Management Accounting

Maharaja Agrasen Institute of Management Studies

Affiliated to GGSIP University; Recognized u/s 2(f) of UGC
Recognized by Bar Council of India; ISO 9001:2015 Certified Institute

Semester Course Code Paper Type L T/P Credits

3 BBA 207 Management Core/ Skill 4 - 4
Accounting enhancement

Faculty : Mr. Manish Sharma

 Learning Objectives / Outcome
• After this session, you will be able to understand:
• Course Objectives
• Course Outcomes (COs)
• Course Contents / Syllabus
• Pedagogy for Course Delivery
• Assessment Scheme
• Suggested Readings
 Course Objective

The objective of this course is to

familiarize the learners with the
basic management accounting
concepts and their applications in
managerial decision making
 After successfully completing the
Course course, you will be able to:
Outcomes (COs) COI: Understand the nature and scope of
Management Accounting
COII: Analyse and interpret the accounting
financial statements of a company and its
limitations
COIII: Executing skills to prepare various budgets
COIV: Examining the impact of different ratios on
the financial performance of a company
COV: Compute cash flow analysis and its likely
impact on the company
Course Contents
 Pedagogy for Course Delivery
• Lectures
• Individual Assignments
• Case Study Discussions
• Presentation
• Viva-voce
• Group Discussion
• Class Participation
 Assessment Scheme

25 Marks 75 Marks
Internal Assessment External Examination
15 Marks 10 Marks
Class Test- 15 Individual
Marks Assignments/
Written Test Presentation/ Viva-
Compulsory (to be
voce/ Group
conducted as per the
academic calendar of Discussion/ Class
the university) Participation
Note: Latest Edition of Books may be used for reference
 Unit I

Introduction: Meaning, Objectives and Scope of management accounting;

Difference between financial accounting, cost accounting and
management accounting; Comparative financial statements, common size
financial statements, trend analysis, Ratio analysis, cash flow statement.
 Accounting

• “Accounting is an art of recording, classifying and

summarizing in a significant manner and in terms of money
transactions and events that are, in part at least, of a financial
character and interpreting the results thereof”.
 Financial Accounting

• The accounting for revenues, expenses , assets and liabilities

that is commonly carried on the general offices of business is
known as Financial Accounting.
• Financial accounting involves recording the financial
transactions of an organisation and summarising them in
periodic financial statements for external users who wish to
analyse and interpret the financial position of the
organisation.
 Two main types of financial statements

Profit & Loss Account The Balance sheet

(showing the incomes and (showing assets and
expenses of the accounting liabilities, revealing
period to financial position as on
ascertain the profit or loss) that date)
 Use of Financial Accounting

• The owners, creditors, management, employees, financiers etc.,

make use of information provided by financial accounting

• Information produced by the financial accounting system is

usually insufficient for the needs of management for
decision making
 Cost Accounting and Management
Accounting
• Managers usually want to know about the costs and the profits
of individual products and services.
• In order to obtain this information, details are needed for each
cost, revenue, profit and investment centre.

• Such information is provided by cost accounting and

management accounting systems.
 Cost Accounting

• It is that branch of accounting which deals with

classification, recording, allocation, summarization of
current and prospective cost.
• Cost accounting is essential for pricing of products and services
and for cost reduction and cost control.

• Cost accounting data is useful to the management of the business;

outsiders are not usually provided with costing data.
 Management Accounting

• The main thrust of Management Accounting is towards

determining policy and formulating plans to achieve desired
objectives of management.
• It helps the management in planning, controlling and analysing
the performance of the organization in order to follow the path of
continuous improvement.
• Management Accounting utilizes the principles and practices of
financial accounting and cost accounting in addition to
modern management techniques for effective operation of a
company.
 Meaning of Management Accounting

• Management Accounting which is also known as Accounting for

Managers is a process of collecting information (both
qualitative and quantitative) from various sources such as
Financial Accounting, Cost Accounting, Tax Accounting,
Human Resource Accounting, etc. selecting the important
ones out of the total, analyzing them with the help of certain
tools or techniques and then pass on to the management for
taking decisions in the interest of the organization and the
parties interested into it
 Definition of Management Accounting

“Any form of accounting which enables a business to be

conducted more efficiently can be regarded as Management
Accounting”.
The Institute of Chartered Accountants of England and Wales

“Management Accounting is the application of professional

knowledge and skill in the preparation of accounting
information in such a way as to assist management in the
formation of policies and in the planning and control of the
operations of the undertaking”.
Chartered Institute of Management Accountants, London
 Definition of Management Accounting

“Management Accounting is the terms used to describe the

account methods, systems and techniques which, coupled
with special knowledge and ability, assist management in the
task of maximizing profits or minimizing losses”.
J. Batty

“Management Accounting is concerned with accounting

information that is useful to management”.
Robert N. Anthony
 Objectives of Management Accounting
1. Planning and 3. Performance 4. Cost Management
2. Decision-Making
Forecasting Evaluation and Control

5. Resource Allocation 6. Profitability

7. Risk Management 8. Strategic Planning
and Utilization Analysis

9. Communication 10. Continuous 11. Revenue

Improvement generation

12. Controlling 13. Reporting

 Scope of Management Accounting

• Scope covers the area of operations for performing a

particular task.
• As under Management Accounting the management accountant
has to gather the quantitative and qualitative information
from various sources which further enables him in selecting the
important ones to be sent to the management for making
appropriate decisions.
• All the sources from where such information is collected
constitute the scope of the Management Accounting
 Scope of Management Accounting
Financial
Accounting
Internet/Print Cost
Media Accounting

All the sources from where the

Budgeting
quantitative and qualitative Audit and
Forecasting

information is collected that helps

the management for making Scope of
Office Service Management Inventory
Control
appropriate decisions constitute Accounting
the scope of the Management
Management
Accounting Financial
Analysis
Reporting
System

Human
Tax
Resource
Accounting
Accounting Interim
Reporting
 Tools or Techniques of Management Accounting

1. Common-size Statements 6. Funds Flow Statement

2. Comparative Statements 7. Standard Costing

3. Ratio Analysis 8. Budgetary Control

4. Trend Analysis 9. Marginal Costing

5. Cash Flow Statement 10. Responsibility Accounting

 Financial Accounting vs Cost Accounting
S.No. Basis Financial Accounting Cost Accounting

1 Purpose The main purpose of Financial The main purpose of Cost Accounting is to
Accounting is to record financial analyze, ascertain and control costs
transactions and prepare financial
statements.
2 Decision Financial accounts are of limited use in The Cost Accounts are basically designed
Making decision making. to facilitate decision-making in the areas of
production, purchase, sales etc.
3 Analysis of Financial Accounting shows the overall The Cost Accounting shows the detailed
Cost and profit/loss of the entire organization. cost and profits for each product, process,
Profit job, contract etc.
4 Transaction Financial Accounts keep records of only Cost Accounting keeps records of both
s external transactions with outsiders. external and internal transactions.
Recorded
 Financial Accounting vs Cost Accounting
S.No. Basis Financial Accounting Cost Accounting

5 Access In Financial Accounting anybody can In Cost Accounting the outsiders generally
have access to Financial Statements of have no access to cost records.
Companies.
6 Control Financial Accounting does not exercise Cost Accounting Control all elements of
adequate control over material, labour Costs.
and overhead costs.
7 Profit or Financial Accounting determines the Cost Accounting determines the profit or
Loss profit or loss of the entire business. loss of each product, process, job and
department.
8 Units Financial Accounting records only Cost Accounting records both monetary
monetary units in the books of accounts. and physical units such as labour hour,
machine hour etc.
9 Valuation of In Financial Accounting Closing Stock is Closing Stock is valued at cost price only in
Closing valued at cost or market price {Net Cost Accounting
Stock Realizable value} whichever is lower.
 Financial Accounting vs Cost Accounting
S.No. Basis Financial Accounting Cost Accounting

10 Audit Financial Accounting needs a system of Cost Accounting need not be followed by a
independent audit of the financial system of external audit.
records by an external auditor.
11 Tax Financial Accounting forms a basis for Cost Accounting does not form a basis for
Assessment determination tax liability of the tax assessment.
business.
12 Parties Financial Accounting serves the Cost Accounting serves the information
information needs of owners, creditors, needs of the management.
employees and the society at large.
13 Mandatory Maintaining Financial Accounting is Installing a costing system is purely
mandatory optional.
14 Lack of There are fixed rules and regulations in There are no fixed rules and regulations in
Uniformity Financial Accounting. Cost Accounting. Therefore, different cost
accounting system may be followed by
different firms in the same industry which
makes comparison difficult.
 Financial Accounting vs Management Accounting
S.No. Basis Financial Accounting Management Accounting

1 Objective Financial Accounting is designed to Management Accounting is designed for

supply information in the form of providing accounting information for
Trading, P&L A/c and Balance Sheet to internal use by the management.
external parties like stakeholders,
creditors, banks, investors and
government.
2 Nature Financial accounting is mainly Management accounting deals with
concerned with the historical data projection of data for the future. It also
considers historical data.
3 Approach It adopts the backward looking It adopts the forward-looking approach
approach i.e. focuses on past events or i.e. focuses on the projection for future
activities events or activities
4 Subject Financial accounting is concerned with Management accounting deals separately
Matter assessing the results of the whole with different units, departments and cost
business centres
 Financial Accounting vs Management Accounting
S.No. Basis Financial Accounting Management Accounting

5 Compulsion Financial accounting is compulsory in Management Accounting is not

certain undertakings compulsory
6 Precision Financial accounting records actual Not much emphasis is given on actual
figures figures
7 Description Financial accounting records only Management Accounting records both
Monetary events Monetary and Non-monetary events
8 Quickness Reporting of financial accounting is slow Reporting of management accounting is
and time consuming very quick
9 Accounting Financial accounts are governed by the Management accounts is used for taking
principles generally accepted principles and policy decisions, so the method of
conventions presenting data differs from concern to
concern
 Financial Accounting vs Management Accounting
S.No. Basis Financial Accounting Management Accounting

10 Period Financial accounts are prepared for a Management accounting supplies

particular period, (say one year) information from time to time during the
whole year
11 Audit Financial accounts can be audited Management accounts cannot be audited

12 Users Here information are intended to assist Here information are meant for
outside users such as shareholders, insiders i.e. management, owners, etc.
government, creditors, etc.
13 Static It provides a static picture of the It provides a non-static view of the
organisational activities organisational activities
14 Criterion Here information is meant to be fair Here information is meant to be useful
and true for management in making decision
 Cost Accounting vs Management Accounting
S.No. Basis Cost Accounting Management Accounting

1 Objective The objective of cost accounting is to The objective of management accounting

determine the cost of a product or a is to provide information to the
service. It also deals with cost control, management for planning and controlling
matching of cost with revenue and the activities of the business
decision making
2 Scope Cost Accounting deals primarily with the Scope of management accounting is very
ascertainment of cost. The scope of Cost wide and broader than Cost Accounting. It
Accounting is narrow than Management includes financial accounting, cost
Accounting. accounting, tax planning and reporting to
management
3 Nature Cost accounting uses both past and Management accounting is generally
present figures concerned with the projection of figures for
future
4 Data used Quantitative aspect is recorded in cost Management accounting uses both
accounting quantitative and qualitative information
 Cost Accounting vs Management Accounting
S.No. Basis Cost Accounting Management Accounting

5 Principles Certain principles and procedures are No specific rules and procedures are
followed for recording cost of different followed in management accounting
products

6 How it It developed due to the limitations of the It developed due to the limitations of the
developed? financial accounting Cost Accounting

7 Time It only involves short-term planning It involves short-term as well as long-term

horizon decisions planning decisions
 Comparative Financial Statements:

• In comparative financial statement, the financial

statements of two periods are kept by side so that
they can be compared.
• It is sometimes referred to as Horizontal Analysis
• By comparing with the data of the previous years it
can be ascertained what type of changes in the
different items of current year have taken place and
future trends of business can be estimated.

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Comparative Financial Statements:

34
 Common Size Statement:
• Common size financial statements are such statements in
which items of the financial statements are converted in
percentage on the basis of common base.
• In common size Income Statement, net sales may be
considered as 100 percent.
• Other items are converted as its proportion.
• Similarly, for the Balance sheet items total assets or
total liabilities may be taken as 100 percent and
proportion of other items to this total can be calculated in
percentage.
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Common Size Statement:

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 Trend Analysis:
• Trend analysis helps in future forecast of various items on
the basis of the data of previous years.
• Under this method one year is taken as base year and on
its basis the ratios in percentage for other years are
calculated.
• Sometimes sales may have an increasing trend but
profit may remain the same.
• Here the investor has to look into the cost and
management efficiency of the company.
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 Cash Flow Statement:
• The investor is interested in knowing the cash inflow and outflow
of the enterprise.
• The cash flow statement expresses the reasons of change in cash
balances of company between two dates.
• It provides a summary of stocks of cash and uses of cash in
the organization.
• With the help of cash flow statement the investor can review the
cash movement over an operating cycle.
• The factors responsible for the reduction of cash balances in
spite of increase in profits or vice versa can be found out.

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 Accounting Standard 3 (AS-3): Cash
Flow Statement
• The Institute of Chartered Accountants of India (ICAI) issued AS 3
(Revised): Cash Flow Statement in March 1997.
• The standard supersedes AS 3: Changes in Financial Position
which was issued in June 1981.
• AS 3 has become mandatory with effect from 1-4-2001 for the
following enterprises”
1. Enterprises whose equity or debt securities are listed or going to
be listed on a recognised Stock Exchange in India
2. All other commercial, industrial and business reporting
enterprises whose turnover for the accounting period exceeds
₹50 Crores.
 Sources and Uses of Cash
(I) Sources of Cash Inflows: (II) Sources of Cash Outflows:
(1) Business operations/operating (1) Purchase of long-term assets (plant and
activities machinery, land and building, office
(2) Non-business/operating activities equipments and furniture)
(interest/dividend received) (2) Redemption of preference shares and
(3) Sale of long-term assets (plant, building debentures
and equipment) (3) Repurchase of equity shares
(4) Issue of additional long-term securities (4) Repayment of long-term borrowings
(equity, preference shares and debentures) (5) Cash dividends paid to shareholders
(5) Additional long-term borrowings (preference and equity)
(banks and financial institutions) (6) Others items
(6) Others sources
Net Increase (Decrease) in Cash [I – II]
 Classification of cash flows

• Operating Activities: Cash inflows from operating activities

primarily accrue from the major revenue producing activities (i.e.,
sale of goods and rendering of services) of the enterprise.
• Investing Activities: The investing activities relate to acquiring
and disposing long-term assets and other investments not
included in cash-equivalents.
• Financing Activities: The financing activities report the changes
in the size and composition of the share/owner’s capital and debt
of the enterprise.
Direct Method Cash Flow Statement
 Treatment of other items

Income Tax:
• Cash flows arising from income tax should be classified as flows
from operating activities unless they can be specifically identified
with financing and investing activities.
• Example: capital gain tax on the sale of land is an investing
activity
 Treatment of other items

Interest and dividends:

• In the case of financing enterprise, cash flows from interest
paid and interest and dividend received should be treated as cash
flow from operating activities.
• Dividends paid should be classified as cash flows from financing
activities
• In the case of other enterprises, cash flow arising from interest
and dividends paid should be classified as cash flows from
financing activities while interest and dividends received should
be classified as cash flows from investing activities.
 Treatment of other items

Non cash transactions:

• Non-cash transactions are excluded from cash flow
statement
Examples:
1. Acquisition of assets by issue of share or debentures
2. Conversion of convertible debentures into shares
3. Acquisition of a fixed asset say machinery on credit etc.
Indirect Method Cash
Flow Statement
Indirect Method Cash Flow Statement
Indirect Method Cash Flow Statement
 Indirect method

• Indirect method is more popular in actual practice

• Indirect method is also known as reconciliation method

as it involves or reconciliation of the net profit with net
cash flows from operating activities
Computation of cash from operating activities
 Question 1

31st March 2009 31st March 2010

Profit and loss account 60,000 65,000
Debtors 85,000 48,000
Bills receivable 40,000 81,000
General reserve 1,72,000 2,07,000
Wages outstanding 26,000 8000
Salaries prepaid 8000 10,000
Goodwill 70,000 60,000
Calculate cash from operating activities
Solution 1
 Question 2

• Prepare a cash flow statement on the basis of the

information even in the balance sheet of PS limited.
Liabilities 2009 2010 Assets 2009 2010
Share capital 2,00,000 2,50,000 Goodwill 10,000 2000
12% debentures 1,00,000 80,000 Land and building 2,00,000 2,80,000
General reserve 50,000 70,000 Machinery 1,00,000 1,30,000
Creditors 40,000 60,000 Debtors 40,000 60,000
Bills payable 20,000 1,00,000 Stock 70,000 90,000
Outstanding expenses 25,000 20,000 Cash 15,000 18,000
4,35,000 5,80,000 4,35,000 5,80,000
Objectives and Uses of Cash Flow Statement
Useful in cash planning

Assesses cash flow from operating activities

Payment of dividends

Cash from investing and financing activities

Explains reasons for surplus or shortage of cash

Comparing a company’s performance over time

Comparing a company’s performance to its peers

Legal requirements
 Direct method Indirect method
The direct method lists all the actual cash The indirect method starts with the net income
inflows and outflows related to the company’s and makes adjustments for non-cash items and
operating activities. changes in working capital to arrive at the cash
flow from operating activities.
It provides a more detailed and accurate picture It is a quicker and easier way to prepare the cash
of the company’s cash flow from operating flow statement, but it may not provide as detailed a
activities, but can be more time-consuming to picture of the company’s actual cash flows.
prepare.
The direct method shows actual cash receipts The indirect method shows the changes
and payments in balance sheet accounts that affect cash flows.
The direct method is preferred by users of Companies more commonly use the indirect
financial statements, such as investors and method, because it is easier to prepare and requires
analysts, because it provides more detailed less time and resources.
information about a company’s cash flows.
The direct method does not use net income as The indirect method starts with net income.
a starting point.
 Question 3
The balance sheets of VXL limited as at December 31st of 2 years are given
below:
Liabilities 2008 (₹) 2009 (₹) Assets 2008 (₹) 2009 (₹)
Trade creditors 30,000 40,000 Cash balances 50,000 60,000
Debentures 1,50,000 90,000 Trade debtors 75,000 1,00,000
Provision for depreciation 60,000 80,000 Inventory 1,40,000 1,20,000
on plant
Equity share capital 2,00,000 2,40,000 Land 1,00,000 80,000
Retained earnings 1,25,000 1,60,000 Plant and Machinery 2,00,000 2,50,000
Total 5,65,000 6,10,000 Total 5,65,000 6,10,000

Cash dividends of ₹ 25,000 have been paid during the year. You are required to
prepare a cash flow statement on indirect basis
 Question 4
Balance Sheets of X Ltd. as on 31st March 2008 and 31st March 2009 were as follows:
Liabilities and Capital 2008 (₹) 2009 (₹) Assets 2008 (₹) 2009 (₹)
Share capital 5,00,000 7,00,000 Land and building 80,000 1,20,000
Profit and loss account 1,00,000 1,60,000 Plant and machinery 5,00,000 8,00,000
General reserve 50,000 70,000 Stock 1,00,000 75,000
Sundry creditors 1,63,000 2,00,000 Sundry debtors 1,40,000 1,50,000
Bills payable 30,000 40,000 Prepaid expenses 14,000 12,000
Outstanding expenses 7000 5000 Cash at bank 16,000 18,000
Total 8,50,000 11,75,000 Total 8,50,000 11,75,000
Additional information:
i. ₹ 50,000 depreciation has been charged to plant and machinery during the year 2009.
ii. A piece of machinery was sold for ₹ 8000 in 2009. It had cost ₹ 12,000, and depreciation of
₹ 7000 has been provided on it.
Prepare a Cash Flow Statement from the above details.
 Question 5
Liabilities and Capital 2005 (₹) 2006 (₹) Assets 2005 (₹) 2006 (₹)
Equity share capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
Red. Preference 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 8000
Total 6,77,000 8,17,000 Total 6,77,000 8,17,000
• Depreciation of ₹ 20,000 on land and building and ₹ 10,000 on plant has been charged in 2006
• Interim dividend of ₹ 20,000 has been paid in 2006
• Income tax ₹ 35,000 has been paid during 2006
Prepare cash flow statement for the year 2006
 Funds Flow Statement vs Cash Flow Statement
Fund Flow Statement Cash Flow Statement
Funds flow statements record the Cash flow statements record the
changes in working capital. movement of cash only.
It helps understand the financial It helps understand the net cash flow
position of the company. of the company.
The fund flow statement determines The cash flow statement records
the source and application of funds.
changes in opening balance and
closing balance of cash.
It works on the accrual basis of It works on a cash basis of
accounting. accounting.
The analysis is for the long term. The analysis is for a short duration.
Fund flow is useful for capital Cash flow is useful for cash budgeting.
budgeting.
 Ratio Analysis:
• Ratio is a relationship between two figures expressed
mathematically. It is quantitative relationship between two items for
the purpose of comparison.
• It helps in estimating financial soundness or weakness. Ratios
present the relationships between items presented in profit and loss
account and balance sheet.
• It summaries the data for easy understanding, comparison and
interpretation.
• Financial Statements are available on yearly basis, whereas
Ratios can be calculated at any point of time.

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 Classification of ratios

Classification according to the nature of the accounting

statement from which the ratios are derived:

Balance sheet Current ratio, liquid ratio, debt equity ratio

ratios
Profit and loss Gross profit ratio, net profit ratio, operating ratio,
account ratio stock turnover ratio
Combined or Rate of return on capital employed, debtors turnover
composite ratios ratio, stock turnover ratio, capital turnover ratio
 Classification of ratios

Classification from the point of view of financial

management or objective
Liquidity ratios reveal the ability of a company to pay off its short-term
obligations

Capital structure ratios show the long term solvency of a company

Turnover ratios measure the efficiency with which various assets are utilised

Profitability ratios indicate the success of a business in terms of profits

 a) Liquidity Ratios:
• Liquidity rations means ability of the company to pay the short term
debts in time. These ratios are calculated to analyze the short term
financial position and short term financial solvency of firm.
• Commercial banks and short term creditors are interested in such
analysis.

or Working Capital Ratio

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 a) Liquidity Ratios:
• When analyzing a company, investors and creditors want to
see a company with liquidity ratios above 1.0.
• Normally a current ratio of 2:1 is considered satisfactory.
• A company with healthy liquidity ratios will likely be approved for
credit.
• Companies with an acid-test ratio of less than 1 do not have
enough liquid assets to pay their current liabilities and should be
treated with caution.

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 a) Liquidity Ratios:
- Prepaid Expenses
or Quick Ratio - Bank Overdraft

• The quick assets include cash, debtors (excluding bad debts) and
securities which can be realised without difficulty.
 a) Liquidity Ratios:

• If the acid-test ratio is much lower than the current ratio, it

means that a company's current assets are highly dependent
on inventory.
• This is not a bad sign in all cases, however, as some business
models are inherently dependent on inventory. Retail stores, for
example, may have very low acid-test ratios without necessarily
being in danger.

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 Question 1
Liabilities ₹ Assets ₹
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 5000 Stock in trade 50,000
Outstanding expenses 2000 Debtors 59,000
Prepaid expenses 1000
Cash in hand 4000
Total 3,65,000 Total 3,65,000
Calculate the following ratios
i) Current ratio, ii) Quick ratio
 Solution
Current ratio = Current assets / Current liabilities
Current assets= Investments+ Stock+ Debtors+ Prepaid
Expenses+ Cash
= 16,000+ 50,000+ 59,000+ 1000+ 4000
= 1,30,000
Current liabilities= Sundry Creditors+ Outstanding
Expenses+ Bills Payable+ Bank Overdraft
= 48,000+ 2000+ 10,000+ 5000
= 65,000
Current ratio= 1,30,000/65,000= 2 : 1
 Solution
Quick ratio = Quick assets / Quick liabilities
Quick assets= Investments+ Debtors+ Cash
= 16,000+ 59,000+ 4000
= 79,000
Quick liabilities= Sundry Creditors+ Outstanding
Expenses+ Bills Payable
= 48,000+ 2000+ 10,000
= 60,000
Quick ratio= 79,000/60,000= 1.32 : 1
 Question 2

• X limited has a current ratio of 4.5: 1 and a quick ratio of

3: 1. If the inventory is ₹ 60,000, find out its total current
assets and total current liabilities.
Solution
• Current Assets = ₹ 1,80,000
• Current Liabilities= ₹ 40,000
• Quick Assets= ₹ 1,20,000
 Question 3

• A firm has a current ratio of 3:1. Its net working capital is ₹

2,00,000. You are required to determine current assets,
current liabilities, and liquid assets, assuming an inventory
of ₹ 2,20,000
Solution
• Current Assets = ₹ 3,00,000
• Current Liabilities= ₹ 1,00,000
• Quick Assets= ₹ 80,000
 b) Capital Structure Ratios:

Debt equity Proprietary

ratio ratio

Interest
Capital
coverage
gearing ratio
ratio
 Debt equity ratio

• Long term Debt Equity Ratio = Long term debts .

Shareholders’ funds

Long term debt include debentures, long term loans, etc.

Shareholders’ funds include share capital (both equity and

preference) and accumulated profits like general reserve, capital
reserve and any other fund that belongs to shareholders.
 Debt equity ratio

• Debt Equity Ratio = Total debts (short term + long term) .

Shareholders’ funds

Long term debt + sundry creditors, bills payable, bank overdraft,

short and long term loans, outstanding expenses, taxation provision,
proposed dividend.

Shareholders’ funds include share capital (both equity and

preference) and accumulated profits like general reserve, capital
reserve and any other fund that belongs to shareholders.
 Debt and Equity Financing
• One of the best ways of measuring the proportions of debt
and equity financing is:

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 Proprietary ratio

• Proprietary ratio = Shareholders’ funds

total assets
The proprietary ratio shows the extent to which the
business and thus indicates the general financial strength of
the business.
The higher the proprietary ratio, the greater the long-term
stability of the company and, consequently, greater
protection to creditors.
 Interest coverage ratio

• Ratio indicates whether the business earns sufficient

profits to pay the interest charges periodically.
• Interest coverage ratio
= Earnings before interest and tax (EBIT)__________
Fixed interest charges interest on debentures and long term loans
• This ratio is very important as it indicates the ability of a
company to pay interest out of its profits.
 Capital gearing ratio

• Capital gearing ratio= Fixed income securities .

Equity shareholders’ funds

Fixed-income securities include debentures and preference

share capital.

A company is highly geared if this ratio is more than

one, low geared if the ratio is less than one, and evenly
geared if ratio is exactly one.
 c) Turn over Ratios
(Performance Ratios or Activity Ratios):

Inventory Debtors
turnover ratio/ turnover These ratios show how
well the assets are used
Inventory Velocity ratio and the extent of excess
inventory.
(For every 1 Rupee of
Fixed assets Capital asset, how
Rupees of Revenue
many

turnover turnover company generates.)

ratio ratio
 Inventory turnover ratio/ Inventory
Velocity
• Inventory turnover ratio = Cost of goods sold .
Average Stock (or Inventory)
Where Cost of goods sold = Sales - Gross Profit
Or
= opening stock+ purchases+ carriage inward and other
direct expenses- closing stock

Average stock = ½ (Opening stock+ Closing stock)

 Inventory turnover ratio/ Inventory
Velocity
• If the value of the cost of goods sold is not available, the
inventory turnover ratio may be calculated by the following
method:

• Inventory turnover ratio = Net Sales

Average Stock
 Question

• Opening stock ₹ 29,000

• Purchases ₹ 2,42,000
• Sales ₹ 3,20,000
• Gross Profit 25% of sales
• Calculate Stock turnover ratio.
 Solution
• To find out value of closing stock, trading account will be prepared:
Trading A/c
Particulars Amount Particulars Amount
To Opening stock 29,000 By sales 3,20,000
To Purchases 2,42,000 By Closing stock (balancing figure) 31,000
To Gross profit (25% of ₹3,20,000) 80,000
3,51,000 3,51,000
Cost of goods sold = Sales - Gross Profit = 3,20,000 - 80,000 = ₹ 2,40,000
Or
= opening stock+ purchases+ carriage inward and other direct expenses-
closing stock = 29,000 + 2,42,000 – 31,000 = ₹ 2,40,000
Average stock = (29,000 + 31,000) / 2 = ₹ 30,000
Stock turnover ratio = 2,40,000/ 30,000 = 8 times
 Debtors turnover ratio

• Debtors turnover ratio = Credit sales .

Average debtors
• The term debtors includes trade debtors and bills
receivables. Doubtful debts are not deducted from
debtors.
• The debtors turnover ratio is usually supplemented by
average collection period:
• Average collection period = Days in the year .
Debtors turnover ratio
 Creditors turnover ratio

• Creditors turnover ratio = Credit purchases .

Average creditors
• The term creditors includes trade creditors and bills
payable.
• The creditors turnover ratio is usually supplemented by
the average payment period:
• Average payment period = Days in the year .
Creditors turnover ratio
 Example

• Credit sales for the year ₹ 5,40,000

• Debtors at the end ₹ 90,000
• Debtors turnover ratio = Credit sales .
Average debtors
= 5,40,000 / 90,000
= 6 times
• Average collection period = Days in the year .
Debtors turnover ratio
= 365 / 6 = 61 days
 Fixed assets turnover ratio

• Fixed assets turnover ratio = Sales ( or cost of sales)

Net Fixed Assets

Net fixed assets means depreciated value of fixed assets

 Capital turnover ratio

• Capital turnover ratio = Cost of Sales ( or Sales)

Total Capital Employed

• Total capital employed = equity capital+ preference

capital + reserves + debentures + long term loans -
fictitious assets - non operating investments
• Fictitious assets = preliminary expenses + discount on the
issue of shares + debit balance of profit and loss account
 c) Turnover Ratios:

• The ratio measures the efficiency of how well a company

uses assets to produce sales.
• A higher ratio is favorable, as it indicates a more efficient
use of assets.
• The benchmark asset turnover ratio can vary greatly
depending on the industry.
• Capital-intensive industries tend to report a lower ratio.

93
 d) Profitability ratios
1. Gross profit ratio
Profitability
2. Net profit ratio ratio based
on sales
3. Operating ratio

4. Return on investments Profitability

ratio based
on
5. Return on equity
investments

6. Earning per share (EPS)

7. Dividend payout ratio

8. Dividend yield ratio

9. Price earning ratio

 1. Gross Profit Ratio

• Gross Profit Ratio = Gross profit x 100

Net Sales
= Net Sales- Cost of goods Sold x 100
Net Sales

• Gross profit ratio indicates the average margin on the goods sold.
• It shows whether the selling prices are adequate or not.
• It also indicates how much selling prices may be reduced without
resulting in losses.
 2. Net Profit Ratio (net profit margin)

• There are 2 variations of this ratio:

– Net Operating Profit Ratio
– Net Profit Ratio

Net Operating Profit Ratio = Net Operating Profit x 100

Net Sales
Net operating profit = Gross Profit - Administrative and
Selling Expenses
 2. Net Profit Ratio (net profit margin)

• There are 2 variations of this ratio:

– Net Operating Profit Ratio
– Net Profit Ratio

Net Profit Ratio = Net Profit x 100

Net Sales
Net Profit = Net Operating Profit + Non-Operating Incomes
– Non-Operating Expenses
= Gross Profit - All Expenses + All Other Incomes
 Profit Margin Ratios:
• Earning of more and more profit with the optimum use of available
resources of business is called profitability.
• The investor is very particular in knowing net profit to sales, net
profit to total assets and net profit to equity.
• The profitability ratio measures the overall efficiency and
control of firm.

98
 3. Operating ratio

Operating ratio = Cost of Goods Sold + Operating Expenses x 100

Net Sales

Cost of Goods Sold = Opening Stock + Purchases + Carriage Inward +

Wages - Closing Stock

• The operating ratio is the yard state to measure the efficiency of a

business.
• This ratio indicates that for every ₹ 1 of net sales how much is
the operating cost?
 4. Return on Investments (ROI) or Return
on Capital Employed (ROCE)
• ROI or ROCE = Profit Before Interest and Taxes X 100
Capital Employed
Capital employed is computed as follows:
Equity share capital
Add: preference share capital
Add: reserves and other undistributed profits
Add: long term loans and debentures
Less: fictitious assets (e.g. Preliminary expenses)
Capital employed may also be computed in the following way:
Fixed assets cost less depreciation
Add: Net working capital (current assets minus current liabilities and provisions)
 Dupont Analysis
• It is a method of performance measurement that was started by
DuPont corporation in USA in 1920s.
• A simplified Dupont financial analysis model is given here with
figures: ÷×

×
÷ ÷
 5. Return on equity

• This ratio has 2 variations:

– Return on Proprietors Equity
– Return on Equity Capital
Return on Proprietors Equity = Net profit after taxes and interest x 100
Shareholders’ fund

Shareholders’ funds include equity capital, preference capital, capital

reserve, general reserve and other undistributed profits.
 5. Return on equity

• This ratio has 2 variations:

– Return on Proprietors Equity
– Return on Equity Capital
Return on Equity Capital = Net profit after taxes, interest and pref. dividend x 100
Equity Shareholders’ fund

This ratio establishes the relationship between the net profit available to equity
shareholders and the amount of capital invested by them.
 6. Earning per share (EPS)

Earning per share = Net Profit after Taxes - Preference Dividend

Number of Equity shares

This ratio is quite significant. EPS affects the market value of

shares. It is an indicator of the dividend paying capacity of the
firm.
 7. Dividend payout ratio
• Dividend per Share (DPS): All the profits after tax and preference dividend
available for equity shareholders are not distributed among them as dividend.
Rather, a part of it is retained in business. The balance of profits is distributed
among equity shareholders.

• Dividend payout ratio = Dividend per share .

Earning per share (EPS)
 8. Dividend yield ratio

• Earning per share (EPS) and Dividend per Share (DPS)

are calculated on the basis of book value of share but
yield is always calculated on the basis of market value of
shares.
 9. Price Earning ratio
Price to Earnings Ratio: This ratio is calculated by dividing
the market price of a share by earnings per share.

Company A Company B Company C Company D

Market Price of the Share Rs. 100 Rs. 100 Rs. 500 Rs. 250
Earning Per Share 10 20 150 85
P/E Ratio 10 5
Interpretation: How much money is to be invested to earn Rs. 1 as earnings per share.

107
Financial Statements of TATA

108
 Question
Liabilities ₹ Assets ₹
600 shares of ₹100 each 60,000 Land 40,000
General Reserve 35,000 Plant 20,000
Dividend Equalisation Reserve 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 Bills receivable 13,500
Profit And Loss Account: Cash and Bank 12,000
Balance 1,000 Preliminary expenses 8,000
Current Year 20,000 21,000
Total 1,76,000 Total 1,76,000

Calculate a) Current ratio; b) Fixed asset to net worth ratio; c) Debt equity
ratio; d) Return on capital employed
 Solution

• Current ratio = Current Assets .

Current Liabilities
Current assets = Inventories+ Bills Receivable+ Cash and Bank
= 30,000+ 13,500+ 12,000 = ₹55,500
Current liabilities = Bills Payable+ Provision for Tax
= 30,000+ 5000 = ₹35,000

Current ratio = ₹55,000 / ₹35,000 = 1.56: 1

 Solution
• Fixed assets to net worth ratio = Fixed Assets
Net Worth
Fixed Assets = Land+ Plant+ Machines+ Investments
= 40,000+ 20,000+ 27,500+ 25,000 = ₹1,12,500
Net worth = Share Capital+ General Reserve+ Dividend
Equalisation Reserve+ Profit and Loss Account- Preliminary
Expenses
= 60,000+ 35,000+ 5000+ 21,000-8000 = ₹1,13,000
Fixed assets to net worth ratio = ₹1,12,500/ ₹1,13,000
= 0.99:1
 Solution

• Long term Debt Equity Ratio = Long term debts .

Shareholders’ funds
Long Term Debt = ₹20,000
Shareholders’ Funds = 60,000+ 35,000+ 5000+ 21,000- 8,000
= ₹1,13,000
Long term Debt Equity Ratio = ₹20,000/ ₹1,13,000
= 0.17 : 1
 Solution
• ROI or ROCE = Profit Before Interest and Taxes X 100
Capital Employed
Net profit before interest and tax = net profit+ tax
= 20,000+ 5,000 = ₹25,000
Capital employed= Share Capital+ General Reserve+ Dividend
Equalisation Reserve+ Long term Loans+ Profit - Preliminary
Expenses
= 60,000+ 35,000+ 5000+ 20,000+ 21,000 – 8000 = ₹1,33,000
ROCE = (25,000/1,33,000)x100 = 18.79%
 Question
Company having a net working capital law ₹2.8 lakhs as of 30-06-2010
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 are 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 30-06-2010
showing step by step calculations.
 Solution
• Current ratio = Current Assets .
Current Liabilities
• 2.4 = Current Assets .
Current Liabilities
Current Assets = 2.4 Current Liabilities

Working Capital = 2,80,000 (Given)

Current Assets- Current Liabilities = 2,80,000
2.4 Current Liabilities- Current Liabilities = 2,80,000
Current Liabilities = 2,00,000
Current Assets = 2.4 Current Liabilities
Current Assets = 4,80,000
 Solution
Liquidity Ratio = 1.6 (Given)

Current Assets – Stock = 1.6

Current Liabilities

4,80,000- Stock = 1.6

2,00,000

Stock = 1,60,000
 Solution
• Inventory turnover ratio = Cost of goods sold .
Average Stock (or Inventory)
8 = Cost of Sales
Stock
8 = Cost of Sales
1,60,000
Cost of Sales = 12,80,000
 Solution
• Gross Profit on Sales = 20%
• Gross Profit on Cost of Sales = 25%
Cost of Sales = 12,80,000
Gross Profit = 25% of 12,80,000
Gross Profit = 3,20,000

Sales = COGS+Gross Profit

= 12,80,000+3,20,000
Sales = 16,00,000
 Solution
• Average Collection Period = 12 .
Debtors turnover ratio
Average Collection Period = 12 x Average Debtors.
Credit Sales
1.5= 12 x Average Debtors.
16,00,000
Average Debtors= 2,00,000
 Solution
• Net Worth = Fixed Assets + Net Working Capital
• Net Worth = 90% of Net Worth + Net Working Capital
• Net Worth = 90% of Net Worth + 2,80,000
• Net Worth = 28,00,000

• Fixed Assets= 90% of Net Worth

• Fixed Assets= 25,20,000
 Solution
• Net Worth = Capital + Reserves
• 28,00,000 = Capital + 40% of Capital (Given)
• Capital = 20,00,000
• Reserve = 40% of Capital
= 8,00,000
 Solution

Balance Sheet as on 30-06-2010

Liabilities ₹ Assets ₹
Capital 20,00,000 Fixed Assets 25,20,000
Reserves 8,00,000 Cash 1,20,000
Current Liabilities 2,00,000 Debtors 2,00,000
Inventory/Stock 1,60,000
Total 30,00,000 Total 30,00,000
 Advantages of Ratio analysis
Useful in analysis of financial statements

Useful in improving future performance

Useful in inter firm comparison

Useful in judging the efficiency of our business

Useful in simplifying accounting figures

 Limitations of Ratio Analysis

1. Reliability of ratios depends upon the correctness of the basic

data
2. An individual ratio may by itself be meaningless
3. Ratios are not always comparable
4. Ratios sometimes give a misleading picture
5. Ratios ignore qualitative factors
6. Changes in price levels make ratio analysis ineffective
7. There is no single standard for comparison
8. Ratios based on past financial statements are no indicators of
future
 Unit II

Budgetary control and Variances: Concept and types of budgeting and

budgetary control; meaning, objectives, merits, and limitations of budgetary
control; budget administration; Functional budgets including cash budget; Fixed
and flexible budgets: meaning and preparation; Zero-based budgeting;
Performance budgeting, difference between performance & traditional
budgeting. Meaning of Variance and Variance analysis – Material, Labour,
Overheads, and Sales Variances, Disposition of Variances, Control Ratios.
 Important Question

• Define budgetary control. State its objectives. Explain the

process by which various budgets are prepared.
Distinguish between fixed budget and flexible budget.
 Budget

• “Budgets are the expressions, largely in financial terms of

management’s plan for operating and financing the
enterprise during specific periods of time. The budget
can be defined as a predetermined detailed plan of
action developed and distributed as a guide to
current operations and as a partial basis for the
subsequent evaluation of performance.”
—Gordon, M.J. & Shillinglaw, G. in Accounting: A Management Approach
• According to Robert Anthony,
• “Budgeting also called profit planning involves a
projection of the activity of the enterprise in terms of
expenses, revenues, assets and equities over a
specific period of time in future, usually one year”.
• The Chartered Institute of Management Accountants,
London, defines budget as:
•
• “A financial and/or quantitative statement prepared
and approved prior to a defined period of time of the
policy to be pursued during that period for the
purpose of attaining a given objective. It may include
income, expenditure and the employment of capital”.
 Distinctive features of a budget

• A budget is primarily a planning device, but it also serves

as a basis for performance evaluation and control.
• It is prepared, generally, a year in advance of the
operations.
• It is a guide or blueprint for the forthcoming period.
• It is expressed in monetary terms though usually it is
drawn in physical quantities.
 Budgeting

• The act of preparing budgets is called

budgeting.

• In the words of J. Batty, “the entire process of

preparing the budgets is known as budgeting.”
 Budgetary control

• Budgetary control involves a constant checking and

evaluation of actual results compared with budget goals
which should result in corrective action where indicated.
• “The establishment of budgets relating to the responsibilities
of executives to the requirements of a policy and the continuous
comparison of actual with budgeted results, either to secure
by individual action the objectives of that policy or to
provide a basis for its revision”.
The Chartered Institute of Management Accountants, London
 Steps of budgetary control
1. Clear allocation of duties and responsibilities.
2. Establishment of budgets or fixation of targets of performance for
each department or function of the organization.
3. Comparison of actual with budgeted figures, calculation of the
variations between the two,
4. Analysis of variances according to causes and responsibilities and
reporting to management for corrective actions.
5. When however, a scrutiny of variations reveals that there has been some
change in the basic conditions in which the budget was prepared and the
change is of permanent nature, steps have to be taken to revise the
budget.
Objectives of budgetary control
1. Planning annual operations (production, sales, raw material requirements,
labour needs, advertising and sales promotion performance, R&D activities, etc.)

2. Co-ordinating the activities of various parts of the organization (there should

be coordination in the budgets of various departments)

3. Communicating the plans to those who are responsible for carrying them out

4. Allocating resources

5. Motivating managers at all levels

6. Controlling profit and activities (through a comparison of planned and actual

performance)

7. Evaluating the performance of the managers and providing incentives

 Advantages of budgetary control
1. Budgeting compels managers to think ahead- to anticipate
and prepare for changing conditions
2. Budgeting coordinates the activities of various departments
and functions of the business
3. It increases production efficiency, eliminates waste and
controls the cost
4. It aims at maximization of profits through careful planning
and control
5. It provides a yardstick against which actual results can we
compared.
 Advantages of budgetary control
6. It ensures that working capital is available for the efficient
operation of the business
7. A budget motivates executives to attain the given goals
8. Control system creates necessary conditions for the
introduction of standard costing technique
9. A budgetary control system assists in the delegation of
authority and assignment of responsibility
10. It helps in achieving an organization’s long-term goal.
 Limitations of budgetary control
1. The budget plan is based on estimates. The future is
unpredictable, so a budget always does not guarantee a
smooth future for an organization.
2. Danger of rigidity
3. Budgeting is only a tool for management
4. Opposition from staff
5. Expensive technique
6. This process sometimes requires coordination between
various departments and is difficult.
 Budget administration
1. Creation of 2. Introduction of
3. Preparation of an
budget centres adequate
organization chart
accounting records

4. Establishment of
budget committee
Organization chart
for budgetary control

7. Determination of
5. Preparation of
the principal budget 6. Budget Period budget manual
factor or key factor
 Types of Budgets
Time Functions Flexibility
1. Long term Budget 1. Sales budget 1. Fixed Budget
(strategic plan) 2. Production budget
3. Cost of production budget 2. Flexible Budget
2. Short term Budget 4. Raw materials budget
5. Purchase budget
3. Current Budget 6. Labour budget
7. Production overhead
4. Rolling Budget budget
(continuous budget) 8. Selling and distribution
cost budget
9. Administration cost budget
10. Cash budget
11. Capital expenditure
budget
12. Master budget
 Functional budgets
Functional Budgets
• A functional budget relates to a 1. Sales budget
particular function of the business, 2. Production budget
3. Cost of production budget
e.g., sales, production, purchase, 4. Raw materials budget
etc. 5. Purchase budget
6. Labour budget
7. Production overhead budget
8. Selling and distribution
• These are components of the cost budget
9. Administration cost budget
master budget. 10. Cash budget
11. Capital expenditure budget
12. Master budget
 Cash Budget

• The cash budget is one of the most important and last to

be prepared.
• It is a detailed estimate of cash receipts from all sources,
cash payments for all purposes, and the resulting cash
balances during the budget period.
• Cash budget plays a vital role in the financial
management of the business.
 Purpose of cash budget
It ensures that sufficient cash is available when required

It indicates cash accesses and shortages so that excess cash can be

invested or funds can be borrowed

It establishes a sound basis for credit

It shows whether capital expenditure may be financed internally

It establishes a sound basis for control of the cash position

 Preparation of Cash Budget

• There are three methods of preparing Cash Budget:

Receipts and Balance

Adjusted
Sheet
Payments profit and
methods
Method Loss method
 Receipts and Payments Method
• This method is usually used for short-term cash
forecasts and is much more detailed than the other
two methods.
Opening balance of Cash + receipts – Payments
Receipts and = Closing Balance
Payments • In the case of credit sales, adjustments should be
Method made for the time lag between the point of sale
and realization of cash
• Similarly, the period of credit appropriate to the
payment concern should be taken into account
 Preparation of Cash Budget- Question
Company is expecting to have ₹25,000 cash in hand on 1st April 2010 and it requires you
to prepare a cash budget for the 3 months, April to June 2010.
The following information is supplied to you:
Sales (₹) Purchase (₹) Wages (₹) Expenses (₹)
February 70,000 40,000 8000 6000
March 80,000 50,000 8000 7000
April 92,000 52,000 9000 7000
May 1,00,000 60,000 10,000 8000
June 1,20,000 55,000 12,000 9000
Other information:
1. Period of credit allowed by suppliers is two months;
2. 25% of sales is for cash and the period of credit allowed to customers for credit
sales is one month;
3. Delay in payment of wages and expenses one month;
4. Income tax ₹25,000 is to be paid in June 2010.
 Solution
Cash Budget for Three months ending June 2010
April (₹) May (₹) June (₹) Total (₹)
Opening Balance 25,000 53,000 81,000 25,000
Receipts:
Cash Sales 23,000 25,000 30,000 78,000
Debtors 60,000 69,000 75,000 2,04,000
Total 83,000 94,000 1,05,000 2,82,000
Payments:
Creditors 40,000 50,000 52,000 1,42,000
Wages 8,000 9,000 10,000 27,000
Expenses 7,000 7,000 8,000 22,000
Income Tax 25,000 25,000
Total 55,000 66,000 95,000 2,16,000
Closing Balance 53,000 81,000 91,000 91,000
 Preparation of Cash Budget

• Method is suitable for long term cash

forecast.
• The profit as per profit and loss account is
Adjusted converted into cash figure by preparing
profit and and adjusted profit and loss account.
Loss method • This method is often termed as cash
flow statement because it converts the
profit and loss account into a cash
forecast.
 January (₹) February (₹) March (₹) Total (₹)
Opening Balance of Cash
Additions:
Budgeted net profit
Depreciation
Provisions
Sale of plant
Issue of capital and debentures
Reduction in debtors
Adjusted Reduction in stocks
Accrued expenses
Profit and Increase in liabilities
Loss Method Total additions

of Cash Total cash available

Deductions:
Budget Dividends
Prepayments
capital profit
increasing stocks
increase in debtors
decrease in liabilities
Total deductions
Closing Balance of Cash
 Preparation of Cash Budget

• This method is also similar to the

adjusted profit and loss account method.
• Under this method, a budgeted balance
Balance
sheet is prepared with all items of assets
Sheet and liabilities accepting cash or bank
methods balance.
• The two sides of the balance sheet are then
totalled, and the balancing figure is taken as
cash.
 Fixed and flexible budgets: meaning
and preparation
Fixed Budget:
• A fixed budget is one which is prepared keeping in mind one level
of output.
• It is defined as a budget which is designed to remain
unchanged irrespective of the level of activity attained.
• If actual output differs from the budgeted level of output,
variances will arise.
• Fixed budget is prepared on the assumption that output and
sales can be estimated with a fair degree of accuracy
 Fixed and flexible budgets: meaning
and preparation
Flexible Budget:
• A flexible budget is one which is designed to change in
relation to the level of activity attained.
• Flexible budget might be prepared for various levels of
activity say 70% 80% 90% 100%, and 110% capacity
utilization.
• Flexible budgets are prepared in those companies where it is
extremely difficult to forecast output and sales with accuracy.
 Fixed budget Flexible budget
Fixed budget assumes static business Flexible budget is based on the assumption
conditions of changing business conditions
Fixed budget is prepared for only one level
Flexible budget may be prepared for
of activity different capacity levels or for any level of
activity
Fixed budget figures are not changed when In Flexible budgets, the figures are
actual level of activity changes adjusted according to the actual level of
activity attained
Fixed budgets have very limited use for Flexible budgets are very useful for cost
control under changing business control and performance evaluation under
environments changing business environments
 Fixed budget Flexible budget
It is rigid or inflexible and does not It is not rigid. It can be quickly changed to
change with the level of activity attainted suit actual level of activity attainted
It has only one level of activity and one It consists of a number of budgets for
set of conditions. It is based on the different level of activity
assumption that there will be no change in
the prevailing conditions which is
unrealistic
Greater level of control is not possible in Flexible budget is essential for a
a fixed budget which shows the estimates meaningful control over expenses
only at one level of activity
 Fixed budget Flexible budget
In a fixed budget, all costs-fixed, variable and In a flexible budget, costs are analysed
semi-variable are related to only one level of according to behaviour into fixed, variable
activity. As such analysis of variance is not and semi-variable. For different levels of
informative activity, cost relevant for these levels are
considered. It provides useful information
about variances
Cost ascertainment, price fixation etc. do not It facilitates ascertainment of cost, price
give a correct picture if the actual and fixation, submission of tenders and
budgeted level of activity differ quotations
Comparsion of actual performance with It provides a meaningful basis for comparison
budgeted levels will not be meaningful if of the actual performance with the budgeted
there has been a change in the activity level targets
 Preparation of Flexible Budget
• It is essential to segregate the cost into fixed and variable costs
in flexible budgets.
• While computing fixed cost at various levels it is to be noted that
fixed cost in total amount remains unchanged at various
levels of activity.
• It is essential to note that total variable cost increases in
proportion to the increase in the level of activity and vice
versa.
• Semi-variable costs should be separated into fixed and
variable components. The fixed component will not change
between levels, but the variable part will change in proportion
to the level of activity.
 Question
• Draw up a flexible budget for overhead expenses on the
basis of the following data and determine the overhead rates
at 70% 80%, and 90% plant capacity.
At 80% capacity (₹)
Variable overheads:
Indirect labour 12,000
Stores including spares 4,000
Semi variable overheads:
Power(30% fixed, 70% variable) 20,000
Repairs and maintenance (60% fixed, 40% variable) 2,000
Fixed overheads:
Depreciation 11,000
Insurance 3,000
Salaries 10,000
Total Overheads 62,000
Estimated direct labour hours 1,24,000 hours
 Solution
Flexible budget for the period …..
At 70% capacity At 80% capacity At 90% capacity
(₹) (₹) (₹)
Variable overheads:
Indirect labour 10,500 12,000 13,500
Stores including spares 3500 4,000 4500
Semi variable overheads:
Power - 30% fixed 6000 6000 6000
- 70% Variable 12,250 14,000 15,750
Repairs and maintenance - 60% fixed 1200 1200 1200
- 40% Variable 700 800 900
Fixed overheads:
Depreciation 11,000 11,000 11,000
Insurance 3000 3,000 3000
Salaries 10,000 10,000 10,000
Total Overheads 58,150 62,000 65,850
Estimated direct labour hours 1,08,500 hours 1,24,000 hours 1,39,500 hours
Direct Labour Hour Rate (A-B) ₹ 0.536 ₹0.500 ₹0.472
 Question

• Prepare a flexible budget for production at 80% and 100%

activity based on the following information:
• Production at 50% capacity 5000 units
• Raw materials ₹80 per unit
• Direct labour ₹50 per unit
• Direct expenses ₹15 per unit
• Factory expenses ₹50,000 (50% Fixed)
• Administration expenses ₹60,000 (60% Variable)
 Solution
Particulars 80% Capacity (8,000 Units) 100% Capacity (10,000 Units)
Per Unit Total Per Unit Total
Raw materials ₹80 6,40,000 ₹80 8,00,000
Direct labour ₹50 4,00,000 ₹50 5,00,000
Direct expenses ₹15 1,20,000 ₹15 1,50,000
Factory expenses
Fixed ₹3.125 25,000 ₹2.5 25,000
Variable ₹5 40,000 ₹5 50,000
Administration
expenses
Fixed ₹3 24,000 ₹2.4 24,000
Variable ₹7.2 57,600 ₹7.2 72,000
Total ₹163.325 13,06,600 ₹162.10 16,21,000
 Zero-based budgeting
• Before preparing any budget, a base is generally determined from
which the budget process begins.
• Quite often, the current year's budget is taken as the base or the
starting point for preparing the next year's budget.
• The figures in the base are changed as per the plan for the next year
• This approach of preparing a budget is called incremental
budgeting.
• For instance, sales of the current year's budget may be taken as
the base and next year's budget for sales will be current year
sales plus an allowance for price increases and expected
changes in sales volumes.
 Zero-based budgeting
• Zero-based budgeting is an alternative to incremental
budgeting.
• It was introduced at Texas Instruments in USA in 1969 by
Peter Phyrr, who is known as the father of zero-based
budgeting.
• In zero-based budgeting previous year’s figures are not
taken as the base for preparing next year's budget
• Instead, the budget figures are developed with zero as the
base, which means a budget will be prepared as if it is
being prepared for a new company for the first time.
 Zero-based budgeting
“A planning and budgeting process which requires each
manager to justify his entire budget request in detail from
scratch (hence zero base). Each manager states why he
should spend any money at all. This approach requires that
all activities be identified as decision packages which will be
evaluated by systematic analysis ranked in order of
Pete Pyhrr, developed zero- importance.”
based budgeting as a young
manager with Texas Instruments Peter Phyrr

“A method of budgeting whereby all activities are revaluated each time a budget is
set. Discrete levels of each activity are valued, and a combination chosen to match
funds available.”
C.I.M.A., London
 Zero-based budgeting
• In simple words, zero base budgeting is a system
whereby each budget item, regardless of whether it is a
new or existing must be justified in its entirety each time a
new budget is prepared.
• It is a formalised system of budgeting for the activities of
an enterprise as if each activity were being performed for
the first time, i.e., from zero base.
• Budget request for appropriation are accepted based on
cost-benefit approach which ensures value for money.
 Main features of Zero-base Budgeting

All budget items, both old

₹
The amount to be spent A detailed cost-benefit
and newly proposed, are on each budget item is analysis of each budget
considered totally afresh. to be totally justified. programme is undertaken, and
each program has to compete
for scarce resources

Departmental objectives The main stress is not on Managers at all levels

are linked to corporate ‘how much’ a department will participate in the ZBB process
goals spend but on ‘why’ it needs to and have corresponding
spend. accountabilities.
Advantages of Zero-based Budgeting
1. All activities are justified based on cost-benefit
analysis that promotes effective allocation of
resources
2. Inefficient and loss-making operations are identified
and may be removed
3. It adds a psychological push to employees to avoid
wasteful expenditure
4. This kind of budgeting is helpful in changing business
environment
5. Cost behaviour patterns are more closely examined
6. Deliberately inflated budget requests get
automatically weeded out in the ZBB process.
Disadvantages of Zero-based Budgeting
1. Enormous increase in paperwork and high cost
2. Managers may resist new ideas and changes
3. Managers may feel threatened because all
expenditures are questioned and need to be
justified
4. The focus may be more on short-term gains at the
expense of long-term benefits
5. Proper training and education are required for
creating budgets based on this method
6. It is a time-consuming process
7. It may not always be easy to properly rank decision
packages and this may give rise to conflicts.
 Performance budgeting

• Performance budgeting is a budgeting approach that

focuses on the outcomes and results achieved by
government agencies or organizations rather than simply
allocating funds based on historical expenditures or
inputs.
• It is a method used by governments, public sector
organizations, and some private sector entities to improve
accountability, transparency, and the efficiency of resource
allocation.
 Performance budgeting
• Performance budgeting focuses on functions,
programmes and activities.
• Performance budgets are established in such a manner
that each item of expenditure related to a specific
responsibility centre is closely linked with the performance
of that centre.
• It tries to answer questions like:
– what is to be achieved?
– how is it to be achieved?
– when is it to be achieved?
Key features of performance budgeting

Emphasis on Clear Objectives Resource

Outcomes and Metrics allocation based
on Performance

Transparency and Continuous Linkage to

Accountability Improvement Strategic Plans
 Steps in performance budgeting
Establishment of responsibility centre

Establishment of performance targets

Estimating financial requirements

Comparison of actual with budgeted performance

Reporting and action

 Difference between Performance & Traditional budgeting

Basis Performance Budgeting Traditional Budgeting

Focus Performance budgeting focuses Traditional budgeting focuses
on achieving specific outcomes on allocating resources based
and results on past spending patterns
Measures It uses performance measures to It typically uses financial
track progress towards specific measures such as cost centres
goals and outcomes and account courts to allocate
resources
Prioritization Performance budgeting Traditional budgeting often
prioritises resources based on prioritises resources based on
the results that programs and historical spending patterns and
activities are expected to achieve political priorities
 Difference between Performance & Traditional budgeting

Basis Performance Budgeting Traditional Budgeting

Accountability Performance budgeting holds Traditional budgeting often
managers and staff accountable for lacks this level of
achieving specific outcomes and accountability
results
Flexibility Performance budgeting allows for Traditional budgeting often
greater flexibility in budgeting as follows a rigid process that
adjustments can be made based on is difficult to change
changes in performance and
outcomes
Evaluation Performance budgeting includes Traditional budgeting often
ongoing evaluation of programs and lacks this level of evaluation
activities to determine their
effectiveness
 Responsibility Accounting
• Responsibility accounting is a method of accumulating and
reporting both budgeted and actual costs and revenues by
divisional managers responsible for them
• In responsibility accounting, costs are identified with
persons rather than products or functions
• Managers will be held responsible only for those items over which
they can exercise a significant amount of control
• A manager should also not claim credit for those revenues which
is not the result of his action and performance
 Responsibility Accounting

A system of accounting that recognises

various responsibility centres throughout
the organization and reflects the plans
and actions of each of these centres by
Charles Thomas Horngren
assigning particular revenues and costs (October 28, 1926 – October 23, 2011)

to the one having the pertinent Horngren is known for his

work in "pioneering

responsibility. modern-day management

accounting."
 Responsibility Centre
• The basic idea of responsibility accounting is that large
diversified organisations are difficult, if not possible, to
manage as a single segment
• They must be decentralised or separated into smaller
manageable parts
• The parts or segments are referred to as responsibility
centres
• A responsibility centre is a division of the
organization for which a manager is held responsible.
 Types of Responsibility Centers
Cost Center: Profit Center:
Production or service A part of a business
location function activity accountable for Cost
or item of equipment and revenues. It may be
whose costs may be called a business
attributed to cost units. centre, business unit, or
strategic business unit.

Investment Center: Revenue Center:

A profit centre whose Responsibility centre in
performance is which the manager
measured by its return controls revenues but
on capital employed does not control either
the cost of products or
the level of investment
made.
 Meaning of Variance
• To understand Variance, it is essential to understand the
meaning of Standard Costing.
• In Standard costing, all costs are predetermined, i.e., costs are
determined in advance of production.
• Predetermined Costs are then compared with the actual costs.
• The difference between the actual costs and predetermined
costs, known as variance, is then analysed and investigated to know
their reasons.
• Variances are reported to management for taking remedial steps
so that actual costs adhere to predetermined or standard costs.
 Steps in Standard Costing
The reporting of variance to find out
The determination of inefficiency and take necessary
standard cost corrective measures
The comparison between
standard cost and actual cost

01 03
05

02 04
Analysing variances for
The recording of ascertaining reasons thereof
the actual cost
 Types of Standard
Attainable Current Basic
Ideal Standards
Standards Standards Standards
• These are based upon • They are based upon • These are standards • These are long-term
perfect operating efficient (but not based on current standards which
conditions. perfect) operating working conditions. remain unchanged over
• This means that there is conditions. a period of years.
no wastage or scrap, no • They are useful when • Their sole use is to show
breakdowns, no • The standard will include current conditions are trends over time for such
stoppages or idle time; in allowances for normal abnormal, and any items as material prices,
short, no inefficiencies. material losses, realistic other standard would labour rates and
• In their search for perfect allowances for fatigue, provide meaningless efficiency and the effect
quality, Japanese machine breakdowns, information. of changing methods.
companies use ideal etc.
standards for pinpointing • The disadvantage is that • They cannot be used to
areas where close • These are the most they do not attempt to highlight current
examination may result in frequently encountered motivate employees to efficiency.
large cost savings. type of standard. improve upon current • These standards may
• Ideal standards may working conditions and, demotivate employees
have an adverse as a result, employees if, over time, they
• These standards may
motivational impact may feel unchallenged. become too easy to
motivate employees to
since employees may achieve and, as a result,
work harder since they
feel that the standard is employees may feel
provide a realistic but
impossible to achieve bored and unchallenged.
challenging target.
 Variance Analysis

Material Cost Variance

This is the difference between the standard cost of direct
materials specified for the output achieved and the actual cost
of direct materials used.
It is calculated as:
Material Cost Variance = Standard cost of actual output – actual cost
= SC- AC
or
= (SQ x SP) – (AQ x AP)
 Variance Analysis

Material Price Variance

This portion of the material cost variance is due to the difference
between the standard price specified and the actual price paid.
It is calculated as:
Material Price Variance = (Standard Price– Actual Price)x Actual Quantity
= (SP-AP) x AQ
 Reasons for Material Price Variance
1. Change in the market prices of material
2. Rush deliveries
3. Market-driven pricing changes, such as changes in the
prices of commodities
4. Bargaining power changes by suppliers, who may be
able to impose higher prices than expected
5. Buying in unusually large or small volumes in
comparison to what was expected when the standard
was created
6. A change in the quality of the materials purchased
 Variance Analysis

Material Usage Variance

This portion of the material cost variance is due to the difference
between the standard quantity specified and the actual quantity
used.
It is calculated as:
Material Price Variance = (Standard Q– Actual Q) x Standard Quantity
= (SQ-AQ) x SP
 Reasons for Material Usage Variance
1. Lack of due care in the use of materials;
2. Defective production necessitating additional materials
for correction;
3. Abnormal wastage through pilferage or other losses in
the use of materials;
4. Inefficiency in production due to improper method or lack
of necessary skill in workmen;
5. Use of a material-mix other than the standard mix; and
 Reasons for Material Usage Variance
6. Purchase of inferior materials or change in quality of
materials;
7. Rigid technical specifications and strict inspection
leading to more rejections which require more materials
for rectifications;
8. Use of substitute material leading to poor quality;
9. Improper maintenance of machine leading to
breakdowns and more use of materials; and
10.Poor inspection of raw materials.
 Example 1
The standard Cost Card shows the following details relating to
material needed to produce 1 kg of groundnut oil:
• Quantity of groundnut required : 3 Kg
• Price of ground nut : ₹ 2.50 per Kg
Actual Production Data
• Production during the Month : 1,000 Kg
• Quantity of Material used : 3,500 Kg
• Price of groundnut : ₹ 3 per Kg

Calculate: a) Material Cost Variance ; b) Material Price Variance; c)

Material Usage Variance
 Solution
Standard Quantity (SQ) = 1,000 Kg. of production x 3 Kg
= 3,000 Kg
Standard Price (SP) = ₹ 2.50 per Kg
Actual Quantity (AQ) = 3,500 Kg
Actual Price = ₹ 3 per Kg
Material Cost Variance = SC - AC
= (SQ x SP) – (AQ x AP)
= (3,000 x 2.50) – (3,500 x 3)
= ₹ 3,000 (A)
 Solution
Standard Quantity (SQ) = 1,000 Kg. of production x 3 Kg
= 3,000 Kg
Standard Price (SP) = ₹ 2.50 per Kg
Actual Quantity (AQ) = 3,500 Kg
Actual Price = ₹ 3 per Kg
Material Price Variance = (SP-AP) x AQ
= (2.50 - 3) x 3,500
= ₹ 1,750 (A)
Material Price Variance = (SQ-AQ) x SP
= (3,000 – 3,500) x 2.5 = ₹ 1,250 (A)
 Classification of Material Usages Variance

Material Usage Variance

Material Mix Variance Material Yield Variance

(or Material Sub Usage
Variance)
 Material Mix Variance
• This is a sub-variance of material usage variance.
• It arises only where more than one type of material is used for
producing the product.
• The material mix variance is defined as that portion of the material
usage variance which is due to the difference between the
standard and actual composition of material.
• Material Mix Variance
= (Revised Standard Quantity – Actual Quantity) x Standard Price
= (RSQ - AQ) x SP
RSQ= Standard Quantity of one material x Total of actual quantities of
Total of Standard Quantities of all materials all materials
 Material sub-usage (Material Revised
Usage) Variance
• This is sub-varianceof the material usage variance and
represents that portion of the material usage variance
which is attributed to reasons other than those which give
rise to the material mix variance.

MRUV = (Standard Quantity – Revised Standard Quantity) x Standard Price

= (SQ - RSQ) x SP
 Material Yield Variance

• This is also a sub variance of material usage variance.

• Yield variance represents a gain or loss on output in
terms of finished production, while other variances
represents a gain or loss in terms of inputs.

MYV = (Actual Yield- Standard Yield) x Standard Output price

Standard Output price is the standard material cost per unit of

output =Actual usage of materials/ standard usage per unit of output
 Question
A standard mix to produce one unit of product is as follows:
Material A 60 Units @ ₹ 15 per unit = 900
Material B 80 Units @ ₹ 20 per unit = 1,600
Material C 100 Units @ ₹ 25 per unit = 2,500
240 Units 5,000
During the month of July, 10 units were actually produced and consumption
was as follows:
Material A 640 Units @ ₹ 17.50 per unit = 11,200
Material B 950 Units @ ₹ 18.00 per unit = 17,100
Material C 870 Units @ ₹ 27.50 per unit = 23,925
2460 Units 52,225
Calculate all material variances.
 Labour Variances

• The analysis and computation of labour variances are

similar to material variances.
• Labour Cost Variance (LCV)
= Standard Labour Cost of actual output – Actual Labour Cost
= SC – AC
Or
= (St. hours for actual output x St. rate per hr.) – (Actual Hrs. x Actual rate)
= (SH x SR) – (AH x AR)
 Labour Cost Variance

Labour Rate Variance Labour Efficiency

Variance
 Labour Rate Variance

• Labour Rate Variance is that portion of the labour cost

variance, which is due to the difference between the
standard rate of labour specified and the actual rate paid
• LRV = (Standard rate - Actual rate) x Actual hours
= (SR – AR) x AH
 Reasons for labour rate variance

Employing workers
Use of a different
Change in the basic of grades different
method of wage
wage rates from the standard
payment
grades specified

New workers not

Unscheduled
being paid at full
overtime
rates
 Labour Time (or Efficiency) Variance

• This is that portion of the labour cost variance, which is due to

the difference between labour hours specified for actual output
and the actual labour hours expended.

LEV = (Standard hours for actual output – Actual hours) x Standard rate
= (SH – AH) x SR
 Reasons for labour efficiency variance

• Poor working conditions

• Defective tools and plant and machinery
• Inefficient workers
• Incompetent supervision
• Use of defective or nonstandard materials
• Machine breakdown
• Insufficient training of workers
• Change in the method of operation
 Classification of Labour Efficiency
Variance

Labour Efficiency
Variance

Labour Yield
Idle Time Variance Labour Mix Variance
Variance
 Idle Time Variance

• This variance represents that portion of the labour

efficiency variance due to abnormal ideal time such as
time loss due to machine breakdown, power failure, strike,
etc.

• ITV = Idle hours x standard rate

= IH x SR
 Labour Mix Variance

• This variance is similar to material mix variance. It arises

only when more than one grade of workers are employed,
and the composition of actual grade of workers differ from
those specified.
LMV = (Revised standard hours – Actual hours) x Standard rate
= (RSH – AH) x SR
 Labour Revised Efficiency Variance

• This is similar to material revised usage variance and is a

sub-variance of labour efficiency variance.
• It arises due to factors other than those which give rise to
idle time variance and labour mix variance.

• LREV = (Standard hours for actual output – Revise

standards) x Standard rate
= (SH – RSH) x SR
 Labour Yield Variance

• This is quite similar to material yield variance This

variance reveals the effect on labour cost of actual output
or yield being more or less than the standard yield.

• LYV = (Actual yield - Standard yield from actual input)

x Standard labour cost per unit of output
 Disposition of Variances
• When standard costs are incorporated into the accounting
system through journals and ledgers, there arises a
question of adjustment and disposition of variances at the
end of the accounting.
• The methods of disposition of variances based on
practise followed in certain firms are as follows:
1. Transfer to profit and loss account
2. Allocation of variances to inventories and cost of sales
3. Combination method
 Disposition of Variances
1. Transfer to profit and loss account:
Under this method, all variances are transferred to profit
and loss account at the end of the accounting period.
The top of work in progress and finish stock and cost of
sales are maintained at standard costs.
This method is based on the assumption that standard
costs represent correct or real cost, and all forms of
variances represent conditions of inefficiency, waste and
below standard performance.
 Disposition of Variances
2. Allocation of variances to inventories and cost of
sales:
Under this method variances are distributed over stocks of
work in progress, finished stock and cost of sales.
This will result in showing inventories and cost of sales at
actual costs.
According to this method, actual cost should be reflected in
the financial statements
 Disposition of Variances
3. Combination method:
All those variances which result from controllable factors
and represent responsibilities of executives, should be
transferred to profit and loss account.
On the other hand, those variances resulting from incorrect
standards or uncontrollable causes should be allocated to
inventories and cost of goods sold equitably.
 Control Ratios
• In addition to variances certain control ratios are
commonly used by management for use in controlling
operations.

Efficiency Ratio

Activity Ratio

Capacity Ratio

Calendar Ratio
 Efficiency Ratio
• It is defined as the standard hours equivalent to the work
produced, expressed as a percentage of actual hours
spent in production.

Efficiency ratio = Standard hours for actual output x 100

Actual hours worked
 Activity Ratio

• It is defined as the standard hours equivalent to the work

produced expressed as percentage of budgeted standard
hours.

Activity ratio = Standard hours for actual output x 100

Budgeted hours
 Calendar Ratio

• This ratio indicates the extent of actual working days available

during the budget period.

Calendar ratio = Actual working days in the budget period x 100

Budgeted working days in the budget period
 Capacity Ratio

• It shows the relationship between actual hours work and

the budgeted hours.

Capacity ratio = Actual hours worked x 100

Budgeted hours
 Unit III

Costing and Profit Planning: Meaning of Variable Costing, Absorption

Costing and Marginal Costing; uses of Marginal costing; Cost-Volume-Profit
Analysis, Profit/Volume ratio, Break-even Analysis- Algebraic and Graphic
Methods, Angle of Incidence and Margin of Safety
 Meaning of Marginal (Variable) Costing

• There are mainly two techniques of product

costing and income determination.

Marginal (variable)
Absorption costing
costing
 Absorption costing

• This is the total cost technique under which total cost (i.e.
fixed cost as well as variable cost) is charged as
production cost.
• In other words, all manufacturing costs are ‘absorbed’ in
the cost of the products produced.

• Absorption costing is a traditional approach and is also

known as ‘Conventional Costing’ or ‘Full Costing’.
 Marginal (variable) costing

• It is an alternative to absorption costing. It is sometimes

also referred to as direct costing.
• 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 period costs and thus
charged directly to the Profit and Loss Account of
that year.
• Fixed costs also do not enter into inventory valuation.
 Product costs and period costs

• Product costs are those costs • Period Costs are those

which become a part of costs which are not
production cost. included in production cost
and inventory valuation.
• Such costs are also included • Such costs are treated as an
in inventory valuation. expense of the period in which
these are incurred and are
written off in the profit and loss
account of the period.
• Example: Administration and
selling expenses
 Meaning of Marginal Cost

• Marginal cost is the additional cost of producing an

additional unit of product.
• It is the total of all variable costs.
• It is the cost of one unit of product, which would be
avoided if that unit were not produced.
• Marginal cost per unit remains unchanged irrespective of
the level of activity.
 Meaning of Marginal Costing

• 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 cost and variable
costs.
• “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”. - CIMA
 Characteristics of marginal costing
Segregation of costs into fixed and variable elements

Marginal costs as Product costs

Fixed costs as Period Costs

Valuation of inventory at marginal cost

Contribution (Sales- Marginal cost)

Prices are based on marginal cost plus contribution

 Marginal costing and profit
Sales of product A Sales of product B Sales of product C

less less less

Marginal Cost of A Marginal Cost of B Marginal Cost of C

= = =

Contribution of A Contribution of B Contribution of C

Total Contribution
less
Total Fixed Cost
=
Profit
 Absorption Costing and Marginal Costing
Basis Absorption Costing Marginal Costing
1. Treatment In absorption costing, all In marginal costing, only
of fixed and costs (both fixed and variable costs are charged to
variable variable) are charged to products.
costs the product. Fixed costs are treated as
period costs and charged to
Profit and Loss Account of the
period.
2. Valuation Stocks are valued at total Stock of work in progress and
of stock cost, which includes both finished goods are valued at
fixed and variable cost. marginal cost only.
 Absorption Costing and Marginal Costing
Basis Absorption Costing Marginal Costing
3.Measureme In absorption costing, In marginal costing, the
nt of relative profitability is relative profitability of products
profitability judged by profit figures, or departments is based on a
which is also a guiding study of the relative
factor for managerial contribution made by
decisions. respective products or
departments.

The managerial decisions are

thus guided by contribution.
 Uses/Advantages of Marginal costing
Easy to Marginal costing is easier to understand than other costing methods.
Understand:

Marginal costing adapts easily to changes in the production process or price upon variable
Flexible: costs, making it more flexible than other costing methods.

Useful for Decision Managers find marginal costing very helpful as it helps them identify the most profitable
products and decide which ones should not be in continuation. It also assists them in
Making: determining which products should be in priority when resources are limited.

Helps to Control Marginal costing helps managers to identify and control costs. Since it focuses on variable
expenses, it allows managers to monitor and reduce costs while maintaining the production
Costs: level.

Helps in Pricing Marginal costing helps managers to determine the right price for their products. They can
Decisions: decide the right price to yield maximum profits by calculating the total variable costs.

Marginal costing helps managers to compare the performance of different products and
Comparison: services. Managers can decide which is more profitable by comparing the total variable
cost of two products.
 Question
• SKF company is currently working at 50% capacity and produces 10,000
units. At 60% working, raw material cost increases by 2% and selling price
falls by 2%. At 80% working, raw material cost increases by 5% and selling
price falls by 5%.
• At 50% capacity, product costs ₹180 per unit and is sold at ₹200 per unit. The
unit cost of ₹180 is made up as follows:
Material ₹ 100
Wages ₹ 30
Factory Overheads ₹ 30 (40% Fixed)
Administration overheads ₹ 20 (50% Fixed)
Prepare a marginal cost statement showing the estimated profit of the
business when it is operated at 60% and 80% capacity.
 Marginal Cost Statement
50% Capacity 60% Capacity 80% Capacity
Items 10000 12000 16000
Per Unit (₹) Total (₹) Per Unit (₹) Total (₹) Per Unit (₹) Total (₹)
Sales ₹ 200.00 ₹ 20,00,000 ₹ 196.00 ₹ 23,52,000 ₹ 190.00 ₹ 30,40,000
Material ₹ 100.00 ₹ 10,00,000 ₹ 102.00 ₹ 12,24,000 ₹ 105.00 ₹ 16,80,000
Wages ₹ 30.00 ₹ 3,00,000 ₹ 30.00 ₹ 3,60,000 ₹ 30.00 ₹ 4,80,000
Factory Overheads ₹ 18.00 ₹ 1,80,000 ₹ 18.00 ₹ 2,16,000 ₹ 18.00 ₹ 2,88,000
Administration overheads ₹ 10.00 ₹ 1,00,000 ₹ 10.00 ₹ 1,20,000 ₹ 10.00 ₹ 1,60,000
Marginal Cost ₹ 158.00 ₹ 15,80,000 ₹ 160.00 ₹ 19,20,000 ₹ 163.00 ₹ 26,08,000
Contribution ₹ 42.00 ₹ 4,20,000 ₹ 36.00 ₹ 4,32,000 ₹ 27.00 ₹ 4,32,000
Fixed Overheads:
Factory Overheads ₹ 12.00 ₹ 1,20,000 ₹ 10.00 ₹ 1,20,000 ₹ 7.50 ₹ 1,20,000
Administration overheads ₹ 10.00 ₹ 1,00,000 ₹ 8.33 ₹ 1,00,000 ₹ 6.25 ₹ 1,00,000
Fixed Cost ₹ 22.00 ₹ 2,20,000 ₹ 18.33 ₹ 2,20,000 ₹ 13.75 ₹ 2,20,000
Profit: ₹ 20.00 ₹ 2,00,000 ₹ 17.67 ₹ 2,12,000 ₹ 13.25 ₹ 2,12,000
 Cost-Volume-Profit Analysis
• Cost Volume Profit analysis (CVP analysis) is an extension of the
principles of variable costing.
• Every company must earn profits to stay in business And CVP
analysis helps management in profit planning.
• CVP analysis studies the interrelationship of three basic
factors of business operations:
• Cost of production,
• Volume of production/Sales,
• Profit
 Cost-Volume-Profit Analysis
• These three factors are interconnected, so they act and react to one
another because of their cause-and-effect relationship.
• The cost of a product determines its selling price, and the selling
price determines the level of profit
• The selling price also affects the volume of sales which directly affects
the volume of production and the volume of production in turn,
influences cost.
• CIMA London has defined CVP analysis as “the study of the
effects on future profits of changes in fixed cost, variable cost,
sales price, quantity and mix.”
 Cost-Volume-Profit Analysis
• Understanding CVP analysis is extremely useful to
management in budgeting and profit planning.
• It explains the impact of the following on the net
profit:
a) Changes in selling prices,
b) Changes in volume of sales,
c) Changes in variable cost,
d) Changes in fixed cost
 Break-Even Analysis
• Break-even analysis is widely used to study the CVP relationship.
• Narrow meaning: In its narrow sense, break-even analysis is
concerned with determining the break-even point, i.e., that level
of production and sales where there is no profit and no loss.
• At this point, total cost is equal to total sales revenue.
• Broad meaning: When used in a broad sense, break-even
analysis is used to determine probable profit/loss at any given
level of production/sales.
• It also helps to determine the amount or volume of sales to earn a
desired profit.
 Assumptions underlying break-even analysis
or CVP analysis
1. All costs can be separated into fixed and variable components.
2. Variable cost per unit remains constant and total variable cost varies in
direct proportion to the volume of production.
3. Total fixed cost remains constant.
4. The selling price per unit does not change as volume changes.
5. There is only one product, or in the case of multiple products, the sales
mix does not change
6. Volume of production equals the volume of sales.
7. Productivity per worker does not change.
8. There will be no change in the general price level.
Contribution and Marginal Cost equation

Sales
- Variable Cost Contribution = Sales- Variable cost
Contribution
- Fixed Cost Contribution – Fixed Cost = Profit
Profit
 Profit-Volume Ratio (P/V Ratio)
• The profit/volume ratio, better known as the
contribution/sales ratio (C/S ratio), expresses the relation of
contribution to sales.
• P/V Ratio = Contribution/Sales
• P/V Ratio May also be computed by comparing the change in
contribution to change in sales (or change in profit to change
in sales)
• P/V Ratio = Change in Contribution/Change in Sales
• P/V Ratio = Change in Profit/Change in Sales
 Question

• Calculate P/V ratio in each of the following

independent situations:
a) Variable cost ₹ 60, contribution ₹ 40
b) Sales ₹ 20, variable cost ₹ 15
c) Ratio of variable cost to sales 84%
d) Profit ₹ 5000, sales ₹ 25,000, fixed cost ₹ 8000
e) Year I sales ₹ 50,000, total cost ₹ 40,000; Year II sales ₹
60,000, ₹ total cost 45,000
Solution
 Uses of P/V ratio

• It is an indicator of the rate at Calculation of break-even point

which profit is being earned
Calculation of profit at a given level
• A high P/V ratio indicates of sales
high profitability and vice
versa Calculation of the volume of sales
required to earn a given profit
• The profitability of different
sections of the business can Calculation of profit when margin of
be compared with the help of safety is given
P/V ratio Calculation of the volume of sales
required to maintain the present level
of profit, if selling price is reduced
Methods of break-even analysis

a) Algebraic b) Graphic
calculations presentation
 Algebraic method

• The break-even point is the volume of output for sales at which

total cost is exactly equal to sales.
• It is a point of no profit and no loss.
 Question

Calculate the break-even point (in units) and (in rupees)

for the following data:
Total fixed cost = ₹ 12,000
Selling price = ₹ 12 per unit
Variable cost = ₹ 9 per unit
 Solution
Total fixed cost = ₹ 12,000
Selling price = ₹ 12 per unit
Variable cost = ₹ 9 per unit
Contribution = SP- VC = ₹ 12 - ₹ 9 = ₹ 3 per unit

Break-even point (in units) = Fixed Cost/ Contribution per unit

= 12,000/ 3 = 4,000 units
Break-even point (in rupees) = 4000 X 12 = ₹ 48,000
 Calculation of profit at different sales volume
Total fixed cost = ₹ 12,000
Selling price = ₹ 12 per unit
Variable cost = ₹ 9 per unit
What will be the profit when sales are 60,000 and 1,00,000?
P/V ratio = Contribution / Sales = 3 / 12 = 0.25 or 25%
P/V ratio = Contribution / Sales
25% = Contribution / 60,000
Contribution = 15,000
Profit = Contribution - Total fixed cost = ₹ 3,000
 Calculation of profit at different sales volume
Total fixed cost = ₹ 12,000
Selling price = ₹ 12 per unit
Variable cost = ₹ 9 per unit
What will be the profit when sales are 60,000 and 1,00,000?
P/V ratio = Contribution / Sales = 3 / 12 = 0.25 or 25%
P/V ratio = Contribution / Sales
25% = Contribution / 1,00,000
Contribution = 25,000
Profit = Contribution - Total fixed cost = ₹ 13,000
 Calculation of Sales for desired profits
Total fixed cost = ₹ 12,000
Selling price = ₹ 12 per unit
Variable cost = ₹ 9 per unit
What will be the amount of sales if it is desired to earn a profit of
6,000 and 15,000?
Profit = Contribution - Total fixed cost
6,000 = Contribution – 12,000
Contribution = 18,000
P/V ratio = Contribution / Sales
25% = 18,000 / Sales
Sales = 18,000 / 25% = 72,000
 Calculation of Sales for desired profits
Total fixed cost = ₹ 12,000
Selling price = ₹ 12 per unit
Variable cost = ₹ 9 per unit
What will be the amount of sales if it is desired to earn a profit of
6,000 and 15,000?
Profit = Contribution - Total fixed cost
15,000 = Contribution – 12,000
Contribution = 27,000
P/V ratio = Contribution / Sales
25% = 27,000 / Sales
Sales = 27,000 / 25% = 1,08,000
 Question
• Break-even point= ₹30,000
• Profit = ₹1500
• Fixed Cost = ₹6000
What is the amount of variable cost?
Contribution – Fixed Cost = Profit
Contribution – ₹6000 = ₹1500
Contribution = ₹7,500
• Break-even point= ₹30,000; Profit = ₹1500
• Fixed Cost = ₹6000; Contribution = ₹7,500
Break-even point = (Fixed Cost/ Contribution) x Sales
30,000 = (6,000/ 7,500) X Sales
Sales = ₹37,500
Sales – Variable cost = Contribution
37,500 - Variable cost = 7,500
Variable cost = ₹30,000
 Margin of Safety (M/S)

• Margin of safety may be defined as the difference

between actual sales and sales at break-even point.
• It is the amount by which the actual volume of sales
exceeds the break-even point.
• It may be expressed in absolute money terms or as a
percentage of sales.
M/S = Actual sales – break-even point
• Margin of safety is directly related to profit.
• Profit = Margin of safety X Profit / Volume ratio
• Thus, Margin of safety = Profit / (Profit / Volume ratio)

• Also,
• Margin of safety (in units)= Profit / Contribution per unit
 Question
• Calculate Break-even point in each of the following independent
situations:
a) Fixed Cost ₹ 10,000; P/V Ratio 50%
b) Fixed Cost ₹ 15,000; Contribution ₹3 per unit
c) Margin of Safety 25%
d) Fixed Cost ₹ 9,000; Variable cost to sales ratio 60%
e) Actual Sales ₹ 50,000; Margin of Safety 30%
f) Profit ₹ 30,000; Margin of safety 20%; Variable cost 70% of
sales
g) Margin of Safety ₹70,000; Actual Sales ₹ 4,00,000
h) Actual Sales 10,000 units; Margin of Safety 2,500 units
 a) Fixed Cost ₹ 10,000; P/V Ratio 50%

B.E.P = Fixed Cost / P/V ratio

= 10,000 / 50%
= ₹ 20,000

Margin of safety = Actual sales – break-even point

Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per
unit
 b) Fixed Cost ₹ 15,000; Contribution ₹3 per unit

B.E.P = Fixed Cost / Contribution per

unit
= 15,000 / 3
= 5,000 units

Margin of safety = Actual sales – break-even point

Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per
unit
 c) Margin of Safety 25%

M/S = Sales – B.E.P

B.E.P = Sales - M/S
= 75%

Margin of safety = Actual sales – break-even point

Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per
unit
 d) Fixed Cost ₹ 9,000; Variable cost to sales ratio 60%

Contribution = Sales – variable

Cost
Contribution = 40%
P/V Ratio = 40%

B.E.P = Fixed Cost / P/V Ratio

= ₹ 9,000 / 40%
Margin of safety = Actual sales – break-even point
Margin of safety = Profit / (Profit / Volume ratio) = ₹ 22,500
Margin of safety (in units)= Profit / Contribution per
unit
 e) Actual Sales ₹ 50,000; Margin of Safety 30%

M/S = Sales – B.E.P

B.E.P = Sales - M/S
= 50,000 – 30%
= ₹ 35,000

Margin of safety = Actual sales – break-even point

Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per
unit
 f) Profit ₹ 30,000; Margin of safety 20%; Variable cost 70% of
sales
Contribution = Sales – variable Cost
Contribution = 30%
P/V Ratio = 30%

M/S = Profit / (Profit / Volume ratio)

= 30,000 / 30%
= 1,00,000

M/S = 20% of Sales

Margin of safety = Actual sales – break-even point 1,00,000= 20% of Sales
Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per Sales = 5,00,000
unit
B.E.P = Sales - M/S = 4,00,000
 g) Margin of Safety ₹70,000; Actual Sales ₹ 4,00,000

M/S = Sales – B.E.P

B.E.P = Sales - M/S
= 4,00,000 – 70,000
= ₹ 3,30,000

Margin of safety = Actual sales – break-even point

Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per
unit
 h) Actual Sales 10,000 units; Margin of Safety 2,500 units

M/S = Sales – B.E.P

B.E.P = Sales - M/S
= 10,000 – 2,500
= 7,500 units

Margin of safety = Actual sales – break-even point

Margin of safety = Profit / (Profit / Volume ratio)
Margin of safety (in units)= Profit / Contribution per
unit
 Angle of Incidence
• Angle of Incidence is
formed by the interaction
of the sales line and total
cost line at the break-
even point.
• This angle shows the
rate at which profits are
being earned once the
break-even point has
been reached.
 Graphic presentation of Break-even chart

• The Break-even chart is a

graphic representation of the
break-even analysis.

• A break-even chart not only

shows the break-even point
but the profit or loss at
various levels of activity.
Construction of Break-even analysis
1. Select a scale on X axis (Sales/Production)

2. Select a scale on Y axis (Cost and Revenue)

3. Draw the Fixed Cost line

4. Draw the Total Cost line

5. Draw the Sales Line

 Question

• Draw a Break-even chart with the following Data:

• Fixed Cost ₹ 40,000
• Variable Cost ₹ 60,000
• Sales ₹ 1,40,000
• Sales/Production 1,40,000 units
Fixed Cost ₹ 40,000
Variable Cost ₹ 60,000
Sales ₹ 1,40,000
Sales/Production 1,40,000 units
 Unit IV

Managerial Decision Making: Decision making based on Marginal cost

Analysis- profitable product mix, Make or Buy, Addition or Elimination of a
product line, sell or process further, operate or shut down, Managerial Decision-
making spreadsheets.
 Managerial decisions
Decisions regarding raising the price of the product,
lowering it or leaving it unchanged

Decisions regarding selling the product at a loss in a

falling market or shutting down its operations for the
The basic function time being.
of Management is Decisions regarding producing one of the
Components within the company or buying it from
to make decisions outside suppliers
regarding various
alternatives. Decisions regarding whether to change the present
product mix to make it more profitable

Decisions regarding whether to accept an export

order at less than normal domestic price to utilise idle
capacity.
 Short term and long term decisions

• The focus here will be on short term decisions where the

period is generally less than a year.

• Long-term decisions involving consideration of return in

capital employed, discounted cash flow, etc, are outside
the scope of our discussion.
 Relevant costs and relevant revenues
• The relevant costs and revenues are those expected future costs
and future revenues that differ under different alternative course
of action being considered.
i. The cost and revenues must relate to future
ii. They must differ among different alternative courses of
action
Management cannot change the cost which has already been
incurred or related to the past.
Cost and revenues that remain unaffected by a decision are
irrelevant and need not be considered when making a decision
 Cost and non-cost factors in decision-
making
• Case 1: Cost of production is ₹100 per unit and margin of
profit is 20%. You are selling the product at rupees ₹120
whereas a new competitor starts selling the same product
at ₹95 per unit.
• In order to compete, you have to incur a loss of ₹ 5 per
unit as your cost is ₹100 per unit.
• On cost considerations alone, the company should stop
selling the product as it is giving a loss of ₹5 per unit.
 Cost and non-cost factors in decision-
making
• Case 2: A company plans to enter export business. And it
receives an export order at a price which is less than the
own cost.
• On cost factors, the export order should be outrightly
rejected because it does not cover even the cost.
• However, the management should consider the non-cost
factors, such as goodwill earned by the company for
getting the export house status, earning valuable foreign
exchange, etc.
 Variable costing and differential
costing as aids in decision making
• For short-term business decisions, two valuable
techniques can be used while taking decisions:

Variable or
Differential
marginal
costing
costing
 Decision-making based on Marginal
cost (Variable Cost) Analysis
Variable costing aids in decisions, such as:
Fixation of selling prices

Exploring new markets

Make or buy

Product mix

Operate plant or shutdown

 Fixation of selling prices
• In the long run, the selling prices of products or services must be
higher than the total cost, whereas in the short run, or in some
special circumstances management may decide to sell its
regular product at a special price which may be lower than
the total cost.
• Selling price may have to be fixed below total cost, but it should
be above variable cost.
• In other words, the selling price may be temporarily fixed at
marginal cost contribution.
• In case of acute competition or in periods of depression
products may have to be priced below total cost.
 Fixation of selling prices
Special circumstances when selling price is below variable cost:
1. To popularise a new product
2. To eliminate competitors from the market
3. To dispose of perishable products so as to avoid total loss
4. To export so as to earn foreign exchange and Goodwill
5. To keep plant and machinery in operation as idle machines
may be liable to deterioration
6. To maintain production and to keep employees occupied
7. To help in the sale of a conjoint product, which is making
large profits
 Exploring new markets
Sometimes a company cannot fully utilise plant capacity when selling at total
cost plus profit basis.

In such a case, it may explore new markets and find opportunities to receive
additional bulk order or export order at a price which may be below total cost,
but above variable cost, so that the price makes our contribution.

When a company has an idle capacity which is not able to utilise because of
sales constraint, and it receives a bulk order at below normal selling price, such
an order should be accepted, provided existing sales are not affected by price
discrimination It will earn the company additional profit by utilising spare
capacity.
 Question
• A manufacturer of plastic buckets makes an average profit of ₹2.5 per piece on a
selling price of ₹14.5 by producing and selling 60,000 pieces at 60% of potential
capacity. His cost of sales is:
₹ per piece
Direct materials 4
Direct wages 1
Factory overhead (variable) 3
Selling overhead (variable) .25
Total fixed cost is ₹2,25,000
• During the current year, he intends to produce the same number of units but
anticipates that (a) Fixed cost will go up by 10%, and (b) Material and labour costs
will go up by 5% each.
• Under these circumstances, he obtains an offer for a further 20% of his capacity.
What minimum price you would recommend for acceptance to ensure an overall
profit of ₹1,60,000?
 Question
• XYZ Limited has a capacity to produce 5000 articles, but actually produces
only 2000 articles for home market at the following costs:
Materials ₹40,000
Wages ₹36,000
Factory overheads- Fixed ₹12,000
Factory overheads- Variable ₹20,000
Administration overhead- Fixed ₹18,000
Selling and distribution overheads- Fixed ₹10,000
Selling and distribution overheads- Variable ₹16,000
Total cost ₹1,52,000
• The home market can consume only 2000 articles at a selling price of ₹80
per article. An additional Order for the supply of 3000 articles is received from
a foreign country at ₹65 per article. Should this order be accepted or not? If
execution of this order entails an additional packing cost of ₹3000.
 Make or buy Decisions
• Case: Total cost of making a component is ₹100 per unit,
Consisting of ₹80 as variable cost and ₹20 as fixed cost.
• Suppose an outside firm is prepared to supply this component at
₹90, It may appear that it is cheaper to buy the component.
• Study of cost analysis will show that each unit, if manufactured,
makes a contribution of ₹20 towards the recovery of fixed cost.
• The offer of ₹90 per unit should not be accepted because, if
accepted, the component will really cost ₹110, i.e., ₹90 of
purchase price plus ₹20 of fixed cost, which cannot be saved if
component is not produced.
 Question
• A radio manufacturing company finds that, while it costs ₹6.25 to make
component R518, The same is available in the market at ₹5.75 each
with an assurance of continued supply. The breakdown of the cost is:
₹
• Materials 2.75 each
• Labour 1.75 each
• Other variables 0.50 each
• Depreciation and other fixed costs 1.25 each
a) Should you make or buy?
b) What would be your decision if the supplier offered the
component at ₹4.85 each?
 Make or buy Decisions
• When a firm has no spare capacity and
manufacturing of components involves setting
aside other work, the loss of contribution of
displaced work should also be considered.
• In other words, it will be profitable to buy only when
the purchase prices are below variable cost plus
loss of contribution of displaced work.
 Question

• Manufacture of product A takes 20 hours on machine No. 101.

It has a selling price of ₹ 150 and marginal cost of ₹ 110.
Component part Y could be made on Machine No. 101 in 4
hours. The marginal cost of component part is ₹ 9 of which
outside supplier’s price is ₹ 15.
• Should you make or buy component Y. Discuss in both
situations:
a) Machine No. 101 is working at full capacity
b) There is idle capacity
 Solution
We need to first calculate the contribution of displaced work
(Product A) when Component Part Y is produced
(a) Contribution per unit of A = ₹ 150 - ₹ 110 = ₹ 40

Contribution per machine hour = ₹ 40 / 20 hrs = ₹ 2 per hour.

If component Y is manufactured, it would take 4 hours, the loss of

contribution, i.e. opportunity cost is ₹ 8 (i.e. 4hrs @ ₹ 2)

The total cost to make Y will be ₹ 9+ ₹ 8 = ₹17

Supplier’s Price is ₹ 15, so it is better to buy.

 Make or buy Decisions
Non-Cost or Qualitative Factors
Assurance of continued Supply, if bought from
outside

Assurance of quality of the product by the

supplier

Assurance of no price increase during the

period of agreement
 Product Mix Decisions
• Sales or product mix denotes the proportion in which various
products are sold or produced.
• Any change in sales mix changes the profit position of the
company.
• The technique of marginal costing helps the management in
determining the most profitable sale mix.
• Selection of the most profitable product mix may be
discussed in two parts:
a) When there is no key (or limiting) factor
b) When there is a key (or limiting) factor
 Limiting or key factor

• A key factor is defined as the factor in the activities of an

undertaking which, at a particular point of time or over a
period, will limit the volume of output.
• Non-availability of raw material
• Non availability of labour
• Not able to sell what you can produce / limited sales
• Production capacity or machine hours
• Financial resources
 Product Mix Decisions
a) When there is no key (or limiting) factor
• When there is no key factor, the product mix that provides
the highest amount of contribution is considered as the
most profitable sales mix.
• This holds good when fixed cost does not change due to
changes in sales mix.
• When the changes in sales mix are associated with changes
in fixed cost, that sales mix, which provides the highest
profit, is considered the most profitable.
 Question
• The following production sales mix are capable of achievement in a factory:
i. 2000 units of product A and 2000 units of product C.
ii. 4000 units of product B
iii. 1000 units of product A, 2000 units of product B, and 1600 units of
product C.
• Cost per unit is as follows: A B C
Direct materials ₹ 20 16 40
Direct Wages ₹ 8 10 20
Fixed cost is ₹ 20,000 and variable overheads per unit of A, B and C are ₹ 2,
₹ 4 and ₹ 8 respectively. Selling prices of A, B and C are ₹ 36, ₹ 40 and ₹
100 per unit, respectively. Determine the marginal contribution per unit of A, B
and C, and the profits resulting from product mix (i), (ii) & (iii)
 Product Mix Decisions
a) When key (or limiting) factor is given
• When a key factor is operating, selection of the most profitable
sales mix is based on contribution per unit of key factor.
• The product which makes the highest amount of contribution per
unit of key factor is the most profitable one, and its production is
pushed up.
• The second preference is to be given to product which yields the
second highest contribution per unit of key factor and so on.
 Question
• Accompany manufacturers three products. The budgeted quantity,
selling prices and unit costs are as follows:
A B C
₹ ₹ ₹
Raw materials @ ₹ 20 per kg 80 40 20
Direct wages @ ₹ 5 per hour 5 15 10
Variable overheads 10 30 20
Fixed overheads 9 22 18
Budgeted production (in units) 6,400 3,200 2,400
Selling price per unit (in ₹) 140 120 90

i. Present a statement of budgeted profit

ii. Set optimal product makes and determine the profit if the supply of
raw materials is restricted to 18,400 kg
 Solution
Production 6400 3200 2400
A B C
Total
(₹) (₹) (₹)
(₹)
Per unit Total Per unit Total Per unit Total
Sales 140 896000 120 384000 90 216000 1496000
Raw Material 80 512000 40 128000 20 48000
Direct Wages 5 32000 15 48000 10 24000
Variable overheads 10 64000 30 96000 20 48000
Total Variable Cost 95 608000 85 272000 50 120000 1000000
Contribution 45 288000 35 112000 40 96000 496000
Less: Fixed Cost 9 57600 22 70400 18 43200 171200
Profit 324800
 ii) When raw material is the key factor
A B C
Raw Material per unit of Output 4 Kg 2 Kg 1 Kg
Total Raw material Consumed 6400x4 3200x2 2400x1
25,600 6,400 2,400

Contribution per kg of Raw Material 2,88,000 1,12,000 96,000

25,600 kg 6,400 kg 2,400 kg

= ₹ 11.25 ₹ 17.50 ₹ 40

RANKS III II I
Suggested Sales Mix:
• Rank I – Product C – 2,400 units x 1 kg = 2,400 Kg
• Rank II – Product B – 3,200 units x 2 kg = 6,400 Kg
• Rank III – Product A – 2,400 units x 4 kg (Balance) = 9,600 Kg
Total Materials available = 18,400 kg
Calculation of Profit
Contribution
Product A - 2,400 units @ ₹ 45 per unit = ₹ 1,08,000
Product B - 3,200 units @ ₹ 35 per unit = ₹ 1,12,000
Product C - 2,400 units @ ₹ 40 per unit = ₹ 96,000
Total Contribution = ₹ 3,16,000
Less: Total Fixed Cost = ₹ 1,71,200
Profit = ₹ 1,44,800
 Operate plant or shutdown Decisions
• This type of decision may be either:
a) temporary suspension of production activities, or
b) permanent closing down of production
• Temporary suspension of production activities: Temporary
suspension of activities is a short-term measure. The object is
usually to stop operations until trade depression has passed.
• Production should be continued till the time you are able to
contribute something towards the fixed cost.
• Or in other words, we can say the Selling price is higher than the
marginal cost.
 Question
• Normal capacity of plant 10,000 units
• Fixed cost when plant is operating ₹ 1,00,000
• Fixed cost when plant is shut down ₹80,000.
• Variable cost per unit ₹75
• Selling price per unit ₹80
• Estimated sales volume at this price - 5000 units
 Solution

Sales (5000 units @₹80) 4,00,000

Less: marginal cost (5000 units @₹75) 3,75,000
Contribution 25,000
Less: fixed cost if plant is operating 1,00,000
Loss (-)75,000
Fixed cost when plant is shut down ₹80,000