING

Decision making is a daily activity for any human being. There is no exception about that. When it comes to
business organizations, decision making is a habit and a process as well. Effective and successful decisions make
profit to the company and unsuccessful ones make losses. Therefore, corporate decision making process is the most
critical process in any organization.

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In the decision making process, we choose one course of action from a few possible alternatives. In the process of
decision making, we may use many tools, techniques and perceptions.

Usually, decision making is hard. Majority of corporate decisions involve some level of dissatisfaction or conflict
with another party.

Let's have a look at the decision making process in detail.

2.1 STEPS IN DECISION MAKING

The following are the seven key steps of the decision making process.

.
1. Identify a problem or opportunity

 The first step is to recognise a problem or to see opportunities that may be worthwhile.
 Will it really make a difference to our customers?
 How worthwhile will it be to solve this problem or realise this opportunity?

2. Gather information
What is relevant and what is not relevant to the decision?
What do you need to know before you can make a decision, or that will help you make the right one?
Who knows, who can help, who has the power and influence to make this happen (or to stop
it)?

3. Analyze the situation

 What alternative courses of action may be available to you?
 What different interpretations of the data may be possible?

4. Develop options
 Generate several possible options.
 Be creative and positive.
 Ask “what if” questions.
 How would you like your situation to be?

5.Evaluate alternatives
 What criteria should you use to evaluate?
 Evaluate for feasibility, acceptability and desirability.
 Which alternative will best achieve your objectives?

6.Select a preferred alternative

 Explore the provisional preferred alternative for future possible adverse consequences.
 What problems might it create?
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  What are the risks of making this decision?

7. Act on the decision

 Put a plan in place to implement the decision.
 Have you allocated resources to implement?
 Is the decision accepted and supported by colleagues?
 Are they committed to making the decision work?

Essential Steps in Decision Making: Evaluate and Learn

It’s useful to review how successful the decision has been, and the effectiveness of the decision making process.
Monitor these by asking:

 How will you evaluate the success of the decision?

 How can you improve on the decision making process?
 What did you do well?
 What can be improved?
 What are you now able to do that you couldn’t, before implementing the decision?

3. DECISIONS REGARDING DETERMINATION OF SALES MIX

3.1 SALES MIX

Sales mix is the proportions of different products and services that comprise the total sales of a company. The
concept is used to understand the reasons for changes in net profits, even when total sales remain approximately
the same from period to period.

In many cases, each product or service that a company provides has a different profit, so changes in sales mix
(even if sales levels remain the same) usually result in differing amounts of profit from period to period.
Thus, if a company introduces a new product that has a low profit, and which it sells aggressively, it is quite
possible that profits will decline even as total sales increase. Conversely, if a company elects to drop a low-profit
product line and instead push sales of a higher-profit product line, total profits can actually increase even as
total sales decline.

One of the best ways for a company to improve its profits in a low-growth market where increases in market share
are difficult to obtain is to use its marketing and sales activities to alter the sales mix in favor of those products
having the largest amount of profit associated with them.

Sales managers have to be aware of sales mix when they devise commission plans for the sales staff, since the
intent should be to incentivize the sales staff to sell

When adjusting the sales mix, it is of considerable importance to understand the impact on the company
constraint. Some products require more bottleneck time than others, and so ma y leave little room for the production
of additional units. high-profit items. Otherwise, a poorly-constructed commission plan could push the sales staff in
the direction of selling the wrong products, which alters the sales mix and results in lower profits.

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3.2 TYPES OF DECISIONS

3.2.1 EXPLORING NEW MARKETS

When a company has spare capacity which it is not able to utilize because of sales constraint and it receives a
bulk order at below normal selling price, such an order should be accepted. Such additional sales at below total
cost is possible only because in accepting bulk orders and export sales , price discrimination is possible. In
this way the spare plant capacity can be utilized to earn additional profit.

3.2.2 MAKE OR BUY DECISION

Make-or-Buy decision (also called the outsourcing decision) is a judgment made by management whether to
make a component internally or buy it from the market. While making the decision, both qualitative and
quantitative factors must be considered.
The quantitative factors are actually the incremental costs resulting from making or buying the component. For
example: incremental production cost per unit, purchase cost per unit, production capacity available to
manufacture the component, etc

Though quantitative considerations are important and may be decisive but make or buy decision may not be
appropriate if relevant qualitative factors are ignored. Some of the qualitative factors relating to make or buy
decision are as follows:
(1) Quality and reliability of goods to be bought as a defective component may damage the reputation and
reliability of the firm’s ability.

(2) Reliability of the supplier on timely deliveries of goods as an interruption in the delivery of a component part
may significantly affect a firm’s operations.

(3) Possibility of ceasing production in near or medium distance future.

(4) Can guarantee be obtained from the supplier about no price change in foreseeable future? A long term
contract with a reliable supplier may solve this problem.

(5) Can an alternative use be found for resources made idle by a decision to purchase from outside.

(6) How long it would take to start manufacturing the product/component again if supplier fails to deliver as
promised. Retaining and rehiring of personnel may be important considerations.
3.2.3 EQUIPMENT REPLACEMENT DECISION

In replacement analysis, the defender is an existing asset; the challenger is the best available replacement
candidate.

The current market value is the value to use in preparing a defender’s economic analysis. Sunk costs—past
costs that cannot be changed by any future investment decision— should not be considered in an economic
analysis.

Two basic approaches to analyzing replacement problems are the cash-flow approach and the opportunity-
cost approach. The cash flow approach explicitly considers the actual cash- flow consequences for each
replacement alternative as it occurs. Typically, the net proceeds from the sale of the defender are subtracted from
the purchase price of the challenger. The opportunity-cost approach views the net proceeds from the sale of the
defender as an opportunity cost of keeping the defender. That is, instead of deducting the salvage value from the
purchase cost of the challenger, we consider the salvage value an investment required in order to keep the asset.

Economic service life is the remaining useful life of a defender (or a challenger) that results in the minimum
equivalent annual cost or maximum annual equivalent revenue. We should use the respective economic service
lives of the defender and the challenger when conducting a replacement analysis.
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Ultimately, in replacement analysis, the question is not whether to replace the defender, but when to do
so. The AE method provides a marginal basis on which to make the year-by-year decision about the best time to
replace the defender. As a general decision criterion, the PWmethod provides a more direct solution to a variety
of replacement problems with either an infinite or a finite planning horizon or a technological change in a future
challenger.

The role of technological change in asset improvement should be weighed in making long-term replacement
plans: If a particular item is undergoing rapid, substantial technological improvements, it may be prudent to
shorten or delay replacement (to the extent where the loss in production does not exceed any savings from
improvements in future challengers) until a desired future model is available.

3.2.4 DISCONTINUANCE OF A PRODUCT LINE

A decision whether or not to continue an old product line or department, or to start a new one is called an add-or-
drop decision. An add-or-drop decision must be based only on relevant information.
Relevant information includes the revenues and costs which are directly related to a product line or department.
Examples of relevant information are sales revenue, direct costs, variable overhead and direct fixed overhead.
Such decision must not be based on irrelevant information such as allocated fixed overhead because allocated
fixed overhead will not be eliminated if the product line or department is dropped.

3.2.5 CHANGE VERSUS STATUS QUO

Maintenance of status quo leads a business to static conditions and makes management lethargic. The change
contemplated by management will yield better results .

The differential costs regarding – interest on capital, operating costs, fixed overheads and differential gains
regarding- contribution due to increase in sales revenue, better margin , savings in operating costs, tax benefits
are to be particularly quantified in order to arrive at the decision.

3.2.6 EXPAND OR CONTRACT

Management having ambitions to grow in size and volume may have diversification plan or an expansion plan in
mind. Expansion of capacity may involve additional fixed costs, additional marginal costs. The difference of
present sales and present costs will be compared with revised sales and revised costs. In case the profit is likely to
increase the expansion may be undertaken.

The business may think of contraction if there is a permanent tendency of customers to shift or due to other
internal reasons like managerial handicap etc. possible decrease in selling price due to increase in production is
another factor to be considered.

3.2.7 SHUT DOWN OR CONTINUE

If the project undertaken does not yield the minimum rate of return expected by the investors it will have to be
given up. The decision to shut down or continue will depend upon the cost and benefit analysis of two
alternatives.

The different costs to be considered are- setting up cost, loss of goodwill, layman compensation, packing and
storing cost of equipment etc.

The benefits to be considered are- fixed cost saving, less repair and maintenance cost, less indirect costs etc.

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