H I

SHIVAJI UNIVERSITY, KOLHAPUR

CENTRE FOR DISTANCE EDUCATION

Semester-III : Paper-I (CC-C1)

Management Accounting

Semester-IV : Paper-II (CC-C2)

Management Accounting
(Management Control System)

For

M. Com. Part-II

(Academic Year 2021-22 onwards)

K J
Copyright © Registrar,
Shivaji University,
Kolhapur. (Maharashtra)
First Edition 2022

Prescribed for M. Com. Part-II

All rights reserved. No part of this work may be reproduced in any form by mimeography
or any other means without permission in writing from the Shivaji University, Kolhapur
(MS)

Copies : 1,000

Published by:
Dr. V. N. Shinde
Ag. Registrar,
Shivaji University,
Kolhapur-416 004.

Printed by :
Shri. B. P. Patil
Superintendent,
Shivaji University Press,
Kolhapur-416 004

ISBN- 978-93-92887-45-1

H Further information about the Centre for Distance Education & Shivaji University may be
obtained from the University Office at Vidyanagar, Kolhapur-416 004, India.

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 Centre for Distance Education
Shivaji University, Kolhapur
n ADVISORY COMMITTEE n

Prof. (Dr.) D. T. Shirke Prof. (Dr.) S. S. Mahajan

Honourable Vice Chancellor, I/c. Dean, Faculty of Commerce and
Shivaji University, Kolhapur Management, Shivaji University, Kolhapur

Prof. (Dr.) P. S. Patil Prin. (Dr.) Smt. M. V. Gulavani

Honourable Pro-Vice Chancellor, I/c. Dean, Faculty of Inter-disciplinary
Shivaji University, Kolhapur Studies, Shivaji University, Kolhapur

Prof. (Dr.) M. M. Salunkhe Prin. (Dr.) R. G. Kulkarni

Former Vice-Chancellor, I/c. Dean, Faculty of Humanities,
Yashwantrao Chavan Maharashtra Open Shivaji University, Kolhapur
University, Nashik.
Dr. V. N. Shinde
Prof. (Dr.) K. S. Rangappa Ag. Registrar,
Former Vice Chancellor, Shivaji University, Kolhapur
University of Mysore
Shri. G. R. Palase
Prof. P. Prakash I/c. Director, Board of Examinations and
Additional Secretary, Valuation, Shivaji University, Kolhapur
Distance Education Bureau,
University Grants Commission, New-Delhi. Shri. A. B. Chougule
I/c. Finance and Accounts Officer,
Prof. (Dr.) Cima Yeole Shivaji University, Kolhapur
Git Govind, Flat No. 2,
1139 Sykes Extension, Prof. (Dr.) D. K. More
Kolhapur-416001 (Member Secretary) Director,
Centre for Distance Education,
Prof. (Dr.) R. K. Kamat Shivaji University, Kolhapur.
I/c. Dean, Faculty of Science and
Technology, Shivaji University, Kolhapur

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 n B. O. S. MEMBERS OF MANAGEMENT n
Chairman- Dr. Sarang Shankar Bhola
Karmaveer Bhaurao Patil Institute of Management Studies and Research, Varye, Satara

l Prof. (Dr.) A. M. Gurav

Department of Commerce & Management, l Dr. Dattatray Tatyaba Chavare
Shivaji University, Kolhapur Dhananjayrao Gadgil College of Commerce,
Satara
l Prof. H. M. Thakar
Department of Commerce & Management, l Dr. Prafulla Arjun Pawar,
Shivaji University, Kolhapur Professor and Head,
Department of Management Science,
l Dr. Vinod Babar Savitribai Phule Pune University, Pune
Jaywant Institute of Management,
Vathar-Karad, Dist. Satara l Prin. N. V. Shah
Anandi Arts, Commerce and Science
l Dr. U. M. Deshmukh College, Gaganbawada
Chh. Shahu Institute of Business Education
& Research, (CSIBER), Kolhapur l Dr. Smt. Sharwari Sharad Kulkarni
Harihar Chaitraban Society Road,
l Dr. R. S. Salunkhe
Vishrambag, Sangli 416 415
Arts, Commerce & Science College, Palus,
Dist. Sangli
l Dr. V. N. Deshpande,
Chairman, Sound Lasting Pvt., Ltd.,
l Dr. B. D. Girigosavi
MIDC, Shiroli, Kolhapur
The New College, Kolhapur

l Dr. T. D. Mahanavar l Shri. Abhar Kardeguddi,

D. G. College of Commerce, Satara NIVA Growth Consultants,
61, Sheela Vithar Colony,
l Dr. Ravindra Basawant Teli 112, Neramb, Karve Road,
Shivraj College of Arts and Commerce and Near Kimaya Restrauant,
D. S. Kadam Science College, Gadhinglaj, Pune 411038
Dist. Kolhapur

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 Preface
Modern approach of the business propounds the concept of management with new horizon,
according to which management is art and science of utilizing resources effectively and
efficiently to achieve the organizational goal. Such effectiveness and efficiency can be attained
by specific and scientific tools and techniques which can support managerial decision making.
Management Accounting is such a branch of knowledge, which assists the management for
planning, controlling and decision-making for each and every facets of management. It is
expected that the students from M. Com. should be familiar with and skilled in various tools and
techniques of management accounting. Hence, this self instructional material has been developed
to the students on distance mode to learn this subject smoothly and it covers both theoretical
and practical aspects.
In the first part of this book there are four units. The first unit puts the light on introductary
part of management accounting including meaning, need, importance and scope of management
accounting, difference between management accounting and financial accounting, and tools
and techniques of management accounting etc. The second unit covers financial statement
analysis focusing on the ratio analysis. The third unit is about working capital which consists
of meaning, types of working capital the estimation of working capital requirement. The fourth
unit includes funds flow statement and cash flow statement which presents meaning of these
two statements difference between them and practical approach of preparing these statements.
The second part of this book is also divided into four units. The first unit is devoted to
management control system whereas the second unit emphasis on marginal costing. It includes
meaning, applications, merits and demerits of marginal costing, breakeven analysis, cost
volume profit analysis and decision making through marginal costing. The third unit consists of
meaning, objectives, advantages, limitations of budgetary control, types of budgets, performance
budgeting and responsibility accounting and preparation of budgets etc. The forth unit covers
the concept of standard costing and variance analysis. It includes meaning, advantages and
limitations of standard costing, variance, material variances, labour variances and overhead
variances etc. The students should read the theoretical part first and then they can solve the
problems which are given wherever necessary. Practical approach to learning has been adopted
in every unit especially to develop analytical skills and decision-making skills.
We express our deep sense of gratitude to Hon. Vice-Chancellor and Director, the Centre
for Distance Education for giving us opportunity to contribute this book. We would welcome
suggestions for improvement in the book, from stakeholders of all corners.

n Editors n

Prof. (Dr.) Shrikrishna S. Mahajan Dr. Pratapsinh V. Mohite

Department of Commerce & Management, Arts & Commerce College, Ashta
Shivaji University, Kolhapur Tal. Walwa, Dist. Sangli.

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Centre for Distance Education Management Accounting
Shivaji University, M. Com. II
Kolhapur.
Writing Team

Unit No. Unit No.

Author's Sem. III Sem. IV

Dr. V. K. Sawant 1 -
Dhananjayrao Gadgil College of Commerce, Satara

Dr. D. R. Bhutiyani 2 -
L. B. S. College, Satara
Dr. V. A. Patil - 2
D. R. K. College of Commerce, Kolhapur
Dr. P. N. Devali 2 2
Centre for Distance Education,
Shivaji University, Kolhapur

Dr. P. V. Mohite 3, 4 -
Arts & Commerce College, Ashta

Dr. N. S. Pandit 4 -
S. G. M. College, Karad

Prof. (Dr.) S. S. Mahajan - 1

Dept. of Commerce & Management,
Shivaji University, Kolhapur

Dr. G. J. Fagare - 3
Smt. Gangabai Khivraj Ghodowat Kanya
Mahavidyalaya, Jaysingpur

Dr. P. M. Herekar - 4
Devchand College, Arjunnagar

n Editors n

Prof. (Dr.) Shrikrishna S. Mahajan Dr. P. V. Mohite

Dept. of Commerce & Management, Arts & Commerce College, Ashta,
Shivaji University, Kolhapur
Tal. Walwa, Dist. Sangli

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 M. Com Part-II
Semester III and IV
SIM IN MANAGEMENT ACCOUNTING PAPER I AND II

INDEX

Unit Page
Topic
No. No.

Semester-III

1 Introduction 1

2 Analysis of Financial Statements 28

3 Working Capital 173

4 Funds flow Statement & Cash Flow Statement 200

Semester-IV

1 Management Control System 323

2 Marginal Costing and CVP Analysis 349

3 Budgetary Control 392

4 Standard Costing and Variance Analysis 435

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Each Unit begins with the section 'Objectives' -

Objectives are directive and indicative of :

1. What has been presented in the Unit and

2. What is expected from you

3. What you are expected to know pertaining to the specific

Unit once you have completed working on the Unit.

The self check exercises with possible answers will help you to
understand the Unit in the right perspective. Go through the possible
answer only after you write your answers. These exercises are not
to be submitted to us for evaluation. These are provided to you as
Study Tools to help keep you in the right track as you study the
Unit.

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 Unit-1
Introduction

Index
1.0 Objectives
1.1 Introduction
1.2 Presentation of Subject Matter
1.2.1 Meaning of Management Accounting
1.2.2 Scope of Management Accounting
1.2.3 Functions of Management Accounting
1.2.4 Role of Management Accountant in Decision Making
1.2.5 Management Accounting Versus Financial Accounting
1.2.6 Tools and Techniques of Management Accounting
1.2.7 Group Discussion Practical
1.3 Summary
1.4 Terms to Remember
1.5 Answers to Check Your Progress
1.6 Exercise
1.7 Reference for Further Study

1.0 Objectives:
After studying this unit you will able to:

Understand the meaning of management accounting.

Explain the scope and functions of management accounting.

Understand the role of management accountant in decision making.

Find difference between management accounting and financial accounting.

Identify the tools and techniques of management accounting.
1
1.1 Introduction:
Management plays crucial role in every organization. It may be business
organization or non-business organization. Management of every business concern
aims at ensuring maximum profitability with financial stability. That’s why
management needs various kinds of information for use in operational needs of the
business like costs, funds, profits etc. Management accounting provides accounting
information to management with the internal reporting. Management accounting is
essential to help the management in formulating policies and plans. Management
accounting has emerged as a special branch of accounting which provides adequate
information to the management in order to perform its various tasks Management
accounting is purely voluntary and its use depends on its utility to the management.

1.2 Presentation of Subject Matter:

1.2.1 Meaning of Management Accounting:
Management accounting deals with presenting and providing accounting
information to the management in such a systematic way so that it can perform its
managerial functions of planning, controlling and decision making in an effective
and efficient manner. The term ‘management accounting’ is the modern concept of
accounts as a tool of management. It is a broad term and is concerned with all such
accounting information that is useful to the management. The term ‘management
accounting’ refers to accounting for management, i.e., accounting which provides
necessary information to the management for discharging its functions. Management
accounting is a system of accounting concerned with the internal reporting. In the
words of P F Drucker “the most exciting and innovative work in management
today is found in accounting”.
Some of the important definitions of management accounting are as under:
1. According to Robert N. Anthony, “Management accounting is concerned with
accounting information which is useful to management”.
2. In the words of J. Batty, “Management accounting is the term used to describe
the accounting methods, system and techniques which, coupled with special
knowledge and ability, assist management in its task of maximizing profits or
minimizing losses”.

2
3. The Institute of Chartered Accountants of England and Wales defines “any
form of accounting, which enables a business to be conducted more efficiently,
can be regarded management accounting”.
4. The Institute of Cost and Management Accountants, London has defined
Management accounting as, “the application of professional knowledge and skill
in the preparation of accounting information in such a way as to assist
management in the formulation of policies and in the planning and control of the
operation of the undertaking.”
5. The most acceptable definition of Management accounting has been furnished
by the Management Accounting Team of the Anglo-American Council of
Productivity, “Management accounting is the presentation of accounting
information in such a way as to assist management in the creation of policy and
in the day-to-day operations of an undertaking.”
6. In the words of R. H. Garrison “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”.
In views of these definitions, it is clear that management accounting refers to
accounting for the management. Efficiency of the various phases of management is,
as a manner of fact, the common thread which underlies all these definitions. It
therefore, lies between the following two activities:

Completing the accounting results on the one hand, and

Controlling the business by the management on the other.
Management accounting, therefore, covers all rearrangement, combination or
adjustment of orthodox accounting figures which may require providing Chief
Executive with the information from which he can control the business.
1.2.2 Scope of Management Accounting:
Management accounting has a very wide scope. Management accounting
includes not only financial accounting and cost accounting but also all types of
internal financial controls, internal audit, tax accounting, office services, cost control
and other methods and control procedures. Hence, the scope of management

3
accounting is beyond the boundaries of accounting and costing. Thus scope of
management accounting includes the following:
1. Financial accounting: Financial accounting provides basic historical data
which helps management to forecast and plan its financial activities for the
future period. In short, for an effective and successful management accounting,
there should be a proper and well designed financial accounting system.
Management accounting applies the principles and practices of financial
accounting. Thus, without efficient financial accounting system, management
accounting cannot be operative.
2. Cost accounting: Cost accounting provides cost-related basic data to the
management accounting, which analyses and interprets those costing data and
provides necessary information to the management for the purpose of its
controlling and decision making. Management accounting uses the principles
and practices of cost accounting. The techniques of cost control, like standard
costing, budgetary control, and the techniques of profit planning and decision
making, like marginal costing, Cost-Volume-Profit (CVP) analysis and
differential cost analysis, are used by the management accounting. Hence, cost
accounting is considered as the backbone of management accounting.
3. Forecasting and budgeting: Management accounting exercises the tool of
forecasting and budgeting in the process of planning, controlling and decision
making. Budgeting lies at the heart of management accounting. Forecasting
helps in the preparation of budgets and budgeting helps management accountant
in exercising budgetary control.
4. Statistical tools: Various statistical tools like graphs, charts, diagrams, time
series, sampling, index numbers and regression analysis are used in management
accounting in the process of planning, controlling and decision making.
5. Operational research techniques: Various operational research techniques like
Linear Programming, Transportation Theory, Games Theory and Simulation
Method are used in management accounting to resolve various problems
prevailing under the existing situation in the process of decision-making.
6. Financial analysis and interpretation: Various financial analysis techniques
such as Ratio Analysis, Funds Flow Analysis, Cash Flow Analysis, Comparative
Financial Statements, Common-Size Statements and Trend Analysis are widely
4
 used in management accounting to analyze and interpret financial data to make
them easily understandable and useable to the management. Successful
application of management accounting depends a lot on these financial analysis
and interpretation works.
7. Tax accounting and tax planning: Determination of taxable income and tax
liability of the enterprise fall within the purview of the management accounting.
In the process of decision-making, the analysis of implication of tax provisions
on future projects also falls within the purview of management accounting. The
management accountant must have a vast knowledge of tax laws and their
accounting procedures, and also tax planning, to minimize the tax burden of the
enterprise.
8. Reporting to management: For effective and timely decisions, there should be
a system of prompt and intelligent reporting to management. Both routine and
special reports are prepared for submission to top management, middle order
management and operating level management depending on their requirements.
Clear, informative, timely reports are essential management tools in reaching
decisions that make the best use of a company’s resources.
9. Cost control procedures: Any system of management accounting is incomplete
without effective cost control procedures, like inventory control, labour control,
overhead control and budgetary control.
10. Internal control and internal audit: Management accounting highly depend
upon internal control system existing in the organization, like internal check and
internal audit, to appraise the targeted performance and to identify the weaker
area of organization.
11. Legal Provisions: Management accounting system should also be well
informed about relevant and necessary legal provisions like Companies Act,
Foreign Exchange Act, Securities Act, and Direct and Indirect Tax Laws. In
decision-making process, management accountants should restrict their plan and
action within the periphery of such legal provisions.
12. Office Services: Management accountant is expected to maintain and control
office routines and procedures, like filing, copying, communicating, electronic
data processing, information network system, email, tax system and relevant
allied services.
5
13. Other areas: Apart from the aforementioned areas, management accounting
also includes various newly developed areas of accounting like Human
Resource Accounting, Social Accounting, Environmental Accounting and
Inflation Accounting within preview of its scope.
1.2.3 Functions of Management Accounting:
Main functions or objectives of management accounting are described as below-
1. Planning: Planning is an essential aspect of every field of activity. Information
and data provided by management accounting helps to management for
forecasting and preparation of short-term and long-term plans for the future
activities of the business and formulate corporate strategy. For this purpose
management accounting techniques like budgeting, standard costing, marginal
costing etc., are used.
2. Coordinating: Due to proper financial reporting, management accounting helps
in achieving coordination in various business activities and accomplishing the
set goals. While preparing budgets for various departments like production,
sales, purchase etc, there should be full coordination so that there is no
contradiction.
3. Controlling: Controlling is one of the important functions of management. It is
a continuous process. Management accounting helps in controlling performance
by control techniques such as standard costing, budgetary control, internal audit
etc.
4. Communication: Management accounting system prepares report for
presentation to various level of management which shows the performance of
various sections of the business. Such communication in the form of reports to
various level of management helps to exercise effective control on various
business activities and successfully running the business.
5. Financial analysis and interpretation: Ratio analysis, cash flow statement,
funds flow statement trend analysis etc; are some of the management accounting
techniques which may be used for financial analysis and interpretation.
6. Qualitative information: Apart from monetary and quantitative data,
management accounting provides qualitative information which helps in taking
better decisions. Quality of goods, customers, employees, legal judgements,

6
 opinion polls, logic, etc are some of the examples of qualitative information
supplied and used by the management accounting system for better
management.
7. Tax administration: In modern business organizations, the responsibilities of a
management accountant also include the tax administration. This task involves
submission of necessary documents and return to the tax authorities and
supervision of all matter relating to tax administration.
8. Decision making: Management accounting provides necessary and relevant
information to the management in the process of its decision making. Correct
decision making is the crucial task. The success of the management highly
depends on a perfect decision making. Techniques like marginal costing,
differential costing, discounted cash flow etc. help in decisions such as pricing
of products, make or buy, discontinuance of a product line, capital expenditure
etc.
9. Special studies: 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 accountant undertakes various special studies such
as sales analysis, economic forecasts, price spread analysis etc.
10. Advisory service: Management accounting renders valuable advice to the
management for resolving any financial or other problems of the enterprise. To
overcome any financial and other problems, various management accounting
techniques are applied according to the nature of the problem. Management
accounting also plays a very important role as an advisor to the management.
1.2.4 Role of Management Accountant in Decision Making:
Decision making is an integral part of all managerial functions viz.: planning,
organizing, directing and controlling.
The decision making process includes the following steps:
1. Indentifying a problem requiring managerial action.
2. Specifying the objective or goal to be achieved.
3. Listing the possible alternative courses of action.
4. Gathering the information about the consequences of each alternative.

7
 5. Making a decision, by selecting one of the alternatives.
Management accounting plays a critical role for gathering the information about
the consequences of each alternative in the decision making process. Management
accountant does the formal structuring of decision making problems and places the
information showing the outcome of each of the alternative courses of action making
it easy for management to evaluate different alternatives and make rational decision.
Marginal costing, particularly Differential Cost Analysis, Break-Even Analysis
etc. helps the management accountant to take decisions about cost control,
maximization of profit etc. Therefore, the management accountant is sometimes
called the ‘Controller’. Management accountant plays a very important role in an
organization He analyses and interprets accounting information and meets the
informational needs of management at different levels. In an organization, a
management accountant generally performs advisory role.
Sometimes management accountant has to collect, analyze and present the
information for some special decisions which are not regular such as:

Whether to establish a new plant.

Whether to develo1p own distribution system.

Whether to introduce a new market line or whether to enter a new market.
The data for such decisions should be obtained from internal as well as external
sources and presented in comparable form. This is a critical and skillful task. The
management accountant in such a situation determines what information is
necessary, obtains it from proper source and present it in an understandable form to
the concerned managerial personnel who are to make such decision.
Management accounting thus plays a crucial role in making managerial decision
in every field of activity like production, marketing and in every function of
management such as planning, organizing, directing and controlling.

8
1.2.5 Management Accounting Versus Financial Accounting:
The following are main factors of distinction between management accounting
and financial accounting.
Factor Management Accounting Financial Accounting
1. Meaning Management accounting is a Financial accounting is
system of accounting meant to serve parties
concerned with the internal external to the operating
reporting or information to responsibility of the
the management for planning undertakings.
and controlling operations,
decision making on special
matters and formulating long
range plans.
2. Object The object of management The object of financial
accounting is to provide accounting is to record
financial, cost as well as various transactions with
other information to the purpose of maintaining
managerial personnel at all accounts and to know the
levels in the hierarchy to financial position and to
facilitate decision making. find out profit or loss at the
end of financial year.
3. Entity Under management Financial accounting
accounting system each considers the business as
unit/department/ division/ one entity and accordingly
cost centre of the business is financial accounting reports
treated as a separate entity in have been confined to the
order to ensure effective business operation as a
planning and control. whole. Such statements
Therefore, profitability and present the position and the
performance reports are performance of the entire
prepared for each unit or business.
division of business
separately.

9
4. Accounting Management accounting is Financial accounting is
Method not based on double entry based on double entry
system. system for recording
business transactions.
5. Nature of Data Management accounting has Financial accounting has a
Used a futuristic orientation. It historical orientation. It
supplies projected or uses actual data. It is a post
estimated data on basis of mortem analysis of
past analysis. Thus, financial statements.
management accounting has
prospective character.
6. Description Management accounting Only those things which
uses both monetary and non- can be measured in
monetary events. The monetary terms are
competition in the market, recorded in financial
impact of political changes, a accounting. Anything
situation of trade cycles and which cannot be recorded
such other factors are in figures is outside the
considered in management scope of financial
accounting though these accounting. Hence,
cannot be measured in financial accounting makes
monetary terms. Hence, use of data which is
management accounting historical in nature,
makes use of data which is quantitative, monetary and
descriptive, subjective and objective.
relates to future.
7. Precision In Management accounting In financial accounting
no emphasis is given to only actual figures are
actual figures. The recorded and there is no
approximate figures are room for using approximate
considered more useful than figures. Hence, there is
the exact figures. Hence, the great emphasis on precision
information may be less and accuracy.
precise only indicating the

10
 trends to guide the
management.
8. Methodology In management accounting In financial accounting
information is collected and transactions relating to
analyzed according to Nominal Accounts, Real
responsibility centre or cost Accounts and Personal
centre. Accounts are to be
recorded.
9. Importance Management accounting Financial accounting gives
gives more importance on more importance on
qualities such as flexibility, obligation such as
consistency, comparability objectivity, precision,
etc. correctness etc.

10. Accounting No Generally Accepted Financial accounts are

Principles Accounting Principles strictly prepared on the
(GAAP) and standard rules basis of Generally
are followed in management Accepted Accounting
accounting. While preparing Principles (GAAP) and
reports, there is a lot of standard rules. The
flexibility in method and principles and standard
style of presentation of rules are rigidly followed in
information. financial accounting.
11. Reporting Management accounting Financial accounts are
reports are meant for internal prepared to find out the
use only. These are prepared profitability and financial
for the benefit of different position of the concern.
levels of management. Financial accounting
reports are useful for
outsiders like bankers,
investors, creditors,
Government agencies, etc.
12. Quickness Reporting of management Reporting of financial

11
 accounting is very quick. accounting is slow and time
Management is fed with consuming. Profit and Loss
reports at regular intervals. Account and Balance Sheet
are prepared at the end of
financial year. The
management is able to
know profitability and
financial position only after
the preparation of the final
accounts.
13. Compulsion The management is free to The preparation of financial
use or not to use accounts is
management accounting. mandatory/compulsory in
certain undertakings while
these are a necessity of
others.
14. Use of Other Management accounting Financial accounting does
Subjects uses certain aspect of other not use any other subjects
subjects such as Economics, to record and prepare its
Statistics, Law, statements.
Management, Finance,
Costing, Taxation,
Marketing and Computers
etc. to prepare its reports.
15. Period The management accountant Financial statements are
supplies information from prepared for a particular
time to time during the period. Financial
whole year by considering statements like Profit and
the need of management. Loss Account, Balance
There are no specific periods Sheet are prepared at a
for furnishing accounting longer time interval such as
information to management. half yearly or yearly.
16. Publication Publication of records and Financial statements like
reports prepared by Profit and Loss Account
12
 management accountant is and Balance Sheet are
not compulsory under any published in the form of
law. Management annual report for the
accounting statements are benefit of the public. Under
prepared for the benefit of the Companies Act, every
the management only and registered company is
hence, these are not supposed to supply a copy
published. of Profit and Loss Account
and Balance Sheet to the
Registrar of Companies at
the end of the financial
year.
17. Audit Management accounting Financial accounting
statements cannot be audited. records can get audited.
They are not based on the Under the Company Act,
actual figures and projected auditing of financial
data are also used in accounts is compulsory.
management accounting. So
it is not possible to get
management accounting
statements audited.

1.2.6 Tools and Techniques of Management Accounting:

Management accounting uses various tools and techniques for providing
necessary and effective information to the management for performing its managerial
functions. Some of the important tools and techniques are as follows:
1. Financial Statement Analysis
2. Historical Cost Accounting
3. Marginal Costing
4. Standard Costing
5. Budgetary Control

13
 6. Funds Flow Analysis
7. Cash Flow Statement
8. Statistical Analysis
9. Inflation Accounting
10. Reporting / Communicating
These tools and techniques have been elaborated as under:
1. Financial Statement Analysis: Financial planning helps to determine in
advance the financial activities which are necessary in order to achieve primary
objectives of a business enterprise. Financial statements are the indicators of
profitability and financial position of business. Financial statement analysis is
the process of identifying the financial strength or weakness by properly
establishing relationships between the items of the financial statements. Tools of
financial statement analysis are:
a) Comparative Financial Statements: A business concern does not exist in
isolation. It coexists with other competing concerns in the same industry. It
has to constantly compare its performance with such competing concerns.
Such comparison is called inter-firm comparison. It also needs to compare
its own past performance with its current performance to ascertain it
progress or decline over the years. This is known as inter-period
comparison. Comparative financial statement is a tool of arranging the
Balance Sheets and Profit and Loss Accounts of business enterprises in
comparable form so as to enable enterprises to facilitate inter-firm
comparison and inter-period comparison.
b) Common-Size Financial Statements: Common-size financial statement is
a tool of rearranging the financial statements (i.e. Profit and Loss Account
and Balance Sheet) by converting the figures therein into percentages to
some common base so as to facilitate inter-firm comparison or inter-period
comparison of the same business. In common-size Profit and Loss Account
the sale figure is assumed as common base and treated to be 100 and all
other figures therein are expressed as a percentage of sale. Similarly, in
common-size Balance Sheet the total of assets or liabilities is taken as 100
and rests of the figures are expressed as a percentage of this figure.

14
 c) Trend Analysis: The comparative statements and common-size statements
compare the figures of year 2 with those of year 1, the figures of year 3
with those of year 2, and the figures of year 4 with those of year 3 and so
on. But, a trend analysis is a technique which treats year 1 as the base year
and compares the figures of all the years (year 2, year 3, year 4 and so on)
with those to the base year to ascertain trend in the figures. For example,
trend analysis of sales will reveal whether compared to base year i.e. year 1,
the sales show a trend of increase or decrease in the subsequent years i.e.
year 2, year 3, and year 4 and so on. Thus, trend of sales, debtors and
inventory may studied together to arrive at meaningful conclusion.
d) Ratio Analysis: A ratio shows the relationship between two numbers.
Accounting ratios show relationship between the two accounting figures.
Ratio analysis is a tool of studying the financial status and performance of a
concern on the basis of accounting ratios. It helps to evaluate the
performance of business concern over a period of time as well as in
comparison with other competing concerns. We know ratios are the best
tool for measuring liquidity, solvency, profitability and activity of a
concern and it is also equally useful to the internal management,
prospective investors, creditors and outsiders etc. The role of accounting
ratios is very significant to increase the efficiency of the management. As
such, it is a very important tool of management accounting also.
2. Historical Cost Accounting: Historical cost accounting provides financial past
data relating to cost of each job, process and department etc, so that proper
comparison may be made with the standard cost which ultimately helps to
control cost and makes future planning properly.
3. Marginal Costing: Marginal cost is an economic concept. Marginal costing,
particularly Differential Cost Analysis, Break-Even Analysis etc. helps the
management accountant to take decisions about cost control, maximization of
profit etc. Hence, marginal costing is a technique of guiding the management in
decision making, in assessment of pricing and profitability.
4. Standard Costing: Standard costs are pre-determined or forecast estimates of
cost to manufacture a single unit or a number of units of a product, during a
specific immediate future period and are used as a measure with which the

15
 actual cost, as ascertained, may be compared. As such, this technique, i.e. the
analysis of variance is considered while controlling costs and helps to take
correct decision for future. Standard costing is a specialized technique of
costing. It is also treated as a powerful tool in the hands of management
accountant which enables him to guide the managerial person in their task of
cost control and improve the economy, efficiency and productivity of the
manufacturing operations.
5. Budgetary Control: Budgetary control system is a system of controlling and
planning costs. So this technique is widely used in management accounting for
planning and controlling different activities of a business unit. In other words, it
helps the management to achieve a desired return on investment. Hence,
budgetary control has become an essential technique of management for
controlling costs and maximizing profits.
6. Funds Flow Statement: This statement discloses the analytical information
about the different sources of a fund and the application of the same in an
accounting cycle. It deals with the transactions which changes either the amount
of current assets and current liabilities (with their respective reasons) or fixed
assets, long-term loans including ownership fund between two different dates. It
also explains how the funds are coming and from which sources and application
of the same. Funds Flow Statement helps in making better estimate about
company’s financial position and policies. It has become an important tool in the
hands of management accountant.
7. Cash Flow Statement: It indicates the inflows and outflows of cash during a
period. It shows the receipts of cash from various sources and the payment of
cash for various purposes during a particular period. It is a tool in the hands of
financial analyst, and this is also useful in management accounting. Cash Flow
Statement overcomes the limitation of Balance Sheet that it shows only the cash
balance as on a particular day and fails to depict the movements of cash over a
period.
8. Statistical Analysis: At present statistical data are widely used in financial and
management accounting for the purpose of financial data to be made more
meaningful for future guidance, comparative studies etc. Some of the statistical
techniques are Correlation and Regression, Time Series Data, Index Number,

16
 Measures of Dispersion, Graphical Presentation etc. which are really very useful
to management accountant.
9. Inflation Accounting: This technique is very useful and widely accepted for
ensuring the maintenance of original capital under conditions of changing prices
i.e., inflation. It also incorporates its effect on the financial statements as well.
10. Reporting and Communicating: It helps to communicate desired financial
information through reports to the users of financial statements by which the
management can take right decision at right time and determine the future
courses of action which proves useful to the business enterprise as well.
Check Your Progress
(A) State whether the following statements are True or False:
1. Management accounting provides decisions to management.
2. In management accounting only those figures which can be measured in
monetary terms are used.
3. Management accounting is a traditional concept.
4. Specific rules are followed in management accounting.
5. Management accounting presents reports covering shorter or longer
periods.
6. Reporting of management accounting is slow and time consuming.
7. Management accounting deals only with the information which is useful to
the management.
8. Management accounting deals with both quantitative and qualitative
information.
9. Management accounting reports are based on current year’s figures as in
financial accounting.
10. Publication of management accounting statements is not compulsory.
11. Management accounting is a branch of financial accounting.
12. Management accounting is a backward looking tool to the management.
13. Management accountant is sometimes called the ‘Controller’.

17
 14. Management accountant must be a qualified MBA or CA.
15. Small organizations find it difficult to afford a system of management
accounting.
(B) Fill in the blanks:
1. ------------------------- accounting is more subjective
2. Management accounting is an ------------------- reporting.
3. Accounting designed to serve parties external to the operating responsibility
of the business is termed as -----------------------.
4. Accounting designed for use in the operational needs of the business is
termed as --------------------.
5. Management accounting is helpful in increasing------------------- of an
organization.
6. Management accounting is helpful in ------------------------ of data.
7. No generally accepted accounting principles and standard rules are
followed in --------------------------- accounting.
8. Success of the management accounting highly depends on ---------------.
(C) Select the most appropriate answer:
1. The basic function of management accounting is to:
a) record all business transactions
b) interpret the financial data
c) record some transactions
d) assist the management in performing its functions effectively
2. Management accounting rearranges for management control, data provided by:
a) financial accounting
b) cost accounting
c) revaluation accounting
d) taxation

18
3. Management accounting involves:
a) preparation of financial statements
b) analysis and interpretation of data
c) recording of transactions
d) following standard rules
4. Management accounting relates to:
a) recording of accounting data
b) recording of costing data
c) recording of general data
d) presentation of accounting data
5. The use of management accounting is:
a) compulsory b) optional c) common d) none of these
1.2.7 Group Discussion Practical:
1) Introduction: Group discussion is a group activity. It involves exchange of
ideas on a specific topic/ issue. Participation in a discussion is the role of every
group member. It is the tool of screening. It is the means of thought exposure.
The basic aim of a group discussion is to evaluate the effectiveness of a student/
candidate/participant in a group activity by means of team spirit and
communication skills displayed by him/her during the discussion. Initiating,
agreeing, disagreeing, interrupting, adding and summarizing are the elements of
group discussion.
2) Some Do’s and Don’ts for Group Discussion (GD):
Do’s Don’ts
It is advisable to take a stand – in Sit with arms and legs crossed.
favour (agree) or against (disagree)
topic.
Express opinion based on facts, Maintain a sardonic smile on your
figures and statistics. face throughout the GD.
Ability to read between the lines. Never agree to anyone else’s point of

19
 view.
Be creative and innovative, thought Disagreement with everyone will
provoking. guarantee you more enemies.
Candidate should be audible. Stare at your GD members and point
fingers at others.
Voice Modulation. Interrupt if someone is making a good
point.
Sit attentively in GD. Use abbreviations and acronyms
without explaining them. Use Slang –
words like ‘yar’ etc.
Analyze somebody’s viewpoints and Maintain a blank look on your face.
reason own viewpoint.
Contribute to the GD through content Only listen and never speak.
and ideas.
Try to put GD into proper Aggression, shouting in GD.
perspective to have focuses
discussion towards topic.
Encourage other candidates to speak. Enforce views on others and
questioning.

3) How to carry out Group Discussion?

Forming Groups- Group size may range from 6 to 10 students for
classroom discussion.

Topics from syllabi or related happenings.

Groups should be mixed- Heterogeneous (involvement of male and female
students.)

Sitting Arrangement- Considerable distance.

Choosing a leader

Time to think and jot down points before discussion.

Consensus at the end of discussion is desired.

Mentor’s / Teacher’s Role.

20
4) Evaluation/ Assessment Criteria:
Suppose, if Group Discussion is held for 10 Marks. Evaluation/ Assessment
criteria for that shall be as under-
Evaluation Criteria Marks
Communication skills 3
Subject knowledge 3
Analytical ability 2
Consistency of Participation 1
Leadership and Group Behaviour 1
Total 10
5) Example: Group Discussion on ‘Functions of Management Accounting’.
BACKGROUND INFORMATION
It is a group of eight students/participants/ candidates who are sitting in a closed
circle. The teacher/ mentor extend them a welcome, announce the topic of group
discussion and wish them success. A time limit of 30 minutes is fixed. After this
silence breaks and students start whispering. Gradually the noise in the group
increases and a chaotic scene takes shape. At this stage student No.2 raises his voice
and addresses the group.

Student No. 2: Friends, I appeal to all of you to take assignment seriously. As

the teacher has given us only 30 minutes time, we have to plan accordingly. Keeping
in view that all students get equal chance to express their view on topic, we are free
to exchange our arguments but we have to be decent and differential to one another’s
ideas. Let us begin with No.1 and move on to the last speaker.
Student No. 6: Hey, what is all this about? Why does Mr.2 think of himself? Is
he self styled commander? Group discussion is a free-for-all fair, doesn’t he know
this? Everybody is at his liberty to make his/ her point. This is the way of the world.
Student No. 5: Please go ahead. Be quiet everyone.
Student No. 3: Thank you, may I draw kind attention of all of you towards topic
of our group discussion that is functions of management.

21
 Student No. 8: Friends. I think management is the need of every organization.
Without management, an organization cannot run properly, therefore, role of
management is very significant to the organization.
Student No. 1: As per my knowledge, I would like to highlight here the term
‘Management’ and ‘Accounting’ separately for further discussion. Management is a
task of planning, controlling and co-ordinating efforts of others towards a specific
objective. It mainly involves planning and controlling functions. Management is a
continuous process. Whereas, accounting is the process of identifying, measuring and
communicating economic information to users of information. Hence, accounting is
mainly concerned with monetary information.
Student No. 4: Our friend (i.e. No.1) has given meaning of ‘Management’ and
‘Accounting’ separately, but I am focusing here, ‘Management Accounting’ only.
Management accounting is a separate branch of accounting which provides
accounting information to the management for decision making. The term
‘management accounting’ refers to accounting for management. Management
accounting is fundamentally based on judgement rather than on measurement. It is a
modern concept.
Student No. 7: Well, friends, the topic for our discussion is quite interesting.
Our friends especially No. 1 and No.4 have given information pertaining to
management, accounting and management accounting. I would like to express the
functions of management accounting viz.: planning, co-ordinating, communicating
and controlling. Planning helps to do things as per pre-determined way.
Management accounting provides data to the management for short and long term
planning. Co-ordination is essential in every activity for smooth functioning. Due to
proper financial reporting, management accounting helps in achieving coordination
in various business activities and accomplishing the set goals. Communication is the
need of hours for success in every line of activity. Management accounting does
communication by preparing reports of performance of various sections of the
enterprise. Management accounting applies various useful techniques such as
Standard Costing, Budgetary Control and Responsibility Accounting, to ensure an
effective managerial control over the use of resources of the enterprise. Hence,
planning cannot success without suitable controlling.

22
 Student No. 6: Our friend No.7 has clearly pointed out the functions of
management accounting in right way. I would also like to add certain functions of
management accounting namely decision making, financial analysis and
interpretation, qualitative information, and tax policies.
Student No. 3: Right, I would like to elaborate some functions of management
accounting as mentioned by No.6 such as decision making and financial analysis.
Decision making is a complex task. It requires accurate information, knowledge and
experience. Management accounting has certain special techniques such as marginal
costing. differential costing, discounted cash flow etc which help management in
short and long term decisions. There are certain techniques of management
accounting like ratio analysis, cash flow statement and funds flow statement which
may used for financial analysis and interpretation.
Student No. 1: Well friends, the topic of our discussion is quite interesting. I
wanted to say that, to provide qualitative information is one of the important
functions of management accounting. . Quality of employees, opinion polls, legal
judgements, logic etc; are some examples of qualitative information supplied and
used by the management accounting system for better management.
Student No.7: Friends, I have listened about functions of management
accounting. I find that more speakers have pointed out the functions of management
accounting properly. But, no one speaks about limitations of management accounting
in regards to performing its functions. Management accounting uses data that are
available from financial and costing statements. Thus, the validity of the decisions
largely depends on the reliability of the historical data as obtained from financial
statements. Any drawback in such statements is bound to affect the effectiveness of
the decisions. The principle of objectivity is not followed in its real spirit in
management accounting. The interpretation of information as provided by
management accounting in the form of reports may be influenced by a personal bias
of the interpreter, which may reduce the utility of management accounting.
Student No. 2: I feel that tax administration and performance evaluation are
two important functions of management accounting. In modern business
organizations, the responsibilities of a management accountant also include the tax
administration. This task involves submission of necessary documents and return to
the tax authorities and supervision of all matter relating to the tax administration.

23
Management accounting evaluates the performance of activities of different
departments/ divisions as well as the business as a whole of an enterprise by using
various tools and techniques.
Student No. 4: Friends, thank you all for making my task easier. As the topic of
discussion has been properly covered by all of you. I do not believe in criticizing or
contradicting others. I agree with everyone.
Student No. 8: Dear Friends, I am summarizing our discussion by saying that,
the role of management accounting is to assist the management to perform its
functions of planning, organizing, directing, controlling and decision-making.
Student No. 5: Friends, I am glad that I am the last speaker. Since all of you
have covered functions of management accounting thoroughly and ably. I do not
disagree with anyone. Thank you.

1.3 Summary:
The aim of management accounting is to assist management in decision making
and control. 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 enterprise in order for decisions to be taken
in various areas of business. It is oriented primarily towards managerial control and
other decision-making groups inside the organization. Management accounting has
emerged as a special branch of accounting which provides adequate information to
the management in order to perform its various tasks. It is a system of accounting
concerned with the internal reporting. It refers to accounting for the management. It
is more subjective.
Management accounting is fundamentally based on judgement rather than on
measurement. It is a modern concept. The management accounting serves the
management by providing information which is necessary to run the business
smoothly and efficiently. It is helpful in increasing efficiency of an organization. It
involves analysis and interpretation of data. Management accounting has a very wide
spread scope. It includes not only financial accounting and cost accounting but also
all types of internal financial controls, internal audit, tax accounting, office services,
cost control and other methods and control procedures. Monetary and non-monetary
events like technical changes, competition etc., are to be recorded in management

24
accounting. The use of management accounting is optional. No specific rules are
followed in management accounting as in the case of financial accounting. In
management accounting there are no prescribed formats for presentation of
information to the management.
Management accounting plays a crucial role in making managerial decision in
every field of activity like production, marketing and in every function of
management such as planning, organizing, directing and controlling. Management
accounting makes use of data which is descriptive, subjective and relates to future.
On the other hand, financial accounting makes use of data which is historical in
nature, quantitative, monetary and objective. Management accounting statements
cannot be audited. They are not based on the actual figures and projected data are
also used in management accounting. So it is not possible to get management
accounting statements audited. On the contrary, financial accounting records can get
audited. Under the Company Act, auditing of financial accounts is compulsory. In
management accounting various tools and techniques are being used such as ratio
analysis, funds flow analysis, marginal costing, standard costing, budgetary control,
statistical analysis, reporting/communicating etc. It is the duty of management
accountant to supply necessary information to management by using different tools
and techniques.

1.4 Terms to Remember:

Accounting: The process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by users of information.

Financial Accounting: The art of recording, classifying and summarizing in a

significant manner and in terms of money transactions and events which are at
least in part of a financial character and interpreting the results thereof.

Financial Management: The efficient raising and optimum utilization of funds.

Cost Accounting: The accounting mechanism through which the costs of the
products and services ascertained and controlled.

Management Accounting: The presentation of accounting information in order
to formulate the policies to be adopted by the management and assist its day-to-
day activities.

25

Management Accountant: The official who uses the accounting information
for management planning and control.

Management Accounting Tools: The techniques used by the management
accountant in performance of his job.

1.5 Answers to Check Your Progress:

(A) 1. False 2. False 3. False 4. False 5. True
6. False 7. True 8. True 9. True 10. True
11. False 12. False 13. True 14. False 15. True.
(B) 1. Management 2. internal 3. financial accounting
4. management accounting 5. efficiency 6. interpretation
7. management 8. decision-making.
(C) 1. d 2. a 3. b 4. d 5. b.

1.6 Exercise:
1. Describe the scope of management accounting.
2. What are the functions of management accounting?
3. Explain the role of management accountant in decision making.
4. Define management accounting. How does it different from financial
accounting.
5. Explain in brief tools and techniques of management accounting.
6. Conduct Group discussion (Practical) on:
a) Scope of management accounting
b) Tools and techniques used in management accounting
c) Importance of management accounting in relation to management

26
1.7 Reference for Further Study:
1. Arora, M.N. (2018). Cost and Management Accounting. (10th Edition). Noida:
Vikas Publishing House Pvt Ltd.
2. Bhattacharyya, Debarshi. (2011). Management Accounting. New Delhi:
Dorling Kindersley (India) Pvt Ltd., licensees of Pearson Education in South
Asia.
3. Gordon, E., Jeyaram, N., Sundram, N. & Jayachandran, R. (2010). Management
Accounting. Mumbai: Himalaya Publishing House.
4. Jain, S.P. & Narang, K.L. (2000). Advanced Accountancy. New Delhi: Kalyani
Publishers.
5. Jefferson, Richard. (2005). Learn the Art of Group Discussions. Chandigarh:
Abhishek Publications.
6. Maheshwari, S.N. & Maheshwari, S.K. (2008). An Introduction to Accountancy.
New Delhi: Vikas® Publishing House Pvt Ltd.
7. Paul, S. Kr., (1994). Management Accounting. Calcutta (Kolkata): New Central
Book Agency (P) Ltd.
8. Patnaik, Priyadarshi. (2014). Group Discussion and Interview Skills. New Delhi:
CAMBRIDGE HOUSE.
9. Prasad, Hari Mohan. & Mohan, Rajnish. (2005). New Delhi: Tata McGraw-Hill
Publishing Company Limited.
10. Sahaf, M.A. (2000). Management Accounting Principles and Practice. New
Delhi: Vikas Publishing House Pvt Ltd.


27
 Unit-2
Analysis of Financial Statements

Structure
2.0 Objectives
2.1 Introduction
2.2 Presentation of Subject Matter
2.2.1 Managing & Types of Financial Statements
2.2.2 Analysis of Financial Statements
2.2.3 Comparative Statement Analysis
2.2.4 Common-size Statement Analysis
2.2.5 Trend Analysis
2.2.6 Ratio Analysis
2.2.7 Advantages of Ratio Analysis
2.2.8 Limitations of Ratio Analysis
2.2.9 Classification of Ratios
2.2.10 Practical Problems
2.3 Summary
2.4 Terms to Remember
2.5 Answers to Check Your Progress
2.6 Exercise
2.7 Reference for Further Study

28
2.0 Objectives :
After studying this unit you will be able to:

understand the concept of financial statements

explain the types of financial statements

understand the different tools of financial statement analysis.

calculate and interpret the various ratios.

2.1 Introduction
Business is mainly concerned with the financial activities. In order to ascertain
the financial status of the business every enterprise prepares certain statements,
known as financial statements. Financial statements are mainly prepared for decision
making purposes. But the information as is provided in the financial statements is not
adequately helpful in drawing a meaningful conclusion. Thus, an effective analysis
and interpretation of financial statements is required.

2.2 Subject Matter

2.2.1 Meaning and Types of Financial Statements
The term financial statements refer to two basic statements which an accountant
prepares at the end of an accounting period for a business enterprise. These are:
1. Balance Sheet (or Statement of Financial Position) which reflects the assets,
liabilities and capital as on a certain date, and
2. Profit and Loss Account (or Income Statement) which shows the results of
operations i.e. profit or loss during a certain period. ,
Other Statements - Apart from the Balance Sheet and Profit-and Loss Account,
the following financial statements are also prepared.
3. Profit and Loss Appropriation Account - This shows how profit of a business is
utilised for declaring dividends, transfer to general reserve or other reserves etc.
4. Funds Flow Statement' - This shows increase or decrease in working capital
during the accounting period. .

29
5. Cash Flow Statement - This shows changes in cash position between the
beginning and end of the accounting period.
All these statements taken together are called package of financial statements.
2.2.2 Financial Statement Analysis
Analysis of financial statements means to critically examine the composition of
an item or amount appearing in the financial statements. In other words, analysis
means breaking up of an amount into its elements so that a particular element may be
correlated to another and significant relationship may be established between them
and conclusions may be drawn on the data presented in financial statements. Such an
analysis makes use of various analytical tools and techniques to data of financial
statements so as to derive from them certain relationships that are significant and
useful for decision making.
In the words of John N. Myers, "Financial statement analysis is largely a study
of the relationships among the various financial factors in a business as disclosed by
a single set of statements and a study of the trends of these factors as shown in a
series of statements." Interpretation is determining the meaning and drawing
inferences or conclusions with regard to the results of significant relationship
between the items correlated.
Thus, financial statement analysis converts the mass of data into useful
information which is always in scarce supply. It pinpoints the strengths and
weaknesses of a business undertaking by use of various techniques such as ratio
analysis, comparative statements etc. Such analysed information is used by
management, bankers, creditors, investors and others to form judgement about the
operating performance and financial position of the business. Thus financial
statement analysis helps in evaluating a business performance according to some
Analysis means establishing a meaningful relationship between various items of
the two financial statements with each other in such a way that a conclusion is
drawn. By financial statements we mean two statements:
(i) Profit and loss Account or Income Statement
(ii) Balance Sheet or Position Statement

30
 These are prepared at the end of a given period of time. They are the indicators
of profitability and financial soundness of the business concern. The term financial
analysis is also known as analysis and interpretation of financial statements. It refers
to the establishing meaningful relationship between various items of the two
financial statements i.e. Income statement and position statement. It determines
financial strength and weaknesses of the firm.
Analysis of financial statements is an attempt to assess the efficiency and
performance of an enterprise. Thus, the analysis and interpretation of financial
statements is very essential to measure the efficiency, profitability, financial
soundness and future prospects of the business units.
The following are the principal tools of analysis of financial statements.
i) Comparative Financial & Operating Statements.
ii) Common-size Financial Statements.
iii) Trend Percentages/Trend Ratios.
iv) Ratio Analysis.
2.2.3 Comparative Statement Analysis :
i) Comparative Balance Sheet
Comparison of financial statements is one of the very important tools of analysis
of financial statements. It has been seen that balance sheet and profit and loss
account are the two most important financial statements. Information contained in
these financial statements for a particular year is extremely important and useful.
However such information becomes still more useful if it is compared with the data
shown in the financial statements of the previous few years. Such comparison of
financial statements is accomplished by setting up balance sheet and profit and loss
account of two or more years side by side and studying the changes that have
occurred in the individual figures therein from year to year and over the years. Thus
comparison of financial statements means financial statements of a company for any
year are compared with financial statements of the same company for earlier years.
Comparative financial statements take the form of comparative balance sheets and
comparative profit and loss accounts.

31
Illustration: 1
From the following information prepare a Comparative Balance Sheet.
31st March 2003 31st March 2004
Rs. Rs.
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
31st March Increase or Decrease
Items 2003 2004 Absolute Percentage
Rs. Rs. Rs. %
Equity share Capital 4,00,000 6,00,000 2,00,000 50
Debentures 2,00,000 3,25,000 1,25,000 62.25
Sundry Creditors 2,55,000 1,17,000 (-)1,38,000 (-)54.12
Bank Overdraft 7,000 10,000 3,000 42.86
Total Liabilities and Capital 8,62,000 10,52,000 1,90,000 22.04
Plant and Machinery 1,00,000 2,00,000 1,00,000 100
Land and Building 3,60,000 5,40,000 1,80,000 50
Investments 2,70,000 1,70,000 (-)1,00,000 (-)37.04
Sundry Debtors 1,00,000 88,000 (-)12000 (-)12
Cash in hand 32,000 54,000 22,000 40.74
Total Assets 8,62,000 10,52,000 1,90,000 22.04

32
ii) Comparative Income Statement (or Profit and Loss Account)
An income statement shows the net profit or net loss resulting from the
operation of a business for a definite period of time. A comparative income statement
is prepared to show the net profit or loss for a number of years in comparative form.
By comparing income statement for two or more years, it is possible to observe the
progress of a business.
A comparative income statement contains the same columns as the comparative
balance sheet and provides the same type of information. The first two columns are
provided to show the balances of various accounts for two years for which
comparison is to be made. Third column is provided to show the change i.e. increase
or decrease in various items in absolute amounts in rupees, the fourth column shows
the increase or decrease for each item in percentage.
Illustration: 2
From the following information, prepare a comparative Income Statement.
31st March 2003 31st March 2004
Rs. Rs.
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 2003 and 2004
Year Change
Particulars 2003 2004 Absolute
%
Rs. Rs. Rs.
Sale 10,00,000 8,00,000 (-)2,00,000 (-)20.00
Less: Cost of Goods Sold 6,00,000 4,00,000 (-)2,00,000 (-)33.33
Gross Profit 4,00,000 4,00,000 Nil Nil
Less: Operating Expenses: 2,00,000 1,40,000 (-)60,000 (-)30.00

33
 Year Change
Particulars 2003 2004 Absolute
%
Rs. Rs. Rs.
Adm., Selling and Dist. Exp.
Net Operating Profit 2,00,000 2,60,000 60,000 30.00
Other Incomes 40,000 20,000 (-)20,000 50.00
Net Profit before tax 2,40,000 2,80,000 40,000 16.67
Less: Income Tax (50% of Net 1,20,000 1,40,000 20,000 16.67
Profit)
Net Profit after Income Tax 1,20,000 1,40,000 20,000 16.67

2.2.4 Common Size Statements Analysis

Common size statement is a type of comparative financial statement in which
each item of the financial statement is expressed as percentage of the appropriate
total. The appropriate total is taken as 100 per cent and each item is shown as a
proportion of this 100 per cent. Such a statement is also known as 100 per cent
Statement or 'Vertical analysis'. It should be noted that when a comparative statement
is prepared for a number of years to show the trend, it is known as 'Horizontal
analysis', a common size statement may be prepared for balance sheet as well as
income statement.
Common Size Balance Sheet
In common size balance sheet, each item of asset is shown as a percentage of
total assets and each, item of liability and capital is shown as a percentage of total
liabilities and capital (which is the same as total assets). In other words, the total of
the assets and also that of liabilities and capital is taken as 100 per cent and each item
appearing on the assets side as well as liabilities side is shown as a proportion of the
total of 100.
Illustration: 3
Please refer Illustration No: 1. A common Size Balance Sheet should be
prepared as follows

34
 Common Size Balance Sheet
31st March 2003 31st March 2004
Particulars % of
Rs. % of Total Rs.
Total
Liabilities and Capital
Equity share Capital 4,00,000 46.40 6,00,000 57.03
Debentures 2,00,000 23.20 3,25,000 30.89
Sundry Creditors 2,55,000 29.58 1,17,000 11.13
Bank Overdraft 7,000 0.82 10,000 0.95
Total Liabilities and Capital 8,62,000 100 10,52,000 100
Assets:
Plant and Machinery 1,00,000 11.60 2,00,000 19.01
Land and Building 3,60,000 41.76 5,40,000 51.33
Investments 2,70,000 31.32 1,70,000 16.16
Sundry Debtors 1,00,000 11.60 88,000 8.37
Cash in hand 32,000 3.72 54,000 5.13
Total Assets 8,62,000 100 10,52,000 100
Procedure of preparing common size balance sheet
Assume total of the balance sheet as 100 %. Then express each item in the
balance sheet ·as a percentage of total of 100. For example, in the above Illustration,
equity capital on 31st March 2003 is Rs. 4,00,000. Total of the balance sheet on this
date is Rs. 8,62,000. We can now calculate percentage of equity capital in the total of
100% as follows:

,,
Equity Capital = × 100 = 46.40%
,,

Similarly calculation of other items in the balance sheet is made. For example:
,,
Debentures = × 100 = 23.20%
,,
,,
Plant and Machinery = × 100 = 11.60%
,,

As on 31st March 2004, each item is calculated as a percentage of Rs. 10,52,000.

For example:

35
 ,,
Equity Capital = × 100 = 57.03%
, ,
,
,
Land and Building = × 100 = 51.33%
, ,

In this way each and every items is calculated.

Common Size Income Statement
This statement is similar to common size balance sheet. In the common size
income statement, total sales figure is taken as 100 per cent and each item is then
calculated as a percentage of sales.
Illustration: 4
Please refer Illustration No: 2 . A common Size Income Statement should be
prepared as follows
Solution:
Common Size Income Statement
2003 2004
Particulars % of % of
Rs. Rs.
Sales Sales
Sale 10,00,000 100.00 8,00,000 100.00
Less: Cost of Goods Sold 6,00,000 60.00 4,00,000 50.00
Gross Profit 4,00,000 40.00 4,00,000 50.00
Less: Operating Expenses 2,00,000 20.00 1,40,000 17.50
Net Operating Profit 2,00,000 20.00 2,60,000 32.50
Other Incomes 40,000 4.00 20,000 2.50
Net Profit before tax 2,40,000 24.00 2,80,000 35.00
Less: Income Tax (50% of Net Profit) 1,20,000 12.00 1,40,000 17.50
Net Profit after Income Tax 1,20,000 12.00 1,40,000 17.50

Procedure of preparing common size income statement

Total net sales figure is taken as 100% and then each item appearing in the
income statement is taken as a percentage of sales. For example, in the above
illustration, sales of Rs. 10,00,000 in the year 2003 are taken as 100 per cent. Then
cost of sales is calculated as a percentage of sales as follows:

36
    ,,
× 100 = × 100 = 60%
 ,,

,,
Gross Profit as a % of sales = × 100 = 40%
,,

Calculations for other items of the years 2003 and 2004 are similarly made.
2.2.5 Trend Analysis
A trend percentage is a technique of studying financial statements of a company
over a number of years. Under this method, a representative year is selected as the
base year and the values of items in the base year are assumed to be 100. Then the
relationship of each item in the subsequent years is expressed as a percentage of the
same item in the base year. This means, when an item is expressed as 100, all other
values expressed in term of the base year will reflect in trend, upward or downward,
in relation to 100. Any year may be taken as the base but generally the starting or
initial year is taken as the base year.
Trend percentages may be used for both Balance Sheet and Profit and Loss
Account.
Advantages
1) Trend percentages analysis is of immense use in making a comparative analysis
over a series of years.
2) It is easy to identify changes and interpret the same because percentage figures
disclose more than the absolute figures.
Illustration: 5
Calculate the trend percentages from the following figures taking 1995 as the
base and interpret them:
Rs. in lakhs
Sales Stocks PBT
Year 1995 1,881 709 321
Year 1996 2,340 781 435
Year 1997 2,655 816 458
Year 1998 3,021 944 527
Year 1999 3,768 1,154 672

37
Solution
 
The formula for calculating the trend percentages = × 100
  
1995 has been taken as the base year
Year 1995 1996 1997 1998 1999
Sales 100 124.40 141.15 160.61 200.32
Stock 100 110.16 115.10 133.15 162.76
PBT 100 135.51 142.68 164.18 209.35
PBT = Profit Before Tax
Interpretation: Sales and profit are showing a rising trend thereby indicating a
smooth rate of growth of company over the years. It is important to note that while
both sales and profit are rising, rate of increase of PBT is more than the rate of
growth in sales. This means that quite a good part of the total cost is fixed in nature
because total cost is not increasing in proportion to sales. The stock is also showing a
rising trend. The company should review its production policy in coordination with
sales department so that unnecessary stocks are not built up.
Illustration: 6
From the following information, interpret the results of operations of a
manufacturing concern using Trend Ratios. Use 1995 as the base. (Amount in Rs.
lakhs for the year ended.)

Year 1995 1996 1997 1998

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

Solution
Year 1995 1996 1997 1998
Net sales 100.00 95.00 120.00 130.00
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

38
 Interpretation: The performance in the year 1996 was quite poor as compared
to the base year 1995 because of lower sales and profit. Sales have declined by 5%
but the net operating profit has come down by 12% i.e. from 100% to 88%.
Significant recovery was made in the year 1997 in respect of sales and profit. This
trend of recovery was continued in 1998. One important point to be noted is that rate
of change in net operating profit is more than rate of change in sales. For example
when sales decline by 5% in 1996, profit declines by 12%. Similarly when sales
increase in 1997 and 1998 by 20% and 30% respectively, net profit increase by 31 %
and 50% respectively. This means that a substantial portion of the cost of goods sold
and operating expenses are of fixed nature which do not change when there is a
change in sales.
Illustration: 7
From the following Profit & Account of Philips Co. Ltd. for the year ending 31st
Dec. 2003 and 2004 you are required to prepare a comparative Profit & Loss
Account and given your comments:
Profit & Loss Account
2003 2004 2003 2004
Particulars Particulars
Rs. Rs. Rs. Rs.
To Cost of goods sold 420 560 By Sales 600 720
To Administration 50 66 By Dividend received 30 90
expenses
To Selling and distribution 25 23
expenses
To Interest on debentures 12 12
To Loss on Sale of Plant 6 4
To Provision for income 40 48
tax
To Net Profit 77 97
630 810 630 810

39
Solution:
(Figures in Rs. Lakhs)
Increase or
2003 2004
Particulars Decrease
Rs. Rs. Rs. %
Sales 600 720 120 20.00
Less: Cost of goods Sold 420 560 140 33.33
Gross Profit (A) 180 160 (-)20 (-)11.11
Less: Operating expenses:
Administration expenses 50 66 16 32.00
Selling & distribution expenses 25 23 (-)2 (-)8.00
Total operating expenses (B) 75 89 +14 +18.67
Operating Profit (A- B) 105 71 (-)34 (-)32.38
Add: Dividend received 30 90 +60 200.00
Total income (C) 135 161 +26 19.26
Less: Other expenses:
Interest on debentures 12 12 - -
Loss on sale of plant 6 4 (-)2 (-)33.33
Total other expenses (D) 18 16 (-)2 (-)11.11
Income before tax (C-D) 117 145 28 23.93
Less: Provision for tax 40 48 8 12.00
Income after Tax 77 97 20 25.97
Comments
1. Increase in sales is 20% in 2004 while the cost of goods sold has increased by
33.33% resulting in a fall in gross profit by 11.11 %. As the increase in cost is
more than the increase in sales, it is a matter of concern for the management of
the company
2. Administration expenses have gone up by 32%-which is not justified because of
falling profitability. The management should look into this matter.
3. There is a 32.38% fall in operating profit whereas the fall in net profit before tax
is lower at 23.93%. This is because non-operating income (dividend) has
increased substantially by 200%

40
Illustration: 8
Prepare comparative balance sheets from the Balance sheet given.

2002 2003 2002 2003

Liabilities Assets
Rs. Rs. Rs. Rs.
Equity Share Capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
Redeemable Pref. Capital 1,50,000 1,00,000 Land and Building 2,00,000 1,70,000
General Reserve 40,000 70,000 Plant 80,000 2,00,000
Profit and Loss Account 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed Dividend 42,000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 Bills Receivable 20,000 30,000
Bills Payable 20,000 16,000 Cash in Hand 15,000 10,000
Provision for Taxation 40,000 50,000 Cash at Bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000

Comparative Balance Sheets

Increase Increase
or or
2002 Rs. 2003 Rs.
Decrease Decrease
Rs. %
Assets
Goodwill 1,15,000 90,000 (-)25,000 (-)21.74
Land and building 2,00,000 1,70,000 (-)30,000 (-)15.00
Plant 80,000 2,00,000 1,20,000 150.00
Debtors 1,60,000 2,00,000 40,000 25.00
Stock 77,000 9,000 32,000 41.56
Bills Receivable 20,000 30,000 10,000 50.00
Cash in hand 15,000 10,000 (-)5,000 (-)33.33
Cash at bank 10,000 8,000 (-)2,000 (-)20.00
6,77,000 8,17,000 1,40,000 20,68
Liabilities
Equity share capital 3,00,000 4,00,000 1,00,000 33.33
Redeemable pref. capital 1,50,000 1,00,000 (-)50,000 (-)33.33

41
 Grand reserve 40,000 70,000 30,000 75.00
Profit and loss account 30,000 48,000 18,000 60.00
Proposed dividend 42,000 50,000 8,000 19.05
Creditors 55,000 83,000 28,000 50.91
Bill payable 20,000 16,000 (-)4,000 (-)20.00
Provision for taxation 40,000 50,000 . 10,000 25.00
6,77,000 8,17,000 1,40,000 20.68
Illustration: 9
With the help of Balance-sheet given in the above problem prepare Common
Size Balance Sheet.
Solution:
2002 2003
Rs. % of Total Rs. % of Total
Assets:
Goodwill 1,15,000 16.99 90,000 11.02
Land and Building 2,00,000 29.54 1,70,000 20.81
Plant 80,000 11.82 2,00,000 24.48
Debtors 1,60,000 23.63 2,00,000 24.48
Stocks 77,000 11.38 1,09,000 13.34
Bills Receivables 20,000 2.95 30,000 3.67
Cash in hand 15,000 2.21 10,000 1.22
Cash at bank 10,000 1.48 8,000 0.98
6,77,000 100 8,17,000 100
Liabilities
Equity share capital 3,00,000 44.32 4,00,000 48.96
Redeveable Prof. Capital 1,50,000 22.16 1,00,000 12.24
Grand resorce 40,000 5.91 70,000 8.57
Profit and loss account 30,000 4.43 48,000 5.87
Proposed dividend 42,000 6.20 50,000 6.12
Creditors 55,000 8.12 83,000 10.16
Bills payable 20,000 2.95 16,000 1.96
Provision for taxation 40,000 5.91 50,000 6.12
6,77,000 100 8,17,000 100

42
Illustration: 10
Prepare Common Size Balance Sheets of A Ltd. and B Ltd. as on 31st March
2004 from the following balance sheets of the two companies
A Ltd. BLtd. ALtd. BLtd.
Liabilities Assets
Rs. Rs Rs. Rs.
Equity Share
4,80,000 7,20,000 Investments 43,200 -
Capital
Preference Share Discount on
2,60,000 1,20,000 1,20,000 96,000
Capital issue of shares
Factory
General Reserve 48,000 72,000 2,00,000 1,20,000
Building
Profit and Loss
- 64,800 Machinery 2,16,000 4,58,400
A/c
Current
Fixed Deposits 24,000 84,000
liabilities:
Proposed Preliminary
67,200 93,600 24,000 16,800
dividend expenses
Sundry creditors 70,000 1,00,000 Current assets:
Bills payable 17,200 27,200 Sundry debtors 1,80,000 2,59,200
Outstanding
39,200 14,400 Stock 2,04,000 1,87,200
salary
Provision for
67,200 76,800 Bank 30,600 50,000
taxation
Cash 7,000 17,200
10,48,800 12,88,800 10,48,800 12,88,800

Solution:
Common Size Balance Sheets
for the year ending 31-3-2004
A Ltd. B Ltd
Rs. % of total Rs. % of total
Fixed Assets:
Investments 43,200 4.12 - -
Discount on issue of shares 1,20,000 11.44 96,000 7.45
Building 2,00,000 19.07 1,20,000 9.31
-Machinery 2,16,000 20.59 4,58,400 35.57
Fixed deposits 24,000 2.29 84,000 6.52

43
 Prel. expenses 24,000 2.29 16,800 1.30
Total Fixed Assets 6,27,200 59.80 7,75,200 60.15
Current Assets:
Sundry debtors 1,80,000 17.16 2,59,200 20.11
Stocks 2,04,000 19.45 1,87,200 14.53
Bank 30,600 2.92 50,000 3.88
Cash 7,000 0.67 17,200 1.33
Total current Assets 4,21,600 40.20 5,13,600 39.85·
Total Assets (Fixed + Current) 10,48,800 100.00 12,88,800 100.00
Capital and Reserves:
Equity capital 4,80,000 45.77 7,20,000 55.86
Pref. share capital 2,60,000 24.79 1,20,000 9.31
General reserves 48,000 ·4.57 72,000 5.59
Profit and loss account - - 64,800 5.03·
Total capital and reserves 7,88,000 75.13- 9,76,800 75.79
Current Liabilities:
Proposed dividend 67,200 6.41 93,600 7.26
Sundry creditors 70,000 6.67 1,00,000 7.76
Bills payable 17,200 1.64 27,200 2.11
Outstanding salaries 39,200 3.74 14,400 1.12
Provision for taxation 67,200 6.41 76,800 5.96
Total current Liabilities 2,60,800 24.87 3,12,000 24.21
Total Capital and Liabilities 10,48,800 100 12,88,800 100
2.2.6 Ratio Analysis
The analysis of the financial statements and interpretations of financial results of
a particular period of operations with the help of 'ratio' is termed as "ratio analysis."
Ratio analysis used to determine the financial soundness of a business concern.
Alexander Wall designed a system of ratio analysis and presented it in useful form in
the year 1909.
Meaning and Definition
The term 'ratio' refers to the mathematical relationship between any two inter-
related variables. In other words, it establishes relationship between two items
expressed in quantitative form.

44
 According J. Batty, Ratio can be defined as "the term accounting ratio is used to
describe significant relationships which exist between figures shown in a balance
sheet and profit and loss account in a budgetary control system or any other part of
the accounting management."
Ratio can be used in the form of (1) percentage (20%) (2) Quotient (say 10) and
(3) Rates. In other words, it can be expressed as a to b; a: b (a is to b) or as a simple
fraction, integer and decimal. A ratio is calculated by dividing one item or figure by
another item or figure.
Interpretation of Ratios :
Ratios may be interpreted in the following four different ways :
(a) Interpretation or Analysis of an Individual (or) Single ratio.
(b) Interpretation or Analysis by referring to a group of ratios.
(c) Interpretation or Analysis of ratios by trend.
(d) Interpretations or Analysis by inter-firm comparison.
Principles of Ratio Selection
The following principles should be considered before selecting the ratio:
(1) Ratio should be logically inter-related.
(2) Pseudo ratios should be avoided.
(3) Ratio must measure a material factor of business.
(4) Cost of obtaining information should be borne in mind.
(5) Ratio should be in minimum numbers.
(6) Ratio should be facilities comparable.
2.2.7 Advantages of Ratio Analysis
Ratio analysis is necessary to establish the relationship between two accounting
figures to highlight the significant information to the management or users who can
analyse the business situation and to monitor their performance in a meaningful way.
The following are the advantages of ratio analysis:
(1) It facilitates the accounting information to be summarized and simplified in a
required form.

45
(2) It highlights the inter-relationship between the facts and figures of various
segments of business.
(3) Ratio analysis helps to remove all type of wastages and inefficiencies.
(4) It provides necessary information to the management to take prompt decision
relating to business.
(5) It helps to the management for effectively discharge its functions such as
planning, organizing, controlling, directing and forecasting.
(6) Ratio analysis reveals profitable and unprofitable activities. Thus, the
management is able to concentrate on unprofitable activities and consider
improving the efficiency.
(7) Ratio analysis is used as a measuring rod for effective control of performance of
business activities.
(8) Ratios are an effective means of communication and informing about financial
soundness made by the business concern to the proprietors, investors, creditors
and other parties.
(9) Ratio analysis is an effective tool which is used for measuring the operating
results of the enterprises.
(10) It facilitates control over the operation as well as resources of the business.
(11) Effective co-operation can be achieved through ratio analysis.
(12) Ratio analysis provides all assistance to the management to fix responsibilities.
(13) Ratio analysis helps to determine the performance of liquidity, profitability and
solvency position of the business concern.
2.2.8 Limitations of Ratio Analysis
Ratio analysis is one of the important techniques of determining the
performance of financial strength and weakness of a firm. Though ratio analysis is
relevant and useful technique for the business concern, the analysis is based on the
information available in the financial statements. There are some situations, where
ratios are misused; it may lead the management to wrong direction. The ratio
analysis suffers from the following limitations:

46
1) Ratio analysis is used on the basis of financial statements. Number of limitations
of financial statements may affect the accuracy or quality of ratio analysis.
2) Ratio analysis heavily depends on quantitative facts and figures and it ignores
qualitative data. Therefore this may limit accuracy.
3) Ratio analysis is a poor measure of a firm's performance due to lack of adequate
standards laid for ideal ratios.
4) It is not a substitute for analysis of financial statements. It is merely used as a
tool for measuring the performance of business activities.
5) Ratio analysis clearly has some latitude for window dressing.
6) It makes comparison of ratios between companies which is questionable due to
differences in methods of accounting operation and financing.
7) Ratio analysis does not consider the change in price level, as such; these ratios
will not help in drawing meaningful inferences.
2.2.9 Classification of Ratios
Accounting Ratios are classified on the basis of the different parties interested in
making use of the ratios. A very large number of accounting ratios are used for the
purpose of determining the financial position of a concern for different purposes.
Ratios may be broadly classified:
(1) On the basis of Balance Sheet.
(2) On the basis of Profit and Loss Account.
(3) On the basis of Mixed Statement (or) Balance Sheet and Profit and Loss
Account.
This classification further grouped in to:
I. Liquidity Ratios
II. Profitability Ratios
III. Turnover Ratios
IV. Solvency Ratios
V. Overall Profitability Ratios

47
Classifications of Ratios can be explained as under:
1. On the basis of Balance Sheet: Balance sheet ratios which establish the
relationship between two balance sheet items. For example Current Ratio, Fixed
Asset Ratio, Capital Gearing Ratio and Liquidity Ratio etc.
2. On the basis of Income Statements: These ratios deal with the relationship
between two items or two group of items of the income statement or profit and
loss account. For example Gross Profit Ratio, Operating Ratio, Operating Profit
Ratio, and Net Profit Ratio etc.
3. On the basis of Mixed Statements: These ratios also known as Composite or
Mixed Ratios or Inter Statement Ratios. The inter statement ratios which deal
with relationship between the item of profit and loss account and item of balance
sheet. For example, Return on Investment Ratio, Net Profit to Total Asset Ratio,
Creditor's Turnover Ratio, Earning per Share Ratio and Price Earnings Ratio etc.
Classification of ratios by statement is given below showing clearly the types of
ratios may be broadly classified on the basis of Income Statement and Balance Sheet.
Classification of Ratios by Statement
On the Basis of
On the Basis of B/S On the Basis of P & L
P&L and B/S
1. Current Ratio 1. Gross Profit Ratio 1. Stock Turnover Ratio
2. Liquid Ratio 2. Operating Ratio 2. Debtors Turnover Ratio
3. Absolute Liquid Ratio 3. Operating Profit Ratio 3. Payable Turnover Ratio
4. Debt Equity Ratio 4. Net Profit Ratio 4. Fixed Asset Turnover
5. Proprietary Ratio 5. Expense Ratio Ratio
6. Capital Gearing Ratio 6. Interest Coverage 5. Return on Equity
7. Assets-Proprietorship Ratio 6. Return on
Ratio Shareholder's Fund
8. Capital Inventory to – 7. Return on Capital
Working Capital Ratio Employed
9. Ratio of Current Assets 8. Capital Turnover Ratio
to Fixed Assets 9. Working Capital
Turnover Ratio
10. Return on Total
Resources
11. Total Assets Turnover

48
A) LIQUIDITY RATIOS
(Short Term Solvency)
'Liquidity' means ability of a firm to meet its current obligations. The liquidity
ratios, therefore, try to establish a relationship between current liabilities, which are
the obligations soon becoming due and current assets, which presumably provide the
source from which these obligations will be met. In other words, the liquidity ratios
answer the question: "Will the company probably be able to meet its obligations
when they become due?" The failure of a company to meet its obligations when they
become due to lack of adequate liquidity will result in bad credit ratings, loss of
creditor’s confidence or even in law suits against the company. The following ratios
are commonly used to indicate the liquidity of business.
A.1 Current Ratio (Working Capital Ratio)
This ratio is most commonly used to perform the short-term financial analysis.
Also known as the working capital ratio, this ratio matches the current assets of the
firm to its current liabilities. In order to compute this ratio, the following formula is
used:
 ! "##!#
Current Ratio =
 ! $%&'%(%!%#
Meaning of Current Assets: Current assets include: (a) Cash in hand and at
bank; (b) Readily marketable securities, (c) Bill Receivable, (d) Debtors less
provision for bad and doubtful debts, (e) Stock in trade, (f) Prepaid expenses, (g)
Any other asset which, in the normal course of business, will be converted in cash in
a year's time.
Meaning of Current Liabilities: These include all obligations maturing within
a year, such as :
(a) Sundry Creditors (b) Bills Payable (c) Bank Overdraft (d) Income Tax Payable
(e) Dividends Payable (f) Outstanding expenses (g) Provision for taxation (h)
Unclaimed dividends.
Significance: Current ratio throws good light on the short-term financial
position and policy. It is an indicator of a firm's ability to promptly meet its short-
term liabilities. A relatively high current ratio indicates that the firm is liquid and has

49
the ability to meet its current liabilities. On the other hand, a relatively low current
ratio indicates that the firm will find it difficult to pay its bills.
Normally a current ratio of 2: 1 is considered satisfactory. In other words,
current assets should be twice the amount of current liabilities. If the current ratio is
1: 1, it means that funds yielded by current assets are just sufficient to pay the
amounts due to various creditors and there will be nothing left to meet the expenses
which are being currently incurred. Thus the ratio should always be more than 1: 1.
A very high current ratio is also not desirable because it indicates idleness of funds
which is not a sign of efficient financial management.
Illustration
The following is the Balance Sheet of India Manufacturing Co. Ltd, as on 31st
Dec. 2012:
Liabilities Rs. Assets Rs.
Equity Capital 48,000 Plant and Machinery 90,000
Profit and Loss Ne 12,000 Sundry Creditors 18,000
Debentures 30,000 Stock 24,000
Sundry Creditors 46,800 Cash at Bank 4,560
Taxation Provision 1,200 Prepaid Insurance 1,440
1,38,000 1,38,000
From the above data, current ratio is calcuated as under:
 )  48,000
Current Assets = = 48,000 = 1:1
 *+,++ +

Current Assets = Sundry Debtors + Stock + Cash + Prepaid insurance

= 18,000 + 24,000 + 4,560 + 1,440 = Rs. 48,000
Current Laibilities = Sundry Creditors + Taxation Provision
= 46,800 + 1,200 = Rs. 48,000
A.2 Quick Ratio / Liquid Ratio
This ratio is also known as acid test ratio or liquid ratio. It is a more severe test
of liquidity of a company. It shows the ability of a business to meet its immediate
financial commitments. It is used to supplement the information given by the current
ratio.
50
 *+1+ ) 
=
*+1+ *+,++ +

*+1+ ) 
(  )  3  4  56+ 786  )
Liquid Ratio = *+1+ *+,++ +
(  *+,++ + 34 :; )

Quick Ratio can be calculated by two basic components of quick assets and
current liabilities.
Quick Assets = Current Assets – (Inventories + Prepaid expenses)
Current liabilities represent those liabilities which are payable within a year.
The ideal Quick Ratio of 1:1 is considered to be satisfactory. High Acid Test
Ratio is an indication that the firm has relatively better position to meet its current
obligation in time. On the other hand, a low value of quick ratio exhibiting that the
firm's liquidity position is not good.
Advantages
(1) Quick Ratio helps to measure the liquidity position of a firm.
(2) It is used as a supplementary to the current ratio.
(3) It is used to remove inherent defects of current ratio.
Illustration
Calculate Quick Ratio from the information given below:
Current Assets 4,00,000
Current Liabilities 2,00,000
Inventories (Stock) 25,000
Prepaid Expenses 25,000
Land and Building 4,00,000
Share Capital 3,00,000
Good will 2,00,000

51
Solution:
<+4 ) 
Quick Ratio =
 *+,++ +
 )  3(=; + >56+ 786  )
=
 *+,++ +
? .
,,3( ,> ,)
=
? .,,
? .
,,3 ,
=
? .,,
? . A, ,
=
? .,,

= 1.75 (or) 1.75 : 1

Illustration
The following is the Balance Sheet of Bharat Electronics Co. as on 30th June
2013.
Liabilities Rs. Assets Rs.
Equity Capital 3,00,000 Land and Building 1,50,000
Sundry Creditors 48,000 Plant and Machinery 85,000
Bills Payable 10,000 Short term Investments 16,000
Bank Overdraft 5,000 Stock in trade 50,000
Outstanding expenses 2,000 Debtors 59,000
Prepaid expenses 1,000
Cash in hand 4,000
3,65,000 3,65,000
Calculate the following ratios:
(i) Current ratio,
(ii) Quick ratio.
What conclusions do you draw about the company on the basis of these ratios?

52
Solution:
 )  =; C > 4>D,  >56+ 786.>  E
Current Ratio = = .
 *+,++ B .>: + 86.>+ 5B,>4 :;

,> ,> F,>,>
,

=

,>,>,> ,
,A,
Current Ratio = = 2:1
 ,

Comments. The current ratio of 2:1 as calculated above shows that short term
liquidity position of the company is quite satisfactory.
<+4 )  =; C >D, >  E
Quick Ratio = =
<+4 *+,++ + .  .>: + 786.>+ 5B,
,> F,>
, GF,
= = = 1.32 : 1

,>,>, ,

Comments. The liquid or quick ratio of 1.32 : 1 is more than satisfactory. It may
therefore be said that short term liquidity of the company is very sound.
Illustration
The following ascertain Liquid Assets & Current Liabilities.
Current Ratio 3 : 1, Quick Ratio 1: 1, Current Assets are Rs. 180000/-.
Solution:
 ) 
Current ratio =
 *+,++ +
,,
3 =
 *+,++ +
,,
Current Liabilities = = Rs. 60,000
A
<+4 ) 
Quick ratio =
 *+,++ +
 ) 
1 =
,

Quick Assets = Rs. 60,000.

53
Illustration
Suyog Ltd. has a current ratio of 4.5: 1 and a quick ratio of 3: 1. If its inventory
is Rs, 60,000, find out its total current assets and total current liabilities.
Solution:
Current Ratio: 4.5:1
Quick ratio: 3:1
Difference between current assets and Quick assets is stock (or inventory)
Thus 60,000 = Current Assets – Quick Assets
60,000 = 4.5 – 3
60,000 = 1.5
, ×
.
Current Assets = = Rs. 1,80,000
.
, × 
Current Liabilities = = Rs. 40,000
.
, × A
Quick Assets = = Rs. 1,20,000
.

Illustration
Yogesh Ltd has a current ratio of 3: 1 and quick ratio of 1:1. It’s current
liabilities are Rs. 1,50,000. Find out the value of stock in trade.
Stock in trade = Current Assets – Quick Assets.
 ) 
Current ratio = =3
 *+,++ +
Thus current assets = current liabilities x 3
Current assets = 1,50,000 x 3 = Rs. 4,50,000
 ) 
Quick ratio = =1
 *+,++ +

Quick Assets = Rs. 1,50,000

Stock in trade = Current Assets – Quick Assets
= 4,50,000 – 1,50,000 = Rs. 3,00,000

54
Illustration
A firm has a current ratio of 3: 1. Its net working capital is Rs. 2, 00,000. You
are required to determine (i) current assets, (ii) current liabilities, and (iii) liquid
assets assuming inventory of Rs. 2, 20,000.
Solution:
Working Capital = Current Assets – Current Liabilities
 ) 
Current ratio = =3:1
 *+,++ +

Suppose Current Liabilities = x, then current assets = 3x

Thus 2,00,000 = 3x – x
2,00,000 = 2x
x = Rs. 1,00,000 i.e. Current Liabilities
3x = Rs. 3,00,000 i.e. Current Assets
Liquid Assets = Current Assets – Stock
= 3,00,000 – 2,20,000 = Rs. 80,000.
Illustration
Sony Ltd. has a quick ratio of 3: 1 and current liabilities of Rs. 1,00,000. Stock
in trade is Rs. 50,000. Find out its current assets and current ratio.
Solution :
<+4 )  A
Quick ratio = =
 *+,++ + 

Thus Quick Assets = Current liabilities x 3

= Rs. 1,00,000 x 3 = Rs. 3,00,000
Current Assets = Quick Assets + Stock
= 3,00,000 + 50,000 = Rs. 3,50,00
 )  A, ,
Current Ratio = = = 3.5 :1
 *+,++ + ,,

55
A.3) Absolute Liquid Ratio
Absolute Liquid Ratio is also called as Cash Position Ratio (or) Over Due
Liability Ratio. This ratio established the relationship between the absolute liquid
assets and current liabilities. Absolute Liquid Assets include cash in hand, cash at
bank, and marketable securities or temporary investments. The optimum value for
this ratio should be one, i.e., 1: 2. It indicates that 50% worth absolute liquid assets
are considered adequate to pay the 100% worth current liabilities in time. If the ratio
is relatively lower than one, it represents that the company's day-to-day cash
management is poor. If the ratio is considerably more than one, the absolute liquid
ratio represents enough funds in the form of cash to meet its short-term obligations in
time. The Absolute Liquid ratios can be calculated by dividing the total of the
Absolute Liquid Assets by Total Current Liabilities. Thus,
),   *+1+ ) 
Absolute Liquid Ratio =
 *+,++ +

Illustration
Liabilities Rs. Assets Rs.
Bills Payable 30,000 Goodwill 2,00,000
Sundry Creditors 20,000 Land and Building 2,00,000
Share Capital 1,0,000 Inventories 50,000
Debenture 2,00,000 Cash in Hand 30,000
Bank Overdraft 25,000 Cash at Bank 20,000
Sundry Debtors 50,000
Bills Payable 75,000
Marketable Securities 10,000

Solution :
),   *+1+ ) 
Absolute Liquid Ratio =
 *+,++ +
Absolute Liquid Assets = Cash in Hand + Cash at Bank +
Marketable Securities
= Rs. 30,000 + 20,000 + 10,000
= Rs. 60,000

56
 Current Liabilities = Rs. 30,000 + 20,000 + 25,000
= Rs. 75,000
,
Absolute Liquid Ratio =
G ,

= 0.8
The ratio of 0.8 is quite satisfactory because, it is much higher than the optimum
value of 50%.
Illustration
You are given the following information:
Cash in Hand Rs. 10,000
Cash at Bank Rs. 15,000
Sundry Debtors Rs.75,000
Stock Rs. 60,000
Bills Payable Rs. 25,000
Bills Receivable Rs.30,000
Sundry Creditors Rs.40,000
Outstanding Expenses Rs.20,000
Prepaid Expenses Rs.10,000
Dividend Payable Rs.15,000
Land & Building Rs. 2,00,000
Goodwill Rs. 1,00,000
Calculate: (a) Current Ratio (b) Liquid Ratio (c) Absolute Liquidity Ratio
Solution :
 ) 
a) Current Ratio =
 *+,++ +
Current Assets Rs.
Cash in Hand 10,000
Cash in Bank 15,000
Sundry Debtors 75,000
Stock 60,000

57
 Bills Receivable 30,000
Prepaid Expenses 10,000
Total Current Assets Rs. 2,00,000
Current Liabilities: Rs.
Bills Payable 25,000
Sundry Creditors 40,000
Outstanding Expenses 20,000
Dividend Payable 15,000
Total Current Liabilities 1,00,000
? .,,
Current Ratio =
? .,,

= 2 times (or) 2:1

*+1+ ) 
b) Liquid Ratio =
 *+,++ +
Liquid Assets = Current Assets – (Stock and Prepaid Expenses)
= Rs. 2,00,000 – (60,000 + 10,000)
= Rs. 2,00,000 – 70,000
= Rs. 1,30,000
,A,
Liquid Ratio = = 1.3 times (or) 1:3:1
,,
),   *+1+ ) 
c) Absolute Liquid Ratio =
 *+,++ +

Absolute Liquid Assets = Cash in hand + Cash at Bank

+ Marketable Securities
= Rs. 10,000 + 15,000 + Nil
= Rs. 25,000
 ,
Absolute Liquid Ratio =
,,

= 0.25

58
B) CAPITAL STRUCTURE RATIOS/SOLVENCY RATIOS
Capital structure Ratios are also known as gearing ratios or solvency ratios or
leverage ratios. The term 'Solvency' generally refers to the capacity of the business to
meet its short-term and long term obligations. Short-term obligations include
creditors, bank loans and bills payable etc. Long-term obligations consist of
debenture, long-term loans and long-term creditors etc. Solvency Ratio indicates the
sound financial position of a concern to carry on its business smoothly and meet its
all obligations. Liquidity Ratios and Turnover Ratios concentrate on evaluating the
short-term solvency of the concern have already been explained. Now under this part
of the chapter only the long-term solvency ratios are dealt with. Some of the
important ratios which are given below in order to determine the solvency of the
concern:
(1) Debt - Equity Ratio
(2) Proprietary Ratio
(3) Capital Gearing Ratio
(4) Debt Service Ratio or Interest Coverage Ratio
B.1) Debt Equity Ratio
This ratio also termed as External - Internal Equity Ratio. This ratio is calculated
to ascertain the firm's obligations to creditors in relation to funds invested by the
owners. The ideal Debt Equity Ratio is 1: 1. This ratio also indicates all external
liabilities to owner recorded claims. It may be calculated as
78  71+ +
a) Debt – Equity Ratio =
=  71+ +

(or)
: + H
b) Debt – Equity Ratio =
EE  H
The term External Equities refers to total outside liabilities and the term Internal
Equities refers to all claims of preference shareholders and equity shareholders' and
reserve and surpluses.
I  * 3IC D,
c) Debt – Equity Ratio =
I  * 3IC H

59
 (or)
I  * 3IC D,
d) Debt-Equity Ratio =
EE  H
The term Total Long-Term Debt refers to outside debt including debenture and
long-term loans raised from banks.
Illustration
From the following figures calculate Debt Equity Ratio:
Preference Share Capital 1,50,000
Equity Share Capital 5,50,000
Capital Reserve 2,00,000
Profit and Loss Account 1,00,000
6% Debenture 2,50,000
Sundry Creditors 1,20,000
Bills Payable 60,000
Provision for taxation 90,000
Outstanding Creditors 80,000

Solution:
78  71+ +
a) Debt Equity Ratio =
=  71+ +

External Equities = Debenture + Sundry Creditors + Bills Payable

+ Provision for taxation + Outstanding Creditors
= Rs. 2,50,000 + 1,20,000 + 60,000 + 90,000 + 80,000
= Rs. 6,00,000
Internal Equities = Preference Share Capital + Equity Share Capital
+ Capital Reserve + Profit and Loss A/c
= Rs. 1,50,000 + 5,50,000 + 2,00,000 + 1,00,000
= Rs. 10,00,000
,,
Debt Equity Ratio = = 0.6 (or 3:5)
,,

60
 I  * 3IC D,
b) Dept Equity Ratio =
EE  H

Total Long-Term Debt = Rs. 2,50,000

Shareholders Fund = Rs. 10,00,000
? ., ,
Debt- Equity Ratio =
? .,,

= 0.25
: + H
d) Debt Equity Ratio =
EE  H
Outsiders Fund = Total Outside Liabilities
= Rs. 6,00,000
,,
Debt Equity Ratio =
,,

= 0.6 (or) 3:5

Significance: This ratio indicates the proportion of owner's stake in the
business. Excessive liabilities tend to cause insolvency. This ratio also tell the extent
to which the firm depends upon outsiders for its existence.
B.2) Proprietary Ratio
Proprietary Ratio is also known as Capital Ratio or Net Worth to Total Asset
Ratio. This is one of the variant of Debt-Equity Ratio. The term proprietary fund is
called Net Worth. This ratio shows the relationship between shareholders' fund and
total assets. It may be calculated as :
EE  H
Proprietary Ratio =
I  ) 

Shareholders Fund = Preference Share Capital + Equity Share Capita

+ All Reserves and Surplus
Total Assets = Tangible Assets + Non-Tangible Assets
+ Current Assets (or) All Assets including Goodwill
Significance: This ratio used to determine the financial stability of the concern
in general. Proprietary Ratio indicates the share of owners in the total assets of the

61
company. It serves as an indicator to the creditors who can find out the proportion of
shareholders' funds in the total assets employed in the business. A higher proprietary
ratio indicates relatively little secure position in the event of solvency of a concern. A
lower ratio indicates greater risk to the creditors. A ratio below 0.5 is alarming for
the creditors.
Illustration
From the following information’s calculate the Proprietary Ratio:
Rs.
Preference Share Capital 2,00,000
Equity Share Capital 4,00,000
Capital Reserve 50,000
Profit and Loss Account 50,000
9% Debenture 2,00,000
Sundry Creditors 50,000
Bills Payable 50,000
Land and Building 2,00,000
Plant and Machinery 2,00,000
Goodwill 1,00,000
Investments 3,00,000

Solution:
EE  H
Proprietary Ratio =
I  ) 

Shareholders Funds = Preference Share Capital + Equity Share Capital

+ Capital Reserve + Profit And Loss Account
= Rs. 2,00,000 + 4,00,000 + 50,000 + 50,000
= Rs. 7,00,000
Total Assets = Land and Building + Plant and Machinery
+ Good will + Investment
= Rs. 2,00,000 + 2,00,000 + 1,00,000 + 3,00,000
= Rs. 8,00,000

62
 G,,
Proprietary Ratio =
,,

= 87.5% (or) 0.87

B.3) Capital Gearing Ratio
This ratio also called as Capitalization or Leverage Ratio. This is one of the
Solvency Ratios. The term capital gearing refers to describe the relationship between
fixed interest and/or fixed dividend bearing securities and the equity shareholders'
fund. It can be calculated as shown below:
71+ B E 6+ 
Capital Gearing Ratio =
H+8 =  + H

Equity Share Capital = Equity Share Capital + Reserves and Surplus

Fixed Interest Bearing Funds = Debentures + Preference Share Capital
+ Other Long-Term Laons
A high capital gearing ratio indicates a company is having large funds bearing
fixed interest and/or fixed dividend as compared to equity share capital. A low
capital gearing ratio represents preference share capital and other fixed interest
bearing loans are less than equity share capital.
Illustration
From the following information, you are required to find out Capital Gearing
Ratio
Rs.
Preference Share Capital 5,00,000
Equity Share Capital 6,00,000
Capital Reserve 3,00,000
Profit and Loss Account 1,00,000
12% Debenture 3,00,000
Secured loan 1,00,000

Solution:
71+ B E 6+ 
Capital Gearing Ratio =
H+8 =  + H

63
 Equity Share Capital = Equity Share Capital + Capital Reserve
+ Profit and Loss Account
= Rs. 6,00,000 + 3,00,000 +1,00,000
= Rs. 10,00,000
Fixed Interest Bearing Funds = Debenture + Preference Share Capital
+ Secured Loan
= Rs. 3,00,000 + 5,00,000 + 1,00,000
= Rs. 9,00,000
,,
Capital Gearing Ratio =
F,,

= 10:9 (Low Gear)

B.4) Debt Service Ratio
Debt Service Ratio is also termed as Interest Coverage Ratio or Fixed Charges
Cover Ratio. This ratio establishes the relationship between the amount of net profit
before deduction of interest and tax and the fixed interest charges. It is used as a
yardstick for the lenders to know the business concern will be able to pay its interest
periodically. Debt Service Ratio is calculated with the help of the following formula:
J 5 K+ ,  =   = C I8
Interest Coverage Ratio = × 100
H+8 =  E

Significance: Higher the ratio the more secure the debenture holders and other
lenders would be with respect to their periodical interest income. In other words,
better is the position of long-term creditors and the company's risk is lesser. A lower
ratio indicates that the company is not in a position to pay the interest but also to
repay the principal loan on time.
Illustration
Calculate Interest Coverage Ratio
Profit before Interest Rs. 7,00,000
Income Tax Paid Rs. 50,000
Interest On Debenture Rs. 3,00,000
Interest on Long-Term Loan Rs. 1,00,000

64
Solution:
J 5 K+ ,  =   = C I8
Interest Coverage Ratio = × 100
H+8 =  E

Net Profit before Interest and Taxes = Rs. 7,00,000 + 50,000

= Rs. 7,50,000
Fixed Interest Charges = Rs. 3,00,000 + 1,00,000
= Rs. 4,00,000
G, ,
Interest Coverage Ratio = × 100

,,

= 187.5% (or) 1.87 :1

A) TURNOVER RATIOS
Turnover Ratios may be also termed as Efficiency Ratios or Performance Ratios
or Activity Ratios. Turnover Ratios highlight the different aspect of financial
statement to satisfy the requirements of different parties interested in the business. It
also indicates the effectiveness with which different assets are vitalized in a business.
Turnover means the number of times assets are converted or turned over into sales.
The activity ratios indicate the rate at which different assets are turned over.
Depending upon the purpose, the following activities or turnover ratios can be
calculated:
1. Inventory Ratio or Stock Turnover Ratio (Stock Velocity)
2. Debtor's Turnover Ratio or Receivable Turnover Ratio (Debtor's Velocity)
Debtor's Collection Period Ratio
3. Creditor's Turnover Ratio or Payable Turnover Ratio (Creditor's Velocity)
Debt Payment Period Ratio
4. Working Capital Turnover Ratio
5. Fixed Assets Turnover Ratio
6. Capital Turnover Ratio.

65
C.1) Stock Turnover Ratio
This ratio is also called as Inventory Ratio or Stock Velocity Ratio. Inventory
means stock of raw materials, working in progress and finished goods. This ratio is
used to measure whether the investment in stock in trade is effectively utilized or not.
It reveals the relationship between sales and cost of goods sold or average inventory
at cost price or average inventory at selling price. Stock Turnover Ratio indicates the
number of times the stock has been turned over in business during a particular
period. While using this ratio, care must be taken regarding season and condition.
Price trend, supply condition etc. In order to compute this ratio, the following
formulae are used:
L   
1) Stock Turnover Ratio =
); =; B 

Cost of Goods Sold = Opening Stock + Purchase + Direct Expenses

– Closing Stock
(or)
= Total Cost of Production + Opening Stock of
Finished Goods – Closing Stock of Finished Goods
Total Cost of Production = Cost of Raw Material Consumed + Wages
+ Factory Cost
= (or)
= Sales – Gross Profit
:6+  4>  +  4
Average Stock =

J 
2) Stock Turnover Ratio =
); =; B 

J 
3) Stock Turnover Ratio =
); =; B  + 5+

J 
4) Stock Turnover Ratio =
=; B

The formulas given above can be used on the basis of the information given in
the illustration
66
Significance:
(1) This ratio indicates whether investment in stock in trade is efficiently used or
not.
(2) This ratio is widely used as a measure of investment in stock is within proper
limit or not.
(3) This ratio highlights the operational efficiency of the business concern.
(4) This ratio is helpful in evaluating the stock utilization.
(5) It measures the relationship between the sales and the stock in trade.
(6) This ratio indicates the number of times the inventories have been turned over in
business during a particular period.
Illustration
Opening Stock Rs. 29,000
Purchase Rs. 2,42,000
Sales Rs. 3,20,000
Gross Profit 25% of Sales

Calculate stock turnover ratio.

Solution:
In order to calculate this ratio, figure of closing stock is required which is not
given in the question. It is thus computed as follows by preparing Trading Account:
Rs. Rs.
To Opening Stock 29,000 By Sales 3,20,000
To Purchase 2,42,000 By Closing Stock 31,000
(Balancing Figure)
To Gross Profit (25% of 80,000
3,20,000)
3,51,000 3,51,000

67
Cost of goods sold = 3,20,000 – 80,000 = Rs. 2,40,000
OR = 29,000 + 2,42,000 – 31,000 =Rs. 2,40,000
L    ,
,
Average Stock = = = 8 times
);  4 A,

C.2) Debtors Turnover Ratio (Receivables Turnover Ratio)

This ratio indicates the relationship between net credit sales and trade debtors. It
shows the rate at which cash is generated by the turnover of debtors. It is computed
as follows :
The term debtors include trade debtors and bills receivables. Doubtful debts are
not deducted from debtors. Moreover, debtors that do not arise from regular sales
should be excluded, e.g. a bill receivable from buyer of an old plant and machinery
should be excluded.
J + 
1) Debtor's Tunnover Ratio =
); ?+;,

or
Average Account Receivable
Net Credit Sales = Total Sales – (Cash Sales + Sales Return)
Accounts Receivable = Sundry Debtors or Trade Debtros + Bills Receivable
:6+ ?+;,>  + ?+;,
Average Accounts Receivable =

It is to be noted that opeing and closing receivable and credit sales are not
available, the ratio may be calculated as
I  
Debtor's Turnover Ratio =
)  ?+;,
Significance: The significance of this ratio lies in the fact that debtors
constitute one of the important items of current assets and this ratio indicates as to
how many days' average sales are tied up in the amount of debtors. The efficiency of
debt collection is also indicated by this ratio. A higher debtor’s turnover ratio
indicates that debts are being collected more quickly. Changes in this ratio show the
changes in the company's credit policy or changes in its ability to collect from its

68
debtors. This ratio is an excellent supplement to the information provided by current
ratio.
Illustration
From the following information calculate debtors Turnover Ratio:
Total Sales for 2002 Rs. 5,00,000
Cash Sales for 2002 Rs. 1,00,000
Debtors on 1st Jan, 2002 Rs. 1,90,000
Debtors on 31st Dec, 2002 Rs. 2,10,000

Solution:
Credit sales are total sales minus cash sales.
+ 
,,
Debtors Turnover Ratio = = = 2 times
); D,  ,,

Average Debtors = 1/2(1,90,000 + 2,10,000) = Rs. 2,00,000

Average Collection Period. The debtors turnover ratio is usually supplemented
by average collection period. the debtors turnover ratio together with average
collection period involves the following steps:
a) Calculation of daily sales – This is computed as follows:
J  ( + )
Sales per day =
J .  M 4+ B +  B

b) Calculation of average collection period – This is calculated as follows:

DB + E B
Average Collection Period =
D,   ;  +
D, 
Or, Alternatively = × 365 days
 ( + )

Suppose – Credit sales for the year Rs. 5,40,000

Debtors at the end Rs. 90,000
D,  F,
Average collection Period = × 365 days = × 3656 = 61
+  ,
,
days.

69
 Thus debtors represent uncollected accounts in respect of 61 days of sales. In
this case, debtors turnover ratio is as follows:
,
,
Debtors Turnover Ratio = = 6 times
F,

Average collection period may also be calculated as follows:

DB + E B A
Average collection period = = = 61 days.
D,   ;  + 

C.3) Fixed Assets Turnover Ratio

This ratio indicates the efficiency with which the firm is utilising its investments
in fixed assets such as plant and machinery, land and building etc. It is computed as
under:
L   
Fixed Assets Turnover Ratio =
I  H+8 ) 

(or)

=
J H+8 ) 
The term net fixed assets means depreciated value of fixed assets.
Significance: Generally speaking, a high ratio indicates efficient utilisation of fixed
assets in generating sales and a low ratio may signify that the firm has an excessive
investment in fixed assets.
Significant Components of Fixed Assets (or) Non-Current Assets are as followes
1) Goodwill
2) Land and Building
3) Plant and Machinery
4) Furniture and Fittings
5) Trade Mark
6) Patent Rights and Livestock
7) Long-Term Investment
8) Debt Balance of Profit and Loss Account

70
9) Discount on Issue of Shares
10) Discount on Issue of Debenture
11) Preliminary Expenses
12) Other Deferred Expenses
14) Government or Trust Securities
15) Any other immovable Prosperity
Illustration
From the following figures calculate Fixed Assets Turnover Ratio.
Sales Rs. 10,00,000
Gross Profit 20% on sales
Fixed Assets (Gross) Rs. 2,50,000
Less Depreciation 50,000
Fixed Assets (Net) 2,00,000
Solution:
Cost of Sales = Sales less Gross Profit = 10,00,000 less 20% = Rs. 8,00,000
  ,,
Fixed Assets Turnover Ration = = = 4:1
J H+8 )  ,,

C.4) Working Capital Turnover Ratio

This ratio indicates the efficiency or inefficiency in the utilisation of working
capital in making sales. It is computed as follows:
J 
Working Capital Turnover Ratio =
N 4+ 6+ 

Net Sales = Gross Sales – Sales Return

Work Capital = Current Assets – Current Liabilities
The term net working capital means current assets minus current liabilities.
Significance: A high working capital turnover ratio shows the efficient utilisation of
working capital in generating sales. A low ratio, on the other hand, may indicate
excess of net working capital. This ratio thus shows whether working capital is
efficiently utilised or not. This ratio is considered better than Stock Turnover Ratio
71
because it shows the utilisation of the entire working capital whereas stock turnover
ratio indicates only the turnover of inventories which is only a part of the working
capital.
Illustration
Calculate Working Capital Turnover Ratio:
Current Assets Rs. 3,20,000
Current Liabilities Rs. 1,10,000
Gross Sales Rs. 4,00,000
Sales Return Rs. 20,000
Solution:
J 
Working Capital Turnover Ratio =
N 4+ 6+ 

Net Sales = Gross Sales – Sales Return

Working Capital = Rs. 4,00,000-20,000
Rs. 3,80,000
Working Capital = Current Assets – Current Liabilities
= Rs. 3,20,000 – 1,10,000
= Rs. 2,10,000
A,,
Working Capital Turnover Ratio =
,,

= 1.80 times
C.5) Capital Turnover Ratio
This ratio shows the relationship between cost of sales (or sales) and the total
capital employed.
Formula:
  
1) Capital Turnover Ratio = or
6+  7C6 B 6+  7C6B

Capital Employed = Shareholders Funds + Long- Term Loans

(or)
72
 = Total Assets – Current Liabilities
  
2) Capital Turnover Ratio = (or)
EE  H EE  H
The term capital employed includes the long term liabilities and total of
shareholders funds. From this are deducted non-operating assets (e.g., investments)
and fictitious assets like preliminary expenses, discount on the issue of shares, debits
balance of Profit and Loss Account, etc. Thus, Total Capital Employed = Equity
Capital + Pref. Capital + Reserves + Debentures + Long-term Loans - Fictitious
Assets - Non operating Investments.
It should be noted that capital employed as used in this ratio is computed in the
same way as used in Return on Investment (ROI) discussed in Profitability Ratios
later in this Chapter.
Illustration
From the following information find out (a) Cost of Sales (b) Capital Employed
and (c) Capital Turnover Ratio.
Rs.
Total Assets 10,00,000
Bills Payable 1,50,000
Sundry Creditors 75,000
Opening Stock 50,000
Purchases 3,00,000
Closing Stock 60,000
Solution:
a) Cost of Sales = Opening Stock + Purchases – Closing Stock
= Rs. 5,00,000 + 4,00,000 - 60,000
= Rs. 3,90,000
b) Capital Employed = Total Assets – Current Liabilities
= Rs. 10,00,000 – 2,25,000 = Rs. 7,75,000
 
c) Capital Turnover Ratio=
6+  7C6 B
A,F,
=
G,G ,

= 0.50 times
73
Illustration
Equity Share Capital Rs. 3,00,000
General Reserve Rs. 50,000
Preference Share Capital Rs. 2,00,000
Long-Term Loans Rs. 1,50,000
Profit and Loss Account (Credit Balance) Rs. 70,000
Total Sales Rs. 10,00,000
Gross Profit Rs. 80,000

Form the above information find out Capital Turnover Ratio

Solution:

Capital Turnover Ratio =
6+  7C6 B

Capital Employed = Shareholder Fund + Long-Term Loans

= Equity Share Capital + General Reserve
+ Preference Share Capital + Long-Term Loans
+ Credit Balance of P & L A/c
= Rs. 3,00,000 + 50,000 + 2,00,000
+ 1,50,000 + 70,000
= Rs. 7,70,000
,,
Capital Turnover Ratio =
G,G,

= 1.29 times
Alternatively
 
Capital Turnover Ratio =
6+  7C6 B

Cost of Sales = Sales – Gross Profit

= Rs. 10,00,000 – Rs. 80,000
= Rs. 9,20,000

74
 F,,
Capital Turnover Ratio =
G,G,

= 1.19 times
C.6) Creditor's Turnover Ratio:
Creditor's Turnover Ratio is also called as Payable Turnover Ratio or Creditor's
Velocity. The credit purchases are recorded in the accounts of the buying companies
as Creditors to Accounts Payable. The Term Accounts Payable or Trade Creditors
include sundry creditors and bills payable. This ratio establishes the relationship
between the net credit purchases and the average trade creditors. Creditor's velocity
ratio indicates the number of times with which the payment is made to the supplier in
respect of credit purchases. Two kinds of ratios can be used for measuring the
efficiency of payable of a business concern relating to credit purchases. They are: (1)
Creditor's Turnover Ratio (2) Creditor's Payment Period or Average Payment Period.
The ratios can be calculated by the following formulas:
J + 5E 
1) Creditors Turnover Ratio =
); )  5B,

Net Credit Purchases = Total Purchases – Cash Purchases

:6+ 5B,>  + 5B,
Average Accounts Payable =

O  E ( )DB +  B
2) Average Payment Period =
+  I ; ? +

(or)
); I + 
= × 365
J + 5E 
Significance: A high Creditor's Turnover Ratio signifies that the creditors are being
paid promptly. A lower ratio indicates that the payments to creditors are not paid in
time. Also, high average payment period highlight the unusual delay in payment and
it affect the creditworthiness of the firm. A low average payment period indicates
enhancing the creditworthiness of the company.
Illustration
From the following information calculate (1) Creditors Turnover Ratio and (2)
Average Payment Period

75
 Rs.
Total Purchases 3,00,000
Cash Purchases 1,75,000
Purchases Return 25,000
Sundry Creditors 1.1.2003 30,000
Sundry Creditors 31.12.2003 15,000
Bills Payable 1.1.2003 7,000
Bills Payable 31.12.2003 8,000

Solution:
J + 5E 
1) Creditor's Turnover Ratio =
); )  5B,

= Total Purchase–(Cash Purchases +Purchase Return)

= Rs. 3,00,000 –(1,75,000+25,000)
= Rs. 1,00,000
:6+ 6B,>  + 6B,
Average Accounts Payable =

(A,>G,)>  ,>)
=

,
= = Rs. 30,000

,,
Creditors Turnover Ratio = = 3.33 times
A,
O  E  DB +  B
2) Average Payment Period =
+  I ; ? +
 C  E
= = 3.60 months
A.AA

(or)
A B
= = 109.61 days
A.AA

76
B) PROFITABLITY RATIOS
The term profitability means the profit earning capacity of any business activity.
Thus, profit earning may be judged on the volume of profit margin of any activity
and is calculated by subtracting costs from the total revenue accruing to a firm during
a particular period. Profitability Ratio is used to measure the overall efficiency or
performance of a business. Generally, a large number of ratios can also be used for
determining the profitability as the same is related to sales or investments.
The following important profitability ratios are discussed below:
1. Gross Profit Ratio.
2. Operating Ratio.
3. Operating Profit Ratio.
4. Net Profit Ratio.
5. Return on Investment Ratio.
6. Return on Capital Employed Ratio.
7. Earnings Per Share Ratio.
8. Dividend Payout Ratio.
9. Dividend Yield Ratio.
10. Price Earnings Ratio.
11. Net Profit to Net Worth Ratio.
D.1) Gross Profit Ratio.
Gross Profit Ratio established the relationship between gross profit and net
sales. This ratio is calculated by dividing the Gross Profit by Sales. It is usually
indicated as percentage.
L 5 K+
Gross Profit Ratio = × 100
J 

Gross Profit = Sales – Cost of Goods Sold

Net Sales = Gross Sales – Sales Return (or) Return Inwards

77
 Higher Gross Profit Ratio is an indication that the firm has higher profitability.
It also reflects the effective standard of performance of firm's business.
Higher Gross Profit Ratio will be result of the following factors.
(1) Increase in selling price, i.e., sales higher than cost of goods sold.
(2) Decrease in cost of goods sold with selling price remaining constant.
(3) Increase in selling price without any corresponding proportionate increase
in cost.
(4) Increase in the sales mix.
A low gross profit ratio generally indicates the result of the following factors:
(l) Increase in cost of goods sold.
(2) Decrease in selling price.
(3) Decrease in sales volume.
(4) High competition.
(5) Decrease in sales mix.
Illustration:
Calculate Gross Profit Ratio from the following figures :
Rs.
Sales 5,00,000
Sales Return 50,000
Closing Stock 35,000
Opening Stock 70,000
Purchases 3,50,000
Solution :
L 5 K+
Gross Profit Ratio = x 100
J 

Net Sales = Sales – Sales Return

= Rs. 5,00,000 – 50,000
= Rs. 4,50,000

78
 Gross Profit = Sales – Cost of Goods Sold
Cost of goods sold = Opening Stock + Purchase – Closing Stock
= Rs. 70,000 + 3,50,000 – 35,000
= Rs. 4,20,000 – 35,000 = Rs. 3,85,000
Gross Profit = Rs. 4,50,000 – 3,85,000 = Rs. 65,000
 ,
Gross Profit Ratio = x 100

, ,

= 14.44%
D.2) Operating Ratio
Operating Ratio is calculated to measure the relationship between total operating
expenses and sales. The total operating expenses is the sum total of cost of goods
sold, office and administrative expenses and selling and distribution expenses. In
other words, this ratio indicates a firm's ability to cover total operating expenses. In
order to compute this ratio, the following formula is used:
:6 +
Operating Ratio = x 100
J 
Operating Cost = Cost of goods sold + Administrative Expenses +
Selling and Distribution Expenses
Net Sales = Sales – Sales Return (or) Return Inwards.
Illustration:
Find out Operating Ratio :
Cost of goods sold Rs. 4,00,000
Office and Administrative Expenses Rs. 30,000
Selling and Distribution Expenses Rs. 20,000
Sales Rs. 6,00,000
Sales Return Rs. 20,000
Solution :
:6 +
Operating Ratio = x 100
J 

79
 Operating Cost = Cost of goods sold + Administrative Expenses +
Selling and Distribution Expenses
= Rs. 4,00,000 + 30,000 + 20,000
= Rs. 4,50,000
= Rs. 6,00,000 – 20,000
= 5,80,000

, ,
Operating Ratio = x 100
,,

= 77.58%
This ratio indicated that 77.58% of the net sales have been consumed by cost of
goods sold, administrative expenses and selling and distribution expenses. The
remaining. 23.42% indicates a firm's ability to cover the interest charges, income tax
payable and dividend payable.
D.3) Operating Profit Ratio
Operating Profit Ratio indicates the operational efficiency of the firm and is a
measure of the firm's ability to cover the total operating expenses. Operating Profit
Ratio can be calculated as :
:6 +
Operating Profit Ratio = x 100
J 
Operating Profit = Net Sales – Operating Cost
(or)
= Net Sales – (Cost of Goods Sold + Office and
Administrative Expenses + Selling and
Distribution Expenses)
(or)
= Gross Profit – Operating Expenses
(or)
= Net Profit + Non-Operating Expenses –
Non-Operating Income
Net Sales = Sales – Sales Return (or) Return Inwards

80
Illustration:
From the following information given below, you are required to calculate
Operating Profit Ratio :
Rs.
Gross Sales 6,50,000
Sales Return 50,000
Opening Stock 25,000
Closing Stock 30,000
Purchases 4,10,000
Office and Administrative Expenses 50,000
Selling and Distribution Expenses 40,000

Solution :
:6 + 5 K+
Operating Profit Ratio = x 100
J 

Operating Profit = Net Sales – Total Operating Cost

Net Sales = Gross Sales – Sales Return
= Rs. 6,50,000 – 50,000
= Rs. 6,00,000
Total Operating Cost = Cost of Goods Sold + Office and
Administrative Expenses + Selling and
Distribution Expenses
Cost of goods sold = Opening Stock + Purchase – Closing Stock
= Rs. 25,000 + 4,10,000 – 30,000
= Rs. 4,05,000
Total Operating Expenses= Rs. 4,05,000 + 50,000 + 40,000
= Rs. 4,95,000
Operating Profit = Net Sales – Total Operating Expenses
= Rs. 6,00,000 – 4,95,000

81
 = Rs. 1,05,000
, ,
Operating Profit Ratio = x 100
,,

= 17.5
Illustration:
Calculate Operating Profit Ratio from the following figures :
Net Sales Rs. 4,00,000
Cost of goods sold Rs. 3,00,000
Office and Administrative Expenses Rs. 20,000
Selling and Distribution Expenses Rs. 15,000
Solution :
:6 + 5 K+
Operating Profit Ratio = x 100
J 

Operating Profit = Sales – Total Operating Cost

Total Operating Cost = Cost of Goods Sold + Office and
Administrative Expenses + Selling and
Distribution Expenses
= Rs. 3,00,000 + 20,000 + 15,000
= Rs. 3,35,000
Operating Profit = Rs. 4,00,000 – 3,35,000
= Rs. 65,000
 ,
Operating Profit Ratio = x 100

,,

= 16.25%
D.4) Net Profit Ratio.
Net Profit Ratio is also termed as Sales Margin Ratio (or) Profit Margin Ratio
(or) Net Profit to Sales Ratio. This ratio reveals the firm's overall efficiency in
operating the business. Net profit Ratio is used to measure the relationship between

82
net profit (either before or after taxes) and sales. This ratio can be calculated by the
following formula:
J 5 K+ )  I8
Net Profit Ratio = x 100
J 
Net profit includes non-operating incomes and profits. Non-Operating Incomes
such as dividend received, interest on investment, profit on sales of fixed assets,
commission received, discount received etc. Profit or Sales Margin indicates margin
available after deduction cost of production, other operating expenses, and income
tax from the sales revenue. Higher Net Profit Ratio indicates the standard
performance of the business concern.
Illustration:
From the following Trading and Profit and Loss Account of Heena & Co. for the
year 31st Dec 2012:
Rs. Rs.
To Opening Stock 60,000 By Sales 4,00,000
To Purchase 2,75,000 By Closing Stock 75,000
To Wages 25,000
To Gross Profit c/d 1,15,000
4,75,000 4,75,000
To Administrative Expenses 45,000 By Gross Profit b/d 1,15,000
To Selling and Distribution 10,000 By Interest on Investment 10,000
Expenses
To Office Expenses 5,000
To Non Operating Expenses 15,000
To Net Profit 50,000
1,25,000 1,25,000

You are required to calculate:

(1) Gross Profit Ratio.
(2) Operating Ratio.
(3) Operating Profit Ratio.
(4) Net Profit Ratio.
83
Solution:
L 5 K+
1) Gross Profit Ratio = × 100
J 
, ,
= × 100

,,

= 28.75%
I  :6 +
2) Operating Ratio = × 100
J 

Total Operating Cost = Cost of Goods Sold + Operating Expenses

= Opening Stock + Purchases – Closing Stock
= Rs. 60,000 + 2,75,000 -75,000
= Rs. 2,60,000
Operating Expenses = Office Expenses + Administrative Expenses
+ Selling and Distribution Expenses
= Rs. 5,000 + 45,000 + 10,000
= Rs. 60,000
Total Operating Cost = Rs. 2,60,000 + 60,000
= Rs. 3,20,000
A,,
Operating Ratio = × 100

,,

= 80 %
J :6 + 5 K+
3) Operating Profit Ratio = × 100
J 

Net Operating Profit = Net Sales – Total Operating Cost

= Rs. 4,00,000 – 3,20,000
= Rs. 80,000
,
Operating Profit Ratio = × 100

,,

= 20%

84
 J 5 K+ ()  I8)
4) Net Profit Ratio = × 100
J 
,
= × 100

,,

= 12.5 %

1) Gross Profit Ratio = 28.75%

2) Operating Ratio = 80%
3) Operating Profit Ratio = 20%
4) Net Profit Ratio = 12.5%

Illustration:
The following are the summarized profit and loss account of Darshan India Ltd.
for the year ending 31 Dec. 2014 and the Balance sheet as on that date:
You are required to calculate:
(a) Current Ratio
(b) Liquid Ratio
(c) Gross Profit Ratio
(d) Operating Ratio
(e) Operating Profit Ratio
(f) Net Profit Ratio

85
 Dr. Profit and Loss Account Cr.
Particulars Rs. Particulars Rs. Rs.
To Opening Stock 10,000 By Sales 1,20,000
1,10,000
Less: Sales Return 10,000
To Purchases 60,000 By Closing Stock 15,000
To Freight Expenses 5,000
To Gross Profit c/d 50,000
1,25,000 1,25,000
To Operating Expenses: By Gross Profit 50,000
b/d
Office Expenses 5,000 By Non-Trading
Income:
Administrative Expenses 15,000 Interest on 5,000
Investment
Selling and Distribution 5,000 Profit on sales of 1,000
Expenses fixed Assets
To Non-Operating Dividend 4,000
Expenses: Received
Loss on sale of Fixed 1,000
Assets
To Net Profit 34,000
60,000 60,000

Solution:
 ) 
a) Current Ratio =
 *+,++ +

Current Assets = Rs. 2,000 + 3,000 + 5,000 +15,000 + 6,000 + 4,000

= Rs. 35,000
A ,
Current Ratio =
,

= 1.75 (or) 1.75 :1

86
 *+1+ ) 
b) Liquid Ratio =
 *+,++ +

Liquid Assets = Current Assets – (Stock and Prepaid Expenses)

= Rs. 35,000 – (15,000 + 4,000)
= Rs. 16,000
,
Liquid Ratio =
,

= 0.8 (or) 0.8:1

L 5 K+
c) Gross Profit Ratio = × 100
J 
,
×= 100
,,

= 45.45%
I  :6 +
d) Operating Ratio = × 100
J 

Total Operating Cost = Cost of Goods Sold + Operating Expenses

Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
= Rs. 10,000 + 60,000 – 15,000
= Rs. 55,000
Operating Expenses = Office Expenses + Administrative Expenses
+ Selling and Distribution Expenses
= Rs. 5,000 + 15,000 + 5,000
= Rs. 25,000
Total operating Cost = Rs. 55,000 + 25,000
= Rs. 80,000
,
Operating Ratio = × 100
,,

= 72.72%

87
 I  :6 + 5 K+
e) Operating Profit Ratio = × 100
J 

Net Operating Profit = Net Sales – Total Operating Cost

= Rs. 1,10,000 – 80,000
= Rs. 30,000
A,
Operating Profit Ratio = × 100
,,

= 27.27%
Alternatively
Net Operating Profit = Net Profit + Non-Operating Expenses – Non- Operating
Income
Net Operating Profit = Rs. 34,000 + 1,000-(5,000 + 1,000 + 4,000)
= Rs. 35,000 – 10,000
= Rs. 25,000
 ,
Operating Profit Ratio= × 100
,,

= 22.72%
J 5 K+ (  8)
f) Net Profit Ratio = × 100
J 
A
,
= × 100
,,

= 30.90%
a) Current Ratio = 1.75 (or) 1.75 : 1
b) Liquid Ratio = 0.8 (or) 0.8:1
c) Gross Profit Ratio = 45.45%
d) Operating Ratio = 72..75%
e) Operating Profit Ratio = 27.27% or 22.72%
f) Net Profit Ratio = 30.90%

88
D.5) Return on Investment Ratio:
This ratio is also called as ROL This ratio measures a return on the owner's or
shareholders' investment. This ratio establishes the relationship between net profit
after interest and taxes and the owner's investment. Usually this is calculated in
percentage. This ratio thus can be calculated as:
J 5 K+ (  +   8)
Return on Investment Ratio = × 100
EE  H ( )=; C

Shareholder's Investment = Equity Share Capital + Preference Share Capital

+ Reserves and Surplus – Accumulated Losses
Net Profit = Net Profit – Interest and Taxes
Significance
(1) This ratio highlights the success of the business from the owner's point of view.
(2) It helps to measure an income on the shareholders' or proprietor's investments.
(3) This ratio helps to the management for important decisions making.
(4) It facilitates in determining efficiently handling of owner's investment.
Illustration:
Calculate Return on Investment Ratio from the following information:
Rs.
1000 Equity shares @ of Rs. 10 each 10,000
2000, 5% preference share @ of Rs. 10 each 20,000
Reverses 5,000
Net Profit before interest and Tax 10,000
Interest 2,000
Taxes 3,000
Solution:
J 5 K+   +   8
Return on Investment Ratio = × 100
EE  =; C
Shareholder's Investment = Equity Share Capital + Preference Share Capital
+ Reserves and Surplus – Accumulated Losses

89
 Shareholder's Investment = Rs. 10,000 + 20,000 + 5,000 – Nil
= Rs. 35,000
Net Profit after Interest and Taxes = Rs. 10,000 – (2,000 + 3,000)
= Rs. 10,000 – 5,000
= 5,000
,
Return on Investment Ratio = × 100
A ,

= 14.28%
D.6) Return on Capital Employed Method:
With the help of Return on Capital Employed Ratio it would be easy to measure
a relationship between profit and capital employed. This ratio is also called as Return
on Investment Ratio. The term return means Profits or Net Profits. The term Capital
Employed refers to total investments made in the business. The concept of capital
employed can be considered further into the following ways:
(a) Gross Capital Employed
(b) Net Capital Employed
(c) Average Capital Employed
(d) Proprietor's Net Capital Employed
a) Gross Capital Employed = Fixed Assets + Current Assets
b) Net Capital Employed = Total Assets – Current Liabilities
Opening Capital Employed + Closing
6+  7C6 B
c) Average Capital Employed =

(or)
Average Capital Employed = Net Capital Employed +
½ of Profit After Tax
d) Properietor's Net Capital Employed = Fixed Assets + Current Assets
– Outside Liabilities
(both long-term and short-term)

90
 In order to compute this ratio, the below presented formulas are used:
J 5 K+ )  I8
1) Return on Capital Employed = × 100
L 6+  7C6 B

(or)
Net ProKit After Taxes Before Interest
2) Return on Capital Employed = × 100
Gross Capital Employed

(or)
Net ProKit After Taxes Before Interest
3) Return on Capital Employed = Average Capital Employed or × 100
Net Capital Employed

Illustration:
The following is the Balance sheet of Gargi Ltd. for the year ending Dec. 31st 2013.
Liabilities Rs. Assets Rs.
Equity Share Capital 4,00,000 Good will 1,50,000
Reserves 40,000 Building 2,00,000
Profit and Loss A/c 80,000 Machinery 2,50,000
Debenture 1,00,000 Stock 80,000
Secured Loans 1,00,000 Sundry Debtors 60,000
Creditors 80,000 Bills Receivable 40,000
Provision for Tax 50,000 Cash at Bank 50,000
Bills Payable 40,000 Preliminary Expenses 60,000
8,90,000 8,90,000

You are required to calculate:

a) Current Ratio
b) Liquid Ratio
c) Gross Capital Employed
d) Net Capital Employed
e) Average Capital Employed
f) Return on Capital Employed Ratio

91
Solution:
Current Assets
a) Current Ratio =
Current Liabilities
Current Assets = Stock + Sundry Debtors + Bills Receivable
+ Cash at Bank + Preliminary Expenses
= Rs. 80,000 + 60,000 + 50,000 + 60,000
= Rs. 2,50,000
Current Liabilities = Creditors + Provision for Tax + Bills Payable
= Rs. 80,000 + 50,000 + 40,000
= Rs. 1,70,000
2,50,000
Current Ratio =
1,70,000

= 1.47 (or) 1.47 : 1

b) Liquid Assets = Liquid Assets – (Stock and Preliminary Expenses)
= Rs. 2,50,000 –(80,000 + 60,000)
= Rs. 1,10,000
1,10,000
Liquid Assets = 1,70,000

= 0.64 (or) 0.64 : 1

c) Gross Capital Employed = Fixed Assets + Current Assets
Fixed Assets = Goods will + Building + Machinery
= 1,50,000 + 2,00,000 + 2,50,000
= Rs. 6,00,000
Current Assets = Rs. 2,50,000
Gross Capital Employed = Rs. 6,00,000 + 2,50,000
= Rs. 8,50,000
d) Net Capital Employed = Total Assets – Current Liabilities

92
 Total Assets = Rs. 8,50,000
Current Liabilities = Rs. 1,70,000
Net Capital Employed = Rs. 8,50,000
= Rs. 6,80,000
(e) Average Capital Employed = Net Capital Employed + ½ of Profit After Tax
½ of profit afgter tax = ½ (80,000 – 50,000)
= Rs. 15,000
Average Capital Employed = Rs. 7,20,000 + 15,000
= Rs. 7,35,000
J 5 K+ )  I8
(f) Return on Capital Employed = × 100
L 6+  7C6 B
,3 ,
= × 100
, ,
A,
= × 100
, ,

= 3.52%
Alternatively
J 5 K+ )  I8
Return on Capital Employed = × 100
L 6+  7C6 B
A,
= × 100
G,,

= 4.16%
(a) Current Ratio = 1,47 (or) 1.47 : 1
(b) Liquid Ratio = 0.64 (or) 0.64 : 1
(c) Gross Capital Employed = Rs. 8,50,000
(d) Net Capital Employed = Rs. 7,35,000
(e) Average Capital Employed = Rs. 7,35,000
(f) Return on Capital Employed = 3.52% (or) 4.16 %

93
D.7) Earning Per Share Ratio:
Earnings Per Share Ratio (EPS) measures the earning capacity of the concern
from the owner's point of view and it is helpful in determining the price of the equity
share in the market place. This ratio helps to measure the price of stock in the market
place, also highlights the capacity of the concern to pay dividend to its shareholders.
This ratio used as a yardstick to measure the overall performance of the concern.
Earnings Per Share Ratio can be calculated as:
J 5 K+ )  I8  5 D+;+
Earning Per Share Ratio =
J .  71+ B E

Illustration:
Calculate the Earning Per Share from the following data:
Net Profit before tax Rs. 2,00,000.
Taxation at 50% of Net Profit.
10% Preference share capital (Rs. 10 each) Rs. 2,00,000. Equity share capital
(Rs. 10 each) Rs. 2,00,000.
Solution:
J 5 K+ )  I8 
5 D+;+
Earning Per Equity Share =
J .  71+ B E

Net Profit before Tax = Rs. 2,00,000


Taxation at 50% of Net Profit = 2,00,000 ×


= Rs. 1,00,000
= Rs. 2,00,000 – 1,00,000
= Rs. 1,00,000

10 % of Preference Dividend = 2,00,000 ×


= Rs. 20,000
Net Profit after Tax and = Rs. 1,00,000 – 20,000
Preference Dividend = Rs. 80,000
94
 ,,
No. of Equity Share =


= 20,000 Share
,
Earning Per Equity Share =
,

= Rs. 4 Per Share

D.8) Dividend Payout Ratio
This ratio highlights particularly the relationship between payment of dividend
on equity share capital and the profits available after meeting tax and preference
dividend. This ratio indicates the dividend policy adopted by the top management
about utilization of divisible profit to pay dividend or to retain or both. The ratio,
thus, can be calculated as:
71+ B D+;+
Dividend Payout Ratio = × 100
J 5 K+ )  I8  5 D+;+
D+;+ 5 71+ B E
= × 100
7+ 5 71+ B E

Illustration:
Compute Dividend Payout Ratio from the following data:
Net Profit Rs. 60,000
Provision for tax Rs. 15,000
Preference dividend Rs. 15,000
No. of Equity Share Dividend Per Equity Share = 0.30 Rs. 6,000

Solution:
71+ B D+;+
Dividend Payout Ratio = × 100
J 5 K+ )  I8  5 D+;+

Equity Dividend = No. of Equity Shares × Dividend Per Equity Share

= 6,000 × 0.30
= Rs. 1,800
Net Profit After Tax = Rs. 60,000 –(15,00+15,000)

95
 Preference Dividend = Rs. 60,000 – 30,000
= Rs. 30,000
Alternatively
D+;+ 5 71+ B E
Dividend Payout Ratio = × 100
7+ 5 71+ B E

Dividend Per Equity Share = 0.30

J 5 K+ )  8  5 D+;+
Earning Per Equity Share =
J .  71+ B E
A,
=
,

= Rs. 5 Per Share

.A
Dividend Payout Ratio = × 100

= 6%
D.9) Dividend Yield Ratio:
Dividend Yield Ratio indicates the relationship is established between dividend
per share and market value per share. This ratio is a major factor that determines the
dividend income from the investors' point of view. It can be calculated by the
following formula:-
D+;+ 5 E
Dividend Yield Ratio = × 100
O4 q 5 E

Illustration:
The following details have been given to you for M/s HR Ltd, Pune you are
required to find out (1) Dividend Yield Ratio (2) Dividend Payout Ratio and (3)
Earnings Per Share Ratio.
10% Preference Share of Rs. 10 each Rs. 5,00,000
60,000 Equity Shares of Rs. 10 each Rs. 6,00,000
Rs. 11,00,000

96
Additional Information
Profit after tax at 50%
Equity Dividend Paid 20%

Market Price of Equity Share Rs. 30

Solution:
Rs.

Profit after Tax = 1,50,000

Less: Preference dividend (10% of 5,00,000) = 50,000

Equity Earnings = 1,00,000

Profit after tax and preference dividend = Rs. 1,00,000

No. of Equity Share = 60,000 Share

D+;+ 5 E

1) Dividend Yield Ratio = × 100
O4 q 5 E
 %  ? .
= × 100
? .A

= × 100
A
= 6.66%
J 5 K+   8 6 +;+
2) Earning Per Equity Share = × 100
J .  71+ B E
,,
=
,

= Rs. 1.67 Per Share

D+;+ 5 71+ B E
3) Dividend Payout Ratio = × 100
7+ 5 71+ B E

= × 100
.G
= 119.76 %

97
D.10) Price Earnings Ratio:
This ratio particularly focuses on the earning per share reflected by market
share. Price Earnings Ratio establishes the relationship between the market price of
an equity share and the earning per equity share. This ratio helps to find out whether
the equity shares of a company are undervalued or not. This ratio is also useful in
financial forecasting. This ratio is calculated by using the following formula:
O4 5+ 5 71+ B E
Price Earning Ratio =
7+ 5 E

Illustration:
Calculate 1) Earning Per Share 2) Dividend Yield Ratio and 3) Price Earning
Ratio from the following figurs:
Rs.
Net Profit 6,00,000
Market price Per Equity Shares 60
No. of Equity Shares 40,000
Provision for Tax 1,60,000
Preference Dividend 50,000
Depreciation 70,000
Bank Overdraft 50,000

Solution:
J 5 K+   8 6 +;+
1) Earning Per Share =
J .  71+ B E

Net Profit After Tax and = Rs. 6,00,000 – (1,60,000 + 50,000)

Preference Dividend
= Rs. 6,00,000 - 2,10,000
= 3,90,000
A,F,
Earning Per Share =

,

= Rs. 9.75

98
 7+ 5 E
2) Dividend Yield Ratio = × 100
O4 q 5 E
F.G
= × 100


= 16.25%
O4 5+ 5 71+ B E
3) Price Earning Ratio =
7+ 5 E

=
F.G

= 6.15
Explanation: The market price of a share is Rs. 60 and earning per share is Rs. 9.75,
the price earning ratio would be 6.15. It shows that the market value of every one
rupee of earning is 6.15 times or Rs. 6.15.
D.11) Net Profit to Net Worth Ratio
This ratio measures the profit return on investment. This ratio indicates the
established relationship between net profit and shareholders' net worth. It is a reward
for the assumption of ownership risk. This ratio determines the incentive to owners,
measure the profit as well as net worth, ratio indicates the overall performance and
effectiveness of the firm & measures the efficiency with which the resources of a
firm have been employed. This ratio is calculated as :
J 5 K+ )  I8
Net Profit to Net Worth = × 100
EE  J N  E

Shareholder Net Worth = Total Tangible Net Worth

Total Tangible Net Worth = Company's Net Assets – Long-Term
Liabilities
(or)
= Shareholders Funds + Profit Retained
in business

99
Illustration:
Compute Net Profit to Net Worth Ratio from the following data:
Rs.
Net Profit 80,000
Provision for Tax 15,000
Shareholders Fund 8,00,000
Dividend to Equity Shares 20,000
Dividend to Preference Share @ 10% 10,000

Solution:
J 5 K+ )  I8
Net Profit to Net Worth = × 100
I  I+, J N  E

Net Profit after Taxes = Rs. 80,000 – 15,000

= Rs. 65,000
Total Tangible Net Worth = Shareholders Fund + Profit retained in
business
Profit Retained in Business = Profit – (Taxes + Preference dividend
+ Equity dividend)
= Rs.80,000–(15,000 + 20,000 + 10,000)
= Rs. 80,000 – 45,000
= 35,000
Total Tangible Net Worth = Rs. 8,00,000 + 35,000
= Rs. 9,15,000
 ,
Net Profit Net Worth = × 100
F, ,

= 7.10%
Net Profit to Net Worth Ratio = 7.10%

100
SUMMARY OF FORMULAE
Liquidity Ratios
 ) 
1) Current Ratio =
 *+,++ +
*+1+  <+4 ) 
2) Liquid (or Quick) Ratio =
<+4 *+,++ +

Capital Structure Ratios (or Solvency Ratios or Leverage Ratios)

*  C ,
1) Debt Equity Ratio =
EE  71+ B

78  71+ B
Or =
=  71+ B

EE  H

2) Proprietary Ratio =
I  ) 
7+ ,  +  
I8 (7=I)
3) Interest Coverage Ratio =
H+8 +  E

D,
4) Debts to Total Funds Ratio =
I  

Turnover (or Activity) Ratios

  
1) Inventory (or Stock) Turnover Ratio =
); +; B  


Alternatively =
); +; B  + 6+


Alternatively =
); +; B  

J + 
2) Debtors Turnover Ratio =
); , 

D, 
Average collection period (in term of days) = × 365 days
+ 
J + 6E 
3) Creditors Turnover Ratio =
); + 

101
  
4) Working Capital Turnover Ratio =
J M 4+ 6+ 

 
5) Fixed assets turnover ratio = H+8      C 
6+ + 

 
6) Capital turnover ratio =
6+  C6 B

Profitability Ratios
L 5 K+ J  3   
1) Gross Profit ratio = × 100= × 100
J  J 
J 5 K+
2) Net Profit ratio = × 100
J 
  >:6 + 86 
3) Operating ratio =
J 
:6 +  6 K+
4) Operating profit ratio = × 100
J 

5) Expense ratio :
O +   C
a) For cost of materials = × 100
J 
+ 86 
b) For selling expenses = × 100
J 

Such ratios may be separately computed for each category of expense.

J 5 K+ ,  + 
 8
6) Return on Investment (ROI) = × 100
I  6+  C6 B

7) Returns of Shareholders Funds or Return on Proprietors Equity

J 5 K+   +   8
= × 100
EE  
J 5 K+   +  , 8 
6 +;+
8) Return on Equity Capital = × 100
71+ B EE  

J 5 K+   8 35 +;+

9) Earning Per Share (EPS) =
J .  1+ B E

102
 D+;+ 6 E
10) Dividend Payout Ratio =
7+ 6 E

O4 6+ 6 1+ B E

11) Price Earning Ratio (P/E ratio) =
7+ 6 E

2.2.10 PROBLEMS FOR PRACTICE

Illustration: 1
From the following information determine opening and closing stocks:
Stock Turnover 5 times
Total Sales Rs. 2,00,000
Gross Profit 25% of sales
The closing stock value was more by Rs. 4,000 than the opening stock.
Solution:
Gross Profit = 2,00,000 × 25%
= Rs.50,000
Cost of Goods Sold = Sales – Gross Profit
= Rs. 2,00,000 – Rs. 50,000
= Rs. 1,50,000
Let the Opening Stock =X
Closing Stock = X + Rs. 4,000
Stock Turnover = 5 times
L   
Stock Turnover Ratio =
);  4
? ., ,
5=
s(t>t>? .
,)

5X + Rs. 10,000 = Rs. 1,50,000

5X = Rs. 1,50,000 – Rs. 10,000
X = Rs. 28,000 (Opening Stock)
Closing Stock = Rs. 28,000 + Rs. 4,000
= Rs. 32,000
103
 Thus opening stock is Rs. 28,000 and closing stock is Rs. 32,000
Illustration:2
Rate of gross profit is 25% on cost. Total sales Rs. 5,00,000. Average stock Rs.
80,000.
Calculate stock turner ratio.
Solution:
Suppose Cost = Rs. 100, Sales = Rs. 100 + 25% = Rs. 125

Profit as a percentage of sales = = 20%


Gross Profit = Sales× 25% = 5,00,000× 25% = Rs. 1,00,000

Cost of goods sold = 5,00,000 – 1,00,000 = Rs. 4,00,000
);  4 ,
Stock turnover ratio = = = 5 times
  
,,

Illustration:3
Calculate Creditors Turnover Ratio from the information given below:
Opening creditors Rs. 25,000
Purchases returns Rs. 5,000
Cash paid to creditors Rs.1,30,000
Closing creditors Rs.15,000
Solution:
:6+ +  >  + +   ,> ,
Average Creditors = =
 
= Rs. 20,000
Net Credit Purchase = Purchases (Credit) – Purchase Returns
* Net Credit Purchases = Rs. 1,25,000 – Rs. 5,000
= Rs. 1,20,000
J + 5E  ? .,,
Creditors Turnover Ratio = = = 6 times
); +  ? .,

104
* Calculation of Credit Purchase
Total Creditors Account
Particulars Rs. Particulars Rs.
To Purchase Returns 5,000 By Balance b/d 25,000
To Cash A/c 1,30,000 By Purchases A/c (Credit) 1,25,000
To Balance C/d 15,000
1,50,000 1,50,000

Illustration:4
From the information given below, calculate the following ratios:
(i) Quick Ratio (ii) Stock Turnover Ratio
(iii) Debt-Equity Ratio (iv) Return on Investment
Information: Current Assets Rs. 5,00,000; Opening Stock Rs. 50,000; Closing
Stock Rs. 1,50,000; Cost of Goods Sold Rs. 12,00,000; Gross Profit Rs. 2,00,000;
Indirect expenses Rs 20,000; Equity Share Capital Rs. 7,00,000; 10% Preference
Share Capital Rs. 3,00,000; 12% Debentures Rs. 2,00,000; Current Liabilities Rs.
2,00,000; General Reserve Rs. 1,00,000.
Solution:
<+4 )  ,,3, , ? .A, ,
i) Quick ratio = = =
 *+,++ + ,, ? .,,

= 1.75 : 1
  
ii) Stock turnover ratio =
); 4
,, ? .,,
=u = = 12 times
( ,>, ,) ? .,,
v

*  C ,
iii) Debt equity ratio =
EE  
,, ? .,,
= = = 2:11
G,,>A,,>,, ? .,,

105
 5 K+ ,  +   8 (5=I)
iv) Return on investment =
6+  C6 B

L 5 K+ 3=+ .>=   , 

=
71. E 6+ >5.6+ >D,  >L ? ;
,,3,>
,
=
G,,>A,,>,,>,,
? .,
,
= × 100 = 15.69%
? .A,,

Illustration:5
Current ratio 2.50; Acid test ratio 1.75; Stock Rs. 1,50,000.
Calculate net working capital.
Solution:
Current ratio = 2.5; Acid test ratio = 1.75.
Difference between current ratio and acid test ratio is stock
Thus Stock = Current ratio – Acid test ratio]
1,50,000 = 2.50 – 1.75
1,50,000 = 0.75
, , ×. 
Current assets = = Rs. 5,00,000
.G
, , ×
Current Liabilities = = Rs. 2,00,000
.G
Net working capital = Current assets – Current liabilities
= 5,00,000 – 2,00,000 = Rs. 3,00,000
Illustration:6
(i) Calculate Stock Turnover Ratio from the following information:
Opening Stock Rs. 30,000
Purchases Rs. 1,15,000
Closing Stock Rs, 20,000
(ii) Calculate Quick Ratio from the following Balance Sheet figures:

106
 Liabilities Rs. Assets Rs.
Capital 2,20,000 Fixed Assets 2,00,000
Loan (long-term) 50,000 Stock 50,000
Creditors 40,000 Debtors 50,000
BIP 10,000 BIR 15,000
Provision for Tax 7,500 Cash and Bank Balance 15,000
Provision for Doubtful Debts 2,500
3,30,000 3,30,000

Solution:
L   
i) Stock Turnover Ratio =
);  4

Cost of Goods Sold = Opening Stock + Purchases – Closing Stock

= Rs. 30,000 + Rs. 1,15,000 – Rs. 20,000 = Rs. 1,25,000
:6+  4>  +  4 ? .A,>? .,
Average Stock = =
 

= Rs. 25,000
<+4 )  ? .,
ii) Quick Ratio = = = 4:3
 *+,++ + ? .,

Quick Assets = Debtors + Bills Receivable + Cash and Bank Balance

= Rs. 50,000 + Rs. 15,000 + Rs. 15,000 = Rs. 80,000
Current Liabilities = Creditors + B/P + Provision for Tax + Provision for
Doubtful Debts
= Rs. 40,000 + Rs. 10,000 + Rs. 7,500 + Rs. 2,500
= Rs. 60,000
Illustration:7
Calculate the following ratios from the given Balance Sheet:
(i) Current Ratio;
(ii) Fixed Assets to Net worth Ratio;
(iii) Debt Equity Ratio;
(iv) Return on Capital Employed
107
 Balance Sheet
Liabilities Rs. Assets Rs.
600 Shares of Rs. 100 60,000 Land 40,000
General Reserve 35,000 Plant 20,000
Dividend Equalisation 5,000 Machines 27,500
Long-term Loans 20,000 Investments 25,000
Bills Payable 30,000 Inventories 30,000
Provision for tax 5,000 Bill Receivable 13,500
Profit & Loss Ne Cash and Bank 12,000
Balance 1,000 Preliminary expenses 8,000
Current year 20,000 21,000
1,76,00 1,76,000
0

Solution:
 )  ? . , 
i) Current Ratio = = 1.56:1
 *+,++ + ? .A ,

Current Assets = Inventories + Bills Receivable + Cash and Bank

= 30,000 + 13,500 + 12,000 = Rs. 55,500
Current Liabilities = Bills Payable + Provision for Tax
= Rs. 30,000 + Rs. 5,000 = Rs. 35,000
H+8 )  ? . ,, 
ii) Fixed Assets to Net Worth Ratio = = = 0.99:1
J N  E ? .,A,

Fixed Assets = Land + Plant + Machines + Investments

= 40,000 + 20,000 + 27,500 + 25,000 = Rs. 1,12,500
Net Worth = Share Capital +General Reserve +Dividend Equalization
Reserve+ Profit & Loss Account – Preliminary expenses
=60,000+ 35,000 + 5,000 + 21,000 – 8,000 = Rs. 1,13,000
*  C , ,
iii) Debt Equity Ratio = = = 0.17 : 1
EE   ,A,

Long term debts = Long term loans = Rs. 20,000

Shareholders funds = Net Worth = Rs. 1,13,000

108
 J 5 K+ ,  +   8
iv) Return on Capital Employed = × 100
6+  C6 B
? . ,
= = 18.79%
?.,AA,

Net Profit before interest and tax = Net Profit + Tax

= 20,000 + 5,000 = Rs. 25,000
Capital employed = Share capital + General Reserve + Dividend Equilisation
Reserve + Long term loans + Profit – Prel. Expenses
= 60,000 + 35,000 + 5,000 + 20,000 + 21,000 – 8,000
= Rs. 1,33,000
Illustration:8
A DR Pharmaceuticals having a net working capital of Rs. 2.8 lakhs as on 30-6-
2003 indicates the following financial ratios and performance figures:
Current ratio 2.4
Liquidity ratio 1.6
Inventory turnover (on cost of sales) 8
Gross profit on sales 20%
Credit allowed (months) 1.5
The company's fixed assets is equivalent to 90% of its net-worth (share capital
plus reserves) while reserves amounted to 40% of share capital.
Prepare the Balance Sheet of the company as on 30-6-2003 showing step by step
calculations.
Solution:
 )  ( ))
Current ratio =
 *+,++ + ( *)
)
2.4 =
*

CA = 2.4 CL
Net Working Capital = CA – CL = Rs. 2,80,000

109
 2.4 CL – CL = 2,80,000
1.4 CL = 2,80,000
,,
CL = = Rs. 2,00,000
.

Thus Current Liabilities = Rs. 2,00,000

Current assets = 2.4 CL = 2.4 × 2,00,000 = Rs. 4,80,000
2) Calculation of Stock
)3 4
Liquidity ratio =
*

,,3 4
1.6 =
,,

2,00,000 × 1.6 = 4,80,000- Stock

Stock = 4,80,000-3,20,000 =Rs. 1,60,000
3) Calculation of Cost of Sales
Inventory turnover ratio = 8
   
8 = =
 4 ,,

Cost of Sales = 1,60,000 × 8 = Rs. 12,80,000

4) Calculation of Gross Profit
Gross Profit on sales = 20%

Gross Profit on cost of sales = 25%

Gross profit = Rs. 12,80,000 × 25% = Rs. 3,20,000

5) Calculate of Sales

Cost of sales Rs. 12,80,000

Add. Gross Profit 3,20,000

Sales Rs. 16,00,000

110
6) Calculation of Debtors
D, 
Average collection period = × 12 months
+ 
D, 
1.5 months = × 12
,,

12 × Debtors = 16,00,000 × 1.5


,,
Debtors = = Rs. 2,00,000


7) Calculation of Cash
Current assets = Stock + Debtors + Cash
4,80,000 = 1,60,000 + 2,00,000 + Cash
Cash = 1,20,000
8) Calculation of Fixed Assets
Fixed assets = 90% of net worth
Net worth = Capital + Reserve
Also Net worth = Fixed assets + Net working capital
= 0.9 Net worth + 2,80,000
0.1 Net worth = 2,80,000
,,
Net worth = = Rs. 28,00,000
.

Fixed assets = 28,00,000 × 90% = 25,20,000

9) Calculation of Capital and Reserves
Net worth (i.e. Capital + Reserves) = Rs. 28,00,000
Reserve = 40% of Capital

Capital + 0.4 Capital = 28,00,000

1.4 Capital = 28,00,000

,,
Capital = = Rs. 20,00,000
.

111
 Reserves = 20,00,000 × 40% = Rs. 8,00,000

Balance Sheet as on 30th June 2003

Liabilities Rs. Assets Rs.

Share Capital 20,00,000 Fixed Assets 25,20,000
Reserves 8,00,000 Stock 1,60,000
Current liabilities 2,00,000 Debtors 2,00,000
Cash 1,20,000
30,00,000 30,00,000

Illustration: 9
From the following information given below Prepare a Balance Sheet
Stock Velocity 6
Gross Profit Margin . 20%
Capital Turnover Ratio 2
Fixed Assets Turnover Ratio 4
Debt Collection Period 2 months
Creditors Payment Period 73 days
Gross Profit was Rs. 60,000
Excess of closing stock over opening stock was Rs. 5,000.
Difference in Balance Sheet represents Bank Balance.
The entire sales and purchases are made on credit basis.
Solution:
Computation of various items for balance sheet
1) Calculation of cost of goods sold
L 5 K+
Gross Profit Ratio = × 100


Or

112
 L 5 K+
Sales =
L 5 K+ ? +
,
Sales = = Rs. 3,00,000
%

Gross Profit = 3,00,000 × 20% = Rs. 60,000

Cost of Goods Sold = Sales - Gross Profit
= Rs. 3,00,000 – Rs. 60,000 = Rs. 2,40,000
2) Calculation of Opening and Closing Stocks
Taking stock velocity as stock turnover
L   
Stock Velocity =
);  4
? .,
,
6 =
);  4
2,40,000
Average Stock = 6
= Rs. 40,000

Opening Stock = 40,000 - = Rs. 37,500

,
Closing Stock = 40,000 + = Rs. 42,500

3) Calculation of Capital
 
Capital Turnover Ratio =
6+ 

 
or Capital =
6+   ;  +
,
,
Capital = = Rs. 1,20,000

4) Calculation of Fixed Assets
 
Fixed Assets Turnover Ratio =
H+8 ) 
? .,
,
4 =
H+8 ) 

113
 ,
,
Fixed Assets = = Rs. 60,000


5) Calculation of Debtors
Debt collection period = 2 month
 C  E 
Debtors Turnover Ratio = = = 6 times
D,  +  6+  

+ 
Also Debtors Turnover Ratio =
D, 
? .A,,
Debtors = = Rs. 50,000


6) Calculation of Creditors
Creditors payment period = 73 days
A  B
Creditors Turnover Ratio = = 5 times
GA B

The amount of credit purchases is determined as follows:

Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
2,40,000 = Rs. 37,500 + Purchases – Rs. 42,500
Purchases = Rs. 2,45,000
+ 5E 
Creditors Turnover Ratio =
+ 
+ 5E 
Or Creditors =
6+  I ;  +
,
,
Creditors = = Rs. 49,000
Balance Sheets as on
Liabilities Rs. Assets Rs.
Capital 1,20,000 Fixed Assets 60,000
Creditors 49,000 Closing Stock 42,500
Debtors 50,000
Cash (Balancing Figure) 16,500
1,69,000 1,69,000

114
Illustration:10
Following is the Profit and Loss Account of DRB Ltd. for the year ended 31st
March, 2013
Rs. Rs.
To Opening stock 90,000 By Sales 9,00,000
To Purchases 5,60,000 By Closing stock 90,000
To Wages 2,14,000
To Gross Profit 1,26,000
9,90,000 9,90,000
To Salaries 16,000 By Gross profit 1,26,000
To Electricity 10,000
To Misc. expenses 10,000
To Depreciation 30,000
To Net profit 60,000
1,26,000 1,26,000

Balance-sheet of DRB Ltd.

As on 31/03/2013
liabilities Rs. Assets Rs.
Equity Share Capital 1,80,000 Fixed assets 5,40,000
Reserves and Surplus 1,20,000 Less: Depreciation 1,50,000 3,90,000
Secured loans 2,10,000 Stock 90,000
Creditors 90,000 Debtors 1,05,000
Cash 15,000
6,00,000 6,00,000

Discuss under the following important functional grouping the usual ratios and
comment on the financial strength and weakness:
(i) Liquidity and solvency ratios; and (ii) Profitability test ratios.

115
Solution:
A) Liquidity Ratios
 )  F,>, ,> ,
1) Current ratio = =
 *+,++  F,
,,
= = 2.33:1
F,
*+1+   , ,> , ,,
2) Liquid ratio = = = = 1.33:1
 +,++  F, F,

Comments : Current ratio of 2:1 and liquid ratio of 1:1 are considered satisfactory.
Since company current ratio and liquid ratios are 2.33:1 and 1.33:1 respectively,
company liquidity position is quite satisfactory.
B) Solvency Ratios
*  C , ,, ,,
1) Debt Equity ratio = = =
EE   ,,>,, A,,

= 0.7
EE   A,,
2) Proprietary ratio = = = 0.5
I    ,,

C) Profitability Ratios
L 5 K+ ,,
1) Gross Profit ratio = × 100 = × 100 = 14%
 F,,
J 5 K+ ,
2) Net Profit ratio = × 100 = × 100 = 6.7%
 F,,
J 5 K+
3) Return on capital employed = × × 100
6+  C6 B
, ,
= = × 100 = 11.76%
,,>,,>,, ,,

Comments : All the profitability ratio indicate that rate of profitability is not
impressive and needs to be improved.

116
Illustration:11
Hindustan Co. Ltd supplies the following information.
Balance Sheet
Capital and Liabilities Rs. Assets Rs.
Share capital 2,00,000 Good will 1,20,000
Reserves and surplus 58,000 Plant and machinery 1,50,000
Debentures 1,00,000 Stock 80,000
Creditors 40,000 Debtors 45,000
Bills payable 20,000 Cash 17,000
Other current liabilities 2,000 Misc. current assets 8,000
4,20,000 4,20,000
Calculate:
1) Current ratio
2) Inventory turnover
3) Proprietor's funds to liabilities
4) Quick or liquid ratio
5) Average collection period
Solution:
    4>D,  >  E>O+ .   
i) Current Ratio= =
 +,++ +  .>xsy> : E  +,++ +

,>
,>G,>, , ,

= = = 2.42:1

, > , > , ,
*+1+      3 4
ii) Liquid Ratio = =
 +,++ +  +,++ +
, ,3, G,
= = = 1.13:1
, ,
 
,,3,, ,
,
iii) Inventory Turnover = = = = 3 times
);  4 , ,

D, 
iv) Average Collection Period = × 365 days
+ 

117

,
= × 365 days = 41 days

,,
:M 1+ B
v) Propritors funds to liabilities ratio =
I  +,++ 
,,> ,
=
,,>
,>,>,
, ,
= = 1.59:1
,,

Illustration:12
The summarised Balance Sheet of YDB Traders Ltd. for the year ended 31-3-
2014 is given below:
The following further particulars are also given for the year: (in lakhs of rupees)
Sales: 120
Earnings before interest and tax (EBIT): 30
Net profit after tax (PAT): 20
Calculate the following for the company and sentences. Explain the significance
of each in one or two.
(Rs.in lakhs)
Capital and Liabilities Rs. Assets Rs.
Equity share capital (fully 140 Fixed assets (at cost) 210
paid-up)
Reserves and surplus 45 Less: Depreciation 25 185
Profit and loss account 20 Current Assets:
Provision for taxation 10 Stock 25
Sundry creditors 40 Debtors 30
Cash 15 70
255 255
1) Current ratio;
2) Liquidity ratio;
3) Profitability ratio;
4) Profitability on funds employed;

118
 5) Debtors' turnover;
6) Stock turnover;
7) Average collection period;
8) Return on equity
Solution:
    4>D,  >  E
i) Current Ratio = =
 +,++ + . +  >5 ;+ +    8 + 
 >A> G
= = = 1.4:1

> 
*+1+      3 4
ii) Liquidity Ratio = =
 +,++ +  +,++ 
G3

= = = 0.90:1
 
7=I A
iii) Profitability Ratio = = × 100 = 25%
 
7=I
iv) Profitability on Funds Employed = × 100
H C6 B
7=I
= × 100
71+ B 6+ >? ; >5&{ |/~
A A
= × 100 = × 100 = 14.63%

>
> 
 
v) Debtors Turnover = = = 4 Times
); ,  A

 
vi) Stock Turnover = = = 4.8 Times
);  4 

); D, 
vii) Average Collection Period = × 12 months
+ 
A
= × 12 = 3 months

5 K+   8
viii) Return on Equity = × 100
EE  
 
= × 100 = × 100 = 9.76%

>
> 

119
Illustration:13
The HDB Company’s financial statements give you the following information
as on 31/03/2014.
Rs.
Cash 160000
Sundry debtors 400000
Temporary investments 320000
Stock 2160000
Prepaid expenses 12000
Total current assets 3052000
Total-assets 6400000
Current liabilities 800000
10% Debentures 1600000
Equity share capital 2000000
Retained earnings 812000

Statement of Profit for the year ended 31st March, 2014

Rs.
Sales 40,00,000
Less : Cost of goods sold 28,00,000
Interest 1,60,000 29,60,000
Net Profit 10,40,000
Less: Taxes @ 50% 5,20,000
5,20,000
Dividend declared on equity shares Rs. 220000
From the above figures, appraise the financial position of the company from the
points of view (i) liquidity (ii) solvency; (iii) profitability and (iv) activity.
Solution:
I) Liquidity Ratios
 )  A, ,
1) Current ratio = = = 3.82:1
 *+,++ + ,,

120
 *+1+ )  ,,
2) Acid Test ratio = = = 1.1 :1
 *+,++ + ,,

II) Solvency Ratios

*  C D, ,,
1) Debt Equity ratio = = = 0.57 : 1
EE   ,,
5=I ,,
2) Interest Coverage ratio = = = 7.5 times
=  E ,,

III) Profitability Ratios

J 5 K+   8 ,,
1) Net Profit ratio = × 100 = × 100 = 13%

,,
5=I ,,
2) Return on Capital employed = × 100 = × 100
6+  C6 B

,,

= 27.2%
IV) Activity Ratios
   ,,
1) Stock Turnover ratio = = = 1.4 times
);  4 ,,


,,
2) Assets Turnover ratio = = = 0.625 times
I  )  
,,

Check Your Progress

A) Multiple Choice Questions
1. Debt equity ratio is an indicator of................
a) Liquidity b) Profitability c) Solvency d) Activity
2. A high debtors turnover ratio is an indicator of..............
a) Inefficiency in debt collection b) Efficiency in debt collection
c) Profitability d) solvency
3. Inventory turnover ratio is __________
a) Liquidity ratiob) Solvency ratio c) Profitability ratio d) Activity ratio
4. An ideal debt equity ratio is ____________
a) 1:1 b) 2:01 c) 3:1 d) 1:2

121
 5. Four times stock turnover ratio implies inventory holding period of ........
a) 4 months b) 3 months c) 2 month d) 1 month

2.3 Summary
Analysis of financial statement means to critically examine the composition of
an items or amount appearing in the financial statements. The term financial
statements refer to two basic statements which an accountant prepares at the end of
an accounting period for a business enterprise. These are Balance Sheet and Profit
and Loss Account. The purposes of financial analysis are measuring the profitability,
indicating the trend of achievements, assessing the growth potential of the business,
compare with other firms, assess overall financial strength, assess solvency of the
firm etc. There are different methods of analysis and interpretation of financial
statements, such as comparative financial and operating statements, common-size
financial statements, Trend percentages/Trend Ratios, Ratio analysis etc.
Ratio analysis is a one of the important methods of analysis of financial
statements. The term ratio refers to the mathematical relationship between any two
interrelated variables. Ratio analysis is necessary to establish the relationship
between two accounting figures to highlight the significant information to the
management or users who can analyse the business situation and to monitor their
performance in a meaningful way. Accounting ratios are classified on the basis of
different criterias. The functional classification of ratios include Liquidity Ratios,
Profitability Ratios, Turnover Ratios and Solvency Ratios.
2.4 Terms to Remember

Financial Statements : The term financial statements refer to two basic
statements which an accountant prepares at the end of an accounting period for a
business enterprise. These are Balance Sheet (or Statement of Financial
Position) which reflects the assets, liabilities and capital as on a certain date, and
Profit and Loss Account (or Income Statement) which shows the results of
operations i.e. profit or loss during a certain period.

Financial Statement Analysis : Financial statement analysis is largely a study
of the relationships among the various financial factors in a business as
disclosed by a single set of statements and a study of the trends of these factors
as shown in a series of statements.

122

Ratio : Ratio can be defined as the term accounting ratio is used to describe
significant relationships which exist between figures shown in a balance sheet
and profit and loss account in a budgetary control system or any other part of the
accounting management.

Ratio Analysis : Ratio analysis is the relationship between two accounting
figures to highlight the significant information to the management or users who
can analyse the business situation and to monitor their performance in a
meaningful way.

2.5 Answers to Check Your Progress

1. c 2. b 3. d 4. c 5. b

2.6 Exercise
A) Short answer Questions:
1) What do you mean by analysis of financial statements?
2) What are the limitations of financial statements?
3) Enumerate the purposes of financial statement analysis.
4) What is meant by internal analysis and external analysis?
5) What is a comparative financial statement?
6) What is the difference between comparative statement and common size
financial statement?
7) What do you mean by trend percentage analysis?
B) Long Answer Questions:
1) Discuss the nature of financial statements.
2) Financial statements reflect a combination of recorded facts, accounting
conventions and personal judgements. Explain.
3) Explain the limitations of financial statements.
4) What do you mean by Comparative Balance Sheet and Comparative Profit
and Loss Account? Explain and Illustrate.

123
 What are the various tools of analysis of financial statements? Critically
examine these.
5) Explain the utility of financial statement analysis to various parties
interested in business
C) Short answer Questions:
1) What are the advantages of Ratio Analysis?
2) What are the limitations of ratio analysis?
3) What are the different categories of ratios? How are they classified?
4) Write short notes on :
a) Liquidity Ratios. b) Profitability Ratios. c) Turnover Ratios.
d) Solvency Ratios. e) Overall Profitability Ratios.
5) What do you understand by current ratio? What are it uses? What are its
limitations?
6) How can solvency of a firm be measured?
7) What you understand by Liquidity ratios? Discuss their significance.
8) Explain the importance of profitability Ratio. How they are worked out?
9) Discuss the usefulness of the following ratios:
a) Inventory Ratio. b) Operating Ratio.
c) Price Earning Ratio. d) Creditor's Turnover Ratio.
e) Debtor's Turnover Ratio
D) Long Answer Questions:
1) Explain any two of the following ratios with example:
I) Return on Investment Ratio (ROI);
II) Creditors Turnover Ratio;
III) Operating Profit Ratio.
2) Briefly explain the meaning and significance of any two of the following
ratios:

124
 i) Operating ratio ii) Liquidity ratio iii) Stock turnover ratio.
3) Write short notes on:
i) Price earning ratio
ii) Debt-equity ratio.
4) What do you mean by ratio analysis? Discuss its advantages and
limitations.
5) Briefly explain the various profitability ratios.
E) Practical problems:
1) The following Trading and Profit and Loss Account of Sudarshan Ltd is given,
Calculate:
a) Gross Profit ratio b) Net Profit ratio c) Operating ratio
d) Operating Profit ratio e) Stock turnover ratio.
Trading and Profit and Loss A/c
for the Year ending 31st Dec. 2002
Rs. Rs.
To Opening Stock 76,250 By Sales 5,00,000
To Purchases 3,15,250 By Closing Stock 98,500
To Carriage 2,000
To Wages 5,000
To Gross Profit 2,00,000
5,98,500 5,98,500
To Administrative Exp. 1,00,000 By Gross Profit 2,00,000
To Selling and Dist. Exp. 13,000 By Non-operating Incomes 6,000
To Finance Exp. 7,000
To Other Non-operating exp. 2,000
To Net Profit 84,000
2,06,000 2,06,000

125
Ans.
a) Gross Profit ratio (2,00,000/ 5,00,000) = 40%)
b) Net Profit ratio = (84,000/ 5,00,000) = 16.8%
c) Operating ratio = 4,,13,000/ 5,00,000 = 82.6%
d) Operating Profit ratio = 100 – 82.6 = 17.4%
e) Stock turnover = 3,00,000/87,375 = 3.43 times
2) From the information given below of MCS ltd, find out:
a) Current Assets b) Current Liabilities c) Liquid Assets
d) Proprietor's funds e) Share Capital f) Fixed Assets g) Stock-in-trade;
Information: (i) Current ratio 2.5; (ii) Liquid ratio 1.5 ; (ii) Proprietary ratio (fixed
assets/proprietary funds) 0.75; (iv) Working Capital Rs. 60,000; (v) Reserves and
Surplus Rs. 40,000; and (vi) Bank Overdraft Rs. 10,000. There-is no long-term loan
or fictitious asset.
Ans.
a) Current assets Rs. 1,00,000
b) Current liabilities Rs. 40,000
c) Liquid assets Rs. 60,000
d) Proprietor's funds Rs. 2,40,000
e) Share Capital Rs. 2,00,000
f) Fixed assets Rs. 1,80,000
g) Stock in trade Rs. 40,000.]
3) The following is the Profit and Loss Account of Priya & Co. for the year ended
on December 31, 2002 :
Rs.
Net Sales 30,00,000
Less: Cost of Goods Sold
Opening Stock 5,00,000
Add: Purchase 20,00,000

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 Rs.
25,00,000
Less: Closing Stock 7,00,000
18,00,000
Gross Profit 12,00,000
Less: Operating Expenses 4,80,000
Operating Profit 7,20,000
Less: Interest Charge 1,80,000
Profit before taxation 5,40,000
Additional information as on 31-12-2002
Current Assets 9,75,000
Current Liabilities 6,00,000
Fixed Assets 5,25,000

From the above particulars, calculate any four ratios out of the following:
i) Cost of Goods Sold Ratio ii) Operating Ratio
iii) Operating Profit Ratio iv) Stock Turnover Ratio
v) Assets Turnover Ratio vi) Return on Capital Employed.
4) From the final accounts of Sona Alies Ltd. given below, calculate the following:
i) Gross profit ratio ii) Current ratio
iii) Liquid ratio; and iv)Return on investment (ROT).
Trading and Profit and loss account for the year ended 31st March, 2003
Rs. Rs.
To Material Consumed By Sales 85,000
Opening Stock 9,050 By Profit 600
Purchases 54,525 By Interest on Investment 300
63,575
Less: Closing Stock 14,000 49,575
To Carriage inwards 1,425
To Office expenses 15,000
To Sales expenses 3,000
To Financial expenses 1,500

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 To Loss on sales of 400
tired assets
To Net Profit 15,000
85,900 85,900

Balance Sheet as on 31st March, 2003

Liabilities Rs. Assets Rs.
Share capital 2000 20,000 Fixed assets:
equity shares of Rs. 10
each, fully paid
General Reserve 9,000 Building 15,000
Profit and loss Account 6,000 Plant 8,000 23,000
Bank Overdraf 3,000 Current asstes:
Sundry Creditors: Stock-in-trade 14,000
for expenses 2,000 Bills receivable 1,000
for others 8,000 10,000 Bank balance 3,000 25,000
48,000 48,000

A
,
(Ans. i) Gross profit ratio = × 100 = 40%
 ,
 ,
ii) Current ratio = = 1.92:1
A,
,
iii) Liquid ratio = = 0.85:1
A,
,
iv) ROI = × 100 = 45.71%)
A ,
5. From the following particulars, you are required to calculate (a) Current Ratio
(b) Gross Profit Ratio (c) Stock Turnover Ratio (d) Debt Equity Ratio (e) Proprietary
Ratio (t) Debtor's Turnover Ratio
Rs. Rs.
Annual Sales 74,40,000 Paid up Capital 15,00,000
Gross Profit 7,44,000 Reserve & Surplus 6,00,000
Fixed Assets 16,50,000 7% Debentures 5,00,000

128
 Inventories 9,10,000 Bank Overdraft 2,00,000
Sundry Debtors 12,40,000 Sundry Creditors 12,00,000
Short-Term 1,60,000
Investments
Cash Balance 40,000

6) From the following Profit and Loss Account and Balance sheet, compute: (1)
Current Ratio (2) Liquid Ratio (3) Fixed Asset to Net Worth Ratio (4) Proprietary
Ratio (5) Debt Equity Ratio (6) Operating Ratio (7) Stock Turnover Ratio (8) Fixed
Assets Turnover Ratio (9) Creditors Turnover Ratio (10) Gross Profit Turnover Ratio
(II) Net Profit to Sales Ratio (12) Return on Investment Ratio.
Dr. Profit and Loss Account for the year ended 31-12-2002 Cr.
Particulars Rs. Particulars Rs.
To Opening Stock of 5,000 By Sales 50,000
Raw materials
To Purchases 32,000 Less: Return 1,000 49,000
Less: Return 2,000 30,000 By Closing Stock of 8,750
Raw materials
To Factory Expenses 1,000
To Gross profit c/d 21,750
57,750 57,750
To Operating expenses 8,750 By Gross Profit b/d 21,750
To Interest on 400
Debenture
To Provision for income 6,300
tax
To Net Profit 6,300
21,750 21,750

Balance Sheet as on 31st Dec. 2003

Liabilities Rs. Assets Rs.
Equity Share Capital 12,500 Land & Building 10,000
Capital Reserves 5,000 Plant & Machinery 6,000

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 Profit and Loss Account 2,500 Stock 8,750
8 % Debenture 5,000 Debtors 4,500
Sundry Creditors 5,000 Cash 2,000
Bank Overdraft 1,250
31,250 31,250

Ans.
1) Current Ratio = 2.44:1
2) Liquid Ratio = 1.04:1
3) Fixed Assets Net Worth Ratio = 80%
4) Debt Equity Ratio = 25:1
5) Operating Ratio = 0.74:1
6) Stock Turnover Ratio = 7.1 3 times
7) Fixed Assets Turnover Ratio = 3.06 times (or) 3.1 times
8) Creditors Turnover Ratio = 6 times
9) Gross Profit Turnover Ratio = 44.39%
10) Net Profit to Sales = 25.71%
11) Return on Investment Ratio = 52%
12) Proprietary Ratio = 064
7. The following are the summarised Profit and Loss Account Apex Ltd. for the
year ended 31 st December, 2002 and a Balance Sheet of the company as on that
date: Calculate the following ratios:
i) Gross Profit Ratio ii) Operating Profit Ratio
iii) Current Ratio iv) Fixed Assets Turnover.
Dr. Profit and Loss Account Cr.
Rs. Rs.
To Opening Stock 9,950 By Sales 85,000
To Purchases 54,525 By Closing Stock 14,900
To Carriage Inwards 1,425
To Gross Profit 34,000
99,900 99,900

130
 To Office Expenses 15,000 By Gross Profit 34,000
To Selling Expenses 3,000 By Profit on Sales of Shares 600
To Financial Expenses 1,500 By Interest on Investment 300
To Loss on Sale of an Asset 400
To Net Profit 15,000
34,900 34,900
Balance Sheet
Liabilities Rs. Assets Rs.
Share Capital: Land and Building 15,000
2,000 Equity Shares of 20,000 Plant 8,000
Rs. 10 each
Reserves 9,000 Stock 14,000
Profit and Loss Account 6,000 Debtors 7,000
Bank Overdraft 3,000 Bills Receivable 1,000
Sundry Creditors 8,000 Cash and Bank Balance 3,000
Outstanding Expenses 2,000
48,000 48,000
Ans.
A
,
i) × 100 = 40%
 ,
,
ii) × 100 = 18.82%
 ,
 ,
iii) = 1.92:1
A,
 ,
iv) = 3.7
A,

8. The Assets of Stock Limited consists of fixed assets and current assets while its
current liabilities comprise bank credit and trade credit. From the following figures
pertaining to the Pratiksha Ltd for the year 2012-13, prepare its balance sheet
showing the details of working:
Share Capital Rs. 1,99,500
Working Capital (CA - CL) Rs. 45,000
Gross Margin 20%

131
 Inventory turnover 6
Average collection period 2 months
Current ratio 1.5
Quick ratio 0.9
Reserves and surplus to cash 3

Ans.
Balance Sheet
Liabilities Rs. Assets Rs.
Share capital 1,99,500 Fixed assets 1,95,000
Reserves & Surplus 40,500 Current assets
Current liabilities 90,000 Stock 54,000
Debtors 67,500
Cash 13,500
3,30,000 3,30,00

9. The Capital of Patil & Co. Ltd. is as follows:

Additional Information
9% Preference Shares of 10 each Rs. 3,00,000
Equity Shares of Rs. 10 each Rs. 8,00,000
Profit (after tax at 60%) Rs. 2,70,000; Depreciation Rs. 60,000;
Equity dividend paid 20%; Market Price of Equity Shares Rs. 40. You are
required to calculate the following:
a) Dividend yield on the Equity Shares
b) Cover for the Preference and Equity Dividends
c) Earnings for Equity Shares
d) Price-Earnings Ratio
Ans:
a) 5%

132
b) Preference IO times, Equity 1,52 times
c) Rs. 3.04 per Share
d) 13.2 times
10. Prepare Trading Account and Balance Sheet from the following particulars:
Stock velocity 6,
Gross Profit Margin 20%,
Capital Turnover Ratio 4,
Debt collection period 3 months,
Creditor’s payment period 2 months
Ans.
Balance Sheet
Liabilities Rs. Assets Rs.
Share capital 1,99,500 Fixed assets 1,95,000
Reserves & Surplus 40,500 Current Assets:
Current liabilities 90,000 Stock 54,000
Debtors 67,500
Cash 13,500
3,30,000 3,30,000

11. The following is the Balance Sheet of Reliance India Ltd., as on 31st December,
2014:
Other information supplied is as follows:
a) Net Sales Rs. 30,00,000
b) Cost of goods sold Rs. 25,80,000
c) Net Income before Tax Rs. 2,00,000
d) Net Income after Tax Rs. 1,00,000
You are required to calculate (i) Liquid Ratio; (ii) Proprietary Ratio; (iii)
Current Ratio; (iv) Gross profit Ratio and (v) Net Profit Ratio.

133
Ans.

,,
i) = 1.33:1
A,,
,,
ii) = 1:2
,,
G,,
iii) = 2.33:1
A, 

,,
iv) = 14%
A,,
,,
v) = 3.33%
A,,

12. From the following information, prepare a summarised balance sheet as on 31st
March, 2013:
i) Working Capital Rs. 1,20,000 ii) Reserves and surplus Rs.80,000
iii) Bank Overdraft Rs. 20,000 iv) Assets (fixed) - Proprietary ratio 0.75
v) Current Ratio 2.5 (vi) Liquidity Ratio 1.5
Ans.
Balance Sheet as at 31st March, 2003
Liabilities Rs. Assets Rs.
Share Capital 4,00,000 Fixed Assets 3,60,000
Reserves and Surplus 80,000 Current assets:
Current liabilities Stock 1,10,000
Creditors 60,000 Other current assets 90,000
Bank Overdraft 20,000
5,60,000 5,60,000
13. Using the following ratios, complete the Balance Sheet below:
Total assets/Net worth: 3.5 Sales/Inventory:15
Sales/Fixed assets: 6 Sales/Debtors:18
Sales/current assets: 8 Current ratio:2.5
Annual sales Rs. 25: lakhs.

134
 Balance Sheet
............
Liabilities Rs. Assets Rs.
Net worth ........ Fixed Assets .......
Long term debts ........ Inventory ........
Current liabilities ........ Debtors ........
Liquid assets ........
Total current assets .........
......... .........
Ans.
Balance Sheet
Liabilities Rs. Assets Rs.
Net worth 2,08,333 Fixed Assets 4,16,667
Long term debts 3,95,834 Inventory 1,66,666
Current liabilities 1,25,000 Debtors 1,38,888
Liquid assets 6,946
Total current assets 3,12,500
7,29,167 7,29,167

14. The following are the summarised Profit and Loss Account for the year ending
31st December 2003, and the Balance sheet as on that date :
Trading and Profit and Loss Account
Rs. Rs.
To Opening Stock 1,00,000 By Sales 10,00,000
To Purchases 5,50,000 By Closing stock 1,50,000
To Gross profit c/d 5,00,000
11,50,000 11,50,000
To Administrative expenses 1,50,000 By Gross profit b/d 5,00,000
To Interest 30,000
To Selling expenses 1,20,000
To Net Profit 2,00,000
5,00,000 5,00,000

135
 Balance Sheet
Liabilities Rs. Assets Rs.
Capital 10,00,000 Land and Building 5,00,000
Profit and loss A/c 2,00,000 Plant and Machinery 3,00,000
Creditors 2,50,000 Stock 1,50,000
Bills payable 1,50,000 Sundry debtors 1,50,000
Bills receivable 1,25,000
Cash in hand and at bank 1,75,000
Furniture 2,00,000
16,00,000 16,00,000
Additional information:
a) Average debts Rs. 1,25,000 b) Average credit purchases Rs. 8,00,000
You are required to calculate: (i) Stock turnover ratio (ii) Current ratio (iii)
Quick ratio (iv) Operating ratioand (v)Return on equity.
Ans.
i) 4 ii) 1.5 ii) 1.12 iv) 77% v) 16.67%
long term non-current investment is 10.13% and its total fixed assets total is
98.02%. Beside this working capital is 1.98% and were excess of current assets i.e.
121.20% and on the other hand current liability were 119.23% as percentage
compare to total assets or total funds employed.
Common-Size Profit and Loss Account for the year 31st March 2020
Sr. Particular Year Ended Percentage
March 31, (%)
2020
1 Gross Sale and Services
A (Revenue from Operation) 20,787.46 99.68
B Other Income 65.84 0.32
2 Less: returns & Allowance
3 Net Sale 20,853.30 100.00
4 Less: Cost of Goods Sold
a Raw Material Consumed 7,363.58 35.31

136
 b Direct Expenses 1,928.86 9.25
c Manufacturing Exp. 7,528.24 36.10
d Operating Stock (WIP) 540.16 2.59
Less: Total Cost of Goods Sold 17,360.84 83.25
5 Gross Profit 3,492.46 16.75
6 Less: Operating Expenses
A Administrative Expenses 369.91 1.77
B Selling and Distribution Expenses 802.75 3.85
C Finance Expenses 828.88 3.97

Total operating Expenses 2,001.53 9.60

7 Operating Profit Before Interest 1,490.93 7.15

8 Less: Interest Paid 867.19 4.16
9 Net Profit after Interest 623.74 2.99
10 Net Non-Operating Income
11 Net Profit before Tax (NPBT) 623.74 2.99
12 Less: Income Tax
Less : Tax Expenses /Deferred Tax
290.96 1.40
Liability/(Asset)
13 Net Profit After Tax 332.78 1.60

It shows that the vertical analysis of common size income statement, which
helps to comparisons of items within the same financial statement. It is understood
that the common-size income statement is an income statement where each line item
is expressed as a percentage of a base figure. And present common size income
statement divided in each line items by Net Sale i.e. Rs. 20,853.30 is 100%,
followed by is as compare to net revenue percentage cost of goods sold is 83.25%
and after deduction of Cost of Goods sold from net revenue company got 16.75%
gross profit with compare to net revenue, followed by total operating expenses
9.60%, net profit after interest 7.15% , net profit before tax is 2.99% and finally net
profit after tax was 1.60% which shows the percentage relationship with net sale.

137
 Trend Analysis of Balance Sheet
Sr. Particular As at As at As at 2018 2019 2020
March March March
31, 2018 31, 2019 31, 2020
I Sources of Fund
1 Own Fund
A Capital
Equity Shares 1,035.00 1413.00 1413.00 100 136.52 136.52
Preference Shares 1,071.00 1071.00 1071.00 100 100.00 100.00
Total Capital 2,106.00 2,484.00 2,484.00 100 117.95 117.95

Reserve and Surplus

B (1,209.25) (1,326.12) (1,658.89) 100 (109.66) (137.18)
(Other equity)
Less: Losses and
C
Fictitious Assets
Net Reserves and
Fictitious Reserves (B- (1,209.25) 1,326.12 1,658.89 100 (109.66) (137.18)
C)

Own Fund/ Net Worth

(1) [Capital + Reserves
896.75 3,810.12 4,142.89 100 424.88 461.99
& Surplus - Losses &
Fictitious Assets]

2 Loan Fund
Secured Loans/ Long
A 2,737.61 2,217.49 2,494.00 100 81.00 91.10
Term Borrowings
B Unsecured Loan
Other Long term
C 0.12 0.12 0.12 100 100.00 100.00
Liabilities

138
D Long-Term Provisions 28 34 37 100 120.27 133.58
Owe Fund (a +b + C)
[Secured Loan +
2,765.75 2,251.31 2,531.56 100 81.40 91.53
Unsecured Loans +
Other Liabilities]

Total Fund Available

/Capital Employed 3,662.50 6,061.43 6,674.45 100.00 165.50 182.24
[Own Fund+ Owed
Funds] (1+2)
Application of the
II
Fund
Net Fixed/ Non-
1
Current Assets
A Tangible Assets 3,314.74 3,269.91 5,662.93 100 98.65 170.84
Capital work-in-
45.09 363.29 87.20 100 805.69 193.39
progress
Intangible assets under
0.00 67.14 0.00 0.00 100 0.00
development
Less: Depreciation
Net Tangible Assets 3,359.83 3,700.34 5,750.13 100 110.13 171.14

B Intangible Assets 7.70 11.57 116.68 100 150.31 1515.25

Total Fixed Assets

(A+B) 3,367.53 3,711.91 5,866.81 100 110.23 174.22
[Net Tangible Assets +
Intangible Assets]

2 Long Term. Non-

139
 Current Investment
Long term Loans Givens 43.50 234.57 425.36 100 539.27 977.92
Deferred Receivables 585.24 524.90 235.16 100 89.69 40.18
Others 11.27 20.93 15.27 100 185.81 135.57

Total Long Term.

Non-Current 640.00 780.40 675.80 100 121.94 105.59
Investment

Total Fixed Assets

4,007.54 4,492.31 6,542.60 100 112.10 163.26
(A+B)

3 Working Capital
Quick Assets
a Cash in Hand 250.88 1,325.95 356.16 100 528.52 141.96
Debtors (Net) /Trade
b 1,797.70 2,927.33 1,671.43 100 162.84 92.98
Receivables
c Bills Receivables 0.00 0.00 0.00 0.00 0.00 0.00
Short Term Loan and
d 5.20 12.38 132.55 100 238.02 2549.43
Advances
g Other Current Assets 1,009.07 883.57 1,286.26 100 87.56 127.47
Total Quick Assets 3,062.85 5,149.22 3,446.39 100 168.12 112.52
h Inventory 3,765.11 4,809.05 4,643.33 100 127.73 123.33
Pre-Payment (Prepaid
i Expenses, Advanced for 0.00 0.00 0.00 0.00 0.00 0.00
Goods., Advanced Tax)
A Current Assets 6,827.97 9,958.27 8,089.72 100 145.85 118.48

Less: Quick Liabilities

140
 Creditors/Trade
a 4,977.15 5,161.33 4,886.60 100 103.70 98.18
Payables
b Short Term Loans 893.72 1,778.80 1,791.21 100 199.03 200.42
c Other Current liabilities 1,298.53 1,058.30 1,272.26 100 81.50 97.98
d Short-Term provisions 3.61 4.12 7.80 100 114.32 216.10
Total Quick Liabilities
7,173.00 8,002.56 7,957.87 100 111.57 110.94
(a to d)
e Bank Overdraft 0.00 386.59 0.00 0 100.00 0.00
Current Liabilities
B [Quick Liability + Bank 7,173.00 8,389.15 7,957.87 100 116.95 110.94
Overdraft]
Net Current Assets /
Working Capital (A- (345.03) 1,569.12 131.85 100 (454.78) (38.21)
B)

Total Assets or Total

Funds Employed 3,662.50 6,061.43 6,674.45 100.00 165.50 182.24
(1+2+3)
(Note: In bracket figures indicate the minus figures)
From the trend analysis of the Balance Sheet reveals that the total of total fund
available or capital employed and total assets or total funds employed
correspondingly increased last two years i.e. 165.50% and 182.24% as compare to
the base year 2018. It seems that the correspondingly increased net worth i.e.
424.88% and 461.99% by the year 2019 and 2020 respectively with compare to base
year 2018, followed by increased owe fund i.e. 81.40% and 91.53% by the year
2019 and 2020. Moreover, in term of application of fund total fixed assets increased
i.e. 87.56% and 127.47% by the year 2019 and 2020 respectively. Furthermore it
seem that working capital was found negative trend, which reveals the change in the
current operating assets has increased higher than the current operating liabilities.

141
 Trend Analysis of Income Statement
Sr. Particular Year Year Year 2018 2019 2020
Ended Ended Ended
March 31, March 31, March 31,
2018 2019 2020
1 Gross Sale and Services
(Revenue from Operation) 10,286.18 16,502.47 20,787.46 100 160.43 202.09
Other Income 26.81 53.11 65.84 100 198.11 245.59
2 Less: returns & Allowance
3 Net Sale 10,312.99 16,555.58 20,853.30 100 160.53 202.20
4 Less: Cost of Goods Sold
Raw Material Consumed 3,774.62 6,375.93 7,363.58 100 168.92 195.08
e Direct Expenses 1,154.31 1,439.45 1,928.86 100 124.70 167.10
Manufacturing Exp. 4,259.48 6,405.01 7,528.24 100 150.37 176.74
g Operating Stock (WIP) (1,243.33) (617.03) 540.16 100 49.63 (43.44)
Less: Cost of Goods Sold 7,945.10 13,603.36 17,360.84 100 171.22 218.51
5 Gross Profit 2,367.89 2,952.21 3,492.46 100 124.68 147.49
6 Less: Operating Expenses
A Administrative Expenses 271.81 305.40 369.91 100 112.36 136.09
Selling and Distribution 420.71 583.64 802.75 100 138.73 190.81
B
Expenses
C Finance Expenses 747.61 732.91 828.88 100 98.03 110.87

Total operating Expenses 1,376.52 1,621.95 2,001.53 100 117.83 145.41

7 Operating Profit Before Interest 991.37 1,330.27 1,490.93 100 134.18 150.39
8 Less: Interest Paid 700.31 815.28 867.19 100 116.42 123.83
9 Net Profit after Interest 291.06 514.99 623.74 100 176.93 214.30
10 Net Non-Operating Income
11 Net Profit before Tax (NPBT) 291.06 514.99 623.74 100 176.93 214.30
12 Less: Income Tax
Less : Tax Expenses (175.36) 60.34 290.96 100 (34.41) (165.92)
/Deferred Tax
Liability/(Asset)
13 Net Profit After Tax 466.42 454.64 332.78 100 97.47 71.35
(Note: In bracket figures indicate the minus figures)

142
 From the trend analysis of Income statement it is shown that the net sale last
subsequently two years i.e. 160.53% and 202.20% by the year 2020 and 2019
respectively. Similarly cost of goods sold increased by the year 2019 and 2020 i.e.
171.22 % and 218.51% respectively, furthermore, it is seems that correspondingly
increased other items like gross profit, total operating items, net profit after interest,
net profit after tax respectively. Hence, the income statement the figures of 2020
when compared with 2019 reveal that the Sales have increased by 41.67%
respectively. Similarly, the cost of goods sold and the expenses have increased by
47.29% and 27.58% respectively. Its resulted Net Profit were slightly decreased by
26.12% by the year 2020 as compare to preceding year 2019.
Ratio Analysis:
It is observed that ratio analysis helps to make appropriate decisions in keeping
with the objectives of the respective company. The financial ratio analysis which is a
tool of financial analysis, which helps to take financial decision.
Balance Sheet Ratio:
Sr. Types of Ratio Formulas Calculations Result

Current Current Assets

1 = ,F.G
1.02
Current Liabilities =
G,F G.G

Quick/Liquid €‚ƒ „ †‡ A,

.AF

2 = = 0.4
G,F G.G
€‚ƒ ˆ‰Š‹‡†

Stock to Working
,
A.AA

Œ‡‚ƒ =
3 Capital = A. 35.22
Žƒ‘ ’‰“‡‰‹

”“†‡ •€–
,
.F

Proprietors = =
,.
4 —‡‰ „ †‡ 28.31

143
 ˜™†– •€– , A. 
=
,
.F
5 Debt Equity = 0.61
”“†‡ •€–

From the above table calculate financial ratio including current ratio, quick ratio,
and stock to working capital ratio, proprietary ratio and debt to equity ratio.
Therefore, it is interpreted that the current ratio of the company is not satisfactory
because the ratio (1.02), was below the generally accepted standard of 2:1. It means
company face some hurdles to the pay short term debts. On the other hand quick or
liquid Ratio was 0.4 which is slightly less than the accepted standard of 1:1.
Moreover, stock to Working Capital Ratio i.e. 35.22% reveals that efficiency of
company to use working capital, which was company to turnover its inventories to
make short term payments to its creditors and accounts payable. It is also revealed
that the proprietor’s ratio is expressed in the form of a percentage, and that was
28.31%. It means 28.31% funds of the company are financed by the proprietors. It is
understood that the high proprietary ratio indicates that a company uses more
proprietors' funds for purchasing total assets and it is financed by shareholders. It is
noted that the considering present ratio, it should need to improve proprietary ratio
to judge the long term solvency and stability of company. It is also indicated the
composition of capital structure in term of debt and equity. Current ratio of the
company is satisfactory because the ratio (0.61), it was below the generally accepted
standard of 2:1, and it is noted that the low ratio suitable for company and its helps
to judge the long-term solvency and stability of company.

144
 Profit and Loss Ratio:

Sr. Types of Ratio Formulas Calculations Result

6 Gross Profit Gross ProKit 3,492.46 16.75

= × 100 = × 100
Sale 20,853.30

7 Net Profit Ratio Net ProKit 332.78 2.99

= × 100 = × 100
Sale 20,853.30

8 Operating OPerating Expenses Ratio 2,001.53 9.60

= × 100 = × 100
Expenses Sale 20,853.30

9 Stock Turnover Cost of Goods Sold (COGS) 17,360.84 3.67

= =
Opening Stock + Closing Stock 4809.05 + 4643.33 times
2 2
× 100 × 100

It is understood that Gross profit ratio showcases the relationship between Gross
Profit and Net Revenue of your business. It seems that gross profit ratio was 16.75%
it means 83.25 % cost of goods sold, in mother worlds company got 16.75% revenue
from sales. It indicates that the company has adopted the unfavourable purchase and
sales policy. Considering gross profit company should concentrate on the improving
gross profit ratio. It’s Standard i.e. Std> 100% and high ratio suitable for company
and Its helps to judge profitability and operating efficiency of company. Moreover,
it is stated Net profit (NP) ratio is a useful tool to measure the overall profitability of
the Company. It’s Standard i.e. Std> 100% and high ratio suitable for company and
Its helps to judge profitability. It is noted that the net profit ratio of Synergy Pvt.,
Ltd was 2.99%, which was slightly decrease as compare to previous year.
Furthermore, it is stated that operating expenses ratio measures portion of a
particular expenses in comparison to sale. It’s Standard i.e. Std< 100% and low ratio
suitable for company and It helps to know operating cost and profit. The operating
expense ratio is 9.60%, which reveals the proportion of expenses to revenues for
income generating activities, and low operating expenses ratio positively lead to
profit generating activities. It is also noted that the stock Turn over measures the

145
efficiency of the firm to manage its inventory. It’s Standard ratio based on it past
ratio and low ratio suitable for company and its helps to know operating cost and
profit. It is found that during the year 2020 Stock Turnover ratio was 3.67 times,
which means stock was converted into sale 3.67 times.

Practical: Download financial statement of any company and analyse it with

any technique of financial analysis also write interpretation
Financial Statements Analysis refers to the evaluation financial statements to
take financial or business decision. It helps to assess the present profitability and
operating efficiency of company and find out the relative importance of different
components of the financial position of the firm. Thus, it is possible, to identify the
reasons for change in the profitability/financial position of the firm, and assess the
short term as well as the long term liquidity position of the company. Hence,
herewith download financial statement of Synergy Pvt. Ltd consecutive last three
years and convert it vertical form and calculate comparative, common size, trend
and ratio analysis of particular financial statement of Synergy Pvt Ltd. as follow.

146
(Sources:https://www.synergygreenind.com/investors/annual-report 2019-20)

147
(Sources:https://www.synergygreenind.com/investors/annual-report 2019-20)

148
(Sources:https://www.synergygreenind.com/investors/annual-report 2018-19)

149
(Sources:https://www.synergygreenind.com/investors/annual-report 2018-19)

150
 Vertical Balance Sheet of Synergy Pvt., Ltd as at
As at As at As at
Sr. Particular March 31, March March 31,
2018 31, 2019 2020
I Sources of Fund
1 Own Fund
A Capital 2,106.00 2,484.00 2,484.00
1,035.0 1,413.0
Equity Shares 1,413.00
0 0
1,071.0 1,071.0
Preference Shares 1,071.00
0 0

Reserve and Surplus

B (1,209.25) 1,326.12 1,658.89
(Other equity)

Less: Losses and

C
Fictitious Assets
Own Fund/ Net Worth (1)
[Capital + Reserves &
896.75 3,810.12 4,142.89
Surplus - Losses &
Fictitious Assets]

2 Loan Fund
Secured Loans/ Long
A 2,737.61 2,217.49 2,494.00
Term Borrowings
B Unsecured Loan
Other Long term
C 0.12 0.12 0.12
Liabilities
D Long-Term Provisions 28 34 37
Owe Fund (a + b +
c)[Secured Loan +
2,765.75 2,251.31 2,531.56
Unsecured Loans + Other
Liabilities]

Total Fund Available

/Capital Employed [Own 3,662.50 6,061.43 6,674.45
Fund+ Owed Funds] (1+2)

II Application of the Fund

Net Fixed/ Non-Current
1
Assets

151
A Tangible Assets 3,314.74 3,269.91 5,662.93
Capital work-in-progress 45.09 363.29 87.20
Intangible assets under
0.00 67.14 0.00
development
Net Tangible Assets (a-b) 3,359.83 3,700.34 5,750.13

B Intangible Assets 7.70 11.57 116.68

Total Fixed Assets (A+B) 3,367.53 3,711.91 5,866.81
[Net Tangible Assets +
Intangible Assets]
Long Term. Non-Current
2
Investment
Long term Loans Givens 43.50 234.57 425.36
Deferred Receivables 585.24 524.90 235.16
Others 11.27 20.93 15.27

Total Long Term. Non-

640.00 780.40 675.80
Current Investment

Total Fixed Assets (A+B) 4,007.54 4,492.31 6,542.60

3 Working Capital
Quick Assets
a Cash in Hand 250.88 1,325.95 356.16
Debtors (Net) /Trade
b 1,797.70 2,927.33 1,671.43
Receivables
c Bills Receivables
Short Term Loan and
d 5.20 12.38 132.55
Advances
e Other Current Assets 1,009.07 883.57 1,286.26
Total Quick Assets 3,062.85 5,149.22 3,446.39
f Inventory 3,765.11 4,809.05 4,643.33
Current Assets [Quick
A 6,827.97 9,958.27 8,089.72
Assets + Inventory]

Less: Quick Liabilities

a Creditors/Trade Payables 4,977.15 5,161.33 4,886.60
b Short Term Loans 893.72 1,778.80 1,791.21
c Other Current liabilities 1,298.53 1,058.30 1,272.26

152
 d Short-Term provisions 3.61 4.12 7.80
Total Quick Liabilities (a
7,173.00 8,002.56 7,957.87
to d)
e Bank Overdraft 386.59
Current Liabilities
B [Quick Liability + Bank 7,173.00 8,389.15 7,957.87
Overdraft]

Net Current Assets /

(345.03) 1,569.12 131.85
Working Capital (A-B)

Total Assets or Total

3,662.50 6,061.43 6,674.45
Funds Employed (1+2+3)
(Note: In bracket figures indicate the minus figures)
Vertical Profit and Loss Statement As on 31st March
Year
Year Ended Year Ended
Ended
Sr. Particular March 31, March 31,
March
2019 2020
31, 2018
1 Gross Sale and Services
(Revenue from
10,286.18 16,502.47 20,787.46
Operation)
Other Income 26.81 53.11 65.84

Less: returns &

2
Allowance

3 Net Sale 10,312.99 16,555.58 20,853.30

Less: Cost of Goods
4
Sold
Raw Material Consumed 3,774.62 6,375.93 7,363.58
Direct Expenses 1,154.31 1,439.45 1,928.86

Manufacturing Exp. 4,259.48 6,405.01 7,528.24

Depreciation

Operating Stock (WIP) (1,243.33) (617.03) 540.16

Less: Cost of Goods

7,945.10 13,603.36 17,360.84
Sold

153
 5 Gross Profit 2,367.89 2,952.21 3,492.46
Less: Operating
6
Expenses
A Administrative Expenses 271.81 305.40 369.91
Selling and Distribution
B 420.71 583.64 802.75
Expenses
C Finance Expenses 684.00 732.91 828.88

Total operating
1,376.52 1,621.95 2,001.53
Expenses
Operating Profit Before
7 991.37 1,330.27 1,490.93
Interest
8 Less: Interest Paid 700.31 815.28 867.19

9 Net Profit after Interest 291.06 514.99 623.74

Net Non-Operating
10
Income
Net Profit before Tax
11 291.06 514.99 623.74
(NPBT)
12 Less: Income Tax

Less : Tax
Exp/Deferred Tax (175.36) 60.34 290.96
Liability/(Asset)

13 Net Profit After Tax 466.42 454.64 332.78

(Note: In bracket figures indicate the minus figures)

Comparative Balance Sheet:
Sr. Particular As at As at Absolute Percentag
March 31, March 31, Increase or e Increase
2019 2020 Decrease or
Decrease
I Sources of Fund
1 Own Fund
A Capital
Equity Shares 1413.00 1413.00 0.00 0.00

154
 Preference Shares 1071.00 1071.00 0.00 0.00
Total Capital 2,484.00 2,484.00 0.00 0.00

Reserve and Surplus (Other

B 1,326.12 1,658.89 332.78 25.09
equity)

Less: Losses and Fictitious

C 0.00 0.00 0.00 0.00
Assets

Net Reserves and Fictitious

1,326.12 1,658.89 332.78 25.09
Reserves (B-C)
Own Fund/ Net Worth (1)
[Capital + Reserves & Surplus - 3,810.12 4,142.89 332.78 8.73
Losses & Fictitious Assets]

2 Loan Fund
Secured Loans/ Long Term
A 2,217.49 2,494.00 276.52 12.47
Borrowings
B Unsecured Loan
C Other Long term Liabilities 0.12 0.12 0.00 0.00
D Long-Term Provisions 34 37 3.73 11.07
Owe Fund (a + b + C)
2,251.31 2,531.56 280.25 12.45
[Secured Loan + Unsecured
Loans + Other Liabilities]
Total Fund Available /Capital
Employed [Own Fund+ Owed 6,061.43 6,674.45 613.02 10.11
Funds] (1+2)]

II Application of the Fund

1 Net Fixed/ Non-Current Assets
A Tangible Assets 3,269.91 5,662.93 2393.02 73.18
Capital work-in-progress 363.29 87.20 (276.09) (76.00)
Intangible assets under 67.14 0.00 0.00 0.00

155
 development
Net Tangible Assets (a-b) 3,700.34 5,750.13 2049.79 55.39

B Intangible Assets 11.57 116.68 105.10 908.08

Total Fixed Assets (A+B)
3,711.91 5,866.81 2154.90 58.05
[Net Tangible Assets + Intangible
Assets]
Long Term. Non- Current
2
Investment
Long term Loans Givens 234.57 425.36 190.80 81.34
Deferred Receivables 524.90 235.16 (289.74) (55.20)
Others 20.93 15.27 (5.66) (27.04)
Total Long Term. Non-
780.40 675.80 (104.60) (13.40)
Current Investment

Total Fixed Assets (A+B) 4,492.31 6,542.60 2050.30 45.64

3 Working Capital
Quick Assets
a Cash in Hand 1,325.95 356.16 (969.79) (73.14)
b Debtors (Net) /Trade Receivables 2,927.33 1,671.43 (1255.90) (42.90)
c Bills Receivables
d Short Term Loan and Advances 12.38 132.55 120.18 971.12
e Other Current Assets 883.57 1,286.26 402.69 45.58
Total Quick Assets 5,149.22 3,446.39 (1702.83) (33.07)
h Inventory 4,809.05 4,643.33 (165.72) (3.45)
Current Assets [Quick Assets +
A 9,958.27 8,089.72 (1868.55) (18.76)
Inventory]

Less: Quick Liabilities

a Creditors/Trade Payables 5,161.33 4,886.60 (274.73) (5.32)
b Short Term Loans 1,778.80 1,791.21 12.41 0.70
c Other Current liabilities 1,058.30 1,272.26 213.96 20.22

156
 d Short-Term provisions 4.12 7.80 3.67 89.03
Total Quick Liabilities 8,002.56 7,957.87 (44.68) (0.56)
e Bank Overdraft 386.59 0.00 (386.59) (100)
Current Liabilities [Quick
B 8,389.15 7,957.87 (431.27) (5.14)
Liabilities + Bank Overdraft]

Net Current Assets / Working

1,569.12 131.85 (1437.27) (91.60)
Capital (A-B)
Total Assets or Total Funds
6,061.43 6,674.45 613.02 10.11
Employed (1+2+3)
(Note: In bracket figures indicate the minus figures)
It is stated that the comparative balance sheet compares balance sheet figures of
last two years. The comparative balance sheet shows the composition of sources and
application of the fund and it is noted that net worth of company increase 8.73%
over the period 2020, followed by owe fund increased 12.45 over the period 2020
and its result increased the source of fund 10.11 by the year 2020. Similarly in term
of application of fund the total noncurrent assets increased 58.05% by the year 2020.
Moreover, long term investment decreased by 13.40% and its effect on total fixed
assets which was slightly increased i.e. 45.64%, followed by it is noted that
decreased working capital 91.60%, which shows the shortage of fund and increased
obligation during the year 2020, its reason behind that increased quick assets and
other hand decreased inventory 3.45 by the year 2020. Beside the slightly decreased
quick and current liability, and its result reveals the decrease working capital
requirement over the year 2020. Thus, it is stated that the comparative financial
statement helps to explains about the changes in different items of the financial
statements of balance sheet.
Comparative Profit and Loss Statement:
Sr. Particular Year Ended Year Ended Absolute Percentage
March 31, March 31, Increase Increase or
2019 2020 or Decrease
Decrease
1 Gross Sale and Services
(Revenue from 16,502.47 20,787.46 4,285.00 25.966

157
 Operation)
Other Income 53.11 65.84 12.73 23.969
Less: returns &
2
Allowance
3 Net Sale 16,555.58 20,853.30 4,297.72 25.959
Less: Cost of Goods
4
Sold
Raw Material
6,375.93 7,363.58 987.64 15.490
Consumed
Direct Expenses 1,439.45 1,928.86 489.41 34.000
Manufacturing Exp. 6,405.01 7,528.24 1,123.24 17.537
Depreciation
Operating Stock (WIP) (617.03) 540.16 1,157.19 (187.541)
Less: Total Cost of
13,603.36 17,360.84 3,757.48 27.622
Goods Sold
5 Gross Profit 2,952.21 3,492.46 540.25 18.300
6 Less: Operating Expenses 0.00 0.00 0.00 0.00
a Administrative Expenses 305.40 369.91 64.51 21.122
Selling and Distribution
b 583.64 802.75 219.11 37.541
Expenses
c Finance Expenses 732.91 828.88 95.97 13.095

Total operating
1,621.95 2,001.53 379.59 23.403
Expenses

Operating Profit Before

7 1,330.27 1,490.93 160.66 12.077
Interest
8 Less: Interest Paid 815.28 867.19 51.91 6.367
9 Net Profit after Interest 514.99 623.74 108.75 21.118
Net Non-Operating
10
Income
Net Profit before Tax
11 514.99 623.74 108.75 21.118
(NPBT)

158
 12 Less: Income Tax
Less : Tax
Exp./Deferred Tax 60.34 290.96 230.62 382.175
Liability/(Asset)
13 Net Profit After Tax 454.64 332.78 (121.87) (26.805)
(Note: In bracket figures indicate the minus figures)
On the basis of comparative income statement it can be said that Gross Profit for
the year 2020 has increased by 18.30% over the profit for the year 2019. The Net
Sales during the same period has increased by 25.96%, which was coupled with
increase in the cost of goods sold which also increased by same 27.62%. This means
that Input/Output ratio or the production efficiency level has been maintained during
2020. The same increase of 25.96% in Net Sales and the Cost of goods sold has
resulted in increase in Gross Profit by 18.30%. The increase in Net Profit is more
pronounced i.e. by 21.11%. The reason for a slightly increase in Net Profit is the
comparatively high total expenses i.e. 23.40. The General Expenses during 2019 and
2020 were same but the increase in Selling Expenses by 37.54% has resulted due to
increase of total expenses by 23.40%. It’s affected on the net profit of the company.
Common-Size Balance Sheet:
Sr. Particular As at Percentage
March 31, (%)
2020
I Sources of Fund
1 Own Fund
A Capital
Equity Shares 1,413.00 21.17
Preference Shares 1,071.00 16.05
Total Capital 2,484.00 37.22
B Reserve and Surplus (Other equity) 1,658.89 24.85
C Less: Losses and Fictitious Assets
Net Reserves and Fictitious Reserves (B-C) 1,658.89 24.85

159
 Own Fund/ Net Worth (1) [Capital + Reserves &
4,142.89 62.07
Surplus - Losses & Fictitious Assets]
2 Loan Fund
A Secured Loans/ Long Term Borrowings 2,494.00 37.37
B Unsecured Loan

C Other Long term Liabilities 0.12 0.00

D Long-Term Provisions 37 0.56

Owe Fund (a + b + C) [Secured Loan + Unsecured

2,531.56 37.93
Loans + Other Liabilities]
Total Fund Available /Capital Employed [Own Fund+
6,674.45 100.00
Owed Funds] (1+2)

II Application of the Fund

1 Net Fixed/ Non-Current Assets
a Tangible Assets 5,662.93 84.84
Land and Building
Capital work-in-progress 87.20 1.31
Intangible assets under development 0.00
b Less: Depreciation
Net Tangible Assets 5,750.13 86.15

B Intangible Assets 116.68 1.75

Total Fixed Assets (A+B)[Net Tangible Assets +
5,866.81 87.90
Intangible Assets]
2 Long Term. Non-Current Investment

160
 Long term Loans Givens 425.36 6.37
Deferred Receivables 235.16 3.52
Others 15.27 0.23
Total Long Term. Non-Current Investment 675.80 10.13

Total Fixed Assets (1+2) 6,542.60 98.02

3 Working Capital
Quick Assets
a Cash in Hand 356.16 5.34
b Debtors (Net) /Trade Receivables 1,671.43 25.04
c Bills Receivables
d Short Term Loan and Advances 132.55 1.99
e Accrued Income
f Short Term or Marketable Investment
g Other Current Assets 1,286.26 19.27
Total Quick Assets 3,446.39 51.64
h Inventory 4,643.33 69.57
Pre-Payment (Prepaid Expenses, Advanced for Goods.,
i
Advanced Tax)
A Current Assets [Quick Assets + Inventory] 8,089.72 121.20
Current Liabilities
a Creditors/Trade Payables 4,886.60 73.21
b Short Term Loans 1,791.21 26.84
c Other Current liabilities 1,272.26 19.06
d Short-Term provisions 7.80 0.12
Total Quick Liabilities (a to d) 7,957.87 119.23

161
 e Bank Overdraft
Total Current Liabilities [Quick Liabilities + Bank
B 7,957.87 119.23
Overdraft]
Net Current Assets / Working Capital (A-B) 131.85 1.98

Total Assets or Total Funds Employed (1+2+3) 6,674.45 100.00

(Note: In bracket figures indicate the minus figures)

The above common size balance sheet is divided in two part as sources of fund
and application of fund, followed by total fund available or capital employed amount
as well as total assets or total funds employed is equal to 100 and individual items
of sources of fund and application of fund are expressed as percentage. It is noted
that percentage of own fund was 62.07%, followed by loan or woe fund 37.93% as
compared to total of total fund available or capital employed amount. Furthermore,
it seems that the total assets or total fund employed Rs 6,674.45 i.e. 100% and it
percentage divided with total non-current fixed assets 87.90%, followed by total
long term non-current investment is 10.13% and its total fixed assets total is
98.02%. Beside this working capital is 1.98% and were excess of current assets i.e.
121.20% and on the other hand current liability were 119.23% as percentage
compare to total assets or total funds employed.
Common-Size Profit and Loss Account for the year 31st March 2020
Sr. Particular Year Ended Percentage
March 31, (%)
2020
1 Gross Sale and Services
A (Revenue from Operation) 20,787.46 99.68
B Other Income 65.84 0.32
2 Less: returns & Allowance
3 Net Sale 20,853.30 100.00
4 Less: Cost of Goods Sold
a Raw Material Consumed 7,363.58 35.31
b Direct Expenses 1,928.86 9.25

162
 c Manufacturing Exp. 7,528.24 36.10
d Operating Stock (WIP) 540.16 2.59
Less: Total Cost of Goods Sold 17,360.84 83.25
5 Gross Profit 3,492.46 16.75
6 Less: Operating Expenses
A Administrative Expenses 369.91 1.77
B Selling and Distribution Expenses 802.75 3.85
C Finance Expenses 828.88 3.97

Total operating Expenses 2,001.53 9.60

7 Operating Profit Before Interest 1,490.93 7.15

8 Less: Interest Paid 867.19 4.16
9 Net Profit after Interest 623.74 2.99
10 Net Non-Operating Income
11 Net Profit before Tax (NPBT) 623.74 2.99
12 Less: Income Tax
Less : Tax Expenses /Deferred Tax
290.96 1.40
Liability/(Asset)
13 Net Profit After Tax 332.78 1.60

It shows that the vertical analysis of common size income statement, which
helps to comparisons of items within the same financial statement. It is understood
that the common-size income statement is an income statement where each line item
is expressed as a percentage of a base figure. And present common size income
statement divided in each line items by Net Sale i.e. Rs. 20,853.30 is 100%,
followed by is as compare to net revenue percentage cost of goods sold is 83.25%
and after deduction of Cost of Goods sold from net revenue company got 16.75%
gross profit with compare to net revenue, followed by total operating expenses
9.60%, net profit after interest 7.15% , net profit before tax is 2.99% and finally net
profit after tax was 1.60% which shows the percentage relationship with net sale.

163
 Trend Analysis of Balance Sheet
Sr. Particular As at As at As at 2018 2019 2020
March March March
31, 2018 31, 2019 31, 2020
I Sources of Fund
1 Own Fund
A Capital
Equity Shares 1,035.00 1413.00 1413.00 100 136.52 136.52
Preference Shares 1,071.00 1071.00 1071.00 100 100.00 100.00
Total Capital 2,106.00 2,484.00 2,484.00 100 117.95 117.95

Reserve and Surplus (1,209.25 (1,326.12 (1,658.89 (109.66 (137.18

B 100
(Other equity) ) ) ) ) )
Less: Losses and
C
Fictitious Assets
Net Reserves and
(1,209.25 (109.66 (137.18
Fictitious Reserves (B- 1,326.12 1,658.89 100
) ) )
C)

Own Fund/ Net Worth

(1) [Capital + Reserves
896.75 3,810.12 4,142.89 100 424.88 461.99
& Surplus - Losses &
Fictitious Assets]

2 Loan Fund
Secured Loans/ Long
A 2,737.61 2,217.49 2,494.00 100 81.00 91.10
Term Borrowings
B Unsecured Loan
Other Long term
C 0.12 0.12 0.12 100 100.00 100.00
Liabilities

164
D Long-Term Provisions 28 34 37 100 120.27 133.58
Owe Fund (a +b + C)
[Secured Loan +
2,765.75 2,251.31 2,531.56 100 81.40 91.53
Unsecured Loans +
Other Liabilities]

Total Fund Available

/Capital Employed 3,662.50 6,061.43 6,674.45 100.00 165.50 182.24
[Own Fund+ Owed
Funds] (1+2)
Application of the
II
Fund
Net Fixed/ Non-
1
Current Assets
A Tangible Assets 3,314.74 3,269.91 5,662.93 100 98.65 170.84
Capital work-in-
45.09 363.29 87.20 100 805.69 193.39
progress
Intangible assets under
0.00 67.14 0.00 0.00 100 0.00
development
Less: Depreciation
Net Tangible Assets 3,359.83 3,700.34 5,750.13 100 110.13 171.14

B Intangible Assets 7.70 11.57 116.68 100 150.31 1515.25

Total Fixed Assets

(A+B) 3,367.53 3,711.91 5,866.81 100 110.23 174.22
[Net Tangible Assets +
Intangible Assets]

2 Long Term. Non-

165
 Current Investment
Long term Loans Givens 43.50 234.57 425.36 100 539.27 977.92
Deferred Receivables 585.24 524.90 235.16 100 89.69 40.18
Others 11.27 20.93 15.27 100 185.81 135.57

Total Long Term.

Non-Current 640.00 780.40 675.80 100 121.94 105.59
Investment

Total Fixed Assets

4,007.54 4,492.31 6,542.60 100 112.10 163.26
(A+B)

3 Working Capital
Quick Assets
a Cash in Hand 250.88 1,325.95 356.16 100 528.52 141.96
Debtors (Net) /Trade
b 1,797.70 2,927.33 1,671.43 100 162.84 92.98
Receivables
c Bills Receivables 0.00 0.00 0.00 0.00 0.00 0.00
Short Term Loan and
d 5.20 12.38 132.55 100 238.02 2549.43
Advances
g Other Current Assets 1,009.07 883.57 1,286.26 100 87.56 127.47
Total Quick Assets 3,062.85 5,149.22 3,446.39 100 168.12 112.52
h Inventory 3,765.11 4,809.05 4,643.33 100 127.73 123.33
Pre-Payment (Prepaid
i Expenses, Advanced for 0.00 0.00 0.00 0.00 0.00 0.00
Goods., Advanced Tax)
A Current Assets 6,827.97 9,958.27 8,089.72 100 145.85 118.48

Less: Quick Liabilities

166
 Creditors/Trade
a 4,977.15 5,161.33 4,886.60 100 103.70 98.18
Payables
b Short Term Loans 893.72 1,778.80 1,791.21 100 199.03 200.42
c Other Current liabilities 1,298.53 1,058.30 1,272.26 100 81.50 97.98
d Short-Term provisions 3.61 4.12 7.80 100 114.32 216.10
Total Quick Liabilities
7,173.00 8,002.56 7,957.87 100 111.57 110.94
(a to d)
e Bank Overdraft 0.00 386.59 0.00 0 100.00 0.00
Current Liabilities
B [Quick Liability + Bank 7,173.00 8,389.15 7,957.87 100 116.95 110.94
Overdraft]
Net Current Assets /
(454.78
Working Capital (A- (345.03) 1,569.12 131.85 100 (38.21)
)
B)

Total Assets or Total

Funds Employed 3,662.50 6,061.43 6,674.45 100.00 165.50 182.24
(1+2+3)
(Note: In bracket figures indicate the minus figures)
From the trend analysis of the Balance Sheet reveals that the total of total fund
available or capital employed and total assets or total funds employed
correspondingly increased last two years i.e. 165.50% and 182.24% as compare to
the base year 2018. It seems that the correspondingly increased net worth i.e.
424.88% and 461.99% by the year 2019 and 2020 respectively with compare to base
year 2018, followed by increased owe fund i.e. 81.40% and 91.53% by the year
2019 and 2020. Moreover, in term of application of fund total fixed assets increased
i.e. 87.56% and 127.47% by the year 2019 and 2020 respectively. Furthermore it
seem that working capital was found negative trend, which reveals the change in the
current operating assets has increased higher than the current operating liabilities.

167
 Trend Analysis of Income Statement
Sr. Particular Year Year Year 2018 2019 2020
Ended Ended Ended
March 31, March 31, March 31,
2018 2019 2020
1 Gross Sale and Services
(Revenue from Operation) 10,286.18 16,502.47 20,787.46 100 160.43 202.09
Other Income 26.81 53.11 65.84 100 198.11 245.59
2 Less: returns & Allowance
3 Net Sale 10,312.99 16,555.58 20,853.30 100 160.53 202.20
4 Less: Cost of Goods Sold
Raw Material Consumed 3,774.62 6,375.93 7,363.58 100 168.92 195.08
e Direct Expenses 1,154.31 1,439.45 1,928.86 100 124.70 167.10
Manufacturing Exp. 4,259.48 6,405.01 7,528.24 100 150.37 176.74
g Operating Stock (WIP) (1,243.33) (617.03) 540.16 100 49.63 (43.44)
Less: Cost of Goods Sold 7,945.10 13,603.36 17,360.84 100 171.22 218.51
5 Gross Profit 2,367.89 2,952.21 3,492.46 100 124.68 147.49
6 Less: Operating Expenses
A Administrative Expenses 271.81 305.40 369.91 100 112.36 136.09
Selling and Distribution 420.71 583.64 802.75 100 138.73 190.81
B
Expenses
C Finance Expenses 747.61 732.91 828.88 100 98.03 110.87

Total operating Expenses 1,376.52 1,621.95 2,001.53 100 117.83 145.41

7 Operating Profit Before Interest 991.37 1,330.27 1,490.93 100 134.18 150.39
8 Less: Interest Paid 700.31 815.28 867.19 100 116.42 123.83
9 Net Profit after Interest 291.06 514.99 623.74 100 176.93 214.30
10 Net Non-Operating Income
11 Net Profit before Tax (NPBT) 291.06 514.99 623.74 100 176.93 214.30
12 Less: Income Tax
Less : Tax Expenses (175.36) 60.34 290.96 100 (34.41) (165.92)
/Deferred Tax
Liability/(Asset)
13 Net Profit After Tax 466.42 454.64 332.78 100 97.47 71.35
(Note: In bracket figures indicate the minus figures)

168
 From the trend analysis of Income statement it is shown that the net sale last
subsequently two years i.e. 160.53% and 202.20% by the year 2020 and 2019
respectively. Similarly cost of goods sold increased by the year 2019 and 2020 i.e.
171.22 % and 218.51% respectively, furthermore, it is seems that correspondingly
increased other items like gross profit, total operating items, net profit after interest,
net profit after tax respectively. Hence, the income statement the figures of 2020
when compared with 2019 reveal that the Sales have increased by 41.67%
respectively. Similarly, the cost of goods sold and the expenses have increased by
47.29% and 27.58% respectively. Its resulted Net Profit were slightly decreased by
26.12% by the year 2020 as compare to preceding year 2019.
Ratio Analysis:
It is observed that ratio analysis helps to make appropriate decisions in keeping
with the objectives of the respective company. The financial ratio analysis which is a
tool of financial analysis, which helps to take financial decision.
Balance Sheet Ratio:
Sr. Types of Ratio Formulas Calculations Result

Current Current Assets

1 = ,F.G
1.02
Current Liabilities =
G,F G.G

Quick/Liquid €‚ƒ „ †‡ A,

.AF

2 = = 0.4
G,F G.G
€‚ƒ ˆ‰Š‹‡†

Stock to Working
,
A.AA

Œ‡‚ƒ =
3 Capital = A. 35.22
Žƒ‘ ’‰“‡‰‹

”“†‡ •€–
,
.F

Proprietors = =
,.
4 —‡‰ „ †‡ 28.31

169
 ˜™†– •€– , A. 
=
,
.F
5 Debt Equity = 0.61
”“†‡ •€–

From the above table calculate financial ratio including current ratio, quick ratio,
and stock to working capital ratio, proprietary ratio and debt to equity ratio.
Therefore, it is interpreted that the current ratio of the company is not satisfactory
because the ratio (1.02), was below the generally accepted standard of 2:1. It means
company face some hurdles to the pay short term debts. On the other hand quick or
liquid Ratio was 0.4 which is slightly less than the accepted standard of 1:1.
Moreover, stock to Working Capital Ratio i.e. 35.22% reveals that efficiency of
company to use working capital, which was company to turnover its inventories to
make short term payments to its creditors and accounts payable. It is also revealed
that the proprietor’s ratio is expressed in the form of a percentage, and that was
28.31%. It means 28.31% funds of the company are financed by the proprietors. It is
understood that the high proprietary ratio indicates that a company uses more
proprietors' funds for purchasing total assets and it is financed by shareholders. It is
noted that the considering present ratio, it should need to improve proprietary ratio
to judge the long term solvency and stability of company. It is also indicated the
composition of capital structure in term of debt and equity. Current ratio of the
company is satisfactory because the ratio (0.61), it was below the generally accepted
standard of 2:1, and it is noted that the low ratio suitable for company and its helps
to judge the long-term solvency and stability of company.

170
 Profit and Loss Ratio:

Sr. Types of Ratio Formulas Calculations Result

6 Gross Profit Gross ProKit 3,492.46 16.75

= × 100 = × 100
Sale 20,853.30

7 Net Profit Ratio Net ProKit 332.78 2.99

= × 100 = × 100
Sale 20,853.30

8 Operating OPerating Expenses Ratio 2,001.53 9.60

= × 100 = × 100
Expenses Sale 20,853.30

9 Stock Turnover Cost of Goods Sold (COGS) 17,360.84 3.67

= =
Opening Stock + Closing Stock 4809.05 + 4643.33 times
2 2
× 100 × 100

It is understood that Gross profit ratio showcases the relationship between Gross
Profit and Net Revenue of your business. It seems that gross profit ratio was 16.75%
it means 83.25 % cost of goods sold, in mother worlds company got 16.75% revenue
from sales. It indicates that the company has adopted the unfavourable purchase and
sales policy. Considering gross profit company should concentrate on the improving
gross profit ratio. It’s Standard i.e. Std> 100% and high ratio suitable for company
and Its helps to judge profitability and operating efficiency of company. Moreover,
it is stated Net profit (NP) ratio is a useful tool to measure the overall profitability of
the Company. It’s Standard i.e. Std> 100% and high ratio suitable for company and
Its helps to judge profitability. It is noted that the net profit ratio of Synergy Pvt.,
Ltd was 2.99%, which was slightly decrease as compare to previous year.
Furthermore, it is stated that operating expenses ratio measures portion of a
particular expenses in comparison to sale. It’s Standard i.e. Std< 100% and low ratio
suitable for company and It helps to know operating cost and profit. The operating
expense ratio is 9.60%, which reveals the proportion of expenses to revenues for
income generating activities, and low operating expenses ratio positively lead to
profit generating activities. It is also noted that the stock Turn over measures the

171
efficiency of the firm to manage its inventory. It’s Standard ratio based on it past
ratio and low ratio suitable for company and its helps to know operating cost and
profit. It is found that during the year 2020 Stock Turnover ratio was 3.67 times,
which means stock was converted into sale 3.67 times.

2.6 Reference for Further Study

1. Khan M.Y. and Jain P.K., Management accounting, Tata McGrow Hill, New
Delhi.
2. Pandey I. M. : Management Accounting, Vani Publication, Delhi
3. Manmohan & Goyal : Principles of Management Accounting.
4. Maheshwari : Principles of Management Accounting.
5. Management Accounting : M.N.Arora, Himalaya Publishing House.


172
 Unit-3
Working Capital

Index :
3.0 Objectives
3.1 Introduction
3.2 Presentation of Subject Matter
3.2.1 Meaning of Working Capital
3.2.2 Significance / Importance of Working Capital
3.2.3 Determinants of Working Capital
3.2.4 Operating Cycle
3.2.5 Types of Working Capital
3.2.6 Computation/Estimation of Working Capital Required
3.2.7 Check Your Progress
3.2.8 Illustrations
3.3 Summary
3.4 Terms to Remember
3.5 Answers to Check Your Progress
3.6 Exercise
3.7 Reference for Further Study

173
3.0 Objectives:
After studying this unit you should be able to —
• Understand the concept of working capital
• Know the significance of working capital
• Explain the determinants of working capital
• Understand the planning for working capital requirement
• Explain the sources and applications of working capital
• Compute/Estimate the working capital required

3.1 Introduction:
Management of each business firm is interested in knowing the financial
position of the business. Financial statements show the financial position of the firm.
But these statements only show the financial status and not give the details.
Management is interested in understanding the changes in the financial position.
There are different tools and techniques available to analysis the financial statements
and to know the changes. A statement showing changes in working capital, funds
flow statements are the important tools. Capital is important for every business. It is
essential to start the business as well as to run the business. There are mainly two
types of capital i.e. Fixed Capital and Working Capital. Management must have the
knowledge of these concepts in detail. In this unit we are going to study the concept
of working capital.

3.2 Presentation of Subject Matter

3.2.1 Meaning of Working Capital:
In general sense, the working capital means, the capital which is needed to carry
on the day to day working of the business.
Shubin defined the working capital as, ''the funds necessary to cover the cost of
operating the business enterprise." The cost of operating the enterprise includes
purchases of raw materials or finished goods, wages and salaries of staff, payment of
other expenses like rent, insurance, printing, lighting, advertisement etc. The funds
need to cover this cost is called as working capital. Such capital is in the form of

174
different current assets and they change their form in the ordinary course of business
e.g. from cash to inventories, inventories to receivables and receivables into cash.
Hoagland defines it as, “the difference between the book value of the current
assets and the current liabilities.
In this view, Gestenberg called it as a circulating capital. The most widely used
concept of working capital is defined as, "the difference between current assets and
current liabilities." This concept is useful to know the liquidity of the firm.
3.2.2 Significance / Importance of Working Capital:
The definition of working capital itself explains the significance of it in the
business that it is the amount which is used to carry on day to day working of the
business. That means without working capital the working of the business cannot be
possible. Working capital is called as the life blood or heart of the business. The
significance or importance of working capital can be explained as under —
i) It is important to maintain the smooth flow of the working of the business.
ii) With the help of working capital, the required raw materials and other materials
can be purchased in time which leads to full utilization of the capacity of the
business.
iii) It is possible to avail the benefits of large scale purchases.
iv) If the working capital is sufficient, the firm can pay its short term claims in time
which will useful to maintain good relations with claimants.
v) Working capital is the indicator of liquidity position and if it is good short term
loans can easily be made available from banks and financial institutions.
vi) It is possible to take the advantage of favorable and profitable market
conditions.
vii) A firm can pay the government dues and other claims in time and avoid
penalties.
viii) If a firm ensures a good flow of working capital, there is no need to borrow
funds at high rate of interest.
ix) The sufficient working capital ensures the payment of wages and salaries to the
staff in time which develops good working environment.

175
x) A firm having sufficient working capital can increase the sales by allowing
credit facility to customers.
3.2.3 Determinants/Factors affecting on working capital:
Each business firm needs the working capital but the requirement of the working
capital of each firm is different because it depends upon various factors. These
factors are as follows:
i) Size of the firm: The amount of working capital required depends upon the size
of the firm. Big firm require more working capital as compare to the small
firms.
ii) Nature of business: The requirement of working capital also depends on the
nature of the business carried out by the firm. If the firm is a trading firm it
requires more working capital and if the firm is an industrial or public utilities
concern it requires less working capital.
iii) Volume of business: If the volume of business is large it requires more working
capital and if the volume of business is small there is a less need of working
capital.
iv) Length of processing or selling period: If the processing or selling period is
large it requires more working capital and vice versa.
v) Policy of purchase and sale: The requirement of working capital depends upon
the firm's policy of purchase and sale. If a firm has a policy of cash purchases
and credit sales it requires more working capital and if a firm has a policy of
credit purchases and cash sales it requires less working capital.
vi) Large stock of raw materials: Some firms require large stock of raw materials
for some reasons such as seasonal nature, long distance etc. Such firms need
more working capital than others.
vii) Expansion: If a firm wants to make rapid expansion or expansion on large scale
it require more working capital.
viii) Cash requirements: If a firm requires more cash for payment of different
expenses, taxes, charges etc. the requirement of working capital is more and if
cash requirement is less, the need of working capital is also less.

176
ix) Use of Labour: The firm, who use labour on large scale for business activities,
needs more working capital and if the firm is highly mechanized it needs less
working capital.
x) Management attitude and efficiency : The attitude or policy of management in
respect of payments of dividend, discount, price, expenses etc. is of cash saving
and efficiency of management is more that time requirement of working capital
is less and vice-versa.
3.2.4 Operating Cycle:
The working capital is important for each business. The estimation of working
capital depends on operating cycle. If the operating cycle is lengthy the working
capital requirement is more and if the operating cycle is short the working capital
requirement is less. Operating Cycle is also termed as Working Capital Cycle or
Cash Cycle. The Operating Cycle refers to the cycle of operations for which working
capital required. The Operating Cycle refers to the length of time between the firms
paying cash for materials, etc., entering into the production process / stock and the
inflow of cash from debtors (sales). That means this cycle shows the journey of
changing the form of cash into cash. Suppose a company has a certain amount of
cash it will need raw materials. Some raw materials will be available on credit but,
cash will be paid out for the other part immediately. Then it has to pay labour costs
and incurs other factory overheads. These three combined together will constitute
work-in-progress. After the production cycle is complete, work-in-progress will get
converted into finished products. The finished products when sold on credit get
converted into sundry debtors. Sundry debtors will be realized in cash after the
expiry of credit period. This cash can again be used for financing of raw materials,
work-in-progress, etc. Thus there is a complete cycle from cash to cash wherein cash
gets converted into raw materials, work-in-progress, finished goods, debtors and
finally into cash again. Short term funds are required to meet the requirements of
funds during this time period. This time period is dependent upon the length of time
within which the original cash gets converted into cash again. The Operating Cycle is
depicted below:

177
 OPERATING CYCLE

Cash

Raw
Materials,
Debtors
Labour,
Overheads

Finished Work in
Goods Progress

Operating Cycle indicates the length of time between a company's paying for
materials, entering into stock and receiving the cash from sales of finished goods. It
can be determined by adding the number of days required for each stage in the cycle.
For example, a company holds raw-materials on an average for 60 days, it gets credit
from the supplier for 15 days, production process needs 15 days, finished goods are
held for 30 days and 30 days credit is extended to debtors. The total of all these, 120
days, i.e., 60 — 15 + 15 + 30 + 30 days is the total working capital cycle.
The operating cycle or working capital cycle consists of the following events
which continue throughout the life of business.
• Conversion of cash into raw-materials;
• Conversion of raw-materials into work-in-progress;
• Conversion of work-in-progress into finished stock;
• Conversion of finished stock into accounts receivables through sales; and
• Conversion of account receivables into cash.
The duration of the operating cycle for the purpose of estimating working
capital is equal to the sum of the durations of each of the above said events, less the
credit period allowed by the suppliers.

178
 In the form of an equation, the operating cycle process can be expressed as
follows :
Operating Cycle = R + W + F + D — C
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Debtors collection period
C = Credit period availed.
The various components of operating cycle may be calculated as shown below:
    
(1) Raw material storage period =           

      

(2) Work-in-progress holding period =
       

     

(3) Finished goods storage period =
     

  
(4) Debtors collection period =     

   

(5) Credit period availed = =
      

The determination of working capital cycle helps in the forecast, control and
management of working capital. It indicates the total time lag and the relative
significance of its constituent parts. The duration of working capital cycle may vary
depending on the nature of the business.
3.2.5 Types/Concepts of Working Capital:
There are different concepts/types of working capital having different meanings
which are explained as follows –
1. Gross working capital – It is a broad concept of working capital. According to
this concept working capital means the total of all current assets of the firm.
This concept is important from view point of management because the
management can plan for the working capital well in advance and use

179
 effectively all the current assets. As per this concept working capital and current
assets are the two inter-changeable terms.
2. Net working capital – According to this concept the working capital means the
net current assets that mean current assets minus current liabilities. This concept
is widely used. It is used to find out the soundness of short term financial
position of the firm by the concerned parties.
3. Negative working capital – It means the excess of current liabilities over the
current assets. It is opposite to net working capital. Negative working capital is
also called as working capital deficit. It shows that the working capital position
of the firm is not good.
4. Permanent working capital – It is the minimum amount of investment in
current assets required at all time to carry out minimum level of business
activities. In other words it is the amount of working capital which remains in
the business permanently in one form or another. Every business firm is required
to maintain a minimum balance of cash, inventory and receivables irrespective
of the short term ups and downs in the level of activity. It is referred to as the
care current assets by the Deheja committee and Tondon committee. It is also
called as fixed working capital or minimum working capital. It represents the
long term capital.
5. Variable working capital – It means the working capital invested in the
business over and above the fixed/permanent working capital. The amount of
variable working capital keeps on fluctuating from time to time depending upon
the scale of operations and stage of business cycle. It increases during the peak
period and decreases during the period of recession. It represents the short term
capital.
6. Cash working capital – The cash working capital refers to the working capital
which is available in cash. It is determined with the help of cash-flow statement.
3.2.6 Computation/Estimation of Working Capital:
Working capital is called as the lifeblood or heart of the business without
adequate working capital no business firm can survive. Therefore proper estimation
of working capital is necessary. As working capital is defined the difference between
current assets and current liabilities, the computation of working capital depends

180
upon the estimation of current assets and current liabilities. While computing the
working capital estimation regarding various current assets and current liabilities is
to be made as under —
A) Estimation of Current Assets :
1) Stock/Inventories : A business firm needs various types of stock like Raw
materials, Work-in-progress, Finished Goods. The working capital required for
maintaining the stock is based on the period for which stock of goods is
remained in the business. It is estimated as follows —
i) Raw Materials : The period for which the raw materials remain in stores.
ii) Work in Progress : The period in which the work in progress remain in
manufacturing process.
iii) Finished Goods : The period for which the finished goods remain in stock
unsold.
2) Sunday Debtors : The period of credit allowed to debtors / customers.
3) Cash and Bank Balance : As per estimation of cash requirements.
4) Prepaid Expenses : Any expenses paid in advance.
B) Estimation of Current Liabilities :
1) Sundry Creditors : The period of credit allowed by suppliers or creditors.
2) Outstanding Expenses : On the basis of time lag in payment of wages and
other expenses.
By deducting the total of current liabilities from the total of current assets (A-
B), the working capital is calculated. While computing working capital stock is
valued at cash costs as well as debtors are also to be taken at cash cost basis and not
on sales value basis. If cash costs are not available, the sales value may be taken.
3.2.7 Check Your Progress:
A. Choose the correct alternative:
1. The current assets minus the current liabilities is termed as ---------
a) Working Capital b) Circulating Capital
c) Net Current Assets d) All of above
181
2. Which of the following is not a source of working capital?
a) Purchase of machinery b) Profit earned during the year
c) Issue of share capital d) Issue of debentures
3. Which one of the following items represents a potential use of working capital?
a) Goodwill amortization b) Sale of fixed assets at loss
c) Net loss from operations d) Declaration of share dividend
4. Which of the following is not normally paid from the working capital?
a) Payment to creditors b) Redemption of debentures
c) Payment of wages d) Purchases of raw materials
5. Permanent working capital is also known as -----------
a.) Minimum working capital b) Fixed working capital
c) Care current assets d) All of above
B. Fill in the Blanks
i) Difference between current assets and current liabilities is known as.......
ii) -------- working capital remains in the business in one form or another.
iii) Negative working capital means the excess of current ----- over the current
------
iv) Firm which follow liberal credit policy will require ----------working
capital.
v) Purchase of raw materials is ---------- working capital.
C. State 'True' or 'False'.
i. Working capital is necessary to purchase the fixed assets.
ii. Payment of dividend is a use working capital.
iii. Variable working capital is financed out of short term funds.
iv. Permanent working capital is different from fixed capital.
v. Bank credit is a long term source of working capital.

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3.2.8 Illustrations:
1. From the following information prepare a statement showing the working
capital requirement.
Budgeted sales Rs. 2,08,000 p.a. Analysis of one rupee of sales is as under —
Particulars Rs.
Raw Materials 0.40
Direct Labour 0.30
Overheads 0.20
0.90
Profit 0.10
Sales 1.00
It is assumed that —
a) Raw materials are carried in stock for 3 weeks and finished goods for 2 weeks.
b) Factory processing will take 3 weeks.
c) Suppliers will give 5 weeks credit.
d) Customers will allowed 8 weeks credit.
It may be assumed that production and overheads accrue evenly throughout the
year.
Solution:
Statement showing Working Capital Requirement
Particular Rs.
Current Assets
1) Stock :
i) Raw Materials (3 weeks) 4800
(Rs. 2,08,000 x 3/52 x 0.40)
ii) Work in Progress 10800
(Rs. 2,08,000 x 3/52 x 0.90)

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 iii) Finished Goods 7200
(Rs. 2,08,000 x 2/52 x 0.90)
2) Sundry Debtors at cost 28,800
(Rs. 2,08,000 x 8/52 x 0.90
51600
Less : Current Liabilities
1) Sundry Creditors 8000
(Rs. 2,08,00 x 5/52 x 0.40)
Working Capital Required 43600

2. A Hindustan industry sells its product on a Gross Profit of 20% on sales. The
following information is extracted from its annual accounts for the year ended
31st March,2009.
Particulars Rs.
Sales of 3 month's credit 20.00,000
Raw Materials 6,00,000
Wages paid (15 days in arrears) 4,80,000
Manufacturing Expenses paid (one month in arrears) 6,00,000 -
Administration Expenses paid (one month in arrears) 2,40,000
Sales promotion expenses payable 1,00,000
(1/2 yearly in advance)
Income Tax payable quarterly 2,00,000
(Last installment falls due in June 2009)
The company enjoys one month's credit from the suppliers of raw materials and
maintains 2 months stock of raw materials and one and half months of finished
goods. Cash balance is maintained at Rs. 50,000. Assume a 10% margin for
contingencies. Compute working capital required by the company.

184
Solution :
Statement showing Working Capital Requirement
Particulars Rs.
Current Assets:
1) Stock
i. Raw Materials (Rs. 6,00,000 x 2/12 months) 1,00,000
ii. Finished Goods (Rs. 19,20,000 x 1.5/12 months) 2,40,000
2) Sundry Debtors (Rs. 19,20,000 x 3/12 months) 4,80,000
3) Cash in hand 50,000
4) Prepaid Sales Promotion Expenses (Rs. 1,00,000 x 6/12) 50,000
9, 20,000
Less: Current Liabilities:
1) Sundry Creditors (Rs. 6,00,000 x 1/12 months) 50,000
2) Outstanding Expenses
i) Wages (Rs. 4,80,000 x 0.5 / 12 months) 20,000
ii) Manufacturing Expenses (Rs. 6,00,000 x 1/12months) 50,000
iii) Administration Expenses (Rs. 2,40,000 x 1/12months) 20,000
iv) Income Tax (Rs. 2,00,000 x 3/12months) 50,000
1, 90,000
Net Working Capital 7, 30,000
Add : 10% margin for contingencies 73,000
Total working Capital 8,03,000
3. You are required to prepare a forecast of working capital requirement from the
following data.
Output 15600 units per annum.
Elements of Cost Per unit Rs
Raw Materials 6
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 Direct Labour 4
Overheads 5
Total Cost 15
Profit 3
Selling Price 18
Raw materials are kept in stock on an average of one month and work in process
is on an average of 2 weeks. Finished goods are in stock on an average 1.5 months.
Credit allowed to debtors is 2 months. Credit allowed by creditors is one month. Lag
in payment of wages is one week. Allow 15% for contingency.
Solution:
Statement showing Estimate of Working Capital
Particulars Rs Rs
Current Assets:
1. Stock:
i. Raw Materials (15600x1/12= 1300xRs 6) 7800
ii. Work in Process 6300
Raw Materials (15600x2/52= 600xRs 6) 3600
Labour (15600x2/52=600xRs 4=2400x50%) 1200
Overheads (15600x2/52=600xRs 5=3000x50%) 1500
iii. Finished Goods (15600x1.5/12=1950xRs 15) 29250
2. Debtors (15600x2/12=2600xRs 15) 39000
Total 82350
Less: Current Liabilities:
1. Creditors (15600x1/12=1300xRs 6) 7800
2. Outstanding Wages (15600x1/52=300xRs 4) 1200 9000
Net Working Capital 73350
Add: 15% for contingencies (15% of Rs 73350) 11003
Working Capital Required 84353

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4. A factory produces 84000 units during the year and sells them at Rs 50 per unit.
Cost structure of a product is as follows:
Raw Materials 55%
Direct Labour 18%
Overheads 17%
Total Cost 90%
Profit 10%
Selling Price 100%
The following additional information is available:
1. The activities of purchasing, producing and selling occur evenly throughout the
year.
2. Raw materials in godown are equal to 1½ months’ supply.
3. The production process takes 15 days.
4. Finished goods equal to one month production are in stock.
5. Debtors get one month credit.
6. Creditors allow 2 months credit.
7. Time lag in payment of wages and overheads is one month.
8. Cash and Bank balance is maintained at 15% of the working capital.
9. 25% purchases are for cash.
Prepare a Statement showing Working Capital Requirement.
Solution:
Statement showing Estimate of Working Capital
Particulars Rs Rs

Current Assets:
1. Stock:
i. Raw Materials (84000x1.5/12= 24500xRs 27.50) 288750
126875

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 ii. Work in Process 96250
Raw Materials (84000x0.5/12= 3500xRs 27.50) 15750
Labour (84000x0.5/12=3500xRs 9=31500x50%) 14875
Overheads (84000x0.5/12=3500xRs 8.5=29750x50%) 315000
iii. Finished Goods (84000x1/12=7000xRs 45) 315000
2. Debtors (84000x1/12=7000xRs 455) 1045625
Total
Less: Current Liabilities: 288750
1. Creditors (84000x2/12=14000 x Rs
27.50=385000x75%) 63000
2. Outstanding Wages (84000x1/12=7000xRs 9) 59500 411250
3. Outstanding Overheads (84000x1/12=7000xRs 8.50) 634375
Net Working Capital 95156
Add: 15% as Cash and Bank Balance (15% of Rs 634375) 729531
Working Capital Required

5. XYZ Ltd. has the under mentioned projected Profit and Loss Account:
Particulars Rs Rs
Sales 210000
Less: Cost of Goods Sold 153000
Gross Profit 57000
Less: Administrative Expenses 14000
Selling Expenses 13000 27000
Profit before tax 30000
Less: Provision for tax 10000
Profit after tax 20000

The Cost of Goods Sold has been arrived at as under:

Particulars Rs
Materials used 84000
Wages and Manufacturing Expenses 62500
Depreciation 23500

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 170000
Less: Stock of Finished Goods (10% of goods produced not yet sold) 17000
Cost of Goods Sold
153000
Goods equal to 15% of the year’s production will be in process on the average,
requiring full materials but only 40% of the other expenses. The company believes in
keeping materials equal to two months consumption in stock.
All expenses will be paid one month in advance. Suppliers of materials will
extend 1 ½ months credit. Sales will be 20% for cash and the rest at two month’s
credit. 70% of the income tax will be paid in advance in quarterly installments. The
company wishes to keep Rs. 8000 in cash.
Prepare an Estimate of Working Capital.
Solution:
Statement showing Estimate of Working Capital
Particulars Rs Rs
Current Assets:
1. Stock
Raw Materials (84000 x 2/12 months) 14000
Work in Progress (15%) 17760
i) Materials (15% of Rs 84000) 12600
ii) Other Expenses (40% of Rs 12900) (15% of Rs 5160
86000)
Finished Goods (Actual) 17000
2. Debtors (168000 x 2/12) 28000
Credit Sales (80% of Rs 210000 = Rs 168000)
3. Prepaid/Advance Expenses
i. Wages (Rs 62500 x 1/12 months) 5208
ii. Administrative and Selling Expenses (Rs 2250 7458
27000x1/12)
4. Cash in hand 8000

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 Total Current Assets 92218
Less: Current Liabilities
1. Creditors (84000 x 1 ½ /12 months) 10500
2. Provision for Taxation (10000 Less Advance Tax 3000
7000)
Total Current Liabilities 13500
Net Working Capital Required 78718

6. Calculate the average amount of working capital required of Swastik Products

Ltd. from the following:
Particulars Rs
a) Average amount locked up in stocks
Finished Goods 10000
Stock of Stores 16000
b) Lag in payments
Wages 1.5 weeks 520000
Stores and materials 1.5 months 96000
Office staff salary ½ month 124800
Rent 6 months 20000
Other expenses 1.5 months 96000
Managers salary ½ months 9600
c) Pre-payments
Expenses paid (quarterly in advance) 16000
d) Period of average credit given
Domestic sales 6 weeks 624000
Foreign sales 1.5 weeks 156000
e) Add 10% for contingencies

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Solution:
Statement showing Estimate of Working Capital
Particulars Rs Rs
Current Assets:
1. Stock 26000
Stock of stores 16000
Finished Goods 10000
2. Debtors 76500
Domestic (624000 x 6/52 weeks) 72000
Foreign (156000 x 1.5/52 weeks) 4500
3. Prepaid/Advance Expenses (16000 x 3/12 months) 4000
Total Current Assets 106500
Less: Current Liabilities
1. Creditors (96000 x 1 ½ /12 months) 12000
2. Outstanding Expenses
Wages (520000 x 1.5/52 weeks) 15000
Office staff salary (124800 x ½ /12 months) 5200
Rent (20000 x 6/12 months) 10000
Other expenses (96000 x 1.5/12 months) 12000
Managers salary (9600 x ½ /12 months) 400
Total Current Liabilities 54600
Net Working Capital 51900
Add: 10% for Contingencies 5190
Total Working Capital 57090

3.3 Summary:
Working capital is called the lifeblood or heart of the business. It is defined as
the excess of current assets over current liabilities. It is also defined as the capital
which is needed to carry on day to day working of the business. Each business firm

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needs more or less working capital. The requirement of working capital depends
upon various factors such as size of the firm, nature of business, volume of business,
policy of purchase and sale etc. It is necessary to compute essential working capital
because with inadequate working capital no business firm can survive. Computation
of working capital depends upon the proper estimation of current assets and current
liabilities.

3.4 Terms to Remember:

1. Working Capital: The capital which is needed to carry on the day to day
working of the business and it is expressed as the excess of current assets over
current Liabilities.
2. Gross working capital – It is a broad concept of working capital. According to
this concept working capital means the total of all current assets of the firm.
3. Net working capital – According to this concept the working capital means the
net current assets that mean current assets minus current liabilities.
4. Permanent working capital – It is the minimum amount of investment in
current assets required at all time to carry out minimum level of business
activities. In other words it is the amount of working capital which remains in
the business permanently in one form or another. It represents the long term
capital.
5. Variable working capital – It means the working capital invested in the
business over and above the fixed/permanent working capital. It represents the
short term capital.

3.5 Answers to Check Your Progress:

A–1–d
2–a
3–c
4–b
5–d
B: - i) working capital

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 ii) Permanent
iii) liabilities, assets
iv) more
v) use / application
C - : i) - F
ii) - T
iii) - T
iv) - T
v) - F

3.6 Exercise
i) What is meant by working capital? Explain the factors which determine the
working capital requirement.
ii) Define working capital. State the significance of working capital.
iii) What do you mean by working capital? How it is determined?
iv) What are the factors considered in planning for working capital
requirement?
v) Explain the sources and applications of working capital.
Practical Problems:
1) From the following information prepare a statement showing working capital
requirement. Budgeted sales Rs. 2,60,000 p.a.
Analysis of one rupee of sales
Rs.
Raw Materials 0.30
Direct labour 0.40
Overheads 0.20
0.90
Profit 0.10
Sales 1.00
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It is assumed that —
a) Raw materials are carried in stock for 3 weeks and finished goods for 2 weeks.
b) Factory Processing will take 3 weeks.
c) Suppliers will give 5 weeks credit.
d) Debtors will require 8 weeks credit.
It may be assumed that production and overheads accrue evenly throughout the
year. (Answer — W.C. Rs. 55500)
2) From the following particulars of National Co-Ltd., calculate the amount of
working capital required.
Amounts for the
Particulars
year
a) Lag in Payment
Wages — 2 weeks 39000
Purchases of Materials – 4 weeks 78000
Overheads – 1 week 26000
b) Average amount locked up in stock.
Finished Goods 6000
Raw Materials 12000
Work in Progress 3000
c) Period of average credit given
Inland Sales — 6 weeks 208000
Export sales — 2 weeks 52000
d) Safety Margin – 10%
(Ans. W.C. Rs. 42900)
3. Reliance Ltd. present you the budgeted Profit and Loss Account as under and
request you to prepare a Statement showing Working Capital Requirement.
Particulars Rs Rs
Sales 4500000
Less: Expenses

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 Materials 1800000
Labour 1350000
Expenses 450000 3600000
Profit 900000

Additional Information:
1. The production and sales take place evenly throughout the year.
2. Raw materials are carried in stock for one month and finished goods for half
month.
3. The production cycle take one month.
4. There is a custom in market both for purchase of raw materials and sales of
finished goods to give two months’ credit.
5. Time lag in payment of wages is one month.
6. 25% of sales are for cash and balance on credit.
7. Cash in hand is estimated at Rs 62500.
(Answer: W. C. Rs 737500)
4. The following annual figures relate to Bharat Industries Ltd.
Particulars Rs
Sales (Two months credit) 3600000
Materials consumed (Suppliers extend 2 months credit) 900000
Wages paid (Monthly in arrear) 720000
Manufacturing expenses outstanding at the end of the year (Cash 80000
expenses are paid one month in arrear)
Total administrative expenses, paid as above 240000
Sales promotion expenses, paid quarterly in advance 120000
Company sales its product on gross profit of 25% computing depreciation as of
the cost of production. It keeps one month’s stock, each of raw materials and finished
goods and a cash balance of Rs 100000.

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 Work out the working capital requirements of the company on cash cost basis,
assuming a 20% safety margin. Ignore work in progress.
Answer: Working Capital Rs 720000, Cost of Production Rs 2580000 ( Materials
900000 + Wages 720000 + Manufacturing Expenses 960000), Cost of Sales Rs
2940000 ( Cost of Production 2580000 + Adm. Exp. 240000 + Sales Promotion Exp.
120000)

Practical:
Exercise for Simulation of estimation of working capital can be arranged in the
classroom
Illustration: A company producing steel furniture provides you the following
information. You are required to estimate the working capital requirement for the
year 2021.
Particulars Cost per unit Rs.
Raw Materials 40
Direct Labour 15
Overheads 30
Total Cost 85
Additional Information:
Selling price Rs. 100 per unit
Output 52000 units per annum
Raw materials in stock average 4 weeks
Work in progress average 2 weeks
(assume 50% completion stage with full materials consumption)
Finished goods in stock average 4 weeks
Credit allowed by suppliers average 4 weeks
Credit allowed to debtors average 8 weeks
Cash at bank is expected to be Rs. 50000

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 Assume that production is made at even pace during the year. 20% sales are on
cash basis.
Simulation of estimation of working capital:
1. Working Capital is calculated on the basis of difference between Current Assets
and Current Liabilities. The formula is:
Working Capital = Current Assets - Current Liabilities
2. Current Assets include Inventory/Closing Stock, Sundry Debtors, Cash and
Bank Balance and Prepaid Expenses/ Advance Payments. In the given
illustration the current assets are Inventory/Closing Stock, Sundry Debtors, Cash
and Bank Balance.
3. Current Liabilities include Sundry Creditors and Outstanding Expenses/Delay in
Payments. In the given illustration the current liabilities include Sundry
Creditors.
4. Inventory/Closing Stock is of three types namely Raw Materials, Work in
Process and Finished Goods. It is estimated on the basis the period of
inventory/stock with company.
5. Sundry Debtors are calculated on the basis of period of credit allowed to
customers and only on credit sales. These are calculated generally on the basis
of cost of sales.
6. Sundry Creditors are calculated on the basis of period of credit allowed by
suppliers.
7. If period is given in weeks 52 weeks in a year, in months 12 months in a year
and in days 360 days in a year are considered.
On the basis of above simulation the actual estimation is made as follows:

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Solution:
Statement showing Working Capital Requirement
Particulars Amount Amount
Rs. Rs.
Current Assets:
1. Inventory/Stock:
a) Raw Materials (4 weeks) 1,60,000
(52000 units × Rs. 40 per unit × 4/52 weeks)
b) Work in progress (2 weeks)
Raw Material 80,000
(52000 units × Rs. 40 per unit × 2/52 weeks) 15,000
Direct Labour (50% completion)
(52000 units × Rs. 15 per unit × 2/52 weeks × 30,000 1,25,000
50/100)
Overheads (50% completion)
(52000 units × Rs. 30 per unit × 2/52 weeks × 3,40,000
50/100)
c) Finished Goods (4 weeks)
(52000 units × Rs. 85 per unit × 4/52 weeks) 5,44,000
2. Sundry Debtors (8 weeks)(80% sales on credit)
(52000 units × Rs. 85 per unit × 8/52 weeks × 50,000
80/100)
3. Cash at Bank
Total Current Assets 12,19,000
Less : Current Liabilities : 1,60,000
1. Sundry Creditors (4 weeks)
(52000 units x Rs. 40 per unit x 4/52 weeks
Working Capital 1,59,000

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3.7 Reference for Further Study:
1) Dr.Maheshwari S. N: Principles of Management Accounting, Sultan Chand &
Sons, New Delhi.
2) Man Mohan, S. N. Goyal: Principles of Management Accounting,
SahityaBhavan, Agra.
3) Pandey I. M.: Management Accounting, Vikas Publishing House Pvt. Ltd., New
Delhi.
4) Paul S. Kr.: Financial Statement Analysis, New Central Book Agency (P) Ltd.
Kolkata.
5) Raman B. S.: Management Accounting, United Publishers Mangalore.

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 Unit-4
Funds Flow Statement and Cash Flow Statement

Structure:
4.0 Objectives
4.1 Introduction
4.2 Subject Matter
4.2.1 Meaning and Concept of Funds
4.2.2 Current and Non-Current Account
4.2.3 Meaning and Definition of Funds Flow Statement
4.2.4 Limitations of Funds Flow Statement
4.2.5 Procedure for Preparing a Funds Flow Statement
4.2.6 Sources of Funds
4.2.7 Applications of Funds
4.2.8 Some Typical Items Which Require Particular Care
4.2.9 Illustrations - Funds Flow Statement
4.2.10 Meaning and Concept of Cash Flow Statement
4.2.11 Cash and cash equivalents
4.2.12 Preparation of Cash Flow Statement
4.2.13 Difference between Funds Flow Statement and Cash Flow Statement
4.2.14 Illustrations - Cash Flow Statement
4.3 Summary
4.4 Terms to Remember
4.5 Answers to Check Your Progress
4.6 Exercise
4.7 Reference for Further Study

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4.0 Objectives:
• Understand the meaning, and concept of funds.
• Meaning and concept of flow of funds.
• Current and non-current accounts.
• Procedure for knowing whether flow of funds or not.
• Meaning of funds flow statement and cash flow statement
• Procedure for preparing a funds flow statement and cash flow statement
• Various sources and applications of funds.
4.1 INTRODUCTION
The basic financial statements. i.e., the balance sheet and profit and loss account
or income statement of business. Reveal the net effect of the various transactions on
the operational and financial position of the company. The balance sheet gives a
summary of the assets and liabilities of an undertaking at a particular point of time. It
reveals the financial status of the company. The assets side of a balance sheets shows
the deployment of resources of an undertaking while the liabilities side indicates its
obligations, i.e., the manner in which these resources were obtained. The profit and
loss account reflects the results of the business operations for a period of time. It
contains a summary of expenses incurred and the revenue realized in an accounting
period. Both these statements provide the essential basic information on the financial
activities of a business, but their usefulness is limited for analysis and planning
purpose. The balance sheet gives a static view of the resources (Liabilities) of a
business and the uses (assets) to which these resources have been put at a certain
point of time. It does not disclose the causes for changes in the assets and liabilities
between two different points of time The profit and loss account, in a general way,
indicates the resources provided by operations. But there are many transactions that
take place in an undertaking and which do not operate through profit and loss
account. Thus, another statement has to be prepared to show the change in the assets
and liabilities from the end of one period of time to the end of another period of time.
The statement is called a Statement of changes in Financial Position or a Funds
Statement.

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 The funds flow Statement is a statement which shows the movement of funds and
is a report of the financial operations of the business undertaking. It indicates
various means by which funds were obtained during a particular period and the
ways in which these funds were employed. In simple words, it is a statement of
sources and application of funds.
4.2 Subject Matter
4.2.1 MEANING AND CONCEPT OF FUNDS
The term ‘funds’ has been defined in a number of ways.
(a) In a narrow sense, it means cash only and a funds flow statement prepared on
this basis is called a cash flow statement. Such a statement enumerates net
effects of the various business transactions on cash and takes into account
receipts and disbursements of cash.
(b) In a broader sense, the terms ‘funds’ refers to money values in whatever form it
may exist. Here ‘funds’ means all financial resources, used in business whether
in the form of men, material, money, machinery and others.
(c) In a popular sense, the term ‘funds’ means working capital, i.e., the excess of
current over current liabilities. The working capital concept of funds has
emerged due to the fact that total resources of a business are invested partly in
fixed assets in the form of fixed capital and partly kept in form of liquid or near
liquid form as working capital.
The narrower concept of ‘funds’, i.e., cash or working capital concept. Fails to
reveal the changes in the total financial resources of a business. Some significant
items. Such as purchase of building in exchange of shares or payment of bonus in the
form of shares, which do not directly affect cash or working capital are not revealed
from the analysis based on these concepts. However, the concept of funds as working
capital is the most popular one and in this chapter we shall generally refer to ‘funds’
as working capital and a funds flow statement as a statement of sources and
application of funds.
MEANING AND CONCEPT OF ‘FLOW OF FUNDS’
The term ‘funds’ means movement and includes both ‘inflow’ and ‘outflow’.
The Term ‘flow of funds’ means transfer of economic values from one asset of
equity to another. Flow of funds is said to have taken place when any transaction

202
makes changes in the amount of funds available before happening of the transaction.
If the effect of transaction results in the increase of funds, it is called a source of
funds and if it results in the decrease of funds, it is known as an application of funds.
Further, in case the transaction does not change funds, the term ‘flow of funds’ refers
to the movement of funds in the working capital. If any transaction results in the
increase in working capital. It is said to be a source or inflow of funds and if it results
in the decrease of working capital, it is said to be an application or out-flow of funds.
Rule
The flow of funds occurs when a transaction changes on the one hand a non-
current account and on the other a current account and vice-versa.
When a change in a non-current account e.g. fixed assets, long-term liabilities,
reserves and surplus, fictitious assts etc., is followed by a change in another non-
current account, it does not amount to flow of funds. This is because of the fact that
in such cases neither the working capital increases nor decreases. Similarly, when a
change in one current account results in a change in another current account, it does
not affect funds. Funds move from non-current to current transactions or vice-versa
only. In simple language funds move when a transaction affects (i) a current asset
and a fixed asset, or (ii) a fixed and a current liability, or (iii) a current asset and a
fixed liability, or (iv) a fixed liability and current liability; and funds do not move
when the transaction affects fixed assets and fixed liability or current assets and
current liabilities.
4.2.2 CURRENT AND NON-CURRENT ACCOUNT
The understand flow of funds, it is essential to classify various accounts and
balance sheet items into current and non-current categories.
Current Accounts can either be current assets or current liabilities. Currents
assets are those assets which in the ordinary curse of business can be or will be
converted into cash within a short period of normally one accounting year.
Current liabilities are those liabilities which are intended to be paid in the
ordinary course of business within a short period of normally one accounting year
out of the current assets or the income of the business.

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 The following is the list of Current or Working Capital Accounts :
LIST OF CURRENT OR WORKING CAPITAL ACCOUNTS
Current Liabilities Current Assets
1. Bills Payable 1. Cash in Hand
2. Sundry Creditors or Account 2. Cash at bank
Payable 3. Bills Receivable
3. Accured or Outstanding Expenses 4. Sundry Debtors or Accounts
4. Dividends Payable Receivable
5. Bank Overdraft 5. Short-term loans & advances
6. Short-term loans advance & 6. Temporary or Marketable
deposits Investments
7. Provision against Current Assets 7. Inventories or stocks such as
(a) Raw Material
(b) Work-in-process
(c) Stores and Spares
(d) Finished Goods
8. Provision for taxation. If it does not
amount to appropriation of profits 8. Prepaid Expenses

9. Proposed Dividend (May be a

current or a Non-Current liability) 9. Accrued Incomes

LIST OF NON-CURRENT OR PERMANENT CAPITAL ACCOUNTS

Non-Current or Permanent Liabilities Non-Current or Permanent Assets
1. Equity Share Capital 1. Goodwill
2. Preference Share Capital 2. Land
3. Redeemable Preference Share 3. Building
Capital 4. Plant and Machinery
4. Debentures

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5. Long-term Loans 5. Furniture and Fittings
6. Share Premium Account 6. Trade Marks
7. Share Forfeited Account 7. Patent Rights
8. Profit and Loss Account (Balance of 8. Long-term investment
profit. i.e., credit balance)
9. Capital Reserve 9. Debit Balance of Profit and Loss
10. Capital Redemption Reserve account
11. Provision for depreciation against 10. Discount on Issue of Debentures
fixed assets. 11. Discount on Issue of Share
12. Appropriation of Profits 12. Preliminary Expenses
(a) General Reserve 13. Other Deferred Expenses
(b) Dividend Equalization Fund
(c) Insurance Fund
(d) Compensation Fund
(e) Sinking Fund
(f) Investment Fluctuation Fund
(g) Provision for Taxation
(h) Proposed Dividend

PROCEDURE FOR KNOWING WHETHER A TRANSACTION RESULTS

IN THE FLOW OF FUNDS OR NOT :
(1) Determine whether the account involved in the transaction are current or non-
current.
(2) If both the accounts involved are current i.e. either current assets or current
liabilities, it does not result in the flow of funds.
(3) If both the account involved are non-current, i.e., either permanent assets or
permanent liabilities, it still does not result in the flow of funds.

205
(4) If the accounts involved are such that one is a current account while the other is
a non-current liability and fixed asset, or current liability and permanent liability
then it result in the flow of funds.
4.2.3 MEANING AND DEFINITION OF FUNDS FLOW STATEMENT
Funds flow statement is a method by which we study changes in the financial
position of a business enterprise between beginning and ending financial statements
dates. It is a statements showing sources and uses of funds for a period of time.
Foulke defines this statements 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.”
In the words of Anthony “The funds flow statement describes the sources from
which additional funds were derived and the use to which these sources were put.”
I.C.W.A. in Glossary of Management Accounting terms defines Funds Flow
Statement as “a statement either prospective or retrospective, setting out the sources
and applications of the funds of an enterprise. The purpose of the statement is to
indicate clearly the requirement of funds and how they are proposed to be raised and
the efficient utilisation and application of the same.”
Thus, funds flow statement is a statement which indicates various means by
which the funds have been obtained during a certain pertain and the ways to which
these funds have been used during that period. The term ‘funds’ used here means
working capital, i.e., the excess of current assets over current liabilities.
Funds flow statement is called by various names such as Sources and
Application of Funds; statement of Changes in Financial Position; Sources and Uses
of Funds; Summary of Financial Operations; Where came in and Where gone out
statement; Where got, Where gone statement; Movement of Working Capital
Statement; Movement of Funds Statement; Funds Received and Disbursed Statement;
Funds Generated and Expended Statement; Sources of Increase and Application of
Decrease ; Funds Statement, etc.
USES, SIGNIFICANCE AND IMPORTANCE OF FUNDS FLOW
STATEMENT
A funds flow statement is an essential tool for the financial analysis and is of
primary importance to the financial management. Now-a-days, it is being widely

206
used by the financial analysts, credit granting institutions and financial managers.
The basic purpose of a funds flow statement is to reveal the changes in the working
capital on the tow balance sheet dates. It also describes the sources from which
additional working capital has been financed and the uses to which working capital
has been applied. Such a statement is particularly useful in assessing the growth of
the firm, its resulting financial needs and in determining the best way of financing
these needs. By making use of projected funds flow statements, the management can
come to know the adequacy or working capital even in advance. One can plan the
intermediate and long-term financing of the firm, repayment of long-term debts,
expansion of the business, allocation of resources, etc.
The significance or importance of funds statement can be well followed
from its various uses given below :
1. It help in the analysis of finical operation operations. The finical statements
reveal the net effect of various transactions on the operational and financial
position of a concern. The balance sheet gives a static view of the resources of a
business and uses to which these resources have been put at a certain point of
time. But it does not disclose the causes for changes in the assets and liabilities
between two different points of time. The funds flow statement explains causes
for such changes and also the effect of these changes on the liquidity position of
the company. Sometimes a concern may operate profitably and yet its cash
position may become more and more worse. The funds flow statement gives a
clear answer to such a situation explaining what has happened to the profits of
the firm.
2. It throws light on may perplexing question of general interest which
otherwise may be difficult to be answered, such as :
(a) Why were the net current assets lesser in spite of higher profits and vice-
versa?
(b) Why more dividends could not be declared in spite of available profits?
(c) How was it possible to distribute more dividends than the present earnings”
(d) What happened to the net profit? Where did they go?
(e) What happened to the proceeds of sales fixed assets or issue f shares,
debentures, etc?
(f) What are the sources of the repayment of debt?

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3. It helps in the formation of a realistic dividend policy. Sometimes a firm has
sufficient profits available for distribution as dividend but yet it may not be
advisable to distribute dividend for lack of liquid or cash resources. In such
cases, a funds flow statement helps in the formation of a realistic dividend
policy.
4. It helps in the proper allocation of resources/ The resources of a concern are
always limited and its wants to make the best use of these resources. A projected
funds flow stamen constructed fro the future helps in making managerial
decision. The firm can plan the deployment of its resources and allocate them
among various applications.
5. It acts as a future guide. A projected funds flow statement also acts as a guide
for future to the management. The management can come to know the various
problems it is going to face in near future for want of funds. The firm’s future
needs of funds can be projected well in advance and also the timing of these
needs. The firm can arrange to finance these needs more effectively and avoid
future problems.
6. It helps in appraising the use of working capital. A funds flow statement helps in
explaining how efficiently the management has use its working capital and also
suggests ways to improve working capital position of the firm.
7. It helps knowing the overall creditworthiness of a firm. The financial
instructions and banks such as State Financial Institutions. Industrial
development Corporation. Industrial Finance Corporation of India. Industrial
Development Bank of India. Etc. all ask for funds flow statement constructed
for a number of years before granting loans to know the creditworthiness and
paying capacity of the firm. Hence, a firm seeking financial assistance from
these instructions has no alternative but to prepare funds flow statements.

4.2.4 LIMITATIONS OF FUNDS FLOW STATEMENT

The funds flow statement has a number of uses, however, it has certain limitations
also, which are listed below:
1. It should be remembered that a funds flow statement is not a substitute of an
income statement or balance sheet. It provides only some additional information
as regards changes in working capital.

208
2. It cannot reveal continuous changes.
3. It is not an original statement but simply are-arrangement of data given in the
financial statements.
4. It is essentially historic in nature a projected funds flow statement cannot be
prepared with much accuracy.
5. Changes in cash are more important and relevant for financial management than
the working capital.

4.2.5 PROCEDURE FOR PREPARING A FUNDS FLOW STATEMENT

Funds Flow statement is method by which we study changes in the financial
position of a business enterprise between beginning and ending financial statements
dates. Hence, the funds flow statement is prepared by comparing two balance sheets
and with the help of such other information derived from the accounts as may be
needed. Broadly speaking, the preparation of a funds flow statement consists of two
parts:
1. Statement or Schedule of Charges in Working Capital.
2. Statement of Sources and Application of Funds.
1. Statement or Schedule of changes in Working Capital
Working Capital means the excess of current assets over current liabilities.
Statement of changes in working capital is prepared to show the changes in the
working capital between the two balance sheet dates. This statement is prepared with
the help of current assets and current liabilities derived from the tow balance sheets.
So, (i) An. Increase in current assets increase working capital
(ii) A decrease in current assets decreases, working capital
(iii) A decrease in liabilities decreases, working capital; and
(iv) A decrease in current liabilities increases, working capital
The Change in the amount of any current asset or current liability in the current
balance sheet a compared to that of the previous balance sheet either results in
increase or decrease in working capital. The difference is recorded for each
individual current asset and current liability. In case a current asset in the current
period is more than in the previous period, the effect is an increase in working capital
and it is recorded in the increase column. But if a current liability in the current

209
period is more than in the previous period, the effect is decrease in working capital
and it is recorded in the decrease column or vice versa. The total increase and the
total decrease are compared and the difference shows the net increase or net decrease
in working capital. It is worth noting that schedule of changes in working capital is
prepared only from current assets and current liabilities and the other information is
not of any use for preparing this statement. A typical form of statement or schedule
of changes in working capital is as follows :

Statement of Schedule of Changes in working Capital

Effect on Working Capital
Particulars Previous Current
Increase Decrease
Year Year
Current Assets
Cash in hand
Cash at bank
Ills Receivable
Sundry Debtors
Temporary
Investments
Stocks/Inventories
Prepaid Expenses
Accrued Incomes
Total Current Assets
Current Liabilities :
Bill Payable
Sundry Creditors
Outstanding Expenses
Bank Overdraft
Short-term advances
Dividends Payable

210
Proposed dividends*
Provision for
taxation*
Total Current
Liabilities
Working Capital (CA-
CL)
Net Increase or
Decrease in
Working Capital
* May or may not be a current liability.

Illustration 1 : Prepare a Statement of changes in working capital form the

following Balance Sheets of Manjit and Company Limited.
Balance Sheets
(as at 31st March)
31/03/2013 31/03/2014 31/03/2013 31/03/2014
Liabilities Assets
` ` ` `
Equity Capital 5,00,000 5,00,000 Fixed Assets 6,00,000 7,00,000
Debentures 3,70,000 4,50,000 Long-term
Tax Payable 77,000 43,000 Investments 2,00,000 1,00,000
Accounts Work-in-
96,000 1,92,000 80,000 90,000
Payable Progress
Interest Stock-in-trade
37,000 45,000 1,50,000 2,25,000
Payable
Dividend Accounts
50,000 35,000 70,000 1,40,000
Payable Receivable
Cash 30,000 10,000
11,30,000 12,65,000 11,30,000 12,65,000

211
Solution :
Statement of Changes in working Capital
Effect on
31/03/2013 31/03/2014 Working Capital
Particulars
` ` Increase Decrease
` `
Current Assets
Cash 30,000 10,000 20,000
Accounts Receivable 70,000 1,40,000 70,000
Stock-in-trade 1,50,000 2,25,000 75,000
Work-in-progress 80,000 90,000 10,000
3,30,000 4,65,000
Current Liabilities :
Tax Payable 77,000 43,000 34,000
Accounts Payable 96,000 1,92,000 96,000
Interest Payable 37,000 45,000 8,000
Dividend Payable 50,000 35,000 15,000
2,60,000 3,15,000
Working Capital (CA-CL) 70,000 1,50,000
Net Increase in Working
80,000 80,000
Capital
1,50,000 1,50,000 2,04,000 2,04,000

(2) Statement of Source and Application of Funds.

Funds flow statement is a statement which indicates various sources from which
funds (working capital) have been obtained during a certain period and the uses or
applications to which these funds have been put during that period. Generally, this
statement is prepared in two formats :
(a) Report Form
(b) T Form or An Account Form or Self Balancing Type.

212
 Specimen of Report From of Funds Flow Statement
`
Sources of Funds:
Funds From Operations
Issues of Share Capital
Raising of long-term loans
Receipts form partly paid shares, called up
Sales of non current (fixed) assets
Not-trading receipts, such a dividends received
Sale of Investments (long-term)
Decrease in Working Capital (as per schedule of changes in Working
Capital
Total
Applications or Uses Funds :
Funds Lost in Operations
Redemption of Preference Share Capital
Redemption of Debentures
Repayment of Long-term loans
Purchase of non-current (fixed) assets
Purchase of long-term Investments
Non-trading payments
Payments of dividends*
Payment of tax*
Increase in Working Capital ) as per schedule of changes in working
capital)
Total

213
 To Form An Account Form or Self Balancing Type
Funds Flow Statement
(For the year ended………)
Sources ` Applications `
Funds From Operations Funds Lost in Operations
Issues of Share Capital Redemption of Preference
Share Capital
Raising of long-term loans Redemption of Debentures
Receipts form partly paid Repayment of Long-term
shares, called up loans
Sales of non current (fixed) Purchase of non-current
assets (fixed) assets
Not-trading receipts, such a Purchase of long-term
dividends Investments
Sales of Long-term Investments Non-trading payments
Net Decrease in Working Payments of dividends*
Capital
Payment of tax*
Increase in Working Capital

• Note – Payment of dividend and tax will appear as an application of funds only
when these items are appropriations of profits and not current liabilities.
4.2.6 SOURCES OF FUNDS
The Following are the sources from which funds generally flow (come) into the
business :
(1) Funds From Operations or Trading Profits, Trading profits or the profits from
operations of the business are the most important and major source of funds.
Sales are the main source of inflow of funds into the business as they increase
current assets (cash, debtors or bills receivable) but at same time funds flow out
of business for expense and out of goods sold. Thus, the net effect of operations
will be a source of funds if inflow from sales exceeds the outflow for expense

214
 and cost of goods sold and vice-versa. But it must be remembered that funds
from operations do not necessarily mean the profit as shown by the profit and
loss account of a firm. Because there are many non-fund or non-operating items
which may have been either debited or credited to profit and loss account. The
examples of such items on the debit side of a profit and loss account are :
Amortization of fictitious and intangible assets such as goodwill, Preliminary
expense and Discount on issue of shares and debentures written of;
Appropriation of Retained earrings, such as Transfers to Reserves, etc., The
non-fund items are those which may be operational expenses but they do not
affect funds of the business, e.g. for deprecation charged to profit and loss
account, funds really do not move out of business. Non-operating items are
those which although may result in the outflow of funds but are not related to
the trading operations of the business, such as loss on sale of machinery or
payment of dividends. The methods of calculating funds from operations have
been discussed in the following pages.
Basically, there are two methods of calculating funds from Operations:
(a) The first method is to prepare the profit and loss account afresh by taking into
consideration only fund and operational items which involve funds and are
related to the normal operations of the business. The balancing figure in this
case will be either funds generated from operations or funds lost in operations
depending upon whether the income or credit side of profit and loss account
exceeds the expense or debit side of profit and loss account or vice-versa.
(b) The second method (which is generally used) is to processed from the figure of
net profit or net loss as arrived at from the profit and loss account already
prepared. Funds from operations by this method can be calculated as under :

215
 (a) Calculation of funds from Operation
Closing Balance of P & L A/c. or Retained Earnings (as Given in the
balance sheet)
Add : Non-fund and Non-Operating items which have been already
debited to P & L A/c:
(i) Depreciation and Depletion
(ii) Amortization of fictitious and Intangible Assets such as :
a) Goodwill
b) Patents
c) Trade Marks
d) Preliminary Expenses
e) Discount on Issue of Shares, etc.
(iii) Appropriation of Retained Earnings, such as :
a) Transfer to General Reserve
b) Dividend Equalisation Fund
c) Transfer to Sinking Fund
d) Contingency Reserve etc.
(iv) Loss on Sale of any non-current (fixed) assets such as:
a) Loss on sale of Land and building
b) Loss on sale of machinery
c) Loss on sale of furniture
d) Loss on sale of long-term investments etc.
(v) Dividends including :
a) Interim dividend
b) Proposed Dividend (if it is an appropriation of profits and not
taken as current liability
(vi) Provision for Taxation (if it is not taken as current liability :
(vii) Any other non-fund/non-operation items which have been debited to
P/L A/c

216
 Total (A)
Less : Non-fund and Non-Operating items which have been already
credited to P & L A/c:
(i) Profit or Gain from the sale of non-current (fixed) assets such as :
a) Profit on sale of Land and building
b) Profit on sale of plant & machinery
c) Profit on sale of long-term investment, etc
(ii) Appreciation in the value of fixed assets, such as increase in the
value of land if it has been credited to P/L A/c :
(iii) Dividends Received
(iv) Excess Provision retransferred to P/L A/c or written off
(v) Any other non-operating item which has been credited to P/L A/c
(vi) Opening balance of P & L A/c or Retained Earnings (as given the
balance sheet)
Total (B)
Total (A) – Total (B) = Funds generated by operations
(B) Funds from Operations can also be calculate by preparing
Adjusted Profit and Loss Account as follows :
Adjusted Profit and Loss Account
` `
To Depreciation & Depletion or By Opening Balance
amortization of fictitious and (of P & L A/c)
intangible assets, such as : By Transfers from
Goodwill, Patents, Trade Marks, excess provisions
Preliminary Expenses etc. By Appreciation in
To Appropriation of Retained Earnings, the value of Fixed
such as : Transfers to General assets
Reserve, Dividend Equalisation By Dividends
Fund, Sinking Fund, etc. Received
To Loss on sales of any non-current or By Interest on
fixed asset investments

217
To Dividends (including interim By Profit on Sale of
dividend) fixed or non-current
To Proposed Dividend (if not taken as a assts
current liability) By Funds from
To Provision for taxation (if not taken Operations
as a current liability) (Balancing figure in
To Provision for taxation (if not taken case debit side
as a current liability) exceeds credit side)
To Closing balance (of P & L A/c)
To Funds lost in Operations (balancing
figure, in case credit side exceeds
the debit side)

Illustration 2 : B. M. Company presents the following information and you ar

required to calculate funds from operations :
Profit and Loss Account
` `
To Expenses : By Gross Profit 2,00,000
Operation 1,00,000 By Gain on Sale of
20,000
Plant
Depreciation 40,000
To Loss on Sale of Building 10,000
To Advertisement Suspense 5,000
A/C
To Discount (allowed to 500
customers)
To Discount on Issue of Shares 500
written of
To Good will 12,000
To Net Profit 52,000
2,20,000 2,20,000

218
Solution :
Calculation of Funds From Operations
`
Net Profit (as given) 52,000
Add : Non-fund or non-operation items which have been `
debited to P/L A/c.
Depreciation 40,000
Loss on sale of building 10,000
Advertisement written of 5,000
Discount on issue of shares written of 500
Goodwill written of 12,000 16,500
1,19,500
Less : Non-fund or non-operation items which have been
Credited to P/L A/c. : Gain on sale of Plant 20,000 20,000
Funds from Operations 95,500

Alternatively
Adjusted Profit and Loss Account
` `
To Depreciation 40,000 By Opening Balance -
To Loss on sale of building 10,000 By Gain on Sale of
20,000
Plant
To Advertisement Suspense 5,000 By Funds from
95,500
A/c Operations
To Discount on issue of shares 500 (Balance figure)
To Goodwill 12,500
To Closing Balance 52,000
1,19,500 1,19,500

219
(2) Issue of Share Capital. If during the year there is any increase in the share
capital. Whether preference or equity, it means capital has been raised during
the year. Issue of shares is source of funds as it constitute inflow of funds. Even
the calls received from partly paid shares constitutes an inflow of funds. It
should also be remembered that it is the net proceeds from the issue of share
capital which amounts to a source of funds and hence in case shares are issued at
premium, even the amount of premium collected shall become a source of
funds, The same is true when shares are issued at discount; it will not be the
nominal value of share but the actual realisation after deducting discount that
shall amount to inflow of funds. But sometimes shares are issue otherwise than
in cash, the following rules must be followed :
(i) Issue of shares or making of partly paid shares as fully paid out of
accumulated profits in the form of bonus shares is not a source of
funds.
(ii) Issues of shares for consideration other than current assets such as
against purchase of land, machines, etc. dos not amount to inflow of
funds.
(iii) Conversion of debentures or loans into shares also does not amount to
inflow of funds. In all the three cases mentioned above, both the
amounts involved are non-current and do not involve any current
assets or funds.
(3) Issue of Debentures and raising of Loans, etc. Issue of debentures or raising
of loans (long- term). Whether secured or unsecured results in the flow of funds
into the business. The inflow of funds is the actual proceeds from the issue of
such debentures or raising of loans, i.e., including the amount of premium or
excluding discount, if any, However, loans raised for consideration other than a
current asset, such as for purchase of building, will not constitute inflow of
funds because in that case the accounts involved are only fixed or non-current.
(4) Sale of fixed (non-current) Assets and Long-term or Trade investments.
When any fixed or non-current asset like land, building, plant and machinery,
furniture, long-term investments, etc. are sold it generates funds and becomes a
source of funds. However, it must be remembered that if one fixed assets is

220
 exchanged for another fixed asset, is does not constitute an inflow of funds
because no current assets are involved.
(5) Non-Trading Receipt. Any not-trading receipt like divided received, refund
of tax, rent received, etc. also increases funds and is treated as a sources of funds
because such an income is not included in the funds from operations.
(6) Decrease in Working Capital. If the working capital decreases during the
current period as compared to the previous period, it means that there has been a
release of funds from working capital and it constitutes a source of funds.
4.2.7 APPLICATION OR USES OF FUNDS
(1) Funds lost in operations. Sometimes the result of trading in a certain in a
certain year is a loss and some funds are lost during that period, it trading
operations I Such loss of funds in trading amounts to an outflow of funds and is
treated as an application of funds.
(2) Redemption of preference share capital. If during the year any preference
shares are redeemed, it will result in the outflow of funds and is taken a an
application of funds. When the shares are redeemed at premium or discount, it is
the net amount paid (including premium or excluding discount, as the case may
be). However, if shares are redeemed in exchanges of some other type of shares
or debentures, it does not constitute an outflow of funds as no current account is
involved in that case.
(3) Repayment of loans or redemption of debentures, etc. In the same way as
redemption of preference share capital, redemption of debentures or repayment
of loans also constitute an application of funds.
(4) Purchase of any non-current or fixed asset : When any fixed or non-current
asset like land. Building, plant and machinery, future, long-term investments,
etc. are purchased, funds outflow from the business. However, if fixed assets are
purchased for a consideration of issue of shares or debentures or if some fixed
asset is exchanged for another, it does not involve any funds and hence not an
application of funds.
(5) Payments of dividends and tax. Payments of dividends and tax are also
applications of funds, It the actual payment of dividend ( may be interim

221
 dividend) and tax which should be taken as an outflow of funds and not the mere
declaration of dividend of dividend or creating of a provision for taxation.
(6) Any other non-trading payment. Any payment or expense not related to the
trading operations of the business amounts to outflow of funds and is taken as an
application of funds. The examples could be drawings in case of sole trader or
partnership firm. Loss of cash, etc.
SOME TYPICAL ITEMS WHICH REQUIRE PARTICULAR CARE
The following items require particular care while preparing a funds flow
statement.
1. Digging out Hidden information : While preparing a funds flow statement,
one has to analyse the given balance sheets. Items relating to current accounts.
i.e. current assets and current liabilities have to be shown in the schedule of
changes in working capital. But the non-current assets and non-current liabilities
have to be further analysed to find out the hidden information in regard to sale
or purchase of non-current asset, issue or redemption of share capital, raising or
repayment of long-term loans, transfers to reserves and provisions etc.
The hidden information can be dug out either by preparing working notes in the
stamen form or preparing concerned account of non-current assets and non-current
liabilities.
2. Investments : The treatment o investments while preparing funds flow
statement depends upon their nature, i.e., whether they are current assets or fixed
(long-term) or non-current assets. If the investments represent surplus funds
temporarily invested in marketable or short-term securities, they are to be treated as
current assets. But if investments are long-term, permanent or trade investments,
these should be treated as fixed assets.
(a) Temporary investments. When the surplus funds are temporarily invested in
marketable securities, they are treated as current assets and hence shown in the
schedule of changes in Working Capital. Temporary investments do not require
any further treatment while preparing funds flow stamen like all other current
assets.
(b) Long-term, Permanent or Non-Current Investments. If the investments are of
non-current nature, these should not be shown in the schedule of changes in

222
 working capital because they are not current assets. However, in this case, an
investment account should be prepared as it is prepared in the books of accounts
to find out the cost of investments purchased or sold during the year and the
profit or loss on sale of such investment, if any. Sometimes, the investments are
purchased-cum-dividend and the preaquisition dividend received is credited to
the investment account. If there is a loss on sale of such investments and it has
been debited to P/L A/c, it should be added back while finding funds from
operations or shown on the debit side of adjusted profit and loss account
(depending upon which method is followed) for the reason that such loss is not
an operating loss. However, for the same reason, if a profit on sale of such
investments has been credited to profit and loss account. Is should be deducted
while finding funds from operations or shown on the credit side of adjusted
profit and loss account, as the case may be the purchase of non-current or trade
investments is an application of funds while the proceeds realized from the sales
of such investments are a source of funds.
Illustration 3 : The extracts of a balance sheet reveal that there is an opening
balance of trade investments amounting to ` 20,000 and a closing balance of `
30,000 ` 3,000 by way of dividends have been received during the year including `
1,000 from pre-acquisition profits which have been credited to Investments Account.
You are required to find out the cost of investments purchased during the year to be
shown as application of funds.
Solution :
Investment Account
` `
To Balance b/d (opening balance) 20,000 1,000
To Cash (Purchase during the year- 11,000 30,000
balancing figure)
31,000 31,000

223
 Alternatively :
Calculation of Purchase of investments
`
Opening Balance 20,000
Less : Dividend being pre-acquisition credited to Investments 1,000
A/c
19,000
Closing Balance 30,000
Purchase of investments during the year (balancing figure) 11,000

Try yourself :
Extracts of a Balance Sheet
2013 2014
` `
Trade Investments 50,000 70,000

Additional Information :
(i) `. 5,000 by way of dividend has been received during the year including `. 2,000
from preacquisition profits which have been credited to investments A/c.
(ii) Investments costing `. 10,000 have been sold during the year for `. 10,000
Find out sources/application of funds.
[Ans.] (i) Dividend of `. 5,000 received on trade investments is a source of
funds.
(ii) `. 10,000 realised from sale of trade investments is a source of funds.
(iii) Investments purchased during the year for `. 32,000 is an application of
funds.
2. Provision for Taxation : There are two ways of dealing with provision for
taxation :
(i) As a Current liability
(ii) As a appropriation of profits.

224
(i) As a current liability. Provision of taxation may be treated as a current liability
as it, generally, represents an immediate obligation of the company to pay tax to the
Government. When it is treated as a current liability, provision for taxation will
appear in the schedule of change in working capital like all other current liabilities
and no further treatment is required while preparing the funds flow statement. In this
case, there is no need to prepare the provision for Taxation Account and the payment
of tax made during the year shall not be shown as an application funds because in
that case both the accounts involved for the payment of tax shall be current account,
e.g., the entry for taxes paid during the year shall :
Provision for Taxation A/c Dr. (already taken as Current Liability)
To Cash A/c (Current Assets)
It is clear from the above entry that only the current account are involved and
hence there is no movement of funds (Working Capital)
(ii) As on appropriation of profits. When the provision for taxation is treated as an
appropriation of profits and not as a current liability, then it shall not appear in the
schedule of changes in working capital. Provision for taxation made during the year
then shall be the appropriation of profits made during the year and will have to be
added back while finding funds from operation being a non-fund item. If an adjusted
profits and loss account is prepared. Provision for taxation made during the year shall
appear on the debit side for the same reason. Moreover, the taxes paid during the
year shall be an application side.
A provision for taxation account may have also to be prepared in case of hidden
information, i.e., when the provision for taxation made during the year or the taxes
paid during the year are not given.
However, the students may note that it is preferable to assume provision for
taxation as a current liability as generally it is an immediate obligation of the
company to pay it and it rarely represents an appropriation of profits.
Illustration 4 : The opening balance in the Provision for Taxation Account as on 1st
April 2014 was ` 30,000 and the closing balance on 31st December 2015 was `
40,000. The taxes paid during the year amounted to ` 25,000. How will year deal
with this item in the funds flow statement?
(A) When provision for taxation is treated as a current liability.

225
Provision for taxation shall simply be shown be shown in the schedule of changes in
working capital and it will have no further effect on the funds flow statement :
Schedule of changes in Working Capital
1-4-2014 31-3-2015 Increase in Decrease in
` ` Working Working
Capital Capital
` `
Current Liabilities
Provision for 30,000 40,000 10,000
Taxation

(B) When Provision for taxation is treated as an appropriation of profits :

(1) It will not be shown in the schedule of changes in working capital.
(2) Taxes paid during the year i.e. ` 25,000 is an application of funds and will
appear on the application side of funds statement.
Funds Flow Statement
For the year ended 31-3-2015
Sources ` Application `
Payment of tax 25,000

(3) Provision for taxation made during the year i.e., ` 35,000 shall have to be
calculated as below and it will be added back (or shall be shown on the debit
side of adjusted profit and loss account while finding funds from operations.

Calculation of Provision for taxation made during the year

`
Opening balance of provision for tax on 30,000
1/4/2014
Less: taxes paid during the year 25,000
5,000

226
Closing balance of provision on 31/03/2015 40,000
Provision made during the year 35,000
Or
Provision for Taxation A/c
` `
To Cash (tax 25,000 By Balance b/d 30,000
paid)
To Balance c/d 40,000 By Adjusted P/L A/c (Provision made- 35,000
balancing figure)
65,000 65,000

3. Proposed Dividends : Proposed dividend though show on the liabilities side of

a Balance Sheet is not a liability in real sense until it is formally declared to be
paid to the shareholder in the Annual General meeting of the Company. Till
such declaration of dividends, it simply represents an appropriation of profits
and is like a reserve or surplus. But generally, declaration of dividends proposed
by the directors are accepted in the shareholders meeting. In that case, proposed
dividend cannot be said to be an appropriation of profits as these become
payable within a short time after they are proposed. So there are two alternatives
to deal with this item in the same way as that of provision for taxation :
(i) As current liability. When proposed dividend is treated as a current liability it
represents an obligation of the company which is payable in a short period.
Hence, it is shown in the schedule of changes in working capital as a current
liability and it requires no further treatment in the funds flow stamen.
(ii) As an Appropriation of profits. When proposed dividend is treated as an
appropriation of profits it is not a current liability and hence will not be shown
in the schedule of changes in working capital. In this case, dividends proposed
during the year, being an appropriation, are added back (for shown on the debit
side of adjusted profit and loss account) while finding funds from operations.
Thus, dividends paid during the year represent an application of funds and have
to be shown on the application side of funds flow stamen, In the absence of any
information, proposed dividend for the previous year may be assumed to be paid

227
 during the year and taken as an application of funds while the proposed dividend
of the current year, being an appropriation, may be added while finding funds
from operations.
In any case, the students may note that the treatment of proposed dividend is
much similar to the provision for taxation and its is also preferable to treat proposed
dividend as a current liability because generally the dividends proposed by the
directors are accepted by the shareholders in the Annual General Meeting and these
become payable within a short period.
4. Interim Dividend: The expression ‘interim dividend’ denotes a dividend paid
to the members of the company during a finical year, before the finalization
annual account. The dividend paid or declared in between the two Annual
General Meeting, i.e., interim dividend, should be added back (or debited in the
adjusted profit and loss account) while calculation funds from operations.
However, if the figure of profit is taken prior to the debit of interim dividend
this adjustment is not required, The interim dividend is also an application of
fund and has appear on the application side of funds flow statement.
Illustration 5 : Extracts from the Balance Sheets:
31-03-2013 31-03-2014
` `
Proposed Dividend 50,000 70,000
Profit and loss A/c (Cr.) 2,00,000 3,00,000
Additional information:
Dividend paid during the year is `50,000
Find out sources and applications of funds.
Solution:

Propose Dividend A/C

` `
To Cash-Dividend By Balance b/d
50,000 50,000
Paid
To Balance c/d 70,000 By Adjusted P/L. A/c (balancing 70,000

228
 figure)
1,20,000 1,20,000
Adjusted P/L A/c
` `
To Proposed 70,000 By Balance b/d 2,00,000
Dividend
By Balance c/d 3,00,000 By Funds from operations 1,70,000
(balancing figure)
3,70,000 3,70,000

(i) Dividend paid `50,000 is an application of funds.

(ii) Funds from operations of ` 1,70,000 is a source of funds.
Note: in case proposed dividend is taken a current liability and shown in the
schedule of changes in working capital payment of dividend of ` 50,000 is not a
application of funds and no adjustment is required to calculate funds from operations.
5. Provision Against Current Assets: Provision against current assets, such as.
Provision for bad and doubtful debts, provision for loss on stock. Etc. may be
treated by any of the following methods:
(a) The opening and closing balance of provision against current assets should be
deducted from the respective opening and closing balance of the concerned
asset, The net amount of the current assets should then be shown in the schedule
of changes in working capital. It does not require any further treatment in the
funds flow stamen.
(b) The amount of the opening and closing balance of the current assets may be
taken as gross in the schedule of changes in working capital, i.e., without
deducting the amount of provision, But, them, the opening and closing balance
of the provision against current assets shall have to be taken as current liability
in the schedule of changes in working capital and will not need any further
treatment in the funds statement.
(c) If excess provision has been created, if any be treated as an appropriation of
profits and should be added while calculating funds from operations. The

229
 amount of the excess provision will not be shown in the schedule of changes in
working capital.

4.2.9 ILLUSTRATIONS
(A) When only balance Sheets are given:
Illustration 6.: Form the following Balance Sheets of the Company for the ending
31st March 2013 and 31st March 2014 prepare schedule of changes in working capital
and a stamen showing sources and application of funds.
31-March 31-March
2013 2014 2013 2014
Liabilities ` ` Assets ` `
Share Capital 3,00,000 4,00,000 Plant & 50,000 60,000
Machinery
Sundry 1,00,000 70,000 Furniture & 10,000 15,000
Creditors Fixtures
P/L A/c. 15,000 30,000 Stock-in-trade 85,000 1,05,000
Debtors 1,60,000 1,50,000
Cash 1,10,000 1,70,000
4,15,000 5,00,000 4,15,000 5,00,000

Solution :
Schedule of Changes in working Capital
Effect on
31/03/2013 31/03/2014 Working Capital
Particulars Increase Decrease
` ` ` `
Current Assets
Cash 1,10,000 1,70,000 60,000 ---
Debtors 1,60,000 1,50,000 -- 10,000
Stock-in-trade 85,000 1,05,000 20,000

230
 3,55,000 4,25,000
Current Liabilities
Sundry Creditors 1,00,000 70,000 30,000

1,00,000 70,000
Working Capital 2,55,000 3,55,000
Net Increase in Working Capital 1,00,000 1,00,000

3,55,000 3,55,000 1,10,000 1,10,000

Statement of Source and Application of Funds.
For the year ended 31/03/2014
Sources ` Application `
Issue of Share Capital 1,00,000 Purchase of Plant & Machinery ( 60,000- 10,000
50,000)
Funds from 15,000 Purchase of Furniture & Fixtures (15,000- 5,000
Operations 10,000)
Net Increase in Working capital 1,15,000
1,15,000 1,10,000

Funds From operations : `

Balance of P/L A/c 30, ,000
Less Balance in the beginning of the year
31/03/2013 i.e. 1/04/2013 15,000
Funds from operations 15,000

231
Illustration 7 : From the following Balance Sheets of S.M. Industries Prepare a
Funds Flow Statement showing your working Clearly :
Liabilities 31/03/20 31/03/201 Assets 31/03/20 31/03/20
13 4 13 14
` ` ` `
Share Capital 60,000 65,000 Goodwill 30,000 25,000
Profit and 34,000 26,000 Plant & 60,000 50,000
Loss A/c Machinery
Current 12,000 3,000 Current Assets 16,000 19,000
Liabilities
1,06,000 94,000 1,06,000 94,000

Additional Information :
(i) Depreciation of `. 20,000 on plant and machinery was charged to Profit and
Loss Account
(ii) Dividends of ` 2,000 were paid during the year.
Schedule of Changes in Working Capital
31/03/2013 31/03/2014 Increase in Decrease in
` ` Working Working
Capital Capital
` `
Current Assets 16,000 19,000 3,000
Current Liabilities 12,000 3,000 9,000
Working Capital (C.A- 4,000 16,000
C.L)
Net Increase in W.C. 12,000 12,000
16,000 16,000 12,000 12,000
Funds Flow Statements
Sources ` Application `

232
 Issue of Shares 5,000 Purchase of Plant and Machinery 10,000
Funds from 29,000 Payment of divided 12,000
Operations
Net Increase in W.C. 12,000
34,000 34,000

Working Notes :
(1) Share Capital A/c
` `
To Balance c/d 65,000 By Balance b/d 60,000
By Cash-Issue (balancing 5,000
figure)
65,000 65,000
(2) Plant and Machinery A/c
` `
To Balance c/d 60,000 By Depreciation 20 ,000
By Cash-Purchase 10 ,000 By Balance b/d 50 ,000
(balancing figure)
70,000 70,000
(3) Goodwill A/c
` `
To Balance c/d 30,000 By Adjusted P/L A/c 5,000
(Balance figure)
By Balance b/d 25 ,000
30 ,000 30 ,000
(4) Adjusted Profit and Loss A/c
` `
To Depreciation 20,000 Bu Balanced b/d 34,000

233
To Goodwill 5,000 By Funds from Operations 29,000
To Dividend 12,000 (balancing figure)
To Balance c/d 26,000
63,000 63,000

Illustration 8 : The following are the summarized balance sheets of X Ltd., on 31

March 2013 and 31 March 2014.
Liabilities 2013 2014 Assets 2013 2014
` ` ` `
Share Capital 6,00,000 8,00,000 Plant & 4,00,000 6,45,000
Machinery (at
cost)
Debentures 2,00,000 3,00,000 Land & Building 3,00,000 4,00,000
(cost)
Profit and Loss A/c 1,25,000 2,50,000 Stock 3,00,000 3,50,000
Creditors 1,15,000 90,000 Bank 20,000 40,000
Provision for bad and 6,000 3,000 Preliminary 7,000 6,000
doubtful debts Expenses
Provision for Debtors 69,000 61,000
Depreciation
On Land & Building 20,000 24,000
On Plant & Machinery 30,000 35,000
10,96,000 15,02,000 10,96,000 15,02,000
Additional Information:
(i) During the year a part of machinery costing ` 70,000 (accumulated
depreciation thereon ` 2,000) was sold for ` 6,000
(ii) Dividends of `50,000 were paid during the year.
You are required to ascertain:
(a) Changes in Working Capital for 2013-2014
(b) Funds flow Statement.

234
Schedule of Changes in Working Capital
31/03/2013 31/03/2014 Increase in Decrease in
Working Working
Capital Capital
` ` ` `
Current Assets
Stock 3,00,000 3,50,000 50,000
Bank 20,000 40,000 20,000
Debtors 69,000 61,000 8,000
3,89,000 4,51,000
Current Liabilities :
Creditors 1,15,000 90,000 25,000
Provision for bad and 6,000 3,000 3,000
doubtful debts
1,21,000 93,000
Working Capital 2,68,000 3,58,000
Net Increase in W.C. 90,000 90,000
3,58,000 3,58,000 98,000 98,000
Funds Flow Statements
Sources ` Application `
Issue of Shares Capital 2,00,000 Purchase of plant & 3,15,000
Machinery
Issue of debentures 1,00,000 Purchase of land & 1,00,000
building
Sale of machinery 6,000 Dividends Paid 50,000
Funds from Operations 2,49,000 Net Increase in Working 90,000
Capital
5,55,000 5,55,000

235
Workings :
Provision for Depreciation on Plant & Machinery A/c
` `
To Plant & Machinery A/c 2,000 By Balance b/d 30,000
(Dep. on Machinery sold) By Adjusted P/L A/c (Dep. 7,000
Provided)
To Balance c/d 35,000 (Balancing figure)
37,000 37,000
Provision for Depreciation on Land & Building A/c
` `
To Balance c/d 24,000 To Balance b/d 20,000
By Adjusted P/L – A/c (Balancing 4,000
figure)
24,000 24,000
Land and Building A/c
` `
To Balance b/d 3,00,000 To Balance c/d 4,00,000
1,00,000
4,00,000 4,00,000
Adjusted Profit and Loss Account
` `
Tor Provision for By Balance b/d 1,25,000
depreciation
Plant & Machinery 7,000 By Funds from Operations 2,49,000
Land and Building 4,000
To Preliminary Expenses 1,000
written of
To dividend 50,000
To Loss sale of Machinery 62,000
To Balance c/d 2,50,000
3,74,000 3,74,000

236
Illustration 9 : The following schedule shows the balance sheets I condensed from
of Machinery Manufacturing Company, Ltd. At the end of year 2014
Assets 31/03/2013 31/03/2014
` `
Cash and bank balance 90,000 90,000
Sundry Debtors 67,000 43,000
Temporary Investments 1,10,000 74,000
Prepaid Expense 1,000 2,000
Stock in trade 82,000 1,06,000
Land and Buildings 1,50,000 1,50,000
Machinery 52,000 70,000
5,52,000 5,35,000
Liabilities and Capital
Sundry Creditors 1,03,000 96,000
Outstanding Expenses 13,000 12,000
8% Debentures 90,000 70,000
Depreciation Fund 40,000 44,000
Reserve for Contingencies 60,000 60,000
Profit and Loss Account 16,000 23,000
Capital 2,30,000 2,30,000
5,52,000 5,35,000
The Following information concerning the transactions is available :
1. 10% Dividend was paid in cash.
2. New Machinery for ` 30,000 was purchased but old machinery costing ` 12,000
was sold for 4,000, accumulated depreciation was ` 6,000.
3. ` 20,000 8 % Debentures were redeemed by purchase from open market @ 96
for a debentures of `100.
4. ` 36,000 investments were sold at book value.

237
You are required to prepare a Schedule of Changes in Working capital and statement
showing Sources and Application of Funds.
Schedule of Changes in Working Capital
31/03/2013 31/03/2014 Increase in Decrease in
Working Working
` ` Capital Capital
` `
Current Assets : Cash 90,000 90,000
and Bank
Sundry Debtors : 67,000 43,000 24,000
Temporary Investments 1,10,000 74,000 36,000
Prepaid Expenses 1,000 2,000 1,000
Stock-in-trade 82,000 1,06,000 24,000
3,50,000 3,15,000
Current Liabilities :
Sundry Creditors 1,03,000 96,000 7,000
Outstanding expenses 13,000 12,000 1,000
1,16,000 1,08,000
Working Capital 2,34,000 2,07,000
Net Decrease in W.C. 27,000 27,000
2,34,000 2,34,000 60,000 60,000
Statement of Sources and Application of Funds
Sources ` Applications `
Sale of Machinery 4,000 Redemption of Debentures 19,200
Funds from Operations 41,200 Purchase of Machinery 30,000
Net Decrease in 27,000 Dividends Paid 23,000
Working Capital
72,200 72,200

238
Note. As investment are given to be temporary investments, they are taken as current
assets and hence, sale of investments for ` 36,000 is not a source of funds.
Workings :
Machinery A/c
` `
To Balance b/d 52,000 By Cash (sale) 4,000
To Cash 30,000 By Accumulated depreciation (on 6,000
(Purchase) sold machine)
By Adjusted P/L A/c (Loss on sale) 2,000
By Balance c/d 70,000
82,000 82,000

Depreciation Fund A/c

` `
To Machinery A/c 6,000 To Balance b/d 40,00
To Balance c/d 44,000 By Adjusted P/L A/c (Dep. Charged 10,000
during the yr.)
50,000 50,000
Adjusted Profit and Loss A/c
` `
To Depreciation 10,000 To Balance b/d 16,000
To Loss on sale of 2,000 By Profit on redemption of debentures 8 000
machinery
To Dividend 23,000 By Funds from operations 41,200
To Balance c/d 23,000
58,000 58,000

239
Illustration 10 : The following are the summaries of the Balance Sheets of Parveen
Ltd. As at 31st March 2013 and 2014
Liabilities 31/03/2013 31/03/2014 Assets 31/03/2013 31/03/2014
` ` ` `
Share Capital 2,00,000 2,50,000 Land & 2,00,000 1,90,000
Buildings
General 50,000 60,000 Plant 1,50,000 1,74,000
Reserve
Profit & 30,500 30,600 Stock 1,00,000 74,000
Loss
Account
Bank Loan 70,000 -- Debtors 80,000 64,200
(Short-term)
Creditors 1,50,000 1,35,200 Cash 500 600
Provision for 30,000 35,000 Bank -- 8,000
Taxation
5,30,500 5,10,000 5,30,500 5,10,000

Additional Information :
(a) Depreciation was written off plant ` 14,000 in 2013-2014
(b) Dividend of ` 20,000 was paid during 2013-2014
(c) Income Tax provision made during the year was ` 25,000
(d) A piece of land has been sold during the year at cost.
You are required to prepare a stamen showing sources and application of funds for
the year 2013-2014 and a schedule of changes in working capital.

240
Solution :
Schedule of Changes in Working Capital
31/03/2013 31/03/2014 Increase in Decrease in
Working Working
Capital Capital
` ` ` `
Current Assets :
Stock 1,00,00 74,000 26,000
Debtors 80,000 64,200 5,800
Cash 500 600 100
Bank 8,000 8,000
1,80,500 1,46,800
Current Liabilities
Bank Loan 70,000 - 70,000
Creditors 1,50,000 1,35,200 14,800
2,20,000 1,35,200
Working Capital (CA- (--) 39,500 11,600 92,900
CL)
Net increase in W.C. 51,100 51,100
11,600 11,600 92,900 92,900

241
 Statement of Sources and Application of Funds
For the year ended 31st March 2014
Sources ` Applications `
Issue of Capital 50,000 Purchase of Plant 38,600
Sales of Land & Buildings 10,000 Dividend Paid 20,000
Funds from Operations 69,100 Income Tax Paid during 51,100
2014
1,29,100 Net increase in W.C. 1,29,100
Plant A/C
` `
To Balance b/d 1,50,000 By Depreciation 14,000
To Cash-Purchases (balancing 38,000 By Adjusted P/L A/c 1,74,000
figure)
1,88,000 1,88,000
Provision for Taxation A/c
` `
To Cash (Tax paid balancing 20,000 By Balance b/d 30,000
figure)
To Balance c/d 35,000 By Adjusted P/L A/c 25,000
55,000 55,000
Adjusted Profit and loss A/c
` `
To Transfer to General 10,000 By Balance b/d 30,500
Reserve
To Depreciation 14,000 By Funds from 69,100
Operations
To Provision for Taxation 25,000
To Dividend 20,000
To Balance c/d 30,600
99,600 99,600

242
Illustration 11 : The following are the summaries of the Balance Sheet of a limited
Company as at 31st March 2013 and 31st March 2014
31/03/2013 31/03/2014
` `
Sundry Creditors 39.500 41,135
Bills Payable 33,780 11,525
Ban Overdraft 59,510
Provision for Taxation 40,000 50,000
Reserves 50,000 50,000
Profit and Loss Account 39,690 41,220
Share Capital 2,00,000 2,60,000
4,62,480 4,53,880
` `
Cash at Bank 2,500 2,700
Sundry Debtors 85,175 72,625
Sundry Advances 2,315 735
Stock 1,11,040 97,370
Land And Buildings 1,48,500 1,44,250
Plant and Machinery 1,12,950 1,16,200
Goodwill
4,62,480 4,53,880

The Following additional information is obtained from the general ledger :

1. During the year ended 31st March 2014 an interim dividend of ` 26,000 was
paid.
2. The assets of another company were purchased for ` 60,000 payable in fully
paid shares of the company. These assets consisted of stock ` 21,640 machinery
` 18,360 and goodwill ` 20,000. In addition, sundry purchases of plant were
made totaling ` 5,650.

243
3. Income tax paid during the year amounted to ` 62,530
4. The net profit for the year before tax was ` 62,530.
You are required to prepare a statement showing the sources and applications of
funds for the year 2013-1 and a schedule setting out changes in working capital.
Solution :
Schedule of Changes in Working Capital
Increase in Decrease in
31/03/2013 31/03/2014 Working Working
Capital Capital
` ` ` `
Current Assets :
Cash 2,500 2,700 200
Sundry Debtors : 85,175 72,625 -- 12,550
Sundry Advance 2,315 735 -- 1,580
Stock 1,11,040 97,370 -- 13,670
2,01,030 1,73,430
Current Liabilities
Sundry Creditors 39,500 41,135 - 1,635
Bills, Payable 33,780 11,525 22,255 --
Bank Overdraft 59,510 -- 59,510 --
1,32,790 52,550
Working Capital (C.A.- 68,240 1,20,770
C.L.)
Net Increase in Working 52,530 -- -- 52,530
Capital
1,20,770 1,20,770 81,965 81,965

244
 Statement of Sources and Application of Funds
For the year ended 31st March 2014
Sources ` Applications `
Issue of Share Capital 21,640 Purchase of Machinery 5,650
Funds from 87,540 Payment of Dividend 26,000
Operations
1,09,180 Payment of Income Tax 25,000
Net Increase in W.C. 52,530
1,09,180 1,09,180

Notes and Assumptions

(1) Although there is an increase in Share Capital Amounting to ` 60,000 only
`21,640 which has been issued against stock i.e. current asset has been taken as
a sources. The balance of capital has been issued against purchase of fixed-
assets machinery and goodwill; it has neither been taken a source nor an
application.
(2) As bank overdraft has been paid in 20-13-14, it has been assumed as a current
liability.
(3) Provision for taxation has not been treated as a current liability.
Working
Share Capital A/c
` `
To Balance C/d 2,60,000 By Balance b/d 2,00,000
By Stock (Source of funds) 21,640
By Goodwill 20,000
By Machinery 18,360
2,60,000 2,60,000

245
 Plant and Machinery A/c
` `
To Balance b/d 1,12,960 By Adjusted P/L A/c 4,250
To Share Capital-Purchase 18,360 (Depreciation –balancing
figure)
To Cash-Purchase 5,650 By Balance c/d 1,44,250
1,36,960 1,48,500

Provision for Taxation A/c

` `
To Cash (Paid) 25,000 By Balance b/d 40,000
To Balance c/d (balancing 50,000 By Adjusted P/L A/c 35,000
figure)
75,000 75,000
Adjusted Profit and Loss A/c
To Depreciation : By Balance b/d 39,690
Land & Building 4,250 By Funds from operations 87,540
Plant & Machinery 20,760
To Provision of Taxation 35,000
To Dividend 26,000
To Balance c/d 41,220
1,27,230 1,27,230

Illustration 12 : From the following condensed balance sheets of A Ltd. For the year
ending 31st March 2013 and 31st March 2014 draw out a Funds flow Statement and a
Statement of Changes in Working Capital for 2014

246
 Balance Sheets of a Ltd.
Liabilities 31/03/2013 31/03/2014 Assets 31/03/2013 31/03/2014
` ` ` `
Equity Share 3,00,000 4,00,000 Equity Share 60,000 55,000
Capital Capital
6% 6% 1,25,000 85,000
Redeemable Redeemable
Preference 80,000 50,000 Preference 1,20,000 2,25,000
Share Share
Capital Capital
Capital 20,000 Capital 15,000 2,000
Reserve Reserve
General 30,000 40,000 General 12,000 48,000
Reserve Reserve
Profit and 26,000 35,000 Profit and 65,000 1,05,000
Loss A/c Loss A/c
Sundry 30,000 58,000 Sundry 90,000 84,000
Creditors Creditors
Bill Payable 12,000 8,000 Bill Payable 16,000 30,000
Outstanding 6,000 5,000 Outstanding 13,000 20,000
Expenses Expenses
Proposed 30,000 42,000 Proposed 42,000 20,000
Dividend Dividend
Provision for 32,000 36,000 Provision for 36,000 10,000
Taxation Taxation
5,46,000 6,94,000 5,46,000 6,94,000

Additional Information :
(i) A Piece of land has been sold out in 2013-2014 and the balance has been
revalued profits on sale and revaluation being transferred to capital Reserve
Account.

247
 (ii) Depreciation of Plant and Machinery has been written off `24,000 in 2013-
2014 and no depreciation has been charged on hand and building.
(iii) A Machinery was sold for `16,000 (w. d. v. being Rs. `20,000) and no
furniture has been sold during the year.
(iv) An interim dividend of `20,000 has been paid in 2013-2014
(v) ` 3,000 has been received as Dividend on Trade Investments.

Solution :
The readers must have noticed Proposed Dividend and Provision for taxation
appear in the Balance Sheets of the given illustration. This Problem has been taken
with a particular purpose to make clear to the readers the treatment of these two
items of balance sheets. There are to ways of dealing with these items.
(A) When Proposed Dividend and Provision for Taxation are considered as current
Liabilities.
(B) When Proposed Dividend and Provision for Taxation are not considered as
current Liabilities but are treated as appropriation of Profits.
Solution :
The problem has been solved with both the methods.
(A) When propose divided and provision for taxation are considered as current
liabilities.
Schedule of Changes in Working Capital
Increase in Decrease in
31/03/2013 31/03/2014 Working Working
Capital Capital
` ` ` `
Current Assets 13,000 20,000 7,000
Cash and bank 15,000 20,000 5,000
Bills Receivable 16,000 30,000 14,000
Stocks 90,000 84,000 6,000
Sundry Debtors 65,000 1,05,000 40,000
1,99,000 2,29,000

248
Current Liabilities :
Outstanding 6,000 5,000 1,000
Expenses
Bills Payable 12,000 8,000 4,000
Sundry Creditors 30,000 58,000 28,000
Proposed Dividend 30,000 42,000 12,000
Provision for 32,000 36,000 4,000
Taxation
1,10,000 1,49,000
Working Capital 89,000 1,10,000
Net Increase in W.C. 21,000 21,000
1.10,000 1,10,000 71,000 71,000
Statement of Sources and Application of Funds
Sources ` Applications `
Issue of Share 1,00,000 Redemption of Preference 30,000
Capital Share Capital
Sale of Land 60,000 Purchase of Plant & Machinery 1,49,000
Building
Sale of machinery 16,000 Purchase of Trade Investment 36,000
Dividend Received 3,000 Interim Dividend Paid 20,000
Funds from 77,000 Net Increase in W.C. 21,000
Operations.
2,56,000 2,56,000

249
Working :
Land and Building
` `
Balance b/d 1,25 ,000 By Cash (sale) 60 ,000
Balance Capital Reserve (balancing figure)
(Profit on sale and 20 ,000 By Balance c/d 85 ,000
revaluation)
1,45 ,000 1,45 ,000
Plant and Machinery A/c
` `
Balance b/d 1,20,000 By Cash (sale) 16 ,000
To Cash (Purchase) 1,49,000 By Adjusted P/L A/C 4,000
(Loss on sale of
Machinery)
By Depreciation 24,000
By Balance c/d 2,25,000
2,69,000 2,69,000
Furniture A/c
` `
To Balance b/d 15,000 By Depreciation 3,000
(Balancing figure)
By Balance c/d 12,000
15,000 15,000
Trade Investments A/c
` `
To Balance b/d 12,000 By Balance b/d 48,000
36,000
48,000 48,000
Adjusted Profit and Loss A/c
` `
Transfer to General Reserve 10,000 By Balance b/d 26,000
To Depreciation on plant 24,000 By Dividend on Trade 3,000

250
and machinery Investment
To Depreciation on 3,000 By Funds from Operations 77,000
furniture
To Loss on sale of 4,000
Machinery
To Goodwill written off 5,000
To Preliminary Expenses 5,000
written off
To Interim Dividend 20,000
TO Balance c/d 35,000
1,06,000 1,06,000
(B) When Proposed dividend and provision for taxation ar treated as appropriation
of profits and not as current Liabilities.
Statement of Changes in Working Capital
Increase in Decrease in
31/03/2013 31/03/2014 Working Working
Capital Capital
` ` ` `
Current Assets : 13,000 20,000 7,000 -
Cash in Hand 15,000 20,000 5,000 -
Cash at Bank 16,000 30,000 14,000 -
Bills Receivable 90,000 84,000 6,000
Stocks 65,000 1,05,000 40,000 -
Sundry Debtors 1,99,000 2,59,000 -
Current Liabilities:
Outstanding 6,000 5,000 1,000 -
Expenses
Bills Payable 12,000 8,000 4,000 -
Sundry creditors 30,000 58,000 28,000
48,000 71,000

251
Working Capital 1,51,000 1,88,000
Net increase in 37,000 37,000
W.C.
1,88,000 1,88,000 71,000 71,000
Statement of Sources and Application of Funds
Sources ` Applications `
Issue of Share Capital 1,00,000 Redemption of 30,000
Preference Share Capital
Sale of Land & Building 60,000 Purchase of Plant & 1,49,000
Machinery
Sales of Machinery 16,000 Purchase of Trade 36,000
Investments
Dividends Received 3,000 Interim Dividend 20,000
Funds from Operations 1,55,000 Proposed Dividend
(For 2006, assumed to 30,000
be paid)
Provision for taxation
(for 2006, assumed to be 32,000
paid)
Net Increase in W.C. 37,000
3,34,000 3,34,000
Adjusted Profit and Loss A/c
` Applications `
To Transfer to General 10,000 By Balance b/d 26,000
Reserve
To Depreciation on Plant 24,000 By Dividend Received 3,000
and Machinery
To Depreciation on 3,000 By Fund from Operation 1,55,000
Furniture
To Loss on sale of 4,000

252
 Machinery
To Proposed Dividend 20,000
To Interim Dividend 42,000
Provision for taxation (200) 36,000
To Goodwill Written off 5,000
To Preliminary expense 5,000
To Balance c/d 35,000
1,84,000 1,84,000

Illustration 13 : The provisional Balance Sheet of Rupali Ltd. As on 31st March

2014 and final Balance Sheet of the same company as on 31st March 2013 were as
follows.
2014 2013 2014
` ` ` `
Share Capital Plant & 2,50,000 2,00,000
Machinery at
Cost
Preference - 1,00 ,000 Less: 1,20,000 80,000
Depreciation
Equity 5,00,000 4,00,000 1,30,000 1,20,000
General Freehold 10,00,000 -
Reserve : Property at cost
Profit on Sale Trade 1,50,000
of Trade Investment at
cost
Investments 30,000 -- Stock & Work- 4,40,000 3,00,000
In-Progress
Profit and 3,50,000 1,50,000 Trade Debtors 3,00,000 2,00,000
Loss Amount
6% 5,00,000 Balance with 10,000 1,50,000

253
Debentures Bankers and
(Secured) Cash in Hand
Bank Loan 2,00,000
Trade 2,20,000 1,80,000
Creditors
Proposed 30,000
Dividend
Free of tax --
Taxation
Future 50,000 40,000
Current 30,000 20,000
18,80,000 9,20,000 18,80,000 9,20,000

The directors decide on the following adjustment to the 2013-2014 accounts:

(i) General provision of ` 20,000 for doubtful debts.
(ii) Reduction in book value of work-in-progress by ` 60,000 to conform with a
new basis of valuation
(iii) Transfer of ` 50,000 to general reserve.
(iv) Recommendation of a dividend at the rate of 8% per annum, free of tax.
You are required to prepare a statement of sources and applications of funds, for
the financial year 2013-2014
Solution :
Before preparing the stamen of sources and application of funds, it would be
better to prepare and adjusted balance sheets, after making adjustment decided by the
directors, as on 31.12.2007.

254
 ADJUSTED BALANCE SHEET
(as on 31-03-2014)
Liabilities Assets
` ` ` `
Share Capital 5,00,000 Plant and 2,50,000
(Equity) Machinery at Cost
General Reserve : Less: Deprecation 1,20,000 1,30,000
Profit on sale of Freehold Property 10,00,000
trade at cost
Investments 30,000 80,000 Stock and Work- 4,40,000
in-Progress
Transfer from P/L 50,000 Less: Reduction 60,000 3,80,000
A/c in value
Profit and Loss 3,50,000 Trade Debtors 3,00,000
Account
Less : Provision 20,000 Less : Provision 20,000 2,80,000
for D.D. for D.D.
Reduction in Balance With 10,000
value of Bankers and cash
in hand
Work-in-progress 60,000
Transfer to
general
Reserve 50,000
Proposed 40,000 1,70,000 1,80,000
Dividend
6% Debentures 5,00,000
(Secured)
Ban Loan 2,00,000
Trade Creditors 2,20,000
Proposed 40,000
Dividend
Taxation :
Future 50,000
Current 30,000
18,00,000 18,00,000

255
 SCHEDULE OF CHANGES IN WORKING CAPITAL
Decrease
Increase in
in
31/03/2013 31/03/2014 Working
Working
Capital
Capital
` ` ` `
Current Assets :
Stock and Work-in- 3,00,000 3,80,000 80,000 --
Progress
Trade Debtors 2,00,000 2,80,000 80,000 --
Cash and Bank Balance 1,50,000 10,000 - 1,40,000
6,50,000 6,70,000
Current Liabilities
Trade Creditors 1,80,000 2,20,000 -- 40,000
Proposed Dividend 30,000 40,000 -- 10,000
Current Taxation 20,000 30,000 -- 10,000
2,30,000 2,90,000
Working Capital (C.A. – 4,20,000 3,80,000
C.L.)
Net Decrease in W.C. 40,000 40,000
4,20,000 4,20,000 2,00,000 2,00,000
STATEMENT OF SOURCES AND APPLICATION OF FUNDS
Sources ` Applications `
Issue of Equity Share 1,00,000 Purchase of Plant and
Capital Machinery
(5,00,000-4,00,000) 5,00,000 (2,00,000-2,00,000) 50,000
Issue of 6% Debentures 2,00,000 Purchase of Freehold 10,00,000
Property
Raising of Bank Loan Redemption of Preference 1,00,000
Shares
Sale of Trade

256
Investments
(1,50,000+30,000) 1,80,000
Funds from Operations 1,30,000
Net Decrease in Working 40,000
Capital
11,50,000 11,50,000
Adjusted Profit and Loss Account
To Transfer to General 50,000 By Balance b/d 1,50,000
Reserve
To Depreciation (1,20,000- 40,000 By Funds from Operations
80,000)
To Future Taxation (50,000- 10,000 (Balancing figure) 1,30,000
40,000)
To balance c/d 1,80,000
2,80,000 2,80,000

Illustration 14 : The Following balance sheets have been prepared from the books of
Rais Limited as appearing on 31-3-2013 and 31-03-2014
Balance Sheet
Liabilities 2013 2014 Assets 2013 2014
` ` ` `
Equity Capital 4,00,000 6,00,000 Buildings 5,70,000 5,00,000
Share Premium 1,00,000 1,10,000 Plant & Machinery 3,60,000 3,51,000
General Reserve 2,00,000 2,20,000 Furniture 90,000 81,000
Debenture Redemption 1,00,000 1,10,000 Cash in Hand 5,000 8,000
Reserve
Debentures 3,00,000 2,90,000 Stock 1,55,000 1,45,000
Provision for Taxation 40 35,000 Debtors 1,80,000 1,60,000
Secured Loans 2,00,000 1,10,000 Bill Receivable 4,000 40,000
Current Liabilities 24,000 30,000 Investments (long- 2,40,000
term)
13,64,000 14,95,000 13,64,000 14,95,000

257
(a) During 2013-14 the company paid 12% Dividend on its Equity Share Capital of
` 40,00,000

(b) The Shares are of ` 100 each fully paid.

(c) Taxation Provision was utilized to the extent of `30,000 for Income-tax paid in
2013-14
(d) Depreciation was charged on building at 5% on plant and machinery at 10% and
on furniture at 10% for a full one year.
(e) A building worth ` 70,000 was sold on 1-4-2013 at ` 60,000 and a new building
was constructed at a value of `25,000 on 31-3-2014
(f) A machine was purchased at a cost of ` 40,000 and 1-4-2013 while a machine
having a book value of `10,000 was sold on 1-10-2014 at `20,000.
Prepare a statement showing movement in working capital, profit and loss
appropriation account and a stamen showing the sources and applications of funds.
Solution :
Statement Showing Movement in Working Capital
31/03/2013 31/03/2014 Increase in Decrease in
Working Working
Capital Capital
` ` ` `
Current Assets :
Cash in hand 5,000 8,000 3,000
Stock 1,55,000 1,45,000 10,000
Debtors 1,80,000 1,60,000 20,000
Bills Receivable 4,000 40,000 36,000
3,44,000 3,53,000
Current Liabilities :
Current Liabilities 24,000 30,000 6,000
24,000 30,000
Working Capital 3,00,000 3,23,000
Net Increase in Working 3,000 3,000
Capital
3,23,000 3,23,000 39,000 39,000

258
 Statement of Sources and Application of Funds
Sources ` Applications `
Issue of Shares 2,00,000 Redemption of Debentures 10,000
Share Premium 10,000 Payment of Secured Loans 1,00,000
Sale of Building 60,000 Purchase of Building 25,000
Sale of Machinery 20,000 Purchase of Machinery 40,000
Funds from Operations 1,76,000 Purchase of Investments 2,10 ,000
4,66,000 Purchase of Dividend 48,000
Purchase of Tax 30,000
Net Increase in W.C. 3,000
4,66,000 4,66,000
Workings :
(1) Investment have been assumed as a non-current asset.
(1) Provision for Taxation A/C
` `
To Income Tax (-cash paid) 30,000 By Balance b/d 40,000
To Balance c/d 35,000 By P/L A/c (Provision created 25,000
during the year)
65,000 65,000
(2) Building A/c
` `
To Balance b/d 5,70,000 By Cash (Sale) 60,000
To Cash (Construction) 25,000 By Loss on sale of building 10,000
(Balancing figure) (Adjusted P/L A/c)
By Depreciation (5% on 25,000
5,00,000)
By Balance c/d 5,00,000
5,95,000 5,95,000

259
 (3) Plant & Machinery Account
` `
To Balance b/d 3,60,000 By Cash (Sale) 20,000
To Cash (Purchases) 40,000 By Depreciation 39,000
To Adjusted P/L A/c 10,000 By Balance c/d 3,51,000
(Profit on Sale)
4,10,000 4,10,000
(4) Adjusted Profit & Loss A/c
` `
To Depreciation By Balance b/d (General 2,00,000
Reserve)
Furniture 9,000 By Profit on Sale of Machine 10,000
Building 25,000 By Funds from Operations 1,76,000
Plant & Machinery 39,000
To Provision for Taxation 25,000
To Debenture Redemption 10,000
Reserve
To Dividend Paid 48,000
To Loss on sale of Building 10,000
To Balance c/d (General 2,20,000
Reserve)
3,86,000 3,86,000

260
Illustration 15 : The following are the Balance Sheets of Beta Ltd. For the year
ending March 31,2014 and March 31,2015
Balance Sheet
(as on March 31)
2014 2015
` `
Capital and Liabilities 15,75,000
Share Capital 13,50,000 5,62,000
General Reserves 4,50,000 22,500
Capital Reserve (Profit on sale of Investments)
Profit and Loss Amount 2,25,000 4,50,000
12% Debentures 6,75,000 4,50,000
Accrued Expense 22,500 27,000
Creditors 3,60,000 5,62,000
Provision for Dividends 67,500 76,500
Provision for Taxation 1,57,500 1,71,000
33,07,500 38,97,000
Assets
Fixed Assets 22,50,000 27,00,000
Less : Accumulated Depreciation 4,50,000 5,62,500
Net Fixed Assets 18,00,000 21,37,500
Long-term Investments (At cost) 4,05,000 4,05,000
Stock (At Cost) 4,50,000 6,07,500
Debtors (Net of Provision for doubtful debts of ` 5,06,250 5,51,250
90,000 and 1,12,500 for 2014 and 2015 respectively
Bills Receivables 90,000 1,46,250
Prepaid Expenses 22,500 27,000
Miscellaneous Expenditure 33,750 25,000
33,07,500 38,97,000

261
Additional Information :
(i) During the year 2014-15, fixed assets with a net book value of ` 22,500
(accumulated depreciation ` 67,500) were sold for ` 18,000
(ii) During the year 2014-15 investments costing ` 1,80,000 were sold, and also
investments costing ` 1,80,000 were purchased.
(iii) Debentures were retired at a premium of 10%
(iv) Tax of ` 1,23,750 was paid for 2013-2014
(v) During the year 2014-2015 bad debts of 31,500 were written of against the
Provision for Doubtful Debt Account
(vi) The Proposed dividend for 2013-2014 was paid in 2014-2015
Solution :
Statement of Changes in Working Capital
Increase in Decrease in
31/03/2013 31/03/2014 Working Working
Capital Capital
` ` ` `
Current Assets :
Stock (At cost) 4,50,000 6,07,500 1,57,500
Debtors (Net) 5,06,250 5,51,520 45,000
Bill Receivables 90,000 1,46,250 56,200
Prepaid Expenses 22,500 27,000 4,500
10,68,750 13,32,000
Current Liabilities :
Accrued Expenses 22,000 27,000 4,500
Creditors 3,60,000 5,62,500 2,02,500
3,85,500 5,89,500
Working Capital (CA- 6,82,500 7,42,500
CL)

262
Net Increase in 56,250 56,250
Working Capital
7,42,500 7,42,500 2,62,750 2,62,750
Statement of Sources and Application of Funds
Sources ` Applications `
Issue of Share Capital 2,25,000 Purchase of fixed assets 5,40,000
Sale of Fixed assets 18,000 Purchase of long-term 1,80,000
investments
Sale of Long-term 2,02,500 Redemption of debentures 2,47,500
investments (at premium of 10%)
(1,80,00+22,500) Payments of tax 1,23,750
Funds from operations 7,69,500 Payment of dividend 67,500
(2006-07)
Net Increase in Working 56,250
Capital
12,15,000 12,15,000

Working Notes :
1. Provision for dividends and provision for taxation have been taken a non-
current.
(2) Fixed Assets A/c (At Cost)
` `
To Balance b/d 2,25,000 By Accumulated 67B500
Depreciation A/c
To Cash-purchase 5,40,000 By Cash (Sales 18,000
(Balancing figure) By Adjusted P/L A/c 4,500
(Loss on sale)
By Balance c/d 27,00,000
27,90,00 27,90,00

263
 (3) Accumulated Depreciation A/c
` `
To Fixed Assets A/c 67,500 By Adjusted P/L A/c 18,000
(Dep. Provided-
Balancing Figure)
To Balance c/d 5.62.500
6,30,000 6,30,000
(4) Long-term Investments A/c
` `
To Balance b/d 4,05,00 By Cash-Sale 2,02,500
(18,00,000+22,500)
To Capital Reserve (Profit on 22,500 By Balance c/d 4,05,000
sale)
To Cash (Purchase) 1,80,000
6,07,500 6,07,500
(5) Provision for Taxation A/c
` `
To Cash (Paid) 1,23,750 To Balance (c/d) 1,57,500
To Balance (c/d) 1,71,000 Adjusted P/L A/c 1,37,250
2,94,750 2,94,750
(6) Adjusted Profit and Loss A/c
` `
To Depreciation 1,80,000 By Balance b/d 2,25,000
To Loss on Sale of Fixed 4,500 By funds from 7,69,500
Assets
To Transfer to General
Reserve
(5,62,500-4,50 ,000) 1,12,500
To Misc. Expenditure written 11,250

264
off
To Provision for Taxation 1,37,250
To Provision for Dividends 76,500
To Premium on Redemption 22,500
of Debentures
To Balance c/d 4,50,000
9,94,500 9,94,500

Illustration 16 : The balance Sheets of X Ltd. As at 31st March 2014 and 2015
are given below :
Particulars 31/03/2014 31/03/2015
` `
Share Capital 4,00,000 5,00,000
Capital Reserve 20,000
General Reserve 1,80,000 2,10,000
Debentures 3,00,000 2,00,000
Profit and Loss Account 70,000 90,000
Current Liabilities 1,30,000 1,20,000
Provision for Income tax 80,000 60,000
Proposed Dividend 40,000 50,000
12,00,000 12,50,000
Fixed Assets at Cost 10,00,000 10,00,000
Less : Depreciation 2,60,000 3,10,000
7,40,000 6,90,000
Trade Investments 1,10,000 90,000
Current Assets 3,20,000 4,50,000
Preliminary Expenses 30,000 20,000
12,00,000 12,50,000

265
During the year ended 31st March 2015 the company :
(i) Sold one machine for 40,000 the cost of which was 80,000 and the
depreciation provided on it was 30,000
(ii) Provided 1,00,000 as depreciation :
(iii) Redeemed the debentures at 105 :
(iv) Sold some trade investments at a profit which was credit to capital reserve :
(v) Decided to write off fixed assets (duly depreciated) costing 20,000;
(vi) Decided to value opening stock at cost which was value previously at cost
less 10%. The opening stock according to books was 63,000. The Closing
stock was correctly valued at cost.
Prepare the statements of source and Applications of Funds for the year ended 31st
March 2015 showing the changes in working capital.
Statement of Changes in Working Capital
Increase in Decrease in
2014 2015 Working Working
Capital Capital
` ` ` `
Current Assets :
Current Assets (as given) 3,20,000 4,50,000
Add : Write up for 7,000
opening stock
10
63,000x
90
Total Current Assets 3,27,000 4,50,000 1,23,000
Current Liabilities :
As given 1,30,000 1,20,000 10,000
Working Capital (CA-Cl) 1,97,000 3,30,000
Net Increase in W.C. 1,33,000 1,33,000
3,30,000 3,30,000 1,33,000 1,33,000

266
 Statement of Sources and Application of Funds
Sources ` Applications `
Issue of Share Capital 1,00,000 Purchase of Fixed Assets 1,00,000
Sale of Machine 40,000 Redemption of Debentures 1,05,000
Sale of Trade 40,000 Proposed Dividend for 40,000
Investments 2014
(Assumed to be paid)
Funds from operations 2,78,000 Provision for Taxation for 80,000
2014
(Assumed to be paid)
Net Increase in W.C. 1,33,000
4,58,000 4,58,000

Working :
(1) As current liabilities are specifically given, proposed dividend and provision for
income-tax have been treated as no-current liabilities.
(2) Share Capital A/c
` `
To Balance A/c 5,00,000 By Balance b/c 4,00,000
By Bank/Cash 1,00,000
(balancing figure)
5,00,000 5,00,000
(3) Capital Reserve A/c
` `
By Balance b/c -
To Balance b/c 20,000 By Trade Investment 20,000
A/c (Profit on sale)
20,000 20,000

267
 (4) General Reserve A/c
` `
To Balance c/d - By Balance b/c 1,80,000
2,10,000 By Adjusted P/L A/c 30,000
( balancing figure)
2,10,000 2,10,000
(5) Debentures A/c
` `
To Bank 1,05,000 By Balance b/d 3,00,000
To balance cd 2,00,000 By Adjusted P/L A/c ( 5,000
loss on Red)
3,05,000 3,05,000
(6) Fixed Assets (At Cost) A/c
` `
To Balance b/d 10,00,000 By Cash (sale) 40,000
By Accumulated 30,000
Depreciation
To Cash (Purchase) By Adjusted P/L A/c 10,000
(Loss on sale)
(Balancing figure) 1,00,000 By Accumulated Dep. 20,000
A/c
11,00,000 (Fixed Asset Written
off)
By Balance c/d 10,00,000
11,00,000 11,00,000
(7) Accumulated depreciation A/c
` `
To Fixed Assets A/c (Dep. 30,000 By Balance b/c 2,60,000
On Machinery sold)

268
To Fixed Assets A/c 20,000 By Adjusted P/L A/c 1,00,000
(written off)
To Balance c/d 3,10,000 (Dep. Provided during
the year)
3,60,000 3,60,000
(8) Trade Investments A/c
` `
To Balance b/d 1,10,000 By Cash (sale) 40,000
To Capital Reserve A/c 20,000 By Balance c/d 90,000
(profit on sale)
1,30,000 1,30,000
(9) Preliminary Expenses A/c
` `
To Balance b/d 30,000 By Adjusted P/L A/c 10,000
(written off-balance
figure)
By Balance c/d 20,000
30,000 30,000
(10) Adjusted Profit and Loss Account A/c
` `
To Transfer to General 30,000 By Balance b/d 70,000
Reserve A/c
To Loss on Redemption of 5,000 By Opening Stock 7,000
Debentures written up
To Loss on sale of 10,000 By Funds from 2,78,000
Machine Operations
To Depreciation provided 1,00,000 (Balancing figure)
To Preliminary Expense 10,000
To Proposed Dividend 50,000

269
To provision for Income 60,000
Tax
To Balance c/d 90,000
3,55,000 3,55,000

Illustration 17 : From the following particulars of Mr. Kumar, Prepare fund flow
Statements on (i) Working capital Basis and (ii) Cash Basis..
1st April 2013 31st March 201
` `
Cash 5, ,000 4,000
Debtors 40,000 45,000
Stock 30,000 25,000
Land 30,000 40,000
Building 50,000 55,000
Machinery 70,000 80,000
2,25,000 2,49,000
Current Liabilities 35,000 40,000
Loan from Mrs. Suba 25,000
Bank Loan 0,000 30,000
Capital 1,50,000 1,54,000
2,25,000 2,49,000

During the year Mr. Kumar Brought an additional capital ` 10,000 and his
drawings during the year were `31,000
Provision for depreciation on machinery-opening balance ` 30,000, closing
balance ` 40,000
No depreciation need be provided for other assets.

270
Solution:
Schedule of Changes in Working Capital
Increase in Decrease in
31/03/2013 31/03/2014 Working Working
Capital Capital
` ` ` `
Currents Assets :
Cash 5,000 4,000 1,000
Debtors 40,000 45,000 5,000
Stock 30,000 25,000 5,000
75,000 74,000
Current Liabilities
Current Liabilities 35,000 40,000 5,000
35,000 40,000
Working Capital (CA- 40,000 34,000
CL)
Net Decrease in W.C. 6,000 6,000
40,000 40,000 11,000 11,000
Funds Flow Statement (On Working Capital Basis)
For the year ended 31st March 2014
Sources ` Applications `
Additional Capital 10,000 Purchase of Land 10,000
Introduced
Loan Raised from Mrs. 25,000 Purchase of Building 5,000
Suba
Cash Operating Profit 35,000 Purchase of Machinery 20,000
Net Decrease in W.C. 6,000 Drawings 31,000
Repayment of Bank Loan 10,000
76,000 76,000

271
 Funds Flow Statement on Cash Basic For the year ended 31st March 2014
Sources (Inflows) ` Applications (Outflows) `
Opening Balance of 5,000 Purchase of Land 10,000
Cash on 1-4-2013
Additional Capital 10,000 Purchase of Building 5,000
introduced
Decreased in Stock 5,000 Purchase of Machinery 20,000
Increase in Current 5,000 Increase in Debtors 5,000
Liabilities
Loans raised from Mrs. 25,000 Repayment of Bank Loan 10,000
Suba
Cash Operating Profit 35,000 Drawings 31,000
Closing Balance of Cash 4,000
on 31-03-2014
85,000 85,000

Working :
(1) Land A/c
` `
To Balance b/d 30,000 To Balance c/d 40,000
To Cash-purchases (balance 10,000
figure)
40,000 40,000
(2) Building A/c
` `
To Balance b/d 50,000 To Balance c/d 55,000
To Cash-purchases (balance 5,000 55,000
figure)

272
 (3) Machinery A/c
` `
To Balance b/d 70,000 By Depreciation 1,50,000
(40,000-30,000)
To Cash-purchases (balance 20,000 By Balance c/d 55,000
figure)
90,000 90,000
(4) Capital A/c
` `
To Cash (drawings) 31,000 To Balance c/d 1,50,000
To Balance c/d 1,54,000 By Cash 10,000
(Additional)
By Profit 25,000
(Balancing figure)
1,85,000 1,85,000
(5) Cash operation Profit
`
Profit made during the year 25,000
Add : Depreciation changed 10,000
during the year being non-cash
item.
Cash Operation Profit 35,000

Cash Flow Statement:

Introduction:
The Balance Sheet and Profit and Loss Account are the two very important final
products of the entire financial accounting process. The balance sheet shows the
financial state of affairs of an organization as on a particular date while the profit and
loss account shows the profit earned or loss incurred by an organization from its
transactions over a period. No doubt, these two statements serve various important

273
purposes but they do not tell the complete story which a financial analyst needs to
know. The Balance Sheet and Profit and Loss Account have their own limitations.
The Balance Sheet shows the cash balance as on a particular date. It may show the
opening and closing cash balance. But does not show details of cash received during
the year and the cash paid during the year. For analysis of financial position of an
organization, sometimes this information is essential. This limitation of balance sheet
is overcome by cash flow statement.
Similarly, the Profit and Loss Account which is an another important
financial statement shows the book profit earned by a concern. Such profit is
calculated after debiting non-cash expenditure like depreciation, preliminary
expenses written off etc. This book profit is different from cash profit earned by the
concern. The financial analyst who is interested in knowing the cash profit has to
adjust such book profit for noncash expenses to arrive at cash profit. Such cash profit
has special significance for cash flow analysis of business.
4.2.10 Meaning and Concept of Cash Flow Statement
A Cash Flow Statement is a statement which is prepared by acquiring cash from
different sources and the application of the same for different payments throughout
the year. It is prepared from analysis of cash transactions, or it converts the financial
transactions prepared under accrual basis to cash basis. The information about the
amount of resources provided by operational activities or net income after the
adjustment of certain other charges can also be obtained from it. The changes in Cash
both the beginning and at the end can also be known with the help of this statement
and that is why it is called Cash Flow Statement.
Cash Flow statement is a statement of financial analysis which summarizes the
change in the amount of cash for particular period. It shows the sources from which
the cash was obtained and the uses to which the cash was put. In short, it indicates
the inflows and outflows of cash during a period.
The following terms are used in this Statement with the meanings specified:
Cash comprises cash on hand and demand deposits with banks.
Cash equivalents are short term, highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an insignificant risk
of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.

274
 Operating activities are the principal revenue-producing activities of the
enterprises and other activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
Financing activities are activities that result in changes in the size and
composition of the owner's capital including preference share capital in the case of a
company and borrowings in the enterprise.
Features of Cash Flow Statement
The significant features are:
(i) Cash Flow Statement is very dynamic in character since it records the
investment of cash from the beginning of the period to the end of the period.
(ii) It is a periodical statement as it covers a particular period.
(iii) This statement does not recognize matching principles.
(iv) This statement helps to calculate Cash from Operations/Cash Flows from
Operational Activities.
(v) It exhibits the changes of financial positions relating to operational activities,
investing activities and financing activities, respectively by which an analyst can
draw his conclusion.
(vi) It records the changes in both fixed assets and current assets.
4.2.11 CASH AND CASH EQUIVALENTS:
Cash equivalents 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).
Cash flows exclude movements between items that constitute cash or cash
equivalents because these components are part of the cash management of an

275
enterprise rather than part of its operating, investing and financial activities. Cash
management includes the investment of excess cash in ca equivalents.
Accounting Standard - 3 (AS - 3)
Indian Accounting Standard - 3 issued by the Institute of Chartered Accountants
of India (ICAI) deals with the various aspects of cash flow. ICAI has recommended
that AS 3 should use by listed companies and other large concerns. Even Securities
Exchange Board of India (SEBI) has made it compulsory for listed companies to
attach the Cash Flow Statement to their accounts. The term Cash Flow involves two
aspects viz. ( 1 ) Cash ( 2 ) Flow
(1) Cash:
As per AS 3 Cash Flow Statement deals with cash and cash equivalents. Cash
includes cash in hand and demand deposits with hank. Cash equivalents refer to short
- term liquid investments of an organization which arc readily convertible to a known
amounts of cash and are subject to an insignificant risk of change in value. This cash
equivalent include item like Fixed Deposits for 30 days, treasury bills and market
instruments. AS 3 requires that the Cash Flow Statement should disclosed the
components of cash and cash equivalents and their reconciliation with the amounts
shown in the balance sheet. Therefore during this topic we have often used the term
cash as covering both cash and cash equivalents.
(2) Cash Flow:
When a business transaction results in either increase or decrease in the amount
of cash balance with the concern there is flow of cash. If there is a increase in cash
balance the inflow of cash occurs and if there is decrease in cash balance the outflow
of cash occurs. The difference between the total cash inflows and total of cash
outflows is called net cash flow (which may be surplus or deficit). The contra entries
for depositing cash into hank or selling short term investments do not result in cash
flow.
Classification of cash flow:
As per AS- 3, Cash Flow Statement (CFS) provides information about the
historical change in cash by classifying cash flows during the period from operating,
investing and financing activities. It is a condensed report on the operating activities,
financing activities and investing activities of concern. It shows the summary of cash
flow on account of these activities.

276
Classification of cash flows at a glance:
Activity Cash Flow Examples
Operating Activity Cash Inflow Receipts from goods, services, debtors
Cash Outflow Payments towards goods, services,
creditors
Investing Activity Cash Inflow Receipts from sale of fixed assets /
investments
Cash Outflow Paid for purchase of fixed assets /
investments
Financing Activity Cash Inflow Receipts from fresh shares / debentures
Cash Outflow / loans
Repayment of shares / debentures /
loans

4.2.12 Presentation and Preparation of Cash Flow Statement as per the

recommendation of ICAI in Accounting Standard (AS 3)
It has already been stated earlier that the Institute of Chartered Accountants of
India has recommended, rather revised, its Accounting Standard (AS 3) which makes
the Cash Flow Statement more informative to the users. It divides the Cash Flow
Statement into three groups/headings viz. (a) Operating Activities, (b) Investing
Activities and(c) Financing Activities. The form of Cash Flow Statement is as
follows:
Direct Method
Cash Flow Statement
Rs. Rs.
(a) Cash Flow from Operating Activities
Cash Sales ***
Collection from Customers ***
Trading Commissions received ***
***
Less : Cash paid to creditors ***

277
 Cash paid to employees (Wages, Salaries ***
etc.)
Cash paid for other Operating Expenses ***
(Office, Administrative , Selling & ***
Distribution expenses etc.)
***
Cash Generated from Operation
Less : Income Tax paid ***
Cash flow before extraordinary items ***
Add: Extraordinary Receipts ***
Net Cash from Operating Activities ***
(b) Cash Flow from Investing Activities
Sale of Fixed Assets ***
Sale of Investments ***
Interest Received ***
Dividend Received ***
***
Less : Purchase of Fixed Assets ***
Purchase of Investments ***
Loan given etc. ***
***
Net Cash from Investing Activities ***
(c) Cash Flow from Financing Activities
Proceeds from fresh issue of shares ***
Receipts from long-term loans, etc. ***
***
Less : Loan paid ***
Redemption of Preference Shares ***
Interest paid ***

278
 Dividend paid ***
Buy-back of equity shares etc. ***
***
Net Cash Flows from Financing ***
Activities
Net Increase (Decrease) in Cash or Cash ***
equivalent
Add : Cash at the (beginning) ***
Cash at the (closing) ***

4.2.13 Difference between Funds Flow Statement and Cash Flow Statement:
There are no major differences between a Funds Flow Statement and Cash Flow
Statement, but the following points of differences may be noted:
Funds Flow Statement Cash Flow Statement
1. It indicates change in cash position
1. It indicates change in working capital
between the two periods.
position between the two periods.

2. Schedule of changes in working 2. Schedule of changes in working

capital is prepared. capital is not necessary.
3. Opening & closing balance of cash are 3. Cash flow statement starts with
not taken directly in funds flow opening cash balance and ends with
statement. closing cash balance.
4. Funds from operations are ascertained 4. Cash from operations is ascertained
while preparing funds flow statement. while preparing cash flow statement.
5. It is the managerial tool of financial 5. It is the managerial tool of financial
analysis to help long term decisions. analysis to help short term decisions
6. Inflow of funds does not mean inflow 6. Inflow of cash however results in
of cash. inflow of funds.
7. Sound funds position does not mean 7. Sound cash position however is
sound cash position always followed by sound funds position.

279
4.2.14 Illustrations: - Cash Flow Statement
Illustration – 1: Compute the Cash Flows from Operating Activities from the
following particulars:
Trading & Profit & Loss Account
For the year ended 31st March, 2015
By Sales
To Opening stock 25000 - Cash
100000 400000
- Credit
300000
To Purchases By Closing Stock 100000
- Cash
50000 250000
- Credit 225000
200000
To Gross Profit
500000 500000
To Depreciation 40000 By Gross Profit b/d 525000
To Office & Administrative 50000 By Refund of Tax 10000
Exp. 30000 By Dividend Received on 30000
To Selling & Distribution 5000 Investment (Long Term)
Exp. 10000 By Profit on Sale of Investment 10000
To Preliminary Exp. 5000 By Profit of sale of Plant 10000
To Goodwill 40000 By Accrued Commission 5000
To Provision for Doubtful 3000
Debt 2000
To Provision for Tax 50000
To Loss on Sale of Furniture 20000
To Provision for Discount on 35000
Debtors
To Transfer to General
Reserve
To Proposed dividend
To Net Profit
290000 290000

280
Additional Information:
31.3.2014 31.3.2015
Accrued Commission - 50000
Creditors 50000 100000
Debtors 100000 80000
Outstanding Office & Administrative Expenses 5000 10000
Prepaid Selling and Distribution Expenses 1000 4000
Provision for doubtful Debts - 5000
Provision for discount on Debtors - 2000
Provision for Tax 20000 30000

Solution:
Computation of Cash Flows from Operating Activities
Rs. Rs. Rs.
Cash Flows from Operating activities
Net Profit (as per P & L A/c) 35000
Add Non-Operating Expenses
Depreciation 40000
Proposed Dividend 20000
Transfer to Reserve 50000
Provision for Tax 40000
Loss on Sale of Furniture 3000
Preliminary Expenses 5000
Goodwill written-off 10000
168000
203000

Less Non-Operating Income

Refund of Tax 10000

281
 Profit on Sale of Plant 10000
Dividend Received 30000
Profit on Sale of Investments 10000
60000
143000
Fund from Operations
Add Decrease in Current Assets or
Increase in Current Liabilities
Decrease in Current Assets :
Decrease in Debtors 20000
Increase in Current Liabilities
Increase in Creditors 50000
Increase in Outstanding Expenses 5000
Increase in Provision for Doubtful 5000
Debts
2000
Increase in Provision for Discount on
Less 82000
Debtors
Increase in Current Assets Or
Decrease in Current Liabilities 225000

Increase in Current Assets: 60000

Increase in Stock 3000

Increase in Prepaid Expenses 5000

Increase in Accrued Commission 68000

157000
20000
Less
Income-Tax Paid
137000
(Net of Refund) (Rs. 30,000 — Rs.
10,000)
Net Cash Flows from Operating
Activities

282
Illustration – 2 : From the following particulars prepare a Cash Flow Statement for
the year ended 31st March 2015, as per Direct Method:
Cash Account
Dr Cr
Rs. Rs.
To Balance b/d 1000 By Purchase of P & M 8000
To Customers 25000 By Office & Administration 5000
Overhead
To Sale of Plant 4000 By Selling & Dist. Overhead 3000
To Issue of Equity Shares 10000 By Creditors 10000
By Bank Loan (Repayment) 5000
By Dividend paid 2000
By Taxation 4000
By Balance c/d 3000
40000 40000

Solution:
Cash Flow Statement
for the year ended………..
Rs. Rs. Rs.
Cash Flows from Operating Activities
Operating Receipts in Cash
Receipts from Customers 25000
Less : Operating Expenses in Cash
Payment to Creditors 10000
Office & Administration Overhead 5000
Selling and Distribution Overhead 3000 18000
7000
Less: Income-Tax Paid 4000
Net Cash Flows from Operating Activities 3000

283
Cash Flows from Investing Activities
Sale of Plant 4000
Less : Purchase of Plant 8000
Net Cash Flows from Investing Activities (4000)
Cash Flows from Financing Activities
Issues of Equity Share 10000
Less : Repayment of Loan 5000
Dividend 2000
7000
Net Cash Flows from Financing Activities 3000
Net Increase in Cash or Cash Equivalent 2000
Cash and Cash Equivalent at the beginning 1000
Cash and Cash Equivalent at the end 3000

Illustration-3 : Prepare a Cash Flow Statement from the following Balance Sheets X
Ltd. for the year ended 31st March 2015.
Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Equity Share 2,00,000 3,00,000 Goodwill 50,000 40,000
Capital
Pref. Share 1,00,000 50,000 Patents 10,000 60,000
Capital
Profit & Loss 50,000 80,000 Plant & 1,00,000 90,000
A/c Machinery
General Reserve 30000 40000 Land & 100000 80000
Building
Securities 10000 15000 Furniture & 50000 65000
Premium Fittings

284
12% Debenture 100000 150000 12% Investment 50000 40000
Creditors 40000 60000 Stock 150000 250000
Bills Payable 10000 15000 Debtor 40000 100000
Outstanding 10000 5000 B/R 10000 40000
Exp.
Bank Overdraft 20000 30000 Accrued Interest 5000 9000
(UBI)
Provision for 2000 3000 Prepaid 5000 1000
Discount on expenses
Debtors
Proposed 20000 30000 Cash in Hand 10000 5000
Dividend
Provision for 30000 46000 Cash at Bank 20000 15000
Tax (SBI)
Provision for 3000 5000 Preliminary 10000 8000
Doubtful Debts Exp.
Commission 5000 1000 Underwriting 10000 12000
Received in Commission
Advance
Discount on 10000 15000
Issue of
Debtures
630000 830000 630000 830000

Solution:
Cash Flow Statement
for the year ended 31st March 2015
Rs. Rs. Rs.
Cash Flows from Operating
Activities
Net Profit for the year :

285
 Net Profit for the year 2015 80,000
Less : Net Profit for the year 2014 50,000
30,000
Add : Non-Operating Expenses
Depreciation on Plant & Machinery 10,000
Depreciation on Land & Building 20,000
Proposed Dividend 30,000
Transfer to Reserve 10,000
Provision for Taxation 46,000
Preliminary Expenses-written-off 2,000
Goodwill-written-off 10,000
Interest on Debentures 12,000
1,40,000
1,70,000
Less : Non-Operating Income
Interest on Investment 6,000
1,64,000
Add : Decrease in Current Assets or
Increase in Current Liabilities
Drecease in Current Assets :
Decrease in Prepaid Expenses 4,000
Increase in Current Liabilities :
Increase in Creditors 20000
Increase in B/P 5000
Increase in Provision for Discount on 1000
Debtors
Increase in Provision for Doubtful 2000
Debts
32000

286
 196000
Less: Increase in Current Assets or
Decrease in Current Liabilities
Increase in Current Assets
Increase in Stock 100000
Increase in Debtors (Gross) 60000
Increase in B/R 30000
Increase in Accrued Interest 4000
Decrease in Current Liabilities
Decrease in Outstanding Expenses 5000
Decrease in Commission Received in 4000
Advance
203000
(7000)
Less: Income-Tax Paid (Net of Refund) (30000)
Net Cash Flows from operating (37000)
Activities

Cash Flows from Investing

Activities
Sale of Investment 10000
Interest on Investment 6000
16000
Less: Purchase of Patents 50000
Purchase of Furniture & Fittings 15000
65000
(49000)
Net Cash Flows from Investing
Activities

287
 Cash Flows from Financing
Activities
Issue of Shares 103000
(Rs. 1,00,000 + Rs. 5,000 — Under
Com. Rs. 2,000)
Issue of Debentures (Rs. 50,000 — 45000
Rs. 5,000)
148000
Less: Dividend Paid 20000
Interest on Debenture 12000
Redemption of Preference Shares 50000
82000
Net Cash Flows from Financing 66000
Activities
Net Increase or Decrease in Cash or (20000)
Cash Equivalent
Add: Cash and Cash Equivalent at the
beginning
Cash 10000
Bank 20000
30000
Less: Bank Overdraft 20000
10000
Cash and Cash equivalent at the end
Cash 5000
Bank 15000
20000
Less : Bank Overdraft 30000
(10000)

288
Illustration – 4 : Following are the Balance Sheets of X Ltd. for the year ended 31st
March 2014 and 31st March 2015s, respectively.
Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,50,000 Fixed Assets 1,00,000 1,30,000
Profit & Loss 60,000 80,000 Less : 9,000 12,000
A/c Depreciation
Creditors 30,000 25,000 91,000 1,18,000
Provision for 20,000 25,000 Investment 4,000 8,000
Tax
Proposed 10,000 15,000 Stock 80,000 1,09,000
Dividend
Debtors 30,000 40,000
Cash 15,000 20,000
2,20,000 2,95,000 2,20,000 2,95,000

Additional Information:
Tax and Dividend were paid Rs. 22,000 and Rs. 12,000, respectively, during the
year. Prepare a Cash Flow Statement.
Solution:
Cash Flow Statement
for the year ended 31st March 2015
Rs. Rs. Rs.
Cash Flows from Operating
Activities
Net Profit (Rs. 80,000 - Rs. 60,000) 20000
Add : Non-Operating Expenses
Depreciation (Rs. 12,000 - Rs. 9,000) 3000
Proposed Dividend 17000

289
 Provision for Tax 27000 47000
67000
Less : Non-Operating Income Nil
67000
Add : Decrease in Current Assets or Increase Nil
in Current Liabilities
67000
Less : Increase in Current Assets or Decrease Nil
in Current Liabilities
67000
Increase in Current Assets :
Increase in Debtors 10000
Increase in Stock 29000
Decrease in Current Liabilties
Decrease in Creditors 5000
44000
23000
Less : Income-Tax paid (Net of Refund) 22000
Net Cash Flows from Operating 1000
Activities
Cash flows from Investing Activities
Sale of Fixed Assets Nil
Less : Purchase of Fixed Asset; 30,000
(Rs. 1,30,000 — Rs. 1,00,000)
Purchase of Investment 4,000
(Rs. 8,000 — Rs. 4,000)
34,000
Net Cash Flows from Investing (34,000)
Activities

290
 Cash Flows from Financing
Activities
Proceeds from Issue of Shares 50,000
(Rs. 1,50,000 — Rs. 1,00,000)
Less : Dividend Paid 12,000
38,000
Net Cash Flows from Financing 38,000
Activities
Net Increase or Decrease in Cash or 5,000
Cash Equivalent
Add : Cash and Cash Equivalent at the 15000
beginning of Period : Cash in hand
Cash and Cash Equivalent at the
closing of Period : Cash in hand 20000

Workings:
Equity Share Capital Account
Dr. Cr.
Rs. Rs.
To Balance c/d 150000 By Balance b/d 100000
Bank (bal. fig.) 50000
150000 150000

Provision for Taxation Account

Dr. Cr.
Rs. Rs.
To Bank A/c 22000 By Balance b/d 20000
To Balance c/d 25000 By P & L A/c (bal. fig.) 27000
47000 47000

291
 Proposed Dividend Account
Dr. Cr.
Rs. Rs.
To Bank A/c 12000 By Balance b/d 10000
To Balance c/d 15000 By P & L A/c (bal. fig.) 17000
27000 27000

Illustration – 5 : X Ltd. presented the following Balance Sheets as on 31st March

2014 and 31st March 2015. You are asked to prepare a Cash Flow Statement:
Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Equity Share 1,00,000 1,50,000 Fixed Asset 1,00,000 1,50,000
Capital
10% Pref. Share 1,00,000 50,000 12% Investment 50,000 60,000
Cap.
12% Debebture 50,000 1,00,000 Stock 80,000 70,000
Profit & Loss 40,000 80,000 Debtors 65,000 95,000
A/c
Creditors 30,000 20,000 Cash 10,000 20,000
Provision for 5,000 10,000 Prepaid 20,000 25,000
Doubtful Debts Expenses
Provision for 10,000 15,000 Discount on 10,000 5,000
Taxation Issue of
Debentures
3,35,000 4,25,000 3,35,000 4,25,000

Additional Information:
1. A Plant Costing Rs. 30,000 (W.D.V. 18,000) was sold for Rs. 8,000.
2. Income-Tax Paid Rs. 12,000.

292
3. Depreciation Charged. during the year amounted to Rs. 20,000, other than item
(1).
4. Preference shares were redeemed at a premium of 10% on 31.5.2007.
5. Preference dividend was paid, in addition to an interim dividend @ 15% on
31.3.2007.

Solution:
Cash Flow Statement
for the year ended 31st March 2015
Rs. Rs. Rs.
Cash Flows from Operating
Activities
Net Profit for the year
Net Profit for 2007 80,000
Less : Net Profit for 2006 40,000
40,000
Add : Non-Operating Expenses
Depreciation on Fixed Assets (Rs. 32,000
12,000 + Rs. 20,000)
Interim Dividend 15,000
Preference Dividend 10,000
Discount on Issue of Debentures 5,000
written-off
Premium on Redemption of 5,000
Preference Shares
Loss on Sale of F.A. (Plant) 10,000
Interest on Debenture (assume 6,000
debentures were issued at the end of
the year)
Provision for Taxation 17,000

293
 1,40,000
Less : Non-Operating Incomes
Interest on Investment 6,000
1,34,000
Add : Decrease in Current Assets or
Increase in Current Liabilities
Decrease in Current Assets
Decrease in Stock 10,000
Increase in Current Liabilities
Provision for Doubtful Debts 5,000
15,000
1,49,000
Less : Increase in Current Assets or
Decrease in Current liabilities
Increase in Current Assets
Increase in Debtors 30,000
Prepaid Expenses 5,000
Decrease in Current Liabilities
Decrease in Creditors 10,000
45,000
1,04,000
Less : Income-Tax paid 12,000
Net Cash Flows from Operating 92,000
Activities
Cash Flows from Investing
Activities
Sale of Fixed Assets 8,000
Interest on Investment 6,000
14000

294
Less : Purchase of F.A. 1,00,000
Purchase of Investment 10,000
1,10,000
Net Cash Flows from Investing (96,000)
Activities
Cash Flows from Financing
Activities
Issue of Equity Shares 50,000
Issue of Debentures 50,000
1,00,000
Less : Redemp. of Pref. Shares (Rs. 50,000 55,000
+ Rs. 5,000)
Interim Dividend 15,000
Preference Dividend 10000
Interest on Debentures 6000

86000
Net Cash Flows from financing 14000
Activities
Net Increase or Decrease in Cash or 10000
Cash Equiv.
Add: Cash and Cash Equivalent at the 10000
beginning
Cash and Cash Equivalent at the end 20000

295
Workings:
Provision for Taxation A/c
Dr. Cr.
Rs. Rs.
To Bank 12000 By Balance b/d 10000
To Balance c/d 15000 By P & L A/c (bal. fig.) 17000
A/c
27000 27000

Fixed Asset A/c

Dr. Cr.
Rs. Rs.
To Balance b/d 1,00,000 By Bank-Sale 8,000
To Bank A/c - Purchase 1,00,000 By Depreciation 12,000
By Loss on Sale 10,000
By Depreciation 20,000
By Balance c/d 1,50,000
2,00,000 2,00,000

Illustration – 6 : From the following information prepare Cash Flow Statement for
the year ended 31.3.2015
Balance Sheet
Liabilities 31.3.14 31.3.15 Assets 31.3.14 31.3.15
Rs. Rs. Rs. Rs.
Equity Share 2,00,000 2,50,000 Land & Building 2,00,000 1,90,000
Capital
General Reserve 50,000 60,000 Plant & 1,50,000 1,69,000
Machinery
Profit & Loss A/c 30,500 30,600 Stock 1,00,500 74,000
Bank Loan 70,000 - Debtors 80,000 64,200
Creditors 1,50,000 1,35,200 Cash - 600

296
Provision for Tax 30,000 35,000 Bank - 8000
Goodwill - 5000
530500 510800 530500 510800

Additional Information:
(i) Dividend of Rs. 23,000 was paid during the year.
(ii) The following assets of another company were purchased for a consideration of
Rs. 50,000 paid for in shares. Stock Rs. 20,000, Machinery Rs. 25,000.
(iii) Further machinery was purchased at Rs. 25,000 during the year.
(iv) Depreciation written-off on Building Rs. 10,000 and on Machinery Rs. 14,000.
(v) Income-Tax paid during the year Rs. 28,000. Prepare a Cash Flow Statement.
Solution:
Cash Flow Statement
for the year ended 31st March 2015
Rs. Rs. Rs.
Cash Flows from Operating
Activities
Net Profit (Rs. 30,600 — Rs. 30,500) 100
Add : Non-Operating Expenses
Depreciation on Plant & Machinery 14,000
Depreciation on Land Sr Building 10,000
General Reserve (Rs. 60,000 - Rs. 10,000
50,000)
Provision for Tax 33,000
67,000
67,100
Less : Non-Operating Income Nil
Funds from Operation 67,100
Add : Decrease in Current Asset or Increase
in Current Liabilities

297
 Decrease in Current Asset
Decrease in Stock 26,500
Decrease in Debtors 15,800
42,300
Increase in Current Liabities Nil
42,300
Less : Increase in Current Assets or Decrease
in Current Liabilities
Increase in Current Assets Nil
Decrease in Current Liabilities
Decrease in Creditors 14,800
27,500
94,600
Less : Income-Tax paid (Net of Refund) 28,000
Net Cash Flows from Operating 66,600
Activities
Cash Flows from Investing
Activities
Sale of Plant & Machinery 17,000
Less : Purchase of Plant & Machinery 25,000
Net Cash Flows from Investing (8,000)
Activities
Cash Flows from Financing
Activities
Proceeds from fresh issue of Shares 20,000
(Stock being Current Asset)
Less : Repayment of Bank Loan 70000
Net Cash Flows from Financial (50000)
Activities

298
 Net Increase or Decrease in Cash or 8600
Cash Equivalent
Add : Cash and Cash Equivalent at the
beginning
Cash Nil
Bank Nil Nil
Cash and Cash Equivalent at the end
Cash 600
Bank 8,000
8600

Workings:
Equity Share Capital A/c
Dr. Cr.
Rs. Rs.
By Balance b/d 2,00,000
By Bank (Stock) 20,000
To Balance c/d 2,50,000 By Plant 25,000
By Goodwill 5,000
250000 250000

Plant & Machinery A/c

Dr. Cr.
Rs. Rs.
To Balance b/d 1,50,000 By Depreciation 14,000
To Equity Share Capital 25,000 By Bank —Sale 17,000
To Bank — Purchase 25,000 By Balance c/d 1,69,000
2,00,000 2,00,000

299
 Goodwill A/c
Dr. Cr.
Rs. Rs.
To Balance b/d -
To Equity Share Capital 5000
By Balance c/d 5000
5000 5000

Provision for Taxation A/c

Dr. Cr.
Rs. Rs.
To Bank 28,000 By Balance c/d 30,000
To Balance b/d 35,000 By P & L A/c (bal. fig.) 33,000
63,000 63,000
Land & Building A/c
Dr. Cr.
Rs. Rs.
To Balance b/d 200000 By Depreciation 10,000
By Balance b/d 1,90,000
2,00,000 2,00,000

Check your Progress

1. State whether each of the following statements is True or False :
(a) Fund’s is the difference between fixed assets and current assets.
(b) A Fund flow statement is a good substitute for income statement.
(c) Flow of funds mean increase or decrease of working capital.
(d) Any transaction that increases working capital is a source of funds.
(e) Depreciation in current assets means increase in working capital.
(f) There will be a flow of funds when both the accounts in a transaction are
non-current.

300
 (g) Net losses mean drain on working capital.
2. Fill in the blanks :
(a) The word ‘fund’ means the difference between ………… and …..
(b) Purchase of plant will mean……. In working capital.
(c) Issue of capital will mean …… working capital.
(d) Goodwill is a ….. … transaction.
(e) When one account is current and another a non-current it results in ……
3. Tick the correct answer :
(a) Current assets include :
(i)Trade investments.
(ii)Machinery
(iii)Sundry debtors.
(b) Which of the following is a non-current asset?
(i)Goodwill
(ii)Cash balance
(iii)Bills receivables.
(c) State which of the following is a non-current liability?
(i)Mortgage loan
(ii)Bank balance
(iii)Outstanding Salary
(d) Depreciation of Machinery is :
(i)Source of Funds
(ii)Application of Funds
(iii)Non of the two.
(e) Stock in the beginning result in :
(i)Application of Funds

301
 (ii)Source of funds
(iii)No flow of funds.

4.3 Summary
The term funds has been defined in different ways. In a narrow sense, it means
cash only; in a broader sense, it refers to money values in whatever formit may exist
that means all financial resources and in a popular sense, it means the working
capital. The term funds means movement and includes both 'inflow' and 'outflow'.
The funds flow statement is a statement which shows the movement of funds and is a
report of the financial operations of the business undertaking. It indicates various
means by which funds were obtained during a particular period and the ways in
which these funds were employed. In simple words, it is a statement of sources and
applications of funds. The preparation of a funds flow statement consists three steps
– 1) Statement of Changes in Working Capital, 2) Statement of Funds from
Operations/Adjusted P & L A/c and 3) Statement of Sources and Applications of
Funds.
A Cash Flow Statement is a statement which is prepared by acquiring cash from
different sources and the application of the same for different payments throughout
the year. Cash flows are inflows and outflows of cash and cash equivalents from
Operating activities, Investing activities and Financing activities.
4.4 Terms to Remember
1. Fund : The term ‘funds’ has been defined in a number of ways. In a narrow
sense, it means cash only. In a broader sense, the terms ‘funds’ refers to money
values in whatever form it may exist. Here ‘funds’ means all financial resources,
used in business whether in the form of men, material, money, machinery and
others. In a popular sense, the term ‘funds’ means working capital, i.e., the
excess of current over current liabilities.
2. Funds Flow Statement : The funds flow Statement is a statement which shows
the movement of funds and is a report of the financial operations of the business
undertaking. It indicates various means by which funds were obtained during a
particular period and the ways in which these funds were employed. In simple
words, it is a statement of sources and application of funds.

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3. Cash Flow Statement : A Cash Flow Statement is a statement which is
prepared by acquiring cash from different sources and the application of the
same for different payments throughout the year. Cash flows are inflows and
outflows of cash and cash equivalents from Operating activities, Investing
activities and Financing activities.
4.5 Answers to Check Your Progress
[Ans. True (c) (d) (e) (f) (h) : False (a) (b) (g) ]
[Ans. (a) current assets, current liabilities, (b) decrease; (c) increase (d) non-
current (e) flow of funds ]
[Ans. (a), (iii), (b) (i), (c) (i) (d) (i) (e) (i) ]
4.6 Exercise - Funds Flow Statement
A. Short Answer Type Question
1. Define a fund flow statement
2. When does flow of funds take place?
3. Write a note on the importance of fund flow statement.
4. Give any three managerial use of fund flow statement.
5. Name various sources of funds.
6. Is depreciation a source of funds?
B. Essay Type Question
1. What is fund flow statement? Examine its use and significance for
management.
2. Explain the meaning, importance and objectives of fund flow statement.
3. Discuss in detail the procedure of making a fund flow statement,
4. (a) What are the source of fund?
(b) What are the applications of funds?

Practical Problems on Funds Flow Statements

Ex. 1 Find out the changes in the working capital from the Balance Sheet data
given below:
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 31.03.2013 31.03.2014
` `
Capital and Liabilities
Share Capital 3,00,000 3,75,000
Trade Creditors 1,06,000 70,000
Profit and Loss A/c 14,000 31,000
4,20,000 4,76,000
Assets :
Machinery 70,000 1,00,000
Stock-in-trade 1,21,000 1,36,000
Debtors 1,81,000 1,70,000
Cash 48,000 70,000
4,20,000 4,76,000
[Ans. Increase in W.C. `62,000]
Ex. 2 Calculate funds from operations from the following Profit and Loss
Accunt of M/s R. Kumar and Co.
Profit & Loss Account
`

To Salaries 10,000 By Gross Profit 2,00,000

To Rent 3,000 By Profit on sale of 5,000
Machine
To Commission 2,000 By Refund of tax 3,000
To Discount allowed 1,000 By Dividends received 2,000
To Provision for 14,000
Depreciation
To Transfers to General 20,000
Reserve
To Provision for tax 10,000
To Loss on sale of 5,000
Investments

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 To Discount on Issue of 2,000
Debentures
To Preliminary Expenses 3,000
To Selling Expenses 20,000
To Net Profit 1,20,000
2,10,000 2,10,000
[Ans. Funds from Operations : ` 1,64,000]
Ex. 3 . From the following Balance Sheets of X Co. Ltd. You are required to
prepare a schedule of changes in working capital and statement of flow of funds.
31.03.2013 31.03.2014
` `

Assets:
Land and Building 50,000 50,000
Plant 24,000 34,000
Stock 9,000 7,000
Debtors 16,500 19,500
Cash at Bank 4,000 9,000
Capital and Liabilities
Capital 80,000 85,000
Profit and Loss Appropriation A/c 14,500 24,500
Creditors 9,000 5,000
Mortgage 5,000
[Ans. Increase in Working Capital – Rs. 10,000; Total of Sources and
Applications- ` 20,000 and ` 10,000 respectively]
Ex .4. From the following Balance sheets XYZ Co. Ltd. You are required to prepare
fund flow stamen including a schedule of changes in Working Capital for the year
ended 31.03.2014

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 Liabilities 31.03.2013 31.03.2014 Assets 31.03.2013 31.03.2014
` ` ` `

Share Capital 70,000 74,000 Cash 9,000 7,800

Debentures 12,000 6,000 Debtors 14,900 17,700
Reserve for 700 800 Stock 49,200 42,700
Doubtful Debts
Trade Creditors 10,360 11.840 Land 20,000 30,000
P/L A/c 10,040 1,03,200 Goodwill 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
Additional information :
(1) Dividend paid ` 3,500
(2) During the year, land was purchase for ` 10,000
[Ans. Decrease in Working Capital ` 6,480. Funds from operations ` 9,020 Total
of Sources and Applications of Funds ` 13,020 and ` 19,500 respectively].
[Hnt. Reserve for doubtful debts is Current Liability].

Ex. 5 Following are the condensed Balance Sheets of a Company.

Liabilities 31.03.2013 31.03.2014 Assets 31.03.2013 31.03.2014
` ` ` `

Equity 50,000 53,000 Cash 20,000 25,000

Long-term debt 14,000 13,000 Accounts 24,000 27,000
Receivable
Retained 28,000 37,000 Inventories 31,000 32,000
Earnings
Accumulated 21,000 25,000 Other 8,000 7,000
Depreciation Current
Assets

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 Sundry 20,000 21,000 Fixed 5,000 58,000
Creditors Assets
1,33,000 1,49,000 1,33,000 1,49,000

Additional Information
(i) Fixed Assets costing ` 12,000 were purchased during 2013-14 for cash.
(ii) Fixed Assets (original cost ` 4,000, accumulated depreciation ` 1,500) were
sold at book value.
(iii) Depreciation for the year 2013-14 amounted to ` 5,500 which has been
debited to Profit and Loss Account.
(iv) During 2013-2014 dividends paid ` 3,000.
You are required to prepare a Statement of Source and Application of Funds.
[Ans. Increase in Working Capital ` 7,000 Funds from operations ` 17,500, Total of
source and application `23,000 and ` 16,000 respectively ]
Ex. 6. From the balance sheet of XYZ Ltd., make out a statement of sources and
application of funds and schedule of changes in working capital.
Assets 2014 2013 Liabilities 2014 2013
` ` ` `

Cash 50,000 40,000 Creditors 1,80,000 1,25,000

Debtors 30,000 15,000 5% Debentures 1,00,000 2,00,000
Stocks 1,00,000 80,000 Equity 2,00,000 1,00,000
Investments (short- 1,20,000 50,000 Profit and Loss 20,000
term) A/c
Fixed Assets 2,00,000 2,00,000
Profit & Loss A/c - 40,000
5,00,000 4,25,000 5,00,000 4,25,000
Provision for depreciation on the last day of 2013 was Rs. 50,000. The same on
the last day of 2014 was Rs. 60,000. During the year 2014 was Rs. 60,000. During

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the year 2014 a machine costing Rs. 30,000 (depreciation Rs. 10,000) was sold for
Rs. 16,000.
(Ans. Net increase in W.C. Rs. 60,000; Funds from Operations Rs. 84,000; Total
sources Rs. 2,00,000; Total applications Rs. 1,40,000).

Ex. 7. Given here are the comparative Balance Sheets of a company as on March 30,
2013 & 2014.
Liabilities 2013 2014 Assets 2013 2014
` ` ` `

Share Capital 50,000 50,000 Plant at cost 20,000 25,000

(50,000 Equity Less: 8,000 12,000
Shares of Rs. 1 Depreciation
each fully paid)
12,000 13,000
General Reserve 3,000 Freehold 1,00,000
property
6% Debentures 50,000 Investment 15,000
(Long-term)
Bank Loan 20,000 Stock-in-trade 30,000 44,000
(Long-term)
Trade Creditors 18,000 22,000 Debtors 30,000 30,000
1,33,000 1,49,000 Cash at Bank 15,000 1 ,000
P & L A/c 15,000 35,000
92,000 1,88,000 92,000 1,88,000

You are required to prepare for the year 2007, a statement showing the source
and application of funds and schedule of changes in working capital after taking the
following facts into consideration:
(a) 8% dividend p.a. was declared during 2013-14.

308
(b) Plant sole during the year for Rs. 3,500 was originally bought for Rs. 5,000 on
which Rs. 1,800 depreciation had accumulated.
(c) Total Bank Loan raised during the year was Rs. 28,000.
(Ans. Increase in Working Capital Rs. 7,000; Funds from Operations Rs. 28,500;
Total of Sources and Application of Funds Rs. 1,25,000 and Rs. 1,18,000
respectively).
(Hints. Provision for taxation and Proposed Dividend have been considered as
current liabilities)

Ex. 8. From the following particulars of AB Ltd., prepare a statement of sources and
application of funds for the year ended 31.3.2014.
(i) AB Ltd. has issued 2000 equity shares of Rs. 100 each at a premium of Rs. 5 per
share and all the shares are fully paid.
(ii) The company has redeemed preference shares of Rs. 2,00,000 at a premium of
5%.
(iii) Trade investments are sold for Rs. 80,000 resulting in a profit of Rs. 30,000.
(iv) Machinery was sold during the year for Rs. 40,000 resulting in a loss of Rs.
10,000.
(v) Fixex assets purchased for Rs. 1,60,000.
(vi) Dividend paid Rs. 50,000 and income tax paid Rs. 30,000.
(vii) Working capital of the company was Rs. 1,50,000 on 1.4.2013 and Rs. 2,00,000
on 31.3.2014.
(viii) Depreciation provided for the year was Rs. 40,000.
(ix) Preliminary expenses written off Rs. 5,000.
(x) Closing balance of profit and loss account was Rs. 65,000 more than opening
balance as per balance sheet.
[Ans. Net Increase in W.C. Rs. 50,000; F.F.O.R. 1,70,000; Sources of Funds Rs.
5,00,000; Application of Funds Rs. 4, 50,000]

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Ex. 9. The following are the summarised Balance Sheets of Mridul Ltd. for the years
ending.
Liabilities 2013 2014 Assets 2013 2014
` ` ` `
Share Capital 40,000 50,000 Fixed Assets 50,000 70,000
General Reserve 10,000 15,000 Investments 20,000 18,000
(Long-term)
Profit and Loss 10,000 15,000 Stock 15,000 10,000
A/c
10% Debentures 20,000 20,000 Sundry Debtors 12,000 20,000
Depreciation 15,000 20,000 Cash 2,500 9,500
Provision
Tax Provision 4,000 5,000 Underwriting 1,000 500
Commission
Sundry Creditors 1,00,000 3,000
1,00,500 1,28,000 1,00,500 1,28,000

The following transactions took place during the year 2013-14

(a) Dividend paid Rs. 4,000 and income tax paid Rs. 5,000
(b) Profit on sale of investments amounted to Rs. 1,000.
(c) A fixed asset (cost Rs. 5,000 on which accumulated depreciation Rs. 4,000) was
sold for Rs. 2,000.
You are required to prepare a Funds Flow Statement and a Statement Showing
Changes in Working Capital.
(Ans. Net Increase in W.C. Rs. 8,500; Funds from Operations Rs. 27,500; Total
of Sources and Application of Funds Rs. 42,500 and Rs. 34,000 respectively; Tax
Provision is taken as non-current)

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Ex. 10. The summarized Balance Sheets of Super Fast Ltd. As on 31.03.2014 and
31.03.2015 are as follows.
Liabilities 31.03.2014 31.03.2015 Assets 31.03.2014 31.03.2014
` ` ` `
Share Capital 2,00,000 2,50,000 Building 2,00,000 1,25,000
General 40,000 70,000 25,000 20,000
Plant
Reserve
Profit and Loss 30,000 37,500 30,000 17.500
Stock
A/c
Bank Loan 1,50,000 50,000
Debtors
(Long-term)
Trade 1,50,000 70,000 Cash at
Creditors Bank
Taxation 40,000 60,000
Reserve
Dividend 20,000 25,000
Propos
6,30,000 5,62,000 6,30,000 5,62,000

Additional information for the year ending 31.03.2015

(a) The company paid tax of ` 30,000 during the year.
(b) The company acquired a building worth 50,000 by issuing equal amount of
shares of 10 each to the vendor.
(c) The Company sold plant worth ` 25,000 for ` 20,000 and the loss on sale was
debited to profit and loss account.
(d) Dividend paid in cash during the year amounted to ` 15,000.
[Ans. Net Decrease in W.C. 12,500; Funds from Operations ` 1,12,500; Sources of
Funds ` 1,32,500; Applications of Funds ` 1,45,000 ]
Hint. Taxation reserve and dividend proposed have been considered as non-current.

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Exercise - Cash Flow Statements
Theoretical Questions:
1. Define Cash Flow Statement. State the difference between Cash Flow
Statement and Funds Flow Statement.
2. What are cash and cash equivalents?
3. Explain the operating activities of cash.
4. Explain the investing activities of cash.
5. Explain the financing activities of cash.

Practical Problems on Cash Flow Statement

1. Prepare a Cash Flow Statement from the following Balance Sheets presented
by Y Ltd. for the year ended 31st March 2014 and 31st March 2015:

Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Equity Share 1,60,000 1,60,000 Plant & 1,20,000 1,00,000
Capital Machinery
Pref. Share Capital - 40,000 Stock 1,20,000 1,40,000
Profit & Loss A/c 4,000 4,800 Debtors 80,000 96,000
General Reserve 8,000 8,000 B/R 1,200 2,000
10% Debenture 24,000 28,000 Cash 4,800 14,000
Creditors 48,000 44,000
Proposed Divided 20,000 23,200
Provision for Tax 12,000 16,800
Bank Overdraft 50,000 27,200
3,26,000 3,52,000 3,26,000 3,52,000

[Ans. : Cash Flows from Operating Activities Rs. 6,400;

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Cash Flows from Investing Activities Rs. 4,000;
Cash Flows from Financing Activities Rs. 21,600]
2. Prepare a Cash Flow Statement on the basis of the information given in the
Balance Sheets of P. S. Ltd.:
Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Share Capital 2,00,000 2,50,000 Goodwill 10,000 2,000
12% Debenture 1,00,000 80,000 Land & 200000 280000
Building
General Reserve 50,000 70,000 Machinery 1,00,000 1,30,000
Creditors 40,000 60,000 Debtors 40,000 60,000
B/P 20,000 1,00,000 Stock 70,000 90,000
Outstanding Exp. 25,000 20,000 Cash 15,000 18,000
4,35,000 5,80,000 4,35,000 5,80,000

[Ans. : Cash Flows from Operating Activities Rs. 95,000;

Cash Flows from Investing Activities (-) Rs. 1,10,000;
Cash Flows from Financing Activities Rs. 18,000]
3. The following Balance Sheets have been presented by X Ltd. for the years
ended 31st March 2014 and 31st March 2015:
Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Equity Share 4,00,000 5,00,000 Fixed Asset 6,05,000 5,70,000
Capital
10% Pref. Share 2,00,000 - Debtors 1,20,000 1,40,000
Cap.
5%, Debenture - 1,00,000 Inventory 2,00,000 1,80,000
Cap. Redemp. - 1,00,000 Cash 90,000 60,000

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Reserve
Profit and Loss 2,50,000 60,000 Preliminary 60,000 40,000
A/c Expense
Creditors 1,50,000 1,40,000
Other 75,000 90,000
Liabilities
10,75,000 9,90,000 10,75,000 9,90,000

Additional Information:
1. Preference Share were redeemed at 10% premium on 30/09/2014 and
Debentures were issued on the same date.
2. Fixed Assets were purchased for Rs. 1,95,000.
3. Fixed Asset at book value of Rs. 1,40,000 was sold for Rs. 80,000.
4. Dividend on equity shares was paid for Rs. 40,000.
5. Prepare a Cash Flow Statement.
[Ans. : Cash Flows from Operating Activities Rs. 1,57,500;
Cash Flows from Investing Activities (—) Rs. 1,15,000;
Cash Flows from Financing Activities (—) Rs. 72,500]
4. Prepare a Cash Flow Statement from the following particulars:
Balance Sheets
Liabilities 31.3.2014 31.3.2015 Assets 31.3.2014 31.3.2015
Rs. Rs. Rs. Rs.
Eq. Share 3,00,000 3,50,000 P& M (Net) 5,10,000 6,20,000
Capital
18% Pref. Share 2,00,000 1,00,000 10% Investment 30,000 80,000
Cap.
Profit & Loss 1,10,000 2,70,000 Stock 1,00,000 90,000
A/c
14% Debentures 1,00,000 2,00,000 Debtors 1,00,000 2,10,000
Creditors 80,000 1,60,000 Cash 40,000 75,000

314
 Discount on 10,000 5,000
issue of
Debenture
7 90 000 10,80,000 7 90 000 10,80,000
Additional Information:
1. Preference Shares were redeemed at a premium of 5% on 31.3.2015 and
debentures were issued on the same date.
2. An interim dividend @ 15% was paid on equity shares on 31.3.2015 along with
the dividend on preference shares.
3. A Plant (book value Rs. 40,000) was sold for Rs. 25,000.
4. Depreciation charged during the year amounted to Rs. 70,000.
Ans.: Cash Flows from Operating Activities Rs. 3,27,000;
Cash Flows from Investing Activities Rs. 2,42,000;
Cash Flows from Financing Activities Rs. 50,000)

Practical:
a) Prepare fund flow statement on hypothetical data and try to interpret it.
Illustration: Royal Company Ltd. provides you the Balance Sheet as on 31-03-2020
and 31-03-2021.
Liabilities 31-03- 31-03- Assets 31-03- 31-03-
2020 Rs. 2021 Rs. 2020 Rs. 2021 Rs.
Share Capital (Share 20,00,000 25,00,000 Fixed Assets Cost 25,00,000 30,00,000
of Rs. 100 each)
Reserves and Surplus 8,00,000 8,70,000 Less: Dep. till date 6,80,000 8,20,000
13.5% Convertible 10,00,000 8,00,000 Trade Investments 18,20,000 21,80,000
Debentures
Public Deposits 3,00,000 2,50,000 Current Assets 12,50,000 13,50,000

Current Liabilities 6,20,000 7,10,000 Marketable 60,000 30,000

and Provisions Investments
Proposed Dividend 2,00,000 2,50,000 Inventories 4,10,000 5,20,000
Book Debts 5,30,000 5,05,000

315
 Cash and Bank 1,20,000 1,40,000
Balance
Preliminary Expenses 1,00,000 50,000
Capital work in 6,30,000 6,05,000
progress
49,200,000 53,80,000 49,20,000 53,80,000

Additional information:
1. Rs. 2,00,000 debentures were converted into shares at par.
2. Rs. 2,00,000 shares were issued to the shareholders as bonus shares fully paid,
out of reserve.
3. Rs. 1,00,000 shares were issued to the vendor of fixed assets who had supplied a
machine costing Rs. 1,20,000.
4. A machine costing Rs. 50,000, book value Rs. 30,000 as on 31-03-2020, was
disposed off for Rs. 20,000.
You are required to prepare the Funds Flow Statement of the company for the
year ending 31-03-2021, indicating there in the Working Capital at the beginning and
at the end of the year.
Solution:
Computation of Funds from Operation
Net profit earned during the year and retained in the company Rs. 2,70,000
(Difference between opening (Rs. 8,00,000 – Rs. 2,00,000
Utilized for bonus issue Rs. 6,00,000) and closing balance
(Rs. 8,70,000) of reserve and surplus)
Add: Proposed dividend for the year 2,50,000
Depreciation for the year 1,60,000
Preliminary expenses Written off 50,000
Loss on Sale of Machine 10,000 4,70,000
7,40,000
Less: Premium on issue of shares (assumed to have been taken to P&L A/c) 20,000
Funds from Operations 7,20,000

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 Statement showing Changes in Working Capital
Particulars Amount Rs. Changes in Working
Capital Rs.
31-03-2020 31-03-2021 Increase Decrease
Current Assets
Marketable Securities 60,000 30,000 0 30,000
Inventories 4,10,000 5,20,000 1,10,000 0
Books Debts 5,30,000 5,50,000 0 25,000
Cash and Bank balance 1,20,000 1,40,000 20,000 0
11,20,000 11,95,000
Less: Current Liabilities and 6,20,000 7,10,000 0 90,000
Provisions
Working Capital 5,00,000 4,85,000
Total changes in Working Capital 1,30,000 1,45,000
Net decrease in Working Capital 15,000 15,000
5,00,000 5,00,000 1,45,000 1,45,000

Funds Flow Statement

(Indicating there in the Working Capital at the beginning and at the end of the year)
Sources of Funds Amount Rs. Uses of Funds Amount Rs.
Opening balance of Working 5,00,000 Repayments of Public 50,000
Capital Deposits
Funds from Operation 7,20,000 Payment of Dividend 2,00,000
Issue of shares (for Fixed 1,20,000 Acquisition of Fixed Assets 5,25,000
Assets)
Sale of machine 20,000 Acquisition of Trade 1,00,000
Investments
Closing balance of Working 4,85,000
Capital
13,60,000 13,60,000
OR

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 Funds Flow Statement
(Indicating increase or decrease in the Working Capital during the year)
Sources of Funds Amount Rs. Uses of Funds Amount Rs.
Funds from Operation 7,20,000 Repayments of Public 50,000
Deposits
Issue of shares (for Fixed 1,20,000 Payment of Dividend 2,00,000
Assets)
Sale of machine 20,000 Acquisition of Fixed Assets 5,25,000

Decrease in the working 15,000 Acquisition of Trade 1,00,000

capital Investments
8,75,000 8,75,000

Working Notes:
1. Loss on sale of machine:
Acquisition Cost Rs. 50,000
Less: Depreciation to date 20,000
Written-down-value 30,000
Selling price 20,000
Loss 10,000
2. Calculation of Depreciation:
Depreciation up to 31-03-2020 Rs. 6,80,000
Less: Depreciation on Machine Sold 20,000
6,60,000
Depreciation up to 31-03-2021 8,20,000
Depreciation for the year 1,60,000

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 Fixed Assets A/c
(Including Capital WIP)
Sources of Funds Amount Uses of Funds Amount
Rs. Rs.
To balance b/d By Depreciation A/c 20,000
(Including Capital WIP) 31,30,000 (accumulated)
To Purchases (difference) By Cash (Selling Price) 20,000
Shares 1,20,000 5,25,000 By Profit and Loss A/c) (Loss) 10,000
Cash (balance) 4,05,000 By Balance c/d
(Including Capital WIP)
8,75,000 8,75,000

Comments and Interpretation

1. Conversion of debentures (Rs. 2,00,000) into shares does not cause the flow of
Funds and therefore, not taken to the funds statement.
2. Issue of bonus shares (Rs. 2,00,000) out of Reserves has no effect on the flow
of Funds and therefore, does not figure in the Funds Statement.
3. Acquisition of fixed assets (Rs. 1,20,000) by issuing (Rs. 1,00,000) shares at Rs.
20,000 premium may be considered as causing both inflow (Rs. 1,20,000 due to
issue) and outflow (Rs. 1,20,000 due to acquisition) of Funds and therefore,
appears in the Funds Statement. If it is considered as not causing the flow of
funds then it will not be appear in the Funds Statement.
4. The main source of funds is Funds from Operations followed by Issue of Shares.
5. The main use/application of funds is Acquisition of Fixed Assets followed by
Payment of Dividend.
6. There is net decrease in the working capital during the year Rs. 15000, due to
net increase in current liabilities (Rs. 90000) is more than the net increase in
current assets (Rs. 75000).

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Cash Flow Statement
b) Download cash flow statement of any company and interpret
Cash Flow Statement of Coal India Ltd. for the year ended 31st March, 2019
and 31st March, 2020
(Rs. in Crore)
For the Year For the year
ended ended
31.03.2020 31.03.2019
CASH FLOWS FROM OPERATING
ACTIVITIES
Profit before tax 11,299.26 10,562.42
Adjustments for :
Depreciation, amortisation and impairment 54.39 26.25
of Fixed Assets
Interest income (103.44) (40.95)
Dividend income (11,103.95) (8,932.75)
Fair Value Change (321.04) (299.01)
Income on sale of investments in - (1,025.35)
subsidiaries
Finance Cost 5.26 18.04
(Profit)/ Loss on sale of Assets 0.01 -
Liability written back (0.46) (191.95)
Provision / (Provision written back) (4.03) (34.75)
Allowance for trade Receivables and 2.27 0.85
Advances
Operating Profit before Current/Non (171.73) 82.80
Current Assets and Liabilities
Adjustment for :
Trade Receivables (7.72) 1.59
Inventories 15.69 (9.28)
Loans and Advances and other financial (2,371.59) 14.23
assets

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Financial and Other Liabilities (49.32) (893.62)
Trade Payables 18.86 21.88
Cash Generated from Operation (2,565.81) (782.40)
Income Tax (Paid) / Refund (74.64) (150.83)
Net Cash Flow from Operating (A) (2640.45) (933.23)
Activities
CASH FLOW FROM INVESTING
ACTIVITIES
Purchase of Property, Plant and Equipment (24.31) (93.71)
Proceeds from Sale of Property Plant and 0.03 0.49
Equipment
Proceeds/(Investment) in Bank Deposit (1,161.06) (409.29)
Proceeds/(Investment) in Mutual Fund (71.23) 3.32
Proceeds/(Investment) in Inter-Corporate 0.00 195.00
Deposits
Proceeds from sale of investments in - 1,064.99
subsidiaries
Investment in Joint Venture (453.92) (118.40)
Interest from Investment 104.41 48.07
Interest / Dividend from Mutual Fund 1.80 7.30
Dividend from Subsidiaries 11,102.15 8,925.45
Net Cash from Investing Activities (B) 9,497.87 9,623.22
CASH FLOW FROM FINANCING
ACTIVITIES
Interest & Finance cost pertaining to (2.60) (15.58)
Financing Activities
Receipt of Shifting & Rehabilitation Fund 516.87 397.20
Dividend on Equity shares (7,393.88) (8,112.89)
Buyback of Equity Share Capital - -- (1,049.99)
Net Cash used in Financing Activities (C) (6,879.61) (8,781.26)
Net Increase / (Decrease) in Cash & (22.19) (91.27)
Cash equivalent (A+B+C)
Cash & Cash equivalent as at the 58.98 150.25

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beginning of the period
Cash & Cash equivalent as at the end of 36.79 58.98
the period
Interpretation:
1. There is decrease in Net Cash Flow during the year 2018-2019 (Rs. 91.27 Cr.)
and 2019-2020 (Rs. 22.19 Cr.)
2. Out of three activities of cash flow the company generated the cash flow from
Investing Activities only during the year 2018-2019 (Rs. 9623.22 Cr.) and 2019-
2020 (Rs. 9497.87 Cr.)
3. Other two activities namely Operating Activities show decrease in Net Cash
Flow during the year 2018-2019 (Rs. 933.23 Cr.) and 2019-2020 (Rs. 2640.45
Cr.) and Financing Activities show decrease in Net Cash Flow during the year
2018-2019 (Rs. 8781.26 Cr.) and 2019-2020 (Rs. 6879.61 Cr.)
4. The main source of cash inflow is Dividend from Subsidiaries Rs. 8925.45 Cr.
during the year 2018-2019 and Rs. 11,102.15 Cr. during the year 2019-2020.
5. The main reason of cash outflow is Dividend paid on Equity shares Rs. 8112.89
Cr. during the year 2018-2019 and Rs. 7393.88 Cr. during the year 2019-2020.

4.7 Reference for Further Study:

1) Dr. Maheshwari S. N: Principles of Management Accounting, Sultan Chand &
Sons, New Delhi.
2) Man Mohan, S. N. Goyal: Principles of Management Accounting,
SahityaBhavan, Agra.
3) Pandey I. M.: Management Accounting, Vikas Publishing House Pvt. Ltd., New
Delhi.
4) Paul S. Kr.: Financial Statement Analysis, New Central Book Agency (P) Ltd.
Kolkata.
5) Raman B. S.: Management Accounting, United Publishers Mangalore.

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 Unit-1
Management Control System

Index:
1.0 Objectives
1.1 Introduction
1.2 Presentation of Subject Matter
1.2.1 Meaning of Management Control System
1.2.2 Need and Importance of Management Control System
1.2.3 Scope of Management Control System
1.2.3.1 Management Control and Strategic Planning:
1.2.3.2 Management Control and Task Control
1.2.4 Management Control Process
1.2.5 Management Information System (M. I. S.)
1.2.5.1 Meaning of M. I. S.
1.2.5.2 Characteristics of M. I. S.
1.2.6 Reporting to Management
1.2.6.1 Meaning of Reporting
1.2.6.2 Methods of Reporting
1.2.6.3 Types of Reports
1.2.6.4 Characteristics of Good Report
1.3 Summary
1.4 Terms to Remember
1.5 Answers to Check Your Progress
1.6 Exercises
1.7 Reference for Further Study

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1.0 Objectives :
After studying this Unit you will be able to:
1. Understand the concept, need and importance of management control system
2. Explain the scope or boundaries of management control
3. Describe the management control process
4. Understand the meaning and characteristics of management information system
(M. I. S.)
5. Understand the meaning of reporting and types of reports.
6. Explain the characteristics of good report.

1.1 Introduction:
Control is an important function of management. It is process of monitoring an
activity and initiate corrective action if necessary. Control is essential for proper
management. But general control is different from management control.
Management is the art and science of proper utilisation of resources with maximum
benefit to the society. Resources include men, money, materials, machinery and time.
Any organisation requires knowledge, insight and analytical skills related to how
company’s senior executives design and implement the ongoing management system
which are used to plan and control the firm’s performance. Management is not
possible without controlling. Management control is a must in any organisation
which practices decentralisation. Planning is precondition of controlling. The
elements of management control systems include strategic planning, budgeting,
resource allocation, performance measurement, evaluation and reward; responsibility
centre allocation and transfer pricing. In changing business environment,
management control systems are gaining great significance in the decentralised
organisation, for becoming successful. This unit support you to understand various
aspects of management control system like meaning, nature and scope of it. It also
consists of meaning and characteristics of M. I. S., meaning of reporting, types of
reports and characteristics of good report.

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1.2 Presentation of Subject Matter:
1.2.1 Basic Concept of Management Control System
Before defining the concept of management control system we can understand
the meaning of three concepts involved in it such as management, control and system
separately.
1.2.1.1 Management: Management is the art and science of proper utilisation of
resources effectively and efficiently to achieve an organizational goal. An
organisation consists of a group of people who work together to achieve certain
common goals. Management refers to the team of people at the helm of affairs of an
organisation which is responsible for running and guiding the destiny of the
enterprise.
People who are leaders in the organisations are known collectively as
‘Management’. It includes a hierarchy of mangers from Chief Executive to all other
managers. This team has the responsibility of planning, organising, activating and
formulation of organisation’s strategies which are expected to attain its objectives.
Apart from this, they are also responsible for coordination, directing, staffing and
management control by the use of people and resources.
1.2.1.2 Control: Giglione and Bedeiari L.M Prasad have observed, in management,
control means measurement and controlling is a process of gathering and feeding
back information about performance so that decision makers can compare actual
results with planned results and decide what to do amount any apparent discrepancies
or problems.
Control is forward looking. It is both an executive process and a result. It is a
continuous process. A control system is a co-ordinated and integrated system.
Control includes after planning, preparing report about actual outcome, comparing
these with plan, analysing & classifying deviations from plan, by responsibility
centres, taking corrective actions on the basis of significance of variance. Control is
an element of management process. It is analysing whether actions are being taken as
planned. It also includes taking corrective actions to make these to conform to
planning.
1.2.1.3 System: A system is a prescribed and usually repetitions way of carrying out
an activity or a set of activities. System is more or less rhythmic, recurring and

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coordinated series of steps intended to accomplish a specified purpose. The
complexity in business environment imposes the need of various systems in the
organisation. A system may be defined as a prescribed manner of carrying out
repetitive activities. It involves coordination. A system is the mechanism where input
is processed for getting required output. We can see basic elements of control system
in Table 1.1
Table 1.1
Elements of Control System
Sr. No. Participant Role to play
1. Detector or sensor information
2. Assessor Comparison
3. Effecter Behaviour alteration
4. Communication Network Reporting

Management control is not automatic. But it is much self-control. It requires

coordination among individuals.
1.2.1.4 Identification of areas of control: Prior to the designing and installing any
management control system it is necessary to identity areas of control. But they are
not fixed for all organisations at all time. As per the requirement they should be
newly identified whenever the revision is required. The authorities in the subject
have identified areas of control which we can understand them as they are enlisted in
Table 1.2
Table 1.2
Areas of Control
Peter Drucker has identified eight areas Market standing, innovation,
of control productivity, physical and financial
resources, profitability, manager
performance and attitude development.
Holden, Fish & Smith have identified Policies, organisation, personnel, wages
thirteen areas of control and salaries, costs, methods and

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 manpower, capital expenditure, service
department efforts, line of products,
research and development, foreign
operations, external relations and overall
control.

1.2.1.5 Management Control System:

Management Control System is a logical integration of management accounting
tools to gather and report data and to evaluate performance.1
A well-designed management control system aids and coordinates the process of
making decisions and motivates individuals throughout the organisation to act in
correct. A management control system coordinates forecasting sales and cost-driver
activities, budgeting, measuring and evaluating performance, and motivating
employees. Indeed, explicit coordination of individual’s activities, actions, and
choices is the hallmark of the management control system. Different thinkers have
defined management control system in their own perspective as given below:
1. Billy E. Goaz defined management control as ‘Management control seeks to
compel events to conform to plans’.
2. According to D. E. McFarland ‘Control, in its managerial sense, can be defined
as ‘the presence in a business of that force which guides it to a predetermined
objective by means of predetermined policies and decisions.’
3. As per view of W. T. Jerome, ‘Control, in some sort of systematic effort to
compare current performance to a predetermined plan or objectives, presumably
in order to take any remedial action required.’
4. According to J. K. Rosen, ‘Control is that function of the system which provides
direction in conformance to the plans.’
5. Prof. John Dearden has defined management control system in different words
as he stated, “Management control system is the process by which managers
assure that resources are obtained and used effectively and efficiently in the
accomplishment of the organisation goals.”

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6. According to Prof. Joseph A. Maciariello& Calvin J. Kirby, “Management
control system is a set of integrated communication structures that facilitates the
processing of information for the purpose of assisting managers in coordinating
the parts and attaining the purpose of an organisation on continuous basis.”
The management control system focuses on organisational goals and objectives,
internal management decision making, and motivation and evaluation of
performance consistent with the organisational goals. The control process in an
organisation involves planning. In many situations, planning and control can be
viewed as two separate activities. Management control, however, involves both
planning and control.
1.2.2 Need and Importance of Management Control System:
Management control system is important in respect of planning and controlling.
It is present need of decentralized organizations. Management control system (MCS)
is used as a tool for controlling in administration. Obviously managers need criteria
to determine how well they do and to control their performance. MCS helps
managers to find information and ensure them those performances and behaviours of
employees are consistent with organization objectives.
1.2.2.1 Guidance to Management: MCS guides the management in achieving pre-
determined goals. It has the continuous flow of information about projects which
keeps the long range of planning on the right track. It helps in taking corrective
actions in future if the performance is not up to the mark.
1.2.2.2 Effective Use of Resources: MCS ensures effective use of scarce and
valuable resources. The control system helps in improving organizational efficiency.
Various control devices act as motivators to managers. The performance of every
person is regularly monitored and any deficiency if present is corrected at the
earliest.Controls put psychological pressure on persons in the organization. On the
other hand control also enables management to decide whether employees are doing
right things.
1.2.2.3 Coordination: MCS facilitates coordination among the members of the
organization.
Control helps in coordination of activities through unity of action. Every
manager will try to coordinate the activities of his subordinates in order to achieve

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departmental goals. Similarly the chief executive also coordinates the functioning of
various departments. The control acts as a check on the performance and proper
results are achieved only when activities are coordinated.
1.2.2.4 Delegation and Decentralization of Authority: MCS leads to delegation
and decentralization of authority at different operational levels. It facilitates a
decision about follow-up action. Control makes delegation easier/better.
Decentralization of authority is necessary in big enterprises. The management cannot
delegate authority unless and until ensuring proper control. The targets or goals of
various departments are used as a control technique. Various control techniques like
budgeting, cost control; pre action approvals etc. allow decentralization without
losing control over activities.
1.2.2.5 Policy Making: MCS spares top management to concentrate on policy
making.For control processes management’s attention is not required every now and
then. The management by exception enables top management to concentrate on
policy formulation.
1.2.3 Scope or Boundaries of Management Control:
There are similar but not same systems or activities which are strategic planning,
management control and task control. Firstly, we have to see the conceptual
difference between these three systems. Strategy planning is a process of deciding on
the goals of organisation and the strategies for attaining these goals. Task control
refers to a process of assuring that specified tasks are carried out effectively and
efficiently. Where, management control means a process by which manager
influence other members of the organisation to implement the organisation’s
strategies.
1. As a system: Strategic planning is the least systematic of the three, task control
is the most systematic and management control lies in between.
2. Periodicity: Strategic planning focuses on the long-run, task control focuses on
short-run activities and management control is in between.
3. Accuracy: Strategic planning uses rough approximations of the future, task
control uses current accurate data, and management control is in between.
4. Portion of Planning and Control: The planning process is much more
important in strategic planning, the control process is much more important in

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 task control and planning & control are of approximately equal importance in
management control.
5. Nature of end product: The outcome of strategic planning is farming out goals,
strategies and policies. Management control involves the implementation of
strategies. Task control comes out with efficient and effective performance of
individual task.
After seeing, the meaning of management control, strategic planning and task
control we have to view the differences between them, in detail. The scope and
boundary of management control can be identified by differentiating it from strategic
planning and task control.
1.2.3.1 Management Control and Strategic Planning:
Strategic planning is different from Management control with following points
of view:
1. Strategic planning is a process of deciding on the objectives of the organisation,
on changes in these objectives, on the resources used to attain these objectives,
and on the policies that are to govern the acquisition use, and disposition of
these resources. Whereas Management Control is a process by which managers
assure that resources are obtained and used effectively and efficiently in the
accomplishment of the organisation’s objectives.
2. Strategic planning need not require definite system when it implies designing
strategies to capture opportunities and to reduce risks and problems. But
management control follows a system to achieve organisational goals and take
actions to detect and correct inefficient performance.
3. Strategic planning is made as and when some problems, opportunities or better
ideas emerge in the organisation. Management control is regular, systematic and
continuous activity.
4. Strategic planning is made for a long-term period when management control
focuses short-term period.
5. Strategic planning covers a specific problem at a time. But management control
covers total organisation and all departments and activities within the
organisation.

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6. Strategic planning comes up with policies and programmes where ultimate aim
of management control is to take corrective actions for desired results.
7. Strategic planning is the responsibility of top management. In management
control, other managers are also participatealongwith top and senior managers.
8. The evaluation of strategic planning is difficult but evaluating management
control is not much difficult.
9. Strategic planning requires small number of persons where large number of
persons is involved in management control.
Beside the above differences, there are some common points.
1.2.3.1 Management Control and Strategic Planning:
1.2.3.2 Management Control and Task Control
Management Control is different from task control in the following manner:
1. Management Control is a process by which managers assure that resources are
obtained and used effectively and efficiently in the accomplishment of the
organisation’s objectives. Where task control is a process of correcting or
preventing variation of performed scheduled activities from the objectives,
procedure or standards set in advance.
2. Management control focuses on whole organisation where task control focuses
on the control of works performed by individuals in an organisation.
3. The functions and steps in management control are framed in terms of strategies
formulated by top/senior management where, functions of task control are based
on procedures and rules which are derived from management control.
4. Task control is done on transaction based information, on the other hand,
management control requires summaries of transactions and consolidated or
summarised reports.
5. The standard set for evaluating procedures, rules and activities are more precise
and objective as compared to management control.
6. The exact and real situation data are used in task control when management
control may also use approximations and estimates.

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7. The financial and non-financial measures are used for control purposes and in
management control, mostly financial or monetary measures are used for control
purposes.
Beside the above differences, there are some similarities.
1.2.4 Management Control Process:
Management control system has a process of establishing standard, measuring
performance, comparison between performance and standard, communication and
corrective actions for unfavourable deviations from standards. There are four stages
of management control process which are as follows:
1.2.4.1 Establishment of Control Standards:
The organization prepare overall strategic plan. Here, managers define goals for
organizational departments. It also include standards of performance to compare with
organizational activities. For some of the activities, the standards cannot be specific
and precise. Standards may be developed from past experience. It can be also
determined by statistical methods and benchmarking. The standards are developed
keeping in view the organization’s goals. Standards may be tangible (clear, concrete,
specific, and generally measurable) – numerical standards, monetary, physical, and
time standards; and intangible (relating to human characteristics) – desirable
attitudes, high morale, ethics, and cooperation.
1.2.4.2 Measurement of Performance:
In control process, measuring performance is an important stage. Organizations
prepare formal reports of performance measurements both quantitative and
qualitative. The managers review those reports regularly. These measurements
should be related to the standards set in the first step of the control process.
organization should have a means of gathering and reporting data.
1.2.4.4 Communication:
After measuring performance it should be communicated in the form of data.
Data can be collected through various means such as (1) personal observation
(through management by walking around the place where things are happening), (2)
statistical reports (made possible by computers), (3) oral reporting (through
conferencing, one-to-one meeting, or telephone calls), (4) written reporting

332
(comprehensive and concise, accounting information). Data should be normally a
combination of all. The information flow should be regular and timely as far as its
use at proper time is concerned.
1.2.4.3 Comparison between Performance and Standard:
The actual performance is compared with standards. Managers read computer
reports or walk through their plants. They identify variances considering whether
actual performance meets, exceeds, or falls short of standards. The variance is the
difference between actual performance and the associated standard. The manager
must know of the standard permitted variation (both positive and negative).
Management by exception is most appropriate and practical to keep insignificant
deviations away. Timetable for the comparison depends upon many factors including
importance and complexity attached with importance.
1.2.4.5 Correction of deviations from standards:
If actual performance deviates from standards, managers must determine what
changes, if any, are necessary and what necessary action is to be taken. After
identifying causes of deviation, corrective action may be taken. The corrective action
may be (1) to maintain status quo (reinforcing successes), (2) correcting the
deviation, or (3) changing standards. The most effective course may be prescribed by
policies or may be best left up to employees’ judgment and initiative.

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 Management Control Process

Analysis
Desired Implementation Corrective
of causes of
Performance of Corrections Action Plan
deviations

Measurement Comparison Identification

Actual Of
of of actual and
Performance deviation
Performance Standard

1.2.5 Management Information System (MIS):

The concept of MIS is as old as the management science. Information is the life-
blood of an organization, particularly in the case of systems approach of
management. The collection, analysis, interpretation and presentation of data were
being done manually. In changing business environment, management information
system has become important in any organization due to the complexity of business
operations. Decision-making is focus of management in present scenario. Proper
decision requires relevant information in time. System can lead to smooth and
effective management. The modern approach of MIS consists of using IT facilities
for the collection, analysis, interpretation and presentation of data which facilitates
managerial working, brings efficiency and effectiveness. MIS handles databases,
provides computing facilities to end users and gives number of decision making tools
to the user of the system.

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1.2.5.1 Meaning of Management Information System:
Management Information System is a planned, organized and systematic
collection of relevant, accurate, precise and timely information which are properly
processed and supplied to required persons economically for the purpose of
achieving organizational objectives.
Walter J. Kennevan defined Management Information System as, “a formal
method of collecting timely information in a presentable form in order to facilitate
effective decision-making and implementation in order to carry out organizational
operations for the purpose of achieving the organizational goals.”
James A. F. Stoner defined Management Information System as, “a formal
method of making available to management accurate and timely information
necessary to facilitate the decision-making process and enable the organization’s
planning, control and operational functions to be carried out effectively.”
Management Information System Committee of the Financial Executive
Institute defined, “A Management Information System is a system designed to
provide selected decision-oriented information needed by management to plan and
evaluate the activities of the corporation. It is designed within a framework that
emphasizes profit planning, performance planning and control at all levels. It
contemplates the ultimate integration of required business information sub-systems
both financial and non-financial within the company.”
According to Kelly, “MIS is a combination of human and computer based
resources which result in collection, storage, retrieval, communication and use of
data for the purpose of efficient management of operations and for business
planning.”
Lucey has defined MIS as “a system to convert data from internal and external
sources into information to communicate the information in an appropriate form to
managers at all levels, in all functions to make timely and effective decisions for
planning, directing and controlling the activities for which they responsible.”
Management Information System is a planned and organized approach which is
the transferring intelligence within an organization. The information is furnished into
useful quantum of knowledge in the form of reports. This information is used by the
organization for making various decisions. Now MIS is defined as a computer based

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information system. It synchronizes the efforts for management and information
processing so as to arrive at better decision options.
Management Information System can be defined as the system of providing
needed information to each manger at the right time, in right form, and relevant one
which aids his understanding and stimulates his action.
1.2.5.2 Characteristics of Management Information System:
The effective and efficient MIS collects data from all possible sources and it
provides that data after processing to the management for taking appropriate
decision. The data processed may be stored and will be used in future. Such system
consists of the following characteristics of MIS:
1. Management Oriented: Top-down approach means the approach by which the
system development starts from the determination of the management needs and
overall business objectives. When MIS is designed, top-down approach should be
followed. Management oriented characteristic of MIS also implies that the
management actively directs the system development efforts.
2. Availability of Information: MIS makes available accurate and relevant based
on inadequate, inaccurate and irrelevant information, the results may lead to
uncertainties and differential risks. The criteria for adequacy, accuracy and relevance
are not available. However, managers have to take decisions on the basis of available
information.
3. System Approach: MIS follows a system approach. It is a set of systems which
helps management at different levels to take better decisions by providing the
necessary information to mangers. The system’s approach implies a holistic approach
to study the organization as a system and its performance to achieve the objective for
which it has been formed.
4. Quality of Information: MIS expounds its compactness and accuracy. Quality
information helps to take sound decisions. Such information should be precise and
highly reliable. Now a day, MIS is computerized. It should be able to process data
accurately and with high speed, using various techniques like operations research,
simulation, heuristics, etc. It should provide extreme flexibility in data storage and
retrieval.

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5. Database Management: In MIS the integrated approach is adopted towards
data handling. The information collected should be properly processed, sorted and
stored. The information stored in a system is to be used as and when required. It
should be in right form and it should be provided in right time. Hence, it should be
processed by proper way and it should be stored. A central database is the backbone
of a well-built MIS. Thus data management will avoid duplication of data and data-
redundancy. It will also help to simplify operations and decision-making. It should
allow easy flow of information through various sub-systems.
6. Need based: MIS design and development should be as per the information
needs of managers at different levels that are strategic planning level, management
control level and operational control level. MIS determines the informational needs
of the various levels of management in any organization. What type of information is
required, what is the source of information are the important questions to determine
these needs.
7. Exception based: Exception means an abnormal situation where the maximum,
minimum or expected values vary beyond the limits. MIS should be developed on
the exception based reporting principle. In such situation, organization should adopt
exception reporting to the decision-maker at the required level. MIS provides this
option.
8. Integrated Approach: MIS should be comprehensive in nature. It is integrated
system. It is significant because of its ability to produce more meaningful
information. For example, in order to develop an effective production scheduling
system, it is necessary to balance such factors as: set-up costs, work force, overtime
rates, production capacity, inventory level, capital requirements and customer
services. Integration is nothing but a comprehensive view of the subsystems that
operate within the organization. An integrated system can provide complete
information. Hence, it can provide a complete picture of the scenario. It should work
as a complete and comprehensive system covering all interconnecting sub-systems
within the organization.
9. Future Oriented: MIS should not merely provide past or historical information.
It should provide information predicting future or estimation for future. On the basis
of that steps may be taken to fruition the plans.

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1.2.6 Reporting to Management:
At every moment management want to take decision for operating business.
Unless and until the information is available about the phenomenon nobody can take
decision. By taking proper and timely decision, management can sustain the business
and grow it as per the organizational goal. Hence, proper reporting plays an
important role in management accounting process. Management reporting is nothing
but transferring information to management. It is a process of providing information
to management. Reports are sent regularly to various levels of management. It is
useful to them to judge the effectiveness of respective responsibility centres.
1.2.6.1 Meaning of Reporting:
Report is a tool of conveying the information to higher authorities for proper
decision making and consequential favourable effects. Reports helps management to
frame out different policies. With the help of reports management can evaluate the
performance of various divisions and sections within the organization and people
working therein. Reports are useful for assessing the policy implementation. They
also assist management to take corrective actions if any unfavourable situation
occurs. It also helps to control the situation and affairs of the business.
A management reporting system is an organized mechanism of providing all
data to management or every manager for his decisions, at a time when it needs them
and in the lucid form to understand easily. Reporting system is the formal system
which continuously fed the information to management to assist decision-making.
According to Anthony and Reece, "Reports on what has happened in a business,
are used for two general purposes which may be called information and control,
respectively."
1.2.6.2 Methods of Reporting:
Reporting may be made by written reporting, graphic reporting or oral reporting.
The method of reporting depends upon the nature of information required, the
volume of data and the media available for communications.
1. Written Reporting: Different written reports include (i) formal financial
statements, (ii) tabulated information and (iii) accounting ratios.

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2. Graphic Reporting: Some reports are presented in the form of charts, diagrams
and pictures. Due to such reports, the trends of information are grasped quickly.
3. Oral Reporting: Oral reporting can be done in the form of (a) group meeting
and (b) conversation with individuals. It is helpful to limited extent.
In actual practice, a single method is not sufficient. A combination of written,
graphic and oral reporting may be useful for the organization.
1.2.6.3 Types of Reports:
The reports are classified on the basis of different factors which are as follows:
(A) Classification of reports on the basis of Period:
(1) Routine Reports
(2) Special Reports
(B) Classification of reports on the basis of Functions:
(1) Operating Reports
(2) Financial Reports
(C) Classification of reports on the basis of Nature:
(1) Enterprise Reports
(2) Control Reports
(3) Investigative Reports
(D) Classification of reports on the basis of Purpose:
(1) External Reports
(2) Internal Reports
1. Routine Reports: These reports are prepared and submitted as a regular activity.
They are about day-to-day working of the organization. They are periodically sent to
various levels of management. According to nature of information and details to be
reported, these reports are different. Important information should be highlighted as
these reports may be ignored with seeing their routine nature. These reports may be
sent daily, weekly, monthly or quarterly. Routine reports may be related to sales,
production, capital expenditure, purchase, market trends and labour situations etc.

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2. Special Reports: Special reports are required in special situation or for special
purpose. Available data may not be sufficient, so additional data may be collected
specially.
According to J. Batty, ‘special reports should be divided into sections, each
covering the following main purposes: 1. Reasons for the report, 2. Investigation
made and 3. Finding, conclusion and recommendations.’
3. Operating Reports: Operating reports are divided into two: information reports
and control reports. Information reports facilitate information useful for policy
prescription. Trend reports provide information in comparative form over a period of
time. Control reports are used for managerial purpose or managerial control. They
are useful for immediate corrective action to be taken. They are used to assess the
performance of individuals. Control reports are for measuring and comparing
performance or evaluation of performance.
4. Financial Reports: Financial reports facilitate the information related to financial
performance. The income statement provides the outlook of financial result and the
balance sheet put forth financial position. Fund flow statement reflects sources of
funds and application of funds for the business which indicates fund management.
Cash flow statement shows inflow of cash and outflow of cash which reveals cash
management.
5. Enterprise Reports: Enterprise reports are prepared for the organization as a
whole. They may concern all activities of the enterprise or may be related to different
activities. These reports are useful to outsiders. Enterprise reports include balance
sheet, income statement, income tax return, employment report, chairman’s report,
directors’ report etc.
6. Control Reports: Control reports are related to personal performance and the
economic performance. The performance of managers and heads of responsibility
centres is evaluated. The efficiency of responsibility centres is tested as an economic
entity. The reasons for deviations in performance are also identified.
7. Investigative Reports: If any serious issue arises, the causes of the situation
studied and analysed. These studies are used to prepare investigative reports. The
investigative reports are prepared according to the nature of every situation and they
are useful to management to analyse the causes of the problem.

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8. External Reports: Many parties are interested to know about the organization.
These outsiders who are interested in company’s reports may be shareholders,
suppliers, bankers, creditors, potential investors, regulatory bodies etc. Hence, it has
to prepare reports meant for external users which are called external reports. Main
example of external reports is financial statements.
9. Internal Reports: The reports which are prepared for the purpose of internal use
of the organization are called internal reports. They are not available for external
users. These reports are mainly used for decision-making by management. They are
meant for top level, middle level and lower level management.
1.2.6.4 Characteristics of Good Report:
Good reporting is essential for effective communication from executives to
various levels of management. The usefulness of report is dependent on quality and
method of reporting. Following are pre-requisites for a good report:
1. Accuracy: The report should facilitate the accurate information. The accuracy
may be in the form of conceptual, statistical or grammatical approach. The extent of
accuracy is dependent on the nature of information and the purpose of its collection.
If the information lose its form and utility, at that level it should not be
approximated. Hence, accuracy should be considered as quality measure to enhance
the utility of reports.
2. Promptness: Report should be quickly available as and when it requires. If the
report is timely available, it can be used properly. The delay in report will be defeat
the purpose of reporting. Management can take corrective actions as early as
possible. The promptness is dependent on quick collections of facts and figures.
3. Relevancy: The relevance of report is very important factor as far as wastage of
expenditure is concerned. It should be sent to whom it is relevant and to be marked to
proper person who will concern it in proper way rather than routine way.
4. Simplicity: The report should be presented in lucid language so as to understand it
by the users. It should be simple, unambiguous and clear to understand. It should not
be loaded by technical language. It should be readable. The graphical presentation
may make report simple and easy to understand. Hence, graphs, diagrams and charts
may be used in the report to enhance simplicity.

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5. Consistency: The comparison is possible only if the reports are prepared
consistently. If the uniform reports are prepared for consecutive periods with similar
type of information and statistics, it will facilitate comparability. Consistency in
reporting would enhance the utility of reports.
6. Controllability: The reports should consist of details of variances related to
responsibility centres so as to take corrective actions. Reports should be submitted to
proper head of the responsibility centres. The variances which are not controllable
should be mentioned separately.
7. Cost Effectiveness: The cost of preparing and presenting reports should not be
more than the benefits of reports. Reporting should be feasible as far as cost is
concerned. For this purpose, cost benefit analysis will be useful for adoption of
reporting system.
8. Form and Content: Proper format should be maintained while preparing reports.
Proper title, headings, sub-headings, paragraphs and divisions, proper statistical
figures are elements of good form of reports. Reports should contain facts. It should
include date of preparation, date of submission and the period of the report, reference
number etc. The content of the reports should serve the purpose and it should be in a
logical sequence.
9. Frequency of Reports: Frequency of reports means how frequently any specific
report is sent. The timing of reporting is dependent on the nature and purpose of
report. Some reports are sent daily, some weekly, some monthly and so on. Such
reports should be sent whenever due.
Check Your Progress
Check Your Progress:
A. Fill in the blanks:
1. A ...........................................is an aggregate of machines and people that
work toward a common objective.
2. In a ............……………., data/information is typically fed back to
managers of the various system phases.
3. A system is an aggregate of ...................... and ......................... that work
toward a common objective.

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 4. Output is .......................... and ............................... against a plan.
5. The controller’s main responsibility is to ensure that the systems throughout
the organization are .............................. and compatible with one another.
B. Multiple Choice Questions:
1. A group of interacting, interrelated or interdependent functional elements
forms a collective entity called as ______.
a. Management b. System c. Inventory d. Standards
2. _____________ has an efficient characteristic of producing maximum
output with minimum input per unit.
a. Information control b. Management control
c. Project control d. None of the above
3. There are 4 types of Management Control – Strategic control, operational
control, _______and __________.
a. Profitability control & Annual plan control
b. Accountability control & Profitability control
c. Influencing control & Profitability control
d. Reporting control & Annual plan control
4. Operational control is also referred as _________
a. Planning control b. Task control
c. Corrective control d. Risk control.
5. Process whereby top management examines the actual outcomes of its
company's effort manually is known as __________
a. Strategic control b. Active control
c. Annual plan control d. Objective control

1.3 Summary:
The elements of management control systems include strategic planning,
budgeting, resource allocation, performance measurement, evaluation and reward;
responsibility centre allocation and transfer pricing. Management Control System is a
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logical integration of management accounting tools to gather and report data and to
evaluate performance. A well-designed management control system aids and
coordinates the process of making decisions and motivates individuals throughout
the organization to act in correct. Need and Importance of Management Control
System has been covered in this unit. There are similar but not same systems or
activities which are strategic planning, management control and task control as far as
their scope is concerned. Management control process is also included in this unit.
MIS handles databases, provides computing facilities to end users and gives
number of decision making tools to the user of the system. Management Information
System is a planned, organized and systematic collection of relevant, accurate,
precise and timely information which are properly processed and supplied to required
persons economically for the purpose of achieving organizational objectives. The
Characteristics of Management Information System include (1) Management
Oriented, (2) Availability of Information, (3) System Approach, (4) Quality of
Information, (5) Database Management, (6) Need based, (7) Exception based, (8)
Integrated Approach and (9) Future Oriented.
Proper reporting plays an important role in management accounting process. A
management reporting system is an organized mechanism of providing all data to
management or every manager for his decisions, at a time when it needs them and in
the lucid form to understand easily. Reporting may be made by written reporting,
graphic reporting or oral reporting. The reports are classified on the basis of different
factors such as period, functions, nature and purpose etc. On these basis, types of
reports are (1) Routine Reports, (2) Special Reports, (3) Operating Reports, (4)
Financial Reports, (5) Enterprise Reports, (6) Control Reports, (7) External Reports
and (8) Internal Reports. This unit also describes the characteristics of good report
which are: (1) Accuracy, (2) Promptness, (3) Relevancy, (4) Simplicity, (5)
Consistency, (6) Controllability, (7) Cost Effectiveness, (8) Form and Content and
(9) Frequency of Reports.

1.4 Terms to Remember:

1. Management Control Systems (MCS): A MCS is a set of interrelated
communication structures that facilitates the processing of information for the
purpose of assisting managers in coordinating the parts and attaining the purpose
of an organization on a continuous basis.

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2. Task Control: It is an efficient and effective performance of individual task.
3. Strategic Planning: Strategic planning occurs at top management levels; task
control at the lowest levels in the organization and management control is in
between.
4. Management information system: it is an information system[1] used for
decision-making, and for the coordination, control, analysis, and visualization of
information in an organization.

1.5 Answer to Check Your Progress:

Section A: 1. System, 2. Management control system, 3. Machines, People, 4.
Measured, Compared, 5. Efficient
Section B: 1. -b, 2.-b, 3.-a, 4.-b, 5.-c

1.6 Exercise:
1. Write answers in detail.
1. What is management control system? Explain the need and importance of
management control system.
2. What is the scope of management control system?
3. Describe the management control process.
4. What is management information system? Explain its characteristics.
5. What is reporting? Describe various types of reports.
2. Write a short note on.
1. Management Control System
2. Management Information System
3. External and Internal Reports
4. Routine Reports and Special Reports
5. Characteristics of Good Report

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Practical: Group discussion will be conducted in the classroom on the content of
Unit-I.
Group Discussion Topic: “Importance of Strategic Planning in Management
Accounting”

Date: 12thJanuary, 2021

Time: 10.00 am to 11.00 am

Teacher: Good Morning everyone!!! Today we are arranging a group discussion on

‘Importance of Strategic Planning in Management Accounting’ where ten students
are participating for this session. I hope remaining students will also be participated.
So, let’s start the discussion. Is strategic planning really important in management
accounting? what do you think???
Paresh: yes sir, strategic planning plays a very important role in management
accounting. It is a one of the important aspects of management accounting. It helps to
collect accounting data from all departments, which is analysed and it leads to take
effective management decision.
Sumit: Exactly… I agree with you Paresh… strategic planning is closely related to
top level management. Management accounting includes analysing internal business
data. The top-level management can take effective managerial decisions on the basis
of analysed financial data. It seems that the management accounting helps to
formulate strategies and policies. The strategic planning leads to achieve
organisational goal.
Supriya: Theoretically it is easy to talk about strategies and strategic planning, but
when it is applied in real work, it seems more challenging.
Dipali: You are right Supriya… but this accounting data helps to preparing strategic
planning, which requires business information include finance, cost, taxation,
auditing, statistics, managerial economics and functional operations etc.,such types
data is useful for preparing strategic planning in management accounting.
Nitin: Using strategic planning in management accounting to develop cost leadership
strategies and strong economic forecasts. It can be helpful to improve market value

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of companies. Companies may also be able to create a distinct competitive advantage
over competitors in its business industry or sector.
Supriya: yes, but it has also some limitations… Implementing strategic planning in
management accounting can be difficult and expensive process for companies.
Strategic planning attempts to change this mentality by including management
accountants. It is also very useful in decision-making process of the company.
Dinesh: Right… I am very much agree with Supriya. This change goes against
traditional accounting approach, which requires to develop new business thought and
ideas, in their accounting system.
Professor: Okay… the time is over students… It was a good discussion as all of you
shared various views regarding strategic planning in Management accounting. I am
very happy for your discussion… Now let me conclude this…
Strategic planning helps to take effective managerial decision and develops cost
leadership strategies and strong economic forecasts. It helps to improve the
company’s functional performance and achieve organisational goals. Though, it is
expensive, it has various benefit to implement. So, if companies or any organisations
want to improve profit margin and reduce wasteful operation. Hence, they should
adopt Strategic planning in the Management Accounting. It will be really
beneficial!!!
Thank you!!!

1.7 References for further study

1. Charles T. Horngren, and Gary L. Sundem (1994): Introduction to Management
Accounting, Prentice-Hall of India Private Limited, New Delhi, Ninth Edition.
2. Robert Anthony & Vijay Govindrajan (2004): Management Control Systems,
Tata McGrw-Hall Publishing Company Limited, New Delhi, Eleventh Edition,
p.93.
3. Sharma, R. K. and Gupta, Shashi K. (1996): Management Accounting Principles
and Practice, Kalyani Publishers, Ludhiana, 7th Revised Edition.
4. Dr. Maheshwari S. N: Principles of Management Accounting, Sultan Chand &
Sons, New Delhi.
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5. Man Mohan, S. N. Goyal: Principles of Management Accounting,
SahityaBhavan, Agra.
6. Pandey I. M.: Management Accounting, Vikas Publishing House Pvt. Ltd., New
Delhi.

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 Unit-2
Marginal Costing and CVP Analysis

Index
2.0 Objectives
2.1 Introduction
2.2 Presentation of Subject Matter
2.2.1 Meaning and Definition of Marginal Costing
2.2.2 Break-Even Analysis
2.2.3 Cost Volume Profit Analysis
2.2.4 Decision making by using marginal Costing
2.2.5 Make buy Decision
2.2.6 Shut Down and Continue Decision
2.2.7 CVP Analysis in Multi-Product Decision
2.2.8 Alternative Course of Action
Check your Progress
Illustrations
2.3 Summary
2.4 Terms to Remember
2.5 Answer to check your progress
2.6 Exercise
2.7 Reference to further study

2.0 Objectives:
After studying this unit you will be able to understand
• The technique and concept of Marginal costing and Absorption costing
• Difference between marginal costing and absorption costing
• Cost-Volume-profit (CVP) analysis
• The concept of P/V ratio, Break even analysis, Margin of Safety
• The use of marginal costing in different managerial decisions etc.

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2.1 Introduction:
There are two techniques of product costing and income determination i.e.,
Absorption Costing and Marginal Costing. Marginal costing is also known as
variable costing or direct costing or contributory costing and comparative costing etc.
Under this technique, only variable costs are charged as product costs and included
in inventory valuation. Fixed manufacturing costs are not allotted to products but are
considered as period costs and thus charged directly to the Profit and Loss Account
of that year. Marginal costing is the ascertainment of marginal costs and of the effect
of changes in volume or type of output by differentiating between fixed costs and
variable costs. Marginal costing is not a method of costing such as job costing,
process costing and operating costing etc. but it is a special technique concerned with
effect of fixed overhead on the profitability of a business. It brings out the
relationship between the cost, volume of output and profit. In this unit we will
discuss the application of marginal costing and how the various managerial decisions
are taken by applying this technique.

2.2 Presentation of Subject Matter

2.2.1 Meaning and Definition of Marginal Costing:
Marginal Cost is derived from the word ‘margin’ and is a well-known concept
of economic theory. In this way, and in line with the economic meaning of the term,
it is narrated in simple words as the cost that arises from the production of extra
increments of output. Naturally, it does not exist where there is no production of
extra increments. Marginal costing is the ascertainment of marginal cost and the
effect on profit of changes in volume or type of output by differentiating between
fixed costs and variable costs.
CIMA defines marginal costing as “The accounting system in which variable
costs are charged to cost units and fixed costs of the period are written off in full
against the aggregate contribution. Its special value is in decision making”.
According to Institute of cost and Works Accountant, London, in its publication
‘A report on Marginal Costing as “ The amount at any given volume of output y
which aggregate costs are changed if the volume of output is increase or decreased
by one unit.”

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 According to Institute of Chartered Accountants of England, “Marginal Cost in
every expense whether of production, selling or distribution incurred by the taking of
a particular decisions.”
In simple words, marginal costing is a principle whereby marginal cost of cost
units is ascertained. Only variable costs are charged to cost units, the fixed costs
attributable to a relevant period being written off in full against the contribution for
that period. Marginal cost is defined as the amount at any given volume of output by
which aggregate costs are changed if the volume of output is increased or decreased
by one unit. It is the sum total of prime cost plus variable overheads plus variable
portion of semi-variable overheads. In the marginal costing technique, profit is
measured by contribution less fixed overheads which include the fixed portion of
semi-variable overhead also. Semi-variable overheads are segregated and the
variable potion is added to the variable overheads and fixed amount is added to the
fixed overheads, variable costs vary directly with output and cost per unit is the
same. This is a linear relationship. Fixed costs remain the same regardless of the
level of output and vary only with time.
The concept of marginal costing is a formal recognition of ideas underlying
flexible budgets, break even analysis and cost volume profit relationships which
involve a change in the conventional treatment of fixed overheads in relation to
income determination.
Features of Marginal costing:
a. Segregation of costs on the basis of behavior i.e., fixed and variable elements
and also the segregation of semi-variable overheads into variable portion and
fixed amount is made.
b. Fixed costs are treated as period costs and are charged to the Costing Profit and
Loss Account of the period in which they are incurred.
c. In marginal costing Break even technique is employed.
d. The valuation of closing stock and closing work-in-progress is valued at
marginal cost.
e. Prices are based on marginal costs and marginal contribution.
f. In marginal costing price of the products are fixed for exports.

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g. The unit cost of a product means the average variable cost of manufacturing the
product.
h. Contribution is the difference between sale value and marginal cost of sales. it
facilitates decision-making in regard to product mix, sales mix, make or buy,
machine or manual etc.
Merits of Marginal Costing:
a. This technique is simple to understand and easy to calculate
b. Per unit marginal cost remains the same irrespective of its volume of production
c. Since variable cost measure does not require the calculation of fixed overheads
as unit amounts it is extremely useful for dynamic planning and decision making
d. This technique simplifies the problems of price estimation and price fixation
e. This technique is very useful in controlling the cost
f. The break even analysis, profit volume ratio techniques are useful in quick
decisions.
Demerits of Marginal Costing:
a. The difficulty in realistically segregating some of the actual costs into fixed and
variable components is the primary problem.
b. There has been absence of support and acceptability of marginal costing, none
of the regularity authorities have accepted the method for valuing inventories for
external reports and tax purposes.
c. In a long run the fixed costs cannot be ignored in decision making.
Marginal Cost Equation:
The basic equation is:
Sales – Marginal cost or variable cost = Contribution
S – M = C or S – V = C
Contribution = Fixed cost + Profit
C=F+P
Alternatively: S – V = F + P

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In case of Loss (L), S – V = F – L
At the Break-even point, profit = 0
Hence, S – V = F – 0 or S – V = F or S – V – F = 0
Profit = Contribution – Fixed cost. Or Profit = Sales – Variable cost – Fixed cost.
If any three of the above factors are known, the forth one can be ascertained.
2.2.2 Break- Even Analysis:
This technique uses the marginal costing to predict cost behavior and thereby to
predict profits or losses of a business in future period of time. 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. Break-even analysis is very much an extension or even part
of marginal costing. Carl Heyel in Encyclopedia of Management defines break-even
analysis as “ a method of studying the relationship among sales revenue, fixed costs
and variable expenses to determine the minimum volume at which production can be
profitable. It is a useful technique in business decision-making.”
Sales – (Variable Cost + Fixed Cost) = Zero Profit
Fixed Cost
BEP (Units) = -----------------------------
Contribution per unit
Fixed Cost
BEP (Value) = -----------------
P/V ratio
Fixed Cost
BEP (Value) = ------------------ X 100
P/V ratio

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Influence of fixed cost, variable cost and selling price on BEP:
Particulars P/V ratio Effect on BEP Profit
a. Increase in fixed cost No effect Higher Lower
b. Decrease in fixed cost No effect Lower Higher
c. Increase in variable cost Decrease Higher Lower
d. Decrease in variable cost Improve Lower Higher
e. Increase in selling price Improve Lower Higher
f. Decrease in selling price Decrease Higher Lower
g. Increase in sales volume No effect No effect Higher
h. Decrease in sales volume No effect No effect Lower
Whenever there is influence or effect, revised calculation of P/V ratio, BEP and
profitability are worked out and submitted to the Management for necessary action in
this regard.
Margin of Safety:
It is the difference between total sales revenue and sales at Brea-Even point. If
the distance between total sales revenue and BEP is long, it indicates the soundness
of the business.
Margin of safety = Total Sales – Sales at BEP
Total Sales – Sales at BEP
Margin of Safety ratio = --------------------------------- X 100
Total Sales
With the help of margin of safety ratio, profit can be ascertained as follows:
Profit = P/V ratio X M/s ratio X Sales.
Profit—Volume Ratio (P/V Ratio):
Profit volume ratio, as is obvious, is the ratio of contribution margin to sales. If
the excess of unit sales revenue over its variable cost is divided by unit selling price
the result is P/V ratio, i.e., (P- V) + P. Put it differently, it is the complement of the
variable cost ratio such that P/V ratio = 1 – V/P ratio. Usually expressed as a
percentage of sales, it shows what percentage of each rupee sales is a available for
the coverage of fixed costs and then yield profit. Symbolically, it is

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 Contribution per unit
P/V Ratio = -----------------------------
Selling price per unit
Sales revenue – Variable cost i.e. (Contribution)
P/V Ratio = -------------------------------------------------------------
Sales revenue
Fixed expenses + profit
P/V Ratio = -------------------------------
Sales revenue
Change in profit
P/V Ratio = ------------------------
Change in Sales
Hence, Contribution = Sales X P/V ratio
Variable cost is the complement of P/V ratio, in another way it is 1- P/V ratio.
Thus, if the P/V ratio is 40%, the variable cost ratio will be 60%.
P/V ratio can be improved by—
1. Increasing selling price
2. Reducing the variable costs
3. Changing the product mix, i.e, sale of products having a high P/V ratio should
be increased and sale of products having a low P/V ratio should be reduced or
eliminated.
Increase or decrease in fixed overheads does not affect the P/V ratio. But it may
reduce the profit or increase the profit respectively.
2.2.3 Cost Volume Profit Analysis:
As the name suggests cost-volume-profit analysis is a study of the relationships
between costs and volume, and their impact on profit. The three parameters are
related to each other so that the volume is a function of price, and cost is a function
of volume. The analysis seeks to determine and express the interrelationships of the
activity, costs, sales prices and sales mix to earning. More specifically, it concerned
with what will be the effect on earnings of changes in sales volume, sales prices,
sales mix, and costs. The analysis is concerned with the effect on profits of changes
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in a. fixed costs b. variable costs c. sales quantities d. sales prices and e.sales mix.
Such a comprehensive dissection allows management to determine relative
profitability of a product by examining the incremental effect of volume on costs
revenues, and profits. It is primarily a planning tool to assist management in
effectively utilizing fixed resources in the short run.
Summary of formulae:
1. Contribution = Sales – Variable Cost (S- V) or
= Fixed Cost + profit (F + P) or
= Fixed Cost – Loss (F-L)
Also, Contribution = Sales in Rs. X P/V ratio
Contribution = Sales at BEP in units X Contribution per unit ) + Profit
Contribution = Sales at BEP in Rs. X P/V ratio ) + Profit
Contribution
2. P/V Ratio = -------------------- X 100
Sales
Fixed expenses + profit
P/V Ratio = -------------------------------- X 100
Sales revenue
Change in profit
P/V Ratio = --------------------------- X 100
Change in Sales
Fixed Cost
3. BEP (Units) = ------------------------------
Contribution per unit
Fixed Cost
BEP (Value) = ----------------------
P/V ratio
4. Calculation of sales to earn a given profit
Fixed Cost Fixed Cost + Profit
(In Units) = ------------------ Or (In Rs) -------------------------
P/V ratio P/V ratio
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5. Margin of safety = Actual sales -- Break even point
6. Sales to earn a desired profit
Fixed Cost + Desired Profit
= ----------------------------------
P/V Ratio
2.2.4 Decision making by using Marginal Costing:
Following managerial decisions are taken with the help of marginal costing:
a. Acceptance or rejection of an order
b. Selection of product mix
c. Discontinuation of a product line
d. Introduction of a new product line
e. Selection of best method of production
f. Pricing of product
g. Make or buy decisions
h. Expand or buy decisions
i. Replacement of machinery
j. Closing down of business or to continue the business at a loss.
2.2.5 Make buy Decision:
A make-or-buy decision is an act of choosing between manufacturing a product
in-house or purchasing it from an external supplier. It is also referred to as an
outsourcing decision, a make-or-buy decision compares the costs and benefits
associated with producing a necessary good or service internally to the costs and
benefits involved in hiring an outside supplier for the resources in question. Hence,
to compare costs accurately, a company must consider all aspects regarding the
acquisition and storage of the items versus creating the items in-house, which may
require the purchase of new equipment, as well as storage costs.
Marginal costing renders useful assistance when a management has to take
decision on whether a particular component or part should be manufactured
internally or purchased from outside supplier. As per marginal costing technique it is

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normally done by comparing the outside price with firm’s own marginal costing
technique, it is normally done by comparing the outside price with firm’s own
marginal cost. If the outside price of the component is lower than the marginal cost
of manufacturing it, then it is advisable to buy it. On the other hand, if the outside
price is higher than the marginal cost, then it is worth to manufacture it.
Illustration 1:
A T.V. manufacturing company finds that while it costs to make component X,
the same is available in the market at Rs.5.75 each, with all assurance of continued
supply. The breakdown of cost is: Materials Rs.2.75 each Labour Rs.1.75 each
Variable overheads Rs.0.50 each Depreciation and other fixed cost Rs.1.25 each
Rs.6.25 each
(a) Should the company make or buy the component?
(b) What should be your decision if the supplier offered component at Rs.4.85
each?
Solution:
Marginal cost per unit of component X
Rs.
Materials 2.75
Labour 1.75
Variable overheads 0.50
Total 5.00
(a) The purchase cost of the above component is Rs.5.75 each. If the company is
having spare capacity which can not be filled with more remunerative jobs, it is
recommended that the above component be manufactured in the company since
the marginal cost at Rs.5.00 each is less than the purchase cost of Rs.5.75.
(b) In the event of purchase cost of Rs. 4.85 each being less than the marginal cost
of Rs.5.00 each, it is recommended that the component be bought from the
supplier as this results in a saving of Rs. 0.15 each. The spare capacity thus
available can be utilised for other purposes, as far as possible.

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Illustration 2:
Phillips Radio Company finds that while it costs Rs. 12.50 to make a component X,
the same is available in the market at Rs. 11.50 with an assurance of continued
supply. The break-down of the cost is;
Rs.
Materials 5.50
Labour 3.50
Other variable overheads 1.00
Depreciation & other fixed cost 2.50
Total Cost 12.50
a. Should you make or buy?
b. What would be your decision, if the supplier offered the component at Rs. 9.70
each.
Solution:
Marginal Cost Statement
Particulars Per Unit Rs.
Materials 5.50
Labour 3.50
Variable Overheads 1.00
Marginal Cost 10.00

a. The marginal cost of producing the component is Rs. 10 per unit and fixed cost
per unit is Rs. 2.50, thereby making a total cost of Rs. 12.50 per unit. But this
component is available in the market at Rs. 11.50. As the market price per unit
is less than the total cost, apparently it looks better to buy the component instead
of making it. But a close observation reveals that the component will actually
cost Rs. 14 (i. e. 11.50+2.50) if it is purchased, as the fixed cost of Rs. 2.50 is
required to be incurred even if the component is purchased. Therefore, it may

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 not be wise to buy a component which will actually cost Rs. 14, which is being
manufactured at Rs. 12.50.
b. If the price offered by the supplier is Rs. 9.70 per unit, then it is advisable to
purchase the component from the outside market as the outside market price of
Rs. 9.70 is less than marginal cost of Rs. 10. There will be saving of Re. 0.30
per unit if the component is purchased from outside market.
2.2.6 Shut Down and Continue Decisions:
A shutdown point is an operating level where a business does not benefit in
continuing production operations in the short run when revenue from selling their
product is unable to cover variable costs of production. The shutdown point
represents a point where a firm will incur higher and increasing losses if it continues
production, as opposed to reduced losses if production is ceased. The shutdown point
occurs at a point where marginal profit reaches a negative scale.
Illustration 3 :
A cost sheet shows the following situations prevailing in Star Ltd., which is facing
depression:
Rs.
Direct Materials 50,000
Direct Wages 20,000
Overheads:
Variable Rs. 10,000
Fixed Rs. 20,000 30,000_
Total Cost 1,00,000
Sales 4,000 units @ Rs. 23 per unit 92,000
Loss: 8,000
There is no sign of improvement in the situation. Therefore, the management wants
to know whether it is desirable to stop the production. What should be the minimum
price at which company should shut down its production?

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Solution:
Even if there is a loss of Rs. 8,000, it is not desirable to stop the production. Because,
fixed costs will be incurred even if production is stopped and loss would be equal to
fixed cost of Rs. 20,000. The present loss is less because selling price is more than
marginal cost and the same contributes towards recovery of fixed costs. Therefore, so
long as there is contribution, it is not advisable to stop the production. The following
statement gives the clear idea of the situati
situation

The price per unit of Rs. 23 is more than marginal cost of Rs. 20. Therefore, the
production should be continued. The minimum price at which production should be
discontinued should be equal to marginal cost. In this case marginal cost is Rs. 20, so
minimum price should be Rs. 20. It is better to stop the production if selling price
falls below the marginal cost of Rs. 20 to avoid the loss more than fixed cost of Rs.
20,000.
2.2.7 CVP Analysis in Multi product Decision:
This categorisation of costs into “variable” and “fixed” elements and their
relationship with sales and profits has been developed as “break-even
even analysis”. This
break-even
even analysis is also known as Cost Cost-volume-profit
profit (CVP) analysis (ICSI,
2017). The Cost-volume
volume profit (CVP) analysis is the study of the effects on future
profit of changes in fixed cost, variable cost, sales price, quantity and mix. The aim
of CVP analysis is to estimate the total cost, total revenue and thereby profit of
various sales volumes. Managers use this techniq
technique
ue extensively to determine the
break-even
even point and margin of safety. Break
Break-even
even point is the level of activity at
which there is neither profit nor loss. Margin of safety ratio indicates the percentage

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by which forecast turnover exceeds or falls short of breakeven turnover. The CVP
analysis assumes that output is the only cost and revenue driver.
It means cvp is a managerial tool showing the relationship between various
ingredients of profit planning viz. cost selling price, and volume of activity. As the
name suggests, cvp analysis is the analysis of three variable cost, volume and profit.
Such an analysis explores the relation between cost revenue, activity levels and the
resulting profit. Its aim at measuring variation in cost and volume (ICAI, 2021). Cost
volume profit analysis for the company that sells multiple products or renders varied
services is somewhat difficult, since different products or services have different
selling prices, different costs and different contribution margins. There is a need here
to consider the impact of sales mix on a company’s profit. The term sales mix refers
to the relative proportions of different products or services sold by a company. To
maximize profits, most companies will aim to achieve an ideal mix of products or
services (Gill Suveera, 2015, pp 352-353).
It seems that the many times, the management has to take a decision whether to
produce one product or another instead. Generally, decision is made on the basis of
contribution of each product. Other thing being the same the product which yield the
highest contribution is best one to produce. But, if there is shortage or limited supply
of certain other resources which may act as a key factor like for example, the
machine hours, then the contribution is linked with such a key factor for taking a
decision e.g. in an undertaking the availability of machine capacity is limited and the
machine hours required for one unit of the two products are different. In such case
the contribution is to be linked with the machine hours and the product which yield
the highest contribution per machine hour is to be preferred for taking decision
(ICAI, 2002, pp 3.35).
A concern, which manufactures more than one product, may have to decide in
what proportion should these products be produced or sold. The technique of
marginal costing helps to a great extent in the determination of most profitable
product or sales mix. The best product mix is that which yields the maximum
contribution. In the absence of key factor, contribution under various mix will be
found out and the mix which gives the highest contribution will be selected for
production. In a multi-product environment, where more than one product is
manufactured by using a common fixed cost. The contribution is calculated by taking

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weights for the products. The weighted may be sales mix quantity or sales mix values
(Rashid Javed, 2021).
The CVP multi product analysis helps to take product mix decision which refers
to choosing particular product or combination of products with view to maximise the
profits. Hence, herewith consider following example for the understanding the
concept of CVP analysis in multi-product decision.
Particular A B C
Sold 1000 1000 1000
Sales Price 80 100 200
Variable Cost 50 105 195
Contribution 30 -5 5
Fixed Cost 10 10 10
Total Cost 60 115 205
Profit 20 -15 -5

In this case ignore fixed cost and calculate contribution per unit because fixed
cost will be incurred irrespective of whether a particular product is produced or not.
Therefore contribution (Sale - Variable Cost) should be the basis for decision
making. It is suggested that the discontinue product B because the contribution is
negative. Hence, we can continue products A and C as the contribution is positive.
Thus, we can give first rank to A product and second rank to B (V. Venkatasiva
Kumar, 2003).
Formula:
A multi-product company can compute its break-even point using the following
formula:

   
Break-even point =               

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Example 1:
The XYZ Ltd Company manufactures three products - product X, product Y and
product Z. The variable expenses and sales prices of all the products are given below:
Particular Product X Product Y Product Z
Sales Per Unit 200 100 50
Variable Expenses Per Unit 100 75 25

The total fixed expenses of the company are Rs. 50,000 per month. For the
coming month. XYZ ltd expects the sale of three products in the following ratio:
Product X: 20%;
Product Y: 30%;
Product Z: 50%
Compute the break-even point of XYZ Ltd company in units and dollars for the
coming month.
Solution:
XYZ Ltd company sells three products and is, therefore, a multi-product
company. Its break-even point can be computed by applying the above formula:

   
Break-even point =               

= Rs. 50,000 / Rs. 95 – RS. 55

= Rs. 50,000 / Rs. 40
= 1,250 units
Note 1: Weighted average selling price:
= (Rs.200 × 20%) + (Rs.100 × 30%) + (Rs.50 × 50%)
= Rs.40 + Rs.30 + Rs.25
= Rs.95
Note 2: Weighted average variable expenses:
= (Rs.100 × 20%) + (Rs.75 × 30%) + (Rs.25 × 50%)

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= Rs.20 + 22.50 + 12.50
= Rs.55
The company will have to sell 1,250 units to break-even. Now I would compute
the number of units of each product to be sold:
Product X (1,250 × 20%): 250 units
Product Y (1,250 × 30%): 375 units
Product Z (1,250 × 50%): 625 units
Total: 250 units + 375 units + 625 units = 1,250 units
As the number of units of each individual product to be sold have been
computed, we can compute the break-even point in rupees as follows:
Rs.
Product X (250 units x Rs. 200) 50000
Product X (375 units x Rs. 100) 37,500
Product X (625 units x Rs. 50) 31,250
Break-Even Point (in Rs) 118,750
The break-even point of XYZ Ltd company is Rs. 118,750. It can be verified by
preparing a contribution margin income statement as follows:
Rs.
Sales (BEP in Rs.) 118,750
Less: Variable Expenses 68,750
_________
Contribution Margin 50000
Less: Fixed Expenses 50000
_________
Net Operating Income 0.00
Note 3: (250 units X Rs. 100) + (375 units X Rs. 75) + (625 units X Rs. 25) = Rs.
68,750

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Example 2:
A company engaged in plantation activities has 200 hectares of virgin land
which can be used for growing jointly or individually tea, coffee, and cardamom.
The yield per hectare of the different crops and their selling price per kg. are as
under:
Particular Yield (kgs.) Selling Price
(Rs. per kg.)
Tea 2,000 20
Coffee 500 40
Cardamom 100 250

The relevant cost data are given below:

(a) Variable cost per kg.:
Particular Tea Coffee Cardamom
(Rs.) (Rs.) (Rs.)
Labour charges 8 10 120
Packing materials 2 2 10
Other costs 4 1 20
Total cost 14 13 150
(b) Fixed cost per annum:

Cultivation and growing cost 10,00,000

Administrative cost 2,00,000
Land revenue 50,000
Repairs and maintenance 2,50,000
Other costs 3,00,000
Total cost 18,00,000

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 The policy of the company is to produce and sell all the three kinds of products and
the maximum and minimum are to be cultivated per product is as follows:
Particular Maximum Area Maximum Area
(hectares) (hectares)
Tea 160 120
Coffee 50 30
Cardamom 30 10
Calculate the priority of production, the most profitable product mix and the
maximum profit which can be achieved (ICSI, 2017).
Solution:
Contribution of different products:
Particular Tea (Rs.) Coffee Cardamom
(Rs.) (Rs.)
Selling price per kg 20 40 250
Less: Variable cost per kg.:
Labour charges 8 10 120
Packing materials 2 2 10
Other costs 4 1 20
Total variable cost 14 13 150
Contribution per kg 6 27 100
Contribution per hectare 12000 13500 10000
Rating on the basis of contribution per II I III
hectare

i. Therefore, to maximise profit, subject to other constraints, the order of priority

of production would be Coffee, Tea and Cardamom.

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ii. Optimum product mix:
Sr. Particular Area Yield Total
(hectares) (kg./hect.) Production
(kgs.)
a Maximum of coffee 50 500 25000
b Minimum of Cardamom 10 100 1000
c Balance of Tea 140 2000 2800000
Total 200 2600 306000

iii. Maximum profit:

Particular Production Rate Total
(kgs.) (Rs.) (Rs.)
Contribution from Coffee 25,000 27 6,75,000
Contribution from Cardamom 1,000 100 1,00,000
Contribution from Tea 2,80,000 6 16,80,000
Total 24,55,000
Less: Fixed Costs 18,00,000
Profit 6,55,000

Example 3:
A business produces three products A, B and C for which the standard variable
costs and budgeted selling
prices are as follows:
A B C
(Rs.) (Rs.) (Rs.)
Direct Material 3 6 8
Direct Wages 4 4 10
Variable overhead 3 5 7
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Selling price 18 25 48
In two successive periods, sales are as follows:
A B C
Units Units Units
Period I 10,000 10,000 10,000
Period II 20,000 13,000 5,000
The budgeted fixed overheads amounted to ` 1,35,000 for each period. In spite
of increased sales, the profit for the second period has fallen below that of the 1st
period.
Present figures to management to show why this fall in profit should, or should
not have occurred (ICSI, 2017).
Solution:

Comments: Sales have increased by 8,000 units but the sales value has increased
by Rs.15,000. Marginalcosts have increased by Rs.20,000 to meet cost of increased
units of production, resulting in the fall of profit by Rs.5,000.
Product C which yields the highest percentage of contribution to sales is the
most profitable line. Product A comes next and product B is the least profitable of
the three.

369
 The unsatisfactory position in Period II is because of unfavourable sales mix as
the production of most profitable line C has been cut down and the less profitable
products A and B have been pushed up.
2.2.8 Alternative Course of Action:
When alternative use of production facilities or alternative methods of manufacturing
a product are available, contribution analysis should be used to arrive at the final
choice. The alternative which will yield highest contribution, shall generally and
obviously be selected. Decision making is a process of selecting best course of action
from available alternatives. Various problems like selection of production method,
capacity utilisation, discontinuation of line of production, market expansion etc.,
need decision making. In such cases the best course should be selected on the basis
of contribution analysis.
Illustration 4:
You are given the following information in respect of products X and Y of Bee Cee
Co. Ltd.
Product X Product Y
Selling price Rs. 42 Rs. 33
Direct material Rs. 15 Rs. 15
Labour hours (50 paise per hour) 18 hours 9 hours
Variable overheads 50% of Direct wages
Show which product is more profitable during labour shortage.
Solution:
Computation of Marginal Contribution
Particulars Product X Product Y
Selling price per unit in Rs. 42 33
Direct Material per unit in Rs. 15 15
Labour Hours (A) 18 9
Labour cost per hour (B) in Rs. 0.50 0.50

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Labour cost per unit (A x B) in Rs. 9 4.50
Variable overhead (50% of Labour Cost) in Rs. 4.50 2.25
Total Variable Cost per unit in Rs. 28.50 21.75
Contribution per unit in Rs. 13.50 11.25
Since Labour is in shortage so it will be treated as Key factor and the product which
is generating higher contribution per hour will be preferred.
Contribution per labour hour:
Product X = Rs. 13.50/18
= Rs. 0.75
Product Y = Rs.11.25/9
= Rs.1.25
Since contribution per labour
abour hour for product Y is higher so product Y is more
profitable.
Illustration 5:

371
Solution:

372
Recommendations:
a. Product ‘B’ is recommended when material is in short supply
b. Product ‘A’ is recommended when labour is scarce factor
c. Product ‘B’ is recommended when production capacity is the limiting factor
Check your Progress:
Section I
• Choose the correct alternative from the given alternatives:
1. The method of costing that leads itself to break-even analysis is ---
a. Standard Costing b. Marginal Costing
c. Absorption Costing d. Operating Costing
2. Given the sales volume, which of the following circumstances would lead
to an increase in contribution margin?
a. When variable cost per unit remains the same
b. When variable cost per unit decreases
c. When fixed cost decreases
d. When variable cost per unit increases
3. If margin of safety is --- the firm cannot withstand, if there is a large fall in
sales
a. Low b. High c. Does not exist d. Equal
4. Contribution would occur early to a firm if fixed costs are----
a. Low b. High c. Does not exist d. Not relevant
5. Profit Volume (P/V) ratio = ------/ Sales X 100
a. Contribution b. Fixed Cost c. Variable Cost d. Profit
Section II
• Fill in the blanks:
a. --- indicates the relationship of contribution to sales
b. ---- is the sales volume at which sales revenue equals total cost

373
 c. ---- means difference between total sales volume and sales at break-even
point
d. With the help of ----- analysis, it is possible to decide which product is most
profitable and lease profitable.
e. ------ Costing is a full cost or total input concept.
Section III
• State the following statements are ‘True’ or ‘False’:
a. Marginal costing is not a method of costing.
b. Increase in sales volume does not affect on profit volume ratio
c. CVP analysis helps the firm in understanding the impact of change in cost
volume and price on the behavior of profit
d. Contribution is also known as Gross Margin
e. P/V ratio can be used to calculate BEP and ascertain required sales to
achieve a desired level of profit.
ILLUSTRATIONS:
• Short Questions:
a. BE point Rs.40,000, Fixed cost Rs. 15,000. What is the P/V ratio?
b. Fixed cost Rs. 12,000, Actual sales Rs. 48,000. Margin of safety Rs. 8,000.
What is the P/V ratio?
c. Margin of safety 60%, Fixed cost Rs. 2,10,000, Variable cost ratio to sales
70%. Determine the amount of sales.
d. Find out BEP when P/V ratio 40%, Margin of safety 30%, Profit Rs.
12,000.
e. What is the amount of margin of safety when profit is Rs. 50,000,
Contribution Rs. 70,000 and sales Rs. 7,00,000. Also determine the break
even point.
f. Variable cost is 80% of sales and margin of safety is 40%. What is the
amount of fixed cost if sales are Rs. 2,00,000?

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Solution:
Fixed Cost
a. BEP (Value) = ----------------
P/V ratio
Fixed Cost 15000
So, P/V ratio = ----------------- 100 = ----------- X 100 = 37.50%
BEP 40,000
b. BEP = Actual sales - Margin of safety
= 48,000 – 8,000 = Rs. 40,000
Fixed Cost 12,000
P/V ratio = ------------------- 100 = ----------- X 100 = 30%
BEP 40,000
c. P/V ratio = 100 – 70% = 30%
Fixed Cost 2,10,000
BEP (Value) = ------------------- = ---------------- = Rs. 7,00,000
P/V ratio 30%
BEP in Rs. 7,00,000 7,00,000
Sales = ------------------- = ---------------- = ----------------- = Rs. 17,50,000
100 – M/S % 100 – 60% 40%
d. Profit = Actual sales X Margin of safety% X P/V ratio
Profit 12,000
Actual sales = -------------------------- = ----------------- = Rs. 1,00,000
M/S ratio X P/V ratio 40% X 30%
BEP = Actual sales - Margin of safety
= 1,00,000 – 30% = Rs. 70,000
Contribution 70,000
e. P/V ratio = ------------------ X 100 = ------------- X 100 = 10%
Sales 7,00,000

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 Profit 50,000
Margin of safety = ----------- = ----------- = Rs. 5,00,000
P/V ratio 10%
Fixed Cost = Contribution -- Profit
= Rs. 70,000 – 50,000 = Rs. 20,000
Fixed Cost 20,000
BEP (Value) = ----------------- = -------------- = Rs. 2,00,000
P/V ratio 10%
f. P/V ratio = 100 – 80% = 20%
BEP sales = Rs. 2,00,000 – 40% = Rs. 1,20,000
Fixed Cost
BEP (Value) = -------------------
P/V ratio
Fixed Cost = BEP X P/V ratio
= Rs. 1,20,000 X 20% = Rs. 24,000
• Practical problem:
1. Given the following information;
Units of out put 5,00,000
Fixed Cost Rs. 7,50,000
Variable cost per unit Rs. 2
Selling price per unit Rs. 5
You are required to determine:
i. The break even point
j. The sales needed for a profit of Rs. 6,00,000 and
k. The profit if 4,00,000 units are sold at Rs.6 per unit
Solution:
Contribution = S – V = 5 – 2 = Rs. 3

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 Contribution 3
P/V ratio = ------------------ X 100 = ---- X 100 = 60%
Sales 5
Fixed Cost 7,50,000
i. BEP (Value) = ------------------- = ---------------- = Rs. 12,50,000
P/V ratio 60%
Fixed Cost + Profit 7,50,000 + 6,00,000
ii. Sales = --------------------------- = ---------------------------- = Rs. 22,50,000
P/V ratio 60%
iii. Sales (40,000 X 6) = Rs. 24,00,000
Contribution (4,00,000 X 4*) = Rs. 16,00,000
Less: Fixed Cost = Rs. (7,50,000)
Profit Rs. 8,50,000
(*New contribution per unit = Rs. 6 – 2 = Rs. 4 )
2. A company manufactures a single product having a marginal cost of Rs. 0.75 a
unit. Fixed costs are Rs. 12,000. The market is such that up to 40,000 units can
be sold at Rs. 1.50 a unit, but any additional sales must be made at Rs. 1.00 a
unit. There is a planned profit of Rs. 20,000. How many units must be made and
sold?
Solution:
Planned profit = Rs. 20,000
Add: Fixed Cost = Rs. 12,000
Contribution Required = Rs. 32,000
Contribution per unit = Rs. 1.50 – 0.75 = Rs. 0.75
Contribution from 40,000 units = 40,000 X 0.75 = Rs. 30,000
New Contribution = Rs. 1.00 – 0.75 = 0.25 per unit
Additional contribution of Rs. 2,000 @ Rs. 0.25 per unit will require 8,000 units
Total sales required = 40,000 + 8,000 = 48,000 units.

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3. Consider on the basis of the following data as to the reasonable of accepting a
foreign order:
1. Variable cost per unit Rs. 24
2. Selling price per unit Rs. 40
3. Break even volume : 60% production capacity
4. Total production capacity : 50,000 units
5. Margin of safety : 1,00,000 units before export order
6. Export order : 10,000 units at Rs. 30 per unit
Note: Units to be exported require some modifications resulting in an increase of Rs.
1 in variable costs per unit.
Solution:
Statement showing position with export order
Particulars Present position For export order Total
(Capacity 80% ) (Capacity 20%) Capacity
(100%)
Sales (Units) 40,000 10,000 50,000
Sales Price (Rs) 40,000 30,000 --
Rs. Rs. Rs.
Sales Value 16,00,000 3,00,000 19,00,000
Less: Marginal cost 9,60,000 2,50,000 12,10,000
6,40,000 50,000 6,90,000
Less: Fixed costs 4,80,000 4,80,000
Profit 1,60,000 50,000 2,10,000
Export order should be accepted so far as cost considerations are concerned.
Acceptance of the said order will result in an increase of Rs.50,000 in the
contribution and the net profit.

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Workings:
1. Production and sales at selected level of Activity : Margin of safety is 10,000
units Break even point is 60% production capacity (60% of 50,000 units =
30,000 units
Sales at Selected activity = BEP Sales + Margin of safety
= 30,000 + 10000 = 40,000 units
2. Fixed costs:
BEP (in units) = Fixed cost / Contribution per unit
= 30,000 units X Rs. 16 per unit = Rs. 4,80,000
3. Total variable costs at current production and for Export order:
At current position: 40,000 units X Rs. 24 = Rs. 9,60,000
For Export order: 10,000 units X Rs.24 + 1) = Rs. 2,50,000
4. A manufacturer is planning to drop one item from his product line and replace it
with another. The present cost and out put data represented below:
Item Price Rs. Variable cost Per item Percent of sales volume
A 20 10 40%
B 25 15 35%
C 30 18 25%
Total fixed cost per year – Rs. 1,50,000
Total sales for the previous year –Rs. 5,00,000
The item proposed to be dropped is A.
Do you agree with the proposal of the management? If you don’t agree, give an
alternative suggestion to the management.

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Solution:
Present Profitability (Rs)
Particulars A B C Total
Selling price 20 25 30
Less: Variable cost 10 15 18
Contribution per unit 10 10 12
P/V Ratio 10/20 10/25 X 12/30 X
C/S X 100 X100 100 100
50% 40% 40%
% of Sales Volume 40% 100%
Sales
40% of 5,00,000 2,00,000 1,75,000 1,25,000 5,00,000
Contribution= Sales X P/V
ratio
200000 X 50% 1,00,000 70,000 50,000 2,20,000
Less: Fixed Cost 1,50,000
Profit 70,000
I will not agree with the proposal to drop A. It gives the highest contribution of
Rs.1,00,000. Its P/V ratio also is the highest. Hence A should not be dropped. It is
also suggested that C should be dropped as its P/V ratio is 40% and its total
contribution is Rs. 50,000 only which is the lowest.

2.3. Summary:
On the basis of separating costs into fixed and variable components, there are
absorption and marginal cost approaches. These two alternative cost models have
been offered to determine product costs and operating profit. It is, however, difficult
to say as to which one is superior to the other because ultimately all costs have to be
recouped out of revenues. Despite the developments over the years, marginal costing
has not so far been accepted the world over by accounting profession and the

380
taxation authorities for external reporting. They continue to insist on full costs for
inventory values and cost of goods sold. Marginal costing has been used only for
internal reporting.
Marginal costing is “a principle whereby marginal cost of cost units is
ascertained. Only variable costs are charged to cost units, the fixed costs attributable
to a relevant period being written off in full against the contribution. Marginal
Costing is not a method of costing such as job costing, process costing and operating
costing etc. but it is a special technique concerned with effect of fixed overhead on
the profitability of a business. It brings out the relationship between the cost, volume
of output and profit. Other terms in use are direct costing, contributory costing,
variable costing and comparative costing. CVP model is extremely useful in planning
the profits. Over a short time horizon, it offers valuable insights into the effect upon
profits when any of the basic parameters are changed. It is helpful in such short term
decisions as pricing adding or deleting product lines. In the case of multi-product
situations too, the basic formulae for B-E point remain unchanged. CVP is an
elementary analysis and at best a static concept based on some rigid assumptions. It
is not a cut and dried decision tool, and has to be used with caution.

2.4 Terms to Remember:

• Absorption Costing: This is a total cost technique under which total cost is
charged as production cost.
• Marginal costing: It is known as variable costing or direct costing. Under this
technique only variable costs are charged as product costs and included in
inventory valuation.
• Product costs: Product costs are those costs which become a part of production
cost.
• P/V Ratio: It is one of the important ratios to watch in business. It is an
indicator of the rate at which profit is being earned.
• Break-even-point: This is the volume of output or sales at which total cost is
exactly equal to sales. It is point of no profit and no loss.
• Margin of Safety: It is the difference between actual sales and sales at break-
even-point.
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2.5 Answer to check your progress:
Section I 1— b. 2— b. 3— a. 4— a. 5-- a.
Section II a. P/V ratio b. Break-even point c. Margin of safety d. CVP
e. Absorption
Section III – All statements are True.

2.6 Exercise:
A. Write Short Notes on the following:
1. Marginal costing—meaning
2. Break- even Analysis
3. Make or Buy decisions
4. Margin of Safety
5. Profit Volume ratio
B. Essay type questions:
1. Distinguish between Absorption costing and Marginal costing
2. Explain clearly what do you understand by “Contribution” in a cost
accounting sense? How is it related to profit?
3. “Cost Volume Profit relationship provides management with a simplified
framework for organizing, thing on a number of problems”. Elaborate.
4. What is meant by term CVP relationship? Why is this relationship
important in business management?
C. Practical Problems
5. The following figures relating to the performance of the company of the years I
and II are available. You are asked to ascertain:
a. P/V ratio
b. Amount of fixed cost
c. Break even point

382
 d. The budgeted profit for the IIIrd year if the budgeted sales for that year are
Rs.1 crore.
Year Total Sales Total cost
(Rs. in ‘000’) (Rs. in ‘000’)
First 7,000 5,800
Second 9,000 6,600

Solution :
Year Total Sales Total cost Profit
(Rs. in ‘000’) (Rs. in ‘000’) (Rs. in ‘000’)

First 7,000 5,800 1200

Second 9,000 6,600 2400
Change in Profit 2,000 800 1200
Change in profit 1200
a. P/V Ratio = ----------------------- X 100 = -------------- X 100 = 60%
Change in sales 2000
b. Fixed Cost = (Sales X P/V ratio) -- Profit
Year I = (70,000 X 60%) – 12,00,000 = Rs. 30,00,000
Fixed Cost 30,00,000
c. BEP (Value) = ------------------- = ---------------- = Rs. 50,00,000
P/V ratio 60%
d. Budgeted sales = 100,00,000
Contribution = 100,00,000 X 60% = 60,00,000
Profit = 60,00,000 – 30,00,000 = Rs. 30,00,000
6. A business expects to operate with fixed costs of Rs. 20,000 and variable costs
of 60% of sales. You are required to ascertain;
a. The present break even point
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b. the new break even point when (i) the fixed costs are increased by Rs.5000 (ii)
the variable costs are increased by 15% sales (iii) sales price is decreased by
20% (iv) Fixed costs are decreased by Rs.5000 (v) variable costs are decreased
by 10% of sales (vi) sale price is increased by 20%.
Solution:
a. The present break-even-point = Rs. 20,000 / 40% = Rs. 50,000
b. The new break-even-point is in case:
i. Rs. 25,000 / 40% =Rs. 62,500
ii. Rs. 20,000 / 25% = Rs. 62,500
iii. The decrease in sale price will not effect the amount of variable costs.
Hence, the new ratio of variable costs to sales will be 60/80 X 100 or 75%.
Therefore, the new BEP = Rs. 20,0000/25% = Rs. 80,000
iv. Rs. 15,000/40% = Rs. 37,500
v. Rs. 20,000/ 40% = Rs. 40,500
vi. The increawe3 in sale price will not affect the amount of variable costs.
Hence, the new ratio of variable costs to sales will be 60/120 X 100 or 50%
The new BEP = Rs. 20,000/50% = Rs. 40,000.
7. Ravi products Ltd. Products T.V sets and sells them at Rs. 2,500 each. Variable
cost per unit is Rs.1,250. Fixed costs amount to Rs. 125 lakhs.
Company operates at 75% production capacity and produces 12,000. TV sets
accordingly. It considers the following two proposals.
a. 10% reduction in price to yield an increase in sales volume from 12,000 units to
14000 units.
b. 10% increase in price with decrease in volume of sales from 12,000 units to
11,000 units.
You are required to prepare a statement comparing goods revenue contribution
and the P/V ratio of the two alternatives with present results. Which proposal is more
profitable?

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Solution:
Comparative Profit/ Loss Statement
Particulars Current position Proposal A Proposal B
Sales unit 12,000 14,000 11,000
Sales price 2,500 2,250 2,750
Sales revenue 3,00,00,000 3,15,00,000 3,02,50,000
Variable cost 1,50,00,000 1,75,00,000 1,37,50,000
Contribution 1,50,00,000 1,40,00,000 1,65,00,000
Fixed cost 1,25,00,000 1,25,00,000 1,25,00,000
Net profit 25,00,000 15,00,000 40,00,000
P/V ratio 50% 44.44% 54.55%
Proposal B is more profitable as the contribution and P/V ratio is the maximum.
However, before taking a final decision other cost and non-cost considerations like
labour, possibility of labour unrest on account of retrenchment of labour staff,
utilization of production capacity should be given due consideration.
8. A Component (X), the purchase price of which is Rs.10 per unit, is proposed to
be manufactured at a marginal cost of Rs. 5 per unit. The processing time for the
component on a machine is 5 hours. This machine is at present working at full
capacity and is manufacturing another product (P), the selling price, marginal
cost and processing time per unit of which are Rs.100, Rs. 60 and 20 hours
respectively. The problem is whether to make or buy. Advise.
Solution:
In the above case key factor is machine hours. Hence let us find out the
contribution per machine hour in respect of Component (X) and Product (P).

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 Particulars Component (X) Product (P)
Rs. Rs.
Price 10 100
Less : Marginal Cost 5 60
Contribution per unit 5 40
Processing time --- hours 3 20
 5/3 = Rs.1.67 40/20= Rs.2
Profitability = Contribution !"#$ %

Advise: It is advised to buy Component (X) from the market.

Reason: The Processing Time of Component (X) may be diverted to
manufacture Product (P) as it contribution is Rs.2 per machine hour which is higher
than that of Component (X).
Practical:
a) Exercise for Simulation of computing break-even point and margin of safety and
interpret the situations.
b) Draw break-even charts on graph paper considering hypothetical data and
compare output of graphical method with algebraic method.
Practical:
It is simulated that the Shahu Cashew nut Processing Unit has Cashew nut
process product. Herewith collected relevant cost data from Shahu Cashew nut
Processing Unit. The Shahu Cashuew nut processing unit purchased 10 tonn raw
cashew and it is processed during the year. Its output as processed cashew nut 2600
kg out of which 100 kg broken cashew nut. It is noted that, after crushed 10 tonn raw
cashew, its output as processed cashew nut 2600 kg, out of which 2500 kg processed
cashew nut sell @ Rs. 900 and 100 kg broken cashew nut sell @ Rs. 750. Therefore,
it is also noted that there is incurred 16,95,412/- variable cost and 2,58,197/- fixed
cost for the crushed 10 tonn cashew per annum. Hence, herewith we have to exercise
for simulation of computing break-even point and margin of safety and interpret the
situations are given below,

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 (Rs. in ‘000’)
Particular Rs.
Sales Revenue (Production 2600 kg @ Rs. 825*) 21.45
Variable Cost (Rs. in Lakh)
Raw Cashew Nut (Av.10 Tonn @ Rs. 150/Kg ) 15.00
Packaging materials 0.53
Casual staff salaries 0.28
Utilities (Electricity, Fuel) 0.72
Repair & maintenance 0.22
Miscellaneous expenses 0.04
Interest on working capital @ 15% 0.15
Total Variable Cost 16.95
Fixed Cost (Rs. in Lakh)
salaries 1.56
Depreciation p.a. 0.25
Interest on term loan 0.23
Insurance 0.54
Total Fixed Cost 2.58
(Sources: Compiled Field Survey Data)
Solution:
• It is simulated that the Shahu Cashew nut Processing Unit has Cashew nut
process product. Herewith, collected relevant cost data from Shahu Cashew nut
Processing Unit and we have to exercise for simulation of computing break-even
point and margin of safety and interpret the situations are given below,

387
 (Rs. in ‘000’)
Particular Rs.

Sales Revenue (Production 2600 kg @ Rs. 825*) 21.45

Variable Cost (Rs. in Lakh)

Raw Cashew Nut (Av.10 Tonn @ Rs. 150/Kg) 15.00
Packaging materials 0.53
Casual staff salaries 0.28
Utilities (Electricity, Fuel) 0.72
Repair & maintenance 0.22
Miscellaneous expenses 0.04
Interest on working capital @ 15% 0.15
Total Variable Cost 16.95

Contribution 4.50

Fixed Cost (Rs. in Lakh)

salaries 1.56
Depreciation p.a. 0.25
Interest on term loan 0.23
Insurance 0.54
Total Fixed Cost 2.58

BEP in Sale (in Rs.) 12.32

Profit 1.91
P/V Ratio 20.96
Margin of Safety in Rs. 9.13
(Sources: Compiled field survey data, Note *Sales Price of 1kg processed cashew
nut: Rs.900 and Sales Price of 1kg broken cashew nut: Rs 750 and its average price
consider Rs. 825.)

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Form the collected given cost data from the Shahu Cashew nut Processing Unit.
Herewith calculated BEP, P/V Ratio, Margin of Safety and Profit as below,
1. Break Even Point (in Rs.):
Fixed Cost
Break Even Point 2in Rs. 6 =
P / V Ratio
2.58 Lakh
Break Even Point 2in Rs. 6 =
20.96%
= 12.32 Lakh
2. Profit:
Profit = Contribution – Fixed Cost
Profit = 4.50 Lakh - 2.58 Lakh
Profit = 1.91 Lakh
3. P/V Ratio:
Contribution
P/ V Ratio = × 100
Sale
4.50 Lakh
P/ V Ratio = × 100
21.45 Lakh
P/ V Ratio = 20.96%
4. Margin of Safety (in Rs.):
Margin of Safety (in Rs.) = Total Sale − Break Even Sale
Or
Proit
Margin of Safety 2in Rs. 6 =
P / V Ratio
1.91 Lakh
Margin of Safety 2in Rs. 6 =
20.96%
Margin of Safety 2in Rs. 6 = 9.13 Lakh
The collected above cost data and calculation of BEP, Profit P/V Ratio, Margin
of Safety and Profit, which compiled by Shahu Cashew nut Processing Unit which
helps to calculate Break-Even-Point (BEP) and Margin of Safety (MoS). The BEP
represents the cut- off point for profit and loss of the Shahu Cashew nut Processing
389
Unit. The BEP situation helps to identify level of sales and its impact on profit such
as if sale less than BEP firm then incurred the losses i.e. contribution less than fixed
cost, followed by equal to BEP, where is found no profit -no loss situation i.e.
contribution equal to fixed cost and sale greater than BEP firm then carn profit i.e.
contribution greater that fixed cost. Therefore, it is noted than Shahu Cashew nut
Processing Unit earn profit, because contribution is greater that fixed cost.
Moreover, Margin of Safety represent the difference between the sale at BEP and the
total Sale. It can be expressed as a percentage of total sales, or in value or in term of
quantity. It is stated that the Margin of Safety is large and its slight fall does not
affect on the business and it MOS if small and its slight fall, it may adversely affect
on the business. Hence, it is stated that MOS of Shahu Cashew nut Processing Unit
has large and its not affected on its business operation.
• Break-Even Charts draw on graph paper considering above hypothetical data
and compare output of graphical method with algebraic method.

(Sources: Compiled field survey data, Note *Sales Price of 1kg processed cashew
nut: Rs.900 and Sales Price of 1kg broken cashew nut: Rs 750 and its average price
consider Rs. 825.)
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 The above Break-Even Chart shows BEP with correlation of the sales and cost
in value and its production output in kg. The Production in kg plotted on the X axis
and sales and Cost plotted on the Y axis. The compiled cost data and calculation of
BEP, P/V Ratio, Margin of Safety and Profit, which compiled by Shahu Cashew nut
Processing which Unit, helps to calculate Break-Even-Point (BEP) analysis and find
out Margin of Safety (MoS). The BEP represents the cut- off point for profit and loss
of the Shahu Cashew nut Processing Unit. The BEP situation helps to identify level
of sales and its impact on profit. Therefore, it is noted that Shahu Cashew nut
Processing Unit earn profit, because contribution is greater than fixed cost.
Moreover, Margin of Safety represent the difference between the sale at BEP and the
total sale. It can be expressed as a percentage of total sales, or in value or in term of
quantity. Hence, it is stated that MOS of Shahu Cashew nut Processing Unit has
large and its not affected on its business operation.
2.7 Reference to further study:
1. B.M. Lalla Nigam G. l. Sharma(2002) ‘Cost Analysis and Conrol—A
Managaemen Approach’, Himalaya Publishing House,Mumbai
2. M.N. Arora (2009), ‘Management Accounting’ Himalaya Publishing
House, Mumbai
3. P.VRatnam and D. Hanumanth Raju, (1996), ‘Cost Accounting Theory,
problems and Solutions’, Pragati Publications, Jaipur
4. ICSI. (2017, July 31). https://www.icsi.edu. Retrieved January 8, 2022,
from www.icsi.edu: https://www.icsi.edu pp348-349.
5. ICAI. (2021). Marginal Costing. Retrieved January 08, 2022, from
https://www.icai.org/post.
6. Suveera Gill. (2015). Cost and Management Accounting: Fundamentals
and its Application (1st ed.). New Delhi: Vikas Publishing House Pvt. Ltd.
ISBN: 978-93259-9032-6 pp 352-353. Retrieved from
www.vikaspublishing.com.
7. C. R. T. Varama ed. al. (2002). Cost Management. ICAI. NOIDA: Unique
Press (P) Ltd. pp 3.35. Retrieved from www.icai.org.
8. Rashid Javed. (2021, October 24). Cost-Volume-Profit-Analysis. Retrieved
January 08, 2022, from https://www.accountingformanagement.org.

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 Unit-3
Budgetary Control

Index
3.0 Objectives
3.1 Introduction
3.2 Presentation of Subject Matter
3.2.1 Meaning of Budget
3.2.2 Meaning of Budgetary Control
3.2.3 Objectives
3.2.4 Advantages of Budgetary Control
3.2.5 Limitations
3.2.6 Types of Budgets
3.2.7 Preparation of Budgets
3.3 Summary
3.4 Terms to Remember
3.5 Answer to check your progress
3.6 Exercise
3.7 Reference to further study

3.0 Objectives
After studying this unit, you should be able to:
1. To understand what is mean by budgetary control
2. To explain the importance of budgeting
3. To prepare various budgets
4. To find out relationship between budget and control.

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3.1 Introduction
We have studied Marginal Costing and its importance to the management in
decision making process. Management always tries to maximise profit by adopting
various tools and techniques in its business operations. Budgetary control is one of
them. The budgets are prepared with the help of data available by way of cost and
financial record, using marginal costing and other tools. Each activity is budgeted
with keeping in mind the expected result and the performance is compared with.
Thus, it helps management to come to a concrete conclusion, that leads to judge
future performance more accurately, by controlling and eliminating unnecessary
activities. There are two types of control-budgetary and financial. Present chapter
deals with budgetary control only.

3.2 Presentation of Subject Matter

3.2.1 Meaning of Budget
Budgeting is a systematic approach to attain the effective management
performance. It is an integral part of the management. The budget regulates flow of
fund. It involves preparation of a plan relating to the future activities. The term
budget can be defined in a more specific way as under.
“A budget is comprehensive and co-ordinated plan, expressed in financial
terms, for the operations and resources of an enterprise for some specific period in
the future.”
Thus, the term budget refers to-
a) integrated plan that reduces uncertainty,
b) expression of activities in financial terms,
c) planning of an organisation’s operations and resources; and
d) future plan of action of an organisation for a specific period of time.
3.2.2 Meaning of Budgetary Control
Budgetary control is the process of setting standards and then comparing it with
the actual performance for calculating variances, if any. This enables the
management to find out discrepancies and take remedial measures at a proper time.
The budgetary control is a continuous process which helps in planning and co-

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ordination. It provides a method of control too. A budget is a means and budgetary
control is the end-result.
Thus, the term budgetary control refers to exercise control for execution of
budget. It is used as a system of planning and controlling the production and sale of
goods and services. Thereby, the performance of an organisation can be evaluated to
see whether the goals of an organisation have been achieved or not and to take
corrective actions, if necessary. The institute of Cost and Management Accountants
(ICMA), London has defined the term budgetary control as-
“The establishment of budgets relating to responsibilities of executives to
requirements of a policy and the continuous comparison of actual with budgeted
results, either to secure by individual action the objective of the policy or to provide
a basis for its revision.”
Thus, the term budgetary control refers to-
a) Comparison of actual results with budgets
b) Find out variations, if any, in the budgeted and actual results.
c) Fix the responsibility of a key persons who can exercise control action or
revises the original budget.
In short, the budgetary control is a management control system in which actual
income and expenses are compared with the planned income and expenses, the actual
output is compared with planned output and actual profit with planned profit in order
to see whether the activities are being carried out as per the plans, whether there are
any deviations and how those deviations can be eliminated.
3.2.3 Objectives
The fundamental objective of budgetary control is to maximise the use of given
resources in order to achieve the goal of an organisation. The aim of the budgetary
control is to enable management to carry out basic functions of planning, co-
ordinating and controlling all the functions of an organisation smoothly and
efficiently. Thus, the objectives of budgetary control can be expressed in terms of
planning, co-ordination and control.
(a) Planning – A budget is detailed plan of action prepared well in advance. It
provides directions to employees that reduces ambiguity and uncertainty. It

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 makes way of action clear that enables all concerned (the employees and
management) in performing efficiently their work relating to the production,
sales, advertising, inventory, finance, etc.
(b) Co-ordination – Co-ordination implies establishment of proper balance
between man, material and machinery. More specifically, co-ordination refers to
keep the activities of all departments in harmony with each other. e.g., Purchase
department must purchase raw material of a quality requested by production
department in required quality and quantity at required time so as to produce
desired product of a desired quality in desired quantity. The sales department
must create demand for the produced goods and services and sell them in time.
(c) Communication – Budgeting is a vehicle to communicate goals of an
organisation to its employees. A clear and written communication of goals
through budget enables employees to understand, support and accomplish the
goals of an organisation.
(d) Control – It is necessary to observe control over activities in order to achieve
the set goals through budgets. The control ensures planned efforts directed
towards common goal of an organisation. The budget enables comparison of
actual performance with the budgeted one. This discloses whether employees
are performing to the extent expected at or not. It also evaluates variation in
performance, the causes thereof and the responsibility. Once causes and
responsibility of variations between actual and budgeted performance have been
identified, a corrective action can be initiated to avoid recurrence of variations in
future.
(e) Preparedness – The budgeting ensures availability of required resources in
required quality on proper time. It readily brings to the notice of concerned, well
in advance, what are the goals and what actions are required to achieve these
goals. Thus, budget makes organisation ready in all respects to perform as per
pre-determined line of action.
(f) Elimination of wastes and increase in profitability of an organisation
3.2.4 Advantages of Budgetary Control
There are several advantages of budgetary control.

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1. Planned and Forced Efforts -The budgetary control compels and motivate
management to think well in advance about future and to set detailed plan of
action for each department, activity and each manager. This ensures planned
efforts towards every activity that leads towards better performance.
2. It Promotes Co-ordination and Communication- The budgets of different
departments have a bearing on one another. Therefore, working of all
departments and sections is properly coordinated. Proper co-ordination and
communication ensure smooth functioning of each department, process and
activity that lead towards achievement of organizational goals.
3. Reduction in Uncertainty-Budgetary control fixes responsibility centers in the
process of achievement of budgeted targets. This makes respective centers and
concerned employees fully aware of their course of action that reduces
uncertainty to a great extent.
4. Better Performance Appraisal- It provides basis for performance appraisal
through analysis of variations in performance. As the budgets are pre-
determined targetsthatare to be compared with actual performance, the detailed
analysis can be made regarding variations in the performance. The variations
can be further classified into controllable and uncontrollable that enables
remedial action to minimise those variations in future. This also motivates
employees to participate in determination of goals and ensures their full co-
operation in the performance.
5. Ensures Full Utilisation of Resources- The budgetary control ensures prompt
allocation and full utilisation of available resources.
6. Effective Management Control- Budget co-ordinates and correlates all
business activities that enables effective management control over all business
activities.
7. Cost Consciousness- Budgeting develops cost consciousness among all
employees that stimulates them to use all available resources effectively.
8. Increase in Productivity- Budgeting makes aware employees of their duties
and responsibilities and compels them to give best performance. This
automatically increases productivity of each employee and that of organisation
as a whole.

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9. Maximization of Profits: The budgetary control aims at the maximization of
profits of the enterprise. A proper planning and co-ordination of different
functions is undertaken in order to achieve this goal. A proper control over
various capital and revenue expenditures is observed. The resources are put to
the best possible use.
10. Corrective Action-Budgeting provides a systematic approach to the solution of
the problems of the organisation.
11. Saving in Time- Budgeting saves management time by planning each and every
activity.
12. Tool of Controlling- It is effective tool of controlling all activities of an
organisation.
13. Basis of Standard- Budgets sets basis for standard costing.
14. Introduction of Incentive Schemes: Budgetary control system enables the
introduction of incentive schemes of remuneration for better performance. The
comparison of budgeted and actual performance will enable the use of such
schemes.
3.2.5 Limitations
Though the budgetary control is beneficial to an organisation, it has some
limitations which are explained below.
1. Based on Estimates – The budgets are prepared on the basis of forecast and
estimates which cannot be proved cent percent correct. Therefore, accuracy of
budgets depends upon the accuracy of estimates.
2. Lack of Flexibility – The budget is prepared on the basis of prediction related
to future environment. However, actual environment may differ from predicted
one. This creates conflicts between budgeted action and that planned. Thus, the
budgets must have some flexibility.
3. Pressure on Employees –Budgets can be seen as pressure on employees that
may disturb relationship between management and employees. This may lead to
poor performance on the part of employees.
4. Departmental Conflicts – When the budgeted targets are not achieved, the
departments blame each other that create departmental conflicts.

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5. There may arise disputes over resource allocation.
6. There are possibilities of under or over estimation that leads to misleading
analysis of performance.
3.2.6 Types of Budgets
All organisations make plans, some in systematic and formal way whereas,
others in informal way. Each one adopts different practices. The large organisations
prepare budget for all important operations. Whereas, small and medium
organisations prepare budgets for few of their operations. Some of the organisations
prepare budget for short period, whereas others prepare it for long period. From this
view point the budgets can be classified as under.
(A) Functional Budgets
1. Sales Budget
2. Production Budget
3. Purchase Budget
4. Cash Budget
5. Capital Budget
6. Personnel Budget
7. Research budget
8. Master Budget
(B) Periodical Budget
1. Short-term Budget
2. Long-term Budget
3. Current Budget
(C) Budgets according to flexibility
1. Fixed Budget
2. Flexible Budget

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3.2.7 Preparation of Budgets
(Note that the budgets which are included in the syllabus are discussed hereafter)
1. Sales Budget
The sales budget is the basic budget. All other budgets depend upon the sales
budget. Therefore, it can be said that the sales budget is backbone or the nerve centre
of the organization. It is the base of all other budgets. It shows which products are to
be sold, how much quantity of the product is to be sold, when it will be sold, what
will be the selling price per unit.
Forecasting of sales can be made either in quantity or the value. In case of an
enterprise producing heavy goods, the budget can be mentioned in quantity.
Whereas, in case of an enterprise producing FMCG products, the budget may be
prepared in terms of value. The Sales Manager is to prepare and execute this budget.
He may take assistance of salesmen and market research personnel for the
preparation of sales budget. The following factors are to be considered while
preparing sales budget.
a) Potential Market and Demand for the Product–It is quite necessary to
understand first the potential market for our product. The market survey can
give concrete idea about demand for the product, seasonal variation in the
demand, buying behaviour of the customers, competitive product range, market
share of each product, possible change in market, its impact (short term and long
term) on demand, purchase power of customers etc. This enables the sales
manager to prepare sales budget more accurately.
b) Plant Capacity – The most limiting factor is plant capacity which determines
maximum possible volume of production and the sale. The capacity utilization is
to be considered for economic way of production.
c) Proposed expansion or discontinuance of product.
d) Past experiences and the trends in production, demand and supply.
e) Financial capacity of an organisation
f) The terms of credit by suppliers and to the customers.
g) Promotion activities and cost of sales and distribution.

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h) Government policies, rules, regulations and restrictions.
i) Policy of an organisation, product design, new product launching etc.
j) After sales services
The following example will illustrate the steps in preparation of sales budget.
Illustration1
ABC Co. Ltd. is to prepare sales budget for the month of April, May and June
2021. It sells its products in Maharashtra, Karnataka and Gujrat. Product-I is sold
10%, 20% and 70% respectively in Maharashtra, Karnataka and Gujrat and Product-
II is sold 50%, 30% and 20%. The selling price of Product-I is ` 100 and that of
Product-II is ` 140 per unit.
The terms of sale are 50% on cash and 50% on credit. The credit period is
allowed to customers is one month.
1. Finished goods are valued at cost.
2. The monthly forecast of sales in units are –
Product March April May June July
I 10,000 9,000 10,500 12,000 13,500
II 14,500 22,500 24,000 25,500 27,000
3. The same raw material is used for the production of both the products. The cost
of raw material used is ` 10 per unit.
4. Two units of raw material are required to produce one unit of Product-I and four
units are required for one unit of Product-II.
5. Wages are paid ` 6 per hour.
6. Production period required to produce one unit of each Product is one hour.
7. It is the policy of company to maintain stock of finished goods at 80% of next
month’s sale and that of raw material at 150% of current month’s production.
8. The suppliers allowed credit period of one month.
9. Salary and wages are paid during same month.
10. Sales commission is paid @ 5% on total sales during the same month.

400
11. A machinery costing ` 1,50,000 needs to purchase during the month of May on
cash.
12. A cash balance of ` 1,20,000 is required to maintain at the end of each month.
The shortfall, if any, in the cash balance will be made available by taking cash
credit facility from the State Bank of India @ 12% interest per annum. The loan
can be availed or repaid at the end of the month along with interest. Surplus is
also to be invested in SBI in Time Deposit.
The other details are as under
Salaries ` 15,000, rent ` 6,000 and Miscellaneous expenses at 1% of sales are
paid during the month, Depreciation per month is ` 20,000/-.
The balance sheet of the company as on 31-3-2021.
ABC Co. Ltd.
Balance Sheet as on 31-3-2021
Liabilities ` Assets `
1. Creditors 12,30,000 1. Plant and Machinery 24,95,400
2. Reserve and Surplus 10,30,000 2. Stocks
3. Share Capital 43,85,600 Raw Material: 15,00,000
(1,50,000 units @ `10)
Finished Goods:
Product-I (7,200 units @ 1,87,200
` 26) 8,28,000
Product-II (1,800 units @
` 46)
3. Debtors 15,15,000
4. Cash in hand 1,20,000
66,45,600 66,45,600

401
 We can prepare sales budget, production budget and cash budget from the above
data. Also, we can prepare budgeted Profit and Loss A/c and the budgeted Balance
Sheet.
Solution:
(1) Sales Budget (in `)
ABC Co. Ltd.
Area and Products Months Total
April ` May ` June ` `
Maharashtra Product-I (10%) 90,000 1,05,000 1,20,000 3,15,000
Product-II (50%) 15,75,000 16,80,000 17,85,000 50,40,000
Total 16,65,000 17,85,000 19,05,000 53,55,000
Karnataka Product-I (20%) 1,80,000 2,10,000 2,40,000 6,30,000
Product-II (30%) 9,45,000 10,08,000 10,71,000 30,24,000
Total 11,25,000 12,18,000 13,11,000 36,54,000
Gujrat Product-I (70%) 6,30,000 7,35,000 8,40,000 22,05,000
Product-II (20%) 6,30,000 6,72,000 7,14,000 20,16,000
Total 12,60,000 14,07,000 15,54,000 42,21,000
Total Sales Product-I 9,00,000 10,50,000 12,00,000 31,50,000
Product-II 31,50,000 33,60,000 35,70,000 1,00,80,000
Total 40,50,000 44,10,000 47,70,000 1,32,30,000
Alternatively, Sales Budget can be prepared in units
ABC Co. Ltd.
Sales Budget (in number of Units)
for the period April-June, 2021
Area and Products Months Total
April ` May ` June ` `
Maharashtra Product-I (10%) 900 1,050 1,200 3,150
Product-II (50%) 11,250 12,000 12,750 36,000
Total 12,150 13,050 13,950 39,150

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Karnataka Product-I (20%) 1,800 2,100 2,400 6,300
Product-II (30%) 6,750 7,200 7,650 21,600
Total 8,550 9,300 10,050 27,900
Gujrat Product-I (70%) 6,300 7,350 8,400 22,050
Product-II (20%) 4,500 4,800 5,100 14,400
Total 10,800 12,150 13,500 36,450
Total Sales Product-I (10%) 9,000 10,500 12,000 31,500
Product-II (50%) 22,500 24,000 25,500 72,000
Total 31,500 34,500 37,500 1,03,500

2. Production Budget
Production Budget is based upon the sales budget. Therefore, it is prepared after
sales budget. It is expressed in quantitive terms only. The production department
prepares this budget. The following points are required to be considered while
preparing production budget.
a) Analysis of Plant Utilization – How the plant is to be utilized, how many
products are produced through the plant, the plant capacity, the capacity to be
utilized etc. are to be considered first while preparing production budget.
b) Work-in-progress – The time required to complete the production cycle and the
goods blocked in the process. The speed of processes.
c) Plan for Overtime – If the production needs to increase, the manager has to
plan for overtime work in order to produce demanded quantity.
d) Introduction of Shift work – If overtime fails to produce required quantity of
goods and there is unutilized capacity of a plant, production can be initiated
through additional shifts.
e) Subcontract or Outsourcing– If the plant capacity is fully utilized and further
production needs to increase, the simple alternative to increase production is the
subcontracting for production. It can be the outsourcing of production.

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f) Hire or Buy – The alternative that can be considered, if feasible, to increase the
production capacity, by hiring the plant and machinery or by purchasing them at
own.
g) Material Purchase Budget – It is crucial to take into account the material
purchase budget in term of quantity and finance also. The budgeted production
can be calculated with the help of following equation –
Budgeted Production (in units) = Sales estimate + Closing inventory required –
Opening inventory required
Illustration 2
Prepare production budget with the data provided by ABC Co. Lit. in illustration-1.
Solution:
Units to be purchased =
Estimated Sales (units): xxxx
Add = Closing inventory required: xxxx
Less – Opening inventory required: xxxx
ABC Co. Ltd.
Production Budget (in Units)
for the period of April-June, 2021
Months
April May June
1. Product-I
Estimated Sales 9,000 10,500 12,000
Add: Closing Inventory Required 8,400 9,600 10,800
(80% of next month sale)
17,400 20,100 22,800
Less: Opening Inventory Required 7,200 8,400 9,600
(80% of Current month’s sale)
Units of Product-I to be produced 10,200 11,700 13,200

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2. Product-II
Estimated Sales 22,500 24,000 25,500
Add: Closing Inventory Required 19,200 20,400 21,600
(80% of next month sale) 41,700 44,400 47,100
Less: Opening Inventory Required 18,000 19,200 20,400
(80% of Current month’s sale)
Units of Product-II to be produced 23,700 25,200 26,700

3. Cash Budget
The cash budget is the summary of cash receipts and cash payments during
particular period of time-say month, quarter or a year. The cash budget is prepared to
ensure timely availability of cash in required amount so as to conduct smooth
production, sale and all other activities of an organisation. It reveals the shortage or
surplus of cash. When there is shortage an action can be taken to bridge the gap by
way of bank overdraft or loan. On the contrary, if there is surplus cash balance, it can
be invested properly.
The cash budget requires pragmatic forecast of sales, production, purchases,
other expenses and all other activities. The cash budget is prepared on cash basis.
The receipts are added whereas, payments are deducted there from and the balance is
arrived at.
There are three methods of preparation of cash budget.
(1) Receipts and Payments Method
(2) Adjusted Earnings and Adjusted Profit and Loss Method
(3) Balance Sheet Charges Method
(1) Receipts and Payments Method
Under this method cash receipts and payments are estimated. Cash receipts form
the following activities–
• Cash Sales
• Collection from the debtors

405
 • Sale of fixed assets
• Issue of shares and debentures
• Receipts of interest, rent, discount, commission, royalty, etc.
• Receipts of bonus and dividends on investments.
The payments may be –
• Operating expenses-
o Payment to creditors
o Purchases of raw materials
o Wages and Salaries
o Repair and maintenance etc.
• Non-operating expenses,
o Payment of Tax
o Payment of Dividend, Bonus
o Payments of Rent, Rates, cess etc.
• Capital Payments
o Purchase of Assets
o Repayments of Loans
o Investments etc.
Majority of the companies use this method to prepare cash budget.
Illustration 3
From the details available of ABC Co. Ltd., a cash budget of the company can
be prepared as under. It is necessary to consider detailed information provided by the
Co. and the budgets prepared for various functions.

406
Solution:
ABC Co. Ltd.
Cash Budget
for period April-June, 2021
Months
April ` May ` June `
Opening Cash balance / cash in hand 1,20,000 1,20,000 1,20,000
Add – Receipts of Cash
Cash Sales (50%) 20,25,000 22,05,000 23,85,000
Collection from Debtors *15,15,000 20,25,000 22,05,000
Total Cash Receipts (A) 36,60,000 43,50,000 47,10,000
Less: Cash Payments
Creditors (for Supply of Raw Material) *12,30,000 **13,80,000 **13,77,000
Salaries 15,000 15,000 15,000
Wages (@ `6/unit of production) 2,03,400 2,21,400 2,39,400
(as per production budget
2,02,500 2,20,500 2,38,500
10,200+23,700 units)
Sales Commission (@ 5% on Sales) 6,000 6,000 6,000

Rent 40,500 44,100 47,700

Miscellaneous Exp. (1% of Sales) - 1,50,000 -

Purchase of Machinery
Total Cash Payments (B) 16,97,400 20,37,000 19,23,600
Surplus / Deficit of Cash [(A) – (B)] 19,62,600 23,13,000 27,86,400
Minimum balance required 1,20,000 1,20,000 1,20,000
Surplus to be invested with SBI 18,42,600 21,93,000 26,66,400
* As given in the Balance Sheet
** Note-Creditors for purchases of raw materials are computed as under.
Purchase Budget (of raw materials) for April-June, 2021

407
 Months
Particulars April May June
Materials Required to Produce Product –I (2 20,400 23,400 26,400
units)
Materials Required to Produce Product -II (4 94,800 1,00,800 1,06,800
units)
Total Material Required for Production 1,15,200 1,24,200 1,33,200
Add: Closing stock required (150%) 1,72,800 1,86,300 1,99,800
Total 2,88,000 3,10,500 3,33,000
Less: Opening Stock of Material (Last month’s
closing balance is current month’s opening *1,50,000 1,72,800 1,86,300
balance)
Raw Materials Required to Purchase 1,38,000 1,37,700 1,46,700
Creditors for supplyof Raw Materials@ ` 13,80,000 13,77,000 14,67,000
10/unit
* As given in the Balance Sheet
4. Master Budget
A master budget is prepared by summerising all functional budgets. It is also
called as summery budget. This summery budget is presented in the form of –
a) The budgeted Profit and Loss A/c; and
b) The budgeted Balance Sheet
The budgeted profit and loss A/c is the summery of all revenue accounts and the
budgeted balance sheet is summery of all capital items. The previous year figures are
also shown in the master budget, in order to find variations if any and to analyse it
for further improvement.

408
Illustration 4
We can prepare master budget of ABC Co. Ltd. For the period April-June 2021
from the data available in Illustration 1 and the different functional budgets prepared
for the same period.
Solution:
a) Budgeted Profit and Loss A/c
ABC Co. Ltd.
Master Budget
for the period April-June, 2021
` `
Budgeted Sales 1,32,30,000
Less: Cost of Goods Sold*
Product-I (31,500 units x ` 26**) 8,19,000
Product-II (72,000 units x ` 46***) 33,12,000 41,31,000
Gross Profit 90,99,000
Less: Opening Expenses
Salaries 45,000
Rent 18,000
Sales Commission 6,61,500
Miscellaneous Expenses 1,32,000
Depreciation on Machinery ` 20,000 p.m. 60,000 9,16,800
Budgeted Net Profit 81,82,200
(a) Budgeted Balance Sheet
` `
Share Capital 43,85,600
Reservesand Surplus 10,30,000
Profit and Loss A/c 81,82,200 92,12,200
Creditors 14,67,000
1,50,64,800

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Cash in hand 1,20,000
Debtors 23,85,000
Stock – Raw Materials (1,99,800 units x ` 10) 19,98,000
Finished Goods-
Product-I (10,800 units x ` 26) 2,80,000
Product-II (21,600 units x ` 46) 9,93,600 32,72,400
Plant and Machinery (24,95,400 + 1,50,000) 25,45,400
Less: Depreciation 60,000 25,85,400
Investments 67,02,000
1,50,64,800

*Cost of goods sold are taken at material and labour cost

**Product-I consumes 2 units of raw material @ ` 10 and labour cost ` 6 (20 + 6)
***Product-II consumes 4 units of raw material @ ` 10 and labour cost ` 6 (40 + 6)
5. Fixed Budget
The Budget which is prepared on the basis of an estimated volume of production
and sale is called fixed budget. There is no plan for change in activity level from the
budgeted one. It is not adjustable to new levels of activity. The variability in an
activity is not taken into account while preparing fixed budget. It is assumed that the
activities and the situation will remain unchanged. Whereas, the fact differs from the
plan / estimate or budget. Therefore, this budget remains of no use for assessment of
performance when actual level of activity differs from that budgeted activity. This
budget can be useful for assessment when the level of activity. Sales budget,
purchase budget, production budget, cash budget are the examples of fixed budget.
6. Flexible Budget
The budget, which take into account changes in the level of activity and provide
for the same while budgeting is called flexible budget. it is designed to change
according to change in the level of activity. This budget gives different budgeted
costs for different levels of activities. This budget is useful in business, of which
sales cannot be predicted. e.g., sale of fashionable goods. The change in fashion is
unpredictable, where flexible budget is useful.
410
 The flexible budget is prepared by classifying the overhead expenses into fixed,
variable and semi- variable. As well as the budget is prepared for different levels of
activity. This gives several alternative budgets that enable organisation to manage its
activities at different levels coping with the changes in actual practice. This
budgeting uses principles of marginal costing. In short, this budget is prepared to
control manufacturing overhead costs. Flexible budgets are also called as variable
budget. This budget may be prepared in (a) table form, (b) equation form or (c)
graphical form.
Illustration 5
Prepare flexible budget of ABC Co. Ltd., on the basis of data given below.
Ascertain the overhead rates at 50%, 60% and 70% capacity.
Particulars At 60%
Capacity
`
Variable Overheads –
Indirect Material 6,000
Indirect Labour 18,000
Semi-variable Overheads –
Electricity (40% Fixed, 60% Variable) 30,000
Repairs (80% Fixed, 20% Variable) 3,000
Fixed Overheads –
Depreciation 16,500
Insurance 4,500
Salaries 15,000
Total Overheads 93,000
Estimated direct labour hours 1,86,000

411
Solution:
ABC Co. Ltd.
Flexible Budget for Overheads
Capacity
50% (`) 60% (`) 70% (`)
Variable Overheads – Indirect Material 5,000 6,000 7,000
Indirect Labour 15,000 18,000 21,000
Semi-variable Overheads
(a) Electricity- Fixed 12,000 12,000 12,000
Variable 15,000 18,000 21,000
(b) Repairs - Fixed 2,400 2,400 2,400
Variable 500 600 700
Fixed Overheads – Depreciation
16,500 16,500 16,500
Insurance
4,500 4,500 4,500
Salaries
15,000 15,000 15,000
Total Overheads
85,900 93,000 1,00,100
Estimated direct labour hours
1,55,000 1,86,000 2,17,000
Overhead rate per direct labour hour=
0.55 0.50 0.46
(Total overheads / Estimated direct labour
hours)

Illustration 6
The following data are available in ABC Co. Ltd., for the year ended 31-3-
2021.
` (000)
Fixed Expenses – Wages and Salary 950
Rent and Rates 660
Depreciation 740
Administrative Expenses 650

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 Semi-Variable Expenses (at 50% Capacity)
Repairs and Maintenance 350
Indirect Labour 790
Sales Department Salaries 380
Administrative Salaries 280
Variable Expenses (at 50% Capacity)
Material 2,170
Labour 2,140
Other Expenses 790
Total Cost 9,800

(a) Fixed expenses remain constant at all levels of production.

(b) Semi-variable expenses remain constant between 45% and 65% capacity,
increasing by 10% between 65% and 80% capacity and 20% between 80% and
100% capacity.
(c) Sales at various levels of capacity are (` 000)
50% Capacity ` 10,000
60% Capacity ` 12,000
75% Capacity ` 15,000
90% Capacity ` 18,000
100% Capacity ` 20,000
Prepare flexible budget for the year 2021-22 and forecast the profit at each level
of capacity.

413
Solution:
ABC Co. Ltd.
Flexible Budget
For the year 2021-22 (` 000)
Capacity 50% 60% 75% 90% 100%
I)Sales 10,000 12,000 15,000 18,000 20,000
Fixed Expenses
Wages and Salaries 950 950 950 950 950
Rent and Rates 660 660 660 660 660
Depreciation 740 740 740 740 740
Administration Expenses 650 650 650 650 650
Total Fixed Cost (A) 3,000 3,000 3,000 3,000 3,000
Semi-Variable Expenses
Repair and Maintenance 350 350 385 420 420
Indirect Labour 790 790 869 948 948
Sales Department Salaries 380 380 418 456 456
Administration Expenses 280 280 308 336 336
Total Semi-variable cost (B) 1,800 1,800 1,980 2,160 2,160
Variable Expenses – Material
2,170 2,604 3,255 3,906 4,340
Labour
2,040 2,448 3,060 3,672 4,080
Other Exp.
790 948 1,185 1,422 1,580
Total Variable Cost (C)
5,000 6,000 7,500 9,000 10,000
II) Total Cost (A + B + C)
9,800 10,800 12,480 14,160 15,160
III) Profit (I – II )
200 1,200 2,520 3,840 4,840

Capital Expenditure Budgeting

Capital expenditure budget represents the estimated expenditure on fixed assets
during the period of budget. It is related with the decision relating to investment in
fixed assets. It includes addition, disposition, modification or replacement of fixed

414
assets. The problem involves decision whether the investment in (purchase of) asset
is justified and the investment gives expected results / benefits. The decision may be
based on traditional criterion and discounted cash flow criterion.
The Traditional criterion includes –
(a) Payback Period Method
(b) Return on Investment (ROI) Method
Discounted cash flow (DCF) criterion includes –
(a) Net Present Value (NPV) Method
(b) Internal Rate of Return (IRR) Method
(c) Profitability Index (PI) Method
(d) Discounted Payback Period
The criterion or method to be selected for decision making will depend upon
circumstances. Accordingly, the management is to decide which method is to be
adopted. Once the method is adopted should be used consistently and uniformly.
Payback Period Method
This method involves computation of number of years required to recover the
original cash invested in the asset. The following equation is used for this purpose.
Cash Outlay
Payback Method =
Annual cash inlow from the investment
e.g., If a project cost ` 50,000 and it yields annual cash inflow of ` 10,000 each year,
the payback period will be –
Rs. 50,000
= 5 years
Rs. 10,000
The decision is to be taken as under
• When there are alternative choices of investment, the project which shows
shorter payback period is to be preferred.
• If there is no alternative, the management will decide the desirable payback
period. Accordingly, if the project shows less payback period than the desired,
than the project will be considered for investment.

415
Limitations:
1. This method does not consider the maximization of wealth of an organisation.
2. This also does not consider the time value of money.
3. More emphasis is given on how quick investment is released.
4. The life after payback and earning thereafter is ignored.
When there are unequal cash inflows every year, the payback period is traced
out by adding the annual cash inflows until the total comes to an equal amount of
cash outflow (initial investment).
E.g., If a project costs ` 50,000 and the annual cash inflows during its life time of 5
years are ` 10,000, ` 11,000, ` 13,000, ` 15,000 and ` 18,000.
The payback period will be computed as under –
Initial cash outflow (Investment / project cost) ` 50,000 calculation of cash inflows
Year Cash in flows Cumulative cash in flow
1 10,000 10,000 I Year
2 11,000 21,000 II Year
3 13,000 34,000 III Year
4 15,000 49,000 IV Year
5 18,000 67,000 V Year

Here the project cash inflows attain the total ` 50,000 in the fifth year. Thus, the
actual payback period is
#,$$$
= 4 years + #%,$$$ × 360 days

= 4 years + 20 days
= 4 years and 20 days

416
Illustration 7
The following details are given to you by ABC Co. Ltd. for alternative three
project –
Project – P, Project – Q, Project -R
Cost ` 50,000 70,000 70,000
Life in years 10 12 14
Estimated Scrap Value ` 5,000 10,000 7,000
Annual Cash Inflow ` 9,500 11,000 10,000
Rank the projects under (1) Payback period (2) Surplus life over payback period and
(3) Surplus cash inflow
Solution:
(a) Calculation of Payback Period Project – P Project – Q Project – R
Project Cost (`) (A) 50,000 70,000 70,000
Annual Cash Inflow (`) (B) 9,500 11,000 10,000
Payback Period = (A) ÷ (B) 5.26 years 6.36 years 7 years
Rank I II III
(b) Surplus Life over payback 10–5.26 years 12 – 6,36 14 – 7 years
period 4.27 years years 7 years
5.64 years
Rank III II I
(c) Surplus Cash Flow =
Total cash inflow over a life 95,000 1,32,000 1,40,000
period 50,000 70,000 70,000
Less: Cash outlay (Initial
investment)
45,000 62,000 70,000
Add: Scrap value 5,000 10,000 7,000
Net Cash Inflow (Surplus) 50,000 72,000 77,000
Rank III II I

417
Check your Progress-
1. State whether following statements are true or false.
1. Budgets are past results.
2. Cash budget is a part of financial budget.
3. Production budget always shows a constant output every year.
4. Budgetary control and standard costing do not go together.
5. A flexible budget is one that is prepared for changing level of activity.
6. A flexible budget is a profit and loss A/c and a balance sheet at the end of
budget period.
7. Budgeting leads to forecasting and forecasting leads to budgetary control.
8. Budgetary control involves comparison of actual results with budgetary
one.
9. Functional budgets are base for master budget.
10. Budget variance is the difference between a budgeted figure and the actual
figure.

Return on Investment (ROI) Method

This method takes into consideration the return on investment. The rate of
return is ascertained by considering total earning from the project over a period of its
life. The projectthat shows higher rate of return is accepted. The return on investment
is determined as under.
*+,-. /0+1, 23,40 5460471-,1+8
(a) Return on Investment = 9+:, +3 ;8<4:,=48,
× 100
2<40->4 /0+1, 23,40 5460471-,1+8
(b) Average Return on Investment = × 100
9+:, +3 ;8<4:,=48,
*+,-. /0+1, 23,40 5460471-,1+8
(c) Return on Average Investment = × 100
2<40->4 ;8<4:,=48,

;8<4:,=48, -, ,?4 @4>1818> A

;8<4:,=48, -, ,?4 48B +3 ,?4 /0+C47,
Average Investment = × 100
D

418
 2<40->4 /0+1,
-3,40 5460471-,1+8
(d) Average Return on Average Investment = 2<40->4 ;8<4:,=48,
× 100

*+,-. /0+1, 23,40 5460471-,1+8

Average Profit after Depreciation = × 100
E134 +3 /0+C47, 18 F4-0:

Illustration 8
ABC Co. Ltd. is to acquire new machinery. There are two alternatives, the details of
which are as under.
Machine – A Machine – B
` `
Cost of Machinery 3,00,000 3,00,000
Expected Profits before depreciation for
Year 1 1,50,000 60,000
Year 2 1,50,000 90,000
Year 3 90,000 1,50,000
Year 4 30,000 1,50,000
Estimated Life 4 years 4 years
Scrap Value NIL NIL

You are requested to suggest the company, which machine to be acquired on

the basis of return on investment?
Solution:
Machine – A Machine – B
Total Profit before Depreciation 4,20,000 4,50,000
Less: Depreciation (cost – scrap) 3,00,000 3,00,000
Total Profit after Depreciation 1,20,000 1,50,000
Average Profit 30,000 37,500
Average Investment 1,50,000 1,50,000
(a) Return on Investment #,D$,$$$ #,H$,$$$
= G,$$,$$$ × 100 = G,$$,$$$ × 100

= 40% = 50%

419
(b) Average Return on Investment G$,$$$ GI,H$$
= G,$$,$$$ × 100 = G,$$,$$$ × 100

= 10% = 12,50%
(c) Return on Average Investment #,D$,$$$ #,H$,$$$
=
#,H$,$$$
× 100 = #,H$,$$$ × 100

= 80% = 100%
(d) Average Return on Average Investment = G$,$$$ × 100 GI,H$$
= #,H$,$$$ × 100
#,H$,$$$

= 20% = 25%
Recommendation: The company may acquire Machine – B as it gives higher return.
Discounted Cash Flow Methods
These methods are based on time value of money. Under this method, it is clear
that the value of ` 1 received today is not same in value as ` 1 received after a period
of time. As ` 1 received today, if invested will fetch interest for a period of
investment and the total value will be ` 1 + interest of the period. Thus, a ` 1
received today is worth more than the ` 1 received after a period. E.g. ` 1 received
today invested @ 12% interest rate will give us ` 0.12 interest after one year. Thus,
the value of ` 1 today is ` 1.12 after a year.
Therefore, a ` 1 received after one year is a lesser value that a ` 1 received today.
This method considers overall profitability of a projects and also the timing of
returns.
The term discounting is reverse to compounding.
The formula for compounding is as under.
Amount to be received in future = Present Amount (1 + Rate of Interest)8
Where n = No. of years
The formula for present value is as under.
#
Present value of amount to be received in future = (# A N-,4 +3 18,404:,)O

Where n = number of year

420
 The ready recknor for discount table shows present value of ` 1 at different
rates of interest and at different years. These discounting factors can be obtained as
under.
Illustration 9
Calculate the present value of ` 1 earned at the end of 1st, 2nd, 3rd, 4th and 5th
year @ 10% interest per annum.
Solution:
# Present Value Factor
Present Value = (# A $.#$)P

Present Value of ` 1 at the end of #

1st year =(# A $.#$)P= 0.9091
#
2ndyear =(# A $.#$)Q= 0.8264
#
3rdyear =(# A $.#$)R= 0.7513
#
4thyear=(# A $.#$)S= 0.6830
#
5thyear =(# A $.#$)T= 0.6209

Net Present Value (NPV) Method

Net Present Value is the excess of present value of expected earnings (cash
inflows) over the present value of cash outlay (outflow) of a project. The cash
inflows and outflows are discounted at applicable present value factor in order to
ascertain its present value. The present value of cash outflows is deducted from the
total of the present values of all cash inflows. The resulting figure is termed as net
present value (NPV). If NPV is positive, the project is accepted and vice-versa.
Symbolically it can be presented as under.

E.g., Outcome Decision

NPV > zero Accepted
NPV < O Reject
NPV = O Neutral

421
This method is consistent with the objective of maximization of wealth.
Illustration 10
You are the financial analyst of ABC Co. Ltd. You are asked to analyse two
proposals of investment – viz. Project-X and Project-Y. Each project has a cost of
` 1,00,000 and the cost of capital for each project is 12%. The net cash inflows are as
under –
Year Project-X Project-Y
` `
0 (1,00,000) (1,00,000)
1 65,000 35,000
2 30,000 35,000
3 30,000 35,000
4 10,000 35,000

(a) Calculate Payback period and (b) NPV and suggest which project is to be
accepted.
(The discounting factors @ 12% of ` 1 for 1 to 4 years are respectively 0.8929,
0.7972, 0.7118 and 0.6355)
Solution:
(a) Calculation of Payback period
Cash flows (`)
Project -X Project -Y
Actual Cumulative Actual Cumulative
0 (1,00,000) -1,00,000 (1,00,000) -1,00,000
1 65,000 -35,000 35,000 -65,000
2 30,000 -5,000 35,000 -30,000
3 30,000 25,000 35,000 5,000

422
4 10,000 35,000 35,000 40,000
Payback period = H,$$$ G$,$$$
2 + G$,$$$X 12 Months 2 + GH,$$$ X 12 Months

= 2 years + 2 Months 2years + 10.29 Months

2 years 2 Months 2 years 10.29 Months
Project-X may be accepted as it has less payback period than that Project-Y has.
(b) Calculation of NPV
Year Project -X Project -Y
Cash flow Discounting Present Cash flow Discounting Present
factor Value factor Value

(1) (2) (3) (4) = (5) (6) (7) =

(2)x(3) (5)x(6)
0 (1,00,000) 1 (1,00,000) (1,00,000) 1 (1,00,000)
1 65,000 0.8929 58,039 35,000 0.8929 31,252
2 30,000 0.7972 23,916 35,000 0.7972 27,902
3 30,000 0.7118 21,354 35,000 0.7118 24,913
4 10,000 0.6355 6,355 35,000 0.6355 22,243
NPV= Inflow - Outflow 9,664 NPV= Inflow - Outflow 6,310

Project -Xmay be accepted as it has higher NPV.

Profitability Index (PI)
It is also called as Benefit Cost (B/C) Ratio. This is time adjusted technique of
evaluation of an investment proposal or a project. The index of a proposal or a
project is ascertained on the basis of present value of cash inflows and outflows. The
equation of PI is as under.
/04:48, U-.V4 +3 9-:? 18.+W:
Profitability Index (PI) = /04:48, U-.V4 +3 9-:? +V,.+W:

It shows present value of return (cash inflows) per rupee invested (cash
outflows). The investment proposal may be accepted, when PI is more than 1. When
423
a project from alternative proposals is to be selected the criterion will be the higher
PI. The project proposal which shows higher PI will be accepted. Because higher the
PI, more will be the profit from the project proposal and vice-versa. This is called
gross PI method.
Some times PI is expressed in net, which is computed as –
PI (Net) = PI (Gross) – 1
When PI net is positive, the proposal will be profitable. On the other hand, if PI
net is negative, the investment proposal will not be worthwhile.
This method gives most reliable result. Therefore, this is most suitable method
for evaluation of the project or investment proposal.
Internal Rate of Return (IRR) Method
IRR is the rate of return which gives zero NPV. It is also termed as yield of an
investment, marginal efficiency of capital, rate of return on cost, time adjusted rate of
return, etc. It is called internal rate of return because it depends on outflows and the
inflows of investment. There is no other outside factor considered in determination of
IRR.
In calculation of IRR of a project, it is necessary to use two discount rates
(selected by trial-and-error basis) of the cash flows and find the NPV by each of
them.
1. This method considers time value of money.
2. It considers all cash flows over the entire life of the project.
3. It is accepted by more users as it shows rate of return on capital.
4. The IRR suggests maximization of owners’ wealth.
The limitations of the method are-
1. It involves complicated computations and therefore, difficult to understand.
2. It may give inconsistent results as compared to NPV method.

424
Check your Progress-
2. Fill in the blanks with correct word or phrase.
1. Budget is a comprehensive plan, expressed in terms of …………
2. Sales budget, purchase budget, production budget, labour budget are the
examples of ………… budget.
3. Budgeted profit and loss A/c and budgeted balance sheet are …………
budgets.
4. Difference between discounted cash inflows and outflows is called
…………
5. When profitability index is …………, the project may be rejected.
6. When IRR is greater than cost of capital, the project may be …………
7. Cash budget shows ………… and ………… of cash during budget period.
8. Return on Investment (ROI) is the ratio of ………… to investment.
9. The time required to equate cash inflow to initial cash outlay is called
………… period.

Illustration 11(Calculation of IRR when cash inflows are constant / equal / same
every year).
A project to be undertaken costs ` 1,60,000 at the beginning. It is expected to
yield ` 60,000 p.a. for 3 years. What will be the internal rate of return of a project?
Solution:
As the cash inflow is constant for each year the annuity table can be used to find
a closer or nearer rate of return from which we can compute IRR.
IRR is the rate at which the present value of cash flow and that of outflow are
equal.
⸫ PV of cost = PV of cash inflow
` 1,60,000 = 60,000 x discounting factor of ` 1 p.a. for 3 years say x
` 1,60,000 = 60,000 x

425
 #,X$,$$$
⸫ x=
X$,$$$

= 2.667
Here, the discounting factor = 2.667
The annuity table shows cumulative discounting factors of ` 1 p.a. for 3 years as
under.
The nearer discounting factors to 2.667 are –
2.624 at 7% rate of interest and
2.673 at 6% rate of interest, where differencebetween these two factors is
0.049 for 1% difference of rate of interest.
using interpolation, IRR = 6% + (Y.YYZ∗
Y.YS\
)
= 6.12%
*(0.006 = 2.673 – 2.667)
Illustration 12 (Calculation of IRR when cash inflows p.a. differs year to year)
ABC Co. Ltd. desires to establish a project costing ` 22,00,000 having life of 3
years.
The net cash inflows per year (after tax and including scrap value at the end of
third year) are ` 7,70,000, ` 9,68,000 and ` 13,31,000 respectively. The company has
sufficient funds to invest in the project without expecting any borrowings. The best
alternative to the company is to invest funds elsewhere @ 10% p.a. compounding
rate of interest.
Calculate
(a) NPV and give your recommendations.
(b) Internal Rate of Return using 16% and 17% discounting rate.

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Solution:
(a) Calculation of NPV
Year Cash flow Discounting P.V.
` Factors @ `
10%
0 (22,00,000) 1 (22,00,000)
End of year 1 7,70,000 0.9091 7,00,000
End of year 2 9,68,000 0.8264 8,00,000
End of year 3 13,31,000 0.7513 10,00,000
NPV = (25,00,000 – 22,00,000 = 3,00,000)

Recommendation – As the NPV is positive, investment in the project is worthwhile

@ 10% dcf.
(b) Calculations of IRR based on 16% and 17% dcf.
Year Cash flows Discounting P.V. Discounting P.V.
` Factors @ 16% ` Factors @ 17% `

0 (22,00,000) 1 (22,00,000) 1 (22,00,000)

1 7,70,000 0.8621 6,63,817 0.8547 6,58,119
2 9,68,000 0.7432 7,19,418 0.7305 7,07,124
3 13,31,000 0.6407 8,52,718 0.6244 8,31,076
35,953 (3,681)

NPV at 16% rate = (+) ` 35,953

at 17% rate = (–) ` 3,681
difference for 1% = 39,634
GH,]HG
⸫ IRR = 16% +
G],XG^

= 16.91% (approximately)

427
Check your Progress:
3. Choose correct alternative from given below the statement.
1. The activities and the situation are assumed remain unchanged in …………
budget.
a) cash b) production c) fixed d) all of these
2. Budgets are helpful in …………
a) controlling cost b) controlling activities
c) controlling business d) All of these
3. Payback period, return on investment, NPV are the techniques / tools used
in ………… budgeting.
a) cash b) purchase c) capital d) sales
4. Master budget represents ………… of all budgets.
a)base b) summary c) tool d) hurdle

3.3 Summary
The term budget refers to future financial plan which, help management in
controlling business activities. Whereas budgetary control refers to continuous
comparison of actual results with budgets of activities, functions or processes of an
organisation. It includes (a) establishment of budgets for each process, department,
activity or section of the organisation (b) recording actual performance and
comparison with budgeted figures and (c) ascertainment of variances and taking
remedial action in order to achieve the objectives of the organisation.
Various types of budgets are prepared based on the functions and activities of
the organisation. E.g., sales budget, production budget, purchase budget, labour
budget, production overhead cost budget, working capital budget, capital expenditure
budget etc. Master budget is prepared on the basis of all functional budgets. It is
presented in the form of budgeted profit and loss A/c and budgeted balance sheet.
Capital expenditure budget is prepared to evaluate the project proposals for
capital investment. Payback period, net present value, internal rate of return,

428
profitability index are the tools / techniques used for evaluation of capital
expenditure project proposals.
Performance budgeting determines target for each activity, department or
process of organisation. Several ratios are also set for these departments and / or the
activities. The departmental heads or authorities prepare reports of their respective
departments and submit to the higher authority. The variances and their reasons are
them analyzed.
Responsibility accounting more specifically related to the responsibility of
head of each department. It helps management in decision making and control over
persons.

3.4 Terms to Remember

1. Budget: A budget is a comprehensive and co-ordinated plan, expressed in
financial terms, for the operations and resources of an enterprise for some
specific period in the future.
2. Budgetary Control: It means the establishment of budgets relating to
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."
3. Performance budgeting: It is the budgetary system where the input costs are
related to performance i. e. the result.
4. Zero Base Budgeting: The ‘Zero‐Base’ refers to a ‘nil‐budget’ as the starting
point.
5. Responsibility Accounting: It is the method of assessing performance of an
individual authority. Each person has given some authority in an organisation.
The revenue and cost relating to the work or area assigned to a person are
compared.

3.5 Answers to check your progress

1. 1) False 2) True 3) False 4) False 5) True 6) True
7) False 8) True 9) False 10) True 11) True
2. 1) money / finance 2) functional

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 3) summary / master 4) NPV
5) negative / less than 1 6) accepted
7) inflows and outflow / receipts and payments
8) profit / return / earnings 9) payback
3. 1) d 2) d 3) c 4) b

3.6 Exercise
1. Define “Budget” and “Budgetary Control”. State the advantages of budgetary
control.
2. What are the objectives of budgetary control?
3. Explain in brief the types of functional budgets.
4. Explain fixed and flexible budgets with suitable examples.
5. Explain the steps involved in preparation of sales budget.
6. Explain in detail the cash budget and give its specimen.
7. What is meant by master budget? Explain how it is prepared.
8. Explain payback period with suitable example.
9. What is meant by net present value (NPV)? How is it ascertained?
10. Write the importance of cash budget.
11. Real Life Corporation Ltd. is manufacturing two types of products – Product X
and Product Y. The product is sold in two Regions of the State-East and West.
The company has submitted you the following data.
1. Budgeted Sales for the current year-
Product East Region West Region
X 40,000 Units @ ` 14 per 60,000 Units @ ` 14 per
unit unit
Y 30,000 Units @ ` 31 per 50,000 Units @ ` 31 per
unit unit
2. Actual Sales for the current year-

430
 Product East Region West Region
X 50,000 Units @ ` 14 per 70,000 Units @ ` 14 per
unit unit
Y 20,000 Units @ ` 31 per 40,000 Units @ ` 31 per
unit unit

It is found that Product X is fast moving in the market but the price is low,
whereas Product Y is slow moving but high priced. Therefore, the management has
decided to revise price of both products. To increase sales price of Product X by ` 2
and to decrease sales price of Product Y by ` 2 in order to improve in sales of both
products.
The following estimates have made by the market research department
considering the change in selling price of the products.
Product East Region West Region
X Increase in Sales by 10% Increase in Sales by 5%
Y Increase in Sales by 20% Increase in Sales by 10%
Prepare Sales Budget for the next year.
12. A German Company furnished the following data for May, 2021.
Sales – Mens-ware ` 17,50,000
Ladies-ware ` 12,50,000
Direct Material Cost 60% of sales
Direct Wages for 26 days 50 workers @ ` 300 per day
Factory Overheads – Indirect ` 60,000 per month
Labour
2.50% on sales
Stores and Spares
` 80,000 per month
Repair and Maintenance
` 50,000 per month
Power Consumption
` 31,000 per month
Other Expenses
` 40,000 per month

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 Administrative Expenses ` 80,000 per month
Selling and Distribution Expenses

You are asked to prepare master budget of the Co. for the month of May, 2021.
13. An Electric Company manufactures two types of bulbs LED-10 Watt and CFL-
10 Watt. Estimated Sales of both products for seven months from June, 2021 to
Dec. 2021 are given below.
a. There will be no work in progress at the end of only month.
b. Stock of finished goods will be equal to half of sales during next month.
You are required to prepare production budget showing month wise production in
units for the second half year July-December, 2021.
14. A factory is working at 50% capacity and producing 5,000 units at a cost of ` 90
per unit. The details are as under
1) Material ` 50
Labour ` 15
Factory Overheads ` 15 (` 6 fixed)
Administrative Overheads ` 10 (` 5 fixed)
2) The current selling price is ` 100 per unit.
3) At 60% capacity, Material cost per unit increase by 2% and selling price
per unit falls by 2%
4) At 80% capacity, Material cost per unit increase by 5% and selling price
per unit falls by 5%
Estimate profit of the factory at 60% and 80% level of capacity and give
your comment.
15. Roxy Ltd. manufactures a single product of Iron with single labour grade. The
sales budget and finished goods stock budget for a month are as under
1) Sales 2,100 units
2) Opening Stock of finished goods 150 units

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3) Closing Stock of finished goods 210 units
4) There are 10% of finished work is scrapped.
5) The standard labour house is 3 per unit.
6) The budgeted productivity ratio direct labour is only 80%
7) The company employs 36 labour who are expected to work for 144 house each
in a month.
You are required to prepare
A) Production Budget
B) Direct Labour Budget
16. Prepare cash Budget for three months ending 30-06-2021
a)
Month Sales ` Materials Wages ` Overheads
` `
February 1,40,000 96,000 30,000 17,000
March 1,50,000 90,000 30,000 19,000
April 1,60,000 92,000 32,000 20,000
May 1,70,000 1,00,000 36,000 22,000
June 1,80,000 1,04,000 40,000 23,000
b) Sales are made 10% on credit 90% on cash
c) 50% of the credit sales are collected in the next month and the balance in the
following month.
d) Creditors for materials are of 2 months, wages ¼ month
e) Cash and bank balance expected at the beginning of April, 2021 v 60,000
Other information is –
1. Plant and Machinery will be installed in the month of February 2021 at a cost of
` 9,60,000.
The monthly installment is payable ` 20,000 from April, 2021 onwards.
2. Dividend @ 5% on shares capital of ` 20,00,000 is to be paid on 1-6-2021

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3. Advance on account of sales of old machinery will be received in the month of
June, 2021 ` 90,000
4. Interest on Investment is due ` 10,000 in the month of June, 2021.
5. Advance Income Tax is to be paid in the month of June, 2021 ` 20,000.
17. The Alfa Co. Ltd. intends to acquire one machine where increase two alternative
available in the market Details of which are as under. Cost of each machine is `
5,50,000/-
Year Annual Cash inflow
Machine - I Machine – II
st
1 Year End 1,00,000 1,50,000
nd
2 Year End 2,00,000 1,50,000
rd
3 Year End 1,50,000 1,50,000
th
4 Year End 1,50,000 1,50,000
th
5 Year End 1,75,000 1,50,000
You are asked to suggest best alternative applying –
a) Payback period method
b) Internal Rate of Return
c) Net Present Value Method
Note – The Discounting factors for consecutive five years @ 10% are
1) 0.9091 2) 0.8264 3) 0.7513 4) 0.6830 5) 0.6209
3.7 Reference for Further Study:
1. Maheshwari S. N: Principles of Management Accounting, Sultan Chand & Sons,
New Delhi.
2. Man Mohan, S. N. Goyal: Principles of Management Accounting,
SahityaBhavan, Agra.
3. Pandey I. M.: Management Accounting, Vikas Publishing House Pvt. Ltd., New
Delhi.
4. Paul S. Kr.: Financial Statement Analysis, New Central Book Agency (P) Ltd.
Kolkata.
5. Raman B. S.: Management Accounting, United Publishers Mangalore.

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 Unit-4
Standard Costing and Variance Analysis

Index
4.0 Objectives
4.1 Introduction
4.2 Presentation of Subject Matter
4.2.1 Definition
4.2.2 Characteristics of Standard Costing
4.2.3 Setting up Standard Costing
4.2.4 Advantages of Standard Costing
4.2.5 Limitations of Standard Costing
4.2.6 Variances
4.2.6.1 Material Variances
4.2.8 Wage or Labour Variances
4.2.9 Overhead Variances
4.3 Summary
4.4 Terms to Remember
4.5 Answers to Check Your Progress
4.6 Exercise
4.7 Reference for Further Study

4.0 Objectives
After studying this unit, you should be able to:

To understand the theory of technique of standard costing

To compute and analyse various cost variances

4.1 Introduction
The principal objection to normal system of costing is that it helps to ascertain
the cost only but it fails to provide information as to what the cost should have been
and whether the results achieved are satisfactory or not. The efficient cost system is,

435
therefore, one which not only shows the cost of each unit produced but also explains
why such cost differs from a pre-determined standard. This is achieved by means of
the standard costing which provides a suitable yardstick to measure the actual
performance. Predetermined costs are those which are computed in advance of
production on the basis of a specification of all the factors affecting cost. Thus
standard costing is not only a method of cost ascertainment but is a technique of cost
control as well.

4.2 Presentation of Subject Matter

4.2.1 Definition of Standard Costing
Let us see some definitions of standard cost & standard costing.
(1) According to Wheldon : "Standard Costs are pre-determined, or fore-cast
estimates of costs to manufacture a single unit, or a number of units of a product
during a specific immediate future period."
(2) Standard Cost is a pre-determined cost which is calculated from the
management's standards of efficient operation and the relevant necessary
expenditure. It may be used as a basis for price fixing or for cost control through
variance analysis.
(3) Standard Costing is the preparation and use of standard costs, their
comparison with actual costs and the analysis of variances to their causes and points
of incidence.
(4) Standard Costing is a method of ascertaining the cost whereby statistics
are prepared to show
(a) the standard cost;
(b) the actual cost; and
(c) the difference between these costs, which is termed the variance.
4.2.2 Characteristics of Standard Costing
From the definitions given above, the following characteristics of standard
costing emerge:
(1) Standard cost is a predetermined cost.
(2) Standard cost is determined after considering what can be the cost under
efficient management.
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(3) It is used for two purposes (i) as a basis of price determination and (ii) as a tool
of cost control.
(4) Standard costing is a method of determining and using the standard cost for cost
control.
(5) For the purpose of control, standard cost is compared with actual costs and
variances are calculated.
(6) The variances arrived at are then analysed in order to find out the root causes of
variances, so that corrective steps can be taken.
Thus, in standard costing (a) cost of each element is determined before
production starts. e.g. the cost of materials per unit, cost of direct labour per unit etc.
are fixed on the basis of past experience, prevailing conditions and future changes
likely to take place. (b) The actual costs are ascertained when actual production takes
place. (c) The figures of actual costs are compared with predetermined (Standard)
costs. (d) If differences are found, causes of such differences are ascertained and
corrective measures are taken.
The importance of standard costing as a modern technique of planning and
control is increasing in recent times. Particularly in industrially advanced countries
like the U. S. A. and the U. K., the standard costing system is widely used.
4.2.3 Setting up Standard Costing:
Setting standard cost is very crucial for ensuring expected profit margin
irrespective of the nature of company; however, in manufacturing companies it is
more critical. There are number of prerequisites for setting up standard costing via
setting standards across different cost categories. These prerequisites may be pointed
as below:
1. Define bills of material parameters;
2. Define resources;
3. Define the cost centre;
4. Assign resources to cost centre;
5. Define overheads and assign to cost centre;
6. Review routing and bill structures to confirm that costs will roll-up properly;

437
7. Control overheads by resource;
8. Confirm that the WIP parameters, Recognize Period Variance and Require
Scrap Account are set as required.
9. Confirm that the Work in Process accounting classes and their valuations and
accounts are properly set up.
Thus, it is stated that the success of a standard costing system depends upon the
reliability and accuracy of the standards. Therefore, every case should be taken into
account while establishing standards. The number of people involved with the setting
of standards will depend on the size and nature of the business. The responsibility for
setting standards should be entrusted to a specific person. In a big concern a Standard
Costing Committee is formed for this purpose. The committee consists of Production
Manager, Personnel Manager, Production Engineer, Sales Manager, Cost Accountant
and other functional heads. The cost accountant is an important person, who has to
supply the necessary cost figures and coordinate the activities of budget committee.
He must ensure that the standards set are accurate and present the statements of
standard cost in most satisfactory manner.
4.2.4 Advantages of Standard Costing
The main advantages derived by installation of standard costing may be
summarised as follows:
(1) Useful in measuring performance: The actual performance can be readily
compared with the pre-determined standards showing favorable or unfavorable
variances. A standard cost is a figure which gives a fair and reasonable cost and the
comparison of actual cost with such standards reveal the level of efficiency.
(2) Cost Reduction: The variances can be analysed in detail and thus it
enables the management to investigate the causes. e.g. any inefficiencies of labour or
use of materials will be discovered and necessary corrective actions can be taken by
the management. This helps in controlling and reducing cost.
(3) Management by Exception: The principle of 'management by exception'
can be applied, which means that the attention of management is concentrated only
on important matters. Analysis of variances makes it possible.

438
 (4) Assists in performing managerial function: Standard costing provides
valuable aid to the management in performing their managerial functions such as
formulation of production policies, price policies, etc. It helps in planning,
coordinating, organising and controlling.
(5) Less Clerical Work: On one hand it saves clerical labour and on the other
hand, it gives more useful information to management. Under historical costing, a
number of forms are in use, which are of little use to management. The standard
costing standardises such forms and reduces the forms and records.
(6) Atmosphere of Cost Consciousness: It creates an atmosphere of cost
consciousness among the personnel working in the organisation.
(7) Useful for Tenders: It facilitates submission of tenders and quotations. The
scientifically fixed standards are ready at hand and quick computation becomes
possible. It also serves as a guide for fixing selling price.
(8) Saving in Cost: While preparing standards, sources of inefficiency are
likely to be disclosed. The setting of standards may, for instance, disclose that
materials are being purchased in uneconomic lots, and that less frequent orders for a
larger quantity would produce a significant saving through quantity discount.
(9) Basis of Inventory Valuation: Valuation of inventory for balance sheet
purpose is made prompt and easy. Unnecessary expenditure of time and money in
stock-taking is saved.
(10) Co-operation and Co-ordination: Cooperation among different
departments is made possible and coordination of their work is facilitated.
4.2.5 Limitations of Standard Costing
(1) Lack of Reliable Standards: In some of the business units, the system of
standard costing has failed, because it has not been able to set the dependable
standards of cost. This proves that the standards and variances are not useful for the
purposes of control and guidance of management unless reasonable and dependable
standards are fixed.
(2) Useless, if not flexible: Likewise, standards of cost serve no useful
purpose, if they are not flexible. It means the standards must be modified in the light
of the new developments or else they are useless.

439
 (3) Duplication: Though historical costing suffers from certain limitations, it is
necessary for certain purpose, e.g. for reconciling financial accounts with cost
accounts. In such circumstances, it is duplication of cost accounts, if standard costing
is adopted.
(4) Difficulties in setting standards: In some industries, particularly where
production is carried on as per customers' orders, it is difficult to lay down standards
each time a separate order is received. Besides, in industries where rapid
technological changes are taking place, the standards have to be constantly revised.
This makes the use of standard costing difficult.
(5) Adverse effects on Employees: Sometimes determining standards have
adverse psychological effects on the employees. If the standards are fixed at a high
level, they are not achieved and employees get frustrated. and hence they tend to
oppose this system. Thus instead of encouraging efficiency, this system affects
efficiency adversely.
(6) Controllable and Uncontrollable Variances: In order to fix responsibility
for adverse variances, they are to be classified as controllable by responsible person
and not controllable by him. But such classification is difficult. e.g. if wages increase
due to idle time who is responsible? It may be controllable by Production Manager or
may not be controllable by him.
Standard costing is thus a useful tool in the hands of management, provided its
limitations are also kept in mind.
4.2.6 Variances
After standards for all elements of costs have been set, the next step is to
compare the actual with standard costs to obtain the variances. When actual
performances are recorded and compared with the standards set, then some
deviations are found. These deviations are known as variances. "A variance is the
difference between a standard cost and the comparable actual cost incurred during a
period."
The variances may be favorable or unfavorable depending on circumstances.
When the actual cost is more than the standard cost, the variance is unfavorable,
adverse or red variance. But, if actual cost is less than the standard cost, it is
favorable variance.

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 There are many variances used in practice, but the cost variances may be
broadly classified as shown below.
Variances can be presented in the form of a chart as follows:
Variances

Materilas Labour Fixed Variable

Overheads Overheads
Variance Variances
1) Material Cost 2) Labour Cost 1) Fixed Overhead 1) Variable
Variance Variance Variance: Overhead
2) Material Price 2) Labour Rate 2) Expenditure Expenditure
Variance Variance Variance Variance
3) Material Usage 3) Labour Effciency 3) Volume 2) Variable
Variance Variance Variance overhead
4) Material Mix 4) Labour Mix 4) Efficiency Efficiency
Variance Variance Variance Variance
5) Material Yield 5) Idle Time 5) Capacity
Variance Variance Variance
6) Calendar
Variance
4.2.6.1 Material Variances
When the standard for cost of raw materials is established and the actual cost of
materials turns out to be more or less, the difference is known as Material Cost
Variance. This variance consists of two variances on the basis of price and use. They
are (i) Material Price Variance and (ii) Material Usage Variannce.
Besides, the Material Usage Variance consists of three variance (1) Material
Mix Variance (2) Material Sub-usage Variance and (3) Material Yield Variance.
Thus the following Variance relate to material cost.

441
 Material Cost Variance

Material Price Material Usage

Variance Variance

Material Sub- Material Mix Material Yield

Usage Variance Variance Variance
We discuss below these variance in detail:
(1) Material Cost Variance: As we have seen above, it is the difference
between the standard cost of materials and the actual cost of materials used e.g.
suppose, the standard cost of material for manufacturing one unit of a product is 100
kg. @ Rs. 5 per kg. i.e. Rs. 500. If the actual material used is 110 kilos at Rs. 6 per
kg. then the material cost would be Rs. 660. It means that the actual material cost is
Rs. 160 more than the standard fixed. This difference of Rs. 160 is called Material
Cost Variances. As the actual cost is more than the standard, the variance is
'Unfavourable' or 'Adverse'. It is also known as 'Red' Variance. If the actual expense
turns out to be less than the standard, then the variance will be 'Favourable'. It is also
known as 'Black' Variance.
The above calculation can be presented as follows:
Material Cost Variance = (Standard Quantity × Std. Price)
- (Actual Qty. × Actual Price)
= (100 × Rs. 5) – (100 × Rs. 6)
= Rs. 500 – Rs. 660
= - 160 (U)
Here (U) written in bracket suggests unfavourable variance. In fact, the Standard
Quantity written in the first bracket is the Standard Quantity of actual production.
Hence the formula may be written as

442
 Material Cost Variance = (Std. Qty. of Actual Output × Std. Price)
- (Actual Qty. × Actual Price)
= (SQ × SP) - (AQ × AP)
or = Standard Cost – Actual Cost
There are two causes of unfavorable material cost variance viz. (i) Price
difference and (ii) difference in usage i.e. Quantity of materials used.
Accordingly, Material Cost Variance can be divided into (i) Material Price
Variance and (ii) Material Usage Variance.
(i) Material Price Variance: When the actual price paid for the material is
more or less than the standard price specified, the difference is known as Material
Price Variance. When the actual material is issued for production it is charged at
standard price and the difference i.e. the variance is transferred to price variance
account. The formula for material price variance is as follows:
Material Price Variance = Actual Quantity (Std. Price – Actual Price)
= AQ (SP- AP)
This formula suggests that price variance is obtained by multiplying the price
difference by actual quantity. Here, price difference = Std. Price – Actual Price.
Illustration 1:
A Co. Ltd. has fixed standard usage of material at 100 kg. at Rs.5 per kg. But
the actual usage was 110 kg. at 6 per kg. Calculate Material Price Variance.
Solution:
Material Price Variance = Actual Qty. (Std. Price – Actual Price)
= AQ (SP - AP)
= 110 kgs. (Rs. 5 – Rs. 6)
= 110 × -1
= -110 (U)
It means that material cost increased by Rs. 110 due to change in the price of
materials used.

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 Here the price difference is Rs. 5 – Rs. 6 = -Re. 1 and it is multiplied by actual
quantity of 110 kgs. 110 × -1 = -110.
The following are the causes of material price variance;
1) Change in the basic price of raw material.
2) Loss of discount due to purchase of material in smaller quantity or
uneconomic size.
3) Loss of cash discount because of non-payment in specified time.
4) Payment of excess freight or purchase from a distant supplier.
5) Purchase of goods of different quality.
6) Inefficiency of purchase department.
7) Purchase of some substitute at a higher or lower price.
8) Changes in government taxes or duties.
Generally, the purchase officer is answerable for the material price variance. He
may sometimes be called upon to prepare a report on analysis of causes of price
variance. Sometimes, the price situation may be beyond the control of purchase
officer e.g. when the prices are rising continuously in the market or due to lack of
cash resources, the benefit of cash discount may have been lost. Even in such
circumstances the price variance analysis provides a useful guide for taking measures
to maintain the targeted profit.
(ii) Material Usage Variance: When the actual quantity of materials used in
production differs from the standard quantity specified, the difference in the cost is
called Material Usage Variance. As we have seen, the material is charged to
production at standard price, the material usage variance is calculated at standard
price. e.g. in the above illustration the standard usage was 100 kgs. but the actual
quantity used is 110 kgs. which means that the excess material used is 10 kgs., which
is priced at Rs. 5 per kgs. comes to Rs. 50 i.e. the material usage variance is Rs. 50. It
is calculated as follows:
Material Usage Variance = Std. Price (Standard Quantity – Actual Quantity)
= SR (SQ - AQ)
= Rs. 5 (100 kg. – 110 kg.)
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 = Rs. 5 × 10
= - 50 (U)
Now let us tally the variance. The total material cost variance is Rs. 160 (U)
which arises due to excess two reasons; one, increase of Rs. 110 is due to the price
and increase of Rs. 50 is due to excess usage of material.
Material Cost Variance = Price Variance + Usage Variance
= Rs. 110 (U) + Rs. 50 (U)
= 160 (U)
The following are generally, the causes of material usage variance:
1) Use of inferior quality goods or defective materials.
2) Carelessness in usage of material.
3) Theft or pilferage of materials.
4) Inefficiency in production leading to greater wastage.
5) Strict inspection leading to higher rejections.
6) Change in design or specifications.
7) More or less yield from the materials used.
8) Defective standards of yield or usage.
9) Change in mixture of different materials.
The analysis of this variance may help in locating responsibility for more
consumption of materials and in taking corrective steps.
Illustration 2:
A factory has implemented standard costing. The standard of usage fixed for
production of 1,000 units of a product is 400 kg. at a price of Rs. 2-50 per kg. 2,000
units were manufactured, it was found that 820 kgs. of materials were used at Rs.
2.60 per kg.
Calculate Materials Variances.

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Solution:
We shall calculate three material variances in this example:
1) Material Cost Variance 2) Material Price Variance and 3) Material Usage
Variance.
1) Material Cost Variance = (Std. Qty. × Std. Price) – (Actual Qty. × Actual Price)
= (800 × 2.50) – (820 × 2.60)
= Rs. 2,000 – Rs. 2,132
= -132 (U)
This shows that the Material Cost has increased by Rs. 132. This increase is due
to two reasons (1) There is a difference in material price and also 2) The actual use of
material is more.
2) Material Price Variance = Actual Quantity (Std. Price – Actual Price)
= 820 kgs. (Rs. 2.50 - Rs. 2.60)
= 820 x - 0.10
= - 82 (U)
This calculation shows that the material cost has increased by Rs. 82 due to
increase in the price of material. Hence it is unfavourable and is denoted by (U).
Had the price declined, the variance would have been favourable and would be
denoted with + i.e. (F).
(3) Material Usage Variance = Standard Price (Std. Qty. - Actual Qty.)
= Rs. 2.50 (800 - 820)
= 2.50 x - 20
= - 50 (U)
This suggests that the material cost has increased by Rs. 50 due to increase
in use of material. This is unfavourable or adverse variance. Material Cost
Variance = M. Price Variance + M. Usage Variance
= - 82 - 50
= - 132 (U)

446
Illustration 3 :
In a factory, it is estimated that for the use of 1 ton of materials, 100 units are
manufactured. The standard price of material is Rs. 10. During August, 2015, 100
tons of material was issued to production at Rs. 10-50 per ton. Actual production was
10,250 units.
Calculate : 1) Material Cost Variance 2) Material Price Variance 3) Material
Usage Variance.
Solution :
: Let us find out standard quantity for actual production.
For 100 units 1 ton is used

,
∴ 10,250 units (?) = 102.5 tons



1) Material Cost Variance = (Std. Qty. of Actual Prod. x Std. Price)

= - (Actual Qty. x Actual Price)
= (102.5 x Rs. 10) – (100 x Rs. 10.50)
= Rs. 1,025 – Rs. 1,050
= - 25 (U)
2) Material Price Variance = Actual Qty. (Std. Price – Actual Price)
= 100 ton (10 – 10.50)
= 100 x 0.50
= - 50 (U)
3) Material Usage Variance = Std. Price (Std. Qty. – Actual Qty.)
= Rs. 10 (102.5 - 100)
= 10 x 2.5
= + 25 (F)
Illustration 4 :
Calculate : A) Material Cost Variance, B) Material Price Variance, C) Material
Usage Variance from the following data.
447
 Purchase of Material 6,000 units
Cost of Purchase of Material Rs. 24,000
For Production of 1 ton,
Standard quantity of material required 50 units
Standard Price Rs. 3.50 per unit
Closing stock of material 1,000 units
Actual production 95 ton
Solution :
A) Let us find out Standard Quantity for actual production.
1 Ton Production = 50 Units

for 95 Production ? = 4,750 units


Let us Find out Actual Material used :
Purchase of Material 6,000 units
Less : Closing stock 1,000 units
Actual usage 5,000 units
1) Material Cost Variance = (Std. Qty. of Actual Prod. x Std. Price)
- (Actual Qty. x Actual Price)
= (4,750 units x Rs. 3.50) – (5,000 x Rs. 4)
= Rs. 16,625 – Rs. 20,000
= - 3,375 (U)
2) Material Price Variance = Actual Qty. (Std. Price - Actual Price)
= 5,000 (3.50 – 4.00)
= 5,000 x – 0.50
= - 2,500 (U)
3) Material Usage Variance = Std. Price (Std. Qty. – Actual Qty.)

448
 = Rs. 3.50 (4,750 – 5,000)
= Rs. 3.50 x -250
= - 875 (U)
iv) Material Mix Variance : In some industries two or more materials are used in
the production of a single commodity in a fixed proportion. The budgeted mixture of
two or more materials in called standard material mix. If actual mix is different from
the standard mix for any reason, then there will arise material cost variance, which is
known as material mix variance. In short, material mix variance refers to the
difference between actual material mix and standard material mix. For instance,
suppose materials A and B both are used in the production of a product. Their
relative proportion is as follows:
A 20 kgs. at the price of Rs. 5 per kg. = Rs. 100
B 30 kg. at the price of Rs. 2 per kg. = Rs. 60
Total material 50 kg Rs. 160
Suppose, actually 25 kg of A and 25 kg. of B have been used in production. In
that case material cost will be as under:
A 25 kg x Rs. 5 = Rs. 125
B 25 kg x Rs. 2 = Rs. 50
Total 50 kg Rs. 175
Thus and adverse variance of Rs. 15 (Rs. 175 – Rs. 160) has arisen. Rs. 150 will
be debited to production while Rs. 15 will be debited to material mix variance
account.
Note that two types of situations have be to considered to find out the material
mix variance.
a) When standard weight and actual weight of the material mix are equal:
For instance the standard quantity of material A is 40 kg and that of material B
is 30 kg. Hence, the weight of the standard mix is 70 kg.
Now, if actual quantity used of A is 45 kg and that of B is 25 kg. Hence
actual weight of the mix is 70 kg. which is the same as standard weight. In this case,
variance can be obtained with the help of following formula:
Material Mix Variance = Standard Price (Standard Mix - Actual Mix)
= SP (SM - AM)
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Illustration 5 :
Find out material mix variance from the following information taken from cost
accounts of a factory:
Standard Actual
Material
A 60 kg at 70 kg at
Rs. 5 per kg. Rs. 5 per kg.
B 50 kg. at 40 kg. at
Rs. 6 per kg. Rs. 6.20 per kg.
110 kg. 110 kg.
Solution :
On the basis of the data given above, it is seen that the weight of the standard
material mix is 110 kg. and actual weight is also 110 kg. Hence, following formula
can be used:
Material Mix Variance = Std. Price (Std. Mix – Actual Mix.)
A = Rs. 5 (60 – 70 kg)
= Rs. 5 (-10 kg.)
= - Rs. 50 (U)
B = Rs. 6 (50 – 40 kg.)
= Rs. 6 (10 kg)
= Rs. 60 (F)
∴ Mix Variance = 50 + 60 = Rs. + 10 (F)
Note : When the total weight of actual mix equals the total weight of standard mix
and yet there arises a mix variance, it will be treated as material mix variance and the
usage has neither increased nor decreased. Hence, we need not calculate material
usage variance in such cases. Also, the formula of material mix variance is the same
of material usage variance in such case.

450
Illustration 6 :
Two material X and Y are used in the production of a commodity in a factory.
The information about its production in August, 2015 is as under:
Standard Material Mix : X 100 kg at Rs. 30 per kg. Rs. 3,000
Y 50 kg at Rs. 12 per kg. Rs. 600
150 kg. Rs. 3,600
Actual Material Mix : X 110 kg. at Rs. 32 Rs. 3,520
Y 40 kg. at Rs. 11 Rs. 440
150 kg. Rs. 3,960
Compute Material Variances.
Solution:
In this case, two variances are self evident : firstly, there is a difference in the
standard rate and actual rate for both materials, and hence the price variance arises.
Secondly their relative amounts in the actual mix is also different. This gives rise to
mix variance. No doubt, the quantity of actual mix is same as the quantity of standard
mix. Therefore Material mix variance can be calculated on the basis of the above
formula.
1) Material Cost Variance = Standard Cost – Actual Cost = (SQ x SP)
– (AQ x AP)
= Rs. 3,600 – Rs. 3,960
= - Rs. 360 (U)
There are two parts of material cost variance:
2) Material Price Variance = Actual Qty. (Std. price – Actual Price)
X = 110 (Rs. 30 – Rs. 32)
= - Rs. 220 (U)
Y = 40 (Rs. 12 – Rs. 11)
= + Rs. 40 (F)
Total Material Price Variance = -220 + 40 = - Rs. 180 (U)

451
3) Material Mix Variance = Std. Price (Std. Mix – Actual Mix)
X = Rs. 30 (100 kg. – 110 kg.)
= Rs. 30 (-10)
= - Rs. 300 (U)
Y = Rs. 12 (50 kg – 40 kg.)
= Rs. 12 (10 kg)
= + Rs. 120 (F)
Total Material Mix Variance = - 300 + 120
= - Rs. 180 (U)
b) When the weight of standard Mix and weight of Actual mix are unequal: In
this case too the above formula is to be applied, but the standard quantity needs to be
revised. The formula will be as follows:
∴ Material Mix Variance = SP (Revised SM - AM)
          
Here, Revised Mix = AQ x
    

= TAQ x


Where, SQ = Standard quantity of one material

TAQ = Total actual quantity
TSQ = Total standard quantity.
We may clarify this point with the help of an example.
Illustration 7 :
Calculate material mix variance in a factory on the basis of the data given
below:
Material Standard
Actual
A 120 units at Rs. 10 per unit 150 units at Rs. 10
B 180 units at Rs. 8 per unit 180 units at Rs. 9
300 units 330 units
452
Solution:
In the above case, standard mix is 300 units, while actual mix is 330 units.
Hence standard mix should be revised.
       
Revised standard Mix = TAQ x



A = 330 units x units = 132 units.



B = 330 units x units = 198 units.


Now, apply the formula.

Material mix variance = Std. Price (Revised Std. Mix – Actual Mix)
A = Rs. 10 (132 units – 150 units)
= Rs. 10 (-18 units)
= - Rs. 180 (U)
B = Rs. 8 (198 units – 180 units)
= Rs. 8 x 18 units
= Rs. 8 x 18 units
= + Rs. 144 (F)
∴ Total Mix Variance = - 180 + 144
= - Rs. 36 (U)
Two other variances in the above example are : 1) material price variance and 2)
material usage variance.
These two variances can be computed as follows:
Material Price Variance = AQ (SP - AP)
A+B = 150 (10-10) + 180 (8-9)
= 0 + (-180)
= - Rs. 180 (Adverse)
Material Usage Variance = SP (SQ - AQ)

453
 A+B = Rs. 10 (120 – 150 units) + Rs. 8 (180 - 180)
= Rs. 10 x 30 + 0
= - Rs. 300 (A)
The total of these two variances will give material cost variance.
Material Cost Variance = (SP x SQ) – (AP x AQ)
= (10 x 120 + 8 x 180) – (10 x 150 + 9 x 180)
= (1200 + 1440) – (1500 + 1620)
= Rs. 2640 – Rs. 3120
= - Rs. 480 (A)
Note: Material mix variance is a part of material usage variance. Hence it is not
taken into account while tallying the total variances.
v) Material Sub- usage Variance: In the above example, total usage variance is
Rs. 300, while mix variance is Rs. 36. What, then, about Rs. 264? That is material
sub-usage variance. When the sum of standard mix is not equal to the sum of actual
mix, material sub-usage variance arises. It means that the quantity used has also
increased or decreased. So there are two reasons for Material usage variance i) Mix
has changed ii) More quantity is used. It is calculated in the following manner:
Material Sub- usage Variance = Std. Price (Std. Mix – Revised Std. Mix)
A = Rs. 10 (120 kg – 132 kg)
= Rs. 10 (-12)
= - Rs. 120 (U)
B = Rs. 8 (180 kg. – 198 kg)
= Rs. 8 (-18)
= - Rs. 144 (U)
Total Rs. 264 (U)
Material Usage Variance

Material Mix Variance Material Sub- usage Variance

454
iv) Material Yield Variance: If, for any reason, actual yield (actual good units
produced) of a given amount of material is different from the standard yield, this
difference is known as material yield variance. Generally, in the processing
industries where some wastage of material is inevitable, the problem of material
yield variance arises.
Here, too when standard mix and actual mix are equal, following formula is to
be used:
Material Yield Variance = Standard cost per unit (Actual Yield- Standard
Yield)
Per unit standard cost can be obtained by dividing total standard cost by
total standard output.
   
Cost per unit =
    

Illustration 8 :
Calculate Material Yield variance from the following information.
Material standard price : Rs. 13.50 per kg.
Actual standard Quantity : 2,000 kg.
Normal loss : 10%
Actual Production : 1,700 kg.
Solution:
First we find out standard cost per unit
   
Standard cost per unit =
     (! )

= Std. Qty. x Std. Price

= 2,000 kg. x Rs. 13.50
= Rs. 27,000
= Std. Qty. – Normal Loss

455
 = 2,000 kg. – 200 kg. loss (10% of 2,000)
= 1,800 kg.
#.%,
∴ Standard cost per unit = = Rs. 15

, &'.

Material Yield Variance = Std. cost per unit (Actual Yield – Std. Yield)
= Rs. 15 (1,700 kg. – 1,800 kg.)
= Rs. 15 x -100
= - 1,500 (U)
Remember that in all other variances worked out above, we were writing
Standard amount first in the bracket. But here Actual yield is written first. This is
because it is a credit item, whereas in other variances, there were debit items of
expenses. If we want to write standard item first, even in this variances, the formula
will be changed. Instead of yield, we write wastage in the bracket.
Material Yield Variance = Standard cost per unit (Std. Wastage – Actual
Wastage)
= Rs. 15 (200 kg. – 300 kg.)
= Rs. 15 x -100
= - Rs. 1,500
Illustration 9:
In a factory, the standard production during April, 2001 was fixed at 180 kgs.
for which standard cost was as follows:
Material O : 120 kg. per Rs. 10 Rs. 1,200
Material P : 80 kg. per Rs. 50 Rs. 4,000
200 kg. Rs. 5,200
Less : 10 % loss 20 -
180 kg. Production Rs. 5,200
Details about actual production were as follows:
Material O 130 kg. per Rs. 12 Rs. 1,560

456
 Materials P 70 kg. per Rs. 50 Rs. 3,500
200 kg. production Rs. 5,060
Less: Loss 30 kg. -
170 kg. Rs. 5,060
Calculate Material Variances
Solution :
First we shall calculate price variance. But in case of P there seems to be no
price difference. Hence we shall find out price variance for O only.
A) Material Price Variance = Actual Qty. (Std. Price – Actual Price)
= 130 (Rs. 10 – Rs. 12)
= 130 (- Rs. 2)
= - 260 (U)
Now are shall find out mix variance. As the quantity of standard mix and
quantity of actual mix are the same, there is no need to find out revised standard mix.
B) Material Mix Variance = Std. Price (Std. Mix – Actual Mix)
For O = Rs. 10 (120 kg. – 130 kg.)
= - Rs. 100 (U)
For P = Rs. 50 (80 kg. – 70 kg)
= Rs. 50 x 10
= + Rs. 500 (F)
∴ Total Mix Variance = - Rs. 100 + Rs. 500 = Rs. 400 (F)
C) Material Yield Variance = SC (AY - SY)
 
Now per unit standard Cost =
 !
,
= = Rs. 28.9



∴ Yield Variance = Rs. 28.9 (170 kg. – 180 kg.)

457
 = 28.9 (-10)
= - Rs. 289 (U)
Now we shall calculate Material cost variance.
D) Material Cost Variance = (Std. Qty. x Std. Price) – (Actual Qty. x Actual
Price)
= (170 kg. x 28.9) – Rs. 5,060
= - 149 (U)
Verification :
Material Cost Variance = Price Variance + Mix Var. + Yield Variance
= -260 + 400 – 289
= -149 (U)
Illustration 10 :
The standard cost of a certain chemical mixture is as follows:
40% Material A at Rs. 20 per ton.
60 % Material B at Rs. 30 per ton.
A standard loss of 10 % is expected in production. During one month 171 ton is
produced and 90 tons of Material A at Rs. 18 per kg. and 110 tons of Material B at
Rs. 34 is used.
Calculate : 1) Material Price Variance 2) Material Mix Variance 3) Material
Yield Variance.
Solution:
1) First we shall find out standard quantity of material for actual production of
171 tons. If 100 tons of material are used, then at 10 % standard loss, we get standard
output of 90 tons.
For 90 tons production = 100 tons materials used
100 x 171
∴ For 171 tons of actual prod. = (?)
90
= 190 tons
2) We find out standard quantity of 190 tons

458
 - .
A 40% = 190 tons x = 76 tons: B 60% = 190 x = 114 tons



1) Material Cost Variance = (Std. Qty. x Standard Price) – (Actual
Quantity x Actual Price)
A = (76 tons x Rs. 20) – (90 tons x Rs. 18)
= 1,520 – 1,620= -100
B = (114 tons x Rs. 30) – (110 tons x Rs. 34)
= 3,424 – 3,740 = -320
Total -420 (U)
2) Material Price Variance = Actual Quantity (Std. Price – Actual Price)
A = 90 tons (Rs. 20 – Rs. 18) = +180
B = 110 tons (Rs. 30 – Rs. 34) = - 440
-260 (U)
Std. Mix = 90 tons + 110 tons = 200 tons
A = 200 tons x 44% = 80 tons
B = 200 tons x 60% = 120 tons
3) Material Mix Variance = Std. Price (Std. Mix – Actual Mix)
A + B = Rs. 20 (80-90) + Rs. 30 (120 - 110)
= (20 x -10) + (30 + 10)
= -200 + 300
= + 100 (F)
Std. Qty. = A 80 x Rs. 20 = Rs. 1,600
B 120 x Rs. 30 = Rs. 3,600
Std. cost = Rs. 5,200
Std. Yield = Actual Quantity – Std. Loss
= 200 units – 10% loss 20 units = 180 units

459
  .
∴ Per unit std. cost =
 !
,
= = Rs. 28.89



4) Material Yield Variance = Std. cost (Actual Yield – Std. Yield)

= Rs. 28.89 (171 - 180)
= 28.89 x -9
= -260 (U)
5) Material Cost Variance = Price Variance + Mix Variance + Yield Variance
= -260 + 100 – 260
= -420 (U)
Illustration 11:
The Standard mix of product 'M' is as follows:
Material Kgs. Price per Kg. Rs.
A 50 5-00
B 20 4-00
C 30 10-00

The standard loss in production is 10% of the input. There is no scrap value.
Actual production of product M was 7,200 kgs.
Actual consumption of material and cost were as follows:
Material Kgs. Price per Kg. Rs.
A 4,160 5-50
B 1,680 3-75
C 2,560 9-50

You are required to calculate the following variances:

i) Material cost variance ii) Material price variance

460
 iii) Material usage variance iv) Material Mix variance
v) Material Yield variance
Solution:
First of all we shall find out std. quantity for actual output.
Here actual output is 7,200 kgs. while std. loss is 10%
If the output is Std. quantity
90 kgs. = 100 kg.
∴ 7,200 kgs. (?)


= 7,200 x = 8,000 Std. quantity

The standard quantity for each type of material:

For A = 8,000 kg. x = 4,000 kgs.



B = 8,000 kg. x = 1,600 kgs.



C = 8,000 kg. x = 2,400 kgs.



8,000 kgs.
Now we shall calculate necessary variances.
1) Material Cost Variance = (Std. Quantity x Standard Price) – (Actual
Quantity x Actual Price)
A = (4,000 kg. x Rs. 5) – (4,160 x 5.50)
= 20,000 – 22,880
= - 2,880 (U)
B = (1,600 kg. x Rs. 4) – (1,600 x Rs. 3.75)
= 6,600 – 6,300
= + 100 (F)
C = (2,400 kg. x Rs.20) – (2,560 x 9.50)

461
 = 24,000 – 24,320
= -320 (U)
= - 2,880 + 100 – 320
Total Variance = -3,100 (U)
2) Material Price Variance = Actual Quantity (Std. Price – Actual Price)
= A 4,160 (5 – 5.50) + B 1,680 (4-3.75) +
C 2,560 (10-9.50)
= (4160 x 0.50) + (1,680 x 0.25) + (2560 x 0.50)
= - 2,080 + 420 + 1,280
= - 380 (U)

3) Material Usage Variance = Std. Price (Std. Qty. – Actual Qty.)

= A 5 (4,000 – 4,060) + B 4 (1,600 – 1,680) +
C 10 (2,400 – 2,560)
= - 800 – 320 - 2,560
= - 2,720 (U)
4) Material Mix Variance:
For computing mix variance, it is necessary to find out revised std. mix, because
the total standard quantity is 8,000 kgs. while the total actual quantity is 8,400 kgs.
(4,160 + 1,680 + 2,560).
-,
∴ Revised Std. mix A = 8,400 x = 4,200 kgs.


,.
B = 8,400 x = 1,680 kgs.

,-
C = 8,400 x = 2,520 kgs.

8400 kgs.
Material Mix Variance = Std. Price (Revised Std. Mix – Actual Mix)

462
 = 5 (4,200 – 4,160) + 4 (1,680 – 1,680) + 10 (2,520
– 2,560)
= 200 + Zero - 400
= - 200 (U)
Material Yield Variance –
Std. Cost per unit
A 4,000 kgs. x Rs. 5 = 20,000
B 1,600 kgs. x Rs. 4 = 6,400
C 2,400 kgs. x Rs. 10 = 24,000
8,000 50,400
Less 10% Loss 800 kgs. -
7,200 kgs. 50,400
,-
Per unit Std. Cost = = Rs. 7
%,

Revised Std. Yield = Actual Qty. – Std. Loss

= 8,400 – 840 = 7,560 kgs.
5) Material Yield Variance = Std. Cost (Actual Yield – Revised Std. Yield)
= Rs. 7 (7,200 – 7,560)
= Rs. 7 x – 360
= - 2,520 (U)
Verification :
Material Cost Variance ( + 3,100) (F)

Material Price Variance Material Usage Variance (-2720)

(-380) (A)
Material Mix Variance Material Yield
(-200) (A) Variance (-2520) (A)

463
 Material Variances
1 Material Cost Variance (SQ x SP) – (AQ x AP)
(Std. Quantity x Standard Price) – (Actual
Quantity x Actual Price)
2 Material Price Variance AQ (SP - AP)
3 Material Usage Variance SP (SQ - AQ)
4 Material Mix Variance:
a) When standard mix SP (SM - AM)
quantity and actual mix
quantity are equal.
SP (RSM - AM)
b) When they are unequal.
RSM = Revised Standard Mix
       
= AQ x 

5 Material Sub- Usage SP (SQ - RSQ)

Variance
When standard mix quantity
and actual mix quantity are
unequal.
6 Material Yield Variance Per unit standard cost (AY SY)
When standard mix quantity Per unit standard cost
and actual mix quantity are (Standard loss - actual loss)
unequal.
where standard cost = total standard
Price ÷ SQ
Per unit standard cost (AY - RSY)
Where RSY = AQ introduced – loss at the
standard rate

464
4.2.6.2Wage or Labour Variances:
If the actual wages are more or less than the standard amount of wages fixed,
then the difference is the labour variance. There are two reasons for labour cost
variances : 1) The wage rate actually paid may differ from wage rate fixed (standard
wage rate). This is wage rate variance. 2) The workers may take more time or less
time. Then the time fixed and as a result the wage cost may increase or decrease.
This is called Labour Efficiency Variance. Thus labour variances are mainly two.
Labour Cost Variance

Wage Rate Variance Labour Efficiency Variance

The formulas for labour variances can be derived from the formulas for material
variances. If we write wage rate in place of 'price' in case of material price variance,
we get labour rate variance. But in place of material quantity, we have to write labour
hours.
Similarly, if we write actual hours instead of actual quantity in Material usage
variance, we get Labour Efficiency variance.
i) Labour Cost Variance: It is the difference between standard labour cost and
actual labour cost. This is total labour cost variance. It is obtained as follows:
Labour Cost Variance = (Standard Wage Rate x Standard Hours)
- (Actual Wages Rate x Actual Hours)
= Standard Labour Cost – Actual Labour Cost
Illustration 12 :
Standard wage rate is Rs. 2 per hour and standard time is 10 hours. But actual
wage rate is Rs. 2.25 per hour and actual hours used are 12 hours.
Calculate labour cost variance.
Solution:
Labour Cost Variance = (Std. Rate x Std. Hours) – (Actual Rate x Actual Hours)
= (SR x SH) – (AR x AH)
= (Rs. 2 x 10) – (RS. 2.25 x 12)
465
 = Rs. 20 – Rs. 27
= - Rs. 7 (U)
Here labour variance is adverse or unfavorable because actual labour cost
exceeds standard labour cost by Rs.7
ii) Wage Rate Variance: Standard labour cost is calculated on the basis of
standard wage rate. But if more efficient and skilled workers are required, then it
becomes necessary sometimes to pay higher wage rate than the standard one. Hence
actual labour cost will rise. It is very useful to differentiate between various labour
cost variance according to the difference in their causes. More particularly, the
labour cost variance arising out of the controllable factors must be separated from the
labour cost variance caused by some uncontrollable factors. For example, suppose
standard time of a job is 10 hours and standard wage rate is Rs. 2 per hour. If,
however, actually 12 hours are taken on the job and if workers are actually paid at
the wage rate of Rs. 2.25 per hour, the labour cost will be up by Rs. 3 due to the fact
that for each hour used up in production, 25 paise more have been paid to the
laboures (25 paise x 12 hours = Rs. 3.00) This is known as Wage Rate Variance. It is
just like material price variance.
Wage Rate Variance = Actual Hours (Std. Rate – Actual Rate)
= AH + (SR - AR)
Illustration 13 :
Calculate labour cost variance and wage rate variance from the following
information:
Standard production : 200 units
Standard hours : 1,000 hours
Wage rate per hour : Rs. 4
Actual production : 170 units
Actual time taken : 900 hours
Actual wage rate paid : Rs. 4.20 per hour

466
Solution:
Actual production is 170 units, for which standard hours will have to be
calculated, because we are required to multiply wage rate per hour with standard
hours of actual production.
Std. time for one unit = 1,000 hours ÷ 200 units = 5 hours
∴ Std. hours for actual production 170 units = 170 x 5 = 850 hours.
Labour Cost Variance = (Std. Hours of Actual Prod. x Std. Rate) - (Actual
Hours x Actual Rate)
= (850 Hours x Rs. 4) – (900 Hours x Rs. 4.20)
= Rs. 3,400 – Rs. 3,780
= Rs. -380 (U)
Wage Rate Variance = Actual Hours (Standard Rate – Actual Rate)
= 12 hours (Rs. 2.00 – Rs. 2.25)
= 12 hours (-Rs. 0.25) – Rs. 3 (U)
Some of the causes of wage rate variances are as follows:
1) A change in the method of wage payment, e.g piece wage system may be
substituted for time wage system.
2) If workers are guaranteed daily wage, it must be paid irrespective of
whether they complete a standard task or not.
3) Newly required workers may not be paid full amount.
4) A change may be introduced in the structure of wages e.g. a new scale may
be introduced in response to the tribunal's award.
5) Workers may be paid for overtime work which may not have been taken
into account while calculating the standard rate.
6) The workers employed actually may be more or less skilled than
anticipated.
7) The workers employed on temporary basis may be more or less than the
standard rate.

467
 A this point, it is important to note that in most cases wage rate is beyond the
control of management. It is determined by the market forces of demand and supply
in the labour market or by the tribunal award or by the government ligislation.
Illustration 14 :
The data about wages paid in a factory is as follows:
Type Standard Actual
Skilled 200 hours at Rs. 2 210 hours at Rs. 2.20
Semi-skilled 200 hours at Rs. 1.50 190 hours at Rs. 1.40
Calculate wage rate variance.
Solution:
Wage Rate Variance = Actual Hours (Standard Rate – Actual Rate)
Skilled = 210 Hours (Rs. 2.00 – Rs. 2.20)
= 210 x –Rs. 0.20
= -Rs. 42 (U)
Semi- skilled = 190 Hours (Rs. 1.50 – Rs. 1.40)
= 190 x 0.10
= + 19 (F)
Total Variance = -42 + 19 = -21 (U)
iii) Labour Efficiency Variance: A worker is expected to produce a standard
quantity of output during standard period of time. If actually he produces more or
less than the standard quantity within the standard time, a labour cost variance
emerges which is known as labour efficiency variance. This can be calculated as
follows:
Labour Efficiency Variance = Standard Rate (Standard Hours – Actual Hours)
= SR (SH - AH)
Note : Standard hours taken here are that of actual production.
As in the above example, if standard output is one unit during 10 hours in a
factory and standard rate is Rs. 2.00 per hour, but if actually 12 hours are taken and
468
actual rate paid is Rs. 2.25 per hour, then labour efficiency variance will be as
follows:
Labour Efficiency Variance = Standard Rate (Std. Hours – Actual Hours)
= SR (SH- AH)
= Rs. 2.00 (10 hours – 12 hours)
= - Rs. 4 (U)
In this case, a labourer taken 12 hours instead of 10 hours as expected in
producing a unit of the product. He turns out to be less efficient than expected.
Consequently labour cost has increased by Rs. 4 (Rs. 2 x 2 hours). If follows that
labour efficiency variance is just like material usage variance.
In the above example, total labour cost has gone up by Rs. 7.00 of this, increase
in cost of Rs. 3.0 has been caused by an increase in wage rate, while increase in cost
of Rs. 4.00 has been the result of low labour efficiency.
Thus, Labour Cost Variance = Wage rate variance + Labour efficiency variance
= - Rs. 3 – Rs. 4
= -Rs. 7 (U)
Some of the causes responsible for labour efficiency variance are inefficiency of
workers, defective machines and equipment, incompetence of the supervisor,
defective planning, irresponsible inspection and unfavorable working conditions in
the factory etc.
Illustration 15:
The data regarding labour cost of production in February 2001 in a factory is as
follows:
Actual direct wages paid Rs. 26,240
Standard hours 8,640
Standard wage rate per hour Rs. 3.00
Actual hours 8,200
Calculate labour cost variances

469
Solution:
/0   1 ' 2 
Actual wage rate per hour =
/0   3 
.,-
= = Rs. 3.20
,

1) Labour Cost Variance = SLC – ALC

= Std. Labour Cost - Actual Labour Cost
= (Std. Hours x Std. Rate) – (Actual Hours x
Actual Rate)
= (8640 x Rs. 3) – Rs. 26,240
= Rs. 25,920 - Rs. 26,240
= - Rs. 320 (U)
This labour variance is made up to two variances: wage rate variance and labour
efficiency variance.
2) Wage Rate Variance = Actual Hours (Std. Rate – Actual Rate)
= 8,200 (Rs. 3.00 – Rs. 3.20)
= 8,200 (- Rs. 0.20)
= - Rs. 1640 (U)
3) Labour Efficiency Variance = Std. Rate (Std. Hours – Actual Hours)
= Rs. 300 (8640 - 8200)
= Rs. 3.00 x 440
= Rs. 1,320 (F)
Labour Cost Variance = Wage Rate Variance + Labour Efficiency Variance
= - 1,640 + 1,320
= - Rs. 320 (U)

470
Illustration 16:
Data about a company for March, 2015 are as follows:
Total Direct Labour Rs. 4,320
Direct Standard Hours 2,000 hours
Standard wage rate per hour Rs. 2
Actual paid hours 1,800 hours
Abnormal Idle Time 80 hours
Solution:
Let us calculate actual wage rate per hour in this case.
/0     2  
Actual wage rate per hour =
/0   4 
#.-,
=

,

= Rs. 2.40
1) Labour Cost Variance = Standard wage rate for std. time
– Actual wage rate for actual time
= (2,000 hours x Rs. 2) – (1,800 hours x Rs. 2.40)
= Rs. 4,000 – Rs. 4,320
= - Rs. 320 (U)
2) Wage Rate Variance = Actual hours (Standard rate – Actual rate)
= 1,800 hours (Rs. 2 – Rs. 2.40)
= 1,800 x – 0.40
= - Rs. 720 (U)
3) Labour Efficiency Variance= Std. rate (Std. hours – Actual hours)
= Rs. 2 (2,000 – 1,720)
= Rs. 2 x 280
= + Rs. 560 (F)

471
 Note: Here, the idle hours must be deducted from actual hours.
Actual hours 1,800 – Idle time 80 hours = 1,720 hours.
4) Idle Time Variance = Abnormal Idle x Standard wage rate
= 80 hours x Rs. 2
= - Rs. 160 (U)
Verification:
Labour Cost Variance = Wage Variance + Efficiency Variance + Idle
time Variance
= - 720 + 560 – 160
= - Rs. 320 (U)
5) Labour Mix Variance : When number of different types of workers required
for a job is fixed, but in practice, a different mix of labour is used for the job, a
labour cost variance arises which is described as labour mix variance. It is just
like material mix variance. It is also known as Labour Gang Composition
Variance. Its formula is as follows:
Labour Mix Variance = Standard Wage Rate (Standard Mix – Actual Mix)
Illustration 17 :
The standard mix of labour for a job is as under (This job finishes within 50
hours).
5 male workers paid at Rs. 2.50 per hour
6 female workers paid at Rs. 2.00 per hour
2 child workers paid at Rs. 1.50 per hour
But, actually, 7 male workers, 5 female workers and 1 child are employed for
this job. Compute labour mix variance.
Solution:
Labour Mix Variance = Standard Rate (Standard Mix – Actual Mix)
Males = - Rs. 2.50 (5-7) = Rs. 2.50 x -2 = -Rs. 5
= - Rs. 5 x 50 hours = -Rs. 250 (U)

472
 Females = Rs. 2 (6-5) = 2 x 1 = Rs. 2
= Rs. 2 x 50 hours = Rs. 100 (F)
Child = Rs. 1.50 (2-1) = Rs. 1.50
= Rs. 1.50 x 50 hours = Rs. 75 (F)
Total Mix Variance = -250 + 100 + 75 = - 75 (F)
Note: In this problem total number of Standard workers are 13 and actual
number of workers are also 13 and so standard mix has not been revised. If both are
different, then instead of Std. mix. Revised Std. Mix will have to be written in the
formula as we are doing in material mix variance.
Illustration 18 :
Following labour mix had been provided in the budget to produce 1000 units of
a product :
Total Standard Total Standard
Hours Cost (Rs.)
30 males 0.40 per hour 50 hours 1,500 600
20 Females 0.30 per hour 30 hours 600 180
10 Children 0.20 per hour 20 hours 200 40
2,300 820
The information abour actual hours of work and labour mix is as follows:
Total Actual Total Actual
Hours Cost (Rs.)
25 males 0.45 per hour 50 hours 1,250 562-50
30 Females 0.30 per hour 30 hours 900 270-00
10 Children 0.20 per hour 15 hours 150 30-00
2,300 862-50
Calculate: 1) Labour cost variance 2) Wage rate variance 3) Labour efficiency
variance and 4) Labour mix variance.

473
Solution:
1) Labour Cost Variance = (Std. hrs x Std. Rate) – (Actual hrs. x Actual
Rate)
Male = (1500 hours x 0.40) – (1250 x 0.45)
= Rs. 600 – Rs. 562.50 = + Rs. 37.50 (F)
Females = (600 x 0.30) – (900 x 0.30)
= Rs. 180 – Rs. 270 = - Rs. 90 (U)
Children = (200 x 0.20) – (150 x 0.20)
= Rs. 40 – Rs. 30 = + Rs. 10 (F)
Total Labour Cost Variance = -Rs. 42.50 (U)

OR
= Std. Wage Cost - Actual Wage Cost
= 820 – 862.50
= -42.50 (U)
2) Wage Rate Variance = Actual Hours (Standard Rate – Actual Rate)
Male = 1250 (0.40 – 045)
= 1250 (0.05) = -Rs. 62.50 (U)
Females = 900 (0.30 – 0.30) = 0
Children = 150 (0.20 – 0.20) = 0
Total Wage Rate Variance = - Rs. 62.50 (U)
3) Labour Mix Variance = Standard Rate (Standard Mix - Actual Mix)
Male = 40 paise (1500 - 1250)
= 40 paise x 250 = + Rs. 100 (F)
Females = 30 Paise (600 - 900)
= 30 paise x – 300 = - Rs. 90 (U)
Children = 20 paise (200 – 150)

474
 = 20 paise x 50 = + Rs. 10 (F)
Total labour mix variance = + Rs. 20 (F)
Note: Since standard hours and actual hours are equal (2300) in this case, there
is no need to revise standard mix. Hence there is no efficiency variance in this case.
Labour efficiency variance does not arise when labour mix variance is accompanied
by the equality between standard hours and actual hours. But if standard hours and
actual hours are unequal, labour efficiency variance does arise and is similar to
material sub- usage variance. It is known as Revised Labour Efficiency Variance.
Illustration 19 :
Data about standard cost of a unit of output in a factory is as follows:
Material : 4 kg. Rs. 50 per kg. Rs. 200
Labour : 50 hours Re. per hour Rs. 50
Rs. 250
Data about actual cost:
Actual production : 100 units
Material : 390 kg. Rs. 52 per kg. Rs. 20,280
Labour : 4,920 hours Rs. 1.10 per hour Rs. 5,412
Rs. 25,692
Solution:
Standard material cost of actual production of 100 units
100 units x 4 kg. = 400 kg. x Rs. 50 = Rs. 20,000
Let us now compute material variance.
1) Material Cost Variance = (Std. Qty. x Std. Price)
- (Actual Qty. – Actual price)
= Rs. 20,000 – Rs. 20,280
= - Rs. 280 (U)
2) Material Price Variance = Actual Quantity (Std. Price – Actual Price)

475
 = 390 kg. (Rs. 50 – Rs. 52)
= 390 x -2
= - Rs. 780 (U)
3) Material Usage Variance = Std. Price (Std. Qty – Actual Qty.)
= Rs. 50 (400 kg. – 390 kg.)
= Rs. 50 x 10
= Rs. 500 (F)
Now, Material Cost Variance = Material Price Variance + Material Usage
Variance
= - 780 + 500
= - Rs. 280 (U)
Labour Variance:
1) Labour Cost Variance = (Std. Hours x Std. Rate) – (Actual Hours x
Actual Rate)
= (100 units x 50 hours x Re. 1) – (Rs. 5,412)
= Rs. 5000 – Rs. 5,412
= - Rs. 412 (U)
2) Wage Rate Variance = Actual Hours (Std. Rate – Actual Rate)
= AH (SR - AR)
= 4,920 hours (Re. 1 – Re. 1.10)
= 4,920 x 0.10
= - Rs. 492 (U)
3) Labour Efficiency Variance = Std. Rate (Std. Hours – Actual Hours)
= SR (SH - AH)
= Re. 1 (5,000 hours 4,920 hours)
= Re. 1 x 80 hours

476
 = + Rs. 80 (F)
Labour Cost Variance = Wage Rate Variance + Efficiency Variance
= - 492 + 80
= - Rs. 412 (U)
Illustration 20 :
Following is the data about standard and actual issues of Chemical No. 15
as obtained from the accounts of A chemical Company Limited.
Calculate relevant variances.
Kgs. Standard Rs. Kgs. Actual Rs.
450 Material X 900 450 Material X 8,550
Rs. 20 per kg. Rs.19 per kg.
360 Material Y 3,600 360 Material Y 3,960
Rs. 10 per Kg. Rs. 11 per kg.
810 12,600 810 12,510
2,400 hours for skilled 4,800 2,400 hours for skilled 5,400
workers at the rate of workers at the rate of
Rs. 2 per hour Rs. 2.25 per hour

1,200 hours for unskilled 1,200 1,200 hours for unskilled 1,500
workers, at the rate workers at the rate of
of Re. 1 per hour Rs. 1.25 per hours
6,000 6,900
90 Normal loss 50 Loss
720 Production 760 Production
Total Rs. 18,600 Total Rs. 19,410

477
Solution:
A) Material Variances:
Standard Cost per unit: Per unit standard cost is required to calculate
material yield variance. It can be calculated as under:
X = 450 kg. x Rs. 20 = Rs. 9,000
Y = 360 kg. x Rs. 10 = Rs. 3,600
Rs. 12,600
The standard quantity is 720 kg. the standard cost of which is Rs. 12,600

,.
Hence per unit standard Cost =
%
= Rs. 17.50
1) Material Cost Variance = (Actual Production x per unit standard Cost)
– (Actual production x Actual Cost)
= (760 kg. x Rs. 17.50) – Rs. 12,510
= Rs. 13,300 – Rs. 12,510
= + Rs. 790 (F)
2) Material price Variance= Actual Qty. (Std. Price – Actual price)
X = 450 kg.(Rs. 20 – Rs. 19) = + Rs. 450 (F)
Y = 360 kg. (Rs. 10 – Rs. 11) = - Rs. 360 (U)
Total = Rs. 90 (F)
3) Material Yield Variance = Standard Cost (Actual yield – Standard yield)
= Rs. 17.50 (760 - 720)
= Rs. 17.50 x 40
= Rs. 700 (F)
Labour Variances:
It is necessary to calculate per unit standard labour cost to obtain labour yield
variance. It can be calculated as follows:

478
     5 0 #..,

= = Rs. 8
   0  % &'. 

1) Labour Cost Variance = (Actual production x per unit standard cost)

– (Actual hours x Actual wage rate)


= (760 x 8 ) – (6,900)


= 6,333.33 – 6,900
= - Rs. 566.67 (U)
2) Wage Rate Variance = Actual Hours (Standard Rate – Actual Rate)
Skilled = 2,400 (2 – 2.25) = - Rs. 600 (U)
Unskilled = 1,200 (1 – 1.25) = - Rs. 300 (U)
Total = - Rs. 900 (U)
3) Labour Yield Variance = Per unit Standard labour cost
(Actual production – Standard Production)
= Rs. 25/3 (760 - 720)
= Rs. 25/3 x 40
= Rs. 333.33 (F)
Labour Cost Variance = Wage Rate Variance + Labour Yield Variance
= 900 + 333.33
= - Rs. 566.67 (U)
Illustration 21:
Find out variance from the following data:
Standard cost per unit:
Material : 5 kg Rs. 50
Wage Cost : 20 hours Rs. 10
Rs. 60

479
 For actual production of 500 units, 2.7 metric tons of materials costing Rs.
25,650 was used and wages of Rs. 6,050 for 11,000 hours were paid, which include
20 hours of idle time due to machine breakdown.
Solution:
Standard : For 500 units, Usage = 500 x 5 kgs. = 2,500 kgs.
Price = 500 units x Rs. 50 = Rs. 25,000
Actual : Usage = 2.7 m. tons x 1,000 kgs. = 2,700 kgs.
Price = Rs. 25,650
Actual Price per kg. = Rs. 25,650 ÷ 2,700 = Rs. 9.50
Remember : 1 metric ton = 1,000 kilograms
1) Material Cost Variance = Standard Cost – Actual Cost
= Rs. 25,000 – 25,650
= - 650 (U)
2) Material Price Variance = Actual Qty. (Std. Price – Actual Price)
= 2,700 (Rs. 10 – Rs. 9.50)
= 2,700 x 0.50
= + 1,350 (U)
3) Material Usage Variance = Std. Price (Std. Usage – Actual Usage)
= 10 (25,000 – 25,650)
= -650 (U)
B) Labor Variance :
Std. Labour Cost = 500 units x Rs. 10 = Rs. 5,000
Actual Labour Cost = Rs. 6,050
Standard hours = 500 units x 20 hrs per unit = 10,000
Standard wage rate = 10 ÷ 20 hrs. = 0.50 per hour
Actual wage rate = Rs. 6,050 ÷ 11,000 = 0.55 per hour.

480
1) Labour Rate Variance = Std. Labour Cost – Actual Cost
= Rs, 5,000 – Rs. 6,050
= - 1,050 (U)
2) Wage Rate Variance = Actual Hours (Std. Rate – Actual Rate)
= 11,000 (0.50 – 0.55)
= -550 (U)
3) Labour Efficiency Variance = Std. Rate (Std. Hours – Actual Hours)
= 0.50 (10,000 – 10,980)
= 0.50 x – 980
= -490 (U)
Remember that while calculating Efficiency Variance, idle time is deducted
from actual Hours.
4) Idle Time Variance = 20 hours x Std. Rate 0.50
= - Rs. 10 (U)
4.2.6.3 Overhead Cost Variance (OCV)
Overhead Cost Variance is the difference between the standard cost of overhead
allowed for actual output achieved and the actual overhead cost incurred. It arises
due to under or over recovery of overhead. The formula for the calculation of
overhead cost variance is as under:
Overhead Cost Variance = [(Standard Overhead Rate per unit x Actual Output) –
Actual Overhead cost]
Overhead cost variance can be classified as under:
1) Variable Overhead Variance (VOV)
2) Fixed Overhead Variance (FOV)
1) Variable Overhead Variance (VOV) : It is the difference between the
standard variable overhead cost allowed for actual output and the actual overhead
cost incurred during the period. The formula for the calculation of overhead cost
variance is as under:

481
Variable overhead Variance = [(Std. Variable Overhead Rate x Actual Output) –
Actual Variable Overhead]
Or
Variable Overhead Variance (VOV) = [(Std. Variable Overhead Rate per Hour x
Standard Hours for Actual Output) – Actual Variable Overhead]
In case the standard time allowed and actual time taken is given, Variable
overhead Variable can be classified into i) Variable Overhead Expenditure Variance
ii) Variable Overhead Efficiency Variance as under:
i) Variable Overhead Expenditure Variance =
[(Standard Variable Overhead Rate per Hour x Actual Hours Worked) – Actual
Variable Overheads]
Or
Actual Hours (Std. Variable Overhead Rate per Hour – Actual Variable
Overhead Rate per Hour)
ii) Variable Overhead Efficiency Variance =
(Std. time for actual production x Std. Variable Overhead Rate per Hour) –
(Actual hours worked x Std. Variable Rate per Hour.)
Or
Std. Variable Overhead Rate per Hour (Std. Hours for Actual Production –
Actual Hours)
Illustration 22 : (Variable Overhead Variances)
From the following data, calculate variable overhead variances:
Budgeted Actual
Variable overhead (Rs.) 2,50,000 2,60,000
Output in units 25,000 20,000
Working Hours 1,25,000 1,10,000

482
Solution:
Standard Variable Overhead per unit= Budgeted Variable Overhead / Budgeted
output in units
= 2,50,000/ 25,000 = Rs. 10 per unit
Std. Variable Overhead per hour = Budgeted Variable Overhead /
Budgeted output in hours
= 2,50,000 / 1,25,000 = Rs. 2 per hour
Time Allowed per unit of output = Budgeted Working Hours / Budgeted
output in units
= 1,25,000 / 25,000 = 5 hours per unit
Overhead Cost Variance
= [(Standard Overhead Rate per unit x Actual Output) - Actual Overhead cost]
= [(10 x 20,000) – 2,60,000] = (2,00,000 – 2,60,000) = (-) Rs. 60,000 Adverse
Variable Overhead Expenditure Variance
= [(Std. Variable Overhead Rate per Hour x Actual Hours Worked) – Actual
Variable Overheads]
= [(2 x 1,10,000) – 2,60,000] = (-) Rs. 40,000 Adverse
Variable Overhead Efficiency Variance
= Std. Variable Overhead Rate per Hour (Std. Hours for Actual Production – Actual
Hours)
= 2[(20,000 x 2) – 1,10,000] = (-) 20,000 Adverse
2) Fixed Overhead Variance (FOV): It is a part of total overhead cost variance. It
occurs due to difference between the standard cost of fixed overhead allowed for the
actual production undertaken and the actual fixed overhead cost incurred. The
formula for the calculation of overhead cost variance goes as under:
FOV = (Std. Fixed Overhead Rate per unit x Actual Production) – Actual Fixed
Overheads
Or

483
FOV = (Std. Fixed Overhead Rate per Hour x Actual Hours of Production) - Actual
fixed Overhead
Fixed Overhead Variance can be further analyzed as under:
3) Expenditure Variance: It is a portion of Fixed Overhead Variance that occurs
when actual fixed overhead expenditure incurred is not as per the budgeted fixed
overhead expenditure. Budgeted fixed Overhead Expenditure (consisting of standing
charges like Rent, Lighting, Depreciation, Insurance, Administrative Expenses etc.)
is expected to remain unchanged irrespective of small changes in the production
level. But in reality they may change marginally causing expenditure variance. The
formula for the calculation of overhead cost variance goes as under:
Expenditure Variance = Budgeted fixed Overhead – Actual Fixed Overhead
Or
Expenditure Variance = (Std. Fixed Overhead Rate per Hour x Budgeted Hours) –
Actual Fixed Overhead
4) Volume Variance = Total Fixed Overhead are expected to remain constant over
a period of time irrespective of changes in the production. Hence with the same
amount of fixed overhead if we increase the volume of production the firm is going
to gain and if we decrease the volume of production the firm is going to lose. Such
gain or lose if fixed overhead arising form increase or decrease in the volume of
production is indicated by volume variance. This variance indicates the over or under
absorption of fixed overheads arising from the changes in the volume of production
during a particular period. This variance can be ascertained as under:
Volume Variance = Std. Rate of Fixed Overhead p.u. (Actual Output – Budgeted
Output)
Or
Volume Variance = Std Rate per Hour (Std. Hours for Actual Output – Actual
Hours)
Or
Volume Variance = (Actual Output x Std. Rate) – Budgeted Fixed Overhead

484
Volume variance can be further subdivided into three variance as: i) Capacity
Variance ii) Calendar Variance, and iii) Efficiency Variance
i) Capacity Variance = It represent that portion of volume variance that arises
due to working at higher or lower capacity than the budgeted capacity. In other
words, this variance occurs when a factory works for more or less hours than the
budgeted working hours. Thus this variance is related to the under or over utilization
plant capacity can arise due to several reasons like idle time, strikes, lockouts,
breakdown of the machinery, power failure, shortage of material, labour,
absenteeism, overtime working changes in the number of shifts etc. This variance
can be ascertained as under:
Capacity Variance = Standard Rate of Fixed Overhead p. u. (Revised budgeted units
due to changed capacity – Budgeted Output in Units)
Or
Capacity Variance = Std. Rate of Fixed Overhead per Hour (Revised Budgeted hours
due to changed capacity – budgeted Hours)
ii) Calendar Variance = It represents the portion of volume variance that arises
due to difference between the actual working days and budgeted working days
during the period. In other words, this variance occurs when a factory works for
more or less days than the budgeted working days during the period. If actual
working days are more than the budgeted working days this variance will be
favorable. On the other hand if the actual working days are less than the budgeted it
will be favorable. On the other hand if the actual working days are less than the
budgeted it will be unfavorable. The formula to compute this variance is as under:
Calendar Variance = Standard Rate of Fixed Overhead p.u. (Revised budgeted units
due to changed working days – Budgeted Output in Units)
Or
Calendar Variance = Std. Rate of Fixed Overhead per Hour (Revised Budgeted hours
due to changed working days – Budgeted Hours)
Or
Calendar Variance= Increased or decreased production due to more or less working
days at the rate of budgeted capacity x Std. rate per unit.

485
iii) Efficiency Variance = It is the portion of volume variance that arises due to the
difference between the budgeted efficiency of workers and actual efficiency
achieved. It indicated the gain or loss arising from the efficiency or inefficiency of
workers respectively. The formula for ascertainment of this variance is as under:
Efficiency Variance = Standard Rate per Unit (Actual Production units – Standard
Production units)
Efficiency Variance = Standard Rate per Hour (Standard hours for actual output –
Actual hours worked)
Following chart indicates the relationship between variance overhead variances:
Total Overhead Cost Variance

Fixed Overhead Variance Variable Overhead Variance

Volume Variance Expenditure Variance

Capacity Variance Calendar Variance Efficiency Variance

Illustration 23:
Rajesh Ltd. has furnished you the following data:
Budgeted Actual
Output 15,000 units 16,000 units
No of working days 25 27
Fixed Overhead Rs. 30,000 Rs. 30,500
Variable Overhead Rs. 45,000 Rs. 47,000
There was an increase of 5% in capacity
Calculate all the overhead variacne.
Solution:
Standard Fixed Overhead Rate p. u. = Budgeted Fixed Overhead / Budgeted
Output
486
 = 30,000 / 15,000 = Rs. 2 p.u.
Standard Variable Overhead Rate p.u = Budgeted Variable Overhead /
Budgeted Output
= 45,000 / 15,000 = Rs. 3 p.u.
Standard Total Overhead Rate p.u = Budgeted Total Overhead / Budgeted
Output
= 75,000 / 15,000 = Rs. 5 p.u.

1) Total Overhead Cost Variance:

= Std. total overhead rate x Actual units- Actual total Overhead cost
= Rs. 5 x 16,000 – 77,500 = Rs. 2,500 Favorable
2) Variable Overhead Cost Variance:
= (Std. Variable Overhead Rate per Hours x Standard Hours for Actual Output)
– Actual Variable Overhead
= (3 x 16,000) – 47,000 = Rs. 1,000 Favorable
3) Fixed Overhead Cost Variance:
= (Std. Fixed Overhead Rate per unit x Actual Production) – Actual Fixed
Overhead
= (2 x 16,000)- 30,500 = Rs. 1,500 Favorable
4) Expenditure Variance:
= Budgeted Fixed Overhead – Actual Fixed Overhead
= 30,000 – 30500 = (-) Rs. 500 Adverse
5) Volume Variance:
= Std. Rate of Fixed Overhead p. u. (Actual Output - Budgeted Output)
= 2 (16,000 – 15,000) = Rs. 2,000 Favorable

487
6) Calendar Variance:
= Std. Rate of Fixed Overhead per Hour (Revised Budgeted Output due to
changed working days – Budgeted Output)
%
= Rs. 2 (15,000 x - 15,000) = 2 (16,000 – 15,000) = Rs. 2,400 Favorable


7) Capacity Variance:
= Standard Rate of Fixed Overhead p. u. (Revised Budgeted Output with
changed working days & capacity – Revised Budgeted Output with changed
working days)


= Rs. 2 (16,200 - 16,200) = 2(17,010- 16,200) = Rs. 1,620 Favorable



8) Efficiency Variance:
= Standard Rate of Fixed Overhead p. u. (Actual output - Revised Budgeted
Output with changed working days & capacity)
= 2(16,000- 17,010) = Rs. 2,020 unfavorable.
Verification:
1) Total Overhead Variance = Variable Overhead Variance + Fixed
Overhead Variance
2500 = 1000 + 1500
2) Fixed Overhead Variance = Expenditure Variance + Volume Variance
1500 = -500 + 2000
3) Volume Variance = Capacity V. + Calendar V + Efficiency V.
2,000 = 1620 + 2400 + 2020
Illustration 24 : (Fixed Overhead Variance)
Rajkamal Ltd. has furnished you the following data:
Budgeted Actual
No of working days 25 27
Production in units 20,000 22,000

488
Fixed Overheads Rs. 30,000 Rs. 31,000
Budgeted Fixed Overhead Rate is Re. 1 per hour. In July, 2015 the actual hours
worked were 31,500
Calculate: 1) Total Overhead Variance 2) Expenditure Variance 3) Volume Varinace
4) Capacity Variance 5) Calendar Variance 6) Efficiency Variance
Solution:
Budgeted Fixed Overhead Rate per hour = Re. 1 per hour (Given)
Budgeted Fixed Overhead = Rs. 30,000 (Given)
Therefore, Budgeted Hours = (30,000 / 1) = 30,000 Hours
Budgeted Production in units = 20,000 (Given)
Therefore, Standard time per unit =Budgeted Hours/ Budgeted Production in units
= (30,000 / 20,000)
= 1.50 hours
Standard Rate per Unit = (Budgeted Overhead / Budgeted Output) =
(Rs. 30,000 / 20,000 units) = Rs. 1.50
Fixed Overhead Variance = [(Std. Fixed Overhead Rate per unit x Actual
Production) – Actual Fixed Overhead]
= [(1.5 x 22,000) – 31,000] = (33,000 – 31,000) =
Rs. 2,000 Favorable
Expenditure Variance = Budgeted Fixed Overhead – Actual Fixed Overhead
= 30,000 – 31,000= (-) Rs. 1,000 Adverse
Volume Variance = Std. Rate of Fixed Overhead p. u. (Actual Output –
Budgeted Output)
= 1.50 (22,000 – 20,000) = Rs. 3,000 Favorable
Calendar Variance:
Budgeted Fixed Overhead Rate is Re. 1 per hour and Budgeted Fixed Overhead
are Rs. 30,000 Therefore, Budgeted Working Hours are 30,000 for 25 days that is
30,000 / 25 = 1200 hours per day.

489
 Actual number of days worked is 27 days, Therefore revised budgeted hours for
27 days are 27 days at 1200 hours = 32,400 hours.
Calendar Variance = Std. Rate of Fixed Overhead per Hour (Revised Budgeted
hours due to changed working days - Budgeted Working Hours)
= Re. 1 (32,400 – 30,000) = Rs. 2400 Favorable
Capacity Variance = Revised Budgeted hours due to changed working days are
32,400, however, actual hours worked as given in the problem are 31,500
Capacity Variance:
= Std. Rate of Fixed Overhead per Hour (Revised Budgeted hours due to
changed capacity – Budgeted Hours)
= Re. 1 (31,500 – 32,400) = (-) Rs. 900 Adverse
Efficiency Variance:
= Standard Rate per Hour (Standard hours for actual output – Actual hours
worked)
= Re. 1 [(1.5 x 22,000) – 31,500) = Re. 1(33,000 – 31,500) = Rs. 1,500]
Favorable
Verification:
3) Fixed Overhead Variance = Expenditure Variance + Volume Variance
2000 = - 1000 + 3000
4) Volume Variance = Capacity V. + Calendar V + Efficiency V.
3000 = - 900 + 2400 + 1500
Check Your Progress
I) Choose the correct answer from the following multiple choice question:
1) An unfavorable material price variance occurs because of :
a) Price increase in materials
b) Price decrease in materials
c) Less than normal wastage of materials
d) More than normal wastage of materials

490
 2) An unfavorable material usage variance arises because of:
a) Price increase in materials
b) Price decrease in materials
c) Less than normal wastage of materials
d) More than normal wastage of materials
3) Volume variance arise because of :
a) Increase in overhead rate per hour
b) Decrease in overhead rate per hour
c) Change in actual output
d) Difference in overhead rate per hour
4) Expenditure variance arises because of :
a) Increase in overhead rate per hour
b) Decrease in overhead rate per hour
c) Change in actual output
d) Difference in budgeted and actual overhead
5) Adverse capacity variance arises because of:
a) More than normal wastage
b) Less than budgeted working hours
c) Increase in working days
d) Deterioration in working conditions
6) Favorable calendar variance arises because of
a) More than normal wastage
b) Less than budgeted working hours
c) Increase in working days
d) Deterioration in working conditions
II) Say TRUE or False:
1) A standard costing is a technique of cost control.
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 2) Labor absenteeism leads to adverse labor rate variance.
3) Idle time variance= Idle time x actual rate.
4) Volume variance is a portion of capacity variance.
5) Adverse efficiency variance leads to adverse volume variance.
6) Material usage variance = Actual rate (Standard time – actual time)
7) Abnormal material wastage leads to unfavorable material yield variance.
8) Material yield variance is a portion of material usage variance.
9) Standard costing is a method of ascertainment of cost.
10) Standard costing may be used for cost control by trading organizatons.
III) Fill in the blanks:
1) Standard cost is ....... cost.
2) Material usage variance = Material Yield Variance + ........
3) Idle Time Variance = Idle time x .......
4) Fixed Overhead Variance is divided into Volume Variance and .....
5) Volume Variance ........ (Actual Output – Budgeted Output)

4.3 Summary
Standard Costing is a method of ascertaining the cost whereby statistics are
prepared to show the standard cost, the actual cost and the difference between these
costs, which is termed as variance. The basic characteristics of standard costing are
predetermined cost, cost under efficient management, tool of cost control, a basis of
price determination etc.
A variance is the difference between a standard cost and the comparable actual
cost incurred during a period. The variances may be favorable or unfavorable
depending an circumstances. There are different types of variances like Materials
Variances, Labour Variances, Fixed Overhead Variances, Variable Overhead
Variances etc.

492
4.4 Terms to Remember
1. Variance : Difference between expected cost and Actual Cost indicating level
of efficiency in operations;
2. Favourable Variance : Indicates savings or gain due to efficiency in the
conduct of production;
3. Unfavourable or Adverse Variance : Indicates wastage or loss due to
inefficiency in the conduct of production;

4.5 Answers to self learning questions:

I) 1 – a , 2-d, 3-c, 4-d, 5-b, 6-c.
II) True - 1, 5,,7, 8 False – 2, 3, 4, 6, 9, 10.
III) 1- Predetermined, 2- Material Mix Variance, 3- Standard Rate, 4-
Expenditure Variance, 5- Standard Rate.

4.6 Exercise
A) Broad Answer Type Questions:
1) What is standard costing ? Explain the features of standard costing.
2) Define standard costing and explain the merits and limitations of standard
costing.
3) Explain any six variances, two each under material, labor and overhead.
4) What are variances? How do they arise ? What are the benefits of analyzing
variances?
B) Write Short Notes:
1) Standard cost and standard costing
2) Merits of standard costing
3) Limitations of standard costing
4) Material Yield variance
5) Volume variance

493
C) Practical Problems with solutions :
Problem 1 :
Calculate : (1) Material Cost Variance (2) Material Price Variance (3) Material
Usage Variance from following data.
Material Standard Actual
Quantity Price Quantity Price
(kg.) Rs. (kg.) Rs.
A 600 8 720 7.50
B 900 10 1,080 10.20
1,500 1,800
Solution:
i) Material Cost Variance = (Std, Qty. × Std. Price) – (Actual Qty. × Actual
Price)
A = (600 x Rs. 8) – (720 x 7.50)
= Rs. 4,800 – Rs. 5,400
= - 600 (U)
B = (900 x Rs. 10) – (1,080 x 10.20)
= Rs. 9,000 – Rs. 11,016
= -2,016 (U)
A+B = -600 – 2,016
= -2,616 (U)
ii) Material Price Variance = Actual Qty. (Std. Price – Actual Price)
A = 720 (8.00 – 7.50)
= 720 x 0.50 = + 360 (F)
B = 1080 (10 – 10.20)
= 1080 (-0.20) = -216(U)
Total = + 144 (F)

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iii) Material Usage Variance = Std. Price (Std. Qty. – Actual Qty.)
A = 8 (600 - 720)
= 8 x -120 = -960 (U)
B = 10 (900 - 1080)
= 10 x -180 = -1800 (U)
Total = - 2,760 (U)
∴ Material Cost Variance = M. Price Variance + M. Usage Variance
= + 144 – 2,760
= - 2,616 (U)
Problem 2 :
Standard costing is used in a factory in which the information regarding
production of August 2015 is as follows:
Standard : for production of 80 kg. material required 100 kg.
Standard price of material is Rs. 2 per kg.
Actual : production 24,000 kg.
Material used 29,000 kg.
Cost of material used Rs. 52,200
Calculate : 1) Materials Cost 2) Material Price Variance 3) Material Usage
Variance.
Solution :
a) Let us find out standard quantity for actual production :
for production of 80 kg. Std. quantity is 100 kg.
for 24,000 kg. = ?

×-,
= = 30,000 kg.

#.,
b) Actual Price = = Rs. 1.80
, &'.

495
1) Material Cost Variance = (Std. Qty. of Actual Prod x Std. Price)
- (Actual Qty. x Actual Price)
= (30,000 x 2) – (29,000 x 1.80)
= Rs. 60,000 – Rs. 52,200
= + 7,800 (F)
2) Material Price Variance = Actual Qty. (Std. Price – Actual Price)
= 29,000 (Rs. 2 – Rs. 1.80)
= + 5,800 (F)
3) Material Usage Variance = Std. Price (Std. Qty – Actual Qty.)
= Rs. 2 (30,000 – 29,000)
= 2 x 1,000
= + 2,000 (F)
Problem 3 :
Calculate Material Yield Variance on the basis of following data:
Material Standard Actual
A 120 unit at Rs. 20 105 unit at Rs. 22
B 80 unit at Rs. 15 95 unit at Rs. 15
200 kg. 200 kg.
Normal loss is 10 percent and actual production is 170 units.
Solution:
First, we shall calculate per unit standard cost. Standard mix is 200 units and
actual mix is also 200 units.
Hence it is not necessary to calculate revised standard mix.
Standard cost of A 120 units x Rs. 20 = Rs. 2,400
Standard cost of B 80 units x Rs. 15 = Rs. 1,200
200 units Rs. 3,600
200 units of input – loss of 20 units (being 10 % of 200) = 180 units of production
496
 #.,.
∴ Per unit standard cost =

   

= Rs. 20
Material Yield Variance = Std. Cost per Unit (Actual Yield - Std. Yield)
= R.s 20 (170 units – 180 units)
= Rs. 20 (-10)
= - Rs. 200 (U)
If actual mix and standard mix are not equal, revised standard yield is to be
calculated first, and then the above formula is to be applied. In this formula revised
standard yield is considered in place of standard yield. Revised standrad yield means
actual units introduced minus standard rate of loss. If the standard loss is 10 % and
materials introduced is 400 kgs., then revised standard yield is 400 – 40 = 360 kgs.
Problem 4 :
Compute Material Yield Variance in a factory on the basis of the information
given below:
Material Standard Actual
A 20 kg. at Rs. 50 30 kg. at Rs. 40
B 30 kg. at Rs. 80 50 kg. at Rs. 90
50 kg. 80 kg.
Standard loss is 15 per cent of the input and actual output is 70 kg.
Solution:
In this example, the weight of standard mix is 50 kg. while that of actual mix is
80 kg. Hence, revised standard yield should be calculated.
Revised standard yield = Actual mix introduced – standard loss
= 80 kg. – 12 kg (loss at 15%)
= 68 kg.
Total Cost of standard mix:
Material A 20 kg. x Rs. 50 = Rs. 1,000

497
 Material B 30 kg. x Rs. 80 = Rs. 2,400
50 kg. Rs. 3,400
Less : 15% loss 07.50 kg. -
Standard yield 42.50 kg. Rs. 3,400
,-
Per unit standard cost = = Rs. 80
-..
Now, Material Yield Variance = Standard cost (Actual yield –
Revised Standard yield)
= Rs. 80 ( 70- 68 kg.)
= Rs. 80 (2)
= Rs. 160 (F)
Problem 5 :
From the following data, calculate labour variance:
Standard Actual
Number of workers employed 200 180
Average monthly wages per worker Rs. 600 Rs. 720
Number of working days during the month 25 24
Production during the month (units) 20,000 18,000
Solution :
1) Here standard wage rate is to be found out per day and not per hour,
because details about hours are not given.
/7 '  4 8 '
Std. wage rate per day =
9. 8 & ' 
#..
= = Rs. 24.

Now we shall write no. of days in the formula instead of no. of hours.
2) Here we have to compute not total hours, but total man-days.
Total man days = Total No. of Days x Total no. of workers.

498
 3) Again Actual wage rate per day will have to be found out.
/0    4 8 '
Actual wage rate per day =
/0  . 
#.%
= = Rs. 30.
-
4) We shall now find out standard no. of man days for actual production.
For 20,000 std. units, man days are 200 x 25 = 5,000
For, 20,000 std. units = 5,000 man days are fixed
∴ 18,000 actual production = (?)

,
= 5,000 x
,

= 4,500 man days

5) Finally, the actual man days for actual production will be found out:
= 180 workers x 24 days
= 4,320 man days
1) Labour Cost variance = (Std. Rate x Std. man days) – (Actual Rate x
Actual man days)
= (4,500 x Rs. 24) – (4,320 x Rs. 30)
= Rs. 1,08,000 – Rs. 1,29,600
= - Rs. 21,600 (U)
2) Wage Rate Variance = Actual mandays (Std. Rate – Actual Rate)
= 4,320 (Rs. 24 – Rs.30)
= - Rs. 25,920 (U)
3) Labour Efficiency Variance= Std. Rate (Std. mandays – Actual mandays)
= Rs. 24 (4,500 – 4,320)
= Rs. 24 x 180
= + Rs. 4,320 (F)

499
Verification:
Labour Cost variance = Wage Rate Variance + Labour Efficiency
Variance
= - 25,920 + 4,320
= - 21,600 (U)
iv) Idle Time Variance: By the idle or unproductive time is meant the period
of duty hours during which workers do not work for any reason and yet they are paid
for it. If idle time is abnormal its cost must be reported to the management. Only the
cost of productive time should be debited to production, while the cost of
unproductive time should be transferred to idle or unproductive time account. It is
debited to "Idle Time Variance Account".
For example, in a factory, 5,000 hours were fixed for production in January,
2015. But actually, labourers could work for 4800 hours only. They had to sit idle for
200 hours due to some brekdown in the machinery. The wage rate paid is Rs. 2 per
hour. Therefore, there is a loss of Rs. 400 (200 hours x Rs. 2), which will be debited
to the idle time variance account.
Idle Time Variance = Abnormal Idle Time x Standard Wage Rate.
Problem 6:
Data about labour employed in a factory to produce one unit of product X are as
follows:
Hours Wage Rate (Rs.) Total Payment (Rs.)
Skilled Workers 10 3.00 30.00
Unskilled Workers 16 1.00 16.00
Semiskilled workers 8 1.50 12.00
58.00
Actual situation:
Actual Production : 200 units
Hours Wage Rate (Rs.) Total Payment (Rs.)
Skilled Workers 1,800 4.00 7,200

500
Unskilled workers 4,000 0.90 3,600
Semi- skilled workers 1,680 1.50 2,520
7,480 13,320
Calculate following variance:
1) Labour cost variance.
2) Wage rate variance.
3) Labour efficiency variance.
4) Labour mix variance.
Solution:
Information is given about standard hours to produce one unit of output;
and 200 units are produced. We can calculate, therefore, total standard cost of labour.
Standard Cost
Skilled workers 200 x 10 hours = 2,000 hours x Rs. 3.00 = Rs. 6,000
Unskilled workers 200 x x16 hours = 3,200 hours x Rs. 1.00 = Rs. 3,200
Semiskilled workers 200 x 8 hours = 1,600 hours x Rs. 1.50 = Rs. 2,400
6,800 hours Rs. 11,600
Let us now compute variances.
1) Labour Cost Variance = Standard Labour Cost – Actual Labour Cost
= Rs. 11,600 – Rs. 13,320
= - Rs. 1,720 (U)
2) Wage Rate Variance = Actual Hours (Standard Rate – Actual Rate)
Skilled = 1,800 (Rs. 3 – Rs.4) = -Rs. 1,800 (U)
Unskilled = 4,000 (Rs. 1.0 – Rs. 0.90) = + Rs. 400 (F)
Semi- skilled = 1,680 (Rs. 1.50 – Rs. 1.50) = Rs. 0
- Rs. 1,400 (U)
3) Labour Mix Variance:
Since standard hours and actual hours are unequal in this case, it is
necessary to calculate revised standard labour mix.

501
 3   04    5
Revised Standard Mix = Total Actual Horus x
   3 
,
Skilled workers = 7,480 x = 2,200 hours
.,
,
Unskilled workers = 7,480 x = 3,520 hours
.,

,.
Semiskilled workers = 7,480 x = 1,760 hours
.,

Labour Mix Variance = Standard wage rate (Revised Standard Mix –

Actual Mix)
Skilled = Rs. 3 (2200 hours – 1800 hours)
= Rs. 3 x 400 = + Rs. 1,200 (F)
Unskilled = Rs. 1 (3520 - 4000)
= Rs. 1 x -480
= - Rs. 480 (U)
Semi Skilled = Rs. 1.50 (1760 - 1680)
= Rs. 1.50 x 80 = + Rs. 120 (F)
Total Mix Variance = + 1,200 – 480 + 120 = Rs. 480 (F)
4) Revised Labour Efficiency Variance = Standard Wage Rate (Standard
Hours – Revised Standard Hours)
Skilled = Rs. 3 (2000 hours – 2,200 hours)
= Rs. 3 x -200 = - Rs. 600 (U)
Unskilled = Re. 1 (3,200 hours – 3,520 hours)
= Re.1 x -320 = - Rs. 320 (U)
Semi skilled = - Rs. 1.50 (1,600 hours – 1,760 hours)
= - Rs. 1.50 (-160) = - Rs. 240 (U) – 600 (U)
- 320 (U)
- 240 (U)
Total = -Rs. 1,160 (U)

502
Verification:
Labour Cost Variance = Wage rate variance + Labour mix variance
+ Efficiency variance
= - 1,400 + 840 – 1,160 = - 1,720 (U)
Let as now summaries formulas for labour cost variance.
Labour Variances
1 Labour Cost Variance (Std. Hours x Std. Rate)- (Actual Horus x
Actual Rate)
(SH x SR) – (AH x AR)
2 Wage Rate Variance Actual Hours (Std. Rate – Actual Rate)
AH – (SR - AR)
3 Labour Efficiency Variance Std. Rate (Std. Hours – Actual Hours)
When standard mix hours SR (SH - AH)
and actual mix hours differ SR (SH – Revised SH)
Revised Eff. Variance
Here, labour efficiency variance is just like material Sub- usage variance. Hence
theri formulas are almost the same. It is known as Revised Labour Efficiency
Variance.
4 Labour Mix Variance Std. Rate (Std. Mix – Actual Mix)
When standard mix and actual SR (SM - AM)
mix are different SR (Revised SM - AM)
5 Idle Time Variance Idle Time x Standard Rate
6 Labour Yield Variance Standard Labour Cost per unit
(Actual production – Standard
Production )

Combined sums on Material and Labour Variance.

Problem 7: (Fixed Overhead Variances)
From the following data, calculate overhead variance:

503
 Budgeted Actual
Fixed Overhead Rs. 3,75,000 Rs. 3,77,500
No of working days 25 27
Man hours per day 5,000 5,500
Output per man hour in units 2 1.9
Solution:
Standard working days = 25
Standard man hours per day = 5,000
Standard output per man hour =2
Therefore, Standard output = 25 x 5,000 x 2 = 2,50,000 units
Standard Fixed Overhead = Rs. 3,75,000
Therefore, Std. Rate per unit = (Std. Output / Std. Fixed Overhead) = (3,75,000
/ 2,50,000) = Rs. 1.50
Actual working days = 27
Actual man hours per day = 5500
Actual Output per man hour = 1.9
Therefore, Actual Output = 27 x 5,500 x 1.9 = 2,82,150 units
Fixed Overhead Variance:
= [(Std. Fixed Overhead Rate per unit x Actual Production) – Actual Fixed
Overhead]
= [(1.5 x 2,82,150) – 3,77,500] = (4,23,225 – 3,77,500) = Rs. 45,725 Favorable
Expenditure Variance:
= Budgeted Fixed Overhead – Actual Fixed Overhead
= 3,75,000 – 3,77,500 = (-) Rs. 2500 Adverse
Volume Variance:
= Std. Rate of Fixed Overhead p. u. (Actual Output – Budgeted Output)

504
 = 1.50 (2,82,150 – 2,50,000) = Rs. 48,225 Favorable
Calendar Variance:
= Standard Rate of Fixed Overhead p.u. (Revised budgeted units due to changed
working days – Budgeted Output in Units)
= 1.50 [{2,50,000 x (27 / 25) – 2,50,000}]= 1.50 (2,70,000 – 2,50,000) = Rs.
30,000 Favorable
Or
Budgeted Production in 25 days = 2,50,000 units
Excess production in two extra days worked = (2,50,000 / 25) x 2 = 20,000 units
Therefore, Calendar Variance = 20,000 units @ Standard Rate of Rs. 1.50 per unit =
Rs. 30,000 Favorable
Capacity Variance:
= Standard Rate of Fixed Overhead p. u. (Revised budgeted units due to
changed capacity – Budgeted Output in Units)
= 1.50 [{2,70,000 x (5,500 / 5,000)} – 2,70,000] = 1.50 (2,97,000 – 2,70,000) =
Rs. 40,500 Favorable
Efficiency Variance:
= Standard Rate per Unit (Actual Production units – Revised Standard
Production units with increased capacity and calendar)
= 1.50 (2,82,150 – 2,97,000) = Rs. 22,275 Unfavorable
Revised Standard Production units with increased capacity and calendar:
Budgeted Output = 2,50,000 units
Add : 1) Production increase due to increase in capacity = 27,000 units
2) Production increase due to 2 more working days = 20,000 units
Revised Standard output with increase capacity and calendar = 2,97,000 Units
Verification:
1) Fixed Overhead Variance = Expenditure Variance + Volume Variance

505
 45,725 = - 2,500 + 48,225
2) Volume Variance = Capacity V. + Calendar V + Efficiency V.
48,225 = 40,500 + 30,000 – 22,275

Practical Problem : (Critical)

Lloyds Construction Co. has entered into a contract at an agreed price of Rs.
1,50,00,000 subject to an escalation clause for materials and labour as spent out on
the correct and corresponding actual are as under:
Standard Actual
Particulars
Qty. Tonnes Rate Rs. Qty. Tonnes Rate Rs.
Bricks 3,000 1,000 3,400 1,100
Sand 2,400 800 2,300 700
Cement 500 4,000 600 3,900
Steel 100 30,000 90 31,500
Labour Hours Rate Rs. Hours Rate Rs.
Unskilled 60,000 15 56,000 18
Skilled 40,000 30 38,000 35
You are required to :
1) Give your analysis of admission escalation claim and determine the final
contract price payable.
2) Prepare contract account if all expenses other than materials and labour related
to the contract are Rs. 13,45,000.
3) Calculate the following variance and verify them
a) Material Cost Variance b) Material Price Variance
c) Material Usage Variance d) Labour Cost Variance
e) Labour Rate Variance f) Labour Efficiency Variance

506
Solution :
Standard of Escalation Claim
Std. Std. Actual Variation in Escalation
Particulars Qty/Hrs Rate Rs. Rate Rs. Rate Rs. Claim Rs.
(a) (b) (c) (d) = (c - b) (e = d x a)
Bricks 3,000 1,000 1,100 + 100 + 3,00,000
Sand 2,400 800 700 -100 -2,40,000
Cement 500 4,000 3,900 -100 -50,000
Steel 100 30,000 31,500 + 1,500 + 1,50,000
Material Escalation Claim : + 1,60,000
Labour Unskilled 60,000 15 18 +3 + 1,80,000
Labour Skilled 40,000 30 35 +5 + 2,00,000
Labour Escalation Claim + 3,80,000

Computation of Final Contract Price

Contract Price 1,50,00,000
Add : Material cost escalation 1,60,000
Labour cost escalation 3,80,000
Final Contract Price 1,55,40,000

Contract Account
Particulars Rs. Particulars Rs.
To Materials By Contractor 1,55,40,000
Bricks 3,4000 x 1,100 37,40,000
Sand 2,300 x700 16,10,000
Cement 600 x 3,900 23,40,000
Steel 90 x 31,500 28,35,000
1,05,25,000

507
To Labour
Unskilled (56,000 x 18) 23,38,000
Skilled (38,000 x 35) 13,30,000 23,38,000
To Other Expenses 13,45,000
To Profit Transfer to P. & L. A/c 13,32,000
1,55,40,000 1,55,40,000
Calculation of Variances :
Material Cost Variance : Standard Cost – Actual Cost
Bricks = (3,000 x 1,000) – (3,400 x 1,100) = Rs. 7,40,000 (A)
Sand = (2,400 x 800) – (2,300 x 700) = Rs. 3,10,000 (F)
Cement = (500 x 4,000) – (600 x 3,900) = Rs. 3,40,000 (A)
Steel = (100 x 30,000) – (90 x 31,500) = Rs. 1,65,000 (F)
MCV = Rs. 6,50,000 (A)
Material Price Variance : (Standard Price – Actual Price) Actual Quantity
Bricks = (1,000 – 1,100) x 3,400 = Rs. 3,40,000 (A)
Sand = (800 – 700) x 2,300 = Rs. 2,30,000 (F)
Cement = (4,000 – 3,900) x 600 = Rs. 60,000 (F)
Steel = (30,000 – 31,500) x 90 = Rs. 1,35,000 (A)
MPV = Rs. 1,85,000 (A)
Material Usage Variance : Standard Qty. – Actual Qty.) Standard Price
Bricks = (3,000 – 3,400) x 1,000 = Rs. 4,00,000 (A)
Sand = (2,400 – 2,300) x 800 = Rs. 80,000 (F)
Cement = (500 – 600) x 4,000 = Rs. 4,00,000 (A)
Steel = (100 – 90) x 30,000 = Rs. 3,00,000 (F)
MUV = Rs. 4,20,000 (A)
Labour Cost Variance : Standard Labour Cost – Actual Labour Cost
Unskilled = (60,000 x 15) – (56,000 x 18) = Rs. 1,08,000 (A)
508
 Skilled = (40,000 x 30) – (38,000 x 35) = Rs. 1,30,000 (A)
LCV = Rs. 2,38,000 (A)
Labour Rate Variance : (Standard Rate – Actual Rate) Actual Hours
Unskilled = (15 – 18) x 56,000 = Rs. 1,68,000 (A)
Skilled = (30 – 35) x 38,000 = Rs. 1,90,000 (A)
LRV = Rs. 3,58,000 (A)

4.7 Reference for Further Study

1) Dr. Maheshwari S. N: Principles of Management Accounting, Sultan Chand &
Sons, New Delhi.
2) Man Mohan, S. N. Goyal: Principles of Management Accounting,
SahityaBhavan, Agra.
3) Pandey I. M.: Management Accounting, Vikas Publishing House Pvt. Ltd., New
Delhi.
4) Paul S. Kr.: Financial Statement Analysis, New Central Book Agency (P) Ltd.
Kolkata.
5) Raman B. S.: Management Accounting, United Publishers Mangalore.


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