BBA 407 – MANAGEMENT ACCOUNTING

SET-1

Q1. In Zero base budgeting, all expenses have to be justified for every new term Explain
Zero Based Budgeting

Answer:

Zero-base budgeting is the preparation of budget starting from scratch. Conventional budgets are
prepared mainly on past performance and actual costs. On the other hand, zero-base budgeting is
not based on the previous year’s figures and is developed on the basis of likely activities for the
future period.

Zero-base budgeting involves decision-making and planning and reverses the process of how a
traditional budget is made. In traditional budgeting, managers justify only the differences
compared to the previous year’s assuming that the "baseline" is approved automatically.
However, in zero based budgeting, all line items included in the budget need to be approved.
Further, there is no reference made to the expenditure in the previous years. The budget request
is re-evaluated starting from zero base and is not dependent on whether there is an increase or
decrease in the total budget or specific line items.

Zero-base budgeting is used in personal finance to explain “zero-sum budgeting”. It is a method

According to Sarant, zero-base budgeting is “a technique that complements and links to existing
planning, budgeting and review processes. It identifies alternative and efficient methods of
utilising limited resources. It is a flexible management approach that provides a credible
rationale for reallocating resources by focusing on a systematic review and justification of the
funding and performance levels of current programmes.”

In zero-base budgeting, all expenses have to be justified for every new term. It starts from zero-
base and every function of the firm is studied for its needs and costs. Then, budgets are built for
essential items for the forthcoming period not considering if the budget is higher or lower
compared to the past year.

This process helps in the implementation of strategic company goals into the budgeting process
by confining them to a particular functional area of the company. Hence, costs can be grouped
and measured against previous results and present expectations.

Companies that implement a budgeting system for a particular period usually have the tendency
to justify the forthcoming year’s budget; this can be done by reference to the actual level
attained. An appropriate financial analysis process should consider the changes that would affect
the future activities of the organisation. Some organisations find that historical comparisons,
particularly resource constraints, could exhibit novel changes in budgets. This could be a
deterrent factor for organisations. Therefore, in case changes are not specified during the budget
period, it would be difficult for organisations to progress, which is essential for attaining its
longer term goals.

The zero-base method is a way to solve this cyclical budgeting problem; organisations have to
start from the basics and develop a budget with an assumption that there are no existing
resources. Here, every resource must be justified and the method chosen to attain an objective
has to be compared with the alternatives.

A disadvantage of zero-based budgeting is the huge amount of managerial time needed to carry
out this exercise. Hence, some organisations execute the entire process every five years.
However, in that year, the business may almost come to a halt. To avoid this, companies can
alternatively analyse one division every year on a rolling basis such that every division
undergoes a zero-base budget once every five years.

Q2 Margin of Safety is the excess of normal or actual sales over sales at breakeven point
Explain Margin of safety

Answer:
The positive difference between actual sales and the breakeven sales is called margin of safety. It
is the excess of actual sales over the breakeven sales. The margin of safety is the area of earning
profit. It is the excess of production or sales over the breakeven point.

Margin of safety is an important concept in marginal costing approach. Total sales minus the
sales at breakeven point are known as the margin of safety (MIS). In other words, MIS is the
excess of normal or actual sales over sales at breakeven point. It is nothing but sales over and
above breakeven sales. The MIS refers to the amount by which sales revenue can fall before a
loss is incurred. That is, it is the difference between the actual sales and sales at the breakeven
point. Breakeven point can be compared to a red signal point. If the MIS is large, it is a sign of
the business being sound and vice versa. The MIS serves as a guide and it is a reliable indicator
of the business strength and soundness. Margin of safety can be expressed in absolute sales
amount or in percentage.

High MIS indicates the soundness of a business because even with substantial fall in sale or fall
in production, some profit shall be made. Small margin of safety on the other hand is an indicator
of the weak position of the business and even a small reduction in sale or production will
adversely affect the profit position of the business.

Margin of safety can be increased by:

 Decreasing the fixed cost

Every enterprise tries to know how much above they are from the breakeven point. This is
technically called MIS. It is calculated as the difference between sales or production units at the
selected activity and the breakeven sales or production.

MIS 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 MIS indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of
sales or selling price and changing product mix, so as to improve contribution and overall P/V
ratio.

Any one of below given formulas may be used for calculation of margin of safety.

Margin of safety= Profit / P/V Ratio

OR

Margin of safety = Actual sales - sales at BEP

Q3 Explain the Concept of Working Capital Cycle and Optimum Working Capital.

Answer:

Working Capital Cycle

The working capital cycle refers to the length of time between payment of cash by the firm for
material, etc. entering into the production process/stock and the inflow of cash from debtors.
Suppose a company has a certain amount of cash, it will need raw materials. Some raw material
will be available on credit but cash will be paid out for part of the raw material required
immediately. Then, the company has to pay for labour costs and incur factory overheads. These
three put together will constitute work in progress. After the production cycle is complete, work
in progress will get converted into finished products. The finished products, when sold on credit,
get converted into sundry debtors. Sundry debtors will be realised in cash after the expiry of
credit period. This cash can again be used for financing of raw materials, work in progress, etc.
Thus, there is a complete cycle from cash to cash, wherein cash gets converted into raw
materials, work in progress, finished goods, debtors and finally into cash again. Short-term funds
are required to meet the requirements of funds during this time period. This time period is
dependent upon the length of time within which the original cash gets converted into cash again.
This cycle is also known as operating cycle or cash cycle.
Working capital cycle indicates the length of time between a company’s paying for materials,
entering into stock and receiving cash from sales of finished goods. It can be determined by
adding the number of days required for each stage in the cycle.

Optimum Working Capital

Current ratio (with acid test ratio to supplement it) has traditionally been considered the best
indicator of the working capital situation. It has been stated by many accountants that a current
ratio of 2:1 for a manufacturing firm implies that the firm has an optimum amount of working
capital. This is supplemented by acid test ratio which should be at least 1:1. Thus, it is considered
that, there is a comfortable liquidity position if liquid current assets are equal to current
liabilities. However, it cannot be over emphasised that optimum working capital can be
determined only with reference to the particular circumstances of a specific situation. Thus, in a
company where inventories are easily saleable and sundry debtors are as good as liquid cash, the
current ratio may be lower than 2:1 and yet the firm may be sound. Also, a company having short
conversion cycle (from cash to cash) may have a lower current ratio.

For a company manufacturing heavy electrical equipment and machinery, it takes long time for it
to assemble pieces of machinery. Hence, it has to carry large inventories and the realisation of
debtors may not be quick. Here, the working capital requirement may be high and the company
may have to maintain a current ratio of more than ‘three’. This does not mean that it has idle
funds. It is very important therefore, to work out the requirements of working capital specifically
in a given situation. An optimum working capital ratio is dependent upon a business situation as
such and the nature and composition of various current assets.
 SET-II

Q1 Explain the term Divisional Performance Analysis

Answer:

Divisional Performance Analysis:

Just as corporate net income is used to assess the overall company’s performance, divisional
income is used to assess the performance of each division. The calculation of divisional income
must take into account transactions between divisions, and between the division and corporate
headquarters. The transfer of goods between divisions is an example of intra-company
transaction. These transfers, which signify revenue to the division making the sale and a cost of
inventory to the purchasing division, are performed as discussed in transfer pricing. The
acceptance of services, such as human resources, legal service, risk management, and computer
support, from corporate headquarters or from other responsibility centres located within the
company is another kind of transaction. Many companies“ charge out” these services to the
divisions that use them.

As divisional income does not account for the size of the division, we cannot use it to compare
performance of divisions of varying sizes. We can use divisional income to compare the current
income of the division with the incomes in past periods or with its budgeted income.

Return on Investment (ROI): This is calculated as:

Return on Investment =

Divisional income/Divisional investment

For assessing the divisional investment, the senior management must identify the need and
manner of allocating shared assets among divisions, such as service departments at the corporate
level, or shared manufacturing facilities. Management must also determine the method for
evaluating the capital assets that constitute the division’s investment. We value these assets
usually at their gross book value (the acquisition cost) or their net book value (usually the
acquisition cost minus depreciation expense). Less often, we use some other valuation method
such as fair market value, replacement cost or net realisable value. The calculation of divisional
income should be consistent with the valuation method chosen for the divisional investment.

It is better to use gross book value instead of net book value while calculating ROI as net book
value discourages divisional managers from replacing old equipment, even if new equipment
could prove to be more efficient and have the capability to increase divisional profits. Managers
are reluctant to replace old equipment because replacement of existing equipment that is
completely depreciated, but functional, can decrease the division’s ROI. It decreases the
divisional income (due to greater depreciation expense) and increases the divisional investment
(because the net book value of fully depreciated assets is zero).

At the divisional level, we can use ROI to compare divisions of varying sizes. However, just as
Internal Rate of Return is used for evaluation of capital projects, ROI can dissuade managers
from making some investments that are favoured by shareholders.

The best alternative provided by accounting for the concept of economic profits is residual
income. Residual income measures what shareholders are really concerned about (shareholders
mostly are concerned with maximising profits). We can calculate residual income at the
corporate level and at the divisional level. Many companies prefer to use residual income at the
divisional level as their management considers that the alignment of the incentives of divisional
managers with that of senior management and shareholders can be done by residual income.

Q2 A Company belongs to a risk class of which appropriate capitalisation rate is 10%. It

i) What will be the price of the shares at the end of the year if a dividend is declared and
not declared respectively?
ii) Assuming that the firm pay dividend has net income of Rs 20, 00,000 and makes new
investment of Rs 40, 00,000 how many shares must be issued.

Answer:

i)

P0=D1+P1/1+Ke

If dividend is not declared:

100 = 0 + p1/1+0.10

P1=110

If dividend is declared:

100= 8+P1/1+.10

P1=102

ii)

Let no. of new shares be m, then

m= I -(E – ND1)/P1

40, 00,000 – (20, 00,000 - 1200000)/102

=31372 shares
Q3.

Particulars Amount
Sales 1,50,000
Total Costs 85,000
Fixed Costs 20,000
Variable Costs 65,000
Net Profit 65,000
From the above details find out:

a. Profit Volume Ratio

b. B.E.P (Sales)

c. Margin of Safety

Answer:

(a) P/V ratio = Contribution x 100 / Sales

Contribution = Sales – Variable cost

= 150000-65000

= 85,000

P/V ratio = 85000X100/150000

= 56.67%

(b) B.E.P (Sales) = Fixed cost / P/V ratio

= 20000/56.67%

= RS. 35292

(c) Margin of Safety = Profit / P/V Ratio

= RS. 114699