MANAGEMENT ACCOUNTING AND

FINANCIAL ANALYSIS AND

CONTROL

M.Com
First Year
101

SAVITRIBAI PHULE PUNE UNIVERSITY

School of Open Learning
(Distance Education Program)
Authors:
M A Sahaf, Professor, The Business School, University of Kashmir, Srinagar
Units: (1.2-1.2.1, 1.3, 1.5-1.6, 2.2, 2.4, 2.6, 3.2-3.2.1, 3.2.3-3.3, 5.2-5.2.1, 6.2-6.4, 7.2-7.2.1, 7.3-7.7, 8.2-8.5)
M N Arora, Ex-Associate Professor, Department of Commerce, Hans Raj College, Delhi University
Units: (1.2.2, 1.4, 2.3, 2.5, 3.2.2, 5.2.2, 6.5, 7.2.3, 8.6)
Dr Kiran Mehta, Professor (Finance) at Chitkara Business School, Chitkara University, Chandigarh
Dr Renuka Sharma, Professor (Finance) at Chitkara Business School, Chitkara University, Chandigarh
Unit: (4)
Vikas Publishing House, (1.0-1.1, 1.7-1.11, 2.0-2.1, 2.7-2.11, 3.0-3.1, 3.4-3.8, 5.0- 5.1, 5.3-5.7, 6.0-6.1, 6.4.1, 6.6-6.9, 7.0-7.1,
7.2.2, 7.8-7.12, 8.0-8.1, 8.5.1, 8.7-8.11)
All rights reserved. No part of this publication which is material protected by this copyright notice
may be reproduced or transmitted or utilized or stored in any form or by any means now known or
hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording
or by any information storage or retrieval system, without prior written permission from the Publisher.

Information contained in this book has been published for School of Open Learning, Savitribai Phule
Pune University, Pune by VIKAS Publishing House Pvt. Ltd. and has been obtained by its Authors
from sources believed to be reliable and are correct to the best of their knowledge. However, the
Publisher and its Authors shall in no event be liable for any errors, omissions or damages arising out
of this information and specifically disclaim any implied warranties or merchantability or fitness for
any particular use.

Vikas® is the registered trademark of Vikas® Publishing House Pvt. Ltd.

VIKAS® PUBLISHING HOUSE PVT. LTD.
E-28, Sector-8, Noida - 201301 (UP)
Phone: 0120-4078900  Fax: 0120-4078999
Regd. Office: A-27, 2nd Floor, Mohan Co-operative Industrial Estate, New Delhi 1100 44
 Website: www.vikaspublishing.com  Email: [email protected]
 SYLLABI-BOOK MAPPING TABLE
Management Accounting and Financial Analysis and Control
Syllabi Mapping in Book

Unit 1: Accounting for Emerging Sectors Unit 1: Accounting for

1. Limitations of Conventional Financial Accounting Emerging Sectors
2. Emergence of Management Accounting and Cost Accounting (Pages 1-31)
3. Advantages of Management Accounting and Cost Accounting
4. Distinction between Management Accounting and Cost Accounting
5. Management Accounting as a Decision Making Tool

Unit 2: Application of Management Accounting Techniques Unit 2: Application of

1. Marginal Costing and Cost-Volume Profit (CVP) Analysis, Key Factors Management Accounting
2. Decision Making through Managerial Cost Accounting (Make or Buy Decision) Techniques
Purchasing and Leasing (Pages 33-69)
3. Techniques and Managerial Cost Accounting
4. Standardization of Accounting System
a. Fixed and Variable Cost Analysis
b. Application of Fixed and Variable Cost Analysis Technique in Decision Making
Process

Unit 3: Budgets as a tool for Decision Making Unit 3: Budgets as a Tool for
1. Budget Manual Decision Making
2. Budget Committee and Budgetary Control (Pages 71-97)
3. Preparation of Budget
4. Master Budget
5. Purchase and Sales Budgets
6. Fixed and Flexible Budget
7. Cash Budget

Unit 4: Working Capital Management Unit 4: Working Capital

1. Concept and definition of working capital, Management
2. Determination of Working capital, Assessment of Working (Pages 99-134)
3. Capital needs - Study of components of working capital such as cash management
4. Accounts receivable management and inventory management.

Unit 5: Fundamentals of Financial Analysis and Control Unit 5: Fundamentals of Financial

Meaning of Financial Analysis and Control, Importance, Advantages Limitations Uses Analysis and Control
(Pages 135-142)

Unit 6: Comparative and Common Size Statement Unit 6: Comparative and

Meaning, Importance, Advantages Limitations Uses, Problems on Intra & Inter Common Size Statement
Company Comparison (Pages 143-159)

Unit 7: Cash Flow and Fund Flow Statements Unit 7: Cash Flow and Fund Flow
Meaning, Importance, Advantages Limitations, Uses, Problems on Cash Flow and Statements
Fund Flow Statements (Pages 161-212)

Unit 8: Ratio Analysis and Trend Analysis Unit 8: Ratio Analysis and
Meaning, Importance, Advantages Limitations Uses, Problems on Ratio Analysis and Trend Analysis
Trend Analysis (Pages 213-253)
 CONTENTS
INTRODUCTION

UNIT 1 ACCOUNTING FOR EMERGING SECTORS 1-31

1.0 Introduction
1.1 Objectives
1.2 Limitations of Conventional Financial Accounting
1.2.1 Financial Accounting: Objectives and Limitations
1.2.2 Emergence of Management Accounting
1.3 Advantages and Limitations of Management Accounting
1.4 Advantages and Limitations of Cost Accounting
1.5 Distinction between Financial, Management and Cost Accounting
1.5.1 Difference between Financial Accounting and Management Accounting
1.5.2 Distinction Between Cost Accounting and Management Accounting
1.6 Management Accounting as a Decision-Making Tool
1.6.1 Changing Role and Tasks of Management Accountants
1.6.2 Adaptation In Management Accounting As per Changing Business Environment
1.7 Answers to Check Your Progress Questions
1.8 Summary
1.9 Key Words
1.10 Self Assessment Questions and Exercises
1.11 Further Readings

UNIT 2 APPLICATION OF MANAGEMENT ACCOUNTING TECHNIQUES 33-69

2.0 Introduction
2.1 Objectives
2.2 Marginal Costing
2.2.1 Advantages and Limitations
2.2.2 Absorption Cost
2.3 Cost-Volume Profit (CVP) Analysis and Break-Even Analysis
2.3.1 Profit-Volume Ratio (P/V Ratio)
2.3.2 Margin of Safety (M/S)
2.3.3 Limiting or Key Factor
2.4 Decision Making through Managerial Cost Accounting: Make or Buy Decisions, Purchasing and
Leasing, etc.
2.5 Techniques and Managerial Cost Accounting
2.6 Standardization of Accounting System
2.6.1 Fixed and Variable Cost Analysis
2.6.2 Application of Fixed and Variable Cost Analysis Techniques
2.7 Answers to Check Your Progress Questions
2.8 Summary
2.9 Key Words
2.10 Self Assessment Questions and Exercises
2.11 Further Readings
UNIT 3 BUDGETS AS A TOOL FOR DECISION MAKING 71-97
3.0 Introduction
3.1 Objectives
3.2 Concept and Preparation of Budgets
3.2.1 Master Budget
3.2.2 Purchase Budget
3.2.3 Sales Budget
3.2.4 Fixed and Flexible Budget
3.2.5 Cash Budget
3.3 Budgetary Control
3.3.1 Budget Committee
3.3.2 Budgetary Period
3.3.3 Budget Manual
3.3.4 Budget Centre
3.3.5 Principle Budget Factor
3.4 Answers to Check Your Progress Questions
3.5 Summary
3.6 Key Words
3.7 Self Assessment Questions and Exercises
3.8 Further Readings

UNIT 4 WORKING CAPITAL MANAGEMENT 99-134

4.0 Introduction
4.1 Objectives
4.2 Concept and Definition of Working Capital
4.3 Determination of Working Capital
4.4 Assessment of Working Capital Needs
4.5 Study of Components of Working Capital
4.5.1 Cash Management
4.5.2 Accounts Receivable Management
4.5.3 Inventory Management
4.6 Answers to Check Your Progress Questions
4.7 Summary
4.8 Key Words
4.9 Self Assessment Questions and Exercises
4.10 Further Readings

UNIT 5 FUNDAMENTALS OF FINANCIAL ANALYSIS AND CONTROL 135-142

5.0 Introduction
5.1 Objectives
5.2 Meaning and Steps Involved in Financial Analysis and Control
5.2.1 Uses and Types
5.2.2 Importance, Advantages and Limitations
5.3 Answers to Check Your Progress Questions
5.4 Summary
5.5 Key Words
5.6 Self Assessment Questions and Exercises
5.7 Further Readings
UNIT 6 COMPARATIVE AND COMMON SIZE STATEMENT 143-159
6.0 Introduction
6.1 Objectives
6.2 Comparative Statements: Meaning
6.3 Common Size Statements: Meaning
6.4 Comparative Statement Versus Common Size Statement
6.4.1 Importance, Advantages, Limitations and Uses
6.5 Problems on Intra and Inter Company Comparison
6.6 Answers to Check Your Progress Questions
6.7 Summary
6.8 Key Words
6.9 Self Assessment Questions and Exercises
6.10 Further Readings

UNIT 7 CASH FLOW AND FUND FLOW STATEMENTS 161-212

7.0 Introduction
7.1 Objectives
7.2 Cash Flow Statements: Meaning
7.2.1 Advantages
7.2.2 Limitations
7.2.3 Importance and Uses
7.3 Preparation of Cash Flow Statements
7.4 Problems on Cash Flow Statements
7.5 Fund Flow Statements: Meaning
7.5.1 Uses and Advantages
7.5.2 Limitations
7.5.3 Importance
7.6 Preparation of Funds Flow Statement
7.7 Problems on Fund Flow Statements
7.8 Answers to Check Your Progress Questions
7.9 Summary
7.10 Key Words
7.11 Self Assessment Questions and Exercises
7.12 Further Readings

UNIT 8 RATIO ANALYSIS AND TREND ANALYSIS 213-253

8.0 Introduction
8.1 Objectives
8.2 Ratio Analysis: Meaning
8.2.1 Importance and Uses
8.2.2 Advantages and Limitations
8.3 Types and Classification of Ratios
8.4 Problems on Ratio Analysis
 8.5 Trend Analysis: Meaning
8.5.1 Importance, Advantages, Limitations and Uses
8.6 Problems on Trend Analysis
8.7 Answers to Check Your Progress Questions
8.8 Summary
8.9 Key Words
8.10 Self Assessment Questions and Exercises
8.11 Further Readings
 INTRODUCTION

Accounting is a significant decision making organizational tool. Proper identification and treatment of financial
aspects are key to managing company's transactions in an efficient manner. This will further help the company
recognize problematic areas will need improvement.
The accounting activities which have a significant bearing and acts like a driver for management
activities is called management accounting. Similarly financial analysis and control is concerned with efficient
utilization of financial information to make sound decisions regarding the estimating, planning and sourcing
of finances for the company.
This book, Management Accounting and Financial Analysis and Control, is written with the
distance learning student in mind. It is presented in a user-friendly format using a clear, lucid language. Each
unit contains an Introduction and a list of Objectives to prepare the student for what to expect in the text.
At the end of each unit are a Summary and a list of Key Words, to aid in recollection of concepts learnt. All
units contain Self Assessment Questions and Exercises, and strategically placed Check Your Progress
questions so the student can keep track of what has been discussed.
 Accounting for

UNIT 1 ACCOUNTING FOR Emerging Sectors

EMERGING SECTORS
NOTES
Structure
1.0 Introduction
1.1 Objectives
1.2 Limitations of Conventional Financial Accounting
1.2.1 Financial Accounting: Objectives and Limitations
1.2.2 Emergence of Management Accounting
1.3 Advantages and Limitations of Management Accounting
1.4 Advantages and Limitations of Cost Accounting
1.5 Distinction between Financial, Management and Cost Accounting
1.5.1 Difference between Financial Accounting and Management Accounting
1.5.2 Distinction Between Cost Accounting and Management Accounting
1.6 Management Accounting as a Decision-Making Tool
1.6.1 Changing Role and Tasks of Management Accountants
1.6.2 Adaptation In Management Accounting As per Changing Business
Environment
1.7 Answers to Check Your Progress Questions
1.8 Summary
1.9 Key Words
1.10 Self Assessment Questions and Exercises
1.11 Further Readings

1.0 INTRODUCTION

Accounting plays a crucial role in the functioning of an organization. It not only helps in
enhancing decision making capabilities, but also facilitates the efficient utilization of
resources. Organizations across the globe operate in a highly dynamic and complex
business environment, in which managers need relevant and current information to aid
them in decision making. Accounting must respond to the changing needs of the decision-
makers in order to justify its relevance in contemporary business. In fact, the significance
of financial information has always been recognized, but in the present business scenario,
such information has become a resource parallel in importance to factors of production.
Consequently, accounting information is becoming increasingly critical to the continuing
success of an organization. With the growing importance of information as a resource,
organizations have felt the need for a system that is capable of managing this resource
efficiently. This is, perhaps, the basic reason for business students to study the anatomy
and operation of the accounting system, which provides information to managers for
decision making.
Modern accounting as a dynamic and growing field is emerging as a strategic
weapon that is helping to shape the direction and growth of organizations in the changing
business environment. However, to explore and utilize the financial information generated
Self-Instructional
by the accounting system of an organization for competitive advantage, managers must Material 1
Accounting for have a fair knowledge of the tools and techniques that they can use for analysing and
Emerging Sectors
interpreting the available information. Both the prerequisites of effective decision
making—financial information and analytical techniques—are covered under
management accounting, which involves the study of accounting information and
NOTES techniques that managers use in analysing such information.

1.1 OBJECTIVES

After going through this unit, you will be able to:

 Discuss the limitations and objectives of conventional financial accounting
 Describe the emergence of management and cost accounting
 Explain the nature, scope and characteristics of management accounting
 Assess the advantages and limitations of management and cost accounting
 Differentiate between financial, cost and management accounting
 Analyse management accounting as a decision making tool

1.2 LIMITATIONS OF CONVENTIONAL FINANCIAL

ACCOUNTING

Accounting can be divided into three broad categories—financial, management and

cost accounting.
1.2.1 Financial Accounting: Objectives and Limitations
Financial accounting as a growing discipline helps to regulate a system that is capable
of recording, classifying and summarizing the mercantile transactions occurring in an
organization.
The American Accounting Association has defined financial accounting as ‘the
process of identifying, measuring, and communicating economic information to
permit informed judgements and decisions by users of the information.’
According to the American Institute of Certified Public Accountants, ‘accounting is
the art of recording, classifying and summarizing in a significant manner and in
terms of money, transactions and events, which are, in part at least, of a financial
character and interpreting the results thereof.’

The analysis of the above definitions brings to light the following facts about the
nature and task of financial accounting:
• It is the art of recording and classifying business transactions and events in a
systematic manner.
• Transactions are recorded in monetary terms.
• It involves summarizing, analysing and interpreting the results of accounting
information, as well as communicating and explaining the information to
Self-Instructional decision makers.
2 Material
 The study of the above facts leaves one in no doubt that the routine tasks of Accounting for
Emerging Sectors
classifying transactions, checking that they have been properly processed, and reconcile
the books with external evidence is usually the responsibility of financial accountants.
The job of financial accounting is to prepare financial statements i.e., profit and loss
account and balance sheet at the end of financial period. Financial accounting is oriented NOTES
more towards inter-firm resources allocations and, thus, it meets the needs of individuals
and groups outside the organization such as prospective investors, creditors, financiers,
government regulatory agencies and the general public.
Objectives of financial accounting
A modern financial accounting system has to accomplish the following objectives:
• To identify financial events and transactions that occur in an organization;
• To measure the value of these occurrences in terms of money;
• To organize the accumulated financial data into meaningful information; and
• To analyse, interpret, and communicate that information to a broad range of
persons and groups, both within and outside the organization.
Limitations of financial accounting
Financial accounting suffers from many serious drawbacks. A few of them are mentioned
below:
• It is historical in nature as it deals with mercantile transactions that occur in an
organization. As a consequence thereof, it fails to throw light on the future of the
business. It can inform the management about the present position of the business
but cannot throw light on its future position.
• It depicts only a partial picture of the business by considering only those business
events that can be expressed in monetary terms. Any event that is not directly
measurable in terms of money, howsoever important it may be, does not fall
within the scope of financial accounting. The analysis of qualitative events such
as efficient management, strikes, lock-outs, quality products, goodwill, etc., are
not considered under financial accounting. But such factors do play a crucial
role in the performance and growth of the organization.
• Changes in the economic conditions of the country have a direct impact on the
business position of an organization. The conditions of inflation or deflation
significantly change the value of the business. Such a change is not reflected in
the financial accounts, as the set of accounts of the business has to be maintained
on the basis of cost concept. As a result the balance sheet of an organization
fails to give a true and fair view of the business.
• To ensure proper cost control, management requires cost details in terms of
unit, department or cost centre, which financial accounting fails to give, as it
records and maintains information for the overall operations of the business.
• Financial accounting fails to evaluate the plans and programmes of the business,
as it does not have any arrangement within its system that can indicate whether Self-Instructional
Material 3
Accounting for the operations of the business are being carried out in conformity with the
Emerging Sectors
schedules of the business or otherwise.
• A serious limitation of financial accounting is that it needs accounting knowledge
to understand financial statements. Therefore, such statements do not have any
NOTES
significance for stakeholders of an organization who do not have such knowledge.
• Financial accounting does not indicate the cost behaviour, therefore, cost control
in its right perspective cannot be adhered to by engaging financial accounting.
• Inter-firm comparison and comparative study of two periods is not possible
under the financial accounting system, as the required cost information cannot
be obtained under this accounting system.
1.2.2 Emergence of Management Accounting
Management accounting is a segment of accounting that deals specifically with the
analysis and reporting of information to management about the operations of the
organization with an objective to facilitate decision making. On the one hand,
management accounting aims to provide adequate financial information to managers
for decision making and on the other, it is oriented towards managerial control.
Management frequently requires timely financial information concerning different aspects
of the organization, ranging from special purpose report of a specific department’s
operating performance to the preparation of annual budgets and forecasts, which
encompass the entire business.
The term ‘management accounting’ was first formally mentioned in 1950 in a
report entitled ‘Management Accounting’, published by the Anglo-American Council
of Productivity Management Accounting Team after its visit to the United States in the
same year. The team in its report defined management accounting as ‘the presentation
of accounting information in such a way as to assist management in the creation
of policy and in the day-to-day operation of an undertaking.
Thereafter, a number of attempts have been made by various professional bodies
and associations to define management accounting in its right perspective. As a
consequence thereof, numerous definitions on management accounting are added to
the literature year after year.
Popular Definitions of Management Accounting
The Institute of Chartered Accountants in England and Wales (ICAEW): Any
form of accounting which enables a business to be conducted more efficiently can be
regarded as management accounting.
American Accounting Association: Management accounting is the application of
appropriate techniques and concepts in processing historical and projected economic
data of an entity to assist management in establishing plans for reasonable economic
objectives in the making of rational decisions with a view towards these objectives.
Association of Chartered Certified Accountants (ACCA), USA: Management
accounting is the application of accounting and statistical techniques to the specified
purpose of producing and interpreting information designed to assist management
Self-Instructional in its functions of promoting maximum efficiency and in envisaging, formulating and
4 Material co-ordinating their execution.
 J Batty (1966): Management accounting is the term used to describe the accounting Accounting for
methods, system and techniques which, coupled with special knowledge and ability, Emerging Sectors
assist management in its task of maximizing profits or minimizing losses.
Institute of Cost and Management Accountants (ICMA), London: Management
accounting is the application of professional knowledge and skill in the preparation NOTES
of accounting information in such a way as to assist management in the formation of
policies and in the planning and control of the operations of the undertaking.
R L Smith (1962): Management accounting is a more intimate merger of the two
older professions of management and accounting, wherein the informational needs
of the manager determine the accounting means for their satisfactions.
Brown and Howard (1966): Management accounting is concerned with the efficient
management of a business through the presentation to management of such
information as will facilitate efficient and opportune planning and control.
Robert N Anthony (1965): Management accounting is concerned with accounting
information which is useful to management.
Broad and Carmichael (1957): The term ‘management accounting’ covers all those
services by which the accounting department can assist top management and other
departments in the formation of policy, the control of its execution and appreciation
of its effectiveness.
Shillinglow (1982): Accounting which serves management by providing information
as to the cost or profit associated with some portion of firm’s total operations, is
called management accounting.
T G Rose, (1957): Management accounting is the adaptation and analysis of
accounting information and its diagnosis and explanation in such a way as to assist
management.
R H Garrison (1982): Management accounting is concerned with providing
information to managers; that is, to those who are inside an organization and who are
charged with directing and controlling its operations.
All these definitions place emphasis on the information processing and decision
making aspects of accounting. The analysis of the definitions further reveals that the
system of management accounting is not designed to appraise and monitor the past
performance of individuals and groups but to assist managerial decisions affecting the
future. Thus, management accounting is a system for gathering, summarizing, reporting
and interpreting accounting data and other financial information primarily for the internal
needs of management. Thus, management accounting is a system capable of
generating accounting information that assists internal management in the
efficient formulation, execution and appraisal of business plans that help the
organizations to achieve their strategic objectives.
Thus, management accounting in addition to helping managers in the decision
making process, facilitates them in intra-firm resource allocations, fixation of
responsibilities and the evaluation of future policies and strategies. All this brings to
light an important fact—that management accounting has to perform two separate,
distinct functions of financial and management reporting and that the data needs for
each are often different. Few intelligent financial and economic decisions can be made
in the absence of that information reservoir. Involvement with both time dimensions,
Self-Instructional
Material 5
Accounting for past and future, places the executive near the centre of the control and decision making
Emerging Sectors
processes in any organization.
Nature and Characteristics of Management Accounting
NOTES It is clear from the above definitions that management accounting is concerned with
accounting data that is useful in decision making. The main characteristics of management
accounting are as follows:
1. Useful in decision making: The essential aim of management accounting is
to assist management in decision making and control. It is concerned with all
such information which can prove useful to management in decision making.
2. Financial and cost accounting information: Basic accounting information
useful for management accounting is derived from financial and cost accounting
records.
3. Internal use: Information provided by management accounting is exclusively
for use by management for internal use. Such information is not to be given to
parties external to the business, like shareholders, creditors and banks.
4. Purely optional: Management accounting is a purely voluntary technique and
there is no statutory obligation. Its adoption by any firm depends upon its utility
and desirability.
5. Concerned with future: As management accounting is concerned with
decision making, it is related with future because decisions are taken for future
course of action and not the past.
6. Flexibility in presentation of information: Unlike financial accounting, in
management accounting there are no prescribed formats for presentation of
information to management. The form of presentation of information is left to
the wisdom of the management accountant who decides which is the most useful
format of providing the relevant information, depending upon the utility of each
type of form and information.
Objectives and Functions of Management Accounting
The basic role of management accounting is to provide accurate and relevant information
to the internal parties of an organization for decision making. To discharge this
responsibility effectively, management accounting has to undertake collection,
processing, analysing and interpreting of data, as well as communication of the resulting
information to such internal parties who intend to use the same in their decision making
process. In fact, the said activities can be recognized as the bases to identify and
examine the functions of management accounting and accordingly the major functions
are summarized below:
 Data Collection: The first function of management accounting is to collect the
requisite data from all possible resources. Since the data was traditionally
restricted only to economic and financial items/factors, management accountants
Self-Instructional
would make use of the financial statements like profit & loss account and balance
6 Material
 sheet for the purpose. Over the past few years, the activities of management Accounting for
Emerging Sectors
accounting have crossed all traditional boundaries by considering not only
monetary items and factors in its studies but also non-monetary factors like.
Such paradigm shift in the approach of the management accounting has made
its scope much wider. To meet the growing demands of the wider scope, NOTES
management accounting is bound to utilize both internal as well as external sources
of data collection.
 Data Processing: The data so collected and stored needs to be converted
into information through processing. Data processing refers to the series of
activities consisting of compilation, classification, tabulation and summarization
that aims to make data information.
 Analysis and Interpretation: The data collected from various internal as well
as external sources does not have inherent meaning and in fact, its meaning is
generally influenced by the nature and scope of the tools and techniques used
for its analysis. Further, the data as such is not of much use for the management
but it becomes so once it is analysed and interpreted in the context of the nature
of the decisions. Thus, the process of analysis and interpretation makes the data
so significant for the success of the organization that it is being recognized as a
strategic asset for the company in a competitive market. However, the
management accountant has to choose the relevant and most appropriate
technique for proper interpretation of the data after taking into consideration
the nature of the concerned problem.
 Communication: as a crucial function of management calls for the transmission
of information to the concerned parties for use. Management accounting plays
a special role in managing the affairs of the business by providing not only the
conventional reports to the decision makers of an organizations but also in taking
necessary measures to ensure the supply of adequate information at right time
to enable the decision-makers of the organization to address the challenges of
the changing environment.
 In addition to basic functions discussed above, management accounting is also
responsible to carry out some secondary functions that are summarized below:
 Coordinating: Management accounting is often entrusted with the responsibility
to coordinate the various activities of a business. Organizations generally use
techniques such as budgeting and financial reporting for the purpose.
 Special Studies: Contemporary business is operating in a dynamic environment
where even a minor change in any of its elements can have a significant impact
on the business outcomes. Therefore, management is always interested to know
the areas of business which can contribute to the stability and profitability of the
concern. To meet this objective, management accounting carries out various
special studies such as sales analysis, economic forecasts, price spread analysis,
etc.
 Tax Administration: In the modern business organizations, tax administration
Self-Instructional
is being recognized as a significant area of study that falls within the scope of Material 7
Accounting for management accounting. Tax administration involves tasks like the submission
Emerging Sectors
of necessary documents and return to the tax authorities, including the supervision
of all matters relating to tax.

NOTES Scope of Management Accounting

Traditionally, the subject matter of management accounting mainly consisted of financial
statement analysis and costing theory. As organizations began to operate in a highly
dynamic and complex business environment, they realized that the existing subject
matter of management accounting was insufficient to meet the challenges of the changing
environment. To address the emerging challenges, management accounting enhanced
its scope by including in its ambit many frameworks, tools and techniques borrowed
from other disciplines such as economics, finance, mathematics, statistics and operations
research. The contemporary subject matter of management accounting is summarized
below:
Financial Accounting: Financial accounting is a prerequisite for any discussion on
the subject of management accounting. Financial statements as generated by financial
accounting contain enough data that is converted into information by organizations and
used in their decision making. In fact, management accounting provides only tools and
techniques for interpretation and analysis and the management accountants get the
data for the purpose mainly from financial accounting. Thus, management accounting
cannot exist without efficient financial accounting system.
Cost Accounting: Although managers generally use financial information in decision
making, they often supplement their decisions with cost information as they have realized
that any activity of an organization can be described by its cost. They make use of
various cost data in managing organizations effectively. In fact, cost accounting is
considered the backbone of management accounting as it provides the analytical tools
such as budgetary control, standard costing, marginal costing, inventory control,
operating costing, etc., which are used by management to discharge its responsibilities
efficiently.
Financial Statement: Analysis Managers frequently use information based on the
data collected from financial statements. This information can be obtained either by
selecting individual numbers from the statements or by developing certain trends and
ratios. Any attempt in this direction is referred to as financial statement analysis. The
analysis and interpretation of the data contained in financial statements can provide a
reader meaningful insights and conclusions about the organization. Over the past few
decades, numerous techniques have been developed which are useful for the proper
interpretation and analysis of financial statements.
Budgeting: Budgeting, which lies at the heart of management accounting, refers to a
systematic plan for the utilization of organizational resources. As a management tool,
budgeting aims to coordinate and integrate the efforts and activities of various
departments with the cooperation of those who seek to achieve a common goal. In
fact, the organizations exercise their operational control through the budgets prepared
Self-Instructional in advance for every major activity of the business.
8 Material
Inflation Accounting: Inflation accounting attempts to identify certain characteristics Accounting for
Emerging Sectors
of accounting that tend to distort the reporting of financial results during periods of
rapidly changing prices. It devises and implements appropriate methods to analyse
and interpret the impact of inflation on the business transactions.
NOTES
Management Reporting: Clear, informative and timely reports have always been
recognized as managerial tools in reaching decisions that not only help the organizations
to improve their performance but also make the best use of their resources. Thus, one
of the basic responsibilities of management accounting is to keep the management well
informed about the operations of the business. To discharge this responsibility efficiently,
management accounting needs to prepare quarterly, half-yearly and other interim reports
and submit the same to the management.
Quantitative Techniques: Many managers recognize that the financial and economic
data available for managerial decisions can be more useful if analysed with highly
sophisticated techniques of analysis and evaluation. Such techniques as the subject
matter of quantitative analysis allow managers to create information from their financial
database that is not, otherwise, available. In addition to the techniques like time series,
regression analysis and sampling techniques, the managers also make use of linear
programming, game theory and queuing theory for this purpose.
Tax Accounting: Since taxation plays an important role in the profitability of a
commercial organization, it is essential for a management accountant to have a complete
knowledge of business taxation. The business profit and the tax thereon are to be
ascertained as per the provision of taxation. The filing of tax returns and the payment
of tax in due time is the exclusive responsibility of the management accountant.
Internal Audit: Internal audit as a discipline of management accounting makes
arrangements for performance appraisal of the organization’s various departments.
Thus, a management accountant must possess knowledge about the fixation of
responsibilities and measurement of results.
Office Services: To discharge the responsibilities efficiently, a management accountant
has to deal with data processing, filing, copying and duplicating. His area of
responsibilities also included the evaluation and reporting about the utility of different
office procedures and machines.
Cost accountancy is an extension of the general accounting system. It is responsible
for gathering, classifying and analysing the cost data required by the management to
attain various organizational objectives. These include identifying the most efficient
methods of operating, achieving control over cost and reducing expenses. Cost
accounting helps organizations to conduct an analysis of cost data such as to enable
them not only to ascertain the total cost of any particular unit of production with
reasonable degree of accuracy but also to disclose exactly how such total cost is
constituted.
According to the Institute of Cost and Works Accountants (ICWA), London, cost
accounting is ‘the process of accounting for cost from the point at which expenditure
is incurred or committed to the establishment of its ultimate relationship with cost
centres and cost units. In its widest usage it embraces the preparation of statistical Self-Instructional
Material 9
Accounting for data, the application of cost control methods and the ascertainment of the
Emerging Sectors profitability of activities carried out or planned.’
W J Morse, (1978) defines cost accounting as ‘the processing and evaluation of
monetary and
NOTES
non-monetary data to provide information for external reporting, internal planning
and control of business operations and special analysis and decisions.’

Thus, cost accounting is the branch of accounting designed to determine

and accumulate the costs of certain activities and to report cost information to
management. It provides the means to gather the data needed to determine unit costs
and to prepare reports, schedules, statements and analyses that are relevant to
management. Cost accounting procedures and routines are used as a means of
accumulating and allocating all elements of manufacturing cost in a manner that will
produce meaningful data for the use of management.
Objectives of cost accounting
The main objectives of cost accounting are:
• To aid in the development of long-term plans by providing cost data that acts as
a basis for projecting data for planning;
• To ensure efficient cost control by communicating essential data regarding costs
at regular intervals;
• To determine cost of products or activities;
• To identify profitable areas of business; and
• To provide management with information in connection with various operational
problems.
Emergence of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are often used interchangeably. Cost
accounting is a formal system of accounting for costs in the books of account, by
means of which, costs of products and services are ascertained and controlled.
According to L C Cropper, ‘cost accounting means a specialized application of
the general principles of accounting, in order to ascertain the cost of producing
and marketing any unit of manufacture or of carrying out any particular job or
contract.’ An authoritative definition of cost accounting has been given by CIMA,
London as follows: ‘Cost accounting is the process of accounting for costs from
the point at which expenditure is incurred or committed to the establishment of
its ultimate relationship with cost centres and cost units. In its widest usage, it
embraces the preparation of statistical data, the application of cost control
methods and ascertainment of profitability of activities carried out or planned.’
Costing and Cost Accounting—Difference
Though the terms ‘costing’ and ‘cost accounting’ are interchangeably used, there is a
Self-Instructional difference between the two. Costing is simply the method of determining costs by
10 Material
using any method like arithmetic process, memorandum statements, etc. Cost Accounting for
Emerging Sectors
accounting, on the other hand, denotes the formal accounting mechanism, by means of
which costs are ascertained by recording them in the books of account. In simple
words, costing means finding out the cost of products or services by any technique or
method, while cost accounting means costing using the double entry system. NOTES

Cost Accountancy
Cost accountancy is a very wide term. It means and includes the principles, conventions,
techniques and systems which are employed in a business to plan and control the
utilization of its resources. It is defined by CIMA, London as, ‘the application of
costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control and the ascertainment of profitability. It includes
the presentation of information derived therefrom for the purposes of managerial
decision making.’
Cost accountancy is thus the science, art and practice of a cost accountant. It
is a science in the sense that it is a body of systematic knowledge, which a cost
accountant should possess for the proper discharge of his duties and responsibilities.
It is an art as it requires the ability and skill on the part of a cost accountant, in applying
the principles of cost accountancy to various managerial problems, like price fixation,
cost control, etc. Practice refers to constant efforts on the part of cost accountant, in
the field of cost accountancy. Theoretical knowledge alone would not enable a cost
accountant to deal with the various intricacies involved. He should, thus, have sufficient
practical training, and exposure to real life costing dilemmas.
Cost accountancy has a very wide scope. It includes costing, cost accounting,
cost control and cost audit.
Factors Leading to the Emergence of Cost Accounting
Cost accounting has emerged mainly because of certain limitations of financial
accounting. Financial accounting is so limited and inadequate in regard to the information
which it can supply to management that businessmen have been eager to adopt
supplementary accounting systems like cost accounting. The limitations of financial
accounting as discussed before can be summarized as follows:
 Shows only overall performance
 Historical in nature
 No performance appraisal
 No material control system
 No labour cost control
 No proper classification of costs
 No analysis of losses
 Inadequate information for fixing of prices
 No cost comparison
 Fails to supply useful data to management Self-Instructional
Material 11
Accounting for
Emerging Sectors
Check Your Progress
1. What was included in the traditional subject matter of management accounting?
NOTES 2. Why is inter-firm comparison and comparative study of two periods not possible
under financial accounting system?
3. State the aim of budgeting.

1.3 ADVANTAGES AND LIMITATIONS OF

MANAGEMENT ACCOUNTING

Management accounting offers the following benefits to the organizations:

• It increases the efficiency in business activities.
• It ensures efficient regulation of business activities by establishing an efficient
system of planning and budgeting.
• It makes possible the efficient utilization of the available resources and thereby
increase the return on capital employed.
• It ensures effective control by comparing actual results with the standards.
• It helps maintain good relations with the public by providing quality service to
the customers.
• It provides the means to motivate the employees.
• It keeps managers informed about the ongoing operations, thereby enabling
them to suggest remedial measures in case of deviations.
• It helps in evaluating the efficiency and effectiveness of the organization’s business
policies by incorporating management audit.
Limitations of Management Accounting
Despite the benefits mentioned above, management accounting suffers from several
drawbacks:
• Management accounting uses data that are available from financial statements.
Thus, the validity of the decisions largely depends on the reliability of the historical
data as obtained from conventional financial statements. Any drawback in such
statements is bound to affect the effectiveness of the decision.
• The application of management accounting tools and techniques requires
knowledge about various subjects like accounting, costing, economics, taxation,
statistics and mathematics, engineering and management. To find a manager in
the organization with a comprehensive knowledge of all these subjects is almost
impossible.
• Though management accounting attempts to analyse both qualitative and
Self-Instructional
12 Material quantitative factors that influence a decision, the element of intuition in managerial
 decision has not been completely eliminated. There is a tendency among business Accounting for
Emerging Sectors
executives to use a short-cut approach to managerial problems rather than the
lengthy process as required by the scientific analysis prescribed by management
accounting.
NOTES
• The installation of management accounting system requires a huge investment
both in terms of money and manpower. Therefore, smaller concerns may not be
able to afford it.
• Management accounting is in the process of evolution and as such it still has to
go through many developmental processes before reaching a final stage.
Consequently, the techniques of management accounting lack the sharpness
and fluidity that is required of an efficient system. Even the analysis and
interpretation considerably differ from organization to organization.
• The management system cannot be replaced by a system of management
accounting, as the latter system simply provides the necessary data for a decision
and not the decision itself.
• The principle of objectivity is not always followed in its real spirit in management
accounting as the collection and analysis are considerably influenced by the
personal bias of the management accountant.

1.4 ADVANTAGES AND LIMITATIONS OF COST

ACCOUNTING

Cost accounting and management accounting are intimately related areas, so much so
that Horngren, a renowned author on the subject, has gone to the extent of saying,
‘Modern cost accounting is often called management accounting. Why? Because
cost accountants look at their organisation through a manager’s eyes.’ Thus
managerial aspects of cost accounting are inseparable from management accounting.
Advantages and Disadvantages of Cost Accounting
The deficiencies of financial accounting may be re-stated as the advantages of cost
accounting because the latter has emerged to overcome the limitations of the former.
However, the extent of the advantages obtained will depend upon the efficiency with
which the cost system is installed and also the extent to which the management is
prepared to accept the system.
The principal advantages of cost accounting are discussed in the following
sections.
Advantages to Management
 Reveals profitable and unprofitable activities: A system of cost accounting
reveals profitable and unprofitable activities. On this information, management
may take steps to reduce or eliminate wastages and inefficiencies occurring in
any form, such as idle time, under-utilization of plant capacity and spoilage of Self-Instructional
materials. Material 13
Accounting for  Helps in cost control: Cost accounting helps in controlling costs with special
Emerging Sectors
techniques, like standard costing and budgetary control.
 Helps in decision making: It supplies suitable cost data and other related
information for managerial decision making, such as introduction of a new product
NOTES
line, replacement of old machinery with an automatic plant, make or buy.
 Guides in fixing selling prices: Cost is one of the most important factors to
be considered while fixing prices. A system of cost accounting guides the
management in the fixation of selling prices, particularly during a depression
period when prices may have to be fixed below cost.
 Helps in inventory control: Perpetual inventory system, which is an integral
part of cost accounting, helps in the preparation of interim profit and loss account.
Other inventory control techniques, like ABC analysis, level setting, etc., are
also used in cost accounting.
 Aids in formulating policies: Costing provides information that enables the
management to formulate production and pricing policies and preparing estimates
of contracts and tenders.
 Helps in cost reduction: It helps in the introduction of a cost reduction
programme and finding out new and improved ways to reduce costs.
 Reveals idle capacity: A concern may not be working to full capacity due to
reasons, such as shortage of demand, machine breakdown or other bottlenecks
in production. A cost accounting system can easily work out the cost of idle
capacity so that the management may take immediate steps to remedy the
position.
 Checks the accuracy of financial accounts: Cost accounting provides a
reliable check on the accuracy of financial accounts with the help of reconciliation
between the two at the end of the accounting period.
 Prevents frauds and manipulation: Cost audit system, which is a part of
cost accountancy, helps in preventing manipulation and frauds and thus reliable
cost data can be furnished to the management and others.
Advantages to Workers
 Workers are benefited by introduction of incentive plans which are an integral
part of a cost system. This results not only in higher productivity but also higher
earnings for them.
Advantages to Society

 An efficient cost system is bound to lower the cost of production, the benefit of
which is passed on to the public at large, in the form of lower prices of products
or services.

Self-Instructional
14 Material
 Accounting for
Advantages to Government Agencies and Others Emerging Sectors

 A cost system produces ready figures for use by government, wage tribunals,
chambers of commerce and industry trade unions, etc., for use in problems like
NOTES
price fixing, wage level fixing, settlement of industrial disputes, policy matters,
etc.

Disadvantages of or Objections Against Cost Accounting

Despite the fact that the development of cost accounting is one of the most significant
steps to improve performance, certain objections are raised against its introduction.
These are as follows:
 It is unnecessary: It is argued that maintenance of cost records is not
necessary and involves duplication of work. It is based on the premise that a
good number of concerns are functioning prosperously without any system of
costing. This may be true, but in the present world of competition, to conduct a
business with utmost efficiency, the management needs detailed cost information
for correct decision making. Only a cost accounting system can serve this need
of the management and thus help in the efficient conduct of a business.
 It is expensive: It is pointed out that installation of a costing system is quite
expensive which only large concerns can afford. It is also argued that installation
of the system will involve additional expenditure which will lead to a diminution
of profits. In this respect, it may be said that a costing system should be treated
as an investment and the benefits derived from the system must exceed the
amount spent on it. It should not prove a burden on the finances of the company.
For an economical operation of the system, the maintenance of the records
should be kept to the minimum, taking into account the need and use of each
record.
 It is inapplicable: Another argument sometimes put forward is that modern
methods of costing are not applicable to many types of industry. This plea is
hardly tenable, given the complexities of operating any enterprise today. The
fault lies in an attempt to introduce a readymade costing system in an industry.
A costing system must be specially designed to meet the needs of a business.
Only then will the system work successfully and achieve the objectives for
which it was introduced. In fact, applications of costing are very wide. All
types of activities, manufacturing and non-manufacturing, should consider the
use of cost accounting.
Self-Instructional
Material 15
Accounting for
Emerging Sectors
 It is a failure: The failure of a costing system in some concerns is quoted as
an argument against its introduction in other undertakings. This is a very
fallacious argument. If a system does not produce the desired results, it is
NOTES wrong to jump to the conclusion that the system is at fault. The reasons for its
failure should be probed. Often it is discovered that employees were opposed
to the introduction of a costing system because they might have looked with
suspicion at the introduction of any method which was not known to them or
to which they were not accustomed. Thus, to make the system a success, the
utility of the system should be explained to the management and the cooperation
of the employees should be sought by convincing them that the system is for
the betterment of all.

1.5 DISTINCTION BETWEEN FINANCIAL,

MANAGEMENT AND COST ACCOUNTING

In this section, you will learn about the distinction between financial, management and
cost accounting.
1.5.1 Difference between Financial Accounting and Management Accounting
The compartmentalization of accounting into various branches generally sounds
somewhat artificial and misleading as all these branches are usually drawn from a
common pool of financial data used in preparing reports for groups who are often
involved in making a variety of interdependent decisions. But a close examination of
the two systems shows that they differ in several ways from each other. Some major
differences between these two accounting systems are summarized in Table 1.1
Objectives: The basic objective of accounting is to measure the business result and
assess the financial position of an organization. To achieve this objective, financial
accounting has to perform functions like recording, classifying and summarizing business
transactions of an organization during the accounting period. Such functions are related
to the preparation of final accounts, i.e., profit and loss account and balance sheet.
Contrary to this, the objective of management accounting is to facilitate managerial
decisions. Management accounting deals with the preparation of analytical and critical
financial reports to assist management in improving the organization’s performance.
Nature: Financial accounting is historical in its outlook in the sense that it has to
maintain records of such business events that have taken place during the accounting
period. Under financial accounting system a transaction is recorded as and when it
takes place. Therefore, prospective transactions are not considered before their maturity
under such system of accounting. On the other hand, management accounting system
is devised to help managers in shaping future operations of the business. It deals with
projection of data to be used for planning and decision making for the future. Thus,
Self-Instructional management accounting has prospective character.
16 Material
 Table 1.1 Comparison of Financial Accounting and Management Accounting Accounting for
Emerging Sectors

NOTES

Adherence to Accounting Principles: Financial accounting system is based on some

accounting principles and conventions which a financial accountant has to strictly follow
while preparing financial accounts and statements. The financial accounting system
can be result-oriented only when the accounting principles and conventions have been
properly followed and applied. But management accounting is not bound by the
constraints of generally accepted accounting principles and conventions. The preparation
of reports and statements under management accounting are governed by the
requirements of the management. Management can frame its own ground rules and
principles regarding the form and content of information required for internal use.
Subject Matter: Financial accounting considers the business as one entity and
accordingly financial accounting reports have been confined to the business operations
as a whole. Such statements present the position and the performance of the entire
business. Whereas under management accounting system each unit/department/division/
cost centre of the business is treated as a separate entity in order to ensure effective
planning and control. Therefore, profitability and performance reports are prepared
for each unit or division of the business separately.
Compulsion: The Indian Companies Act has made it obligatory for the companies to
maintain a system of financial accounting. At the same time, the benefits as offered by
Self-Instructional
a financial accounting system have made it more or less compulsory for the non- Material 17
Accounting for company organization. On the other hand, the setting up of management accounting
Emerging Sectors
system is at the discretion of the management.
Precision: Financial accounting pays more emphasis on precision and considers only
actual figures in the preparation of its statements. There is no scope for approximate
NOTES
figures in financial accounting. But the reports and statements as prepared under
management accounting system contain more approximate figures than the actual figures.
Thus, management accounting is less precise as compared to financial accounting.
Frequency of Reports: The financial statements, the outcome of financial accounting,
are prepared at the end of the financial period which is usually a period of 12 months.
But the management accounting reports and statements are prepared at regular intervals
so that management may not face any difficulty in decision making. Management is
constantly informed about the business performance through these reports and
statements. Thus, the reporting frequency of management accounting is much higher
as compared to reporting of financial accounting.
Recipients: Financial statements such as profit and loss and balance sheet, are
extensively used by outsiders i.e., shareholders, creditors, tax authorities, etc. On the
other hand, management accounting reports are exclusively meant for management.
Such reports are not easily available to outsiders.
Nature of Data Used: The financial statements as prepared under financial accounting
contain only such transactions that are expressed in monetary terms. The non-monetary
events such as nature of competition, business reputation, change in fashion, are not at
all considered by financial accounting. But management accounting uses both monetary
and non-monetary data.
Publication: Financial accounting statements are published by almost every business
organization for the information of the general public. The Indian Companies Act has
made it compulsory for every company to publish its final accounts i.e., profit and loss
account and balance sheet. By contrast, the publication of management accounting
reports and statements is not mandatory.
1.5.2 Distinction Between Cost Accounting and Management Accounting
An examination of the meaning and definitions of cost accounting and management
accounting indicates that the distinction between the two is quite vague. Some writers
even consider these two areas as synonymous while others distinguish between the
two. Horngren, a renowned author on the subject, has gone to the extent of saying,
‘Modern cost accounting is often called management accounting. Why? Because
cost accountants look at their organization through manager‘s eyes.’ Thus
managerial aspects of cost accounting are inseparable from management accounting.
One point on which all agree is that these two types of accounting do not have clear
cut territorial boundaries. However, distinction between cost accounting and
management accounting may be made on the following points mentioned in Table 1.2.

Self-Instructional
18 Material
 Table 1.2 Cost Accounting vs Management Accounting Accounting for
Emerging Sectors

Basis Cost Accounting Management Accounting

1. Scope Scope of cost accounting is Scope of management accounting is
limited to providing cost broader than that of cost accounting NOTES
information for managerial as it provides all types of
uses. information, i.e., cost accounting as
well as financial accounting
information for managerial uses.
2. Emphasis Main emphasis is on cost Main emphasis is on planning,
ascertainment and cost controlling and decision making to
control to ensure maximum maximize profit.
profit.
3. Techniques employed Various techniques used Management accounting also uses all
by cost accounting these techniques used in cost
include standard costing accounting but in addition it also
and variance analysis, uses techniques like ratio analysis,
marginal costing and funds flow statement, statistical
cost volume profit analysis, operations research and
analysis, budgetary certain techniques from various
control, uniform costing branches of knowledge like
and inter-firm mathematics, economics, etc.,
comparison, etc. whatsoever can help management in
its tasks.

4. Evolution Evolution of cost Evolution of management

accounting is mainly due to accounting is due to the limitations
the limitations of financial of cost accounting. In fact,
accounting management accounting is an
extension of the managerial aspects
of cost accounting.
5. Statutory Requirements Maintenance of cost Management accounting is purely
records has been made voluntary and its use depends upon
compulsory in selected its utility to management.
industries as notified by the
Govt. from time to time.
6. Database It is based on data derived It is based on data derived from cost
from financial accounts. accounting, financial accounting and
other sources.
7. Status in organization In the organizational set-up, Management accountant is generally
cost accountant is placed at placed at a higher level of hierarchy
a lower level in hierarchy than the cost accountant.
than the management
accountant.
8. Installation Cost accounting system can Management accounting cannot be
be installed without installed without a proper system of
management accounting. cost accounting.

Check Your Progress

4. The existence of which type of accounting depends on the discretion of the
organization?
5. Mention the difference in the emphasis of cost and management accounting.

Self-Instructional
Material 19
Accounting for
Emerging Sectors 1.6 MANAGEMENT ACCOUNTING AS A DECISION-
MAKING TOOL

NOTES The primary objective of a management accounting system is to provide accurate and
relevant information to internal users with the aim of helping the management to attain
efficiency and effectiveness in the organization. To achieve this goal, management
accounting helps an organization in the process of management which generally consists
of activities like planning, organizing, evaluating, and communicating (Figure 1.1).

Fig. 1.1 Management Accounting as an Aid to the Management Process

Planning: Planning is an activity of management that requires the application of not

only a scientific approach but also a systemic approach to decision making. All
organizations irrespective of their nature of business, need to plan both at strategic and
operational levels to remain competitive in the market. Since the most crucial dimension
of planning that the management of an organization must focus upon is strategic in
nature, one of the basic functions of the management accountant is to help management
not only in the selection of the company’s goals and formulation of policies and strategies
but also in the allocation of resources to achieve these goals. Different accounting
techniques are used by the management to discharge the function of planning efficiently.
Important among them are cost-volume-profit analysis, direct costing, capital budgeting
and cash budgeting.
Organizing: Organizing, which basically involves grouping of activities, defining the
responsibility and granting authority to employees, aims to develop structural relationship
among people and physical resources to carry out plans and accomplish the
organization’s stated objectives. Since organizing is prerequisite for the success of any
organization, therefore, this function not only calls for undivided attention from the
management of an organization but also continuous monitoring and audit to ensure its
effectiveness and relevance in a dynamic business environment. To attain this objective,
management accounting assists the management of an organization in organizing by
Self-Instructional establishing cost and/or cost centres.
20 Material
Evaluating: Evaluating, commonly known as controlling, is the process of determining Accounting for
Emerging Sectors
whether the organizational performance is consistent with the plans. This function of
management, in fact, involves the comparison of actual performance with the standards
to identify the deviation if any for the purpose of initiating and implementing measures
to adjust organizational activities toward goal attainment. Management accounting helps NOTES
the management of an organization to monitor progress and make appropriate
adjustment by generating various feedback/performance reports. An effective evaluation
system contributes to the efficiency of organization which in turn increases the profitability
of the concern.
Communication: Communication, which involves transmission of information to the
stakeholders, has been recognized as an essential function of management accounting.
In fact, the management accountant spends the maximum time in communicating with
various parties that are interested in the affairs of the business. In addition to the
publication of company’s annual report, which is considered the basic task of a
management accountant, it becomes equally important for him to prepare various
supplementary reports required by the management to address various problems and
challenges that emerge due to changing and competitive business environment.
1.6.1 Changing Role and Tasks of Management Accountants
Traditionally, the role of the management accountant has been of a facilitator responsible
for providing sufficient accounting information to the decision-makers in an organization.
Therefore, the management accountant was responsible for devising and operating an
accounting information system that was capable of collecting, processing, interpreting
and communicating the accounting information for use within the organization with the
aim of attaining organizational efficiency and effectiveness. Thus, traditionally, the job
of the management accountant in an organization as advocated by Williamson (2003),
has revolved around the following major activities:
• Accounting for product valuation and pricing
• Policy formulation and planning
• Decision making
• Cost control
Recent developments in information technology, accompanied by the emergence of
knowledge management, a rapidly changing competitive environment and increasing
globalization of business have led corporate houses to introduce strategic orientation
in their planning process. The change in orientation is bound to bring a drastic change
not only in the nature and scope of management accounting but also in the task and
role of the management accountant in business organizations. Realizing the need to
bring changes in the role of management accountants, Siegel and Sorensen state that
the role of accountants should continually evolve to remain relevant in the changing
business environment. The traditional role of the management accountant, which has
been restricted to the supplier of operational and financial information within the
organization, is no longer sufficient to meet the growing demands of a changing business
environment. Therefore, the management accountnt needs to grow into a high-level Self-Instructional
Material 21
Accounting for decision support specialist who would help a company in strategic management efforts.
Emerging Sectors
Thus, the emerging role of a managerial accountant will be quite different from his
traditional role in the sense that he has to be an active participant in the decision
making process, along with the functional managers in an organization. Such participation
NOTES will not only make him a member of a firm’s functional team that is responsible for
value creation but also change the nature of his job from a ‘staff’ to a ‘business partner’.
The new role of the management accountant, which calls for a change not only
in the task but also in his status within an organization, has been captured by many
scholars as:
Management accountants will get a number of opportunities to initiate and execute
specific actions to address the changes in the global economic environment. The
traditional role of providing accurate, timely and relevant information of a management
accountant will be replaced by a wider and vibrant role where he will be an active
participant in the strategic process of an organization.
The below-mentioned comments of Siegel and Kulesza about the new role of
management accountant are not different from the above-mentioned views:
Management accountants are business partners with their customers (managers in
operating or service units), internal consultants and organizational educators.
These views are also supplemented by the remarks of Siegel and Sorensen,who
said that the characterization of management accountants in leading-edge companies
has gone from ‘bean counter’ and ‘corporate cop’ on the periphery of business decision
making, to ‘business partner’ and ‘valued team member’ at the very centre of strategic
activity.
Thus, the emerging role of managerial accountant will be quite different from his
traditional role in the sense that he will be active participant in the decision making
process along with functional managers in an organization. Such participation will not
only make him a member of a firm’s functional team that is responsible for value creation
but also change the nature of his job from a ‘staff’ to a ‘business partner’. The change
in the role of management accountant on the one hand will widen the horizon of his job
and on the other hand will make his job more demanding in terms of potential and
skills. The new role, in fact, will provide the management accountant more opportunities
to explore his potential in meeting the expectations of the stakeholders in an organization.
However, to address the emerging challenges of the new role, the management
accountant must be adaptable with sufficient knowledge of a range of relevant disciplines
so as to be able to provide the right information at the right time.
To compete and grow in a highly competitive and complex business environment
of the future, organizations need to develop capacity and competence to create and
deliver superior delivered value to customers and use the same as a sustainable
competitive advantage. Consequently, management accountants are bound to help
their organizations not only in measuring the cost of operation accurately but also in
identifying and devising the means for eliminating non-value added costs which they
will be able to do only if they possess adequate knowledge of the value-creating
Self-Instructional
process of their respective organizations. While commenting on the opportunities of
22 Material enhancing the value of a firm’s output, Cooper states that cost management, like quality,
has to become a discipline practised by virtually every person in the firm. Since the Accounting for
Emerging Sectors
effective use of cost management techniques calls for the application of tools and
techniques not only from management accounting but also from engineering and other
functional areas of management, the task of management accountants has become
multifaceted, which demands knowledge of project management and manufacturing NOTES
processes. Thus, management accountants need to possess sufficient knowledge of
the latest costing tools and techniques like target costing, activity-based costing,
throughput costing, strategic cost management, kaizen costing and balanced scorecard.
Management Accountant in an Organization
The questions that generally strike the mind of a student while studying management
accounting are (i) who is a management accountant? and (ii) what is his status in the
organization? A management accountant occupies a pivotal position in the organization
and is responsible for devising and operating an accounting information system that is
capable of collecting, process, interpreting and communicating the accounting information
for internal users of the organization. However, in Indian corporate houses, the position
is commonly known as ‘financial controller’, ‘controller of finances’, ‘financial adviser’,
and ‘director finance’ rather than management accountant. To answer the question ‘what
is the status of management accountant’ in an organization, one needs to examine a firm’s
organizational structure. Organizational structure, which is basically a framework within
which people work together to achieve organizational goals, involves breaking up of the
total work of the organization into workable units with clearly defined duties and
responsibilities. Such a structure not only helps the employees of an organization to
understand their positions and authority within the organization but also defines their
relationship with each other. Therefore, it is essential for an organization not only to have
a clearly defined organizational structure but also communicate the same to its employees.
The most popular tool to make employees understand the organizational structure is
‘organizational chart’, which is the schematic diagram of the various job positions. Figure
1.2 portrays the status and physical location of management accountants in the Oil and
Natural Gas Corporation (ONGC) of India Ltd.

Fig. 1.2 Organizational Chart of the Oil and Natural Gas Corporation (ONGC) Ltd
Self-Instructional
Source: Compiled from the information available on the ONGC website (www.ongcindia.com) Material 23
Accounting for The chart, in fact, clearly depicts line and staff positions in the corporation. In
Emerging Sectors
the context of employees’ authority and role, the position of the corporation can be
conveniently categorized into two forms: ‘line’ and ‘staff’. Since in a line position, the
employee has the authority to plan, organize, direct and control the activities of the
NOTES organization, therefore, he is directly involved in attaining organizational goals. Whereas
a staff position serves in the capacity of an advisor, he indirectly contributes towards
achieving the organizational goals. Management accountants are generally recognized
as staff positions that are devoid of the formal right to make decisions and as such
have no direct responsibility for accomplishing the objectives of an organization.
Therefore, management accountants are meant to assist functional managers in carrying
out the tasks that are necessary for attaining the goals of the organization. However,
the accountants possess the authority over their staff deployed in their respective units.
It must be understood that management accountants in India are generally
members of strategic teams in large organizations. In fact, they have the responsibility
of providing relevant and timely data to the team in order help it in planning and
controlling activities of the organization.
1.6.2 Adaptation In Management Accounting As per Changing Business
Environment
As mentioned already, management accounting is in the process of evolution and as
such it has to go through many developmental processes before reaching a final stage.
Further, during the past few decades the business environment has drastically changed,
which has affected not only the task and role of management accounting but also its
scope in the business. Consequently, it becomes imperative for students of management
accounting to identify and examine not only the factors that are responsible for changing
environment of business but also their impact on the scope of management accounting
in the organizations. Accordingly, this section of the unit attempts to study the
environmental factors that directly or indirectly influence the role and scope of
management accounting in business.
Growth of Service Sector
The services sector across the globe has been growing at a phenomenal rate over the
past decade. With its immense contribution to the GDP, this sector has been playing a
dominant role in the growth of economies, especially in high-income economies which
have transited to services-led economies. The emergence of India as one of the fastest
growing economies in the world during the 1990s is attributable to a great extent to the
rapid growth of its services sector. India is now known across the globe for its growth
in service sector which has been registered over 10 per cent annually over past few
years. In fact, the service sector has contributed more than 50 per cent of the GDP
continuously since 2007. This growth has made a remarkable contribution to the Indian
economy in terms employment, exports, and foreign direct investment. Consequently,
India has joined the list top 15 countries in the world where the service sector contributes
more than 50 per cent of their respective GDP. Some economists strongly believe that
Self-Instructional the contribution of the service sector to the Indian economy is likely to go up by 10 per
24 Material
cent in next few years. Thus, the service sector is emerging as a dominant force that Accounting for
Emerging Sectors
would shape the Indian economy in the near future. The growing services sector would
provide tremendous opportunities for organizations to improve their performance but
they need to convert them into successful commercial ventures by addressing the
challenges that might emerge with the growth. NOTES

New Ways of Competing

Business experts believe that intensive competition would emerge as a major force in
the near future, which would shape the business approach and strategies of organizations.
In fact, growing competition would not only change the traditional business practices
but also pose new challenges to organizations in designing appropriate business strategies.
To address the challenges of highly competitive markets of the near future, organizations
need to possess unprecedented capabilities that can serve as distinctive competencies
for them to gain competitive advantage. Of course, the distinctive competencies must
be able to provide incremental value to the organizations’ marketing offering when
compared to competitors’ offerings to the customers. Organizations have been using
different sources of competencies at different times such as loyal customers, better
product, better customer services and customers relationship. However, in the past
few years, organizations have realized the significance of knowledge as a source of
competitive advantage and have been using it for this purpose. It is expected that with
the developments in information and communication technology, knowledge would
emerge as a strategic weapon to sustain competitiveness. In a knowledge-based
competition of the future, organizational learning which is basically combination of
discovering new things and acting in new ways that allow an organization to adopt to
changes, has to be a pivot around which the organization’s programmes for organizational
change should revolve. Therefore, the success of an organization in the future depends
on its ability to learn faster than its competitors. Thus, the major challenge before the
organizations is to find appropriate ways that would help them to sustain
competitiveness. Organizations have to create the combination of culture and climate
in order to make learning possible. Management accounting can help organizations
significantly in attaining this purpose.
Higher Expectations of Customers
The highly competitive markets of the future not only call for the selection of the right
customers but also an understanding of customer expectations—the customers’
perceived potential of the marketer to meet their demands. Such an attempt would
provide the organization an understanding of its role desired to make customers delight—
a prerequisite for the retention of the customers. An organization in order to meet
customer expectations completely and consistently needs to devise a proper framework
to communicate with customers for learning about their expectations and levels of
satisfaction with existing marketing offering. Every effort needs to be made to obtain
the following information that is essential for understanding such expectations:
• The set of product/service characteristics that customers want;
• The level of performance needed to exceed customers’ expectations; Self-Instructional
Material 25
Accounting for • The relative significance of each product/service characteristic in customers’
Emerging Sectors
expectations; and
• The existing level of customer satisfaction with the marketer’s current
performance.
NOTES
Once understood, customers’ expectations need to then be translated into product
and service specifications in which the technique of quality function deployment—a
process that builds customer wants and desires into the final product offering—can be
of great use to an organization.
New Standards in Customer Value
To meet the growing demands of competitive markets, organizations have to find out
new and effective ways of creating value for the customers’ investment. The emerging
changes in the business environment have given a different outlook to the concept of
business by holding it responsible for creating value than creating exchange or
transaction. Consequently, organizations have begun to focus on providing superior
delivered value to their customers. Until quite recently, managers believe that customers’
perception of value is based on quality and price of market offering of an organization.
But there is a paradigm shift in this perception today, as customers have started to
perceive value in a much broader spectrum that includes issues like customer service,
delivery procedure and schedule, and convenience. As organizations grow and develop
in future, they have to carefully analyse these issues, which will serve as a framework
for them to understand customer’s perception of value. Thus, one of the major challenges
for the organizations in the near future is to create and deliver superior value to their
customers consistently. To address this challenge, management accounting has to help
organizations in implementing programmes like total quality management (TQM) and
business process reengineering (BPR) that aim to maximize the value of the organizations’
output.
Increased Reliance on Strategic Alliance
Higher expectations of customers, along with fierce competition, would render even
the most capable companies unable to meet the market requirements in the near future.
To deal with such situations strategically, organizations in the near future would be
forced to opt for strategic alliance—an arrangement in which the organizations join
their resources to form a long-term collaboration that is capable of meeting their common
goals such as competitive advantage or customer value creation. To plan a strategic
alliance, organizations have to identify their respective core competencies because
under such an arrangement each collaborator would contribute what it considers its
core competencies. However, the identification of core competencies may be far from
straightforward within an organization or between partners. The alliance should be
designed in such a way as to indicate clearly the role and responsibility of each
collaborator without losing its flexibility and innovativeness. The collaborators of
strategic alliance not only have to share goals and agree on how to achieve them but
also have to be prepared to take risks, share confidential information and make
Self-Instructional significant investment to make collaboration a success. In fact, the success of strategic
26 Material
alliances depends to a large extent on the compatibilities of the collaborators in terms Accounting for
Emerging Sectors
of goals, strategies, procedures and cultures. In the absence of such compatibilities, it
is almost impossible to achieve coordination between collaborators. Unfortunately,
the basis of strategic alliance has been core competencies of the collaborators rather
than the issues of their complementarily. NOTES

Focus on Customer Retention

Traditionally, marketers have focused on the acquisition of customers rather than on
their retention. However, research in actual practice brings to light the important fact
that it is far cheaper to hold on to existing customers than to acquire new ones. In fact,
the existing (loyal) customers will not only provide a formidable support a firm needs
to continue operating but also drum up fresh prospects for it. In fact, marketers have
now realized that their competitors will gain a customer who is dissatisfied with their
offer, and thereby they are allowing their competitors to gain market share by losing
their own share. These realities help explain the greater focus on customer retention.
Consequently, in highly competitive markets of the future, customer retention will be
an important area of focus. In fact, in future the success of organizations would be
greatly dependent on winning and retention of customers. This is because the higher
the rate of customer retention, the greater the profit impact. Thus, the ultimate objective
of any given effort of an organization in the near future will be to attract, delight and
retain target customers. To ensure a higher rate of customer retention, firms need to
first discover what a customer expects and then transcend that expectation.
Developments in Information Technology
Today’s competitive markets are characterized by accelerating changes, innovations
and massive amounts of new information. Much of this rapid evolution in markets is
fuelled by technology and technological advancements. The pace of technological
development has been increasing and promises to accelerate in future. In fact,
technological progress over the next decades is predicted to be several times greater
than that experienced during the past ten years; much of it will be spurred by
developments in information technology. In fact, several important technologies now
beginning to be implemented will soon have a profound impact on business. The use of
all these technologies will make the future a digital age, where an attempt will be made
to integrate digital communications technologies and digital computer technology. These
technological developments will have a far-reaching consequence on every activity of
business. In fact, many business experts believe that the developments in digital
technology will not only change the present outlook of the business but will serve as
the next source of competitive advantage. On the one hand these developments will
make it possible for organizations to reach customers and establish partnering
relationships with them with greater efficiency, on the other hand, the extremely complex
and diversified technology-based business environment will render obsolete many of
the currently available management practices that have driven the business exchanges
for decades. To remain competitive in such a changing environment, organizations
need to perceive and respond quickly to the changes. In fact, the organizations which Self-Instructional
Material 27
Accounting for learn to adapt in a highly dynamic and partnering environment will be successful. The
Emerging Sectors
changes call for the measures to be taken by the organizations with the aim of improving
the managerial understanding and professional skills of their employees and to integrate
all technological elements properly within an automated information processing system.
NOTES The measures, in fact, are bound to bring paradigm shift in the role of management
accountant as he would be expected to help the organizations not only in creating such
systems and processes like enterprise resource planning (ERP) but also in addressing
the challenges that would emerge in their implementation.
Growth and Development of New Industries
Recent developments in technology have not only substantially improved the
competitiveness in the entrepreneurial environment but also succeeded in creating
opportunities in such industries that were not even contemplated in the recent past.
Despite the high success rate of new scientific discoveries in many countries across the
globe, India’s response to the scientific insights and novel technologies in the recent
past has been relatively slow. With emergence of opportunities as a result of the growing
Indian economy, there is greater realization among the entrepreneurs that there is enough
scope to build new industries on the recent scientific discoveries like nanotechnology,
synthetic biology and metabolic engineering. Management accounting in its own way
has to help the organizations to address the creation of substantial new industries, and
the infrastructure needed to support them.

Check Your Progress

6. Define data processing.
7. Which function of management accounting makes data information a strategic
asset for the company in the long run?
8. Name two programmes whose implementation by management accounting will
help companies maximize the value of the organizations’ output.

1.7 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. The traditional subject matter of management accounting included financial

statement analysis and costing theory.
2. Inter-firm comparison and comparative study of two periods is not possible
under the financial accounting system, as the required cost information cannot
be obtained under this accounting system.
3. The aim of budgeting is to coordinate and integrate the efforts and activities of
various departments with the cooperation of those who seek to achieve a common
goal.
Self-Instructional
28 Material
 4. Management accounting is the type of accounting whose existence is at the Accounting for
Emerging Sectors
discretion of the organization.
5. The difference in the emphasis of cost and management accounting is that cost
accounting emphasizes on cost ascertainment and cost control to ensure maximum
NOTES
profit whereas management accounting emphasizes on planning, controlling and
decision making to maximize profit.
6. Data processing refers to the series of activities consisting of compilation,
classification, tabulation and summarization that aims to make data information.
7. The process of analysis and interpretation is the function of management
accounting which makes the data information a strategic asset for the company
in a competitive market.
8. Two programmes whose implementation by management accounting will help
companies maximize the value of the organizations’ output are total quality
management (TQM) and business process reengineering (BPR).

1.8 SUMMARY

 Accounting plays a critical role not only in the efficient use of a firm’s resources
but also in its performance.
 Financial accounting is a discipline that is employed in industry and commerce
to record, classify and summarize the mercantile transactions that occur in an
organization.
 Limitations of financial accounting include its historical nature, its depiction of
partial picture, its ignorance of impact of changing economic conditions, its lack
of details, its pre-requisite of accounting knowledge, etc.
 Management accounting is a segment of accounting that deals specifically with
the accounting and reporting of information to management regarding the detailed
operations of the company in order for decisions to be taken in various areas of
business.
 Management accounting helps an organization in the process of management,
which generally consists of activities like planning, organizing, evaluating and
communicating.
 Cost accounting is the branch of accounting designed to determine and
accumulate the costs of certain activities and to report cost information to
management.
 Emergence of cost accounting is due to the limitations of financial accounting.
 Cost accounting and management accounting are intimately related areas, so
much so that Horngren, a renowned author on the subject.
 The deficiencies of financial accounting may be re-stated as the advantages of
cost accounting because the latter has emerged to overcome the limitations of
Self-Instructional
Material 29
Accounting for the former. However, the extent of the advantages obtained will depend upon
Emerging Sectors
the efficiency with which the cost system is installed and also the extent to which
the management is prepared to accept the system.
 A management accountant is responsible for devising and operating an accounting
NOTES
information system that is capable of collecting, processing, interpreting and
communicating accounting information for internal users of the organization.
 During the past few decades the business environment has drastically changed,
which has affected not only the task and role of management accounting but
also its scope in business.
 Traditionally, the role of management accounting has been more of a catalyst by
helping the firms to utilize their resources efficiently.
 To remain competitive in highly dynamic and complex business environment,
the firms prefer to use more recently developed management accounting tools
and techniques which, in fact, focus mainly on the effectiveness of the business
rather than efficiency.
 The new role provides management accounting greater scope in the formulation,
execution and evaluation of a firm’s business strategies.

1.9 KEY WORDS

 Financial accounting: It is a discipline of accounting which helps to regulate a

system that is capable of recording, classifying and summarizing the mercantile
transactions occurring in an organization.
 Cost accountancy: It an extension of accounting system which is responsible
for gathering, classifying and analysing the cost data required by the management
to attain various organizational objectives.
 Management accounting: It is segment of accounting that deals specifically
with the analysis and reporting of information to management about the operations
of the organization with an objective to facilitate decision making.

1.10 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short-Answer Questions
1. What are the objectives and limitations of financial accounting?
2. Mention the objectives of cost accounting.
3. ‘Management accounting is the presentation of accounting information in such a
way as to assist the management in decision making.’ Comment.
4. State the nature and characteristics of management accounting.
Self-Instructional
30 Material
 5. What is the difference between costing, cost accounting and cost accountancy? Accounting for
Emerging Sectors
6. Differentiate between cost accounting and management accounting.
Long-Answers Questions
NOTES
1. Explain the concept of management accounting. How is it different from financial
accounting?
2. Discuss the scope of management accounting.
3. Describe the limitations of management accounting.
4. Assess the advantages and disadvantages of cost accounting.
5. Describe the objectives and functions of management accounting.
6. Examine management accounting as a decision-making tool.
7. Discuss the changing role and tasks of management accountants.
8. Explain the adaptation in management accounting as per changing business
environment.

1.11 FURTHER READINGS

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House.
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
Material 31
 Application of

UNIT 2 APPLICATION OF Management

Accounting Techniques

MANAGEMENT
NOTES
ACCOUNTING TECHNIQUES
Structure
2.0 Introduction
2.1 Objectives
2.2 Marginal Costing
2.2.1 Advantages and Limitations
2.2.2 Absorption Cost
2.3 Cost-Volume Profit (CVP) Analysis and Break-Even Analysis
2.3.1 Profit-Volume Ratio (P/V Ratio)
2.3.2 Margin of Safety (M/S)
2.3.3 Limiting or Key Factor
2.4 Decision Making through Managerial Cost Accounting: Make or Buy
Decisions, Purchasing and Leasing, etc.
2.5 Techniques and Managerial Cost Accounting
2.6 Standardization of Accounting System
2.6.1 Fixed and Variable Cost Analysis
2.6.2 Application of Fixed and Variable Cost Analysis Techniques
2.7 Answers to Check Your Progress Questions
2.8 Summary
2.9 Key Words
2.10 Self Assessment Questions and Exercises
2.11 Further Readings

2.0 INTRODUCTION

To make optimum use of the output capacity, the manufacturing organizations are
frequently confronted with the decision of additional output as long as they operate
below their output capacity. Since this decision involves additional cost, therefore, the
organizations need to analyse and understand the behaviour of additional costs before
arriving at such a decision. Such an understanding is essential because every increase
in the level of output would not increase profits rather would diminish the organization’s
marginal profit if the organization is already operating at the optimum level of its existing
output capacity. However, such a decision will definitely prove financially sound if the
organization has any unutilized output capacity. Consequently, the management needs
to possess knowledge about the behaviour of costs as a result of a change in the level
of output in order to arrive at an accurate decision. It is in this context an attempt has
been made in this chapter to identify and examine the impact of change in the level of
output on cost and business result. In this unit, you will learn about the concept of
marginal cost and absorption cost.
Self-Instructional
Material 33
Application of
Management 2.1 OBJECTIVES
Accounting Techniques

After going through this unit, you will be able to:

NOTES  Discuss the concept, advantages and limitations of marginal costing
 Describe absorption costing
 Explain Cost-Volume Profit (CVP) Analysis and Break-Even Analysis
 Examine decision making through managerial cost accounting: make or buy
decisions, purchasing and leasing, etc.
 Discuss the techniques and Managerial Cost Accounting
 Assess the standardization of accounting system and application of fixed and
variable cost analysis

2.2 MARGINAL COSTING

The analysis of cost behaviour reveals that the cost of a product can be divided into
two major categories:
 fixed cost; and
 variable cost
As per cost behaviour, fixed cost remains constant to a particular level of output whereas
variable cost has the tendency to change proportionately with the volume of output.
The example given below will clarify the concept further.
Example Suba Company Limited sold 2,000 units @ 100 per unit during the year
2011–12 with the following details of production expenditure:
(i) Wages 20 per unit.
(ii) Rent of factory 5000 per annum.
(iii) Salary of executive 50,000 per annum.
(iv) Raw material required to produce one unit of finished product 2 kg @ 2 per
kg.
In the above-mentioned example, the costs of raw material and wages must have
changed proportionately with the change in the level of output, and therefore, they fall
within the scope of variable costs whereas the rent of factory and salary of executive
must have remained unchanged despite the change in output. In fact, they must have
remained constant at every level of output and as such fall within the scope of fixed
costs. On account of this reason, it is not logical to apportion fixed costs to production
in case of any additional output. Marginal costing is the technique which deals with this
phenomenon.
The cost of one additional unit of output is known as marginal cost. In other
words, it refers to the cost that is incurred by a business to move from output level `n’
Self-Instructional to ‘n + 1’. According to terminology of cost accountancy of the Institute of Cost and
34 Material
Management Accountants, 1974, Marginal cost is the amount of any given volume Application of
Management
of output by which aggregate costs are changed if the volume of output is increased Accounting Techniques
by one unit. Blocker and Weltmore, 1972, defines marginal cost as the increase or
decrease in total cost which results from production or selling additional or fewer
units of a product or form a change in the method of production or distribution NOTES
such as the use of improved machinery, addition or exclusion of a product or
territory, or selection of an additional sales channel. Thus, marginal cost is the
cost incurred by a business for the additional output.
Marginal Costing
Marginal costing is an accounting technique which ascertains marginal cost of additional
output by differentiating between fixed and variable costs. This technique aims to charge
only those costs to the cost of additional product that vary directly with sales volumes.
Those costs would be direct material, direct labour and factory overhead expenses
like supplies and some indirect labour and power. The cost of the additional product
would not include fixed or non-variable expenses such as depreciation, factory insurance,
taxes and supervisory salaries.
Marginal costing is defined by the National Association of Accountants, 1961,
London, as a method which proposes that fixed expenses be classified as period
expenses and be written off currently as is generally done with selling and
administration expenses, and that only the variable costs become the basis of
inventory value and profit determination.
According to the Institute of Cost and Management Accountants, marginal costing
is the ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable
costs... In this technique of costing only variable costs are charged to operations,
process or products, leaving all indirect costs to be written off against profits in
the period in which they arise.
As per M.A. Sahaf, marginal costing is a costing technique that considers
only the costs that vary directly with volume—direct materials, direct labour
and variable factory overheads and ignores fixed cost in additional output
decisions. Thus, the technique of marginal costing lies in
 differentiation between fixed and variable costs;
 ascertainment of marginal costs; and
 finding out effect on profit due to change in volume or type of output.
Characteristics of Marginal Costing
Marginal costing reveals the following four features:
 Method of Recording and Reporting Marginal costing is a method of recording
as well as reporting costs. Unlike differential cost analysis and break-even
analysis which utilize traditional records, marginal costing requires a unique
method of recording cost transactions as they originally take place. Self-Instructional
Material 35
Application of  Separation of Costs into Fixed and Variable Elements Under marginal
Management
Accounting Techniques costing, all types of operating costs (factory, selling and administrative) are
separated into fixed and variable components and are recorded separately.
 Variable Costs Applied to Product Variable cost elements are recognized as
NOTES
product costs, i.e., they are charged to the product at the appropriate movements
and follow the product through the inventory accounts, and thus are treated as
expenses when the product is sold. Variable distribution costs normally are
chargeable to product at or near the moment of sale, and thus do no become
part of the inventory values.
 Fixed Cost Written Off as Period Cost Fixed costs (including fixed factory
overheads) are handled as period costs, i.e., they are written off as expenses in
the period in which they are incurred. They do not follow the inventories through
the accounts but rather are treated in a way which is traditionally for selling and
general administrative expenses.
From the above discussion, it is clear that marginal costing is not a system of
cost ascertainment-like job, operating or process costing but is a technique to
deal with the effect on profits as a result of changes in volume or type of output.
It may be incorporated into the system of recording and collecting costs or it
may be used as an analytical tool for studying and reporting the effects of changes
in volume and type of output. Where it is incorporated into the system of recording
and collecting costs, the stocks are valued at variable costs, and fixed costs are
treated as period costs in profit statements.
2.2.1 Advantages and Limitations
According to the National Association of Accountants, marginal costing has the following
advantages and disadvantages:
Advantages
 Cost–volume–profit relationship data required for profit planning purposes are
readily obtained from the regular accounting statements. Hence, management
does not have to work with two separate sets of data to relate one to the other.
 The profit for a period is not affected by changes in absorption of fixed expenses
resulting from building or reducing inventory. Other things remaining equal (e.g.,
setting prices, costs, sales mix) profits move in the same direction as sales when
marginal costing is in use.
 Manufacturing cost and income statements in the marginal cost form follow
management’s thinking more closely than does the absorption cost form for
these statements. For this reason, management finds it easier to understand and
to use marginal cost reports.
 The impact of fixed costs on profits is emphasized because the total amount of
such cost for the period appears in the income statement.
Self-Instructional
36 Material
  Marginal income figures facilitate relative appraisal of products, territories, classes Application of
Management
of customers and other segments of the business without having the result Accounting Techniques
obscured by allocation of joint fixed costs.
 Marginal costing ties in with such effective plans for cost control as standard
NOTES
costs and flexible budgets. In fact, flexible budget is an aspect of marginal costing
and many companies thus use marginal costing methods for this purpose without
recognizing them as such.
 Marginal cost constitutes a concept of inventory cost which corresponds closely
with the current out-of-pocket expenditure necessary to manufacture the goods.
Disadvantages
 Difficulty may be encountered in distinguishing fixed costs. In particular, certain
semi-variable costs may fall in a border-line area and more or less arbitrary
classification may be considered necessary in order to arrive at a practical
determination of fixed and variable components.
 Complete manufacturing cost is not determined in the process of costing
production and supplementary allocation of fixed overheads on normal or some
other volume base must be made to provide product costs for long-range pricing
and other long-range policy decisions.
 Serious taxation problems may be encountered if a change is made from full
cost to marginal cost for costing inventory and definite rulings are not available
for guidance.
2.2.2 Absorption Cost
Absorption costing is a system of costing that recognizes all costs including fixed ones
as product costs, and therefore, considers all of them in ascertaining the cost of the
product. Since the costing system does differentiate between variable and fixed costs,
it charges the full costs to a product irrespective of the fact whether such costs are
relevant to the product. Thus, absorption costing promotes the philosophy of charging
all types of costs—fixed, variable, direct and indirect to processes, operations or
products. Although this system of costing has been criticized by many scholars on the
plea that it fails to report inventories of the business at a genuine value, yet it is preferred
by many business firms even today.
Absorption Costing vs. Marginal Costing
The two major differences between marginal costing and absorption costing are
summarized below:
 In marginal costing the product is charged only with those costs that are directly
affected by changes in volume. Under the absorption costing method period
costs (fixed costs) which are a function of time and, therefore, are not affected
by volume changes, are also charged to the cost of production.

Self-Instructional
Material 37
Application of  Under the absorption costing method, inventories will normally be reported at a
Management
Accounting Techniques higher figure than the marginal costing method. This is due to the fact that fixed
costs, under the absorption method, are deferred by being included in the cost
of goods inventory. The element of fixed cost will not be reported as a deduction
NOTES from revenue until the goods are sold and then it is shown as expense in the cost
of goods sold in the income statement. Under the marginal cost method, no
fixed costs are deferred; they are charged against revenue in the period in which
they are incurred.
Illustration 2.1: From the following data prepare statements of cost according to
both absorption costing and marginal costing system:

Solution:
Statement of Cost and Profit (Absorption Costing)

Self-Instructional
38 Material
 Application of
Management
Accounting Techniques

NOTES

Sometimes fixed costs are not traceable to different products, then the statement
of cost will be prepared after contribution margin as under:
Statement of Cost (Marginal Costing)

Check Your Progress

1. Mention the types of costs which vary directly with sales volume.
2. Which are the types of cost analysis method that utilize traditional records
unlike marginal costing method?
3. What is the most prominent argument of critics of the absorption method?

Self-Instructional
Material 39
Application of
Management 2.3 COST-VOLUME PROFIT (CVP) ANALYSIS AND
Accounting Techniques
BREAK-EVEN ANALYSIS

NOTES Cost-volume-profit analysis (CVP analysis) is an extension of the principles of marginal

costing. It studies the interrelationship of three basic factors of business operations:
(a) Cost of production
(b) Volume of production/sales
(c) Profit
These three factors are interconnected in such a way that they act and react on
one another because of cause and effect relationship amongst them. The cost of a
product determines its selling price and the selling price determines the level of profit.
The selling price also affects the volume of sales which directly affects the volume of
production and volume of production in turn influences cost. In brief, variations in
volume of production results in changes in cost and profit. CIMA London has defined
CVP analysis as, ‘the study of the effects on future profits of changes in fixed
cost, variable cost, sales price, quantity and mix.’
An understanding of CVP analysis is extremely useful to management in budgeting
and profit planning. It explains the impact of the following on the net profit:
(a) Changes in selling prices
(b) Changes in volume of sales
(c) Changes in variable cost
(d) Changes in fixed cost
In fact, CVP analysis helps in determining the probable effect of change in any
one of these factors on the remaining factors.
Break-even analysis is a widely-used technique to study the CVP relationship.
It is interpreted in narrow as well as broad sense.
In its narrow sense, break-even analysis is concerned with determining break-
even point, i.e., that level of production and sales where there is no profit and no loss.
At this point total cost is equal to total sales revenue.
When used in broad sense, break-even analysis is used to determine probable
profit/loss at any given level of production/sales. It is also used to determine the amount
of sales to earn a desired amount of profit.
Assumptions underlying Break-even Analysis
The break-even analysis is based on the following assumptions:
1. All costs can be separated into fixed and variable components.
2. Variable cost per unit remains constant and total variable cost varies in direct
proportion to the volume of production.
3. Total fixed cost remains constant.
Self-Instructional
40 Material
 4. Selling price per unit does not change as volume changes. Application of
Management
5. There is only one product or in the case of multiple products, the sales mix does Accounting Techniques
not change. In other words, when several products are being sold, the sale of
various products will always be in some predetermined proportion.
NOTES
6. There is synchronization between production and sales. In other words, volume
of production equals volume of sales.
7. Productivity per worker does not change.
8. There will be no change in the general price level.
Contribution and Marginal Cost Equation
As stated earlier, contribution is the difference between sales and the marginal (variable)
cost of sales. It is also known as contribution margin (Cm) or gross margin. Thus
contribution is calculated by the following formula:
Contribution = Sales – Variable cost (C = S – V)
Also, Contribution = Fixed cost + Profit (C = F + P)
or Contribution = Fixed cost – Loss (C = F – L)
From this, the following marginal cost equation is developed:
S–V=F+P
If any three of the above four factors in the equation are known, the fourth one
can be easily found out. Thus:
or P =S–V–F
P =C–F
F =C–P
V =S–F–P
The concept of contribution is extremely helpful in the study of break-even
analysis and management decision making.
2.3.1 Profit-Volume Ratio (P/V Ratio)
The profit/volume ratio, better known as contribution/sales ratio (C/S ratio), expresses
the relation of contribution to sales.

Symbolically, P/V ratio =  

By transposition, we have
(i) C = S × P/V ratio

(ii) S =

Self-Instructional
Material 41
Application of Uses of P/V ratio
Management
Accounting Techniques
P/V ratio is one of the most important ratios to watch in business. It is an indicator of
the rate at which profit is being earned. A high P/V ratio indicates high profitability and
NOTES a low ratio indicates low profitability in the business. The profitability of different sections
of the business such as sales areas, classes of customers, product lines, methods of
production, etc., may also be compared with the help of profit-volume ratio. The P/V
ratio is also used in making the following type of calculations:
(a) Calculation of break-even point
(b) Calculation of profit at a given level of sales
(c) Calculation of the volume of sales required to earn a given profit
(d) Calculation of profit when margin of safety is given
(e) Calculation of the volume of sales required to maintain the present level of
profit, if selling price is reduced
Methods of Break-even Analysis
Break-even analysis may be performed by the following two methods:
(a) Algebraic calculations
(b) Graphic presentation
Algebraic Method (Calculations in Break-even Analysis)
Break-even point: The break-even point is the volume of output or sales at which
total cost is exactly equal to sales. It is a point of no profit and no loss. This is the
minimum point of production at which total cost is recovered and after this point profit
begins.
The fundamental formula to calculate break-even point is:

Break-even point (in units) = 



Break-even point (in Rupees) = =


or Break-even point (in Rupees) =

Illustration 2.2: The following information is given:

Sales = 2,00,000
Variable cost = 1,20,000
Fixed cost = 30,000
Calculate (a) Break-even point
(b) New break-even point if selling price is reduced by 10%
(c) New break-even point if variable cost increases by 10%
Self-Instructional (d) New break-even point if fixed cost increases by 10%
42 Material
Solution: Application of
Management
  Accounting Techniques
P/V ratio =   × 100 = 40%

NOTES
(a) Break-even point = = 75,000

(b) When selling price in reduced by 10%, new sales = 2,00,000 – 10% =
1,80,000

New P/V ratio =  

New Break-even point =  = 90,000

(c) When variable cost increases by 10%, new variable cost

= 1,20,000 + 10% = 1,32,000

New P/V ratio = = × 100 = 34%

New Break-even point= = 88,235 (Approx)

(d) If fixed cost increases by 10%, new fixed cost = 30,000 + 10% = 33,000
P/V ratio remains unaffected at 40%

New Break-even point = = 82,500

Cash Break-even Point

When break-even point is calculated only with those fixed costs which are payable in
cash, such a break-even point is known as cash break-even point. This means that
depreciation and other non-cash fixed costs are excluded from the fixed costs in
computing cash break-even point. Its formula is—

Cash break even point =

2.3.2 Margin of Safety (M/S)

Margin of safety may be defined as the difference between actual sales and sales at
break-even point. In other words, it is the amount by which actual volume of sales
exceeds the break-even point. Margin of safety may be expressed in absolute money
terms or as a percentage of sales. Thus,
M/S = Actual sales – Break-even point
The size of the margin of safety indicates soundness of a business. When margin Self-Instructional
of safety is large, it means the business can still make profits even after a serious fall in Material 43
Application of sales. In such a situation, the business stands better chance of survival in times of
Management
Accounting Techniques depression. A large margin of safety usually indicates low fixed costs. When margin of
safety is low, any loss of sales may be a matter of a serious concern.
Margin of safety is directly related to profit. This is shown below:
NOTES
Profit = Margin of safety × Profit/volume ratio
P = M/S × P/V ratio

Thus M/S =

If profit is 10% and P/V ratio is 40%, then

M/S = = 25%

When actual sales are given—

Profit = M/S ratio × P/V ratio × Actual sales
When profit is not known but M/S is known, then
P = M/S × P/V ratio
P = 25% × 40% = 10%
Improvement in M/S: When margin of safety is not satisfactory, the following steps
may be taken to improve it:
(a) Increase the volume of sales; (b) Increase the selling price; (c) Reduce fixed
cost; (d) Reduce variable cost; (e) Improve sales mix by increasing the sales of products
with larger P/V ratio.
The effect of a price reduction is always to reduce P/V ratio, raise the break-
even point and shorten the margin of safety.
This is illustrated on the following page:
Example: Suppose price is reduced from 75 to 60, variable cost 50 per unit,
fixed cost 10,000, calculate margin of safety.
Before After
price reduction price reduction

Selling price per unit (S) 75 60

Variable cost per unit (V) 50 50
Total fixed cost (F) 10,000 10,000
Contribution (S – V) 25 10

P/V ratio

Self-Instructional
44 Material
 Application of
  Management
Break-even point   Accounting Techniques

= 30,000 = 60,000
NOTES
Actual sales (assumed) 75,000 75,000
M/S (Actual sales – B.E. Point) 75,000 – 30,000 75,000 – 60,000
= 45,000 = 15,000
Cost Indifference Point
Cost indifference point refers to that level of output where the total cost or the profit of
the two alternatives is equal. Such a level may be calculated where two or more
alternative methods of production or machines are considered and the use of one
machine involves higher fixed cost and lower variable cost per unit while the other
machine involves lower fixed cost and higher variable cost per unit. The calculation of
point of cost indifference helps in a cost minimization exercise and identifies the alternative
which is more profitable for a given level of output or sales. A machine with a lower
fixed cost and a higher variable cost per unit is more profitable when actual sales are
below the point of cost indifference and vice versa, a machine with a higher fixed cost
and a lower variable cost per unit is more profitable when actual sales are more than
the point of cost indifference. The formula for calculation is as follows:

Cost indifference point (in units) =

Cost indifference point (in ) =

Illustration 2.3: GMR Co. Ltd has to choose between machine X1 and X2 and
provides the following data:
X1 X2
Output per annum (units) 10,000 10,000
Profit at the above level 30,000 24,000
Fixed cost per annum 30,000 16,000
Compute:
(i) B.E. Point of the two machines
(ii) Level of output where the two machines are equally profitable
(iii) The machine suitable for different levels of output of the product
Solution:
Contribution = Fixed cost + Profit
Machine A = 30,000 + 30,000 = 60,000
Machine B = 16,000 + 24,000 = 40,000
Self-Instructional
Material 45
Application of C or contribution per unit – A = 60,000  10,000 units = 6
Management
Accounting Techniques
– B = 40,000  10,000 units = 4
(i) Break-even point = FC  C
NOTES
A = 30,000  6 = 5,000 units
B = 16,000  4 = 4,000 units

(ii) Cost indifference point =


=  = 7,000 units

At 7,000 units, both the machines will produce the same amount of profit.
(iii) Machine B will be more profitable between break-even point and point of cost
indifference, i.e., between 4,000 units and 7,000 units.
A is more profitable when sales one more than 7,000 units.
2.3.3 Limiting or Key Factor
The objective of a business is to earn maximum profit. However, it is not always easy
to achieve this objective because profit earning is affected by a variety of factors. For
example, an undertaking may have sufficient orders on hand, ample skilled labour and
production capacity, but may be unable to obtain all the quantity of material it needs
for the manufacture of maximum quantities which could be sold. Thus, material is the
factor which limits the size of output and prevents an undertaking from maximizing its
profit. Similarly, sometimes a business is not able to sell all that it can produce. In such
a case, sales is the limiting factor.
A limiting or key factor may thus be defined as the factor in the activities of an
undertaking, which at a particular point in time or over a period will limit the
volume of output. Examples of limiting factors are:
(i) Sales
(ii) Materials
(iii) Labour of particular skill
(iv) Production capacity or machine hours
(v) Financial resources.
The purpose of the limiting factor technique is to indicate the most profitable
course of action in all such cases where alternatives are possible.
Contribution per unit of key factor—When a key factor is operating, the most
profitable position is reached when contribution per unit of key factor is maximum.
For instance, if a choice lies between producing product A which yields a contribution

Self-Instructional
46 Material
of 15 per unit and product B which yields a contribution of 20 per unit, product B Application of
Management
would be more profitable. Accounting Techniques
If, however, product A takes 3 kg of material (which is a limiting factor) and
product B takes 5 kg the respective contributions per kg of material would be:
NOTES
Product A = 15 ÷ 3 kgs = 5
Product B = 20 ÷ 5 kgs = 4
Product A, which gives the greater contribution in terms of per unit of limiting
factor will be more profitable.
Illustration 2.4: The following data at is given:
Product A Product B
Direct materials 24 14
Direct labour @ 3 per hour 6 9
Variable overhead @ 4 per hour 8 12
Selling price 100 110
Standard time 2 hrs 3 hrs
State which product you would recommend to manufacture when:
(a) Labour time is the key factor
(b) Sales value is the key factor
Solution:
Product A Product B

Selling price (S) 100 110

Direct material 24 14
Direct labour 6 9
Variable overhead 8 12
Variable cost (V) 38 35
Contribution (S – V) 62 75
(a) Contribution per labour hour 62 ÷ 2 hrs 75 ÷ 3 hrs
= 31 = 25
(b) Contribution per rupee of sales value = 62 ÷ 100 = 75 ÷ 110
= 62 paise = 68 paise

Conclusion
(a) Product A is recommended when labour time is the key factor because
contribution per labour hour of product A is more than that of product B.
(b) When sales value is the key factor, product B is recommended because
contribution per rupee of sales value of product B is more than that of product
A.
(c) When sale quantity is the key factor, product B is more profitable because its
contribution per unit is higher than that of product A.

Self-Instructional
Material 47
Application of
Management
Accounting Techniques Check Your Progress
4. List the factors whose effect on net profit is revealed by the CVP analysis.
NOTES 5. Name the point after which the minimum point of production at which total
cost is recovered.
6. State the purpose of the limiting factor technique.

2.4 DECISION MAKING THROUGH MANAGERIAL

COST ACCOUNTING: MAKE OR BUY
DECISIONS, PURCHASING AND LEASING, ETC.

The focus of this unit is on short-term decisions, such as:

(i) Whether to sell a product in the domestic market or export it
(ii) Whether to make a component part inhouse or buy it from an outside supplier
(iii) Whether to change the present product mix to make it more profitable or not
Most managers consider a decision as a short-term if it involves a period of one year
or less. This cut off period is arbitrary but commonly used, though a better distinction
is that long-term decisions normally require substantial capital investment with
implications for several future years. Moreover, short-term decisions are more easily
reversed than long-term. For example, price of a product can always be changed
according to market conditions, export sales can be stopped, if necessary, and
so on.
Long-term decisions involve consideration of return on capital employed,
discounted cash flow, etc. Such decisions have not been discussed in this unit.
Relevant Costs and Relevant Revenues
When management makes decisions, it has to concentrate on relevant costs and relevant
revenues. Not all costs and revenues are relevant. The relevant costs and relevant
revenues are those expected future costs and expected future revenues that differ
under different alternative courses of action being considered. Thus relevant costs and
relevant revenues should have two characteristics:
(a) The costs and revenues must relate to future; and
(b) They must differ among different courses of action.
The focus is on the future because decision to be made affect only future. Nothing can
be done to change the past. Management cannot change the cost of plant and machinery
purchased in the past. It can change future costs by its current decisions. Hence,
relevant costs are future costs that will differ depending on the actions of the management.
For each decision, the management must decide which costs are relevant.
Self-Instructional
48 Material
Cost and Non-cost Factors in Decision Making Application of
Management
Accounting Techniques
In strategic decision making, the management has to assess not only cost factors but
also certain non-cost factors. Cost factors or quantitative factors are those which
can be quantified in monetary terms. For example, in determining the selling price of a NOTES
product, the cost of production of which is 100 per unit, the management will add,
say 20% margin of profit and decide the selling price at 100 + 20 = 120 per unit.
While the company is selling its product at 120 per unit, a competitor enters the
market and starts selling the same product at 95 per unit. Now the company will
incur a loss of 5 per unit if in order to compete, it sells the product at competitor’s
price because its own cost is 100 per unit. So, on cost considerations alone, the
company should stop selling the product because selling results in a loss of 5 per unit.
The management has to decide whether to sell at a loss or stop production of the
product to avoid the loss or how to establish a long-term competitive advantage.
In such a situation, it is difficult to make a decision on cost factors alone. It is
essential that non-cost factors or qualitative factors must be brought to the attention
of the management in decision making process, since otherwise there is a danger of
wrong decision being made. Non-cost factors are those which cannot be expressed in
monetary terms with accuracy. For example, it may not be possible to quantify in
monetary terms the effect of a decline in the morale of employees or loss of customer
goodwill, if the company closes down the manufacturing facilities of a particular product.
Non-cost factors vary according to the decision under consideration. For
example, a company plans to enter export business and it receives an export order at
a price which is less than the own cost. On cost factors, the export order should be
outrightly rejected because it does not cover even the cost. However, the management
should consider the non-cost factors such as goodwill earned by the company for
getting the export house status, earning valuable foreign exchange from the order, and
so on. For getting these benefits, the company should consider incurring a small and
tolerable amount of loss, if it can afford it.
Special Costs for Management Decision Making
There are certain costs which are specially computed for use by the management for
the purpose of decision making. These costs may not be recorded in the books of
account.
Marginal Costing and Differential Cost Analysis are the two valuable
techniques used for short-term business decisions.
Decision Making and Marginal Costings
The most useful contribution of marginal costing is the assistance that it renders to the
management in vital decision making. This is to say that marginal costing is an invaluable
aid to management decision making. Specific areas where marginal costing proves its
worth in decision-making are in this section:

Self-Instructional
Material 49
Application of 1. Selling Price Decisions
Management
Accounting Techniques
Although prices are regulated more by market conditions of demand and supply and
other economic factors than by the decisions of management, the management while
NOTES fixing prices has to keep in view the level of profit desired. In the long-run, the selling
prices of products or services must be higher than the total cost as otherwise the profit
cannot be earned. But frequently circumstances arise for management to consider
special conditions and sell its regular product at a special price which may be lower
than the total cost. Such conditions may be like the following:
(a) Under normal circumstances
(b) In times of competition and/or trade depression
(c) Accepting additional bulk orders at lower prices to utilize spare plant capacity
(d) Pricing of export sales
(a) Selling prices under normal circumstances
In the long run, under normal circumstances, the selling price must cover total cost
(i.e., variable cost plus fixed cost) and also give a reasonable amount of profit. This is
essential for the survival of a business.
In the short run, the selling price may have to be fixed below total cost but it
should be above variable cost. In other words, the selling price may be temporarily
fixed at marginal cost plus contribution basis and the amount of contribution depends
upon demand and supply, acuteness of competition, non-cost factors, etc. But it should
be noted that fixation of selling price below total cost may be made only on a short-
term basis.
(b) Pricing in competition and depression
When there is acute competition or in periods of depression, products may have to be
priced below total cost, if such a step is necessary to meet the special situation. When
marginal cost technique is used for pricing, the price should be higher than the marginal
cost so that it makes a contribution towards fixed cost and help reduce the loss. When
price is just equal to marginal cost, the amount of loss will also be equal to the amount
of fixed cost because in such situations the selling prices make no contribution towards
fixed cost.
Thus, under special circumstances, like the trade depression or competition, if
selling price is higher than marginal cost, even though it is below total cost, the production
should not be stopped. This is because fixed costs will have to be incurred irrespective
of whether production is continued or not, and continuing the production will help in
reducing the amount of loss.
As a note of caution, fixation of selling price below total cost should be made
only on a short-term basis. Pricing based on marginal cost plus contribution helps
companies to take advantage of short-term opportunities. But at the same time, no
firm can afford to incur loss on a long-term basis and thus in the long-run, the selling
Self-Instructional price must cover total cost and give a reasonable amount of profit.
50 Material
Example: Application of
Management
Fixed cost 1,00,000 (total) Accounting Techniques
Marginal cost 7 per unit
Current market price 8 per unit
Output 50,000 units NOTES
Should company sell or not?
Solution:
Marginal cost (50,000 units @ 7) 3,50,000
Fixed cost 1,00,000
Total cost 4,50,000
Cost per unit = 4,50,000 ÷ 50,000 units = 9
Although the selling price does not cover the total cost, yet it is wise to continue to
produce and sell because such a step will reduce the loss (on account of fixed cost)
that will be incurred if production is stopped. If production is stopped, the loss would
be 1,00,000 (the amount of fixed cost), but if production is continued the loss will be
as follows:
Sales (50,000 units @ 8) 4,00,000
Less: Total cost (Marginal cost + Fixed cost) 4,50,000
Loss 50,000

Thus, by continuing to produce and sell at below total cost, the loss is reduced
by 50,000, i.e., from 1,00,000 to 50,000.
Selling Price Below Marginal Cost
When selling price falls below marginal cost, the loss will be more than the amount of
fixed cost. In such an eventuality, it will be better to stop production so as to reduce
the amount of loss because stoppage in production means loss will be just equal to
fixed cost.
However, in certain special circumstances like the following, production may be
continued even if the selling price is below the marginal cost:
1. To popularize a new product. A new product introduced in the market may be
sold at a very low price so as to make it popular.
2. To eliminate competitors from the market.
3. To dispose of perishable products so as to avoid total loss.
4. To export so as to earn foreign exchange. Government may allow import quota
against foreign exchange earnings and profit from import quota may be more
than the loss on exporting the product at low prices.
5. To keep plant and machinery in operation as idle machines may be liable to
deterioration.
6. To prevent loss of future orders as temporary closure may break business
connections with customers that can be re-established at a heavy expenditure.
Self-Instructional
Material 51
Application of 7. To help in the sale of a conjoined product which is making large profits.
Management
Accounting Techniques 8. To maintain production and to keep employees occupied.
(c) Exploring New Markets at Lower Prices to Utilize Spare Plant
NOTES Capacity
Sometimes, a company is not able to fully utilize plant capacity when selling at total
cost plus profit basis. In such a case, it may explore new markets and find opportunities
to receive additional bulk order or export order at a price which may be below total
cost but above marginal cost so that the price makes a ‘contribution’. The entire
amount of contribution form such sales is profit because fixed cost is already recovered
from current sales at total cost plus profit basis. 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 spare plant capacity can be utilized to earn
additional profit.
Illustration 2.5: A manufacturer of plastic buckets makes an average profit of 2.50
per piece on a selling price of 14.50 by producing and selling 60,000 pieces at 60%
of potential capacity. His cost of sales is:
per piece
Direct materials 4.00
Direct wages 1.00
Factory overheads (variable) 3.00
Selling overheads (variable) 0.25
Total fixed cost is 2,25,000
During the current year, he intends to produce the same number of units, but
anticipates that (a) fixed cost will go up by 10%, and (b) material and labour costs will
go up by 5% each.
Under these circumstances, he obtains a bulk offer for a further 20% of his
capacity. What minimum price you would recommend for acceptance to ensure an
overall profit of 1,60,000.
Solution:
Budgeted Statement for the Current Year Prior to Acceptance of
20% Capacity Order

Per piece Total

Sales (60,000 pieces) 14.50 8,70,000

Direct material ( 4 + 5%) 4.20 2,52,000
Direct labour ( 1 + 5%) 1.05 63,000
Variable factory overheads 3.00 1,80,000
Variable selling overheads 0.25 15,000
Variable cost 8.50 5,10,000
Contribution (Sales – Variable cost) 6.00 3,60,000

Self-Instructional
52 Material
 Fixed cost 2,25,000 + 10% = 2,47,500 Application of
Management
Profit = Contribution – Fixed cost Accounting Techniques
= 3,60,000 – 2,47,500 = 1,12,500
Planned profit = 1,60,000
Increase in profit (or contribution) required = 1,60,000 – 1,12,500 = 47,500 NOTES
Variable cost of additional 20,000 pieces (order
for 20% capacity, i.e., 20,000 × 8.50) 1,70,000
Add: Additional contribution desired 47,500
Total sales value 2,17,500
Selling price per unit = 2,17,500 ÷ 20,000 units = 10.875
Thus, minimum price for sale of additional 20,000 units is 10.875, so as to ensure an overall
profit of 1,60,000.

(d) Pricing of Export Sales

Additional orders may be accepted from a foreign market at below normal price or
below total cost but above marginal cost. Export sales yield additional contribution
when such sales are at a price which is above marginal cost.
While determining profitability of accepting export orders, the following additional
factors should be considered.
1. Export sales may result in additional costs, like special packing cost, additional
quality checks, freight and insurance charges, etc., if not borne by importer.
These costs should be deducted from contribution to determine profit from
export order.
2. Export sales may result in certain cost benefits, like export subsidy from
government, exemption or concessions in excise duty or duty drawbacks, etc.
In determining profit from export order, these items should be deducted from
cost or added in contribution.
Illustration 2.6: Indo-British Company has a capacity to produce 5,000 articles but
actually produces only 2,000 articles for home market at the following costs:

Materials 40,000
Wages 36,000
Factory Overheads — Fixed 12,000
— Variable 20,000
Administration overheads — Fixed 18,000
Selling and distribution overheads — Fixed 10,000
— Variable 16,000
Total Cost 1,52,000

The home market can consume only 2,000 articles at a selling price of 80 per
article. An additional order for the supply of 3,000 articles is received from a foreign
country at 65 article. Should this order be accepted or not, if execution of this order
entails an additional packing cost of 3,000.
Self-Instructional
Material 53
Application of Solution:
Management
Accounting Techniques Statement of Marginal Cost and Contribution
(of 3,000 articles for export)

NOTES
Materials @ 20 per article 60,000
Wages @ 18 per article 54,000
Variable overheads — Factory @ 10 per article 30,000
— Selling and dist. @ 8 per article 24,000
Marginal cost of sales 1,68,000
Sales (3,000 articles @ 65) 1,95,000
Contribution 27,000
Less: Additional packing cost 3,000
Additional profit 24,000

Acceptance of this export order results in additional profit of 24,000 and thus
the order should be accepted.
Note: Fixed overheads have not been taken into account in deciding the acceptability of this
order because fixed overheads have already been recovered from sale in the home market.
Non-cost Factors or Qualitative Factors: Apart from cost and profit considerations,
certain non-cost factors should also be kept in mind while making an exporting decision.
These include:
(a) Foreign exchange earnings
(b) Export house status
(c) Enhancement in company prestige and goodwill
(d) Employment opportunities
Conclusion
1. In normal times, prices should be based on total cost plus profit.
2. In market conditions like trade depression and competition, price may be fixed
on marginal cost plus basis so as to make a contribution. This is valid only for a
short period.
3. In order to utilize spare plant capacity, bulk orders from home market or from
foreign market may be accepted at less than total cost but above marginal cost.
This adds to the total profit of the company. This is possible only when price
discrimination is such sales in different markets is possible.
2. Make or Buy Decisions (Insourcing vs Outsourcing)
Marginal cost analysis renders useful assistance when a decision has to be taken by
the management on whether a component part should be manufactured internally or
purchased from an outside firm. Insourcing is producing the goods by the firm itself
whereas outsourcing is the process of purchasing the goods or services from outside

Self-Instructional
54 Material
suppliers. For example, a car manufacture may rely on outside vendors to supply Application of
Management
some component parts but may choose to manufacture other parts internally. Accounting Techniques
This is particularly common when a component part is available in the market at
a price below firm’s own total cost. This type of decision based on total cost analysis
NOTES
may be misleading. Such a decision can be arrived at by comparing the outside supplier’s
price with firm’s own marginal cost. On the face of it, since the only cost to manufacture
the component is its marginal cost, then the amount by which marginal cost falls below
supplier’s price is the saving that arises in making. Therefore, it will be profitable to
buy from outside only when supplier’s price is below firm’s own marginal cost.
For example, total cost of making a component is 100 per unit, consisting of
80 as variable cost and 20 as fixed cost. Suppose, an outside firm is prepared to
supply this component at 90, it may appear that it is cheaper to buy the component.
But a study of cost analysis will show that each unit if manufactured makes a contribution
of 20 towards recovery of fixed cost. This fixed cost has to be incurred whether we
make or buy. The real cost of making the component part is only 80 which is its
variable cost. This offer of 90 per unit should not be accepted because if accepted,
the component will really cost 110, i.e., 90 of purchase price plus 20 of fixed cost
which cannot be saved if component is not produced.
However, before arriving at final decision, due consideration should be given to
other factors. For example, it should also be considered as to whether plant capacity
released by the non-manufacture of the component part is put to some alternative use
or not.
Illustration 2.7: Auto Parts Ltd has an annual production of 90,000 units for a motor
component. The component cost structure is as below:
Materials 270 per unit
Labour (25% fixed) 180 per unit
Expenses:
Variable 90 per unit
Fixed 135 per unit
Total 675 per unit

(a) The purchase manager has an offer from a supplier who is willing to supply the
component at 540. Should the component be purchased and production
stopped?
(b) Assume the resources now used for this component’s manufacture are to be
used to produce another new product for which the selling price is 485.
In the latter case, the material price will be 200 per unit. 90,000 units of this product
can be produced at the same cost basis as above for labour and expenses. Discuss
whether it would be advisable to divert the resources to manufacture that new product,
on the footing that the component presently being produced would, instead of being
produced, be purchased from the market.

Self-Instructional
Material 55
Application of Solution:
Management
Accounting Techniques
Material 270
Labour (75% of 180) 135
NOTES Variable expenses 90
Total variable cost when component is produced 495
Suppliers price 540
Excess of purchase price over variable cost = 540 – 495 = 45
(a) Fixed expenses have to be incurred whether the component is made or purchased.
Thus company should make the component itself because if purchased from outside
it will have to pay 45 per unit more and on 90,000 units @ 45 it comes to 40,50,000.
(b) Cost implications of proposal to divert available production facilities for a new product:

Selling price of per unit of new product 485

Less: Variable costs — Material 200
Labour 135
Expenses 90 425
Contribution per unit 60
Loss if present component is purchased = 540 – 495 = 45.
If company diverts the resources for the production of a new product, it will
benefit by 15 (i.e., 60 – 45) per unit.
On 90,000 units it will save @ 15, i.e., 13,50,000. Thus, it is advisable to
divert the production facilities in the manufacture of the new product and the component
presently being manufactured should be bought from outside. This will result in additional
profit of 13,50,000.
Outsourcing and Idle Capacity When a firm has no spare capacity and
manufacturing a component involves setting aside other work, the loss of contribution
of displaced work should also be given due consideration. In other words, it will be
profitable to buy only when the purchase price is below marginal cost plus loss of
contribution of displaced work. The loss of contribution is usually best found by the
use of contribution per unit of key factor.
Illustration 2.8: Manufacture of product A takes 20 hours on machine no. 101. It
has a selling price of 150 and marginal cost of 110. Component part Y could be
made on machine no. 101 in 4 hours. The marginal cost of component part is 9 of
which outside supplier’s price is 15.
Should one make or buy component Y. Discuss in both situations when—
(a) Machine no. 101 is working at full capacity.
(b) There is idle capacity.

Self-Instructional
56 Material
Solution: Application of
Management
(a) Contribution per unit of A = 150 – 110 = 40 Accounting Techniques

Contribution per machine hour = 40 ÷ 20 hrs = 2 per hour.

If component Y in manufactured then as it takes 4 hours, the loss of contribution NOTES
is 8 (i.e., 4 hrs @ 2). The total cost to make component Y will be 9 + 8 =
17.
This is more than supplier’s price of 15 and so it is better to buy than to make
component Y.
(b) If, however, there is some unutilized machine capacity, then there would be no
loss of contribution and so the cost of making component Y would only be its
marginal cost, i.e., 9. In such a case, it would be economical to make the
product than buy it.
Non-cost or Qualitative Factors: While making a decision on make or buy a
component, the following non-cost factors should also be considered.
(a) Assurance of continued supply, if bought from outside
(b) Assurance of quality of the product by the supplier
(c) Assurance of no price increase during the period of agreement
3. Sales Mix Decisions
Sales mix or product mix denotes the proportion in which various products are sold or
produced. The problem of selecting a profitable mix of sales thus, arises only when a
business enterprise has a variety of product lines and each making a contribution of its
own. Any change in sales mix also results in the change in profit position. The technique
of marginal costing helps the management in determining the most profitable sale mix.
The discussion on selection of the most profitable product mix may be discussed
in two parts:
(a) When there is no key factor; and (b) When there is a key factor.
(a) When there is no key (or limiting) factor
When there is no key factor, the product mix that provides the highest amount of
contribution is considered as the most profitable sales mix. This holds good when
fixed cost does not change due to changes in sales mix.
However, when changes in sales mix are associated with changes in fixed cost,
then that sales mix which provides the highest profit is considered as the most profitable
sales mix. In other words, relative profitability of mixes will be evaluated on the basis
of their profit and not on the basis of their contribution when a change in product mix
is associated with change in fixed cost.

Self-Instructional
Material 57
Application of Illustration 2.9
Management
Accounting Techniques Allied Manufacturing Company given you the following information.
Product A Product B

NOTES
Fixed overheads – 10,000 p.a.
Direct materials per unit 20 25
Direct labour per unit 10 15
Variable overheads (100% of direct labour)
Selling price per unit 60 100

You are required to present a statement showing the marginal cost of each
product and recommend which of the following sales mixes should be adopted:
(a) 900 units of A and 600 units of B
(b) 1,800 units of A only
(c) 1,200 units of B only
(d) 1,200 units of A and 400 units of B
Solution:
Marginal Cost Statement

Per unit
Product A Product B

Direct materials 20 25
Direct labour10 15
Variable overheads 10 15
Marginal cost 40 55
Contribution 20 45
Selling price 60 100

Statement of Contributions and Profits of Different Sales Mixes

Contribution Contri- Total Fixed

Sales mix Profit
per unit bution contribution cost

(a) A – 900 units 20 18,000

B– 600 units 45 27,000 45,000 10,000 35,000
(b) A – 1,800 units 20 36,000
B– Nil 45 Nil 36,000 10,000 26,000
(c) A – Nil 20 Nil
B – 1,200 units 45 54,000 54,000 10,000 44,000
(d) A – 1,200 units 20 24,000
B – 400 units 45 18,000 42,000 10,000 32,000

Thus, sales mix (c) is recommended as it yields the highest profit of 44,000.
This is because contribution per unit of B is more than that of A, and therefore, any
sales mix that takes into account the maximum number of units of B would be more
Self-Instructional
58 Material
profitable.
(b) When there is a key factor Application of
Management
Accounting Techniques
When a key factor is operating, selection of the most profitable sales mix is based on
contribution per unit of key factor. The product which makes the highest amount of
contribution per unit of key factor, is the most profitable one and its production is NOTES
pushed up. The second preference is to be given to product which yields the second
highest contribution per unit of key factor and so on and in the end that product should
be produced which yields least contribution per unit of key factor and to the extent of
availability of the key factor.
In case a number of key factors are operating simultaneously, the basic principle
remains the same but problem becomes more mathematical in nature and one has to
resort to Linear Programming to determine the optimal product mix.
Illustration 2.10: A company manufactures three products. The budgeted quantity,
selling prices and unit costs are as under:
A B C

Raw materials (@ 20 per kg) 80 40 20

Direct wages (@ 5 per hour) 5 15 10
Variable overheads 10 30 20
Fixed overheads 9 22 18
Budgeted production (in units) 6,400 3,200 2,400
Selling price per unit (in ) 140 120 90

Required:
(i) Present a statement of budgeted profit.
(ii) Set optimal product mix and determine the profit, if the supply of raw materials
is restricted to 18,400 kgs.
Solution:
(i) Statement of Budgeted Profit

A B C Total
Budgeted production (units) 6,400 3,200 2,400
Selling price 140 120 90
Sales (S) 8,96,000 3,84,000 2,16,000 14,96,000
Raw materials 5,12,000 1,28,000 48,000
Direct wages 32,000 48,000 24,000
Variable overheads 64,000 96,000 48,000
Total variable cost (V) 6,08,000 2,72,000 1,20,000 10,00,000
Contribution (S – V) 2,88,000 1,12,000 96,000 4,96,000
Less: fixed cost* 1,71,200
Profit 3,24,800

*Calculation of Fixed Cost

A = 6,400 unit × 9 57,600
B = 3,200 units × 22 70,400
C = 2,400 units × 18 43,200
Total fixed cost = 1,71,200
Self-Instructional
Material 59
Application of (ii) When raw material is the key factor
Management
Accounting Techniques A B C
Raw material per unit of output 4 kgs 2 kgs 1 kgs
Total raw material consumed (kg) 6400 × 4 3200 × 2 2400 × 1
NOTES = 25,600 = 6,400 = 2,400

*Contribution per kg of raw material = = =

= 11.25 = 17.50 = 40
Ranks III II I
* Contribution per kg of raw material is calculated as:
Total contribution ÷ Total raw materials consumed
Suggested sales mix (raw material is the key factor)
Rank I – Product C – 2,400 units × 1 kg = 2,400 kgs
Rank II – Product B – 3,200 units × 2 kgs = 6,400 kgs
Rank III – Product A – 2,400 units × 4 kgs (balance) = 9,600 kgs
Total materials 18,400 kgs
Thus product mix is: A – 2,400 units, B 3,200 units and C – 2,400 units
Calculation of Profit Contribution
Product A 2,400 units @ 45 p.u. 1,08,000
B 3,200 units @ 35 p.u. 1,12,000
C 2,400 units @ 40 p.u. 96,000
Total contribution 3,16,000
Less: Total fixed cost 1,71,200
Profit 1,44,800

4. Selection of a Suitable Method of Production

Sometimes the management is confronted with the problem of choosing from amongst
alternative methods of production. For example, a new product may have been developed
and the management is faced with the problem of determining the best method of
production, i.e., whether to employ a machine or to produce entirely by hand labour.
Similarly, management may have to decide whether to employ an ordinary machine or an
automatic machine. The management should select the method which gives the largest
contribution (i.e., the lowest marginal cost), keeping in view the limiting factor.
Example: X Ltd has developed a new product which can be manufactured on Machine
I or II.
Machine I Machine II
(a) Total machine hours per annum 3,000 3,000
(b) Production per hour 5 units 8 units

(c) Selling price per unit 200 200

Material per unit 70 70
Labour per unit 30 20
Variable overheads per unit 50 70
(d) Marginal cost per unit 150 160
(e) Contribution per unit (c – d) 50 40
(f) Contribution per hour (e × b) 250 320
Self-Instructional
60 Material (g) Contribution per annum (f × a) 7,50,000 9,60,000
 Apparently, machine II is more profitable as it make a larger contribution Application of
Management
provided there is no other factor to be considered. Accounting Techniques

5. Plant Shutdown Decisions

The management under certain circumstances might feel that plant shutdown, i.e., NOTES
closing down the business, is better than operating at a loss. However, marginal costing
analysis may prove that this is not always so. This type of situation usually arises when
sufficient sales cannot be achieved.
This type of decision may be either (a) temporary suspension of production
activities, or (b) permanent closing down of production.
Temporary Closing Down Temporary suspension of activities is a short-term
measure. The object is usually to stop operations until trade depression has passed.
The question before management is: when should operations be suspended? or in
other words, how long should the operations be continued? The answer to this question
is that if products are making a contribution towards fixed cost, then generally speaking,
production should not be suspended. This is so because continuing production will
help minimizing loss which would be incurred if plant is shut down. Thus, the information
needed to solve this type of problem involves a comparison between probable loss at
a given level of output and the loss that would be suffered if production is suspended
temporarily.
Example: A manufacturing company supplies you the following information:
Normal capacity of plant 10,000 units
Fixed cost 1,00,000
Marginal cost per unit 75
Estimated selling price 80
Estimated sales volume at this selling price 5,000 units
Marginal Cost Statement

Total sales (5,000 units × 80) 4,00,000

Less: Marginal cost (5,000 units × 75) 3,75,000
Contribution 25,000
Fixed cost 1,00,000
Loss (–) 75,000

If plant is shut down, the loss due to fixed cost would be 1,00,000. However,
if plant is operated, the loss would only be 75,000. This is because selling price is
above the marginal cost and is making a contribution towards fixed cost.
Role of Committed and Discretionary Fixed Costs Sometimes, certain fixed costs
can be avoided by management when plant is not operative. These are termed as
discretionary fixed costs. Committed fixed costs, on the other hand, are those that
cannot be avoided even if production is discontinued.
In decisions to close down temporarily, contribution should be compared with
fixed cost which is to be incurred when plant is shut down, i.e., committed fixed cost.
Self-Instructional
Material 61
Application of Examples of fixed costs which may be avoided by closing down are advertisement
Management
Accounting Techniques costs, research and development, part of salaries, etc. Longer the period of shut down,
the larger the amount of avoidable fixed cost is likely to be.
Example:
NOTES Normal capacity of plant 10,000 units
Fixed cost when plant is operating 1,00,000
Fixed cost when plant is shut down 80,000
Variable cost per unit 75
Selling price per unit 80
Estimated sales volume at this price 5,000 units
Marginal Cost Statement

Sales (5,000 units @ 80) 4,00,000

Less: Marginal cost (5,000 units @ 75) 3,75,000
Contribution 25,000
Fixed cost if plant is operating 1,00,000
Loss (–) 75,000

Now if the plant is shut down, the loss due to fixed cost would be 80,000
whereas, if plant is operated, the loss would be 75,000. The effect of plant operating
is only a small amount of loss of 5,000 (i.e., 80,000 – 75,000). Thus keeping in view
this small amount, operating a plant offers certain non-cost advantages like keeping
the plant in gear, retaining the customers, retaining all the skilled labour and managerial
personnel. Thus, it would be advisable to continue the production even if there is a
small amount of loss because the non-cost factors outweigh the loss.
In case the selling price is below the marginal cost and makes no contribution
towards fixed cost, then on cost considerations, the plant should be temporarily
shutdown. But a final decision in the regard should be taken after considering non-cost
factors, like effect of shutdown on plant, fear of losing the market, effect on relationship
with workers and suppliers, etc.
Permanent Shutdown So far as permanent closing down of business is concerned,
such a decision is a drastic step and should be taken only when in the long run, the
business does not expect to earn a sufficient return to cover the risk involved. In other
words, in the long-run, selling price must not only cover the total cost but should also
give a reasonable return on the capital employed.

Check Your Progress

7. State the characteristics of the relevant costs and relevant revenues.
8. Which category of costs is ‘goodwill’ a part of?
9. Enlist the non-cost factors which must be considered while making an exporting
Self-Instructional
62 Material
decision.
 Application of
2.5 TECHNIQUES AND MANAGERIAL COST Management
Accounting Techniques
ACCOUNTING

Management accounting is an information system designed to communicate meaningful NOTES

economic and financial information to managers, so that they may discharge their
functions efficiently. It makes extensive use of a number of tools and techniques to
meet the increasing needs of business. Important among them are:
Financial Planning: Planning is necessary not only for better organizational
performance and progress, but also for efficient utilization of available resources. In
fact, it is recognized as a prerequisite for financial functions wherein finance plays a
deciding role in executing them effectively. Financial planning is the process of deciding
in advance the financial objectives, policies and procedures. An organization can achieve
long-term, as well as short-term, financial objectives by employing financial planning.
In the short term, it can help a concern in meeting its obligations by balancing the flow
of funds. At the same time, its proper application can ensure efficient utilization of
available financial resources in the long term.
Analysis of Financial Statement: Financial statement analysis is a growing and ever
changing set of systems and procedures designed to provide decision makers with
relevant information derived from basic sources of data such as company financial
statements and government and industry publications. Over the years, a number of
techniques have been devised to analyse financial statements e.g., comparative financial
statements, common-size statements, ratio analysis, trend analysis and fund flow
statement.
Cost Accounting: Cost accounting is a vital part of the accounting system. It includes
recording, classifying, analysis and reporting of all cost facets in a company’s
performance. Cost accounting procedures have to be designed carefully after taking
into consideration the nature and requirements of the business and the data required at
the different levels of management for effective cost control and cost reduction.
Standard Costing: Another major technique commonly used by the organizations for
exercising control is standard costing. Under this arrangement standard costs are used
to control the major activities of the business. Standard costs are predetermined targets
against which actual results are evaluated. This is the basis for a system of management
control for which the proper monitoring of performance is a key factor. The variances
between standard and actual costs are computed and reported to management.
Marginal Costing: Marginal costing is a managerial technique that considers only
variable cost in the decisions concerning with additional output. It is a reporting system
that values inventory and cost of sales at its manufacturing variable cost. It is frequently
used an internal management reporting system.
Budgetary: Control Budgetary control refers to a system of business control that
uses budgets to control the major activities of business. The budgets for all major
activities of the business are prepared in advance and the actual operations are carried
Self-Instructional
Material 63
Application of out in accordance with the budget estimates. Generally the budgets are prepared by
Management
Accounting Techniques updating the previous year’s figures in the light of some forward projections.
Funds Flow Analysis: Funds flow analysis attempts to highlight the causes of change
in the financial position of a business enterprise between two balance sheet dates. Any
NOTES
statement prepared for this purpose refers to as funds flow statement. A funds flow
statement helps managers in the efficient management of funds.
Management: Reporting Management reporting is considered as an essential
component of a well designed planning and control system. Decision makers frequently
require information on various aspects of business. Thus, it is the responsibility of the
management accountant to communicate the required information to management at
the right time and in a right manner.
Statistical Analysis: Accountants frequently confront masses of data from which
they have to draw systematic and logical conclusions. Statistical analysis in general
and sampling theory in particular provides them a scientific method to draw reliable
and valid conclusions about the properties of an entire population by studying only a
chosen sample of the population.

2.6 STANDARDIZATION OF ACCOUNTING SYSTEM

Financial statements have incredible importance for both internal and external
stakeholders. They basically are a report card for the company. So it is important that
they are regulated and do not report misleading information. Accounting Standards
(AS) provide us with a framework for this regulation.
A financial statement analyst must possess knowledge of the general accepted
accounting principles (GAAP) that govern the accumulation and presentation of the
data appearing in financial statement. The expression generally accepted accounting
principles are broad general guidelines used to measure, record and report the financial
affairs and activities of a business. Such principles provide a comprehensive and
standardized body of theory capable of handling the almost infinite variety of financial
transactions that may occur during the life of a business enterprise. They are required
to assure some degree of uniformity and comparability in the data received and relied
on by those who have no direct influence over the accumulation and presentation of
the accounting data on which they rely. The established accounting standards seek to
achieve a fair presentation of financial statements.
It should be noted that GAAP differ from country to country because of the
legislative requirements of each country, local accounting practices, customs, usage
and business environment peculiar to each country. India has not adopted the
International Financial Reporting Systems (IFRSs). It has adopted the policy of
convergence of Indian Accounting Standards (IAS) with IFRSs. Convergence means
to make such changes, as local conditions permit, in the Indian Accounting Standards
to keep them as much closer to the IFRSs as possible. In line with the global trend, a
list of 39 Indian Accounting Standards (Ind ASs) have been developed and finalized
Self-Instructional
64 Material
by the Institute of Chartered Accountants of India, and approved by the National Application of
Management
Advisory Committee on Accounting Standards and notified by the Ministry of Corporate Accounting Techniques
Affairs (MCA).
2.6.1 Fixed and Variable Cost Analysis NOTES
The cost which varies directly in proportion to every increase or decrease in the volume
of output or production is known as variable cost. The cost which does not vary but
remains constant within a given period of time and range of activity in spite of the
fluctuations in production, is known as fixed cost. Such range of activity over which
fixed costs do not change is called relevant range. The cost which does not vary
proportionately but simultaneously cannot remain stationary at all times is known as
semi-variable cost. It can also be named as semi-fixed cost.
Examples:
Fixed Costs : Rent or rates; insurance charges; management salary, etc.
Variable Costs : Wages of labourers; cost of direct material, power, etc.
Semi-Variable Cost : Depreciation, repairs, etc.
Fixed costs are sometimes referred to as ‘period costs’ and variable costs as
‘product costs’ in system of direct costing. Fixed cost can be further classified into
(i) committed fixed costs and (ii) discretionary fixed costs. Committed fixed costs are
unavoidable in the short run if the organization has to function. Examples of such fixed
costs are depreciation, rent, pay and allowance of staff. Discretionary fixed costs are
those which are set at a fixed amount for specific time periods by management in the
budgeting process. Examples of such costs are research and development costs,
advertisement and market research expenses. Certain costs remain fixed over a range
of activity and then jump to a new level as activity changes. Such costs are treated as
‘Step costs.’ For example, a foreman is in a position to supervise a given number of
employees. Beyond this number it will be necessary to hire a second then a third and
so on. Similarly, rental cost of delivery vehicles will also follow a similar pattern. These
costs may also be taken as a type of semi-variable costs.
2.6.2 Application of Fixed and Variable Cost Analysis Techniques
Classifying costs as either variable or fixed is important for companies because by
doing so, companies can assemble a financial statement called the Statement/Schedule
of Cost of Goods Manufactured (COGM). This is a schedule that is used to calculate
the cost of producing the company’s products for a set period of time.
The COGM is then transferred to the finished goods inventory account and
used in calculating the Cost of Goods Sold (COGS) on the income statement.
By analysing variable and fixed cost prices, companies can make better decisions
on whether to invest in Property, Plant, and Equipment (PPE). For example, if a
company incurs high direct labour costs in manufacturing their products, they may
look to invest in machinery to reduce these high variable costs and incur more fixed
costs instead. Self-Instructional
Material 65
Application of These decisions, however, also need to consider how many products are actually
Management
Accounting Techniques being sold. If the company invested in machinery and incurred high fixed costs, it
would only be beneficial in a situation where sales are high enough so that the overall
fixed costs are less than the total labour costs would have been had the machine not
NOTES been purchased.
If sales were low, even though unit labour costs remain high, it would be wiser
to not invest in machinery and incur high fixed costs because the high unit labour costs
would still be lower than the overall fixed cost of the machinery.
The volume of sales at which the fixed costs or variable costs incurred would be
equal to each other is called the indifference point. Finally, variable and fixed costs are
also key ingredients to various costing methods employed by companies, including
job order costing, process costing, and activity-based costing.

Check Your Progress

10. What is semi-variable cost?
11. Mention some of the costing methods for which fixed and variable costs are
used.

2.7 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. The types of costs which vary directly with the sales volumes are direct material,
direct labour and factory overhead expenses like supplies and some indirect
labour and power.
2. Differential cost analysis and break-even analysis are the types of cost analysis
method that utilize traditional records unlike marginal costing method.
3. The most prominent argument of the critics of the absorption method is that this
system of costing fails to report inventories of the business at a genuine value.
4. An understanding of CVP analysis is extremely useful to management in budgeting
and profit planning. It explains the impact of the following on the net profit: (a)
Changes in selling prices, (b) changes in volume of sales, (c) changes in variable
cost and (d) changes in fixed cost.
5. The break-even point is the minimum point of production at which total cost is
recovered and after this point profit begins.
6. The purpose of the limiting factor technique is to indicate the most profitable
course of action in all such cases where alternatives are possible.
7. The two characteristics of relevant costs and relevant revenues are that the
costs and revenues must relate to future; and they must differ among different
courses of action.
Self-Instructional
66 Material
 8. ‘Goodwill’ is a part of ‘non-cost’ category. Application of
Management
9. The factors which must be kept in mind while making an exporting decision Accounting Techniques
include: Foreign exchange earnings, export house status, enhancement in company
prestige and goodwill; and employment opportunities.
NOTES
10. The cost which does not vary proportionately but simultaneously cannot remain
stationary at all times is known as semi-variable cost. It can also be named as
semi-fixed cost.
11. Variable and fixed costs are key ingredients to various costing methods employed
by companies, including job order costing, process costing, and activity-based
costing.

2.8 SUMMARY

 The analysis of cost behaviour reveals that the cost of a product can be divided
into two major categories: fixed cost and variable cost. As per cost behaviour,
fixed cost remains constant to a particular level of output whereas variable cost
has the tendency to change proportionately with the volume of output.
 According to terminology of cost accountancy of the Institute of Cost and
Management Accountants, 1974, Marginal cost is the amount of any given
volume of output by which aggregate costs are changed if the volume of
output is increased by one unit.
 Marginal costing is an accounting technique which ascertains marginal cost of
additional output by differentiating between fixed and variable costs. This
technique aims to charge only those costs to the cost of additional product that
vary directly with sales volumes.
 Advantages of marginal costing include readily availability of cost-volume-profit
relationship, profit for the period remains unaffected by changes in absorption
of fixed expenses, closely follows management thinking through manufacturing
costs and income statements etc.
 Disadvantages of marginal costing are problems in distinguishing fixed costs,
lack of determination of manufacturing cost and taxation problems etc.
 Absorption costing is a system of costing that recognizes all costs including
fixed ones as product costs, and therefore, considers all of them in ascertaining
the cost of the product.
 Absorption costing promotes the philosophy of charging all types of costs—
fixed, variable, direct and indirect to processes, operations or products.
 Cost-volume-profit analysis (CVP analysis) is an extension of the principles of
marginal costing. It studies the interrelationship of three basic factors of business
operations: (a) Cost of production, (b) Volume of production/sales, (c) Profit
 Break-even analysis is a widely-used technique to study the CVP relationship.
It is interpreted in narrow as well as broad sense. Self-Instructional
Material 67
Application of  In its narrow sense, break-even analysis is concerned with determining break-
Management
Accounting Techniques even point, i.e., that level of production and sales where there is no profit and
no loss. At this point total cost is equal to total sales revenue.
 When used in broad sense, break-even analysis is used to determine probable
NOTES
profit/loss at any given level of production/sales. It is also used to determine the
amount of sales to earn a desired amount of profit.
 P/V ratio is one of the most important ratios to watch in business. It is an indicator
of the rate at which profit is being earned. A high P/V ratio indicates high
profitability and a low ratio indicates low profitability in the business.
 Margin of safety may be defined as the difference between actual sales and
sales at break-even point. In other words, it is the amount by which actual
volume of sales exceeds the break-even point.
 Marginal Costing and Differential Cost Analysis are the two valuable techniques
used for short-term business decisions.
 The most useful contribution of marginal costing is the assistance that it renders
to the management in vital decision making. This includes selling price decisions,
make or buy decisions, sales mix decisions, selection of a suitable method of
production and plant shutdown decisions.
 Financial statements have incredible importance for both internal and external
stakeholders. They basically are a report card for the company. So it is important
that they are regulated and do not report misleading information. Accounting
Standards (AS) provide us with a framework for this regulation.
 The cost which varies directly in proportion to every increase or decrease in the
volume of output or production is known as variable cost. The cost which
does not vary but remains constant within a given period of time and range of
activity in spite of the fluctuations in production, is known as fixed cost.

2.9 KEY WORDS

 Marginal cost: It is the amount of any given volume of output by which

aggregate costs are changed if the volume of output is increased by one unit.
 Marginal costing: It is an accounting technique which ascertains marginal cost
of additional output by differentiating between fixed and variable costs.
 Absorption costing: It is a system of costing that recognizes all costs including
fixed ones as product costs, and therefore, considers all of them in ascertaining
the cost of the product.
 Cost-volume-profit analysis: It refers to the study of the effects on future
profits of changes in fixed cost, variable cost, sales price, quantity and mix.
 Key factor: It is defined as the factor in the activities of an undertaking, which
at a particular point in time or over a period will limit the volume of output.
Self-Instructional
68 Material
 Application of
2.10 SELF ASSESSMENT QUESTIONS AND Management
Accounting Techniques
EXERCISES

Short-Answer Questions NOTES

1. Differentiate between absorption and marginal costing.

2. Write short notes on margin of safety and cost indifference point.
3. Briefly explain the concept of key or limiting factor.
4. Write a short note on the concept and application of fixed and variable cost
analysis.
5. How is marginal costing used in make or buy decisions?
Long-Answer Questions
1. Describe the meaning and characteristics of marginal costing.
2. Discuss the advantages and disadvantages of marginal costing.
3. Explain cost volume profit analysis and break-even analysis.
4. Assess the applications of marginal costing in sales mix decision.
5. Examine how marginal costing is used in plant shutdown and permanent shutdown
decisions.
6. Describe the major techniques of managerial cost accounting.

2.11 FURTHER READINGS

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House.
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
Material 69
 Budgets as a Tool for

UNIT 3 BUDGETS AS A TOOL FOR Decision Making

DECISION MAKING
NOTES
Structure
3.0 Introduction
3.1 Objectives
3.2 Concept and Preparation of Budgets
3.2.1 Master Budget
3.2.2 Purchase Budget
3.2.3 Sales Budget
3.2.4 Fixed and Flexible Budget
3.2.5 Cash Budget
3.3 Budgetary Control
3.3.1 Budget Committee
3.3.2 Budgetary Period
3.3.3 Budget Manual
3.3.4 Budget Centre
3.3.5 Principle Budget Factor
3.4 Answers to Check Your Progress Questions
3.5 Summary
3.6 Key Words
3.7 Self Assessment Questions and Exercises
3.8 Further Readings

3.0 INTRODUCTION

Budgetary control plays a significant role in sustaining the efficiency of a firm as it helps
it to achieve its goals at a minimum cost. Budgetary control as an effective management
tool for planning and coordinating various business activities helps executives to
anticipate the influence and impact of a given set of events on the firms’ business and
their resources. To serve as an effective tool for managerial control, budgetary control
at the same time provides a proper yardstick for the evaluation of actual performance.
Some authors believe that budgets serve more effectively as a planning tool than a
controlling device. However, firms need to bring flexibility in their budgets to make
them work as a control device. In fact, budgets help organizations to attain their
objectives by providing the feedback necessary for making changes in the plans in a
changing business environment. In this unit, you will learn about the concept of budgeting
and budgetary control.

Self-Instructional
Material 71
Budgets as a Tool for
Decision Making 3.1 OBJECTIVES

After going through this unit, you will be able to:

NOTES  Explain the concept and characteristics of budgets
 Describe the preparation of master, purchase, sales and cash budget
 Discuss fixed and flexible budgets
 Examine the concept and advantages of budgetary control
 Discuss the organization of budgetary control including budget manual and budget
committee

3.2 CONCEPT AND PREPARATION OF BUDGETS

Budget is generally recognized as a plan of action to be pursued by an organization

during a defined period of time in order to achieve its objectives. It is a statement of
anticipated results expressed either in financial or non-financial terms. According to
Williamson (2003); A budget is a formal plan of action expressed in monetary
and other quantitative terms. Gordon and Shillinglow (1974) state, Budget is a
pre-determined detailed plan of action developed and distributed as a guide to
current operations and as a partial basis for the subsequent evaluation of
performance.
CIMA (1991) defines A budget is a financial or quantitative statement
prepared prior to a definite period of time of the policy to be pursued during that
for the purpose of attaining a given objective.
Sizer (1979) explains Budgets are financial and/or quantitative statements
prepared and approved prior to a defined period of time of the policy to be
pursued during that period for the purpose of attaining given objective.
As per M.A. Sahaf, a budget is a detailed schedule of the proposed
combinations of the various factors of production which the management deems
to be the most profitable for the defined period. It may be a forecast of sales,
production costs, distribution costs, and administrative and financial expenses–
and, therefore, of profit or loss. It serves as a road map for executives and makes
them aware when the company is straying from its planned route.
Considerations in Preparing Budget
The following important points must be borne in mind while preparing budget:
 Budgets are prepared to achieve the objectives of the business. No useful budget
can be prepared without a complete knowledge of the objectives, nature and
policies of the business.
 The duration of the budget must be determined according to the special
circumstances of each business. Ordinarily, every company needs both short-
Self-Instructional
72 Material
 term as well as long-term budgets. Short-term are usually in the form of income, Budgets as a Tool for
Decision Making
expenditure, cash and sales. Similarly, the examples of long-term budgets are
capital expenditure, training of business personnel, and expansion of the business.
 The persons who prepare the budgets must be honest and sincere. They should
NOTES
possess full knowledge of the nature, targets and the resources of the company.
They must have foresight and competence to prepare well-balanced budgets.
 Adequate, accurate and reliable statistical information must be available for the
preparation of a good budget. Past experience helps in projecting future.
 Budget must be reasonably elastic and flexible. It must be capable of being
adjusted and changed according to new changes.
 An overenthusiastic business may fix-up extraordinarily high targets. They may
prove to be unrealistic or incapable of being achieved. Efforts made in preparing
the budgets may go waste. To avoid these dangers, budgets must be prepared
by men of experience and foresight. On the one hand, they will try to fix up the
targets according to their resources and on the other hand, they will keep the
targets of the previous budgets quite separate from the new targets.
Classification of Budgets
Different authorities have given different classifications of budgets. Some classify them
on the basis of functions involved, period covered, nature of transactions while others
classify them according to activity levels. Accordingly, the following classifications are
given:
Budgets according to activity levels:
 Fixed budget
 Flexible budget
Classification on the basis of nature of transactions:
 Operating budget
 Capital budget
Period classification:
 Long-term budget
 Short-term budget
Functional classification:
 Master budget: It refers to the summary budget. You will learn about this in the
following section.
 Subsidiary budget
Subsidiary budgets are those budgets which show income or expenditure appropriate
to or the responsibility of a particular activity of the business. They are prepared on the
basis of the guidelines framed by the master budget. There may be different kinds of
Self-Instructional
Material 73
Budgets as a Tool for subsidiary budgets depending on the size, nature and policy of the concern but the
Decision Making
following are frequently prepared:
 sales budget
NOTES  production budget
 production cost budget
 materials budget
 labour budget
 manufacturing overhead budget
 expenses budget
 plant budget
 cash budget.
3.2.1 Master Budget
The master budget sets out a firm’s plan for the operations and resources expressed in
financial terms for a given period. It is a summary of the budget schedules in capsule
form made for the purpose of presenting in one report the highlights of the budget
period. The CIMA (1991), defines it as, The summary budget, incorporating its
component functional budgets which is finally approved, adopted and employed.
Davidson and others state, The master budget, sometimes called the
comprehensive budget is a complete blueprint of the planned operations of the
firm for a period.
Thus, the master budget is an overall budget of a firm which includes all other
small departmental budgets. It is network consisting of many separate budgets that are
interdependent. In fact, the master budget contains consolidated summary of all the
budgets prepared by the organization. Such a budget coordinates various activities of
the business, directing them towards a common goal. Few top executives of the business
are supplied with copies of master budgets. Such a budget is of no use to departmental
executives. It draws the attention of the management to those issues which must require
immediate attention or which must be avoided without any delays in the interest of the
business.
Preparation of a Master Budget It is a complex process that requires much time
and effort by the management at all levels. It includes the preparation of a projected
profit and loss account (income statement) and projected balance sheet. The preparation
of master budget involves the preparation of:
 sales budget;
 production cost budget;
 cost budget;
 cash budget;

Self-Instructional
74 Material
 projected profit and loss account on the basis of information collected from the Budgets as a Tool for
Decision Making
above stated four steps; and
 projected balance sheet from the information available in last year’s balance
sheet and with the help of the steps stated above.
NOTES
The format of the master budget is given in Tables 3.1 and 3.2.
Table 3.1
........ Co. Ltd.,
Master Budget
(For the year ending as on . . . . . . . . . .)

Table 3.2
Budgeted Balance Sheet

Self-Instructional
Material 75
Budgets as a Tool for 3.2.2 Purchase Budget
Decision Making
Careful planning of purchases offers one of the most significant areas of cost saving in
many companies. The purchase manager should be assigned the direct responsibility
NOTES for preparing a detailed plan of purchases for the budget period and for submitting the
plan in the form of a purchase budget.
The purchase budget provides details of the purchases which are planned to be
made during the period to meet the needs of the business. It indicates:
(a) The quantities of each type of raw material and other items to be purchased;
(b) The timing of purchases;
(c) The estimated cost of material purchases.
Factors: In preparing a purchase budget, a number of factors must be considered,
including the following:
(a) Opening and closing stocks to be maintained, as they will affect material
requirements
(b) Maximum and minimum stock quantities
(c) Economic order quantities
(d) Financial resources available
(e) Purchase orders placed before the budget period against which supplies
will be received during the period under consideration
(f) Policy of the management regarding materials or components to be
manufactured within the business, as distinct from those purchased from
outside.
Purposes: The main purposes of a purchase budget are as follows:
(a) To enable the purchasing department to plan its purchases and enter into long-
term contracts, where advantageous.
(b) To record the material prices on which the plan represented by the budget is
based.
(c) To facilitate the management of finance of the business by defining the cash
requirements in respect of the budget period and for shorter runs.
The purchase budget differs from the raw material budget in that purchase budget
specifies both quantities and rupee costs, whereas raw material budget is usually limited
to quantities only. Secondly, purchase budget includes direct and indirect materials,
finished goods for resale, services like electricity and gas, etc. while raw material
budget includes only direct material requirements.
Illustration 3.1: The sales manager of Mahindra & Co. Ltd reports that next year he
expects to sell 50,000 units of a certain product.
The production manager consults the storekeeper and casts his figures as follows:
Two kinds of raw materials A and B are required for manufacturing the product. Each
Self-Instructional
76 Material
unit of the product requires 2 kgs of A and 3 kgs of B. The estimated opening balances Budgets as a Tool for
Decision Making
at the commencement of the next year are—Finished Product, 10,000 units; A, 12,000
kgs; B 15,000 kgs. The desirable closing balances at the end of the next year are:
Finished product, 14,000 units; A, 13,000 kgs; B, 16,000 kgs.
NOTES
Draw up a Materials Purchases Budget for the next year.
Solution:
As production quantity during the year is not given, it is calculated as under:
Sales during the year 50,000 units
Add: Desired stock at the end of next year 14,000 units
Total 64,000 units
Less: Expected stock at the beginning of the next year 10,000 units
Estimated production 54,000 units

Purchases Budget
for the period ...........

Item Material A Material B

kgs kgs
Consumption during the year:
A—54,000 units @ 2 kg per unit 1,08,000 —
B—54,000 units @ 3 kg per unit — 1,62,000
Add: Desired stock at the end of next year 13,000 16,000
1,21,000 1,78,000
Less: Expected stock at the commencement
of next year 12,000 15,000
Quantities of materials to be purchased 1,09,000 1,63,000

3.2.3 Sales Budget

It is an estimate of future sales expressed in quantities and/or money. Such a budget, in
fact, calls for projection of a firm’s sales on a periodic basis. The preparation of an
effective sales budget demands the study of both internal and external factors. The
internal factors to be considered for the purpose are past activity, present and projected
plant capacity, proposed management policies, financial position, sales force size,
availability of materials, and promotional campaign. The external factors that must be
analysed to enable managers prepare sales budget include extent of competition,
government policies and regulations, economic conditions of the country and general
trade prospectus. The management should constantly review the above-mentioned
factors in order to find out the quantum of change in them and its impact on product
demand.
Generally, sales budget is recognized as the key budget that leads to the
preparation of all other functional budgets. The success of any commercial enterprise
largely depends upon the quick turnover of its production. Against this background,
every company wants to maximize its sales. However, the maximization of sales has
always remained a complex problem that requires proper attention from the
Self-Instructional
Material 77
Budgets as a Tool for management. Every effort must be made to achieve sales targets. The sales budget
Decision Making
can be broken down by:
 product lines
NOTES  geographic territories
 time span
 types of customers.
A forecast of sales on an industry-wide basis must be broken down so that it
applies to a particular firm. Each firm studies its position relative to the total market
and calculates its share of the market. In some areas and in certain product lines, one
firm may dominate while in other areas and in other product lines, the sales may be
shared by the firms in different proportions. The following techniques are used for
sales forecasts:
 past trends
 sales executives opinion
 survey methods
The following illustration will further clear the idea about the preparation of sales budget.
Illustration 3.2: MAS Co. Ltd. operates two sales divisions by selling two quality
cement products—White and Black in them. For the purpose of submission of sales
budget to the budget committee, the following information has been made available.
Budget sales for the current year were as follows:

Actual sales for the current year were as follows:

The sales division of the company has taken the following decisions at a meeting:
(i) The sales manager observed that product White is popular but underpriced.
Therefore, the price of product should be increased by 20.
(ii) The product Black has less market and the main reason responsible for it is the
over price of the product. However, if the price of the product is reduced by
5, it is expected to generate more demand.
On the basis of these price changes and reports from the sales force, the following
estimates have been prepared by divisional sales manager:
Self-Instructional
78 Material
 Percentage increase in sales over current budget. Budgets as a Tool for
Decision Making

NOTES

You are required to prepare a sales budget to be presented to the budget

committee.
Solution:
Sales Budget
MAS Co. Ltd.

Illustration 3.3: Super National Company Ltd. has three items in its product line—
EX, YEE and ZED. These products are sold in two markets—Super and Superior.
The following information on the sales of these products in these markets is available:

The EX product is sold at 5 per unit whereas products YEE and ZED are sold
for 4 and 7 respectively, in both markets.
The research department of the company submitted the following proposals to
be kept in mind while preparing sales budget:
(a) Product EX has stiff competition in future and as a result of which the sales may
decline. To maintain present state of demand the price of the product may be
reduced by 10 per cent.
(b) Product YEE is popular but underpriced. It is reported that if its price is increased
Self-Instructional
by 25 per cent it will still find a ready market. Material 79
Budgets as a Tool for (c) The sale of product ZED may decline by 10 per cent due to entrance of new
Decision Making
firms in the industry.
(d) With the help of an intensive campaign 5 per cent additional sales over the
estimated sales are expected in all products in both markets except of product
NOTES
ZED in superior market.
The management has approved the proposal without any change. You are required
to prepare a budget for sales incorporating the above proposals.
Solution:
Sales Budget
Super National Company Ltd.

3.2.4 Fixed and Flexible Budget

Although this approach to budgeting is not popular among the firms yet a few firms do
use fixed budget in certain areas of expenses management. Generally fixed budget is
referred to as predetermined costs projected at a particular capacity level. That is,
once capacity is projected at a particular level, the individual department gathers and
classifies their costs at that level. The budget thus prepared is known as a fixed budget.
Such budgets assume that the amount of rupees shown in the budget is triggered by
the passage of time irrespective of production levels or the volume of activity. The
CIMA (1991) defined fixed budget as a budget which is designed to remain unchanged
irrespective of the level of activity actually attained. In the words of Wilson (1975) a
fixed budget is one that is compiled for a given set of assumed operating
conditions and for a clearly specified but estimated level of activity, and which
management proposes to leave unchanged during the period to which it relates—
regardless of changes in the actual level of activity experienced or in the conditions
Self-Instructional
80 Material facing the company during that period. Thus, fixed budget is a plan that expresses
only one level of estimated activity or volume. Such a budget is also known as static Budgets as a Tool for
Decision Making
budget. The term ‘fixed budget’ is probably a misnomer because this budget really is
never fixed. Business and economic conditions constantly change and the management
has to review and change the budgets in the light of those changes.
NOTES
Flexible Budget
Firms that recognize the tendency of fixed overhead to vary with substantial changes in
production prefer to use a flexible budget. This is simply a series of fixed budgets that
apply to varying levels of production. According to CIMA (1991), a flexible budget is
a budget which, by recognizing the difference between fixed, semi-fixed and
variable costs, is designed to change in relation to the level of activity attained.
Thus, a flexible budget is a series of cost budgets, each prepared for a different level of
capacity. The capacity levels are set at percentages of capacity or at the production of
a specified number of units at set levels of capacity. In fact, costs are broken down
into fixed, variable, and semi-variable under various levels of capacity. Although flexible
budgets generally do not distinguish between variable and fixed overhead yet they
provide a single rate for both types of overheads. This rate is established by dividing
estimated overhead at the normal production level by the normal volume of production.
Flexible budgeting can be incorporated in one of two ways—step budget,
wherein budgets are developed for different levels of operation, or variable budget,
where budgets are prepared on a variable cost basis providing progressively greater
budget allowances as the volume of activity increases. Business executives prefer the
technique of flexible budgeting as it can be easily understood by the supervisors at all
levels and with all degrees of education because of the realistic way in which such
budgets accommodate actual operating conditions in the plant. The major significance
of flexible budgeting is that it provides completely realistic budget amounts. There are
very less chances for variances, which too can be the result of inefficient control or
changes in operating conditions.
Illustration 3.4: The cost details obtained from financial records of Safa Ltd., for
production of 500 units are given below:

You are required to prepare a budget for production of:

(i) 700 units; and
Self-Instructional
(ii) 900 units. Material 81
Budgets as a Tool for Solution
Decision Making
Safa Ltd.
Flexible Budget

NOTES

3.2.5 Cash Budget

The availability of cash in adequate quantity at proper time at a reasonable cost is
essential for smooth operation of a business. The cash budget attempts to estimate
cash requirements of a business well ahead of time. According to Soloman, (1968)
‘the cash budget is an analysis of flow of cash in a business over a future, short or long
period of time. It is a forecast of expected cash intake and outlay’. The cash budget
converts all planned actions into cash inflows and cash outflows. Thus, it shows the
anticipated flow of cash and the timing of receipts and disbursements based upon
projected revenues and expenses. This budget is significant because it helps
management in planning to avoid unnecessary idle cash balances on the one hand and
avoidable expensive borrowings on the other. It indicates not only the total amount of
financing required but its timing as well. The cash budget generally consists of the
following two major sections, viz., receipt section and payment section.
Normally, the major source of cash receipts for any business is sales. For credit
sales, accounts receivable are eventually converted into cash as debtors pay their
accounts. However, in this connection, management has to estimate properly the time
taken to collect outstanding accounts. At the same time, provisions must be made for
discounts, returns, allowance granted and uncollectible accounts. From a study of
past records and recent experience in the rate of collection, it should be possible to
predict approximate receipts on accounts.
Special items such as increase in cash from sale of equipment, issuance of shares,
borrowing, and so on must be considered in the estimation of cash receipts. Thus,
cash receipts are expected to be generated from the following sources:
Self-Instructional  cash sales;
82 Material
  collection from debtors, Budgets as a Tool for
Decision Making
 non-operating incomes like dividend, commission, interests, and so on,
 sale proceedings from capital assets;
 share capital and debentures; and NOTES
 loans and overdrafts.
The payment section of the cash budget consists of all cash payments that are
planned for the budget period. These payments will include payments for merchandise
and overhead acquired or incurred for the current budget period as well as for payables
on the past budget period. Payments on various accounts are not made simultaneously
with the cost incurred or materials and services used. The expenditure on various
items like insurance, rent and advertising are often paid in advance while payments for
materials, labour and other costs of operation frequently follow acquisition and use.
Capital expenditures for expansion and replacement in addition to mandatory
expenditures for a variety of other purposes such as taxes, donations, repayments of
loans, dividends, and so on must be taken into account. The major items of payments
are:
 payment for various inputs like materials, labour and machinery;
 payment of loans and deposits;
 redemption of capital and debentures; and
 investments.
The difference between cash receipts and payments represents cash overage
or shortage. If a shortage exists, the company will have to arrange the cash through
bank loans or other financing methods. If an excess exists, funds borrowed in previous
period can be repaid, or the idle funds can be temporarily invested.
How frequently cash budget should be prepared and the time intervals covered
by the budget depend on the individual company’s circumstances, problems and
objective. However, cash budget should be broken down into time periods that are as
short as feasible. Many organizations maintain cash budgets on a weekly basis and
even some prefer to do it on daily basis. But firms prefer to have case budgets on a
monthly basis. However, a firm might be interested to prepare a cash budget every
quarter if it is considering expansion.
Cash budgets may be prepared in three ways with varying formats and
appearances. However, all forms require the same estimates and result in the same
forecast. The methods are
 Receipt and payment method;
 Adjusted profit and loss method; and
 Balance sheet method.
Receipt and Payment Method This method is a line-by-line estimate of receipts and
payments. A good starting point for developing the cash budget is the opening cash
balance to which expected cash receipts during the budget period are added. The Self-Instructional
Material 83
Budgets as a Tool for figure so obtained is reduced by the amount of cash payment that is planned for the
Decision Making
budget period. The outstanding payments and receipts are excluded from cash budget
as this method is based on the concept of actual cash flows rather than on their accrual.
Accordingly pre-payments and pre-receipts are to be considered in the preparation
NOTES of cash budget. The receipt and payment method of cash budget is demonstrated in
Illustration 3.5.
Illustration 3.5: Prepare a cash budget for the first four months from the following
estimated revenue and expenses:

Additional Information:
(i) Cash balances on 1st April was 35,000.
(ii) 50 per cent of sales are on credit basis which are realised in the subsequent
month.
(iii) Suppliers are paid in the month following the month of supply.
(iv) Delay in payment of wages and overheads is 30 days.
(v) Dividends on investments amounting 10,000 may be received in April and
July.
(vi) Company plans to purchase a machine for 60,000 for which it has to pay the
consideration in three equal instalments in the month of April, June and July.
Solution:
Cash Budget
for the Period April to July

Self-Instructional
84 Material
Adjusted Profit and Loss Method Under this method, the profit forecast for the budget Budgets as a Tool for
Decision Making
period is adjusted for non-cash transactions and for expected changes in assets and
liabilities not involved in the calculation of profit. Thus, net estimated profit for the budget
period is increased by the amount of no-cash transactions like depreciation, provisions,
outstanding expenses, and so on, which in turn is added by capital receipts, reduction in NOTES
assets and increase in liabilities to form total cash receipts. The amount so calculated is
reduced by the amount resulting from payment of dividends, pre-payments, increase in
assets and decrease in liabilities. The resultant figure will be the amount of cash available
at the end of the budget period. The top management always prefers to use adjusted
profit and loss for cash forecasting but most firms are compelled to use the line-by-line
estimate to provide the detailed information needed by lower management levels for
control. The essential information for the preparation of adjusted profit and loss account
is collected from profit and loss account and balance sheet. Illustration 3.6 will demonstrate
the process of preparation of cash budget as per adjusted profit and loss account method.
Illustration 3.6: The following data is made available to you to prepare a cash budget
under the adjusted profit and loss method:
Balance Sheet
as on 31st March 2012

Projected Trading and Profit and Loss Account

for the Year Ending 31st March, 2013

Self-Instructional
Material 85
Budgets as a Tool for The following closing balance of certain items as on 31st March 2013 are also given
Decision Making
as additional information:
Share capital 2,40,000
NOTES Debentures 90,000
Building 1,40,000
Machinery 80,000
Bills payable 25,000
Solution:
Cash Budget

Balance Sheet Method Under this method the cash balances at the end is computed
with the help of a projected balance sheet. The projected balance sheet begins with
the current balance sheet and the same is adjusted in accordance with the data contained
in the other budgets. All the balance sheet items except cash balances are adjusted in
the light of changes that might take place between current balance sheet and the
projected balance sheet. The difference between projected assets and projected
liabilities represents cash balance.

Check Your Progress

1. Which budget is also called comprehensive budget?
2. What does a purchase budget indicate?
Self-Instructional 3. What are the ways in which flexible budgeting can be incorporated?
86 Material
 Budgets as a Tool for
3.3 BUDGETARY CONTROL Decision Making

Commercial organizations always aim to attain the highest volume of sales at the minimum
cost in order to maximize their profits. To attain this objective, organizations need to NOTES
realize that planning and control of activities become essential absolutely. It is, in fact,
the system of budgetary control that provides the organizations with the framework
which helps them to achieve this objective.
Budgetary control is a systematic process designed to plan and control the
major activities of a firm’s business through budgets prepared in advance with an
objective to ensure effective use of resources. In the words of Batty (1978), Budgetary
control is a system which uses budgets as a means of planning and controlling all
aspects of producing and/or selling commodities or services. According to Scott
(1970), it is the system of management control and accounting in which all
operations are precasted and so far as possible planned ahead and the actual
results compared with the forecasted and planned ones.
CIMA (1991) defines budgetary control as, the establishment of budgets relating
to the responsibilities of executives to the requirements of a policy and the continuous
comparison of actual with budgeted results, either to secure by individual action the
objective of that policy or to provide a basis for its revision.
In the opinion of Brown and Howard (1975), Budgetary control is a system
of controlling costs which includes the preparation of budgets, coordinating the
departments and establishing responsibilities, comparing actual performance
with the budgeted and acting upon results to achieve maximum profitability.
As per author M.A. Sahaf, budgetary control is a process of managing an
organization in accordance with an approved budget in order to keep total
expenditure within authorized limits. It is designed to assist the management in
deciding the future course of action and to develop the basis for evaluating the
efficiency of operations. Thus, a budgetary control consists of:
 Preparation of budgets for major activities of the business;
 Measurement and comparison of actual results with budgeted targets;
 Computation of deviation, if any; and
 Revision of budget, if required.
Thus, budgetary control requires preparation and designing of the budgets
revealing clearly the financial responsibilities of executives in relation to the requirements
of the overall policy of the company followed by a continuous comparison of actual
business results with budgeted results to secure the objectives of the policy. If the
principles of budgeting are carried out in a proper manner, the company can be assured
that it will efficiently use all of its resources and achieve the most favourable results
possible in the long run.

Self-Instructional
Material 87
Budgets as a Tool for Objectives of Budgetary Control
Decision Making
The main objectives of budgetary control are as under:
 To provide useful, accurate and reliable information to enable managers formulate
NOTES future business policies.
 To help the organizations in exercising control over costs by preparing separate
budgets for each department To evaluate the results of various policies and
facilitate supervision over the various factors of production.
 To eliminate the danger of over capitalization and under capitalization by
determining the total capital requirements of a business firm with the help of
production budget and working capital estimates.
 To locate deficiencies in production system by preparing separate production
capable of ascertaining the efficiency of production.
 To promote research and development activities of an organization as budgetary
control policies and programmes are usually based on past experience.
Benefits of Budgetary Control
Budgetary control is perhaps the most useful tool used by the management for planning
and controlling major activities of the business. However, the system of budgetary
control in itself does not ensure good planning or control but it helps executives to plan
ahead and exercise control over people and operating events. In fact, such a system
not only provides information on probable future business results but also the resources
like money, men, materials and facilities required to achieve such results. The most
notable benefits derived from the system of budgetary control are as follows:
 Through its disciplined approach, it coordinates the planning of all functional
executives towards the common profit making goal.
 Motivates executives to think ahead by impressing upon them to formalize their
planning efforts.
 Provides managers an opportunity for self-evaluation by offering them goals
and objectives against which they can evaluate their performance without any
difficulty. Such an arrangement makes each member of the organization clear
about his role and contribution in attaining organizational goals.
 Enables an organization to predetermine the benefits and costs of the projects
under various alternative operating conditions. Such a comparative analysis helps
it to evaluate the most appropriate allocation of resources.
 Provides a framework that specifies measurable periodic objectives for each
phase of planning.
 Helps managers to identify expected operation problems from business activities
but also provides them the basis for solving these problems or avoiding them
before they occur.

Self-Instructional
88 Material
  Make employees of the organization conscious of the needs to conserve business Budgets as a Tool for
Decision Making
resources.
 Maximize benefits of decentralization.
 Makes it obligatory for the enterprise to maintain adequate financial records NOTES
that can be associated with the budget.
 Serves as an excellent vehicle and effective communication system for the
exchange of ideas and coordination of plans among various levels of management.
 Reveals budgets prepared for efficient and effective use of resources.
 Increases participation of employees in the preparation and execution of budgets
thereby boosting the morale among them which in turn contributes to the output.
 Helps a company meet market competition efficiently by keeping the cost at the
minimum level.
Limitations of Budgetary Control
Despite the benefits mentioned earlier, budgetary control suffers from serious limitations.
Management must keep such limitations in mind while using the tool of budgetary
control. The major limitations of budgetary control system are summarized below:
 Since budget estimates are based on approximations and personal judgements,
therefore, they are always doubtful. In fact, the quality of budgets is always
associated with the intelligence, skills and experience of the budget persons.
 The premises of the budgetary control system change rapidly with the change in
business conditions. As a result, business executives face a lot of difficulties in
the execution of budgets.
 The success of budgetary control largely depends on its execution which in turn
depends on the cooperation and participation of all levels of management. Every
member of the organization must direct his efforts to achieve the objectives of
the budget. Any lapse in their coordination or cooperation may result in poor
performance.
 The installation of budgetary control system is a costly affair, and therefore,
small organizations may not afford it. Even financially sound enterprises must
adopt this system only after analysing properly its cost and benefits.
 Budget targets sometimes are considered as pressure tactics which lower the
morale of the employees.
 The formulation of the budgets is a time-consuming process as a good amount
of time is wasted in their preparation, evaluation and revision.
 There is an old saying to the effect that ‘a man is usually down or what he isn’t
upon’. Often executives do not realize the utility of the budgetary control system.
 Under budgetary control system every budget centre tries to achieve its objectives
without taking into consideration the objectives of other budget centres and overall
objectives of the budgetary control system. This creates conflict among various
units of the organization which ultimately interrupts the efficiency of the system. Self-Instructional
Material 89
Budgets as a Tool for Essential Characteristics of a Good Budgetary Control
Decision Making
A good budgetary control must possess the following characteristics:
 There must be a common authority to enjoy the rights and privileges as well as
NOTES to fulfil the obligation. Actual users must be consulted before actually allocating
different resources.
 The supervisory staff must be held responsible for all the functions of the business
and proper utilization of all the resources of the business.
 Independence of action must be ensured for the administration in those matters
for which they are accountable. In such matters, they must be consulted and
their views should be given due weightage.
 One who gives orders must also provide facilities for the execution of those
orders.
 There must be test checking of the work at regular intervals and the results must
be compared with the targets. Shortcomings must be ascertained and measures
should be suggested to overcome them.
 There must be some system for rewarding better results and penalizing poor
results. Incentives for better work must be provided. Inefficiency must not be
condoned.
Requirements for Budgetary Control
The prerequisites for good budgetary control are essentially the same as for sound
business management. For effective budgetary control, the firms need to:
 develop the statement of objectives and policies to guide management in reaching
its business goals;
 build up a sound plan for the organization with clearly defined responsibilities
and authorities for each management and supervisory position;
 establish a clear understanding of cost behaviour and product cost structure;
 develop a plan of operations over a given period of time to achieve objectives
efficiently and effectively;
 provide for measurement of performance through timely comparative control
reports;
 take necessary action in the execution of plans to set right unsatisfactory
performance;
 revise the budgets when required.
The concept of budgetary control formalizes the process implied in these requirements
by incorporating the above steps into a comprehensive financial plan or budget. It
should be obvious that the financial plan or budget is not just a forecast or a summary
of the business results a year ahead. It is instead a plan of operation. The plan must be
based on good operating practices and soundly conceived management strategy. It
Self-Instructional
90 Material
should have a certain extent of flexibility, a ‘stretch’ in it. This means that operating Budgets as a Tool for
Decision Making
men should incorporate in the budget performance, goals that are attainable by hard
work and dedicated effort. An easy test of whether or not a business budget has been
built on good planning and control concept is to check these points:
NOTES
 Sales and production requirements should be defined in terms of quantities by
products.
 The variable and total costs of producing each product should be identified on
a predetermined basis in the budget.
 Budgeted costs and expenses should be stated for each responsibility centre.
 The degree of capacity utilization of major equipments and facilities should be
clearly defined in the budget plan.
 All departmental budgets should be based on the same volumes of product and
service requirements and should meet an acceptable profit goal.
If an organization’s budgetary control system does not meet these tests, functional
executive need to discuss the lapses with the budget personnel to seek improvements
in the system.
Organization of Budgetary Control
The proper organization of a budgetary control system helps the management in
coordinating the entire operational activity. Therefore, the management need to take
due care in the installation of a sound budgetary control system which requires the
following:
 Budget committee
 Budget period
 Budget manual
 Budget centre
 Principal budget factor
3.3.1 Budget Committee
For an effective budgetary control system, someone must be responsible for the
preparation of budgets in the organization. In small concerns this job is assigned to
financial managers, however, in large enterprises a budget committee is generally formed
for this purpose. The committee establishes the budget procedures, collects and
coordinates the relevant data and prepares the final budget-which is then communicated
to various budget levels. Further, the committee is also responsible to resolve the
conflicts between various units of the enterprise regarding any issue related to budgets.
Thus, the budget committee is a high-powered decision making body that formulates
the budget planning for key areas of the enterprise. In order to discharge its
responsibilities efficiently, the Committee must constitute the members from all
departments that are involved in the execution of budgets. The Committee is usually
chaired by the Chief Executive who is known as budget controller or budget officer. Self-Instructional
Material 91
Budgets as a Tool for The budget programme is usually organized and administered by finance executive.
Decision Making
The major functions of budget committee are:
 To formulate the essential guidelines for the preparation of the budgets;
NOTES  To gather and disseminate necessary information for budget preparations;
 To reconcile divergent views of various budget members to avoid conflicts;
 To receive, review and coordinate budgets submitted by various departmental
heads;
 To approve budgets and latter revise them in the light of changes;
 To offer technical consultancy to various budget units;
 To receive and analyze periodic reports on the progress of the company; and
 To suggest measures for the improvement in the financial and operational
efficiency of the enterprise.
3.3.2 Budgetary Period
A firm may budget for any time period. The time span for budgeting will vary from
organization to organization depending on a number of factors such as nature of business,
the degree of risk and uncertainty, financial resources, economic conditions, etc. The
length of the budget period may be a week, a month, quarter of a year, or even more
than a year. Firms do not have any set interval of time. The formal budget most often
is prepared for a year and is divided into months or quarters of a year. This approach
clearly reveals the influence of financial accounting and the annual cycle of operations
on management’s thinking towards business planning.
Long-range budgets are usually concerned with capital investments and may
include a period of five or more years into the future. The plans for later years will
probably be somewhat indefinite, because they are based upon long-term prospects.
Such budgets should be revised in the light of current economic and business conditions
which have changed with the passage of time.
A shorter period may be deceptive as it will not reflect all seasonal conditions
while a larger period increases the difficulty of accurate forecasting. However,
comparatively budget for a shorter period can be formulated with more accuracy than
the one with a longer period. Thus for specific decisions and planning situations, budgets
for periods less than one year are always preferred. As a result, rolling or progressive
budgets are becoming very popular. This approach to budgeting covers a period of
twelve months which is extended to one more month into the future when a month
expires. This provides the management an opportunity to incorporate changing business
conditions in the formulation of budgets for future months. Budgeting is then a continual
process and that is why such budgets are also known as continuous or perpetual
budgets. Management experts claim that rolling approach to budgeting is superior to
all other approaches as it has a wide planning horizon.

Self-Instructional
92 Material
 Under normal business conditions, it may be profitable to have at least a Budgets as a Tool for
Decision Making
condensed budget for one year in advance as a basis for broad plans and policy
decisions. The condensed budget should be revised quarterly to keep it a year ahead.
At the same time, it is prescribed to have capital investment budgets running as much
as five years ahead. NOTES

3.3.3 Budget Manual

Budget manual sets out the responsibilities of the various executives concerned with
the budgetary control system. According to the CIMA (1991) budget manual is a
document which sets out, inter alia, the responsibilities of the persons engaged
in, the route of, and the forms and records required for budgetary control. Thus
budget manual is a document which contains the essential information required for the
construction, administration, and execution of the budget. It further indicates the reporting
and communicating system within the organization. The budget manual may also give
details of periodical budgetary reviews and the forms and procedures necessary for
such reviews for exercising budgetary control (Shankaraih, 1983). Thus, the main
contents of a budget manual are:
 principles and objectives of the budgetary control system;
 responsibilities of persons engaged in a budgetary programme;
 procedures to be followed for the preparation of budgets;
 details of periodical budgetary reviews;
 time schedule indicating the various stages in the process of budget;
 role of various executives in the organization of the budget;
 essential records to be maintained;
 reporting and communication system to be installed; and
 scope, period and areas of budgets.
A detailed budget manual serves a ready reference for the executives connected
with the budgeting system as it provides them proper guidelines in the organization and
preparation of budgets. Thus, it forms an essential component of the budgetary control
system. Therefore, it is necessary for every commercial enterprise to maintain a budget
manual. Commenting on the importance of budget manual, a corporate controller of
reputed American firm is of the opinion:
‘Budget manuals serve to define and clarify many matters. Numerous uncertainties
may be discovered, and through clarification, a better understanding of the parts and
the whole may evolve. Periods of training may be reduced when oral instructions are
supplemented by written procedures. Less embarrassment may occur if answers to
questions can be obtained from a manual. Reliance on memory is eliminated when a
procedure is reduced to writing. Furthermore, unless procedures have been reviewed
and written down, employees’ turnover and the passage of time may help change
procedures without the knowledge or consent of superiors’ (Bullock et al., 1983).
Self-Instructional
Material 93
Budgets as a Tool for 3.3.4 Budget Centre
Decision Making
The budget centre represents the segment of the organization for which a budget is
prepared. According to the CIMA (1991), a budget centre is a section of the
NOTES organization of an undertaking defined for the purpose of budgetary control.
Each such centre is under the control of a responsible officer who is accountable to the
management for the proper execution of the budget in his centre. Budget evaluation
becomes easy with the establishment of budget centres.
3.3.5 Principle Budget Factor
The ‘principal budget factor’ or ‘limiting factor’ as it is often called is the key constraint
in the system for the particular budget period. According to the CIMA (1991), a
principal budget factor is the factor the extent of whose influence must first be
assessed in order to ensure that the function budgets are reasonably capable of
fulfilment. A company may be limited by the amount of service or volume of products
that can be sold to the customers. Thus, the amount of sales is the principal budget
factor due to slack demand. Ordinarily, a commercial or industrial enterprise may
have the following principal budget factors:
 non-availability of material;
 non-availability of key personnel;
 non-availability of finance;
 inadequate space;
 low market demand;
 poor management resources; and
 production capacity.

Check Your Progress

4. What is the required of the budgetary control for securing the objectives of a
company’s policy?
5. Name the components of a sound budgetary control system.
6. Which type of budget is better for incorporating changing business conditions?

3.4 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. A master budget is sometimes called the comprehensive budget.

2. The purchase budget provides the details of the purchases which are planned to
be made during the period to meet the needs of the business. It indicates:
a) The quantities of each type of raw material and other items to be purchased;
Self-Instructional
94 Material
 b) The timing of purchases; Budgets as a Tool for
Decision Making
c) The estimated cost of material purchases.
3. Flexible budgeting can be incorporated in one of two ways: step budget, wherein
budgets are developed for different levels of operation, or variable budgets, NOTES
where budgets are prepared on a variable cost basis providing progressively
greater budget allowances as the volume of activity increases.
4. The budgetary control requires preparation and designing of the budgets revealing
clearly the financial responsibilities of executives in relation to the requirements
of the overall policy of the company followed by a continuous comparison of
actual business results with budgeted results to secure the objectives of the
company’s policy.
5. The components of a sound budgetary control system are budget committee,
budget period, budget manual, budget centre and a principal budget factor.
6. A rolling or progressive budget is better for incorporating changing business
conditions.

3.5 SUMMARY

 Budget is generally recognized as a plan of action to be pursued by an organization

during a defined period of time in order to achieve its objectives. It is a statement
of anticipated results expressed either in financial or non-financial terms.
 While preparing a budget, certain factors must be considered. This includes
complete knowledge of objectives, determination of the duration of the budget,
availability of competent and experienced budget managers, ensuring the making
of elastic and flexible budgets, realistic aims.
 Different authorities have given different classifications of budgets. Some classify
them on the basis of functions involved, period covered, nature of transactions
while others classify them according to activity levels.
 Budgets according to activity levels include fixed budget and flexible budget.
Classification on the basis of nature of transactions includes operating budget
and capital budget. Period classification consists of long term and short term
budgets. Functional classification includes master and subsidiary budget.
 The preparation of master budget involves the preparation of sales budget,
production of cost budget, cost budget, cash budget, projected profit and loss
account on the basis of information collected from the above stated four steps;
and projected balance sheet from the information available in last year’s balance
sheet and with the help of the steps stated above.
 A subsidiary budget requires the preparation of sales budget, cash budget,
production cost budget, materials budget, labour budget, manufacturing overhead
budget, expenses budget, and plant budget.
Self-Instructional
Material 95
Budgets as a Tool for  Commercial organizations always aim to attain the highest volume of sales at the
Decision Making
minimum cost in order to maximize their profits. To attain this objective,
organizations need to realize that planning and control of activities become
essential absolutely. It is, in fact, the system of budgetary control that provides
NOTES the organizations with the framework which helps them to achieve this objective.
 Budgetary control is a systematic process designed to plan and control the
major activities of a firm’s business through budgets prepared in advance with
an objective to ensure effective use of resources.
 Budgetary control consists of preparation of budgets for major activities of the
business; measurement and comparison of actual results with budgeted targets,
computation of deviation and revision of budget.
 The objectives of budgetary control includes providing accurate information to
the managers, helping the control of costs, eliminating the danger of over
capitalization and under capitalization, locating deficiencies in the production
system and promoting research and developmental activities.
 Benefits of budgetary control includes help in the coordinating of planning of the
executive functions, motivating the executives, self-evaluation of managers,
predetermination of benefits and costs, conserving resources, and increase of
participation of employees etc.
 Limitations of budgetary control consists of doubtful data due to approximation
and personal judgements, high costs, over consumption of time, slow adaptation
to the changing business conditions etc.
 Organization of a sound budgetary control system requires a budget committee,
budget period, budget manual, budget centre and a principle budget factor.

3.6 KEY WORDS

 Budget: It is a plan of action to be pursued by an organization during a defined

period of time in order to achieve its objectives. It is a statement of anticipated
results expressed either in financial or non-financial terms.
 Budgetary control: It is a systematic process designed to plan and control the
major activities of a firm’s business through budgets prepared in advance with
an objective to ensure effective use of resources.
 Budget manual: It is a document which sets out, inter alia, the responsibilities
of the persons engaged in, the route of, and the forms and records required for
budgetary control.
 Budget centre: It is a section of the organization of an undertaking defined for
the purpose of budgetary control.
 Principal budget factor: It is that factor the extent of whose influence must
first be assessed in order to ensure that the function budgets are reasonably
Self-Instructional capable of fulfilment.
96 Material
 Budgets as a Tool for
3.7 SELF ASSESSMENT QUESTIONS AND Decision Making

EXERCISES

Short-Answer Questions NOTES

1. What are the factors that must be kept in mind while preparing a budget?
2. How are budgets classified?
3. What does the preparation of master budget involve?
4. What are the objectives of budgetary control system?
5. State the essential characteristics of a good budgetary control system.
Long-Answer Questions
1. Describe the preparation of materials purchase and sales budget.
2. Explain the ways in which a cash budget is prepared.
3. Assess the concept and preparation of fixed and flexible budgets.
4. Discuss the benefits and limitation of a budgetary control system.
5. Briefly explain the organization of a budgetary control system.

3.8 FURTHER READINGS

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House.
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
Material 97
 Working Capital

UNIT 4 WORKING CAPITAL Management

MANAGEMENT
NOTES
Structure
4.0 Introduction
4.1 Objectives
4.2 Concept and Definition of Working Capital
4.3 Determination of Working Capital
4.4 Assessment of Working Capital Needs
4.5 Study of Components of Working Capital
4.5.1 Cash Management
4.5.2 Accounts Receivable Management
4.5.3 Inventory Management
4.6 Answers to Check Your Progress Questions
4.7 Summary
4.8 Key Words
4.9 Self Assessment Questions and Exercises
4.10 Further Readings

4.0 INTRODUCTION

The operational expenses of firms is something that cannot be handled without proper
working capital management. This strategy of handling short-term assets and short-
term liabilities is crucial to the smooth operation of businesses everywhere. Working
capital management is responsible for the appropriate amount of cash flow that should
be with a firm for its various functions. In this unit, the concept, assessment and study
of components of working capital will be discussed.

4.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the concept of working capital
 Describe the determination of working capital
 Discuss the assessment of working capital needs
 Assess the study of components of working capital such as cash, accounts
receivable and inventory management

4.2 CONCEPT AND DEFINITION OF WORKING

CAPITAL

Long term financing decisions, management of fixed assets and current assets/working Self-Instructional
capital is essential for the financial strength of a company. Management of current Material 99
Working Capital assets and fixed assets are similar in the sense that both these type of decisions involve
Management
risk-return analysis, but these two decisions also differ in sense that fixed asset
management decisions are related to long term while current assets decision are related
to short term.
NOTES
In fixed asset management, the decision time is a very critical factor which is
why discounting and compounding techniques are essential. It requires capital budgeting
analysis. Level of holding current assets and fixed assets is dependent upon the level of
sales of the firm but the firm itself can make changes only in the holding of current
assets. Current assets can be adjusted with the change in sales of the firm but fixed
assets cannot be changed because that would bring loss to the firm. Holding of current
assets affects the liquidity and profitability position of the firm which makes risk-return
trade-off vital for holding the current asset.
Working capital management deals with the day-to-day operations of a business and
directly affects the liquidity and profitability of the business. Therefore, it is essential to
understand its key aspects. Basically the working capital is understood in two ways:
 Gross Working Capital (Quantitative concept)
 Net Working Capital (Qualitative concept)
Gross working capital: According to the gross working capital concept, the working
capital means the total of current assets in a business. Current assets includes: cash,
debtors (account receivables), bank balance, stock, inventories, marketable securities
and short term securities and prepaid expenses.
Net working capital: According to the net working capital concept, the working
capital means the total amount of current assets and current liabilities. It can be
calculated by finding the difference between current assets and current liabilities.
Current liabilities include creditors, bills payable and outstanding expenses. Net
working capital can be of positive value or of negative value. If it is positive, it means
current assets are more than current liabilities whereas if working capital is negative
then current liabilities are more than current assets. So, net working capital can be
of positive or negative value. Excess of current assets over current liabilities is called
as net working capital. Excess of current liabilities over current assets is called as
working capital deficit.
There should be an optimum amount of liquidity within the business to run
its day-to-day operations and maintain its credit worthiness. Therefore, the focus
of working capital management is on liquidity management. Current assets should
not be in surplus or in scarcity. If current assets are in excess, it leads to idle funds
in the firm which adversely affects its profitability position. If however, current
assets are in scarcity, the firm will not be able to pay its day-to-day obligations
which adversely affect the liquidity position of the firm. Therefore, there should be
adequate current assets in the firm so that a balance can be maintained in its
liquidity and profitability positions. The investment in working capital should be
Self-Instructional
100 Material
optimum. The optimum cash balance and investment in other current assets directly Working Capital
Management
affects the profitability of company. Any excess amount of current assets increases
the liquidity but reduces the profitability on other sides. Therefore, a balanced
approach should be followed.
NOTES
Permanent and Temporary Working Capital
The minimum working capital required on regular basis is known as permanent working
capital. Due to change in demand and seasonal factors, there can be temporary
variations in working capital requirement. This proportion of total working capital
requirement is known as temporary working capital (Figure 4.1).

Fig. 4.1 Temporary Working Capital

Operating and Cash Conversion Cycle

Operating and cash conversion cycle refers to the time required to convert cash-
raw material semi-finished, stock-finished stocks-accounts, and receivables/debtors-
cash. So, operating cycle involves the duration to convert sales into cash. A firm
requires many years to convert its fixed assets into cash but it requires less than a
year to convert its current assets into cash. Even investment in current assets is
twisted over numerous times a year. Inventories and debtors are two current assets
which change many times a year and take less than a year time to convert into cash.
The operating cycles starts with the purchase of raw materials, conversion into finished
good, sale of goods to the customers on credit or cash, cash collection from the
customers, payments made to the suppliers of the goods and again purchase of raw
materials for the production process. The operating cycle of a firm is depicted in the
following diagram.

Self-Instructional
Material 101
Working Capital
Management

NOTES

Fig. 4.2 Operating Cycle of a Firm

The operating cycle is the time required to convert inventory into cash and it
also considers the time taken to make payments to accounts payable.
Acquiring of resources, manufacturing of products and sale of products are the
major steps of operating cycle and time allotted to these steps are not fixed. This is
why cash inflow and cash outflows are not in harmonization. Generally, cash outflows
are prior to the cash inflows. So, firms have to invest some amount in current assets for
the smooth functioning of the firm and timely payment of various expenses like wages,
salaries, manufacturing expenses, selling and other administrative expenses. Firms also
have to maintain a minimum level of cash balance to meet uncertain expenses during
the course of business. Stock of raw material, work in progress and finished goods
have to be kept in order to smoothly maintain business. Finished goods have to be
kept in case of uncertain demands from the customer’s side. Debtors or account
receivables are also maintained to boost up sales on credits. Therefore, a firm invests
huge funds in inventories and debtors for smooth functioning. Length of operating
cycle of a firm depends on the following cycles:
1. Inventory conversion period
 Raw material conversion period
 Work-in-progress conversion period
 Finished goods conversion period
2. Debtor conversion period
The adding of the inventory conversion period and the debtor conversion period leads
to the gross operating cycle (GOC). When we subtract creditor conversion period
from the gross operating cycle it is called the net operating cycle (NOC). When we
Self-Instructional exclude the depreciation from the calculation of the net operating cycle, it is called
102 Material
cash conversion cycle (CCC). Creditors of a firm allow it to postpone their payment Working Capital
Management
and in this firm, they can use that money for the liquidity. Such a source of finance is
called the spontaneous source of finance.
Illustration 4.1
NOTES
 Expected level of production 20 lac units
 Selling price per unit 10
 Raw material, wages and overheads constitute 40%, 20% and 20% respectively.
 Holding periods:
o Raw material: 3 months Work in process; 2 months
o Finished goods: 2 months Credit given: 3 months
o Credit availed: 4 months
o 15 days credit is available for wages and overheads
 Cash balance required 3,00,000
 Contingency 10% of current assets
Find Gross Working Capital and Net Working Capital by using the above
mentioned information.
Solution:
Current Assets lacs
 Raw materials 4 × 20L × 3/12 = 20.00
 Work in process 8 × 20L × 2/12 = 26.67
 Finished goods 8 × 20L × 3/12 = 40.00
 Debtors 8 × 20L × 3/12 = 40.00
 Cash = 3.00
 Contingencies 10% of 129.67 = 12.967
Current Assets = Gross working capital = 142.637
Current Liabilities; Creditors for
 Materials 4 × 20L × 4/12 = 26.68
 Wages 2 × 20L × 1/24 = 1.66
 Overheads 2 × 20L × 1/24 = 1.66
Current Liabilities = 30.00
Net working capital (CA – CL) = 112.637

Check Your Progress

1. What is permanent working capital?
2. What do you mean by operating and cash conversion cycle?
Self-Instructional
Material 103
Working Capital
Management 4.3 DETERMINATION OF WORKING CAPITAL

There is no any set rule for the estimation of working capital requirement. A large
NOTES number of factors have influence on the estimation of working capital requirement.
Importance of various factors change over time and with the change in nature of business.
So, before finalizing the working capital, firms should analyse the relevant factors.
These include:
1. Nature of business: Trading and financing firms have a small investment in
fixed assets but invest huge funds in working capital. E.g. Retail stores have to
maintain a large level of variety in their stores which increases their level of
working capital. Whereas public utilities firms have less amount of working
capital and large levels of fixed assets in their business. But manufacturing
concerns fall between retail stores and public utilities. Manufacturing firms have
to main an adequate balance of working capital.
2. Market and demand: Before finalizing the working capital requirement, firms
have to study the market and demand of their product in the market. If the firm
is in its growing stage then it has to maintain a large level of current as well as
fixed assets.
3. Length of operating cycle: If operating cycle of a firm is long then it has to
maintain a large level of current assets to support the operation of the business.
Whereas if the operating cycle is short then firm can manage with a lesser level
of current assets.
4. Conditions of financial market: If the financial market of the country is
developed then firms can have a small level of working capital and as and when
they require funds for working capital, they would be able to arrange it from the
financial markets. If the situation is reversed, financial markets are less developed
and firms have to maintain a large level of current assets to support their day-to-
day business.
5. Technology and manufacturing policy: If manufacturing cycle of the business
is long then it has to maintain a large level of working capital. Firms may follow
a steady or stable production policy in which production of goods takes place
throughout the year. In this case, the company need more working capital. If
firms follow a variable manufacturing policy then they may need less amount of
working capital.
6. Credit policy: It is the policy via which firms decide who to lend money to.
Some firms follow a liberal credit policy and consequently have huge amount of
debtors. Such firms have to have large investments in working capital.
7. Other factors: Degree of risk in business and industry, supplies’ credit, operating
efficiency, inflation, credit worthiness of business, quality of fixed assets, level
and quality of existing current assets and other resources of the business (financial,
physical and human) are some other factors which are important in estimating
Self-Instructional the working capital requirement.
104 Material
 Working Capital
4.4 ASSESSMENT OF WORKING CAPITAL NEEDS Management

There following issues are present in the management of working capital in any business:
 Levels of current assets in business NOTES
 Ratio of current assets to fixed assets
 Liquidity vs. profitability
 Cost trade-off (cost of liquidity and illiquidity)
 Sources of financing the working capital requirement
1. Level of current assets in a business: What should be the total of current
assets and what type of current assets will the firm have? These decisions are
important as it affects the day-to-day functioning of the business.
2. Ratio of current assets to fixed assets: Second important aspect is the
proportion of current assets to fixed assets as it affects the short term solvency
of the business. In the following figure, the proportion of current asset to fixed
assets has been depicted (Figure 4.3). In conservative policy, firms have more
current assets whereas in aggressive policy firms maintains a minimum balance
of current assets which is at times, very dangerous for the firm. In average
policy, firms have an appropriate balance of current assets in proportion to
fixed assets.

A Conservative

L B Average Policy
e
v
e C Aggressive Policy
l
o
f Fixed
C Assets
A Level

Output

Fig. 4.3 Proportion of Current Asset to Fixed Assets

3. Liquidity vs. profitability: The focus of working capital management is on

liquidity management. Current assets should not be in surplus or in scarcity. If
current assets are in excess, it leads to idle funds in the firm which adversely
affects the profitability position of the firm, and if current assets are in scarcity,
the firm will not be able to pay its day-to-day obligations which adversely affect
the liquidity position of the firm. Therefore, there should be adequate current Self-Instructional
Material 105
Working Capital assets in the firm so that a balance can be maintained in the liquidity and profitability
Management
positions of the firm.
4. Cost trade-off (cost of liquidity and illiquidity): These two types of costs
are organized in working capital management and an attempt is made to trade-
NOTES
off between them.

Fig. 4.4 Cost Trade-Off

5. Sources of financing the working capital requirement: Working capital

can be financed through long term and short term sources of finance. Permanent
portion of the working capital is financed through long term sources of finance
and temporary working capital is financed through the short term sources of
finance.
 Permanent/Fixed/Long Term: It includes shares, debentures, term
loans, retained earnings and public deposits.
 Temporary/Variable/Short Term: It includes trade creditors,
commercial papers, accounts receivables, indigenous bankers,
advances, accounts receivables, factoring, installment credit and
commercial banks.
6. Spontaneous sources of finance: This refers to then postponing the payment
of current liabilities and using that money to pay day to day expenses.
Both short term and long term sources of finance can be used for financing working
capital requirement. Here the company can follow three types of approaches:
 Aggressive approach
 Conservative approach
 Matching approach
(i) Aggressive financing policy: When permanent working capital is financed
through short sources of finance then it is called aggressive approach (Figure
4.5).

Self-Instructional
106 Material
 Working Capital
Management

NOTES

Fig. 4.5 Aggressive Financing Policy

(ii) Conservative Approach: In this approach, even temporary working capital

requirement is financed through long term sources of finance
(Figure 4.6).

Fig. 4.6 Conservative Approach

(iii) Matching Approach: In such an approach, working capital requirement is

exactly matched with the sources of finance. For permanent working capital
requirement, long term sources of finance are used and for temporary working
capital requirement short term sources of finance are used (Figure 4.7).

Fig. 4.7 Matching Approach Self-Instructional

Material 107
Working Capital Estimation of working capital requirement
Management
For the estimation of working capital, the following three methods are used:
1. Current assets holding period: As discussed in the above illustration 4.1. In
NOTES this method operating cycle calculations are done.
2. Ratio of Sales: In this method, some specific percentage of sales amount can
be used as the estimation of working capital requirement.
3. Ratio of fixed investment: Some firms use this method for working capital
requirement.
Illustration 4.2
The following information has been provided by a company for the year ended 31
March 2013.

Liabilities Assets
Equity Share Capital 700000 Fixed Assets less Depreciation 1050000
8% Debentures 350000 Inventories 350000
Reserves and Surplus 175000 Sundry Debtors 245000
Long-term Loans 175000 Cash and Bank 35000
Sundry Creditors 280000
1680000 1680000

Sales for the year ended 31 March 2013 amounts to 35, 00,000 and it is
estimated that same will amount to 42, 00,000 for the year 2013-14. Estimate the
requirement of working capital assuming a linear relationship between sales and working
capital.
Solution:
Estimate of Working Capital Requirement

Actual Percentage to Sales Estimate

2012-13 2012-13 2013-14

Sales 3500000 100 4200000
Current Assets:
Inventories 350000 10 420000
Sundry Debtors 245000 7 294000
Cash and Bank 35000 1 42000
Total Current Assets 630000 18 756000
Current Liabilities:
Sundry Creditors 280000 8 336000
Total Current Liabilities (CL) 280000 8 336000
Self-Instructional Working Capital (CA-CL) 350000 420000
108 Material
 Working Capital
Management
Check Your Progress
3. How is technology and manufacturing policy relevant for the estimation of
working capital? NOTES
4. Mention any two issues in working capital management.
5. What are the three approaches to spontaneous sources of finance?

4.5 STUDY OF COMPONENTS OF WORKING

CAPITAL

In this section, you will learn about the components of working capital including cash,
accounts receivables and inventory.
4.5.1 Cash Management
Cash management is one of the most important decision areas of working capital
management. The worst use of cash is to keep it idle. That includes cash in hand as
well as cash at bank. Idle funds may result in zero returns and therefore, maintaining
optimum cash balance is very important. It affects the liquidity and profitability of the
business. Firms need cash for the smooth conduct of business because shortage of
cash will obstruct their operations. Cash is not like other assets of the firm, as assets
such as plant and machinery help in the production of goods and the like. Cash itself
cannot produce goods and services but it helps in the production of goods and services.
Firms require cash for the smooth and uninterrupted production of goods. They needs
cash balance to pay day-to-day expenses, too.
Cash is the most liquid current asset. If there is a scarcity of cash, firms have to
arrange a loan to acquire some. It suggests that there is a gap in cash inflows and cash
outflows. There are many instances when cash receipts are more than cash payments,
and vice versa. In such situations, firms have to manage their cash. They should invest
excess cash to earn interest on it and arrange for the shortage. A financial manager
tries to manage the cash inflows with cash outflows. Perfect synchronization of cash
inflows and cash outflows however, is not possible and that is why financial managers
have to devote sufficient time for the management of cash.
Motives for Holding Cash
 Transaction motive: For day-to-day operations of the business, a firm needs
cash. For cash payment, such as expenses, purchase of raw material, taxes and
dividend, etc. firms need cash. So, firms are required to manage their cash in
full.
 Precautionary motive: Sometimes, firms need cash to meet uncertainties in
business. For example, sometimes debtors are unable to pay their dues on
time. So, to meet such type of requirements, firm have to keep some cash
balance. Self-Instructional
Material 109
Working Capital  Speculative motive: Occasionally, to meet uncertain price fluctuations, firms
Management
need cash to buy raw material at a low price. These types of opportunities are not
regular ones. Firms see such type of instances quite rarely. Thus, firms have to
manage sufficient cash for such type of objectives, too.
NOTES
Facets of Cash Management
Cash management includes the following aspects of management:
1. Cash Planning
2. Managing the cash flows
3. Investing surplus cash
4. Optimum cash level
1. Cash Planning
Cash planning is a technique to plan and control the use of cash. Firms use a cash
budget for such purposes. A projected cash flow statement can be prepared for this
purpose. Generally, firms prepare the cash budget in advance to forecast cash inflows
and cash outflows. Cash forecasting and budgeting are used for cash planning.
 Cash budget is the most significant device to plan for and control cash receipts
and payments.
 Cash forecasts are needed to prepare cash budgets.
Cash budget
The cash budget is prepared to forecast the cash requirement and control its spending
in business. The cash inflows and cash outflows from various sources are assessed
and the surplus and deficit cash is determined from the balance. Cash budgets can be
prepared on daily, weekly, monthly or quarterly basis depending upon the requirement
of business.
Cash forecasting
Cash forecasting is required in order to anticipate cash requirement for operations and
for managing the surplus. Cash forecasting has short-term and long-term methods at
its disposal.
Short-term cash forecast
This forecasting methods include:
 The receipt and disbursements method
 The adjusted net income method
Long-term cash forecast
Long term cash forecasting is done to assess the financial requirement for capital
projects. This forecast for cash can only be done after receiving the requirement of
Self-Instructional long term funds by all divisions of the business.
110 Material
 The following is an example of a cash budget. Working Capital
Management
Illustration 4.3
From the following information prepare cash budget for the month of July, August,
September and October: NOTES
Wages Selling and
Sales Manufacturing Administrative
Months Purchase and Distribution
(credit) expenses Expenses
Salaries Expenses
April 650000 630000 25000 10000 9000 1500
May 650000 730000 35000 12000 8000 1600
June 550000 550000 30000 14000 9500 1100
July 680000 650000 32000 13000 8500 1000
August 710000 550000 32000 16000 7500 1300
September 730000 600000 28000 10000 8000 1400
October 680000 600000 33000 12000 7000 1000

 The customers are allowed a credit period of three months.

 A dividend is payable of 30,000 in the month of September.
 In the month of August firm is required to incur one capital expense. Firm is
required to buy one plant and machinery of 1, 00,000.
 The creditors allow a credit of three months.
 Wages and salaries are paid on the first of next month.
 There is a lag of one month in the payment of other expenses.
 Cash in hand on 1st July 2014 is 100000.
Solution:
July August September October
Receipts
Opening Balance of Cash 100000 295400 100900 44100
Cash receipts from debtors 650000 650000 550000 680000
total Cash available 750000 945400 650900 724100
Payments
Payments made to creditors 630000 730000 550000 650000
Wages and Salaries 30000 32000 32000 28000
Manufacturing Expenses 14000 13000 16000 10000
Administrative Expenses 9500 8500 7500 8000

Selling and Distribution Expenses 1100 1000 1300 1400

Dividend Payment
Purchase of Plant and Machinery 100000
Total Expenses 684600 884500 606800 697400

Closing Balance of Cash 65400 60900 44100 26700 Self-Instructional

Material 111
Working Capital 2. Managing Cash Collections and Disbursements
Management
To have proper cash balance, firms tries to accelerate their cash collection. For this,
firms commonly follow these two methods:
NOTES  Decentralized Collections: By setting multiple collection centers, firm can speed
up their cash collection and use that money to finance their cash flows.
 Lock-box System: In this system, firms have lock-boxes at different locations.
The objective of this is also to speed up their cash collections.
Controlling disbursements
Controlled disbursement is a method via which an institution increases its funds for the
purposes of investments or the payment of debts. This method capitalizes on the
availability of cash and makes the most out of it during the time it is present in the
money market. It controls the flow of checks in a banking system.
Disbursement or Payment Float: Firms should linger on their cash payment as
much as they can. For that duration, firms can use that money to make payments. This
method is a bit harmful for the goodwill of the firm. So, firms should take due care in
postponing the payment to any creditor. They should make payments only through
cheques and as frequently as possible.
By using the following methods, firms can accelerate collections of cash
(Figure4.8):

Fig. 4.8 Cash Collection Instruments in India

3. Investing Surplus Cash

The profits that have been accumulated overtime by firms is a good opportunity for
cash management. The surplus cash can be invested in the most ideal fashion, so that
the firm can grow exponentially and reap even more benefits.
4. Optimum Cash Level/Balance
The optimum cash balance has various methods that a firm should know about. There
are some mathematical models to estimate the optimum cash balance level. The following
two methods are particularly popularly in this regard:
 William J. Baumol’s Model
Self-Instructional  M H Miller and Daniel Orr’s Model
112 Material
Optimum Cash Balance Models Working Capital
Management
The optimum cash balance is a vital part of cash management because that is how
firms calculate their requirements of cash and other things in advance. This is how
they plan whether they are to move ahead with their investments or are they to go NOTES
down other roads. The meaning of the models is right there in the name. Their
primary function is to provide firms with the ability to develop a system using
which they can preserve the most ideal cash balance for themselves. The cash
budget is prepared also keeping in mind this very notion because shortage of cash
is very problematic.
1. William J. Baumol’s Model: Cash Balance under Certain Conditions
The model developed by Baumol is applicable in certain conditions. These conditions
require a firm which is able to forecast cash requirements with certainty. Throughout
the year, firms incur cost and receive cash from various sources. So, firms hold an
average cash balance (Figure 4.9).

Fig. 4.9 Average Cash Balance

This model is based on some assumptions. These assumptions are as follows:

(a) Transaction cost of converting securities into cash remains constant.
(b) Opportunity cost of capital remains constant.
(c) The cash requirements of the firm are known with certainty.
(d) Cash outflows of the firm (cash disbursement) of the firm are known and certain.
This technique resembles Economic Order Quantity (EOQ) of inventory
management. EOQ is the quantity where carrying cost/holding cost and ordering
cost is minimized. Similarly the optimum cash balance is the tradeoff between
transaction cost (cost of converting marketable securities into cash) and opportunity
cost of holding cash. The point of optimum cash balance is when these two costs are
equal.

Self-Instructional
Material 113
Working Capital
Management

NOTES

Fig. 4.10 Optimal Cash Balance

Following formula is used to calculate the amount of optimum cash balance.

In this equation, C is optimum cash balance, A is annual cash disbursement/

requirement, F is fixed cost per transaction and O is the opportunity cost of holding
cash. This method can be explained with the help of following example.
Illustration 4.4
Annual cash requirement of Jolly Ltd. is 20 lakh. The company has marketable
securities in lot size of 50,000, 1, 00,000, 1, 50,000 and 2, 00,000. Cost of
conversion of marketable securities per lot size is 1,000. The company has 8%
opportunity cost of capital on its securities. Calculate optimum cash balance by using
Baumol’s model.
Solution:
Calculation of lot size by using Baumol’s model
Here, Annual cash requirement is 20 lakh, F fixed cost per transaction is
1000, O is the opportunity cost of holding cash which is 0.08.

= 223607

2. Miller and Orr Model of Optimum Cash Balance

One of the biggest limitations of Baumol’s model is that it assumes certain business
conditions. Baumol’s model assumes the firm is able to forecast its cash requirement,
Self-Instructional
114 Material
its timings and size of cash flows with certainty. In practice however, cash flows are Working Capital
Management
difficult to estimate. Cash flows are not certain and fixed. These are flexible. To meet
such type of uncertainty, Miller and Orr gave a model of optimum cash balance. In this
model, there is one upper control limit and lower control limit. With this, there is one
return point. When the firm keeps on paying its dues and cash balance hits the lower NOTES
limit then the firm is required to sell a few marketable securities to increase cash balance
to the previous level. Now, suppose there are continuous cash inflows and cash balance
hits upper control limit. Then it’s time to invest in marketable securities. These two
limits upper and lower limit are the action point of the firm’s financial manager.
Following formula is used to calculate the difference in upper limit and lower limit.
1
3 Transaction cost × variance of Cash Flows 3
Z 3
4 per day interest rate
Return point = Lower Limit + (Spread (Z))/3
The above mentioned method can be used to calculate the optimum cash balance
requirement of a firm.
Illustration 4.5
A company has a policy of maintaining a cash balance of 2, 00,000. Standard
deviation of daily cash balance is 20, 000. The interest rate on daily basis is 0.02%.
The transaction cost of each sale or purchase of is 100. You are required to calculate
upper and lower control limit by using these information.
Solution:
1
3 Transaction cost × variance of Cash Flows 3
Z 3
4 per day interest rate
1
3 50 × (2000)2 3
Z 3
4 .0002
4.5.2 Accounts Receivable Management
Account receivables constitute an important place in current assets. Companies are
required to sell their products not only on cash basis but on credit basis too. Receivables
are also known as accounts receivables, customers receivables, trade receivables,
and book debts. To increase their sales, companies are required to sell their products
on credit too. This credit sale depends on credit policy of the company/firm. The
customers from whom receivables or book debts have to be collected in the future are
called trade debtors or debtors. Credit sale involves risk. Cash sales of a business are
totally risk free. However, credit sales are made today in the hope that amount of
credit sale will be recovered in the future without much loss. In credit sales, the buyer
of the product receives the right to use that product for which he can pay in future. In
India, debtors have a major portion of the current asset of the firm. Credit sales (debtors)
constitute at least one third portion of the current assets of the firms. Credit sales block Self-Instructional
Material 115
Working Capital firm’s funds in debtors. So firms have to finance their requirement of funds through
Management
loans from banks and financial institutions. Therefore, trade debtors involve investments
of the firms, so it should be carefully analysed.
Receivables management is focused towards various issues related to credit policy of
NOTES
the business. The key issues involved in receivables management are as under:
 Terms and conditions for credit sales: A firm’s investment in debtors depends
on the volume of sales and collection policy. Investment manager can make
changes in the investment in debtors by changing the terms and conditions of
credit sales i.e. through change in credit policy. Credit policy of a firm is
dependent on credit standards, credit terms and collection efforts. If firm follows
a liberal credit policy then it should have large investment in debtors.
 Duration for credit sales: It refers to the duration given to debtors within
which they are allowed to make payment of their purchase.
 Collection policy: It involves the detailed procedure that a firm is going to
follow to collect cash from the debtors.
The main objective of a firm’s credit policy is to maximize the shareholders
wealth by increasing sales which leads to the improvement in profitability. Increase in
sales leads to increase in operating profits as well as increase in investment and cost.
Firms have to maintain a trade off in incremental cost and incremental benefits from the
increased sales. A liberal credit policy may result in more credit sales but simultaneously
block the funds of the business and risk might increase. A tight credit policy has opposite
effects. Therefore, cost benefit analysis based on liquidity-profitability trade-off must
be done.

Costs & Benefits

Profitability

Liquidity

Tight Credit Loose

policy

Fig. 4.11 Cost Benefit Analyses based on Liquidity-Profitability Trade-off

Cost of Maintaining Receivables

Cost of maintaining receivables includes cost of financing receivables, cost of collection
and bad debts. Cost of financing receivables means cost incurred to finance the
investment in receivables. Proper collection of receivable is essential for the management
of receivables. For collection of cash from debtors various reminders are generally
sent to the debtors and sometimes, when debtors delay payment for long then some
Self-Instructional legal action is also taken against them. All this collection efforts include some cost
116 Material
which is called collection costs. Bad debts occur when debtors are unable to pay Working Capital
Management
amount due towards them. This can be controlled by an efficient collection mechanism
but this cost cannot be reduced to zero.

NOTES

Fig. 4.12 Factors Affecting Size of Receivables

Tools to manage credit sales

A firm is required to monitor its receivables to ensure the success of its collection
efforts. Following methods are used to manage credit sales:

Fig. 4.13 Tools to Manage Credit Sales

1. Collection period: Average collection period is calculated as follows:

Debtors × 360
Average collection period =
Credit sales
The calculated average collection period is compared with the firm’s pre-defined
collection period. Let us take an example, if by using above method average
collection period comes out to be 45 days and firm has set 30 days of average
collection period, it means firm is following a slow practice of cash collection Self-Instructional
Material 117
Working Capital from debtors. Extended collection period is a hindrance in smooth and timely
Management
cash inflows. These delays badly affect the firm’s liquidity position. This method
also suffers from a limitation. It provides an average figure of collection period
which might not be accurate. It also does not provide meaningful information
NOTES about the quality of outstanding debtors so as to take timely corrective measures.
2. Aging schedule: This method breaks down the receivables as per the length of
time for which receivables have been outstanding. Let us suppose that a firm
has stated its credit period to be of 20 days and its experience states that 60%
of the receivables remain outstanding after a period. Then firm has to main a
significant amount of investment in receivables. Therefore, aging schedule provides
more information about the collection period and collection experience of the
firm.
Outstanding days Outstanding Debtors/ Receivables %
0-20 1000000 60%
21-25 600000 36.00%
26-30 360000 14.40%
31-35 216000 5.76%
Over 35 days 129600 2.30%
Total investment in 2305600
receivables for 35 days

It is clear from the above mentioned sample table of calculation of investment in

receivables that this firm has to maintain a balance of 23,05,600 in its account
on account of credit sales/debtors.
3. Collection experience matrix: The basic limitation of the aging schedule method
and other traditional methods of receivable management is that all these methods
fail to correlate the outstanding debtors to their credit sales. This limitation may
lead to the difference in the estimation of receivables by different experts.
However, this limitation can be worked out by using disaggregate data for
analyzing collection experience of the firm. This method has one major advantage
that it relates receivables of a period to the sales of that particular period. In this
method, a matrix is constructed by taking time period in rows and receivables in
column. This is the reason that this method is called collection experience matrix.
Let us take an example in order to understand this method better. Suppose a
financial manager is analysing the receivables emerged from the credit sales of
the firm for last 6 months. Following table shows the credit sales of the firm for
last 6 months,
Credit Sales ( Lakh) Credit Sales ( Lakh)
January 600 April 420
February 750 May 390
March 570 June 550

From the sales ledger, financial manager collects information related to the
Self-Instructional
outstanding receivable data for each of the above said month.
118 Material
 The aging schedule of above sale can be presented in the following table. In the Working Capital
Management
month of January, outstanding receivables are 80% of the sales, in the month of
February, outstanding receivables are 40% of the sales and in the month of
March, outstanding receivables are 40% but in the month of April there is no
receivable for the sales of January. So, we can say that sales for the month of NOTES
January will be recovered till April month. Likewise in case of other months.
January February March April May June
Sales receivables 600 750 570 420 390 550
January 480
February 240 600
March 240 300 456
April 0 300 342 336
May 0 0 228 168 312
June 0 0 0 168 156 440

Factoring
Receivables are one of the important parts of the firm’s current assets as they represent
credit sales which are important ingredients of total sales of any business these days.
Receivable management is very crucial for the business as it contributes in the total sales
by increasing it. By increasing investment in receivables, firms can generate more sales
but at the same time it increases default rate (non-payment by debtors), collection cost
and cost of managing receivables. Receivable management involves two basic costs i.e.
financing receivables and other one is collection cost including default cost.Asmall business
firm can manage such costs and can do receivable management in efficient manner. But
for large business firm/companies receivable management is very difficult (as it involves
large cost) and they need services of some specialized institutions who have expertise in
the receivable management. This business is called factoring business.
Factoring can be defined as a specialized service provided by financial institutions
in which financial institutions buy (through an agreement) receivables from the seller of
services/goods and manage seller’s receivables. Here, specialized institution is called
‘factor’. The word ‘factoring’ has different meanings in different countries. However,
a study constituted by international institute for the Unification of Private Law in Rome
(1988) has given the definition of the term, ‘Factoring means an arrangement between
a factor and his client which includes at least two of the following services: finance,
maintenance of accounts, collection of debts and protection against credit.’
It is clear from the above definition that factoring includes not only financing of
receivables of the client but also gives some other services to the clients like maintenance
of books of accounts of the client, collection of debts on behalf of the client and
protection of the client against the non-payment of receivables.
Some special terminology of factoring is as follows:
Client: It means supplier (business institution) who gives goods on credit and wants
to get factoring facility. Self-Instructional
Material 119
Working Capital Customer or Debtor: It refers to person or business who bought goods on credit
Management
from the supplier or client.
Account Receivables: When goods are sold on credit, they generate account
receivables.
NOTES
Eligible Debt: Before entering into an agreement with client usually factor analyze
the account receivables of the customer and find out debts eligible for the process of
factoring.
Prepayment: The advance payment made by factor to the client is called prepayment.
Open Account sales: When goods are sold by the client to the customers without
raising promissory note or any bills of exchange.
Features of factoring
 It is a financial service in which factor converts credit sales of client business
into cash on the payment of some commission.
 While doing factoring, factor takes overall risks attached to the receivables of
the client when the factoring is without recourse.
 A factor performs at least two of the following functions- finance, maintenance
of accounts, collection of debts and protection against credit risk (risk associated
with the default in repayment of receivables).
 Financial institution (factor) performs the role of intermediary between client
(seller) and buyer. Seller sells goods to the buyer on credit and factor obtains
those debtors.
 Other than financing receivables, factor maintains sales accounting, collects debt,
gives safety against loss due to bad debts and other valuable services and advises
the client for management of sales.
Parties of the factoring and system of factoring
Buyer of goods (debtor), seller of goods (client) and financial institution (factor) are
the three parties of any factoring process.
 Buyer is the person who buys goods/services from the client and makes an
agreement to pay for these goods on some future date. He receives instructions
from the seller to pay money, for the goods bought on credit, to the factor. In
case he fails to pay, he has to face legal actions.
 Seller is the person who sells goods on credit and avail the services of factoring
from the factor in which seller receives 80% or more of debtor’s amount (depends
on his negotiability with factor). With this seller sends instruction (with invoice
and delivery challan) to the buyer to pay money to the factor.
 Factor (financial institution) discounts bills of seller and give him money on the
promise that debtor of seller will pay him on some future date. For this, he
charges some percentage as commission from the seller.
Self-Instructional
120 Material
The whole system (mechanism) of factoring can be summed up with the help of Working Capital
Management
following diagram:

2
Seller of Buyer of NOTES
Goods 1 Goods

3 4
Factor

Fig. 4.14 System of Factoring

1. First of all, seller and client enter into an agreement of factoring. In this agreement
they decide about the terms and conditions of factoring.
2. Seller sells the goods to the buyer on credit.
3. Now seller sends invoice to the factor and discount his bills after payment of
commission to the factor. Usually this amount is 80% or more of the final payment
which factor is to receive from the buyer at some future point.
4. Now factor has to wait till the due date. On the due date, he receives money
from the buyer of the goods.
5. Factor makes final payment to the seller of the good after deducting fees,
commission or charges for providing this service to the seller.
Types of factoring
Contract of factoring can be of various types. However, it can be divided on the
following basis as well:
1. Recourse and non-recourse factoring: In recourse type of factoring
agreements, factor has right for the recourse on client which means if buyer fails
to make payment for the goods on due date then factor has the right to receive
payment from the seller of goods. In such type of factoring agreements, factor
works as the agent of the seller who receives money on due date from the buyer
of goods and factor does not cover default risk associated with the non-payment
of interest and principal by the buyer. In other words, seller is responsible for
the non-payment by the buyer and for buyer’s creditworthiness. Usually factor
manages sales ledger and debt collections of the client.
On the other hand, non-recourse factoring is that type of factoring in which
factor gives cover for the default risk of buyer to the client. If buyer of goods
does not make payment on the due date to the factor then factor cannot claim
that amount from the seller of the goods. In this case of factoring, commission
and other charges of the factor are high as compared to recourse type of factoring.
Commission charged by factor for buyer’s default risk is called del credere
commission. Self-Instructional
Material 121
Working Capital 2. Advance/maturity factoring: Advance factoring is that type of factoring in
Management
which factor gives definite percentage of the receivables in advance to the client.
It can range from 75% to 95%. After agreement, this amount is made available
to the client. This discount rate is determined on the basis of creditworthiness of
NOTES the buyer, prevailing rates, volume of sales and duration of the factoring agreement.
Sometimes, banks are also involved in such types of factoring. In case of maturity
factoring, factor waits till payment date. After receiving payment from the buyer
of goods, factor make this payment to the client. In this case, factor performs
the role of agent of the client and collects receivables on his behalf.
3. Conventional/full factoring: In this case of factoring, factor carries out almost
all the services of the factoring like maintenance of sales ledger, credit collection
and other for the client. This is called conventional factoring in which factor
performs various services for the client like advising him on receivable
management, bill collection on the basis of maturity, maintenance of books of
accounts of client etc. This method is very popular in developed countries, not
in India. In India, SBI (state bank of India) is the example for such type of
factoring and is given to the creditworthy clients for creditworthy buyers of
goods with recourse.
4. Domestic and export factoring: This segregation is made on the basis of
number of parties involved in the factoring agreement. In domestic factoring,
three parties- client, customer and factor are involved. Moreover, all these parties
are from the same country i.e. having domicile of same country. In case of
export factoring, (also called international factoring or cross boarder factoring)
four parties are involved. These are- exporter, importer, export factor and import
factor. Export factoring is also called two factor factoring as there are two
factors involved in it. In it, two agreements are made one is between importer
and import factor and other one is between exporter and export factor. This
factoring type is generally non-recourse type.
5. Limiting factoring: In this type of factoring, factor discounts service of factoring
is given on some selected bills only not for all receivables.
6. Selected seller and selected buyer based factoring: In selected seller based
factoring, seller sells all receivables to the factor after selling goods to the
customers. Factor carries out all functions associated with factoring and seller is
approved by the factor before entering into the agreement. But in case of selected
buyer based factoring, factor approves buyers on the basis of their
creditworthiness and makes a list of them. Approved buyer contacts factor for
factoring their bills. After this, factor discounts the bills and makes payments to
the seller on the request of buyer of goods.
7. Disclosed and undisclosed factoring: Factoring agreement in which name of
factor is mentioned in the agreement between seller and buyer and seller asks
buyer to make payments to the factor on due date is called disclosed factoring.
Supplier bears all risk associated with the sale without giving it to the factor. In
Self-Instructional case of undisclosed factoring, factor name is not disclosed to the buyer but
122 Material
factor still controls the factoring deal and maintains sales ledger of client etc.
Functions of a factor Working Capital
Management
A factor performs following functions:

Administration of Sales ledger Receivables Collection NOTES

Functions of a Factor
Other advisory services

Provision of Finance

Risk Protection

Fig. 4.15 Functions of a Factor

Functions of a Factor
1. Administration of sales ledger: The main function of factor is to maintain
administration of the sales ledger of every seller. While performing this function,
factor does the following activities:
 Factors verify the originality of the invoice bills prepared by the seller
of goods.
 After every invoice bill, factor updates sales ledger of his client and
keeps an up-to-date record of credit sales of the client.
 Factor prepares monthly statement of receivables and sends reminders
to the customers to pay on time.
 Factor maintains good relation between the buyer and seller and
solves various disputes between them. These disputes can be
regarding the quality of goods, rate of discount term of sales agreement
etc.
 After receiving money from the buyer, factor remits this amount to
the seller after deducting his dues (commission etc.).
 Factor checks the creditworthiness of the buyers (debtors) in order
to check their debt repaying capacity.
 Factor also submits client reports on overdue unpaid buyers, legal
case etc.
2. Receivable collection: It is another task of factor. Factor relieves the client
from the collection of receivables so that the client can concentrate more on
other important aspects of the business. Factors have huge resources like good
infrastructure and technology, experienced work force by which they help their
clients to manage their receivables in an efficient and effective manner.
3. Provision of finance: Providing early finance on receivables or debtors is one Self-Instructional
of the main functions of the factor by which clients can get finance on non-cash Material 123
Working Capital items of current assets and convert them into more liquid asset (cash). Client
Management
can have up to 95% of debtor’s amount by availing factor’s services.
4. Protection against risk: When factoring is of non-recourse type, then factor
issues some credit limits to the client upto which he can sell his goods on credit
NOTES
to the customers. Factor takes all debtors within this prescribed limit and bears
all default risk associated to credit sales. By doing so, factors help their clients
to have better credit control policy. Credit risk, credit control and credit
protection are all interrelated.
5. Advisory services: In addition to the functions mentioned above, factor also
performs following advisory functions related to factoring:
 Gives advice to the clients about the creditworthiness of the buyers.
 Conducts research on market competitors.
 Helps client in getting finance from the financial institutions.
 Gives suggestions related to the procedural aspect or receivable
management to the clients.
 Provides client with monthly statement about the schedule of payment
by the debtors, overdue debtors, average debtor collection period,
creditworthiness of the clients etc.
Advantages of factoring
Factoring is becoming very popular these days as it offers various benefits to the
clients. In fact, by availing the services of factoring seller can transfer full administration
of credit sales to the factor and concentrate on other important aspect of their business.
Other benefits which seller has from factoring are listed below:
 Helps to improve the efficiency of seller. Seller transfers the administration of
receivables to the factor who performs all operations to manage receivables
with the help of specialized people. This helps seller to have ample time to
concentrate on the other aspects of the business in order to improve efficiency.
 Helps to increase liquidity. Factor provides almost 75% to 95% of amount of
receivables which provides liquidity to the seller. Now seller can pay his day to
day expenses on time which improves his creditworthiness among suppliers,
lenders, bankers and competitors.
 By increasing their cash flows, sellers can meet their commitment on time.
 By availing the service of factoring, seller can meet temporary cash requirement
or seasonal cash requirements of the business.
 As factoring increases cash flows in the business, client is in a position to make
a concrete planning of the purchases and can get cash discounts.
 Factoring is an off-balance sheet transaction and it does not affect financial
structure of the balance sheets. Therefore, it does not affect efficiency ratios of
the client.
Self-Instructional
124 Material
  Factor helps his client to enquire about the creditworthiness of the buyers and Working Capital
Management
provides information about market scenario which helps client to make better
credit policy.
 Factors maintain all records for better administration and control of the receivables
NOTES
of the clients.
Disadvantages of factoring
These are as follows:
 Uncertainty in the rights of factor.
 Lack in the performance of factor services due to lack of management skills
and competence to adapt environment.
 Careless behavior of the client in selecting buyers and making credit sales.
 Increase in fraudulent activities by making false invoices by clients.
Effective mobilization and allocation of funds
Effective mobilization of funds is necessary for the organizations because it has an
impact on the liquidity, profitability, solvency, capital structure decisions, growth and
diversification of business, risk exposure and risk management and so on. So a firm’s
growth and survival is dependent on the effective and efficient mobilization of funds.
Moreover, market value of a business and its shares can be increased by the efficient
fund management. Firms can minimize their overall/weighted cost of capital by effective
fund management. These days fund management is significant because firm credit rating,
employee’s, supplier’s and customer’s faith depends on effective fund management.
Moreover, fund management is not only related to the internal fund management but it
has global dimensions also. In short, fund management affects all aspects of a business
like profitability, liquidity, solvency, growth and so on. So, proper allocation of funds is
necessary for the growth and survival of any business in long run. Precisely, the following
activities are connected to the allocation of funds in any business:
 Total amount of investment in assets (size of the business).
 Deciding about the proportion of fixed assets to the current assets (related to
risk level of business).
 Proper mix of all fixed assets (related to risk level of business).
 Finding and evaluating various alternatives of investment in fixed assets (capital
budgeting decisions).
 Risk and return evaluation of the various investment alternatives (capital budgeting
decisions).
 Proper mix of current assets (cash, debtor, stock and so on) (working capital
management).
 Study of liquidity and profitability aspects of short term sources of finance (cash
management, stock management, credit management and short term sources of
Self-Instructional
finance management). Material 125
Working Capital  Making portfolio of various assets (current as well as fixed) efficient and effective
Management
(balancing of overall portfolio of fixed and current asset held by the business).
A good deal of planning, organization, coordination, control is necessary at
every stage of fund management. For this, capital budgeting decisions (fixed asset
NOTES
management), capital rationing decisions, working capital decisions (cash management,
credit management and so on), dividend decisions etc. are necessary.
Consequences of mal-mobilization and misallocation of funds
Misallocation of funds means over-allocation or under-allocation of funds. Over-
allocation leads to wastage of funds and idle capacity, low returns on investment,
some projects or assets may be given more priority when it should not be given and so
on. Under-allocation of funds leads to long gestation period, increase in competition
due to delay in projects, increased cost and time out operations so on. Misallocation
or faulty allocation of funds leads to the wastage of right resources which causes harm
to the other projects in hand. Wrong allocation harms the liquidity, profitability, solvency,
credit rating and so on. This whole circle leads to the winding up of the company in
long run. In nut shell, we can say that funds allocation is a significant task. Thus, proper
consideration is given in allocation of the long and short term funds by the fund manager.
4.5.3 Inventory Management
The focus of inventory management is on maintaining optimum level of inventory for
smooth running of the operations and meeting the demand of the final product in time.
In case of inventory there is a time lag between ordering of inventory and receiving it.
By having sufficient inventory, firm can protect itself from price fluctuation and unseen
demand of the product. The ultimate objective of inventory management is to ensure
the availability of inventory as and when there is a requirement of it.

Fig. 4.16 Inventory Management

Self-Instructional
126 Material
 Inventory is commonly known as stock of goods or list of goods. Following are Working Capital
Management
the components of inventory.
Raw Material: it is the major part of the inventory. Firms are required to carry out
their production process smoothly for this they need to have sufficient inventory in
NOTES
their stock.
Work-in-progress: This is the stage of material after RM and before finished
goods. Quantity of work in progress is dependent upon the entire manufacturing
process.
Consumables: This inventory is not directly related to the manufacturing process but
firms need to have such kind of inventory for the smooth functioning of the production
process.
Finished goods: To meet unseen demand of the product of the firm such kind of
inventory is required in the organization. If the production of the firm is on order basis
then firm is not required to have large quantity of finished goods. But if the demand of
the product is uncertain then firm is required to have a minimum number of finished
goods.
Spare Parts: This is also the part of inventory. Although its amount is not much but
firm need spare part for the smooth production process.
Purpose and benefits of holding inventory
These are same as in case of cash management.

Fig. 4.17 Benefits of Holding Inventory

Tools and Techniques of Inventory Management

Inventory management is required for the smooth and uninterrupted production process
so that demand of the product is timely met. Inventory management also has some
costs. These are holding cost, ordering cost, risk of obsolescence, risk of price decline
and risk deterioration in quality. For many firms more than 80% of the investment in
Self-Instructional
Material 127
Working Capital current asset is in inventory. An efficient inventory management includes following
Management
question: What to buy? When to buy? At what price to buy? Where to store inventory?
What quantity to order and so on? An inventory management includes all these questions
and their answers. Different departments of the firm have conflicting interests in the
NOTES inventory management. As finance manager say firm should have fewer amounts in
inventory, purchase department say firm should have large level of raw material etc.
The inventory management is required to have to support smooth production process
without any delay in fulfilling orders. Different types of techniques are used for this. A
brief discussion of all these techniques is as follow:
1. Determinants of various stock levels: Firm should carry an optimum level
of inventory to minimize its cost and for this purpose firms use following levels:
Minimum Level Re-order Level – (Normal consumption normal Re-order period)
Re-order Level Maximum Consumption X Maximum re-order period
Maximum Level Re-order level + Re-order quantity – (Minimum Consumption X
minimum re-order period)
Danger Level Average Consumption X Maximum re-order period for emergency
purchase
Average Stock Level Minimum stock level + ½ of re-order quantity

2. Determination of Safety Stock: It is also called buffer stock which a firm has
to manage at any cost. Inventory stock fluctuates over time and purchase of
inventory may take more time then estimated. For such type of situations firm
have to manage safety stock for itself. This level protects firm from stock out
situations. A firm consider two types of costs for the determination of safety
stock. These two types of costs are stock out cost and carrying cost.
3. Ordering System of Inventory: A firm can follow different type of ordering
system. It can be fixed order quantity system, fixed period order and Single
order followed by scheduled part of delivery.
4. Economic Order Quantity: This technique is used to know what should be
the size of the order. Firm should decide an optimum order quantity which is not
high or less so that firm can control cost. EOQ is the idle size of the order which
is economical and viable. At this level of inventory carrying cost and ordering
cost are equal.
Carrying cost: Cost of capital invested in inventories, cost of storage, loss of
material due to depreciation and obsolescence, cost of insurance and cost of
spoilage in handling material.
Ordering Cost: Cost of staff, transportation cost, inspection cost and cost of
stationary etc
The following formula is used to calculate EOQ.

Self-Instructional
128 Material
 A is Annual consumption of inventory in rupee. Working Capital
Management
O is Cost of placing an order.
I is inventory carrying cost for one unit.
5. ABC Analysis: This is the most important technique of inventory NOTES
management which is used by maximum companies in real life. In this
technique inventory is divided in three parts. One is less in number but the
value is very high. Third one more in quantity and value is very less. Second
one is the average number and average investment. Following table will
show all these three categories.

Class No of Items Value of items

A 10% 70%
B 20% 20%
C 70% 10%

There may be some variation in this method in some business organisations but
ultimate idea is to divide all inventories in three categories to have better control
of them. This technique helps firm to concentrate more on more valuable material
and less on less valuable material.
6. VED Analysis: This technique is known as vital-essential and desirable
technique of inventory management. This technique is applicable in spare
parts. ABC technique of inventory management is not applicable for spare
part here VED technique is used. The vital spare parts are must for the
smooth functioning of the business. The non-availability of vital part will
stop the production process. Essential material is also required for the
business but not as important as vital spare parts are. Desirable material is
not necessary to keep with the business firm. If possible firm can avoid its
storage and order such material as and when there is requirement of it
emerges. Essential thing for this technique is dividing the spare parts in three
categories. Therefore, due care should be taken to understand and divide
spare parts in these three categories.
7. Inventory Turnover Ratio: To know the efficiency level in the usage of
inventory this method is used. This ratio is also called stock velocity ratio and
calculated as:
Inventory Turnover Ratio = sales/average inventory or Cost of goods sold/
average inventory cost
This turnover ratio should not be too much high or too much low e.g. if it is 3
months means firm is somewhere ordering unnecessarily and it is pilling the
stock of raw material. If this ratio is 4-5 day then there is some problem in order
size and in this situation ordering cost will increase. So firms have to take due
care of this ratio to have effective inventory management.
8. Aging Schedule of Inventory: One of the important techniques of inventory Self-Instructional
management is aging schedule in which inventory is dividing according to the Material 129
Working Capital period of their holding. Performa of aging schedule of inventory can be as
Management
follows:
Date of Percentage of total
Item code Age Classification Amount
Acquisition inventory
NOTES 0001 0-10 days 30 April 50000 20
0002 11-20 days 20 April 40000 16
0003 21-30 days 10 April 50000 20
0004 30-45 days 25 March 60000 24
0005 45-60 days 10 March 30000 12
2 months and more
0006 10 February 20000 08
old
2,50,000 100

9. Inventories Reports: This method is also used to control and manage inventory
of the firm. Management of the business should be informed about the current
status of the inventory by preparing periodic reports. On the basis of these
reports management take corrective measure to have more control on inventory.

10. Just in Time (JIT) Inventory Control System: Toyota company first use
this techniques in Japan in 1950 but this technique is firstly used by US companies
in 1980s. These days this technique is very important to reduce inventory cost.
As per this technique firms produces only the needed quantity at the required
time. As per CIMA definition off JIT is “a technique for the organization of
workflows to allow rapid, high quality flexible production whilst minimizing the
manufacturing work and stock level.” This technique has two basis aspect one
is just in time purchase and second one is just in time production. As per this
technique delivery of material purchased is in such a way that delivery matches
with the requirement of the material. The basic philosophy of this technique is
that firm should maintain a zero level of minimum level of inventory and firms
should rely on supplier of the product for the supply of material as per the
requirement of it.
Following are the basic principles of the JIT technique:
 Minimum level of inventory and less cost of inventory
 Minimum lot size
 Elimination of waste and non-value added services
 Manufacturing the right product at right time
 Continuous flow of production
 Ensure timely delivery of products both inside and outside of the business
organization
Above mentioned list of techniques are not exhaustive, in practical life firms are
using very different techniques to manage inventory. But JIT, ABC and EOQ are the
most popular techniques of inventory management and almost every firm is using this
Self-Instructional
130 Material technique.
 Working Capital
Management
Check Your Progress
6. What do you mean by cash planning?
7. Mention any two optimum cash balance models. NOTES
8. What do you understand by cost of financing receivables?
9. What do you understand misallocation of funds?
10. What is the ultimate objective of inventory management?
11. Give the two types of costs for the determination of safety stock.

4.6 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. The minimum working capital required on regular basis is known as permanent

working capital.
2. Operating and cash conversion cycle refers to the time required to convert
cash-raw material semi-finished, stock-finished stocks-accounts, and
receivables/debtors-cash.
3. If the manufacturing cycle of the business is long then it has to maintain a large
level of working capital. Firms may follow a steady or stable production policy
in which production of goods takes place throughout the year.
4. Two issues in working capital management are levels of current assets in business
and ratio of current assets to fixed assets.
5. The three approaches to spontaneous sources of finance aggressive approach,
conservative approach and matching approach.
6. Cash planning is a technique to plan and control the use of cash. Firms use a
cash budget for such purposes.
7. Two optimum cash balance models are William J. Baumol's Model and Miller
and Orr Model of optimum cash balance.
8. Cost of financing receivables means cost incurred to finance the investment in
receivables.
9. Misallocation of funds means over-allocation or under-allocation of funds. It
leads to the wastage of right resources which causes harm to the other projects
in hand.
10. The ultimate objective of inventory management is to ensure the availability of
inventory as and when there is a requirement of it.
11. The two types of costs for the determination of safety stock are stock out cost
and carrying cost.

Self-Instructional
Material 131
Working Capital
Management 4.7 SUMMARY

 Management of working capital is very essential for the survival of a company.

NOTES  Both management of current assets and fixed assets involve risk-return analysis.
 Fixed asset management decisions are related to long term whereas current
assets decision are related to short term.
 Fixed asset management requires capital budgeting analysis.
 Holding of current assets affects the liquidity and profitability position of the firm
which makes risk-return trade-off vital for holding the current asset.
 The key aspects of working capital management are gross working capital
concept and net working capital concept.
 According to the gross working capital concept, the working capital means the
total of current assets in a business.
 According to the net working capital concept, the working capital means the
total amount of current assets and current liabilities.
 The minimum working capital required on regular basis is known as permanent
working capital.
 This proportion of total working capital requirement is known as temporary
working capital.
 The operating and cash conversion cycle involves the duration to convert sales
into cash.
 Length of operating cycle of a firm depends on the following cycles: inventory
conversion period and debtor conversion period.
 The issues in the management of working capital are: levels of current assets in
business, ratio of current assets to fixed assets, liquidity vs. profitability, cost
trade-off (cost of liquidity and illiquidity) and sources of financing the working
capital requirement.
 For the estimation of working capital, the following three methods are used:
current assets holding period, ratio of sales and ratio of fixed investment.
 A large number of factors have influence on the estimation of working capital
requirements. Some of which are: nature of business, market and demand, length
of operating cycle, conditions of financial market, technology and manufacturing
policy, credit policy and some others.
 Cash management is one of the most important decision areas of working capital
management. Cash is the most liquid current asset.
 He aspects of cash management are cash planning, managing the cash flows,
investing surplus cash and optimum cash balance.
 Account receivables constitute an important place in current assets. Companies
Self-Instructional are required to sell their products not only on cash basis but on credit basis too.
132 Material
  Receivables management is focused towards various issues related to credit Working Capital
Management
policy of the business.
 Cost of maintaining receivables includes cost of financing receivables, cost of
collection and bad debts. Cost of financing receivables means cost incurred to
NOTES
finance the investment in receivables.
 Factoring can be defined as a specialized service provided by financial institutions
in which financial institutions buy (through an agreement) receivables from the
seller of services/goods and manage seller's receivables.
 Factor relieves the client from the collection of receivables so that the client can
concentrate more on other important aspects of the business.
 Inventory management is required for the smooth and uninterrupted production
process so that the demand of the product is timely met.
 The inventory management is required to have to support smooth production
process without any delay in fulfilling orders.

4.8 KEY WORDS

 Operating conversion cycle: Operating cycle involves the duration to convert

sales into cash. A firm requires many years to convert its fixed assets into cash
but it requires less than a year to convert its current assets into cash.
 Length of operating cycle: Length of operating cycle is a used to a determinant
of working capital requirement. If operating cycle of a firm is long then it has to
maintain a large level of current assets to support the operation of the business
whereas if the operating cycle is short then firm can manage with a lesser level
of current assets.
 Receivable: Receivables is an asset designation applicable to all debts, unsettled
transactions or other monetary obligations owed to a company by its debtors
or customers.
 Inventory: Stock of direct or indirect material (raw materials or finished items
or both) stocked in order to meet the expected and unexpected demand in the
future.

4.9 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short-Answer Questions
1. What is working capital? Give examples.
2. Write a short note on gross and net working capital.
3. Define various factors which affect the size of the receivables.
Self-Instructional
Material 133
Working Capital 4. What are the components of inventory?
Management
5. What are the activities associated with allocation of funds in any business?
6. State the disadvantages of factoring.
NOTES Long-Answer Questions
1. Explain the operating cycle of firm function.
2. Describe the relevant determinants of working capital.
3. Examine the issues present in the management of working capital.
4. Discuss in detail the cost and tools of receivable management.
5. What are the functions of a factor? What are the advantages and disadvantages
of it?
6. Describe the tools and techniques of inventory management.

4.10 FURTHER READINGS

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House.
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
134 Material
 Fundamentals of

UNIT 5 FUNDAMENTALS OF Financial Analysis and

Control

FINANCIAL ANALYSIS AND

NOTES
CONTROL
Structure
5.0 Introduction
5.1 Objectives
5.2 Meaning and Steps Involved in Financial Analysis and Control
5.2.1 Uses and Types
5.2.2 Importance, Advantages and Limitations
5.3 Answers to Check Your Progress Questions
5.4 Summary
5.5 Key Words
5.6 Self Assessment Questions and Exercises
5.7 Further Readings

5.0 INTRODUCTION

The fundamental, clear and definite understanding of financial statements is recognized

as a prerequisite for an accurate, complete and relevant financial decision. However,
this does not mean that decision makers like a business executive, commercial or
investment banker, or investor, speculator, business counsellor, mercantile creditman,
or financial analyst need to master themselves in the preparation of these statements.
In fact, qualified financial accountants capable of preparing such statements are available
almost everywhere in the world. But the unchallenged ability to interpret these financial
statements intelligently and accurately are essential to understand the financial status
and performance of a business.

5.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the meaning and steps involved in financial analysis and control
 Describe the important, uses and types of financial statement analysis
 Discuss the advantages and limitations of financial statement analysis

5.2 MEANING AND STEPS INVOLVED IN FINANCIAL

ANALYSIS AND CONTROL

Like lines in the palm or horoscope, financial statements can be studied, puzzled over,
and scrutinized (Woelfel, 1980). The analysis of such statements provide valuable Self-Instructional
information for managerial decisions. Financial statement is—as nearly as the financial Material 135
Fundamentals of executive can make it so—simply a report of facts. The utility of the statement does
Financial Analysis and
Control not lie in the amount of information it contains but in the expertise and the skill of the
analyst to analyse and interpret the information in the statement in order to get the
story behind the facts—to read between the lines. Financial statement does not speak
NOTES anything in and of itself. It merely contains financial data about business events. The
user gains meaningful insights and conclusions about the firm only through his own
analysis and interpretation of the information in the statements (Woelfel, 1908).
Financial statement analysis involves a systematic and careful examination of
the information contained in the financial statements with a definite purpose. It is a
detailed inquiry into financial data to evaluate an organization’s performance, future
risks and potential. It attempts to determine the significance and meaning of the business
information as depicted by financial statements so that prospects for future earnings,
ability to pay interest and debt maturities (both current and long-term) and profitability
of a sound dividend policy may be forecast. According to Myer, 1969 Financial
statement analysis is largely a study of relationships among the various financial
factors in a business, as disclosed by a single set of statements and study of these
factors as shown in a series of statements.
Thus, financial statement analysis is a process of analysing the financial data in
order to judge the profitability and financial position of an organization. It is the evaluation
of the economic and financial data presented in the financial statements for making
decisions and maintaining control.
Steps Involved in Financial Statements Analysis
The process of financial statement analysis consists of the following six steps:
• determination of scope and objectives of analysis;
• study of financial statements;
• collection of relevant information;
• rearrangement of the data;
• analysis of data by analytical techniques; and
• interpretation, presentation and preparation of reports.
5.2.1 Uses and Types
Before, you learn about the uses and types of financial statement analysis, let’s discuss
the qualifications of a financial analyst.
To be qualified to analyse financial statements, the analyst should be clear and familiar
with:
• business systems and practices;
• purpose, nature and limitation of accounting system of the concern;
• accounting terminology; and
• tools and techniques of analysis.
Self-Instructional
136 Material
The analysis and interpretation of a financial analyst would be more meaningful and Fundamentals of
Financial Analysis and
accurate, if he possesses knowledge about the following: Control
Firm’s Financial History: Financial statements contain information in a condensed
form, therefore, the analyst requires a detailed knowledge about firm’s financial history
NOTES
in order to draw proper conclusions from the financial statement analysis.
Depreciation and Inventory Policies: The analyst cannot analyse the financial
statements in the right perspective unless he is aware of the firm’s accounting procedure,
particularly he must be clear about depreciation and inventory costing policies as in
vogue in the organization.
Location and Type of Company: Specific financial tests and tools may span a wide
range of acceptability, depending on such features as the geographic location or the
type of industry in which the firm is located. The analyst must be aware of the effect of
location and nature of industry in analysing financial statements.
Non-financial Items or Variables: An analyst should be able to measure the impact
of non-financial items on financial performance. These variables may include:
• calibre, reputation and creativity of the management;
• public relations;
• labour – management; and
• research and development facilities.
Uses and Users Financial Statement Analysis
Generally speaking, every segment of the society is directly or indirectly interested in
the analysis of financial statements. Although every stakeholder is interested in the
financial position and operating results of the organization, the primary information that
each seeks to obtain from these statements differs materially, reflecting the purpose
that the statement is to serve. However, it is practically impossible that a set of financial
statements will satisfy the precise needs of each group. Financial statements are,
therefore, general purpose statements intended to serve the various needs of general
stakeholders as discussed below.
Owners have an obvious interest in the analysis of financial statements as they
assume the primary risk of business by investing their money. This group requires
information periodically on how their investment is performing and whether or not their
continued investment in a particular company is justified. The owners, in fact, need
periodic reports to find answers to various questions relating to profitability and financial
position of the organization.
Creditors are individuals, agencies or institutions who extend credit facilities to
a firm. They are primarily concerned not only with the safety of their investment in the
borrowing firm but also in the prompt receipt of interest when due and the collection
of the loan on the schedule date. Therefore, the money-lending institutions are interested
in knowing whether a firm that seeks financial resources has the ability to meet its
obligations as they mature. For this purpose, the lending institution usually investigates
Self-Instructional
Material 137
Fundamentals of the credit standing of the firm, its past and projected earnings, and the size of the
Financial Analysis and
Control requested loan in relation to the firm’s financial structure.
Management depends heavily on the financial and managerial reports in order
to formulate company policies, establish organizational objectives, evaluate company’s
NOTES
performance and its employees, and make other related decisions. In order to plan
and control business operations efficiently, functional managers require accurate and
current financial information pertinent to specific areas of responsibility. For this purpose,
managers have to use both internal as well as external reports.
Employees are also interested in the company’s financial position and its
operations. They make frequent use of available information to gain insights into such
matters as fringe benefits, salary determination and working conditions. Prospective
employees prior to accepting a position frequently investigate the company’s past
earnings record and other related information that appear in its financial statements.
Government—central, state and local government agencies—become
increasingly interested in the internal operations of business enterprises. They use financial
statements to ensure that the company is meeting its various legal obligations.
Financial analysts are experts in the study of the financial information. Their
responsibility is to assemble and examine volumes of financial information for use by
their clients for investment decision-making purposes.
Institutional investors such as mutual investment companies, banks, insurance
firms and trustees of large estates normally employ their own staff for financial analysis
who serve as advisors to the institutions’ management on investment opportunities.
Investors in a business learn a great deal about a company from its financial
statements. An investor would like to be clear about the nature and prospectus of
investment opportunity offered by a particular business before he commits his money
to it. The most significant aspect of such an investigation is the analysis of the growth
potential of the firm and its earning trend as compared to its competitors. Investors
desire primarily a basis for estimating earning capacity and the rate at which the capital
is utilized.
Types of Financial Analysis
The methods of financial analysis are divided into different types: horizontal, vertical,
internal and external.
Horizontal and Vertical Analysis
In horizontal analysis, financial date of two or more years of the company is presented
horizontally in a number of columns in comparative form. Comparative financial
statements and trend percentages are types of horizontal analysis.
Vertical analysis covers a period of only one year and analysis is made on the
basis of one set of financial statements. Common size financial statements and ratio
analysis are the techniques employed in vertical analysis.
Self-Instructional
138 Material
Internal and External Analysis Fundamentals of
Financial Analysis and
Control
In external analysis the outside parties including the likes of government agencies,
suppliers, creditors, investors etc. undertake a study based on the reports and
information published by the management itself. They have no access to internal records NOTES
and accounting policies.
Internal analysis is undertaken by the management of the company, to analyse
their performance vis a vis the set objectives. This type of analysis is slightly more
reliable as it based on the internal policies and reports.
5.2.2 Importance, Advantages and Limitations
Financial statement analysis performs the essential function of converting mass data
into useful information. Such analysed financial information serves many and varied
purposes, as described below:
1. Judging Profitability: Profitability is a measure of the efficiency and success
of a business enterprise. A company which earns profits at a higher rate is
definitely considered a good company by the potential investors. The potential
investors analyse the financial statements to judge the profitability and earning
capacity of a company so as to decide whether to invest in a company or not.
2. Judging Liquidity: Liquidity of a business refers to its ability to pay off its
short-term liabilities, when they become due. Short-term creditors, like trade
creditors and bankers, make an assessment of liquidity before granting credit to
the company.
3. Judging Solvency: Solvency refers to the ability of a company to meet its
long-term debts. Long-term creditors, like debenture-holders and financial
institutions, judge the solvency of a company before any lending decisions. They
analyse company’s profitability over a number of years and its ability to generate
sufficient cash to be able to repay their claims.
4. Judging the Efficiency of Management: Performance and efficiency of
management of a company can be easily judged by analysing its financial
statements. Profitability of a company is not the only measure of company’s
managerial efficiency. There are a number of other ways to judge the operational
efficiency of management. Financial analysis tells whether the resources of the
business are being used in the most effective and efficient way.
5. Inter-firm Comparison: A comparative study of financial and operating
efficiency of different firms is possible only after proper analysis of their financial
statements. For this purpose, it is also necessary that the financial statements
are maintained on a uniform basis so that financial data of various firms are
comparable.
6. Forecasting and Budgeting: Financial analysis is the starting point for making
plans by forecasting and preparing budgets. Analysis of the financial statements
of the past years helps a great deal in forecasting for the future.
Self-Instructional
Material 139
Fundamentals of Limitations of Financial Statements
Financial Analysis and
Control
It is a general impression that financial statements are precise, exact and final. But
sometimes these statements conceal some very important information. As such they
NOTES suffer from certain limitations. These are discussed below:
1. Effect of accounting concepts and conventions: Various concepts and
conventions of accounting affect the values of assets and liabilities, as shown
in the Balance Sheet. Similarly profit or loss disclosed by Profit and Loss
Account is also affected by these concepts and conventions. For example, on
account of the going concern concept and also the convention of conservatism,
the balance sheet does not show current economic values of various assets
and liabilities.
2. Effect of personal judgements: The financial statements are influenced, to a
certain extent, by the personal judgements of the accountant. For example, the
amount of provision for bad and doubtful debts depends entirely on the judgement
and past experience of the accountant. Similarly, an accountant has also to
make a judgement about the method and rate of depreciation for fixed assets.
There are numerous instances when an accountant has to exercise his personal
judgement in which there is an element of subjectivity. The quality of the financial
statements thus depends upon the competence and integrity of those who are
responsible for preparing these statements.
3. Recording only monetary transactions: Financial statements record only
those transactions and events which can be expressed in terms of money. But
there are many factors which are qualitative in nature and cannot be expressed
in monetary terms. These non-monetary factors do not find any place in the
financial statements. For example, efficiency and loyalty of workers, personal
reputation and integrity of the managing director of the company, advertisement
policy of the company, etc., are not capable of being expressed in money terms
and thus find no place in financial statements even though they materially affect
the profitability of a business.
4. Historical in nature: Financial statements disclose data which is basically
historical in nature, i.e., it tells what has happened in the past. These statements
do not give future projections.
5. Ignores human resources: No business can prosper without an efficient work
force. But financial statements do not include human resources which is a very
important asset for a business.
6. Ignores social costs: Apart from earning a fair return on investments, a business
has certain social responsibilities. Financial statements do not make any attempt
to show the social cost of its activities. Examples of social cost of a manufacturing
company are air pollution, water pollution, occupational diseases, work injuries,
etc.

Self-Instructional
140 Material
 Fundamentals of
Financial Analysis and
Check Your Progress Control

1. What does a financial statement analysis attempt to determine?

2. Who are interested in judging the liquidity of a firm? NOTES
3. Give some examples of vertical analysis.
4. What are the social costs not included in financial statement analysis?

5.3 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. A financial statement analysis attempts to determine the significance and meaning

of the business information as depicted by financial statements so that the
prospects for future earnings, ability to pay interest and debt maturities and
profitability of a sound dividend policy may be forecast.
2. Short-term creditors, like trade creditors and bankers, are interested in making
an assessment of liquidity before granting credit to the company.
3. Common size financial statements and ratio analysis are examples of vertical
analysis.
4. Social costs which are not included in financial statement analysis include air
pollution, water pollution, occupational diseases, work injuries, etc.

5.4 SUMMARY

 Financial statement is-as nearly as the financial executive can make it so-simply
a report of facts. The utility of the statement does not lie in the amount of
information it contains but in the expertise and the skill of the analyst to analyse
and interpret the information in the statement in order to get the story behind the
facts-to read between the lines.
 Financial statement analysis is a detailed inquiry into financial data to evaluate
an organization's performance, future risks and potential.
 The process of financial statements analysis includes determination of scope
and objectives of analysis, study, collection, rearrangement of data, analysis of
data and interpretation, presentation and preparation of reports.
 The financial analyst should possess knowledge of firm's financial history,
depreciation and inventory policies, location and type of company and non-
financial items or variables.
 The financial statement analysis is used by different users like owners, creditors,
management, employees, government, financial analysts for varied reasons.
 The methods or types of financial analysis include horizontal and vertical analysis
and internal and external analysis. Self-Instructional
Material 141
Fundamentals of  The importance of financial statement analysis includes its assistance in judging
Financial Analysis and
Control profitability, judging liquidity, judging solvency, judging the efficiency of
management, inter-firm comparison and forecasting and budgeting.
 The following are the limitations of financial statement analysis: influence of
NOTES
accounting concepts and conventions, personal judgements; ignore human
resources and social costs; records only monetary transactions and is historical
nature.

5.5 KEY WORDS

 Financial statements: It refers to the reporting instruments that provide a

summary of the accounting data of an organization’s business pertaining to a
specific accounting period.
 Financial statement analysis: It is a process of analysing the financial data in
order to judge the profitability and financial position of an organization.

5.6 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short-Answer Questions
1. List the steps involved in the financial statement analysis.
2. What are the things a financial analysis must have a knowledge about in the
context of analysis and interpretation of financial statement analysis?
3. What are the broad categories of financial analysis?
Long-Answer Questions
1. Describe the uses and users of financial statement analysis.
2. Discuss the advantages, importance and limitations of financial statement analysis.

5.7 FURTHER READINGS

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House.
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.
Self-Instructional
142 Material
 Comparative and

UNIT 6 COMPARATIVE AND Common Size

Statement

COMMON SIZE STATEMENT

NOTES
Structure
6.0 Introduction
6.1 Objectives
6.2 Comparative Statements: Meaning
6.3 Common Size Statements: Meaning
6.4 Comparative Statement Versus Common Size Statement
6.4.1 Importance, Advantages, Limitations and Uses
6.5 Problems on Intra and Inter Company Comparison
6.6 Answers to Check Your Progress Questions
6.7 Summary
6.8 Key Words
6.9 Self Assessment Questions and Exercises
6.10 Further Readings

6.0 INTRODUCTION

Financial statement analysis is a very important performance measurement tool in

accounting. It helps company take stock of their activities, identify the problem
areas and make decisions about the future. As you have learnt in the previous unit,
there are many different types of financial analysis tools available for accountants. In
this unit, you will learn about comparative and common size statements. Comparative
size statements help companies assess their operations over several accounting
periods side by side. This is called horizontal financial analysis. Common size
statement on the other hand, assists companies analyse their performance in
percentage terms with respect to a certain base year. This is known as vertical
financial analysis.

6.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the meaning of comparative statements
 Discuss the importance, advantages, limitations and uses of comparative
statements
 Describe the meaning of common size statements
 Discuss the importance, advantages, limitations and uses of common size
statements

Self-Instructional
Material 143
Comparative and
Common Size 6.2 COMPARATIVE STATEMENTS: MEANING
Statement

Any financial statement that reports the comparison of data for two or more
NOTES consecutive accounting periods is known as comparative financial statement.
Commenting on the nature of comparative financial statements Foulke, 1961 states
that such statements which basically reveal the financial position of the business are
designed in such a form as to provide time prospective to the consideration of various
elements of financial position embodied in such statements.
In fact, comparative financial statements highlight trends and establish relationship
between items that appear on the same row of the statement. Such statements disclose
changes in the items of the statement with time in both rupees and percentage. Each
item (such as debtors) on a row for one fiscal period is compared with the same item
in a different period. The analyst calculates the absolute changes—the difference
between the figures of one year and the next—and also the percentage change from
one year to the next, using the earlier year as the base year. Much valuable information
is obtained from financial statements in this manner. The comparative study helps an
analyst to identify and examine the key factors which have affected profitability or the
financial position of the organization.
Illustration 6.1 From the following balance sheet of Saher Ltd. prepare a comparative
balance sheet and comment on the financial position of the concern.
Saher Ltd.
Balance Sheet

Self-Instructional
144 Material
Solution Comparative and
Common Size
Comparative Balance Sheet Statement
(As on 31st December, 2011 and 2012)

NOTES

Interpretation
The analysis of the above comparative balance sheet (see Illustration 6.1) reveals that
the monetary balance in each account has increased between the end of 2011 and
2012 with an exception of marketable securities, cash balances, furniture, sundry
creditors and outstanding. The significant changes which have occurred in specific
balance sheet accounts during the two-year period are:
 There is 50 per cent increase in sundry debtors, 37.5 per cent increase in stock,
45.45 per cent decrease in marketable securities and 50 per cent decrease in
cash balances. Slower paying customers and/or slower moving merchandise
might be responsible for the changes.
 There has been no change in the amount of current assets during the two periods
but current liabilities have decreased by 31.58 per cent. This change has
contributed to the liquidity of the company. Self-Instructional
Material 145
Comparative and  There has been increase in share capital and debentures by 13.64 per cent and
Common Size
Statement 20 per cent, respectively. All this might be due to fresh issue of shares and
debentures.
 The increase in fixed assets during the two periods has been 12.5 per cent. The
NOTES
increase in fixed assets does not sound financially sound when compared with
the amount of current assets that has remained constant during the period under
study.
Illustration 6.2 The income statements of a concern are given for the years ending on
31st December, 2011 and 2012. You are required to prepare a comparative income
statement and interpret the changes.
Income Statements for the Year Ending 2011 and 2012

Solution
Comparative Income Statement
(for the year ended 31st December, 2011 and 2012)

Interpretation
A cursory study of the above comparative income statement (see Illustration 6.2)
reveals the following:
 There is significant change in the operating profit in comparison to other items of
the income statement as it has declined by 21.43 per cent during the period
under study.
Self-Instructional
146 Material
  Although the amount of net sales has increased by 11.54 per cent during the Comparative and
Common Size
period under study yet the cost of goods sold has increased by 17.65 per cent Statement
that has neutralized the benefit gained from the increase in sales. Consequently,
the amount of gross profit has remained constant.
NOTES
 The increase in operating expenses during the period which has been registered
an increase of 35.29 per cent is due to increase in selling and distribution, and
general expenses which have registered an increase of 25 per cent and 60 per
cent, respectively during the period.

6.3 COMMON SIZE STATEMENTS: MEANING

Financial statements that depict financial data in the shape of vertical percentage
are known as common size statements. Since such statements provide the readers
with a vertical analysis of the items of profit and loss account and balance sheet, the
values of the items are converted into a common unit by expressing them as a percentage
of a key figure in the statement. Therefore, the total of financial statement is reduced to
100 and each item of the statement is shown as a component of the whole. For example,
in profit and loss account, the value of each item is expressed as a percentage of sales. In
the same way, the assets and liabilities can be shown as percentage of total assets and
total liabilities, respectively, in a common-sized balance sheet. Since in common size
statements each monetary item of the financial statement is expressed as a percentage of
the sum total of which that item is a part, such an attempt is referred to as common size
statement. Consequently, such statements not only show the relative significance of the
items contained in the financial statements but also facilitates comparison. Common size
statements are recognized as valuable management tool as they reveal both efficiencies
and inefficiencies that are otherwise difficult to identify. However, a common size statement
is especially useful when data for more than one year are used.
Illustration 6.3 The balance sheets of Shaheen Ltd. are given for the year 2011
and 2012. Convert them into common-sized balance sheet and interpret the
changes.
Balance Sheet

Self-Instructional
Material 147
Comparative and Solution
Common Size
Statement Common-size Balance Sheet
(as on 31st December 2011 and 2012)

NOTES

Interpretation
 The study of the above common size balance sheet (see Illustration 6.3) shows
that 61.56 per cent of the total assets in 2011 were fixed. This percentage
increased to 64.57 per cent in 2012. If the organization requires considerable
investment in fixed assets, these percentages might be acceptable. However, if
the organization needs liquid assets, the interested parties might have cause to
be concerned about the decreasing trend of liquidity.
 There has been a major shift from the use of creditors’ provided funds to the
Self-Instructional
148 Material use of owner’s equity funds. In 2011, external equity (current liabilities) and
 owner’s equity (long-term liabilities) accounted for 51.47 per cent and 48.53 Comparative and
Common Size
per cent, respectively, of the total equities. In 2012, these percentages changed Statement
to 40.73 per cent for external equities and 59.27 per cent for owners’ equity.
These changes indicate that the organization has used more internal sources
than external sources in the generation of funds for the business during the period NOTES
under study.
 The organization has not only succeeded in reducing its current liabilities from
51.47 per cent in 2011 to 40.73 per cent in 2012 of their respective total
equities but it has also increased the percentage of its revenue reserve and
surplus from 4.48 per cent in 2011 to 6.11 per cent in 2012 of their respective
total equities.
Illustration 6.4 From the income statement given below, you are required to prepare
a common-sized Income Statement.
Income Statements
(for the year ending 31st Dec, 2011 & 2012)

Solution
Common Size Income Statement
(for the year ending 2011 and 2012)

Self-Instructional
Material 149
Comparative and Interpretation
Common Size
Statement
The study of the above-mentioned common size income statement (see Illustration
6.4) reveals the following facts:
NOTES  Out of every rupee of sales 60.72 per cent in 2011 and 63.63 per cent in 2012
accounted for cost of goods sold.
 The percentage ratio of gross profit to sales was 39.28 per cent in 2011 and the
same was reduced to 36.37 per cent in 2012.
 The operating expenses increased from 15.71 per cent of sales in 2011 to
16.37 per cent in 2012. All this reduced the percentage ratio of net income after
tax to sales from 14.15 per cent in 2011 to 12 per cent in 2012.
In the ultimate analysis, it can be concluded that the operating efficiency of the
organization has not been satisfactory during the period under study.
Illustration 6.5 Following are the Balance Sheets of X Co. Ltd. and Y. Co. Ltd. as
on 31.12.2012.

From the above data, prepare a common size statement and make two comments you
deem fit.

Self-Instructional
150 Material
Solution Comparative and
Common Size
Common Size Balance Sheet Statement

(as on 31st December 2012)

NOTES

Interpretation
The study of the above common size balance sheet (see Illustration 6.5) brings to light
the following facts:
• The balance sheet indicates that 63.31 per cent of total assets of the X Co. Ltd.
were fixed whereas the same was 49.96 per cent for Y Co. Ltd.
• The current liabilities of X Co. Ltd. were 11.97 per cent of the total liabilities
and the said percentage for Y Co. Ltd. was 21.03. Both the companies have
used more equity capital as compared to debt, and therefore, have failed to
take benefit of trading on equity.

Self-Instructional
Material 151
Comparative and
Common Size 6.4 COMPARATIVE STATEMENT VERSUS COMMON
Statement
SIZE STATEMENT

NOTES Although both statements aims to help managers in decision making yet they differ
both in terms of format and approach. The major differs between the two statements
are summarized in Table 6.1.
Table 6.1 Comparison of Comparative Statement and Common Size Statement

6.4.1 Importance, Advantages, Limitations and Uses

In this section, let’s learn about the importance and limitations of comparative and
common size statements.
Importance, Advantages and Use
Comparative Income Statements are advantages for the following reasons:
 It shows the net profit or net loss due to business operations
 It depicts data in absolute figures.
 It is useful in judging data for multiple accounting periods.
Common size financial statements are beneficial for the following reasons:
 It is useful in making intra as well as inter-company comparisons as it helps in
standardizing financial statements.
 It is efficient in studying not just the entire but specific items of the financial
statements.
Limitations
Comparative statements have the following limitations:
 It is not useful in inter-firm comparisons since it requires the companies to follow
the same accounting principles, concepts and conventions for accurate results.
Self-Instructional  In times of inflation, comparative statements are of not much use since price
152 Material
level changes are not recognized by it.
  It fails to reflect accurate data in case of structural changes. Comparative and
Common Size
 Information provided by it is not always meaningful. This is to say that due to Statement
arithmetical reasons, it makes comparisons complicated.
Common size statements have the following limitations: NOTES
 It is not very useful for decision making since there is a lack of benchmark.
 Since the analysis relies on percentages instead of specific figures, there are
risks of window dressing.
 Qualitative elements are often ignored in this financial analysis and so the complete
picture about the performance of the company is not known.
 It is not suitable for businesses who regularly get impacted by seasonal elements.

6.5 PROBLEMS ON INTRA AND INTER COMPANY

COMPARISON

Problem 6.1
From the following information prepare a Comparative Balance Sheet.
31 March 2011 31 March 2012

Equity Share Capital 4,00,000 6,00,000

Debentures 2,00,000 3,25,000
Sundry Creditors 2,55,000 1,17,000
Bank Overdraft 7,000 10,000
Total Liabilities and Capital 8,62,000 10,52,000
Plant and Machinery 1,00,000 2,00,000
Land and Building 3,60,000 5,40,000
Investments 2,70,000 1,70,000
Sundry Debtors 1,00,000 88,000
Cash in hand 32,000 54,000
Total Assets 8,62,000 10,52,000

Solution:
Comparative Balance Sheet

Self-Instructional
Material 153
Comparative and Problem 6.2
Common Size
Statement From the following information, prepare a comparative Income Statement.
31-3-2011 31-3-2012

NOTES
Sales 10,00,000 8,00,000
Cost of Goods Sold 6,00,000 4,00,000
Adm. Selling and Distribution Expenses. 2,00,000 1,40,000
Other Incomes 40,000 20,000
Income Tax 1,20,000 1,40,000

Solution:
Comparative Income Statement
for two years 2011 and 2012

Problem 6.3
With reference to Problem 6.1, Common Size Balance Sheet is prepared as follows:
Common Size Balance Sheet

Self-Instructional
154 Material
Problem 6.4 Comparative and
Common Size
Use the data given in Problem 6.2 to prepare a Common Size Income Statement. Statement

Solution:
Common Size Income Statement NOTES

Check Your Progress

1. Which type of financial statement analysis tool is useful for highlighting trends
and establishing relationship between items that appear on the same row of the
statement?
2. In which cases in common size statement especially useful?
3. Compare the requirements of comparative and common size statements.

6.6 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. Comparative financial statement analysis tool is useful for highlighting trends

and establishing relationship between items that appear on the same row of the
statement.
2. A common size statement is especially useful when data for more than one year
are used.
3. Comparative statement calls for the financial statements related to two
consecutive financial periods, on the other hand, common-size statements need
financial statements of a single financial period.

6.7 SUMMARY

 Any financial statement that reports the comparison of data for two or more
consecutive accounting periods is known as comparative financial
statement.
 Comparative financial statements highlight trends and establish relationship
between items that appear on the same row of the statement. Such statements Self-Instructional
Material 155
Comparative and disclose changes in the items of the statement with time in both rupees and
Common Size
Statement percentage.
 The analyst calculates the absolute changes-the difference between the figures
NOTES of one year and the next-and also the percentage change from one year to the
next, using the earlier year as the base year.
 Financial statements that depict financial data in the shape of vertical percentage
are known as common size statements.
 Since common size statements provide the readers with a vertical analysis of
the items of profit and loss account and balance sheet, the values of the items
are converted into a common unit by expressing them as a percentage of a key
figure in the statement.
 Comparative financial statements differ from common-size statements on account
of approach, type of analysis, popularity, requirements and significance of items.
Each suffers from their own advantages and limitations.

6.8 KEY WORDS

 Comparative financial statement: It refers to any financial statement that

reports the comparison of data for two or more consecutive accounting
periods.
 Common size statements: It refers to the financial statements that depict
financial data in the shape of vertical percentage.

6.9 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short-Answer Questions
1. Write a short note on comparative statements.
2. Why are common size statements recognized as valuable management tool?
Long-Answer Questions
1. Differentiate between comparative and common size statements.
2. Discuss the importance, advantages, uses and limitations of comparative and
common size statements.

Self-Instructional
156 Material
Practical Problems Comparative and
Common Size
Statement
1. The following are the balance sheets of a concern as on 31st December, 2011
and 2012.
NOTES

Prepare a comparative balance sheet of the concern and study its financial
position.
2. From the following information prepare a comparative statement and make
brief comments
Income Statements
(for the year ended 31st March 2011 and 2012)

Self-Instructional
Material 157
Comparative and 3. Convert the following balance sheets into common size balance sheet and make
Common Size
Statement brief comments
Balance Sheets
(as on 31st March 2011 and 2012)
NOTES

Following income statements of a business are given for the years ending 31st
December, 2011 and 2012. Prepare a common size statement and make
comments on the business results.
Income Statements
(for the years ending on 31st Dec, 2011 and 2012)

Self-Instructional
158 Material
 Comparative and
6.10 FURTHER READINGS Common Size
Statement

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House. NOTES
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
Material 159
 Cash Flow and Fund

UNIT 7 CASH FLOW AND FUND Flow Statements

FLOW STATEMENTS
NOTES
Structure
7.0 Introduction
7.1 Objectives
7.2 Cash Flow Statements: Meaning
7.2.1 Advantages
7.2.2 Limitations
7.2.3 Importance and Uses
7.3 Preparation of Cash Flow Statements
7.4 Problems on Cash Flow Statements
7.5 Fund Flow Statements: Meaning
7.5.1 Uses and Advantages
7.5.2 Limitations
7.5.3 Importance
7.6 Preparation of Funds Flow Statement
7.7 Problems on Fund Flow Statements
7.8 Answers to Check Your Progress Questions
7.9 Summary
7.10 Key Words
7.11 Self Assessment Questions and Exercises
7.12 Further Readings

7.0 INTRODUCTION

Cash flow has rightly been recognized as life stream of a successful business as there
is hardly any business transaction that does not involve cash. Recognizing the significance
of management of cash in contemporary business as a strategic resource, business
firms need to control and monitor cash flows efficiently and effectively so that adequate
cash is available to meet the requirements of the business. To attain this objective,
business firms make use of cash flow statement which provides them the details
about cash received and spent on various activities during the period under study.
The traditional balance sheet reveals the financial position of an organization by
mentioning not only the sources of its resources but also the deployment of its resources.
However, such a statement fails to identify the factors that are responsible for the
change in the financial position of the organization between two financial periods. The
identification and analysis of the said factors are essential as they have a direct impact
on the working capital. It is pertinent to mention here that the management of working
capital has always been recognized as a prerequisite for the smooth functioning of the
organization. The most popular framework used for this purpose is statement of
change in financial position. The said statement aims to describe the changes in the
Self-Instructional
Material 161
Cash Flow and Fund financial position of a concern during a particular period. In fact, such a statement
Flow Statements
provides the basis for policy formulation by acting as a financial reporting media. The
statement of changes in financial position is also known as funds flow statement,
where got were gone statement, management funds statement, etc.
NOTES
In this unit, you will learn about the concepts of cash flow and fund flow
statements.

7.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the meaning and preparation of cash flow statements
 Discuss the advantages, importance, uses and limitations of cash flow statements
 Describe the meaning and preparation of fund flow statements
 Assess the advantages, importance, uses and limitations of fund flow statements

7.2 CASH FLOW STATEMENTS: MEANING

In this section, we will learn about the meaning and uses of cash flow statement.
Cash flow statement attempts to measure the inflows and outflows of cash
that result from various business activities during a particular accounting period. In
cash flow analysis, attempts are made to explain the causes of change in the cash
position of a concern during the period. Such an analysis help the business firms in
identifying the areas of business that either have surplus or deficit cash and accordingly
help them in the creation and utilization of cash effectively. Thus, cash flow statement
is a tool that managers utilize to evaluate their ability to manage cash efficiently and
effectively. Therefore, a cash flow statement focuses on cash rather than on working
capital as advocated by a fund flow statement. The Institute of Cost and Works
Accountants of India, 2000 defines cash flow statement as ‘a statement setting out
the flow of cash under distinct heads of sources of funds and their utilization to determine
the requirements of cash during the given period and to prepare for its adequate provision’.
As per M.A. Sahaf, a cash flow statement is a statement which provides a detailed
explanation for the change in a firm’s cash during a particular period by indicating the
firm’s sources and uses of cash during that period. Such a statement is only useful for
management and does not have any utility for external users.
Concept of Cash Flow
The basic objective of cash flow analysis is to identify the business transactions
technically known as cash flow that cause the change in the firms’ cash and cash
equivalents. In fact, cash flow can result either in inflow or outflow of cash and cash

Self-Instructional
162 Material
equivalent. Cash inflow refers to a business transaction that generates cash, and Cash Flow and Fund
Flow Statements
therefore, technically it is referred to as source. In the same way, cash outflow refers
to a business transaction that utilizes cash and therefore, technically it is known as
application. In fact, such cash flows can result from the following three major
activities of an enterprise: NOTES

• Operating activities include such activities that have direct impact on the
enterprise’s business results. Therefore, such activities either result in operating
incomes or operating expenses;
• Investment activities refers to such activities that result in either purchase or sale
of long-term assets;
• Financial activities include activities that are responsible for the change in the
company’s capital structure and therefore are concerned with the capital and
debt of the business.
We will discuss these topics further in the Unit.
To meet the above-mentioned objective of cash flow analysis, one has to use the
same approach that is devised to analyse funds flow (net working capital). However,
such an approach would call for slight modification to make it appropriate for the
analysis of cash flows. In cash flow analysis, the non-current accounts, i.e., fixed
assets and long-term liabilities are given the same treatment as is recommended for
such items in fund flow analysis. However, the changes in current accounts (except
cash) which were reflected in the schedule of changes in working capital in case of
fund flow analysis are now reflected in cash flow statement along with the changes
in non-current accounts. The cash flow can be determined symbolically as:
C = A – L
where
 = Change in C = Cash
A = Total assets except cash L = Total liabilities
The above equation clearly reveals that change in cash can be computed by
analysing the changes that occurred in all non-current and current accounts except
cash. The impact on cash position of a concern by the change in balance sheet items
is given below:
Change in balance sheet items Impact on cash
–Increase in current assets other than cash Outflow of cash
–Decrease in current assets other than cash Inflow of cash
–Increase in non-current assets Outflow of cash
–Decrease in non-current assets Inflow of cash
–Increase in current liabilities Inflow of cash
–Decrease in current liabilities Outflow of cash
–Increase in long-term liabilities Inflow of cash
–Decrease in long-term liabilities Outflow of cash

Self-Instructional
Material 163
Cash Flow and Fund Sources and Application of Cash
Flow Statements
The major sources and uses of cash are mentioned below:
Sources of Cash
NOTES • Issue of capital
• Issue of long-term debts such as debentures
• Sale of assets
• Cash from operation
• Decrease in current assets
• Increase in current liabilities
Application of Cash
• Redemption of capital
• Purchase of fixed assets
• Repayment of long-term debt
• Cash lost in operation
• Increase in current assets
• Increase in current liabilities
7.2.1 Advantages
A cash flow statement is a vital analytical tool that helps a financial manager in
effective management of cash. As a result, the application of cash flow statement
offers the following advantages to the users:
• It ensures effective planning and coordination of financial operations. The analysis
of cash flow statement provides a financial manager sufficient basis to assess
the position of the firm’s cash that can be generated internally as against the
total amount of cash required to meet future obligations of the concern. With
the result, proper arrangements can be made well in advance for the availability
of adequate cash if the future cash requirements of the business cannot be met
internally.
• A comparison of the cash flow statement with the projected cash flow statement
is very useful in evaluating cash forecasting.
• It may be an useful tool for the proper allocation of the firm’s cash among its
various activities/divisions.
The analysis of cash flow statement can also help the management in
formulating appropriate financial policies regarding debts, credits, collections,
dividends, etc.
• It helps the management in investment decisions.
• A comparative analysis of the firm’s cash flow statements enables a financial
manager to assess the liquidity position of the firm.
• A careful study of cash flow statement provides answer to some typical questions
like why cash position of the concern is tight, in spite of high incomes or vice-
versa.
Self-Instructional
164 Material
7.2.2 Limitations Cash Flow and Fund
Flow Statements
Cash flow analysis is a useful tool of financial analysis. However, it has its own limitations.
These limitations are as under:
1. Cash flow statement cannot be equated with the income statement. An income NOTES
statement takes into account both cash as well as non-cash items and, therefore,
net cash does not necessarily mean net income of the business.
2. The cash balance as disclosed by the cash flow statement may not represent the
real liquid position of the business since it can be easily influenced by postponing
purchases and other payments.
3. Cash flow statement cannot replace the income statement or the funds flow
statement. Each of them has a separate function to perform.
In spite of these limitations it can be said that cash flow statement is a useful
supplementary instrument. It discloses the volume as well as the speed at which the
cash flows in the different segments of the business. This helps the management in
knowing the amount of capital tied up in a particular segment of the business. The
technique of cash flow analysis, when used in conjunction with ratio analysis, serves as
a barometer in measuring the profitability and financial position of the business.
7.2.3 Importance and Uses
1. Useful in cash planning: A cash flow statement proves very useful to
management by providing a basis to evaluate the ability of a company to generate
cash. A cash flow statement prepared on an estimated basis for the next
accounting period enables the management to know how much cash can be
generated internally and how much it should arrange from outside. Such estimated
amounts are used for preparing cash budget.
2. Assesses cash flow from operating activities: Cash flow statement provides
information about cash generated from operating activities. It provides
explanation for the difference net profit and cash from operations. Cash provided
by operating activities is very important to assess the cash generated by internal
sources.
3. Payment of dividends: Decisions to pay dividends cannot be based on net
profit only. Availability of profit in the form of cash is also important for dividend
disbursement. Thus cash provided by operating activities assumes importance
for declaration of dividend.
4. Cash from investing and financing activities: Cash flow statement provides
information not only about cash provided by operating activities but also by
non-operating activities under two heads, namely, investing activities and financing
activities. This helps to explain the overall liquidity position of the enterprise and
its ability to meet its cash commitments.

Self-Instructional
Material 165
Cash Flow and Fund 5. Explains reasons for surplus or shortage of cash: A business may have
Flow Statements
made profit and yet running short of cash. Similarly, a business may have suffered
a loss and still has sufficient cash at the bank. A cash flow statement discloses
reasons for such increases or decreases of cash balance.
NOTES
Check Your Progress
1. Which accounting tool follows a cash system of accounting?
2. How does decrease in non-current asset impact cash?
3. Is the redemption of capital a source or application of cash?

7.3 PREPARATION OF CASH FLOW STATEMENTS

According to Accounting Standard (AS)-3, enterprises in India that have a turnover of more
than 50 crore in a financial year need to prepare cash flow statement (CFS) in addition to
basic financial statements i.e., profit and loss account and balance sheet. Such a statement
reflects the various sources from where cash was generated (inflow of cash) by an enterprise
during the relevant accounting year and how these inflows were utilized (outflow of cash)
by the enterprise. However, the Standard is not mandatory for small and medium scale
companies. It is pertinent to mention here that the International Financial Reporting Standard
(IFRS)-7 also prescribes that the enterprises must prepare a cash flow statement. Although
both standards, i.e., AS-3 and IAS-7, by and large prescribe the same mechanism for the
preparation of cash flow statement except the treatment for bank overdraft and extraordinary
items. IAS-7 mentions clearly that bank overdraft must be included in cash and cash
equivalent and extraordinary items need not to be shown separately.
In accordance with the standards, an enterprise needs to take the following steps to
prepare a cash flow statement:
• Identification and calculation of cash flows from various activities like operating,
investing and financing; and
• Ascertaining net change (increase/decrease) in cash and cash equivalents.
A cash flow statement basically provides information to all stakeholders on the historical
changes in cash and cash equivalents during the financial period for which the basic
financial statements have been prepared by the enterprise. The statement helps the users
of accounts:
• To identify the historical changes in the flow of cash and cash equivalents.
• To determine the future requirement of cash and cash equivalents.
• To assess the ability to generate cash and cash equivalents.
• To estimate the further requirement of generating cash and cash equivalents.

Self-Instructional
166 Material
 • To compare the operational efficiency of different enterprises. Cash Flow and Fund
Flow Statements
• To study the insolvency and liquidity position of an enterprise.
Since the understanding of the terms ‘cash’ and ‘cash equivalent’ are a prerequisite for
the preparation of the cash flow statement, therefore, it becomes mandatory for the NOTES
students of accounting to know the meaning of the terms in the context of the standard.
The term ‘cash’ as used in this standard includes cash on hand and demand deposits
with banks. The term ‘cash equivalents’ as referred to in this standard includes:
• Short term (maximum three months of maturity from the date of acquisition)
• Highly liquid investments
• Readily convertible
• Convertible amounts of cash is known
• Subject to an insignificant risk of changes in value
A cash flow statement is recognized as a strategic tool for the management accountants
as it addresses the following vital questions:
• Where did cash come from during the period?
• What was the cash used for during the period?
• What was the change in cash balance during the period?
The standard also provides the treatment of special items like interest, dividend, taxes
on income and some other special items.
Source: Adapted from Training Material, Implementation of Accounting Standard with
Specific Reference to Educational Institutions, The Institute of Chartered Accountants
of India, New Delhi, 2012.
Let us now discuss some of the important concepts mentioned in the Accounting
Standard 3:
Operating Activities
The amount of cash flows arising from operating activities is a key indicator of the
extent to which the operations of the enterprise have generated sufficient cash flows to
maintain the operating capability of the enterprise, pay dividends, repay loans and
make new investments without recourse to external sources of financing. Information
about the specific components of historical operating cash flows is useful, in conjunction
with other information, in forecasting future operating cash flows.
Cash flows from operating activities are primarily derived from the principal
revenue-producing activities of the enterprise. Therefore, they generally result from
the transactions and other events that enter into the determination of net profit or loss.
Examples of cash flows from operating activities are:
(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions and other revenue;
Self-Instructional
Material 167
Cash Flow and Fund (c) cash payments to suppliers for goods and services;
Flow Statements
(d) cash payments to and on behalf of employees;
(e) cash receipts and cash payments of an insurance enterprise for premiums and
NOTES claims, annuities and other policy benefits;
(f) cash payments or refunds of income taxes unless they can be specifically identified
with financing and investing activities; and
(g) cash receipts and payments relating to futures contracts, forward contracts,
option contracts and swap contracts when the contracts are held for dealing or
trading purposes.
Some transactions, such as the sale of an item of plant, may give rise to a gain or
loss which is included in the determination of net profit or loss. However, the cash
flows relating to such transactions are cash flows from investing activities.
An enterprise may hold securities and loans for dealing or trading purposes, in
which case they are similar to inventory acquired specifically for resale. Therefore,
cash flows arising from the purchase and sale of dealing or trading securities are classified
as operating activities. Similarly, cash advances and loans made by financial enterprises
are usually classified as operating activities since they relate to the main revenue-
producing activity of that enterprise.
Investing Activities
The separate disclosure of cash flows arising from investing activities is important
because the cash flows represent the extent to which expenditures have been made
for resources intended to generate future income and cash flows. Examples of cash
flows arising from investing activities are:
(a) cash payments to acquire fixed assets (including intangibles). These payments
include those relating to capitalized research and development costs and self-
constructed fixed assets;
(b) cash receipts from disposal of fixed assets (including intangibles);
(c) cash payments to acquire shares, warrants or debt instruments of other
enterprises and interests in joint ventures (other than payments for those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);
(d) cash receipts from disposal of shares, warrants or debt instruments of other
enterprises and interests in joint ventures (other than receipts from those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);
(e) cash advances and loans made to third parties (other than advances and loans
made by a financial enterprise);
(f) cash receipts from the repayment of advances and loans made to third parties
(other than advances and loans of a financial enterprise);
Self-Instructional
168 Material
 (g) cash payments for futures contracts, forward contracts, option contracts and Cash Flow and Fund
Flow Statements
swap contracts except when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities; and
(h) cash receipts from futures contracts, forward contracts, option contracts and
NOTES
swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities.
When a contract is accounted for as a hedge of an identifiable position the cash
flows of the contract are classified in the same manner as the cash flows of the position
being hedged.
Financing Activities
The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting claims on future cash flows by providers of funds
(both capital and borrowings) to the enterprise. Examples of cash flows arising from
financing activities are:
(a) cash proceeds from issuing shares or other similar instruments;
(b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or
long-term borrowings; and
(c) cash repayments of amounts borrowed.
Cash equivalents
These are held for the purpose of meeting short-term cash commitments rather than
for investment or other purposes. For an investment to qualify as a cash equivalent, it
must be readily convertible to a known amount of cash and be subject to an insignificant
risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent
only when it has a short maturity of, say, three months or less from the date of acquisition.
Investments in shares are excluded from cash equivalents unless they are, in substance,
cash equivalents; for example, preference shares of a company acquired shortly before
their specified redemption date (provided there is only an insignificant risk of failure of
the company to repay the amount at maturity).
Other Important Standards Include:
 An enterprise should report separately major classes of gross cash receipts and
gross cash payments arising from investing and financing activities, except to the
extent that cash flows described under reporting of Cash Flow on a net basis.
 Cash flows arising from the following operating, investing or financing activities
may be reported on a net basis: (a) cash receipts and payments on behalf of
customers when the cash flows reflect the activities of the customer rather than
those of the enterprise; and (b) cash receipts and payments for items in which
the turnover is quick, the amounts are large, and the maturities are short.
 Cash flows arising from each of the following activities of a financial enterprise
may be reported on a net basis: (a) cash receipts and payments for the acceptance Self-Instructional
Material 169
Cash Flow and Fund and repayment of deposits with a fixed maturity date; (b) the placement of
Flow Statements
deposits with and withdrawal of deposits from other financial enterprises; and
(c) cash advances and loans made to customers and the repayment of those
advances and loans.
NOTES
 Cash flows arising from transactions in a foreign currency should be recorded in
an enterprise’s reporting currency by applying to the foreign currency amount
the exchange rate between the reporting currency and the foreign currency at
the date of the cash flow. A rate that approximates the actual rate may be used
if the result is substantially the same as would arise if the rates at the dates of the
cash flows were used. The effect of changes in exchange rates on cash and cash
equivalents held in a foreign currency should be reported as a separate part of
the reconciliation of the changes in cash and cash equivalents during the period.
 The cash flows associated with extraordinary items should be classified as arising
from operating, investing or financing activities as appropriate and separately
disclosed.
 Investing and financing transactions that do not require the use of cash or cash
equivalents should be excluded from a cash flow statement. Such transactions
should be disclosed elsewhere in the financial statements in a way that provides
all the relevant information about these investing and financing activities.
 An enterprise should disclose the components of cash and cash equivalents and
should present a reconciliation of the amounts in its cash flow statement with the
equivalent items reported in the balance sheet.
 An enterprise should disclose, together with a commentary by management, the
amount of significant cash and cash equivalent balances held by the enterprise
that are not available for use by it.
Calculation of Cash from Operations
The major source of cash for a business is cash from trading operations. When the
accounting system is based on cash system, the net profit as shown by profit and
loss represents the cash from operations. However, in actual practice, commercial
organizations maintain mercantile system of accounting. With the result the profit as
disclosed by profit and loss account is not considered the actual cash from operation
as it includes many transactions of notional cash. Thus, net profit as shown in profit
and loss account is to be adjusted as to arrive at actual cash from operation. The
non-cash transactions like outstanding incomes/expenses, prepaid expenses, etc.,
should be adjusted. Further all non-fund items such as depreciation, preliminary
expenses written off, etc., are also to be adjusted as is done in case of fund flow
statement. A detailed proforma of the statement showing computation of cash from
operations is given below:

Self-Instructional
170 Material
 Statement Showing Computation of Cash from Operations Cash Flow and Fund
Flow Statements

NOTES

Note: The current assets and current liabilities will not include cash balances and
bank overdraft respectively in the determination of cash from operations.
Illustration 7.1: From the following balance sheet of M/s S.B. Company Ltd., as
on Dec. 31, 2010 and 2011, calculate cash from operation:

Self-Instructional
Material 171
Cash Flow and Fund Solution:
Flow Statements
Calculation of Cash from Operation

NOTES

Methods of Reporting Cash Flows from Operating Activities:

Direct and Indirect
An enterprise should report cash flows from operating activities using either:
(a) the direct method, whereby major classes of gross cash receipts and gross cash
payments are disclosed; or
(b) the indirect method, whereby net profit or loss is adjusted for the effects of
transactions of a non-cash nature, any deferrals or accruals of past or future
operating cash receipts or payments, and items of income or expense associated
with investing or financing cash flows.
The direct method provides information which may be useful in estimating future cash
flows and which is not available under the indirect method and is, therefore, considered
more appropriate than the indirect method. Under the direct method, information about
major classes of gross cash receipts and gross cash payments may be obtained either:
(a) from the accounting records of the enterprise; or
(b) by adjusting sales, cost of sales (interest and similar income and interest expense
and similar charges for a financial enterprise) and other items in the statement of
profit and loss for:
i) changes during the period in inventories and operating receivables and
payables;
ii) other non-cash items; and
iii) other items for which the cash effects are investing or financing cash flows.
Self-Instructional
172 Material
Under the indirect method, the net cash flow from operating activities is determined Cash Flow and Fund
Flow Statements
by adjusting net profit or loss for the effects of:
(a) changes during the period in inventories and operating receivables and payables;
(b) non-cash items such as depreciation, provisions, deferred taxes, and unrealized NOTES
foreign exchange gains and losses; and
(c) all other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash flow from operating activities may be presented under the
indirect method by showing the operating revenues and expenses excluding non-cash
items disclosed in the statement of profit and loss and the changes during the period in
inventories and operating receivables and payables.
Forms of Cash Flow Statement
A cash flow statement can be prepared in two forms:
(i) Report Form, and
(ii) Account Form.
The format of a cash flow statement (Report Form) is given below:
Cash Flow Statement for the Period Ending

Self-Instructional
Material 173
Cash Flow and Fund Alternatively, it may be shown in an account form as follows:
Flow Statements
Cash Flow Statement for the Period Ending

NOTES

Illustration 7.2: Prepare cash flow statement from the comparative balance sheet
of S. B. Company Ltd. as given in Illustration 7.1.
Solution:
Cash Flow Statement
for the period ending December 31, 2011

Adjustment of Typical Items

The treatment of the typical items like depreciation, dividend, profit on sale of
assets, etc., in the cash flow analysis is the same as is recommended for such items
in the fund flow analysis. However, the provision for taxation is treated as a non-
current item. The actual amount of tax paid during the year is shown in the cash flow
statement as cash outflow. The current provision of taxation is added back to the
amount of profit in order to ascertain cash from operation.
Preparation of Working Accounts and Notes (Hidden Transaction)
The preparation of working accounts and notes is as important in cash flow analysis as
is in case of fund flow analysis. The procedure for ascertaining the hidden information
Self-Instructional
174 Material
is the same as is devised in the case of fund flow analysis.
 Cash Flow and Fund
7.4 PROBLEMS ON CASH FLOW STATEMENTS Flow Statements

Problem 7.1: The following schedule shows balance sheets in con-densed form of
ESS EMM Co. Ltd., at the beginning and end of the year 2011. NOTES

The following information concerning the transactions is available:

(i) An interim dividend of 20,000 was paid in 2011.
(ii) Depreciation of 10,000 and 20,000 have been charged on Machinery and
Building respectively in 2011.
(iii) Income-tax 35,000 was paid during the year.
Solution:
Calculation of Cash from Operations

Self-Instructional
Material 175
Cash Flow and Fund Statement of Sources and uses of Cash
Flow Statements

NOTES

Working Notes:
Provision for Tax Account

Machinery Account

Building Account

Problem 7.2: The income statement and balance sheet of an enterprise for the year
ended 31st December, 2012 was as follows:
(a) Income statement for the year ended 31st Dec, 2012 ( )
Sales 5,00,000
Cost of sales 3,50,000
Tax provision 40,000
Dividend provision 20,000
(b) Balance sheet
Self-Instructional
176 Material
 Cash Flow and Fund
Flow Statements

NOTES

You are required to prepare cash flow statement for the year ended Dec. 31, 2012.
Solution:
Calculation of Profit from Operation

Calculation of Cash from Operation ( )

Self-Instructional
Material 177
Cash Flow and Fund Cash Flow Statement
Flow Statements
for the year ended 31st December 2012

NOTES

Problem 7.3: Shabnam Co. Ltd. wants to prepare a cash flow statement for the year
ended December 31, 2012 from the comparative balance sheets given below:
Comparative Balance Sheets

The following additional information is available:

(i) Depreciation charged to profits on machinery for the year 2012 amounts to
40,000.
(ii) Dividends paid during the year 2012 were as follows:
(a) 2011 (final) on the capital as on 31-12-2011 at 10% less 25% tax
(b) 2012 (interim) 5% free of tax.
Explain how the overdraft of 45,000 as on 31st December 2012 has arisen.

Self-Instructional
178 Material
Solution: Cash Flow and Fund
Flow Statements
Calculation of Cash from Operation

NOTES

Cash Flow Statement

for the year ended 31st Dec., 2012

Self-Instructional
Material 179
Cash Flow and Fund Workings:
Flow Statements
Machinery Account

NOTES

Problem 7.4: Mr Smart submits the following statement in respect of his financial
position as on 31st March, 2011 and 2012:
Balance Sheet

Mr Smart further reports that there were no drawings and no purchase or sale of
buildings. You are required to prepare a Statement of Cash Flow.
Solution:
As reported by Mr Smart there were no drawings during the year and as such the
decrease in the amount of capital from 1,75,000 to 1,20,000 i.e., 55,000 has
been due to trading loss during the year. Accordingly the cash lost in operation is
computed as follows:
Computation of Cash Lost in Operation ( )

Self-Instructional
180 Material
 Cash Flow Statement Cash Flow and Fund
Flow Statements
for the year ended 31st March, 2012

NOTES

Problem 7.5: The following were the Balance Sheets of the Beauty Corporation
for 2010 and 2011. Prepare a Cash Flow Statement for the year.
Balance Sheets of Beauty Corporation

The following additional information is also available:

Sales 3,82,000
Cost of goods sold 2,65,000
Wages 45,000
Rent 12,000
Depreciation 20,000
Solution:
Computation of Net Profit

Self-Instructional
Material 181
Cash Flow and Fund
Computation of Cash from Operation ( )
Flow Statements

NOTES

Cash Flow Statement

for the year ended 31st Dec., 2011

Check Your Progress

4. Which category of activities comprise of option and swap contracts?
5. Define direct method.
6. Mention the accounting treatment of provision for taxation in the cash flow
statement.

Self-Instructional
182 Material
 Cash Flow and Fund
7.5 FUND FLOW STATEMENTS: MEANING Flow Statements

In this section, we will have a look of the meaning, uses, need and limitations of fund
flow analysis and statement. NOTES
For a clear understanding of the funds flow analysis, the meaning of the terms fund
and flow must be clear in one’s mind.
Fund
The term fund can be used both in broader and narrow sense. In broader sense, it
represents the working capital (current assets—current liabilities) of a concern while
in narrow sense it represents only cash balances of a firm. Accordingly two statements
can be prepared, viz.,
• Funds flow statement: A statement prepared on the basis of net current assets/
working capital which is calculated by subtracting current liabilities from current
assets.
• Cash flow statement: A statement that is governed by the narrow sense of fund,
i.e., cash balances, and therefore, considers only receipts and payments of cash
and transactions affecting cash position in its preparation.
Flow
Flow of fund refers to a business transaction that causes a change in the amount of
fund (working capital) that exists before the maturity of the transaction. The flow of
fund is recognized from the degree of change in the amount of working capital. If a
transaction increases the amount of working capital, it is referred to as source of fund
(inflow) whereas the transaction that decreases the amount of working capital results
in the application of fund (outflow). If a transaction fails to cause a change in the amount
of working capital, it does not amount to flow of fund. Suppose a company has a fund
(Current assets–Current liabilities) of 1,20,000 on 31 December 2012. On 1January
2013, it purchased a computer costing 10,000 that brings decline in the amount of
cash to the extent of 10,000 which in turn decreases the amount of working by
10,000. Accordingly, the amount of fund is reduced to 1,10,000 (1,20,000–
10,000). The purchase of computer is treated as flow of fund (outflow) because it
brought a change in the amount of working capital (fund) from 1,20,000 to 1,10,000.
After analysing the above example, it is clear that a change in the amount of working
capital from 1,20,000 to 1,10,000 is the result of change in the two items of the
company. Firstly, the amount of cash (a current item) is reduced by 10,000, and
secondly, the amount of fixed asset (non-current item) is increased by the same amount.
From this fact, we can conclude that:
• the flow of fund (change in working capital) occurs when a similar change is
observed simultaneously in one current and one non-current account as a result
of a single transaction;
• the transaction that involves only current accounts or only non-current accounts
does not amount to flow of fund (change in working capital); and Self-Instructional
Material 183
Cash Flow and Fund • the flow of fund, i.e., change in working capital has a similar impact both on current
Flow Statements
and non-current accounts. Symbolically, this can be expressed as
WC = CA = NA
NOTES where, = aggregate change in
WC = working capital
CA = current accounts
NA = non-current accounts
Thus, the aggregate change in the working capital of a concern during a particular
period can be computed by considering all changes which occurred either in the current
accounts or in the non-current accounts. The changes which occurred in the current
accounts as a result of flow of fund are reflected in a statement known as schedule of
changes in working capital, whereas similar changes in the non-current accounts are
shown in the statement of changes in financial position also known as funds flow
statement.
In the above paragraphs we saw that the flow of fund is identified by analysing
changes in current items and non-current items. Therefore, it becomes imperative to
have a detailed list of current and non-current accounts.
Current Accounts
Current accounts consist of current assets and current liabilities, like:
• Current assets:
o inventories
o bills receivable
o cash and bank balances
o investments
o sundry debtors
o prepaid expenses (temporary)
• Current liabilities:
o bills payable
o sundry creditors
o outstanding expenses and dues
o proposed dividend
o provision for taxation
o bank overdraft
o provision against current assets
Non-current Accounts
Non-current accounts comprise fixed assets and long-term liabilities like:
Self-Instructional • Fixed assets:
184 Material
 • land and building Cash Flow and Fund
Flow Statements
• plant and machinery
• furniture
• long-term investment
• goodwill NOTES
• preliminary expenses
• trade marks
• patent rights
• deferred expenses
• discount on issue of shares/debentures
• debit balances of profit and loss account
• Long-term liabilities:
• share capital (equity and preferential)
• share premium account
• share forfeited account
• capital redemption reserve
• capital reserves
• loans (long-term)
• debentures
• general reserves
• provision for depreciation on fixed assets
• bank loan
• credit balances of profits and loss account
Illustration 7.6: Explain the effect of the below-mentioned transactions on fund
(working capital):
(i) Purchase 6,000 shares at 10 each (temporary).
(ii) Further capital of 12,000 invested during the year.
(iii) Sale of unused plant (completely depreciated) for 40,000.
(iv) Paid cash to sundry creditors 30,000.
(v) Purchase of Insurance Policy (5 years) of 65,000.
Solution:
(i) This transaction will not affect the working capital (fund) because of its temporary
nature. On one hand, current assets will be increased by temporary investment in
shares to the extent of 60,000, and on the other hand, cash will go out of the
business which will reduce the current asset by the same amount. Hence, current
assets will not be affected.
(ii) The additional capital of 12,000 will increase the share capital, a non-current
item, and at the same time, it will also increase cash, a current item. Thus it will
result in the inflow of fund (source).
(iii) On the one hand, sale of unused plant will decrease the non-current asset (plant),
and on the other hand, it will increase the amount of current asset (cash) by
40,000. Therefore, it the amount of fund will increase.
(iv) The transactions will change only current account, viz., cash and sundry creditors,
Self-Instructional
leaving fund unaffected. Material 185
Cash Flow and Fund (v) Purchase of insurance policy will affect current asset (cash) on the one hand and
Flow Statements
non-current asset (insurance policy) on the other hand. Thus, the transaction will
result in the outflow of fund to the extent of 65,000.
Funds flow statement indicates the amount of change in various balance sheet
NOTES items between two accounting dates. It shows the sources and uses of funds during an
accounting period. A funds statement is prepared in summary form to indicate changes
(and trends if prepared regularly) occurring in items of financial conditions between
two different balance sheet dates. According to Anthany, 1970:
The funds flow statement describes the sources from which additional
funds were derived and the use to which these sources were put.
Foulke, 1976 defines funds flow statement as:
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.
As per author M.A. Sahaf, funds flow statement is a technique used to summarize
the financial operations of an organization by studying the sources and application
of funds during the accounting period. Such a statement helps to identify the changes
which have taken place and to demonstrate their impact upon the liquid resources of
the business. It provided a clear indication of the changes which have taken place in
the financial position of the enterprise, particularly for the people who are not well versed
in reading balance sheets.
7.5.1 Uses and Advantages
Funds flow statement plays a significant role in the evaluation of overall performance.
Such a statement provides insights into the financial and investing operations of a business.
It throws light on the financial strategy of a firm and guides financial experts in the
interpretation and predictions of the same. The National Association of Accountants,
1971 in their bulletin list the following uses of this statement:
• estimating the amount of funds needed for the growth;
• improving rate of income on assets;
• planning temporary investments of surplus funds and planning for the working
capital;
• securing additional funds when needed; and
• planning the payment of dividends.
Further, an effective funds flow analysis can offer the following benefits to a business
firm:
• It helps the management in operating and investment decisions by providing a
complete picture of sources and applications of funds.
• It guides experts in the formulation of future financial policies as it discloses the
financial deficiencies of a specified period.
• It can make possible the efficient and economical utilization of future financial
Self-Instructional
resources.
186 Material
 • It provides additional and significant data for decision making which is not Cash Flow and Fund
Flow Statements
presented by historical statements.
• It highlights the relationship between the working capital and the net income.
• It evaluates past financial performance by disclosing the means and uses of
resources. NOTES
• It proves a meaningful technique for economic analysis.
7.5.2 Limitations
Despite its number of uses, the funds flow statement suffers from number of limitations
which are listed below:
• It fails to cover as sufficient information as disclosed by income statement or
balance sheet and as such cannot replace such statements.
• It is of secondary nature as it is prepared with the information as supplied by
financial statements.
• The statement ignores the changes in working capital items, and therefore, fails
to throw light on the financial position of the concern.
• As this statement is simply re-arrangement of data as supplied by financial
statement, the accuracy of the statement is doubtful.
• It is a crude device compared to financial statement because it does not touch
non-fund items.
• It fails to reveal continuous changes.
7.5.3 Importance
The following points reflect the importance of fund flow statements:
i. It explains the financial consequences of business operations: Funds flow
statement provides a ready answer to so many conflicting situations. Such as:
(a) Why the liquid position of the business is becoming more and more unbalanced
in spite of business making more and more profits? (b) How was it possible to
distribute dividends in excess of current earnings or in the presence of a net loss
for the period? (c) How the business could have good liquid position in spite of
business making losses or acquisition of fixed assets? (d) Where have the profits
gone? Definite answers to these questions will help the financial analyst in advising
his employer/client regarding directing of funds to those channels which will be
most profitable for the business.
ii. It answers intricate queries: The financial analyst can find out answer to a
number of intricate questions: (a) What is the overall creditworthiness of the
enterprise? (b) What are the sources of repayments of the loans taken? (c)
How much funds are generated through normal business operations? (d) In
what way the management has utilized the funds in the past and what are going
to be likely uses of funds?
iii. It acts as an instrument for allocation of resources: A projected funds flow
statement will help analyst in finding out how the management is going to allocate
the scarce resources for meeting the productive requirements of the business.
Self-Instructional
Material 187
Cash Flow and Fund The use of funds should be phased in such an order that the available resources
Flow Statements
are put to the best use of the enterprise. The funds should be managed in such
a way that the business is in a position to make payment of interest and loan
instalments as per the agreed schedule.
NOTES
iv. It is a test as to effective or otherwise use of working capital: Funds flow
statement is a test of effective use of working capital by the management during
a particular period. The adequacy or inadequacy of working capital will tell the
financial analyst about the possible steps that the management should take for
effective use of surplus working capital or make arrangements in case of
inadequacy of working capital.

Check Your Progress

7. Where are the changes in the non-current accounts of a firm represented?
8. Name the category of non-current accounts which comprises of patents and
deferred expenses.

7.6 PREPARATION OF FUNDS FLOW STATEMENT

The construction of funds flow statement involves decisions regarding the following two
important facts:
• sources of information; and
• procedural framework.
Sources of Information
For the preparation of funds flow statement, the following information should be available:
• Two comparative balance sheets—one at the beginning and the other at the end
of the period.
• Summarized income statement comprising non-fund and non-operating items
required for computing funds from operation Non-fund items are the transactions
that may cause change (increase or decrease) in the reported net profit but do
not actually change the amount of fund (working capital). The best example of
such an item can be depreciation on fixed assets.
• Non-operating items refer to transactions incidental to the business. For example,
sale of fixed assets, profits from sale of assets, etc.
• Statement of retained earnings to identify hidden information.
• Supplementary information regarding change in the non-current accounts like
plant and machinery, building, share capital, debentures, etc.
This is the minimum information required for the purpose. Any information, in addition
to that mentioned above shall make the funds flow analysis more effective.

Self-Instructional
188 Material
Procedural Framework Cash Flow and Fund
Flow Statements
Procedural framework explains the procedure involved in the preparation of two
statements, viz.,
• Statement or schedule of changes in working capital; and NOTES
• Statement of source and application of funds.
Statement or Schedule of Changes in the Working Capital
Statement or schedule of changes in the working capital is a statement that compares
the change in the amount of current accounts (current assets and current liabilities) on
two balance sheet dates and highlights its impact on working capital. The format of this
statement is as follows:

Statement or Schedule of Changes in Working Capital

The changes in current accounts i.e., current assets and current liabilities are to be
computed by comparing the figures for such accounts in the current period with that of
the previous period. The amount of change so computed for each item of the current
account alongwith its impact on the amount of working capital is to be recorded in the
schedule of change in working capital.
To analyse the effect on working capital as a result of change in current assets and
current liabilities, the following facts should be considered:
Nature of transaction Effect on working capital
1. Increase in current asset Increase (+)
2. Decrease in current asset Decrease (–)
3. Increase in current liabilities Decrease (–)
4. Decrease in current liabilities Increase (+)
Self-Instructional
Material 189
Cash Flow and Fund Illustration 7.7: The comparative balance sheet of M/s Suman Ltd. as on 31st
Flow Statements
December, 2011 and 2012 were as follows:

NOTES

Prepare a schedule of changes in working capital.

Solution:
Schedule of Changes in Working Capital

Self-Instructional
190 Material Remember, both provision for taxation and dividends are treated here as current items.
Illustration 7.8: The summarized balance sheet of M/s Sugee Ltd. as on 31st March Cash Flow and Fund
Flow Statements
are given below:

NOTES

You are required to prepare schedule of changes in working capital.

Solution:
Schedule of Changes in Working Capital

Statement of Sources and Applications of Funds

For the preparation of statement of sources and application of funds, we should be
clear about the terms sources and applications.
Sources (inflow) refer to such business transactions that increase the amount of fund
(working capital) and applications (outflow) means such transactions that result in the
reduction of fund.
As discussed already, such an increase or decrease in the fund may take place when
current and non-current items are changed simultaneously as a result of a transaction.
The increase in the fund (source) is recorded as a credit and the decrease in the fund
(application) is recorded as a debit. Therefore, credits represent sources of fund and

Self-Instructional
Material 191
Cash Flow and Fund debits represent application of fund. For better understanding of the concept of fund,
Flow Statements
important sources and uses of funds are summarized below:
Sources of Funds
NOTES • Operational profits or funds from operation;
• Issue of share capital or debentures;
• Sale of fixed assets and long-term investments (actual amount realized);
• Income from investments (dividend received); and
• Long-term loans.
Applications of Funds
• Repayment of capital (including redemption of preferential shares);
• Redemption of debentures;
• Payment of long-term loans;
• Purchase of investments;
• Purchase of fixed assets;
• Payment of taxation/proposed dividend if treated as non-current items; and
• Operational loss
Thus, from the above discussion, we may conclude that:
• Increase in non-current assets = Applications of funds
• Decrease in non-current assets = Sources of funds
• Increase in non-current liabilities = Sources of funds
• Decrease in non-current liabilities = Applications of funds
The dual-aspect concept of accounting suggests that the total amount of sources of
funds must reconcile with the total amount of applications of funds. This principal is
similar to that of the balance sheet principal where total assets are equal to total liabilities.
Therefore,
• Sources of funds = Applications of funds
• Increase in liabilities + Decrease in assets = Decrease in liabilities + Increase in
assets.
Format of Funds Flow Statement
Different formats are used for this purpose depending upon the objective of analysis.
However, the commonly used format is ‘account form’ (as given below) where sources
are shown on the left side and the application of funds on right side of the statement.

Self-Instructional
192 Material
 Statement of Sources and Application of Funds Cash Flow and Fund
Flow Statements

NOTES

Funds from Operation/Operational Profit

The main source of fund for an enterprise is the funds from operation that represents
actual amount of profit as generated by the business. For the funds flow statement, the
net profit as disclosed by profit and loss account is adjusted in order to calculate the
actual amount of fund from operation. This is done to find the effect of the items such
as depreciation and distribution of profits (general reserve, dividend, provision for
taxation), loss from sale of asset, etc., on net profit which actually do not result in the
outflow of fund but were treated so in the preparation of profit and loss account of the
firm. In the same way, the impact of items like dividend received on investment, capital
gains, etc., which do not represent income (inflow) from business operation, must be
treated properly. The procedure for adjusting profits as disclosed by profits and loss
account in order to ascertain funds from operation is as under:
( ) ( )
Net profits as per profit and loss account
Add: Items which do not result in the outflow of fund: xxx
• Depreciation charged during the year xxx
• Loss on sale of fixed assets/investments xxx
• Capital expenditure (like goodwill, preliminary expenses, patents)
written off against profit and loss account xxx
• Provision for income tax/proposed dividend xxx
• Any other item xxx xxx
Less: Items which do not result in the inflow of funds:
• Gains on sale of fixed assets/investment xxx
• Dividend received on investment (credited to profit and
loss account) xxx
• Any other item xxx xxx
Profit from business operation or fund from operation xxxx

Adjustment of Typical Items

Before attempting a practical problem, we must be familiar with the treatment of some
typical transactions. Accordingly, the discussion that follows deals with adjustment
procedure of typical transactions in fund flow analysis.
• Provision for Taxation There are two approaches to adjust the item of provision
Self-Instructional
for taxation, viz., Material 193
Cash Flow and Fund o As a current item Under this approach, the item of provision for taxation is
Flow Statements
treated as current liability and accordingly it is adjusted in the schedule of
changes in the working capital. However, while attempting a practical problem
on fund flow analysis, the item of tax (if any) given outside the trial balance
NOTES should be omitted under this approach. The logic behind the omission is that
such an adjustment item (actual payment of tax) will affect two current accounts,
i.e., cash and provision for taxation. Therefore, the transaction will not result
in the flow of fund (application).
o As a non-current item Under this approach, it is considered as an
appropriation of profits and thus a non-current liability. Accordingly, the amount
of current provision for taxation is to be adjusted in the funds from operation
and the actual payment of tax appears in the funds flow statement as an
application.
Note: Students may note that it is desirable to treat the item of provision for
taxation as current liability as generally it is the immediate obligation of the
concern to pay tax to the government. As such, it seems somewhat irrational
to treat provision of tax as an appropriation of profit.
• Proposed Dividend It has the same treatment as that of provision for taxation.
• Interim Dividend It is the dividend paid in between two balance sheet dates. It
is a non-operating item and as such is adjusted in the calculation of profits from
operation.
• Depreciation The depreciation is a non-fund item that does not result in the
flow of cash. It involves simply a book entry without actual payment of cash. This
entry in the book account which debits profit and loss account and credits the
fixed asset account, reduces the amount of profit and the book value of the fixed
assets. As such, depreciation does not affect the amount of fund (working capital).
Thus, the amount of depreciation is adjusted in the computation of profits from
operation.
• Preliminary Expenses Preliminary expenses like depreciation is a non-fund
item which simply involves a book entry. Every year a portion of such expenses
is written off by debiting them to profit and loss account. However, this treatment
to preliminary expenses neither results in the flow of fund nor it is considered as
an operating charge. Thus, the amount of preliminary expenses written off during
the current period is to be added back to the net profit as to determine funds
from operation.
• Goodwill The amount of goodwill written off does not involve flow of funds but
requires simply book entry—debited to the profit and loss account. Therefore,
while computing the funds from operations, the amount of goodwill written off
during the current period is added back to the net profits for the year.
• Creation of the Reserves Since reserves are created out of profits, therefore,
such reserves constitute an appropriation of profit and not an operating charge
Self-Instructional against profits. Further, the creation of reserve does not affect the amount of fund.
194 Material
 Therefore, the current amount of the reserve is to be added back to the net profit Cash Flow and Fund
Flow Statements
to determine funds from operation.
• Gain or Loss from the Sale of a Fixed asset Firms often transfer gain or loss
from the sale of asset to profit and loss account. The treatment of this item in the NOTES
funds flow analysis is that it is to be adjusted in the computation of funds from
operation, this being a non-funds item. Thus, the gain from the sale of the asset is
deducted from the net profit and vice-versa to determine profits from operation.

Preparation of Working Accounts and Notes (Hidden Transaction)

Preparation of working accounts and notes is an important step in the funds flow
statement. The need for such accounts and notices arises to find out some hidden
information required for the funds flow statement. The information like depreciation,
provision for taxation, sale or purchase of assets etc. is made available by this step.
The following illustration will help in the clear understanding of this attempt.
Example: The information relating to X Co. Ltd. regarding a machinery stands as:
31st Dec. (2011) 31st Dec. (2012)

( ) ( )
Value of Machinery 1,00,000 2,25,000
Depreciation on machinery during the year 2012 30,000
Calculate the actual amount of application used for the purchase of machinery during
the year 2012.
Solution: Apparently it looks that the amount of application for the purchase of
machinery during the year 2012 is 1,25,000 (2,25,000 – 1,00,000). But actually it
is 1,55,000 (1,25,000 + 30,000). The value of machinery as on 31st December,
2012 (2,25,000) is the ad-justed amount from which the amount of depreciation has
already been deducted. In order to calculate the actual amount of appli-cation for the
purchase of machinery, the amount of depreciation should be added back to the value
of machinery. Thus, actual amount will be:
( )
Value of machinery as on 31st December, 2012 2,25,000
Add: Depreciation charged during the year 30,000
2,55,000
Less: Value of machinery as on 31st December, 2011 1,00,000
Value of machinery purchased during the year (Application) 1,55,000
The value of machinery purchased during the year 2012 can also be ascertained
with the help of an account stated as follows:
Machinery Account

Self-Instructional
Material 195
Cash Flow and Fund In the above account, entries regarding opening and closing balances,
Flow Statements
depreciation, profit or loss from sale of machinery, profit or loss on revaluation etc. are
to be recorded. The bal-ancing figure in the account will represent either sale proceeds
or acquisition cost of the machinery.
NOTES
In the same way, ledger accounts may be prepared to find out inflow/outflow of
funds from other non-current assets and liabil-ities like investment account, building
account, capital account, debentures account etc.

7.7 PROBLEMS ON FUND FLOW STATEMENTS

Problem 7.6
Balance Sheet of Self Ridges Ltd.

Prepare from the above comparative balance sheet:

(a) A schedule of change in working capital; and
(b) Funds flow statement.
Solution:
Schedule of Changes in Working Capital

Working Note:
The increase in working capital is ascertained by subtracting working capital of 2011
from the working capital of 2012. The working capital for 2011 and 2012 is calculated
as under:
Self-Instructional
196 Material
 Working capital as on 31st December, 2011: Cash Flow and Fund
Flow Statements
= Total Current Assets – Total Current Liabilities
(as on 31st Dec., 2011) (as on 31st Dec., 2011)
= 90,000 – 80,000 = 10,000
Working capital as on 31st December, 2012: NOTES
= Total Current Assets – Total Current Liabilities
(as on 31st Dec., 2012) (as on 31st Dec., 2012)
= 1,16,000 – 1,00,000 = 16,000
Therefore, increase in working capital = Wo
rking capital as on 31st Dec., 2012 – Working capital as on 31st Dec., 2011
= 16,000 – 10,000 = 6,000
Funds Flow Statement

Note: In the above illustration, working accounts and notes have not been
prepared as there is no adjustment item. Now, in the next few illustrations
we will study the adjustment of typical items and also the preparation of
working accounts.

Problem 7.7: From the following balance sheets of Oriental Company Ltd., prepare
(a) schedule of changes in working capital, and (b) Funds flow statement.

Additional Information:
Depreciation of 20,000 and 25,000 have been charged on plant, land and building
respectively in 2010.

Self-Instructional
Material 197
Cash Flow and Fund Solution:
Flow Statements
Statement of Changes in Working Capital

NOTES

Funds Flow Statement

Working Notes:
1. Calculation of funds from operation: ( ) ( )
Profit as per P&L A/c (closing balance) 69,000
Add: Depreciation 20,000
Plant 25,000 45,000
Land and building 1,14,000
Less: Opening balance of profit 60,000
Funds from operation 54,000
2. Calculation of plant purchased during the year:
Plant Account

3. Calculation of land and building purchases during the year:

Land and Building Account

Self-Instructional
198 Material
Problem 7.8: From the following balance sheets of MAS Ltd. prepare: Cash Flow and Fund
Flow Statements
(i) Statement of change in working capital (ii) Fund flow statement

MAS Ltd.
(Balance Sheet)
NOTES

Additional Information:
1. An interim dividend of 35,000 has been paid in II year.
2. Payment of income-tax 52,000 was paid during II year.
3. Depreciation of 35,000 and 42,000 have been charged on plant and building
respectively in II year.
Solution:
Schedule of Changes in Working Capital

Funds Flow Statement

Self-Instructional
Material 199
Cash Flow and Fund Working Notes:
Flow Statements
1. Calculation of building sold during II year:
Building Account

NOTES

2. Calculation of funds from operation: ( ) ( )

Profit as given (II year – I year) 15,000
(75,000 – 60,000)
Add: Non-operating items:
Depreciation on:
Plant 35,000
Building 42,000 77,000
Goodwill (written off) (1,90,000 – 1,40,000) 50,000
Interim dividend 35,000 1,62,000
Funds Flow Operation 1,77,000
3. Calculation of plant purchase during II year:
Plant Account

Note: The adjustment items (additional information) relating to provision for taxation
and proposed dividend have been omitted because of being treated these iteme as
current liabilities.
Alternatively, if these items are treated as non-current liabilities then:
(i) The current provison of such items will be added to profits in the calculation of
funds from operation.
(ii) Actual payment on these accounts during the current year will appear in the funds
flow statement as application. However, under this alternative these items will not
be shown in the schedule of change in working capital and as a result, the working
capital will increase by 24,000 (12,000 + 12,000). Now the practical solution
of this prob-lem will take the following form.

Self-Instructional
200 Material
 Schedule of Changes in Working Capital Cash Flow and Fund
Flow Statements

NOTES

Funds Flow Statement

Working Accounts and Notes (For alternative method) ( )

1. Computation of Funds from Operation
Profit as given (II year – I year) (75,000 – 60,000) 15,000
Add: Non-operating items:
Depreciation:
Plant 35,000
Building 42,000 77,000
Provision for taxation4 64,000
Proposed dividend 67,000
Interim dividend 35,000
Goodwill (written off) 50,000 2,93,000
Funds Flow Operation 3,08,000

2. Calculation of the building sold during the year—same as in the first alternative.
3. It has been assumed that the provisioin for dividend made in first year is paid in
second year.

Self-Instructional
Material 201
Cash Flow and Fund 4. Provision for Taxation A/c
Flow Statements

NOTES

Problem 7.9: The following comparative balance sheet of Super Max Ltd. for 2009
and 2010 are available:

Additional Information:
(a) A machine costing 1,20,000 was sold for 75,000.
(b) A redemption at a premium of 15% was done for preference shares on 31st
December, 2010.
(c) Equity shares were paid a divided at 15% for 2009; and
(d) Depreciation was charged on fixed assets during the year was 1,80,000.
You are required to prepare statement showing the sources and application of funds
for the year ended 31st December, 2010.
Solution:
Funds Flow Statement

Self-Instructional
202 Material
Working Notes: Cash Flow and Fund
Flow Statements
1. Calculation of Funds from Operation
Profit as per P&L A/c for 2009 (8,10,000 – 3,30,000) 4,80,000
Add: non-fund/non-operating items appearing in P&L A/c:
Loss on sale of machine 45,000
NOTES
Premium on pref. shares redeemed 45,000
Preference dividend 48,000
Equity dividend 1,35,000
Depreciation 1,80,000
Discount on debentures written off 15,000 4,68,000
Funds flow operation 9,48,000

2. Calculation of premium on prefrence shares:

3. Calculation of dividend: It is assumed that preference dividend was also paid as

equity dividend cannot be declared without declaration of pref. dividend. Preference

dividend

Equity dividend

4. Fixed Asset Account

Problem 7.10: From the following balance sheet of X Ltd., you are required to prepare:
(i) Statement of changes in the working capital; and
(ii) Funds flow statement

During the year machinery was written off by 30,000 and furniture by 2,000. Self-Instructional
Material 203
Cash Flow and Fund Solution:
Flow Statements
Schedule of Changes in Working Capital

NOTES

Funds Flow Statement

Working Notes:
1. Building Account

2. Machinery Account

Self-Instructional
204 Material
3. Furniture Account Cash Flow and Fund
Flow Statements

NOTES

4. Calculation of Funds from Operation

Problem 7.11: From the following balance sheet of M/s Western Company Ltd., as
on 31st December, 2007 and 2008, you are required to prepare:
(a) Fund Flow Statement; and
(b) Schedule of changes in working capital.

Additional Information:
(i) Dividend for 2007 @ 15% was paid during the year 2008;
(ii) A plant costing 75,000 (Depreciation provided 25,000) was sold for
55,000;
(iii) Investment amounting to 40,000 were realised for 32,000.

Self-Instructional
Material 205
Cash Flow and Fund Solution:
Flow Statements
Schedule of Changes in Working Capital

NOTES

Funds Flow Statement

Working Notes:
1. Building Account

2. Plant Account

Self-Instructional
206 Material
*Calculation of gain from sale of plant: Cash Flow and Fund
Flow Statements
Cost of plant sold 75,000
Less: Depreciation charges 25,000
Written down value 50,000
Sale proceeding 55,000 NOTES
Gain (Sale – WDV) (55,000 – 50,000) 5,000

3. Investment Account

4. Calculation of Funds from Operation

Check Your Progress

9. Give an example of non-fund item.
10. What effect does an increase in current liabilities have on the working capital?
11. How is goodwill treated in the fund flow analysis?

Self-Instructional
Material 207
Cash Flow and Fund
Flow Statements 7.8 ANSWERS TO CHECK YOUR PROGRESS
QUESTIONS

NOTES 1. Cash flow statement is the accounting tool which used the cash system of
accounting.
2. Decrease in non-current assets results in inflow of cash.
3. Redemption of capital is an application of cash.
4. Option contracts and swap contracts fall under the category of investing activities.
5. The direct method is a method of reporting cash flows from operating activities
whereby major classes of gross cash receipts and gross cash payments are
disclosed.
6. The provision for taxation in cash flow statement is treated as a non-current
item. The actual amount of tax paid during the year is shown in the cash flow
statement as cash outflow. The current provision of taxation is added back to
the amount of profit in order to ascertain cash from operation.
7. The changes which occur in the non-current accounts if a firm is reflected in the
state of changes in financial position also known as funds flow statement.
8. Patents and deferred expenses fall under the category of fixed assets under the
non-current accounts.
9. Depreciation on fixed assets is an example of non-fund item.
10. An increase in current liabilities results in a decrease in the working capital.
11. While computing the funds from operations, the amount of goodwill written off
during the current period is added back to the net profits for the year.

7.9 SUMMARY

 A cash flow statement is a statement which provides a detailed explanation for

the change in a firm’s cash during a particular period by indicating the firm’s
sources and uses of cash during that period.
 Cash flow statement is governed by the cash system of accounting.
 The basic aim of cash flow analysis is to determine what transactions caused the
cash balance to change during a particular period.
 Cash flow statement is governed by the cash system of accounting.
 To determine cash flow, the non-current accounts i.e., fixed assets and long
term liabilities are analyzed as before, and changes in current accounts except
cash are also analyzed.
 The change in cash can be computed by analyzing change that occurred in all
non-current and current accounts except cash.
Self-Instructional  The major source of cash for a business is cash from trading operations.
208 Material
  A cash flow statement is a vital analytical tool in the hand of financial manager Cash Flow and Fund
Flow Statements
that helps him in the proper management of cash.
 A comparative analysis of the firm’s cash flow statements enables a financial
manager to assess the liquidity position of the firm.
NOTES
 A careful study of cash flow statement provides answer to some typical questions
like why cash position of the concern is tight, in spite of high incomes or vice-
versa.
 Statement of changes in financial position is a statement designed to describe
the changes in the financial position of a concern during a particular period.
 Fund in a broader sense, represents the working capital (current assets – current
liabilities) of a concern while as in narrow sense it represents only cash balances
of a firm.
 Flow of fund would mean when a business transaction causes a change in the
amount of fund (working capital) that exists before the maturity of the transaction.
 Funds Flow Statement is a technique used to summarize the financial operations
of a concern by studying the sources and application funds during the accounting
period.
 Statement or Schedule of changes in working capital is a statement that compares
the change in the amount of current accounts, current assets and current.
 Sources refer to a situation when a transaction increases the amount of fund
(working capital).
 Application means a transaction that results in the reduction of fund.
 The dual-aspect concept of accounting suggests that the total amount of sources
of funds must reconcile with the total amount of application of funds.

7.10 KEY WORDS

 Cash flow statement: It is a statement which attempts to measure the inflows

and outflows of cash that result from various business activities during a particular
accounting period.
 Cash from operations: It is the net profit as shown by profit and loss, when
the accounting system is based on cash system.
 Flow of fund: It refers to a business transaction that causes a change in the
amount of fund that exists before the maturity of the transaction.
 Fund flow statement: It is a statement prepared on the basis of net current
assets/working capital which is calculated by subtracting current liabilities from
current assets.
 Schedule of changes in the working capital: It is a statement that compares
the change in the amount of current accounts (current assets and current liabilities)
on two balance sheet dates and highlights its impact on working capital. Self-Instructional
Material 209
Cash Flow and Fund
Flow Statements 7.11 SELF ASSESSMENT QUESTIONS AND
EXERCISES

NOTES Short-Answer Questions

1. Discuss the objectives of cash flow analysis.
2. What is the difference between funds flow and cash flow statement?
3. Write short notes on:
(a) Notional cash and
(b) Non-cash items.
4. Draw a cash flow statement with the help of imaginary figures.
5. Explain the major sources and application of cash with examples.
6. What is the utility of preparing cash flow statement?
7. Explain the terms:
(i) Funds
(ii) Flow of Funds
(iii) Funds Flow Statement
8. Discuss the procedure for the preparation of Funds Flow Statement.
9. What information would you require to prepare a statement of sources and
application?
10. Write short notes on:
(a) Non-operating items
(b) Funds from operations
(c) Current Accounts.
Long-Answer Questions
1. Explain the procedure of preparing a cash flow statement.
2. Discuss the procedures of ascertaining cash from operation as required for the
preparation of a cash flow statement.
3. What is a Funds Flow Statement? Examine its managerial uses.
4. Examine the major sources and applications of working capital.

Self-Instructional
210 Material
Practical Problems Cash Flow and Fund
Flow Statements
1. Following are the comparative balance sheets of IQRA Ltd.

NOTES

Prepare a Cash Flow Statement.

2. Super Max Co. Ltd. wants to prepare a ‘Cash Flow’ statement for the year
ended December 31, 2012, from the details given below:
(a) Income statement for the year ended 31-12-2012
Sales 29,000
Cost of sales 19,900
Tax provision 2,500
Dividend provided 1,600
(b) Balance Sheets

3. The comparative balance sheet of MAS Ltd., as on 31st December, 2008 and
2009 were as follows:

You are given the following additional information:

(i) Depreciation on building and plant during the year were 20,000 and
10,000 respectively.
(ii) Dividend amounting to 10,000 was paid during 2009.
Prepare a funds flow statement and a statement of changes in working capital.
Self-Instructional
Material 211
Cash Flow and Fund 4. The summarized balance sheet of ESS BEE Enterprises on 31st of Dec.
Flow Statements
2008 and 2009 are given below:
Balance Sheet of ESS BEE Enterprises

NOTES

The following additional information is obtained from the general ledger:

(i) Income-tax paid during the year amounting to 45,000
(ii) Depreciation charged to building and plant during the year was 40,000
and 35,000 respectively.
You are required to prepare:
(i) Schedule of charges in working capital, and
(ii) Funds flow statements.

7.12 FURTHER READINGS

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House.
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
212 Material
 Ratio Analysis and

UNIT 8 RATIO ANALYSIS AND Trend Analysis

TREND ANALYSIS
NOTES
Structure
8.0 Introduction
8.1 Objectives
8.2 Ratio Analysis: Meaning
8.2.1 Importance and Uses
8.2.2 Advantages and Limitations
8.3 Types and Classification of Ratios
8.4 Problems on Ratio Analysis
8.5 Trend Analysis: Meaning
8.5.1 Importance, Advantages, Limitations and Uses
8.6 Problems on Trend Analysis
8.7 Answers to Check Your Progress Questions
8.8 Summary
8.9 Key Words
8.10 Self Assessment Questions and Exercises
8.11 Further Readings

8.0 INTRODUCTION

The preceding unit you learnt about cash and fund flow statements. In this unit, you will
study certain other important types of financial statement analysis: ratio analysis and
trend percentage. Ratio analysis is one of the popular tools of financial statement analysis.
Such an analysis aims to reduce the large number of items involved to a relatively small
set of readily comprehended and economically meaningful indicators. However, given
the large number of ratios available, it is difficult to discern the inter-relationships among
them required for a comprehensive understanding of the entity being analysed. What is
required is an integrated system of financial ratios which will incorporate the essential
ratios and highlight the inter-relationships among them. Trend analysis or trend
percentage seeks to learn about the trend of changes in items from the base year over
a period of time.

8.1 OBJECTIVES

After going through this unit, you will be able to:

 Describe the meaning, advantage, importance and uses of ratio analysis
 Explain the types and classification of ratios
 Discuss the meaning, importance, limitations and uses of trend analysis

Self-Instructional
Material 213
Ratio Analysis and
Trend Analysis 8.2 RATIO ANALYSIS: MEANING

In simple words, a ratio is the quotient formed when one magnitude is divided by
NOTES another measured in the same unit. A ratio is defined as the indicated quotient of two
mathematical expressions and as the relationship between two or more things.
Usually the ratio is stated as a percentage, i.e., distribution expenses might be stated
as 20 per cent of sales. Often, however, the ratio is expressed in units, thus sales might
be expressed as 20 times inventory. Thus, the ratio is a pure quantity or number,
independent of the measurement units being used.
A financial ratio is defined as a relationship between two variables taken
from financial statements of a concern. It is a mathematical yardstick which measures
the relationship between two financial figures. It involves the breakdown of the examined
financial report into component parts which are then evaluated in relation to each other
and to exogenous standards.
As the ratio represents a relationship between figures, a number of ratios can be
formed by taking any two figures from the financial statements. However, such an
approach would not fulfill any purpose unless the figures chosen are significantly
correlated with each other. Furthermore, many of the ratios tend to deal with different
aspects of the same relationship, and there is little point in calculating several ratios in
order to investigate the same point. Experts have identified some ratios as significant
and important since they throw considerable light on the financial position of a concern.
Interpretation of Ratio
One of the most difficult problems confronting the analyst is the interpretation and
analysis of financial ratios. An adequate financial analysis involves more than an
understanding and interpretation of each of the individual ratios. Furthermore, the analyst
requires an insight into the meaning of inter-relationships among the ratios and financial
data in the statements. Gaining such an insight and understanding requires considerable
experience in the analysis and interpretation of financial statements. Moreover, even
experienced analyst cannot apply their skill equally well to analyse and interpret the
financial statements of different organizations. The characteristics may differ from industry
to industry and from firm to firm within the same industry. A ratio that is high for one
firm at one time may be low for another firm or for the same firm at a different time.
Therefore, the analyst must be familiar with the characteristics of the firm of which he
is interpreting the final ratios.
The analyst must not undertake the interpretation and analysis of financial ratios
in isolation from other information. The following factors must be considered while
analysing the financial ratios:
• General economic condition of the firm
• Risk acceptance
• Future expectations
Self-Instructional • Future opportunities
214 Material
 • Accounting system of the industry Ratio Analysis and
Trend Analysis
• Analysing and interpretation system used by other firms in the industry.
The analysis and interpretation of financial ratios in the light of the above-listed
factors can be useful but the analyst must still rely on skill, insight, and even intention in NOTES
order to interpret the ratios and arrive at a decision. The interpretation of the ratios can
be made by comparing them with:
• Previous figures – trend analysis;
• Similar firms – inter-firm comparisons;
• Targets – individual ratio set to meet the objective.
• Trend Analysis The analyst usually use historical standards for evaluating
the performance of the firm. The historical standards represent the financial
ratios computed over a period of time which sets the trend. Trend analysis
provides enough clues to the analyst for proper evaluation of the financial
ratios. However, the changes in firm’s policies over the period must be
considered while interpreting ratios from comparison over time. Further, the
average of the ratios for several years can also be used for this purpose.
• Inter-firm Comparisons Inter-firm comparisons may advocate the
comparisons of similar ratios for a number of different firms in the same
industry. Such an attempt would facilitate the comparative study of financial
position and performance of the firms in the industry. The published ratios of
trade associations or financial institutions can be of great help to the analyst
in interpreting the financial ratios. However, the variations in accounting
system and changes in the policies and procedures of the firm in comparison
with the industry have to be taken care of while making use of inter-firm
comparisons.
• Targets Under this method, the interpretation of the ratio is made by
comparing it with the standard set for this purpose. Such a standard ratio,
based upon well-proven conventions serves as a measuring scale for the
evaluation of the ratios. The best example of such standard is the 1:1 ratio,
which is to be considered as a good ratio for analysing the acid-test ratio.
Generally speaking, the use of single standard ratio for the interpretation of
ratios is not much useful. The accounting experts usually recommend the use of groups
of standard ratios for the evaluation of financial ratios.
8.2.1 Importance and Uses
The importance of ratio analysis can be segregated based on its usefulness to the
management, creditors, employees, investors and government.
Management
• Judging the performance and bringing in improvements for management functions
• Recognizing strengths and weakness of functions
Self-Instructional
Material 215
Ratio Analysis and • Identification of variances and deviations from the standards
Trend Analysis
• Periodic ratio analyses help the firm interpret their performance in a more nuance
way
NOTES Creditors
• Ensuring the payback of credit on specified time
• Judging whether to extend or hold credit based on the solvency ratio
Employees
• Recognizing stability and security of employment through good ratios
• Ascertaining the financial position to judge whether payment of salaries and
wages, increment, promotion and prerequisites will be on time.
Investors
• Judging the safety of investments
• Gauging whether further investments must be made
• Assessing the time period for the return of investments
Government
• Finding out the contribution of different sectors to the GDP
• Ascertaining the requirement and scale of subsidies as per the industry
• Preparing and updating industrial policies based on the performance of different
industries
• Understanding the overall economic health of the country
8.2.2 Advantages and Limitations
Ratio analysis helps the management to identify specific areas that reflect improvement
or deterioration, as well as detect the trouble spots that may prevent the attainment of
objectives. The interested parties undertake frequent examination of different areas of
business to evaluate the management’s ability to maintain a satisfactory balance among
them, and to appraise the efficiency and effectiveness with which the management
directs the firm’s operations. Thus, the purpose of ratio analysis is to help the reader of
financial statements to understand the information shown by highlighting a number of
key relationships. However, the following are the principal advantages claimed by
ratio analysis:
• It guides management in formulating future financial planning and policies.
• It throws light on the efficiency of the business organization.
• It permits comparison of the firm’s figures with data for similar firms, and possibly
with industry-wise data. It also allows the data to be measured against yardsticks
of performance or of sound financial condition.
Self-Instructional
216 Material
 • It ensures effective cost control. Ratio Analysis and
Trend Analysis
• It provides greater clarity, perspective, or meaning to the data, and it brings out
information not otherwise apparent.
• It measures profitability and solvency of a concern. NOTES
• It permits monetary figures of many digits to be condensed to two or three
digits and therefore enhances managerial efficiency.
• It helps in investment decisions.
Limitations of Ratio Analysis
In using ratios, the analyst must keep a few general limitations in mind. The main
limitations attached to it are:
• It lacks standard values for the ratio, therefore, scientific analysis is not possible.
• As there are no standards of comparison, it fails to throw light on the efficiency
of any activity of the business.
• It gives only the relationship between different variables and the actual magnitudes
are not known through ratios.
• Ratios are derived from financial statements and naturally reflect their drawbacks.
• It fails to indicate immediately where the mistake or error lies.
• It does not take into consideration the market and other changes.

Check Your Progress

1. List the factors which must be considered while analysing the financial ratios.
2. Name the technique of interpretation of ratio in which historical standards are
used for evaluating the performance of the firm.
3. What is the purpose of ratio analysis?

8.3 TYPES AND CLASSIFICATION OF RATIOS

Ratios have been classified by different experts differently based on their peculiar
characteristics. Some authorities classify ratios on the basis of the financial statements
or statements from which the financial figures are selected. Accordingly, the following
classification of ratios can be formed:
• Profit and Loss Ratios These ratios indicate the relationship between two
such variables which have been taken from the profit and loss account. Basically,
there are two types of such ratios, viz., those showing the current year’s figures
as a percentage of last year, thus facilitating comparison of the changes in the
various profit and loss items; and those expressing relationship among different
items of the current year, for example, the percentage of distribution expenses
to sales.
Self-Instructional
Material 217
Ratio Analysis and • Balance Sheet Ratios Top management will probably want to view the financial
Trend Analysis
structure of the company in terms of basic ratios of asset or liability categories
to total assets. This set of ratios attempts to express the relationship between
two balance sheet items, e.g., the ratio of stock to debtors, or the ratio of
NOTES owner’s equity to total equity.
• Inter-statement Ratios/Mixed Ratios The components for computation of
these ratios are drawn from both balance sheet and profit and loss account.
These ratios deal with the relationship between operating and balance sheet
items. The examples of such ratios are debtors’ turnover ratio, fixed assets
turnover ratio, working capital turnover ratio, and stock turnover ratio.
Some authorities classify the ratios on the basis of time to which the ratios computed
belong. On this basis, the ratio can be divided into following two major groups:
• Structural Ratios Structural ratios exhibit the relation between two such items
which relate to the same financial period. Thus, the above-mentioned classification
of ratios, i.e., profit and loss ratios, balance sheet ratios and mixed ratios are
covered under structural ratios if the components for the computation of these
ratios are drawn from the financial statement that relate to the same period.
• Trend Ratios These ratios deal with the relationship between items over a
period of time. Trend ratios indicate the behaviour of ratios for the period under
study and thus provide enough scope for the proper evaluation of the business.
Another classification of ratios as developed by financial experts is on the basis of
significance of ratios. Some ratios are considered more important than others when
ratios are evaluated in the light of the objectives of the business. Accordingly, the
following two main groups of ratios are covered under this classification:
• Primary Ratios Every commercial concern considers profit as its prime
objective, and therefore, any ratio that relates to such objective is treated as a
primary ratio. The ratios covered by this category are return on capital, gross
margin to sales, etc.
• Secondary Ratios Ratios other than primary ratios are known as secondary
ratios. Such ratios are treated as supporting ratios to the primary ratios because
these ratios attempt to explain the primary ratios. Ratios such as turnover ratios,
expenses ratios, earnings per share are considered as secondary ratios.
Ratios are also classified according to the financial characteristics they describe.
Accordingly, the following classification of ratios is made:
• Liquidity Ratios;
• Leverage Ratios;
• Profitability Ratios; and
• Activity Ratios.
The classification on the basis of characteristics is simple to calculate and easy to
understand as compared to other classifications discussed above. Therefore, this
Self-Instructional classification is always preferred by the financial analyst to evaluate the business
218 Material
performance. Accordingly, a detailed discussion follows on the classification of ratios Ratio Analysis and
Trend Analysis
based on their financial characteristics.
Liquidity Ratios
The liquidity ratios indicate the liquidity of a company. They, in fact, measure the ability NOTES
of a company to meets its current liabilities as they fall due. If the company has insufficient
current assets in relation to its current liabilities, it might be unable to meet its
commitments, and be forced into liquidation. Thus, ratios comparing the relationship
between various groups of current assets and current liabilities are computed to measure
the liquidity position of the company. Such ratios help in ascertaining the effectiveness
of the working capital management. To gain an insight, analysts also use the variables
other than those covered by the term working capital. The following are the important
liquidity ratios:
• Current Ratio This is a fundamental measure of a firm’s financial position in
the short run, namely, its ability to meet normal operating obligations during one
financial year. The current ratio compares the total current assets with the total
current liabilities to find out whether the net assets are sufficient to meet the
short-term obligation of the business. It is computed by dividing current assets
by current liabilities. Current assets include cash, stock, work-in-progress,
marketable securities and accounts receivable. On the other hand, current
liabilities include accounts payable, sundry creditors, accrued income taxes,
proposed dividend, borrowings from financial institutions and outstanding
expenses. Usually current ratio is used by trade creditors to estimate the
company’s ability to repay its credit. The current ratio is calculated as:

Current Assets
Current Ratio
Current Liabilities

A high current ratio indicates a large proportion of current assets are available
to meet current liabilities. Usually the higher the ratio, the better is a company’s
current financial position and normally the better it can meet current obligations.
But at the same time, a higher current ratio would also mean that the company
may have an excessive investment in current assets that does not produce a
significant return. On the other hand, a low current ratio would indicate that
sufficient cash is not available to pay current liabilities. A frequently used guideline
to evaluate the adequacy of the current ratio is 2:1 or 2. However, there seems
to be very little justification for such a standard. For some businesses, this may
be an adequate current ratio, for others it may be too high or too low. Therefore,
the standard for this ratio will vary from industries to industries. In fact, many
renewed companies have much lower current ratio, as low as 1:1. In evaluating
the appropriateness of current ratios, much depends on the nature of the business,
composition of a firm’s current assets, and turnover of the firm’s certain current
assets.
• Acid-test Ratio It provides an even more critical look at the ability of the
Self-Instructional
company to meet its day-to-day obligations. It signifies a very short-term liquidity Material 219
Ratio Analysis and of a business concern and is, therefore, also called ‘liquid ratio’. If it is desired
Trend Analysis
to apply a still stiffer and rigorous test for evaluating a firm’s financial position in
the short period, the application of acid-test ratio is recommended. The acid-
test ratio is computed by dividing current assets in liquid form by current liabilities.
NOTES Thus, stocks and similar items are excluded from current assets, leaving items
such as debtors, bills receivable, marketable securities, and cash, which are
already in liquid form, or may easily be converted into cash by discounting or
factoring. The acid-test ratio assumes that stock may not be realized immediately
and, therefore, this item is excluded in the computation of this ratio. Some experts
advocate that the bank overdraft should also be excluded from current liabilities
while calculating acid-test ratio. The logic for the exclusion of bank overdraft is
based on the fact that bank overdraft is generally a permanent way of financing.
The acid-test ratio is expressed as follows:

Current Assets
Acid Test Ratio
Current Liabilities

Too low a ratio suggests not only inability to meet current claims but also inability
to take advantage of cash discounts and other rewards for prompt payment
(such as lower interest rates on borrowings). Further, a company with a low
quick ratio may be forced to obtain a short-term loan plus interest charges, or
implement some other measures to obtain the required cash. On the other hand,
an excessive amount of quick assets could indicate that these assets should be
put to more productive or profitable use elsewhere in the enterprise. An acid-
test ratio of 1:1 is usually considered ideal and satisfactory. However, this is a
rule of thumb and should be applied with care. The advocacy of ratios depends
on the industry in which the firm operates.
• Receivables Turnover Another measure of liquidity is receivable turnover,
which indicates the number of times that the average outstanding net receivables
is turned over or converted into cash through collections during each year.
Receivables turnover is the amount of period required for one complete cycle:
From the time receivables are recorded through collection to the time new
receivables are recorded. The faster the cycle is completed, the more quickly
receivables are converted into cash. When the customers’ accounts are collected
promptly with little loss or collection expense, the firm finds it easier to meet its
obligations when they become due. On the other hand, a long credit period
granted to creditors would adversely affect the firms’ liquidity position. The
receivables turnover is the ratio of sales to net accounts receivable. This ratio is
expressed as under:
Receivable include both debtors and bills receivable and average receivable is
calculated as
Receivables at the beginning + Receivables at the end
Average Receivables =
2
Self-Instructional
220 Material
 Net Sales Ratio Analysis and
Receivable Turnover Trend Analysis
Average Receivables

Some experts believe that the use of beginning and ending balances of receivables
to calculate averages fail to give accurate results because year-end balances NOTES
may not represent account balances most of the time during the year due to
seasonal variation in business volume. Therefore, it is advisable to use current
year’s monthly or quarterly data instead of beginning and ending balances for
calculating average receivables.
It is important to note that while calculating receivables turnover, only credit
sales should be used. However, this information often is not available in the
financial statements, and therefore, the net sales is used for the purpose.
Sometimes the receivable turnover is expressed as the ‘collection period’, viz.,
how many days (on the average) it takes to collect each rupee due. For the
period in question (week, month, quarter, year, etc.), the collection period is
calculated as:
Total Credit Sales
Average daily sales = 360 (or 365 days)

The collection period can also be calculated with the help of the following formula:
Total Credit Sales
Days’s sales in receivable = Receivable turnover (ratio)

Note: We use 360 (or 365) day representing a year in the calculation of average
daily sales. Such days can be more or less in a financial year depending on
number of sundays and holidays which have to be excluded.
Average Receivable
Day's sales in Re ceivable
Average Daily Sales (Credit)
A high ratio of receivables to sales suggests over-exposure to credit losses and
excessive costs in terms of interest on the capital required to extend credit to
customers. Whereas a low ratio suggests insufficient extension of credit and
therefore, lost sales and lost profits.
• Inventory Turnover The liquidity of inventories is measured by the number of
times per year that inventory is converted into cost of goods sold. Hence, it is a
device to measure the efficiency of the inventory management. However, in its
zeal to show a high ratio, inventories are not allowed to drop down below the
danger level. This ratio is worked out as under:
Cost of Goods Sold
Inventory Turnover =
Average Inventory

Sometimes it is considered more helpful to express the relationship between

inventory and cost of goods sold as the ‘number of days’ supply of inventory’;
in other words, the number of days the inventory supply could last. For the
period in question, the number of days’ supply of inventory is calculated as: Self-Instructional
Material 221
Ratio Analysis and
Trend Analysis

Average Inventory
Day's supply of Inventory =
NOTES Average day's cost of goods sold

The average day’s supply of inventory can also be computed with the help of
the following formula:

Number of days in period

Day's supply of Inventory =
Inventory Turnover (Ratio)

Inventory turnover rates vary tremendously by the nature of the business. It is

usually desirable to compare a firm’s inventory turnover with the turnover
experience by comparable companies. It is not unusual for retailers of perishable
commodities to experience a higher inventory turnover than those retailers who
deal in durable goods. At the other extreme, retailers of jewellery frequently
reflect a low yearly inventory turnover. A high turnover compensates for a lower
margin on each item, producing a normal profit for the business. On the other
hand, a business that sells slow-moving goods must make up for the low turnover
by a higher profit margin on each item sold. Of great importance, however, is
the need to evaluate the trend in the firm under review. Whether the trend is
desirable would require detailed investigation into such aspects as changes in
manufacturing techniques, labour slow downs, or inventory stockpiling in
anticipation of price increases.
Illustration 8.1: From the following Balance Sheet of Lily Ltd., you are required to
calculate the liquidity ratios and give your comments:
Lily Ltd.
Balance Sheet
(as on 31st Dec., 2012)

Self-Instructional
222 Material
Solution Ratio Analysis and
Trend Analysis

1.

NOTES

2.

Using the traditional guidelines, one would conclude that Lily Ltd. has adequate liquidity.
The value of the current ratio indicates that the company has current assets of 2.33
to pay a current liability of 1. At the same time, acid-test ratio of the company
indicates that for every current liability of 1 the company has the quick assets of
1.72. Depending upon the circumstances, this may be enough to assure the liquidity of
the company.
Illustration 8.2: M/s Sunlight Ltd. submits the following information for the year
ending 31st December 2012:

You are required to calculate Inventory Turnover and Receivable Turnover ratio from
the above given information.
Solution

1.

2.

Self-Instructional
Material 223
Ratio Analysis and Workings:
Trend Analysis

NOTES

Solvency Ratios (or Leverage Ratio)

Leverage is a reflection of the use of borrowed funds by a company to increase the
return on owner’s equity. Leverage ratios measure the contribution of financing by
owners compared with financing provided by the firm’s creditors. As the liquidity test
measures the ability of a firm to meet its current financial obligations, leverage ratios,
which gauge a firm’s solvency, attempt to monitor the ability of a firm to pay all of its
debts—current as well as non-current, as they become due. The capital structure of
almost every company consists of two major components, viz.,
• Equity capital—capital that belongs to owners-investors
• Debt capital—amount that belongs to creditors
The proportion of debt capital to the total capital of a firm is usually referred to as
‘leverage’ or trading on the equity. The fundamental economic principle underlying
leverage is that whenever funds are borrowed at a lower rate of interest than the
borrower can earn on those funds, the rate of return of owner’s equity is increased
over what it otherwise would have been had the borrowed funds been provided by
the owners (Hobbs and Moore, 1979). Borrowing too heavily, however, can invite
financial difficulty primarily because interest payments and principal repayments are
contractual obligations that must be honoured. The ability to obtain and to repay a
long-term debt often depends on a firm’s ability to obtain capital from shareholders.
Therefore, the relationship between shareholders’ equity and creditors’ equity is
evaluated. The leverage ratios commonly used are discussed below.
• Debt–Equity Ratio It develops the relationship between owned funds and
the borrowed funds. This reflects the extent to which borrowed capital is used
in place of equity capital. Business firms acquire assets both with owners’ and
creditors’ funds. The larger the portion of funds provided by owners, the less
risk is assumed by creditors. The debt-equity ratio is worked out as:

Self-Instructional
224 Material
 The ratio represents the proportion of external equity to internal equity in the Ratio Analysis and
Trend Analysis
capital structure of the firm. The external equity represents the amount of debts/
liabilities to outsiders. It includes both short-term as well as long-term liabilities.
On the other hand, owners equity includes all such liabilities that belong to the
shareholders, e.g., share capital (both preferential as well as equity), reserves NOTES
and surpluses. However, the accumulated losses and deferred expenses are to
be deducted from the owner’s equity in the calculation of debt–equity ratio.
Either too high or too low a ratio may be disadvantageous. Too high suggests
that management is not taking advantages of opportunities to maximize profits
through borrowing. Too low suggests undue exposure to risks of bankruptcy
and to a fixed burden of interest expenses in the event of a period of relatively
low profit (when the rate of return on total capital is less than the interest rate on
borrowed capital). As a rule of thumb, debt–equity ratio of less than 2:1 is
taken as acceptable, but this is not based on any scientific analysis. However,
many financial analysts prefer to consider 1:1 as safe. As the ratio increases, the
amount of risk assumed by creditors increases, because the ratio indicates
decreasing solvency. In fact, the acceptable level of ratio will vary from firm to
firm. For example, banking institutions will have much higher debt–equity ratio
as compared to manufacturing or trading concerns.
• Equity Ratio/Proprietary Ratio A variant to the debt–equity ratio is the
proprietary ratio which indicates the relationship between owner’s equity and
total assets. It measures the proportion of a company’s assets that are provided
or claimed by the owners. The ratio of owners’ equity to total assets is a measure
of the financial strength or weakness of the enterprise. Recall that the owners’
equity is the residual interest in a firm’s assets after allowance has been made
for the claims of creditors against the assets. If the owners’ equity is a small
proportion of the total assets, the enterprise may be considered financially weak,
because the owners have a relatively small investment in the firm as compared
to the creditors. On the other hand, a low proprietary ratio would indicate a
relatively larger degree of security for the company. This ratio is worked out as
follows:

The components of the proprietary ratio are owners’ equity and total assets.
The owners’ equity includes share capital both preferential and equity,
undistributed profits, reserves and surplus. The amount of owners’ equity must
be deducted by the amount of accumulated loss, if any. On the other hand, the
total assets represent the total resources of the company. However, some experts
are of the opinion that the total assets of a company for the purpose of proprietary
ratio should include only tangible assets. Consequently, the amount of goodwill
shall be excluded from the total assets in the computation of owners’ equity to
total assets.

Self-Instructional
Material 225
Ratio Analysis and • Ratio of External Equities to Total Assets (Solvency Ratio) This is a
Trend Analysis
variant of the proprietary ratio. This ratio measures the proportion of a firm’s
assets that are financed by creditors. To the creditor, a low ratio would ensure
greater security for extending credit to the firm. However, a too low ratio suggests
NOTES that management is not using its credit most advantageously. This ratio is
expressed as under:

The term external equities represent all debts, both long-term as well as short-
term. On the other hand, total assets refer to total resources of the concern.
• Fixed Assets to Net Worth Ratio (Ratio of Fixed Assets to Proprietor’s
Funds)
This ratio indicates the percentage contributed by owners to the value of fixed
assets. It can be worked out as follows:

Fixed assets represent cost of acquisition of the fixed assets deducted by the
amount of depreciation thereon up to the period. The net worth represents the
amount due to the shareholders, i.e., share capital, reserves and surpluses.
Financial experts are of the opinion that in manufacturing concerns, investment
in plants should be made out of equity rather than borrowed capital, therefore,
a ratio of at least 1:1 is considered desirable. On the other hand, a lower ratio
suggests an undue burden of debt on the enterprise that tends to increase the
internal rate at which an enterprise can borrow.
• Current Assets to Net Worth Ratio This ratio signifies the relationship between
the current assets and net worth. In other words, it is a correlation between
current assets and net worth. We can put this as under:

This ratio indicates the extent to which shareholders’ funds have gone into the
financing of the current assets. It is advisable to study the ratio of current assets
to net worth with the ratio of fixed assets to net worth.
• Interest Coverage Ratio A company is considered solvent if its revenue is
more than its interest and other expenses. Consequently, the company that has
revenue sufficient to meet only the expenses and leaving nothing as net income
is considered less solvent. Against this background, one of the approaches to
test solvency of the enterprise is interest coverage ratio. This ratio measures
how many times a company could pay its interest expenses. This ratio is calculated
by dividing interest expenses into earnings available for payment of interest
expense. We can put this as under:
Self-Instructional
226 Material
 Ratio Analysis and
Trend Analysis

Interest coverage ratio measures the ability of a firm to protect the interests of
long-term creditors. It is often stated that in order to ensure adequate protection
NOTES
to long-term creditors, this ratio should be 2 or more.
Illustration 8.3: From the following balance sheet you are required to calculate leverage
ratios:
Balance Sheet

Solution

Profitability Ratios
Profit has always been considered as the main indicator of a successful business.
However, the real test of success or failure of a business is to evaluate its profit-
earning capacity in relation to capital employed. It is against this background that
financial experts developed profitability ratios which are used to measure the ability of
Self-Instructional
Material 227
Ratio Analysis and the firm to convert sales into profits and to earn profits on assets employed. These
Trend Analysis
indicate degree of success in achieving profit levels. The following are important
profitability ratios:
• Gross Profit Margin Ratio This ratio indicates the relationship between gross
NOTES
profit and sales. It reflects how well cost of goods sold, a major expense item,
is being controlled. It shows the profit made on sales before taking account of
overheads. Thus, the gross profit margin highlights the production efficiency of
a concern. It is always preferred to express this ratio in terms of percentage.
The gross profit margin is computed by deducting cost of goods sold from the
amount of sales as shown below:

In interpreting the gross profit margin ratio, it is important to observe any trend,
but in making comparisons between companies it is vital to appreciate that
gross profit margins vary considerably from industry to industry. However, gross
profit margin must be sufficient to meet administrative and distribution expenses,
dividend and accumulation of reserves.
• Net Profit Margin Ratio It monitors the net profit made in relation to sales.
This ratio, also known as net operating margin, is calculated by dividing the net
profit after tax by the amount of sales. Thus, net profit margins ratio can be
written as under:

In interpreting the net profit margin ratio it is important to bear in mind that such
ratios vary considerably from firm to firm. Firms engaged in retailing are likely
to have quite rapid turnover and to operate on low margins allied to high volume,
while those firms engaged in selling a few large items must make a high profit in
relation to the sales value of each one.
The net profit margin ratio provides a relatively clear picture of how efficiently
the firm maintains control over its total expenses. In addition, the analyst may
wish to calculate the relationship between each expense item and sales to
determine the extent to which specific expenses are under control or are tending
to move out of control. For this purpose, expenses ratios are used. Expenses
ratios monitor the various expenses incurred in relation to sales. A high expense
ratio would indicate low profitability while a low ratio is an indication for higher
profitability. This ratio can be worked out as under:

Self-Instructional
228 Material
• Return on Assets/Capital Employed One of the most widely used ratios is Ratio Analysis and
Trend Analysis
the return on assets.
Since assets are used to generate income, the higher the income, the more
productive assets were during the period. In computing the return on assets, the
NOTES
analyst must bear in mind that both borrowed as well as owned funds are used
by the business for the acquisition of assets, therefore, the return on assets
should be computed before accounting for the interest on borrowed capital. At
the same time, income tax too is not considered while calculating this ratio because
taxes are calculated on income after interest deductions. Consequently, earning
(income) before interest and taxes is usually used to measure the return on
assets. Thus,

In the computation of average assets, the fictious assets must be excluded

When details about interest and tax are not available from financial statements,
the analyst may replace earnings before interest and tax by net income in the
calculation of the return on total assets.
• Return on Owners’ Equity Though the ratio of net profit to sales is a very
useful indicator of performance in comparison to the company’s experience in
prior periods or to the current experience of other companies, it does not give
a direct answer to a vital question: is the business providing an adequate return
on the owners’ investment, taking into account the risk associated with the
company’s business and what could be the earnings of this investment in
alternative ventures? To help answer this question, the ratio of return on owners’
equity is needed. The profit earned by the owners of a business is called return
on owners’ equity. This ratio is considered as an effective indicator of a
company’s profitability because it reflects the management’s success in efficient
utilization of the owners’ investment. The return on owners’ equity is worked
out with the help of the following formula:

• Return on Equity Capital Equity shareholders are more serious as compared

to preference shareholders in the profitability of a company. It is perhaps so because
equity shareholders assume the highest risk in the company. Preference shareholders
are assured of the rate of dividend, and therefore, the profitability of the company
has no meaning for them. On the other hand, the rate of dividend for equity
shareholders largely depends on the availability of profits. With the result, return
on equity capital is a useful indicator for equity shareholders to measure the
performance of the company. Return on equity capital monitors the profit made
by the company in relation to its equity capital. This ratio is worked out as under:

Self-Instructional
Material 229
Ratio Analysis and • Earnings Per Share (EPS) This is a well known and widely used indicator of
Trend Analysis
profitability because it can easily be compared to the previous EPS figure and
to the EPS figure of other companies. The earnings per share represent average
amount of net income earned by single equity share. This is calculated with the
NOTES help of the following formula:

Illustration 8.4: The following are the summarised profit and loss account of Sweety
Ltd. for the year ended 31st March, 2011:
Profit and Loss Account

Assume the rate of tax as 40 per cent

You are required to calculate:
(i) Gross Profit Margin Ratio
(ii) Net Profit Margin Ratio
(iii) Selling and Distribution Expenses Ratio.
Solution

Self-Instructional
230 Material
Working Notes: Ratio Analysis and
Trend Analysis

NOTES

Illustration 8.5: On the basis of information given in Illustration 8.4 and the information
given below, you are required to calculate the following ratios:
(i) Return on Assets
(ii) Return on Equity Capital
(iii) Return on Owner’s Equity
(iv) Earnings Per Share.
Additional Information:
Capital:
5,000, 7% preference shares @ 100 each fully paid: 15,000 equity shares @ 100
each fully paid Assets:
1 - 4 - 2010 5,50,000
31 - 3 - 2011 7,00,000
Solution

Self-Instructional
Material 231
Ratio Analysis and Working Notes:
Trend Analysis
Calculation of Preferential Dividend:
= 7/100 × 5,00,000 = 35,000
NOTES Calculation of Average Assets:

Activity Ratios
Activity ratios measure the efficiency of a firm in utilizing the available resources. Such
ratios reflect the success of a firm in utilizing its resources in business activities. Activity
ratios are popularly known as turnover ratios because they highlight the ability of
management to convert or turnover the assets of the firm into sales. These ratios make
a comparative study of the level of sales and the investment in various assets accounts.
A sharp rise in this ratio may indicate that the company is expanding too quickly and is
allowing sales to increase more rapidly than the underlying asset-base, a situation
often referred to as ‘over trading’. Conversely, a reduction in the ratio can indicate a
decline in efficiency or a fall in demand for a firm’s products. The important activity
ratios are mentioned below:
• Fixed assets turnover
• Total assets turnover
• Inventory turnover
• Average collection period
The last two ratios of the above-mentioned activity ratios have already been discussed
under liquidity ratio in the earlier section of this unit.
• Fixed Assets Turnover The ratio measures the efficiency in the utilization of
fixed assets. The ratio of sales to fixed assets measures the turnover of the plant
and machinery and is expressed as under:

• Total Assets Turnover This ratio measures the overall performance and activity
of the business organization. It is computed by dividing sales by total assets.
The following formula is applied to compute this ratio:

Self-Instructional
232 Material
Illustration 8.6: Compute the Fixed Assets Turnover and Total Assets Turnover from Ratio Analysis and
Trend Analysis
the following particulars:
Sales 3,00,000
Sales Return 40,000
Assets: NOTES
Fixed 2,00,000
Curent 1,50,000 3,50,000
Solution

In the next section, we will have a look at how trading, profit and loss account and
balance sheet are prepared using ratios through the help of practical problems.

8.4 PROBLEMS ON RATIO ANALYSIS

Problem 8.1: From the below given Comparative Balance Sheet of Beauty Co. Ltd.,
you are required to calculate liquidity ratios and give your comments.
Beauty Co. Ltd.,
Comparative Balance Sheet

Solution

Self-Instructional
Material 233
Ratio Analysis and
Trend Analysis

NOTES

The current ratio for Beauty Co. Ltd., was 2.05:1 at the end of 2011 but it has reached
exceedingly low level of 1.14:1 at the end of 2012. The current assets have decreased
and the current liabilities have increased during the year 2012. The current ratio of the
company for 2011 shows that it has adequate liquidity. However, in 2012 the current
ratio of the company indicates inadequate liquidity in the event of a short-term liquidity
crises.
The acid test ratio for the company shows a decline in 2012 from adequate
level in the year 2011. It now has ‘ 0.91 available in the form of liquid assets in order
to meet each ‘ 1 of current liabilities and thus the company appears to be approaching
a liquidity crises.
Problem 8.2: You are given the following information pertaining to current assets and
current liabilities of X Co. Ltd. during the years 2011 and 2012:

Calculate liquidity ratios for the two periods.

Solution

1.

2.

Self-Instructional
234 Material
Problem 8.3: From the information given below calculate Inventory Turnover and Ratio Analysis and
Trend Analysis
Receivable Turnover.
Sales (100% credit): 4 ,50,000
Inventories:
NOTES
1-1-2012 60,000
31-12-2012 70,000
Return inwards: 30,000
Sundry debtors:
1-1-2012 60,000
31-12-2012 40,000
Bills receivable:
1-1-2012 30,000
31-12-2012 50,000
Gross profit -30 per cent
Solution

1.

2.

Working Notes:
1. Net Sales = Sales – Returns
= 4,50,000 – 30,000
= 4,20,000
Gross profit
30
(30% of sales) = 4, 20, 000
100
= 1,26,000
Cost of goods sold = Net sales – Gross profit
= 4,20,000 – 1,26,000
= 2,94,000

2.

Self-Instructional
Material 235
Ratio Analysis and
Trend Analysis 3.

NOTES

Problem 8.4: From the following information given below, calculate

(a) Current liabilities and (b) Inventory:
Current Ratio = 2.5,
Acid-test Ratio = 1.7
Current Assets = 2,50,000
Solution
Calculation of Current Liabilities:

Calculation of Inventory:
Inventory = Current Assets – Liquid Assets
= 2,50,000 – 1,70, 000
= 80,000
Problem 8.5: Calculate current assets from the information given below:
Current Ratio = 2.5
Current Liabilities = 60,000
Solution

By cross multiplication, we get,

Current Assets = Current Liabilities × Current Ratio = 60,000 × 2.5 =
1,50,000.
Problem 8.6: The current ratio of Shugee Ltd. is 2.9 and its working capital 4,27,500
for the year ending 31st December, 1989. Compute its (a) current assets and (b)
current liabilities for the period.

Self-Instructional
236 Material
Solution Ratio Analysis and
Trend Analysis

NOTES
By cross multiplication we get Current Assets = Current Liabilities × Curent Ratio
Now let us substitute the values of current ratio in the above equation, we get
CA = CL × 2.9 or CA = 2.9 CL
Let us assume that current liabilities amounts to ‘x’ then current assets will be
2.9x. Consequently, working capital which is the difference between current assets
and current liabilities, will be:
Working Capital = (CA – CL) = 2.9x – 1.0x = 1.9x
Now let us substitute the value of working capital in the above equation, we get
4,27,500 = 1.9x

= 2,25,000
Since we have put x equal to current liabilities, therefore, the value of ‘x’ i.e.,
2,25,000 represent the current liabilities. Now we can easily calculate the value of
current assets with the use of following formula:

By cross multiplication, we get,

Current Assets = Current Liabilities × Current Ratio
= 2,25,000 × 2.9 = 6,52,500.
Problem 8.7: Following information is given to you:

The current assets of the firm consist of debtors, stock and cash. The firm does not
have any long-term liability. You are required to prepare a balance sheet.

Self-Instructional
Material 237
Ratio Analysis and Solution
Trend Analysis
Balance Sheet

NOTES

Working Notes:

I.

II.

III.

IV. Calculation of Fixed Assets:

Since the firm does not have any long-term liability therefore, shareholder’s
equity should be equal to total net assets. If the fixed assets are 0.75 to
proprietor’s funds, net current assets should be 0.25 of the total net assets.
Thus, fixed assets shall be:

Self-Instructional
238 Material
 Ratio Analysis and
Trend Analysis

V. Calculation of Shareholder’s Funds:

If fixed assets are 0.75, shareholder’s funds should be 1.00. Therefore, when NOTES
fixed assets are equal to 2,25,00 then shareholder’s funds will be :

VI. Calculation of Share Capital:

Shareholders funds = 3,00,000
Less: Reserves and Surplus = 50,000
Share Capital = 2,50,000
VII. Calculation of Sundry Creditors:

Current Liabilities = 1,00,000

Less: Bills Payable = 40,000
Sundry Creditors = 60,000
Problem 8.8: From the below given particulars, prepare the Balance Sheet of Electro
Ltd. on 31st March 2011.

Assume that all sales are made on credit.

Solution
Balance Sheet of Electro Limited

Self-Instructional
Material 239
Ratio Analysis and Working Notes:
Trend Analysis
1. Net Worth:
Sales to net worth = 4 times
4,00,000 × 4 = 16,00,000
NOTES
2. Current Liability:
Current Liability to net worth 50%
16,00,000 × 50/100 = 8,00,000
3. Total Liability:
Total debt to net worth 80%
16,00,000 × 80/100 = 12,80,000
4. Long-term Liabilities:
= Total Liabilities – Current Liabilities
= 12,80,000 – 8,00,000
= 4,80,000

5.

6.

7.

8.

9.

Self-Instructional
240 Material
Problem 8.9: Following is the Balance Sheet of Suman Ltd. for the year ended 31st Ratio Analysis and
Trend Analysis
December 2012:
Balance Sheet
NOTES

You are required to calculate:

(i) Debt–Equity Ratio
(ii) External Equities to Total Assets Ratio
(iii) Fixed Assets to Net Worth Ratio
(iv) Equity Ratio.
Solution

Problem 8.10: The following are the financial statements of M/s Bhola Enterprises for
the year 2012:
Balance Sheet

Self-Instructional
Material 241
Ratio Analysis and Profit and Loss Account
Trend Analysis

NOTES

You are required to calculate:

(i) Rate of Return on Equity Capital
(ii) Rate of Return on Total Assets
(iii) Earnings per Share
Solution

Check Your Progress

4. Give some examples of secondary ratios.
5. How is acid-test ratio calculated?
6. What does interest coverage ratio measure?
7. Which type of earnings are used to measure the return on assets?

Self-Instructional
242 Material
 Ratio Analysis and
8.5 TREND ANALYSIS: MEANING Trend Analysis

Trend analysis is recognized as one of the important tools of financial data analysis.
Such an analysis, in fact, calls for the computation of percentage changes for different NOTES
variables over a long period with an aim to have a comparative study of the variables.
The trend percentages help the analyst to study the changes that have occurred during
the period under study. Such an analysis indicates the progress of business by showing
ups and downs in its activities. The calculation of trend percentages involves the following
steps:
• Selection of base year;
• Assigning a weight of 100 to the value of the variable of base year; and
• Expressing the percentage change in the value of variable from base year to the
study year as shown below.

A trend for a single financial item is seldom very informative. A comparison of trends
for related items often help the analyst in perfect understanding of the business facts as
is clear from the below-mentioned comparative balance sheet.
Comparative Balance Sheet

Self-Instructional
Material 243
Ratio Analysis and Illustration 8.7 Calculate the trend percentage from the following figures of X Ltd.
Trend Analysis
taking 2008 as the base and interpret them.

NOTES

Solution
Trend Percentages

Interpretation
The study of the above-given statement (see Illustration 8.7) of trend percentage reveals
that:
• The sales of the firm has continuously increased over a period of five years
commencing from 2008. However, there has been a substantial increase in the
amount of sales in the year 2012 when it increased by 39 per cent.
• The trend of stock is also upwards. Although the increase in this item has been
constant yet in 2012 the increase has been exceptionally high.
• The profits of the firm has increased at a much higher rate in comparison to
increase in sales and stock during the period under study.
The overall analysis of the financial items indicated that the organization is doing well,
and therefore, its financial position is bound to be good.
8.5.1 Importance, Advantages, Limitations and Uses
In this section, you will learn about the important, advantages, uses and limitations of
trend analysis.
Advantages of Trend Analysis
 Efficient tool for Comparisons: Trend analysis is a great tool which helps
firm make comparisons of their performance over a period of time. This helps
Self-Instructional
the firm understand their relative position in the industry.
244 Material
  Percentages: Since trend analysis provides figures in terms of percentages Ratio Analysis and
Trend Analysis
and absolute figures, it makes comparisons both easy to decipher and effective
to present. This helps the firm take decisions properly.
 Trend ratios are very useful for the firms to study different aspects of their
NOTES
performance including short term as well as long term liquidity.
Disadvantages of Trend Analysis
 Critical base year selection: Trend analysis requires the selection of a base
year. This year needs to be a relatively normal year. But this section itself is very
complicated and if done incorrectly will render the analysis of no value.
 Not consistent: Trend analysis is a difficult accounting tool and the policy and
principles cannot be kept that consistent since the business trends are dynamic.
 Not useful in inflationary situations: In case there is inflation or price level
change, the trends of data will not be truly reflective of the situation and the
comparisons drawn will not be accurate.
Importance and Uses
 It helps the company in identifying and making sense of the movements of the
company both in the present period as well as that of the past.
 It assists the management in trying to predict based on period data how long a
certain trend might continue for.
 It reveals all the variances which might arise in the company’s operations
inadvertently, thereby helping them quickly identify, hold accountable and bring
changes in the department concerned.
 It also highlights the changes in the key items of the financial statements over a
period of time. This helps the company understand the general trend of how the
policies and practices are impacting particular elements of the company.

8.6 PROBLEMS ON TREND ANALYSIS

Problem 8.11
From the following information, interpret the results of operations of a manufacturing
concern using Trend Ratios. Use 2007 as the base.
Amount in lakh for the year ended:
Year 2007 2008 2009 2010
Net sales 100.00 95.00 120.00 130.00
Cost of goods sold 60.00 58.00 69.60 72.80
Gross profit 40.00 36.10 50.40 57.20
Operating expenses 10.00 9.70 11.00 12.00
Net Operating profit 30.00 26.40 39.40 45.20
Self-Instructional
Material 245
Ratio Analysis and Solution:
Trend Analysis
Year 2007 2008 2009 2010
Net sales 100.00 95.00 120.00 130.00
NOTES Cost of goods sold 100.00 96.67 116.00 121.33
Gross profit 100.00 90.25 126.40 143.20
Operating expenses 100.00 97.00 110.00 120.00
Net Operating profit 100.00 88.00 131.33 150.67

Problem 8.12
From the following data relating to the assets side of Ihe Balance Sheet of Kamdhenu Ltd., for
the period 31st Dec., 2012 to 31st December, 2015, you are required to calculate the trend percentage
taking 2012 as the base year.
( in thousands)

Solution:
Comparative Balance Sheet
as on 31st December, 2012–2015

Self-Instructional
246 Material
 Ratio Analysis and
Trend Analysis
Check Your Progress
8. How does trend percentage help an analyst?
9. State the first step of the calculation of trend percentages. NOTES

8.7 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. The factors which must be considered while analysing the financial ratios include
general economic condition of the firm, risk acceptance, future expectations,
future opportunities, accounting system of the industry and analysing and
interpretations system used by other firms in the industry.
2. Trend analysis is the technique of interpretation of ratio in which historical
standards are used for evaluating the performance of the firm.
3. The purpose of ratio analysis is to help the reader of financial statements to
understand the information shown by highlighting a number of key relationships.
4. Turnover ratios, expenses ratios, earnings per share are some examples of
secondary ratios.
5. Acid-test ratio is calculated by dividing current assets in liquid form by current
liabilities.
6. Interest coverage ratio measures the ability of a firm to protect the interests of
long-term creditors.
7. Earnings (income) before interest and taxes are usually used to measure the
return on assets.
8. The trend percentages help the analyst to study the changes that have occurred
during the period under study. Such an analysis indicates the progress of business
by showing ups and downs in its activities.
9. The first step of the calculation of trend percentages is the selection of base
year.

8.8 SUMMARY

 Ratio analysis is one of the popular tools of financial statement analysis.

 A ratio is defined as the indicated quotient of two mathematical expressions and
therefore expresses the relationship between two or more things.

Self-Instructional
Material 247
Ratio Analysis and  Financial ratio expedites the analysis by reducing the large number of items
Trend Analysis
involved to a relatively small set of readily comprehended and economically
meaningful indicators.
 The trend analysis provides enough clues to the analyst for proper evaluation of
NOTES
the financial ratios.
 Inter-firm comparisons may claim the comparisons of similar ratios for a number
of different firms in the same industry.
 Profit and loss ratios indicate the relationship between two such variables which
have been taken from the profit and loss account.
 Balance sheet ratios attempts to express the relationship between two balance
sheet items e.g., the ratio of stock to debtors, or the ratio of owner's equity to
total equity.
 Inter-statement ratios deal with the relationship between operating and balance
sheet items.
 Structural ratios exhibit the relation between two such items which relate to the
same financial period.
 Trend ratios deal with the relationship between items over a period of time.
 Primary ratios refer to any ratio that relates to such objective is treated as primary
ratio.
 Secondary ratios represent such ratios other than the primary ratio.
 The liquidity ratios indicate the liquidity position of a company.
 The current ratio compares the total current assets with the total current liabilities.
 Acid-test ratio provides an even more critical look at the ability of the company
to meet its day-to-day obligations.
 Receivables turnover is the amount of period required for one complete cycle:
From the time receivables are recorded through collection to the time new
receivables are recorded.
 Leverage ratios measure the contribution of financing by owners compared
with financing provided by the firm's creditors.
 Debt-equity ratio develops relationship between owned funds and the borrowed
funds.
 Equity Ratio/Proprietary Ratio measures the proportion of the company's assets
that are provided or claimed by the owners.
 Ratio of external equities to total assets ratio measures the proportion of the
firm's assets that are financed by creditors.

Self-Instructional
248 Material
  Fixed assets to net worth ratio indicates the percentage contributed by owners Ratio Analysis and
Trend Analysis
to the value of the fixed assets.
 The ratio of current assets to net worth signifies the relationship between the
current assets and net worth.
NOTES
 Interest coverage ratio measures how many times a company could pay its
interest expenses which is calculated by dividing interest expenses into earnings
available for payment of interest expense.
 Profitability ratios are used to measure the ability of the firm to convert sales
into profits and to earn profits on assets employed.
 Gross profit margin ratio indicates the relationship between gross profit and
sales.
 The net profit margin ratio monitors the net profit made in relation to sales.
 Return on Assets/ Capital Employed measures relationship earning before interest
and taxes and a firm's average assets.
 Return on owner's equity ratio is considered an effective indicator of the
company's profitability because it reflects the success of management in the
efficient utilization of the owner's investment.
 Return on equity capital monitors the profit made by the company in relation to
its equity capital.
 The earnings per share represent average amount of net income earned by
single equity share.
 Activity ratios measure the efficiency of a firm in employing the available resources.
 Fixed assets turnover ratio measures the efficiency in the utilization of fixed
assets.
 Total Assets turnover ratio measures the overall performance and activity of the
business organization.
 Trend analysis which is one of the important tools of analysing financial data
computes the percentage changes for different variables over a long period and
then makes a comparative study of them.

8.9 KEY WORDS

 Financial ratio: It refers to a relationship between two variables taken from

financial statements of a concern.
 Liquidity ratios: It refers to the ratios comparing the relationship between
various groups of current assets and current liabilities to measure the liquidity
position of the company.

Self-Instructional
Material 249
Ratio Analysis and  Solvency ratios: It refers to the ratios which measure the contribution of
Trend Analysis
financing by owners compared with financing provided by the firm's creditors.
 Profitability ratios: It refers to the ratios which measure the profit-earning
capacity of a firm in relation to the capital employed.
NOTES
 Activity ratios: It refers to the ratios which measure the efficiency of a firm in
utilizing the available resources.
 Trend analysis: It refers to the computation of percentage changes for different
variable over a long period with an aim to have a comparative study of the
variables.

8.10 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short-Answer Questions
1. What do you understand by Accounting Ratios? How does the ratio analysis
technique help in the financial analysis?
2. “A device for making financial data more meaningful is to reduce them to ratios”.
Elucidate.
3. State the significance of each of the following ratios and turnovers and tell how
each is calculated:
(i) Current Ratio
(ii) Receivable Turnover
(iii) Solvency Ratio
(iv) Inventory Turnover
(v) Return on Assets
4. “The return on Capital Employed is often taken as measure of efficiency of an
organization”. Comment.
5. “Ratios are mechanical and incomplete”. Explain.
6. What do you understand by Liquidity Ratio, Leverage Ratio, Profitability Ratio
and Activity Ratio?
7. A company has a 2 to 1 current ratio. List several reasons why this ratio may
not be adequate.
8. What are the steps involved in the calculation of trend percentages?

Self-Instructional
250 Material
Long-Answer Questions Ratio Analysis and
Trend Analysis
1. Discuss the uses and limitation of Accounting Ratios.
2. Discuss the importance of Ratio Analysis for inter-firm and intra-firm
comparisons, including circumstances responsible for its limitation, if any. NOTES
3. Describe the various profitability ratios. How are they worked out?
4. Discuss the significance of the ratio analysis as a decision-making technique.
5. What does the rate of return on assets employed tell about management?
6. Discuss the usefulness of the following ratios:
(a) Acid-Test Ratio
(b) Debt-Equity Ratio
(c) Net Worth to Fixed Assets
(d) Inventory Turnover.
7. “Accounting Ratios are mere guides and complete reliance on them in decision
making is suicidal”. Elucidate.
8. Discuss the ratios that determine the liquidity of a business.
9. “A figure by itself tells nothing, comparison is the key to control”. Explain.
Comment on the significance of accounting ratios in the context.
Practical Problems
1. The following is the balance sheet of SHE Ltd. as on 31st December, 2012:

You are required to comment on the liquidity position of the concern.

Self-Instructional
Material 251
Ratio Analysis and 2. Following accounting information is obtained relating to a limited company:
Trend Analysis

NOTES

Balance Sheet

Opening stock was 3,00,000. Assume 360 days in a year. Compute the following
ratios:
(i) Current ratio
(ii) Debtors ratio
(iii) Gross profit ratio
(iv) Net profit ratio.
3. Prepare a statement showing trend analysis (Base Year 2008):
( in lakh)
2008 2009 2010

Cash 200 240 160

Debtors 400 500 650
Inventory 600 800 700
Other current assets 450 600 750
Land 800 1,000 1,000
Buildings 1,600 2,000 2,400
Plant 2,000 2,000 2,400

Self-Instructional
252 Material
 Ratio Analysis and
8.11 FURTHER READINGS Trend Analysis

Arora, M. N. 2012. A Textbook of Cost and Management Accounting, 10th edition.

New Delhi: Vikas Publishing House. NOTES
Sahaf, M. A. 2013. Management Accounting: Principles and Practice, 3rd edition.
New Delhi: Vikas Publishing House.
Maheshwari, S. N., Suneel K. and Sharad K. 2012. A Textbook of Accounting for
Management, 3rd edition. New Delhi: Vikas Publishing House.
Maheshwari, S.N. and Mittal, S.N. 2009. Management Accounting. New Delhi:
Shree Mahavir Book Depot.

Self-Instructional
Material 253