UNIT – I – Management Accounting

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 UNIT I

INTRODUCTION

Definition, Meaning, Nature, Scope and Objectives of Management Accounting – Distinction

between Financial, Cost and Management Accounting.

MEANING AND DEFINITION

“Management accounting is concerned with accounting information that is useful to

management”.

J.Batty defines “ Management accounting is the term used to describe the accounting methods,
systems and techniques which, coupled with special knowledge and ability, assist management in
its task of maximizing the profits or minimizing losses”.
“Management accounting is the presentation of accounting information in such as way as to
assit management in the creation and in the day-to-day operations of an undertaking” -
I.C.M.A. Institute of Costs and Management Accountants.
According to H.M.Treasury, Management Accounting is “the application of accounting
knowledge to the purpose of producing and of interpreting accounting and statistical information
designed to assist management in its functions of promoting maximum efficiency and in
formulating and co-ordinating future plans and subsequently in measuring their execution”.

NATURE OF MANAGEMENT ACCOUNTING

Though Management Accounting is the latest branch in the accounting arena, it may be regarded
partly as a Science and partly as an Art. It is the science of ‘Quantifying and summarising’ and Art
of ‘Interpreting’ accounting data.
Management Accounts derives its conclusions through collection, processing and objective
analysis of data Quantified in figures. Thus it depends upon “Objectification and Quantification of
progress and problems”. From this point of view Management accounting may be regarded as a
Science.

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However, Management Accounting also involves human judgement, impulses, whims and
prejudices as evidenced in interpretation of data, deductions and conclusions drawn from analysis.
‘Subjectivity’ is inevitable in ‘deriving the meaning of data’. Deductions cannot be scientific with
precision. Personal judgement of Management accountant may influence the interpretations and
deductions significantly. From this point of view, Management Accounting may be regarded as an
Art.
(i) Technique of Selective Nature:
Management Accounting is a technique of selective nature. It takes into consideration only that
data from the income statement and position state merit which is relevant and useful to the
management. Only that information is communicated to the management which is helpful for
taking decisions on various aspects of the business.
(ii) Provides Data and not the Decisions:
The management accountant is not taking any decision by provides data which is helpful to the
management in decision-making. It can inform but cannot prescribe. It is just like a map which
guides the traveler where he will be if he travels in one direction or another. Much depends on the
efficiency and wisdom of the management for utilizing the information provided by the
management accountant.

(iii) Concerned with Future:

Management accounting unlike the financial accounting deals with the forecast with the future. It
helps in planning the future because decisions are always taken for the future course of action.

(iv) Analysis of Different Variables:

Management accounting helps in analysing the reasons as to why the profit or loss is more or less
as compared to the past period. Moreover, it tries to analyse the effect of different variables on the
profits and profitability of the concern.

(v) No Set Formats for Information:

Management accounting will not provide information in a prescribed proforma like that of
financial accounting. It provides the information to the management in the form which may be
more useful to the management in taking various decisions on the various aspects of the business.

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SCOPE OF MANAGEMENTACCOUNTING

 Financial Accounting
Financial accounting is the general accounting, which relates to the recording of business
transaction in the books of prime entry, posting them into respective ledger accounts, balancing
them and preparing trial balance. Then a profit and loss account showing the results of the
business and also a balance sheet depicting assets, and liabilities of the business concern are
prepared. This in turn forms the basis for analysis and interpretation for furnishing
meaningful data to the management, Hence management accounting cannot obtain full
control and coordination of operations without a well designed financial accounting system.
 Cost Accounting
Cost Accounting is a branch of accounting. It is the process and technique of ascertaining costs.
Planning, decision-making and control are the basic, managerial functions. The cost
accounting system as standard costing budgetary control, Inventory control and marginal costing
etc. for carrying out such functions efficiently.
 Budgeting and Forecasting
Budgeting means expressing the plans, policies and goal of the enterprise for a definite period in
future. Forecasting, on the other Rand, is a prediction of what will happen as result of a given set
of circumstances. Targets are set for different departments and responsibility is fixed for achieving
these targets. The comparison of actual performance with budgeted figures will give an idea about
the performance of departments.
 Statistical Methods
Statistical tools such as graphs, charts, diagrams, pictorial presentation, index numbers etc.
makes the information more impressive, comprehensive and intelligible: other tools such as time
series, regression analysis, sampling techniques etc. are highly useful for planning and
forecasting.
 Inventory control
It includes control over inventory from the time it is acquired till its final disposal. Inventory
control is significant as it involves large sums. The management should determine different
levels of stocks - Minimum stock level, maximum stock level, and reordering stock level, for an
inventory control, the study of inventory control will be helpful for taking managerial decisions.
 Interpretation of Data
Analysis and interpretation of financial statements, are important parts of management
accounting. Financial statements may be studies in comparison of statements of earlier periods
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or in comparison with the statements of similar other firms. After analyzing, the interpretation is
made and the reports drawn from this analysis are presented to the management in a simple
language.
 Internal Audit
It needs devising a system of internal control by establishing internal audit coverage for Internal
audit helps the management in fixing responsibility of different individuals.
 Tax Accounting
It includes preparation of income statement, assessing the effect of tax on capital expenditure
proposals and pricing.
 Methods and Procedures
They deal with organization with methods for cost reduction, procedures for improving the
efficiency of accounting and office operations.
 Office Services
They cover a wide range of activities like data processing, filing, copying, printing,
communication, etc.
OBJECTIVES / FUNCTIONS / PURPOSES / ROLE OF MANAGEMENT
ACCOUNTING
 Helps in Planning and Policy formulation
Planning is one of the primary functions of management, it involves forecasting on the basis of
available information, setting goals, framing policies, determining alternative courses of
action and deciding on the programme of activities to be taken. Management can help greatly in
these processes. Management accounting facilitates for the preparation of statements in the light
of past results land gives estimation for the future.
 Helps in the interpretationprocess
The main object of management accounting is to present financial information to the
management. The management accounting presents accounting information in an intelligible
manner and explains with the help of statistical devices like charts, diagrams graphs, index
numbers etc.
 Helps in Decision-making
Management accounting makes decision-making process as more modern an scientific by
providing significant information relating to various alternatives in terms of cost and revenue.
With the help of techniques provided by management accounting, data relating to cost, price,
profit and savings for each of the available alternatives are collected and analyzed and provides a
base for taking sounddecisions.

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 Helps in Controlling performance
Management accounting techniques, like standard costing and budgetary control are helpful in
controlling performance. These techniques are helpful in seeking pre-determined standards and
budgets whereby actual performance is compared to detect deviations. Such deviations are
further analysed to prevent recurrence of negative deviations and appreciation and maintenance
of positive or favourable deviations.
 Helps in Coordination operations
Management accounting- helps in overall control. and coordination of business operations, It
provides tools which are helpful' in coordinating the activities of different sections or
departments. (Ex.Budgets are important means of coordination).
 Helps in organizing
Return on capital employed is one of the tools of management accounting. Since management
accounting stress more on budget centers, investment centers, cost centers and profit centers,
with a view to control costs and responsibilities, it also contributes to principles of
decentralization to a greater extent. All these aspects are helpful in setting up effective and
efficient organization framework.
 Helps in Expansion, Diversification and Strategic business problems
Situations like new project or project for expanding or diversifying the current business,
management accounting helps in decision making by providing data to the management and
recommendations as to which alternative will be suitable. For such decisions, management
accountant takes the helps of techniques like marginal costing and capital budgeting.
 Helps in Communication of Management policies
Management accounting conveys the policies of the management downward to the personnel
effectively for proper implementation.
 Helps in Motivating employees
Through the techniques of standard costing and budgetary control, targets are fixed department-
wise, which in turn make the employees conscious of the targets. Achieving the targets leads to
satisfaction and greater motivation of employees and overall improvement in efficiency and
enhancement of profitability.
 Helps in Reporting
One of the primary objectives of management accounting is to keep the management fully
informed about efficiency and effectiveness of management policies in practice. This is helpful
to the management in reviewing the policies and making improvements.

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IMPORTANCE OF MANAGEMENT ACCOUNTING
1. It helps to increase the efficiency of all functions of management.
2. It helps in target-fixing, decision-making, price-fixing, selection of product-mix and so on.
3. Forecasting and Budgeting help the concern to plan the future and financial activities.
4. Various tools and techniques provide reliability and authenticity to carry out the business
functions.
5. Different techniques of management accounting help in effective control of business
operations.
6. It is proactive-analyses the governmental policies and socio-economic scenario which helps
to assess the external environmental impacts on the organization.
7. It creates harmony in the relationship between the management and employees. It enables
the management to improve its services to itscustomers.
8. The management aims to control the cost for production and at the same time increase the
efficiencyof employees. When cost of production is reduced, it will increase the profit.
9. Unacceptable standards or sub-standards, which are often responsible for unhealthy and
bad relations between management and employees, can be removed by the use of management
accounting.
10. The use of management accounting may control or even eliminate various types of
wastages, production defectives etc.
11. Management accounting helps in communicating up to date information to various parties
interested in successful working of the business organization.

1.3LIMITATIONS OF MANAGEMENT ACCOUNTING

1. It is concerned with financial and cost accounting. If these records are not reliable, it will
affect the effectiveness of management accounting.
2. Decisions taken by the management accountant may or may not be executed by the
management.
3. It is very expensive. Only big concerns can adopt this method of accounting.
4. New rules and regulations are to be framed, hence there is a possibility of opposition from
the employees.
5. It is only in the developing stage.
6. It is a tool to the management and not an alternative of management.
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DIFFERENCES BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL
ACCOUNTING

 Objective
The main objective of financial accounting is to supply information in the form profit and loss
account and balance sheet to outsiders like shareholders, creditors, government etc. But the
objective of management accounting is to provide information for internal use of management.
 Performance Analysis
Financial accounting is concerned with the overall performance of the business. On the other
hand management accounting is concerned with the departments or divisions. It reports about the
performance and profitability of eachthem.
 Data Used
Financial accounting is mainly concerned with the recording of past events whereas
management accounting is concerned with future plans and policies.
 Accuracy
Accuracy is an important factor in financial accounting. But approximations are widely used in
management accounting. This is because most of the information is related to the future and
intended for internal use.
 Legal compulsion
Financial accounting is compulsory for all joint stock companies but management account is
only optional
 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 deviation.
 Flexibility
In financial accounting, attempts are being made to prepare accounts in accordance with the
standards fixed by and or suitable for external parties. On the other hand, management
accounting considers the standards fixed by management itself.
 Coverage
Financial accounting covers entire range of business activity while management accounting
considers only parts of activity, which relevant to management for decision-making.

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 Publication and Audit
Financial statements like profit and loss account and balance sheet are published for the use of
general public also. They are audited by practicing chartered accountants while there is no
provision in management accounting All the reports, statements and forecasts made by
management accounting are for the internal use of management only.
 Principles
Financial accountings are governed by the generally accepted principles and convention. No
such set of principles are followed in management accounting.

DIFFERENCES BETWEEN MANAGEMENT ACCOUNTING AND COSTING

ACCOUNTING
 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 provide information to management
for effiently performing the functions of planning, directing and controlling.
 Scope
Cost accounting is concerned with cost ascertainment and control whereas management
accounting includes financial accounting, cost accounting, budgeting, tax planning and reporting
to management and interpretation of financial data.
 Data Used
Cost accounting uses only transactions which can be expressed in figures are taken whereas
management uses both qualitative and quantitative information.
 Nature
Cost accounting uses both past and present data whereas management accounting deals with
future projections on the basis of past and present cost data.
 Principles and Procedures
Established procedures and practices are followed in cost accounting. No such prescribed
practices are followed in management accounting. The analysis is made and the resulting
conclusions are presented in reports as per the requirements of the management.

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UNIT – II - Management Accounting

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 UNIT II
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
Balance sheet, Profit and loss account, functions of financial statements, meaning, objectives and
importance and limitations of financial statements, Techniques of analysis- Comparative,
Common size and Trend Analysis - Ratio Analysis - Classification of ratios - profitability ratios -
liquidity ratios - solvency ratios - Activity ratios leverage ratios -Interpretation of Financial
Statements with the above ratios.
FINANCIAL STATEMENT
MEANING
Financial Statements are the collective name given to Income Statement and Positional
Statement of an enterprise which show the financial position of business concern in an organized
manner. We know that all business transactions are first recorded in the books of original entries
and thereafter posted to relevant ledger accounts. For checking the arithmetical accuracy of
books of accounts, a Trial Balance is prepared.
Trial balance is a statement prepared as a first step before preparing financial statements of an
enterprise which record all debit balances in the debit column and all credit balances in credit
column. To find out the profit earned or loss sustained by the firm during a given period of time
and its financial position at a given point of time is one of the purposes of accounting. For
achieving this objective, financial statements are prepared by the business enterprise, which
include income statement and positional statement.
These two basic financial statements viz:
(i) Income Statement, i.e., Trading and Profit & Loss Account and
(ii) Positional Statement, i.e., Balance Sheet portrays the operational efficiency and solvency of
any business enterprise.
The income statement shows the net result of the business operations during an accounting
period and positional statement, a statement of assets and liabilities, shows the final position of
the business enterprise on a particular date and time. So, we can also say that the last step of the
accounting cycle is the preparation of financial statements.
Income statement is another term used for Trading and Profit & Loss Account. It determines the
profit earned or loss sustained by the business enterprise during a period of time. In large
business

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organization, usually one account i.e., Trading and Profit & Loss Account is prepared for
knowing gross profit, operating profit and net profit.
On the other hand, in small size organizations, this account is divided into two parts i.e. Trading
Account and Profit and Loss Account. To know the gross profit, Trading Account is prepared
and to find out the operating profit and net profit, Profit and Loss Account is prepared. Positional
statement is another term used for Balance Sheet. The position of assets and liabilities of the
business at a particular time is determined by Balance Sheet.

OBJECTIVES OF FINANCIAL STATEMENTS

(i) Knowing Profitability of Business:
Financial statements are required to ascertain whether the enterprise is earning adequate profit
and to know whether the profits have increased or decreased as compared to the previous year(s),
so that corrective steps can be taken well in advance.
(ii) Knowing the Solvency of the Business:
Financial statements help to analyse the position of the business as regards to the capacity of the
entity to repay its short as well as long term liabilities.
(iii) Judging the Growth of the Business:
Through comparison of data of two or more years of business entity, we can draw a meaningful
conclusion as regard to growth of the business. For example, increase in sales with simultaneous
increase in the profits of the business, indicates a healthy sign for the growth of the business.
(iv) Judging Financial Strength of Business:
Financial statements help the entity in determining solvency of the business and help to answer
various aspects viz., whether it is capable to purchase assets from its own resources and/or
whether the entity can repay its outside liabilities as and when they become due.
(v) Making Comparison and Selection of Appropriate Policy:
To make a comparative study of the profitability of the entity with other entities engaged in the
same trade, financial statements help the management to adopt sound business policy by making
intra firm comparison.

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(vi) Forecasting and Preparing Budgets:
Financial statement provides information regarding the weak-spots of the business so that the
management can take corrective measures to remove these short comings. Financial statements
help the management to make forecast and prepare budgets.
(vii) Communicating with Different Parties:
Financial statements are prepared by the entities to communicate with different parties about
their financial position. Hence, it can be concluded that understanding the basic financial
statements is a necessary step towards the successful management of a commercial enterprise.
IMPORTANCE OF FINANCIAL STATEMENTS
The importance of financial statements lies in their utility to satisfy the varied interest of
different categories of parties such as management, creditors, public, etc.
1. Importance to Management:
Increase in size and complexities of factors affecting the business operations necessitate a
scientific and analytical approach in the management of modern business enterprises.
The management team requires up to date, accurate and systematic financial information for the
purposes. Financial statements help the management to understand the position, progress and
prospects of business vis-a-vis the industry.
By providing the management with the causes of business results, they enable them to formulate
appropriate policies and courses of action for the future. The management communicates only
through these financial statements, their performance to various parties and justify their activities
and thereby their existence.
A comparative analysis of financial statements reveals the trend in the progress and position of
enterprise and enables the management to make suitable changes in the policies to avert
unfavorable situations.
2. Importance to the Shareholders:
Management is separated from ownership in the case of companies. Shareholders cannot,
directly, take part in the day-to-day activities of business. However, the results of these activities
should be reported to shareholders at the annual general body meeting in the form of financial
statements.
These statements enable the shareholders to know about the efficiency and effectiveness of the
management and also the earning capacity and financial strength of the company.

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By analyzing the financial statements, the prospective shareholders could ascertain the profit
earning capacity, present position and future prospects of the company and decide about making
their investments in this company. Published financial statements are the main source of
information for the prospective investors.
3. Importance to Lenders/Creditors:
The financial statements serve as a useful guide for the present and future suppliers and probable
lenders of a company.
It is through a critical examination of the financial statements that these groups can come to
know about the liquidity, profitability and long-term solvency position of a company. This would
help them to decide about their future course of action.
4. Importance to Labour:
Workers are entitled to bonus depending upon the size of profit as disclosed by audited profit and
loss account. Thus, P & L a/c becomes greatly important to the workers. In wages negotiations
also, the size of profits and profitability achieved are greatly relevant.
5. Importance to the Public:
Business is a social entity. Various groups of society, though directly not connected with
business, are interested in knowing the position, progress and prospects of a business enterprise.
They are financial analysts, lawyers, trade associations, trade unions, financial press, research
scholars and teachers, etc. It is only through these published financial statements these people
can analyze, judge and comment upon business enterprise.
6. Importance to National Economy:
The rise and growth of corporate sector, to a great extent, influence the economic progress of a
country. Unscrupulous and fraudulent corporate managements shatter the confidence of the
general public in joint stock companies, which is essential for economic progress and retard the
economic growth of the country.
Financial Statements come to the rescue of general public by providing information by which
they can examine and assess the real worth of the company and avoid being cheated by
unscrupulous persons.
The law endeavors to raise the level of business morality by compelling the companies to
prepare financial statements in a clear and systematic form and disclose material information.

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This has increased the confidence of the public in companies. Financial statements are also
essential for the various regulatory bodies such as tax authorities, Registrar of companies, etc.
They can judge whether the regulations are being strictly followed and also whether the
regulations are producing the desired effect or not, by evaluating the financial statements.
LIMITATIONS OF FINANCIAL STATEMENTS
(i) Manipulation or Window Dressing:
Some business enterprises resort to manipulate the information contained in the financial
statements so as to cover up their bad or weak financial position. Thus, the analysis based on
such financial statements may be misleading due to window dressing.
(ii) Use of Diverse Procedures:
There may be more than one way of treating a particular item and when two different business
enterprises adopt different accounting policies, it becomes very difficult to make a comparison
between such enterprises. For example, depreciation can be charged under straight line method
or written down value method. However, results provided by comparing the financial statements
of such business enterprises would be misleading.
(iii) Qualitative Aspect Ignored:
The financial statements incorporate the information which can be expressed in monetary terms.
Thus, they fail to assimilate the transactions which cannot be converted into monetary terms. For
example, a conflict between the marketing manager and sales manager cannot be recorded in the
books of accounts due to its non-monetary nature, but it will certainly affect the functioning of
the activities adversely and consequently, the profits may suffer.
(iv) Historical:
Financial statements are historical in nature as they record past events and facts. Due to
continuous changes in the demand of the product, policies of the firm or government etc,
analysis based on past information does not serve any useful purpose and gives only postmortem
report.
(v) Price Level Changes:
Figures contained in financial statements do not show the effects of changes in the price level,
i.e. price index in one year may differ from price index in other years. As a result, misleading
picture may be obtained by making a comparison of figures of past year with current year
figures.

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(vi) Subjectivity & Personal Bias:
Conclusions drawn from the analysis of figures given in financial statements depend upon the
personal ability and knowledge of an analyst. For example, the term ‘Net profit’ may be
interpreted by an analyst as net profit before tax, while another analyst may take it as net profit
after tax.
(vii) Lack of Regular Data/Information:
Analysis of financial statements of a single year has limited uses. The analysis assumes
importance only when compared with financial statements, relating to different years or different
firm.
ANALYSIS AMD INTERPRETATION OF FINANCIAL STATEMENTS
Financial statements refer to formal and original statements prepared by a business
concern to disclose its financial information. AICPA (American Institute of Certified Public
Accountants) says “Financial statements are prepared for the purpose of presenting a
periodical review or report on the progress by the management and deals with (i) the status of
investment in the business and
(ii) the results achieved during the period under review”
John N.Myer defines “the financial statements provide a summary of the accounts of a
business enterprise, the balance sheet reflecting the assets and liabilities and the Income
Statement showing the results of operations during a certain period”.
According to Kennedy and Muller, “Analysis and interpretation of financial statement
are an attempt to determine the significance and meaning of the financial statements data so
that forecast may be made of the prospects of future earnings, ability to pay interest, debt
maturities, (both current and long term) and profitability of a sound dividend policy”.
NATURE OF FINANCIAL STATEMENT
1) Recorded facts
The transactions affecting the business are recorded in the books and shown in the
financial statements at the same values. For example, fixed assets are recorded in the
books at cost price and shown in the balance sheet at cost price less depreciation. Facts
which cannot be recorded in books are not disclosed by the financial statements.
2) Accounting conventions
The financial statements are prepared by following certain accounting conventions and
principles. Accounting itself is a dynamic science and accountants have developed
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from time to time, a number of conventions on the basis of experience.

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 When accounts are finalized, some conventions are followed: For example, part of a
particular expense is charged to profit and loss account (revenue) and the rest may be
capitalised. A number of conventions have been developed for valuation of stock,
debtors, etc. Therefore, data shown in the financial statements are subject to the
validity of conventions used in their preparation.
3) Postulates
Accountants always take some facts as accepted or ‘postulates’. Business transactions
are recorded on certain assumptions such as ‘going concern’, ‘stable value of rupee’,
‘profit accrual’, etc. These postulates or assumptions are reflected in the financial
statements.

4) Personal judgements
Even though a number of conventions and assumptions have been propounded in
Accountancy, their use is affected by the personal judgement of accountants. That is
why financial statements prepared by two different persons of the same concern give
dissimilar results and this is due to different personal judgement in suing or applying
particular conventions. Personal judgement of accountants affects the amount kept as
reserve for doubtful debts, amount of depreciation on fixed assets, valuation of stock,
etc. The financial statements are affected by the personal judgement of accountants
and as such they are subjective documents.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

1) To interpret the profitability and efficiency of various business activities with the help
of income statement.
2) To aid in important decision making investment and financial decision.
3) To gauge the financial position and financial performance of the concern.
4) To identify areas of mismanagement and potential danger.
5) To ascertain the investment pattern of the resources.
6) To ascertain the maintenance of financial leverage.
7) To determine the pattern of movement of inventory.

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 8) To determine the diversion of funds, if any
9) To measure utilization of various assets during the period
10) To decide about the future prospects of the firm.
11) To compare operational efficiency of similar concerns engaged the same industry.
TOOLS OR TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

 Comparative financial statement

 Common size financial statement
 Trend analysis
 Ratio analysis
 Funds flow statement
 Cash flow statement

COMPARITIVE FINANCIAL STATEMENT

Comparative financial statement refer to those statement which summarise and present
accounting data for a number of years incorporating therein changes in individual items of
financial statements. These statements mainly include a) Comparative balance sheet b)
Comparative income statement or profit and loss account.
COMPARITIVE BALANCE SHEET
A comparative balance sheet is a balance sheet which is prepared to ascertain the
increase or decrease in proprietors funds, in assets and in liabilities during the course of two
years. This balance sheet is highly useful to study the progress of business.
COMPARITIVE PROFIT AND LOSS ACCOUNT
A comparative profit and loss account is a statement which is prepared to find out the
increase or decrease in various items of cost, expenses and income over a number of years at
least two.
COMMON SIZE FINANCIAL STATEMENT
Common size financial statement refers to the vertical studies single statement for the
relationship of the components of the total. It first convert each amount in the statement to the
percentage of the total amount of the group of which it is a part. It is also known as “common
percentage” or “100 percentage”.

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TREND ANALYSIS
The term trend refers to any general tendency. Analysis of these general tendencies is
called “trend analysis” . the profit and loss account and balance sheet are taken as the base.
Every item in the base year financial statements is taken as equivalent to 100. All the
corresponding figures in the financial statements of other years are expressed as percentage of
their values in the base year’s financial statement. This trend can be computed by dividing
each amount in the other financial statements with the corresponding item found in the base
financial statements.
RATIO ANALYSIS
It is a technique of calculation of a number of accounting ratios from the date
contained in the financial statements, it is used to describe the significant relationship
between two or more
items of the financial statements connected with each other.
FUNDS FLOW STATEMENTS
If the flow of funds are summarized in the form of statement, it is called funds flow
statement. It highlights the underlying financial movements and reflects the changes in the
financial position or working capital position at two different dates. It clearly indicates the
inflows and outflows of working capital during the specified period. It is mainly prepared to
show the application and sources of working capital during the accounting period. It explains
how the increase or decrease in working capital has taken place.
CASH FLOW STATEMENT
Cash flow statement is a statement which highlights the inflows and outflows of cash
during a specified period. It indicates the sources from which the cash has been generated,
uses to which the cash has been put and change in cash balance over the period. It is a
statement which portrays the change in the cash position between two accounting period.

The format for all the tools and techniques of Financial Statement Analysis is given
below:

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 FORMAT FOR COMPARATIVE STATEMENTS
 COMPARITIVE BALANCE SHEET FORMAT
Co. Ltd.
COMPARITIVE BALANCE SHEET AS ON DD/MM/YY & DD/MM/YY
PARTICULARS PREVIOUS CURRENT INCREASE (+) OR DECREASE
YEAR YEAR (-) IN CURRENT YEAR OVER
PREVIOUS YEAR
Amount ( Rs.) Percentage (%)
A B C=B-A D=C/A×100
I. Assets:
A) Current Assets
Inventory, Debtors
Cash and Bank
Other current
assets
Total CA (A) xxx xxx xxx xxx
B) Fixed Assets
Land and buildings
Plant and machinery
Furniture
Total FA (B) xxx xxx xxx xxx
Total Assets (A+B) xxx xxx xxx xxx
II. Liabilities & Capital:
Current Liabilities
Sundry Creditors
Bills payable &Tax payable
Provision for Tax
Proposed Dividend
Total CL (A)
Long-term Liabilities xxx xxx xxx xxx
Debentures & Term Loans
Total long-term liabilities (B)
Total liabilities (A+B) = (C) xxx xxx xxx xxx
Capital and Reserves xxx xxx xxx xxx
Equity Share Capital
Preference Share Capital
Reserves & Surplus
Retained Earnings
General Reserve
Profit & Loss A/c
Total Shareholders’ fund (D) xxx xxx xxx xxx

Total liabilities & Capital (C+D) xxx xxx xxx xxx

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  COMPARITIVE INCOME STATEMENT

Co. Ltd.
COMPARITIVE INCOME STATEMENT FOR THE YEARS ENDED DD/MM/YY &
DD/MM/YY

PARTICULARS PREVIOUS CURRENT INCREASE (+) OR DECREASE (-)

YEAR YEAR IN CURRENT YEAR OVER
PREVIOUS YEAR
AMOUNT ( RS.) PERCENTAGE (%)

A B C=(B-A) (C/A)×100
Net Sales
Less: Cost of Goods Sold
Gross Profit (A) xxx xxx xxx xxx
Operating Expenses:
Administration
Selling & Distribution
Total Operating Expenses (B) xxx xxx xxx xxx
Operating profit (A-B) = (C) xxx xxx xxx xxx
Add: Non-operating Income:
Interest on investments
Total (D) xxx xxx xxx xxx
Non-operating Expenses:
Interest
Income-tax
Finance exp
Goodwill written off
Total Non-operating Expenses (E) xxx xxx xxx xxx
Net profit (D-E) xxx xxx xxx xxx

NOTE:
 Fractions if any should be rounded off to the second digit after decimal point

13
FORMAT FOR COMMON SIZE STATEMENTS

 COMMON SIZE BALANCE SHEET

Co. Ltd.
COMMON SIZE BALANCE SHEET AS ON DD/MM/YY & DD/MM/YY
PARTICULARS PREVIOUS YEAR CURRENT YEAR
AMOUNT ( % AMOUNT ( %
Rs.) Rs.)
I. Assets:
A) Current Assets
Inventory
Debtors
Cash and Bank
Other current assets
Total CA (A) xxx xxx xxx xxx
B) Fixed Assets
Land and buildings
Plant and machinery
Furniture
Total FA (B) xxx xxx xxx xxx
Total Assets (A+B) xxx xxx xxx xxx
II. Liabilities & Capital:
Current Liabilities
Sundry Creditors
Bills payable
Tax payable
Provision for Tax
Proposed Dividend
Total CL (A) xxx xxx xxx xxx
Long-term Liabilities
Debentures
Term Loans xxx xxx xxx xxx
Total long-term liabilities (B) xxx xxx xxx xxx
Total liabilities (A+B) = (C)
Capital and Reserves
Equity Share Capital
Preference Share Capital
Reserves & Surplus
Retained earnings
General Reserve
Profit & Loss A/c
Total Shareholders’ fund (D) xxx xxx xxx xxx
Total liabilities & Capital (C+D) xxx xxx xxx xxx

14
  COMMON SIZE INCOME STATEMENT

Co. Ltd.
COMMON SIZE INCOME STATEMENT FOR THE YEARS ENDED DD/MM/YY &
DD/MM/YY

PREVIOUS YEAR CURRENT YEAR

PARTICULARS AMOUNT ( ) % AMOUNT ( ) %

Net Sales
Less: Cost of Goods Sold
Gross Profit (A) xxx xxx xxx xxx
Operating Expenses:
Administration
Selling & Distribution
Total Operating Expenses (B) xxx xxx xxx xxx
Operating profit (A-B) = (C) xxx xxx xxx xxx
Add: Non-operating Income:
Interest on investments
Total (D) xxx xxx xxx xxx
Non-operating Expenses:
Interest
Income-tax
Finance exp
Goodwill written off
Total Non-operating Expenses (E) xxx xxx xxx xxx
Net profit (D-E) xxx xxx xxx xxx

15
FORMAT FOR TREND PERCENTAGES
 TREND PERCENTAGES (BALANCE SHEET)
Co. Ltd.
STATEMENT SHOWING TREND PERCENTAGES
PARTICULARS YEAR END ( Rs.) TREND
PERCENTAGES BASE
YEAR xxxx (Y1)
Y1 Y2 Y3 Y4 Y1 Y2 Y3 Y4
I. Assets:
A) Current Assets
Inventory
Debtors
Cash and Bank
Other current assets
Total CA (A) xxx xxx xxx xxx xxx xxx xxx xxx
B) Fixed Assets
Land and Buildings
Plant & Machinery
Furniture
Total FA (B) xxx xxx xxx xxx xxx xxx xxx xxx
Total Assets (A+B) xxx xxx xxx xxx xxx xxx xxx xxx
II. Liabilities & Capital:
Current Liabilities
Sundry Creditors
Bills Payable
Tax payable
Provision for tax
Proposed Dividend
Total CL (A) xxx xxx xxx xxx xxx xxx xxx xxx
Long-term Liabilities
Debentures
Term Loans xxx xxx xxx xxx xxx xxx xxx xxx
Total long-term liabilities (B) xxx xxx xxx xxx xxx xxx xxx xxx
Total liabilities (A+B) = (C)
Capital and Reserves
Equity Share Capital
Preference Share Capital
Reserves & Surplus
Retained earnings
General Reserve
Profit & Loss A/c
Total Shareholders’ fund (D) xxx xxx xxx xxx xxx xxx xxx xxx
Total liabilities & Capital (C+D) xxx xxx xxx xxx xxx xxx xxx xxx

16
  TREND PERCENTAGES (INCOME STATEMENT)

Co. Ltd.
STATEMENT SHOWING TREND PERCENTAGES FOR THE PERIOD Y1 TO Y4
PARTICULARS YEAR END ( ) TREND
PERCENTAGES
BASE YEAR xxxx (Y1)
Y1 Y2 Y3 Y4 Y1 Y2 Y3 Y4
Net Sales
Less: Cost of Goods Sold
Gross Profit (A) xxx xxx xxx xxx xxx xxx xxx xxx
Operating Expenses:
Administration
Selling & Distribution
Total Operating Expenses (B) xxx xxx xxx xxx xxx xxx xxx xxx
Operating profit (A-B) = (C) xxx xxx xxx xxx xxx xxx xxx xxx
Add: Non-operating Income:
Interest on investments
Total (D) xxx xxx xxx xxx xxx xxx xxx xxx
Non-operating Expenses:
Interest
Income-tax
Finance exp
Goodwill written off
Total Non-operating Expenses (E) xxx xxx xxx xxx xxx xxx xxx xxx
Net profit (D-E) xxx xxx xxx xxx xxx xxx xxx xxx

RATIO ANALYSIS
Analysis and interpretation of financial statements with the help of ratios is termed as
Ratio analysis. It involves the process of computing, determining and presenting the
relationship of items or groups of items of financial statements.
A ‘ratio’ is a mathematical relationship between two items expressed in quantitative
form. Ratios can be defined as “Relationships expressed in quantitative terms, between
figures which have cause and effect relationships or which are connected with each other in
some, manner or the other”.
“The analysis of financial statement data is an attempt to determine the significance
and meaning of the financial statement data so that the forecast may be made of the future
prospects for earnings, ability to pay interest and debt (both shot and long term) and
profitability”.

17
ADVANTAGES/BENEFITS OF RATIOS ANALYSIS
 Forecasting
Ratio reveals the trends in costs, sales, profits and other inter-related facts, which will be
helpful in forecasting future events.
 Managerial Control
Ratios can be used as “instrument of control” regarding sales, costs and profit.
 Facilitates Communication
Ratios facilitate the communication function of management as ratios convey the information
relating to the present and future quickly, forcefully and clearly.
 Measuring Efficiency
Ratios help to know operational efficiency by comparison of present ratios with those of the
past working and also with those of other firms in the industry.
 Facilitating investment decisions
Ratios are helpful in computing return on investment. This helps the management in
exercising effective decisions regarding profitable avenues of investment.
 Useful to measure financial solvency
The financial statements disclose the assets and liabilities in a format. But they do not convey
relationship of various assets and liabilities with each other, whereas ratios indicate the
liquidity position of the company and the proportion of borrowed funds to total resources
which reveal the short term and long term solvency position of a firm.

 Inter firm Comparisons

The technique of inter-firm comparisons can be carried out successfully only with the help of
ratio analysis. Otherwise no firm may come forward to disclose full information. Inter-firm
comparisons help the management to compare its performance with an external standard.

LIMITATIONS OF RATIO ANALYSIS

 Practical knowledge
The analyst should have thorough knowledge and experience about the firm and industry.
Otherwise his analysis and interpretations are of little practical use.

18
 Ratios are means
Ratios are not an end in themselves- but they are means to achieve a particular purpose or end.

 Inter-relationship
Ratios are inter-related and therefore a single ratio cannot convey a meaning. It has to
be interpreted with reference to other related ratios to draw managerial conclusions.

 Non Availability of standards or norms

Ratios will be meaningful if they can be compared with standards or norms, except for a few
financial ratios, other ratios lack standards which are universally recognized.

 Depends on financial statements

The accuracy of a ratio depends on the accuracy of information derived from financial
statements. If the statements are inaccurate, same will be the result with ratios.

 Consistency in preparation of financial statements

Inter-firm comparisons with the help of ratio analysis will be useful only if the firms use
uniform accounting procedures consistently. Otherwise the comparison may be useless.

 Detachment from financial statements

Ratios are not substitutes to financial statements. They can be meaningful only if they are read
along with information with which they are prepared. If the information is detached, ratios
themselves cannot convey much useful message.
 Time lag
Ratio analysis will be fruitful only if the conclusions are conveyed quickly to the
management. If there is a delay, the utility of the data is diminished and the purpose itself
may be defeated.

 Change in price level

Ratio analysis becomes redundant during periods of heavy price fluctuations. It may be
concluded that ratio analysis, if not done properly or done mechanically, would be both

19
 misleading and dangerous. It is an aid to management to take correct decisions, but as a
mechanical substitute for personal judgment and thinking, it would be useless.

CLASSIFICATIONS OF RATIOS

 CLASSIFICATION ACCORDING TO ACCOUNTING STATEMENTS:

This classification is based on the nature of accounting standards on which the items used
for compiling ratios appear. Accordingly, the different subdivisions are:

 Balance Sheet Ratios:

These ratios are also called as financial ratios. The components for computation of
these ratios are drawn from the balance sheet. Examples: Current ratio, debt equity ratio
etc.
 Profit and loss account ratios:
These ratios are also called as operating ratios. The items used for the calculation of
these ratios are usually taken out from the income statement etc. Examples are Gross profit
ratio, net profit ratio, operating profit ratio etc.
 Combined ratios:
The information required for the computation of these ratios is normally from both
Balance Sheet and Trading and Profit and loss account. Examples are Debtors turnover ratio,
Creditors turnover ratio, Stock turnover ratio etc.

20
 CLASSIFICATION ACCORDING TO USERS:
Ratios are grouped on the basis of the parties who make use of the ratios. The
following is the classification of ratios by major users, though several others also use ratios:

 Ratios for Management:

 Turnover ratios like stock turnover, debtors turnover and fixed assets turnover
relect managerial efficiency in handling the assets.
 Profitability ratios like net profit ratio, gross profit ratio, return on investment
reveal the final result of the managerial policies and performance.
 The short term and long term solvency ratios like current ratio, liquid ratio, debt equity
ratio reveal the solvency position of the firm to the management.
 Ratios for Creditors:
Creditiors are interested in the ability of the firm to repay and the security for their
loans. Coverage ratios, Liquidity ratios and long term solvency ratios are more relevant to the
lenders.
 Ratios for Shareholders:
Shareholders are concerned with profits, dividends and risk. The profitability ratios,
payout ratio, dividend cover, capital gearing, etc., are more relevant for their interests.

21
CLASSIFICATION ACCORDING TO RELATIVE IMPORTANCE:
This classification is being adopted by the British Institute of Management, where
there are four types of ratios:
CLASSIFICATION BY RELATIVE IMPORTANCE

 Primary ratios:
They are also known as explanatory ratios which include, return on capital
employed, assets turnover and profit ratios.
 Secondary performance ratios:
Secondary performance ratios include, working capital turnover, stock to current assets,
current assets to fixed assets, stock to fixed assets and fixed assets to total assets.
 Secondary credit ratios:
Secondary credit ratios include, creditors turnover, debtors turnover, liquid ratio,
current ratio and average collection period.
 Growth ratios:
Growth ratios include growth ratio in sales and growth rate in net assets.

22
 CLASSIFICATION ACCORDING TO PURPOSE/FUNCTION
Under this classification, ratios are grouped as follows:

 Profitability Ratios:
These ratios are intended to measure the end result of business operations. Examples:
Gross profit ratio, Return on capital employed and operating ratio.
 Turnover or activity ratios:
These ratios enable measurement of the effectiveness of the usage of resources at the
command of the concern. Examples: Fixed assets Turnover ratio, Stock turnover ratio. These
ratios would also indicate the profitability position of the business
 Solvency ratios:
 Liquidity ratios - These ratios are used to measure the abilities of the firm to meet its
maturing obligations or current liabilities examples: Current ratio, Acid test ratio.
 Leverage ratios - These ratios help to measure the financial contribution of the
owners compared to that of creditors as also the risk of debt financing. They are also
known as capital structure ratios. Example: Debt to Equity ratio, fixed assets to Net
worth, Inter coverage ratio.

23
RATIO ANALYSIS FORMULA
I. PROFITABILITY RATIOS

GROSS PROFIT RATIO = Gross profit X 100

Net Sales

NET PROFIT RATIO = Net Profit X 100

Net Sales

OPERATING RATIO or OPERATING EXPENSES RATIO

= Cost of Goods Sold + Operating Expenses X 100
Net Sales

Sales = Cost of Goods Sold + Gross

profit Cost of Goods Sold = Sales - Gross Profit
Sales- Gross Profit = Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Purchases - Closing Stock
Operating expenses = All expenses in Profit and Loss account - Non operating
expenses Non-Operating expenses = loss on sale of assets, by fire, Provision for Legal
suit etc.

OPERATING PROFIT RATIO = Operating Profit X 100

Net Sales
Operating profit = Net Profit + Non operating exp - non operating income

Note for Verifications: Operating Ratio + Operating Profit Ratio = 100%

INTEREST COVERAGE RATIO = Net Profit,before Interest and Tax

Total Fixed Interest Payable

24
II. SOLVENCY RATIOS (BALANCE SHEET)
CURRENT RATIO = Current Assets
Current Liabilities
Current Assets = Stock + Cash in hand \ at bank + Sundry Debtors + Bi1ls
receivable + Prepaid expenses + Accrued income
+ Any other amount receivable within a year
Current Liabilities = Sundry creditors + Bills Payable + Outstanding expenses
+ Income received in advance
Working Capital = Current Assets - Current Liabilities

QUICK RATIO OR LIQUID RATIOS = Quick Assets OR

Quick liabilities
= Quick assets
Current liabilities
Quick assets = Current Assets - Stock - Prepaid
exp. Liquid liabilities = Current Liabilities - Bank
Overdraft
CASH POSITION RATIO = Cash and Bank balance + Marketable Securities
Current Liabilities
DEBT EQUITY RATIOS = Outsiders Funds OR Long term Debts
Shareholders Funds Shareholders Funds

Outsiders Funds = All external liabilities like creditors, Bills payable, overdraft,
debentures, mortgage loan etc.
Shareholders Funds = Preference share capital + Equity share capital+Reserves+Profit

FIXED ASSETS RATIO = Fixed Assets

Long term funds
Long term funds = Shareholders fund + long term liabilities
Shareholders funds or Net worth +Long term Liability + Current Liability = Fixed Assets +
Current Assets

25
PROPRIETARY RATIO = Proprietor Fund or Shareholders Fund
Total Assets
CAPITAL SEARING RATIO = Fixed interest bearing securities
Equity capital
Fixed interest bearing securities = Debentures, Preference share Capital

III. TURNOVER RATIOS

STOCK TURNOVER RATIO = Cost of Goods Sold OR Cost of Goods sold

Average Stock Closing Stock
STOCK VELOCITY
Stock Velocity = No of days or No of months in a year
Stock Turnover Ratio

DEBTORS TURNOVER RATIO = Credit sales

Accounts
Receivable Accounts Receivable = Sundry Debtors + Bills Receivable

DEBTOR’S COLLECTION PERIOD (DCP) OR DEBTORS VELOCITY

DCP = No of days or No of months in a
year Debtors Turnover Ratio

CREDITORS TURNOVER RATIO = Credit purchases

Accounts Payable
Accounts Payable = Creditors + payable

CREDITORS PAYMENT PERIOD (CPP) OR CREDITORS VELOCITY

CPP = No of days or No of months in a

year Creditors Turnover Ratio

26
FIXED ASSETS TURNOVER RATIO = Net sales or Cost of Goods Sold
Net fixed Assets Net Fixed Assets
NOTE:
 In the problem if there is no information about cash sales, entire sales should
be considered as credit sales
 If the term "to" is used in between two information, put the first word as
numerator and the last word as denominator.
 In the problem the term TURNOVER refers cost of sales, use cost of sales in
turnover ratios.

HOW TD APPROACH THE PROBLEM

Step 1: Start the problem from the information given as amount (preferably from
working capital or gross profit)
Step 2: At the end of the first step we will get some data as amount.
Step 3: Use the formulas which will relates to the data we had.

27
UNIT – III - Management Accounting
 UNIT III

FUNDS FLOW AND CASH FLOW STATEMENTS

Meaning & Concept of funds - Flow of funds - Fund flow statement - Uses -
Significance and limitations – Procedure for preparing fund flow Statements - Cash flow
Statements - Cash flow - Cash flow Statement - Uses, significance and limitations -
Difference between fund flow statement and cash flow statement - Procedure for
preparing cash flow statements. Interpretation of Funds Flow Statements.

FUNDS FLOW STATEMENT

According to R.N.Anthony, “Funds Flow is a statement prepared to indicate the increase

in cash resources and utilization of such resources of a business during the accounting
period.” According to Smith Brown, “Fund Flow Statement is prepared in summary form
to indicate changes occurring in items of financial condition between two different
balance sheet dates showing clearly the sources and application of funds.”
The major purpose of the Funds flow statement is to provide a detailed
presentation of the results of financial management, as distinguished from operating
management. It summarizes the financing and investing activities of the enterprise. The
statement shows directly the information, that the readers of financial reports could
otherwise obtain only by making an analysis and interpretation of published balance
sheets and statements of income and retained earnings.

Sources of funds Application of funds

Issue of Equity and preference shares Redemption of shares

Issue of Debentures Redemption of debentures

New loans or further loan Repayment of loans

Sale of fixed assets Purchase of fixed assets

Any other income Dividend paid, taxes paid etc

Funds from operations Funds lost in operations

OBJECTIVES
a) Indication of Financial Results
Funds flow statement should reveal the effect of financial decisions taken and their
consequences. For example, the decision to take a bank loan is reflected in the increase of
working capital
b) Emphasis on significance changes
Funds flow statement aims at revealing the changes in assets and asset sources which
are not readily evident in the Income Statement or Balance sheet.
c) Illustration of relationship
Funds flow statement aims at establishing the cause and effect relationship between
events like profit made and dividend disbursed, term loan raised and fixed assets
acquired.
d) Revealing financial strengths and Weakness
Funds flow statement has to throw light on the firm's ability to generate funds and use
them fruitfully. It also has to reveal any weakness in the financial position of the firm.
e) Distinguishing internal and external sources
The internal and external sources of.funds have to be clearly differentiated. Funds from
operation indicate the internal generation of funds. Such analysis is necessary to know
the inherent ability of the firm in generating funds.
f) Giving prominence to dynamic concept of business
Funds flow statement has Jo focus on the dynamic nature of business by revealing the
constant changes in the position of funds.

IMPORTANCE OF FUNDS FLOW STATEMENT

 It provides a detailed analysis and understanding of changes in the distribution of
financial resources between two balancesheets.
 It shows how the funds were obtained and used during a period.
 The sources from which funds were obtained are useful in computation of cost
of capital of the business.
 A detailed analysis of sources of funds in the past acts as a guide for obtaining
funds for future requirements.
  A study of the applications of funds provides an understanding about the
utilization of resources in the past. It can form the basis for selection of
investment proposals or future capital expenditure decision.
 It gives indication of any weakness or strength in the general financial position of a
firm.
 It throws light on the financial consequences of business operations. It can be
compared with the relevant budget to assess the usage of funds as per plans.
 Rearrangement of capital structure, formulating long term financial plans and
policies, etc. is facilitated by funds flow analysis.
 Working capital and the causes for changes in working capital are highlighted.
This can help in the formulation of sound policy for liquidity and shot term
solvency of the firm.

LIMITATIONS

 Funds flow statement is historical in nature. It shows v/hat happened in the

past. So, necessarily, its value is limited from the point of view of future
operations.
 It is nothing but secondary data. The information in financial accounts is
rearranged and presented. So its accuracy and reliability depend on the
accounting department.
 It is a summarized presentation of figures and cannot provide
information about changes on a continuous basis.
 The effects of transactions between current assets arid liabilities are not shown in
the statement. It also ignores transactions between long term assets and
liabilities.
 It is not generally considered as a sophisticated technique of financial analysis.

STEPS INVOLVED IN PREPARATION OF FUNDS FLOW STATEMENT

1) Preparation of schedule of changes in working capital

2) Preparation of non-current accounts (Ledger accounts)
3) Calculation of funds from operations
4) Preparation of funds flow statement
1) PREPARATION OF SCHEDULE OF CHANGES IN WORKING CAPITAL
The following rules may be kept in mind while preparing working capital statement:
a) Increase in Current Asset - Increases Working Capital
b) Decrease in Current Asset - Decreases Working Capital
c) Increase in Current Liability - Decreases Working Capital
d) Decrease in Current Liability - Increases Working Capital

FORMAT STATEMENT OF SCHEDULE OF CHANGES IN WORKING CAPITAL

PARTICULARS PREVIOUS CURRENT EFFECT ON EFFECT ON
YEAR YEAR W.C. W.C
(INCREASE) (DECREASE)
CURRENT ASSET: (A)
Cash in hand xx xx xx
Cash at bank xx xx xx
Sundry debtors xx xx xx
Bills receivable xx xx xx
Short-term investment xx xx xx
Stock xx xx xx
Prepaid expenses xx xx xx
Accrued income but not received xx xx xx
Total (A) xx xx
CURRENT LIABILITIES: (B)
Sundry creditors xx xx xx
Bills payable xx xx xx
Bank overdraft xx xx xx
Short term advances/loan xx xx xx
Dividend payable xx xx xx
Outstanding expenses xx xx xx
 Provision for taxation xx xx xx
 Proposed dividend xx xx xx
Total (B) xx xx
Working capital (A-B) xx xx
Net increase or decrease in
working capital xx - xx

xx xx xx xx
  COMPUTATION OF FUNDS FOR OPERATION

There are two methods for determining funds for operation. They are:
1) Account form
2) Statement form

1) ACCOUNT FORM:

ADJUSTED PROFIT AND LOSS ACCOUNT

PARTICULARS Rs. PARTICULARS Rs.

To depreciation xx By balance b/d (opening balance) xx
To loss on sale of fixed asset xx By profit on sale of fixed asset xx
To loss on sale of investment xx By profit on sale of investment xx
To goodwill written off xx By interest on investment xx
To discount on issue of shares written off xx By dividend received or receivable xx
To preliminary expenses written off xx By excess provision written back xx
To dividend (including interim dividend) xx By refund of income tax xx
To provision for tax xx By funds from operations xx
To proposed dividend xx (balancing Figure)
To transfer to general reserve xx
To balance c/d (closing balance) xx
xx xx
 2) STATEMENT FORM:

STATEMENT SHOWING FUNDS

FROM OPERATION

PARTICULARS Rs. Rs.

Net profit made during the year xx
Add: (Items which do not decrease funds from operatons but
debited to P & L a/c) xx
Depreciation xx
Loss on sale of fixed asset xx
Loss on sale of long term investment xx
Goodwill written off xx
Discount on issue of shares written off xx
Preliminary expenses written off xx
Interim dividend xx
Provision for tax xx
Proposed dividend xx xx
Transfer to general reserve
Less: (Items which do not increase funds from operations but xx
credited to P & L a/c) xx
Profit on sale of fixed asset xx
Profit on sale of investment xx
Interest on investment xx
Dividend received xx
Excess provision written back
Refund of income tax xx
Funds From Operations xxx
  PREPARATION OF FUNDS FLOW STATEMENT

1) ACCOUNT FORM:

FUNDS FLOW STATEMENT FOR THE YEAR

ENDED

SOURCES OF FUNDS Rs. APPLICATIONS OF FUNDS Rs.

Funds from operations xx Funds lost in operations xx
Issue of shares xx Redemption of redeemable preference shares xx
Issue of debentures xx Redemption of debentures xx
Sale of investment xx Repayment of other long term loans xx
Sale of fixed asset xx Purchase of investment xx
Non trading income xx Purchase of other fixed asset xx
Decrease in working capital (B.F) xx Payment of tax xx
Payment of dividend xx
Non trading expenses xx
Increase in working capital (B.F) xx

xxx xxx
2. STATEMENT FORM

FUNDS FLOW STATEMENT FOR THE YEAR

ENDED….
PARTICULARS Rs. Rs.
Sources of funds: (A)
Funds from operations xx
Issue of shares xx
Issue of debentures xx
Sale of debenture xx
Sale of fixed asset xx
Non trading income xx
Total sources (A) xx
Applications of funds: (B)
Funds lost in operations xx
Redemption of redeemable preference shares xx
Redemption of debentures xx
Repayment of other long term loans xx
Purchase of investment xx
Payment of tax xx
Payment of dividend (for last year and interim) xx
Non trading expenses xx
Total applications (B) xx
Net increase in working capital (A-B) xx
CASH FLOW STATEMENT

It is an analysis based on the movement of cash and bank balances. Under cash
flow analysis, all movements of cash, rather than the movement of working capital would
be considered. Such movements of cash are depicted in a statement called cash flow
statement. It is a statement of changes in financial position prepared on cash basis.

ADVANTAGES OF CASH FLOW STATEMENT

a) Historical analysis as guide to forecasting

Cash flow statement presents in detail the movements of cash in the recent past. This can
provide clear indications for the cash flows in the future period, thus helping forecasting
the future commitments and needs.

b) Effective cash management

Cash flow statement can act as a guide for coordinating the inflows and outflows of cash.
The matching of the future cash receipts with payments results in effective cash
management.

c) Formulation of financial policies

A clear, insight into the cash flows of the firm is the basis for financial policies like
dividend policy, cash discount, credit terms, etc.

d) Preparations of cash budget

Cash flow statement is almost like the foundation for cash Budget. The cash flows in the
recent past indicate the quantum and direction of such flows and form the basis for
preparing monthly or quarterly budgets for cash or even the annual cash budget for
ensuing year.

e) Short term financial decisions

Short range financial decisions like repayment of overdraft loans, payment of bonus,
advertising campaigns, investments outside the firm etc., may be taken on the basis of the
analysis provided by the cash flow statement.

f) Liquidity position
It reveals the liquidity position of the firm by highlighting the various sources of cash
and its uses.

g) Revaluations
It can reveal the causes for profitable firms experiencing acute cash shortages. The
reasons for any mismanagement of cash for creating such a position can be analyzed and
its recurrence can be avoided.

LIMITATIONS OF CASH FLOW STATEMENT

Cash flow statement is a useful tool of financial analysis. However, it suffers from some
limitations, which are as follows:

 A cash flow statement only reveals the inflow and outflow of cash. The cash
balance disclosed by this statement may not depict the true liquid position. There
are controversies over a number of items like cheques, stamps, postal orders etc.
to be included in cash.
 A cash fund statement cannot be equated with the income statement. An income
statement takes into account both cash and non-cash items. Hence cash funds do
not mean net income of the business.
 Working capital being a wider concept of funds, a funds flow statement presents a
more complete picture than cash flow statement.
DISTINCTIONS BETWEEN FUNDS FLOW STATEMENT AND CASH FLOW
STATEMENT
STEPS INVOLVED IN PREPARATION OF CASH FLOW STATEMENT

1) Preparation of non current accounts (Ledger accounts)

a) Fixed asset account
b) Accumulated depreciation account
c) Investment account
d) Provision for taxation account
2) Calculation of funds from operation (refer the format given in FFS steps)
3) Calculation of cash from operations
4) Preparation of cash flow statement

III) CALCULATION OF CASH FROM OPERATIONS

CASH FROM OPERATIONS

PARTICULARS Rs. Rs.

Funds From Operations xxx

xxx
Add: Decrease in current asset except Cash & Bank xxx
Increase in current liabilities
xxx
xx
Less: Increase in current asset except Cash & Bank xx
Decrease in current liabilities xxx
Cash From Operations xxx
IV) CASH FLOW STATEMENT AS PER ACCOUNTING STANDERD 3

1) ACCOUNT FORM:

CASH FLOW STATEMENT FOR THE YEAR ENDED ......

SOURCES OF FUNDS Rs. APPLICATIONS OF FUNDS Rs.

Opening balances: Cash & Bank xx Cash outflow on account of operations xx
Cash from operations xx Redemption of preference shares xx
Issue of shares xx Redemption of debentures xx
Issue of debentures xx Repayment of loans xx
Sale of investment xx Purchase of investment xx
Sale of fixed asset xx Purchase of fixed asset xx
Loans borrowed, etc xx Payment of tax xx
Payment of dividend xx
Opening balances: Cash & Bank xx

xxx xxx
2) STATEMENT FORM

CASH FLOW STATEMENT FOR THE YEAR ENDED ......

PARTICULARS Rs. Rs.

Opening balances: Cash & Bank xx
Add: Sources of funds: (A)
Cash from operations xx
Issue of shares xx
Issue of debentures xx
Sale of debenture xx
Sale of fixed asset xx
Non trading income xx
Total sources (A) xx
Applications of funds: (B)
Cash outflow on account of operations xx
Redemption of redeemable preference shares xx
Redemption of debentures xx
Repayment of other long term loans xx
Purchase of investment xx
Payment of tax xx
Payment of dividend (for last year and interim) xx
Total applications (B) xx
Opening balances: Cash & Bank xx
UNIT – IV - Management Accounting
 UNIT IV
MARGINAL COSTING

Nature and Scope Basic concepts - Definition of marginal cost and marginal costing -
Assumptions of marginal costing - CVP Analysis - Meaning, Importance and limitations of
CVP analysis - Break-even Point - Breakeven chart – Margin of Safety - Profit Volume
Graph - Applications in decision making

MARGINAL COSTING

Marginal costing is defined by I.C.M.A., as “the ascertainment of marginal costs and

of the effect on profit of changes in volume or type of output by differentiating between
fixed costs and variable costs.
Marginal costing identifies the Marginal Cost of production and shows its impact on
profit for the change in the output units. Marginal cost refers to “the movement in the total
cost, due to the production of an additional unit of output”. Marginal cost is defined by
I.C.M.A., as “the amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit. As such, it arises
from the production of additional increments ofoutput.
In marginal costing, all the variable costs are regarded as product related costs while

fixed costs are assumed as period costs. Therefore, fixed cost of production is posted to the
Profit & Loss Account. Moreover, fixed cost is also not given relevance while determining
the selling price of the product or at the time of valuation of closing stock.
 FEATURES

 Marginal costing is a technique of working of costing, which is fixed cost and

variable costs are kept separate at every stage. Semi-variable costs are also separated
into fixed and variable.
 As fixed costs are period costs, they are excluded from product cost or cost of
production or cost of sales. Only variable costs are considered as the cost of the
product.
 The stock of finished goods and work-in-progress are valued a t variable costs.
 As fixed costs are period costs they are charged to profit and loss account during
period in which they are occurred. They are carried forward to the next year's
income.
 Contribution is ascertained by finding the difference between the marginal cost or
variable cost and the selling price.
 Profit is ascertained by finding the difference between the contribution and fixed costs
of all products or departments or processes or divisions, etc.
 The profitability at various level of activity is ascertained by calculating Cost-
volume- profit relationship.
 Fixed cost remains constant irrespective of level of activity.
 Sales price and variable cost per unit remain the same.

ADVANTAGES OF MARGINAL COSTING

1. The marginal costing technique is very simple to understand and easy to operate. The
reason is that the fixed costs are not included in the cost of production and there is no
arbitrary apportionment of fixed costs.
2. The current year fixed costs is not carried forward to the next year. As such, cost and profit
are not vitiated. Cost comparisons become meaningful.
3. The contribution is used as a tool in managerial decision-making. It provides a more
reliable measure for decision-making.
4. Marginal costing shows more clearly the impact on profit of fluctuations in the volume of
sales.
5. Under absorption and over absorption of overheads problems are not arisen under
marginal costing.
6. The marginal costing technique can be combined with standard costing.
7. The prevailing relationship between cost, selling price and volume are properly explained
in clear terms.
8. It shows the relative contributions to profit that are made by each of a number of
products and show where the sales effort should be contracted.
9. The management can take short run tactical decisions with the help of marginal costing
information.

DISADVANTAGES OF MARGINAL COSTING

1. The total costs cannot be easily segregated into fixed costs and variable costs.
2. Moreover, it is also very difficult to per-determine the degree of variability of semi-
variable costs.
3. Under marginal costing, the fixed costs remain constant and variable costs are varying
according to level of output. In reality, the fixed costs do not remain constant and the
variable costs are not varying according to level of output.
4. There is no meaning in the exclusion of fixed costs from the valuation of finished goods
since the fixed costs are incurred for the purpose of manufacture of products.
5. In the case of loss by fire, the full amount of loss cannot be recovered from the
insurance company since the stocks are undervalued.
6. Tax authorities do not accept the valuation of stock since the shock does not show true
value.
7. The calculation of variable overheads does not include all the variable overheads.
8. The profit fluctuates as per the fluctuation of sales volume. Hence, the preparation of
periodic operating statements becomes unrealistic.
9. The elimination of fixed costs renders cost comparison of jobs difficult.
10. The management cannot take a quality decision with the help of contribution alone. The
contribution may vary if new techniques followed in the production process.
11. The fixed costs are constant only for short period. In the long run, all the costs are
variable.
ASSUMPTIONS OF MARGINAL COSTING
1. All costs are divided into fixed and variable
2. Fixed cost remain constant at all levels of activity
3. Variable cost varies but unit cost will not vary
4. Selling price remains same
5. Price of material, rates of labour, etc. constant
6. Volume of production only influence costs
7. There is no stock

MARGINAL COSTING PROFORMA

Particulars Amount (Rs.)

Sales xxx
- Variable cost xxx
Contribution xxx
- Fixed Cost xxx
Profit xxx

CONCEPT OF COST-VOLUME-PROFIT ANALYSIS

Cost-volume-pro fit (CVP) analysis is an analytical tool for studying the relationship
between volume, cost, prices, and profits. It is very much an extension, or a part of marginal
costing. It is an integral part of profit planning process of the firm. However, formal profit
planning and control involves the use of budgets and other forecasts and the CVP analysis
provides only an overview of the profit planning process. Besides it helps to evaluate the
purpose and reasonableness of such budgets and forecasts. Generally, CVP analysis
provides answers to questions such as:

 What will be the effect of changes in prices, costs and volume on profits?
 What minimum sales volume need be affected to avoid losses?
 Which product is the most profitable one and which product or operation of a plant
should be discontinued? etc.
IMPORTANCE

The CVP analysis is very much useful to management as it provides an insight into the effects
and inter-relationship of factors, which influences the profits of the firm. The relationship
between cost, volume and profit makes up the profit structure of an enterprise. Hence the CVP
relationship becomes essential for budgeting and profit planning. As a starting point in profit
planning, it helps to determine the maximum sales volume to avoid losses, and the sales volume
at which the profit goal of the firm will be achieved. .As an ultimate objective it helps
management to find the most profitable combination of costs and volume. A dynamic
management, therefore, uses CVP analysis to predict and evaluate the implications of its short
run decisions about fixed costs, marginal costs, sales volume and selling price for its plans on a
continuous basis.

SOME IMPORTANT CONCEPTS AND TERMS IN COST-VOLUME-PROFIT

ANALYSIS

FIXED COST

Expenses that do not vary with the volume of production are known as fixed cost. It should be
noted that fixed charges are fixed only with a certain of range of plant capacity. It should also
be noted that fixed cost per units is not fixed. Examples: manager's salary, office rent, factory
rent insurance etc.

VARIABLE COST

Expenses that vary almost in direct proportion to the volume of production or sales are called
variable expenses. Example: fuel, packing expenses, materials, wage's etc.
 DISTINCTION BETWEEN VARIABLE COST AND FIXED COST

FIXED COST VARIABLE COST

They do not depend on the volume of Depends upon the volume of production and
sales.
production and sales.
They do not normally change up to the They are in the nature of changing as per
full capacity of a firm. capacity utilization.
Fixed cost per unit always Changing Variable cost per unit remains same.
Total of fixed cost remains constant Total of variable always varying.
They are also termed as period cost or Time They are also termed as product costs or
cost Marginal cost

CONTRIBUTION

Contribution is the difference between sales and marginal cost (variable cost) and it
is used to recover the fixed costs first. Any excess of contribution over fixed costs would be
profits. When a, business manufactures more than one product, the Computation of profit
realized on individual products may be difficult due to the problem of apportionment of
fixed cost to different products. The rationale of contribution lies in the fact that fixed costs
are done away with under marginal costing.

The concepts of contribution help to determine the break-even point, profitability of

products departments etc., to select product mix for profit maximization, and to fix selling
prices under different circumstances such as trade depression, export sales, price
discrimination, etc.

Contribution is the definite test to ascertain whether a product or process is

worthwhile to continue among different products or processes. The contribution could be
used as a measure to solve the problem of key factor.
CONTRIBUTION FORMULAE

Contribution = Selling price - Variable cost

Contribution = Fixed expenses + Profit
Contribution = Sales x P/V ratio

PROFIT VOLUME (P/V) RATIO (OR) CONTRIBUTION TO SALES RATIO

The ratio that shows the relationship between the value of sales and contribution is
called as P/V ratio. A more appropriate term might be the contribution/sales ratio. A higher
ratio means a greater profitability and vice versa. This ratio helps in comparison of
profitability of various products. Since high P/V ratio indicates high profits, the objective of
every organisation should be to improve or increase the P/V ratio. P/V ratio can be improved
by:

a) Decreasing the variable cost by efficiently utilizing material, machines and men.
b) Selecting most profitable product mix for production and sales
c) Increasing the selling price per unit

P/V RATIO FORMULAE

P/V Ratio = Contribution or (C/S)
Sales
(or)
P/V Ratio = Sales – Variable Cost or (S – V)
Sales S
(or)
P/V Ratio = Fixed Cost + Profit or (F + P)
Sales S
(or)
P/V Ratio = Change in Profit
Change in Sales

Advantages of P/V ratio

 (a) Ascertainment of profit on a particular level of sales volume.
(b) Determination of break-even point.
(c) Calculation of sales required to earn a particular level of profit.
(d) Estimation of the volume of sales required to maintain the present level of profit in
case selling prices are to be reduced by a stipulated margin.
(e) Useful in developing flexible budgets for cost control purposes.
(f) Identification of minimum volume of activity that the enterprise must achieve to avoid
incurring losses.
(g) Provision of data on relevant costs for decisions relating to pricing, keeping or
dropping product lines, accepting or rejecting particular orders, make or buy decision,
sales mix planning, altering plant layout, channels of distribution specification,
promotional activities etc.
(h) Guiding in fixation of selling price where the volume has a close relationship with the
price level.
(i) Evaluation of the impact of cost factors on profit.

BREAK EVEN ANALYS (BEP)

Break even analysis is a method of studying relationship between revenue and costs
in relation to sales volume of a business enterprise and determination of volume of sales at
which total costs are equal to revenue.
According to Matz Curry and Frank “a break even analysis determines at what level
cost and revenue are in equilibrium”. The study of cost-volume-profit relationship is often
referred to as Break Even Analysis. Break even analysis refers to a system of
determination of that level of activity where total sales are just equal to total costs.
This level of activity generally termed as break-even point (B.E.P.). At break-even point
a business man neither earns any profit nor incurs any loss. BEP is also called no profit, no
loss point or zero profit or zero loss point.
ASSUMPTIONS OF BEP

 All costs are classified into two – fixed and variable.

 Fixed costs remain constant at all levels of output.
 Variable costs vary proportionally with the volume of output.
 Selling price per unit remains constant in spite of competition or changes in the
volume of production.
 There will be no change in operating efficiency.
 There will be no change in the general price level.
 Volume of production is the only factor affecting the cost.
 Volume of sales is equal to volume of production. Hence there is no unsold
stock.

ADVANTAGES
  Total cost, variable cost and fixed cost can be determined.
 Break even output or sales value can be determined.
 Cost, volume and profit relationship can be studied, and they are very useful to the
managerial decision making.
 Inter-firm comparison is possible.
 It is useful for forecasting plans and profits.
 The best product mix can be selected.
 Total profits can be calculated.
 Profitability of different levels of activity based on various products or profit i.e. plans
can 'be known.
 It is helpful for cost control.

LIMITATIONS

 Exact and accurate classification cost into fixed and variable is not possible. Fixed
costs vary beyond a certain level or output. Variable cost per unit is, constant and it
varies in proportion to the volume.
 Constant selling price is not true.
 Detailed information cannot be known from the BEP Chart. To know all the
information about fixed cost, variable cost and selling price, number of charts must be
drawn.
 No importance is given to opening and Closing stocks,
 Various product mixes on profits cannot be studied as the study is concerned with
only one sled mix or product mix.
 Cost, volume and profit relation can be known; capital amount, market aspects, effect
of government policy etc., which are important for decision-making cannot considered
from Break even chart.
 If the business conditions change during a period, the break even chart becomes out of
data as it assumes no change in business condition.
BEP FORMULAE:

BEP (in units) = Fixed cost

Selling price per unit – Variable cost per unit

(or)
BEP (in units) = Fixed cost
Contribution per unit

(or)
BEP (in units) = Break even sales value
Selling price per unit

(or)
Break Even Sales = BEP in units x Selling price per unit

(or)
Break Even Sales = Fixed cost
P/V ratio

5.3.2.2 MARGIN OF SAFETY

Margin of safety is an important concept in marginal costing approach, Total sales

minus the sales at breakeven sales are known as the margin of safety. (That is margin of
safety is the excess of normal or actual sales over sales at breakeven point.) In other words
margin of safety refers to the amount by which sales revenue can fall before a loss is
incurred. That it is the difference between the actual sales and sales at the breakeven point.
In High margin of safety indicates the soundness of a business because even with substantial
fall in sale or fall in production, some profit shall be made. On the other hand thin (low)
margin of safety 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, decreasing the variable cost,
increasing the selling price, increasing output and sales.

MARGIN OF SAFETY FORMULAE

MARGIN OF SAFETY = Actual Sales – Break even sales

(or)
MARGIN OF SAFETY = Profit
P/V ratio

MARGIN OF SAFETY in units = Profit

Contribution per unit

REQUIRED SALES FOR GIVEN PROFIT FORMULAE

Required sales in units = Required profit + Fixed cost

Contribution per unit

Required sales value in rupees = Required profit + Fixed cost

P/V ratios
PROFIT FROM GIVEN SALES

Contribution = Given sales x P/V

ratio Profit = Contribution – Fixed
cost
APPLICATIONS OF MARGINAL COSTING IN DECISION MAKING:
"Marginal costing is a valuable aid for Managerial Decisions”. It helps in taking a
decision in the following situations:
 FIXATION OF SELLING PRICE
Price is one of the most significant factors that determines the market for the
products as well as the volume of the profit for the organization. Under normal
circumstances the price of a product must cover the total costs of that product plus a
margin of profit. However, under certain special circumstances, prices have to be fixed
below the total cast, For example, when there is general trade depression or exploring new
markets or accepting additional orders, the producer has to cut the price even below the total
of the concerned product. Under these special circumstances, the concept of marginal cost is
usefully applied to fix the prices.
 ACCEPTING BULK ORDERS OR FOREIGN MARKET ORDERS
Some bulk orders may be received from local dealers or foreign dealer asking for a
price, which is below the market price. This calls for a decision to accept or reject the order.
This order from a local dealer should not be accepted at a price below the market price
because it will affect the normal market and affect the good will of the company. On the
other hand, the order from the foreign dealer should be accepted because it will give
additional contribution as the fixed costs have already been met.
 MAKE OR BUY DECISION
In a make or buy decision the price quoted by the outside suppliers should be
compared with the marginal cost of producing the component parts. If the outside price of
the component is lower than the marginal cost of producing it, it is worth buying. On the
other hand, 'if the outside prices are higher than the marginal cost in the factory be preferred.
 SELECTION OF SUITABLE PRODUCT MIX
When a factory manufactures more than one product, the management faces a
problem as to which product will give maximum profits. The solution is the products, which
give the maximum contribution, are to be retained ad their production should be increased.
 KEY FACTOR
It is also known as limiting Factor. A key factor is one, which restricts production
and profit of a business. It may arise due to the shortage of material, labor, capital, plant
 capacity or sales. Normally, when there is no limiting factor, the selection of the product will
be on the basis of the highest p/v ratio. But when there are limiting factors, selection of the
product will be on the basis of highest contribution per unit of the key factor.
 MAINTAINING A DESIRED LEVEL OF PROFIT
Management may be interested in maintaining a desired level of profits. The sales
required to earn a desired level -of profits can be ascertained by the marginal costing
techniques.
 ALTERNATIVE METHODS OF PRODUCTION
Marginal costing is helpful it comparing the alternative methods of production. The
method, which gives maximum contribution, is to be adopted keeping the mind the limiting
factor.
 DETERMINATION OF OPTIMUM LEVEL OF ACTIVITY
Marginal costing is helpful it comparing the alternative methods of production. The
method, which gives maximum contribution, is to be adopted keeping the mind the limiting
factor.
The technique of marginal costing helps the management in determining the
optimum level of activity. To make such a decision, contribution at different levels of
activity can be found. The level of activity, which gives the highest contribution, will be the
optimum level. The level of production can be raised till the marginal cost does not exceed
the selling price.
 EVALUATION OF PERFORMANCE
Evaluation of performance efficiency of various departments or product lines can be
made with the help of marginal costing. The management has to discontinue the production
of non-profitable products or departments so as to maximize the profits. In such cases,
decision to discontinue will be on the basis of the lowest contribution or PV ratio.
 MARIGINAL ASCERTAINMENT
Marginal costing technique facilitates not only the recording of costs but their
reporting also. The classification of costs into fixed and variable components makes the. job
of cost ascertainment easier. The main problem in this regard is only the segregation of the
semi- variable cost into fixed and variable elements. However, this may be overcome by
adopting any of the methods in this regard.
 COST CONTROL
Marginal cost statements can be understood easily by the management than those
presented under absorption costing. Bifurcation of costs into fixed and variable enables
management to exercise control over production cost and thereby affect efficiency. In fact
while variable costs are controllable at the lower levels of management, fixed costs can be
controlled at the top level. Under this technique, management can study tire behavior of
costs at varying conditions of output and salts and thereby exercise batter control over costs.
 DECISION-MAKING
Modern management is faced with a number of decision-making problems every
day. Profitability is the main criterion for selecting the best course of action. Marginal
costing through contribution assists management in solving problems. Some of the decision-
making problems that can be solved by marginal costing are: profit planning, pricing of
products, make or buy decisions product mix etc.
UNIT – V - Management Accounting
 UNIT V
STANDARD COSTING AND VARIANCE ANALYSIS

Standard Costing and Variance Analysis: Meaning of Standard cost and Standard Costing - Steps
involved in Standard Costing - Advantages and Limitations of Standard Costing - Variance
analysis - Material Variances, Labour Variances.

INTRODUCTION
Financial Accounting is only historical costing and is only a post – marten examination of
cost and hence, is not very much useful to management for cost control and cost reduction
purposes. Besides this, historical costing is not useful to managerial decision making and
policy formulating purposes. Hence, to the accounting world, a new concept (or) tool by
name “Standard Costing” appeared as a very big way out.
CONCEPT OF STANDARD COSTING
Normally it is understood as a long step by step process of fixing standards, using
standards, and their comparisons with the actuals, finding out of variances in between
standards and actuals, analysing these variances, finding out of causative factors for these
variances, classifying these causes into controllables and uncontrollables, controlling and
taking remedial actions, revising these standards if necessary etc. Thus, it is a cost
controlling and cost reducing device.
ICMA, London Defines “Standard Costing is the preparation and use of Standard costs,
their comparison with actual costs and analysing of variances to their causes and points of
incidence”.
Controlling Process in standard Costing:
 Formulation of Standard Costs : For all elements of cost viz., Materials,
Labour and Expenses, standard costs are fixed very much scientifically by experts based
on multiple criteria.

 Matching Actuals with Standards : In this step, actual costs are compared with
standard costs for the purposes of verifying whether actual cost is more or less than the
standard costs.
 Variances and Analysis thereof : The difference between actual and the
standard is known as variance and this is further analysed to find out whether variance is
debit variance (or) Credit variance.

 Analysis of causative factors for variances : For all debit (or) unprofitable
variances, causative factors (or) reasons responsible are unearthed and then are classified
into controllable and uncontrollable reasons.

 Corrective Measures : In relation to controllable causes, the people responsible

are held up and are instructed to take necessary remedial measures and see that they do not
repeat in the time to come.

 Reporting to Management : Depending upon the degree of severity of the

variances, information by following the principle of “Management by Exception”, will be
reported to the concerned management level for necessary cost control measures.

 Revising the standards : With regard to uncontrollable variances, an idea of

revising the standards watching the changed scenario, may be though of.

STANDARD COST

The whole of standard costing revolves around standard costs. Hence, we are very much
obliged to explain what is standard cost. It is a predetermined cost computed in advance of
production on the basis of specification of all factors affecting costs.

Blocker and Weltmer defines, Standard cost is a common sense cost reflecting the best
Judgement of management as to what costs ought to be if this plant is operated with the
highest degree of efficiency.
TYPES OF STANDARDS
Importantly, there are : Basic, current, Ideal, Expected and Normal standards.
 Basic standards : It is a standard set for a long term in an unaltered way. It is
suitable mostly to those products whose costs / prices do not change much.
 Current Standard : It is a standard set for a relatively shorter period based on
current market conditions. It claims to be more realistic and most companies use it.
 Ideal Standard : It is self explanatory as this is set based on all idealistic
conditions which are never seen.
 Expected Standard : It is a standard set based on certain conditions which are
expected to be attained. Conditions prevailing in industry and that are likely to hit the
industry in future are all considered while this standard is set. So, it is attainable standard.
 Normal Standard : It is a standard set on the basis of average conditions (or)
normal conditions. Since we do not have any control over future, this normal standard may
not be of much use.
Process in setting Standards:
The function of setting standards for costs (or) revenues is a rational and professional job.
Hence, it is entrusted to a committee called – standards Committee consisting of
Production Manager, purchase manager, personnel Manager, Cost Accountants etc. This
committee sets standards for each and every element of cost viz., Materials, Labour and
expense. Let us see them separately.
Standard for Direct Material Cost: [SMC]
This SMC is a product of standard quantity and standard price. So, it is clear that standard
quantity and standard price are to be determined first and SMC is obtained by multiplying
these two. SMC is briefly called as SC (Standard Cost).
Standard Material Quantity [SMQ]:
SMQ is briefly called – Standard Quantity (SQ). Based on input – output relations, normal
material losses as per are laboratory tests, SQ is determined.
Standard price [SP] :
SP is determined taking multiple criteria into account like : price of material in Stock,
materials already contracted, future price trends, discounts etc. So, SC for material is the
product of SQ and SP. Therefore SC = SQ x SP
Standard for Direct Labour Cost [SLC]
This resembles SMC in that it is a product of standard hours and standard rate.
SLC = SH x SR
In this also, SH and SR are to be found out.

 Standard Hours : With the help of time and motion studies in a laboratory,
work study job analysis, Normal idle time, Therbligs etc. standard time (or) Hours are
fixed.

 Standard Rate : This is 2nd aspect in finding SLC. It is fixed based on the past,
going rates, consultations with Trade union, demand for labour, supply of labour etc.
Thus, the product of SH and SR gives SLC.

 Standard for Expenses : [Overheads] While we fix standards for expenses (or)
overheads (OH) we need to go in three steps.
(1) Determination of total overhead
(2) Determination of production in units
(3) Calculation of standard overhead rate.

Sometime, for the entire overhead, a standard rate can be calculated. On the other hand,
overhead can see split into fixed and variable overheads and separately, standard Overhead
rates can be determined. The following formula can be used to calculate the overhead rate.

This rate can be calculated in hours also.

Total OH
Standard OH. Rate per unit
= Budgeted output
Standard overhead rate per hour = Standard overhead Budgeted

Hours in the period

VARIANCE ANALYSIS

This part is the most integral part of standard costing. The purposes of cost Accounting
can be achieved by costing through variance analysis in standard costing. Variances are to
be calculated for all the elements of cost viz., Materials, Labour and Expenses (or)
overhead (OH). We now examine Material Variance Analysis in the first place. The
following chat will explain it best.

MATERIAL VARIANCE ANALYSIS :

(1) (SQ x SR – AQ x AR)

Material Cost Variance

(2) (SR – AR) AQ (3) (SQ – AQ) SR

Price Variance
Quantity Variance

MMV = (RQ – AQ) SR MUV = (SQ – RQ) SR(4)

MYV = (AY – SY) SC MYV = (AY
(5) – RY) RC
Mix variance Yield Variance

(1) Material cost variance: This is the difference between standard cost of
standard quantity for Actual output and actual cost of actual Material used for actual output.
The formula for this is :
MCV = SC – AC = SQ x SR – AQ x AR
Where : SC = Standard cost, AC = Actual cost, SQ = SQ for AY, SR = Standard Rate, AQ
= Actual Quantity, AR = Actual Rate.
Importantly, SQ = SQ for AY
Where AY = Actual Yield (or) Actual output.

(2) Material Price Variance: From the above chart, it is understood that 2nd
variance is price variance and this will also lead to MCV. This is a part of the MCV and
arises due to the difference in standard price set and the actual price paid.
The formula is :
MPV = (SR – AR) AQ where SR = Standard Rate, AR = Actual Rate and AQ = Actual
Quantity of material.

(3) Material quantity variance: (MQV) It is also known as usage variance and it is
a part of the MCV as per the above chart. This may arise due to any of the reasons viz.,
workers, quality of Materials, skill and efficiency of workers, changes in product design
etc. Mostly, it arises due to the difference in utilisation of raw materials. Its formula is :
MQV = (SQ – AQ) SR where SQ = SQ for AY, AQ = Actual Quantity, SR = Standard
Rate, AY = Actual Yield.

(4) Material mix variance [MMV]: As per the chart of material variances, MMV is
that portion of MQV due to changes in standard mix of materials and actual mix of the
materials. It may be also due to subsequent shortage of raw materials. In this case,
standard quantities are to be revised as per a formula and with these revised quantities the
MMV is to be calculated. How do we revise the Quantity?
For the sake of convenience, MMV is discussed in a phased manner. Some assumptions
are made here. In the 1st phase, the following are the assumptions.
(1) only mix ratio differs.
(2) Total weights of the mixes are the same
MMV in this case uses the same formula used for MQV.
Therefore, MMV = (SQ – AQ) SR
In the 2nd phase, the assumption are:
(1) Mix compositions differ.
(2) Total weights of the mixes are also different

MMV in this case is calculated with the following formula.

MMV = (RSQ – AQ) SR where:
RSQ = Revised Standard Quantity, AQ = Actual Quantity, SR = Standard Rate.
RSQ = Total weight of Actual Mix x old standard ratio.
Further, it is to be noted that MQV calculated as per the earlier said formula will be
divided into two parts viz., (1) MMV (due to change in mix Ratio) and (2) MUV (due to
efficiency (or) in efficiency in the utilization of materials).
So, MMV = (RSQ – AQ) SR and
MUV = (SQ – RSQ) SR
From the above it is to be noted that MQV must be equal to the total of MMV and MUV.

(5) Material yield variance (MYV) :

In all processing industries, material loss is inevitable. So, while setting standards for
material and output from materials, a provision is made for normal loss while abnormal
loss is not provided for. Though a provision is made for normal loss in the Standard, some
difference is bound to arise between standard output for the actual input and the actual
output. Hence, need for calculation of yield variance arises. Thus, there is difference
between standard yield and actual yield because of efficiency (or) in efficiency of workers,
poor quality of materials, etc. As per the material variances. Chart given above, it is 5 th
variance which is a part of the MQV which is due to reasons said above. For the sake of
convenience, it is sought to be handled in two situations. They are:

(1) (a) Mix varies , (b) Weights do not vary.

In the above case, the formula for MYV is MY = (AY – SY) SC, where: AY = Actual
Yield, SY = Standard yield for actual input of material used, SC = Standard cost of unit.

(2) (a) Mix Varies, (b) Weights also vary.

In this case, since there is alround change standards set are to be revised and Revised Mix
is to be calculated and Revised yield also is to be found out. The earlier yield variance
formula is expressed now in Revised Terms. The formula is:
MY = (AY – RY) RC
SC (or) RC calculation:
It is standard cost per unit of finished goods. It is calculated as per the following:
SC (pu) (or) RC = Total Standard cost (OR)
Total input - Normalloss
Normal cost of Normal output
Normal output
Verifications (or) checking:
(1) MCV = MPV + MQV
(2) MQV = Mix + Yield
(3) MQV = Mix + usage
(4) MQV = Mix + usage (or) yield
(5) MUV = MYU

DIRECT LABOUR COST VARIANCES

These variances are about the 2nd element of cost, i.e. Labour. We get reminded of all
material variance formula when we look at Labour variances. There is a lot of similarity.
The first variance is Direct Labour Cost Variance (DLCV). This is difference between
standard cost of labour and actual cost of labour. This is like MCV. Formula is given
below:
DLCV = SC – AC = SH X SR – AH X AR
SC = Standard cost,
AC = Actual Cost,
SH = SH for actual output,
SR= Standard Rate,
AH = Actual Hours,
AR = Actual Rate.
1. Labour Rate Variance [LRV]:
This is just like Material Price Variance. This is part of the DLCV which is due
to difference between standard wage rate and actual wage rate paid. Formula is:
LRV = (SR – AR) AH,
Where: SR = Standard Rate AR = Actual Rate, AH = Actual Hours.
2. Labour Time (or) Total Efficiency Variance : (LTV (or) LEV)
This is again like material quantity variance. This is post of DLCV which is due to difference
in standard Hours for Actual output and Actual Hours. The relevant formula is:
LTV (or) LEV : (SH – AH) SR where:
SH = Standard Hours, AH = Actual Hours, SR = Standard Rate.

3. Labour Efficiency variance : (LEV)

(1) Idle Time Variance : As per the chart of labour variances, it is portion of the
Labour Efficiency (or) Time variance. As there is material loss in the case of materials,
there is problem of idle time is the case of Labour. This idle time is due to abnormal
reasons viz., non – availability of raw materials, of special kind of labour, break down of
Plant & Machinery etc. Formula is:
ITV = Abnormal Idle Hours x SR
Note: This is always adverse variance.

(2) Labour Mix variance : This is similar to material mix variance and all the
formula of material mix variance can be used by using SH in the place of SQ and RSH
(Revised standard hours) in the place of RSQ (or) RQ the relevant formula are:
(a) LMV = (RSH – AH) SR
(b) LUV = (SH – RSH) SR
From the above it can be understood that the total Labour Efficiency (or) Time variance is
a sum of (1) Idle Time variance, (2) Mix variance and (3) usage variance. When LUV is
calculated in Labour time variance, there is no need to specially calculate Labour yield
variance as it is very much equal to LYU.

(3) Labour yield variance : This is very much similar to MYV. The formula are :
(1) LYU = (AY – SY) SC
(2) LYU = (AY – RY) RC
 SC – AC = SH x SR – AH x AR
Direct Labour Cost Variance

(SR – AR) AH (SH – AH) SR

Total Efficiency (or) Time Variance
Rate Variance

Idle Hrs x HR [SH – [AH – IT Hrs] SR]

Idle Time Variance Efficiency Variance

4. Labour Efficiency Variance : [LEV]

As per the chart, this is part of Total Efficiency variance. When we seek to calculate the
real efficiency variance, from out of total Hrs. actually worked, Idle Hours lost due to
abnormal condition shall be set aside and with these actual hours, efficiency variance is to
be calculated. The formula is:
LEV = [SH – (AH – Idle Hours)] SR

(SH – AH) SR
When there is mix = =
Total
Efficiency
(AY – SY) SC
(or)
Idle Hrs. x SR (RH – AH) SR (SH – RH) SR (AY – RY) RC

(or)
Idle Mix Usage Yield
Time + Varian + Varian Varian
Varianc ce
TLEV = Idle + Mix + Usage (or) Yield
1. Denotes Total Actual Hours worked including idle Time Hours.
Verifications:
(1) LCV = Rate + Total Time (or) Total Efficiency.
(2) Total Efficiency Variance = Idle Time + Efficiency.
(3) Total Efficiency Variance = Idle + Mix + usage (or) Yield
(4) Usage = Yield.

Advantages of Standard Costing:

In the areas of Accounting, Cost Accounting and Management Accounting,
Standard Costing enjoys a significant place in acting as a cost controlling and cost
reducing managerial tool. The utility of standard costing is unlimited. The following
are some important merits.

1. Application of “Management by Exception” principle: here is no need to

waste away the most significant time of Top management with negligible and
inappropriate things in controlling. With the help of variance analysis, attention
of the Management towards exceptional areas of performance may be drawn and
accordingly, they may be contained. Management by Exception principle says
that only exceptional aspect needs to be reported to the most right level of
management.
2. Optimum utilisation of Resources: Because of the cost consciousness
developed in the minds of people in the organisation, people tend to make the
best utilisation of all scarce resources for the maximisation of profits and
minimisation ofcosts.
3. People are motivated: Since standards are set with the involvement and
participation of lower level people also, they are very much motivated to
accomplish the standards that they also set, along with higher ups in the
organisation.
4. Most Important Managerial Tool of Cost control / Cost Reduction: There
are several tools and techniques to control costs and performance aspects.
Among all these tools, standard costing is a significant tool to control and reduce
costs.
5. Weak sports un earthed: The efficient and inefficient areas of working in the
 entire organisation are revealed by the variance analysis. Accordingly, remedial
action can be planned.
6. Valuation of Inventory at Standard Rates: Since stocks can be valued at
standard costs, this will reduce fluctuation of profits due to adoption of different
methods for stock valuation.
Disadvantages of Standard Costing:
 Setting standards itself is the most difficult task.
 Categorising the causes for variances into controllable and un controllable
itself is another difficult barrier.
 Standard costing is not very much suitable to those industries which are
exposed to constant changes in the market.
 Standards set once are never revised as per the changed scenario and hence,
they may prove to be of no use.
 It is a costly and time-consuming tool.
 Employees resist the new life style in the organisation, because of standard costing.
 Not very much suitable to small and medium sized organisations.

In spite these problems (or) criticisms, standard costing has got its own value and
no limitations can stand against the utility of standard costing.