BBA V - Semester 104 52 Directorate of Distance Education MANAGEMENT ACCOUNTING ALAGAPPA UNIVERSITY [Accredited with ‘A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle and Graded as Category–I University by MHRD-UGC] (A State University Established by the Government of Tamil Nadu) KARAIKUDI – 630 003
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BBAV - Semester
104 52
Directorate of Distance Education
MANAGEMENT ACCOUNTING
ALAGAPPA UNIVERSITY[Accredited with ‘A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle
and Graded as Category–I University by MHRD-UGC]
(A State University Established by the Government of Tamil Nadu)
KARAIKUDI – 630 003
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Work Order No.AU/DDE/DE12-27/Preparation and Printing of Course Materials/2020 Dated 12.08.2020 Copies 600
“The copyright shall be vested with Alagappa University”
AuthorsM A Sahaf, Professor, The Business School University of Kashmir, SrinagarUnits (1-13) Dr Bhavesh M Patel, Director, Post Graduate Institute of Management and Dean, Amrut Mody School of Management Ahmedabad University, Gujarat Unit (14)
Reviewer Dr. G. Nedumaran Professor of Commerce,
Alagappa University, Karaikudi, Tamil Nadu.
SYLLABI-BOOK MAPPING TABLE Management Accounting
BLOCK I: BASICS OF MANAGEMENT ACCOUNTINGUnit 1: Management accounting – Definition – Objectives – Nature – Scope – Merits and limitations – Differences between management accounting and financial accounting. Unit 2: Financial statement analysis – Comparative statement – Common size statement – Trend percentage.
Unit 3: Ratio analysis – Meaning – Classification – Liquidity, sol-vency, turnover and profitability ratios – Dupont chart – Construc-tion of balance sheet.Unit 4: Fund flow statement – Meaning– Preparation – Schedule of changes in working capital – Funds from operation – Sources and applications.
BLOCK II: CASHFLOW STATEMENT AND ANALYSISUnit 5: Cash flow statement – Meaning – Difference between funds flow statement and cash flow statement – Preparation of cash flow statement as per Accounting Standard 3.Unit 6: Budget and Budgetary control – Meaning – Advantages – Preparation of sales, production, production cost, purchase, overhead cost, cash and flexible budgets Unit 7: Standard costing – Meaning, Advantages and Limitations.
Unit 8: Variance analysis – Significance - Computation of variances (Material Labour and overheads)
BLOCK III: COSTING AND ITS APPLICATIONSUnit 9: Marginal costing – CVP analysis – Break even analysis
Unit 10: BEP - Managerial applications – Margin of safety – Profit planning.
Unit 11: Differential Costing.
Syllabi Mapping in Book
Unit 1: Nature and Scope of Management Accounting
(Pages 1-22)Unit 2: Financial Statements
Analysis (Pages 23-47)
Unit 3: Ratio analysis (Pages 48-85)
Unit 4: Funds Flow Statement (Pages 86-113)
Unit 5: Cash Flow Statement and Analysis
(Pages 114-137)Unit 6: Budget and Budgetary Control
(Pages 138-175)Unit 7: Standard Costing
(Pages 176-188)Unit 8: Variance Analysis
(Pages 189-224)
Unit 9: Marginal Costing, CVP
Analysis and Break Even Analysis
(Pages 225-245)Unit 10: Break-Even Analysis/
Point (BEA/BEP) (Pages 246-269);
Unit 11: Differential Costing (Pages 270-294)
BLOCK IV: METHODS OF CAPITAL BUDGETINGUnit 12: Capital Budgeting – Meaning – Importance – Appraisal methods
Unit 13: Payback period –– Accounting rate of return - Discounted cash flow – Net present value – Profitability index – Internal rate of return.Unit 14: Methods of evaluation of Alternative Capital Expenditure Programme.
Unit 12: Capital Budgeting: Meaning and Importance
(Pages 295-305);Unit 13: Appraisal Methods
(Pages 306-344);
Unit 14: Methods of Evaluation of Alternative Capital
Expenditure Programme (Pages 345-364)
INTRODUCTION
BLOCK I: BASICS OF MANAGEMENT ACCOUNTING
UNIT 1 NATURE AND SCOPE OF MANAGEMENT ACCOUNTING 1-22
2.6 Answers to Check Your Progress Questions 2.7 Summary 2.8 Key Words 2.9 Self Assessment questions and Exercises 2.10 Further Readings
UNIT 3 RATIO ANALYSIS 48-85
3.0 Introduction 3.1 Objectives 3.2 Ratio Analysis: Meaning 3.3 Classification of Ratios
3.3.1 Liquidity Ratios
3.3.2 Leverage or Solvency Ratios
3.3.3 Profitability Ratios
3.3.4 Dupont Chart
3.3.5 Activity or Turnover Ratios
3.4 Construction of Balance Sheet 3.5 Answers to Check Your Progress Questions 3.6 Summary 3.7 Key words 3.8 Self Assessment Questions and Exercises 3.9 Further Readings
UNIT 4 FUNDS FLOW STATEMENT 86-113
4.0 Introduction 4.1 Objectives 4.2 Funds Flow Statement : Meaning 4.3 Preparation of Funds Flow Statement
4.3.1 Statement or Schedule of Changes in the Working Capital
4.3.2 Statement of Sources and Applications of Funds
4.3.3 Funds from Operation/Operational Profit
4.3.4 Adjustment of Typical Items
4.3.5 Preparation of Working Accounts and Notes (Hidden Transaction)
4.4 Answers to Check Your Progress Questions 4.5 Summary 4.6 Key Words
4.7 Self Assessment Question and Exercises 4.8 Further Readings
BLOCK II: CASH FLOW STATEMENT AND ANALYSIS
UNIT 5 CASH FLOW STATEMENT AND ANALYSIS 114-137
5.0 Introduction 5.1 Objectives 5.2 Meaning Of Cash Flow Statement
5.2.1 Difference between Cash Flow Statement and Fund Flow Statement
5.2.2 Concept of Cash Flow
5.2.3 Sources and Application of Cash
5.2.4 Calculation of Cash From Operations
5.2.5 Forms of Cash Flow Statement
5.3 Preparation Of Cash Flow Statement as per AS 3 5.4 Answers to Check Your Progress Questions 5.5 Summary 5.6 Key Words 5.7 Self Assessment Questions and Exercises 5.8 Further Readings
UNIT 6 BUDGET AND BUDGETARY CONTROL 138-175
6.0 Introduction 6.1 Objectives 6.2 Budget and Budgetary Control: Meaning
6.2.1 Advantages and Limitations of Budgetary Control
6.2.2 Essential Characteristics of a Good Budgetary Control
6.3 Classification and Preparation of Budgets 6.3.1 Sales Budget
6.3.2 Production Budget
6.3.3 Production Cost Purchase and Overheads Budget
6.3.4 Cash Budget
6.4 Answers to Check Your Progress Questions 6.5 Summary 6.6 Key Words
6.7 Self Assessment Questions and Exercises 6.8 Further Readings
UNIT 7 STANDARD COSTING 176-188
7.0 Introduction 7.1 Objectives 7.2 Meaning of Standard Costing
7.2.1 Advantages and Limitations of Standard Costing
7.3 The Standard Costing System 7.4 Answers to Check Your Progress Questions 7.5 Summary 7.6 Key Words 7.7 Self Assessment Questions and Exercises 7.8 Further Readings
UNIT 8 VARIANCE ANALYSIS 189-224
8.0 Introduction 8.1 Objectives 8.2 Variances Analysis : Meaning, Significance and Types 8.3 Direct Material Variance 8.4 Labour Variances 8.5 Overhead Variance 8.6 Practical Problems 8.7 Answers to Check Your Progress Questions 8.8 Summary 8.9 Key Words 8.10 Self Assessment questions and Exercise 8.11 Further Readings
BLOCK III: COSTING AND ITS APPLICATIONS
UNIT 9 MARGINAL COSTING, CVP ANALYSIS AND BREAK EVEN ANALYSIS 225-245
9.0 Introduction 9.1 Objectives 9.2 Concept of Marginal Costing
9.2.1 Advantages and Disadvantages of Marginal Costing
9.2.2 Contribution
9.2.3 Marginal Cost Equation
9.2.4 Profit/Volume Ratio (P/V Ratio)
9.3 Managerial Application of Marginal Costing 9.4 CVP Analysis And Break Even Analysis 9.5 Answers to Check Your Progress Questions 9.6 Summary 9.7 Key Words 9.8 Self Assessment Questions and Exercises 9.9 Further Readings
UNIT 10 BREAK-EVEN ANALYSIS/POINT (BEA/BEP) 246-269
10.0 Introduction 10.1 objectives 10.2 Concept of Break-Even Point/Analysis
10.2.1 Managerial Applications and Profit Planning
10.2.2 Assumptions, Advantages and Limitations
10.2.3 Margin of Safety
10.2.4 Angle of Incidence
10.2.5 Profit-Volume Graph
10.3 Answers to Check Your Progress 10.4 Summary 10.5 Key Words 10.6 Self Assessment Questions and Exercises 10.7 Further Readings
UNIT 11 DIFFERENTIAL COSTING 270-294
11.0 Introduction 11.1 Objectives 11.2 Nature and Scope of Differential Costing 11.3 Decision Making Process 11.4 Application of Differential Costing 11.5 Answers to Check Your Progress 11.6 Summary 11.7 Key Words
11.8 Self Assessment Questions and Exercises 11.9 Further Readings
BLOCK IV: METHODS OF CAPITAL BUDGETING
UNIT 12 CAPITAL BUDGETING: MEANING AND IMPORTANCE 295-305
12.0 Introduction 12.1 Objectives 12.2 Capital Budgeting: Meaning
12.2.1 Importance
12.2.2 Steps in Capital Budgeting Process
12.2.3 Objectives of Capital Budgeting Programmes
12.2.4 Kinds of Proposals
12.2.5 Appraisal Methods
12.3 Answers To Check Your Progress 12.4 Summary 12.5 Key Words 12.6 Self Assessment Questions and Exercises 12.7 Further Readings
UNIT 13 APPRAISAL METHODS 306-344
13.0 Introduction 13.1 Objectives 13.2 Methods of Evaluation or Appraisal 13.3 Non-discounted Cash Flow Method
13.3.1 Payback and Payback Reciprocal Method
13.3.2 Accounting Rate of Return
13.4 Discounted Cash Flow (Time-adjusted) Method 13.4.1 The Net Present Value Method
13.4.2 Internal Rate of Return (IRR) Method
13.4.3 Profitability Index
13.5 Practical Problems 13.6 Answers to Check Your Progress Questions 13.7 Summary 13.8 Key Words
13.9 Self Assesment Questions and Exercises 13.10 Further Readings
UNIT 14 METHODS OF EVALUATION OF ALTERNATIVE CAPITAL EXPENDITURE PROGRAMME 345-364
14.0 Introduction 14.1 Objectives 14.2 Economic Rate of Return (ERR): Economic Cost-Benefit Analysis 14.3 Social Rate of Return (SRR): Social Cost-Benefit Analysis 14.4 Capital Amortization Schedule (CAS) 14.5 Risk Adjusted Discount Rate (RADR)
14.5.1 Intuitive Approach
14.5.2 Constant Share Price Approach
14.5.3 CAPM Aapproach
14.5.4 Adjusted WACC approach
14.6 Answers to Check Your Progress Questions 14.7 Summary 14.8 Key Words 14.9 Self Assessment Questions and Exercises 14.10 Further Readings
Introduction
NOTES
Self-Instructional 12 Material
INTRODUCTION
Management accounting is a vast subject and encompasses all that accounting information which helps management in planning, controlling, decision making and performance measurement of business operations. CIMA has observed that management accounting combines accounting with finance and management with the leading edge techniques needed to drive successful business.
Management accountant plays a very important role in an organization. He analyses and interprets accounting information and meets the informational needs of management at different levels. In an organization, a management accountant generally performs a staff function, i.e., advisory role. But if he is permitted to participate in planning and decision-making, he is a part of the management team and thus becomes a part of the line function. It is very important that status of the management accountant in the organization is clearly defined so that the scope of his work and responsibilities are accordingly determined.
This book, Management Accounting, is written with the distance learning student in mind. It is presented in a user-friendly format using a clear, lucid language. Each unit contains an Introduction and a list of Objectives to prepare the student for what to expect in the text. At the end of each unit are a Summary and a list of Key Words, to aid in recollection of concepts learnt. All units contain Self-Assessment Questions and Exercises, and strategically placed Check Your Progress questions so the student can keep track of what has been discussed.
NOTES
Self-InstructionalMaterial 1
Nature and Scope of Management AccountingBLOCK - I
1.5 Merits and Limitations 1.6 ChangingRoleandTasksofManagementAccountants
1.6.1 Management Accountant in an Organization 1.7 AnswerstoCheckYourProgressQuestions 1.8 Summary 1.9 Key Words 1.10 SelfAssessmentQuestionsandExercises 1.11 FurtherReadings
1.0 INTRODUCTION
Accountingplaysacrucialroleinthefunctioningofanorganization.Itnotonlyhelpsinenhancingdecisionmakingcapabilities,butalsofacilitatestheefficientutilizationofresources.Organizationsacrosstheglobeoperateinahighlydynamicandcomplexbusinessenvironment,inwhichmanagersneedrelevantandcurrentinformationtoaidthemindecisionmaking.Accountingmust respond to the changing needs of the decision-makers in order tojustifyitsrelevanceincontemporarybusiness.Infact,thesignificanceoffinancialinformationhasalwaysbeenrecognized,butinthepresentbusinessscenario,suchinformationhasbecomearesourceparallelinimportancetofactorsofproduction.Consequently,accounting information isbecomingincreasinglycriticaltothecontinuingsuccessofanorganization.Withthegrowingimportanceofinformationasaresource,organizationshavefelttheneedforasystemthatiscapableofmanagingthisresourceefficiently.Thisis,perhaps,thebasicreasonforbusinessstudentstostudytheanatomyandoperationoftheaccountingsystem,whichprovidesinformationtomanagersfordecisionmaking.
Nature and Scope of Management Accounting
NOTES
Self-Instructional 2 Material
Modernaccountingasadynamicandgrowingfield isemergingasa strategicweapon that is helping to shape the direction and growth oforganizationsinthechangingbusinessenvironment.However,toexploreandutilizethefinancialinformationgeneratedbytheaccountingsystemofanorganizationforcompetitiveadvantage,managersmusthaveafairknowledgeofthetoolsandtechniquesthattheycanuseforanalyzingandinterpretingthe available information. Both the prerequisites of effective decisionmaking—financialinformationandanalyticaltechniques—arecoveredunderManagement Accounting, whichinvolvesthestudyofaccountinginformationandtechniquesthatmanagersuseinanalysingsuchinformation.
In this unit, youwill be introduced to the concept ofmanagementaccounting.
Managementaccountingisasegmentofaccountingthatdealsspecificallywith the analysis and reportingof information tomanagement about theoperationsoftheorganizationwithanobjectivetofacilitatedecisionmaking.Ontheonehand,managementaccountingaimstoprovideadequatefinancialinformationtomanagersfordecisionmakingandontheother,itisorientedtowardsmanagerialcontrol.Managementfrequentlyrequirestimelyfinancialinformationconcerningdifferentaspectsoftheorganization,rangingfromspecialpurposereportofaspecificdepartment’soperatingperformancetothepreparationofannualbudgetsandforecasts,whichencompasstheentirebusiness.
Theterm‘managementaccounting’wasfirstformallymentionedin1950inareportentitled‘Management Accounting’,publishedbytheAnglo-AmericanCouncilofProductivityManagementAccountingTeamafteritsvisit totheUnitedStatesinthesameyear.Theteaminitsreportdefinedmanagement accounting as the presentation of accounting information in such a way as to assist management in the creation of policy and in the day-to-day operation of an undertaking.
NOTES
Self-InstructionalMaterial 3
Nature and Scope of Management Accounting
Thereafter, a number of attempts have beenmade by variousprofessionalbodiesandassociations todefinemanagementaccountinginits right perspective.As a consequence thereof, numerous definitions onmanagementaccountingareadded to the literatureyearafteryear.SomepopularonesareincludedinExhibit1.1.
Exhibit 1.1 Popular Definitions of Management AccountingThe Institute of Chartered Accountants in England and Wales (ICAEW): Any formof accountingwhich enables a business to be conductedmoreefficientlycanberegardedasmanagementaccounting.
American Accounting Association: Managementaccountingistheapplicationofappropriatetechniquesandconceptsinprocessinghistoricalandprojectedeconomicdataofanentity toassistmanagement inestablishingplansforreasonableeconomicobjectivesinthemakingofrationaldecisionswithaviewtowardstheseobjectives.
Association of Chartered Certified Accountants (ACCA), USA: Management accountingistheapplicationofaccountingandstatisticaltechniquestothespecified purpose of producing and interpreting information designed toassistmanagementinitsfunctionsofpromotingmaximumefficiencyandinenvisaging,formulatingandco-ordinatingtheirexecution.
J Batty (1966): Management accounting is the termused to describe theaccountingmethods, system and techniqueswhich, coupledwith specialknowledgeandability,assistmanagementinitstaskofmaximizingprofitsorminimizinglosses.
Institute of Cost and Management Accountants (ICMA), London: Managementaccounting is theapplicationofprofessionalknowledgeandskillinthepreparationofaccountinginformationinsuchawayastoassistmanagementintheformationofpoliciesandintheplanningandcontroloftheoperationsoftheundertaking.
R L Smith (1962): Management accounting is a more intimate merger of the twoolderprofessionsofmanagement andaccounting,wherein theinformationalneedsofthemanagerdeterminetheaccountingmeansfortheirsatisfactions.
Brown and Howard (1966): Managementaccountingisconcernedwiththeefficientmanagementofabusinessthroughthepresentationtomanagementofsuchinformationaswillfacilitateefficientandopportuneplanningandcontrol.
Robert N Anthony (1965):Management accounting is concernedwithaccountinginformationwhichisusefultomanagement.
Broad and Carmichael (1957):Theterm‘managementaccounting’coversallthoseservicesbywhichtheaccountingdepartmentcanassisttopmanagementandotherdepartmentsintheformationofpolicy,thecontrolofitsexecutionandappreciationofitseffectiveness.
Shillinglow (1982):Accountingwhich servesmanagement by providinginformationas to thecostorprofitassociatedwithsomeportionoffirm’stotaloperations,iscalledmanagementaccounting.
Nature and Scope of Management Accounting
NOTES
Self-Instructional 4 Material
T G Rose, (1957):Managementaccountingistheadaptationandanalysisofaccountinginformationanditsdiagnosisandexplanationinsuchawayasto assist management.
R H Garrison (1982):Managementaccountingisconcernedwithprovidinginformationtomanagers;thatis,tothosewhoareinsideanorganizationandwhoarechargedwithdirectingandcontrollingitsoperations.
All thesedefinitionsplace emphasis on the informationprocessinganddecisionmakingaspectsofaccounting.Theanalysisofthedefinitionsfurtherrevealsthatthesystemofmanagementaccountingisnotdesignedto appraise andmonitor the past performanceof individuals andgroupsbuttoassistmanagerialdecisionsaffectingthefuture.Thus,managementaccountingisasystemforgathering,summarizing,reportingandinterpretingaccountingdataandotherfinancial informationprimarilyfor the internalneedsofmanagement.Thus, management accounting is a system capable of generating accounting information that assists internal management in the efficient formulation, execution and appraisal of business plans that help the organizations to achieve their strategic objectives.
Thus,management accounting in addition to helpingmanagersin the decisionmaking process, facilitates them in intra-firm resourceallocations,fixationofresponsibilitiesandtheevaluationoffuturepoliciesandstrategies.Allthisbringstolightanimportantfact—thatmanagementaccountinghastoperformtwoseparate,distinctfunctionsoffinancialandmanagementreportingandthatthedataneedsforeachareoftendifferent.Fewintelligentfinancialandeconomicdecisionscanbemadeintheabsenceofthatinformationreservoir.Involvementwithbothtimedimensions,pastandfuture,placestheexecutivenearthecentreofthecontrolanddecisionmakingprocessesinanyorganization.
1.2.1 Scope of Management Accounting
Traditionally,thesubjectmatterofmanagementaccountingmainlyconsistedoffinancialstatementanalysisandcostingtheory.Asorganizationsbegantooperate in a highlydynamic and complexbusiness environment, theyrealized that the existing subjectmatter ofmanagement accountingwasinsufficienttomeetthechallengesofthechangingenvironment.Toaddressthe emerging challenges,management accounting enhanced its scopebyincluding in its ambitmany frameworks, tools and techniques borrowedfromotherdisciplinessuchaseconomics,finance,mathematics,statisticsandoperationsresearch.Thecontemporarysubjectmatterofmanagementaccountingissummarizedbelow:
Cost Accounting: Althoughmanagers generally use financialinformationindecisionmaking,theyoftensupplementtheirdecisionswithcostinformationastheyhaverealizedthatanyactivityofanorganizationcanbedescribedbyitscost.Theymakeuseofvariouscostdatainmanagingorganizationseffectively.Infact,costaccountingisconsideredthebackboneofmanagementaccountingasitprovidestheanalyticaltoolssuchasbudgetarycontrol, standard costing,marginal costing, inventory control, operatingcosting,etc.,whichareusedbymanagementtodischargeitsresponsibilitiesefficiently.
Budgeting: Budgeting, which lies at the heart ofmanagementaccounting,referstoasystematicplanfortheutilizationoforganizationalresources.Asamanagementtool,budgetingaimstocoordinateandintegratetheeffortsandactivitiesofvariousdepartmentswiththecooperationofthosewhoseektoachieveacommongoal.Infact,theorganizationsexercisetheiroperationalcontrolthroughthebudgetspreparedinadvanceforeverymajoractivityofthebusiness.
Management Reporting: Clear,informativeandtimelyreportshavealwaysbeenrecognizedasmanagerialtoolsinreachingdecisionsthatnotonlyhelptheorganizationstoimprovetheirperformancebutalsomakethebestuseoftheirresources.Thus,oneofthebasicresponsibilitiesofmanagementaccountingistokeepthemanagementwellinformedabouttheoperationsof the business.To discharge this responsibility efficiently,management
Quantitative Techniques: Manymanagersrecognizethatthefinancialandeconomicdataavailableformanagerialdecisionscanbemoreusefulifanalysedwithhighlysophisticatedtechniquesofanalysisandevaluation.Suchtechniquesasthesubjectmatterofquantitativeanalysisallowmanagerstocreate information from theirfinancialdatabase that isnot,otherwise,available.Inadditiontothetechniquesliketimeseries,regressionanalysisandsamplingtechniques,themanagersalsomakeuseoflinearprogramming,gametheoryandqueuingtheoryforthispurpose.
Tax Accounting: Since taxation plays an important role in theprofitabilityofacommercialorganization,itisessentialforamanagementaccountanttohaveacompleteknowledgeofbusinesstaxation.Thebusinessprofitandthetaxthereonaretobeascertainedaspertheprovisionoftaxation.Thefilingoftaxreturnsandthepaymentoftaxinduetimeistheexclusiveresponsibilityofthemanagementaccountant.
Office Services: To discharge the responsibilities efficiently, amanagementaccountanthas todealwithdataprocessing,filing,copyingandduplicating.His area of responsibilities also included the evaluationandreportingabouttheutilityofdifferentofficeproceduresandmachines.
1.3 DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING
The compartmentalizationof accounting into various branches generallysoundssomewhatartificialandmisleadingasallthesebranchesareusuallydrawn from a commonpool of financial data used in preparing reportsforgroupswhoareoften involved inmakingavarietyof interdependentdecisions.Butacloseexaminationofthetwosystemsshowsthattheydifferinseveralwaysfromeachother.SomemajordifferencesbetweenthesetwoaccountingsystemsaresummarizedinExhibit1.2:
NOTES
Self-InstructionalMaterial 7
Nature and Scope of Management Accounting
Exhibit 1.2 Comparison of Financial Accounting and Management Accounting
Areas of Comparison Financial Accounting Management Accounting
Objective
NatureAdherence
Subject matter
Compulsion
PrecisionFrequency of reports
Recipients
Nature of the data used
Publication
• Tomeasureandassessthe businessresultandfinancial position of a concern
• Managementaccounting statements and reports are not generallypublished
Objectives: The basic objective of accounting is tomeasure thebusinessresultandassessthefinancialpositionofanorganization.Toachievethisobjective,financialaccountinghastoperformfunctionslikerecording,classifyingandsummarizingbusinesstransactionsofanorganizationduringtheaccountingperiod.Suchfunctionsarerelatedtothepreparationoffinalaccounts,i.e.,profitandlossaccountandbalancesheet.Contrarytothis,theobjectiveofmanagementaccountingistofacilitatemanagerialdecisions.Managementaccountingdealswiththepreparationofanalyticalandcriticalfinancial reports to assistmanagement in improving the organization’sperformance.
Adherence to Accounting Principles: Financialaccountingsystemisbasedonsomeaccountingprinciplesandconventionswhichafinancialaccountant has to strictly followwhile preparingfinancial accounts andstatements.Thefinancial accounting system can be result-oriented onlywhentheaccountingprinciplesandconventionshavebeenproperlyfollowedandapplied.Butmanagementaccountingisnotboundbytheconstraintsofgenerallyacceptedaccountingprinciplesandconventions.Thepreparationofreportsandstatementsundermanagementaccountingaregovernedbytherequirementsofthemanagement.Managementcanframeitsowngroundrulesandprinciplesregardingtheformandcontentofinformationrequiredforinternaluse.
Precision: Financialaccountingpaysmoreemphasisonprecisionandconsidersonlyactualfiguresinthepreparationofitsstatements.Thereisnoscopeforapproximatefiguresinfinancialaccounting.Butthereportsandstatements as prepared under management accounting system contain more approximatefiguresthantheactualfigures.Thus,managementaccountingislesspreciseascomparedtofinancialaccounting.
Frequency of Reports: Thefinancial statements, the outcome offinancialaccounting,arepreparedattheendofthefinancialperiodwhichis
Recipients: Financialstatementssuchasprofitandlossandbalancesheet, are extensively used by outsiders i.e., shareholders, creditors, taxauthorities, etc.On the other hand,management accounting reports areexclusivelymeantformanagement.Suchreportsarenoteasilyavailabletooutsiders.
Nature of Data Used: Thefinancial statements as preparedunderfinancial accounting contain only such transactions that are expressed inmonetaryterms.Thenon-monetaryeventssuchasnatureofcompetition,businessreputation,changeinfashion,arenotatallconsideredbyfinancialaccounting.Butmanagement accounting uses bothmonetary and non-monetary data.
Publication: Financialaccountingstatementsarepublishedbyalmosteverybusinessorganizationfortheinformationofthegeneralpublic.TheIndianCompaniesActhasmadeitcompulsoryforeverycompanytopublishitsfinalaccountsi.e.,profitandlossaccountandbalancesheet.Bycontrast,the publication ofmanagement accounting reports and statements is notmandatory.
Theprimaryobjectiveofamanagementaccountingsystem is toprovideaccurateandrelevantinformationtointernaluserswiththeaimofhelpingthemanagementtoattainefficiencyandeffectivenessintheorganization.Toachievethisgoal,managementaccountinghelpsanorganizationintheprocessofmanagementwhichgenerallyconsistsofactivitieslikeplanning,organizing,evaluating,andcommunicating(Figure1.1).
Nature and Scope of Management Accounting
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Self-Instructional 10 Material
Fig. 1.1 Management Accounting as an Aid to the Management Process
Planning: Planning is an activity ofmanagement that requires theapplicationofnotonlyascientificapproachbutalsoasystemicapproachtodecisionmaking.Allorganizationsirrespectiveoftheirnatureofbusiness,needtoplanbothatstrategicandoperationallevelstoremaincompetitiveinthemarket.Sincethemostcrucialdimensionofplanningthatthemanagementofanorganizationmustfocusuponisstrategicinnature,oneofthebasicfunctionsofthemanagementaccountantistohelpmanagementnotonlyintheselectionofthecompany’sgoalsandformulationofpoliciesandstrategiesbutalsointheallocationofresourcestoachievethesegoals.Differentaccountingtechniquesareusedbythemanagementtodischargethefunctionofplanningefficiently. Important among themare cost-volume-profit analysis, directcosting,capitalbudgetingandcashbudgeting.
Organizing: Organizing,which basically involves grouping ofactivities,definingtheresponsibilityandgrantingauthoritytoemployees,aimstodevelopstructuralrelationshipamongpeopleandphysicalresourcestocarryoutplansandaccomplishtheorganization’sstatedobjectives.Sinceorganizing is prerequisite for the success of anyorganization, therefore,thisfunctionnotonlycallsforundividedattentionfromthemanagementofanorganizationbutalsocontinuousmonitoringandaudit toensure itseffectivenessandrelevanceinadynamicbusinessenvironment.Toattainthisobjective,managementaccountingassiststhemanagementofanorganizationinorganizingbyestablishingcostand/orcostcentres.
1.4.1 Objectives and Functions of Management Accounting
Thebasicroleofmanagementaccountingistoprovideaccurateandrelevantinformationtotheinternalpartiesofanorganizationfordecisionmaking.To discharge this responsibility effectively,management accounting hastoundertakecollection,processing,analysingandinterpretingofdata,aswellascommunicationoftheresultinginformationtosuchinternalpartieswhointendtousethesameintheirdecisionmakingprocess.Infact, thesaidactivitiescanberecognizedasthebasestoidentifyandexaminethefunctionsofmanagementaccountingandaccordinglythemajorfunctionsaresummarizedbelow:
Data Collection: Thefirst function ofmanagement accounting isto collect the requisite data from all possible resources. Since the datawas traditionally restricted only to economic andfinancial items/factors,managementaccountantswouldmakeuseofthefinancialstatementslikeprofit&lossaccountandbalancesheetforthepurpose.Overthepastfewyears,theactivitiesofmanagementaccountinghavecrossedalltraditionalboundariesbyconsideringnotonlymonetaryitemsandfactorsinitsstudiesbutalsonon-monetaryfactorslike.Suchparadigmshiftintheapproachofthemanagementaccountinghasmadeitsscopemuchwider.Tomeetthegrowingdemandsofthewiderscope,managementaccountingisboundtoutilizebothinternalaswellasexternalsourcesofdatacollection.
Data Processing: The data so collected and stored needs to beconvertedintoinformationthroughprocessing.Dataprocessingreferstotheseriesofactivitiesconsistingofcompilation,classification,tabulationandsummarizationthataimstomakedatainformation.
Analysis and Interpretation:Thedatacollectedfromvariousinternalaswellasexternalsourcesdoesnothaveinherentmeaningandinfact,itsmeaningisgenerally influencedbythenatureandscopeof the toolsandtechniquesusedforitsanalysis.Further,thedataassuchisnotofmuchuseforthemanagementbutitbecomessoonceitisanalysedandinterpretedin
Communication as a crucial function ofmanagement calls for thetransmissionofinformationtotheconcernedpartiesforuse.Managementaccountingplaysaspecialroleinmanagingtheaffairsofthebusinessbyprovidingnotonly theconventional reports to thedecisionmakersofanorganizationsbutalso in takingnecessarymeasures toensure the supplyofadequateinformationatrighttimetoenablethedecision-makersoftheorganizationtoaddressthechallengesofthechangingenvironment.
Special Studies: Contemporary business is operating in a dynamic environmentwhereevenaminorchangeinanyof itselementscanhaveasignificantimpactonthebusinessoutcomes.Therefore,managementisalwaysinterestedtoknowtheareasofbusinesswhichcancontributetothestabilityandprofitabilityoftheconcern.Tomeetthisobjective,managementaccountingcarriesoutvariousspecialstudiessuchassalesanalysis,economicforecasts,pricespreadanalysis,etc.
Tax Administration: In themodern business organizations, taxadministrationisbeingrecognizedasasignificantareaofstudythatfallswithin thescopeofmanagementaccounting.Taxadministrationinvolvestasks like the submission of necessary documents and return to the taxauthorities,includingthesupervisionofallmattersrelatingtotax.
1.4.2 Tools and Techniques of Management Accounting
Management accounting is an information system designed to communicate meaningfuleconomicandfinancialinformationtomanagers,sothattheymaydischargetheirfunctionsefficiently.Itmakesextensiveuseofanumberoftoolsandtechniquestomeettheincreasingneedsofbusiness.Importantamongthemare:
Financial Planning: Planning is necessary not only for betterorganizationalperformanceandprogress,butalso forefficientutilization
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Self-InstructionalMaterial 13
Nature and Scope of Management Accounting
ofavailableresources.Infact,itisrecognizedasaprerequisiteforfinancialfunctionswhereinfinanceplaysadecidingroleinexecutingthemeffectively.Financial planning is the process of deciding in advance the financialobjectives,policiesandprocedures.Anorganizationcanachievelong-term,aswellasshort-term,financialobjectivesbyemployingfinancialplanning.Intheshortterm,itcanhelpaconcerninmeetingitsobligationsbybalancingtheflowoffunds.Atthesametime,itsproperapplicationcanensureefficientutilizationofavailablefinancialresourcesinthelongterm.
Analysis of Financial Statement: Financialstatementanalysisisagrowingandeverchangingsetofsystemsandproceduresdesignedtoprovidedecisionmakerswith relevant informationderived frombasic sourcesofdata such as companyfinancial statements andgovernment and industrypublications.Overtheyears,anumberoftechniqueshavebeendevisedtoanalysefinancialstatementse.g.,comparativefinancialstatements,common-sizestatements,ratioanalysis,trendanalysisandfundflowstatement.
Standard Costing: Anothermajor technique commonly used bythe organizations for exercising control is standard costing.Under thisarrangementstandardcostsareusedtocontrol themajoractivitiesof thebusiness.Standardcostsarepredeterminedtargetsagainstwhichactualresultsareevaluated.Thisisthebasisforasystemofmanagementcontrolforwhichthepropermonitoringofperformanceisakeyfactor.Thevariancesbetweenstandardandactualcostsarecomputedandreportedtomanagement.
Marginal Costing: Marginalcostingisamanagerialtechniquethatconsiders only variable cost in the decisions concerningwith additionaloutput.Itisareportingsystemthatvaluesinventoryandcostofsalesatitsmanufacturingvariablecost.Itisfrequentlyusedaninternalmanagementreporting system.
Budgetary Control: Budgetarycontrolreferstoasystemofbusinesscontrol that usesbudgets to control themajor activitiesofbusiness.Thebudgetsforallmajoractivitiesofthebusinessarepreparedinadvanceandtheactualoperationsarecarriedoutinaccordancewiththebudgetestimates.Generallythebudgetsarepreparedbyupdatingthepreviousyear’sfiguresinthelightofsomeforwardprojections.
twobalancesheetdates.Anystatementpreparedforthispurposereferstoasfundsflowstatement.Afundsflowstatementhelpsmanagersintheefficientmanagement of funds.
Management Reporting: Management reporting is considered as an essentialcomponentofawelldesignedplanningandcontrolsystem.Decisionmakersfrequentlyrequireinformationonvariousaspectsofbusiness.Thus,itistheresponsibilityofthemanagementaccountanttocommunicatetherequiredinformationtomanagementattherighttimeandinarightmanner.
1.6 CHANGING ROLE AND TASKS OF MANAGEMENT ACCOUNTANTS
Traditionally,theroleofthemanagementaccountanthasbeenofafacilitatorresponsibleforprovidingsufficientaccountinginformationtothedecision-makers in an organization.Therefore, themanagement accountantwasresponsible fordevisingandoperatinganaccounting informationsystemthatwascapableofcollecting,processing,interpretingandcommunicatingtheaccountinginformationforusewithintheorganizationwiththeaimofattaining organizational efficiency and effectiveness.Thus, traditionally,thejobofthemanagementaccountantinanorganizationasadvocatedby Williamson(2003),hasrevolvedaroundthefollowingmajoractivities:
Recent developments in information technology, accompanied bytheemergenceofknowledgemanagement,arapidlychangingcompetitiveenvironment and increasingglobalization of business have led corporatehouses to introduce strategic orientation in their planning process.Thechangeinorientationisboundtobringadrasticchangenotonlyinthenatureandscopeofmanagementaccountingbutalsointhetaskandroleof themanagementaccountantinbusinessorganizations.Realizingtheneedtobringchangesintheroleofmanagementaccountants,SiegelandSorensenstatethattheroleofaccountantsshouldcontinuallyevolvetoremainrelevantinthechangingbusinessenvironment.Thetraditionalroleofthemanagementaccountant,which has been restricted to the supplier of operational andfinancialinformationwithintheorganization,isnolongersufficienttomeetthegrowingdemandsofachangingbusinessenvironment.Therefore,themanagement accountnt needs to grow into a high-level decision supportspecialistwhowould help a company in strategicmanagement efforts.Thus,theemergingroleofamanagerialaccountantwillbequitedifferentfromhistraditionalroleinthesensethathehastobeanactiveparticipantinthedecisionmakingprocess,alongwiththefunctionalmanagersinanorganization.Suchparticipationwillnotonlymakehimamemberofafirm’sfunctional teamthat is responsibleforvaluecreationbutalsochange thenatureofhisjobfroma‘staff’toa‘businesspartner’.
Management accountantswill get a number of opportunities to initiateand execute specific actions to address the changes in the global economicenvironment.The traditional roleofprovidingaccurate, timelyand relevantinformation of amanagement accountantwill be replaced by awider andvibrantrolewherehewillbeanactiveparticipantinthestrategicprocessofan organization.
These views are also supplemented by the remarks of Siegel andSorensen,whosaidthatthecharacterizationofmanagementaccountantsinleading-edgecompanieshasgonefrom‘beancounter’and‘corporatecop’on
Tocompeteandgrowinahighlycompetitiveandcomplexbusinessenvironment of the future, organizations need to develop capacity andcompetence to create and deliver superior delivered value to customersanduse the same as a sustainable competitive advantage.Consequently,managementaccountantsareboundtohelptheirorganizationsnotonlyinmeasuringthecostofoperationaccuratelybutalsoinidentifyinganddevisingthemeansforeliminatingnon-valueaddedcostswhichtheywillbeabletodoonlyiftheypossessadequateknowledgeofthevalue-creatingprocessoftheirrespectiveorganizations.Whilecommentingontheopportunitiesofenhancingthevalueofafirm’soutput,Cooperstatesthatcostmanagement,likequality,hastobecomeadisciplinepractisedbyvirtuallyeverypersoninthefirm.Sincetheeffectiveuseofcostmanagementtechniquescallsfortheapplicationoftoolsandtechniquesnotonlyfrommanagementaccountingbutalsofromengineeringandotherfunctionalareasofmanagement, thetaskofmanagementaccountantshasbecomemultifaceted,whichdemandsknowledge of projectmanagement andmanufacturing processes.Thus,managementaccountantsneedtopossesssufficientknowledgeofthelatestcosting tools and techniques like target costing, activity-based costing,throughputcosting,strategiccostmanagement,kaizencostingandbalancedscorecard.
1.6.1 Management Accountant in an Organization
Thequestions that generally strike themindof a studentwhile studyingmanagementaccountingare(i)whoisamanagementaccountant?and(ii)whatishisstatusintheorganization?Amanagementaccountantoccupiesapivotalposition in theorganizationand is responsible fordevisingandoperatinganaccounting informationsystemthat iscapableofcollecting,
Nature and Scope of Management Accounting
NOTES
Self-Instructional 18 Material
process, interpreting and communicating the accounting information forinternal users of the organization.However, in Indian corporate houses,the position is commonly known as ‘financial controller’, ‘controller offinances’,‘financialadviser’,and‘directorfinance’ratherthanmanagementaccountant.To answer the question ‘what is the status ofmanagementaccountant’inanorganization,oneneedstoexamineafirm’sorganizationalstructure.Organizationalstructure,whichisbasicallyaframeworkwithinwhich peoplework together to achieve organizational goals, involvesbreakingupofthetotalworkoftheorganizationintoworkableunitswithclearlydefineddutiesandresponsibilities.Suchastructurenotonlyhelpstheemployeesofanorganizationtounderstandtheirpositionsandauthoritywithintheorganizationbutalsodefinestheirrelationshipwitheachother.Therefore,itisessentialforanorganizationnotonlytohaveaclearlydefinedorganizationalstructurebutalsocommunicatethesametoitsemployees.Themostpopulartooltomakeemployeesunderstandtheorganizationalstructureis‘organizationalchart’,whichistheschematicdiagramofthevariousjobpositions.Figure1.2portraysthestatusandphysicallocationofmanagementaccountantsintheOilandNaturalGasCorporation(ONGC)ofIndiaLtd.
Fig. 1.2 Organizational Chart of the Oil and Natural Gas Corporation (ONGC) Ltd
The chart, in fact, clearly depicts line and staff positions in thecorporation.Inthecontextofemployees’authorityandrole,thepositionofthecorporationcanbeconvenientlycategorizedintotwoforms:‘line’and‘staff’.Sinceinalineposition,theemployeehastheauthoritytoplan,organize,directandcontroltheactivitiesoftheorganization,therefore,heisdirectlyinvolvedinattainingorganizationalgoals.Whereasastaffpositionservesin thecapacityofanadvisor,he indirectlycontributes towardsachievingtheorganizationalgoals.Managementaccountantsaregenerallyrecognized
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Self-InstructionalMaterial 19
Nature and Scope of Management Accounting
asstaffpositionsthataredevoidoftheformalrighttomakedecisionsandas suchhavenodirect responsibility for accomplishing theobjectivesofan organization.Therefore,management accountants aremeant to assistfunctionalmanagersincarryingoutthetasksthatarenecessaryforattainingthegoalsoftheorganization.However,theaccountantspossesstheauthorityovertheirstaffdeployedintheirrespectiveunits.
Itmust be understood thatmanagement accountants in India aregenerallymembersofstrategicteamsinlargeorganizations.Infact, theyhavetheresponsibilityofprovidingrelevantandtimelydatatotheteaminorderhelpitinplanningandcontrollingactivitiesoftheorganization.
Check Your Progress
3.What is the special role played bymanagement accounting inmanagingtheaffairsofthebusiness?
4.Howdoestheelementofintuitionaffectmanagementaccounting? 5.Mention the activities around which the traditional job of
managementaccountingrevolvedasperWilliamson.
1.7 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
1. Inflation accounting attempts to identify certain characteristics ofaccountingthattendtodistortthereportingoffinancialresultsduringperiodsofrapidlychangingprices.
2.Financialaccountingstatementsarepreparedattheendofthefinancialperiodwhichisusuallyaperiodof12monthswhereasmanagementaccounting reports and statements are prepared at regular intervalsdependinguponthedemandofthedecision-maker.
3.Managementaccountingplaysaspecialroleinmanagingtheaffairsof the business by providing not only the conventional reports tothedecisionmakersofanorganizationbutalsointakingnecessarymeasurestoensurethesupplyofadequateinformationatrighttimetoenablethedecision-makersoftheorganizationtoaddressthechallengesofthechangingenvironment.
4.Theelementofintuitionismanagerialdecisionhasnotbeencompletelyeliminated.Thereisatendencyamongbusinessexecutivestouseashort-cut approach tomanagerial problems rather than the lengthyprocessasrequiredbythescientificanalysisprescribedbymanagementaccounting.
•Management accounting is a segment of accounting that dealsspecificallywith the accounting and reporting of information tomanagementregardingthedetailedoperationsofthecompanyinorderfordecisionstobetakeninvariousareasofbusiness.
• Inflation accounting attempts to identify certain characteristics ofaccountingthattendtodistortthereportingoffinancialresultsduringperiodsofrapidlychangingprices.
• Internal audit as a discipline ofmanagement accountingmakesarrangements for performance appraisal of the company’s variousdepartments.
•Todischargetheresponsibilityeffectively,managementaccounting,therefore, has to carry out not only the activities like collection,processing,analysingandinterpretingofthedatabutalsocommunicatingtheresultinginformationtosuchinternalpartieswhointendtousethesameintheirdecisionmakingprocess.
•Management accounting helps an organization in the process ofmanagement,which generally consists of activities like planning,organizing,evaluatingandcommunicating.
•Financial statement analysis is a growing and ever changing setof systems and procedures designed to provide decisions-makerswith relevant information derived from the basic sources of datasuchascompanyfinancialstatementsandgovernmentandindustrypublications.
• In his new role, themanagement accountantwill providemoreopportunitiestoexplorehispotentialinmeetingtheexpectationsofthestakeholdersinanorganization.
•Management accounting: It is a segment of accounting thatdeals specificallywith the analysis and reportingof information tomanagementabouttheoperationsoftheorganizationwithanobjectivetofacilitatedecisionmaking.
•Budgeting: It refers to a systematic plan for the utilization oforganizationalresources.
•Data processing: It refers to the series of activities consisting ofcompilation,classification,tabulationandsummarizationthataimstomakedatainformation.
1. ‘Managementaccountingisthepresentationofaccountinginformationin such away as to assist themanagement in decisionmaking.’Comment.
2.Discussindetailthefunctionsofmanagementaccounting. 3.Explainthetoolsofmanagementaccounting. 4. ‘Management accounting can be viewed asmanagement oriented
2.3 ComparativeFinancialStatements 2.4 Common Size Statement 2.5 TrendAnalysis 2.6 AnswerstoCheckYourProgressQuestions 2.7 Summary 2.8 Key Words 2.9 SelfAssessmentquestionsandExercises 2.10 FurtherReadings
2.0 INTRODUCTION
Thefundamental,clearanddefiniteunderstandingoffinancialstatementsisrecognizedasaprerequisiteforanaccurate,completeandrelevantfinancialdecision.However,thisdoesnotmeanthatdecisionmakerslikeabusinessexecutive,commercialorinvestmentbanker,orinvestor,speculator,businesscounsellor, mercantile creditman, or financial analyst need tomasterthemselvesinthepreparationofthesestatements.Infact,qualifiedfinancialaccountants capable of preparing such statements are available almosteverywhere in theworld.But the unchallenged ability to interpret thesefinancialstatementsintelligentlyandaccuratelyareessentialtounderstandthefinancialstatusandperformanceofabusiness.
Financialstatementsenableareadernotonlytomeasurebusinessresultsof an organization but also to assess its financial position; hence, theyare generally predictive by nature. Such statements contain not onlysufficientbutalsovaluableinformationabouttheorganizationthatwouldhelpmanagersindecisionmaking.ThenatureoffinancialstatementswasadmirablysummarizedontraditionalgroundsanumberofyearsagobytheAmericanInstituteofCertifiedPublicAccountants,1936 inthefollowinglines:Financial statements are prepared for the purposes of presenting a periodical review or report by the management and deal with the status of the investment in the business and the results achieved during the period under review.
Thus,financial statements are reporting instruments that provide asummaryoftheaccountingdataofanorganization’sbusinesspertainingtoaspecificaccountingperiod.Theobjectivesofsuchstatementsaresummarizedbelow:
• Profitandlossaccounts;and• BalancesheetInaddition to theabove-mentionedstatements,manyorganizations
prepare the following twofinancial statements inorder to strengthen theaccounting information system:
• Profit and Loss Appropriation Account: Anaccountthatshowsthedistributionofprofitisknownasprofitandlossappropriationaccount.Generallythisaccounthasthesameformat,i.e.,‘T’form,asisfollowedincaseofprofitandlossaccount.Thecurrentprofitof thebusiness(that is transferredfromprofitandlossaccount)alongwiththebalanceofprofit,ifany,ofthepreviousyearappear
NOTES
Self-InstructionalMaterial 25
Financial Statements Analysis
on the credit sideof the account.Thedebit sideof the accountshowsappropriationtransactionslikedividend,incometax,generalreserve,etc.Aspecimenofthisaccountisgivenbelow:
• Statement ofChanges inFinancial Position The statement ofchanges infinancial position, often referred to as ‘FundsFlowStatement’,providesinformationabouttheflowoffund(workingcapital)duringaparticularperiod.Italsoprovidesinformationaboutthefinancialandinvestingactivitiesofabusinessenterprise.Suchastatementexplainsthecauseofchangeinthefinancialposition(balancesheet)fromthebeginningoftheperiodtotheendoftheperiod.
Since thestudentsneed topossessknowledgeabout thenatureandstructureofprofitandlossaccountandbalancesheetbeforetheyanalysesuchstatementsforagivenpurpose,inthesubsequentsectionsofthischapteranattempthasbeenmadeinthisdirection.
Profit and Loss Account
Profit and loss account reports the results of business activities for anaccountingperiod.Suchanaccountnotonlyrevealsthedetailsoftheincomeandexpenditureofabusinessorganizationoveraperiodoftimebutalsocomparethemwitheachotherwithanobjectivetofindthedeviationwhichrepresents theamountofprofitor loss for theperiod. If incomeexceedsexpenditurethedifferenceiscallednetprofitandincaseexpenditureexceedsincome,thedifferenceiscallednetloss.Dataconcerningsales,costofgoodssold,returnsandallowances,sellinganddistributionexpensesandnetincomearenormallypresentedin theprofitandlossaccount.Theprofitandlossaccountsometimesiscalledincomestatementortheoperatingstatement.
There isnospecificproformafor thepreparationofprofitand lossaccount.However, the proformagivenbelow is commonlyused for thispurpose:
Theabove-givenproformaofprofitand loss iscommonlyusedbyIndianorganizations.Thenameoftheconcernandthetimeperiodforwhichtheaccountispreparediswrittenatthetopoftheaccount.Thebodyoftheaccountcontainsdetailsaboutincomesandexpendituresoftheconcernforthespecificperiod.Anaccountingsystemconsistingofaccountingconceptsandprinciplesisusedtoidentify,recognizeandmeasuresuchincomesandexpenditures.
As is evident from the above-mentionedproforma, profit and lossaccountisdividedintotwomajorcategories—theleft-handsideknownasdebit sideandright-handsidecalledascredit side.Theprofitandlossaccountisnominalincharacter,therefore,allexpendituresaredebitedandallincomesarecredited.However,expenditureincurredforthefuturecommonlyknownas unexpired costs (assets) likebuilding,plantandmachinerycosts, landorinvestmentsarenotreportedintheprofitandlossaccount.Thisrevealsthatonlyexpiredcostsrelatedtothecurrentperiodlikecostofgoodssold,salaries,rent,andsoonareshowninprofitandlossaccount.Inthesameway,expensesrelatedtothepastperiodshavetobeexcludedfromtheprofitandlossaccount.Thesameprocedureisalsoappliedtoincomes.Accordingly,incomes received in advance and incomes received in respect of past periods are not included in the computationof profit for the current period, andtherefore,arenotshownintheprofitandlossaccount.
Theprofitandlossaccountdiscussedabovedepictstheincomeandexpenditurefor a specificaccountingperiod,but it fails to indicate thepositionof theorganizationintermsofitsassetsandliabilities.Topresentsuchaninformation,anaccountingframeworkisrequiredwhichisknownasthebalance sheet. Thebalancesheetisastatementofthefinancialpositionofanenterpriseasatagivendatewhichexhibitsitsassets,liabilities,capital,reservesandotheraccountbalancesattheirrespectivebookvalues(ICAI,1983).
Liabilities denote the amountwhich a business owes to others ondifferentaccounts.Itrepresentsclaimsofcreditorsandequityoftheowners.Theliabilitiesareusuallydividedintothreemajorcategories:
• Currentliabilitiesrepresentshort-termfinancialobligationswhichare expected to be paidwithin the coming year or the normaloperatingcycle.Sundrycreditors,billspayableandoutstandingexpensesarethebestexamplesofsuchliabilities.
• Fixed asssets are those assetswhich are to be used in businessoperationover a relatively longperiodof time.Such assets areincidental to production such as land and building, plant andmachinery,furnitureandfittings,etc.
For a clear understanding of the balance sheet, onemust bewellversedwiththeconceptofbusinessentitywhichsaysbusinesshasgotitsownindividualityasdistinguishedfromthosepersonswhoown,controlorotherwiseareassociatedwiththebusiness.Suchaconceptadvocatesthattheorganizationisliabletothosewhohaveadvancedmoneytoit,thatis,itsliabilitiesarethesumsowedbythebusinesstotheinternalparties(owners)andexternalparties(creditors)whohadadvancedmoneytoit.Similarly,itsassetswouldrepresentthepropertiesandservicesownedorbroughtbythebusinesswiththefundsadvanced.Thus,thebalancesheetisarepresentationoftheaccountingequation:
dataaboutthepastandfailtoreflectonthefuture. •Financial statements fail to throw light on non-monetary facts of
thebusinessdespite thefact that theyplayanimportantrole in theprofitabilityoftheconcern.Factslikecompetition,conflict,loyalty,etc.,directlyinfluencetheconcern’sprofitabilitybutcannotbeexpressedinmonetaryunits,andtherefore,areignoredinfinancialstatements.
•Financialstatementsfailstoreflectthetrueandfairviewofthebusinessasthepreparationofthestatementsisgovernedbyvariousaccountingconcepts and conventionswhich suffer frommanydrawbacks. Forexample,assetsaretoberecordedatcostratherthantheirrealisablevaluewhichdefinitelyhidestherealpositionsoftheconcern.
2.2.2 Meaning of Analysis
Like lines in thepalmorhoroscope,financial statementscanbe studied,puzzledover,andscrutinized(Woelfel,1980).Theanalysisofsuchstatementsprovidevaluableinformationformanagerialdecisions.Financialstatementis—asnearlyasthefinancialexecutivecanmakeitso—simplyareportoffacts.Theutilityofthestatementdoesnotlieintheamountofinformationitcontainsbut intheexpertiseandtheskillof theanalyst toanalyseandinterprettheinformationinthestatementinordertogetthestorybehindthe facts—to readbetween the lines.Financial statement does not speakanythinginandof itself. Itmerelycontainsfinancialdataaboutbusinessevents.Theusergainsmeaningfulinsightsandconclusionsaboutthefirmonlythroughhisownanalysisandinterpretationoftheinformationinthestatements(Woelfel,1908).
Financial statement analysis involves a systematic and carefulexaminationoftheinformationcontainedinthefinancialstatementswithadefinitepurpose.Itisadetailedinquiryintofinancialdatatoevaluateanorganization’sperformance,futurerisksandpotential.Itattemptstodeterminethe significance andmeaningof thebusiness information as depictedbyfinancial statements so that prospects for future earnings, ability to payinterestanddebtmaturities(bothcurrentandlong-term)andprofitabilityofasounddividendpolicymaybeforecast.AccordingtoMyer,1969Financialstatement analysis is largelya study of relationships among the various financial factors in a business, as disclosed by a single set of statements and study of these factors as shown in a series of statements.
Overthepastfewdecadesanumberoftechniqueshavebeendevelopedfortheanalysisoffinancialstatements.Theselectionofappropriateanalyticaltechnique generally depends upon the purpose of the analysis.Usuallyanalystsprefertousesuchtechniquesincombinationtoensurebetterresults.Thecommonlyusedtechniquesare: • comparativefinancialstatement; • common-sizestatement; • trendanalysis; • ratioanalysis; • fundflowstatements;and • cashflowstatementsInthesubsequentsectionsofthisunit,anattemptismadetodiscussindetailthefirstthreetechniquesi.e.,comparativefinancialstatement,common-sizestatement,andtrendanalysis.However,thelastthreetechniquesi.e.,ratioanalysis,fundflowstatementandcashflowstatementhavebeendiscussedindetailinthesubsequentunits.
Check Your Progress
1.Mention the statements apart fromprofit and loss accounts andbalance sheetwhich are prepared to strengthen the accountinginformation system.
Any financial statement that reports the comparison of data for two or more consecutive accounting periods is known as comparative financial statement. CommentingonthenatureofcomparativefinancialstatementsFoulke,1961statesthatsuchstatementswhichbasicallyrevealthefinancialpositionofthebusinessaredesignedinsuchaformastoprovidetimeprospectiveto
Financial statements that depict financial data in the shape of vertical percentage are known as common size statements.Sincesuchstatementsprovidethereaderswithaverticalanalysisoftheitemsofprofitandlossaccount and balance sheet, the values of the items are converted into acommonunit by expressing themas a percentage of a keyfigure in thestatement.Therefore, the total of financial statement is reduced to 100andeachitemofthestatementisshownasacomponentofthewhole.Forexample,inprofitandlossaccount,thevalueofeachitemis expressedasapercentageofsales.Inthesameway,theassetsandliabilitiescanbeshownaspercentageoftotal assetsandtotalliabilities,respectively,inacommon-sizedbalancesheet.Sinceincommonsizestatementseachmonetaryitem of thefinancialstatementisexpressedasapercentageofthesumtotalofwhichthatitemisapart,suchanattemptisreferredtoascommonsizestatement.Consequently,suchstatementsnotonlyshowtherelativesignificance oftheitemscontainedinthefinancialstatementsbutalsofacilitatescomparison.Commonsizestatementsare recognizedasvaluablemanagement toolastheyrevealbothefficienciesand inefficienciesthatareotherwisedifficulttoidentify.However,acommonsize statementisespeciallyusefulwhendataformorethanoneyearareused.Illustration 2.3: ThebalancesheetsofShaheenLtd.aregivenfortheyear2011and2012.Convertthemintocommon-sizedbalancesheetandinterpretthechanges.
Total Assets (A + B) 4,46,800 100.00 4,91,000 100.00
Liabilities
C. Current Liabilities:
Trade creditors 30,000 6.71 40,000 8.15
Bills payable 80,000 17.91 60,000 12.22
Bank overdraft 90,000 20.14 80,000 16.29
Provisions 30,000 6.71 20,000 4.07
Total (C) 2,30,000 51.47 2,00,000 40.73
D. Long-term Liabilities:
Equity share 1,46,800 32.86 1,91,000 38.90
Capital reserve 50,000 11.19 70,000 14.26
Revenue reserve and surplus
20,000 4.48 30,000 6.11
Total (D) 2,16,800 48.53 2,91,000 59.27
Total Liabilities (C + D) 4,46,800 100.00 4,91,000 100.00
Interpretation
•Thestudyoftheabovecommonsizebalancesheet(seeIllustration2.3)showsthat61.56percentofthetotalassetsin2011werefixed.Thispercentageincreasedto64.57percentin2012.Iftheorganizationrequires considerable investment infixed assets, these percentagesmightbeacceptable.However,iftheorganizationneedsliquidassets,the interested parties might have cause to be concerned about the decreasing trend of liquidity.
Financial Statements Analysis
NOTES
Self-Instructional 36 Material
•Therehasbeenamajorshiftfromtheuseofcreditors’providedfundstotheuseofowner’sequityfunds.In2011,externalequity(currentliabilities)andowner’sequity(long-termliabilities)accountedfor51.47percentand48.53 per cent, respectively, of the total equities. In 2012, these percentages changed to 40.73per cent for external equities and59.27per cent forowners’equity.Thesechangesindicatethattheorganizationhasusedmoreinternalsourcesthanexternalsourcesinthegenerationoffunds for the business during the period under study.
•The organization has not only succeeded in reducing its currentliabilities from 51.47 per cent in 2011 to 40.73 per cent in 2012 of their respective total equities but it has also increased the percentage of its revenue reserve and surplus from 4.48 per cent in 2011 to 6.11 per cent in 2012 of their respective total equities.
Illustration 2.4: From the income statement given below, you are required toprepareacommon-sizedIncomeStatement.
Income Statements (for the year ending 31st Dec, 2011 & 2012)
Particulars 2011`
2012`
Sales 1,40,000 1,65,000Less: Cost of goods sold 85,000 1,05,000GrossProfit 55,000 60,000Operating Expenses:Selling&Distributionexpenses 12,000 16,000Administrativeexpenses 10,000 11,000TotalOperatingExpenses 22,000 27,000Netincomebeforetax 33,000 33,000Income-tax(40%) 13,200 13,200Net Income 19,800 19,800
SolutionCommon Size Income Statement
(for the year ending 2011 and 2012)
Particulars 2011 2012Amount
`Percentage Amount
`Percentage
Sales 1,40,000 100.00 1,65,000 100.00Less: Cost of sales 85,000 60.72 1,05,000 63.63GrossProfit 55,000 39.28 60,000 36.37Operating Expenses:Selling & distribution expenses
The study of the above-mentioned common size income statement (see Illustration2.4)revealsthefollowingfacts: •Outofeveryrupeeofsales60.72percentin2011and63.63percent
In theultimateanalysis, itcanbeconcluded that theoperatingefficiencyoftheorganizationhasnotbeensatisfactoryduringtheperiodunderstudy.Illustration 2.5: FollowingaretheBalanceSheetsofXCo.Ltd.andY.Co.Ltd. as on 31.12.2012.
The studyof the above common sizebalance sheet (see Illustration2.4)bringstolightthefollowingfacts: •Thebalancesheetindicatesthat63.31percentoftotalassetsofthe
The study of the above-given statement (see Illustration 2.6) of trendpercentagerevealsthat:
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Self-InstructionalMaterial 41
Financial Statements Analysis
•Thesalesofthefirmhascontinuouslyincreasedoveraperiodoffiveyearscommencingfrom2008.However,therehasbeenasubstantialincreaseintheamountofsalesintheyear2012whenitincreasedby39 per cent.
1.Apart from profit and loss accounts and balance sheet, manyorganizationspreparetheProfitandLossAppropriationAccountandStatementofChangesinFinancialPositiontostrengthentheaccountinginformation system.
•Thestatementofchangesinfinancialpositionoftenreferredtoasthefundsflow statement, provides information about theflowof fund(workingcapital)duringaparticularperiod.
•Financial statements: It refers to the reporting instruments thatprovideasummaryoftheaccountingdataofanorganization’sbusinesspertainingtoaspecificaccountingperiod.
•Financial statement analysis: It involvesasystematicandcarefulexaminationoftheinformationcontainedinthefinancialstatementswithadefinitepurpose.
•Comparative financial statement:Itreferstoanyfinancialstatementthat reports the comparison of data for two ormore consecutiveaccounting periods.
•Common size statements: It refers to thefinancialstatements thatdepictfinancialdataintheshapeofverticalpercentage.
6.Following income statementsof abusiness aregiven for theyearsending 31stDecember, 2011 and 2012. Prepare a common sizestatementandmakecommentsonthebusinessresults.
NOTES
Self-InstructionalMaterial 47
Financial Statements Analysis
Income Statements (for the years ending on 31st Dec,2011and2012)
3.4 Construction of BalanceSheet 3.5 AnswerstoCheckYourProgressQuestions 3.6 Summary 3.7 Keywords 3.8 SelfAssessmentQuestionsandExercises 3.9 FurtherReadings
3.0 INTRODUCTION
Thepreceding chapter examinednot only the nature and significanceoffinancialstatementsinmeasuringfinancialperformanceofanorganizationbutalsotheapplicationofthedatacontainedinthestatementsformanagerialdecisions.Thischaptercontinuesfinancialstatementanalysisbyfocusingonfinancial ratios.Ratioanalysis isoneof thepopular toolsoffinancialstatementanalysis.Suchananalysisaimstoreducethelargenumberofitemsinvolvedtoarelativelysmallsetofreadilycomprehendedandeconomicallymeaningfulindicators.However,giventhelargenumberofratiosavailable,it isdifficult todiscern the inter-relationshipsamong themrequiredforacomprehensiveunderstandingoftheentitybeinganalyzed.Whatisrequiredisanintegratedsystemoffinancialratioswhichwillincorporatetheessentialratiosandhighlighttheinter-relationshipsamongthem.
3.1 OBJECTIVES
Aftergoingthroughthisunit,youwillbeableto: •Explainthemeaningofratioanalysis •Discusstheclassificationofratios •Describe the liquidity, solvency, turnover, profitability ratios and
Insimplewords,aratioisthequotientformedwhenonemagnitudeisdividedbyanothermeasured in thesameunit.Aratio isdefinedas the indicated quotient of two mathematical expressions and as the relationship between two or more things.Usuallytheratioisstatedasapercentage,i.e., distribution expensesmightbestatedas20percentofsales.Often,however,theratioisexpressedinunits,thussalesmightbeexpressedas20timesinventory.Thus,theratioisapurequantityornumber,independentofthemeasurementunits being used.
Afinancial ratio isdefinedasarelationship between two variables taken from financial statements of a concern.Itisamathematicalyardstickwhichmeasurestherelationshipbetweentwofinancialfigures.Itinvolvesthebreakdownoftheexaminedfinancialreportintocomponentpartswhicharethenevaluatedinrelationtoeachotherandtoexogenousstandards.
As the ratio representsa relationshipbetweenfigures, anumberofratioscanbeformedbytakinganytwofiguresfromthefinancialstatements.However,suchanapproachwouldnotfulfillanypurposeunlessthefigureschosenaresignificantlycorrelatedwitheachother.Furthermore,manyoftheratiostendtodealwithdifferentaspectsofthesamerelationship,andthereislittlepointincalculatingseveralratiosinordertoinvestigatethesamepoint.Expertshaveidentifiedsomeratiosassignificantandimportantsincetheythrowconsiderablelightonthefinancialpositionofaconcern.
Interpretation of Ratio
Oneofthemostdifficultproblemsconfrontingtheanalystistheinterpretationand analysis of financial ratios.An adequatefinancial analysis involvesmore than an understanding and interpretation of each of the individualratios. Furthermore, the analyst requires an insight into themeaning ofinter-relationships among the ratios andfinancial data in the statements.Gainingsuchaninsightandunderstandingrequiresconsiderableexperiencein theanalysisand interpretationoffinancial statements.Moreover,evenexperienced analyst cannot apply their skill equallywell to analyse andinterpretthefinancialstatementsofdifferentorganizations.Thecharacteristicsmaydifferfromindustrytoindustryandfromfirmtofirmwithinthesameindustry.Aratiothatishighforonefirmatonetimemaybelowforanotherfirmorforthesamefirmatadifferenttime.Therefore,theanalystmustbefamiliarwiththecharacteristicsofthefirmofwhichheisinterpretingthefinalratios.
The analystmust not undertake the interpretation and analysis offinancialratiosinisolationfromotherinformation.Thefollowingfactorsmustbeconsideredwhileanalysingthefinancialratios:
Theanalysisandinterpretationoffinancialratiosinthelightoftheabove-listed factorscanbeusefulbut theanalystmust still relyonskill,insight, andeven intention inorder to interpret the ratiosandarriveat adecision.Theinterpretationoftheratioscanbemadebycomparingthemwith: •Previousfigures–trendanalysis; • Similarfirms–inter-firmcomparisons; •Targets–individualratiosettomeettheobjective. •Trend Analysis The analyst usually use historical standards for
evaluating the performance of the firm.The historical standardsrepresentthefinancialratioscomputedoveraperiodoftimewhichsets the trend.Trendanalysisprovides enoughclues to the analystforproperevaluationofthefinancialratios.However,thechangesinfirm’spoliciesovertheperiodmustbeconsideredwhileinterpretingratiosfromcomparisonovertime.Further,theaverageoftheratiosforseveralyearscanalsobeusedforthispurpose.
Ratioanalysishelpsthemanagementtoidentifyspecificareasthatreflectimprovementordeterioration,aswellasdetectthetroublespotsthatmaypreventtheattainmentofobjectives.Theinterestedpartiesundertakefrequentexamination of different areas of business to evaluate themanagement’sabilitytomaintainasatisfactorybalanceamongthem,andtoappraisetheefficiencyandeffectivenesswithwhichthemanagementdirectsthefirm’soperations.Thus,thepurposeofratioanalysisistohelpthereaderoffinancialstatementstounderstandtheinformationshownbyhighlightinganumberofkeyrelationships.However,thefollowingaretheprincipaladvantagesclaimedbyratioanalysis: • It guidesmanagement in formulating futurefinancial planning and
Ratioshavebeenclassifiedbydifferentexpertsdifferentlybasedontheirpeculiar characteristics. Some authorities classify ratios on the basis ofthefinancialstatementsorstatementsfromwhichthefinancialfiguresareselected.Accordingly,thefollowingclassificationofratioscanbeformed: •Profit and Loss Ratios: These ratios indicate the relationship
Ratio Analysistheperiodunderstudyandthusprovideenoughscopefortheproperevaluationofthebusiness.Anotherclassificationofratiosasdevelopedbyfinancialexpertsison
Theliquidityratiosindicatetheliquidityofacompany.They,infact,measuretheabilityofacompanytomeetsitscurrentliabilitiesastheyfalldue.Ifthecompanyhasinsufficientcurrentassetsinrelationtoitscurrentliabilities,itmightbeunabletomeetitscommitments,andbeforcedintoliquidation.Thus,ratioscomparingtherelationshipbetweenvariousgroupsofcurrentassetsandcurrentliabilitiesarecomputedtomeasuretheliquiditypositionofthecompany.Suchratioshelpinascertainingtheeffectivenessoftheworkingcapitalmanagement.To gain an insight, analysts also use the variablesotherthanthosecoveredbythetermworkingcapital.Thefollowingaretheimportantliquidityratios: •Current Ratio: Thisisafundamentalmeasureofafirm’sfinancial
obligationsduringonefinancialyear.Thecurrentratiocomparesthetotalcurrentassetswiththetotalcurrentliabilitiestofindoutwhetherthenetassetsaresufficienttomeettheshort-termobligationofthebusiness.Itiscomputedbydividingcurrentassetsbycurrentliabilities.Current assets include cash, stock,work-in-progress,marketablesecurities and accounts receivable. On the other hand, currentliabilitiesincludeaccountspayable,sundrycreditors,accruedincometaxes,proposeddividend,borrowingsfromfinancialinstitutionsandoutstandingexpenses.Usuallycurrentratioisusedbytradecreditorstoestimatethecompany’sabilitytorepayitscredit.Thecurrentratioiscalculatedas:
CurrentRatio =Current Assets
Current Liabilities
A high current ratio indicates a large proportion of current assetsareavailabletomeetcurrentliabilities.Usuallythehighertheratio,thebetterisacompany’scurrentfinancialpositionandnormallythebetteritcanmeetcurrentobligations.Butatthesametime,ahighercurrentratiowouldalsomeanthatthecompanymayhaveanexcessiveinvestmentincurrentassetsthatdoesnotproduceasignificantreturn.Ontheotherhand,alowcurrentratiowouldindicatethatsufficientcashisnotavailabletopaycurrentliabilities.Afrequentlyusedguidelinetoevaluate theadequacyof thecurrent ratio is2:1or2.However,thereseemstobeverylittlejustificationforsuchastandard.Forsomebusinesses,thismaybeanadequatecurrentratio,forothersitmaybetoohighortoolow.Therefore,thestandardforthisratiowillvaryfromindustriestoindustries.Infact,manyrenewedcompanieshavemuchlowercurrentratio,aslowas1:1.Inevaluatingtheappropriatenessofcurrentratios,muchdependsonthenatureofthebusiness,compositionofafirm’scurrentassets,andturnoverof thefirm’scertaincurrentassets.
•Acid-test Ratio: Itprovidesanevenmorecriticallookattheabilityofthecompanytomeetitsday-to-dayobligations.Itsignifiesaveryshort-termliquidityofabusinessconcernandis,therefore,alsocalled‘liquidratio’.Ifitisdesiredtoapplyastillstifferandrigoroustestforevaluatingafirm’sfinancialpositionintheshortperiod,theapplicationofacid-testratioisrecommended.Theacid-testratioiscomputedbydividingcurrentassetsinliquidformbycurrentliabilities.Thus,stocksandsimilaritemsareexcludedfromcurrentassets,leavingitemssuchas debtors, bills receivable,marketable securities, and cash,whicharealreadyinliquidform,ormayeasilybeconvertedintocashbydiscountingorfactoring.Theacid-testratioassumesthatstockmaynotberealizedimmediatelyand,therefore,thisitemisexcludedinthecomputationofthisratio.Someexpertsadvocatethatthebankoverdraft
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Ratio Analysisshouldalsobeexcludedfromcurrentliabilitieswhilecalculatingacid-testratio.Thelogicfortheexclusionofbankoverdraftisbasedonthefactthatbankoverdraftisgenerallyapermanentwayoffinancing.Theacid-testratioisexpressedasfollows:
•Receivables Turnover: Anothermeasureofliquidityisreceivableturnover,which indicates the number of times that the averageoutstanding net receivables is turned over or converted into cashthrough collections during each year.Receivables turnover is theamount of period required for one complete cycle: From the timereceivablesarerecordedthroughcollectiontothetimenewreceivablesare recorded.The faster the cycle is completed, themore quicklyreceivablesareconvertedintocash.Whenthecustomers’accountsarecollectedpromptlywithlittlelossorcollectionexpense,thefirmfindsiteasiertomeetitsobligationswhentheybecomedue.Ontheotherhand,alongcreditperiodgrantedtocreditorswouldadverselyaffectthefirms’liquidityposition.Thereceivablesturnoveristheratioofsalestonetaccountsreceivable.Thisratioisexpressedasunder:
It is important to note thatwhile calculating receivables turnover,onlycreditsalesshouldbeused.However,thisinformationoftenisnotavailableinthefinancialstatements,andtherefore,thenetsalesisusedforthepurpose.
Sometimes the receivable turnover is expressed as the ‘collectionperiod’,viz.,howmanydays(ontheaverage)ittakestocollecteachrupeedue.Fortheperiodinquestion(week,month,quarter,year,etc.),thecollectionperiodiscalculatedas:
• Inventory Turnover:Theliquidityofinventoriesismeasuredbythenumberoftimesperyearthatinventoryisconvertedintocostofgoodssold.Hence,itisadevicetomeasuretheefficiencyoftheinventorymanagement.However,initszealtoshowahighratio,inventoriesarenotallowedtodropdownbelowthedangerlevel.Thisratioisworkedout as under:
Ratio Analysis Inventory turnover rates vary tremendously by the nature of thebusiness.Itisusuallydesirabletocompareafirm’sinventoryturnoverwith the turnover experience by comparable companies. It is notunusualforretailersofperishablecommoditiestoexperienceahigherinventoryturnoverthanthoseretailerswhodealindurablegoods.Attheotherextreme,retailersofjewelleryfrequentlyreflectalowyearlyinventoryturnover.Ahighturnovercompensatesforalowermarginoneachitem,producinganormalprofitforthebusiness.Ontheotherhand,abusinessthatsellsslow-movinggoodsmustmakeupforthelowturnoverbyahigherprofitmarginoneachitemsold.Ofgreatimportance, however, is the need to evaluate the trend in thefirmunderreview.Whetherthetrendisdesirablewouldrequiredetailedinvestigationintosuchaspectsaschangesinmanufacturingtechniques,labourslowdowns,orinventorystockpilinginanticipationofpriceincreases.
Theproportionofdebtcapitaltothetotalcapitalofafirmisusuallyreferredtoas‘leverage’ or trading on the equity.Thefundamentaleconomicprinciple underlying leverage is thatwhenever funds are borrowed at a lowerrateof interest thantheborrowercanearnonthosefunds, therateofreturnofowner’sequityisincreased overwhatitotherwisewouldhavebeen had the borrowed funds been provided by the owners (Hobbs andMoore1,1979).Borrowingtoo heavily,however,caninvitefinancialdifficultyprimarilybecauseinterestpaymentsandprincipalrepayments arecontractualobligationsthatmustbehonoured.Theabilitytoobtainandtorepayalong-term debt often dependsonafirm’sabilitytoobtaincapitalfromshareholders.Therefore,therelationshipbetweenshareholders’ equityandcreditors’equityisevaluated.Theleverageratioscommonlyusedarediscussedbelow. •Debt–Equity Ratio:Itdevelopstherelationshipbetweenownedfunds
Theratiorepresentstheproportionofexternalequitytointernalequityinthecapitalstructureofthefirm.Theexternalequity*representstheamountofdebts/liabilitiestooutsiders.Itincludesbothshort-termaswellaslong-termliabilities.Ontheotherhand,ownersequity**includesallsuchliabilitiesthatbelongtotheshareholders,e.g.,sharecapital(bothpreferential aswell as equity), reservesand surpluses.However, the
**Fewexpertsonthesubjectprefertoconsideronlyequityshareholdersinthecalculationofowners’equityand exclude preferential shareholders in the calculation.The plea to exclude preferential shareholders in thecalculationofowners’equity isbasedon the fact thatsuchsharesareentitled toafixedrateofdividendandthereforetheyfallwithinthescopeoffixedinterestbearingsecurities.
Eithertoohighortoolowaratiomaybedisadvantageous.Toohighsuggeststhatmanagementisnottakingadvantagesofopportunitiestomaximizeprofitsthroughborrowing.Toolowsuggestsundueexposuretorisksofbankruptcyandtoafixedburdenofinterestexpensesintheeventofaperiodofrelativelylowprofit(whentherateofreturnontotalcapitalislessthantheinterestrateonborrowedcapital).Asaruleofthumb,debt–equityratiooflessthan2:1istakenasacceptable,butthisisnotbasedonanyscientificanalysis.However,manyfinancialanalystsprefertoconsider1:1assafe.Astheratioincreases,theamountof risk assumedby creditors increases, because the ratio indicatesdecreasingsolvency.Infact,theacceptablelevelofratiowillvaryfromfirmtofirm.Forexample,bankinginstitutionswillhavemuchhigherdebt–equityratioascomparedtomanufacturingortradingconcerns.
•Equity Ratio/Proprietary Ratio: Avarianttothedebt–equityratioistheproprietaryratiowhichindicatestherelationshipbetweenowner’sequityandtotalassets.Itmeasurestheproportionofacompany’sassetsthatareprovidedorclaimedbytheowners.Theratioofowners’equitytototalassetsisameasureofthefinancialstrengthorweaknessoftheenterprise.Recallthattheowners’equityistheresidualinterestinafirm’sassetsafterallowancehasbeenmadefortheclaimsofcreditorsagainsttheassets.Iftheowners’equityisasmallproportionofthetotalassets,theenterprisemaybeconsideredfinanciallyweak,becausetheownershavearelativelysmallinvestmentinthefirmascomparedtothecreditors.Ontheotherhand,alowproprietaryratiowouldindicatea relatively largerdegreeofsecurity for thecompany.This ratio isworkedoutasfollows:
assets.The owners’ equity includes share capital both preferentialandequity,undistributedprofits,reservesandsurplus.Theamountofowners’equitymustbedeductedbytheamountofaccumulatedloss,ifany.Ontheotherhand,thetotalassetsrepresentthetotalresourcesofthecompany.However,someexpertsareoftheopinionthatthetotalassetsofacompanyforthepurposeofproprietaryratioshouldincludeonlytangibleassets.Consequently,theamountofgoodwillshallbeexcludedfromthetotalassetsinthecomputationofowners’equitytototalassets.
•Ratio of External Equities to Total Assets (Solvency Ratio): Thisisavariantoftheproprietaryratio.Thisratiomeasurestheproportion
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Ratio Analysisofafirm’sassetsthatarefinancedbycreditors.Tothecreditor,alowratiowouldensuregreatersecurityforextendingcredit to thefirm.However,atoolowratiosuggeststhatmanagementisnotusingitscreditmostadvantageously.Thisratioisexpressedasunder:
•Fixed Assets to Net Worth Ratio (Ratio of Fixed Assets to Proprietor’s Funds):Thisratioindicatesthepercentagecontributedbyownerstothevalueoffixedassets.Itcanbeworkedoutasfollows:
Fixedassetsrepresentcostofacquisitionofthefixedassetsdeductedbytheamountofdepreciationthereonuptotheperiod.Thenetworthrepresents the amount due to the shareholders, i.e., share capital,reserves and surpluses.Financial experts areof theopinion that inmanufacturingconcerns,investmentinplantsshouldbemadeoutofequityratherthanborrowedcapital,therefore,aratioofatleast1:1isconsidereddesirable.Ontheotherhand,alowerratiosuggestsanundueburdenofdebtontheenterprisethattendstoincreasetheinternalrateatwhichanenterprisecanborrow.
•Current Assets to Net Worth Ratio: This ratio signifies therelationshipbetweenthecurrentassetsandnetworth.Inotherwords,itisacorrelationbetweencurrentassetsandnetworth.Wecanputthisas under:
• Interest Coverage Ratio A company is considered solvent if itsrevenueismorethanits interestandotherexpenses.Consequently,thecompanythathasrevenuesufficienttomeetonlytheexpensesandleavingnothingasnetincomeisconsideredlesssolvent.Againstthisbackground,oneoftheapproachestotestsolvencyoftheenterpriseisinterestcoverageratio.Thisratiomeasureshowmanytimesacompanycouldpay its interestexpenses.This ratio iscalculatedbydividinginterest expenses into earnings available for payment of interestexpense.Wecanputthisasunder:
Profit has always been considered as themain indicator of a successfulbusiness.However, the real test of success or failure of a business is toevaluate its profit-earning capacity in relation to capital employed. It isagainstthisbackgroundthatfinancialexpertsdevelopedprofitabilityratioswhichareusedtomeasuretheabilityofthefirmtoconvertsalesintoprofitsandtoearnprofitsonassetsemployed.Theseindicatedegreeofsuccessinachievingprofitlevels.Thefollowingareimportantprofitabilityratios: •Gross Profit Margin Ratio:This ratio indicates the relationship
•Return on Owners’ Equity:Thoughtheratioofnetprofittosalesisaveryusefulindicatorofperformanceincomparisontothecompany’sexperience in prior periods or to the current experience of othercompanies,itdoesnotgiveadirectanswertoavitalquestion:isthebusiness providing an adequate return on the owners’ investment,takingintoaccounttheriskassociatedwiththecompany’sbusinessandwhatcouldbetheearningsofthisinvestmentinalternativeventures?Tohelpanswerthisquestion,theratioofreturnonowners’equityisneeded.Theprofitearnedbytheownersofabusinessiscalledreturnonowners’equity.Thisratioisconsideredasaneffectiveindicatorofacompany’sprofitabilitybecauseitreflectsthemanagement’ssuccessinefficientutilizationoftheowners’investment.Thereturnonowners’equityisworkedoutwiththehelpofthefollowingformula:
Ratio Analysis •Return on Equity Capital: Equityshareholdersaremoreseriousascomparedtopreferenceshareholdersintheprofitabilityofacompany.Itisperhapssobecauseequityshareholdersassumethehighestriskinthecompany.Preferenceshareholdersareassuredoftherateofdividend,and therefore, theprofitabilityof the companyhasnomeaning forthem.Ontheotherhand,therateofdividendforequityshareholderslargelydependsontheavailabilityofprofits.Withtheresult,returnonequitycapitalisausefulindicatorforequityshareholderstomeasuretheperformanceofthecompany.Returnonequitycapitalmonitorstheprofitmadebythecompanyinrelationtoitsequitycapital.Thisratioisworkedoutasunder:
• Earnings Per Share (EPS): Thisisawellknownandwidelyusedindicator of profitability because it can easily be compared to thepreviousEPSfigureandtotheEPSfigureofothercompanies.Theearningspersharerepresentaverageamountofnetincomeearnedbysingleequityshare.Thisiscalculatedwiththehelpofthefollowingformula:
Profit analysis is themost important application of profitability ratios.Internalmanagementwouldliketounderstandwhereextraeffortsareneededtoimproveprofitabilityandwherethecompanyhasdonewell.Therearemainlythreefunctionsofbusiness,namely,(a)operations,(b)investmentand(c)financing.Profitscanbeearnedorlostfromanyofthesefunctions.Operations functions involveday-to-daydecisionswhereas investingandfinancingdecisionshavelong-termimplications.Thesethreefunctionsmustbetiedtogethertoidentifyareaswhereprofitisearnedorlost.TheDu-PontCompanydevelopedamethodfortyingthesethreetoexplaintheincidenceofprofitearning.
Activity ratiosmeasure the efficiencyof afirm inutilizing the availableresources.Suchratiosreflectthesuccessofafirminutilizingitsresourcesinbusinessactivities.Activityratiosarepopularlyknownasturnover ratios becausetheyhighlighttheabilityofmanagementtoconvertorturnoverthe
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Ratio Analysisassetsofthefirmintosales.Theseratiosmakeacomparativestudyofthelevelofsalesandtheinvestmentinvariousassetsaccounts.Asharpriseinthisratiomayindicatethatthecompanyisexpandingtooquicklyandisallowingsales to increasemore rapidly than theunderlyingasset-base, a situationoftenreferredtoas‘overtrading’.Conversely,areductionintheratiocanindicateadeclineinefficiencyorafallindemandforafirm’sproducts.Theimportantactivityratiosarementionedbelow: • Fixedassetsturnover • Totalassetsturnover • Inventory turnover • Averagecollectionperiod
Thelasttworatiosoftheabove-mentionedactivityratioshavealreadybeendiscussedunderliquidityratiointheearliersectionofthischapter. • Fixed Assets Turnover: The ratiomeasures the efficiency in the
• Total Assets Turnover: Thisratiomeasurestheoverallperformanceandactivityofthebusinessorganization.Itiscomputedbydividingsalesbytotalassets.Thefollowingformulaisappliedtocomputethisratio:
Illustration 3.7: Compute the FixedAssetsTurnover andTotalAssetsTurnoverfromthefollowingparticulars:
Sinceratioanalysisisusedfortheassessmentoftheitemsofthefinancialstatements, the same ratios canbeused as the foundation to retrace andpreparethebalancesheetofthefirms.Inthissection,youwilllearnabouttheconstructionofbalancesheetfromratiosthroughthehelpofillustrations.Illustration 3.9: Followinginformationisgiventoyou:
`
1. Currentliabilities2. Reservesandsurplus3. Billspayable4. Debtors5. Current ratio6. Acid-testratio7. Fixedassetstoproprietor’sfunds
Sincethefirmdoesnothaveanylong-termliabilitytherefore,shareholder’sequity should be equal to total net assets. If thefixed assets are 0.75 toproprietor’sfunds,netcurrentassetsshouldbe0.25ofthetotalnetassets.Thus,fixedassetsshallbe:
9.Fromtheinformation,youarerequiredtoprepareaBalanceSheet: 1. Current ratio – 1.75 2.Liquidratio –1.25 3.Stockturnoverratio –9 4.Grossprofitratio –25% 5.Debtcollectionperiod –1½months 6.Reservesandsurplustocapital –0.2 7.Turnovertofixedassets –1.2 8.Capitalgearingratio –0.6 9.Fixedassetstonetworth –1.25 10.Salesfortheyear –`24,00,000 10.Describe the effect of each of the transaction listed belowon the
indicatedratios.Willtheratioincrease,decreaseorremainunchanged?Transaction Ratio
(a) Paymentofcreditiors (a) Current ratio of 2.5 : 1
Thetraditionalbalancesheetrevealsthefinancialpositionofanorganizationbymentioningnotonlythesourcesofitsresourcesbutalsothedeploymentofitsresources.However,suchastatementfailstoidentifythefactorsthatareresponsibleforthechangeinthefinancialpositionoftheorganizationbetweentwofinancialperiods.Theidentificationandanalysisofthesaidfactorsareessentialastheyhaveadirectimpactontheworkingcapital.Itispertinenttomentionhere that themanagementofworkingcapitalhas alwaysbeenrecognizedasaprerequisiteforthesmoothfunctioningoftheorganization.Therefore,themanagementalwayspreferstohaveastudythatwouldhelpittoidentifyandanalysethefactorsthatresultinthechangeofworkingcapital.Infact,suchchangesgenerallytakeplaceeitherduetoaninfloworoutflowoffundwhichisnotrevealedbythetraditionalbalancesheet.Themostpopularframeworkusedforthispurposeisstatement of change in financial position. Thesaidstatementaimstodescribethechangesinthefinancialpositionofaconcernduringaparticularperiod.Infact,suchastatementprovidesthebasisforpolicyformulationbyactingasafinancialreportingmedia.Thestatementofchangesinfinancialpositionisalsoknownasfunds flow statement, where got were gone statement, management funds statement,etc.However,wemayusethetermfunds flow statementinthisbook.
Flowoffundreferstoabusinesstransactionthatcausesachangeintheamountoffund(workingcapital)thatexistsbeforethematurityofthetransaction.Theflowoffundisrecognizedfromthedegreeofchangeintheamountofworkingcapital.Ifatransactionincreasestheamountofworkingcapital,itisreferredtoas source of fund (inflow)whereasthetransactionthatdecreasestheamountofworkingcapitalresultsintheapplication of fund (outflow).Ifatransactionfailstocauseachangeintheamountofworkingcapital,itdoesnotamounttoflowoffund.Supposeacompanyhasafund(Currentassets–Currentliabilities)of`1,20,000on31December2019.On1January2020,itpurchasedacomputercosting `10,000thatbringsdeclineintheamountofcashtotheextentof ` 10,000which in turn decreases the amount ofworking by` 10,000.Accordingly,theamountoffundisreducedto`1,10,000(1,20,000–10,000).Thepurchaseofcomputeristreatedasflowoffund(outflow)becauseitbroughtachangeintheamountofworkingcapital(fund)from 1,20,000to 1,10,000.
After analysing the above example, it is clear that a change in theamountofworkingcapitalfrom 1,20,000to 1,10,000istheresultofchangeinthetwoitemsofthecompany.Firstly,theamountofcash(acurrentitem)is reduced by 10,000,andsecondly,theamountoffixedasset(non-currentitem)isincreasedbythesameamount.Fromthisfact,wecanconcludethat: • theflowoffund(changeinworkingcapital)occurswhenasimilar
• theflowoffund,i.e.,changeinworkingcapitalhasasimilarimpactbothoncurrentandnon-currentaccounts.Symbolically,thiscanbeexpressedas ∑∆WC = ∑∆ CA = ∑∆ NAwhere, ∑∆ =aggregatechangein WC=workingcapital CA = current accounts NA=non-currentaccountsThus,theaggregatechangeintheworkingcapitalofaconcernduringa
particularperiodcanbecomputedbyconsideringallchangeswhichoccurredeitherinthecurrentaccountsorinthenon-currentaccounts.Thechangeswhichoccurredinthecurrentaccountsasaresultofflowoffundarereflectedinastatementknownasschedule of changes in working capital,whereassimilarchangesinthenon-currentaccountsareshowninthestatement of changes in financial position alsoknownasfunds flow statement.
In the aboveparagraphswe saw that theflowof fund is identifiedbyanalysingchangesincurrentitemsandnon-currentitems.Therefore,itbecomesimperativetohaveadetailedlistofcurrentandnon-currentaccounts.
Current Accounts
Currentaccountsconsistofcurrentassetsandcurrentliabilities,like: • Current assets:
Solution (i)This transactionwill not affect theworking capital (fund) because
of its temporary nature. On one hand, current assets will beincreased by temporary investment in shares to the extent of `60,000,andontheotherhand,cashwillgooutofthebusinesswhichwillreducethecurrentassetbythesameamount.Hence,currentassetswillnotbeaffected.
Fundsflowstatementindicatestheamountofchangeinvariousbalancesheetitemsbetweentwoaccountingdates.Itshowsthesourcesandusesoffundsduring an accounting period. A funds statement is prepared in summary form toindicatechanges(andtrendsifpreparedregularly)occurringinitemsoffinancialconditionsbetweentwodifferentbalancesheetdates.AccordingtoAnthany,1970:
The funds flow statement describes the sources from which additional funds were derived and the use to which these sources were put.
Foulke,1976definesfundsflowstatementas:A statement of sources and application of funds is a technical device designed to analyse the changes in the financial condition of a business enterprise between two dates.
Totheauthorofthisbook,fundsflowstatement is a technique used to summarize the financial operations of an organization by studying the sources and application of funds during the accounting period.Suchastatementhelps to identify thechangeswhichhave takenplaceand todemonstratetheirimpactupontheliquidresourcesofthebusiness. Itprovidedaclearindicationofthechangeswhichhavetakenplaceinthefinancialpositionoftheenterprise, particularlyforthepeoplewhoarenotwellversedinreadingbalancesheets.
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Funds Flow StatementUses of Funds Flow Statement
Fundsflowstatementplaysasignificant role in theevaluationofoverallperformance. Such a statement provides insights into the financial andinvestingoperationsofabusiness.Itthrowslightonthefinancialstrategyofafirmandguidesfinancialexpertsintheinterpretationandpredictionsofthesame.TheNationalAssociationofAccountants,1971 intheirbulletinlistthefollowingusesofthisstatement: • estimatingtheamountoffundsneededforthegrowth; • improving rate of income on assets; • planningtemporaryinvestmentsofsurplusfundsandplanningforthe
workingcapital; • securingadditionalfundswhenneeded;and • planningthepaymentofdividends.Further,aneffectivefundsflowanalysiscanofferthefollowingbenefitstoabusinessfirm: • It helps themanagement in operating and investment decisionsby
uses of resources. • Itprovesameaningfultechniqueforeconomicanalysis.
Limitations of Funds Flow Statement
Despiteitsnumberofuses,thefundsflowstatementsuffersfromnumberoflimitationswhicharelistedbelow: • It fails to cover as sufficient information as disclosed by income
statementorbalancesheetandassuchcannotreplacesuchstatements. • It is of secondary nature as it is preparedwith the information as
suppliedbyfinancialstatements. •The statement ignores the changes inworking capital items, and
The changes in current accounts i.e., current assets and currentliabilitiesaretobecomputedbycomparingthefiguresforsuchaccountsinthecurrentperiodwiththatofthepreviousperiod.Theamountofchangesocomputedforeachitemofthecurrentaccountalongwithitsimpactontheamountofworkingcapitalistoberecordedinthescheduleofchangeinworkingcapital.
Nature of transaction Effect on working capital 1. Increaseincurrentasset Increase(+) 2. Decreaseincurrentasset Decrease(–) 3. Increaseincurrentliabilities Decrease(–) 4. Decreaseincurrentliabilities Increase(+)
4.3.2 Statement of Sources and Applications of Funds
For thepreparationof statementof sourcesandapplicationof funds,weshouldbeclearaboutthetermssources and applications.
Sources (inflow) refer to such business transactions that increasethe amount of fund (working capital) and applications (outflow)means such transactions that result in the reduction of fund.Asdiscussedalready,suchanincreaseordecreaseinthefundmaytakeplacewhencurrentandnon-currentitemsarechangedsimultaneouslyasaresult
Thedual-aspect concept of accounting suggests that the total amount ofsourcesof fundsmust reconcilewith the total amountof applicationsoffunds.Thisprincipalissimilartothatofthebalancesheetprincipalwheretotalassetsareequaltototalliabilities.Therefore,
Themainsourceoffundforanenterpriseisthefunds from operation thatrepresents actual amount of profit as generatedby the business. For thefundsflowstatement,thenetprofitasdisclosedbyprofitandlossaccountisadjustedinordertocalculatetheactualamountoffundfromoperation.Thisisdonetofindtheeffectoftheitemssuchasdepreciationanddistributionofprofits(generalreserve,dividend,provisionfortaxation),lossfromsaleofasset,etc.,onnetprofitwhichactuallydonotresultintheoutflowoffundbutweretreatedsointhepreparationofprofitandlossaccountofthefirm.Inthesameway,theimpactofitemslikedividendreceivedoninvestment,capitalgains,etc.,whichdonotrepresentincome(inflow)frombusinessoperation,mustbetreatedproperly.Theprocedureforadjustingprofitsasdisclosedbyprofitsandlossaccountinordertoascertainfundsfromoperationisasunder:
• As a non-current item: Underthisapproach,itisconsideredasanappropriationofprofitsandthusanon-currentliability.Accordingly,theamountofcurrentprovisionfortaxationistobeadjustedinthefundsfromoperationandtheactualpaymentoftaxappearsinthefundsflowstatementasanapplication.
• Interim Dividend: It is the dividendpaid in between twobalancesheetdates.Itisanon-operatingitemandassuchisadjustedinthecalculationofprofitsfromoperation.
• Depreciation: Thedepreciationisanon-funditemthatdoesnotresultin theflowofcash. It involvessimplyabookentrywithoutactualpaymentofcash.Thisentryinthebookaccountwhichdebitsprofitandlossaccountandcreditsthefixedassetaccount,reducestheamountofprofitandthebookvalueofthefixedassets.Assuch,depreciationdoesnotaffecttheamountoffund(workingcapital).Thus,theamountofdepreciationisadjustedinthecomputationofprofitsfromoperation.
• Preliminary Expenses: Preliminary expenses like depreciation isanon-fund itemwhichsimply involvesabookentry.Everyyearaportionofsuchexpensesiswrittenoffbydebitingthemtoprofitandlossaccount.However,thistreatmenttopreliminaryexpensesneitherresultsintheflowoffundnoritisconsideredasanoperatingcharge.Thus,theamountofpreliminaryexpenseswrittenoffduringthecurrent
• Creation of the Reserves: Sincereservesarecreatedoutofprofits,therefore,suchreservesconstituteanappropriationofprofitandnotanoperatingchargeagainstprofits.Further,thecreationofreservedoesnotaffecttheamountoffund.Therefore,thecurrentamountofthereserveistobeaddedbacktothenetprofittodeterminefundsfromoperation.
• Gain or Loss from the Sale of a Fixed asset: Firmsoftentransfergainorlossfromthesaleofassettoprofitandlossaccount.Thetreatmentofthisiteminthefundsflowanalysisisthatitistobeadjustedinthecomputationoffundsfromoperation,thisbeinganon-fundsitem.Thus,thegainfromthesaleoftheassetisdeductedfromthenetprofitandvice-versatodetermineprofitsfromoperation.
4.3.5 Preparation of Working Accounts and Notes (Hidden Transaction)
Solution:Apparentlyitlooksthattheamountofapplicationforthepurchaseofmachineryduringtheyear2012is`1,25,000(2,25,000–1,00,000).Butactually it is`1,55,000 (1,25,000+30,000).Thevalueofmachineryason31stDecember,2012(2,25,000)istheadjustedamountfromwhichthe
Working Note:Theincreaseinworkingcapitalisascertainedbysubtractingworkingcapitalof2011fromtheworkingcapitalof 2012.Theworkingcapitalfor2011 and 2012iscalculatedasunder:
=TotalCurrentAssets–TotalCurrentLiabilities (ason31stDec.,2012) (ason31stDec.,2012) = `1,16,000–`1,00,000=`16,000Therefore,increaseinworkingcapital=Working capital as on 31stDec.,
Additional Information: 1. An interim dividend of `35,000hasbeenpaidinIIyear. 2.Paymentofincome-tax`52,000waspaidduringIIyear. 3. Depreciation of 35,000and 42,000havebeenchargedonplantand
Note: The adjustment items (additional information) relating to provision for taxationandproposeddividendhavebeenomittedbecauseofbeingtreatedtheseitemeascurrentliabilities.
Alternatively,iftheseitemsaretreatedasnon-currentliabilitiesthen: (i)The current provison of such itemswill be added to profits in the
calculationoffundsfromoperation. (ii)Actual payment on these accounts during the current yearwill
appear in the fundsflow statement as application.However, underthis alternative these itemswill not be shown in the schedule ofchangeinworkingcapitalandasaresult,theworkingcapitalwillincrease by `24,000(12,000+12,000).Nowthepracticalsolutionofthisproblemwilltakethefollowingform.
in full paid shares of company.These assets consisted of stock` 64,920,machinery 55,080andGoodwill 60,000.Inadditionsundrypurchasesofplantwasmadetotalingto`16,950.
Cashflowhasrightlybeenrecognizedaslifestreamofasuccessfulbusinessasthereishardlyanybusinesstransactionthatdoesnotinvolvecash.Manyresearchstudieshaverevealedthatprofitableventureshavefailedbecauseofinsufficientcashandunprofitableoneshavecontinuedforlongperiodsbecause sufficient cashwas somewhat pumped into thebusiness system.Consequently,managementofcashhasemergedasastrategicareaforthegrowth andprosperity offirms in contemporary business, and therefore,hasreceivedconsiderableattentionofbothacademiciansandpractitioners.Recognizing the significance ofmanagement of cash in contemporarybusinessasastrategicresource,businessfirmsneedtocontrolandmonitorcashflowsefficientlyandeffectivelysothatadequatecashisavailabletomeettherequirementsofthebusiness.Toattainthisobjective,businessfirmsmakeuseofcash flow statement whichprovidesthemthedetailsaboutcashreceivedandspentonvariousactivitiesduringtheperiodunderstudy.
Cashflowstatementattemptstomeasuretheinflowsandoutflowsofcashthatresultfromvariousbusinessactivitiesduringaparticularaccountingperiod.Incashflowanalysis,attemptsaremadetoexplainthecausesofchangeinthecashpositionofaconcernduringtheperiod.Suchananalysishelpthebusinessfirmsinidentifyingtheareasofbusinessthateitherhavesurplusordeficitcashandaccordinglyhelptheminthecreationandutilizationofcasheffectively.Thus,cashflowstatementisatoolthatmanagersutilizetoevaluatetheirabilitytomanagecashefficientlyandeffectively.Therefore,acashflowstatementfocusesoncashratherthanonworkingcapitalasadvocatedbyafundflowstatement.TheInstituteofCostandWorksAccountantsofIndia,2000 definescashflowstatementas‘a statement setting out the flow of cash under distinct heads of sources of funds and their utilization to determine the requirements of cash during the given period and to prepare for its adequate provision’.
Totheauthorofthisbook,a cash flow statement is a statement which provides a detailed explanation for the change in a firm’s cash during a particular period by indicating the firm’s sources and uses of cash during that period.Suchastatementisonlyusefulformanagementanddoesnothaveanyutilityforexternalusers.
5.2.1 Difference between Cash Flow Statement and Fund Flow Statement
In fact, cashflow statement and fundflow statement donot differmuchwitheachotherasboththestatementsdepictthesamepicture—transactionswhichresultinthechangeoffinancialpositionduringaparticularaccountingperiod.CommentingonthedifferencebetweenthesetwostatementsMyer2,1961 isoftheopinionthatthough‘thesestatementscontainingessentiallythesamestoryoffinancialevents’havecertaindifferencesbetweenthemassummarizedbelow: •Afundflowstatementgivesabroadperspectivebyindicatingchanges
•The amount of information as containedby a fundflow statementprovidessufficientbasisforlong-rangeplanning.Incontrast,acashflowstatementtendstobemoreusefulinshort-runanalysis.
•Underfundflowanalysis, thechangesinworkingcapital itemsareshown in a separate statement known as ‘schedule of changes inworkingcapital’because fundflowstatement fails to indicate suchchanges.Incontrast,incashflowanalysischangesinbothcurrentandnon-currentaccountsappearinthecashflowstatement.Therefore,thepreparationofaseparatestatementtoindicatethechangesinworkingcapitalcomponentsdoesnotariseincashflowanalysis.
• Investment activities refers to such activities that result in eitherpurchaseorsaleoflong-termassets;
•Financialactivitiesincludeactivitiesthatareresponsibleforthechangeinthecompany’scapitalstructureandthereforeareconcernedwiththecapitalanddebtofthebusiness.Tomeet the above-mentionedobjective of cashflowanalysis, one
Themajorsourceofcash forabusiness iscash from tradingoperations.Whentheaccountingsystemisbasedoncashsystem,thenetprofitasshownbyprofitandlossrepresentsthecashfromoperations.However,inactualpractice,commercialorganizationsmaintainmercantilesystemofaccounting.With the result the profit as disclosed by profit and loss account is notconsideredtheactualcashfromoperationasitincludesmanytransactionsofnotionalcash.Thus,netprofitasshowninprofitandlossaccountistobeadjustedastoarriveatactualcashfromoperation.Thenon-cashtransactionslikeoutstandingincomes/expenses,prepaidexpenses,etc.,shouldbeadjusted.Furtherallnon-funditemssuchasdepreciation,preliminaryexpenseswrittenoff,etc.,arealsotobeadjustedasisdoneincaseoffundflowstatement.Adetailedproformaof the statement showingcomputationof cash fromoperationsisgivenbelow:
Statement Showing Computation of Cash from Operations
Particulars Amount(`)
Netprofit(asgiveninP&LA/c)Add:(a) Decrease in Current Assets:
Sundry debtorsBillreceivablePrepaidexpensesAccrued income
(b) Increase in Current Liabilities:Sundry creditorsBillspayableOutstandingexpensesIncome received in advance
(c) Non-fund items debited to Profit and Loss Account:DepreciationGoodwillwrittenoffLossonsaleofassetsPreliminaryexpenseswrittenoff
Less:(a) Increase in Current Assets:
Sundry debtorsBillreceivablePrepaidexpensesAccrued income
NOTES
Self-InstructionalMaterial 119
Cash Flow Statement and Analysis(b) Decrease in Current Liabilities:
Sundry creditorsBillpayableOutstandingexpensesIncome received in advance
(c) Non-fund items credited to Profit and Loss Account:Profitonsaleofassets
The analysis of cashflow statement provides a financialmanagersufficientbasis toassess thepositionof thefirm’scash thatcanbegeneratedinternallyasagainstthetotalamountofcashrequiredtomeetfutureobligationsoftheconcern.Withtheresult,properarrangementscanbemadewellinadvancefortheavailabilityofadequatecashifthefuturecashrequirementsofthebusinesscannotbemetinternally.
The analysis of cash flow statement can also help themanagement informulatingappropriatefinancialpoliciesregardingdebts,credits,collections,dividends,etc. • Ithelpsthemanagementininvestmentdecisions. •Acomparativeanalysisofthefirm’scashflowstatementsenablesa
5.3 PREPARATION OF CASH FLOW STATEMENT AS PER AS 3
The followingare the salient featuresof theAS3 (Revised):CashFlowStatements,issuedbytheCounciloftheInstituteofCharteredAccountantsofIndiainMarch1997.ThisStandardsupersedesAS3,ChangesinFinancialPosition,issuedinJune1981.
The standard has beenmademandatory for all enterprises fromaccounting period commencing or after 1.4.2001.
Objectives
Informationaboutthecashflowsofanenterpriseisusefulinprovidingusersoffinancialstatementswithabasistoassesstheabilityoftheenterprisetogenerate cash and cash equivalents andneedsof the enterprise toutilizethosecashflows.Theeconomicdecisionsthataretakenbyusersrequireanevaluationoftheabilityofanenterprisetogeneratecashandcashequivalentsandthetimingsandcertaintyoftheirgeneration.
The statement dealswith the provisionsof information about thehistoricalchangesincashandcashequivalentsofanenterprisebymeansofacashflowstatementwhichclassifiescashflowsduringtheperiodfromoperating,investingandfinancingactivities.
(1)Acashflowstatement,whenusedinconjunctionwiththeotherfinancialstatements, provides information that enables users to evaluate thechangesinnetassetsofanenterprise,itsfinancialstructure(includingitsliquidityandsolvency),anditsabilitytoaffecttheamountsandtimingofcashflowsinordertoadapttochangingcircumstancesandopportunities.Cashflowinformationisusefulinassessingtheabilityof theenterprise togeneratecashandcashequivalentsandenablesuserstodevelopmodelstoassessandcomparethepresentvalueofthefuturecashflowsofdifferententerprises.
(2) It also enhances the comparability of the reporting of operatingperformancebydifferententerprisesbecauseiteliminatestheeffectsofusingdifferentaccountingtreatmentsforthesametransactionsandevents.
Thefollowingtermsareusedinthisstatementwiththemeaningsspecified: (1)Cashcomprisescashonhandanddemanddepositswithbanks. (2)Cash equivalents are short term,highly liquid investments that are
(c) cash payments to acquire shares,warrants, or debt instruments ofotherenterprisesandinterestsinjointventures(otherthanpaymentsforthoseinstrumentsconsideredtobecashequivalentsandthoseheldfordealingortradingpurposes)
(1) Components of cash and cash equivalentsAn enterprise shoulddisclose the components of cash and cash equivalents and shouldpresentareconciliationoftheamountsinitscashflowstatementwiththeequivalentitemsreportedinthebalancesheet.
(2) Other disclosuresAn enterprise should disclose, togetherwith acommentarybymanagement,theamountofsignificantcashandcashequivalentbalancesheldbytheenterprisethatarenotavailableforuse by it.
Check Your Progress
4.Howare cash fromoperating activities to be reportedunder theindirectmethodasperAS3?
•A cash flow statement is a statementwhich provides a detailedexplanationforthechangeinafirm’scashduringaparticularperiodbyindicatingthefirm’ssourcesandusesofcashduringthatperiod.
•Cash flow statement: It is a statementwhich provides a detailedexplanationforthechangeinafirm’scashduringaparticularperiodbyindicatingthefirm’ssourcesandusesofcashduringthatperiod.
•Cash inflow:Itreferstoabusinesstransactionthatgeneratescash. •Cash outflow:Itreferstoabusinesstransactionthatutilizescash. •Mercantile system of accounting:Alsoknownasaccrual system,
under this system, the transactions (revenuesandexpenditures)arerecordedwhentheyoccurortakeplaceratherthanwhentheactualcashareexchanged.
Budgetarycontrolplaysasignificantroleinsustainingtheefficiencyofafirmasithelpsittoachieveitsgoalsataminimumcost.Budgetarycontrolas an effectivemanagement tool for planning and coordinating variousbusinessactivitieshelpsexecutivestoanticipatetheinfluenceandimpactofagivensetofeventsonthefirms’businessandtheirresources.Toserveasaneffectivetoolformanagerialcontrol,budgetarycontrolatthesametimeprovidesaproperyardstickfortheevaluationofactualperformance.Someauthorsbelievethatbudgetsservemoreeffectivelyasaplanningtoolthanacontrollingdevice.However,firmsneedtobringflexibilityintheirbudgetstomakethemworkasacontroldevice.Infact,budgetshelporganizationstoattaintheirobjectivesbyprovidingthefeedbacknecessaryformakingchangesintheplansinachangingbusinessenvironment.
Budget and Budgetary Control6.2 BUDGET AND BUDGETARY CONTROL:
MEANING
Budget is generally recognized as a plan of action to be pursued by anorganizationduringadefinedperiodoftimeinordertoachieveitsobjectives.Itisastatementofanticipatedresultsexpressedeitherinfinancialornon-financialterms.AccordingtoWilliamson(2003)A budget is a formal plan of action expressed in monetary and other quantitative terms.GordonandShillinglow(1974)state,Budget is a pre-determined detailed plan of action developed and distributed as a guide to current operations and as a partial basis for the subsequent evaluation of performance.
CIMA(1991)defines A budget is a financial or quantitative statement prepared prior to a definite period of time of the policy to be pursued during that for the purpose of attaining a given objective.
Sizer (1979) explains Budgets are financial and/or quantitative statements prepared and approved prior to a defined period of time of the policy to be pursued during that period for the purpose of attaining given objective.
To the author of this book,a budget is a detailed schedule of the proposed combinations of the various factors of production which the management deems to be the most profitable for the defined period. It may be a forecast of sales, production costs, distribution costs, and administrative and financial expenses–and, therefore, of profit or loss. It serves as a road mapforexecutivesandmakesthemawarewhenthecompanyisstrayingfromitsplannedroute.
Concept Of Budgetary Control
Commercialorganizationsalwaysaimtoattainthehighestvolumeofsalesattheminimumcostinordertomaximizetheirprofits.Toattainthisobjective,organizationsneedtorealizethatplanningandcontrolofactivitiesbecomeessential absolutely. It is, in fact, the systemof budgetary control thatprovidestheorganizationswiththeframeworkwhichhelpsthemtoachievethisobjective.
Budgetarycontrolisasystematicprocessdesignedtoplanandcontrolthemajoractivitiesofafirm’sbusinessthroughbudgetspreparedinadvancewithanobjectivetoensureeffectiveuseofresources.InthewordsofBatty(1978),Budgetary control is a system which uses budgets as a means of planning and controlling all aspects of producing and/or selling commodities or services.AccordingtoScott(1970),it is the system of management control and accounting in which all operations are precasted and so far as possible planned ahead and the actual results compared with the forecasted and planned ones.
Budget and Budgetary Control
NOTES
Self-Instructional 140 Material
CIMA(1991) definesbudgetarycontrolas,theestablishmentofbudgetsrelatingtotheresponsibilitiesofexecutivestotherequirementsofapolicyand the continuous comparisonof actualwithbudgeted results, either tosecurebyindividualactiontheobjectiveofthatpolicyortoprovideabasisfor its revision.
In theopinionofBrownandHoward (1975),Budgetary control is a system of controlling costs which includes the preparation of budgets, coordinating the departments and establishing responsibilities, comparing actual performance with the budgeted and acting upon results to achieve maximum profitability.
Totheauthorofthisbook,budgetary control is a process of managing an organization in accordance with an approved budget in order to keep total expenditure within authorized limits. It is designed to assist the management in deciding the future course of action and to develop the basis for evaluating the efficiency of operations.Thus,a budgetarycontrolconsistsof: •Preparationofbudgetsformajoractivitiesofthebusiness; •Measurementandcomparisonofactualresultswithbudgetedtargets; •Computationofdeviation,ifany;and •Revisionofbudget,ifrequired.
Thus, budgetary control requires preparation and designing of thebudgets revealing clearly the financial responsibilities of executives inrelationtotherequirementsoftheoverallpolicyofthecompanyfollowedbyacontinuouscomparisonofactualbusinessresultswithbudgetedresultstosecuretheobjectivesofthepolicy.Iftheprinciplesofbudgetingarecarriedoutinapropermanner,thecompanycanbeassuredthatitwillefficientlyuseallofitsresourcesandachievethemostfavourableresultspossibleinthelongrun.
6.2.1 Advantages and Limitations of Budgetary Control
Budgetarycontrolisperhapsthemostusefultoolusedbythemanagementforplanningandcontrollingmajoractivitiesofthebusiness.However,thesystemofbudgetarycontrolinitselfdoesnotensuregoodplanningorcontrolbutithelpsexecutivestoplanaheadandexercisecontroloverpeopleandoperatingevents.Infact,suchasystemnotonlyprovidesinformationonprobable future business results but also the resources likemoney,men,materialsandfacilitiesrequiredtoachievesuchresults.Themostnotablebenefitsderivedfromthesystemofbudgetarycontrolareasfollows: •Through itsdisciplinedapproach, itcoordinates theplanningofall
functionalexecutivestowardsthecommonprofitmakinggoal. •Motivates executives to think ahead by impressing upon them to
goalsandobjectivesagainstwhichtheycanevaluatetheirperformancewithoutanydifficulty.Suchanarrangementmakeseachmemberofthe organization clear about his role and contribution in attainingorganizationalgoals.
•Enables an organization to predetermine the benefits and costs ofthe projects under various alternativeoperating conditions.Such acomparativeanalysishelpsittoevaluatethemostappropriateallocationof resources.
Despitethebenefitsmentionedearlier,budgetarycontrolsuffersfromseriouslimitations.Managementmustkeepsuchlimitationsinmindwhileusingthetoolofbudgetarycontrol.Themajorlimitationsofbudgetarycontrolsystemaresummarizedbelow: •Since budget estimates are based on approximations and personal
•The installation of budgetary control system is a costly affair, andtherefore,smallorganizationsmaynotaffordit.Evenfinanciallysoundenterprisesmustadoptthissystemonlyafteranalysingproperlyitscostandbenefits.
•Budget targets sometimes are considered as pressure tacticswhichlowerthemoraleoftheemployees.
•Theremustbetestcheckingoftheworkatregularintervalsandtheresultsmust be comparedwith the targets. Shortcomingsmust beascertainedandmeasuresshouldbesuggestedtoovercomethem.
•Theremustbesomesystemforrewardingbetterresultsandpenalizingpoorresults.Incentivesforbetterworkmustbeprovided.Inefficiencymust not be condoned.
Requirements for Budgetary Control
Theprerequisites for goodbudgetary control are essentially the same asforsoundbusinessmanagement.Foreffectivebudgetarycontrol,thefirmsneed to: • developthestatementofobjectivesandpoliciestoguidemanagement
inreachingitsbusinessgoals; • build up a sound plan for the organizationwith clearly defined
Theconceptofbudgetarycontrolformalizestheprocessimpliedintheserequirementsbyincorporatingtheabovestepsintoacomprehensivefinancialplanorbudget.Itshouldbeobviousthatthefinancialplanorbudgetisnotjustaforecastorasummaryofthebusinessresultsayearahead.Itisinsteadaplanofoperation.Theplanmustbebasedongoodoperatingpracticesandsoundlyconceivedmanagementstrategy.Itshouldhaveacertainextentofflexibility,a‘stretch’init.Thismeansthatoperatingmenshouldincorporateinthebudgetperformance,goalsthatareattainablebyhardworkanddedicatedeffort.Aneasytestofwhetherornotabusinessbudgethasbeenbuiltongoodplanningandcontrolconceptistocheckthesepoints: •Sales and production requirements should be defined in terms of
quantitiesbyproducts. •The variable and total costs of producing each product should be
Differentauthoritieshavegivendifferentclassificationsofbudgets.Someclassify themon the basis of functions involved, period covered, natureof transactionswhile others classify them according to activity levels.Accordingly,thefollowingclassificationsaregiven:Budgetsaccordingtoactivitylevels: •Fixedbudget •Flexiblebudget
Althoughthisapproachtobudgetingisnotpopularamongthefirmsyetafewfirmsdousefixedbudget in certain areasof expensesmanagement.Generallyfixedbudgetisreferredtoaspredeterminedcostsprojectedataparticularcapacitylevel.Thatis,oncecapacityisprojectedataparticularlevel,theindividualdepartmentgathersandclassifiestheircostsatthatlevel.Thebudgetthuspreparedisknownasafixedbudget.Suchbudgetsassumethattheamountofrupeesshowninthebudgetistriggeredbythepassageof time irrespective of production levels or the volume of activity.TheCIMA(1991)definedfixedbudgetasabudgetwhichisdesignedtoremainunchangedirrespectiveofthelevelofactivityactuallyattained.InthewordsofWilson(1975) a fixed budget is one that is compiled for a given set of assumed operating conditions and for a clearly specified but estimated level of activity, and which management proposes to leave unchanged during the period to which it relates—regardless of changes in the actual level of activity experienced or in the conditions facing the company during that period.Thus,fixedbudgetisaplanthatexpressesonlyonelevelofestimatedactivityorvolume.Suchabudgetisalsoknownasstaticbudget.Theterm‘fixedbudget’isprobablyamisnomerbecausethisbudgetreallyisneverfixed.Businessandeconomicconditionsconstantlychangeandthemanagementhastoreviewandchangethebudgetsinthelightofthosechanges.
Flexible Budget
Firmsthatrecognizethetendencyoffixedoverheadtovarywithsubstantialchangesinproductionprefertouseaflexiblebudget.Thisissimplyaseriesof fixed budgets that apply to varying levels of production.AccordingtoCIMA(1991),aflexiblebudget isa budget which, by recognizing the difference between fixed, semi-fixed and variable costs, is designed to change in relation to the level of activity attained.Thus,aflexiblebudgetisaseries
Budget and Budgetary Control
NOTES
Self-Instructional 146 Material
ofcostbudgets,eachpreparedforadifferentlevelofcapacity.Thecapacitylevelsaresetatpercentagesofcapacityorattheproductionofaspecifiednumberofunitsatsetlevelsofcapacity.Infact,costsarebrokendownintofixed,variable,andsemi-variableundervariouslevelsofcapacity.Althoughflexible budgets generally donot distinguish betweenvariable andfixedoverheadyettheyprovideasinglerateforbothtypesofoverheads.Thisrateisestablishedbydividingestimatedoverheadatthenormalproductionlevelbythenormalvolumeofproduction.
Flexible budgeting can be incorporated in one of twoways—step budget,whereinbudgetsaredevelopedfordifferentlevelsofoperation,orvariable budget,wherebudgetsarepreparedonavariablecostbasisprovidingprogressivelygreaterbudgetallowancesasthevolumeofactivityincreases.Businessexecutivespreferthetechniqueofflexiblebudgetingasitcanbeeasilyunderstoodby thesupervisorsatall levelsandwithalldegreesofeducationbecauseoftherealisticwayinwhichsuchbudgetsaccommodateactualoperatingconditionsintheplant.Themajorsignificanceofflexiblebudgetingisthatitprovidescompletelyrealisticbudgetamounts.Thereareverylesschancesforvariances,whichtoocanbetheresultof inefficientcontrolorchangesinoperatingconditions.Illustration 6.1: ThecostdetailsobtainedfromfinancialrecordsofSafaLtd.,forproductionof500unitsaregivenbelow:
Particulars Per Unit (`)
Material 40Labour 30Variableoverhead 12Sellinganddistributionexpenses(20percentfixed) 10Administrativeexpenses(40percentvariable) 15Fixedoverheads(`7,500) 15Sellingcostperunit 122
Youarerequiredtoprepareabudgetforproductionof:(i) 700units;and (ii) 900units.
Theoperatingbudgetisaplanoftheexpectedrevenuesandexpensesfromnormaloperationsandactivitiestobecarriedoutbytheorganizationinthefuture.Suchabudgetcontainsadetailedprogrammeofactivitiesthatafirmdesirestoperformduringthebudgetperiodwhichnormallyconsistsofoneyear.Theprofitandlossitemslikesales,production,distributionexpensesandadministrativeoverheadsarealsoprojectedinthisbudget.Infact,thebudgetoften states suchperformancemeasureswhicharenotapparentlyseeninthefinancialstatements.Thebestexamplesofoperatingbudgetsarerawmaterialbudget,inventorybudget,labourforcebudget,andsoonThenature and scope of various types of operating budgets are discussed in a latersectionofthisunit.
Capital Budget
Capitalbudgetisaplanreflectingtheinvestmentsofthebusinessinfixedassetsandoftenincludesamountsforlargeexpenditurethathavealong-termimpactonthefirm’sfinancialpositionandgrowth.Theactivitiesthatfallwithinthescopeofcapitalbudgetmainlyconsistsofprogrammesoninfrastructuredevelopment, output expansion, and increase inproductiveresources.Sincetheoutlayofcapitalbudgetisnormallyhigherascomparedtooperatingbudget,theyrequirecarefulplanning,analysisandevaluation.Suchbudgets,infact,aimtocontributemaximumtotheorganizationalgoalsand objectives.
Tomeetthedemandsofgrowingbusinessandcompetition,firmsneedtomovebeyond theshort-rangeplan to lookaheadformore thanoneyear.Long-termbudgetsmaycoverperiodsof one, three,five and evenmoreyearsdependinguponthenatureofthebusiness.AccordingtotheNationalAssociationofAccountants,America,along-termbudgetisa systematic and formalized process for purposeful directing and controlling future operations towards a desired objective for periods extending beyond one year.Theresponsibilityforthepreparationoflong-termbudgetsgenerallyrestswithtop-levelmanagement.Thetop-levelmanagementisgenerallyresponsibleforstrategicdecisionsconcernedwithgrowthandprosperityofbusiness.Sincethepreparationofsuchabudgetdemandsthestudyofbothinternalfactorsaswellasexternalfactorslikeindustrycompetition,economicgrowth,socialandculturalchange,and technologicaldevelopment, it calls for strategiccapabilitiesonthepartofmanagement.
Master Budget
Themasterbudgetsetsoutafirm’splanfortheoperationsandresourcesexpressedinfinancialtermsforagivenperiod.Itisasummaryofthebudgetschedulesincapsuleformmadeforthepurposeofpresentinginonereportthehighlightsof thebudgetperiod.TheCIMA(1991), defines itas,The summary budget, incorporating its component functional budgets which is finally approved, adopted and employed.
Davidsonandothers state,The master budget, sometimes called the comprehensive budget is a complete blueprint of the planned operations of the firm for a period.
Thus,themasterbudgetisanoverallbudgetofafirmwhichincludesall other small departmental budgets. It is network consisting ofmanyseparatebudgetsthatareinterdependent.Infact,themasterbudgetcontainsconsolidated summary of all the budgets prepared by the organization.Suchabudgetcoordinatesvariousactivitiesofthebusiness,directingthemtowardsacommongoal.Fewtopexecutivesofthebusinessaresuppliedwithcopiesofmasterbudgets.Suchabudgetisofnousetodepartmentalexecutives.Itdrawstheattentionofthemanagementtothoseissueswhichmustrequireimmediateattentionorwhichmustbeavoidedwithoutanydelaysintheinterestofthebusiness.Preparation of a Master Budget: Itisacomplexprocessthatrequiresmuchtimeandeffortbythemanagementatalllevels.Itincludesthepreparationofaprojectedprofitandlossaccount(incomestatement)andprojectedbalancesheet.Thepreparationofmasterbudgetinvolvesthepreparationof: • salesbudget; • productioncostbudget;
The following illustrationwill further clear the idea about thepreparationofsalesbudget.Illustration 6.2:MASCo.Ltd.operatestwosalesdivisionsbysellingtwoquality cement products—White andBlack in them.For the purpose ofsubmissionofsalesbudgettothebudgetcommittee,thefollowinginformationhasbeenmadeavailable.
Budgetsalesforthecurrentyearwereasfollows:Product Division I Division II
White 800 at ` 100 600 at ` 100Black 400 at ` 80 500 at ` 80
Actualsalesforthecurrentyearwereasfollows:Product Division I Division II
White 1,000at` 100 700 at ` 100Black 600 at ` 80 450 at ` 80
Thesalesdivisionofthecompanyhastakenthefollowingdecisionsat a meeting: (i)ThesalesmanagerobservedthatproductWhiteispopularbut
(ii)TheproductBlackhaslessmarketandthemainreasonresponsibleforitistheoverpriceoftheproduct.However,ifthepriceoftheproduct is reduced by 5,itisexpectedtogeneratemoredemand.
TheEXproductissoldat 5perunitwhereasproductsYEEandZEDaresoldfor` 4 and `7respectively,inbothmarkets.
The research department of the company submitted the followingproposalstobekeptinmindwhilepreparingsalesbudget: (a)ProductEXhasstiffcompetitioninfutureandasaresultofwhich
(c)The sale of productZEDmaydecline by 10 per cent due toentranceofnewfirmsintheindustry.
(d)With the help of an intensive campaign5 per cent additionalsalesovertheestimatedsalesareexpectedinallproductsinbothmarketsexceptofproductZEDinsuperiormarket.
The quantity ofmaterial so calculatedmust be increased by somepre-determinedpercentagetoallowforwasteandspoilage.Thequantityofmaterialrequiredforproductionandtherequiredinventorylevelwillyieldthequantitiesofeachmaterialwhichwillhavetobeavailableduringthebudgetperiod.Theavailablequantityofmaterialestimatedshouldbedeductedbytheinventoriesofrawmaterialatthebeginningofthebudgetperiod;theresultantmaterialquantityisthequantityofmaterialtobepurchasedduringthebudgetperiod.
Theestimationofmaterial requirements is the responsibilityof theproductionengineeringdepartmentwhiletheestimationofpriceatwhichthe rawmaterial couldbeprocured from themarket is the responsibilityofthepurchasingdepartment.Materialsbudgethelpsthefirmsnotonlyinkeepingwastageofrawmaterialundercontrolbutalsointhedeterminationofeconomicorderquantity.
Labour Budget: It is developeddirectly from the production budget. Itindicatesthequantityandcostofdirectlabourrequiredtomeetproductionneeds.Labourbudget discloses the requirementof the skilled aswell asunskilledworkersforcarryingoutthebudgetoutput.Itfixesupthenumberandclassofworkers,theirwages,incentives,trainingandotherconditionsofworkers.Toensureeffectiveplanning,coordinationandcontroloflabour,
Budget and Budgetary Control
NOTES
Self-Instructional 158 Material
thisbudgethastoprovidesufficientdetails includingtheamountofeachspecific labour operation required to produce each product.This budgethelpspersonneldepartmentindesigningappropriatehiringandtrainingofqualifiedpersonnel.Thus,labourbudgetisessentialnotonlyforproductionplanningbutalsoforplanningpersonnelresources.
The quantity of labour required tomeet production needs can beestimatedeitherfromstandardsorfromrecordsofpastperformance.Thesimplewaytocomputethequantityoflabourrequirementistodividetherequirednumberofunitsoffinishedproductsbythenumberofdirectlabourhoursrequiredtoproduceasingleunit.Foralabourmix,aseparatecalculationistobemadeforeachtypeoflabour.TheresultantismultipliedbythelabourcostperhourasisshowninIllustration17.6.Illustration 6.6: TheGreat Ess Industries Ltd. manufactures threeproducts—X,YandZ.Theenterprisehasdecidedtoproduce2,500,4,000and7,000unitsofX,YandZrespectivelyforthemonthofMarch.
Manufacturing Overhead Budget: Themanufacturingoverheadbudgetisascheduleshowingtheexpectedamountofmanufacturingcostthatwillbe incurred for the budgeted level of activity.Manufacturing overheadsconsistsoffixed,variableandsemi-variablecostcomponents.Asdiscussedearlier,variableoverheadcostschangeproportionatelywiththevolumeofproductionwhereasfixedoverhead costs remain constant irrespective ofoutput.Thesemi-variableoverheadcostsalsochangewiththeoutputbutnotproportionately.Managementhastousesomeequitablebasistoapportion
NOTES
Self-InstructionalMaterial 159
Budget and Budgetary Control
thefixedoverheadsandthefixedelementsofthesemi-variableoverheadstothevariousbudgetcentres.Therefore,thepreparationofthemanufacturingoverheadbudgetrequiresexperience,knowledge,expertiseandintelligenceonthepartofthosepreparingthebudget.Expenses Budget: Once the production plans have been designed, theoverheadsneed to be determined to produce the products.Departmentalmanagers ordinarily prepare their own budgets for indirect labour andoverhead factors.Expenses budget consists of several sections, namely,factory overheads, administration expenses, and sales and distributionexpenses.These budgets are prepared on the basis of figures of incomestatementsofthepreviousyears.Aproperdistinctionofrecurringandnon-recurringismadewhilepreparingthesebudgets.
Theexpensesbudgetformatisgivenasunder:
...... Co. Ltd.Expenses budget (For the Year Ending .......)
Soloman,(1968)‘thecashbudgetisananalysisofflowofcashinabusinessoverafuture,shortorlongperiodoftime.Itisaforecastofexpectedcashintakeandoutlay’.Thecashbudgetconvertsallplannedactionsintocashinflowsandcashoutflows.Thus,itshowstheanticipatedflowofcashandthetimingofreceiptsanddisbursementsbaseduponprojectedrevenuesandexpenses.Thisbudgetissignificantbecauseithelpsmanagementinplanningto avoid unnecessary idle cash balances on the one hand and avoidableexpensiveborrowingsontheother.Itindicatesnotonlythetotalamountoffinancingrequiredbutitstimingaswell.Thecashbudgetgenerallyconsistsofthefollowingtwomajorsections,viz.,receiptsectionandpaymentsection.
on, • saleproceedingsfromcapitalassets; • sharecapitalanddebentures;and • loansandoverdrafts.
Thepaymentsectionofthecashbudgetconsistsofallcashpaymentsthatareplannedforthebudgetperiod.Thesepaymentswillincludepaymentsformerchandiseandoverheadacquiredorincurredforthecurrentbudgetperiodaswellasforpayablesonthepastbudgetperiod.Paymentsonvariousaccountsarenotmadesimultaneouslywiththecost incurredormaterialsand services used.The expenditure onvarious items like insurance, rentand advertising are often paid in advancewhile payments formaterials,labourandothercostsofoperationfrequentlyfollowacquisitionanduse.Capitalexpendituresforexpansionandreplacementinadditiontomandatoryexpenditures for a variety of other purposes such as taxes, donations,repaymentsofloans,dividends,andsoonmustbetakenintoaccount.Themajor items of payments are:
Thedifferencebetweencashreceiptsandpaymentsrepresentscash overage or shortage.Ifashortageexists,thecompanywillhavetoarrangethecashthroughbankloansorotherfinancingmethods.Ifanexcessexists,fundsborrowedinpreviousperiodcanberepaid,ortheidlefundscanbetemporarilyinvested.
(i)Cashbalanceson1stAprilwas`35,000. (ii) 50 per cent of sales are on credit basiswhich are realised in the
subsequentmonth. (iii)Suppliersarepaidinthemonthfollowingthemonthofsupply. (iv)Delayinpaymentofwagesandoverheadsis30days. (v)Dividendson investments amounting` 10,000maybe received in
Adjusted Profit and Loss Method: Underthismethod,theprofitforecastforthebudgetperiodisadjustedfornon-cashtransactionsandforexpectedchangesinassetsandliabilitiesnotinvolvedinthecalculationofprofit.Thus,netestimatedprofitforthebudgetperiodisincreasedbytheamountofno-cashtransactionslikedepreciation,provisions,outstandingexpenses,andsoon,whichinturnisaddedbycapitalreceipts,reductioninassetsandincreaseinliabilitiestoformtotalcashreceipts.Theamountsocalculatedisreducedbytheamountresultingfrompaymentofdividends,pre-payments,increaseinassetsanddecreaseinliabilities.Theresultantfigurewillbetheamountofcashavailableattheendofthebudgetperiod.Thetopmanagementalwayspreferstouseadjustedprofitandlossforcashforecastingbutmostfirmsarecompelledtousetheline-by-lineestimatetoprovidethedetailedinformationneededbylowermanagementlevelsforcontrol.Theessentialinformationfor
Balance Sheet Method: Underthismethodthecashbalancesattheendiscomputedwiththehelpofaprojectedbalancesheet.Theprojectedbalancesheet beginswith the current balance sheet and the same is adjusted inaccordancewiththedatacontainedintheotherbudgets.Allthebalancesheetitemsexceptcashbalancesareadjustedinthelightofchangesthatmighttakeplacebetweencurrentbalancesheetandtheprojectedbalancesheet.Thedifferencebetweenprojectedassetsandprojectedliabilitiesrepresentscashbalance.Illustration 6.9:With the data given in Illustration 6.8 prepare the cashbudgetunderthebalancesheetmethod:Solution
Total 10,628 36,79,760 9,900 34,45,000 10,500 36,05,000
Budget and Budgetary Control
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Self-Instructional 166 Material
Illustration 6.11: SuperSweetCompanymanufacturestwoproductsYandZandrequestyoutoprepareproductionbudgetandmaterialsbudgetfromtheinformationgivenbelow: (a)Salesdivisionreports that thedemandforYandZproductsof the
Y ZMaterialrequired 10,400 22,900MaterialA=20,800unitsforYand68,700unitsforZ=89,500MaterialB=31,200unitsforYand22,900unitsforZ=54,100Quarter 3rd
Y ZEstimatedProduction(Units) 10,800 9,800MaterialrequiredMaterialA=21,600unitsforYand29,400unitsforZ=51,000MaterialB=32,400unitsforYand9,800unitsforZ=42,200
•Aflexible budget is a budgetwhich, by recognizing thedifferencebetweenfixed,semi-fixedandvariablecosts,isdesignedtochangeinrelationtothelevelofactivityattained.
• Budgetary control:Itisasystematicprocessdesignedtoplanandcontrol themajor activities of a firm’s business through budgetsprepared in advancewith an objective to ensure effective use ofresources.
products. STARCo.Ltd.,were enjoying 60 per cent share of thismarket.However, ithasbeenestimated that thecompany’smarketsharewillgodownby20percentforthebudgetperiod.ThesellingpriceofthePEEproductis 20perunit.Thecostdetailsoftheproductare given as under:
Rawmaterial ` 6 per unit Directlabour ` 3 per unit Variableexpenses ` 1 per unit Fixedoverhead `30,000 Prepareasalesbudgetofthecompanyfortheyearshowingcost
ofproductionandgrossprofit. 6.Themanagement of an industrial companydecided to sell 90,000
unitsofBluediamond.Theengineeringdepartmentofthecompanyreportedthatthemanufacturingoftheproductwillrequiretwotypesofmaterial—BEEandDEE.EachunitoftheproductwillrequiretwounitsofBEEandoneunitofDEE.TheestimatedcostoftheBEEandDEEis` 5 and ` 7respectively.Thestockbalancesasdecidedbymanagement are:
It is reported that fixed expenses remain constant for alllevels of production. Semi-variable expenses remain constantbetween 45 per cent and 65 per cent of capacity, increasing by 10percentbetween65percentand75percentcapacity,andby20percentbetween75percentand100percentcapacity.
Forecasted Trading and Profit and Loss Account for the year ending 31st March, 2012
Particulars (`) Particulars (`)
ToOpeningstock 6,000 BySales 1,20,000
ToPurchases 90,000 ByClosingstock 15,000
ToGrossprofitc/d 39,000 –
1,35,000 1,35,000
ToSalaries 3,750
Add:Outstanding 750 4,500 ByGrossprofitb/d 39,000
ToDepreciation: ByInterestreceived 150
Machinery 3,000
FurnitureandFixtures 1,500 4,500
ToAdministrative
Expenses 5,250
ToDistributionexpenses 3,750
ToNetprofitc/d 21,150
39,150 39,150
ToDividendspaid 15,000 ByBalanceb/d 13,500
ToBalancec/d 19,650 ByNetprofit 21,150
34,650 34,650
Additionalinformationfortheforthcomingyearisasfollows: (i) Sharecapitalissued`15,000 (ii) Debenturesissued`3,000 (iii) On31stMarch,1990,debtorswere`30,000,creditors`45,000andbuilding`
60,000.
6.8 FURTHER READINGS
Sahaf,M.A.2013.Management Accounting: Principles and Practice,3rdedition.NewDelhi:VikasPublishingHouse.
Arora,M.N.2012.A textbook of Cost and Management Accounting,10thedition.NewDelhi:VikasPublishingHouse.
Maheshwari,S.N.,SuneelK.andSharadK.2018.A Textbook of Accounting for Management,4thedition.NewDelhi:VikasPublishingHouse.
Standard Cosing
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UNIT 7 STANDARD COSTINGStructure 7.0 Introduction 7.1 Objectives 7.2 Meaning of Standard Costing
7.2.1 Advantages and Limitations of Standard Costing 7.3 TheStandardCostingSystem 7.4 AnswerstoCheckYourProgressQuestions 7.5 Summary 7.6 Key Words 7.7SelfAssessmentQuestionsandExercises 7.8 FurtherReadings
7.0 INTRODUCTION
Tomeet the growing demands of competition, firmsmust continuouslysearchforwaystoattainmaximumoperatingefficiency.Theycanattainthisobjectivebymakingoptimumuseoftheiravailableresources.Consequently,managerialactionsneedtobedirectedtowardsdeficienciesandareasforimprovementthatcanhavethegreatestimpactonthefirms’operatingresults.This requires that themanagementmust not only have appropriate andtimelyinformationonwhattheresultsarebutmostimportantlymustalsoknowhowtheseresultssoundincomparisontothepotentialcapabilitiesoftheoperation.Itiswithinthiscontextthatthestandardcostingandvarianceanalysisbecomeanessentialpartofanyusefulsystemofcontrol.
InthewordsofBigg(1975)standardcostingisasystemofcostingwherea comparison is made of the actual cost with a pre-arranged standard and the cost of any deviations (called variances) is analysed by causes. This method permits management to investigate the reasons for these variances and to take suitable corrective action. It is, therefore, a system of cost control as well as cost ascertainment.
According to theChartered Institute ofManagementAccountants,London,Standard costing is the preparation and use of standard costs, their comparison with actual costs and the analysis of variances to their causes and points of incidence.
Brown andHoward state,Standard costing is a technique of cost accounting which compares the ‘standard cost’ of each product or service with the actual cost, to determine the efficiency of the operation, so that any remedial action may be taken immediately.
Totheauthorofthisbook,standardcostingis a system which attempts to predetermine costs with an aim to measure the efficiency of production. It calls for the determination of standard costs and their application to managerial problems particularly those problems relating to product costs and departmental cost control.Thus,understandard costing system predeterminedcostsarecarefullycomputedwhicharethencomparedwithactual cost to aid in cost control.Accordingly, standard costing systeminvolvesthefollowingsteps:
•Price factors: Standard cost per rupee and per hour bywhich thestandardquantitiesareconvertedtothestandardproductcost.The quantitative factors are based on engineered specifications
For control purposes, various actual activities of a period such asquantityofeachtypeofmaterialused,labourhoursworkedandmachinehoursinvolved,aswellasunitsofgoodsproducedaremultipliedbyappropriateunitstandardcosttoestablishstandardcosttotalsforworkperformancebyjoborprocessandbydepartment.Theactualcostsoftheseactivitiesarethencomparedwiththestandardcostsandtheresultingvariancesareexaminedso as to:
• aidtheinterpretationoffinancialresultsfortheperiod;• fixtheresponsibilityfornon-standardperformance;and• focus attention on areas inwhich cost improvement should be
sought.
Standard Costing Vs. Historical Costing
Standardcostingdiffers fromhistorical costingonanumberofgrounds.However,themaindifferencesareasunder: •Standard costing acts as a controlling device that does not only
Standard Cosing •The scopeof standard costing startswell before the start of actualproductionwhereastheapplicationofhistoricalcostingbeginsaftertheproductiontakesplace.
• Installation of the standard costing system requires intelligence,technicalskillandexpertiseonthepartofthemanagementwhereasthehistoricalcostingsystemcanbeinstalledwithordinarycapabilities.
Budgetary control covers all aspects of the business, for example,production,purchase,sales,finance,incomes,expenditure,etc.Ontheotherhand,standardcostingtechniqueislimitedonlytoproductionand production cost.
•Budgetarycontrolsisemployedtoformulatebusinesspolicieswhereasstandardcostinghelpsmanagementincostascertainmentandfixationof sellingprice and at the same time attempts to keep the costs atminimumlevel.
•Thepartialintroductionofbudgetarycontrolinanyorganizationcaneasilybedone.Forexample,themanagementwouldbeinterestedtoapply thebudgeting system in the important areasofbusiness likecapitalprojects,researchanddevelopment,etc.Itcandoitwithoutmuchdifficulty,however,partialinstallationofthestandardcostingsystemwillnotbeofanyusetothebusiness.
•Under standard costing system, the analysis of variances ismadeaccording to their originating causeswhich is not true in case ofvarianceanalysisinbudgetarycontrol.
•An effective standard costing system involves standardization ofproductswhichisnotnecessarilyrequiredforbudgetarycontrol.
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7.2.1 Advantages and Limitations of Standard Costing
acontinuousdetailedexaminationofall important functionsof theconcern.Italsoresultsinreductionofcosts.
• It provides continual incentives formanagement to keep costs andperformanceintunewithpredeterminedobjective.Thecomparisonbetween actual costs and predetermined standards ismuchmoreeffectivethanacomparisonbetweencurrentactualcostsandactualcosts of prior period.
•Standardcostingsystemmakespossibleforthemanagementtopaymore attention toweak areas that require control as it follows theprincipleofmanagementbyexception.
The standard costing system is designed to furnishmanagementwith ameasure thatwill help it inmakingdecisions regarding the efficiencyofoperations.Asoundstandardcostingsystemconsistsofsixmainactivities,viz., •Establishmentofcostcentre; •Determinationofthequalityofstandard; •Organizationofstandardcosting; •Settingofstandards; •Actualcostaccumulation;and •Analysisofvariance.
Ideal Standards: Theyaresetat the levelofmaximumefficiency,representingconditionsthatcanseldombeattained.Suchastandardfailstopayanyattentiontonormalmaterialsspoilageandidlelabourtime.Thistypeofstandardcanbeusedasthestandardofperfectionratherthanastandardforthemeasurementofpracticalresultsbecauseconditionsthatsatisfyidealstandardsareextremelyrare.Overanyextendedperiodoftime,itwouldbeimpossiblefortheactualactivitiestoequaltheidealstandard.Onthis
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pleasuchstandardsarealsocalledtheoreticalstandards.Thesettingofsuchstandardsmaymotivateemployeestoincreasetheiroutputtothemaximumbut if the standards are still not attained theirmoralemay be seriouslyaffected.However,idealstandardsaremoreeffectivefordirectmaterialcostsandusage.Theapplicationofidealstandardmakesvarianceaccountslesssignificantforcontrolpurposes.
Normal Standards: Theycanbeachievedbyefficientworkingandmanagement.Theyallowfornormalworkersperforminginnormalsettings.Suchstandardsaresetaftertakingintoconsiderationtheconditionsthatareexpectedtoprevailoveralongperiodoftimesufficienttoreflecttheeffectsofseasonalandcyclicalfluctuations.Thesestandardsareofgreatsignificanceformanufacturingoverheadexpenses.
Attainable Standards: Theyarebasedonpastperformanceandcanbeachievedwithreasonableeffort.Perhapsthestandardsshouldbesomewhatlowerthanwhatcanbeachievedbyearnesteffort.Suchstandardsaresetascloselyaspossibletothatlevelwhichrepresentsanticipatedconditions.Theyallowforusualproductionproblemssuchasdowntimeformaintenance,employee errors, or occasional inventory shortages.These standards aremore realistic and satisfactory and thus represent desirable performance.Attainable standards are particularly useful in settingprice standards formaterialandlabour.
Organization of Standard Costing
Thepracticesofstandardsettingvaryfromfirmtofirm.Managementshouldtakesufficientcareinsettingstandardsbecausetheefficiencyofastandardcosting system largely depends upon the accuracy and reliability of thestandards.Inthepast,thejobofstandardsettingwastheresponsibilityofthecostaccountant.However,keepinginviewthedynamicconditionsofthepresentbusiness,itrequiresthecombinedthinkingandexpertiseofallpersonswhoareresponsibleforfixingpricesandquantitiesofinputs.Againstthisbackground,almostineverybigorganization,atpresent,thisfunctionisdischargedbyastandard committee consisting of representatives from various concerneddepartmentsoftheorganization.Thesaidcommitteeestablishesandmonitorsstandardsforvariouscostsandactivitiesandisalsoresponsiblefor changing and updating the standardswhen required. In determiningthereliablestandards,thecommitteemustanalyseandinvestigateallsuchvariablesandfactorsthathavedirectbearingontheworkers’performance.
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Standard CosingThe important among them are: • employee’sattitude; • organizationalstructure; • governmentregulations; • performancefeedback;and • labour–managementrelations.
Setting of Standards
Oneoftheimportantcomponentsofthestandardcostingsystemisthesettingofstandardstheevaluationofactualresults.Itincludesdetailedestimatesofmaterialquantitiesandprices,labourquantitiesandprices,andoverheadquantities and rates.These details serve as the benchmarks of efficiencyagainstwhich actual quantities and costs are compared.Accordingly,standardsareneededtobefixedforeachandeveryelementofcost,viz., • directmaterial; • directlabour;and • overheads.Direct Material Standard: Itrepresentstheamountofmaterialcosttobeincurredforproducingaunitofoutput.Thematerialcostisalwaysaffectedbythepriceandquantityofmaterial.Accordingly,themanagementhastosetstandardsbothformaterialquantityandformaterialprice.
Thequantityofrawmaterialitemsrequiredtomanufactureaunitofoutputisthematerial quantity standard.Thus,itisaprocessthatdeterminesthe quantity ofmaterial that should be priced to produce each unit it ismanufactured. In calculating the rawmaterial required to be included inthe standard,considerationmustbegiventomanufacturingscrap,normalmaterialwastage,spoilage,etc. Material price standard ispre-determinedpricetobepaidforobtainingtherawmaterialfortheoutput. Astandardpriceissetforeachclassofmaterialtobepurchased.Thesestandardsshouldtakeinto consideration economicorder quantities, volumediscounts, inboundtransportationandexpectedshortrangepricingtrends.
Direct Labour Standards: Just as it is necessary to set standardsformaterialtofixuponaunitcostthatmaybeusedinallcases,regardlessoffluctuationsbothinpricesandintheamountofmaterialused,itisalsoessentialtofixdirectlabourstandardstodetermineaunitlabourcostwhichwillremainfixedinspiteofdifferentratesofpayanddifferentperiodsoftimerequiredtodothetask.
Direct labour standard represents the amount of labour cost to bechargedtototaloutputcost.Itiscomputedbymultiplyingstandardlabourratebystandardlabourtime.Thus,directlabourstandardrequiressettingoftwostandards,viz.,labour time standardandlabour rate standard.
Standard Cosing
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Thestandardtimerequiredtoperformeachlabouroperationthatentersintoproductionforproducingaproductisknownaslabour time standard.Suchstandardsareoftenestablished fromworkmeasurementsand time-and-motionstudies.Dueconsiderationshouldalsobegiventotheincentivesofferedtothelaboursinsettingthesestandards.Thesettingoflabourtimestandardrequiresaconsiderableamountofprofessionalmeasurement.Basedonacertainamountofsubjectivity,thesestandardsareoftenlesscertainandmoresensitivetovariationthanmaterialstandards.
Labour rate standard isthepredeterminedlabourratetobechargedtotheoutputcostforservicesrenderedbyalabourontheoutputjob.Thefixationofsuchastandardrequirescarefulattentiontothecompany’swagepaymentmethod.Standard labour rates are often the result of collectivebargainingagreementandunioncontracts.Themanagementhastoidentifytheclassoflabourssuitableforeachoperationandaccordinglyhastofixratesforeachgroup.Thus,thestandardwagerateisusuallyacompositeofmanywageratesassumingaspecificmixofemployeeskills.
Overhead Standards: Overheadstandardsaresetforvariableandfixedoverheads.AccordingtotheCharteredInstituteofManagementAccountants,London, a variable overhead is a costwhich tends to vary directlywiththevolumeofoutputwhereasfixedoverheadisacostwhichtends tobeunaffectedbyvariance in volumeof output.Such standards are set aftercarefulstudyofcost–volumeanalysis.Theseparationoffactoryoverheadcostsintofixedandvariablecomponentsallowsnotonlythepredictionofcostsbutalsoadetailedexaminationofhowcostsbehaverelativetovolume.Thisprovidesanopportunitytomanagementtostudythecoststructureinrelationtovolumesofoutput.
Actual Cost Accumulation
Theestablishmentofstandardsisfollowedbytheaccumulationofactualcostswhicharethencomparedwithstandardsinperformancereports.Foraccumulatingactualmanufacturingcost,firmsuseeitherajobordersystemor a process cost system.The applicationof standard costinggetsmuchinformationfromthecostdatathanispossiblewithjustactualcosts.Asoundsystemofstandardcostingwillhelpthemanagementdeterminethetypeofrequiredcostdataandreportsuchdata.
Analysis of Variances
A variance represents the difference between an actual cost and itscorrespondingstandardcostsofmaterial,labourandoverheads.Thevarianceisthemeasureofinefficienciesorefficiencies.Theobjectivesofvarianceanalysisareto:
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Self-InstructionalMaterial 185
Standard Cosing • indicatewhethercostsarebeingkeptundercontrol. • locateanyapparentdeficiencyincostcontrolefforts. • facilitatetheidentificationoftheprobablecausesofdeviationfrom
Aseriousproblemfacedbythefirmsistodeterminewhenstandardsshouldberevised.Thesettingupofstandardforcostingisanoperationthatrequirescareful investigation and calculation. Consequently standards are notalteredexceptwhenconditionsonwhichsuchstandardsarebasedundergoconsiderable change.Usually changes in product specification, apparentpermanentchangesinmaterialprices,changesinmethodsofusinglabour,changesinlabourrates,etc.aresituationsthatrequirerevisionofstandards.Thuschangeinstandardsissubjecttoachangeintheconditionsuponwhichtheyarebased.However,someexpertsfeelthatrevisionofstandardsshouldbeacontinuousprocess.Accordingto themtheunrevisedstandardsmayfailtoevaluateperformanceproperly.Therefore,managementmustrevisestandardswhenever quantity or price changes significantly so that theycorrespond to current conditions.
1.Budgetarycontroliswiderinscopeascomparedtostandardcosting.Budgetary control covers all aspects of the business, for example,production,purchase,sales,finance,incomes,expenditure,etc.Ontheotherhand,standardcostingtechniqueislimitedonlytoproductionand production cost.
2.Standard costing systemmakes it possible for themanagement topaymoreattentiontoweakareasthatrequirecontrolasitfollowstheprincipleofmanagementbyexception.
3.The important factors that have a direct bearing on theworkers’performanceinclude:• Employee’sattitude;• Organizationstructure;• Governmentregulations;• Performancefeedback;and• Labour-managementrelations.
5.Theestablishmentof standards is followedby theaccumulationofactualcostswhicharethencomparedwithstandardsinperformancereports. For accumulatingmanufacturing cost, firmsuse either joborder system or a process cost system.
Standard Cosing •The standard costing systembeginswith the establishment of thecostcentrewhichisusuallyaprocess,oranoperationoranitemofequipmentetc.Itisaunitofactivitywithinthefactorytowhichcostsmaybepracticallyandequitablyassigned.
8.2 VARIANCES ANALYSIS : MEANING, SIGNIFICANCE AND TYPES
Varianceisthedifferencebetweenactualcostsandstandardcostsduringanaccountingperiod.Itreferstovariationofactualresultswithplannedresults.Varianceanalysisisasystematicprocesswhichanalysesandinterpretsthevariances. It refers to thebreakingdownof total variances intodifferentcomponents.Normally,variancescantaketwoforms,viz.,
Variance Analysis
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Self-Instructional 190 Material
•Favourable variances—whenactualcostsarelessthanthestandardcosts; and
betweenvariances. • Ithelpsinassigningresponsibilityforeveryvariance. • Itisbeneficialforthecostcontrolandcostreductionprocess. • Itrevealsthedegreeofinefficiency. • It helps in communicating the unfavourable variances to the
management. • Itassistswithproperprofitplanning. • Ithelps increatingacost-consciousenvironment foremployees to
Let’s discuss each of these variances in the following sections.
8.3 DIRECT MATERIAL VARIANCE
As discussed earlier, standards may be established for the cost of obtaining materials and for the quantities to be used in production. Accordingly, actual costs can be compared against these standards and variances can be computed. With the result, basically there can be only two types of material variances viz., • pricevariance;and • usagevariance
Material Cost Variance (MCV): Material cost variance represents the differencebetweentheactualcostsandthestandardcostsofmaterialforaspecifiedoutput.Theactualcostiscomputedbymultiplyingactualpricewiththe actual quantity of material. In the same way standard cost is computed by multiplying the standard price with the standard quantity of material. Cost analysts can also develop other variances of material cost to meet specialized purposes of management. However, such variances may either be related to price, quantity or to the combination of price and quantity. Material cost variance can be expressed in abbreviated form as shown below:
MCV = (SP × SQ) – (AP × AQ)where
SP = Standard price SQ = Standard quantity AP = Actual price AQ = Actual quantity
Note: Standard quantity should be taken for actual output.
Variance Analysis
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Self-Instructional 192 Material
Illustration 8.1: Compute material cost variance for a output of 200 units from the information given below:
Standard quantity = 3 kg. per unit of outputStandard price = ` 2 per kg.Actual quantity consumed = 550 kg.Actual price = ` 3 per kg.
Material Price Variance (MPV):Thematerialpricevarianceattemptstomeasure the variance between the actual cost of material and the standard costexpectedtobepaidforthematerial.Itreflectstheactualunitofmaterialabove or below the standard unit cost, multiplied by the actual quantity of material used. Management sets price for each class of material. A systematic andscientificpurchasingfunctionwillattainthestandardprice.Thepaymentof lower prices by the purchasing department for a given quantity would result in a favourable material price variance and thereby maintain the required standard;whereaspurchasingdepartmentwillfailtomeetthestandardifitpayshigherpricesthatwillreflectanunfavourablematerialpricevariance.Thematerialpricevarianceiscomputedasfollows:Material price variance = (Standard price – Actual price) × Actual quantityor MPV = (SP – AP) × AQIllustration 8.2: Calculate material price variance from the information as given in Illustration 8.1SolutionMaterial price variance = (Standard price – Actual price) × Actual quantity MPV = (2 – 3) × 550 = 1 × 550 = ` 550 unfavourable.Material Usage Variance (MUV): Material usage variance is the deviation causedduetodifferenceinthestandardandactualquantitiesused.Itindicatesthe actual quantity of direct material used above or below the standard price. Thematerialusagevarianceiscomputedwiththehelpoffollowingformula:
TheManagementcananalysematerialpriceandusagevariancesandtheninvestigatethembyasking: •Whyhasexcessmaterialbeenused?(MUV=500UF) •What is the difference between actual and standard costs for the
material?(MPV=300F)Sub-variances of Material Usage Variance: Materialusagecanbefurthersub-dividedinto: •materialmixvariance; •materialrevisedusagevariance;and •materialyieldvariance.Material Mix Variance: Whenthemanufacturingoftheproductrequiresinputofmorethanonetypeofrawmaterial,thenrawmaterialsaremixedtogetherinstandardproportions.Thestandardproportionisimpossibletomaintainwhenthereistemporaryshortageofanytypeofmaterialbecausethesaidmaterialistobesubstitutedbyavailablematerial.Asaconsequence,thestandardmixofmaterialhastobechanged.Sincedifferentmaterialshavedifferentcosts,thecostofanactual(i.e.,non-standard)mixwillvaryfromthestandardcostofthestandardmixwhichgivesrisetoadirectmaterialmixvariance.
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Self-InstructionalMaterial 195
Variance AnalysisAccording to theChartered Institute ofManagementAccountants,London,materialmixvarianceisthat portion of the direct material usage variance which is due to the difference between the standard and actual composition of the mixture.Thisvariancecanbeexpressedbythefollowingformulas: •Materialmixvariance=(standardcostofstandardmix–standardcost
Materialmixvariance(MMV) = (SQ–AQ)×SPFormaterialX=(60–50)× 4 = `40(F)FormaterialY=(40–40)× 2 = 0FormaterialZ=(30–40)× 3 = `30(UF) 10(F)Thus,we found that difference inmaterialmix is the only cause
responsible formaterial usagevariance.However,when standardweightand actualweight ofmaterialmix varies, the quantity variance shall beduetomixaccompaniedbyotherreasons.UndersuchasituationMaterialUsageVariance(MUV)wouldbeequaltoMaterialMixVariance(MMV)andMaterialRevisedUsageVariance (MRUV).MaterialRevisedUsageVarianceiscomputedasfollows:Materialrevisedusagevariance=(Standardquantity–Revisedstandardquantity) × Standard price (MRUV)=(SQ–RSQ)×SP
Material Yield Variance: According to the Chartered Institute ofManagementAccountants,London, Materialyieldvarianceisthat portion of direct material usage variance which is due to the difference between the standard yield specified and the actual yield obtained.Itmaybeduetolowqualityofmaterial,mishandlingofmaterials,inefficientproductionsystems,etc.Iftheactualoutputislessthanthestandardoutput,thevarianceistreatedadverseandviceversa.Materialyieldvarianceistheonlyvariancewhichiscalculatedonthebasisofoutputwhereastherestarecalculatedonthebasis of input.
Material yield variance has the samenumerical results asmaterialrevisedusagevariance.Thus,theyrepresentthetwosidesofthesamecoinbecauseMYVrepresentsthedifferencebetweenthestandardoutputandtheactualoutputandiscalculatedonthebasisofactualoutputwhereasMRUViscalculatedonthebasisofinput.
Materialyieldvariance iscalculatedwith thehelpof thefollowingformula:Materialyieldvariance(MYV)=(Standardyield–Actualyield)×Standardrateor MYV=Standard lossofactualmix–Actual lossofactualmix × Standard cost per unitIllustration 8.7:SuperMaxCo.Ltd.whichhasadoptedstandardcostingfurnishesthefollowinginformation:
Labour variances are determined by comparing predetermined labourstandardswith the actual cost of productive labour. Such variances arecalculatedinthesamewayasmaterialvariances.Labourvariancesfallintothefollowingthreecategories: • labourcostvariance; • labourefficiencyvariance;and • labourratevariance.
Labour Cost Variance
Labour Efficiency Variance Labour Rate Variance
Labour Cost Variance: Labour cost variance represents the differencebetweenstandardlabourcostspecifiedfortheactivityandtheactuallabourcostpaidfortheactivity.Thiscanbeexpressedinanabbreviatedformasfollows:Labourcostvariance(LCV)=(standardlabourcost–actuallabourcost) OR LCV=(SH×SR)–(AH×AR)
Labour Efficiency Variance:Labourefficiencyhasdirecteffectonlabourcost.Labourefficiencyvarianceindicatesthenumberofactualdirectlabour(intermsofhours)workedaboveorbelowthestandardfortheactuallevelofproductionatstandardprice.Thelabourquantityvarianceismeasuredinmuchthesamewayasthematerialquantityvariance.Suchavarianceiscausedbyusingmoreorlesslabourthanthestandardfortheoutputproduced.Iftimeconsumedonactualworkislessthanstandard,labourhasbeenusedefficientlyandaccordinglylabourefficiencyvarianceisfavourable.Inthesameway, labour efficiency variance is unfavourablewhen actual timeconsumedismorethanthestandardlabourtime.Labourefficiencyvariancecanbedeterminedbyapplyingthefollowingformula:
Labour Rate Variance:Labourratevariancerepresentstheaverageoftheactualhourlyratepaidaboveorbelowthestandardhourlyrate,multipliedbytheactualnumberofhoursworked.Suchvarianceisoftencreatedbytransferringworkerswithhighpayratestojobsthatcallforlowstandardratesorbyauthorizingovertimeworkatpremiumpay.Thelabourratevariancemaybeexpressedasaformula:
Variance AnalysisTheabovelabourcostvariancecanbeanalysedgraphicallyasshowninFigure8.2.Idle Time Variance:Managementmustconsideridletimewhilecalculatinglabourcostvariance.Idletimerepresentstheamountofperiodforwhichworkers would not work due to abnormal happenings likemachinebreakdowns,powerfailure,lockouts,etc.Idletimemustbeseparatedfromactualworking hours otherwiseworkersmaybe blamed for an adverseefficiencyvariancewhichhas,infact,nothingtodowiththem.Thus,idletimevarianceshouldbesegregatedfromlabourefficiencyvariance.Idletimevariance is computed as under:
Labour Mix Variance (LMV):Likematerialmix variance, labourmixvarianceispossiblewheremorethanonetypeoflabourisusedforthejob.Labourmixvariancerepresentsthevarianceduetothechangeinstandardandactual labour forcecomposition.Thisvariance iscalculatedwith thehelpoffollowingformula: Labourmixvariance= (Revised standard hours –Actual hours) × Standard rate LMV=(RSH–AH)×SR
*LabourmixvarianceisalreadycalculatedinIllustration8.12.Labour Yield Variance (LYV):Itrepresentsthatportionoflabourefficiencyvariancewhich is due to difference between the standardoutput and theactualoutput.Iftheactuallabouroutputishigherascomparedtotherelativestandard,thenvariancewouldbefavourableandviceversa.Thelabouryieldvarianceisalwaysequaltorevisedefficiencyvariancebecausetheformeriscalculatedonthebasisofoutputwhilethelatteriscalculatedonthebasisofinput.Theformulaforitscomputationisasfollows:
Labouryieldvariance=Standardoutputforactualmix–Actualoutput × Standard cost per unit
Illustration 8.14: Inamanufacturingconcern,thestandardtimefixedforaunitis7hours.Astandardwagerateof`20perhourhasbeenfixed.Duringthemonth600unitswereproducedagainstastandardoutputof750units.Calculatelabouryieldvariance.SolutionLabouryieldvariance=(Standardyield–Actualyield)×Standardcostperunit =(750–600)×140* = 150 × 140 21.000unfavourable* Calculation of standard cost per unit:
Overhead costs are indirect costs ofmaterial, labour andother overheadthatcontainbothfixedandvariablecomponents.Theanalysisofoverheadvariance is somewhatdifficult thandirect costvariances.Thepurposeofoverheadvarianceanalysisistoseewhetherthepricepaidandthequantityusedforindirectelementsofcostvaryornotascomparedtospecifiedstandardfigures.Thus,overheadvariancerepresentthedifferencebetweentheamountofoverheadappliedtoproductionduringtheperiodandtheamountofactualoverheadcost incurredduringtheperiod.It is thedifferencebetweenthestandardoverheadand theactualoverheadassigned to theproducts.Thetotaloverheadvarianceiscomputedasfollowed:
IftheAFOislessthantheBFOonactualproduction,thevarianceisfavourableandviceversa.Fixed Overhead Volume Variance (FOVV):Thesecondvariancedevelopedin connectionwithfixedoverhead is thevolumevariance.This variancerepresentstheamountofdifferencebetweenoverheadsabsorbedonactualoutputandthoseonbudgetedoutput.Theunder-orover-absorptionoffixedoverheadsreflectsthattheconcerndidnotoperateatnormalcapacity.Themajorreasonsforthisvariancearepoorschedulingofproduction,improperuse of labour, strikes, lockouts, power failures, etc.Volumevariance ismeasuredbymultiplyingthebudgetedfixedoverheadratebythedifferencebetweenthebudgetedoutputandactualoutput.Thus,Fixedoverheadvolumevariance(FOVV)=(Standardoutput–Actualoutput)× Standard rate per unit FOVV=(SOP–AOP)×SR
Advance Variances:Fixedoverheadvolumevariancecanbefurthersub-dividedintothefollowingtwovariances:Capacity Variance: This variance indicates whether the volume ofproductionwasmoreorlessthannormal.Itrepresentstheamountofvariancethatoccursbecausetheactualactivitylevelwasdifferentfromthebudgetedlevel.Capacityvarianceissimilartovolumevarianceasbothattemptstomeasure the actual activity.However, the difference between these twovariancesliesinthefactthattheformermeasuresactualactivitywithinputsandthelattermeasuresactualactivityintermsofoutputs.Theformulaforcomputingthisvarianceis:
If the budgeted units are less than standard units, the variance isfavourableandviceversa.Efficiency Variance: Efficiency variance reveals the difference infixedoverheadcostasaresultofusingmoreorfewerhoursthanplannedfortheproductionvolume.Suchvariancemaybecausedbyefficientorinefficientuseofthelabour,machine,etc.Thisvarianceiscomputedbymultiplyingthebudgetedfixedoverheadratebythedifferencebetweentheactualandstandardhoursforactualproduction.Thus,
Efficiencyvariance(FOEFV)=(Standardunits–Actualunits) ×Standardoverheadrate FOEFV=(SU–AU)×SRIfstandardunitsare less than theactualunits, thevariancewillbe
favourableandviceversa.Illustration 8.18:Calculatesub-variancesoffixedoverheadvolumevariancefromthecostdataasgiveninIllustration8.17.Solution: In Illustration 18.17 the fixed overhead volume variance hasbeen computed to `400favourablewhichwillbenowverifiedbyitssub-variances—capacityvarianceandefficiencyvariance. Capacityvariance(FOCV) =(BU–SU)×SR FOCV=(5,000–4,832*)×2 =168×2=`336(unfavourable) Efficiencyvariance(FOEFV) =(SU–AU)×SR FOEFV=(4,832–5,200)×2 =`736favourableVerification
Problem 8.3:Acontractjobwasscheduledtobecompletedin40daysbyengaging60workersatanaveragewagerateof`60perday.Theworkwascompletedin55days.70workersactuallyworkedforalldaysonthejob.Thetotalwagespaidforthejobwas`1,92,500.Theworkersdidnotworkfor5daysduetoshortageofrawmaterial.Calculateappropriatelabourvariances.Solution
3. Budgeted hoursStandardlabourhoursforactualunitsproduced= Actual output
Budgeted output×
30,000 12,00015,000
= ×
=24,000hours
NOTES
Self-InstructionalMaterial 217
Variance AnalysisProblem 8.6: StandardhoursformanufacturingtwoproductsMandNare15hoursperunitand20hoursperunitrespectively.Bothproductsrequireidenticalkindoflabourandthestandardwagerateperhouris` 5. In a year 10,000unitsofMand15,000unitsofNweremanufactured.Thetotallabourhoursactuallyworkedwere4,50,500and theactualwagebill came to` 23,00,000.Thisincluded12,000hourspaidfor@` 7perhourand9,400hourspaidfor@`7.50perhour,thebalancehavingbeenpaidat` 5 per hour.Youarerequiredtocomputethelabourvariances.
Variance Analysis 2.Thepayment of lower price bypurchasingdepartment for a givenqualitywouldresultinafavourablematerialpricevarianceandtherebymaintaintherequiredstandard.
5.The following is the formula for labour revisedefficiencyvariance(LREV):
Labourrevisedefficiencyvariance(LREV)= (Standardhour–RevisedStandardhours)×StandardRate 6.Variable overhead variance can be divided into two categories
•Labourefficiencyvarianceindicatesthenumberofactualdirectlabourhoursworked above or below the standard for the actual level ofproduction at standard price.
2.A companymanufactured 12,000 units during the year 2000 byconsuming36,000kgofrawmaterialwhichwaspurchasedat` 3 per kg.Theengineeringsectionofthecompanyhadestimated2kgofrawmaterialforaunitoutput.Thestandardpriceoftherawmaterialwasfixedfor`3.50perkg.Calculatematerialvariances.
3.ThefollowingstandardandactualdatapertaintoSubaLtd. Standard MaterialX—20kgat`3perkg MaterialY—30kgat`4perkg Normalprocesslossis10percentofinput
Variance Analysis
NOTES
Self-Instructional 222 Material
Actual MaterialX—300kgat`3perkg MaterialY—200kgat`3perkg Actuallosswas15percentoninputandoutput350units.Compute
Materialcostvariances. 4.Following information has been taken from the records of a
Variance Analysis 7.ThefollowingdataaretakenfromthebooksofEverestCompanyLtd. Standard MaterialX,50unitsat` 4 per unit MaterialY,40unitsat` 3 per unit 200Men@`2perhourfor50hours 130Women@`1perhourfor40hours Normalloss,10units Actual MaterialX,52unitsat` 3.50 per unit MaterialY,36unitsat` 3.50 per unit 210Men@`2perhourfor65hours 100Women@` 0.75perhourfor45hours Actualloss,7units Calculatematerialandlabourvariances. 8.Fromthefollowingdetails,computethedifferentoverheadvariances: Budgetedvariablecosts `20,000 (for80,000directlabourhours) Budgetfixedcosts ` 40,000 Normalactivity(directorlabourhour) 80,000 Actualhoursworked 22,000 Standardhours 20,000 Actualvariableoverheadcostsincurred `5,100 Actualfixedoverheadcostsincurred ` 9,800 9.Thestandardoutputperweekinafactoryis4,000unitsbuttheactual
To makeoptimumuseoftheoutputcapacity,themanufacturingorganizationsare frequently confrontedwith the decision of additional output as longas theyoperate below their output capacity. Since this decision involvesadditionalcost,therefore,theorganizationsneedtoanalyseandunderstandthebehaviourofadditionalcostsbeforearrivingatsuchadecision.Suchanunderstandingisessentialbecauseeveryincreaseinthelevelofoutputwouldnotincreaseprofitsratherwoulddiminishtheorganization’smarginalprofitiftheorganizationisalreadyoperatingattheoptimumlevelofitsexistingoutputcapacity.However,suchadecisionwoulddefinitelyprovefinanciallysoundiftheorganizationhasanyunutilizedoutputcapacity.Consequently,themanagementneedstopossessknowledgeaboutthebehaviourofcostsasaresultofachangeinthelevelofoutputinordertoarriveatanaccuratedecision.It is inthiscontextanattempthasbeenmadeinthischaptertoidentifyandexaminetheimpactofchangeinthelevelofoutputoncostandbusiness result.
Marginal Costing, CVP Analysis And Break Even Analysis
Theanalysisofcostbehaviourrevealsthatthecostofaproductcanbedividedintotwomajorcategories: •fixedcost;and • variablecostAspercostbehaviour,fixedcostremainsconstanttoaparticularlevelofoutput whereas variable cost has the tendency to changeproportionatelywiththevolumeofoutput.Theexamplegivenbelowwillclarifytheconceptfurther.Example:SubaCompanyLimitedsold2,000units@` 100 per unit during theyear2011–12withthefollowingdetailsofproductionexpenditure: (i)Wages` 20 per unit. (ii)Rentoffactory` 5000 per annum. (iii)Salaryofexecutive`50,000perannum. (iv)Rawmaterialrequiredtoproduceoneunitoffinishedproduct2kg@
According to the Institute ofCost andManagementAccountants,marginalcostingistheascertainmentofmarginalcostsandoftheeffectonprofitofchangesinvolumeortypeofoutputbydifferentiatingbetweenfixedcostsandvariablecosts...Inthistechniqueofcostingonlyvariablecostsarechargedtooperations,processorproducts,leavingallindirectcoststobewrittenoffagainstprofitsintheperiodinwhichtheyarise.
Totheauthorofthisbook,marginalcostingisacostingtechniquethatconsidersonlythecoststhatvarydirectlywithvolume—directmaterials,direct labour and variable factory overheads and ignores fixed cost inadditionaloutputdecisions.Thus,thetechniqueofmarginalcostingliesin • differentiationbetweenfixedandvariablecosts; • ascertainmentofmarginalcosts;and •findingouteffectonprofitduetochangeinvolumeortypeofoutput.
Marginal Costing, CVP Analysis And Break Even Analysis
NOTES
Self-Instructional 228 Material
Characteristics of Marginal Costing
Marginalcostingrevealsthefollowingfourfeatures: • Method of Recording and Reporting:Marginalcostingisamethodof
recordingaswellasreportingcosts.Unlikedifferentialcostanalysisand break-even analysiswhichutilize traditional records,marginalcostingrequiresauniquemethodofrecordingcosttransactionsastheyoriginallytakeplace.
• Separation of Costs into Fixed and Variable Elements:Undermarginalcosting,alltypesofoperatingcosts(factory,sellingandadministrative)are separated intofixed andvariable components and are recordedseparately.
• Variable Costs Applied to Product: Variable cost elements arerecognizedasproductcosts,i.e.,theyarechargedtotheproductattheappropriatemovementsandfollowtheproductthroughtheinventoryaccounts,andthusaretreatedasexpenseswhentheproductissold.Variabledistributioncostsnormallyarechargeable toproductatornearthemomentofsale,andthusdonobecomepartoftheinventoryvalues.
• Fixed Cost Written Off as Period Cost: Fixedcosts(includingfixedfactoryoverheads)arehandledasperiodcosts,i.e.,theyarewrittenoffasexpensesintheperiodinwhichtheyareincurred.Theydonotfollowtheinventoriesthroughtheaccountsbutratheraretreatedinawaywhich is traditionally for selling andgeneral administrativeexpenses.Fromtheabovediscussion,itisclearthatmarginalcostingisnota
systemofcostascertainment-likejob,operatingorprocesscostingbutisatechniquetodealwiththeeffectonprofitsasaresultofchangesinvolumeortypeofoutput.Itmaybeincorporatedintothesystemofrecordingandcollecting costs or itmaybeused as an analytical tool for studying andreportingtheeffectsofchangesinvolumeandtypeofoutput.Whereitisincorporatedintothesystemofrecordingandcollectingcosts,thestocksarevaluedatvariablecosts,andfixedcostsaretreatedasperiodcostsinprofitstatements.
directlyaffectedbychangesinvolume.Undertheabsorptioncostingmethodperiodcosts(fixedcosts)whichareafunctionoftimeand,therefore,arenotaffectedbyvolumechanges,arealsochargedtothecost of production.
•Under the absorptioncostingmethod, inventorieswill normallybereportedatahigherfigurethanthemarginalcostingmethod.Thisisduetothefactthatfixedcosts,undertheabsorptionmethod,aredeferredbybeingincludedinthecostofgoodsinventory.Theelementoffixedcostwillnotbereportedasadeductionfromrevenueuntilthegoodsaresoldandthenitisshownasexpenseinthecostofgoodssoldintheincomestatement.Underthemarginalcostmethod,nofixedcostsaredeferred;theyarechargedagainstrevenueintheperiodinwhichtheyareincurred.Illustration9.1wouldclearlydemonstratethedifferencebetweenthesetwomethods.
•Cost–volume–profit relationship data required for profit planningpurposesarereadilyobtainedfromtheregularaccountingstatements.Hence,managementdoesnothavetoworkwithtwoseparatesetsofdatatorelateonetotheother.
•Marginalcostconstitutesaconceptofinventorycostwhichcorrespondscloselywith the current out-of-pocket expenditure necessary tomanufacturethegoods.
Disadvantages
•Difficultymay be encountered in distinguishing fixed costs. Inparticular,certainsemi-variablecostsmayfall inaborder-lineareaandmoreorlessarbitraryclassificationmaybeconsiderednecessaryinorder toarriveatapracticaldeterminationoffixedandvariablecomponents.
Contributionwhichisrecognizedasastrategictoolformanagerialdecisionmakingrepresentsthedifferencebetweenproductrevenueandvariablecostofproduct.According toBigg,1973,contributionmaybedefinedas thedifferencebetweensalesvalueandthemarginalcostofsales,andnonetprofitarisesuntilthecontributionequalsthefixedoverheads.Whenthislevelofoutputisachieved,thebusinessissaidtobreak-evenasneitherprofitnorlossoccurs.Productioninexcessofthatnecessarytobreak-evenwillresultinaprofitequivalenttotheexcessunitsmultipliedbythe‘contribution’perunit.Conversely,a loss issustainedifoutput is less thanthatrequiredtobreak-even,amountingtotheshortfallofunitsmultipliedbythecontribution.Thus,contributionisthedifferencebetweenthemarginalcostofthevariousproductsmanufacturedandtheirrespectivesellingprice.Sincecontributionrepresentstheexcessofsalesovermarginalcost(variablecost)ofthegoodssold,theresultantfigurereferstotheamounttomeetfixedcostandexpectedprofitofanorganization.Itcanbecalculatedasunder: (i)Contribution=Sales–VariableCost
OR Contribution(perunit)=Sellingpriceperunit–Variablecostperunit (ii)Contribution=Fixedcost+Profit/lossExample: Supposetotalsalesrevenueis 50,000,variablecostis 20,000andsaleintermsofunitsis1,000thencontributionwillbe:
Contribution = `50,000–`20,000=`30,000
OR
Contribution(perunit)=50–20=` 30
9.2.3 Marginal Cost Equation
The analysis ofmarginal cost statement and the contributionmentionedaboverevealsthat (i)Sales–Marginalcost=Contribution (i) (ii)Fixedcost+Profit=Contribution (ii)Bycombiningtheabovetwoequation,wegetfundamentalmarginalcostequation:
Decisionmaking is a regular phenomenon of any business.One of theimportantfactorsthatinfluencemanagerialdecisionsistherelevantcoststhatthemanagersneedtoidentifyandanalysetotaketherightdecisions.Thedecisioncriteriamostoftenusedforthepurposegenerallyincludecostminimization,profitmaximizationandcontributionmaximization.In thisdirection,marginalcosting is recognizedasaneffective toolandassuchmanagers prefer to usethistechniqueinthefollowingareasofmanagerialproblems: • pricingdecision • productionexpansiondecision •makeorbuydecision • scarceresourcesdecision • salesmixdecision
thecompetition.Youarerequestedtocalculatethelevelofoutputtomaintainpresentlevelofprofitiftheproposedreductioninpricesis10percentand20 per cent.Solution:
Themostcommondecisionfacedbymanagersinthegrowthofthebusinessis todecideabout theexpansionofproduction.Opportunities to increasesalesvolumesometimesariseundercircumstancesthatdifferslightlyfromthenormalmarketingpattern.Mostoftenbusinessfirmsreceivespecialorderforthesupplyofbulkquantityofgoodsatapricebelowthemarketpriceofthefirm’sproduct.Ifthisspecialtransactiondoesnotaffectnormalsales,
Marginal Costing, CVP Analysis And Break Even Analysis
NOTES
Self-Instructional 238 Material
problemfacedbymanagement.Thisdecision,fromthefinancialpointofview,requiresaccuratecalculationsthatinvolvetheconceptsofdifferentialcostingandopportunitycost.ThisproblemcanbesolvedwiththehelpofincrementalanalysisasisclearfromIllustration9.7.llustration 9.7:Initsmanufacturingoperations,ShabnumCo.Ltd.,usesacomponent‘ESS’thatcanbepurchasedfromasupplierfor` 20 per unit. Thesamecomponent‘ESS’ismanufacturedbyShabnumCo.Ltd.,atthefollowingunitcost:
Giveyoursuggestionwhethertomakeorbuythiscomponent.Solution: If thecomponent‘ESS’ ispurchaseditwillcost` 20 per unit. However,thepurchasingcostshouldnotalwaysbecomparedwiththefullcostofinternalmanufacture,whichamountsto`23.Forshortrundecisionmakingpurposes, fixedoverheadswill remain constant regardless of thealternativechosen.Therefore,theoutsidepurchasepriceshouldbecomparedonlywith internalmanufacturingcosts thatcanbeavoided if theoutsidepurchaseismade.Theseavoidablecostinclude:
Illustration 9.8:M/sMASLimitedmanufactures three rubber productsusingthesamerubbercompound.Thesuppliersofthecompoundinformedthecompanythatthesupplyofthecompoundwouldbecutby25percent.Theinformationaboutcostofthethreeproductsisasunder:
These three factors are interconnected in such away that they actandreactononeanotherbecauseofcauseandeffectrelationshipamongstthem.Thecostofaproductdeterminesitssellingpriceandthesellingpricedeterminesthelevelofprofit.Thesellingpricealsoaffectsthevolumeofsaleswhichdirectlyaffectsthevolumeofproductionandvolumeofproductioninturninfluencescost.Inbrief,variationsinvolumeofproductionresultsinchangesincostandprofit.CIMALondonhasdefinedCVPanalysisas,‘thestudyoftheeffectsonfutureprofitsofchangesinfixedcost,variablecost,salesprice,quantityandmix.’
•Marginalcostingisacostingtechniquethatconsidersonlythecoststhat varydirectlywith volume—directmaterials, direct labour andvariablefactoryoverheadsandignoresfixedcostinadditionaloutputdecisions.
The plant capacity is 1,00,000 units.A customer fromFrance isinterestedtopurchase40,000unitsatanetpriceof 10 per unit. Advise theproducerwhetherornottooffershouldbeaccepted?
9.9 FURTHER READINGS
Sahaf,M.A.2013.Management Accounting: Principles and Practice,3rdedition.NewDelhi:VikasPublishingHouse.
Arora,M.N.2012.A textbook of Cost and Management Accounting,10thedition.NewDelhi:VikasPublishingHouse.
Maheshwari,S.N.,SuneelK.andSharadK.2018.A Textbook of Accounting for Management,4thedition.NewDelhi:VikasPublishingHouse.
Break-evenanalysis isacosting technique thathelpsexecutives inprofitplanning and consequently it is essential for them to have an in-depthknowledgeaboutthenatureandapplicationofthistechnique.Thenarrowinterpretationofbreak-evenanalysislimitsittothestudyofbreak-evenpoint.Thebreak-even point isdefinedasthevolumeofactivityatwhichtotalsalesrevenueexactlyequalstotalcostsoftheoutputproducedorsold.Atthislevelofoperationsalesrevenueisadequatetocoverallcoststomanufactureandselltheproductleavingnoamountasprofit,andtherefore,thislevelisalsoknownasno profit no loss level.
Break-even analysis is notmerely limited to seeking the break-evenpoint. Inabroadersense,break-evenanalysisrefers to thestudyofrelationshipbetweencost,volumeandprofitatdifferentlevelsofsalesorproductionwhichinaccountingterminologyisknownascost-volume-profit analysis.Cost-volume-profitanalysisasaplanningtoolanalysestheinherentrelationshipbetweenprice,coststructure,volumeandprofit.
Belkaoni definescost-volume-profitanalysisasan examination of cost and revenue behavioural patterns and their relationships with profit. The analysis separates costs into fixed and variable components and determines the levels of activity where costs and revenues are in equilibrium.
AccordingtoSchmiedickeandNagy,1978,cost-volume-profitanalysisis an analytical technique which uses the degree of cost variability for measuring the effect of changes in volume on resulting profits. Such analysis assumes that the plant assets of the firm will remain the same in the short run, therefore, the established level of fixed cost will also remain unchanged during the period being studied.
To theauthorof thisbook, cost-volume-profit analysis is a mature model to study the inter-related relationship between costs, price and profit structure of a company. It is a formal profit planning approach based on established relationship between different factors affecting profit.Theusualstartingpointinsuchananalysisisthe determinationofthecompany’sbreak-evenpoint.Thus,break-evenanalysisformsjustonecomponentofthe totalsystemofcost-volume-profitanalysis.However,itisoftenakeypart,anditcangivethemanagermany insightsintothedatawithwhichheorsheisworking(Garrison,1976).
Cost-volume-profit analysis provides the following importantinformation for managerialdecisionmaking:
The two major approaches to compute break-even are: •Mathematicalapproach •GraphicapproachMathematical Approach: Mathematicallybreak-evencanbecomputedbyengagingthetechniqueofunitcontributionwhichisdevelopedonthebasisofmarginalcostequationasdiscussedearlier.Theequationcanbestatedasfollows:
Sale=Variablecost+Fixedcost+ProfitSince at the break-evenpoint profit is absent, therefore, the same
leavesacertainamountintheshapeofcontributionmargintomeetfixedcosts.Thus,inordertoworkouttherequirednumberofunitstobreak-even(where the amountofcontributionwillbesufficienttocovertotalfixedcost),thetotalfixedcostmustbedividedbytheunitcontribution.Accordingly,thebreak-evenpointcanbecalculatedintermsofunitsbyusingthefollowingequation:
Break-evenpoint(intermsofunits)=
or where BEP=Break-evenpoint FC=Totalfixedcost SP=Sellingpriceperunit VC=VariablecostperunitThe break-even point can also be calculated in terms of rupees.
Solution: The formula applied in the above-mentioned question for thecalculationofbreak-evenpointcannotbeusedinthisproblemasitlackstheinformationonsellingpriceperunitandvariablecostperunit,therefore,thebreak-evenpointwillbecalculatedwiththehelpofP/Vratio.Thus
Break-Even Analysis/Point (BEA/BEP)
NOTES
Self-Instructional 250 Material
Working:Calculation of profit/volume ratio
Graphic Approach to Break-even Analysis
The break-even analyis can also be demonstrated graphicallywhich iscommonly known as break-even chart.A break-even chart is a graphicapproach to thestudyof therelationshipofcost, revenueandprofit.Thegraphicinsteadofmathematicalapproachisoftenusedbecauseittendstobemoreeasilyunderstoodbythepeoplewhoseacquaintancewithmathematicsisminimalanditprovidesanimmediateviewofvariablecosts,fixedcosts,andprofitatanylevelofactivity.
Informationforconstructingabreak-evenchartcanbeobtainedfromthe income statement of the concern.However, the total cost i.e., fixedcost,variablecost,andsemi-variablecostmustbeclassifiedonlyintotwocategoriesofcosts—Fixedcostandvariablecost.Abriefdescriptionofthesecostsisasfollows:
3. Semi-variable Cost: Semi-variable costs possess the charac-teristics of both fixed and variable costs.These costs demandspecialattentionfromthemanagementinsplittingthemintofixedandvariablecosts.
4.Variablecostsareplottedfromthelefthandsideofthefixedcostline.Ifsuchcostsareplottedfromthezerolevel(point)onthegraphasshowninFigure10.2,theyshowonlythevariablecostofproduction.InFigure10.2,OTVCrepresentstotalvariablecostswhichare 2 per kgatalllevelsofoutput.ByplottingvariablecostfromthefixedcostlineasshowninFigure10.3,suchlinerepresentstotaloperatingcost.InFigure10.3,twofunctionscomposedoffixedcostof`2,000andvariablecostof`2perkgarecombinedasisrepresentedbythelineCTC.
8.Draw a perpendicular to theX-axis andY-axis from the point ofintersectionofcostandsaleslinetodeterminebreak-evenpointintermsofunitsandrupeesrespectively.InFigure10.5,MP1andMP2aretheperpendicularsdrawnformsuchintersectionofcostandsaleslinestoY-axisandX-axisrespectivelywhichdeterminebreak-evenpointatanoutputof2,000unitsandatasalesrevenueof 6,000respectively.Abovebreak-evenpoint,afirmwillbeprofitableandbelowitfirmwillincuraloss.
10.2.1 Managerial Applications and Profit Planning
Break-evenchartservesmanagementasaneffectivetoolinprofitplanningandother related decisions.The following areas of decisionmaking areusuallyexposedtotheapplicationofbreak-evenchart.
Budgeting
Theeffectofbudgetedsalesonprofitcanbeeasilyestimatedwiththeuseofbreak-evenchart.Suchananalysiscanbemadefortheentirebusinessorfor a part of it.
The Make-or-Buy Decision
Management isusuallyconfrontedwiththeproblemdecisionofmake-or-buyanitem.Thisproblemissolvedtoalargeextentbybreak-evenchartasisclearfromFigure10.6.Assumethatproductcanbepurchasedfor` 3 perunitandthecompanyhastoincurafixedcostof`2,000andavariablecost of `2perunitifitdecidestomaketheitem.Undersuchconditions,thebreak-evenpoint,wherethetotalcostofmanufacturingequalsthetotalcostofbuying,is2,000units.Heremanagementhastodecideaboutmakeorbuyanitemonthebasisofnumberofunitsrequired.Accordingly,ifmorethan2,000unitsarerequired,itwouldbeeconomicalforthecompanytomaketheproduct.However,thisdecisionisnotaprofitableoneifnumberofunitsrequiredislessthan2,000.
InFigure10.7,ateachvolumelevel,theverticaldistancebetweenthesaleslineandthetotalcostlinerepresentsprofit.Thechartclearlyrevealsthatexpectedprofitisgreatestatasellingpriceof`4perunit,itisthen`4,500.Apriceofeither`3,or`2perunitgivesprofitofonly`2,000.However,themarginofsafetyisnotequallyfavourableat`4perunit.Atthispointthedifferencebetweenplannedsalesandbreak-evensales(wherethesaleslineintersectsthetotalcostline)is1,500units,comparedwith2,000unitsat a price of `2.Ontheotherhand,themarginofsafetyisonly1,000unitsat a price of `3.Onthewholeapriceof` 4 is indicated.
(iv) It fails to take into consideration the important factors like plantcapacity,productiontechnologyandmethodologyandcapitalemployedwhichareveryimportantformanagerialdecisions.
Inbreak-evenchart,wheresaleslineintersectsthetotalcostlinethatangleisknownasangleof incidence.Frommanagerialpoint, a largeangleofincidencewouldmeanhighrateofprofit.Anarrowanglerevealshighvariablecostthatresultsinlowprofits.Managementalwaysaimstomaintainaslargeanangleaspossible.Businessexpertssuggesttostudytogethermarginofsafetyandangleofincidenceforexaminingworthofacompany.
Position of Sales and Profits of S.V. Ltd. for 2006
Particulars Sales (`)
Total Costs (`)
Profits (`)
Firsthalf 45,000 40,000 5,000
Secondhalf 50,000 43,000 7,000
Difference 5,000 3,000 2,000
NowforthecalculationoftheP/Vratio,fixedcostandbreak-evensales,thesameprocedurewillbeusedaswasemployedinthecaseofIllustration10.16. I. CalculationofP/Vratio:
year Salesprice ` 20 per unit Variablemanufacturingcost ` 11 per unit Variablesellingcost ` 3 per unit Fixedfactoryoverhead `5,40,000peryear Fixedsellingcost `2,52,000peryear 5.Thefollowingfiguresforprofitandsalesareobtainedfromtheaccount
Differential Costing11.2 NATURE AND SCOPE OF DIFFERENTIAL
COSTING
Differential costing is a costing technique that examines the effects ofalternativecoursesofactionontotalcosts.Whilecommentingonthenatureand scope of differential costing theChartered Institute ofManagementAccountants,1991,Londonstatesthatitisatechniqueusedinthepreparationofadhocinformationinwhichonlycostandincomedifferencesbetweenalternativecoursesofactionare taken intoconsideration.Suchacostingtechnique focuses on the study of differential costswhich refers to theamountofchangeincostsresultingfromtheselectionofonealternativetotheother.Thus,differentialcostingstudiestheeffectsofalternativedecisionsontotalcosts.Theamountofexpectedchangefromanalternativechoicedecisionmightresulteitherinanincreaseordecreaseinthetotalcosts.Fromthisapparentlyonegetstheimpressionthatadifferentialcostcantaketheformofincrementalordecrementalcostwhichultimatelywillbecoveredby incremental costing and decremental costing, respectively.However,suchaclassificationisjustsuperficialasthescholarsgenerallyusethetermincrementalcostingfordifferentialcosting.
Differential Costing vs. Marginal Costing
Sincedifferentialcostingstudiescostdifferencesbetweenalternativecoursesofaction,therefore,apparentlyitmaysoundsimilartomarginalcosting.Butintherealsense,itisnotsoasdifferentialcostingaimstostudytheimpactof alternative courses of actions on the costswhereasmarginal costingexamines the relationshipbetweencostandvolume.Further, theconceptofdifferentialcostingisbasedontotalcostwhichisnottrueofmarginalcostingthatconsidersonlydirect/variablecostsandignoresfixedcostinitsapplication.Although,boththetechniqueshelpfirmsincostanalysisandcostpresentationyettheyhavelargedistinctiveanduncommonareasofstudyandapplication.Someofthedifferencesaresummarizedbelow: •Differentialcostingisperspectiveinnaturewhereasmarginalcosting
isgenerallyhistoricalinnature. •For differential costing, the firms can use either traditional, i.e.,
a resultofalternativecourseofaction.Thus, thecosts that remainconstantbetweendifferentalternativesdonotfallwithinthescopeofrelevantcosts.
Theanalysisoftheabovefeaturesofrelevantcostsbringsoutclearlythefactthatsuchcostsarebasicallydifferentialcosts—theamountofchangeincostthatafirmexpectsfromacourseofactionascomparedwithanalternative.However,onehas to remember that sunkcostsarenotconsidered in theanalysisofrelevantcosts.
Every rational decisionmakingprocess beginswith the identification ofthe problem.The identificationof a problemprovides a decisionmakeran opportunity towork for the solution of the problem.However,mereidentificationoftheproblemwillnothelpadecisionmakertofindasolutionfortheproblem.Everyproblemcallsforanin-depthstudyasgenerallytheproblemsarecharacterizedby‘ice-berg’principlewherealittleportionisvisibleandthemajorportionishiddenaboutwhichthedecisionmakerhasnoclue.Therefore,adecisionmakerhastomakealleffortstoidentifyandexamineevery issue involved in theproblembeforemakinganyattempttofindalogicalsolutionfortheproblem.Infact,suchanattemptcallsforproblemauditwhichwill help a decisionmaker not only to identify thepossiblecausesoftheproblembutalsoformulatetheobjectivestobemetinsolvingtheproblem.
Identification of Alternatives
The analysis of the problem is followedby the identificationof feasiblealternativesthatmayserveaspotentialsolutionstoaproblem.Thisstepofdecisionmakingcallsforapredictionwhich,infact,isitselfadecisionabouthowtomakedecision.However,adecisionmakerhastorememberthatbestpossiblesolutionsdonotautomaticallysubmitthemselvestothedecisionmakingprocess,hehastoformulateavarietyofwaysofdevisingalternatives.Althoughanumberoftoolsandtechniqueslikelateralthinking,diggingaholeelsewhere,andmorphologicalapproachhavebeendevelopedovertheyeartohelpdecisionmakersinthisregardyetsuchanattemptcallsforalotofeffortonthepartofdecisionmakersintermsofcontinuousresearchandthinking.Inthepastthisactivitywaspurelybasedonamanager’sintuition,however,atpresent,manymanagersprefertousedecisionsupportsystemforthispurpose.
Differential Costing
NOTES
Self-Instructional 274 Material
Evaluation of Alternatives
Inthisstepofdecisionmaking,amanagementaccountanthasatremendousrole toplaybyprovidingadequate information to thedecisionmakeronthe economic andfinancialworth of the alternatives that is essential forevaluation.Todischargethisfunctioneffectively,amanagementaccountantneedstopossessknowledgeaboutanumberoftoolsandtechniqueslikeprofitplanning,capitalbudgeting,risktechniques,linearprogramming,decisiontreeandforecastingtechniques.
Selection of an Alternative
Thecentraltaskofdecisionmakingisthechoicefromamongalternatives.Tochoosethebestalternative,adecision-makerneedstodevisetheselectioncriteriawhichmaynotbeeasy.Generally,thechoiceofthebestalternativeissimplyaccomplishedbyselecting thealternativewhichbestmeets thechosencriterion.Logically,adecisionmakerwouldprefertochoosethebestalternativebutpracticallyspeakingitisdifficulttodefinethe‘best’asdifferentcriteriawouldresultindifferentdecisionsfromthesamesetofalternatives.Although, for certaindecision situations,decisionmakers candevise theselectioncriteriathatwouldhelpthemtoidentifythebestalternativeyetsomedecisionsituationsaresocomplexthatdevisinganyselectioncriteriaforthemispracticallyimpossible.However,adecision-makerhastotakeanumberoffactorsincludingtheoneslikeresources,competenceandexperienceofthecompanythathavegreaterimpactonthechoiceofthealternative.
Detailed Plan for Carrying out of the Alternative
Oncetheselectionofthealternativeismade,adecision-makerhastocarryout the same.Sucha stepmaydemand the implementationofplansandprogrammes.
Evaluation and Control
After the plans and programmes have been implemented to attain thedesired outcome of the decision, a decisionmaker has to evaluate theactualperformancewithapurposetofindhowactualresultsreconcilewiththedesiredoutcomes.Thiswouldalsomeantodeviseandimplementthenecessarymeasuresiftheactualperformanceisnotintunewiththestandards.
Differential Costing11.4 APPLICATION OF DIFFERENTIAL COSTING
Differentialcostinghastremendouspotentialasadecisionmakingtool.Itcanhelpafirminsuchdecisionsthatfallwithinthescopeoffollowingareasof business: •makeorbuy • acceptorrejectspecialorder • addordropproducts • sellorprocess • operateorshutdown • leaseorsell • expandorreduce • reduceormaintainpriceMake or BuyInahighlycompetitivemarket,oneofthemostperplexingproblemsthatamanufacturerfacesisarrivingatagoodmake-or-buydecision.Infact,itisnotuncommontofindthatfirmsneeddifferentcomponentsinthemanufacturingof products like automobiles, electronics and industrial products. Suchcomponentscanbemanufacturedwithinthefirmorcanbeprocuredfromthe suppliers. Such decisions have serious financial implication for thebusiness, therefore,managementhast todealwith this issuecarefully. Inthisregard,differentialcostinghelpsafirmbyascertainingtherelevantcostofboththeoptions—makeorbuy.However,suchanissuecropsuponlyonce thereexists someunutilizedcapacitywithin theexistingproductivecapacitywhichcanbeexploitedwithoutincurringanyinfrastructuralcost.Infact,differentialcostingcanhelpafirminbothsituations,i.e.,whenitisconsideringtomanufactureacomponentthatisbeingcurrentlyprocuredfromasupplierortoprocureacomponentfromthesuppliersthatisbeingcurrentlymanufactured.Illustration 11.1: Anautomobilemanufacturerisconsideringaproposaltoprocureacomponentfromthesupplierwhichiscurrentlybeingmanufacturedinternally.Thecompanyiscurrentlyoperatingat75%ofcapacityandnomajorincreaseinproductionisexpectedinthenearfuture.Thecostperunitofmanufacturingthecomponentisestimatedasfollows:
`
DirectMaterial 120Direct Labour 60Overhead(40%variable) 90TotalCostperunit 270
Differential Costing
NOTES
Self-Instructional 276 Material
Youarerequiredtoadvisethecompanywhethertobuythecomponentfromoutsideifthepartisavailableintheopenmarketfor` 250 per unit.Solution: Acursoryanalysisofmakeprice(`270)andbuyprice(`250)indicatesthatmakepriceismorethanbuypricetherefore,itisprofitableforthefirmtobuytheproduct.However,thisdecisionneedsacomparisonofbuycostwithavoidablecost(variablescostsonlyasfixedcostscannotbeavoidedintheshortrun).Therefore,buycostsofthecomponentwhichamounts to `250ismuchhigherincomparisontoavoidablecostof`216*thatcanbeavoided if thecompanydecides tostopmanufacturingof thecomponent under consideration.Thismean the componentwould cost` 304 (`250i.e.,buycost+`54i.e.,fixedcostswhichcannotbeavoidedintheshortrun)ifthecompanydecidedtostopmanufacturingcomponentinternallyandbuyexternally.Therefore,itisrecommendedthatthecompanymustmanufacturethecomponentinternally.*Calculationofavoidablecostsifcompanydecidestostopmanufacturingofthecomponent:
`
DirectMaterial 120Direct Labour 60Overhead(40%variable) 36TotalCostperunit 216
Accept or Reject Special Order
Itisnotuncommontofindthatfirmsgetopportunitiestoincreaseitssalesvolumeby receiving special orders for supply of such products that arewithinitsproductlines.However,suchordersgenerallydifferfromnormalmarketingpracticeastheycallforspecialdiscountsinprices.Suchadecisionisnotastraightforwarddecisionwhichcanbedecidedonthebasisofpricingthat thefirmchargeundernormalcircumstances.Infact,suchadecisioncallsfordifferentialanalysiswhichaimstocomparethedifferentialcostswithdifferentialrevenuebetweentheexistingvolumeofsalesandexpectedvolumeof sales if a special order is accepted. If the additional output,requiredtomeetthedemandsofspecialordercanbemanagedwithintheexistingproductioncapacityofthefirm,thedifferentialcostswouldincludeonlyvariablecostsoftheadditionaloutputotherwiseitwouldincludebothvariablecostaswellasfixedcostsoftheadditionaloutput.Thus,specialorderisgenerallyconsideredonthebasisofacomparisonbetweenthepriceofferedandexpecteddifferentialcostwhichisgenerallyequaltovariablecostintheshortperiod.Ifthepriceishigherthandifferentialcost,theorderisacceptedotherwiseitisrejected.
NOTES
Self-InstructionalMaterial 277
Differential CostingIllustration: 11.2: DeskPower,amanufacturerofcalculators,whohasbeensellingitsproductsthroughretailshopsforaprice 50,hasreceivedaspecialorderfromagroupofeducationalinstitutionsforsupplyof1,000calculatorsat a price of `40.Thecompanyispresentlyoperatingat60percentofitscapacityandhasproductioncapacityof40,000units.Youareapproachedbythecompanytoguideitintakingrightdecision.Costdataprovidedbythecostingdepartmentofthecompanyissummarizedasunder:
ofthealternative.Infact,differentialanalysisisanappropriatetechniquetohelpafirmintakingsuchadecision.Illustration 11.3: A computer manufacturing company is considering a proposaltodropdesktopbrandandreplacethesaidbrandbyanewproductlaptop.Totalfixedcostfortheyear2006amountsto`54,88,000andtheothercostandsalesdetailsofthevariousproductsofthecompanyfortheyeararegivenbelow:
** Calculation of variable cost per unit:Percentage of variable cost in total cost
Amount of total cost100
60Desktop = 20, 000 12, 000
10070
Laptop = 52, 000 36, 400100
66Interactive Board = 96, 000 62, 400
100
×
× =
× =
× =
` `
` `
` `
Sell or Process
Generally, a product passes through many stages during its manufacturing process. Consequently, a manufacturer gets the opportunities at different stages in the manufacturing process of a product to decide either to sell it at the intermediate stage of production or process it further and then sell. In deciding about this issue, a manufacturer can use the differential analysis to know differential cost and differential revenue of the next stage in the manufacturing process. If the differential revenue of the next stage of the manufacturing process exceeds the differential cost of the stage, the manufacturer has every reason not to sell the product in the intermediate stage and process it further.Illustration 11.4: Sana juice manufacturing company produces 20,000 liters of juice in a batch which involves two processes. The details about cost and quantity of the juice for the batch are given below:
Differential Costing
NOTES
Self-Instructional 280 Material
Particulars Process I Process IIMaterialrequired 20,000Kgs 500 KgsMaterialcostperKg ` 5 ` 2Labourcostperliter `12,000 `6,000Sellingpriceperliter ` 10 ` 12
It is not uncommon toobservethatfirmsareconfrontedwithasituationwheretheyneedtoaddressacrucialdecisionofeithertosuspendtheiroperationsforsometimeortoclosedownpermanently.Infact,suchadecisionhasseriousimplicationsonthefutureprospectsofthebusiness.Thedecisiontoshutdownbyafirmmayresultnotonlyinthelossofapartofthemarketorfewcustomerspermanentlybutalsoexperiencedandtalentedworkers.Further,suchadecisionmayhaveadverseimpactonthegoodwillofthefirm.Atthesametime,resumptionofoperationmaycallforheavyexpenditure.Therefore,afirmneedstobecarefulwhilemakingadecisiontocontinue
The company should not continue its operation as its differentialrevenue is ` 60,000whichwill not be sufficient to recover its fixedcosts. If the company continues its operations itwill suffer a loss of `90,000whichismorethanitsavoidablefixedcosti.e.,`75,000(50percentoffixedcosts).Therefore,thecompanymuststopoperationtemporarily.
Differential Costing
NOTES
Self-Instructional 282 Material
Lease or Sell
Sincethemachineryandequipmentsusedinabusinesslosetheirutilitywiththepassageoftime,therefore,firmsoftenfacesituationswheretheyneedtodecidewhethertoleaseorsellplantandequipmentthathaslostitscommercialviability.Differentialanalysiscanhelpafirmtoevaluatealternativesandidentifythebestcourseofactionunderthegivencircumstances.Illustration 11.6: JelumTextileCompanypurchasedaplantin1999for` 16,00,000.The companywasdepreciating the said plant on straight-linemethodat10percentandbytheendof2006thecompanyhadanaccumulateddepreciation of `11,20,000.InJanuary2007thecompanywasconsideringtodisposeoftheplantfor 3,20,000andChinabTextileCompanywasreadytopaythesaidamount.JelumTextileCompanyhadanotheroptiontoleasetheplantforthreeyearstoanothercompanywhichwasreadytopayJelumTextileCompanyanamountof`4,50,000asrentfortheplant.However,theplantshallhavenoscrapvalueafterthreeyears.DuringtheleaseperiodthemaintenanceoftheplantwasresponsibilityofJelumTextileCompanyforwhichthecompanywassupposedtoincurrepairandinsurancecostof` 50,000.Thecompanydecidedtoselltheplant.Youarerequiredtocalculatenetdifferentialincomefromleaseforthecompany.Solution
Statement Showing Differential Gain from the Alternatives
Thecompanyintendstoexpanditsproductionby2,500units.Tomeetthedemandsofexpandedproduction,thecompanyhastomeetanadditionfixedcost of `35,000.Youarerequiredtoadvisethecompanywhichalternativeisbetterandwhy.Solution
Statement Showing Contribution under Two Alternatives
Althoughapparentlyitlooksthatthecompanyshouldnotgoforexpansionassuchadecisionwoulddecreaseperunitprofitfrom 4 to 2,yetthetotalprofitofthecompanywillincreaseby`20,000bytheexpansion.Thereforeit is recommended that the companymust executive its programmeofexpansion.
In the latter case,material pricewill be` 200 per unit. For labour andexpenses,90,000unitsofthisproductcanbeproducedatthesamecostbasisasabove.Discusswhetheritwouldbeadvisabletodiverttheresourcestomanufacturethenewproduct,onthefootingthatthecomponentpresentlybeingproducedwould,insteadofbeingproduced,bepurchasedfromthemarket.
(CA, Inter)
NOTES
Self-InstructionalMaterial 285
Differential CostingSolution (a) Statement Showing the Cost of the Component in Make or Buy
(II) PurchasePriceoftheComponent 540 486,00,000Extraamounttobespentincaseofthepurchase 45 40,50,000
Sinceincaseofpurchaseofthecomponentfromthemarket,thecompanyhastobearextracostof 45perunitwhichcomesto 40,50,000for90,000units,thereforeitisnotviableforthecompanytopurchasethecomponentratherthecompanyshouldcontinueitsproduction. (b) Statement Showing the Contribution if the Existing Resources are
Differential CostingIllustration 11.11: Modern SewingMachinesCo.manufactures hand-operatedsewingmachines.Prepareascheduleshowingthedifferentialcostsand incremental revenue at each stage from the followingdata.Atwhatvolumeshouldthecompanysetitslevelofproduction?
Output(No. in Lakh)
Selling PricePer Machine
(`)
Total Semi-fixed Cost
(` in Lakh)
Total Variable Cost
(` in Lakh)
Total Fixed Cost(` in Lakh)
0.601.201.802.403.003.60
240220200180160140
303034344040
83.6163.6255.6315.6355.6380.6
28.428.428.428.424.428.4
(ICWA, Final)
SolutionSchedule Showing the Differential Costs and Incremental Revenue
Output(No. in Lakh)
Selling Price
Per Ma-chine
(`)
Sales Value(` in
Lakh)
IncrementalRevenue
(` in Lakh)
Semi-fixed Cost(` in
Lakh)
Vari-able Cost (` in
Lakh)
Fixed Cost(` in
Lakh)
Total Cost(` in
Lakh)
Differen-tial Cost
(` in Lakh)
0.601.201.802.403.003.60
240220200180160140
144.0264.0360.0432.0480.0504.0
–120.096.072.048.024.0
303034344040
83.6163.6255.6315.6355.6380.6
28.428.428.428.424.428.4
142.0222.0318.0378.0424.0449.0
–80.096.060.046.025.0
Itisausualbusinesspracticetoincreasetheoutputasalongincrementalrevenueismorethanitsdifferentialcostandviceversa.Inthepresentcase,thedifferentialcostislessthanincrementalrevenueuptoalevelof3.00lakhunits;beyondthisleveldifferentialcostismorethanincrementalrevenue.Thereforethecompanymustsetitsoutputlevelat3.00lakhunits.Illustration 11.12: QualityProductLimitedhas drawnup the followingbudgetfortheyear2012–13.
Thegeneralmanager suggests to reduce sellingprice by5 per cent andexcepttoachieveanadditionalvolumeof50percent.Themoreintensivemanufacturing programmewill involve additional costs of` 50,000 forproductionplanning.Itwillalsobenecessarytoopenanadditionalsalesofficeatthecostof`1,00,000perannum.
The salesmanager, on the other hand, suggests to increase sellingpriceby10percentwhichitisestimatedwillreducesalesvolumeby10percent.Atthesametimeasavinginmanufacturingoverheadsandgeneraloverheadsof`50,000and`1,00,000perannumrespectivelyisexpectedonthisreducedvolume.
Which of these two proposalswould you accept andwhy?Showcompleteworking.
(B.Com,Hons.,DelhiUniversity)Solution
Statement Showing Profit from the Proposals
Particulars (I) Proposal of General Manager (II) Proposal of Sales ManagerAmount
(`)Amount
(`)Amount
(`)Amount
(`)Sales:ProposalI:(1,05,0002 Units× ` 47.502)ProposalII:(9,0002 units × ` 552)ProposalLess:VariableCost:Rawmaterials3 Labours,stores,powerandothervariablecost4Packingandvariabledistribution cost5
Illustration 11.13: Sports specialists Ltd. are famous for specializedmanufactureofqualitychessboardssets.Presently,thecompanyisworkingbelowitsnormalcapacityof1,000unitspermonth.Thecompanysellschessboards sets in the nationalmarket at` 150per unit.DuringApril 2012, 600unitsweresoldwhichistheregularsalesvolumeforeachmonthallthroughtheyear. Theunitcostofproductionis
Thecompanyreceivedanexportorderon20-4-2012forsupplyof600unitstobedispatchedby30-6-2012.However,theorderstipulatestheprice per unit as 100only.Thecostanalysisindicatedthatthecostofdirectmaterialanddirectlabourthataretobeincurredontheexportorderwouldbethesameamountperunitastheregularoneofproduction.However,anamount of `2,000willhavetobeincurredonspecialpacking,labeling,get
B. Costs:Directmaterials@` 60 per unitDirectlabour@` 30 per unitFactoryoverhead@` 30 per unitSpecialpacking,labelling,etc.Selling&Adm.Overhead@` 15 per unit
72,00036,00036,000
–18,000
36,00018,000 –2,000
–
1,08,00054,00036,0002,00018,000
Total 1,62,000 56,000 2,18,000Profit(A–B) 18,000 4,000 22,000
2.Anumberof tools and techniques are availablewithmanagementaccountantsforevaluationofalternativeslikeprofitplanning,capitalbudgeting, risk techniques, linear programming, decision tree andforecastingtechniques.
3.Specialorderisgenerallyconsideredonthebasisofacomparisonbetween the price offered and expected differential costwhich isgenerally equal tovariable cost in the short period. If theprice ishigherthandifferentialcost,theorderisacceptedotheritisrejected.
•Relevant cost represents the amount of difference in terms ofcost between several alternative courses of action that are underconsiderationofadecision-maker.
•To evaluate decision alternatives in their right perspectives, amanagementaccountantneedstopossessknowledgeaboutanumberof toolsand techniques likeprofitplanning,capitalbudgeting, risktechniques, linear programming, decision tree, and forecastingtechniques.
5.Acompanyhasreceivedanorderfromaforeignbuyertosupply2,000units at a price `90.Thecompanywhichiscurrentlyoperatingat60percentoperatingcapacityproduces10,000units.Thecostsheetfortheexistingoutputofthecompanyisgivenbelow:
Thedecisionsregardingtheprocurementoffixedassetsnotonlyhavestrategicimplications for any business but also involve huge initial investment.Since the investment in such assets is usually of substantialmagnitudeandthebenefitsorservicesreceivedintheformofcashflows from theiracquisitionusuallyextendoverafairlylongperiodoftime,companiesneedto pay serious attentionoverthebudgetingofsuchexpenditures.Forabigcommercialenterprise,itmayentailmillionsofrupeesspentannuallyoninfrastructurefacilitieswhereasforasmallercommercialconcern,itmightentailtheoccasionalpurchaseforonemachinecostingseveralthousandsofrupees.Extensiveresearchandanalysisarerequiredtoaid themanagementinmakingadecisiontocommittheselargesumswhichitisassumedwillbereturnedingreatly reducedinstallmentsovermanyaccountingperiods.Infact,thesuccessofanycommercialenterprisedependslargelyuponefficientutilizationofthefixedassets.Consequently,suchdecisionsaresubjecttoasystematic evaluationprocesswhichisknownascapital budgeting.
Capitalexpendituredecisionsarenotonlyrecognizedasbeingmostcriticalforthesuccessofbusinessbutalsosubjecttoasystematicevaluationprocesstechnicallyreferredtoascapitalbudgeting.Capitalbudgetingreferstothepracticeofallocatingmoney,onaregularbasis, tobeusedforacquiringcapital assets. It is a decisionmaking process used byfirms to analysethepurchaseofmajorfixedassetswhichmayincludebothtangibleassetslike building,machinery, plant and equipment and intangible assets liketechnology,patentsandtrademarks.Commentingonthenatureandscopeofcapitalbudgeting,BiermanandSmidt(2006),statethatcapitalbudgetingis a many-sided activity that includes searching for new and more profitable investment proposals, investigating engineering and marketing considerations to predict the consequences of accepting the investment, and making economic analyses to determine the profit potential of each investment proposal.Thus,capitalbudgetingisconcernedwiththeprocessofplanningandcontrollingmajorexpenditureonprojectswithlivesextendingbeyondoneyear.
Totheauthorofthisbook,capitalbudgetingis a process of long-range planning expenditure for acquiring such assets which not only require significant investment but also generate cash flows beyond one year. It is investment decision making that aims to evaluate the financial desirability of a project with the help of cash flows rather than net income as advocated by accrual accounting.Capitalbudgetingisprimarilytheplanningandcontrolofexpenditureforcapitalassets,suchas: • replacementofexistingassetstomeetgrowingdemandsofthechanging
expandexistingoperations; • developingnewtypesofproductionmethodsand technologies like
automating production system; • respondingtosomechangeinlegal,operatingandsafetyenvironment;
and • developingthefirm’scommercialwebsites.
Exhibit 12.1 Popular Definitions on Capital BudgetingWeston and Brigham (1969): Capitalbudgetinginvolvestheentireprocessofplanningexpenditureswhosereturnsareexpectedtoextendbeyondoneyear.Thechoiceofoneyearisarbitrary,ofcourse,butisacut-offpointfordistinguishingamongthevariouskindsofexpenditures.
NOTES
Self-InstructionalMaterial 297
Capital Budgeting: Meaning and ImportanceJohn J. Hampton (1980): Capitalbudgetingdescribesthefirm’sformalplanningprocess
fortheacquisitionandinvestmentofcapitalandresultsinacapitalbudgetthatisthefirm’sformalplanfortheexpenditureofmoneytopurchasefixedassets.G.C. Philippatos (1973): Capitalbudgetingisconcernedwiththeallocationofthefirm’sscarefinancialresourcesamongtheavailablemarketopportunities.Theconsiderationofinvestmentopportunitiesinvolvesthecomparisonoftheexpectedfuturestreamofearningsfromaproject,withtheimmediateandsubsequentstreamofexpendituresforit.Sidney Davidson and Others (1983): Theprocessofchoosinginvestmentprojectsforanenterprisebyconsideringthepresentvalueofcashflowsanddecidinghowtoraisethefundsrequiredbytheinvestment.
12.2.1 Importance
Althoughthehighquantumof investmentaccompaniedbyhigherriskincapitalprojectsaregenerallyadvocatedasthebasicreasonsfortheapplicationofthecapitalbudgetingprocess,yetMoore and Jaedicke (1980),statethatcapitalinvestment decisionscallforincreasedattentionofthefirmsbecause: • substantialsumsofmoneyareusuallyinvestedincapitalprojects; • theresourcesthatareinvestedinaprojectareoftencommittedfora
The capital budgeting process beginswith invitation of proposals fromvarious departments of the organization. The step, in fact, providesorganizations the opportunities for investment. Project proposals need tobedesignedintunewithafirm’sstrategicplantoensureaperfectmatchbetweencorporateobjectivesandintendedoutcomeoftheproposals.Infact,investmentopportunitiescreatedbytheprojectproposalsmustcontributetoafirm’scorporategoals.Suchacontributionwouldhelptheorganizationtoassessthestrategicsignificanceoftheinvestment.Tohavesufficientandeffectiveprojectproposals,afirmmustencourage,appreciateandrewardthedepartmentstosubmitprojectproposalsthatareeffectivebothstrategicallyandprofitably.
Project Review and Analysis
Thisstepinvolvespreliminaryprojectscreeningandfinancialandcommercialviabilityof theprojects. Thenumberofprojectproposals receivedfromthedepartments is usuallymuchhigher than afirm’s available resourcesfor investment.Due to limited resources, it is not possible for afirm toconsiderallidentifiedprojectsforinvestment.Consequently,afirmneedstodevisesomecriterionthatwouldhelpafirminidentifyingthemostviableproposals for investment.Thecriteriongenerallyusedfor thispurpose isbasedonquantitativemeasureswhicharehighlyinfluencedbytheevaluators’judgements based on their intuitive feeling and experience.Once theprojectqualifiesthepreliminaryscreeningprocess,itissubjecttofinancialanalysiswhichexaminesthepotentialofaninvestmentincontributingtotheperformanceofafirm.Thetechniquesusedforsuchananalysishavebeendiscussed in thenextunit.However, thefinancial analysis involvesquantitative analysis to predict future cashflows from the projects.Theprocessofforecastingcashflowsisconsideredcrucialforinvestmentdecisionmakingprocess.
firmneedstochooseoneappropriatealternativeamongtwoormorealternativesassociatedwithacapitalproject.Forexample,auniversitymayhavetochoosebetweenconventionalande-admissionsystemsforenrollingthestudentsinitsMBAprogrammewithdifferentcoststructures and resources.The decision of the university to admitstudentsfortheprogrammethroughonesystemwouldeliminatetheuseoftheothersystem.Boththesystemsmaybeeffectiveandefficient
NOTES
Self-InstructionalMaterial 299
Capital Budgeting: Meaning and Importance
intheirownwaysbuttheuniversitycan’tacceptboth.Theuniversityneedstochooseonethatinitsopinionisthemostefficientandeffective.Suchsituations fallwithin thescopeofmutually exclusive projects whereafirmhastochooseoneoftheseveralalternativesprojects. In caseofsuchprojects,thefirmsneedtorankprojectsintermsoftheirdefinedcriteriaforthepurposesothatthemostappropriateprojectisidentifiedandselected.
•Ensureefficientcontroloverlargeinvestmentsandexpenditures; •Provideforcashneedsformeetingcapitalprojectprogrammes; •Analyse the impact of capital expenditure on profitability of the
Capitalbudgetingprocessincludesseveraldifferentproposals.Itdiffersfromfirmtofirm.However,themostcommononesare: • expansion; • replacement; • choiceofequipment;and • buyorlease.Expansion: Thequestionof expansionmay includewhether to build orpurchaseanewplant,orbuildorbuyanewfactory.Thisdecisionisconcernedwiththeestimationofcostwhichwillbeincurredandthereceiptswhichwillbeearnedfromaspecificprojectifundertaken.Replacement: Replacement programmes are essential for the overallgrowthanddevelopmentofacompanybecauserapidtechnologicalchangehasbecomeapermanent featureofcorporate life.To remaineffective inachangingbusinessenvironment,thefirmshavetointroducenewcapitalequipments.Consequently,firmshavetolookforcompetitiveadvantagesthroughasystematicapproachtothereplacementprogramme.However,littleattentionispaidbythemanagementtoreplacementdecisionsasindicatedbyvariousresearchstudiesconductedinthisarea.
Themanagement has to evaluate profitability of replacementinvestment.Such an evaluation shouldbebasedon an in-depth studyofallcostandsavingsinvolved.Thestudymustbecarefullymadesothatnofactorisoverlooked.Firmsoftenusesameevaluationprocessforreplacementdecisionswhichtheyuseforexpansiondecisions.Thisisnotahealthysignbecausetheanalysisofthesetwodecisionsdifferswitheachother.
Theanalysisofreplacementdecisiondiffersfromexpansiondecisioninthesensethatinthelatteremphasisisoncalculationofcostsandestimationofearnings over a numberofyearstocomewhereasintheformertheproblemistobedecidedwhethertoreplaceamachineatpresentoratafuturedate.Choice of Equipment: Itisconcernedwithdecisionofpurchaseofspecificitemsofequipmentinordertoproduceanewproduct.Therateofreturnoninvestmentwillgovernthepurchaseofequipment.
Capital Budgeting: Meaning and Importance
NOTES
Self-Instructional 302 Material
Buy-or-lease: Achoiceismadewhethertopurchaseorleasetherequiredequipment or building. In case of leased asset, a series of payments aremadeaftereveryspecificperiodintheshapeofrent.Thus,paymentsarespreadoveraseriesofannualrentalpayments.Sincethefirmhastomakepayments in installments, ithaspracticallyvery less immediatefinancialburden.However,theamountofrentoverthelifeoftheassetmayexceeditscostprice.Thisistheonlyseriouslimitationtothissystem.Incaseofpurchased assets, a huge initial capital is required,which eliminates theinitialpaymentatspecificintervalsoftime.Numberoftechniquesareusedtodecideaboutbuy-or-leasefacility.Themostvaluableandcommonlyusedamongthemisdiscountedcashflowanalysis.Theresultantnetcashinflowwilldiffernotonlyintotalamountbutalsointheirdistributionovertime,andbydiscountingtheseinflowsatanappropriateinterestrate,managementcandiscernwhether it isprofitable tobuyor lease.Thepresentworthoftheinflowsresultingfromleasingandbuyingarecomparedandthehigherpresentworthwillindicatethepreferablecourse,atleastfromthefinancialviewpoint.Ifthepresentworthofinflowsisaboutthesameforbuy-or-lease,managementcanputfinancialconsiderationsasideandmakeitschoiceonthebasisoffactorssuchasgreaterflexibilityandfreedomfromresponsibilityachievedthroughrenting,orbettercontrolandthepossibilityofacapitalgainachievedthroughbuying(Arustein,1976).
Apivotalfactorinbuy-or-leaseistheinterestrateatwhichthefutureinflows are discounted. In essence, this should be the rate atwhich thecompanycanordoesborrowlong-termfunds.Someexpertsarguethatcashinflowsinbuy-or-leaseanalysisshouldbediscountedattheminimumrateofreturnexpectedbythecompany.
Leasing has become a commonly acceptedmethod of obtainingpracticallyany typeofequipmentusedby thefirms.Unfortunately thereisnoeasyruleofthumbwhichcanbeappliedtodeterminewhenaleasingarrangementmightmakeeconomicsense.Eachleasingtransactionmustbeevaluatedinthelightofthecompany’sfinancialconditionandthetermsofthelease.Theadvantagesattributedtoleasingratherthanbuyingequipmentarenumerous,oftenredundant,andusuallyunclear.However,theadvantagesofconvenienceoftenattributedtoleasingarepurelysubjectiveandcannotbythemselvesbescrutinizedthroughquantitativeanalysis.Thisdoesnotmeanthatsubjectiveargumentsinfavourofleasingaremeaningless,butratherthatapotentiallesseeshouldaccuratelyquantifywhatitcoststoobtaintheconvenienceofleasefinancingorwhatissavedbysacrificingtheprestigeofequipmentownership.
Variousmethods of evaluation of the capital budget have been inpractice defi ned by needs and situations. Somemethods,which aim atmeasuringshareholderwealthcreation,haveevolvedoveraperiodthroughacademiccontributionsbymanyauthorsandresearchers.Thelistofvariousmethodsandtheirvariantsare: 1.AccountingMethod:AccountingRateofReturn(ARR) 2.CashflowMethods (a)Non-discountedMethods:PayBackPeriod,ReciprocalofPBP,
1. Incaseofmutuallyexclusiveprojects,thefirmsneedtorankprojectsin terms of their defined criteria for the purpose so that themostappropriateprojectisidentifiedandselected.
2.Theanalysisofreplacementdecisiondiffersfromexpansiondecisioninthesensethatinthelatteremphasisisonthecalculationofcostsandestimationofearningsoveranumberofyearstocomewhereasintheformertheproblemistobedecidedwhethertoreplaceamachineat present or at a future date.
3.Themost valuable and commonly used technique for decisionsregardingbuy-or-leasedecisionisdiscountedcashflowanalysis.
Capital Budgeting: Meaning and Importance
NOTES
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12.4 SUMMARY
•Capitalexpendituredecisionsarenotonlyrecognizedasbeingmostcritical for the successofbusinessbut also subject to a systematicevaluationprocesstechnicallyreferredtoascapitalbudgeting.
Differentapproachesareusedforevaluatingrelativeworthofalternativeinvestmentprojectswhichincludebothqualitativeandquantitativeanalysis.Qualitativeanalysismayrecognizenon-monetaryfactorslikesocialbenefits,quality,safety,flexibility,andthelikeintheevaluationofcapitalproposals.Quantitativeanalysisdeterminestheworthofinvestmentprojectsonthebasisofmonetaryfactorslikeinvestment,rateofreturn,economiclife,incometax,etc.Todealwiththisrathermixedsituation,commercialconcernsutilizeoneofthesoundapproachesfordeterminingtherelativeorabsoluteprofitabilityof all capitalproposals that areup for consideration.Havingmade thesecomputations,proposalsarelistedinthedescendingorderofprofitability.
Manydifferent techniqueshavebeendevelopedtohelpexecutives in theevaluationofcapitalprojects.Suchtechniquesrangefromthosethatrepresentroughapproximationstothosethatarerelativelyprecise.Sometechniques
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Appraisal Methodstake the timevalue ofmoney into accountwhile others ignore it in theprocessofevaluation.Themethodsthatdonottakethetimevalueofmoneyintoaccountaresimple tousebecause theydonot involvepresentvaluecomputation.Accordingly,evaluationtechniquescanbebroadlyclassifiedintotwogeneralcategories,namely: •Non-discountedcashflowmethods
o paybacko paybackreciprocalando accounting rate of return.
Paybackmethodwhichisnotonlyoneoftheoldestmethodsbutalsomostpopularmethodofevaluatinginvestmentproposalsinvolvesthecalculationof thespanof timerequired torecover initialcash investment. Infact, itdeterminesthepaybackperiodwhichisthelengthoftimethatelapsesbeforetotalcumulativecashinflows(aftertaxbeforedepreciation)fromtheprojectequaltheinitialcashoutlaysfortheproject.Theformulaforthepaybackperiod is as under:
Thus, the computation of payback period requires informationlike initialcostof theproject (investment)andnetcash inflowsfromtheinvestment.Thenetcashinflowsrepresenttheamountofprofitaftertaxbutbefore depreciation.
Assume that investment (project cost)of` 4,00,000 is expected toproduceannualreturns(cashinflows)of`50,000fortenyears.Nosalvagerecoveryisexpectedfromtheinvestmentattheendofthetenyears.Theinitialinvestmentwillberecoveredineightyears,ascalculatedbelow:
Appraisal Methods
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In theaboveexample,cashinflowswereevenlydistributedovertime.However,withnon-uniformcashinflows,thecomputationofthepaybackperiodissomewhatdifferentthoughtheconceptisthesame.Theexamplegivenbelowwillcleartheconceptandcalculationofpaybackperiodwhenthecashinflowsareunevenlydistributedovertime.Example: Suppose afirmhas twoprojects to be consideredby it.Eachinvolvesaninitialinvestmentof`40,000.Theannualcashinflowexpectedfrom investment Y and ZareshowninTable13.1
Table13.1revealsthatprojectY gives a return of `32,000inthefirstfouryearswhichis`8,000shortoftheoriginalinvestment.Fromthecashinflowsofthefifthyear,only`8,000areneededtorecovertheinvestment.Therefore, 32,000fromthefirstfouryearsplus8,000/12,000fromthefifthyearisrequired.Thepaybackperiodis4yearsand8*monthsfortheprojectY.Inthesameway,thepaybackperiodfortheprojectZ can be computed. In thisprojectthefirst2yearscanyieldnetcashinflowsof`38,000whichisdeficitby`2,000fromtheoriginalinvestment.Inthethirdyear,outofcashinflowsof`12,000,first`2,000arerequiredtorecoverinitialinvestment.Therefore,` 38,000 form thefirst twoyears plus 2,000/12,000 from thethirdyeararerequired.Thus,thepaybackperiodis2yearsand2**monthsfortheprojectZ.
Intheabove-mentionedexamples,theprojectswerewithoutthesalvagevalueandtherefore,therewasnoscopeforsalvagevalueinthecomputationofpaybackperiod.However, if theproject iswithsalvagevalueand thesameisconsideredinthedeterminationofpaybackperiod,theprocessisknownasbailout.Bailoutisamethodofdeterminingthelengthoftimethatwillberequiredforcashinflowsandsalvagevalueoftheprojecttorecoupthefundsinvestedinaproposedproject.Thisconceptisbasedonthelogic
The paybackmethod suggests the ranking of projects accordingto the lengthof timethey take topayback their initialcosts. Infact, themanagementdecidesbeforehandthemaximumpaybackperiod,i.e.,‘cut-off period’,beyondwhichaprojectisrejected.Cut-off period denotedtherisktolerancelevelinthefirm.Aprojectwithashortpaybackperiodinvolveslessriskthantheonewithalongerpayback.Therefore,managementalwaysprefers to acceptprojectswithquickpaybackbecause the short paybackperiodinrelationtotheeconomiclifewouldalsoindicatehighprofitabilityof a project.However, it is not always true because sometimes projectswithshorterpaybackperiodsmaybelessprofitableascomparedtolongerpaybackprojects.
Another glaringweakness of the payback period as a device forevaluatinginvestmentisthatitfailstoconsiderwhetherthecashinflowsareunevenlydistributedovertime.Thismethodalsodoesnottakeintoaccountthetimevalueofmoney.Thislapsecanbebridgedbyanimprovedmethodofpaybacktechnique—‘Discounted payback method’ whichrecognizesthetimeperiodrequiredtoequatecumulatedpresentvalueofcashinflowswiththepresentvalueofcashoutflowsintheevaluationofcapitalprojects.Itconsiderstheamountoftimerequiredtoconvertthenetpresentvalueofaprojectfromnegativetopositiveratherthanthetimerequiredtorecovertheactualinvestmentoftheproject.Theperiodwherethenetpresentvalueoftheproject’scashflowsamountstozeroisknownasthebreak-even period. Theperioduptobreak-evenperiodisthe‘discounted payback period’.Thebreak-evenperiodbecomestheevaluationcriterionfortheselectionoftheprojects.Theprojectswithshorterdiscountedpaybackperiodarepreferred.
Accounting rate of returnmethod also known as thefinancial statement method, the book value method, the unadjusted rate of return method is consistentwiththeaccounting measurements of income by using accounting records. It isbasedon the traditionalconceptsofaccounting income and returnon investment.Under thismethod, theevaluationof theproject isdoneonthebasisofrate ofreturn.Therateofreturnoninvestmentmaybecomputedbyseveraldifferentmethodsyieldingsomewhat differentresults.Themostcommonamongthemare: • Average rate of return on original investment: Thismethodisperhaps
Appraisal Methods • Average rate of return on average investment: Inthismethod,insteadof original investment, average investment is used for determiningrateofreturnoninvestment.Thephilosophyfortheuseofaverageinvestment is that as time passes and assets depreciate, the bookvalueof theprojectsdeclines.Therefore, theamountof investmentfordetermining rateof return shouldbe average investmentwhichisobtainedbyaddingthebeginningandendingvalueanddivingthesamebytwo.Thus,
Theresultsoftheabovetwoillustrations,clearlyrevealthatthereissignificantvariationintheaccountingrateofreturnwiththechangeintheinvestmentbase.However,thisdoesnotmeanthatonemethodissuperiortotheother.Eachinvestmentbaseissuitableforaparticularbusinessdecision.Therefore,managementshouldusetheinvestmentbasewhichitfindsmostappropriateforthepurpose.Firmsprefertouserateofreturnmethodforevaluatingcapitalprojectsastheyfindrequireddatareadilyavailablefromfinancialstatementsforevaluation.Further,thistechniqueconsidersentireearningsofaprojectratherthanearninguptothepaybackperiod.Atthesametime,theaccountingrateofreturniseasytooperateandsimpletounderstandbecause executivesfind it closely parallel to the traditional concepts ofincome analysis and investment return.However, the accounting rate ofreturnmethodisweakinthatitfailstoconsiderthetimevalueofmoneybytreatingeachfuturerupeeofincomeasequivalenttotherupeeinvestedorearnedpresently.Anotherweaknessofthismethodisthatnoconsiderationisgiventocashinflowsthatmaybeassociatedwithaproject.
Thediscountedcashflowmodelisbasedonthefollowingassumption:• Thecashinflowsfromaprojectoccurattheendofeachperiod;• The cost of capital—cost of funds obtained from investors—is
***Thecostofcapitalisatechnicaltermusedbywritersonbusinessfinancetorefertotheratewhichafirmmust earn on its investments
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Appraisal Methodswhichrepresentsthedifferencebetweenthepresentvalueofcashinflowsandthepresentvalueofcashoutflows.Ifthepresentvalueofthecashinflowsexceedsthepresentvalueofcashoutflowstheresultistermedpositivewhichindicatesthattheprojectearnsmorethantheminimumacceptablerateofinterest.Theresultisnegativeifthepresentvalueofcashoutflowsisgreaterthanthepresentvalueofcashinflowsbecauseitwouldmeanthattherateofreturnislessthantheminimumacceptablerate.Thenetpresentvaluemethodinvolvesthefollowingsteps: (i)Estimation of project’s cash inflows and outflows over the entire
rateof20percentwillbe 83.333.Inotherwordsitmeanswehavetoinvest` 83.333 in order to receive 120 after 2 years at a interest rate of 20 per cent.
Often business executives have to compute the present value of aseriesofcashinflowstobereceivedatperiodicintervalsinthefuture.Forexample`5,000istobereceivedattheendofeachyearofsixyearswithacompoundinterestof10percent.Undersuchasituationthepresentvalueofsixannualreturnistobecomputedasshownbelow:
where NPV=Netpresentvalue F1,F2......=Futurecashinflow r=Rateofinterest n=Expectedlifeoftheproject I=InitialcostoftheinvestmentTheabove-givenmathematicalformulacanonlybeappliedtosuch
decisionswhere all cashoutflowsof the project takeplace in the initialperiod.Incaseoftheinvestmentwherecashoutflowsisspreadovermorethanoneyear,thecashoutflowsaretobeconvertedtopresentvaluealongwithcashinflows.Accordingly,netpresentvaluemodelforconventionalinvestment*asgivenaboveistobemodifiedasshownbelowtohavescopefornon-conventionalinvestment*decisions.
Presentvalueofcashinflows 46,630 65,780Less: Cost of project: 40,000 40,000Netpresentvalue 6,630 25,780
CommentAbovestatementshowsthatprojectBEEiswithhighestnetpresentvalueof `25,780andtherefore,mustbepreferredoverprojectEMMwhichhasnetpresentvalueof`6,630only.Itmeansthatthevalueofthefirmwillincrease by `25,780ifitinvestsinprojectBEEbutbyonly`6,630ifitinvestsinprojectEMM.
Treatment of Project Salvage/Scrap Value in the Computation of NPV: Oftencapitalprojectswhendisposedofontheirexpiryrealisesomecashinflowintheshapeofsalvagevalueorscrapvalue.Suchavalueoftheprojectisconsideredcashinflowfortheprojectandisaddedwiththecashinflowsasgeneratedbytheprojectduringitsactivelifeand,therefore,entersinto
TheseconddiscountedcashflowtechniqueofinvestmentappraisalistheInternalRateofReturnmethod.Itisalsoknownasthediscounted rate of return method, the adjusted rate of return method, investors method,andtime-adjusted rate of return method.Thismethodattemptstodeterminetherateofinterestwhichwhenappliedtothefutureincomestreamwillexactlyequatethepresentvalueofthatstreamtothepresentvalueoftheinvestment.SucharateofinterestistechnicallyknownasInternal Rate of Return.Thus,theinternalrateofreturnisthediscountratethatequatedthepresentvalueofnetbenefitsfromtheprojectwiththecostoftheproject.Insimplewords,theinternalrateofreturnisthatdiscountratewhichwillcausethenetpresentvalueoftheprojecttobeequaltozero.Thisrateisalsoknownasthe“break-even”rate.Theformulaforcalculatingtheinternalrateofreturnis:
where F1,F2andsoon= Futurecashinflow r= Rateofinterest n= Expectedlifeoftheproject I= InitialcostofinvestmentUnderthismethod,thevalueof‘r’—internalrateofreturnisunknown
When the internal rateof return for theproject is determined, it iscomparedwiththecompany’spredeterminedrateofreturntomeasuretheprofitability of the project.The project that produces an internal rate ofreturngreaterthanthecompany’spredeterminedrateofreturn(usuallythecostofcapital)isselectedandisnormallyrejectedinothercases.Wherethemethodisusedtochoosebetweenmutuallyexclusiveprojects,theprojectthatproducesthehigherrateofreturnisselected.
Thecomputationoftheinternalrateofreturnrequiresthesamebasicdatawhich isused for thecomputationofnetpresentvalue.There isnoorganisedsystemforcalculatingtheinternalrateofreturn.Itisfoundbytrialanderror.Thepresentvalueofthecashflowsfromaninvestmentmustbecomputedat somearbitrarily selected interest rate.Where thepresentvalueofcashinflowssocomputedisequaltoinvestmentcostthatrateisselected.Normallytherateofreturnrangesbetween10percentto15percent,therefore,10percentisagoodstartpointformostoftheproblems.
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Appraisal MethodsBusinessexpertshavedevelopedasystematicprocedurefordeterminingtheinternalrateofreturnwhereinafactortechnicallyknownas“factor of the time-adjusted rate of return”iscomputedbydividinginitialinvestmentbyannualcashflowi.e.,
series of `4,000withaninitialinvestmentof`22,600.Tofindinternalrateofreturnwewillnowconsultpresentvalueannuitytables(seeAppendixTable13.1).WecaneasilyfindfromApp.Table13.1thatat12percentrateofreturnforaperiodof10years,thepresentvalueis5.650whichisexactlythefigureofthefactorwehavecomputed.Therefore,12percentrateofreturnistheinternalrateofreturnforthepresentproblem.
Present Value of cash inflows 3,33,930 3,25,740 3,18,030Less: Cost of plant 3,18,030 3,18,030 3,18,030Net present value 15,900 7,710 0
CommentsThe above result clearly shows that project TEE has an inter nal rate of return at 9 per cent whereas the internal rate of return for project SEE is 13 per cent. Therefore, it will be profitable for the company to purchase plant SEE.
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Appraisal MethodsIllustration 13.7: A company has to make a choice between two investments—Project A and B, the immediate capital outlays being 1,35,000 and 1,13,180 respectively. They have an estimated life of 5 years and 4 years respectively with no salvage value. The com pany’s required rate of return is 10 per cent. The anticipated net cash inflows for the projects over the successive years are as follows:
Years Net Cash Inflows
Project-A (`) Project-B (`)
1 20,000 25,000
2 30,000 30,000
3 45,000 40,000
4 55,000 65,000
5 40,000 –
Calculate Internal Rate of Return of the projects. Which project would you recommend and why?
SolutionStatement Showing Internal Rate of Return of Project-A
Year Cash Flows(`)
Trail I Trail II Trail III
Present Value Fac-tor at 10%
PV of Cash Flows(`)
Present Value Fac-tor at 11%
PV of Cash Flows(`)
Present Value Fac-tor at 12%
PV of Cash Flows(`)
1 20,000 0.909 18,180 0.901 18,020 0.893 17,860
2 30,000 0.826 24,780 0.812 24,360 0.797 23,910
3 45,000 0.751 33,795 0.731 32,895 0.712 32,040
4 55,000 0.683 37,565 0.659 36,245 0.635 34,925
5 40,000 0.621 24,840 0.593 23,720 0.567 22,680
Present Value of cash inflows 1,39,160 1,35,240 1,31,415
Less: Cost of plant 1,35,000 1,35,000 1,35,000
Net present value 4,160 240 (–) 3,585
The analysis of the above statement reveals that at 10 per cent discounting rate the net present value of the project amounts to ` 4,160. In the second attempt a higher discounting rate i.e., 11 per cent was used in order to reduce the amount of net present value which reached to a figure of 240. In the third attempt 12 per cent discounting rate was tested to equate the net benefits and cost of the project, it resulted in a nega tive net present value of ` 3,585. The comparative study of the result indicates that 11 per cent rate of return is the rate that approximately equates the present value of inflows
Boththeprojectssatisfythecompany’sselectioncriteriai.e.,minimumrateofreturnof10percent.However,ProjectBwillbepreferredoveraProjectAasitsinternalrateofreturn(13percent)ishigherthantheinternalrateofreturnofProjectAwhichis11.06percent.The NPV and IRR Methods Compared: Bothmethodsmake use ofdiscountedcashflowsandbothconsideramountandtimeofthecashflowarising fromaproject.Therefore, there ismuchsimilaritybetween thesetwotechniques.Butatthesametimetheydifferwitheachotheroncertaingrounds.Theimportantamongthemare: (i)Undernetpresentvaluemethoddiscountingfactori.e.,interestrate
This ratioprovidesacommonmeasurefor investmentsofdifferentmagnitudebyexpressingthepresentvalueofprojectsperrupeeofinvestment.Iftheratioisoneormorethanonetheresultistermedaspositiveandtheprojectisconsidereddesirable.Theprojectisconsideredundesirableunderareverseresult.Thehighertheprofitabilityindex,themoredesirabletheproject.Thus,italsohelpsexecutivesintherankingofcompetingprojectsparticularlywheninvestmentcostdifferssignificantly.Illustration 13.8:Aprojectrequiresinitialinvestmentof`85,000andisexpectedtogivecashflowof`18,000,`25,000,`10,000,`25,000and`30,000forfiveyears.Theprojecthasasalvagevalueof`10,000.Thecompany’stargetrateofreturnis10percent.Calculatetheprofitabilityoftheprojectbyusingprofitabilityindexmethod.
Problem 13.3:Afirmisconsideringtheacquisitionofequipmentcosting` 4,50,000.Theequipmentisexpectedtohaveausefullifeof5years.Beforeconsidering the effect of depreciation the annual cashflow returns afterincome-taxfromtheuseofthisequipmentareestimatedat`1,60,000.Thecompanyhassetacut-offrateof10percent.Calculatediscountedpaybackperiod.
SolutionCalculation of Present Values of Cash Inflows
Problem 13.4: AninterestingprojectisbeingconsideredbyMLtd.Theprojectwillrequireaninvestmentof 6,00,000inequipmentthatisexpectedtohaveausefullifeof8yearswithnosalvagevalue.Thetotalearningafterdepreciationbefore income-tax from this project during its life has been estimated `16,00,000.Incometaxisestimatedat40percentofincomebeforeincome-tax.Aminimumrate-of-returnobjectivehasbeenestablishedat15percent.Commentontheprofitabilityoftheprojectbyanalysingcompany’saveragerate of return on investment.SolutionCalculation of Total Earnings after Tax from the Project
Presentvalueofcashinflows 4,54,845 4,32,245Less: Cost of project: 2,75,000 3,00,000Netpresentvalue 1,79,845 1,32,245
TheabovestatementshowsthattheProjectAmustbepreferredoverprojectBastheprojectAhasthehighestnetpresentvalueascomparedtoProjectB.Problem 13.6:BeautyCompanyLtd. isevaluatingaproposal toacquireportablecomputerterminalforitssalesdivision.Theterminalsimplifyandspeeduporderprocessingandwouldproducecostsavingsof`40,000peryear.Thecomputerhasaeightyearusefullifewithnosalvagevalue.Thecost of computer is `1,20,000excludinginstallationchargesof`30,000.Deprecia tion of 1,50,000istobedeductedineachyearofthenext8years.Theinvestmentmustmeetaminimumrateofreturnrequirementof15percent.Incometaxisestimatedat40percentofincomebeforetax.Youarerequiredtoadvisethemanagementonthepurchaseofthecomputer.
Profitability I IIProblem 13.8: A company proposing to expand its productioncan go in either for an automatic machine costing ` 2,24,000with an estimated life of 5½ years or an ordinarymachine costing `60,000havinganestimatedlifeof8years.Theannualsalesandcostsareestimated as follows:
Labour 12,000 60,000Variableoverheads 24,000 20,000
Compute the comparative profitability of the proposals under the“paybackperiod”andReturnonInvestmentmethods.Explainthedifferenceintheresultobtainedunderthetwomethods.
(ICWA Final)
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Appraisal MethodsSolutionI. Computation of Payback Period
*Calculation of annual cash inflows(i) Automaticmachine:
Sales `1,50,000Less: Cost:
Material 50,000Labour 12,000Variableoverhead 24,000 `86,000
Cashinflow `64,000(ii) Ordinarymachine:
Sales 1,50,000Less: Cost:
Material 50,000Labour 60,000Variableoverhead 20,000 `1,30,000
Cashinflow `20,000II. Computation of Return on Investment
Appraisal Methods
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**Calculation of average investment
= `1,12,000
= `30,000Comments 1.The payback period for automaticmachine has beenworked 3½
yearsandthesameis3yearsfortheordinarymachine.Inaddition,theproductivelifeofautomaticmachineis5½yearswhichincaseoftheordinarymachineis8years.Thepaybackperiodapproachclearlyreveals that ordinarymachine should be preferred over automaticmachine.
2.The analysis of rate of return also reveals the same result that theordinarymachine is preferable to the automaticmachine.The rateofreturnincaseofformeris66.67percentandincaseoflatteritis 57.14percentonly.
Problem 13.9:TheAlphaCo.Ltd. isconsidering thepurchaseofanewmachine.Twoalternativemachines(AandB)havebeensuggested,eachcosting `4,00,000.Earningsaftertaxationareexpectedtobeasfollows:
Thecompanyhasatargetofreturnoncapitalof10percentandonthisbasis,youarerequiredtocomparetheprofitabilityofthemachinesandstatewhichalternativeyouconsiderfinanciallypreferable.Note: Thepresentvalueof` 1 at 10 per cent due in one year = 0.91 dueintwoyears= 0.83
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Appraisal Methods dueinthreeyears= 0.75 due in four years = 0.68 dueinfiveyears= 0.62 (CA Final)Solution:
Statement Showing Net Present Value (NPV) of Machines A and B.
CommentThenetpresentvalueapproachindicatesthatmachineBismoreprofitablethanmachineA as its net present value is higher.This result is furthersupplementedbyprofitabilityindex.
2.Thepayback reciprocal shouldbeusedonly for suchprojects thatgenerate uniform cash inflows.This is because non-uniform cashflowsmaycausethepaybackreciprocaltobeaverypoorestimateoftheinternalrateofreturnwhichisusedasameasuringyardfortheevaluationoftheprojectunderthismethod.
3.Thephilosophyfortheuseofaverageinvestmentisthatastimepassesandassetsdepreciate,thebookvalueoftheprojectdeclines.Therefore,the amount of investment for determining rate of return shouldbeaverage investmentwhich isobtainedbyadding thebeginningandendingvalueanddivingthesamebytwo.
4. Ifthepresentvalueofthecashinflowsexceedsthepresentvalueofcashoutflows the result is termedpositivewhich indicates that theprojectearnsmorethantheminimumacceptablerateofinterest.Theresultisnegativeifthepresentvalueofcashoutflowsisgreaterthanthepresentvalueofcashinflowsbecauseitwouldmeanthattherateofreturnislessthantheminimumacceptablerate.
• Time value of money:Itistheconceptwhichsaysthatarupeeinhandtodaypossessesmoreworththanarupeetobereceivedinfuture.
• Internal rate of return:Itistherateofinterestwhichwhenappliedtothefutureincomestreamwillexactlyequatethepresentvalueofthatstreamtothepresentvalueoftheinvestment.
methodsforevaluatingcapitalproposals. 12.Explainindetailthemajorstepsincapitalbudgeting. 13. “The discounted rate of return and the present valuemethods of
2.MarshallIndustriesLtd.isplanningtoacquireanewmachinewhichwould carry out some operations at present performed bymanuallabour.Thetwoalternativemodelsunderconsiderationare“EMM”and“ESS”.Prepareastatementofprofitabilityshowingthepaybackperiodfromthefollowinginformation:
6.Acompanyhastomakeachoicebetweenthreepossibleprojects,X,Y and Z,eachrequiringaninitialinvestmentof`18,000.Eachwillcontinuefor5yearsandithasbeendecidedthatadiscountrateof10percentisacceptableforallthree.Thecashflowsfortheseprojectsare:
Various techniques for the evaluation of capital investment or capitalexpenditureproposalshavebeendiscussedinthepreviousunit.Academiciansstronglyadvocatethediscountedcashflowtechniquesforthecapitalbudgetevaluation.TheDCFtechniquesaresaidtobeintunewiththefirm’sobjectiveofshareholderwealthmaximization,becausetheyconsiderthetimevalueofmoney.Whiletalkingabouttheindustrypracticesinthepreviouschapter,observationsweremadethatmoreandmoreIndianfirmsareshiftingtowardstheuseofDCFtechniquesfortheprojectevaluation.Almostthree-fourthof the surveyedfirmsusedDCF techniques.However, among them, theIRRwasthemostpreferredtechniquecomparedtotheNPV.AcademiciansadvocateNPVratherthanIRR,becauseinalmostallsituations,NPVservesbetter purpose.
Costsandbenefitsofaproject to thenationaleconomyaremeasuredbymakinganadjustmentinthefinancialcashflowofaproject.Thefollowingtwotypesofmodificationsareimportant: (a)Firm’scashflowbutnotthecashflowfortheeconomy(thecashflows
Someprojectcashflowsoccurforafirmbutinthecontextofthenationaleconomy, itmaynot be a cashflow.These items are excluded from thecalculation of economic cashflow.The following can bementioned asexampleswherethefirm’scashflowisnotthecashflowfortheeconomy: (a)Subsidyreceivedbythecompanyonprojectinvestment (b) Incometaxandotherdirectandindirecttaxexpensesintheproject
Letustakeanexampleoftheforeignexchangecomponentofaproject.Foreignexchangeisdeartomanynations,especiallytounderdevelopedanddevelopingnationsbecausetheyusuallyexperiencethetradedeficitorthebalanceofpaymentisunfavourabletothem.Foreignexchangeisaseriousconcern for such economies.Many corporate projects involve import ofequipmentsandmachinery,importandexportofgoodsandservicesandinsomecases,paymentfordividendsinforeignexchange.Someothersreduceimportastheyproduceimportsubstituteitems.Thefirmwilltaketheactual
Methods of Evaluation of Alternative Capital Expenditure Programme
Theprocessof calculating the economic rateof return isvery similar tothecalculationofinternalrateofreturnofaproject.Fromtheprojectcashflowcalculatedfromthefirm’sperspective,firsttheeconomiccashflowiscalculatedasexplainedinthepreviouspointandthen,arateiscalculatedatwhichthepresentvalueoftheeconomiccashinflowisequaltothepresentvalueoftheeconomiccashoutflow.Theformulacanbepresentedasfollows:
In the context of India, yet another example can bementioned—infrastructureprojects.SettingupapowerplantortheconstructionofroadisessentialfortheeconomicdevelopmentofIndia.Cascadingeffectofpowergenerationorroadontheeconomyissignificant.Therefore,neteconomicbenefitsofapowerplant to thenationwouldbehigher than itsfinancialbenefittothepromoters.Apartoftheeconomicbenefitscanbepassedontothecompanyastheirfinancialbenefitsviasomeincentives(e.g.,taxbreak)andguarantees(e.g.,rateguarantee).
14.3 SOCIAL RATE OF RETURN (SRR): SOCIAL COST-BENEFIT ANALYSIS
The concept ofERRcanbe expanded to encompass the social cost andbenefitsandtherebycalculatethesocialrateofreturn.Thismethodofprojectevaluationisalsopopularlyknownassocialcost-benefitanalysis(SCBA).Governmentandsocialprojectsareevaluatedonthelineofsocialcost-benefitanalysis.Manyinternationalfundingagencieswouldfinanceasocialprojectbasedonitssocialrateofreturn.
SCBA is a very subjectivemethod but conceptually sound.Thefollowingbrieftextgivesaconceptualexplanation.Thedetailsarekeptoutofthedomainofthisbook.Thereaderswhoareinterestedinreadingauthenticmaterial onSCBA should read ‘Manual for theEvaluation of IndustrialProjects’,UNIDOpublication,1980(reprinted1993).Also‘AGuidetotheEconomicAppraisalofProjectsinDevelopingCountries’,bytheMinistryofOverseasDevelopment(1978)ofGreatBritaincanbeuseful.
Financialanalysisiscarriedoutfromtheangleofinvestorsorfirm.Investors’netmonetarybenefitsare in thecentreoffinancial analysisofprojects.Itwasdiscussedinthemethodofeconomicrateofreturnthattheeconomic analysis is employedwhen the government is interested in itspureeconomicconsiderations.Socialimplicationsofaprojectcanalsobeencompassedintheanalysisandsocialrateofreturncanbecalculated.
Some projects, private or government, generate non-quantifiablecost-benefits.Manyprojectsofthiskindareinitiatedtoprovideeconomicimpetusandnotfortappingthecurrentlyavailableopportunities.Therippleeffectsofsuchprojectscannotbemeasuredineconomictermsasseveralcostsandbenefitsarenon-quantifiableat least immediately:forexample,constructionofadamhasseveralsocialcostslikedisplacementofhabitats,loss of agricultural land, potential effect on ecology and so on, againstmanysocialbenefitslikeirrigation,floodcontrol,beautificationandtourismpotential,etc.Thelandscapeoftheareamaychangetobenefitsomeandharmsomeothersonimmediatetermsandlong-termbasis.TheKonkanRailwayprojectisanotherexamplewhichcanbementionedhere.TheperspectivewasthatoncetheKonkanrailwaywouldbecompleted,theareathatitpassesthrough,maystartdeveloping,evenifitisadifficultterrain.However,itcouldnotbeascertainedwhatwouldbetherateofdevelopmentandwhenthedevelopmentcouldhappen.Butsuchprojectsdohaverippleeffects.Ineconomically backward areas, social infrastructure projects like literacyprogrammes,educationinitiativesandfamilyplanningprogrammescreateconditionsforeconomicgrowth.Thenon-quantifiablecostsandbenefitsinsuchprojectsareplenty.Suchprojectsbreakthecyclethatkeepstheregionbackward.Theycannotbeevaluatedeitheronfinancialoreconomicgrounds.
Inprivateprojects,akindofSCBAwouldhelpinshapinggovernmentpoliciesandpoliciesof foundationswhowork for thecommunity.Someimmediateconcernsarebuiltintothesocialcost-benefitanalysisofprivateprojectstodeterminethelevelofgovernmentincentivesanddisincentives.Today,globalwarmingisanissue.Theimpactofglobalwarmingmaynotbefeltintheforeseeablefuturebutatleastall(evenbeyondthescientificcommunity) have started agreeingnow that globalwarming is a seriousissue.Therefore,anyprojectthataffectstheozonelayerislessdesirableanddeservesdisincentivesandotherprojectslikeresearchforalternateenergyor projects using alternative energy deserve incentives.Thus, today theenvironmenteffectmustbebuiltintothesocialcost-benefits.
Most of the factormarkets are imperfect.The degree ofmarketimperfectionishighinunderdevelopedanddevelopingnations.Resourcesdonotgetfairlypricedduetoimperfection.Marketimperfectionismanifestedinimmobilityofresourcesorinmobility-shyresources.Landisnotmobile.Lackofinfrastructurekeepsawaythebusinessfromfarawayplaceswherelandmaybeverycheap.Labourismobilityshyduetofamilyandsocialreasons,coupledwith inadequate communication facilities and immigration laws.Otherresourceslikematerialarealsonotfreelymobileduetotransportation,bankingandwarehousingfacilitiesandassociatedcostsandgovernment-imposedrestrictionsworsenthemechanismofpricingofresourcesplannedasapartoftheproject.Duetosuchreasons,marketpricesdonotreflectthetrueeconomicprices,requiringtheuseofshadowpriceforthevaluationofcostsandbenefits.
Typical low savings and investment rates are also the features ofunderdeveloped and developing nations.Any project,which generatessavings,willdoeconomicgoodtothenationbecausethecascadingeffectsofsavingswillbeexperiencedbytheeconomy.Similarly,unequaldistributionofincomeandincomegeneratingopportunitiesarealsomattersofconcernforsuchnations.Aproject,whichresultsineffectiveredistributionofincome,ismorevaluablethanthoseprojectswhereincomeisconcentratedinafewhands.Someoftheresourcesconsumedorproducedmaybedearer(meritgoods) than the others.These factors of generation of savings, incomeredistribution and consumption or production of merit goods must be assigned ahighervalueastheyaretheimmediateconcernsofdevelopingnations.
Thefirststepofmeasuringthefinancialprofitabilityofaprojectatmarketprice, involves evaluationof the project from the company’s angle only.Whenitistranslatedintotheeconomiccost-benefits,somecostsandbenefitsareexcludedbecausetheyonlyamounttochangeofhandsintheeconomyasstatedinthediscussiononERRandtheeconomiccostandbenefitsarepricedateconomicrates,ratherthanmarketsrates.
• Tradablegoodsandservices,and• Non-tradablegoodsandservicesGoods that are importedor exportedor close tobeing importedor
exportedaretradable goods.Becauseofmarketdistortionsonecannottakemarketpricefortradablegoods.Therefore,tradablegoodsarepricedattheinternationalpriceofgoods.ResourcesconsumedarepricedatCIF(cost,insuranceandfreight),andresourcesproducedatFOB(freeonboard).Itisassumedherethatoneandonlyoneinternationalpriceisavailableandthatisdeterminedonlybymarketforceswithoutanyexternalfactorslikepoliticalpressure or dumping.
The value of rupee of savings is the present value of additionalconsumptionstreamproducedwhenthatrupeeofsavingisinvestedatthemargin.Asathumbrule,itisbelievedthatonerupeeinvestedinagriculturegenerates say `7, industry`10, infrastructure projects`30 and socialinfrastructuregeneratesanetvalueof`70. • IncorporatingImpactonIncomeRedistribution
Theimpactonincomeredistributionismeasuredintermsofwillingnesstopay.Varioussectorsorparties, like theproject itself,otherbusinesses,government,workers,consumersandothers,maygainor losedueto theproject.Theirwillingnesstopay(orcharge)forgoodstheyreceive(orlose)isestimated.However,themethodsofestimationmaybemuchlessobjective.Forexample,asurveymethod,whichinvolvesadministrationofquestionnairemaynotofferreliableshadowpricebecauseoflackofexperienceofgoodsandalsobecauseofpsychologicalissuesiftheyaretheloserofgoods.Onecandetermineweight(price)byusingelasticityofmarginalutilityofincomebasedontheequation14.5.
• IncorporatingImportanceofGoodsMerit goods are the oneswhose social value is greater than their
economic value. For example, conservation of oil and generation ofemploymentaremorevalueditems.Energyisameritgood.Someothersaredemeritgoods,wheresocialvalueislessthaneconomicvalue.Cosmeticsaredemeritgoods.Thelistofmeritanddemeritgoodsandtheirimportancemay vary from nation to nation.
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After-tax interest rate ismore appropriate from thefirm’s angle incalculatingfinancialrateofreturn.Intheabsenceoftheopportunityreturn,theconsumptionrateofinterestcanbetakenasthecut-offrate,asdoneinUNIDOapproach.L-Mapproachisinfavourofusing‘investmentdiscountrate’.Thediscountrateshouldthenbetherelativevalueoffutureversuspresent foreign exchange held by the government.They argue that in adeveloping country’s context,marginal foreign exchange in the hand ofthegovernmentwillbeusedforinvestment,sothediscountrateshouldbeaninvestmentdiscountrateratherthanaconsumptiondiscountrate.Someothersargueandrecommendintegratingequityconcernsbecausethefundsusedby the governments especially have intergenerational equity effect.Intergenerational equity occurs in deficit financing activity, because theburdenofdeficitfinancingisonthefuturegeneration,implyingthatthecostofequityinthefutureisrelevantasadiscountrate.Thus,intergenerationalequitycostshouldbeconsideredasthesocialrequiredrateofreturn.
Amortizationisanaccountingtechniqueusedtoperiodicallylowerthebookvalueofaloanorintangibleassetoverasetperiodoftime.Inrelationtoaloan,amortizationfocusesonspreadingoutloanpaymentsovertime.Whenapplied toanassetorcapital, amortization is similar todepreciation.Allcapitalassetswearoutordeclineinusefulnessandvalueastheybecomeagedandareused,thusanamortizationexpensemustberecorded.Accountingamortizationistheprocessofallocatingormatchingthecostofcapitalassetsoverthetimethattheyareused.Costofcapitalassetsshouldbeamortizedovertheirusefullives.
Theuseful life of aCapital asset is the estimated#of years the asset isexpectedtobeusedinbusinessoperationsofthecompany.Alsoknownas‘servicelife’,usefullifeisnotnecessarilytheasset’stotalproductivelife.Forexample,thetotalestimatedlifeofabrandnewcomputeris3–4years,yetmanylargeorganizationsprefertotradeintheiroldcomputersfornewonesevery2years.Inthisregard,thecomputerswouldhaveausefullifeoftwoyears.
returns.Likewise,abusinessfirminvestsinvariousprojects.Ifshareholdersaresubstitutedwithfirmsandequityshare(security)withprojects,theCAPMcanbeappliedforthecalculationoftherequiredrateofreturnbyafirmfromitsinvestmentinaproject.ForapplicationoftheCAPMinaprojectsituation,Rm (market return)will be the returns from awell- diversified projectportfolio,andßi willbethecovarianceofreturnsfromtheproposedprojectwithprojectmarket returns.Here,manydifficultiesmaybeencountered,someofwhichmaybe: • Unlikethesharemarket,thereisno‘projectmarket’.Therefore,project-
5.WhatistheCAStheperfectsubstitutefor? 6.Whyispredictingtheusefullifeofanassetisahardthingtodo? 7.State the assumption behind the intuitive approach toRADR
calculation.
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Methods of Evaluation of Alternative Capital
Expenditure Programme14.6 ANSWERS TO CHECK YOUR PROGRESS
4.Examplesofthenon-tradablegoodsinthecalculationofeconomiccost-benefits include value of lives saved, value of time saved,cost of pollution etc.Also included in non-traded goods are land,buildings,electricity,transportationandothers,whicharenottradedinternationally.
•Afirm’scostandbenefitsfromtheprojectandinternalrateofreturn(IRR)earnedbytheprojectforthefirmisnotanindicatorofthenetbenefit to the nation’s economy.Economic costs and benefits andeconomicrateofreturnsarecalculatedfordeterminingtheeconomicimpact of a project.
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• Someproject cashflowsoccur for afirmbut in the contextof thenationaleconomy,itmaynotbeacashflow.Theseitemsareexcludedfromthecalculationofeconomiccashflow.
•All agencies that aim at social welfare, like government andinternationalinstitutionsliketheWorldBank,InternationalMonetaryFundandUNIDOwillusesocialcost-benefitanalysisfortheevaluationof projects.
•UnitedNations InternationalDevelopmentOrganization (UNIDO)followsfivesteps(firsttwoplusthreesub-stepslistedinthethirdpointbelow) inestimatingcashflow in theSCBAapproach:Calculationoffinancialprofitability,Calculationofnetbenefitsofprojects,andadjustmentoftheneteconomiccostsandbenefits.
•Riskadjustmentistherealissueinthedeterminationofthecut-offrateforprojects.Whenthediscountrateiscalculatedaftertheadjustmentforrisk, it iscalledriskadjusteddiscountrate,popularlyknownasRADR.