COURSE SEMESTER SUBJECT FACULTY

UNIT I

: III.B.COM. : VI : MANAGEMENT ACCOUNTING : Mrs.M.INDIRAGHANDI

Management Accounting Meaning Objectives and Scope Relationship between Management Accounting, Cost Accounting and Financial Accounting. UNIT II Ratio Analysis Analysis of liquidity Solvency and Profitability Construction of Balance Sheet. UNIT III Working Capital Working capital requirements and its computation Fund Flow Analysis and Cash Flow Analysis. UNIT IV Marginal costing and Break Even Analysis Managerial applications of marginal costing Significance and limitations of marginal costing. UNIT V Budgeting and Budgetary control Definition Importance, Essentials Classification of Budgets Master Budget Preparation of cash budget, sales budget, purchase budget, material budget, flexible budget. Note: Distribution of marks: Theory 40% and Problems 60%

Unit I Meaning of Management Accounting: The term management accounting refers to accounting for the management. Management accounting provides necessary information to assist the management in creation of policy and in the day to- day operations. It enables the management to discharge all its functions i.e. planning, organization, staffing, direction and control efficiently with the help of accounting information.

Definition: Management accounting is the presentation of accounting information is such a way as to assist management in the creation of policy and in the day to day operations of an undertaking Anglo American Council of Productivity. Objectives: The objectives of management accounting are: 1. To assist the management in promoting efficiency, Efficiency includes best possible services to the customers, investors and employees. 2. To prepare budgets covering all functions of a business ( i.e. production, sales, research, and finance ) 3. To analyse monetary and non monetary transactions. 4. To compare the actual performance with plan for identifying deviations and their causes. 5. To interpret financial statements to enable the management to formulate future policies. 6. To submit to the management at frequent intervals operating statements and short- term financial statements. 7. 8. To arrange for the systematic allocation of responsibilities. To provide a suitable organization for discharging the responsibilities.

SCOPE AND FUNCTIONS OF MANAGEMENT ACCOUNTING

The scope of management accounting is very wide. It includes with in its fold all aspects of business operations. The following areas indicate the scope of management accounting.

1. Financial Accounting: Financial accounting provides historical information. It forms the basis for future planning and financial forecasting. A properly designed financial accounting system is a must for securing full control and co- ordination of business operations. 2. Cost Accounting: Cost accounting provides various techniques of costing like marginal costing, standard costing, operation costing etc. These techniques play an important role in assisting the management in the formulation of policy and the operations of the undertaking. 3. Budgetary Control: This includes framing of budgets, comparison of actual performance with budgeted performance, computation of variances, finding out their causes and suggesting remedial measures. 4 Inventory Control: It is concerned with control over inventory from the time it is received till its disposal. 4. Reporting: Reporting includes the preparation of monthly, quarterly, half yearly income statements and other related reports such as cash flow and funds flow statements. These reports are submitted to the management for evaluation of performance and decision making. 5. Statistical Methods: Statistical tools like graphs, charts, index numbers etc., are used for presentation of information to various departments. 6. Taxation: It includes preparation of income statement, assessing the effect of tax on capital expenditure proposals and pricing. 3

7. Methods and procedures: They deal with organizational methods for cost reduction, procedures for improving the efficiency of accounting and office operations. 8. Internal Audit: This refers to the establishment of a suitable internal audit system for internal control. 9. Office Services: They cover a wide range of activities like data processing, filing, copying, printing, communication etc.

FUNCTIONS OF MANAGEMENT ACCOUNTING 1. Forecasting: Making short - term and long term forecasts and planning the future operations of the business. 2. Organizing: Organizing the human and physical resources of the business. This is done by assigning specific responsibilities to different people. 3. Co ordinating: Providing different tools of co-ordination. Ex. Of such tools are budgeting, financial reporting, financial analysis, interpretation etc. 4. Controlling: Controlling performance by using standard costing, variance analysis and budgetary control. 5. Analysis and interpretation: Analyzing and interpreting financial data in a simple and purposeful manner. 6. Communicating: Communicating the results of business activities through prompt and accurate reporting system.

7. Economic Appraisal: Appraising of social and economic forces and government policies and interpreting their effect on business.

ADVANTAGES AND DISADVANTAGES OF MANAGEMENT ACCOUNTING 1. Helps in Decision Making Management accounting helps in decision making such as pricing, make or buy, acceptance of additional orders, selection of suitable product mix etc. These important decisions are taken with the help of marginal costing technique. 2. Helps in Planning: Planning includes profit planning, preparation of budgets, programmes of capital investment and financing. Management accounting assists in planning through budgetary control, capital budgeting and cost -volume- profit analysis. 3. Helps in Organizing: Management accounting uses various tools and techniques like budgeting, responsibility accounting and standard costing. A sound organizational structure is developed to facilitate the use of these techniques. 4. Facilitates Communication: Management is provided with up- to date information through periodical reports. Those reports assist the management in the evaluation performances and control. 5. Helps in Co- ordinating: The functional budgets (purchase budget, sales budget, overhead budget etc.,) are integrated into one known as master budget. This facilitates clear definition of departmental goals and co- ordination of their activities. 6. Evaluations and Control of Performance: Management Accounting is a convenient tool for evaluation of performance. With the help of ratios and variance analysis, the efficiency of departments can be measured. Management accounting assists the management in the location of weak spots and in taking corrective actions. 5

7. Interpretation of financial Information: Management accounting presents information in a simple and

purposeful manner. This facilitates quick decision-making.

8. Economic Appraisal: Management accounting includes appraisal of social and economic forces and government policies. This appraisal helps the management in assessing their impact on the business. Limitations of Management Accounting 1. Based on Accounting Information: Management accounting derives information from past financial

accounting and cost accounting records. If the past records are not reliable, it will affect the effectiveness of management accounting. 2. Wide scope: Management accounting has a very wide scope incorporating many disciplines. This results in inaccuracy and other practical difficulties. 3. Costly: The installation of management accounting system requires a large organization. Hence, it is very costly and only big concerns can afford to adopt it. 4. Evolutionary Stage: Management accounting is still in its initial stages. Tools and techniques are not fully developed. This creates doubts about the utility of management accounting. 5. Opposition to Change Introduction of management accounting system requires a number of changes in the organization structure, rules and regulations. The people involved do not generally like this rearrangement. 6. Intuitive Decisions:

Management accounting helps in scientific decision-making. Yet, because of simplicity and personal factors the management has a tendency to arrive at decisions by intuition.

7. Not an Alternative to Management: Management Accounting will not replace the management and

administration. It is a tool of the management. Decisions are of the management and not of the management accountant. DIFFERENCE BETWEEN THE MANAGEMENT FINANCIAL ACCOUNTING 1. Objectives: The main objective of financial accounting is to supply information in the form of profit and loss account and balance sheet to outside parties like shareholders, creditors, government etc. But the objective of management accounting is to provide information for the internal use of management. 2. Performance Analysis: Financial accounting is concerned with the overall performance of the business. On the other hand management accounting is concerned with the department or divisions. It reports about the performance and profitability of each of them. 3. Data Used: Financial accounting is mainly concerned with the recording of past events whereas management accounting is concerned with future plans and policies. 4. Nature: Financial Accounting is based on measurement while management accounting is based on judgment. Because of this, financial accounting is more objective and management accounting is more subjective. 5. Accuracy: Accuracy is an important factor in financial accounting. But ACCOUNTING AND

approximations are widely used in management accounting. This is because most of the information is related to the future and intended for internal use. 7

6. Legal Compulsion: Financial Accounting is compulsory for all joint stock companies but management accounting is only optional.

7. Monetary Transactions: Financial Accounting records only those transactions, which can be expressed in terms of money. On the other hand, management accounting records not only monetary transactions but also non monetary events, namely technical changes, government policies etc., 8. Control: Financial accounting will not reveal whether plans are properly implemented. Management accounting will reveal the deviations of actual performance from plans. It will also indicate the causes for such deviations. DIFFERENCE ACCOUNTING BETWEEN COST ACCOUNTING AND MANAGEMENT

1. Objective: The objective of cost accounting is the ascertainment and control of costs of products or services. But the objective of management accounting is to help the management in decision-making, planning, control etc. This objective is achieved by furnishing relevant accounting information to the management. 2. Scope: Cost accounting deals primarily with cost data. Bust management accounting deals with both cost and revenue. It includes financial accounting, cost accounting, budgeting, reporting to management and interpretation of financial data. Thus, scope of management accounting is wider than that of cost accounting. 3. Data Used: In cost accounting, only those transactions that can be expressed in figures are taken. Only quantitative aspect is recorded in cost accounting. But management accounting uses both quantitative and qualitative information. 4. Nature:

Cost accounting uses both past and present figures. But management accounting is concerned with the projection of figures for future. The policies and plans are prepared for providing future guidelines.

FUNCTIONS OF A MANAGEMENT ACCOUNTANT 1. Planning for Control: Management accountant establishes, coordinates, and maintains an integrated plan for control of operations. Such a plan includes profit planning, sales forecast, expense budgets, cost standards etc. 2. Evaluation of performance: He should evaluate various policies and programmes. The

effectiveness of planning and procedure to attain the objective of the organization depends upon the caliber of the management accountant. 3. Reporting: He has to compare the actual performance with plans and standards. The results of the operations are to be interpreted and reported to all levels of management. This is done through compilation accounting records, statistical records and reports. 4. Tax Administration: He supervises all matters relating to tax accounting. The management accountant advises the management regarding the effect of taxation on capital expenditure proposals and tax planning. 5. Protection of Assets: The protection of business assets in another function of a management accountant. This function is performed through the maintenance of internal control, auditing and proper insurance coverage to assets. 6. Appraisal of External Effects: He is to assess the effect of various economic and fiscal policies of the government. He has to interpret their effects on business to the management. 9

UNIT II RATIO ANALYSIS Meaning of ratios: A relationship between two figures expressed mathematically is called a ratio. A ratio analysis is a technique of analysis and interpretation of financial statements. Significance of ratios: Ratio analysis is a powerful tool of financial analysis. It is used as a device to analyze and interpret the financial health of a firm. Analysis of financial statements with the aid of ratios helps the management in decision making and control. Uses of ratios: The use of ratio analysis is not confined to financial managers only. Different parties are interested in knowing the financial position of a firm for different purposes. Ratio analysis is used by creditors, banks, financial institutions, investors and shareholders. It helps them in making decisions regarding the granting of credit and making investments in the firm. Limitations of ratios: Inadequacy of standards Limitations of financial statements Ratios alone are not adequate Difficulty in comparison Problem of price level changes Window dressing Personal bias No fixed standards No indicators of future 10

Classification/Types of Ratios: I. Liquidity ratios / Short-term solvency ratios: Liquidity ratios measures the ability of the firm to meet its current obligations. They indicate whether the firm has sufficient liquid resources to meet its short-term liabilities. The following are important liquidity ratios: 1. Current ratio: It is the relationship between current assets and current liabilities. Current assets -----------------Current liabilities A current ratio of 2:1 is considered ideal. 2. Quick ratio/ Liquid ratio/ Acid test ratio: It is a relationship between quick assets and quick liabilities. Quick assets are those assets, which are easily converted into cash. Quick ratio = Quick assets ---------------Quick liabilities Current ratio =

Quick assets= Current assets- (Stock + Prepaid Expenses) Quick liabilities= Current liabilities Bank overdraft. A quick ratio of 1:1 is considered satisfactory. II. Solvency ratios/ Long term ratios:

1. Debt-equity ratios: It is a relationship between shareholders funds and outsiders funds. Outsiders funds include all long term and short-term debts. Shareholders funds include preference share capital, equity share capital and reserves and surpluses. Debt-equity ratio = Debt -----11

( Or )

Equity = Outsiders funds ------------------Shareholders funds

A debt equity ratio of 1:1 is considered satisfactory.

2. Proprietory ratio: It is the relationship between proprietors funds and total tangible assets. Proprietory ratio = Shareholders funds -----------------------Total Tangible assets

III.

Profitability ratios:

Profitability ratios measure the profitability of a firms business operations. 1. Gross profit ratio: This ratio expresses the relationship between gross profit and net sales. Gross profit ratio = Gross profit -------------Net sales X 100

2. Net profit ratio: This ratio expresses the relationship between Net profit and net sales. Net profit ratio= Net profit -------------Net sales X 100

3. Operating ratio: Operating ratio Cost of goods sold + Operating expenses ------------------------------------------------Sales Operating expenses include selling and distribution expenses and =

administration expenses.

4. Return on capital employed: Return on capital employed establishes the relationship between the profits and the capital employed. It is mostly used to measure the overall profitability and efficiency of the business. Return on capital employed = 12 Net profit + Interest + Taxes

-------------------------------------X 100 Average capital employed (Or) Capital employed Capital employed = Fixed Assets + Current Assets Current liabilities (Or) Shareholders funds+ Long-term liabilities.

IV.

Activity Ratios/Turnover ratios:

1. Stock (or) Inventory turnover ratio: This ratio indicates the number of times the stock is turned over or replaced during a year. A higher ratio indicates quick movement of stock and vice versa. Stock turnover ratio = Cost of goods sold --------------------Average stock

2. Debtors turnover ratio: This ratio indicates the number of times debtors are turned over during a year. Debtors turnover ratio= Credit sales -------------Debtors

2.1

Average Collection Period:

This ratio indicates which debtors/accounts receivable are collected. It shows the number days taken to collect money from debtors. Average Collection Period = Debtors + Bills receivable ------------------------Credit sales 3. Creditors Turnover ratios: year. This ratio indicates the number of times Creditors are turned over during a Creditors turnover ratio 3.2 Average Payment Period: It shows the number of days taken by the firm to pay the debts to its 13 = Credit purchases --------------------Creditors x No of working days in a year

creditors. Average payment Period = Creditors + Bills payable --------------------------- x No of working days in a yr Credit purchases 4. Fixed Assets turnover ratio: Fixed assets turnover ratio explains the relationship between sales and fixed assets. Fixed Assets turnover ratio = Sales -----------------Net fixed assets V. Capital structure ratio:

1. Capital gearing ratio: This ratio explains the relationship between equity shareholders funds on the one hand and preference share capital and fixed interest bearing loan on the other. Capital gearing ratio = Preference share capital+ Fixed interest securities ---------------------------------------------Equity shareholders funds

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UNIT III WORKING CAPITAL Meaning of working capital: Capital required for the purchase of raw materials, and for meeting the dayto-day expenditure on salaries, wages, rents and advertising etc., is called working capital. TYPES OF WORKING CAPITAL: 1. Net Working Capital: The net Working capital is the difference between current assets and current liabilities. 2. The concept of net working capital enables a firm to determine how much amount is left for operational requirements. Gross Working Capital: Gross working capital is the amount various components of current assets. This concept has the following advantages: Financial managers are profoundly concerned with current assets. Gross working capital provides the correct amount of working capital at the right time; It enables a firm to realize the greatest return on its investment; It helps in the fixation of various areas of financial responsibility; It enables a firm to plan and control funds and to maximize the return on investment. Gross working capital has become a more acceptable concept in financial management. 3. Permanent Working Capital: Permanent working capital is the minimum amount of current assets, which is needed to conduct a business even during the dullest season of the year. This amount varies from year to year, depending upon the growth of a company and the stage of the business cycle in which it operates. It is the amount of funds required to produce the goods and services, which are necessary to satisfy demand at a 15 of funds invested in the

particular point. It represents the current assets, which are required on a continuing basis over the entire year. It is maintained as the medium to carry on operations at any time. Permanent working capital has the following characteristics: (a) It is classified on the basis of the time factor; (b) It constantly changes from one asset to another and continues to remain in the business process; (c) Amount of capital Working Capital working capital Permanent Its size increases with the growth of business operations. Temporary working

Time

Temporary working capital Amount of Working Capital working capital Time (A) Initial Working Capital: At the time of inception of a company and during the formative period of its operation, it should set up a sizeable cash fund to meet its obligation. In initial years revenues may not be regular and adequate, credit arrangements may not be available from banks etc. till the company established its credit standing; credits may have to be granted on sales to attract the customers. (B) Regular Working Capital: The amount needed to keep the operations in continuity. It refers to excess of current assets over current liabilities so that the process of conversion of cash into stock, stock into sales, receivables and collections is maintained without break. 16 Permanent

4.

Temporary or Variable Working Capital: It represents the additional assets which are required at different times during

the operating year additional inventory, extra cash, etc. Seasonal working capital is the additional amount of current assets-particularly cash, receivables and inventory that is required during the more active business seasons of the year. It is temporarily invested in current assets and possesses the following characteristics: It is not always gainfully employed; through it may change from one asset to another, as permanent working capital does; It is particularly suited to business of a seasonal or cyclical nature. (A) Seasonal Working Capital: Obviously it refers to financial requirements that crop up during the particular season beyond their initial and regular circulating capital. the seasonal busy periods. (B) Special Working Capital: All business enterprises have to be prepared to meet unforeseen risks that may arise in the course of operations. These should have extra funds at unstated period to meet contingencies. Need/ Object of working capital: Modern business enterprises produce goods in anticipation of demand. Goods produced are not sold immediately. Cash for sales is not realized immediately. From the time of Purchase of raw materials, to the time of realization of cash for sales made, an operating cycle is involved. The following stages are usually found in the operating cycle of a manufacturing firm. 1) Conversion of cash into raw materials 2) Conversion of raw materials into work-in-progress 3) Conversion of work-in-progress into finished goods 4) Conversion of finished goods into debtors through sales 5) Conversion of debtors into cash Most businesses will require at stated intervals a larger amount of current assets to fill the demands of

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Debtors

Sales

Cash

Finished goods

Raw Materials

Work in progress

Purposes of working Capital To purchase raw materials, spares and component parts. To Pay wages and salaries. To incur day to day expenses To provide credit facilities to customers. To maintain inventories of raw materials, work-in-progress and finished stock. Advantages/ Importance of working capital: Continuous Production Solvency and goodwill Easy loans Cash discounts Regular payments of expenses. Exploitation of market conditions.

Dangers / disadvantages of excessive working capital: Excessive working capital means idle funds which earn no profits for the business. Due to low rate of return on investments, the value of shares may also fall. It leads to unnecessary purchasing and accumulation of inventories. It is an indication of excessive debtors and defective credit policy. 18

Dangers / disadvantages of inadequate of working capital: A concern cannot pay its short- term liabilities in time; it loses its reputation and faces tight credit terms. It cannot buy its requirements in bulk and take advantage of cash discounts. The concern will face difficulties in meeting its day-to-day expenses. This leads to inefficiency, increase in cost and reduction in profits. Fixed assets are not effectively utilized. Thus the rate of return on investments falls. IMPORTANCE OF WORKING CAPITAL: 1. Bill Payment: Sufficient working capital enables the company to pay its bills, to meet the daily expenses, to make the routine purchases as and when required. in scarcity at materials, irregular payment of wages, etc. 2. Solvency: It also ensures solvency of the firm. Continuing production and sales would generate funds to meet the day-to-day expenses and hence availability at liquid funds brings to the firms a touch of doubtless solvency and strength. 3. The worthiness of credit: The creditworthiness of the company is rated high if its working capital position is found satisfactory. Credit status depends on ability to pay and the A company with adequate promptness with which payments are actually made. s credit standing in the public. 4. More credit facility: A company with sound working capital arrangements having high rated credit standings will be able to procure credit from commercial banks on easy or competitive terms. Particularly the seasonal loans are readily granted by banks to companies which have good reputation of having adequate initial working funds. 5. Cash discount: A company having sufficient funds will be able to take advantage of cash discount offered by suppliers of raw materials or other merchandise for prompt payment. 6. High morale of employees: 19 Thus the business is kept going without interruption arising from shortage of funds reflected

working capital can afford to be regular and prompt in payments and thus maintain it

Regular payment of wages and salaries by a company with working capital maintains and enhances morale among the personnel and efficient performance can be secured thereby. 7. Business cycles: A company having strong finances can successfully whether the storms at business cycles. In depression there would be pressure or working funds; hence a company having sufficient cash reserves will be able to ride over the dark phase at slump and recession. 8. Boom period: In times of boom when there is rush of orders, companies having adequate working capital can execute the routine as well as special caders by purchasing additional raw materials and employing additional staff. 9. Higher prices of product: Companies having sufficient working funds can wait for better marketing opportunities by holding up inventories and secure higher prices. Otherwise, hasty sales by companies with short funds would lower their bargaining power in the competition. 10. Self-confidence: Continued prosperity and progress at the undertaking can be maintained by ample working capital. Managers themselves will get self-confidence and can infuse such confidence among the other levels of administration. Fund flow statement Meaning: The funds flow statement is a report on the movement of funds or working capital. It explains how working capital is raised and used during an accounting period. Definition: 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. Objectives of fund flow statement To show how the resources have been obtained and used. To indicate the results of current financial management. 20

To show how the general expansion of the business has been financed. To have an assessment of the working capital position of the concern. Concept of flow of funds: The term flow means change and therefore the term flow of funds means

change in funds or change in working capital. Flow of funds means increase or decrease in working capital. If the transaction does not affect the working capital there is no flow of funds.

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UNIT IV Marginal Costing Introduction The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term. Marginal costing - definition The ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs. Features of Marginal costing: All costs are classified into two- fixed and variable Only the variable costs are treated as the cost of the product The stock of finished goods and work-in-progress are valued at marginal cost only. Prices are based on marginal cost + contribution. Fixed costs are charged against contribution earned during the period.

Advantages and Disadvantages of Marginal Costing Technique Advantages Marginal costing is simple to understand. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management.

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It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.

Disadvantages The separation of costs into fixed and variable is difficult and sometimes gives misleading results. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.

Theory of Marginal Costing The theory of marginal costing as set out in A report on Marginal Costing published by CIMA, London is as follows: In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.

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Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output. There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing. Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales. The principles of marginal costing The principles of marginal costing are as follows. a. For any given period of time, fixed costs will be the same, for any volume of

sales and production (provided that the level of activity is within the relevant range). Therefore, by selling an extra item of product or service the following will happen. Revenue will increase by the sales value of the item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from the extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. 24

c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.

MARGINAL COST STATEMENT Particulars Sales Less: Marginal cost / Variable cost Direct Material Direct Labour Variable overheads Contribution Less: Fixed cost PROFIT Breakeven Analysis Break-even point refers to the point where the total cost is equal to total revenue. Break Even Points (in Units) = Fixed Expenses ------------------Contribution per unit. Fixed Expenses ------------------Contribution. X sales Rs Rs xxxxx

xxxx xxxx xxxx xxxx xxxx xxxx

Break Even Points (in Rupees) =

Cost-Volume-Profit (C-V-P) Relationship CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows: 1. What is the breakeven revenue of an organization? 2. How much revenue does an organization need to achieve a budgeted profit? 3. What level of price change affects the achievement of budgeted profit? 4. What is the effect of cost changes on the profitability of an operation?

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Cost-volume-profit analysis can also answer many other what if type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to what if theme by telling the volume required to produce.

Objectives of Cost-Volume-Profit Analysis 1) In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other. 2) Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities. 3) Cost-volume-profit analysis assist in evaluating performance for the purpose of control. 4) Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit. Terms used in marginal costing: 1. Contribution Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. Contribution Contribution = Sales Variable cost = Fixed cost + Profit

Sales Variable cost = Fixed cost + Profit 2. Profit Volume Ratio (P/V Ratio), its Improvement and Application The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:

P/V Ratio) = Contribution Sales

(OR)

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P/V Ratio =

Changes in profit -----------------------Changes in sales

X 100

3. Breakeven Point Break-even point refers to the point where the total cost is equal to total revenue. Break-even point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that: Contribution = Fixed cost Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit. Break Even Point (in Units) = Fixed Expenses ------------------Contribution per unit. Break Even Point ( in Rupees) = Fixed Expenses ------------------Contribution. (OR) = Fixed Expenses ------------------P/V ratio X sales

4. Margin of Safety (MOS) Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business. Margin of safety = Margin of safety = Actual Sales - Break Even Sales. (OR) Profit ------P/V ratio

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UNIT V BUDGETING AND BUDGETARY CONTROL Budgeting and budgetary control:Planning is the basic managerial function. It helps in determining the course of action to be followed for achieving organisational goals. It is decision in advance what to do , when to do, how to do, and who will do a particular task? Plans are framed to achieve better results. A budget is the monetary or and quantitative expression of business plans and policies to be pursued in the future period of time. The term budgeting is used for preparing budgets and other procedures for planning, co-ordination and control of business enterprise.

Meaning of

Budget:

Budget is a plan of action expressed in financial terms or non financial terms. It is prepared for a definite period of time. Meaning of Budgetary control:

It is the process of determining various budgeted figures for the enterprises for the future period and then comparing the budgeted figures with the actual performance for calculate variances, if any, first of all budgets are prepared and then actual results are recorded. The comparisons of budgeted and actual figures will enable the management to find out discrepancies and take remedial measures at a proper time. The budgetary control is a continuous process which helps in planning and co-ordination. It provides a method of control too. A budget is a means and budgetary control is the end results.

Definition of Budget: According to ICMA, England, a budget is , A financial and / or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during the period for the purpose of attaining a given objective.

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Definition of Budgetary control: According to ICMA, England, a budgetary control is, The establishment of budgets relating the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with budgeted results either to secure by individual action the objectives of the policy or to provide a basis for its revision. Merits / Advantages of budgetary control: Budgetary control has become an essential tool of the management for controlling cost and maximizing profits. It acts as a friend , Philosopher, and guide to the management . The following are the merits of budgetary control: Budgetary control defines the objectives and policies of the undertaking as a whole It secures proper co-ordination among the activities of various departments It helps the management to fix up responsibility in case the performance is below its expectations. It helps the management to reduce wasteful expenses It facilitates centralized control with decentralize activity It facilitates introduction of standard costing. It acts as internal audit by a continuous evaluation of departmental results and cost. It aids in obtaining bank credit It provides a basis for introducing incentive remuneration plans based on performance It indicates to the management as to where action is needed to solve problems without delay. Demerits/ Limitations of budgetary control: 1. Budget is only a management tool. It is not a substitute for management in decision-making. 2. Budgeting involves heavy expenditure; it is not suitable for small industry. 3. Accuracy in budgeting comes through experience. Hence it should not be suitable in the initial stages 4. The success of budgetary control depends upon willing co-operation and teamwork.

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Objectives of budgetary control: 1. To define the goal of the enterprise. 2. To provide long and short period plans for obtaining these goals. 3. To co-ordinate the activities of different departments 4. To operate various cost centers and departments with efficiency and economy. 5. To eliminate waste and to increase the profitability. 6. To eliminate capital expenditure requirements of the future. 7. To correct deviations from the established standards. 8. To fix the responsibility of various individuals in the organization.

Requisites for successful budgetary control system.:1. Clarifying objectives. 2. Proper delegation of authority and responsibility. 3. Proper communication system. 4. Budgeted education. 5. Participation of all employees. 6. Flexibility. 7. Motivation Essential of budgetary control:1. Organization for budgetary control 2. Budget centers. 3. Budget officers. 4. Budget manual. 5. Budget committee. 6. Budget period. 7. Determination of key factor 1. Organization for budgetary control: The proper organization is essential for the successful preparation, maintenance and administration of budgets. A budgetary committee is formed which comprises the departmental heads of various departments. All the functional heads are entrusted with the responsibility of ensuring proper implementation of their respective departmental budgets. 2. Budgets centers: A budget centers is that part of the organization for which the budget is prepared. A budget center may be in a department, section of a department or any 30

other part of the department. The establishment of budget centers is essential for covering all parts of the organization. The budget centers are also necessary for cost control purposes. The appraisal of performance of different parts of the organization becomes easy when different centers are established. 3. Budget manual: A budget manual is a document that spells relations among various functionaries. 4. Budget officers: The budget officer is empowered to scrutinize the budget prepared by different functional heads and to make changes in them, if the situation so demands. The actual performance of different department is communicated to the budget officer. He determine the deviations in the budgets and takes necessary steps to rectify the deficiencies, if any. He works as a co-ordination among different department and monitors the relevant information. He also informs the top management about the performance of different departments. 5. Budget committee: In small-scale concerns, the accountant is made responsible for preparation and implementation of budgets. In large scale concerns a committee known as Budget Committee is formed. The heads of all the important departments are made members of this committee. The committee is responsible for the preparation and execution of budgets. 6. Budget period: The budget period depends upon a number of factors. It may be different for industries or even it may be different in the same industry or business. The budget period depends upon the following circumstances: i) The type of budget i.e., sales budget, production budget, raw material budget, capital expenditure budget. A capital expenditure budget may be for a longer period i.e., 3 to 5 years; purchase sales budget may be for one year. ii) iii) iv) v) The nature of demand for the products. The timings for the availability of the finances. The economic situation of the cycles. The length of trade cycle out the duties and also the responsibilities of the various executives concerned with the budgets. It specifies the

7. Determination of key factor: The budgets are prepared for all functional areas. These are interdependent and inter-related. A proper co-ordination among different budgets is necessary for making the budgetary control success. The constraints on some 31

budgets may have an effect on other budgets too. A factor that influences all other budgets is known as key factor or principals factor.

BUDGETARY CONTROL SYSTEM: 1. Clarifying objectives: The budgets are used to realize objectives of the business. The objectives must be clearly spelt out so that budgets are properly prepared. In the absence of clear goals, the budgets will also be unrealistic. 2. Proper delegation of authority & responsibility: It is done at every levels of management. Even though budgets are finalized at top level but involvement of persons from lower levels of management is essential for their success. This necessitates proper delegation of authority & responsibility. 3. Proper communication system. An effective system of communication is required for a successful budgetary control. The flow of information regarding budgets should be quick so that these are implemented. The upward communication will help in knowing the difficulties in implementation of budgets. The performance report of various levels will help top management in budgetary control. 4. Budget education: The employees should be properly educated about the benefits of budgeting system. They should be educated about their role in the success of this system. The employees may not take budgetary control only as a device but it should be used as a tool to improve their efficiency. 5. Participation of all Employees:The employees, on the basis of their past experience, may give more practical & useful suggestion. The success of budgetary control system depends upon the participation of all employees of the organization. 6 Flexibility: Flexibility in budgets is required to make them suitable under changed circumstances. Budgets are prepared for the future, which is always uncertain. Even though budgets are prepared by considering the future possibilities but still some occurrences later on may necessitate certain adjustments. Flexibility will make the budgets more appropriate and realistic.

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7.

Motivation: All persons should be motivated to improve their working so that budgeting

is successful. A proper system of motivation should be introduced for making this system a success.

Classification of budgets / Types of budgets: I. Classification according to time: 1. Short period budget: These budgets are usually for a period of one year. Ex ., Cash budget, Material budget 2. Long Period budget: These budgets are usually for a long periods i.e 5-10 years. Ex Capital Expenditure budget. 3. Current budget: These budgets are for a very short period say a month. II . Classification according to function: 1. Sales budget: A sales budget is an estimated of expected sales during the budget period. 2. Production budget: Production budget is an estimate of quantity of goods that must be produced during the budget period 3. Materials budget: The materials budget deals with only the direct materials. Materials budget can be classified into two categories: 1) Materials requirement budget and Materials purchase budget 4. Direct labour budget: This indicates detailed requirements of direct labour and its cost to achieve the production target. This budget is classified into two categories. 1 Labour requirement budget and 2. Labour recruitment budget. 33 2)

5. Factory overhead budget: Factory overhead budgets indicates the factory overheads to be incurred in the budgeted period 6. Administrative expenses budget: The budget is an estimate of administrative expenses to be incurred in the budget period. 7. Selling and distribution overhead budget: The budget gives an estimate of selling and distribution expenses to be incurred in the budgeted period. 8. Capital Expenditure budget: This budget gives an estimated expenditure on fixed assets during the budgeted period. 9. Cash budget: This budget gives an estimate of receipts and payments of cash during the budget period. 10. Master budget: This budget is prepared incorporating all functional budgets. It is defined as, The summary budget incorporating the functional budgets which is finally approved, adopted and employed.

III.Classification according to flexibility: 1. Fixed budget: Fixed budget may be defined as, A budget designed to remain unchanged irrespective of the level of activity actually attained 2. Flexible budget/Variable budget: A budget designed to change in accordance with the level of activity actually attained.

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DIFFERENCE BETWEEN FIXED & FLEXIBLE BUDGETS: Basis distinction 1.Rigidity of Fixed Budget A fixed budget remains the same irrespective of changed situations. It remains inflexible even if volumes of business are changed. A fixed budget assumes that conditions will remain constant. In fixed budget costs arte not classified according to their nature. If the level of activity changes the budgeted and actual results cannot be compared because of changes in basis. Forecasting of accurate results is difficult. Flexible Budget A flexible budget is recast to suit the changed circumstances. Suitable adjustments are made if the situations so demands. This budget is changed if level of activity varies. The costs are studied as per their nature, i.,e., fixed, variable, semi-variable. The budgets are redrafted as per the changed volume and a comparison between budgeted and actual figures will be possible. Flexible budgets clearly show the imp pact of expenses on operations and it helps in making accurate forecasts. The costs can be easily ascertained under different levels of activity. This helps in fixing prices.

2. Conditions 3.Cost classification. 4. Changes volume in

5. Forecasting

6.Cost Ascertainment.

Under changed circumstances costs cannot be ascertained.

ZERO BASE BUDGETING (ZBB):-Zero base budgeting is the latest technique of budgeting and it has an increased use as a managerial tool. This technique was first used in America in 1962. The former president of America, Jimmy Carter used this technique when he was the governor of Gorgia for controlling state expenditure. Zero base budgeting is a management technique aimed at cost reduction and optimum utilization of resources. This technique was introduced by the US Department of agriculture in 1961. The normal technique of budgeting is to use previous years cost level as a base for preparing this years budget. This method carries previous years inefficiencies years to the present year because we take last year as a guide and decide `what is to be done this year when this much was the performance of the last year`. In zero base budgeting every year is taken as a new year and previous year is not taken as a base. The budget for this year will have to be justified according to the present situations.

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In zero-base budgeting a manager is to justify why he wants to spend. The preference of spending on various activities will depend upon their justification and priority for spending will be drawn. It will have to be proved that an activity is essential and the amounts asked for are really reasonable taking into account the volume of activity.

Meaning of ZBB: Every year is taken as a new year and previous year is not taken as the base, in the preparation of budgets. Rather zero is taken as the base . Something will not be allowed simply because it was allowed in the past. ZBB proceeds on the assumption that nothing is to be allowed.

PROCESS OF OR STEPS INVOLVED IN ZBB:_ 1) The objectives of budgeting should be determined. When the objective is clear, then efforts will be made to achieve that objective. Different organizations may have different objectives. One concern try to reduce the expenditure on staff, another may try to discontinue one project in preference to another. So the first step will decide about the object and then other steps will be possible. 2) The extent to which zero base budgeting id to be applied should be decided. Whether it should be used for all operational areas or its should be applied in some areas only should be decided beforehand. 3) The next step in ZBB is developing of `decision package. A decision package is a `document that identifies a specific activity in such manner that management can evaluate and rank it against other activities competing for limited resources, and decide whether to `approve or disapprove it`. 4) Cost & benefit analysis should be undertaken. We should consider the cost involved and the likely benefits to accrue. Only those projects should be taken first where benefit is more as compared to the cost involved. Cost benefit analysis will help in fixing priority for various projects on the basis of their utility or ranking of decision packages. 5) The final step involved in zero-Base budgeting is concerned with selecting, approving decision packages and finalizing the budget.

Benefits or Advantages:-

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1) It

provides

systematic

way

to

evaluate

different

operations

and

programmes. 2) It enables the management to allocate the resources according to benefit or importance 3) It helps in identifying and controlling wasteful expenditure. 4) ZBB does not allow some expenditure/activity simply because it was done in the past. 5) It provides a systematic way to evaluate different operations and programmes. 6) It enables the management to allocate the resources according to benefit or importance 7) It helps in identifying and controlling wasteful expenditure. 8) ZBB does not allow some expenditure/activity simply because it was done in the past. 9) ZBB is appropriate for staff and support areas whose output is not related to production. 10)It enables management to allocate funds according to the jurisdiction of the programme. The priority can be fixed for various activities and their implementation will be in the same order. 11)It improves efficiency of the management. Every manager will have to justify the demand for resources. Only those activities will be undertaken which will have justification and will be essential for the business. 12)It will help in identifying economical and wasteful areas. Emphasis will be given to economical activities and alternative course of action will also be studied. 13)The management will be able to make optimum use of resources . The expenditure will be undertaken only when it will have justification. A list of priorities is prepared and cost-benefit analysis will be the guiding principle in fixing the priority. 14)Budgeting will be related to organizational goals. Something will not be allowed on the plea that it was done in the past. Only those things will be allowed which will help in realizing organizational goals. Limitations of ZBB:1. Computation of cost benefit analysis, which is essential for ZBB is not possible in respect of non-financial matters. 2. Difficulties in formulation and ranking of decision pelages as every manager may not have the necessary expertise. 37

3. The system of zero-base budgeting has no scope to adjust for the changes and thus, flexible budgeting is not possible. 4. It involves a lot of time and cost of operating ZBB is also very high.

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