ADM

ACCOUNTING FOR DECISION MAKING
SYLLABUS
UNIT I FINANCIALACCOUNTING - Introduction to Financial, Cost and

Management Accounting - Generally accepted accounting principles -
Double Entry System – Preparation of Journal, Ledger and Trial Balance
Preparation of Final Accounts: Trading, Profit and Loss Account and Balance
Sheet - Reading the financialstatements.
UNIT II ANALYSIS OF FINANCIAL STATEMENTS - Financial ratio analysis,

Interpretation of ratio for financial decisions - Dupont Ratios Comparative
statements - common size statements. Cash flow (as per Accounting
Standard 3) and Funds flow statement analysis – Trend Analysis.
UNIT III COST ACCOUNTING - Cost Accounts – Classification of costs –

Job cost sheet – Job order costing Process costing – (excluding
Interdepartmental Transfers and equivalent production) – Joint and By
Product Costing – Activity BasedCosting, Target Costing.
UNIT IV MARGINAL COSTING - Marginal Costing and profit planning – Cost,

Volume, Profit Analysis – Break Even Analysis –Decision making problems -
Make or Buy decisions Determination of sales mix - Exploring new markets -
Add or drop products - Expand or contract.
UNIT V BUDGETING AND VARIANCE ANALYSIS - Budgetary Control –

Sales, Production, Cash flow, fixed and flexible budget – Standard costing and
Variance Analysis – (excluding overhead costing) - Accounting standards
and accounting disclosure practices in India.
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UNIT I –FINANCIAL ACCOUNTING
Contents
LEARNING OBJECTIVES ............................................................................................................. 1
1.1 Introduction to Cost, Financial And Management Accounting .............. 2
1.2 Generally Accepted Accounting Principles (GAAP) And Double Entry
............................................................................................................................................... 12
1.3 Journal ........................................................................................................................ 19
1.4 LEDGER ...................................................................................................................... 31
1.5 TRIAL BALANCE ..................................................................................................... 42
1.6 PREPARATION OF FINAL ACCOUNTS ........................................................... 53
1.7 Preparation of Final Accounts – Profit And Loss Account .................... 61
1.8 PREPARATION OF FINAL ACCOUNTS-BALANCE SHEET ..................... 77
LEARNING OUTCOMES............................................................................................................ 91
Short Questions .......................................................................................................................... 91
Long Questions ........................................................................................................................... 91
LEARNING OBJECTIVES
 To understand the meaning and Process of Accounting

 To explain various accounting concepts and conventions
 To Understand the Definition of Journal
 To know the meaning and utility of Ledger
 To know about the Meaning of trial balance
 To understand the meaning of Profit and loss account
 To analyse how adjusting entries are passed in final accounts
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1.1 Introduction to Cost, Financial And Management Accounting
1.1.1. Introduction to Accounting
In an organization, numerous transactions take place. It is not possible for the

Businessman to memorize and recollect what are all the transactions took place in his day
to day business activities. At the same time, it is essential for him and the Users of Financial
Statements in knowing what the business owns and owes, how much profit the business
has earned and the financial position of the business. To remove this hindrance, Accounting
was developed. Accounting helps in knowing the true financial position of the business.
1.1.2. Meaning of Accounting
Accounting is the process of recording, classifying, summarizing, analyzing and

interpreting the business transactions which can be measured in terms of money. It is a
permanent record of business transactions and provides valid financial information to
owners, banks, customers, government and other outside parties to make correct decisions.
1.1.3. Process of Accounting
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USERS OF ACCOUNTING INFORMATION
Accounting Information is used by different groups both inside and outside the
organization to make certain decision.
1.1.4. Internal Users of Accounting Information
An internal user means people who are inside the organization and part of the business.
The internal users of accounting information are:
 Owners: The sole trader or partners or shareholders who have contributed Capital
to the organization and are interested to perform in its performance and progress
are called owners. They use Accounting information for observing their capital
invested and evaluating its upward or downward move, to know the revenues and
expenses, profit or loss, return on investment, net worth and external liabilities and
to keep an eye on the overall wellbeing of the business.
 Management: Management is done by Sole traders or partners of the business and
incase of bigger companies, it is done by paid professionals. Management of a
business involves making day to day decisions based on the situations and also
policy decisions whenever needed. They use Accounting information to take
investment decisions, budgeting and forecasting to take financial decisions and to
compliance with all regulatory, statutory and external body.
 Employees: Employees are people working in the organization. They use
Accounting information to know the profitability and financial health of the business
because it in turn affects their remuneration, bonus, incentives, job security and
working conditions. Their standard of living depends on the success or failure of the
business.
1.1.5. External Users of Accounting Information
The external users are people outside the organization. They use Accounting information
for various purposes. The external users of accounting information are:
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1. Investors: They are interested to invest their surplus funds in the organization.
They would like to know the financial condition of the Business for taking
investment decisions whether to invest or not. They concentrate more on future
earnings and risk.
2. Creditors: Suppliers of Goods and Services for credit are called Creditors. They use
Accounting information to know the credit worthiness of the business for repaying
their credit.
3. Lenders: Banks and Financial institutions fall under this category. They use
Accounting information to know the liquidity position and repaying capacity of the
business for repaying their loans.
4. Tax Authorities: They use Accounting information for computation of Income Tax
to be collected from the business.
5. Researchers: They use the published Financial Statements to evaluate the
performance of the business for a specific objective.
6. Public: They like to know the financial health of the business to get an idea about
the business.
1.1.6. TYPES OF ACCOUNTING
Modern Accounting can be classified into three categories
1. Financial Accounting
2. Cost Accounting
3. Management Accounting
FINANCIAL ACCOUNTING
Financial accounting is mainly concerned with the recording of all financial

transactions and is aimed towards preparation of necessary financial statements such as
profit and loss account and Balance sheet in order to appraise the value of a business.
Definition of Financial Accounting
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According to American Institute of Certified Public Accountants (AICPA) Accounting
is “The art of recording , classifying and summarizing in a significant manner and in
terms of money transactions and events which are in part at least of a financial
character and interpreting the results thereof”
Objectives of Financial Accounting
The main objectives of Financial Accounting are:
1. ecording the transactions occurring in the business.

2. Preparation of necessary accounts and Balance Sheet as per the
requirements of the law.
3. Ascertaining Profit or Loss and Financial position of the Business.
4. Providing Accounting information to the owner of the business and other
interested parties.
Benefits of Financial Accounting
The benefits of Financial Accounting are as follows:
 A business man cannot remember all the transactions made in his business.
Financial Accounting takes in charge of the task maintaining all the records of
transactions made replacing human memory.
 Properly maintained Accounts can be treated as authentic evidence in the
courts of law in the settlement of disputes.
 It is easy for the Business man to settle his tax liability if the accounts are
properly maintained or he has to pay any amount of tax imposed by tax
authorities.
 It helps to compare the various aspects of business such as financial position,
profit and expenses, sales etc. with that of previous years and with the same
type of competing firms in the market.
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 If accounts are properly maintained, proper purchase price of the business
can be determined in case the business man wishes to sell his business.
 Preparation of Financial Accounts helps to provide information to various
parties such as owners, creditors, employees, investors, bank, financial
institutions etc.
COST ACCOUNTING
The primary function of Cost Accounting is to ascertain the cost of the product and
to help in controlling the cost. It relates to collection, classification, recording, allocation
and summarization of cost and helps the management in controlling the cost.
Definition of Cost Accounting
I.C.M.A has defined Cost Accounting as “The process of accounting for cost from the
point at which expenditure is incurred or committed to the establishment of its ultimate
relationship with cost centres and cost units. In its widest usage it embraces the
preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of activities carried out or planned.
Objectives of Cost Accounting
The main objectives of Cost Accounting are:
1. Ascertaining and analyzing the cost and income by product, function and
responsibility.
2. Accumulating and utilizing the cost data to effectively manage the
expenses, to have a control over the cost incurred.
3. Helping Management in Decision Making.
Benefits of Cost Accounting
The benefits of Cost Accounting are as follows:
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 It is useful for fixation of prices. It enables the business man to find out the
accurate cost per unit of output and the expenses contributing to the
corresponding cost.
 It has the ability to manage the cost efficiently and control the cost without
reducing the level of production.
 Cost control can be done through Cost comparison from the same units or
factory or other factories in the industry.
 It provides valuable data that enables the management to decide to which
extent prices can be reduced to prevent or minimize loss in case of
depression.
 It helps in preparation of budgets so that productions can happen in a planned
and systematic manner. It gives an idea priory and helps to know how much
cost will incur in the overall business process, cost of each department,
operating costs and production costs.
 It can help in better decision making in the formation of strategies, level of
production to be carried out, to allocate finances etc.
 It helps to know the accurate and true measurement of cost and expenses.
 It helps in preventing manipulation, misappropriation and frauds in the
process of production.
MANAGEMENT ACCOUNTING
The term Management accounting is concerned with description of accounting

methods, systems and techniques with a special knowledge and ability to help the
management in the objective of maximizing profit or minimizing loss.
Definition of Management Accounting
“Management Accounting is the term used to describe accounting methods, systems

and techniques which coupled with special knowledge and ability, assists
management in its task of maximizing profits or minimizing losses. Management
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Accounting is the blending together into a coherent whole, financial accounting, cost
accountancy and all aspects of financial management.” - Batty
Objectives of Management Accounting
The main objectives of Management Accounting are:
(i) Presenting Accounting information in a form that enables the Management to

analyze the Financial Statements and make decisions.
(ii) Helps in Planning and Policy formulation in the business.
(iii) Helps in organizing and controlling the performance of the
organization.
(iv) Keeping the Management fully informed about the latest positions of
the organization.
Benefits of Management Accounting
The benefits of Management Accounting are as follows:
 It helps in decision making in the areas of pricing, make or buy, acceptance of

additional orders, selection of suitable product mix etc.
 It helps in planning activities like profit planning, preparation of budgets,
capital investment and financing.
 It helps to define the goals of every department clearly and coordinate as well.
 It helps to evaluate and control the performance of the organization through
accounting ratios and Variance analysis and thus the efficiency of the
departments can be measured.
 It assists the Management in location of weak spots and in taking corrective
actions.
 It presents financial information in simple and purposeful manner and that
supports quick decision making.
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1.1.7. DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING
Basis of Distinction Financial Accounting Cost Accounting
Purpose It provides information regarding It guides the Management for

profitability and financial proper planning, operation,
position of the business. coordination, control and
decision making.
Recording Records are kept in a subjective Records are kept in an objective

manner i.e. according to the manner i.e. according to the
nature of the expenditure. purpose for which costs are
incurred.
Items of costs Items of costs are expressed in Items of costs are calculated in
totals. cost per unit.
Analysis of Profit It reveals the profits of the whole It reveals the result of each
business. operation, process, job or
product.
Control It concentrates only on recording It provides a detailed system of

and does not give importance to cost control with the help of
control aspect. standards and budgets.
Periodicity Accounts are prepared at the end It is a continuous system of

of the Accounting year. Accounting and the reports can
be submitted to the
Management as and when they
need it.
Nature It records all commercial It is concerned with internal
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transactions and transactions transactions relating to
with third parties. manufacturing activities.
Inventory Valuation Inventory is valued at cost or Inventory is valued at cost

market price whichever less is. price.
Figures Figures mainly deal with actual It deals partly with actual
figures. figures and partly with
estimates.
1.1.8. DIFFERENCES BETWEEN COST ACCOUNTING AND MANAGEMENT ACCOUNTING
Basis of Distinction Cost Accounting Management Accounting
Nature It deals with ascertaining, It deals with the effect and

allocating, apportioning and impact of costs on the business.
accounting aspect of costs.
Information type It is Quantitative. It is both Quantitative and

Qualitative.
Objective To ascertain the cost of To provide information to

Production. managers to take decisions.
Base It acts as a base for It is derived from both Cost

Management Accounting. Accounting and Financial
Accounting.
Role It is helpful in collecting It plays a role in Decision

costing data for Management. making.
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Tools and techniques It has standard costing, It has funds and cash flow
variable costing, break even statements, ratio analysis etc.
analysis etc. as the basic tools along with Cost Accounting
and techniques. tools and techniques.
Scope It does not include Financial It includes Financial and Cost

Accounting, Tax Planning and Accounting, Tax Planning and
Tax Accounting. Tax Accounting.
Interdependency It can be installed without It cannot be installed without

Management Accounting Cost Accounting.
1.1.9. DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING
Basis of Distinction Financial Accounting Management Accounting
Nature It is an accounting system It is an accounting system

that focuses on preparation which provides relevant
of Financial Statement of an information to the managers
organization to provide to make policies, plans and
financial information strategies to grow the
business successfully.
Nature of data It is mainly based on actual It is based on actual data as

data. well as projected data.
Nature of statements General purposes Financial Special purposes Financial

prepared Statements are prepared. Statements are prepared.
Reality It is mainly objective It is both objective and
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oriented. subjective oriented.
Users Both internal and external Only internal users can

users can access the access the information.
information.
Periodicity Accounts are prepared at the Management reports are

end of the Accounting year. prepared whenever needed.
1.2 Generally Accepted Accounting Principles (GAAP) And Double Entry
1.2.1 MEANING OF GAAP
Generally Accepted Accounting Principles (GAAP) are set of rules, standards and
procedures that certain businesses and organizations must follow as promulgated by the
Institute of Chartered Accountants of India and under the Indian Companies Act.
Generally Accepted Accounting Principles (GAAP) can be divided into two. They are
Accounting Concepts and Accounting Conventions.
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1.2.2 ACCOUNTING CONCEPTS
Accounting Concepts define the assumptions on the basis of which financial

statements of a business entity are prepared.
Separate Entity Concept:
In Accounting, the business is considered as a separate entity from the proprietor or

owner. So Proprietor or owner’s personal transaction does not come into business.
Financial transactions relating to business only will be recorded in the Books of Accounts
and that helps to give a proper financial picture of the business. It is also called as Business
Entity Concept.
Money Measurement Concept:
Events or transactions which cannot be expressed in terms of money cannot find

place in the Books of Accounts though they may be very useful for the business. All the
financial transactions expressed in monetary units can only take place in the Books of
Accounts because Money is the common denominator for quantifying the effects of
transactions.
Going Concern Concept:
The business entity is assumed to be a going concern i.e. the business will continue
for an indefinite amount of time. There is neither intention nor the necessity to liquidate
the particular business venture in the foreseeable future. The importance of this
assumption is in case of liquidating the business in the near future, it would have to restate
its assets and liabilities in accordance with the actual amount that could be realized or
payable. It also helps to reflect the true financial position of the company.
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Dual aspect Concept:
Every transaction must have a double entry called debit and credit while recording
it. The receiving account is debited and the giving account is credited with the same
amount. Thus every Debit must have an equal and corresponding Credit and vice versa. It is
also called as Double entry system of Accounting.
Realisation Concept:
Realisation is the point in which revenue has been generated. Transaction cannot be
recorded only when the cash is received. It should be recorded only when the revenue is
earned i.e., when the goods have been transferred to the buyer or services have been
rendered. And while recording revenue, it is not necessary that cash have to be received. It
can also be in credit.
Cost Concept:
According to this concept, the assets are recorded at their respective prices at the
time the asset was purchased or acquired. The value of the asset cannot be increased
according to the improvements in market value or inflation but can systematically reduce
its values by charging depreciation.
Accounting period Concept:
Accounting period is the span of time at the end of which financial statements are
prepared to throw light on the results of operation during the relevant period and the
financial position at the end of the relevant period. All the Accounting transaction should be
divided into equal time period. It can be either a calendar or fiscal year but also a week,
month or quarter etc.
Matching Concept:
According to this concept, Revenues earned during an Accounting period is

compared with the same expenditure incurred during the same period for earning that
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revenue. It can be done by identifying all the expenses incurred during the Accounting
period, measure the same and match expenses against the revenue earned in the same
period.
1.2.3 ACCOUNTING CONVENTIONS
Convention of Conservatism:
According to this convention, Profits should not be anticipated but provide for all
possible losses. Revenues and Gains are recognized only when realized in the form of cash
or when the money is realized. Provisions must be made for all known liabilities, expenses
and actual and probable losses. This policy can be followed for pre- caution and playing
safe. It helps to safeguard against possible losses in the world of uncertainty. It is also
called as Prudence principle.
Convention of Consistency:
According to this convention, accounting practices should remain unchanged from

one Accounting period to another. It must be consistent. Once a firm has decided on certain
Accounting policies and methods and has used these for some time, it should continue to
follow the same methods or procedures for all subsequent similar events and transactions
unless it has a sound reason to do otherwise.
Convention of Full Disclosure:
Disclosure is the process of making information or facts known to the public.

Financial Statements should be honestly prepared and sufficiently disclose information
which is of material interest to proprietors, present and potential creditors and investors.
Convention of Materiality:
This convention states that business should include only the important and relevant
facts in the Financial Statements. Material facts refers to any information whether excluded
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or misreported in the Financial Statements and that could influence the users of such
Financial Statements. This convention makes the Financial Statements meaningful.
1.2.4 METHODS OF ACCOUNTING
Basically all the methods of Accounting are classified under two heads:
1. Single Entry System

2. Double Entry System
Single Entry System
Kohler defines single entry system as,” A system of books keeping in which as a
rule only records of cash and of personal accounts are maintained, it is always
incomplete double entry varying with the circumstances”.
Usually under this system, the cash book and personal account of debtors and
creditors are maintained; real and nominal accounts are not maintained.
For example, cash paid to acquire a fixed asset, where one aspect is recorded.
Double Entry System
The procedure of recording both the receiving and giving aspects related to
business transactions is called double entry system.
It denotes that every business has two fold effects. Every business transaction has
effect at least on two accounts namely the debit account and credit account. This system is
popularized as scientific and comprehensive accounting procedure.
It refers to an Accounting concept whereby,
Assets = Liabilities + Owners’ Equity
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Importance of Double Entry System
 Business firms get accurate, comprehensive and reliable record of all its
business transactions
 Comprehensive information relating to assets, liabilities, profits and loss of
business will be made available.
 It ensures arithmetical accuracy of books of accounts.
 Effective comparison between two years of various items such as purchases,
sales, incomes, expenses etc.
 Various financial statements like profit and loss account, balance sheet,
statement of fund flow and cash flow can be prepared
 The collection and payment of debtors and creditors will be made effectively
by ascertaining their balance correctly.
 Under this system, errors or frauds can be easily detected and rectified.
 Trial balance preparation is made easy by transferring the amount from the
closing balance of ledger accounts, which proves the arithmetical accuracy of
the accounts.
 The tax authorities depend on the double entry system for proper assessment
of tax.
 The double entry book keeping is a procedure, perfect in all respects and
offers all possible advantage in keeping books of accounts.
Differences between Single Entry System and Double Entry System
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BASIS SINGLE ENTRY SYSTEM DOUBLE ENTRY SYSTEM
Under this system, both the Under this system, both

Aspects of a
aspects of transaction may be aspects of a transaction are
transaction
recorded not recorded
Personal, real and nominal

Only personal accounts and cash
etc. All the accounts are
books are maintained. Hence it
Accounts maintained maintained. Thus, it is a
remains an incomplete record of
complete and scientific
accounts.
system of accounting.
Trial balance cannot be prepared

Trial balance is prepared and
due to incomplete system of
thus the arithmetical
Trial balance accounting. Thus, arithmetical
accuracy of the books of
accuracy of the accounting cannot
account is verified.
be verified.
After a certain period net

Profit and loss account is not
profit or net loss can be
Profit or loss prepared to ascertain the net
ascertained by preparing the
profit or loss.
balance sheet.
Balance sheet is prepared, only

statement of affairs is prepared. Correct financial position of
The reason is that the assets and the business can be
Financial position
liabilities do not stand at real ascertained by preparing the
amounts but at estimated balance sheet.
amounts.
There is no provision to make The adjustments are made at

Adjustments adjustments primarily because of the time of preparing the final
incompleteness of accounts accounts.
The system is used by only tiny The system is used by almost

Use
businesses and institutions all the businesses.
Authenticity The court does not consider this The system is considered
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system as authentic. authentic by Govt.
1.3 Journal
Meaning
Journal is a book of primary entry or a book or original entry in which transactions

are first recorded in a chronological order, i,e.,, in the order or sequence they are entered.
Transactions are recorded in the Journal book from the accounting voucher that are
prepared on the basis of source documents, i.e., cash memo, invoices, purchase bills, etc.
All financial transactions can be recorded in a simple Journal Alternatively, in may

maintain separate Journal to record particular type of transaction, e.g., credit purchases
may be recorded in Purchases Return Journal, and so on. These separate Journals called
Special Journals or Special Purpose Books and often called as Subsidiary Books.
1.3.1 DEFINITIONS
“The basic books of accounting is called Journal. Precisely it is the books or prime
entry which means---Day Book. Trader records his total daily transactions in it. The
process or recording the transactions into Journal is called Journalising”.
Format of a Journal: Journal is divided into five columns.
These are: Date, Particulars, Ledger Folio (L.F.) Debit Amount and Credit Amount.
The format of a Journal is a follows:
Date Particulars L.F. Dr. Amount (Rs.) Cr.Amount(Rs.)
(1) (2) (3) (4) (5)
(L.F. stands for Ledger Folio)
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1. Date: In this column, the transaction date is written.
2.Particulars: According to Dual Aspect Concept of accounting, both the aspects of a

transaction are recorded, i,e., at least two accounts are affected by a transaction. The name
of account to be debited is written first followed by the word ‘Dr.” written close to the
Right-hand margin line, while the name of the account to be credited is written in the next
line preceded by the word “To”, a little to the right.
3. Narration: A brief description of the transaction is also written after the entry.
4.Ledger Folio (L.F.): In this column the number of ledger page iswritten to which the
debit and credit aspect of the transaction is posted. For example, the proprietor invests
further capital of Rs 5,00,000 and Capital Account is maintained at ledger page 53,against
the entry”To Capital A/c’ in the L.F. .Column 53 is written which shows that credit aspect of
the transaction is posted to ledger page’53.
5. Debit Amount: In this column, the amount debited is written.
6. Credit Amount;In this column, the amount credited is written.
Steps in Journalising
Steps involved in Journalising are:
Step 1: Determine the accounts that are affected by a transaction.
Step 2: Determine the nature of the accounts affected.
Step 3: Determine the accounts to be debited and credited by applying the rules of debit
and credit.
Let us, at this point, recapitulate the rules of debit and credit.
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Based on Traditional Classification of Based on Modern Classification on Account
Accounts
Types of account Debit Credit Types of Account Debit Credit
1. Personal The The Giver 1. Asset A/c Increase Decrease

A/c receiver
2. Liability Decrease Increase
A/c
2. Real A/c What comes Whatgoes 3. Capital A/c Decrease Increase

in out.
4. Revenue Decrease Increase
A/c
3. Nominal All All Income 5. Expense Increase Decrease

A/c Expenses and Gains A/C
and Losses
Step 4: Determine the amount by which the accounts are to be debited and credited.
Step 5. Record the date and month or the transaction in the ‘Data” column and the year at
the top.
Step 6: Record in the “Particulars” column the account to be debited. Along with the name
of the account, abbreviation Dr.” is written in the same line against the name of the account.
Write the amount to be debited in the ‘Debit Amount” column.
Step 7. Record in the ‘Particulars” column the account to be credited. Name of the account
to be credited is written in the next line preceded by the word “To”. The word “To’ is
written towards the right after leaving a few spaces. Write the amount to be credited in the
‘Credit Amount’ column.
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Step 8. Record brief description of the transaction starting from the next line in the
‘Particulars” column. This brief description of the transaction is called narration.
Step 9. Draw a line across the ‘Particulars’ column to separate on Journal entry from the
other.
PROBLEMS
1.The following are the transactions of Mr.Kumar during the month of July 2011 on
the following dates:
01. Capital introduced by Mr.Kumar Rs.10,000.
02. Furniture purchased for cash Rs.500.
07. Purchased goods for cash Rs.3000
11. Sold goods to Raman for cash Rs.1500
15.Paid electricity charges Rs.150
Journalise the above transactions in the books of Mr.Kumar.
Solution:
Journal Entries in the books of Mr. Kumar
Debit Credit
Date particulars L.F
Rs. RS.
01.07.2011 Cash A/c Dr. 10,000
To Kumar’s Capital A/c
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(Being capital introduced by 10,000
Kumar)
500
Furniture A/c Dr.
02.07.2011
500
To Cash A/c
(Being furniture purchased for

cash)
Purchase A/c Dr.
To Cash A/c
(Being cash purchase made)

07.07.2011 3,000
Cash A/c Dr.

3,000
To sales A/c
(Being cash sale made)
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11.07.2011 Electricity Charges A/c Dr. 1,500
1,500
To Cash A/c
(Being electricity charges paid)
150
150
15.07.2011
2. Mr.Kiran gives the following information. You are required to journalise them in
his books.
March 2000
1 Commenced business with a cash 2,60,000
3 Opened an account with a bank and deposited.25,000
8 Purchased goods for cash 50,000
10 Purchased furniture for cash 1,500
13 Sold goods for cash 12,000
15 Sold goods to Kumar 8,000
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Solution:
In the books of Mr.Kiran
Date particulars L.F Debit Credit
Rs. RS.
01.03.2000 Cash A/c Dr. 2,60,000
To Kiran Capital A/c 2,60,000
(Being capital introduced by Kiran)
03.03.2000 Bank A/c Dr. 25,000
25,000
To Cash A/c
(Being cashdeposited into bank)
08.03.2000 50,000
Purchase A/c Dr.
50,000
To Cash A/c
25
(Being purchase made)
12,000
Cash A/c Dr.
13.03.2000
12,000
To sales A/c
(Being goods sold for cash)
8,000
Kumar A/c Dr.
15.03.2000
8,000
To Sales A/c
(Being goods sold to Kumar on

credit)
3. Mr. Narayanan, running a business, gives the following transactions during the
month of February 2011 on the following dates:
10 Cash invested into business Rs1,45,000
18 Sold goods to Ganesh Rs. 14000
20 Purchased goods from Daniel Rs.33,000
23 Ganesh settled his account Rs. 13,500
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26 Paid to Daniel Rs.32,000 and settled the account
Journalise the above transactions.
Solution:
In the books of Mr. Narayanan
Date Particulars L.F Debit Credit
Rs. RS.
10.02.2011 Cash A/c Dr. 1,45,000
1,45,000
To Narayanan’s Capital A/c
(Being capital introduced by

Narayanan)
Ganesh A/c Dr.

18.02.2011 14,000
To Sales A/c
14,000
(Being goods sold to Ganesh on
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credit)
08.03.2000 Purchases A/c Dr. 33,000
To Daniel A/c 33,000
(Being goods purchased on credit

from Daniel )
.
Cash A/c Dr.
13.03.2000 13,500
Discount Allowed A/c Dr.

500
To Ganesh A/c
14,000
(Being cash received from Ganesh
28
and allowed a discount)
Daniel A/c Dr.

26.02.2011 33,000
To Cash A/c
32,000
To Discount Received A/c

1,000
(Being cash paid to Daniel in full

settlement)
4. Yogesh provides the following particulars on 1 st June 2006: Cash in hand

Rs.20,000; Cash at bank Rs.15,050;Stock Rs.45,000; Machinery Rs.30000; Debtors
Nalan Rs.10,530,Kovalan Rs.5,500;Creditors :BalaRs. 12,500,Murugan Rs.45,200 and
Loan from Ashish Rs.5,780.Pass Journal entry and calculate the capital.
Solution:
29
In the books of Yogesh
Rs. RS.
01.06.2006 Cash in Hand A/c Dr. 20,000
Cash in Bank A/c Dr. 15,050
Stock A/c Dr. 45,000
Machinery A/c Dr. 30,000
Nalan A/c Dr. 10,530
Kovalan A/c Dr. 5,500
To Bala A/c 12,500
To Murugan A/c 45,200
30
To Loan from Ashiq A/c 5,780
To Capital A/c (Bal. fig.) 62,600
(Being various opening balances of

assets and liabilities on 01.06.2006
and the capital entered
1.4 LEDGER
MEANING OF LEDGER
Ledger is also an important book of Account. Ledger is a book in which personal,

real and nominal accounts are maintained in a summarized and classified form. In other
words, it is a book containing accounts to which debits and credits are posted from books
of original entry. Ledger is a combination of all accounts and is a permanent record. Ledger
is also known as the principal book of accounts as well as book of final entry. The purpose
of preparing the ledger is to
 Summarize the transactions for each account at one place.

 Determine the debit or credit balance of each account.
 Help in reconciling balances with third parties.
 Know the assets and liabilities.
UTILITY OF LEDGER
1. Provides Complete Information of a particular Account:
31
Complete information relating to a particular account is available at one place in the
ledger.
2. Information of Income and Expenses:
In ledger, a separate account is maintained for each income and expense. The
amount of total income and total expenses is known from the ledger account.
3. Preparation of Trial Balance:
Ledger helps in preparing Trial Balance which ensures arithmetical accuracy of the
transactions recorded in books of account.
4. Helpful in preparing Final Accounts:
After preparing Trial Balance, Final Accounts are prepared to know the profitability
and financial position of the business.
Difference between Journal and Ledger:
Basis Journal Ledger
1.Nature of Book It is a book of primary entry It is a book of final entry
2. Basis for preparation Primary documents (such as Journal is the basis for
vouchers, receipts,etc.) are recording transactions in the
the basis for recording Ledger.
transactions in the journal.
3.Stages of Record Recording in the journal is Recording in the Ledger is

the stage. the second stage.
4.Object It is prepared to record all It is prepared to see the net

transactions in a effect of various transactions
32
chronological order. affecting a particular
account.
5.Format Journal has five columns: Ledger has four identical

columns on debit and credit
1. Date, 2. Particulars,
sides.1. Date 2. Particulars 3.
3. Ledger folio, 4. Debit Journal Folio 4. Amount.

Amount 5. Credit Amount
Format of Ledger Account
The format of Ledger account has been explained in an earlier chapter. For convenience, it
is being repeated here.
NAME OF THE ACCOUNT, e.g., WAGES ACCOUNT
Date Particulars J.F.* Amount Date Particulars J.F.* Amount

(Rs) (Rs)
Date of the Name of Amount of Date of Name Amount

transaction the other the the of the of the
account transactio transactio other transacti
n n Account on
1. Journalise the following transactions and post them into the Ledger:
2019
April 1 Ramesh started business with cash 1,00,000
33
April 2 Paid into bank 70,000
April 3 Bought goods for cash 5,000
April 4 Drew cash from bank for office 1,000
April 13 Sold to krishna goods on credit 1,500
April 20 Bought goods from shyam on credit 2,250
April 24 Received from Krishna 1,500
April 28 Paid cash to shyam 2,150
Discounted allowed by him 100
April 30 Cash sales for the month 8,000
April 30 Paid Rent 500
April 30 Paid salary to Ram 3,000
Solution:
In the Books of Ramesh
Rs. RS.
2019
April 1 Cash A/c ...Dr. 1 1,00,000
To Capital A/c 4 1,00,000
(Being the amount invested by
34
Ramesh in the business as capital)
5 70,000
April 2 Bank A/c … Dr. 1 70,000
To Cash A/c
(Being the amount paid into the 5,000

bank)
7 5,000
April 3 1
Purchases A/c … Dr.
To Cash A/c
(Being the goods purchased for

April 4 1,000
cash)
1 1,000
Cash A/c ...Dr.
To Bank A/c
April 13 1,500
(Being the cash withdrawn from the
bank) 9 1,500
Krishna
To sales A/c
35
(Being the goods sold to krishna on
credit)
April 20 2,250
7 2,250
Purchases A/c … Dr.
10
To Shyam
(Being the goods bought from

Shyam
April 24 1 1,500
on credit)
9 1,500
Cash A/c ...Dr.
To Krishna
10 2,250
(Being the cash received from
April 28 krishna) 1 2,150
12 100
Shyam ...Dr.
To Cash A/c
To Discount Received A/c (Note 1 8,000

1)
April 30 8 8,000
(Being the discount allowed by
Shyam on payment being made to
him)
36
Cash A/c ...Dr.
To Sales A/c
(Being the goods sold for cash)
15 500
April 30 14 3,000
1 3,500
Rent A/c …Dr.
Salaries A/c …Dr.
To Cash A/c
(Being the account paid for rent and
salary) 1,95,000 1,95,000
Total
37
Ledger
CASH ACCOUNT
Date Particulars J.F.* Amount( Date Particulars J.F.* Amount(R

Rs.) s.)
2019 2019
April 1 To Capital A/c 1,00,00 April 2 By Bank A/c 70,000

0
April 4 To Bank A/c April 3 By Purchase 5,000
A/c
April 24 To Krishna April 28 2,150
1,000
By Shyam
April 30 To Sales A/c April 30 500
By Rent A/c
1,500 April 30 3,000
By Salaries A/c
April 30 29,850
8,000 By Balance c/d
May 1 To Balance
b/d
1,10,5 1,10,500
00
29,850
38
CAPITAL ACCOUNT
Date Particulars J.F.* Amount(R Date Particulars J.F.* Amount

s.) (Rs.)
2019 2019
April 30 To Balance c/d 1,00,000 April 1 By Cash A/c 1,00,000
1,00,000 1,00,000
May 1 By balance 1,00,000

b/d
BANK ACCOUNT

s.) (Rs.)
2019 2019
April To Cash A/c 70,000 April 4 By Cash A/c 1,000

2
April By Balance 69,000
30 c/d
70,000 70,000
39
May 1 To Balance b/d 69,000
PURCHASES ACCOUNT

s.) (Rs.)
2019 Apr 30 By balance 7,250

c/d
April To Cash A/c 5,000
3
To Shyam 2,250
April
7,250 7,250
20
To balance b/d 7,250
May 1
SALES ACCOUNT

s.) (Rs.)
Apr 30 To balance c/d 9,500 2019
40
April By Krishna 1,500
13
By Cash A/c 8,000
April
30
9,500 9,500
May 1 By balance b/d 9,500
KRISHNA ACCOUNT

s.) (Rs.)
2019 2019
April 30 To Sales A/c 1,500 April By Cash A/c 1,500

24
1,500 1,500
41
1.5 TRIAL BALANCE
1.5.1 MEANING OF TRIAL BALANCE
Trial balance is a statement prepared to check the arithmetical accuracy of

transactions recorded in the journal, posted into the ledger and balanced in the ledger
accounts. The balance of ledger accounts shows the difference between the total of the
debit items and credit items in an account. Personal, real and nominal accounts are
considered for preparing the trial balance. Generally, it is prepared at the end of an
accounting year. However, it may be prepared at the end of any chosen period, which may
be monthly, quarterly, half yearly or annually depending upon when it is required. It helps
in the preparation of the financial statements.
DEFINITION OF TRIAL BALANCE
Eric L.Kohler has described Trial balance as” a list or abstract of the balances or
total debits and total credits of the accounts in a ledger , the purpose being to determine
the equality of posted debits and credits and to establish a basic summary of the financial
statements”
Suspense Account
In certain cases, when the debit column and the credit column of a trial balance do
not agree, then the difference of the trial balance is transferred to a temporary account
which is called a suspense account. This account is created to avoid any delay in creation of
the financial statements. If the debit column falls short of the credit column, then the
suspense account is debited and if the credit column falls short of the debit column then the
suspense account is credited.
When all the errors are detected and rectified, then the suspense account
automatically gets balanced. However, when errors still exist and are not rectified, the
suspense account will not balance off and the balance amount of the suspense account will
42
have to be transferred to the balance sheet. The debit balance of the suspense account is
shown on the assets side and the credit balance is shown on the liabilities side of the
balance sheet.
1. Prepare a Trial Balance from the following balances as on 31.12.2010
Particulars Rs. Particulars Rs.
Capital 19,000
Salary outstanding 11,000
Furniture 22,000
Stock on 1.1.2010 12,000
Purchases 18,000
Sales returns 14,000
Sales 22,000
Sundry creditors 18,000
Sunday Debtors 22,000
Bills payable 8,000
Bank overdraft 10,000
Solution: Trial Balance as on 31.12.2010
Sl.no Name of Account L.F Debit Credit
43
Rs. Rs.
1. Capital - 19,000
2. Furniture 22,000 -
3. Purchases 18,000 -
4. Sales - 22,000
5. Sundry Debtors 22,000 -
6. Bank Overdraft - 10,000
7. Salary outstanding - 11,000
8. Stock on 1.1.2010 12,000 -
9. Sales returns 14,000 -
10. Sundry creditors - 18,000
11. Bills payable 8,000
Total 88,000- 88,000
2. Mr. J furnishes the following particulars relating to his business. You are required
to
(a) Pass Journal Entries
44
(b) Prepare Ledger accounts’
(c) Prepare a Trial Balance as on 31st October 2010
Date Particulars AmountRs.
01.10.2010 J started the business with cash 4,00,000
03.10.2010 Purchased goods for cash@5% trade discount 1,00,000
04.10.2010 Paid electricity charges 1,000
08.10.2010 Purchased machinery for cash 20,000
10.10.2010 Sold goods to Mohan on credit 15,000
Journal Entries in the books of Mr. J
Date particulars DebitRs. CreditRS.
01.10.201 Cash A/c Dr. 4,00,000

0
To J’s capital A/c 4,00,000
(Being capital introduced by Karthik)
Purchase A/c Dr. 1,00,000

03.10.201
0 To Cash A/c 95,0000
To Discount A/c 5,000
45
(Being good purchased for cash)
Electricity charges A/c Dr. 1,000
04.10.201 To Cash A/c 1,000

0
(Being Electricity charges paid)
Machinery A/c Dr. 20,000
To Cash 20,000
08.10.201
(Being machinery purchased for cash)
0
Mohan A/cDr. 15,000
To Sales A/c 15,000
(Being goods sold to Mohan on credit)

10.10.201
0
46
J’S CAPITAL ACCOUNT
Date Particulars J.F. Amount(R Date Particulars J.F Amount(

* s.) .* Rs.)
31.10.2010 To Balance 4,00,000 01.10.201 By Cash A/c 4,00,000

c/d 0
4,00,000 4,00,000
By Balance 4,00,000
01.11.201 b/d
0
Date Particulars J.F.* Amount( Date Particulars J.F. Amount(Rs.

Rs.) * )
3.10.2010 To Cash A/c 95,000 31.10.201 By Balance 1,00,000

0 c/d
3.10.2010 To Discount 5,000

A/c
47
1,00,000 1,00,000
1.11.2010 1,00,000
To balance
b/d
PURCHASES ACCOUNT
Discount Account
Date Particulars J.F.* Amount Date Particulars J.F.* Amount(R

(Rs.) s.)
31.10.2010 To Balance 5,000 31.10.201 By Purchases 5,000

c/d 0 A/c
5,000 5,000
5,000
1.11.2010 By balance b/d
48
Electricity Charges Account
Date Particulars J.F.* Amoun Date Particulars J.F.* Amount(Rs

t(Rs.) .)
4.10.2010 To Cash A/c 1,000 31.10.201 By Balance 1,000

0 c/d
1,000 1,000
1.1.2010 To Balance 1,000

b/d
Sales Account
Date Particulars J.F.* Amoun Date Particulars J.F.* Amount(R

t(Rs.) s.)
31.10.2010 To Balance 15,0 10.10.20 By Mohan 15,000

c/d 00 10 A/c
49
15,0 15,000
00
1.11.201 By Balance
0 b/d 15,000
Mohan’s Account
Date Particular J.F. Amount Date Particulars J.F. Amount(

s * (Rs.) * Rs.)
10.10.2010 To Sales 15,00 31.10. By Balance 15,000

A/c 0 2010 c/d
15,00 15,000
0
1.11.2010
To Balance
b/d 15,00
0
50
Cash Account
Date Particulars J.F.* Amount Date Particulars J.F.* Amou

(Rs.) nt(Rs.)
01.10.20 To J’s Capital 4,00,000 03.10.20 By Purchases 95,000

10 A/c 10 A/c
1,000
04.10.20 By Electricity
10 charges A/c
20,000
By Machinery
A/c
08.10.20
2,84,000
4,00,000 10 By Balance c/d
4,00,000
2,84,000 31.10.20
1.11.201 To Balance 10
0 b/d
51
Trial Balance of Mr.J
Particulars Debit Rs. Credit Rs.
Capital 4,00,000
Purchases 1,00,000
Discount Received 5,000
Electricity Charges 1,000
Machinery 20,000
Cash 2,84,000
Sales 15,000
Mohan (Debtor) 15,000
4,20,000 4,20,000
Total
52
1.6 PREPARATION OF FINAL ACCOUNTS
INTRODUCTION
The synthesis of the financial accounting is a set of reports that are called as
financial statements. Financial accounting is basically a package of accounts and
statements. The trial balance is the base from which the financial accounts are prepared.
The final accounts of a company are prepared in the standardized format and it is
mandatory for all the companies registered under the companies Act.
Objectives in the preparation of Final accounts
1. To access the profit earned or loss incurred by the business during the period
2. To find out the financial position of the firm and to know the total assets and
total liabilities and the net capital of the business on a particular date.
Stages in preparation of Final accounts
1. Trading Account –To find out gross profit

2. Profit & Loss Account– To access Net profit
3. Balance Sheet– To show the total assets and liabilities
Trading account
Trading account is the account which deals with the inflow and outflow of goods i.e.
the expenses and incomes relating to trading activities. It is prepared at the end of each
accounting period to assess the gross profit or gross loss.
53
Proforma of Trading account
Trading account of ___________for the period ended
Particulars Amount Particulars Amount
By Sales
To opening stock XXX XXX
Less: returns
To purchases
XXX By closing stock XXX
Less:returns
To carriage inwards XXX By goods destroyed by fire XXX
By Gross loss a/c(Transferred

To Wages XXX XXX
to P and L a/c)
To Freight XXX
To import duty XXX
To coal,fuel and power XXX
To factory expenses XXX
To Manufacturing expenses XXX
To Gross profit (transferred

XXX
to P and L account)
Total XXX XXX
54
1. Prepare a Trading Account from the following information.
Particulars ₹ Particulars ₹
Opening Stock 1,80,000 Purchases 3,00,000
Sales 6,00,000 Sales Return 50,000
Carriage inwards 50,000 Closing Stock 2,00,000
Wages 60,000
Solution:
Trading Account
To Opening Stock 1,80,000 By Sales 6,00,000
To Purchases 3,00,000 Less: Sales Return 50,000 5,50,000
To Carriage 50,000 By Closing Stock 2,00,000

inwards
60,000
To Wages
1,60,000
To Gross Profit
7,50,000 7,50,000
(Bal. Fig.)
55
Coal & Fuel 50,000 Import Duty 50,000
Wages 1,50,000
Solution: Trading Account
To Coal & Fuel 50,000 By Closing Stock 3,00,000
To Carriage 50,000
inwards
1,50,000
To Wages
50,000
To Import Duty
3,50,000
To Gross Profit
10,50,000 10,50,000
(Bal. Fig.)
3. From the following information, prepare a Trading Account for the year ending
31st
December 2009.
56
Opening Stock 50,000 Purchases 1,50,000
Carriage inwards 25,000 Purchase Return 30,000
Wages 50,000 Closing Stock 1,50,000
Solution:
Trading Account
To Opening Stock 50,000 By Sales 4,00,000
To Purchases 1,50,000 Less: Sales 25,000 3,75,000

Return
Less: Purchase 30,000 1,20,000 1,50,000
Return By Closing
25,000
Stock
To Carriage inwards
50,000
To Wages
2,80,000
To Gross Profit
(Bal. Fig.)
5,25,000 5,25,000
57
Coal & Fuel 50,000 Import Duty 50,000
Wages 1,30,000
Solution:
Trading Account
To Coal & Fuel 50,000 By Closing Stock 3,80,000
To Carriage 60,000
inwards
1,30,000
To Wages
50,000
To Import Duty
40,000
To Gross Profit
9,30,000 9,30,000
(Bal. Fig.)
58
5. Calculate Gross Profit from the following data.
Particulars ₹
Sales 6,60,000
Return Inwards 10,000
Return Outwards 20,000
Purchases 2,00,000
Closing Stock 50,000
Opening Stock 40,000
Wages 1,00,000
Solution:
Trading Account
To Purchases 2,00,000 Less: Return 25,000 6,50,000

Inward
Less: Return 20,000 1,80,000 50,000
Outward By Closing Stock
1,00,000
To Wages
50,000
To Gross Profit
3,80,000
(Bal. Fig.)
59
7,00,000 7,00,000
6. Prepare a Trading Account of Archana for the year ending 31 st December 1996,
from the following information.
Opening Stock 80,000 Wages 24,000
Purchases 8,60,000 Sales 14,40,000
Freight Inwards 52,000 Purchase Returns 10,000
Sales Return 3,16,000 Closing Stock 1,00,000
Import Duty 30,000
Solution: Trading Account
To Purchases 8,60,000 Less: Sales 3,16,000 11,24,00

Return 0
Less: Purchase 10,000 8,50,000
60
Return
52,000 By Closing Stock 1,00,000
To Freight inwards
24,000
To Wages
30,000
To Import Duty
1,88,000
To Gross Profit
(Bal. Fig.)
12,24,000 12,24,00
0
1.7 Preparation of Final Accounts – Profit And Loss Account
INTRODUCTION
Profit and loss account is prepared in continuation of the Trading account to

ascertain the net profit or net loss of the firm for the current accounting year. It is a
yardstick to measure the financial efficiency of the firm. Profit and loss account being
nominal in nature lists down all the indirect (both operating and non-operating) expenses
and income in the debit and credit side respectively.
PROFORMA OF PROFIT AND LOSS ACCOUNT
Profit and loss account for the year ending 31st December_____________
To Gross loss XXX By Gross profit XXX
To office salaries and XXX By Cash discount XXX
61
wages received
To office rent, rates By bad debts

XXX XXX
and Taxes recovered
To Printing and By Income from

XXX XXX
stationery Investments
To postage, By Commission
XXX XXX
telegrams received
By Interest on
To legal expenses XXX XXX
deposits
By Interest on
To Trade expenses XXX renewal of bills of XXX
exchange
By Gain on sale of
To Audit fees XXX XXX
Fixed assets
To Telephone By Apprenticeship
XXX XXX
expenses premium
By Interest on
To General expenses XXX XXX
drawings
By Net loss
To cash discount (Transferred to
XXX XXX
allowed Profit and loss
account)
To Interest on XXX
62
capital
To Interest on loan XXX
To Discount XXX
To Bad debts XXX
To selling and
distribution XXX
expenses
To carriage , freight
XXX
and cartage outward
To salesmen salaries,
expenses and XXX
commission
To Advertising
XXX
expenses
To Depreciation on
XXX
Fixed assets
To loss on sale of
XXX
fixed assets
To Net
profit(Transferred to
XXX
Profit and loss
account)
Total XXX XXX
63
PROBLEMS
1. From the following information, find out the Net Profit of the organization.
Wages 15,000 Rent 11,500
Salaries 22,000 Postage 4,300
Gross Profit 74,000 Commission 6,000

Received
Interest 4,350 1,50,000
Buildings
Solution:
Profit & Loss Account
To Salaries 22,000 By Gross Profit 74,000
To Rent 11,500 By Commission 6,000

Received
To Postage 4,300
To Interest 4,350
To Net Profit (Bal. 37,850

Fig.)
80,000 80,000
64
2. Prepare a Profit and Loss Account from the following information.
Gross Profit 1,00,000 Repairs 400
Carriage Outwards 1,000 Telephone Expenses 1,000
Office Rent 2,000 Loan Interest paid to 800

Bank
General Expenses 1,000 5,400
Bad Debts
Interest from Bank 2,000 5,000
Postage & Printing
Travelling Expenses 1,800 6,000
Trade Expenses
Salaries 3,800 4000
Commission Paid
Solution:
Profit & Loss Account
To Carriage Outwards 1,000 By Gross Profit b/d 1,00,000
To Office Rent 2,000 By Interest from Bank 2,000

To General Expenses 1,000
To Salaries 3,800
To Commission 4,000
To Repairs 400
To Telephone Expenses 1,000
65
To Loan Interest paid to Bank 800
To Bad Debts 5,400
To Postage and Printing 5,000
To Trade Expenses 6,000
To Net Profit (Bal. Fig.) 69,800
1,02,000 1,02,000
3. Prepare Profit and Loss Account from the following information for the year
ending 31stDecember 2017.
Gross Profit 55,000 Repairs and Renewals 500
Carriage on Sales 500 Office Expenses 520
Miscellaneous 900 Insurance Premium paid 900

Expenses for Stock
360
Discount to Customer Bad Debts
200 2,100
Interest from Bank Apprentice premium
700 1,500
(Cr.)
Other Expenses
1,400 2,500
Printing Expenses
Salaries
300 1,040
Telephone Charges
Commission paid to
Raju
66
Solution:
Profit & Loss Account for the year ending 31.12.2017
To Carriage on Sales 500 By Gross Profit b/d 55,000
To Office Expenses 520 By Interest from Bank 200
To Miscellaneous Expenses 900 By Apprentice premium 1,500
To Discount to Customer 360
To Other Expenses 700
To Salaries 1,400
To Commission paid to Raju 300
To Repairs & Renewals 500
To Telephone Charges 1,040
To Insurance Premium paid 900

for Stock
To Bad Debts
2,100
To Printing Expenses
2,500
To Net Profit (Bal. Fig.)

44,980
56,700 56,700
67
4. Prepare Profit and Loss Account from the following information.
Gross Profit 2,00,000 Repairs 1,000
Carriage on Sales 1,000 Electricity charges 1,000
Rent, Rates and Taxes 1,000 Interest Paid 900
General Expenses 1,000 Fire Insurance Premium 1,000

on Stock
Discount to Customer 7,000
Bad Debts
Income from Investments 4,000 4,200
Apprentice Premium(Cr.)
Travelling Expenses 1,400 3,000
Printing & Stationery
Salaries to Staff 1,800 5,000
Trade Expenses
Commission Paid 4,000 6,000
Solution: Profit & Loss Account
To Carriage on Sales 1,000 By Gross Profit b/d 2,00,000
To Rent, Rates and Taxes 1,000 By Income from 4,000

Investments
To General Expenses 1,000
By Apprentice premium
To Discount to Customer 7,000 3,000
68
To Travelling Expenses 1,400
To Salaries to Staff 1,800
To Commission Paid 4,000
To Repairs 1,000
To Electricity Charges 1,000
To Interest Paid 900
To Fire Insurance Premium on 1,000

Stock
To Bad Debts
4,200
To Printing and Stationery
5,000
To Trade Expenses
6,000
To Net Profit (Bal. Fig.)
1,70,700
2,07,000 2,07,000
5. From the following ledger balances of Ravi prepare Trading and Profit and loss
account for theyear ending 31.12.2003
Particulars Amount
Opening stock 1,87,500
69
Purchases 2,71,875
Sales returns 15,000
Furniture 52,500
Machinery 2,43,750
Carriage outward 5,625
Wages 37,500
Sales 6,90,000
Purchase returns 9,375
Carriage inward 7,500
General expenses 7,500
Salaries 7,500
Commission received 1,875
Discount allowed 2,750
Bad debts 1,000
Commission to agent 1,875
Bank charges 563
Interest received 1,125
Rent received 16,875
70
Investment 3,75,000
Insurance 3,750
Closing stock 3,75,000
Solution:
Trading and Profit and loss account of Mr. Ravi for the year ended 31.12.2003
Particulars Amount Amount Particulars Amount Amount
To opening stock 1,87,500 By sales a/c 6,90,000

a/c
Less:
Returns
15,000 6,75,000
To purchases a/c 2,71,875 By closing 3,75,000

stock a/c
Less: Returns 9,375
2,62,500
To carriage inward 7,500
To wages 37,500
To Gross 5,55,000
profit(transferred
to profit and loss
account)
71
10,50,000 10,50,000
Particulars Amount Amount Particulars Amount Amount
To Salaries 7,500 By Gross 5,55,000

profit a/c
To Insurance 3,750 By 1,875

Commission
a/c
To Carriage 5,625 By Interest 1,125

outward a/c
To Commission to 1,875 By Rent a/c 16,875

agent
To General 7,500
expenses
To Bank charges 563
To Discount 2,750
To Bad debts 1000
To Net 5,44,312
profit(transferred
to capital a/c)
72
5,74,875 5,74,875
6. From the following Trial balance prepare Trading and Profit and Loss a/c for the
year ended31.12.2002
Debit balances Amount Credit balances Amount
Plant and Machinery 20,000 Capital a/c 80,000
Manufacturing 34,500 Sundry creditors 44,560

wages
Salaries 15,850 Bank loan 15,000
Furniture 10,000 Purchase returns 1,740
Freight on purchases 1,860 Sales 2,50,850
Freight on sales 2,140 Provision for Bad 2,000

debts
Buildings 24,000
Manufacturing 9,500
expenses
Insurance and Tax 4,250
Good will 25,000
73
General expenses 8,200
Factory , Fuel and 1,280

power
Sundry debtors 78,200
Factory lighting 950
Opening stock 34,200
Motor car 12,000
Purchases 1,02,000
Sales returns 3,100
Bad debts 1,400
Interest and Bank 400

charges
Cash at bank 4,200
Cash in Hand 1,120
Adjustments:
1. Stock in hand on 31.12.2002 was valued at Rs. 30,500

2. Depreciate Plant and Machinery by 10%, Furniture by 5 % and Motor car by
Rs.1000
3. Bring Provision for bad debts to 5 % on sundry debtors.
4. A commission of 1% on the Gross profit is to be provided to works manager.
74
Solution:
Trading and Profit and loss account for the year ended 31.12.2002
34,200 By sales 2,50,850 2,47,750
To opening stock
Less: returns 3,100
1,00,260 By stock 30,500
To purchases 1,02,000
Less: returns 1,740
1,860
To Freight on
purchases
34,500
To Manufacturing
wages
9,500
To Manufacturing
expenses
1,280
To Factory, fuel and
power
950
To Factory lighting
95,700
To Gross profit c/d
2,78,250 2,78,250
15,850 By Gross profit b/d 95,700

To salaries
2,140
To Freight on sales
4,250
To Insurance and Tax
8,200
To General expenses
75
1,400
To Bad debts
400
To Interest and bank
charges
2,000
To Depreciation on
Plant and Machinery
500
To Depreciation on
Furniture
1,000
To Depreciation on
Motor car
To Provision for Bad

debts
(New)78,200X5%
1,910
= 3,910
Less :old 2,000
To commission to
957
Works manager
(95,700 X1%)
To Net profit
c/d(Transferred to
57.093
capital account)
95,700 95,700
76
1.8 PREPARATION OF FINAL ACCOUNTS-BALANCE SHEET
BALANCE SHEET
The balance sheet is a financial statement. It is not a part of ledger and therefore
does not require double entries. The preparation of Balance sheet is the third and last stage
of final accounts. The balance sheet can be prepared only after preparing the trading and
Profit and loss account.
PROFORMA BALANCE SHEET OF MR…. AS ON ……….
Amount Amount Assets Amount Amount

Liabilities
Intangible
Assets:
XXX XXX
Capital Goodwill,
copyright…
Fixed
Add:
Assets
Land and
XXX XXX
Additional Building
capital
Plant and
Interest on XXX XXX
Machinery
capital
Leasehold
XXX XXX
Net profit property
Loose tools XXX

Less:
Furniture
XXX XXX
Drawings and Fittings
77
Current
Interest on XXX
Assets
drawings
XXX Investment XXX

Net loss
XXX XXX Debtors XXX

Income Tax
Bills
Long term XXX XXX
receivable
debts
Closing
Short term XXX XXX
stock
debts
Cash at
Current XXX
bank
liabilities
Cash in
XXX XXX
Creditors hand
Prepaid
Bills XXX XXX
expenses
payable
Accrued
Bank XXX XXX
incomes
overdraft
Outstanding XXX
expenses
Income
XXX
received in
advance
XXX XXX
78
1. Prepare a Balance Sheet of Mr. Narayana as on 31 st December 2011 from the
following information.
Capital 2,00,000 Plant & Machinery 50,000
Salaries Outstanding 15,000 Furniture & Fixtures 40,000
Wages Outstanding 15,000 Stock 80,000
Net Profit 50,000 Cash in Hand 55,000
Bills Payable 40,000 Cash at Bank 55,000
Sundry Creditors 60,000 Sundry Debtors 50,000
Bills Receivable 20,000 Land & Buildings 30,000
Solution:
Balance Sheet of Mr. Narayana as on 31.12.11
Liabilities ₹ Assets ₹
Capital 2,00,000 Bills Receivables 20,000
Add: Net Profit 50,000 2,50,000 Land and Building 30,000
79
Salaries 15,000 Plant and Machinery 50,000
Outstanding
Furniture and Fixtures 40,000
Wages
15,000 Stock 80,000
Outstanding
40,000 Cash in Hand 55,000

Bills Payable
60,000 Cash at Bank 55,000

Sundry Creditors
Sundry Debtors 50,000
3,80,000 3,80,000
2. Prepare a Trading Account, a Profit and Loss Account and a Balance Sheet from
the following information.
Opening Stock 30,000 Purchase less Returns 20,000
Sales 50,000 Capital 1,00,000
Salary 8,000 Bills Payable 5,000
Printing and Stationery 7,000 Closing Stock 40,000
Bills Receivable 40,000 Buildings 50,000
Solution:
80
Trading and Profit & Loss Account
To Opening Stock 30,000 By Sales 50,000
To Purchase Less Returns 20,000 By Closing Stock 40,000
To Gross Profit c/d 40,000
90,000 90,000
8,000 40,000
To Salary 7,000 By Gross Profit
To Printing and Stationery
To Net Profit (transferred to 25,000

capital account)
40,000 40,000
Balance Sheet
Capital 1,00,000 Bills Receivable 40,000
Add: Net Profit 25,000 1,25,000 Buildings 50,000
81
Bills Payable 5,000 Closing Stock 40,000
1,30,000 1,30,000
3. Prepare a Trading Account a Profit and Loss Account and a Balance Sheet from the
following information.
Opening Stock 50,000 Purchases 80,000

3,00,000
Sales Capital 4,00,000
6,000
Rent Bills Payable 38,000
7,000
Printing and Stationery Closing Stock 40,000
1,68,000
Bills Receivable Machinery 2,00,000
25,000
Sales Return Purchase Return 30,000
20,000
Wages Furniture 1,37,000
75,000
Salaries
Solution:
82
Trading and Profit and Loss Account
Particulars ₹ ₹ Particulars ₹ ₹
To Purchases 80,000 Less: Sales 25,000

Return
Less: Purchase Return 30,000 50,000 2,75,000
By Closing Stock
To Wages 20,000 40,000
To Gross Profit c/d 1,95,000
3,15,000 3,15,000
By Gross Profit
To Rent 6,000 1,95,000
By Interest from
To Printing & 7,000
Bank
Stationery
75,000
To Salaries
1,07,000
To Net Profit
1,95,000 1,95,000
(transferred to
capital account)
83
Balance Sheet
Capital 4,00,000 Bills Receivable 1,68,000
Add: Net Profit 1,07,000 5,07,000 Machinery 2,00,000
Bills Payable 38,000 Closing Stock 40,000
Furniture 1,37,000
5,45,000 5,45,000
4. Ms. Supraja provides the following information, prepare a Trading and Profit and
Loss Account and a Balance Sheet as on 31 st December 2016.
Particulars ₹
Opening Stock 30,000
Sales 60,000
Salaries 8,000
Wages 4,000
Creditors 3,000
Sales Return 5,000
Purchase Return 3,000
Computer 49,000
84
Purchases 20,000
Capital 50,000
Additional Information:
a) Closing Stock Rs. 20,000

b) Outstanding Wages Rs.500
Solution:
Particulars ₹ ₹ Particulars ₹ ₹
To Opening Stock 30,000 By Sales 60,000
To Purchases 20,000 Less: Sales 5,000

Return
Less: Purchase Return 3,000 17,000 55,000
By Closing Stock
To Wages 4,000 20,000
Add: Outstanding 500 4,500

wages
23,500
To Gross Profit c/d
75,000 75,000
By Gross Profit
23,500
85
8,000
To Salaries 15,500
To Net Profit
(transferred to 23,500 23,500
capital account)
Balance Sheet as on 31.12.2016
Capital 50,000 Computer 49,000
Add: Net Profit 65,500 Closing Stock 20,000

15,500
Creditors 3,000
Outstanding 500
Wages
69,000 69,000
5. From the following Trial Balance extracted from the books of Mr. Ramesh, prepare
the Trading and Profit and Loss Account and Balance Sheet as on 31 st December
2008.
Particulars Debit (₹) Credit (₹)
86
Sundry Debtors 43,000
Stock (01.01.2008) 23,000
Cash in Hand 1,850
Bank Overdraft 9,500
Plant and Machinery 18,500
Sundry Creditors 11,750
Trade Expenses 375
Sales 1,35,000
Salaries 2,250
Carriage Outwards 350
Rent 950
Bills Payable 18,700
Purchases 1,19,670
Insurance 1,400
Business Premises 35,000
Discount 600
Capital 72,795
Carriage Inwards 2,000
2,48,345 2,48,345
Adjustments:
a) Closing stock as in 31st December 2004: Rs.20,000

b) Rent Rs. 200 per month for the last quarter unpaid
87
c) Depreciate 10% on plant and machinery and business premises
d) Commission earned but not received amount to Rs.500
e) Rs. 400 carry forward for unexpired Insurance.
Particulars ₹ ₹ Particulars ₹
To Purchases 1,19,670 By Closing Stock 20,000
To Carriage Inwards 2,000
To Gross Profit c/d 10,330
1,55,000 1,55,000
To Depreciation on
Plant and Machinery
1,850 By Gross Profit 10,330
To Depreciation on
By Discount 600
Business Premises
3500 By Commission earned 500

To Trade Expenses
but not received

To Salaries
375
To Carriage Outwards
2,250
To Rent
950 350
Add: Outstanding
600
88
1,550
To Insurance
Less: Prepaid Insurance 1,400
400 1,000
To Net Profit 555

(transferred to capita
11,430 11,430
account)
Balance Sheet of Mrs. Ramesh as on 31.12.2008
Capital 72,795 Sundry Debtors 43,000
Add: Net Profit 555 73,350 Cash at Bank 1,850
Sundry Creditors 11,750 Plant & Machinery 18,500
Bank Overdraft 9,500 Less: Depreciation 1,850 16,650

@ 10%
Bills Payable 18,700
Business Premises
Outstanding Rent 600 35,000
Less: Depreciation
3,500 31,500
@ 10%
Commission
Earned but not
received
500
89
Closing Stock
Prepaid Insurance 20,000
400
1,13,900 1,13,900
Reading of Financial statements:
A balance sheet conveys the “book value” of a company. It allows you to see what
resources it has available and how they were financed as of a specific date. It shows its
assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount
invested by shareholders).
The balance sheet also provides information that can be leveraged to compute rates
of return and evaluate capital structure, using the accounting equation: Assets =
Liabilities + Owners’ Equity
Assets are anything a company owns with quantifiable value. Liabilities refer to
money a company owes to a debtor, such as outstanding payroll expenses, debt payments,
rent and utility, bonds payable, and taxes. Owners’ equity refers to the net worth of a
company. It’s the amount of money that would be left if all assets were sold and all
liabilities paid. This money belongs to the shareholders, who may be private owners or
public investors.
90
LEARNING OUTCOMES
 Determination of various types of Accounting

 Meaning of Generally accepted accounting principles
 Understanding the definition of Journal
 Meaning and utility of Ledger
 Meaning of Trial balance
 To understand why balance sheet is prepared
 To analyse how adjusting entries are passed in final accounts
Short Questions
1. Define Accounting?
2. Who are the users of accounting information?
3. What is meant by convention of consistency?
4. What is Journal?
5. Write short notes on Ledger.
6. What is the Meaning of Suspense account?
7. What is Gross profit?
8. What is Balance sheet?
Long Questions
1. State the differences between Financial and management accounting?

2. State the benefits of Management accounting?
3. State the differences between Financial and Cost accounting?
4. What are the basic accounting concepts?
5. Briefly explain the various accounting conventions.
6. State the differences between single entry and double entry
91
PRACTICE PROBLEMS
From the following balances prepare Trial balance
Rs.
Particulars
9000
Capital
120000
Plant and Machinery
8000
Purchases
12000
Sales
8000
Sundry creditors
22000
Bank loan
1000
Rent outstanding
2000
Opening stock
4000
Sales returns
14000
Investments
12000
Debtors
(Trial balance Total- Rs. 160000)
92
1. Calculate Gross profit from the following:
Particulars Amount
3,00,000
Sales
10,000
Sales return
1,00,000
Purchases
50,000
Closing stock
20,000
Opening stock
(Gross profit =Rs. 2, 20,000)
2. From the following particulars prepare a Trading account
Particulars Amount
14,000
Opening stock
21,000
Closing stock
76,000
Purchases
1,20,000
Sales
500
Stationery
800
Office rent
850
Manufacturing expenses
500
Interest (Cr)
93
(Gross profit = Rs.50,150)
1. Prepare Trading and Profit and loss account from the following information.
Particulars Rs.
10,000
Opening stock
60,000
Purchases
11,500
Wages
13,000
Closing stock
1,00,000
Sales
1,500
Carriage inwards
1,200
Carriage outwards
1,200
Rent (Factory)
1,500
Office rent
2,000
Sales returns
3,000
Purchase returns
3,000
General expenses
900
Discount to customers
500
Interest received
94
(Gross profit = Rs. 29,800 Net Profit = Rs. 23,700)
PRACTICE PROBLEMS:
1. Prepare a Balance Sheet from the information given below.
Capital 2,00,000 Bills Receivable 20,000
Bank Overdraft 1,20,000 Land and Building 60,000
Salaries Outstanding 70,000 Plant and Machinery 80,000
Wages Outstanding 50,000 Furniture and Fixtures 1,00,000
Net Profit 1,00,000 Stock 1,20,000
Drawings 40,000 Cash in Hand 1,10,000
Bills Payable 80,000 Cash at Bank 90,000
Sundry Creditors 1,00,000 Sundry Debtors 1,00,000
(Balance sheet total = Rs. 6, 80,000)
2. Prepare a Trading Account, a Profit and Loss Account and a Balance Sheet from
the following information.
Sales 7,00,000 Capital 4,00,000
General Expenses 40,000 Bills Payable 11,000
95
Salaries 35,000 Closing Stock 1,25,000
Sundry Creditors 50,000 Purchase Return 18,000
Sales Return 40,000 Cash in Hand 2,10,000
Wages 9,000 Sundry Debtors 1,85,000
Bills Receivable 30,000
Answer
Gross Profit = Rs. 1, 64,000, Net Profit= Rs. 89,000, Balance sheet =Rs. 5, 50,000
96
UNIT II
ANALYSIS OF FINANCIAL STATEMENTS
Contents
LEARNING OBJECTIVES .......................................................................................................... 98
2.1 ANALYSIS OF FINANCIAL STATEMENTS .................................................... 98
2.2 RATIO ANALYSIS PART - I ................................................................................ 110
2.3 RATIO ANALYSIS PART II ................................................................................. 121
2.4 COMPARATIVE AND COMMON SIZE STATEMENTS ............................. 132
2.5 CASH FLOW STATEMENT ................................................................................ 142
2.6 CASH FLOW STATEMENT ................................................................................ 150
2.7 FUNDS FLOW ANALYSIS ................................................................................... 160
2.8 FUNDS FLOW STATEMENT ............................................................................. 172
LEARNING OUTCOMES.......................................................................................................... 182
Short answer Questions ........................................................................................................ 182
Long Answer Questions ........................................................................................................ 183
PRACTICE PROBLEMS ........................................................................................................... 184
97
LEARNING OBJECTIVES
 To Identify the Meaning of Financial statements
 To Classify the ratios based on statement, users, relative importance and
purpose
 To know turnover ratios and its interpretations
 To know the Meaning of Common size statements
 To understand the Objectives, Advantages and Disadvantages of Cash flow
statement
 To solve Comprehensive problems relating to Cash flow statement
 To examine the Proforma of statement showing Funds from Operation
 To examine the Fund Flow statement
2.1 ANALYSIS OF FINANCIAL STATEMENTS

MEANING OF FINANCIAL STATEMENTS:
Every business concern is curious to know whether the business has earned profit
or suffered a loss during the last accounting period and how the business stands at the end
of the period. So a form of formal reports prepared at the end of the accounting period.
Such reports are called “Financial Statements”. These comprise of two important
statements, the Profit and Loss Account / Income Statement is prepared to know whether
the business has earned profit or suffered a loss and Balance Sheet / Position Statement is
prepared to know the financial position of the business at the end of the period.
SIGNIFICANCE OF FINANCIAL STATEMENTS:

Financial statements are the blueprints of the financial affairs of the firm. It provides
meaningful, useful and valuable information periodically regarding financial position and
future prospects of the business concern. Many parties are interested to utilize the
information provided by the financial statements for the purpose of analysis and
interpretation. The significance of financial statements for each of the parties is discussed
below:
98
For Owners Shareholders / proprietors of the business are interested in the
well-being of the business. They would like to have information about the progress and
financial condition of the business in which they have invested their funds. Therefore, the
financial statements provide information to proprietors and prospective proprietors too, as
relating to earnings, dividend and growth rates, past performance, etc. It acts as a guide to
the value of investments made.
For potential investors the potential investors depend heavily on the information
disclosed in the financial statements for the purpose of taking decisions regarding
investments in the securities of the company. It is due to this significance that the
disclosure of the financial data has been made mandatory for public companies while
inviting deposits, subscriptions to shares and debentures from public under the Companies
act 1956.
For Management, whether or not it is the same as owners relies upon financial
statements for appraising the operating performance of the business. Financial statements
provide a basis for appraising its performance in carrying on individual activities as well as
conducting the business as a whole. For, these statements can supply useful information
about undesirable tendencies that need to be corrected etc. The information furnished in
the financial statements will form a basis for future financial plans.
For creditors, Creditors are interested in continuing profitable performance of the

business to which they have provided financial resources. They are very much concerned
with receipt of interest and repayment of credit given. The Financial statements provide a
measure of degree of risk (creditworthiness) of lending operations to the bank and other
creditors.
For Government, The government likes to have a copy of financial statements of

every business concern as a means of complying with taxation, labour and corporate laws.
99
If needed, the government may direct the officials to examine the accounting records of the
business concerns.
For Employees, The employees mainly reply on the information supplied by the
financial statements because their fortune and well-being are tied to the business. They can
bargain on matters relating to salary determination, bonus, fringe benefits or working
conditions on the basis on the information revealed in financial statements. Thus financial
statements are useful to employees and unions as they insight into matters affecting their
economic and social interests.
For Public, Public, in general, show a lot of interest in studying the financial
statements of a business concern as investors and consumers. With the help of financial
statements they can judge whether the business concern has fulfilled its social obligation or
not. If a business concern is indulging in profiteering, it may get reprimanded from public.
For Students and Research Scholars Students and research scholars can utilise
the information given in the financial statements for their research studies relating to
industry or economic growth in general.
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS:
Financial statements have to be analysed and interpreted to make the accounting

figures in the financial statements meaningful to a layman.
Kennedy and Muller said “Analysis and interpretation of financial statements

are an attempt to determine the significance and meaning of the financial data so
that the forecast may be made of the prospects for future earnings, ability to pay
interest and debt maturities (both current and long term) and probability of a sound
dividend policy”.
100
The balance sheet and profit and loss account are to be interpreted to convey
meaningful message to the layman who is still typical shareholder in our country.
Interpretation is considered to be the most important function of management accountant
because the management of today needs relevant data and information to conduct its
function efficiently.
TYPES OF ANALYSIS
The process of financial statement analysis is of different types. The process of
analysis is classified on the basis of information used and ‘modus operandi’ of analysis. The
classification is as under.
Financial Statement Analysis
On the basis of Information used: On the basis of ‘modus operandi’ of

analysis
a) External Analysis a) Horizontal Analysis
b) Internal Analysis b) Vertical Analysis
External Analysis: This analysis is based on published financial statements of a firm.

Outsiders have limited access to internal records of the concern. Therefore, they depend on
published financial statements. Thus, the analysis done by outsiders namely, creditors,
suppliers, investors and government agencies are known as external analysis. This analysis
serves a very limited purpose.
Internal Analysis: This analysis is done on the basis of internal and unpublished records.
It is done by executives or other authorised officials. It is very much useful and significant
to employees and management.
101
Horizontal Analysis: This analysis is also known as ‘dynamic’ or ‘trend’ analysis. The
analysis is done by analysing the statements of a number of years. According to John N.
Myer “the horizontal analysis consists of a study of the behaviour of each of the entries in
the statement”. Thus, under horizontal analysis we study the behaviour of each item shown
in the financial statements. We examine as to what has been the periodical trend of various
items shown in the statements i.e., whether they have increased or decreased over a period
of time. If the comparative statements are prepared for more than two periods, then one of
the years is taken as basis to calculate the percentage of increase or decrease. Some
analysts prefer to choose earliest year as basis, while some others prefer to take just the
preceding year as basis.
Vertical Analysis: Vertical analysis is also known as ‘static analysis’or ‘structural analysis’.
This analysis is made on the basis of a single set of financial statements prepared at a
particular date. Under vertical analysis, quantitative relationship is established between
different items shown in a particular statement. Common-size statements are a form of
vertical analysis. Different items shown in the statements are expressed as a percentage to
any one item as base.
Use of both the methods of analysis is very much required for proper analysis. Each
method provides specific type of information and in fact both methods constitute the
backbone of financial analysis.
Techniques and Tools of financial statement analysis: The history of financial

statement analysis is tracked back to the beginning of 20 th century. The analysis was
started in western countries for the use of credit analysis. Till 1914, financial institutions
used to rely on the facts of financial statements. But over a period of time, the need for
analysis was felt and a number of techniques were invented and made use of for the
purpose of analysis.
102
The most important techniques of analysis and interpretation of financial statements
are listed below:
1. Ratio analysis;
2. Cash flow analysis;
3. Fund flow analysis;
4. Comparative financial statements;
5. Common measurement or size statements;
6. Net working capital analysis;
7. Trend analysis.
RATIO ANALYSIS
MEANING OF RATIO ANALYSIS:
 Analysis and interpretation of financial statements with the help of ‘ratios’ is
termed as ‘ratio analysis’
 A ratio is a mathematical relationship between two items expressed in a
quantitative form.
 An ACCOUNTING RATIO can be defined as quantitative relationship between
two or more items of the financial statements connected with each other.
 Ratio Analysis help to express the accounting items (financial statements) in
a simple and meaningful way for easy understanding.
 Analysis of accounting items in the form of ratios helps for comparison of the
financial statements by the management for decision making purpose.
Ratio may be expressed in any one of the following ways:
1. In proportion: A: B
2. In rate or times or coefficient: 10 times (cost of sales & stock)
103
3. In percentage: 25% (relationship between net profit & sales)
SIGNIFICANCE OF RATIO ANALYSIS:

Ratio analysis is useful in several ways, according to its application or requirements, it
can give the best possible outcomes to the management, a few such outcomes are as
follows:
 To know the financial strength or weakness of an organization at any point of
time.
 To measure the operational efficiency of an organization.
 To compare the past and present data – intra firm comparisons.
 To evaluate the level of productivity and forecast the potential plans for a
business to develop and prosper in the near future.
 To optimize or improve the capital structure, for the purpose of inter firm
and intra firm comparisons (compared with a benchmark or a standard)
 To evaluate the liquidity, solvency, profitability & managerial efficiency of a
concern.
 To ensure fullest utilization of resources of a company for maximizing the
production.
 To assist in the preparation of budgets or any other estimates.
 To determine the solvency of the company which will portray the financial
position of the same and to correct the deviations causing corporate

sickness.
ADVANTAGES OF RATIO ANALYSIS:

1. Forecasting: Ratios reveal the trends in costs, sales, profits, etc., which will
greatly help to predict the future events.
104
2. Managerial Control: Instrument of control
Facilitates Communication: Convey the information relating to the present
& future very quickly, forcefully & clearly.
3. Measuring Efficiency: Operational efficiency can be measured through the
comparison of the past data and also with other firms in the industry.
4. Facilitating Investment decisions: Helps in computing return on
investment to exercise effective decisions regarding profitable avenues of
investment.
5. Useful in measuring Financial Solvency: Short-term & long-term solvency
can be easily analysed so as to indicate the liquidity position of the firm.
6. Inter firm comparison: Ratio analysis helps for inter firm comparisons,
allowing the firm to compare its performance with the benchmark or
standard set.
LIMITATIONS:
1. Practical knowledge: Thorough knowledge & experience about the firm and
industry is required.
2. Ratios are means: Approximately a tool to achieve something.
3. Inter-relationship: A single ratio cannot convey a meaning as ratios are inter-

related.
4. Non availability of standards or norms: Except few ratios, others lack

standards which are universally accepted, thus becoming meaningless to
compare with the same.
5. Accuracy of financial information: Ratio analysis will be fruitful only when the
financial data is accurate.
6. Consistency in preparation of financial statements: Inter firm comparisons
will be useful only when the firm follows uniform accounting procedures
consistently.
105
7. Detachment from financial statements: Ratios will not be meaningful if they
are detached from the financial statements on which they were prepared.
8. Time lag: Delay in conveying the results of ratio analysis will diminish the
purpose of such analysis itself.
9. Ratio analysis will not reveal all the events happening in a firm.
10. Ratio analysis is useful only when is done by an expert.
11. Ratios are calculated based on the historical data, which may not give a clear
picture of the present situation.
CLASSIFICATION OF RATIOS
CLASSIFICATION BY STATEMENTS:
BALANCE SHEET RATIOS:
a. Liquidity Ratio
b. Current ratio
c. Proprietary ratio
d. Debt equity ratio
e. Fixed assets ratio
f. Capital gearing ratio, etc.
PROFIT & LOSS A/c RATIOS:

a. Gross profit ratio
b. Operating profit ratio
c. Operating ratio
d. Expenses ratio
e. Net profit ratio
COMPOSITE or MIXED RATIOS:

a. Return on Investment
106
b. Return on shareholders’ funds
c. Stock Turnover
d. Debtors Turnover
e. Creditors Turnover
f. Fixed assets turnover
g. Earnings per share, etc.
CLASSIFICATION BY USERS:
I. RATIOS FOR MANAGEMENT:
a. Gross profit ratio
b. Operating profit ratio
c. Operating ratio
d. Expenses ratio
e. Net profit ratio
f. Stock Turnover
g. Debtors Turnover
h. Creditors Turnover
i. Fixed assets turnover
j. Short-term liquidity
k. Long-term liquidity
l. Working capital turnover
II. RATIOS FOR CREDITORS:

a. Current ratio
b. Solvency ratio
c. Debt equity ratio
d. Creditors turnover
e. Fixed assets ratio
f. Assets cover
g. Interest Cover, etc.
107
III. RATIOS FOR SHAREHOLDERS
a. Returns on Shareholders’ funds
b. Pay-out ratio
c. Capital gearing
d. Dividends cover
e. Dividend yield, etc.
CLASSIFICATION BY RELATIVE IMPORTANCE:

I. PRIMARY RATIOS:
a. Return on capital employed
b. Assets turnover
c. Profit ratios
II. SECONDARY PERFORMANCE RATIOS:
a. Working capital turnover
b. Stock to current assets
c. Current assets to fixed assets
d. Stocks to fixed assets
e. Fixed assets to total assets
III. SECONDARY CREDIT RATIOS:

a. Creditors turnover
b. Debtors turnover
c. Liquid ratio
d. Current ratio
e. Average collection period
IV. GROWTH RATIOS:

a. Growth rate in sales
b. Growth rate in net assets
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CLASSIFICATION BY PURPOSE / FUNCTION:
I.PROFITIABILIY RATIOS:
a. Return on investment
b. Net profit ratio
c. Gross profit ratio
d. Operating profit ratio
e. Expenses ratio
f. Operating ratio, etc.
II.TURNOVER RATIOS:
a. Stock turnover
b. Debtors turnover
c. Creditors turnover
d. Working capital turnover
e. Fixed assets turnover, etc.
III.FINANCIAL or SOLVENCY RATIOS:

A. SHORT-TERM SOLVENCY:
a. Current ratio
b. Liquidity ratio / Acid test ratio
c. Cash position ratio
B. LONG-TERM SOLVENCY:
a. Proprietary ratio
b. Debt-equity ratio
c. Fixed assets ratio
d. Capital gearing ratio, etc.
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2.2 RATIO ANALYSIS PART - I
FINANCIAL OR SOLVENCY RATIOS
SHORT TERM SOLVENCY RATIOS

CURRENT RATIO Current Assets/Current Liabilities
LIQUID RATIO/QUICK RATIO/ACID Liquid(or) Quick Assets/Current
TEST RATIO liabilities
Cash and Bank balance + Marketable
CASH POSITION RATIO
securities/Current liabilities
LONG TERM SOLVENCY RATIOS
FIXED ASSET RATIO Fixed Assets/Long term Funds
Total Long term debt/Shareholders

DEBT EQUITY RATIO Funds (or)
External equities/Internal equities
Shareholders funds/Total Tangible
PROPRIETORY RATIO
assets
Long term loans
CAPITAL GEARING RATIO +Debentures+Preference
capital/Equity shareholders funds
1. From the following Balance Sheet of Sudarshan Co. Ltd., you are required to calculate: (a)
Cash position ratio (b) Liquidity ratio
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Balance Sheet
Solution:
(a) Cash position ratio = (Cash + Bank balance + Marketable Securities) / Current Liabilities
= (10,000 + 70,000) / (16,000 + 90,000 + 60,000) = 0.48:1 (near cash items)
(or) = (10,000 / 1, 66,000) = 0.06 times (cash alone).
(b) Liquidity ratio = Liquid assets / Current liabilities
Liquid assets = Cash + Debtors + Marketable securities
= 10,000 + 1, 26,000 + 70,000 = Rs. 2, 06,000.
Liquidity ratio = 2, 06,000 / 1, 66,000 = 1.24:1
2. The following figures are extracted from the Balance Sheet of X Ltd. as on 31st
December:
Calculate current ratio and quick ratio for the two years.
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Solution:
(a) Current ratio = Current assets / Current liabilities
(b) Liquid ratio = Liquid assets / Current Liabilities.
Current assets = Stock + Debtors + Cash @ bank.
Quick assets = Debtors + Cash @ bank.
Current liabilities = Bills payable + Creditors + Bank overdraft + Provision for taxes.
1992:C.A. = 25,000 + 10,000 + 5,000 = Rs. 40,000;
C.L. = 8,000 + 2,000 + 5,000 + 5,000= Rs. 20,000.Q.A. = 10,000 + 5,000 = Rs. 15,000.
Current ratio = 40,000 / 20,000 = 2: 1;
Quick ratio = 15,000 / 20,000 = 0.75:1.
1993: C.A. = 40,000 + 16,000 + 4,000 = 60,000;
C.L. = 3,000 + 15,000 + 7,000 + 15,000 =Rs. 40,000.
Q.A. = 16,000 + 4,000 = Rs. 20,000.
Current ratio = 60,000 / 40,000 = 1.5:1;
Quick ratio = 20,000 / 40,000 = 0.5:1
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3. Calculate Debt-equity ratio from the following:
Solution:
Debt equity ratio = External equities ÷ Internal equities
External equities = Debentures = Rs. 5, 00,000.
Internal equities = Preference share capital + Equity share capital + Capital reserve +
Profit & Loss A/c = 3,00,000 + 11,00,000 + 5,00,000 + 2,00,000 = Rs. 21,00,000.
Debt equity ratio = 5, 00,000 / 21, 00,000 = 0.238:1.
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4. From the following Balance Sheet of Arthi Ltd. calculate: (a) Debt-equity ratio (b)
Fixedassets to current assets.
Balance Sheet
Solution:
(a) Debt equity ratio = Total long-term debt ÷ Shareholders’ funds
Long-term debt = Secured loan = Rs. 1, 60,000.
Shareholders’ funds = Equity share capital + Reserve + P&L Account
= 2, 00,000 + 40,000 + 60,000 = Rs. 3, 00,000.
Debt-equity ratio = 1, 60,000 / 3, 00,000 = 0.53:1
(b) Fixed assets to current assets = Fixed assets / Current assets
Current assets = Stock + Debtors + Bank + Advances
= 60,000 + 60,000 + 20,000 + 60,000 = Rs. 2, 00,000.
Fixed assets to current assets ratio = 2, 80,000 / 2, 00,000 = 1.4:1
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5. From the following balance sheet, calculate (a) current ratio (b) liquid ratio (c) Debt-
equityratio (d) Proprietary ratio.
Balance Sheet
Solution:
(a) Current ratio = Current assets ÷ Current Liabilities
Current assets = Stock + Debtors + Cash
= 5, 00,000 + 2, 00,000 + 1, 00,000 = Rs.8, 00,000.
Current liabilities = Bank overdraft + Creditors = 1, 00,000 + 2, 00,000 = Rs. 3, 00,000.
Current ratio = 8, 00,000 / 3, 00,000 = 2.67:1
(b) Liquid ratio = Liquid assets / Current liabilities.
Liquid assets = Cash + Debtors = 2, 00,000 + 1, 00,000 = Rs. 3, 00,000.
Liquid ratio = 3, 00,000 / 3, 00,000 = 1:1
(c) Debt equity ratio = Total long-term debt ÷Shareholders’ funds
Total long-term debt = Debentures = Rs. 11, 00,000.
Shareholders’ funds = Share capital + Reserves = 5, 00,000 + 3, 00,000 = Rs. 8, 00,000.
Debt equity ratio = 11, 00,000 / 8, 00,000 = 1.375:1
(d) Proprietary ratio = Shareholders’ funds ÷ Total tangible assets.
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Total tangible assets = Fixed assets + Current assets
= 14, 00,000 + 8, 00,000
= Rs. 22, 00,000
Proprietary ratio = 8, 00,000 / 22, 00,000 = 0.364:1
6.From the following particulars, pertaining to assets and liabilities of a company calculate
(a) Liquid ratio (b) Proprietary ratio (c) Debt equity ratio (d) Capital gearing ratio.
Balance Sheet
Solution:
(a) Liquid ratio = (Quick assets (or) Liquid assets) ÷ Current liabilities
Liquid assets = Debtors + Cash at bank = 1, 00,000 + 27,500 = Rs. 1, 27,500.
Current liabilities = Creditors + Bank O/d = 75,000 + 25,000 = Rs. 1, 00,000.
Liquid ratio = 1, 27,500 / 1, 00,000 = 1.275:1
(b) Proprietary ratio = Shareholders’ funds ÷ Total tangible assets.
Total tangible assets = Rs. 8, 00,000.
Shareholders’ funds = Reserves + Equity Share Capital + Preference Share Capital
= 1, 50,000 + 2, 50,000 + 1, 00,000 = Rs. 5, 00,000.
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Proprietary ratio = 5, 00,000 / 8, 00,000 = 0.625:1
Total long-term debt = Debentures = Rs. 2, 00,000; Shareholders’ funds = Rs. 5, 00,000.
Debt equity ratio = 2, 00,000 / 5, 00,000 = 0.40:1
(d) Capital Gearing ratio = (Long term loans + Preference share capital + Debentures)
/ Equity Share capital = (2, 00,000 + 1, 00,000) / (2, 50,000 + 1, 50,000)
= 3, 00,000 / 4, 00,000 = 0.75:1
7. Following is the Balance Sheet of Kovalam & Co. Ltd.
Balance Sheet
During the year, provision for taxation was Rs. 20,000. Dividend was proposed at Rs.
10,000.
Profit carried from the last year was Rs. 15,000. You are required to calculate: (a)
Currentratio (b) Liquidity ratio (c) Debt-equity ratio (d) Fixed assets ratio & € Fixed
charges cover ratio.
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Solution:
(a) Current ratio = Current assets ÷ Current Liabilities
Current assets = Stock + Debtors + Cash + Bank + B/R + Investments = 40,000 +
70,000 + 2,000 + 10,000 + 30,000 + 20,000 = Rs. 1, 72,000
Current liabilities = Bank overdraft + Creditors + O/s Creditors + Proposed dividend
+ Provision for taxation = 40,000 + 60,000 + 7,000 + 10,000 + 20,000 = Rs. 1, 37,000.
Current ratio = 1, 72,000 / 1, 37,000 = 1.26:1
(b) Liquid assets = (Quick assets (or) Liquid assets) ÷ Current liabilities
Quick assets = Current assets – Stock = 1, 72,000 – 40,000 = Rs. 1, 32,000.
Liquid ratio = 1, 32,000 / 1, 37,000 = 0.96:1
Total long-term debt = Debentures + Public Debt = 40,000 + 20,000 = Rs. 60,000.
Shareholders’ funds = Equity Share capital + Preference Share Capital + Proposeddividend

+ Reserves + P & L A/c
= 1, 00,000 + 1, 00,000 + 10,000 + 1, 50,000 + 20,000 =Rs. 3, 80,000.
Debt equity ratio = 60,000 / 3, 80,000 = 0.16:1
(d) Fixed assets ratio = Fixed assets / Long-term funds
Fixed assets = Furniture + Machinery + Land & Buildings
= 30,000 + 1, 00,000 + 2, 20,000 = Rs. 3, 50,000.
Long-term funds = Debentures + Public Debt + Equity Share capital + Preference Share
Capital + Reserves + P & L A/c – Preliminary expenses
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= 1, 00,000 + 1, 00,000 + 40,000 +20,000 + 1, 50,000 + 20,000 –10,000 = Rs. 4, 20,000.
Fixed assets ratio = 3, 50,000 / 4, 20,000 = 0.83:1
(e) Fixed charges cover ratio = Profit before interest & tax / Fixed Interest Charges
Profit before interest & tax = Profit for the year + Provision for taxation + Interestcharges
on Debentures & Public Debt = 15,000 + 20,000 + 4,400 = Rs. 39,400.
Fixed interest charges:
Debentures = 40,000 * 7% = Rs. 2,800 Rs. 4,400
Public debt = 20,000 * 8% = Rs. 1,600
Fixed charges cover ratio = 39,400 / 4,400 = 8.95:1
8. From the following data given below, compute: (a) Working capital (b) Net
capitalemployed (c) Current ratio (d) Acid test ratio (e) Debt-equity ratio (f) Fixed
assets ratio.Usha Ltd. as on December 31, 1999.
Balance Sheet
Solution:
(a) Working capital = Current assets – Current Liabilities
Current assets = Stores + Debtors + Cash + Bank + Stock = 2,000 + 500 + 2,500 + 1,000
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+ 4,000 = Rs. 10,000.
Current liabilities = Creditors + Proposed Dividend + Provision for taxation
= 1,000 +1,000 + 2,000 = Rs. 4,000.
Working capital = 10,000 – 4,000 = Rs. 6,000.
(b) Net working capital employed = Capital employed + Fixed assets
= 6,000 + 30,000 = Rs. 36,000.
(c) Current ratio = Current assets ÷ Current Liabilities = 10,000 / 4,000 = 2.5:1
(d) Liquid ratio = (Quick assets (or) Liquid assets) ÷ Current liabilities
Quick assets = Cash + Bank + Debtors = 500 + 2,500 + 1,000 = Rs. 4,000.
Liquid ratio = 4,000 / 4,000 = 1:1
(e) Debt equity ratio = Total long-term debt ÷Shareholders’ funds
Total long-term debts = Debentures + Bank loan = 8,000 + 4,000 = Rs. 12,000.
Shareholders’ funds = Equity Share capital + Preference Share Capital + Reserves

andsurplus = 25,000 + 5,000 + 4,000 = Rs. 34,000.
Debt equity ratio = 12,000 / 34,000 = 0.35:1
(f) Fixed assets ratio = Fixed assets / Long-term Debts
Long-term debts = Debentures + Bank loan + Equity Share capital + Preference Share
Capital +Reserves – Preliminary expenses – Brokerage on shares
=8,000 + 4,000 + 25,000+ 5,000 + 4,000 – 8,000 – 2,000
= Rs. 36,000. Fixed assets = Rs. 30,000 (given).
Fixed assets ratio = 30,000 / 36,000 = 0.83:1
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2.3 RATIO ANALYSIS PART II
PROFITABILITY RATIOS
Return on investment Operating profit/Capital employed X 100
Return on shareholders funds Net profit after interest and tax/Shareholders funds
X 100
Return on equity shareholders Net profit after interest , tax and preference dividend /
funds Equity share holders funds X 100
Return on Total Assets Net profit after tax + Interest/
Total assets – Fictitious assets X 100
Gross profit ratio Gross profit/Net sales X 100
Operating profit ratio Operating profit / Net sales X 100
Operating ratio Cost of goods sold + Operating expense / Net sales X
100
Expenses ratio Specific expenses/ Net sales X 100
Net profit ratio Net profit after tax/ Net sales X100
Earnings per share Net profit after tax and preference dividend/ No. of.
Equity shares
Price earnings ratio Market price per equity share/Earnings per equity
share
Payout ratio Equity dividend /Net profit after tax and Preference
dividend X 100 (or)
Dividend per Equity share/ Earnings per equity share
X100
Retained earnings ratio Retained earnings/Net profit after tax and preference
dividend X 100
Interest cover ratio Profit before interest and tax/Fixed interest charges
Dividend yield ratio Dividend per share /
Market price per share X 100
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1.Sakthi Ltd. submit the following data regarding sales and cost: Sales = Rs. 1, 00,000; Sales
Returns = Rs. 20,000; Cost of Sales = Rs. 50,000. Calculate Gross Profit Ratio
Solution:
Gross profit ratio = (Gross profit ÷ Net sales) * 100
Net sales = Sales – Sales returns = 1, 00,000 – 20,000 = Rs. 80,000.
Gross profit = Net Sales – Cost of Sales (Cost of goods sold)
= 80,000 – 50,000 = Rs. 30,000.
Therefore, Gross Profit ratio = (30,000 ÷ 80,000) * 100 = 37.5%
2. Veena Ltd. submit the following details for the year ending 31.03.2007. Calculate net
profit
ratio.Sales = Rs. 2, 00,000; Gross profit = Rs. 60,000; Administration, selling &
distributionexpenses = Rs. 25,000; other expenses = 10,000; Income from investments =
Rs. 15,000; Losson sale of machine = Rs. 5,000.
Solution:
Net profit ratio = (Net profit after tax ÷ Net sales) * 100
Calculation of Net Profit
Particulars Amount Amount
Gross profit 60,000
LESS: Administration, selling & distribution expenses 25,000
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Other expenses 10,000 35,000
25,000
ADD: Income from investments 15,000
40,000
LESS: Loss on sale of machine 5,000
Operating profit 35,000
Tax adjustments Nil
Net profit 35,000
Therefore, Net Profit ratio = (35,000÷ 2, 00,000) * 100 = 17.5%
3. Ascertain operating profit ratio from the following details:Net profit after tax = Rs.
80,000;
Profit on sale of buildings = Rs. 30,000; Loss on sale of land = Rs. 20,000;
Preliminaryexpenses written off = Rs. 10,000; Provision for tax = Rs. 40,000; Interest on
debentures paid
= Rs. 20,000; Net Sales = Rs. 7, 00,000
Solution:
Operating Profit ratio =(Operating profit)÷ (Net Sales) * 100
Operating profit = Net profit + Non-operating expenses – Non-operating incomes
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= 80,000 + (20,000+10,000+40,000+20,000) – 30,000
= 80,000 + 90,000 – 30,000 = 1, 70,000 – 30,000
= Rs. 1, 40,000
Therefore, Operating Profit ratio = (1, 40,000÷ 7, 00,000) * 100 = 20%
4. Find out operating ratio and operating profit ratio. Cost of goods sold = Rs. 1, 80,000;
Otheroperating expenses = Rs. 30,000; Net Sales = Rs. 3, 00,000.
Solution:
(a) Operating ratio = {(Cost of sales + Operating expenses) ÷ Net sales} * 100
= {(1, 80,000 + 30,000) ÷ 3, 00,000} * 100
= (2, 10,000 ÷ 3, 00,000) * 100 = 70%
(b) Operating profit ratio = (Operating profit)÷ (Net Sales) * 100
Operating profit = Gross profit – Operating expenses
Gross Profit = Net Sales – Cost of goods sold = 3, 00,000 – 1, 80,000 = Rs. 1, 20,000
Operating profit = 1, 20,000 – 30,000 = Rs. 90,000.
Operating profit ratio = (90,000 ÷ 3, 00,000) * 100 = 30%.
5. Find out earnings per share from the following: Net Profit after tax = Rs. 2, 00,000; 10%
Preference share capital = 4, 00,000; Equity Share capital (Rs. 100 each) = Rs. 10, 00,000
Solution:
Earnings per share =(Net profit after tax & preference dividend÷ No. of equity shares)
No. of equity shares = 10, 00,000 ÷100 = 10,000 shares.
Net Profit after tax = Rs. 2, 00,000; Preference dividend = 4, 00,000 * 10% = Rs. 40,000.
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Net Profit after tax and preference dividend = 2, 00,000 – 40,000 = Rs. 1, 60,000.
Earnings per share = 1, 60,000 ÷ 10,000 shares = Rs. 16.
6. Calculate the Earnings per share from the following data:
Net profit before tax = Rs. 1, 00,000;
Taxation 50% of net profit; 10% preference share capital (Rs. 10 each) = Rs. 1, 00,000;
Equityshare capital (Rs. 10 each) = Rs. 1, 00,000.
Solution:
Earnings per share =(Net profit after tax & preference dividend÷ No. of equity shares)
No. of equity shares = 1, 00,000÷10 = 10,000 shares.
Net profit after tax = 1, 00,000 – 50,000 (1, 00,000 * 50%) = Rs. 50,000.
Net Profit after tax and preference dividend = 50,000 – 10,000 = Rs. 40,000.
Earnings per share = 40,000 ÷ 10,000 shares = Rs. 4.
7. A company has a capital of Rs. 10, 00,000. Its turnover is three times the capital and the
margin on sales is 6%. What is the return on investment?
Solution:
R.O.I. = (Operating profit ÷ Capital employed) * 100
Capital turnover = 3 times, i.e., 3 times = Sales ÷ Capital employed
Therefore, Sales = 3 times * 10, 00,000 = Rs. 30, 00,000
Operating profit = Sales * Margin on sales = 30, 00,000 * 6% = Rs. 1, 80,000.
R.O.I. = (1, 80,000 ÷ 10, 00,000) * 100 = 18%.
8. Ascertain the return on shareholders’ funds from the following data.
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Solution: Return on shareholders’ funds =(Net profit after interest and tax ÷
Shareholders’ funds) * 100
Shareholders’ funds = Equity share capital + Preference share capital + Reserves & profits =
12, 00,000 + 3, 00,000 + 5, 00,000 = Rs. 20, 00,000.
Return on shareholders’ funds = (10, 00,000 ÷ 20, 00,000) * 100 = 50%
TURNOVER RATIO
Inventory turnover ratio Cost of goods sold/Average Inventory
Inventory turnover period Days /months in the year/
Inventory turnover ratio
Debtors turnover ratio Net credit sales/Average receivables
Debtors collection period Days /months in the year/
Debtors turnover ratio
Creditors turnover ratio Net credit Purchases/
Average accounts payables
Average payment period Days/Months in the year/
Creditors turnover ratio
Working capital turnover ratio Cost of sales /Net working capital
Fixed assets turnover ratio Cost of sales /Net Fixed assets
Capital turnover ratio Cost of sales /Capital employed
Owned capital turnover ratio Cost of sales /Share holders funds
1. Calculate Stock turnover ratio from the following trading account:
Particulars Amount Rs. Particulars Amount Rs.
Opening stock 40,000 Sales 2,00,000
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Purchases 1,00,000 Closing stock 20,000
Freight 10,000
Gross profit 70,000
Total 2,20,000 Total 2,20,000
Solution:
Stock turnover ratio = Cost of goods sold ÷ Average Inventory
Cost of goods sold = Opening stock + Purchases + Freight – Closing stock
= 40,000 +1, 00,000 + 10,000 – 20,000 = Rs. 1, 30,000.
Average inventory = (opening stock + closing stock) / 2= (40,000 + 20,000) / 2 = Rs. 30,000
Stock turnover ratio = 1, 30,000 / 30,000 = 4.33 times
2. Calculate the debtors’ turnover ratio from the following: Total sales for the year 1987 –
Rs.
1,00,000; Cash sales for the year – Rs. 20,000; Debtors as on 01.01.1987 – Rs. 10,000;
Debtorsas on 31.12.1987 – Rs. 15,000; Bills receivable as on 01.01.1987 – Rs. 7,500; Bills
receivable ason 31.12.1987 –Rs. 12,500.
Solution:
Debtors turnover ratio = Net Credit Sales ÷ Average a/c receivables
Net credit sales = Total sales – Cash sales – Sales returns = 1, 00,000 – 20,000 = Rs. 80,000.
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Average a/c receivables = {(10,000 + 15,000) + (7,500 + 12,500)} / 2=45,000 / 2 = Rs.
22,500.
Debtors turnover ratio = 80,000 / 22,500 = 3.555 = 3.56 times.
3.Kuberan& Co. makes both cash and credit sales. From the following information,
calculateaverage collection period: Total sales – Rs. 2, 00,000; Cash sales – Rs. 40,000; Sales
returns –
Rs. 14,000; Debtors (31.12.2006) – Rs. 18,000; Creditors (31.12.2006) – Rs. 20,000;
Provisionfor bad debts (31.12.2006) – Rs. 2,000; Bills receivable (31.12.2006) – Rs. 4,000.
Solution:
Debtors turnover ratio = Net Credit Sales ÷ Closing a/c receivables
Net credit sales = 2, 00,000 – 40,000 – 14,000 = Rs. 1, 46,000.
Closing a/c receivables = 18,000 + 4,000 = Rs. 22,000.
Debtors turnover ratio = 1, 46,000 / 22,000 = 6.636 times
Average collection period = Days or months in the year ÷ Debtors turnover ratio
= 365 / 6.636 = 55 days (or) 12 / 6.636 = 1.81 months.
4. Calculate debtors collection period from the following details:
Particulars 2006 Rs. 2007 Rs.
Total sales 5,80,000 6,90,000
Cash sales 80,000 90,000
Debtors 85,000 92,000
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Bills receivable 5,000 8,000
Provision for bad debts 6,000 8,000
Solution:
Debtors turnover ratio = Net Credit Sales ÷ Closing a/c receivables
Net credit sales:
2006 = 5, 80,000 – 80,000 = Rs. 5, 00,000;
2007 = 6, 90,000 – 90,000 = Rs. 6, 00,000.
Closing debtors:
2006 = 85,000 + 5,000 = Rs. 90,000; 2007 = 92,000 + 8,000 = Rs. 1, 00,000.
Debtors turnover ratio:2006 = 5, 00,000 / 90,000 = 5.55 times;
2007 = 6, 00,000 / 1, 00,000 = 6 times.
2006 = 365 days / 5.55 = 65.7 = 66 days;
2007 = 365 days / 6 = 60.8 = 61 days.
5. From the following you are required to calculate: (a) Debtors turnover (b) Average age of
Debtors.
Particulars 1988 Rs. 1987 Rs.
Net sales 18,00,000 15,00,000
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Debtors (beginning of 1,72,000 1,60,000
year)
Debtors (end of year) 2,34,000 1,72,000
Solution:
Debtors turnover ratio = Net Credit Sales ÷ Average Debtors.
Average debtors: 1987 = (1, 60,000 + 1, 72,000) / 2 = Rs. 1, 66,000.
1988 = (1, 72,000 + 2, 34,000) / 2 = Rs. 2, 03,000.
Debtor’s turnover ratio: 1987 = 15, 00,000 / 1, 66,000 = 9.036 = 9.04 times.
1988 = 18, 00,000 / 2, 03,000 = 8.866 = 8.87 times.
1987 = 365 / 9.04 = 40.3 = 40 days;
1988 = 365 / 8.87 = 41.15 = 41 days.
6. A company purchases goods both on cash as well as on credit terms. The

followingparticulars are obtained from the books. Total purchases – Rs. 3, 00,000; Cash
purchases –
Rs.30,000; Purchase returns – Rs. 51,000; Creditors at the end – Rs. 1,05,000; Bills payable
at theend – Rs. 60,000; Reserve for discount on creditors – Rs. 8,000. Calculate average
paymentperiod.
Solution:
Creditors turnover ratio = Net Credit Purchases ÷ Closing a/c payables.
Net Credit purchases = Total purchases - Cash purchases – Purchase returns
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= 3, 00,000 – 30,000 – 51,000 = Rs. 2, 19,000.
Closing a/c payables = Closing creditors + Closing Bills payable
= 1, 05,000 + 60,000 = Rs. 1, 65,000.
Creditors turnover ratio = 2, 19,000 / 1, 65,000 = 1.3272 times.
Average payment period = Days or months in the year ÷ Creditors turnover ratio
= 365 days / 1.3272 = 275 days (or)
12 months / 1.3272 = 9.04 months.
7. You are required to calculate the following: (a) Working capital turnover (b) fixed
assetsturnover (c) Capital turnover. The information is as under: Capital employed – Rs. 4,
00,000;
Current assets – Rs. 2,00,000; Current liabilities – Rs. 40,000; Net fixed assets – Rs.
2,50,000;
Sales – Rs. 5, 00,000; Cost of sales – Rs. 4, 00,000.
Solution:
(a) Working capital turnover ratio = (Sales or Cost of Sales) ÷Net working capital
Net working capital = Current assets – Current Liabilities
= 2, 00,000 – 40,000 = Rs. 1, 60,000.
Working capital turnover ratio = 4, 00,000 / 1, 60,000 = 2.5 times (or)
5, 00,000 / 1, 60,000= 3.125 times
(b) Fixed assets turnover ratio = (Sales or Cost of Sales) ÷Net fixed assets
= 4, 00,000 / 2, 50,000 = 1.6 times (or)
5, 00,000 / 2, 50,000 = 2 times.

131
(c) Capital turnover ratio = (Sales or Cost of Sales) ÷ Capital employed
= 4, 00,000 / 4, 00,000 = 1 time (or)
5, 00,000 / 4, 00,000 = 1.25 times.
DUPONT RATIOS
A system of management control designed by an American company named Du-Pont

Company is popularly called Du-Pont control chart. This system uses the ratio inter-
relationship to provide charts for managerial attention. The standard ratios of the company
are compared to present ratios and changes in performance are judged.
The chart is based on two elements i.e.Net profit and capital employed. Net profit is
related to operating expenses if the expenses are under control then the profit margin will
increase. The earnings as a percentage of sales or earnings divided by sales give us
percentage of profitability. Earnings can be calculated by deducting cost of sales from sales.
Cost of sales include cost of goods sold plus office and administrative expenses and selling
and distribution expenses. Capital employed on the other hand consists of current assets
and net fixed assets.
Current assets include debtors, stock, bills receivable, cash etc., Fixed assets are
taken after deducting depreciation. So profit margin is divided by capital employed and is
multiplied by 100.
The ratio will be = Profit margin/ Capital employed X 100
2.4 COMPARATIVE AND COMMON SIZE STATEMENTS

Meaning
Comparative Financial Statement is a tool of financial analysis used to study the

magnitude and direction of changes in the financial position and performance of a firm
over a period of time. The preparation of Comparative statement is based on the premise
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that a statement covering a period of a number of years is more meaningful and significant
than for a single year only.
The Comparative Statement may show:
1. Absolute figures (rupee amounts).

2. Changes in absolute figures i.e., increase or decrease in absolute figures.
3. Absolute data in terms of percentages.
4. Increase or decrease in terms of percentages.
5. Comparisons expressed in terms of ratios.
6. Percentage of totals.
Objectives
 To indicate the trend and direction of financial position and operating

results.
 To judge the strengths and weakness of a firm in terms of liquidity,
solvency and profitability.
 To help the management in planning and forecasting.
 To indicate the magnitude and direction of changes in various elements of
Financial Statements.
 To enhance the usefulness of financial reports.
Types
The two comparative statements are
1. Comparative Income Statement:

The income statement gives the results of the operation of a business. It shows the
net profit or net loss on account of business operations. The Comparative Income
Statement gives an idea of the progress of a business of a business over a period of
time. The changes in absolute data in money values and percentages can be
determined to analyse the profitability of the business.
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2. Comparative Balance Sheet:
Comparative Balance Sheet of an enterprise is prepared to show different assets,
liabilities and capital as on two or more dates so as to compare or ascertain any
increase or decrease in absolute items and also percentages changes.
PROBLEMS
1. The income statements of a concern are given for the years ending on 31 st
December 2001 and 2002. Re-arrange the figures in a Comparative form and
study the profitability position of the concern.
Particulars 2001 Rs. 2002 Rs. (000)

(000)
Net Sales 785 900
Cost of goods sold 450 500
Operating expenses:
General and administrative expenses 70 72
Selling expenses 80 90
Non – operating expenses:
Interest paid 25 30
Income tax 70 80
Solution:
Comparative Income Statement for the years ending 31 st December, 2001 and 2002
Particulars 2001 2002 Increase (+) or Decrease

Rs. (000) Rs. (000) (-) in 2002 over 2001
Net Sales 785 900 + 115 + 14.64
(-) Cost of goods sold 450 500 + 50 + 11.11
Gross Profit (A) 335 400 + 65 + 19.4
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Operating Expenses:
General & 70 72 +2 + 2.85
administrative
expenses
Selling expenses 80 90 + 10 + 12.5
Total operating 150 162 + 12 +8
expenses(B)
Operating Profit (A-B) C 185 238 + 53 + 28.64
Non-operating expenses:
Interest paid 25 30 +5 + 20
Income tax 70 80 + 10 + 14.2
Total non – operating 95 110 + 15 + 15.7
expenses (D)
Net Profit (C-D) 90 128 + 38 + 42.2
2. Sudeesh & Co. Ltd Furnishes its balance sheet for the years 1999 and 2000 and
requests you to prepare a comparative balance sheet for those years.
Balance sheets
Liabilities 1999 (Rs.) 2000 Assets 1999 2000
(Rs.) (Rs.) (Rs.)
Equity Share 80,000 80,000 Land & 80,000 74,000
capital Buildings
8% Debentures 80,000 90,000 Plant & 60,000 54,000
Machinery
Retained 40,000 49,000 Furniture 20,000 28,000
Earnings
Sundry 50,000 70,000 Inventory 40,000 60,000
Creditors
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Bills payable 10,000 15,000 Debtors 40,000 80,000
Cash 20,000 8,000
Total 2,60,000 3,04,000 Total 2,60,000 3,04,000
Solution:
Comparative Balance sheet of Sudeesh& Co. Ltd as on 31 st December 1999 and 2000
Particulars 1999 (Rs.) 2000 (Rs.) Increase (+) or

Decrease (-) in 2000
over 1999
Amount Percentage
(Rs.) (%)
Assets:
Current assets:
Inventory 40,000 60,000 + 20,000 + 50
Debtors 40,000 80,000 + 40,000 + 100
Cash 20,000 8,000 - 12,000 - 60
+ 48
Total Current Assets(A) 1,00,000 1,48,000 + 48,000
Fixed assets:
Land & Buildings 80,000 74,000 - 6,000 - 7.5
Plant &Machinery 60,000 54,000 - 6,000 - 10
Furniture 20,000 28,000 + 8,000 + 40
Total Fixed Assets(B) 1,60,000 1,56,000 -4,000 -2.5
Total Assets (A+B) 2,60,000 3,04,000 + 44,000 + 16.92
Liabilities
Current liabilities:
Sundry creditors 50,000 70,000 + 20,000 + 40
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Bills payable 10,000 15,000 + 5,000 + 50
Total Current Liabilities(A) 60,000 85,000 +25,000 + 41.67
Long- term liabilities:
8% Debentures 80,000 90,000 + 10,000 + 12.5
Total long – term liabilities 80,000 90,000 + 10,000 + 12.5
(B)
Total Liabilities (A+B) 1,40,000 1,75,000 + 35,000 + 25
Capital & Reserves
Equity share capital 80,000 80,000 - -
Retained earnings 40,000 49,000 + 9,000 + 22.5
Total share holders’ fund 1,20,000 1,29,000 + 9,000 + 7.5
(D)
Total Liabilities and 2,60,000 3,04,000 + 44,000 + 16.92
capital(C+D)
COMMON SIZE STATEMENT
Meaning
The Common Size statements, balance sheet and income statement, are shown in
analytical percentages. The figures are shown as percentages of statement of profit and
loss, total assets revenue from operations, total liabilities and total sales. The total assets
are taken as 100 and different assets are expressed as a percentage of the total. Similarly,
various liabilities are taken as a part of total liabilities. These statements are also known as
component percentage or 100 percent statements because every individual item is stated
as percentage of the total 100. The short comings in comparative statements and trend
percentages where changes in items could not be compared with the totals have been
covered up. The analyst is able to assess the figures in relation to total values.
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The Common Size statement may be prepared in the following way:
 The total of assets or liabilities are taken as 100.

 The individual assets are expressed as a percentage of total assets, i.e., 100
and different liabilities are calculated in relation to total liabilities.
Objectives
 Common size statement is a financial tool for studying key changes and trends
in financial position.
 Comparison of company’s position with the related industry as a whole is
possible with the help of common size statement.
Types
The two Common Size statements are:
1. Common Size Income Statement:
In this statement, sales is taken as the base for all calculations. Therefore, the calculation of
each line item will take into account the sales as a base, and each item will be expressed as
a percentage of the sales.
2. Common Size Balance Sheet:
A common size balance sheet is a statement in which balance sheet items are being
calculated as the ratio of each asset in relation to the total assets. For the liabilities, each
liability is being calculated as a ratio of the total liabilities. Common size balance sheets can
be used for comparing companies that differ in size. The comparison of such figures for the
different periods is not found to be that useful because the total figures seem to be affected
by a number of factors. Standard values for various assets cannot be established by this
method as the trends of the figures cannot be studied and may not give proper results.
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PROBLEMS
1. Following is the P&L A/C of Shekar Fibres Ltd., for the year ended 31.12.85 &
31.12.86. You are required to prepare a Common Size income statement.
Profit & Loss Account (Rs. In Lakhs)
Particulars 1985 1986 Particulars 1985 1986
To cost of Goods sold 300 375 By Net sales 400 500
To Operating expenses:
Administrative 10 10
Selling 15 20
Net profit 75 95
Total 400 500 Total 400 500
Solution:
Common size income statement of ShekarFibres Ltd., for the year ended
31.12.1985 & 31.12.1986
Particulars 31.12.1985 31.12.1986

Amount % Of Sales Amount % Of Sales
(Rs.) (Rs.)
Net sales 400 100 500 100
(-) Cost of goods sold 300 75 375 75
Gross profit(A) 100 25 125 25
(-) Operating expenses:
Administrative 10 2.5 10 2
Selling 15 3.75 20 4
Total operating 25 6.25 30 6
expenses(B)
Net profit (A-B) 75 18.75 95 19
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2. Big Ltd., and Small Ltd., furnish you the following balance sheets and you are
required to prepare a common size balance sheet as on 31 st march 2007 so
that they can make a Comparative assessment of their financial position.
Balance sheet
Liabilities Big Ltd. (Rs.) Small Assets Big Ltd. Small
Ltd. (Rs.) (Rs.) Ltd.
(Rs.)
Share capital 50,00,000 25,000 Fixed 60,00,000 10,000
Assets
Reserves 5,00,000 20,000 Inventories 25,00,000 5,000
Term loans 20,00,000 - Debtors 10,00,000 20,000
Current liabilities 25,00,000 5,000 Cash 5,00,000 15,000
Total 1,00,00,000 50,000 Total 1,00,00,000 50,000
Solution:
Common Size balance sheet of Big Ltd., & Small Ltd., as on 31.03.2007
Particulars Big Ltd. Small Ltd.

Amount % Of total assets Amount % Of
(Rs.) (Rs.) total
assets
Assets
Current assets
Inventories 25,00,000 25 5,000 10
Debtors 10,00,000 10 20,000 40
Cash 5,00,000 5 15,000 30
Total current assets(A) 40,00,000 40 40,000 80
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Fixed assets:
Fixed Assets 60,00,000 60 10,000 20
Total Fixed Assets(B) 60,00,000 60 10,000 20
Total Assets (A+B) 1,00,00,000 100 50,000 100
Liabilities Amount % Of total Amount % Of

(Rs.) liabilities (Rs.) total
liabilities
Current liabilities:
Current liabilities 25,00,000 25 5,000 10
Total current liabilities 25,00,000 25 5,000 10
Long – term liabilities
Term loans 20,00,000 20 - -
Total long – term 20,00,000 20 - -
liability(B)
Capital & Reserves:
Share capital 50,00,000 50 25,000 50
Reserves 5,00,000 5 20,000 40
Shareholder’s fund (C) 55,00,000 55 45,000 90
Total Liabilities & 1,00,00,000 100 50,000 100
Capital (A+B+C)
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2.5 CASH FLOW STATEMENT
INTRODUCTION:
 Changes in the working capital can be analysed by preparing funds flow statement,
which comprises of various current assets and current liabilities.
 Movements of cash are of vital importance for the management, for a given period of
time. The short-term liquidity and long-term insolvency positions of a firm are much
dependent on the “cash flows”.
 The cash inflows and outflows are matched to know the demands for various cash
payments like expenses, payment to suppliers, etc. promptly and not maintain
excessive cash balance.
 The aim of financial management is to utilize the available in the most efficient
ways, not keeping excessive cash (unused).
 Proper analysis of cash payments and cash receipts for a given period has to be
made for efficient cash management.
 The quantum (how much / amount) of cash inflows and outflows can be ascertained
by preparing a cash flow statement.
CASH: The term ‘cash’ refers to the bank balance and cash balance of a business unit.
Cash flow statement:
 A cash flow statement is a statement which portrays the changes in the cash
position between two accounting periods. The detailed analysis of cash flows will
give an insight to the management about the applications and sources of cash, for
the given period of time.
 Such detailed analysis of cash flows can help to improve or accelerate the inflows
from each source and also discover new sources of cash. On the other hand, cash
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outflows are to be examined thoroughly for the purpose of reducing the expenses or
outflows of cash.
 Cash flow analysis is one of the best techniques of financial statement analysis,
generating the most useful information to the management.
OBJECTIVES OF CASH FLOW ANALYSIS (AS-3)
 To provide information about the cash flows of an enterprise to users of financial

statements which can be used as a basis to assess the ability of the enterprise to
generate cash and cash equivalents and the needs of the enterprise to utilise those
cash flows.
 To enable the users of financial statements to evaluate the “Timing and Certainty” of
the generation of cash flows.
 To classify the cash flows on the basis of Operating, Investing and Financing
activities.
ADVANTAGES OF CASH FLOW STATEMENT:
 Assessments of firms’ ability to generate cash flows.
 Classification of cash flows.
 Historical analysis as guide to forecasting.
 Effective cash management.
 Formulation of financial policies.
 Preparation of cash budget.
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 Short term financial decisions.
 Liquidity position.
 Revelations.
DISADVANTAGES OF CASH FLOW STATEMENT:
 Scope is very limited when compared to FFS, as it discloses inflows and outflows of
cash alone.
 CFS reveals only the cash balance, which can be easily manipulated by postponing
payments for purchases or delaying collection of receivables, etc.
 Non cash items of expenses and incomes are excluded, it cannot provide a
comprehensive picture of a firm’s financial position.
144
FORMAT OF CASH FLOW STATEMENT
145
PROBLEMS:
1. Compute the cash flow from operating activities:
Particulars Amount
(Rs.)
4,00,000
P&L A/c balance on
31.03.2004
2,50,000
P&L A/c balance on
31.03.2003
50,000
Transfer to general
reserve
10,000
Depreciation on fixed
assets
Solution:
STATEMENT SHOWING CASH FLOW FROM OPERATING ACTIVITIES
PARTICULARS AMOUNT AMOUNT

Rs. Rs.
4,00,000
P&L A/c balance on 31.03.2004
2,50,000
(-) P&L A/c balance on
31.03.2003
1,50,000
Net profit for the year 2004
(+) Non-operating Expenses:
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50,000
Transfer to general reserve
10,000 60,000
Depreciation on fixed assets
2,10,000
NIL -
(-) Non-operating Income:
2,10,000
Cash Flow from Operating
Activities
2. Find out the Net cash from investing activities from the following details:
Particulars Amount (Rs.)
Sale of fixed assets 2,00,000
Purchase of fixed assets 1,00,000
Issue of shares for cash 2,00,000
Solution:
STATEMENT SHOWING CASH FLOW FROM INVESTING ACTIVITIES
PARTICULARS AMOUNT Rs. AMOUNT Rs.
Sale of fixed assets 2,00,000
(-) Purchase of fixed assets 1,00,000
Cash Flow from Investing Activities 1,00,000
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3. Calculate the Net cash flow from financing activities from the following details:
Issue of Debentures for cash 20,00,000
Long term Loan from bank 5,00,000
Redemption of Preference 6,00,000

shares
Purchase of Land 9,00,000
Solution:
STATEMENT SHOWING CASH FLOW FROM FINANCING ACTIVITIES
Issue of Debentures for cash 20,00,000
Long term Loan from bank 5,00,000 25,00,000
(-) Redemption of Preference shares 6,00,000
Cash Flow from Financing Activities 19,00,000
4. Compute cash flow from operating activities from the following:
Net profit for the year 2003-04 80,000
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Depreciation written off on Fixed 11,000
Assets
Profit on sale of Building 22,000
Loss on sale of machine 13,000
Increase in Current assets (except 46,000

cash)
Increase in Current Liabilities 29,000
Solution:
STATEMENT SHOWING CASH FLOW FROM OPERATING ACTIVITIES
Net profit for the year 80,000
(+) Non-operating Expenses:
Depreciation written off on Fixed Assets 11,000
Loss on sale of machine 13,000 24,000
1,04,000
(-) Non-Operating Income:
Profit on sale of Building 22,000
OPBT&WCC 82,000
(-) Income Tax NIL -
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OPAT&BWCC 82,000
Adjustments in Working Capital
(+) Increase in C.L. & Decrease in C.A.
Increase in Current Liabilities 29,000
OPAWCC 1,11,000
(-) Increase in C.A & Decrease in C.L.
Increase in Current assets (except cash) 46,000
Cash flow from Operating Activities 65,000
2.6 CASH FLOW STATEMENT
COMPREHENSIVE PROBLEMS:
1. The comparative Balance Sheets of Mr.Wheldon for the two years were as follows:
Liabilities 1988 Rs. 1989 Rs. Assets 1988 Rs. 1989 Rs.
Capital 1,50,000 1,75,000 Land & Buildings 1,10,000 1,50,000
Loan from bank 1,60,000 1,00,000 Machinery 2,00,000 1,40,000
Creditors 90,000 1,00,000 Stock 50,000 45,000
Bills payable 50,000 40,000 Debtors 70,000 80,000
Loan from IFC - 25,000 Cash 20,000 25,000
Total 4,50,000 4,40,000 Total 4,50,000 4,40,000
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Additional information:
Net profit for the year 1989 amounted to Rs. 60,000. During the year a machine
costing Rs. 25,000 (accumulated depreciation Rs. 10,000) was sold for Rs. 13,000. The
provision for depreciation against machinery as on 31.12.1988 was Rs. 50,000 and on 1989
was Rs. 85,000. You are required to prepare a cash flow statement.
Solution:
CASH FLOW STATEMENT OF Mr. WHELDON
I. Cash from operating activities:
Net Profit 60,000
(+) Non-operating Expenses: Provision for 45,000

Depreciation
Loss on sale of machinery 2,000 47,000
1,07,000
(-) Non-operating Income: NIL -
OPBT&WCC 1,07,000
Adjustments in Working Capital:
Creditors 10,000
Stock 5,000 15,000
1,22,000
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Bills payable 10,000
Debtors 10,000 20,000
OPAWCC 1,02,000
(-) Income Tax paid 3,200
Cash from in operating activities 1,420
II. Cash from investing activities:
Sale of machinery 13,000
Purchase of Land & Buildings (40,000) (27,000)
III. Cash from financing activities:
Drawings (35,000)
Repayment of Bank Loan (60,000)
Loan from IFC 25,000 (70,000)
Net cash in hand (Increase) (1,02,000 – 27,000 – 5,000

70,000)
(+) Opening balance of cash 20,000
Closing balance of cash 25,000
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2. From the following particulars, prepare cash flow statement of Mr.Thiruvel:
Particulars 01.01.2004 Rs. 31.12.2004 Rs.
Liabilities:
Current Liabilities 35,000 40,000
Loan from Mrs.Deivandi - 25,000
Bank Loan 40,000 30,000
Capital 1,50,000 1,54,000
TOTAL 2,25,000 2,49,000
Assets:
Cash 5,000 4,000
Debtors 40,000 45,000
Stock 30,000 25,000
Land 30,000 40,000
Buildings 50,000 55,000
Machinery 70,000 80,000
TOTAL 2,25,000 2,49,000
During the year Mr.Thiruvel brought in additional capital of Rs. 10,000 and his
drawings during the year were Rs. 31,000. Provision for depreciation on fixed assets on
01.01.04 was Rs. 30,000 and on 31.12.04 was Rs. 40,000.
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Working Notes:
PROVISION FOR DEPRECIATION A/c
Particulars Amount (Rs.) Particulars Amount (Rs.)
To balance c/d 40,000 By balance b/d 30,000
By P & L a/c (provision for 10,000

Deprcn.) (b/f)
TOTAL 40,000 TOTAL 40,000
SHARE CAPITAL A/c
To drawings 31,000 By balance b/d 1,50,000
To balance c/d 1,54,000 By Additional Capital 10,000
By Net profit (b/f) 25,000
TOTAL 1,85,000 TOTAL 1,85,000
FIXED ASSETS A/c
Particulars Amount Particulars Amount (Rs.)

(Rs.)
To balance b/d 1,50,000 By Depreciation 10,000
To Cash (Purchase) (b/f) 35,000 By Balance c/d 1,75,000
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Solution:
CASH FLOW STATEMENT
Net Profit 25,000
(+) Non-operating Expenses: Depreciation on F/A 10,000
35,000
OPBT&WCC 35,000
Stock 5,000
Current Liability 5,000 10,000
45,000
Current assets 5,000
Cash used in operating activities 40,000
Purchase of Fixed Assets (35,000)
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Additional Capital 10,000
Loan from Mrs. D 25,000
Drawings (31,000)
Repayment of Loan (10,000) (6,000)
Net cash in hand (Decrease) (40,000 – 35,000 – (1,000)

6,000)
3. Following are the Balance Sheets of James & Co., a partnership firm.
Liabilities 01.01.2004 31.12.2004 Assets 01.01.2004 31.12.2004

Rs. Rs. Rs. Rs.
Creditors 36,000 41,000 Cash 4,000 3,000
Loan from partner - 20,000 Debtors 35,000 38,400
Loan from bank 30,000 25,000 Stock 25,000 22,000
Capital 1,48,000 1,49,000 Land 20,000 30,000
Buildings 50,000 55,000
Machinery 80,000 86,000
Total 2,14,000 2,35,000 Total 2,14,000 2,35,000
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During the year partners withdrew Rs. 26,000 for domestic expenses. The provision
for depreciation against machinery as on 01.01.04 was Rs. 27,000 and on 31.12.04 was Rs.
36,000. Prepare a cash flow statement.
Working Notes:
PROVISION FOR DEPRECIATION A/c
To balance c/d 36,000 By balance b/d 27,000
By P & L a/c (provision for 9,000

Deprcn.) (b/f)
SHARE CAPITAL A/c
Particulars Amount Particulars Amount (Rs.)

(Rs.)
To drawings 26,000 By balance b/d 1,48,000
To balance c/d 1,49,000 By Net profit (b/f) 27,000
TOTAL 1,75,000 TOTAL 1,75,000
MACHINERY A/c
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To balance b/d 80,000 By Provsion for 9,000
Depreciation
To Cash (Purchase) (b/f) 15,000 By Balance c/d 86,000
Solution:
CASH FLOW STATEMENT OF JAMES & Co
Net Profit 27,000
(+) Non-operating Expenses: Deprecn. on 9,000

machinery
36,000
OPBT&WCC 36,000
Stock 3,000
Creditors 5,000 8,000
44,000
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Debtors 3,400
Cash used in operating activities 40,600
Purchase of Land (10,000)
Purchase of Machinery (15,000)
Purchase of Buildings (5,000) (30,000)
Loan from partner 20,000
Repayment of Loan (5,000)
Drawings by partners (26,000) (11,000)
Net cash in hand (Decrease) ((40,600 – 30,000 (400)

– 11,000)
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2.7 FUNDS FLOW ANALYSIS
FUNDS:
Meaning of ‘funds’: Total resources of a company / Cash or Cash items.
Definition of ‘funds’:“The total amount of funds used in a firm’s operations is equal to the
total assets employed in an enterprise”, says Paul C. Hastings.“The term ‘funds” generally
refers to Cash, to Cash Equivalents or to working capital”, says International Accounting
Standards.Funds means net working capital that results as the difference between current
asset & current liabilities.
FUNDS FLOW STATEMENT:
DEFINITION:
 Foulke defines this statement as “A statement of sources and application of funds, a

technical device designed to analyze the changes in the financial conditions of a
business enterprise between two dates”.
 In the words of Antony, “The funds flow statement describes the sources from which
additional funds were derived and the use to which these sources wereput”.
 Flow means ‘change’. Funds is interpreted as ‘workingcapital’.
 Thus, funds flow statement is a summarised report or explanation of the changes in
working capital for a givenperiod.
 Changes in the working capital can be ‘Inflow’ or ‘Outflow’ offunds.
 Funds flow statement measures and presents in an analytical manner of the
summarised version of the numerous flows of funds for a specific period. It greatly
helps the management for the purpose of evaluating the decisions made for utilizing
the funds or for the decisions to be made in the future for employing the available
source of fundsprofitably.
 Net working capital can be computed as the difference between Current Assets and
Current Liabilities.
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OBJECTIVES OF FUNDS FLOW STATEMENT:
 To show how the resources have been obtained and used in a business.
 To indicate the result of current financial management or the financial position of
the firm in terms of flow of funds.
 To throw light upon the most important changes that have taken place during a
specific period
 To show how the general expansion of the business has been financed through
various sources.
 To indicate the relationship between profit from operations, distribution of
dividend and raising of new capital or term loans.
 To have an assessment of working capital position of the concern
WORKING CAPITAL
Capital required for financing day to day operations of the business such as
purchase of materials, payment of wages, payment of rent is known as working capital (or)
amount invested in short term asset is known as working capital.
CONCEPT OF WORKING CAPITAL:
There are two concepts of working capital.
 Gross concept: Working capital refers to total current assets (i.e) total amount
invested in currentassets.
 Net concept: Working capital refers to excess of current asset over
currentliabilities.
 Gross working capital =Total currentassets
 Net working capital =Current Assets – Current Liabilities
CURRENT ASSETS:
Current assets mean cash and such other assets which are reasonably expected to be
realized in cash or sold or consumed during the normal operating cycle of business within
one year.
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 Cash and bankbalance
 Account receivable (i.e.,) debtors and billsreceivable
 Stock of raw materials (i.e.,) work in progress and finished goods, spares
 Temporary investment (or) short terminvestment
 Prepayment (i.e.,) prepaid rent, unexpired insurance
 Accruedincome
 Reserve for discount oncreditors
CURRENT LIABILITIES:
Current liabilities are short term liabilities which are payable within one accounting
year out of income of the business or out of current asset or by creation of additional
current liabilities
 Account payable (i.e.,) creditors and billspayable

 Outstanding expenses (i.e) wages, rent, commission
 Bankoverdraft
 Income received inadvance
 Dividendpayable
 Short termloans
 Provision for doubtfuldebts
 Provision for discount ondebtors
 Notespayable
 Taxpayable
 Provision for taxation –may be current (or) noncurrent
 Proposed dividend –may be current (or) noncurrent
NON - CURRENT ASSETS:
All those assets which are not current asset are termed as non-current assets.
Goodwill, land &building, plant & machinery, furniture, Long term investment, Profit& loss
(debit balance), preliminary expenses, discount on issue of shares & debentures.
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NON - CURRENT LIABILITIES:
All those liabilities which are not current liabilities\Share capital, debentures &
long- term loans, Profit& loss (credit balance), proposed dividend, share premium, share
forfeiture, provision & reserve (i.e.) capital reserve, general reserve, sinking fund.
WORKING CAPITAL STATEMENT OR SCHEDULE OF CHANGES IN WORKING CAPITAL:
Working capital = Total Current Assets – Current Liabilities
Capital required for financing day to day operations of the business such as
purchase of materials, payment of wages, payment of rent is known as working capital (or)
amount invested in short term asset is known as working capital.
Rules for Working Capital Statement (Or) Schedule of Changes in Working Capital
The working capital statement shows such increase or decrease in the working capital as
the final result.
 INCREASE IN CURRENTASSETS – INCREASE IN WORKINGCAPITAL

 DECREASE IN CURRENT ASSETS – DECREASE IN WORKINGCAPITAL
 INCREASE IN CURRENT LIABLITIES – DECREASE IN WORKING CAPITAL
 DECREASE IN CURRENT LIABLITIES–INCREASE IN WORKING CAPITAL
FORMAT FOR STATEMENT SHOWING FUNDS FROM OPERATION
PARTICULARS AMOUN AMOUNT

T
Net profit for the year (or) Closing balance of P & L a/c Xxx
ADD: Non-operating items which are already debited to P & L a/c
Depreciation on fixed assets Xxx
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Loss on sale of fixed assets (or) investment Xxx
Loss on revaluation of fixed assets Xxx
Intangible asset written off(i.e.,) Goodwill, patents, trade mark, copy Xxx
rights
Fictitious asset written off (i.e.,) Preliminary expenses, discount on Xxx

Issue of shares & debentures
Loss on redemption of debentures Xxx
Others Xxx
Transfer to Reserve: Transfer to general reserve Xxx
Transfer to sinking fund Xxx
Transfer to contingency reserve Xxx
Dividend: Interim dividend Xxx
Proposed dividend (if it is taken as non-current liabilities) Xxx
Provision for taxation (if it is takes as non-current liability) Xxx Xxx
Total (A) XXX
LESS: Non-operating items which are already credited to P & L

a/c
Profit on sale of fixed asset (or) investment Xxx
Profit on revaluation of fixed asset Xxx
Income from investment Xxx
164
Income tax refund Xxx
Dividend received Xxx
Interest received Xxx
Rent / commission received Xxx
Total (B) XXX
FUNDS FROM OPERATION or FUNDS LOST IN XXXXX

OPERATION (A-B)
NOTE: Transfer to reserve & dividend will be added in the statement only when closing
balance of P & L appropriation account is taken as the base for calculating fund from
operation
HINT:
 If Total A is more than Total B, the balance is treated as funds from operation.
 Likewise, if total A is less than Total B, the balance is treated as Funds lost in
operation.

PREPARATION OF LEDGER ACCOUNTS FOR ADJUSTMENTS IN NON– CURRENT ITEMS
1. PROVISION FOR TAX A/c

To Bank (tax paid) (b.f) XXX By balance b/d (op.bal) XXX
To balance c/d(cl.bal) XXX By P & L a/c (provision for XXX
tax) (b.f.)
TOTAL XXX TOTAL XXX
165
2. LAND & BUILDINGS A/c
To balance b/d (op.bal) XXX By depreciation XXX
To bank (purchase) (b.f.) XXX By bank (sale) XXX
By P& L (loss on sale) XXX
By Balance c/d XXX
TOTAL XXX TOTAL XXX
3. INVESTMENTS A/c
To Balance b/d XXX By bank (sale) XXX
To Bank (purchase) (b.f.) XXX By balance c/d XXX
TOTAL XXX TOTAL XXX
4. PROPOSED DIVIDEND A/c

To Bank (Dividend paid) (b/f) XXX By balance b/d (op/bal) XXX
To balance c/d (cl/bal) XXX By P & L a/c (Proposed XXX

dividend) (b/f)
TOTAL XXX TOTAL XXX
5. SHARE CAPITAL A/c
166
To cash (drawings) (b.f.) XXX By Balance b/d XXX
To balance c/d XXX By Cash(shares issued) XXX
By Capital reserve/ general reserve XXX
By Fixed asset (shares issued for fixed XXX
asset)
By Net profit XXX
TOTAL XXX TOTAL XXX
6. GENERAL RESERVE A/c

To Share capital (bonus shares) XXX By Balance b/d XXX
To Balance c/d XXX By P& L appropriation XXX
TOTAL XXX TOTAL XXX
7. DEBENTURES A/c
To cash(redeemed) XXX By balance b/d Xxx
To balance c/d XXX By cash(issued) XXX
By P& L a/c (loss on redemption) XXX
TOTAL XXX TOTAL XXX
167
8. FIXED ASSETS A/c
Note: When fixed assets are shown at written down value (provision for depreciation
account is not opened). Opening & closing balance of the asset should be at the written
down value (i.e.,) original cost of depreciation.
To balance b/d XXX By cash(sale) XXX
To share capital (purchase by XXX By P & L a/c current year XXX

issue ofshares)
depreciation on asset sold)
To cash (purchase) XXX By P & L a/c (loss on sale) XXX
To P & L a/c (profit on sale) XXX By P & L a/c (depreciation XXX
during year)
By balance c/d XXX
TOTAL XXX TOTAL XXX
Note: When fixed asset is shown at original cost (provision for depreciation account is
opened.
A.PROVISION FOR DEPRECIATION A/c
To fixed asset (accumulated XXX By balance b/d XXX

depreciation on assets sold)
To balance c/d XXX By P & L a/c (transfer during XXX

the year)
168
TOTAL XXX TOTAL XXX
B. FIXED ASSETSA/c
To balance b/d XXX By cash(sale) XXX
To share capital (purchase XXX By provision for depreciation XXX

by
(accumulated depreciation on asset sold)
issue of shares)
To cash (purchase) XXX By p & L a/c (loss on sale) XXX
To P & L a/c (profit on sale) XXX
TOTAL XXX TOTAL XXX
FORMAT SHOWING FUNDS FLOW STATEMENT
SOURCE OF FUNDS
Issue of shares XXX
Issue of debentures XXX
Sale of fixed asset XXX
Investments sold XXX
Funds from operation XXX
169
TOTAL SOURCES (A) XXXX
APPLICATION OF FUNDS
Repayment of long-term loans XXX
Redemption of preference shares XXX
Redemption of debentures XXX
Purchase of fixed assets XXX
Dividend paid XXX
Investment purchased XXX
Out flow of funds on account of operation XXX
TOTAL APPLICATIONS (B) XXXX
INCREASE / DECREASE IN WORKING CAPITAL (A - XXXXX

B)
HINT:
 If Total A is more than Total B, the balance is treated as increase in

workingcapital
 Likewise, if Total A is less than Total B, the balance is treated as decrease in
working capital
Problem:
1. M Co., presents the following information and you are required to calculate Funds
from operation Profit and Loss account
To Expenses: By Gross profit 2,00,000
170
Operation 1,00,000 By Gain on sale of 20,000
plant
Depreciation 40,000
To loss on sale of 10,000
building
To Advertisement 5,000
expenses
To Discount allowed 500
to customers
To Discount on issue 500
of shares written off
To Goodwill 12,000
To Net profit 52,000
2,20,000 2,20,000
Solution:
Calculation of Funds from Operation:
Particulars Amount Amount

Net profit 52000
Add: Non fund or Non –operating
items which has been debited to
Profit and loss account
Depreciation 40,000
Loss on sales of building 10,000
Advertisement written off 5,000
Discount on issue of shares written 500
off
Goodwill written off 12,000 67,500
171
1,19,500
Less: Non fund or Non – operating 20,000 20,000
items which has been credited to
Profit and loss account – Gain on
sale of plant
Funds from operations 99,500
2.8 FUNDS FLOW STATEMENT
1. The Balance Sheets of Kanu Co. Ltd., at the end of 1983 and 1984 are given below:
Balance Sheet
Liabilities 1983 Rs. 1984Rs. Assets 1983 Rs. 1984 Rs.

Accounts 20,000 25,000 Cash 20,000 10,000
payable
Notes payable 20,000 5,000 Marketabl 10,000 -
e
securities
Other Current 10,000 15,000 Inventory 60,000 1,00,000
Liabilities
6% Bonds - 30,000 Receivables 30,000 40,000
Common Stock 50,000 50,000 Gross Block 1,00,000 1,40,000
Retained 80,000 1,10,000 (-) (40,000) (55,000)
earnings Accumulated
Depreciation
Total 1,80,000 2,35,000 Total 1,80,000 2,35,000
Prepare schedule of changes in working capital.
Solution: (Marketable securities is a current asset; notes payable is a current liability)
172
SCHEDULE OF CHANGES IN WORKING CAPITAL
PARTICULARS 1983 1984 CHANGES IN WORKING
Rs. Rs. CAPITAL
INCREASE DECREASE
CURRENT ASSETS:
RECEIVABLES 30,000 40,000 10,000 -
CASH 20,000 10,000 - 10,000
INVENTORY 60,000 1,00,000 40,000 -
MARKETABLE SECURITIES 10,000 - - 10,000
TOTAL(A) 1,20,000 1,50,000
ACCOUNTS PAYABLE 20,000 25,000 - 5,000
NOTES PAYABLE 20,000 5,000 15,000 -
OTHER CURRENT 10,000 15,000 - 5,000
LIABILITIES
TOTAL(B) 50,000 45,000 - -
Working capital (A-B) 70,000 1,05,000 - -
Net Increase in Working Capital 35,000 - - 35,000
TOTAL 1,05,000 1,05,000 65,000 65,000
2. A company’s reported current year profit is Rs. 70,000 after incorporating the
following, derive the net inflow of funds from operations.
Loss on sale of equipment 10,000 Gain from sale of 40,000
non- current assets
Premium on redemption 1,500 Excess provision 22,000
of debentures for taxation
Discount on issue of 2,000 Dividend income on 4,000
debentures investment
173
Depreciation on 20,000 Transfer to General 5,000
machinery and buildings reserve
Depletion of natural 10,000 Preliminary expenses 1,000
resources
Amortization of goodwill 30,000 Profit on revaluation of 2,500
Interim dividend 25,000 investments
Solution:
STATEMENT SHOWING FUNDS FROM OPERATION

PARTICULARS Amount (Rs.) Amount
(Rs.)
Net profit for the year 70,000
ADD: Loss on sale of equipment 10,000
Premium on redemption of debentures 1,500
Discount on issue of debentures 2,000
Depreciation on machinery and buildings 20,000
Depletion of natural resources 10,000
Amortization of goodwill 30,000
Interim dividend 25,000
Transfer to General reserve 5,000
Preliminary expenses 1,000 1,04,500
Total (A) 1,74,500
LESS: Excess provision for taxation 22,000
Dividend income on investment 4,000
Gain from sale of non-current assets 40,000
Profit on revaluation of investments 2,500
Total (B) 68,500
FUNDS FROM OPERATIONS (A-B) 1, 06,000
174
3. From the following balance sheets, prepare a funds flow statement.
LIABILITIES 1992 Rs. 1993 Rs. ASSETS 1992 Rs. 1993 Rs.
Equity Share Capital 3,00,000 4,00,000 Goodwill 1,00,000 80,000

8% Redeemable Pref. 1,50,000 1,00,000 Land & Buildings 2,00,000 1,70,000
share capital
Capital Reserve 10,000 20,000 Plant 80,000 2,00,000
General Reserve 30,000 50,000 Investments 20,000 30,000
Profit & Loss a/c 30,000 48,000 Debtors 1,40,000 1,70,000
Proposed dividend 42,000 50,000 Stock 77,000 1,09,000
Sundry creditors 25,000 47,000 Bills receivable 20,000 30,000
Bills payable 20,000 16,000 Cash in hand 15,000 10,000
Expenses 30,000 36,000 Cash at bank 10,000 8,000
outstanding
Provision for tax 40,000 50,000 Preliminary expenses 15,000 10,000
Total 6,77,000 8,17,000 Total 6,77,000 8,17,000
Note:
1. A piece of land has been sold out in 1993 and the profit on sale has been
credited to capital reserve.
2. A machine has been sold for Rs. 10,000. The written down value of the
machine was Rs. 12,000. Depreciation of Rs. 10,000 is charged on Plant
account in1993.
3. Rs. 3,000 by way of dividend on investments is received. It includes Rs. 1,000
from pre-acquisition profit which has been credited to investment account.
4. An interim dividend of Rs. 20,000 has been paid in1993.
Solution:
175
Rs. Rs. CAPITAL
INCREASE DECREASE
CURRENT ASSETS:
DEBTORS 1,40,000 1,70,00 30,000 -
0
STOCK 77,000 1,09,00 32,000 -
0
BILLS RECEIVABLE 20,000 30,000 10,000 -
CASH IN HAND 15,000 10,000 - 5,000
CASH AT BANK 10,000 8,000 - 2,000
TOTAL (A) 2,62,000 3,27,00
0
SUNDRY LIABILITIES 25,000 47,000 - 22,000
BILLS PAYABLE 20,000 16,000 4,000 -
EXPENSES OUTSTANDING 30,000 36,000 - 6,000
TOTAL (B) 75,000 99,000
WORKING CAPITAL (A-B) 1,87,000 2,28,000 - -
INCREASE IN WORKINGCAPITAL 41,000 - - 41,000
2,28,000 2,28,000 76,000 76,000

WORKING NOTES FOR NON-CURRENT ITEMS:
LAND & BUILDINGS A/c

PARTICULARS Amount Rs. PARTICULARS Amount Rs.
To Balance b/d 2,00,000 By Bank (Sale) 40,000
To Capital reserve 10,000 By Balance c/d 1,70,000
(transfer of profit on sale)
2,10,000 2,10,000
176
INVESTMENTS A/c
To Balance b/d 20,000 By Dividends 1,000
To Bank (purchase Bal. Fig.) 11,000 By Balance c/d 30,000
31,000 31,000
PLANT A/c
To Balance b/d 80,000 By Bank (sale) 10,000
To Bank (purchase) (b/f) 1,42,000 By P&L A/c (Loss on sale) 2,000
By Depreciation 10,000
By Balance c/d 2,00,000
2,22,000 2,22,000

Net profit for the year (or) Closing balance of P & L 18,000
a/c
ADD: Non-operating expenses
Transfer to general reserve 20,000
Proposed dividend 50,000
Goodwill written off 20,000
Preliminary expenses written off 5,000
Loss on sale of plant 2,000
Depreciation on plant 10,000
Provision for tax 50,000 1,77,000
Total (A) 1,95000
177
LESS: Non-operating incomes
By dividend received 2,000
Total (B) 2,000
FUNDS FROM OPERATIONS (A-B) 1, 93,000
FUND FLOW STATEMENT FOR THE YEAR 1993

PARTICULARS Amount Rs. Amount Rs.
SOURCES OF FUNDS:
Issue of equity shares (4,00,000-3,00,000) 1,00,000
Sale of land 40,000
Sale of machinery 10,000
Dividend on investments (1,000+2,000) 3,000
Funds from operations 1,93,000
Total Sources (A) 3,46,000
APPLICATION OF FUNDS:
Preference shares redeemed (1,50,000-1,00,000) 50,000
Proposed dividend paid 42,000
Tax paid 40,000
Plant purchased 1,42,000
Interim dividend paid 20,000
Investments purchased 11,000
Total Applications (B) 3,05,000
Increase in Working Capital 41,000
4. From the following Balance Sheets of XYZ Ltd. prepare a Funds Flow Statement.
LIABILITIES 2005 2006 ASSETS 2005 2006
Rs. Rs. Rs. Rs.
Equity Share Capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
178
Preference share 1,50,000 1,00,000 Buildings 2,00,000 1,70,000
capital
General Reserve 40,000 70,000 Plant 80,000 2,00,000
P&L A/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed dividend 42,000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 Bills Receivable 20,000 30,000
Bills Payable 20,000 16,000 Cash in hand 15,000 10,000
Provision for taxation 40,000 50,000 Cash at bank 10,000 8,000
Total 6,77,00 8,17,00 Total 6,77,00 8,17,00
0 0 0 0
Additional Information:
(a) Depreciation: Plant – Rs. 10,000 & Buildings – Rs. 20,000 charged in2006.
(b) An interim dividend of Rs. 20,000 has been paid in2006.
(c) Income tax Rs. 35,000 was paid during 2006.
Solution: (Proposed dividend, interim dividend and provision for tax are
treated as non- current items)
Rs. Rs. CAPITAL
INCREASE DECREASE
CURRENT ASSETS:
DEBTORS 1,60,000 2,00,00 40,000 -
0
STOCK 77,000 1,09,00 32,000 -
0
BILLS RECEIVABLE 20,000 30,000 10,000 -
CASH IN HAND 15,000 10,000 - 5,000
CASH AT BANK 10,000 8,000 - 2,000
179
TOTAL (A) 2,82,000 3,57,00
0
CREDITORS 55,000 83,000 - 28,000
BILLS PAYABLE 20,000 16,000 4,000 -
TOTAL (B) 75,000 99,000
WORKING CAPITAL (A-B) 2,07,000 2,58,000 - -
INCREASE IN WORKINGCAPITAL 51,000 - - 51,000
Total 2,58,000 2,58,00 86,000 86,000

0
WORKING NOTES FOR NON-CURRENT TEMS:
BUILDINGS A/c
To Balance b/d 2,00,000 By Depreciation 20,000
By Sale of asset (b/f) 10,000
By Balance c/d 1,70,000
Total 2,00,000 Total 2,00,000
PLANT A/c
To Balance b/d 80,000 By Depreciation 10,000
To Bank (purchase) (b/f) 1,30,000 By Balance c/d 2,00,000
Total 2,10,000 Total 2,10,000
PROVISION FOR TAX A/c

Particulars Amount (Rs.) Particulars Amount
(Rs.)
To Bank (tax paid) 35,000 By balance b/d 40,000
180
To balance c/d 50,000 By P & L a/c (provision for 45,000
tax) (b/f)
Total 85,000 Total 85,000

Net profit for the year (or) Closing balance of P & L 18,000
a/c
ADD: Non-operating expenses
Transfer to general reserve 30,000
Proposed dividend 50,000
Goodwill written off 25,000
Depreciation on Buildings 20,000
Depreciation on plant 10,000
Provision for tax 45,000 2,00,000
Total (A) 2,18,000
LESS: Non-operating incomes NIL
Total (B) NIL
FUNDS FROM OPERATIONS (A-B) 2,18,000
FUNDS FLOW STATEMENT FOR THE YEAR 2006

PARTICULARS Amount Rs. Amount Rs.
SOURCES OF FUNDS:
Issue of equity shares (4,00,000-3,00,000) 1,00,000
Sale of land 10,000
Funds from operations 2,18,000
Total Sources of funds (A) 3,28,000
181
APPLICATION OF FUNDS:
Preference shares redeemed (1,50,000-1,00,000) 50,000
Proposed dividend paid 42,000
Tax paid 35,000
Plant purchased 1,30,000
Interim dividend paid 20,000
Total Application of funds (B) 2,77,000
Increase in Working Capital (A-B) 51,000
LEARNING OUTCOMES
 Analysis and Interpretation of Financial statements
 Short term solvency ratios and its interpretations
 Meaning of Du-point ratios
 Meaning of Common size statements
 Differentiate operating, investing and Financing activities
 Meaning of Cash and Cash flow statement
 Format of cash flow statement
 Objectives of Fund flow statement
 Preparation of statement showing Funds from Operation
Short answer Questions

1. Give the Meaning of Financial statement Analysis
2. Explain the Meaning of Ratio analysis
3. What is vertical analysis of financial statements?
4. Write the steps on calculation of Net Profit ratio.
5. Write a brief note on Comparative statements
6. Briefly explain the types of Comparative statements.
7. What do you mean by ‘Working Capital”?
8. Define Fund flow statement.
182
Long Answer Questions
1. What do you understand by Analysis and Interpretation of Financial statements?
2. Describe the different types of financial statement Analysis
3. What is Ratio analysis? Discuss its uses and Limitations?
4. Explain the procedure for preparing a Cash flow statement
PRACTICE PROBLEMS
1. From the following information, find out: (a) Current assets, (b) Current Liabilities (c)
Value of inventory. Current ratio = 3.5; Liquid ratio = 2.5; Working capital = Rs. 1, 00,000.
2. Calculate current ratio from the following: Current liabilities = Rs. 2, 00,000; Cash = Rs.
20,000; Debtors = Rs. 50,000; Inventories = Rs. 3, 00,000; Investments: Short-term = Rs.
30,000; Long-term = Rs. 80,000.
3. Calculate liquid ratio from the data given below:
Current assets = Rs. 2, 50,000; Inventories (included in current assets) = Rs. 30,000;
Prepaid expenses (included in current assets) = Rs. 20,000; Current liabilities = Rs. 80,000
4. Find out the debt equity ratio for 2007.Long term debt = Rs. 2, 50,000;
Share capital = Rs.4, 00,000; Retained earnings = Rs. 1, 00,000.
5. Calculate the Proprietary ratio from the following:
Balance Sheet
Liabilities Amount Rs. Assets Amount Rs.
Equity share capital 1,00,000 Fixed assets 1,25,000
183
Preference Share capital 50,000 Current assets 50,000
Reserves & Surplus 25,000 Investments 75,000
Debentures 60,000
Creditors 15,000
Total 2,50,000 Total 2,50,000
PRACTICE PROBLEMS
1. With the following ratios and further information given below, prepare a Trading A/c,
Profit & Loss A/c and a Balance Sheet of Raj Nair.
(i) Gross profit ratio – 25%
(ii) Net profit / Sales – 20%.
(iii) Stock turnover ratio – 10 times.
(iv) Net profit / Capital – 1/5
(v) Capital to total liabilities – 1/2
(vi) Fixed assets / Capital – 5/4
(vii) Fixed assets / Total current assets – 5/7
(viii) Fixed assets – Rs. 10,00,000.
(ix) Closing stock – Rs. 1, 00,000.
2. With the help of the following ratios regarding Jasmine Co. Ltd., draw the Balance Sheet
184
of the Company for the year 2005.
Current ratio – 2.5; Liquidity ratio – 1.5; Net working capital – Rs. 3,00,000; Stock turnover
ratio (cost of sales / closing stock) – 6 times; Gross profit ratio – 20%; Debt collection
period – 2 months; Fixed assets turnover ratio (on cost of sales) – 2 times; Fixed assets to
shareholders net worth – 0.80; Reserves and surplus to capital – 0.50.
3.Following are the balance sheets of Sangeetha Ltd a son31st March2020and2021.

Prepare a Comparative balance sheet.
Particulars 31stMarch2021 31stMarch2020
I Equity and
Liabilities Share
holders’s fund 1,50,000 1,00,000
Share capital 1,00,000 1,00,000
Reserve and Surplus

Non-Current Liabilities 80,000 20,000
Long Term borrowings(loan) 50,000 30,000
Current Liabilities(Tradepayables)
3,80,000 2,50,000
II Assets
3,00,000 2,00,000
Non-Current Assets
80,000 50,000
Fixed assets(Tangible)
Current Assets(TradeReceivables)
3,80,00 2,50,000
0
185
4.The following balance sheets of Harper steel ltd., are given for the years
ending 31st March1998 and1999: Prepare a Comparative Balance sheet
Liabilities 31stMarc 31stMarc Assets 31stMarc 31st

h1998 h1999 h1998 March19
99
Share Capital FixedAssets:Lan
:Equity d and 12,00,000 28,00,000
sharecapitalRe 20,00,000 40,00,000 buildingPlantand
servesandSur machineryFurnit 6,00,000 18,00,000
plus :Capital ure
reserveGeneral 1,00,000 2,00,000 andfixturesInves 2,00,000 3,00,000
reserve 6,00,000 5,00,000 tments:Subsidiar
Secured Loans y in X 1,00,000 1,00,000
:10%debentures 2,00,000 4,00,000 ltd.Immovablepr
CurrentLiabiliti opertiesCurrent 8,00,000 4,00,000
es assets:Cash
:Sundrycreditor 12,00,000 8,20,000 Book 2,00,000 20,000
s debtsStock–in- 6,00,000 2,00,000
trade 4,00,000 3,00,000
TOTAL 41,00,000 59,20,000 TOTAL 41,00,000 59,20,000
5.From the following information Calculate Cash Flow from operating activities
Particulars Amount
2,00,000
Cash sales
60,000
Cash received from customers
186
50,000
Cash purchases
38,000
Cash paid to supplier of goods
20,000
Commission received
14,000
Office expenses paid
6,000
Selling expenses
28,000
Salaries paid
24,000
Income tax paid
6.From the summary Cash Account of Sunny Ltd., prepare Cash Flow statement for the
year ended 31st March 2016 in accordance with AS 3 (Revised ) using the direct
method. The company does not have any cash equivalents. Summary of Cash Account
(For the year ended 31.3.2016)
Particulars ‘000(Rs) Particulars ‘000(Rs)

Balance on 100 Payment of 4000
1.4.2016 suppliers
Issue of equity 600 Purchase of Fixed 400
shares assets
Receipt from 5600 Overhead 400
customers expenses
Sale of fixed assets 200 Wages and 200
Salaries
Taxation 500
Dividend 100
187
Repayment of 600
bank loan
Balance on 300
31.3.2016
6500 6500
7.Following are the comparative Balance Sheets of Somu and Co. Ltd.
Liabilities 31.12.2000 31.12.2001 Assets 31.12.2000 31.12.2001

Rs. Rs. Rs. Rs.
Share capital 70,000 74,000 Cash 9,000 7,800
Provision for 700 800 Trade debtors 14,900 17,700
doubtful (good)
debts
Trade 10,360 11,840 Stock in trade 49,200 42,700
creditors
Debentures 12,000 6,000 Goodwill 10,000 5,000
P&L A/c 10,040 10,560 Land 20,000 30,000
Total 1,03,100 1,03,200 Total 1,03,100 1,03,200
(a) Dividends were paid totallingRs. 3,500.
(b) Land was purchased for Rs. 10,000 and amount provided for amortization of
goodwill totalledRs. 5,000.
(c) Debenture loan was repaid Rs. 6,000.
You are required to prepare Cash Flow Statement
8.Malar Ltd. furnish you the following Balance Sheets for the year 1985 and 1986. You are
required to prepare a cash flow statement for the year 1986.
188
Liabilities 1985 1986 Rs. Assets 1985 1986
Rs. Rs. Rs.
Share capital 20,000 20,000 Goodwill 2,600 2,400
General reserve 2,800 3,600 Land at cost 7,800 7,200
Profit & Loss A/c 3,200 2,600 Buildings at cost 7,900 8,000
Prvsn for 500 800 Investments (long – 2,000 2,200
depreciation on term)
buildings
Sundry creditors 1,600 1,080 Inventories 6,000 4,680
Outstanding 240 160 Accounts receivable 4,000 4,440
expenses
Bills payable 80 120 Bank balance 1,320 3,040
Provision for tax 3,200 3,600
Total 31,260 31,960 Total 31,260 31,960
9. Calculate Funds from operations from the following Profit and Loss account
Profit and Loss account
Particulars Rs Particulars Rs
To expenses paid 3,00,000 By Gross Profit 4,50,000
To Depreciation 70,000 By Gain on sale of 60,000
Land
To Loss on sale of Machine 4,000
To Discount 200
To Goodwill 20,000
To Net profit 1,15,800
5,10,000 5,10,000
189
10.Babu and Co., presents the following Financial statement for the year 1988 and 1999.
Prepare a Source and Application of Funds:
Balance Sheet
Liabilities 1988 1989 Assets 1988 1989

Bills payable 4,52,000 6,28,000 Cash 1,06,000 62,000
Creditors 8,26,000 12,54,000 Investment 1,74,000 ---
Loan from 2,00,000 4,70,000 Debtors 6,92,000 10,56,000
Bank
Reserves and 13,84,000 17,28,000 Stock 8,64,000 13,66,000
surplus
Share capital 12,00,000 12,00,000 Net Fixed 22,26,000 27,96,000
assets
40,62,000 52,80,000 40,62,000 52,80,000
Depreciation of Rs. 3, 78,000 was written off for the year 1989 on fixed assets.
190
UNIT III
Contents
LEARNING OBJECTIVES.................................................................................. 192
3.1 COST ACCOUNTS - CLASSIFICATION OF COSTS ................. 192
3.2 JOB COST SHEET.............................................................................. 201
3.3 PRACTICAL PROBLEMS IN JOB COSTING .............................. 205
3.4 INTRODUCTION TO PROCESS COSTING ................................ 213
3.5 PRACTICE PROBLEMS IN PROCESS COSTING ..................... 219
3.6 JOINT PRODUCT AND BY PRODUCTS ..................................... 230
3.7 PRACTICAL PROBLEMS ON JOINT PRODUCT AND BY

PRODUCTS................................................................................................. 236
3.8 ACTIVITY BASED COSTING AND TARGET COSTING ......... 244
LEARNING OUTCOMES: .................................................................................. 252
Short Answer Questions ................................................................................. 252
Long answer questions ................................................................................... 253
191
LEARNING OBJECTIVES
 Understand the and define the terms Costing and Cost accounting
 Understand the costing procedure.
 Understand the meaning of Process costing and to know the type of
industries in which this method of Costing is used
 Understand the methods of preparing process accounts
 Understand what are subsequent costs
 Learn how to deal with the subsequent costs
 Learn about Traditional costing and its limitations
 Learn about what is Target costing and its applications.
3.1 COST ACCOUNTS - CLASSIFICATION OF COSTS
MEANING OF COST ACCOUNTING
Cost accounting has primarily developed to meet the needs of management. Profit and
loss and Balance sheet are presented to the management by the financial accountant. But
modern management needs much more detailed information than those supplied by these
financial statements. Cost accounting provides detailed cost information to various levels of
management for efficient performance of their functions. The information provided by cost
accounting acts as a management tool for decision making , to optimize the utilization of
scarce resources and ultimately add to the profitability of business by controlling
expenditure under various heads.
Definition of Costing:
The Chartered Institute of Management Accountants (CIMA), London has defined

costing as, “The techniques and processes of ascertaining costs”.
Wheldon has defined costing as, “The proper allocation of expenditure and involves
the collection of costs for every order, job, process, service or unit.”
192
Objectives and functions of Cost Accounting
 Ascertainment of cost and profit

 Cost control and Cost reduction
 Guide to business policy
 Determination of selling price
MEANING OF COST:
The term cost does not have a definite meaning and its scope is extremely broad and
general. It is therefore not easy to define or explain the term without leaving any doubt
concerning its meaning.
According to the Oxford dictionary, cost means “The price paid for something”.
According to W M Harper, “A cost is the value of economic resources used as a

result of producing or doing the things costed”.
Cost Centre:
A cost centre refers to a section of the business to which costs can be charged. It may
be a location (department, a sales area), an item of equipment (a machine, a delivery
van), a person (a salesman, a machine operator) or a group of these (two automatic
machines operated by one workman).
Cost Unit:
According to the Institute of Cost Accountants of India (ICAI),“Cost unit is a form

of measurement of volume of production or service. For example, in a sugar mIll, the
cost per tonne of sugar may be ascertained, in a textile mill the cost per metre of cloth
may be ascertained. Thus a ‘tonne‘of sugar and a ‘metre’ of cloth are cost units.
Examples of cost units in various industries are given below;
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Industry / Business Cost unit
Cement/ Sugar/ Steel Tonne
Chemicals Tonne, Kilogram,liters, gallon
Bricks 1000 bricks or 500 bricks
Soft drink Crate of 24 bottles or 12 bottles
Nursing home/ Hospital Bed epr day/ Out patient
Interior decoration Each job
Flour Tonne
Shoes Pair or dozen pairs
Pencils Dozen or gross
Electricity Kilowatt hours(KWH)
Transport Passenger kilometer/ tonne

kilometer
Car Each car
Paper Ream
194
Printing press Thousand copies
Cotton or jute Bale
Building construction Each building or flat
Timber Cubic foot
Mines Tonne of mineral
Hotel Room per day
Gas Cubic foot/ cubic meter
Education Student
Petroleum Barrel/ tonne/ liter
Cost Object:
It may be defined as” anything for which a separate measurement of cost may be
desired”. A cost object includes a product, service, cost center, activity, sub-activity,
contract, customer or distribution channel or any other unit in relation to which costs
are ascertained.
METHODS OF COSTING:
1. Job order costing

2. Contract costing
3. Batch costing
195
4. Process costing
5. Operation costing
6. Single, output or unit costing
7. Operating or service costing
8. Multiple or composite costing
Classifications of Cost:
Classification is the process of grouping costs according to their common characteristics.
1. Classification into Direct and Indirect costs
Costs are classified into direct costs and indirect costs on the basis of their
identifiability with cost units or jobs or processes or cost centers.
Direct costs: These are costs which can be easily and conveniently identified with a
unit of product or other cost object.
E.g. Wages paid to a tailor in a readymade garments company for stitching a pair of
trousers is a direct cost because it can be easily identified in the cost of that garment.
Indirect costs: These are general costs and are incurred for the benefit of a number
of cost units, processes or departments. These costs cannot be easily and conveniently
identified with a unit of product or other cost object. E.g. depreciation on a machine for
stitching a pair of trousers cannot be shown and thus it is an indirect cost.
2. Classification into Fixed and Variable costs
Certain costs change in sympathy with production level while other costs remain
unchanged.
Fixed costs: These costs remain constant in “Total” amount over a specific range of
activity for a specified period of time. E.g. Building rent and managerial salaries remain
constant and do not change in output level and thus are fixed costs.
Variable costs: These costs tend to vary in direct proportion to the volume of output.
In other words, when volume of output increases, total variable cost also increases, and
196
vice versa, when volume of output decreases, total variable cost also decreases, but the
variable cost per unit remains fixed.
Semi- variable or semi- fixed costs (Mixed costs): These costs include both a fixed
and a variable component, these are partly fixed and partly variable at any level of
output. E.g. the introduction of additional shifts in the factory will require additional
supervisors and certain costs will increase by steps. In the case of telephone connection,
there is a minimum rent and beyond a specified number of calls, the charges vary
according to the number of calls made.
3. Classification into committed and discretionary costs :
It is explained above that costs may be classified into fixed and variable. Fixed costs
are further classified into committed costs and discretionary costs. This classification is
based on the degree to which a firm is locked into an asset or service that is generating
the fixed cost.
Committed Costs: These are those costs that are incurred in maintaining physical
facilities and managerial setup. Such costs are committed in the sense that once the
decision to incur them has been made, they are unavoidable and invariant in the short
run.
E.g. Salary of the managing director may represent a committed cost if, by policy, the
managing director is not to be relieved unless the firm is liquidated. Similarly,
depreciation of plant and equipment is committed because these facilities cannot be
easily changed in the short run.
Discretionary Costs: These are those costs which can be avoided by management
decisions. Such costs are not permanent. Advertising, research and development cost
and salaries of low level managers are examples of discretionary costs because these
costs may be avoided or reduced in the short run, if so desired by the management.
4. Classification into Product costs and Period costs:
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Product costs: These are those costs which are necessary for production and
which will not be incurred if there is no production. These consist of direct materials,
direct labor and some of the factory overheads. Product costs are absorbed by it
attached to the units produced. These are called inventoriable costs because these are
included in the cost of the product as work-in-progress, finished goods or cost of sales.
Period costs: These are those costs which are not necessary for production and are
incurred if there is no production. These are written off as expenses in the period in
which these are incurred. Such costs are incurred for a time period and are charged to
the Profit and Loss account of the period. Showroom rent, salary of company executives,
travel expenses etc are examples of period costs. Administration and selling expenses
are generally treated as period costs.
5. Classification into controllable and Non- controllable costs:
From the point of view of controllability, costs are classified into controllable costs
and non- controllable costs.
Controllable costs: These are costs which may be directly regulated at a given level
of management authority. Variable costs are generally controllable by department
heads. E.g. the cost of raw material may be controlled by purchasing larger quantities.
Non- Controllable costs: These are those costs which cannot be influenced by the
action of a specified member of an enterprise. For example, it is very difficult to control
costs like factory rent, managerial salaries, etc.
6. Classification into Historical costs and Predetermined costs
On the basis of time commutation, costs are classified into historical costs and
predetermined costs.
Historical Costs: These are the costs which are ascertained after these have been
incurred. Historical costs are thus, nothing but actual costs. These costs are not available
until after the completion of the manufacturing corporations.
198
Predetermined Costs: These are future costs which are ascertained in advance of
production on the basis of a specification of all the factors affecting cost. These costs are
extensively used for the purpose of planning and control.
7. Classification into Normal and Abnormal costs:
Normal Coat may be defined as a cost which is normally incurred at a given level of
output. This cost is a part of cost of production.
Abnormal cost is that which is not normally incurred at a given level of output. Such cost
is over and above the norm cost and is not treated as a part of the cost of production. It
is charged to Costing profit and loss account.
COMPONENTS OF TOTAL COST
1.Prime cost
It consists of direct materials, direct labour and direct expenses. It is also known as
basic, first or flat cost.
2. Factory cost
It comprises prime cost and in addition, works or factory overheads which include
costs of indirect materials, indirect labour and indirect expenses incurred in the factory.
This cost is also known as Works cost, production or manufacturing cost.
3. Office cost
If office and administration overheads are added to factory cost, office cost is
arrived at. This is also termed as administration cost or the total cost of production.
4. Total cost
Selling and distribution overheads are added to the total cost of production to get
the total cost or the cost of sales.
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COST SHEET
It is a document which provides for the assembly of the estimated detailed cost in
respect of cost centers and cost units. It analyzes and classifies in a tabular form the
expenses on different items of a particular period. Additional columns may be provided
to show the cost of a particular unit pertaining to each item of expenditure and the total
per unit of cost
FORMAT OF A COST SHEET
Particulars ₹ ₹
Opening stock of raw materials
Add: Purchases
Less: Closing stock of raw materials
i)Value of Raw materials consumed
Direct expenses
Wages paid
ii)Prime cost
Add: Factory/ works overheads
Add: Opening work in progress
200
Less: Closing work in progress
iii)Factory/ Works cost
Add: Administration/ office overheads
iv) Cost of production of goods manufactured
Add: Opening stock of finished goods
Less: Closing stock of finished goods
v) Cost of production of goods sold
Add: Selling and distribution of overheads
vi) Cost of sales
vii) Profit
vii) Sales
3.2 JOB COST SHEET
All industries may be broadly classified into two categories:
1. Job order industries

2. Mass production industries
201
In Job order industries, production work is done against orders from customers. Each
job needs special treatment and can be clearly distinguished from other jobs. Each job is
completed as per customer’s specifications. Examples of job order industries are printing
press, construction of buildings, bridges, roads, ship building.
Meaning of Job Costing: Job Costing or Job order costing is a method of cost
ascertainment used in job order industries. Special features of such industries are as
follows:
1. Production is against customer’s orders and not for stocks.

2. Each job has its own characteristics and requires special attention.
3. The flow of production from one department to another is not uniform. It is the
nature of the job which determines the department through which it is to be
processed.
Job Costing is used in:
 Printing press
 Automobile repair shop
 Interior decoration
 General engineering
 Machine tools, etc.
Objectives of Job Costing:
1. Cost of each job/order is ascertained separately. This helps in finding out the
profit or loss on each individual job.
2. It enables the management to know which jobs are more profitable and those
which are unprofiitable.
3. It provides a basis for determining the cost of similar jobs undertaken in future.
4. It thus helps in future production planning.
5. It helps the management in controlling costs by comparing the factual costs with
the estimated costs.
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Job Costing Procedure:
The following steps are taken in Job costing:
1. Job Number: When an order has been accepted, an individual job number must be
assigned to each job so that separate jobs are identifiable at all stages of production.
Assignment of job numbers also facilitates reference for costing purposes in the ledger
and is conveniently short for use on various forms and documents.
2. Production Order: The production control; department then makes out a

production order, thereby authorizing to start work on the job. Several copies of the
production order are prepared, the copies often being in different colors to distinguish
between them easily. Theses copies are passed on to the following:
i) All departmental foremen concerned with the job
ii) Storekeeper for issuance of materials
iii) Tool room for an advance notification of tools required.
3. Job Cost Sheet:The unique accounting document under job costing is the job cost
sheet. Receipt of production order is the signal for the cost accountants to prepare a
job cost sheet on which he will record the cost of materials used and the labor and
machine time taken. Each concern has to design a job cost sheet to suit its needs.
Job cost sheets are not prepared for specified periods but they are made out for each
job regardless of the time taken for its completion. However, materials, labour and
overheads costs are posted periodically to the relevant cost sheet.
The following is the Proforma of the Job cost sheet.
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JOB COST SHEET
Customer —---------------- Job No. —-------

--
Date of Commencement—-------- Date of

Completion___________
Material cost Labour cost Factory overheads

(Absorbed)
Dat Material Amt. Dat Hour Rat A Dept. Ho Rate Amt.

e Req. No. e s e m urs
₹ ₹ ₹
t
₹
.
Total Total Total
Profit/Loss Cost summary
₹ Material ₹
Price quoted Labour
Less: Cost Prime cost
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—----------------------------------------------------- Factory overhead
Profit Or loss Works cost
Admn. Overheads
Cost of production
Selling andDistn. Overhead
Total cost
3.3 PRACTICAL PROBLEMS IN JOB COSTING
PROBLEM 1:
The following direct costs were incurred on Job no. 415 of Standard Radio Company:
Materials ₹6,010
Wages:
Dept: A - 60 hours @ ₹30 per hour
B- 40 hours @ ₹20 per hour
C- 20 hours @ 50 per hour
Overheads for these departments were estimated as follows:
Variable overheads: Dept:
A - ₹15,000 for 1,500 labour hours
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B - ₹4,000 for 200 labour hours
C- ₹12,000 for 300 labour hours
Fixed overheads: Estimated at ₹40,000 for 2,000 normal

working hours
You are required to calculate the cost of Job no. 415 and calculate the price to give a
profit of 25% on selling price.
SOLUTION:
Job Cost sheet
Job No.415
Particulars ₹` ₹
Direct materials 6,010
Wages - Dept.
A - 60 hours *₹30 1,800
B- 40 hours *₹20 800
C- 20 hours *₹50 1,000 3,600
Variable overheads :
206
Dept: A- 60 hours ₹10 600
B- 40 hours @₹20 800
C- 20 hours @₹40 800 2,200
Fixed overheads 120 hours ₹20 per hour 2,400
Total cost 14,210
Pofit (25% of sales or ⅓ total 4,737

cost)
Selling price 18,947
Working Notes:
1. Variable overheads: Dept. A - ₹15000 / 1,500 hours = ₹10 per hour

B - ₹4,000/200 hours = ₹20 per hour
C- ₹40,000/2,000 hours = ₹20 per hour
2. Fixed overheads : ₹40,000/2000 hour s= ₹20 per hour

3. Total hours worked on the job = 60+40+20 = 120 hours
PROBLEM 2:
M Engineering Co., engaged in job work, has completed all jobs in hand on
30.12.32009, except Job no. 447. The cost sheet on 30 th December showed director
materials and direct labour costs of ₹40,000 and ₹30,000 respectively, as having been
incurred on Job no.447.
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The costs incurred by the business on 31.12.2009, the last day of the accounting year
were as follows:
Particulars ₹
Direct materials ( Job no.447) 2,000
Direct labour 8,000
Indirect labour 2,000
Miscellaneous factory overheads 3,000
It is the practice of the business to make the jobs absorb factory overheads
on the basis of 120% of direct labourcost. Calculate the cost of work-in -progress of
Job no.447 on 31.12.2009.
SOLUTION:
Cost of Work-in -Progress of Job no. 447
As on 31.12.2009
Particulars ₹
Direct materials (40,00+ 2,000) 42,000
Direct labour (30,000+8,000) 38,000
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Prime cost 80,000
Add: Factory overheads (38,000*120%) 45,600
Works cost 1,25,600
PROBLEM 3:
A shop floor supervisor of a small factory presented the following cost for job
no. 303 to determine the selling price:
Per unit ₹
Materials 70
Direct wages 18 hours @ ₹2.50 45
(Dept. X -8 hours, Dept., Y -6 hours ,

Dept. Z -4 hours )
Chargeable expenses (Special stores 5

items)
120
Add: 331/3% for expenses 40
Total cost 160
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Analysis of the Profit and Loss account for 2010 shows the following:
₹ ₹
Materials used 1,50,000 Sales less returns 2,50,000
Direct wages :
Dept. X -10,000
Y - 12,000
Z - 8,000 30,000
Special stores items
4,000
Works overheads :
Dept. X – 5,000
Y- 9,000
Z- 2,000
16,000
Works cost 2,00,000
Gross profit c/d 50,000
2,50,000 2,50,000
210
Selling expenses 20,000 Gross profit b/d 50,000
Net profit 30,000
50,000 50,000
It is also noted that average hourly rates for the 3 departments, X, Y and Z are
similar. You are required to:
1. Draw up a Job cost sheet

2. Calculate the entire revised cost using 2010 actual figures as basis.
3. Add 20% to the total cost to determine the selling price.
SOLUTION:
Job Cost sheet
Job No. 303
Particulars Rate Amt.
₹ ₹
Materials 70.00
Direct wages
20.00
Dept. X - 8 hours 2.50
15.00
Y- 6 hours 2.50
211
Z - 4 hours 2.50 10.00
Chargeable expenses 5.00
Prime cost 120.00
Works overheads
Dept. X- 8 hours 1.250 10.00
Y- 6 hours 1.875 11.25
Z - 4 hours 0.625 2.50
Works cost 143.75
Selling overheads (10% on works 14.38

cost)
Profit on 20% on total cost 31.63
Selling price 189.76
Working Notes:
1. Works overheads have been charged on direct labour hour rate basis. Number of
hours worked in each departments have been ascertained by dividing the direct
wages in each department by the labour hour rate as shown below:
Dept. X - ₹ 10,000/₹2.50 = 4,000 hours
Y- ₹12,000/₹2.50 = 4,800 hours
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Z- ₹8,000/₹2.50 = 3,200 hours
2. Overhead rates are calculated as follows:

Dept. X = Overheads / No. of hours = 5,000/4,000= ₹1.25 per hour
Y= 9,000/4,800=₹1.875 per hour
Z= 2000/3,200= ₹0.625 per hour
3. Selling overheads are charged at 10% on works cost as calculated below:

Selling Overheads / Works cost = ₹20,000/2, 00,000 *100= 10%.
3.4 INTRODUCTION TO PROCESS COSTING
MEANING
Process costing is a form of operations costing which is used where standardized

homogeneous goods are produced. This costing method is used in industries like chemicals,
textiles, steel, rubber, sugar, shoes, petrol etc. Process costing is also used in the assembly
type of industries. It is assumed in process costing that the average cost presents the cost
per unit. Cost of production during a particular period is divided by the number of units.
Definition: CIMA London defines process costing as “That form of operation costing
which applies where standardized goods are produced”
Features of Process Costing
 The production is continuous

 The product is homogeneous
 The process is standardized
 Output of one process becomes the raw material of another process
 The output of the last process is transferred to finished stock
 Costs are collected process-wise
 Both direct and indirect costs are accumulated in each process
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 If there is a stock of semi-finished goods, it is expressed in terms of equivalent
units
 The total cost of each process is divided by the normal output of that process
to find out the cost per unit.
Advantages of Process costing
 Costs are computed periodically at the end of a particular period

 It is simple and involves less clerical work that job costing
 It is easy to allocate the expenses to processes in order to have accurate costs.
 Use of standard costing systems is very effective in process costing situations.
 Process costing helps in preparation of tender, quotations
 Since cost data is available for each process, operation and department, good
managerial control is possible.
Limitations
 The cost obtained at each process is only a historical cost and is not very
useful for effective control.
 Process costing is based on an average cost method, which is not that suitable
for performance analysis, evaluation and managerial control.
 Work-in-progress is generally done on an estimated basis which leads to
inaccuracy in total cost calculations.
 The computation of average cost is more difficult in those cases where more
than one type of product is manufactured and a division of the cost element is
necessary.
 Where different products arise in the same process and common costs are
proportional to various cost units. Such individual products' costs may be
taken as only approximations and hence not reliable.
214
Process Costing is applicable in
1. Textile Mills
2. Chemical works
3. Oil Refining
4. Cement manufacture
5. Paper manufacture
6. Food processing
7. Steel Mills
8. Paint manufacture
9. Soap Making
10. Sugar works
11. Confectionaries
12. Plastic manufacture
PROCESS COSTING AND JOB COSTING - A COMPARISON
Process costing Job costing
Costs are compiled process-wise and cost per unit Costs are separately ascertained for
is the average cost i.e., the total cost of the process each job, which is cost unit
divided by the number of units produced.
Production is of standardized products and cost Production is of non- standard items

units are identical with specifications and instructions
from the customers.
Production is for stocks Production is against orders from

customers
Costs are computed a t the end of a specific period Costs are calculated when a job is
completed.
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The cost of one process is transferred to the next The cost of a john is not transferred to
process in the sequence. another job but to the finished stock
account.
On account of the continuous nature of There may or may not be work-in-

production, work- in-progress in the beginning progress in the beginning and end of
and end of the accounting period is a regular the accounting period.
feature.
Cost control is comparatively easier. This is Cost Control is comparatively more

because factory processes and products are difficult because each cost unit or job
standardized. needs individual attention
COSTING PROCEDURE
For each process an individual process account is prepared. Each process of

production is treated as a distinct cost centre.
Items on the Debit side of Process A/c.
Each process account is debited with – a) Cost of materials used in that process. b)
Cost of labour incurred in that process. c) Direct expenses incurred in that process. d)
Overheads are charged to that process on some predetermined level. e) Cost of ratification
of normal defects. f) Cost of abnormal gain (if any arises in that process)
Items on the Credit side: Each process account is credited with a) Scrap value of
Normal Loss (if any) occurs in that process. b) Cost of Abnormal Loss (if any occurs in that
process)
Cost of Process: The cost of the output of the process (Total Cost less Sales value of
scrap) is transferred to the next process. The cost of each process is thus made up of cost
brought forward from the previous process and net cost of material, labour and overhead
added in that process after reducing the sales value of scrap. The net cost of the finished
216
process is transferred to the finished goods account. The net cost is divided by the number
of units produced to determine the average cost per unit in that process.
Process I Account
Particulars Units Rs. Particulars Units Rs.

To Direct Materials XX XX By Normal Loss XX XX
To Direct Labour XX XX By Abnormal Loss XX XX
To Direct expenses XX XX By Process II a/c (Output transferred to XX XX
next Process)
To Production XX XX XX XX
Overheads
To Abnormal gain XX XX XX XX
XX XX XX XX
Process Losses: In many processes, some loss is inevitable. Certain production

techniques are of such a nature that some loss is inherent to the production. Wastage of
material, evaporation of material is unavoidable in some processes. But sometimes the
losses are also occurring due to negligence of labourers, poor quality raw material, poor
technology etc. These are normally called as avoidable losses. Basically process losses are
classified into Two Categories (a) Normal Loss (b) Abnormal Loss
1. Normal Loss: Normal loss is an unavoidable loss which occurs due to the inherent
nature of the materials and production process under normal conditions. It is normally
estimated on the basis of past experience of the industry. It may be in the form of normal
wastage, normal scrap, normal spoilage, and normal defectiveness. It may occur at any
time of the process. No of units of normal loss: Input x Expected percentage of Normal
Loss. The cost of normal loss is a process. If the normal loss units can be sold as scrap
then the sale value is credited to the process account. If some rectification is required
before the sale of the normal loss, then debit that cost in the process account. After
217
adjusting the normal loss the cost per unit is calculated with the help of the following
formula:
Cost of a good unit:
Total cost increase – Sale Value of Scrap Input – Normal Loss units.
2. Abnormal Loss Any loss caused by unexpected abnormal conditions such as plant
breakdown, substandard material, carelessness, accident etc. such losses are in excess of
predetermined normal losses. This loss is basically avoidable. Thus abnormal losses
arrive when actual losses are more than expected losses. The units of abnormal losses
are calculated as under:
Abnormal Losses = Actual Loss – Normal Loss
The value of abnormal loss is done with the help of following formula:
Value of Abnormal Loss =
Total Cost increase – Scrap Value of normal Loss x Units of abnormal loss
Input units – Normal Loss Units
Abnormal Process loss should not be allowed to affect the cost of production as it is
caused by abnormal (or) unexpected conditions. Such loss representing the cost of
materials, labour and overhead charges is called an abnormal loss account. The sales
value of the abnormal loss is credited to the Abnormal Loss Account and the balance is
written off to Costing P & L A/c.
3. Abnormal Gains
The margin allowed for normal loss is an estimate (i.e. on the basis of expectation in
process industries in normal conditions) and slight differences are bound to occur between
the actual output of a process and that anticipated. This difference may be positive
or negative. If it is negative it is called an abnormal loss and if it is positive it is abnormal
gain i.e. if the actual loss is less than the normal loss then it is called an abnormal gain. The
value of the abnormal gain is calculated in the same manner as the abnormal loss. The
formula used for abnormal gain is:
218
Abnormal Gain
Total Cost incurred – Scrap Value of Normal Loss x Abnormal Gain

Unites Input units – Normal Loss Units
The sales values of abnormal gain units are transferred to the Normal Loss
Account since they arrive out of the savings of Normal Loss. The difference is
transferred to Costing P & L A/c. as a Real Gain.
3.5 PRACTICE PROBLEMS IN PROCESS COSTING
PRACTICE QUESTION 1:
A Product passes through three distinct processes to completion. These processes

are numbered respectively, 1, 2 and 3. During the week ended 21 st January, 1000 units
were produced. The following information is obtained:
Process I Process II Process III
₹ ₹
Materials 6000 3000 2000
Labour 5000 4000 5000
Direct expenses 1000 200 1000
219
The indirect expenses for the period were ₹2800, apportioned to the processes on
the basis of labour cost. Prepare Process cost accounts showing the total cost and cost per
unit.
SOLUTION:
Process I Account
Per unit Total Per unit Total
₹ ₹ ₹ ₹
To Materials 6 6000 By Output 13 13000

transferred
to Process II
To Labour 5 5000
To Direct 1 1000
expenses
To Indirect 1 1000
expenses *
13 13000 13 13000
* Indirect expenses as a % of Labour= 2800 —------------------------------- *100
5000+4000+5000
= 2800 —-------- *100=20% 14000
220
Process II Account
₹ ₹ ₹ ₹
To Process 13.00 13000 By Output 21.00 21000

I(Transfer) transferred
to Process
III
To 3.00 3000
Materials
To Labour 4.00 4000
To Direct 0.20 200

expenses
To Indirect 0.80 800

expenses
21.00 21000 21.00 21000
221
Process III Account
₹ ₹ ₹ ₹
To Process 21 21000 By Output 30 30000

II transferred
(Transfer) to Process
III
To 2 2000
Materials
To Labour 5 5000
To Direct 1 1000
expenses
To Indirect 1 1000
expenses
30 30000 30 30000
222
Finished stock Account
Units Total
To Process 1000 30000

III
(Transfer)
PROCESS LOSSES AND WASTAGES
PRACTICE QUESTION 2:
The following information is given in respect of Process A:
Materials 1000 kgs @₹6 per

kg.
Labour ₹5000
Direct expenses ₹1000
Indirect expenses allocated to Process A ₹1000
Normal wastage 10% of input
Prepare Process A Account when i) Scrap value of normal loss is nil ii) Scrap value of
normal loss has a sale value of ₹1 per unit.
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SOLUTION:
i) Scrap value of normal loss is nil
Process I Account
kgs ₹ kgs ₹
To 1000 6000 By Normal 100 -

Materials loss
To Labour 5000 By transfer to 900 13000

Next process
To Direct 1000
expenses
To Indirect 1000
expenses
1000 13000 1000 13000
Cost per unit = ₹13000
—-------- = ₹14.44 per unit
900 units
ii) Scrap value of normal loss has a sale value of ₹1 per unit.
224
Process I Account
kgs ₹ kgs ₹
To 1000 6000 By Normal 100 100

Materials loss
To Labour 5000 By transfer 900 12900

to Next
process
To Direct 1000
expenses
To Indirect 1000
expenses
1000 13000 1000 13000
Cost per unit = ₹12900
—-------- = ₹14.33 per unit
900 units
Note: Whenever any value is realized from the sale of normal wastage, it reduces the cost
to that extent.
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PRACTICE QUESTION 3
A product passes through three processes A, B and C. The normal wastage of each
process is as follows: Process A - 3%, B- 5% and C - 8%. Wastage of process A was sold at
0.25 paise per Unit., htat of B at .50 paise per unit and that of C at ₹ 1 per unit.
10000 units were issued to process A in the beginning of October 2020 at a cost of ₹
1 per unit. The other expenses were as follows:
Process A Process B Process C ₹
₹ ₹
Sundry materials 1000 ₹ 1500 ₹ 500
Labour 5000 8000 6500
Direct expenses 1050 1188 2009
Actual output (Units) 9500 9100 8100
Prepare the Process accounts, assuming that there were no opening and closing
stocks. Also prepare the abnormal loss and abnormal gain accounts.
SOLUTION:
Process A account
Units ₹ Units ₹
To Units 10000 10000 By Normal 300 75

loss (3% of
226
introduced 10000)@0.2
5
To Sundry 1000 By Abnormal

200 328.35*
materials loss
To Labour 5000 By Process B 9500 15596.65
10000 16000 10000 16000
*Value of Abnormal loss= 16000- ₹75
—-------------------- * 200 units =₹ 328.35
10000-300 units
Process B account
Units ₹ Units ₹
To Process A 9500 15596.6 By Normal loss (5% of 475 238

5 9500)@.50
To Sundry 1500 By Process C

9100 26192.52
materials
To Labour 8000
To Direct 1118
expenses
227
To Abnormal
75 215.87*
gain
26430.5
9575 9575 26430.52
2
*Abnormal gain =₹26214.65-₹238
—----------------- * 75= ₹215.87
9500-475 units
Process C account
Units ₹ Units ₹
To Process B 9100 26192.5 By Normal loss (8% of 728 728

2 9100)@1.00
To Sundry 500 BY Abnormal loss

272 1120.01*
materials
To Labour 6500 By Finished goods 8100 33353.51
To Direct 2009
expenses
9100 35201.5
9100 35201.52
2
228
*Abnormal loss = ₹35201.52 - ₹728
—-------------------- *272 units= ₹1120.01
9100-728 units
Abnormal Loss Account
By Sale of scrap in
200 50
To Process A 200 350 Process A @0.25
272 272
Process C @1.00
By Profit and Loss

To Process C 272 1120.01 1148.01
account(B/F)
472 1470.01 472 1470.01
Abnormal Gain Account
Units ₹ Units ₹
To Normal
loss a/c
(shortfall in 75 38 By Process B 75 215.87

the sale of
normal
wastage @
229
0.50 per unit)
To Profit and
180.87
Loss a/c (B/F)
75 215.87 75 215.87
3.6 JOINT PRODUCT AND BY PRODUCTS
JOINT PRODUCTS:
The term joint products are used for two or more products of almost equal
economic value, which are simultaneously produced from the same manufacturing process
and the same raw material. Joint products thus represent two or more products separated
in the course of processing, each product being in such proportion and of such economic
significance that no single one of them can be regarded as the main product.
Characteristics:
1. Joint products are produced form the same raw material in natural
proportions.
2. They are produced simultaneously by a common process
3. They are comparatively of almost equal value
4. Joint products may be saleable after separation or may be further processed
by incurring additional costs to make them saleable or an improved product.
A classic example of joint products is found in oil refining, where items like petrol,
diesel, naphtha and kerosene are produced from the crude oil. Other examples are in flour
mills, where joint products are white flour, brown flour and animal feeding stuff.
230
Joint products and Co-products:
Co - products refer to more than one product being manufactured by a company but
need not necessarily arise from the same raw materials and manufacturing process and the
quantity of each co-product can be changed by the management. For example, in a bakery
the various co-products are bread, cake, biscuits etc. and the quantity of each such product
may be changed by the management as per needs. On the other hand, in joint products the
quantity of products cannot be changed at will without changing the quantity of other
products.
Examples of Joint products:
Industry Joint products
Oil refining Petrol, diesel, kerosene, grease, lubricating

oils, etc.
Dairy Skimmed milk, butter
Mining Several metals from the same ore , e.g.,

copper, silver, zine etc.
JOINT COSTS AND SUBSEQUENT COSTS
Joint costs are those which are incurred before that stage in manufacture at which
the products get separated. It comprises raw material, labour and overheads.
Subsequent costs, on the other hand, are those costs which are incurred after the
separation or split-off point. These are separately incurred for individual joint or by-
products and thus are identifiable with each product. Subsequent costs are also known as
“after separation costs” or “after split-off costs”
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Accounting for Joint products:
Accounting for joint products means the apportionment of joint cost to each of the
joint products. Such apportionment serves the following objectives:
1. To determine the cost per unit of products

2. To help in inventory valuation
3. To determine the profit or loss on each line of product
4. iV0 To determine the price of each profit
METHODS OF APPORTIONMENT OF JOINT COTS:
1. Sales value method: Under this method, joint costs are apportioned to various joint
products on the basis of sale value of each product. The sale value method has the
following variants:
i) On the basis of unit prices
The apportionment of joint cost is apportioned to various joint products in

the ratio of selling prices of individual joint products without any regard to the
quantities. It is thus suitable when the number of units of production of all the
products are equal.
Example:
Products Selling price per unit Apportioned cost
₹ (Ratio 12:8:4)
A 12 4,500
B 8 3,000
C 4 1,500
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Joint cost 9,000
ii) On the basis of sales value: In this method, the apportionment is done on the
basis of weighted sales value.
Products Selling price Production Sales value Apportioned

per unit quantities joint cost
(a) X (b)
(Units) (24:48:28)
₹
(b)
(a) (c) ₹
A 12 200 2,400 2,160
B 8 600 4,800 4,320
C 4 700 2,800 2,520
Total 10,000 9,000
2. Reverse cost method or Net realizable value method:
In this method, the joint cost is apportioned on the basis of net value for each product.
The net realizable value is calculated by deducting the following from the sales value,
a) Estimated profit margin

b) Selling and distribution costs
c) After split off processing costs
233
3. Physical units method: Under this method, the joint cost is apportioned on the basis of
relative weight, volume or quantity, etc., of each product, obtained at the point where the
split- off occurs.
4. Average Unit cost method: In this method, the joint cost is apportioned by using the
average unit cost which is obtained by dividing the total joint cost by the total number of
units produced of all the products.
5. Survey method: This method apportions the joint cost to various products, on the basis
of the results of a survey or technical evaluation. Cots are apportioned on the basis of such
weights or points.
BY PRODUCTS
By products are products of relatively small value which are incidentally and
unavoidably produced in the course of manufacturing the main product. For example, in
sugar mills, the main product is sugar. But bagasse and molasses of comparatively smaller
value are incidentally produced and thus are by-products. Other examples of by - products
are oil cake produced in the extraction of edible oil; cotton seed produced in the cotton
textile industry, etc. These by-products are much less as compared to secondary value. The
sales value of these by-products is much less as compared to the main product.
By - products may be:
1. Those sold in their original form without further processing.

2. Those which require further processing in order to be saleable.
Examples of by - products:
Industry By-products
Sugar Bagasse, Molasses
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Cotton textile Cotton seed
Edible oil Oil cake
Rice Mills Husk
Distinction between Joint products and By-products
1. Relative sales value: If the sales value of all the products are more or less equal,
they are treated as joint products. If, however, there are wide differences in the
relative sales values of products, the product with the greater sale values is treated
as the main product and the products of lower value are treated as by- products.
2. Objective of manufacturer: If the objective of manufacturing is product A, then
unwanted products B and C be treated as by-products.
3. Policy of management: The management may decide to treat a particular product
as the main product and the other products as by-products. Alternatively, it may
choose to treat all products as joint products.
Accounting for By-products:
i) Where by-products are of small total value:
In such a case it is not considered practicable to apportion any part of the joint cost to by-
products. The net income realized by the sale of by-products may be treated in any one of
the following two ways:
a) It may be treated as “miscellaneous income” and credited to the Costing Profit and
Loss account.
b) It may be credited to the process account in which the by-product has arisen.
235
ii) Where by-products are of considerable total value:
In this case, it is proper to apportion a part of the joint cost to by-products. Such
apportioned cost of by-products is debited to the by-product account and credited to the
main product account or the relevant process account.
iii) Where by-products require further processing:
In such a situation, the share of by-product in joint cost at the split-off point may be
arrived at by subtracting the profit and the further processing cost from the realizable
value of the products, i.e., by using the Reverse cost method. In case the cost of the by-
products at the split - off point is small or negligible, it may be treated as per the method
discussed above.
3.7 PRACTICAL PROBLEMS ON JOINT PRODUCT AND BY PRODUCTS
PROBLEM 1: SALES VALUE METHOD:
Z Ltd., manufactures product A, which yields two by-products B and C. The actual
joint expenses of the manufacturer for a period were ₹8,000. It was estimated that profits
on each product as a percentage of sales would be 30%, 25% and 15% respectively.
Subsequent expenses were:
A B C
₹ ₹ ₹
Materials 100 75 25
Direct wages 200 125 50
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Overheads 150 125 75
450 325 150
Sales 6,000 4,000 2,500
Prepare a statement showing the apportionment of the joint expenses of

manufacture over the different products. Also presume that selling expenses are
apportioned over the products as a percentage to sales.
SOLUTION:
Statement of apportionment of Joint cost
Products Total
A B C (A+B+C)
₹ ₹ ₹ ₹
Sales 6,000 4,000 2,500 12,500
Less: Profit 1,800 1,000 375 3,175
Total cost 4,200 3,000 2,125 9,325
Less; Selling 192 128 80 400

expenses
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Cost of production 4,008 2,872 2,045 8,925
Less: Subsequent 450 325 150 925

expenses
Share in joint cost 3,558 2,547 1,895 8,000
Working notes: Selling expenses are not given in the question.These are calculated as
follows:
Total cost (as calculated above) 9,325
Less: Cost of production 8,925

(8,000+450+150)
Selling expenses 400
Selling expenses as a percentage to sales: 400/12,500*100= 3.20%
PROBLEM 2: REVERSE COST METHOD
In processing a raw material, three joint products, X, Y and Z are produced. The joint
expenses of manufacturing are: Materials ₹ 10,000, Labour - ₹ 8,000, Overheads - ₹ 9,000
(Total ₹ 27,000),Subsequent expenses are as follows:
238
X Y Z
₹ ₹ ₹
Materials 2,000 1,600 1,800
Labour 2,500 1,400 1,700
Overheads 2,500 1,000 1,500
Total 7,000 4,000 5,000
Sales value 42,000 20,000 18,000
Estimated profit on 50% 50% 331/3%

sales
Show how you would apportion the joint costs of manufacture by Reverse Cost method.
SOLUTION:
Statement of Apportionment of Joint costs
X Y Z
₹ ₹ ₹
Sales value 42,000 20,000 18,000
239
Less: Estimated profit on 21,000 10,000 6,000
sales
Estimated total cost 21,000 10,000 12,000
Less: Subsequent costs 7,000 4,000 5,000

(total)
Joint costs (27,000) 14,000 6,000 7,000

apportioned
PROBLEM 3: PHYSICAL UNITS METHOD:
The following data have been extracted from the books of Coke Ltd:
Joint products Yield (in lbs) of recovered products per tonne

of coal
Coke 1,420
Coal tar 120
Benzol 22
Sulphate of ammonia 26
Gas 412
2,000
240
The price of coal is ₹80 per tonne. The direct labour and overhead costs to the point
of split-off are ₹ 40 and ₹ 60, respectively, per tonne of coal. Calculate the material, labour
and total cost of each product on the basis of weight.
SOLUTION:
Apportionment of cost
Yield in % of total Coal Direct Overhead Total

lbs labour s
₹ ₹
₹ ₹
Coke 1,420 71.0 56.80 28.40 42.60 127.80
Coal tar 120 6.0 4.80 2.40 3.60 10.80
Benzol 22 1.1 0.88 0.44 0.66 1.98
Sulphate of 26 1.3 1.04 0.52 0.78 2.34

ammonia
Gas 412 20.6 16.48 8.24 12.36 37.08
Total 2,000 100 80.00 40.00 60.00 180.00
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PROBLEM 4: AVERAGE UNIT COST METHOD
From the following particulars, find out the cost of joint products A, B and C under
the average unit cost method.
i) Pre-separation point cost ₹ 30,000
ii) Other production data:
Product Units produced
X 1,000
Y 400
Z 600
2,000
SOLUTION:
Joint cost
Average unit cost= —-—------------------------------ = ₹30,000/2,000 units = ₹ 15 per unit
Total no. of units produced
Product Units produced Average cost Apportioned cost
(A) ₹ ₹
(B) A * B= C
242
X 1,000 15 15,000
Y 400 15 6,000
Z 600 15 9,000
Total 2,000 30,000
PROBLEM 5: SURVEY METHOD:
X, Y and Z are the three joint products in a factory. Their joint cost is ₹30,000.
Quantities produced are as follows:
X 1,000
Y 400
Z 600
On the basis of technical evaluation, points allotted to X, Y and Z products are 3.2, 5
and 8 per unit, respectively. Apportion the joint cost.
Product Units Points Weighted Cost per Apportione

produced assigned units weighted d cost
(a) unit
(b) c= (a) *(b) (32:20:48)
243
(d)(₹30,000 (e)
/
10,000
units)
X 1,000 3.2 3,200 3.00 9,600
Y 400 5.0 2,000 3.00 6,000
Z 600 8.0 4,800 3.00 14,400
Total 10,000 3.00 30,000
Joint cost
—--------------------------------------- = ₹30,000/10,000= ₹3 per unit
Total number of weighted units
3.8 ACTIVITY BASED COSTING AND TARGET COSTING
TRADITIONAL APPROACH OF COSTING:
The main objective of a costing system is to determine scientifically the cost of a

product or service. For facilitating the calculation, costs are divided into direct and
indirect. Direct costs are the costs which are traceable to the products/services offered.
On the other hand, indirect costs which are also called ‘overheads’ are not traceable
to the products/services. Hence these costs are first identified, classified, allocated,
apportioned wherever allocation is not possible, reapportioned and finally absorbed in the
244
products/services. Charging the direct costs to the products is comparatively a simple
procedure and can be done with accuracy.
However, the indirect costs present problems in charging them to the products and
there is a possibility of distortion of costs though the basis of charging them is quite logical.
Example: One of the methods of absorption of overheads is direct labour cost and this
method is quite satisfactory when the overhead costs of indirect activities is a small
percentage compared to the direct labour component in actually making notes of products.
However, the increased technology and automation has reduced the direct labour
considerably and so the indirect activities have assumed greater importance. Therefore,
using the direct labour as a basis for absorbing the overheads can lead to distortions in the
costs. Distortions in the costs resulting from incorrect cost calculations may lead to
following wrong decisions.
Limitations of Traditional Costing System:
 In a traditional costing system, overheads i.e. indirect costs are allocated,

apportioned and finally absorbed in the cost units.
 There can be distortion in computing costs due to the basis selected for
absorption.
 Also, the division between fixed and variable may not be realistic as there are
many complications due to the complexity of the modern business.
 There should be a link between the activities and the costs.
 Similarly the information should be available simultaneously which means
that information should be made available while the activities are going on.
 Information available after the activity is over will not be of much use.
ACTIVITY BASED COSTING
CIMA defines Activity-based Costing as, ‘Cost attribution to cost units on the
basis of benefit received from indirect activities e.g. ordering, setting up, assuring
quality.’ To understand, Activity based Costing can be said as ‘the collection of financial
245
and operational performance information tracing the significant activities of the firm to
product costs.
Objectives of Activity-based Costing
 To remove the distortions in computation of total costs as seen in the

traditional costing system and bring more accuracy in the computation of
costs of products and services.
 To help in decision making by accurately computing the costs of products and
services.
 To identify various activities in the production process and further identify
the value adding activities.
 To distribute overheads on the basis of activities.
 To focus on high cost activities.
 To identify the opportunities for improvement and reduction of costs.
 To eliminate non value adding activities.
Following procedure is adopted for activity based costing:
1. Understanding and analyzing the manufacturing process for an Activity-

based Costing system also, it is necessary to study the manufacturing process
and ascertain various stages involved in the same so that ‘activities’ involved
in the same can be identified.
2. Study of the Activities involved (This step is very crucial as the entire
Activity-based Costing is based on identification of activities.) Activities that
are involved in the process are identified.
For example, in a bank, opening of an account is one of the services offered to

customers. All the activities involved are studied. Such as opening of a new account
involves activities like issuing the application form, verification of the same and
accepting the initial amount required for opening of an account.
246
Similarly in case of a manufacturing company, purchase procedure may
involve activities like receiving of purchase requisition for concerned department or
the stores department, inviting quotations from various suppliers, placing of an
order, follow up of the same and finally receiving and inspection of the goods.
In the case of an educational institute, activities in a library may include

activities like issue of books, receipt of books, ordering new books, giving accession
numbers, stock taking, removing obsolete and outdated books, identification of slow
moving and fast moving items etc.
3. In this manner, whether in manufacturing or in the service sector, dividing

the activities into value adding and non-value adding. The objective behind
this is that attention can be focused on the value adding activities while non-
value adding activities can be eliminated in the future.
4. Activity Cost Pool: Cost pool is defined by CIMA as, ‘the point of focus for the
costs relating to a particular activity in an activity-based costing system.’ Cost
pool concept is similar to the concept of cost centre. The cost pool is the point
of focus or in other words, it is the total cost assigned to an activity. It is the
sum of all the cost elements assigned to an activity.
For example, In case of a library, the cost of issue and receipts, cost of ordering,
stock taking costs etc. can be identified with ‘Library Cost’. In other words, ‘Library’
will be the cost pool in which all the costs mentioned above may be clubbed. In case
of a manufacturing organization, as regards to stores, cost of classification, cost of
issue of store requisitions, inspection costs etc. can be pooled under the heading
‘stores’.
5. Cost Drivers According to CIMA, ‘cost driver is any factor which causes a
change in the cost of an activity, e.g. the quality of parts received by an activity
is a determining factor in the work required by that activity and therefore
affects the resources required. An activity may have multiple cost drivers
247
associated with it.’ To simplify, cost driver means the factors which determine
the cost of an activity or an activity which generates cost.
For example, if we repeat the example of library, the number of receipts and issue
of books will be cost drivers, in stores, no. of stores requisitions will be cost drivers,
in customer order processing the no. of customers as well as no. of orders will be
cost drivers. The following table shows various activity cost pools and their cost
drivers:
Activity Cost pools Activity Cost Drivers
Purchasing department No. of Purchase orders
Receiving department No. of Purchase orders
Materials handling No. of Materials requisitions
Set up No. of set ups required
Inspection No. of inspections
Engineering department No. of Engineering Change orders
Personnel processing No. of employees hired
Supervisors No. of Direct labour hours
248
6. Identification of costs with the products
❖ The final stage in Activity-based Costing is to identify the cost with the final
products which can also be called cost objects.
❖ Cost objects include, products, services, customers, projects and contracts.
❖ Direct costs can be identified easily with the products but the indirect costs
can be linked with the products by identifying activities and cost drivers.
❖ Thus Activity-based Costing is the process of tracing costs first from resources
to activities and then from activities to specific products.
Limitations of Activity-based Costing
❖ Though this system is quite effective, it suffers from some limitations.

❖ These limitations are: Activity-based Costing is a complex system and
requires a lot of records and tedious calculations.
❖ For small organizations, a traditional cost accounting system may be more
beneficial than Activity-based Costing due to the simplicity of operation of the
former.
❖ Sometimes it is difficult to attribute costs to single activities as some costs
support several activities.
❖ There is a need for trained professionals who are limited in number.
❖ This system will be successful if there is total support from the top
management.
❖ Substantial investment of time and money is required for the implementation
of this system.
ACTIVITY BASED COSTING VS TRADITIONAL COSTING
Limitations of traditional costing have given rise to Activity Based Costing. The
following are differences between the two:
249
Point of difference Activity Based Costing Traditional costing
Primary focus Use multiple cost drivers for Use identical cost driver for
multiple activities different activities
Application It is difficult to apply and Is straightforward and easy to

requires time and effort implement.
Scope Cover product cost only Can cover both product and
period costs
Management use The values can be used in The values cannot be reported
external financial in external reporting.
statements
Effectiveness of operations Enhances management of Does not provide an

activities related to the opportunity to identify any
production process. specific reasons for costs
incurred.
TARGET COSTING
Meaning:
Target costing is part of a product development process. It starts with

understanding the wants and needs of customer segments across targeted competitive
markets, and the prices they're willing to pay for the product and its variants. The business
must specify the margin it needs to get the maximum tenable cost for the product and its
variants. The margin needs to be sustainable across the product's full expected lifecycle.
250
Because target costing encompasses a business' full costs, it applies to its full value
chain. So, at one end of the value chain, customer value must be expressed in terms of the
value the product and its variants generate for customers. At the other end of the value
chain, it incorporates how the business will collaborate with its suppliers to generate this
value. As target costing has an all-encompassing role, it is multidisciplinary, multifunctional
and integral to the business model that generates value for customers. It's as much a
change of culture as a change in process. The role of the management accountant is to
partner with all the disciplines involved and to understand the impact of decisions on
customers. So, it's not just about minimizing product costs, but doing so while maintaining
or enhancing quality for the customer.
Competitive markets are full of uncertainty. Since the process applies to the
product's full lifecycle in competitive markets, businesses will need to continually revise a
product's value proposition and price. This is bound to affect the product's target cost over
time. So, target costing is an ongoing process that needs continuous improvement effort.
What benefits does the process provide?
 Assures that profitability targets for a product portfolio are achievable

 Improves sales prospects, since product development is focused on customer
needs and wants
 Improves profitability of product variants
 Reduces the cost and effort of managing a profitable product lifecycle
 Reduces reliance on costly post-production product revisions to meet
customer needs and wants
 Market and customer-led, rather than business capability-led
 Extends customer centricity beyond sales to all functions in the business.
Applications
Aside from the application of target costing in the field of manufacturing, target
costing is also widely used in the following areas.
251
 Energy
 Healthcare
 Construction
LEARNING OUTCOMES:
 Describe the various objectives and functions of cost accounting
 Discuss the various classifications of cost
 Know the method of preparation of Job cost sheet
 Calculate product costs and track product cost flows
 Understand the meaning of joint products and by-products and the difference
between the two
 Learn about Traditional costing and its limitations

 Learn about what is Target costing and its applications.
Short Answer Questions

1. Define the term costing.
2. What is meant by Cost unit?
3. Write a note on the Cost object.
4. Differentiate between Direct and Indirect costs.
5. What is a job costing?
6. Define Process costing.
7. The output of Process X transferred to Process Y was 2500 units. Normal loss was
10% of input in Process X and was 300 units. Abnormal loss reported to be 200
units. The other information is a s follows: Materials introduced @ ₹5 per unit.
Labor cost ₹4000 and overheads ₹3350. Normal loss realized ₹2.50 per unit.
a. Prepare (i) Process X account (ii) Abnormal loss account.
8. 600 kgs of a material was charged to Process A at the rate of ₹4 per kg. The direct
labor accounted for ₹200 and the other departmental expenses amounted to ₹760.
252
The normal loss is 10% of input and the net production was 500 kgs. Assuming that
process scrap is saleable at ₹2 per kg, prepare Process A account clearly showing
the values of normal and abnormal loss.
Answers:
Q. No. 2 Abnormal loss ₹1600
Q. No.3 no. - Abnormal loss 40 kgs at ₹240: Transferred to B500 kgs at ₹ 3000.
9. Define AB Costing.
10. What are the areas in which Target costing is applied?
Long answer questions

1 . Discuss the various cost units used in the industries.
2. List out the Job costing procedure.
PRACTICE PROBLEMS:
1. The following expenses were incurred for a job during the year ended 31 st December
2012.
Direct wages 4,000
Chargeable expenses 1,000
Factory overheads 2,000
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Selling and distribution 2,000
overheads
Administrative overheads 3,000
The selling price for the above john was ₹18,000. You are required to prepare a statement
showing the profit earned for the year 2009 from the job and an estimated price of a job
which is to be executed in the year 2010. Materials, wages and chargeable expenses
required will be of ₹5,000, ₹ 7,000 and ₹2,000 respectively, for the job. The various
overheads should be recovered on the following basos while calculating the estimated
price;
i) Factory overheads as a percentage of direct wages.
ii) Administration and selling and distribution overheads as a percentage of factory cost.
PROBLEM 3:
From the following information, prepare Job no.314 and 425 accounts in the Job cost
Ledger:
Job No.314 Job No. 425
₹ ₹
Direct materials 2,400 1,200
Materials received from 16,800 14,400

stores
254
Direct wages 9,600 5,000
Other direct expenses 1,000 500
The production overheads are to be taken at 100% of wages and administration

overheads at 20% of the production cost. The contract price of Job no.314, which is
completed, is fixed at ₹ 55,000. Job No. 425 is under progress.
ANSWER:
1. Works cost ₹ 1,708
2. Profit ₹3,000. Factory overheads 50% on direct wages, administration overheads 30%
on factory cost. Selling and distribution overheads 20% on factory cost, Profit 20% on total
cost; estimated selling price of job ₹31,500
3. Job No. 314 Profit ₹7,720, Job No. 425 WIP 31,320
PRACTICE PROBLEMS:
1. One tonne of raw material put into a common process yields four products A, B, C and D,
their weights being 63 kgs, 117 kgs, 180 kgs and 540 kgs, respectively. The balance in
weight is considered as normal loss. Based on the total processing cost of ₹ 20,000 per
tonne of raw material input, you are required to apportion the joint cost to products A, B, C
and D.
2. A Coke manufacturing company produces the following products by putting 5,000 tonnes
of coal @ ₹25 per tonne into the common process.
255
Coke 3,500 tonnes
Tar 1,200 tonnes
Sulphate 52 tonnes
Benzol 48 tonnes
Apportion the joint cost amongst the products on the basis of physical units method.
3. In a manufacturing concern, a certain product A yields by-products B and C. The joint

expenses of manufacture aare materials ₹10,200, labour ₹ 11,400 and on cost ₹7,500, while
subsequent expenses are:
Expenses
A B C
₹ ₹ ₹
Materials 2,500 1,200 1,400
Labour 1,900 1,600 2,000
On cost 1,500 900 1,050
5,900 3,700 4,450
256
The selling prices are: A- 30,000 B- 20,000, C - 15,000. The estimated profits on
turnover are: A-40%, B- 30%, C -25%. Show how you would apportion the joint expenses of
manufacture.
4. In manufacturing the main product A, a company processes the resulting waste material
into two by-products M and N. Using the method of working back from sales value to an
estimated cost, you are required to prepare a comparative Profit and loss statement of the
three products from the following data:
i) Total cost upto separation point was ₹1, 36,000.
A M N
ii) Sales (all production) ₹ 3,28,000 32,000 48,000
iii) Cost after separation ₹ - 9,600 14,400
iv) Estimated net profit % 20 20 20

to sales value
ANSWERS:
1. Apportioned cost - A- ₹1,400 B- ₹2,600 C- ₹4,000 and D - ₹12,000. (Normal loss -100 kgs)
2.₹ 91,146- ₹31,250 - ₹1,250 (Difference between total input of 5,000 tonnes and total
output of 4,800 tonnes is assumed to be a normal loss.)
3. Share in joint cost- A- ₹ 12,054 B- 10,269 C- 6,777: Selling expenses ₹100.
4. Profit for main product - ₹1, 45,600
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UNIT IV– COST ACCOUNTING
Contents
LEARNING OBJECTIVES: ............................................................................................................ 2
4.1 MARGINAL COSTING AND PROFIT PLANNING ........................................... 2
4.2 PRACTICAL PROBLEMS ON MARGINAL COSTING AND PROFIT

PLANNING ........................................................................................................................... 9
4.3 BREAK EVEN ANALYSIS.......................................................................................20
4.4 DECISION MAKING .................................................................................................37
4.5 APPLICATIONS OF MARGINAL COSTING- DETERMINATION OF

SALES MIX .........................................................................................................................45
4.6 APPLICATIONS OF MARGINAL COSTING-EXPLORING NEW

MARKETS ...........................................................................................................................51
4.7 APPLICATIONS OF MARGINAL COSTING- ADD OR DROP PRODUCTS

................................................................................................................................................55
4.8 APPLICATIONS OF MARGINAL COSTING - EXPAND OR CONTRAC ..63
LEARNING OUTCOMES: ...........................................................................................................70
Short Answer questions ...........................................................................................................70
Long answer questions: ...........................................................................................................71
COMPREHENSIVE PROBLEMS ..............................................................................................71
1
LEARNING OBJECTIVES:
 Learn the meaning of Absorption costing
 Understand the need for Marginal costing.
 Learn about CVP Analysis
 Learn to draw a Break Even Chart.
 To understand the applications of Marginal costing
 To understand the applications of Marginal costing
4.1 MARGINAL COSTING AND PROFIT PLANNING
ABSORPTION COSTING:
It is a conventional technique of ascertaining cost. It is the practice of charging all

costs both variable and fixed to operations, processes or products and is also known as “
Full Costing” technique.
Ascertainment of profit under Absorption costing
Sales
Less: Cost of goods manufactured
Direct materials
Direct labour
Factory overheads
2
Variable
Fixed
Add: Value of Opening stock
Less: Value of Closing stock
Ass: Under Absorption or Less Over absorption of Fixed Factory overheads
Gross profit
Less: Administration, selling & Distribution expenses:
Fixed
Variable
Net Income or Profit
ADVANTAGES OF ABSORPTION COSTING
 It suitably recognises the importance of including fixed manufacturing costs

in product cost determination and framing a suitable pricing policy.
 It will show the correct profit calculation.
 It helps to confirm with accrual and matching concepts which require
matching costs with revenue for a particular period.
 It has been recognized by various bodies.
 It avoids the separation of costs into fixed and variable elements which
cannot be done easily and accurately.
3
 It discloses inefficient or efficient utilisation of production resources by
indicating under absorption or over absorption of factory overheads.
 It helps to calculate the gross profit and net profit separately in the income
statement.
LIMITATIONS OF ABSORPTION COSTING
 Difficulty in comparison and control of cost

 Not helpful in managerial decisions.
 Cost vitiated because of fixed cost included in inventory valuation.
 Fixed cost inclusion in cost not justified.
 Apportionment of fixed overheads by arbitrary methods.
 Not helpful for preparation of flexible budget
NEED FOR MARGINAL COSTING
Fixed expenses remain constant in aggregate amount and do not vary with the
increase or decrease in production up to a particular level of output. Just to contrast this
variable expenses increase or decrease proportion to increase or decrease output and
remain constant per unit of output.
Meaning:
The Chartered Institute of Management Accountants, England, defines the term “Marginal
Cost” as follows:
Marginal cost is 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. In this context a
unit may be a single article, a batch of articles, an order, a stage of production capacity or a
department. It relates to the change in output in the particular circumstances under
consideration.
For example, if variable costs per unit are ₹ 10 and fixed expenses are ₹ 1, 50,000 p.a., an
output of 30,000 unit’s p.a. results in the following expenditure.
4
₹
Variable cost of 30,000 units @₹10 3,00,000
Fixed cost 1,50,000
Total cost 4,50,000
If output is increased by one unit, the following expenditure will be incurred:
Variable cost of 30,001 units @₹10 3,00,010
Fixed cost 1,50,000
Total cost 4,50,010
Marginal cost of 1 unit 10
MEANING OF MARGINAL COSTING
According to CIMA Terminology, Marginal costing is the ascertainment of marginal

cost and of the effect on profit of changes in volume or type of output by differentiating
between fixed costs and variable costs.
5
FEATURES OF MARGINAL COSTING
 It is a technique of costing which is used to ascertain the marginal cost and to

know the impact of variable cost on the volume of output.
 All costs are classified into fixed and variable costs on the basis of variability.
Even semi fixed cost is segregated into fixed cost and variable cost.
 Variable costs alone are charged production. Fixed costs are recovered from
contribution.
 Selling Price is based on marginal cost plus the contribution.
 Valuation of stock of work in progress and finished goods is done on the
basis of marginal cost.
 Profit is calculated by deducting marginal cost and fixed cost from sales.
 Cost volume profit (Or Break even) Analysis, is one of the integral part of
marginal costing.
 The profitability of a product/department is based on contributions made
available by each product/department.
Ascertainment of profit under Marginal cost
 Contribution = Selling price - Marginal cost
Or
 Contribution= Fixed expenses + Profit
Or
 Contribution - Fixed expenses = Profit
Advantages of Marginal costing
❖ It is simple to understand and easy to operate.

❖ The valuation of closing stock under marginal costing is done at marginal cost
and thus prevents the illogical carry forward of fixed costs of one period tothe
next period as part of the value of closing stock.
6
❖ There is no problem of commuting fixed overhead recovery rates and their
under or over recovery as fixed overheads are charged against the
contribution.
❖ It facilitates control over variable costs by avoiding arbitrary apportionment
or allocation of fixed costs.
❖ It is a very useful tool of profit planning. It guides the management about the
profitability of earning profit at various levels of production and sales.
❖ It is a very valuable technique in decision -making.it provides information to
the management in making decisions like make or buy, selling price fixation,
export decision etc.
❖ It helps in evaluation of performance of different departments, divisions and
salesmen.
LIMITATIONS OF MARGINAL COSTING
➔ The separation of expenses into fixed cost and variable presents certain technical
difficulties whereas marginal costing technique assumes that all expenses can be
divided into fixed and variable.
➔ Time taken for the completion of a job is not given due attention because marginal
cost excludes fixed expenses which are connected with time.
➔ With the development of technology, fixed expenses have increased and their
impact on production is much more than that of variable expenses. Therefore, a
system of costing which ignores fixed expenses is less effective because a significant
portion of the cost representing fixed expenses is not taken care of.
➔ Marginal costing technique does away with the difficulties involved in the
apportionment of overheads because fixed expenses are deducted from total
contribution.
➔ Marginal costing technique is difficult to apply in contract or the shipbuilding
industry where the value of work-in-progress is high in relation to turnover. If fixed
expenses are not included in the valuation of work in-progress, losses may occur
7
every year till the contract is completed, while on the completion of the contract
there may be huge profits.
➔ Marginal costing technique cannot be successfully applied in cost plus contracts
unless a high percentage over the marginal cost is charged from the contractee to
cover the fixed costs and profits.
DIFFERENCE BETWEEN ABSORPTION COSTING AND MARGINAL COSTING
Absorption costing Marginal costing
1. All costs fixed and variable are 1. Only variable costs are included.
included for ascertaining the Fixed costs are recovered from
cost. contribution.
2. Different unit costs are obtained 2. Marginal cost per unit will remain
at different levels of output the same at different levels of
because fixed expenses remain output because variable
the same. expenses vary in the same
proportion in which output
varies.
3. Difference between sales and 3. Difference between sales and

total cost is profit. marginal cost is contribution and
difference between contribution
and fixed cost is profit or loss.
4. The apportionment of fixed 4. Only variable costs are charged to

expense on an arbitrary basis products, marginal cost
gives rise to over or under technique does not lead to over
absorption of overheads which or under absorption of fixed
ultimately makes the product
8
cost inaccurate and unreliable. overheads.
5. Costs are classified according to 5. Costs are classified according to

functional basis such as the behaviour of costs i.e., fixed
production cost, office and costs and variable costs.
administrative cost and selling
and distribution cost.
6. Absorption costing fails to 6. Cost, volume and profit (CVP)

establish relationships of cost, relationship is an integral part of
volume and profit as costs are marginal cost studies as costs
seldom classified into fixed and are classified into fixed and
variable. variable costs.
4.2 PRACTICAL PROBLEMS ON MARGINAL COSTING AND

PROFIT PLANNING
When there is production but no sales:
Under this case, the income under absorption costing may reflect profit though no
sales have been made. This is due to the fact that fixed manufacturing overheads have been
absorbed above normal capacity production than its actual fixed manufacturing overheads.
But variable income statements will show loss as there are no sales. Though no sales have
been made but income statement will show gross profit equal to the amount of over
absorption of fixed manufacturing overheads. Thus profit under absorption costing is
9
influenced by various factors such as quantity of production units, unit sold, selling price,
cost of production etc.
PROBLEM 1
The following data relate to X Co.-
Normal capacity - 40,000 units p.m.
Variable cost per unit - ₹ 10
Actual production - 44,000 units
Sales - Nil
Fixed manufacturing overheads - ₹1, 00,000 p.m. or ₹2.50 per unit at normal capacity
Other fixed expenses - ₹8,000.
Prepare the income statement under a) Absorption costing b) Marginal costing
SOLUTION:
Income Statement (Absorption Costing)
₹ ₹
Sales —
Less: Variable cost @₹10 4,40,000

per unit
Fixed manufacturing
1,10,000
overheads for 44,000 units
@ ₹2.50 per unit
10
Cost of goods manufactured 5,50,000
Less: Closing inventory 5,50,000
Cost of goods sold Nil
Less: Over absorption of

overheads ( 4,000 *₹2.50)
-10,000
Gross profit/ Loss 10,000
Less: Other fixed expenses +8000
Net Income 2,000
Note: The above income statement will not show the profit if other fixed expenses are
more than the gross profit.
Income Statement (Marginal Costing)
₹ ₹
Sales —
Less: Variable cost @₹10

per unit
11
Cost of goods manufactured 4,40,000
44,000 units @10 per unit
Less: Closing inventory 4,40,000
Cost of goods sold Nil
Contribution Nil
Less: Fixed manufacturing 1,00,000

overheads
Other fixed expenses

8,000 1,08,000
Net loss 1,08,000
COST VOLUME PROFIT ANALYSIS
Cost volume profit analysis (or Break Even analysis) is a logical extension of
marginal costing. It is based on the same principles of classifying the operating expenses
into fixed and variable. It is concerned with finding out the “Crisis point” (i.e. Breakeven
point), the level of activity when the total cost equals total sales value.
Assumptions underlying CVP Analysis
1. Fixed and variable cost patterns can be established with reasonable accuracy
and that fixed costs remain static and marginal costs are completely variable
at all levels of output.
2. Selling prices are constant at all sales volumes.
12
3. Factor prices (e.g. material prices, wage rates) are constant at all sales
volumes.
4. Efficiency and productivity remain unchanged.
5. In a multi-product situation, there is constant sales mix at all levels of sales.
6. Turnover level (volume) is the only relevant factor affecting costs and
revenue.
7. The volume of production equals the volume of sales.
Marginal cost equation:
 Sales = Variable costs + Fixed expenses + -- Profit / Loss

Or
 Sales - Variable costs = Fixed expenses + -- Profit / Loss

1. Contribution:
It is the difference between the sales and the marginal cost of sales and it contributes
towards fixed expenses and profit.
 Contribution = Selling price (S.P.) – Marginal cost (M.C.)

Or
 Contribution = Fixed expenses + Profit

Or
 Contribution– Fixed expenses = Profit
In marginal costing, contribution is very important as it helps to find out the profitability of
a product, department, division to have a better product mix, for profit planning and to
maximise the profits of a concern.
2. Profit Volume ratio(P/V ratio):
13
 P/V ratio= Contribution/ Sales
Or
Fixed expenses + Profit
 —-----------------------------
Sales
Or
Sales — Variable costs (V.C.)
 —-----------------------------
Sales
Or
Change in profits or contribution
 —---------------------------------------
Change in sales
The P/ V ratio is very useful and is used for the calculation of:
a. BEP Fixed costs

= —----------------
P/V ratio
2. Value of sales to earn a desired amount of profit:

Sales = Fixed costs + Desired profit
= —------------------------------------
P/V ratio
3. Variable costs = (Sales * 1- P/V ratio)

4. Profit = (Sales * P/V ratio) –Profit
14
5. Fixed cost = (Sales * P/V ratio) – Profit
6. Margin of safety = Profit
—-------
P/V ratio
PROBLEM 2
Calculate P/V ratio from the following information:
i) Given: Selling price - ₹ 10 per unit, variable cost per unit ₹ 6.
ii) Given the profits and sales of two periods as under:
2000- Sales ₹ 1, 50,000 - Profits ₹20,000
2001 - Sales ₹ 1, 70,000 - Profits ₹ 25,000
SOLUTION:
i) P/V ratio Contribution
= —------------- * 100 = 4/ ₹ 10 * 100= 40%.
Sales
Contribution = S.P. – V.C. = ₹10 - ₹ 6= ₹ 4
ii) P/V ratio = Change in profit
—--------------------------- * 100
Change in sales
= ₹ 5,000/ ₹ 20,000 * 100 = 25%
15
BREAK EVEN POINT (BEP):
A business is said to break even when its total sales are equal to its total costs. It is a
point of no profit no loss. At this point, contribution is equal to fixed cost. A concern which
attains break-even point at less number of units will definitely be better from another
concern where BEP is achieved at more units of production.
BEP (in units)
Total Fixed cost
= —-----------------------------------------------------------
Selling price per unit - Marginal cost per unit
Or
Total Fixed cost
= —----------------------
Contribution per unit
BEP Sales in Value (₹)
Fixed cost
= —-----------------
P/V ratio
PROBLEM 3
From the following calculate
i) Contribution
ii) P/V ratio
16
iii) BEP in units and in Rupees.
iv) What will be the selling price per unit if the BEP is brought down to 25,000 units?
SOLUTION
i) Contribution = S. P. per unit - V.C. per unit = ₹ 15- ₹ 10 =₹ 5.

ii) P/V ratio = Contribution / Sales * 100 = ₹5/ ₹ 15 * 100 = 331/3%.
iii) BEP in units= Fixed expenses / Contribution per unit = ₹ 1, 50,000/₹5 = 30,000 units.’
iv) BEP (in ₹) = Fixed expenses / P/V ratio= ₹1, 50,000/ 331/3% = ₹4, 50,000.
v) BEP (units) = Fixed expenses / Contribution per unit
Or
Contribution per unit = mixed expense / BEP (units) = ₹1, 50,000/ 25,000 = ₹ 6
Selling Price per unit = Variable cost + Contribution per unit
= ₹10 + ₹ 6 = ₹ 16.
PROBLEM 4
A Company has fixed expenses of ₹ 90,000 with sales of ₹ 3, 00,000 and a profit of
₹60,000 during the first half year. If in the next half year, the company suffered a loss of ₹
30,000, calculate: The P/V ratio, BEP and Margin of safety for the first half year.
SOLUTION
P/V ratio= Contribution / Sales * 100 = ₹ 1, 50,000 /₹3, 00,000*100= 50%
(Contribution = ₹90,000 (Fixed expenses) + ₹60,000 (Profit) =₹1, 50,000
BEP = Fixed cost /P/V ratio = ₹90,000/50% = ₹ 1, 80,000
Margin of safety = Actual sales - BEP sales
= ₹3, 00,000 - ₹1, 80,000 = ₹1, 20,000
17
PROBLEM 5
The sales and profit for the two years are given as follows:
Year Sales Profit
₹ ₹
2006 1,40,000 15,000
2007 1,60,000 20,000
Calculate
i) P/V ratio
ii) BEP
iii) Sales required to earn a profit of ₹40,000
iv) Fixed expenses
v) Profitwhen sales are ₹1, 20,000
SOLUTION
i) P/V Ratio Change in profit
= —------------------- * 100
Change in sales
18
20,000-15,000
= —-------------------------- * 100
1, 60,000- 1, 40,000
= 5,000
—------- * 100= 25%
20,000
ii) BEP = Fixed expenses/ P/V ratio
Fixed expenses = Contribution - Profit
Contribution = Sales* P/V ratio
Taking 2006 sales,
Contribution = 1, 40,000 * 25% = ₹35,000
Fixed expenses= 35,000-15,000 = 20,000
BEP= 20,000/ 25% = ₹80,000
iii) Sales required to earn a profit of ₹40,000
Required sales Required profit + Fixed cost
= -------------------------------------
P/V ratio
= 40,000+20,000/ 25% = ₹2, 40,000
iv) Fixed expenses = ₹ 20,000 (Already calculated)
v) Profit when sales are ₹1, 20,000
19
Contribution = Sales * P/V ratio = 1, 20,000*25%= ₹30,000
Profit = Contribution - Fixed cost
= 30,000- 20,000= 10,000
4.3 BREAK EVEN ANALYSIS

MEANING OF BREAK-EVEN CHART (BEC):
The Break-Even Chart is a graphical representation between cost, volume and

profits. No doubt it is an important tool which helps to make profit planning. It has been
defined as “A chart which shows the profitability or otherwise of an undertaking at
various levels of activity and as a result indicates the point at which neither profit
nor loss is made” Construction of a Break-Even Chart:
A Break-Even Chart is constructed on graph paper. Activity or volume of production

is plotted on the ‘X’ axis, whereas cost and revenue are plotted on the ‘Y” axis. In its
simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the
same variation in activity.
The point at which neither profit nor loss is made is known as the "break-even point" and is
represented on the chart below by the intersection of the two lines:
Assumptions Underlying Break Even Chart:
1. All costs can be separated into fixed and variable costs.

2. Fixed costs will remain constant and will not change with the change in level
of output.
3. Variable costs will fluctuate in the same proportion in which the volume of
output varies. In other words, prices of variable cost factors i.e., wage rates,
price of material etc. will remain unchanged.
20
4. Selling price will remain constant even though there may be competition or
change in volume of production.
5. The number of units produced and sold will be the same so that there is no
opening or closing stock.
6. There will be no change in operating efficiency.
7. There is only one product or in the case of many products, product mix will
remain unchanged.
8. Product specifications and methods of manufacturing and selling will not
change.
ADVANTAGES OF BREAK EVEN CHARTS:
1. Information provided by the breakeven chart can be understood by the management

more easily than contained in the Profit and Loss Account and the Cost Statements because
a break even chart is the simple presentation of cost, volume and profit structure of the
company. It summarises a great mass of detailed information in a graph in such a way that
its significance may be grasped even with a cursory glance.
2. A break even chart is useful for studying the relationship of cost, volume and profit. The
chart is very useful for making managerial decisions because it shows the effect on profits
of changes in fixed costs, variable costs, selling price and volume of sales.
3. The chart is very useful for forecasting costs and profits at various volumes of sales.
4. A break even chart is a tool for cost control because it shows the relative importance of
the fixed costs and the variable costs.
5. Profitability of various products can be studied with the help of these charts and a most
profitable product mix can be adopted. Profits at different levels of activity can also be
ascertained.
21
6. The profit potential can be best judged from a study of the position of the breakeven
point and the angle of incidence in the breakeven chart. Low break even point and large
angle of incidence in the breakeven chart indicate that fixed costs are low and margin of
safety is high. It is a sign of financial stability.
In such a case, some monopolistic conditions prevail and high profits are earned
over a large range of production activity. Low break-even point and small angle of
incidence show that fixed costs are low and margin of safety is high, but rate of profit is not
high because of absence of monopolistic conditions. High break-even point and large angle
of incidence show that fixed costs are high and margin of safety is low. A small fall in
volume may put the business into losses and a small increase in volume may give a high
profit because of the large angle of incidence. Last, a high breakeven point and small angle
of incidence is the worst position because it indicates a low margin of safety and a low rate
of profit.
7. It is helpful in the determination of sale price which would give desired profits or a B.E.P.
8. It is helpful in knowing the effect of increase or reduction in selling price.
Limitations:
1. A break even chart is based on a number of assumptions which may not hold well. Fixed
costs vary beyond a certain level of output. Variable costs do not vary proportionately if the
law of diminishing or increasing returns is applicable in the business. Sales revenues do not
vary proportionately with changes in volume of sales due to reduction in selling price as a
result of competition or increased production.
In the break-even chart, we have seen that the total cost line and the sales line look
straight lines. This is possible only with a number of assumptions. But, in practice, the total
cost line and the sales line are not straight lines because the assumptions do not hold good.
Thus, there might be several break even points at different levels of activity.
22
2. A limited amount of information can be shown, in a break even chart. A number of charts
will have to be drawn up to study the effects of changes in fixed costs, variable costs and
selling prices.
3. The effect of various product mixes on profits cannot be” studied from a single break
even chart.
4. A break even chart does not take into consideration capital employed which is a very
important factor in taking managerial decisions. Therefore, managerial decisions on the
basis of a break even chart may not be reliable.
In spite of the above limitations, the break-even chart is a useful management device
for analysing the problems, if it is constructed and used by those who fully understand its
limitations.
USES OF P/V GRAPH:
 To determine breakeven point.

 To show impact on profits of selling profit at different prices for a product.
 To forecast costs and profits resulting from changes in sales volume.
 To show the deviations of actual profit from anticipated profit relative
profitability under conditions of high or low demand.
BREAK EVEN CHART
23
In the diagram above, the line OA represents the variation of income at varying
levels of production activity ("output"). OB represents the total fixed costs in the business.
As output increases, variable costs are incurred, meaning that total costs (fixed + variable)
also increase. At low levels of output, Costs are greater than Income. At the point of
intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.
Normally, following types are most commonly used:
1. Simple break-even chart

2. Contribution break even chart
3. Profit break even chart
4. Profit chart for product-wise analysis
5. Cash break even chart, and
6. Control break even chart.
The above charts are briefly discussed below:
1. Simple Break Even Chart:
24
It is orthodox break even chart. Its preparation is simple.
Normally cost and revenue are shown on Y-axis, while one or more of the following are
shown on X axis:
(1) Quantity of sales (units).

(2) Value of sales (in rupees).
(3) Sales as percentage to capacity.
(4) Volume of production (units).
(5) Value of production (in rupees).
(6) Production as percentage to capacity.
Of the above, which should be shown in the chart depends on the purpose for which the
chart is prepared. It is evident that profit cannot arise unless goods are sold. Therefore it is
logical that sales are shown on the X axis.
How to Draw a Break Even Chart?
A Ltd. has furnished the following details:
25
(2) Contribution Break Even Chart:
In the case of a simple break even chart variable cost line is shown above the fixed
cost line. Sometimes fixed costs can be shown above the variable costs. In such a case the
chart is known as a contribution break even chart. The specialty of this chart is that
contribution is indicated clearly in the chart by way of difference between variable cost line
and sales line.
26
You are given the following data for the coming year of a factory:
27
3. Profit Break Even Chart:
This is also called profit graph. Break-even point can also be ascertained by means
of this chart. Profit graph shows the profit/loss at different levels of output/sales. Sales
units/rupees are plotted on the X axis and profit/loss is measured in y axis. Profit increases
with increase in sales volume and decreases with decrease in sales volume.
Draw the profit – volume graph and find out P/V ratio with the following information:
From the illustration we find that the profit is Rs. 500 and the fixed cost is Rs. 500.
So A line A-B has been drawn intersecting the sales line at point ‘A’ which is the BEP, which
can be read to be Rs. 1,250.
28
The P.V. Ratio can also be ascertained from this graph as follows:
4. Profit Chart for Product-Wise Analysis:
29
This chart is also termed as profit path chart. It is prepared in the case of business
concerns which are engaged in the production of two or more products. It is prepared with
the help of P/V Ratio.
5. Cash Break Even Chart:
Cash break even chart shows break-even point through graph, i.e., the amount of
cash needed to break even. Thus this chart indicates the point at which cash inflow will be
just equal to cash outflow.
A model of cash break even chart is given below:
6. Control Break Even Chart:
This chart is used for control purposes by the management. Control break even
chart forms part of budgetary control system The main purpose of this chart is to compute
budgeted variance in respect of sales, costs and profits, Control break even chart is
prepared with the help of budgeted and actual data and thus it compares budgeted sales
30
with actual sales and budgeted costs with actual costs, budgeted BEP with actual BEP and
budgeted profit with actual profit and so on. To indicate the variance between budgeted
figures and actual figures they are shown with distinct colours/marks.
6. They are helpful in profit planning. Break even charts help by providing information for
forecasting and long-term planning.
PROBLEM 1
A Company has annual fixed costs of ₹14, 00,000. In 2001 sales amounted to ₹60, 00,000 as
compared with ₹ 45, 00,000 in 2000 and profit in 2001 was ₹ 4, 20,000 higher than in
2000:
i) At what level of sales does the company break-even?
ii) Determine profit or loss on a present sales volume of ₹80, 00,000.
iii) If there is a reduction in selling price in 2002 by 10% and the company desires to earn
the same profit as in 2001, what would be the required sales volume?
SOLUTION:
P/V ratio = Change in profit/ Change in sales *100= ₹4, 20,000/ ₹15, 00,000 *100= 28%
i) BEP = Fixed cost /P/V ratio = ₹ 14, 00,000/ 28 *100= ₹50, 00,000.
ii) Profit = (Sales * P/V ratio) - Fixed cost
= (₹80, 00,000*28%) - ₹14, 00,000= ₹8, 40,000
iii) Contribution in 2001 = 28% *₹60,00,000= ₹16,80,000
This has to be maintained.
In 2002, the sales volume and contribution consequent upon 10% reduction in price are:
Sales (₹60, 00,000- 10%) = ₹ 54, 80,000
Contribution =₹10, 80,000
31
(₹16, 80,000- 10% of ₹60, 00,000)
P/V ratio =₹10, 80,000/₹54, 00,000*100= 20%
Required sales volume = Contribution/ P/V ratio = ₹ 16, 80,000/20% = ₹84, 00,000
PROBLEM 2
From the following data, calculate:
i) BEP expressed the amount of sales ₹.
ii) No. of units that must be sold to earn a profit of ₹1, 20,000 per year
Selling price per unit 40
Variable manufacturing cost per unit 22
Variable selling cost per unit 3
Fixed factory overheads 1,60,000
Fixed selling cost 20,000
SOLUTION
i) BEP (in units)
= Fixed cost / Selling price per unit - Marginal cost per unit = ₹1, 60,000+₹20,000/₹40 -
₹25 = ₹1, 80,000/ ₹15 = 12,000 units
BEP = Break even units *Selling Price per unit
32
(In sles value) = 12,000* ₹40 = ₹4, 80,000
ii) Output to earn a profit of ₹1, 20,000:
= Fixed expenses + Profit/ Selling pierce per unit - Marginal cost per unit
= ₹1, 80,000 + ₹1, 20,000 / ₹ 40 - ₹ 25 = ₹3, 00,000/₹ 15 = 20,000 units
PROBLEM 3
Two businesses, Y Ltd., and Z Ltd., sell the same type of product in the same type of market.
Their budgeted profit and loss accounts for the coming year are as follows:
Y Ltd. Z
₹ Ltd.
Sales 1,50,000 1,50,000
Less: Variable cost 1,20,000 1,00,000
Contribution 30,000 50,000
Less: Fixed Cost 15,000 35,000
Budgeted Net Profit 15,000 15,000
a) Calculate the BEPof each business:

b) Calculate the sales volume at which each of business will earn ₹5,000 profit
33
c) Calculate at which sales volume both the firms will earn equal profits.
SOLUTION
Y Ltd. Z Ltd.
a) P/V ratio = ₹30,000/₹1,50,000= ⅕ or ₹50,000/₹1,50,000= ⅓ or

Contribution / sales 20% 33.33%
b) BEP = Fixed ₹15,000/1/5 = ₹75,000 ₹35,000/1/3=₹1,05,000

cost/P/V ratio
Sales volume = Fixed ₹15,000+₹5,000/1/5 ₹3.5,000+₹5,000/1/3=₹1,20,0

cost + Desired 00
= ₹1,00,000
profit/ P/V ratio
c) Sales volume (for both the firms to earn equal profit)

d) = Difference in Fixed cost / Difference in P/V ratio = ₹20,000/ 131/3% = ₹1,50,000
PROBLEM 4
A Company manufactures and markets three products A, B and C. All the three products are
made from the same set of machines. Production is limited by machine capacity. From the
data given below indicate priorities for products A,B and C with a view to maximising
profits.
34
Product A Product B Product C
₹ ₹ ₹
Raw material cost per unit 2.25 3.25 4.25
Direct labour Cost per unit 0.50 0.50 0.50
Other Variable Cost per 0.30 0.45 0.71

unit
Selling price per unit 5.00 6.00 7.00
Standard machine time 39 minutes 20 minutes 28 minutes

required per unit
In the following year the company faced an extreme shortage of raw materials. It is
noted that 3 kg., 4 kg and 5 kg. of raw materials are required to produce one unit of A, B
and C respectively. How would product priorities change?
SOLUTION
Products
A ₹ B₹ C ₹
Current year
Selling price per unit 5.00 6.00 7.00
35
Less: Marginal cost per
unit:
2.25 3.25 4.25
Raw Materials cost -
0.50 0.50 0.50
Direct Labour cost -
0.30 0.45 0.71
Other variable cost-
3.05 4.20 5.46
Contribution per unit 1.95 1.80 1.54
Standard machine time 39 20 28

required per unit
(Minutes)
Contribution per machine 5 paise 9 paise 0.055 paise

minute
Priorities for products III II I
Following year 3 kg. 4 kg 5 kg
Raw materials required to

produce one unit
Contribution per kg of raw 65 paise 45 paise 0.308paise

materials
Priorities for products I II III
36
4.4 DECISION MAKING
APPLICATIONS OF MARGINAL COSTING - MAKE OR BUY
APPLICATIONS OF MARGINAL COSTING
Marginal costing is a very useful tool for management because of its following
applications and merits.
1. Cost control
Marginal costing dividers the total cost into fixed and variable cost. Fixed
cost can be controlled by the top management and that to a limited extent. Variable
costs can be controlled by the lower level of management. Marginal costing by
concentrating all efforts on the variable costs can control and thus provides a tool to
the management for control of cost.
2. Profit Planning
Marginal costing helps the profit planning i.e., planning for future operations
in such a way as to maximise the profits or to maintain a specified level of profit.
Absorption costing fails to bring out the correct effect of change in sale price,
variable cost or product mix on the profits on the concern but that is possible with
the help of marginal costing. Profits are increased or decreased as a consequence of
fluctuations in selling prices, variable costs and sales quantities in case there is fixed
capacity to produce and sell.
3. Evaluation of performance
The different products, departments, markets and sales divisions have

different profit earning potentialities. Marginal cost analysis is very useful for
evaluating the performance of each sector of a concern. Performance evaluation is
better done if distinction is made between fixed and variable expenses. A product,
37
department, market or sales division giving higher contribution should be preferred
if fixed expenses remain the same
4. Decision making
The information provided by the total cost method is not sufficient in solving
the management problems. Material costing technique is used in providing
assistance to the management in vital decision making, especially in dealing with the
problems requiring short-term decisions where fixed costs are excluded. The
following are important areas where managerial problems are simplified by use of
the marginal costing:
1. Fixation of selling prices
2. Key or Limiting factor
3. Make or Buy decisions
4. Selection of a suitable product mix
5. Effect of change in price
6. Maintaining a desired level of profit
7. Alternative methods of production
8. Diversification of products
9. Closing down or suspending activities
10. Alternative course of action
MAKE OR BUY DECISION
A concern can utilise the idle capacity by making component parts instead of buying
them from the market. In arriving at such a make or buy decision, the price asked by the
outside suppliers should be compared with the marginal cost of producing the component
parts. If the marginal cost is lower than the price demanded by the outside suppliers, the
component parts should be manufactured in the factory itself to utilise the unused capacity.
Fixed expenses are not taken in the cost of manufacturing component parts on the
assumption that they have been already incurred, the additional cost involved is only
variable cost.
38
FACTORS THAT INFLUENCE MAKE OR BUY DECISION
Cost factors:
1. Availability of plant facility

2. Quality and type of item- which affects the production schedule
3. The space required for the production of item
4. Any special machinery or equipment required
5. Any transportation involved due to the location of production
6. Cost of acquiring special know how required for the item
7. As to purchases of raw materials the factors like market price, price trend,
availability and others must be kept in view.
8. As to labour factors like availability of the required labour.
9. As to overhead expenses, adoption of lease for apportioning them must be
taken into consideration including other factors.
10. As to application of the techniques of costing it must be viewed for marginal
costing, differential costing or otherwise alike one.
11. Having decided to purchase, it is also to be seen whether the released
capacity can be put to more profitable use or not.
Non-Cost factors
1. Secrecy of company production

2. Idle facility available
3. Quality and stability of market supply
4. Tax considerations
5. Desirability of maintaining certain facilities
6. Lack of capital required
7. Passing the know how to suppliers or not
8. Uneven production of end products
9. Wide selection
10. The general reputation enjoyed by supplier for reliability
39
11. Financial position and reputation
12. Technical knowhow and protection facilities
13. The outside supplier should not be a competitor.
PROBLEM 1
A manufacturing company finds that while the cost of making a component part is ₹10. The
same is available in the market @₹ 9 with an assurance of continuous supply. Give your
suggestion whether to make or buy this part. Give also your views in case the supplier
reduces the price from ₹ 9 to ₹ 8. The cost information is as follows:
Materials 3.50
Direct labour 4.00
Other variable 1.00

expenses
Fixed expenses 1.50
10.00
SOLUTION
To make a decision on whether to make or buy the component part, fixed expenses being
irrelevant cost should not be added to the cost because these will be incurred even if the
part is produced. Thus, additional cost of each of the part will be s follows:
Materials 3.50
Direct labour 4.00
40
Other variable expenses 1.00
Total 8.50
The company should produce the part if the part is available in the market at ₹ 9.00
because the production of every part will give to the company a contribution of 50 paise
(i.e. ₹9.00 - ₹ 8.50).
The company should not manufacture the part if it is available in the market @ ₹8
because the additional cost of producing the part is 50 paise (i.e.₹8.50 - ₹8.00) more than
the price at which is available in the market.
In some cases in spite of lower variable cost of production, there may be an increase
in the fixed costs. In such a case, increase in fixed cost becomes the relevant cost and
should be considered for make or buy decisions. It becomes essential to find out the
minimum requirement of volume in order to justify the making instead of buying. This
volume can be calculated by the following formula:
Increase in Fixed costs
—---------------------------------------------------------------------------------------
----
Contribution per unit (i.e Purchase price - Variable cost of production)
PROBLEM 2
A firm can purchase a separate part from an outside source @₹11 per unit. There is a
proposal that the spare part be produced in the factory itself. For this purpose, a machine
costing ₹1, 00,000 with annual capacity of 20,000 units and life of 10 years will be required.
A foreman with a monthly salary of ₹500 will have to be engaged. Materials required will
be ₹ 4.00 per unit and wage2.00 per unit. Variable overheads are 150% of direct labour.
The firm can easily raise funds @10% p.a. Advise the firm whether the proposal should be
accepted.
41
SOLUTION:
Increase in Fixed costs:
Depreciation of Machine 10,000
Salary of Foreman 6,000
Interest on Capital 10,000
26,000
Contribution per unit
Purchase price 11.00
Less: Variable cost:

Materials 4.00
Wages 2.00
9.00
Variable overheads 3.00
Contribution per unit 2.00
Minimum Volume = 26,000/ 2 = 13,000 units
In order to accept the proposal it is essential that the volume should be at least 13,000
units.
If there is no idle capacity and making of the spare part in the factory involves the
loss of other work, the loss of contribution arising from displacement of work should also
be considered along with variable cost of production. The loss of contribution is found with
reference to key or limiting factor. If the purchase price is higher than the total variable
42
cost of production plus traceable fixed costs plus the loss of contribution of production, it
will be more profitable to manufacture.
PROBLEM 3
Llltd., produces a variety of products, each having a number of component parts. B takes 5
hours to process on a machine working to full capacity. B has a selling price of ₹ 50 and a
marginal cost of ₹30 per unit. A-10 component part used for product A, could be made on
the same machine in 2 hours for a marginal cost ₹5 per unit. The supplier‘s price is ₹ 12.50.
Should K Ltd., make or buy A-10? Assume that machine hour is the limiting factor.
SOLUTION
Contribution per unit of B = ₹ 50- ₹ 30= ₹20
Contribution per machine hour = ₹20/ 5= ₹ 4.
If one unit of A-10 takes 2 hours, then ₹8 (₹482) contribution is lost.
Therefore, full cost to make one unit of A-10 = ₹ 5 +₹8=₹13.
This is more than the supplier’s price of ₹ 12.50. Hence it would be more profitable to buy
A-10 than to make.
PROBLEM 4
R Ltd. purchases 20,000 bells per annum from an outside supplier at ₹5 each. The
management feels that these be manufactured and not purchased. A machine costing₹
50,000 will be required to manufacture the item within the factory. The machine has an
annual capacity of 30,000 units and a life of 5 years. The following additional information is
available:
Materials cost per bell will be - ₹ 2.00
Labour cost per bell will be - ₹ 1.00
Variable overheads - 100% of labour cost
43
Advise whether
i) The company should continue to purchase the bells from the outside supplier or should
make them in the factory and
ii) The company should accept an order to supply 5,000 bells to the market at a selling
price of ₹4.50 per unit?
SOLUTION
i) Statement showing the cost of manufacture of one unit (bell)
Per unit₹
Materials 2.00
Labour 1.00
Variable overheads 1.00
Marginal cost 4.00
Depreciation (₹10,000/20,000) 0.50
Total cost 4.50
Purchase cost 5.00
Saving per bell 0.50
Therefore the company should manufacture the bells resulting in a saving of ₹10,000
annually for 20,000 bells.
ii) Marginal cost per bell is ₹4.00 as shown above. As depreciation of the machine is
recovered on 20,000 bells, there will be no additional depreciation on the extra 5,000 bells
to be sold in the market. Further the machine has additional capacity too. Therefore, the
44
company is advised to supply 5,000 bells to the market at ₹4.50 per unit and make a profit
of Re. 0.50 per unit i.e. total profit ₹2,500.
4.5 APPLICATIONS OF MARGINAL COSTING-

DETERMINATION OF SALES MIX
INTRODUCTION
Presuming that fixed costs will remain unaffected, a decision regarding

sales/production mix is taken on the basis of the contribution per unit of each product. The
product which gives the highest contribution should be given the highest priority and the
product whose contribution is the lease, should be given the least priority. A product giving
a negative contribution should be discontinued, or given up unless there are other reasons
to continue the production.
PRACTICAL PROBLEM 1
Following information has been made available from the cost records of United
Automobiles Ltd., manufacturing spare parts:
Per unit₹
Direct materials 8
X 6
Direct wages 24 hours @25 paise per hour
X 16 hours @25 paise per hour
45
Variable overheads 150% of direct wages
Fixed overheads (Total) ₹750
Selling price 25
X 20
The directors want to be acquainted with the desirability of adopting any one of the
following alternative sales mix in the budget for the next period.
i) 250 units of X and 250 units of Y
ii) 40o units of Y only
iii) 400 units of X and 100 units of Y
iv) 150 units of X and 350 units of Y
State which of the alternative sales mixes you would recommend to the management.
SOLUTION:
Marginal cost statement (Per unit)
X Y
₹ ₹
Direct materials 8 6
46
Direct wages 6 4
Variable overheads 9 6
Marginal cost 23 16
Contribution 2 4
Selling price 25 20
Selection of sales alternative
i) 250 units of X and 250 units of Y ₹
Contribution: 500
X 250 units *2 1000
Y 250 units *4 —--------
1,500
Less: Fixed overheads 750
—--------
Profit 750
ii) 400 units of Y only
Contribution 400*4 1,600
47
—-----
Profit 850
iii) 400 units of X and 100 unit sof Y
Contribution: 800
X 400*2 400
Y 100*4 —---
1,200
—---
Profit 450
iv) 150 units of X and 350 units of Y 300
Contribution: 1,400
X 150*2 —-----
Y 350*4 1,700
Less:Fixed overheads 750
Profit —-----------
950
48
Alternative (iv) is most profitable since it gives the maximum profit of ₹950.
PRACTICAL PROBLEM 2
The budgeted results for A Company Ltd., included the following:
₹.in Lakhs Variable cost as % of

sales value
Sales 60%
A 50.00
B 40.00 50%
C 80.00 65%
D 30.00 80%
E 44.00 75%
244.00 65.77%
Fixed overheads for the period are ₹. 90 lakhs. You are asked to a) Prepare a
statement showing the amount of loss expected, b) recommend a change in the sale volume
of each product which will eliminate the expected loss. Assume that the sale of only one
product can be increased at a time.
49
SOLUTION
Statement showing the estimated loss and the increased sales required to set off the losses
Products
A B C D E Total
i) Sales 50.00 40.00 80.00 30.00 44.00 244.00
ii) Variable cost 30.00 20.00 52.00 24.00 33.00 159.00
iii) Contribution 20.00 20.00 28.00 6.00 11.00 85.00

(i-ii)
iv) Fixed 90.00

overheads
v) Loss (iv-v) 5.00
P/V ratio (iii/i) 40% 50% 35% 20% 25%
Increased sales 12.5% 10 14.29 25.00 20.00

required to set
off the loss*
As there is a budgeted loss of ₹ 5.00 lakhs and the sale of only one product can be
increased, this loss has to be set off by additional contribution. As the fixed overheads are
constant additional contribution has been calculated by dividing the budgeted loss of ₹ 5
50
lakhs by the P/V ratios of respective products. The sale of any one of the products to the
extent of the amount stated in the table would be sufficient to set off the loss.
4.6 APPLICATIONS OF MARGINAL COSTING-EXPLORING

NEW MARKETS
Decision regarding selling goods in a few market (whether Indian or foreign) should
be taken after considering the following factors:
 Whether the firm has surplus capacity to meet the new demand?
 What price is being offered by the new market? In any case, it should be higher
than the variable cost of the product plus any additional expenditure to be
incurred to meet the specific requirement of the new market.
 Whether the sale of goods in the new market will affect the present market for
the goods? It is particularly true in case of sale of goods in a foreign market at
a price lower than the domestic market price. Before accepting such an order
from a foreign buyer, it must be seen that the goods are not dumped in the
domestic market itself.
PRACTICAL PROBLEM 1
A Company annually manufactures 10,000 units of a product at a cost of ₹ 4 per unit and
there is a home market for consuming the entire volume of production at the sale price of ₹
4.25 per unit. In the year 1997, there was a fall in the demand for the home market which
can consume 10,000 units only at a sale price of ₹3.72 per unit. The analysis of the cost per
10,000 unit is:
Materials - ₹ 15,000
Wages - ₹ 11,000
Fixed overheads - ₹8,000
51
Variable Overheads - 6,000
The foreign market is explored and it is found that this market can consume 20,000 units of
the product if offered at a sale price of ₹ 3.55 per unit. It is also discovered that for
additional 10,000 units of the product (over initial 10,000 units) that fixed overheads will
increase by 10%. Is it worthwhile to try to capture the foreign market?
SOLUTION
Statement showing the advisability of selling goods in foreign market
1996 1997
Home Foreign Total market

market market
Home market 30,000 units
10,000 units 20,000 units
10,000 units ₹
₹ ₹
₹
Materials 15,000 15,000 30,000 45,000
Wages 11,000 11,000 22,000 33,000
Overheads: 8,000 8,000 1,600 9,600
Fixed
Variable 6,000 6,000 12,000 18,000
Total cost 40,000 40,000 65,600 1,05,600
52
Profit/Loss 2,500 (2,800) 5,400 2,600
Sales 42,500 37,200 71,000 1,08,200
From the above statement, it is clear that it is advisable to sell goods in the foreign
market. It will compensate not only for the loss on account of sale in the domestic market
but will also result in an overall profit of ₹2,600.
PRACTICAL PROBLEM 2
A machine tool manufacturing company sells its lathes at ₹36,500 each made up as follows:
Direct labour 2,000
Variable overheads 5,000
Fixed overheads 3,000
Variable selling 500

overheads
Royalty 1,000
Profit 5,000 32,500
53
Central excise duty 1,000
Sales tax 3,000
36,500
There is enough idle capacity.
i) A firm in Arabia has offered to buy 10 companies' lathes at ₹ 28,500 each. Should
the company be interested in the business?
ii) It has been decided to sell 5 such lathes to an engineering company under the
same management at bare cost. What price should you charge?
SOLUTION:
Computation of Marginal cost and contribution per Lathe
Direct labour 2,000
Variable overheads 5,000
Variable selling overheads 500
Royalty 1,000
54
Marginal cost 24,500
Price offered (export) 28,500
Gross contribution as Margin 4,000
i) The contribution per latheis ₹4,000 out of which about ₹3,000 will go for sales tax.
There will be savings of about ₹1,000 per lathe in case export order is executed. This
is on the presumption that the Central Government may exempt the company from
payment of central excise duty in order to encourage exports and earn foreign
exchange. There will be no increase in fixed costs since there is already surplus
capacity. The company may, therefore, accept the export order.
ii) The company may charge a price of ₹31,000 {36,500- 5500 (profit and selling
overhead)}as the bare cost, subject to any variation in the sales tax and central
excise duty payable by the company on such sales.
4.7 APPLICATIONS OF MARGINAL COSTING- ADD OR

DROP PRODUCTS
INTRODUCTION
The following factors should be considered before taking a decision about adding or
dropping a product:
1. The contribution given by the product. The contribution is different from profit.
Profit is arrived at after deducting fixed costs from contribution. Fixed costs are
apportioned over different products on some reasonable basis which may not be
55
very much correct. Hence contribution to the profitability of a product as compared
to profit.
2. The capacity utilisation, i.e. whether the firm is working to full capacity or below
normal capacity. In case a firm is having idle capacity, the production of any product
which can contribute towards the recovery of fixed costs can be justified.
3. The availability of products to replace the product which the firm wants to drop
and which is already accounting for a significant proportion of total capacity.
4. The long term prospects in the market for the product.
5. The effect on the sale of other products. In some cases the dropping of a product
may result in heavy decline in sales of other products affecting the overall
productivity of the firm.
PRACTICAL PROBLEM 1
A manufacturer is thinking whether he should drop one item from his product line and
replace it with another. Below are given his present cost and output data:
Product Price Variable cost per % of sales

unit
₹
₹
Book shelfs 60 40 30%
Tables 100 60 20%
Beds 200 120 50%
Total fixed costs per year - ₹ 75, 50,000
Sales last year - ₹25, 00,000
56
The change under consideration consists in dropping the line of tables in favour of
cabinets. If this dropping and change is made the manufacturer forecasts the following cost
output data:
Product Price Variable cost per % of sales

unit
₹
₹
Bookshelves 60 40 50%
Cabinets 160 60 10%
Beds 200 120 40%
Total fixed costs per year - ₹7, 50,000
Sales this year - ₹26, 00,000
Is this proposal to be accepted? Comment.
SOLUTION
COMPARATIVE PROFIT STATEMENT
EXISTING SITUATION
Bookshelve Tables Beds Total

s
Sales 7,50,000 5,00,000 12,50,000 25,00,000
57
Less: Variable 5,00,000 3,00,000 7,50,000 15,50,000
cost
2,50,000 2,00,000 5,00,000 9,50,000
Less: Fixed cost 7,50,000
2,00,000
PROPOSED SITUATION
Bookshelves Cabinets Beds Total
Sales 13,00,000 2,60,000 10,40,000 26,00,000
Less: Variable 8,66,667 97,500 6,24,000 15,88,167

cost
4,33,333 1,62,500 4,16,000 10,11,833
Less: Fixed 7,50,000

cost
2,61,833
58
The above analysis shows that the manufacturer will stand to gain in case he drops the
production of tables in preference to cabinets. However, the demand for cabinets should be
of a permanent nature.
Working notes: Existing situation
Computation of sales and variable costs
Sales Variable costs
Bookshelves 25,00,000*20/100= 7,50,000*40/60=5,00,000

7,50,000
Tables 25,00,000*20/100=5,00,00 5,00,000*60/100=3,00,000

0
Beds 25,00,000*50/100=12,50,0 12,50,000*120/100=7,50,0

00 00
Proposed situation
Computation of sales and variable costs
Sales Variable costs
Bookshelves 26,00,000*50/100= 13,00,000*40/60=8,66,667

13,00,000
Tables 26,00,000*10/100=2,60,00 2,60,000*60/100=97,500
59
0
Beds 26,00,000*40/100=10,40,0 10,40,000*120/100=6,24,0

00 00
PRACTICAL PROBLEM 2
A Company manufactures three products A, B and C. There are no common processes and
the sale of one product does not affect the prices or volume of sale of any other.
The company’s budgeted profit/loss for 1998 has been abstracted thus:
Total A B C
₹ ₹ ₹
Sales 3,00,000 45,000 2,25,000 30,000
Production cost : 1,80,000 24,000 1,44,000 12,000

Variable
Production cost : 60,000 3,000 48,000 9,000

Fixed
Factory cost 2,40,000 27,000 1,92,000 21,000
60
Selling and
administration
costs
Variable
24,000 8,100 8,100 7,800
Fixed 6,000 2,100 1,800 2,100
Total cost 2,70,000 37,200 2,01,900 30,900
On the basis of the above, the board had almost decided to eliminate product C, on
which a loss was budgeted .Meanwhile, they have sought your opinion. As the company’s
cost accountant, what would you advise? Give reasons for your answer.
SOLUTION:
In order to comment upon the profitability of different products, presentation of costs

according to the Marginal costing is essential. We have to compute P/V ratios.
A₹ B₹ C₹ Total₹
i) Sales 45,000 2,25,000 30,000 3,00,000
Production cost 24,000 1,44,000 12,000 1,80,000

(variable)
Selling and 8,100 8,100 7,800 24,000
61
administration
(variable)
ii) Total variable 32,100 1,52,100 19,800 2,04,000

cost
iii) Contribution 12,900 72,900 10,200 96,000
(Sale - Variable
cost)
iv) Total fixed cost 5,100 49,800 11,100 66,000
v) Profit ( iii- iv) 7,800 23,100 (900) 30,000
vi) P/V ratio 28.7% 32.4% 34.0%
If product C is discontinued, the fixed cost of ₹10,200 being recovered now cannot
be recovered since product C is making a contribution of ₹10,200 towards fixed cost.
Considering the P/V ratio, product C doesn’t seem to be unprofitable, as it is 34% being
maximum as compared to the other two products. Therefore if the heavy burden of fixed
cost which has been apportioned to product C, being 39% of the total such burden, is not
taken into account, product C is most profitable. Its profit /volume ratio is higher as
compared to the other products. This leads us to conclude that profit will increase its C’s
output and sales can be increased.
62
4.8 APPLICATIONS OF MARGINAL COSTING - EXPAND OR
CONTRAC
INTRODUCTION
Expansion of business operations results in economies of scale, greater flexibility,

lower fixed costs and greater capacity of the firm to meet the customer’s specifications.
Expansion also brings with it many organisational and communications problems. Control
and monitoring functions become more complex and delegation of authority and
responsibility becomes more confused.
Since profit maximisation is a firm’s primary goal, the expansion of business

operations should also be viewed from that angle. Expansion results in heavy fixed costs, it
means sales volume will have to be increased for meeting such costs though there may be
an increase in per unit contribution on account of economies of scale. The management
must, therefore, make sure that the market will absorb the additional volume of required
sales.
PRACTICAL PROBLEM 1
A company is considering expansion. Fixed costs amount to ₹4, 20,000 and are
expected to increase by ₹1, 25,000 when plant expansion is completed. The present plant
capacity is 80,000 units a year. Capacity will increase by 50% with the expansion. Variable
costs are currently ₹6.80 per unit and are expected to go down by ₹0.40 per unit with the
expansion. The current selling price is ₹16 per unit and is expected to remain the same
under either alternative. What are the break-even points under either alternative? Which
alternative is better and why?
SOLUTION
Computation of BEP under the two alternatives
63
Present position After expansion
₹ ₹
Fixed costs 4,20,000 5,45,000
Capacity (units) 80,000 1,20,000
Selling price per unit 16 16
Variable cost per unit 6.80 6.40
Contribution per unit 9.20 9.60
BEP 4,20,000/9.20= 5,45,000/9.60=
45,652 units 56,771 units
Assuming that the whole production can be sold, the profit under the two
alternatives will be as under:
Present position ₹ After expansion
Sales 12,80,000 19,20,000
Less: Variable cost 5,44,000 7,68,000
Contribution 7,36,000 11,52,000
Less: Fixed cost 4,20,000 5,45,000
64
Profit 3,16,000 6,07,000
It is obvious from the above calculations that profits will be almost doubled after the
expansion. Hence, the alternative of expansion is preferable.
PRACTICAL PROBLEM 2
A Limited company operates a lodging house with a restaurant, shops and

recreational facilities attached. Its manager has entrusted you with the planning of the
coming year’s operations, more particularly on the level of profits the company was likely
to earn. The lodging house has 100 double-bed rooms, which are likely to be rented at ₹150
per day. The manager expects an occupancy ratio of 75% for a period of 250 days during
the tourist season. It is also anticipated that both the beds in a room will be occupied
during the period.
Each person staying in the lodging house is expected to spend, on the basis of past
statistics ₹30 per day per month on shots attached to the lodge and ₹60 per day in the
restaurant. The recreational facilities are not charged to the customer.
Some other relevant data available to you is as under:
i) Variable cost to volume ratio:
Shops Restaurant
Cost of goods sold 40% 30%
Supplies 5% 15%
Others 5% 10%
65
ii) For the lodging house, the variable costs are ₹25 per day per occupied room for cleaning,
laundry etc.
iii) Annual fixed costs for the entire complex are ₹19, 50,000
From the above, you are required to prepare:
a) An income statement for the coming year and

b) An analysis to indicate whether the manager's suggestion of reducing the room rent
to ₹125 per day to enhance the occupancy ratio to 90% should be accepted.
SOLUTION
a) Budgeted Income statement for the coming year
1. Revenue ₹
Hotel Room receipts: 100 rooms *250 28,12,500

days *1.50*75%
Shops 100 rooms *2 11,25,000

persons * 250
days * ₹30 *75%
Restaurant 100 rooms *2 22,50,000

persons*250
days*₹60*75%
61,87,500
2. Variable costs
66
Hotel rooms 100 rooms *250 4,68,750
days*₹25*75%
Shops ₹11,25,000*50% 5,62,500
Restaurant ₹22,50,000*55% 12,37,500 22,68,750
3. Contribution (1-2) 41,40,000
Less: Fixed costs 19,50,000
Profits 21,90,000
The above computations show that the profit based on manager’s suggestion of 21,
90,000 is higher than the expected profit of ₹19, 68,750. Hence, it is advisable that the
manager’s suggestion of reducing the room rent to ₹125 per day to enhance the occupancy
ratio to 90% should be accepted.
PRODUCT ELIMINATION DECISION
PRACTICAL PROBLEM 3
A Company manufactures 3 products and their respective details are furnished below:
X Y Z
Capacity engaged 20% 40% 40%
Units produced 2,000 5,000 6,000
67
Cost per unit ₹ ₹ ₹
Materials 20 32 36
Wages 10 12 16
Variable overheads 7 9 11
Fixed overheads 20 19 20
57 72 83
Selling price per unit 55 75 85
Profit/loss 2(loss) 3 2
The management proposes to discontinue line X. It is intended to utilise the

disengaged capacity in the lines Y and Z equally. Advise the management suitably.
SOLUTION
Statement showing comparative profitability of products X, Y & Z
Particulars X Y Z Total
Per Total Per Total Per unit Total ₹

unit unit 5,000
2,000 ₹ 6,000
units
₹ units ₹ units
68
₹ ₹ ₹
Sales (A) 55 1,10,000 75 3,75,000 85 5,10,000 9,95,000
Variable
costs:
Materials
20 40,000 32 1,6,000 36 2,16,000 4,16,000
Wages 10 20,000 12 60,000 16 96,000 1,76,000
Variable 7 14,000 9 45,000 11 66,000 1,25,000

overheads
Variable 37 74,000 53 2,65,000 63 3,78,000 7,17,000

cost (B)
Contributio 18 36,000 22 1,10,000 22 1,32,000 2,78,000

n (A-B)
Less: Fixed 2,55,000

cost
Profit 23,000
P/V ratio 18/55*100=32.73 22/75*100=29.33 22/85*100=25.88%

% %
69
W No.
Calculation of Fixed cost:
X- 2,000*20=40,000
Y- 5,000*19=95,000
Z-6,000*20=1, 20,000
—---------------------------
2, 55,000
—--------------------------
Conclusion
 Product X is most profitable of the three products because of its higher P/V ratio.
 Loss per unit of ₹2 shown for X is mainly due to fixed overhead apportioned.
 X should not be discontinued .Its sales should be improved if possible.
LEARNING OUTCOMES:
 Learn the meaning of Absorption costing
 Prepare the Income statement under Absorption costing as well as Marginal
costing
 Calculate P/V ratio and BEP
 To understand the applications of Marginal costing
Short Answer questions

1. Define Marginal Costing.
2. What is Absorption Costing?
70
3. How to ascertain profit under Marginal costing?
4. Write The Meaning of the term Margin of Safety.
5. List out the uses of Break-even Charts.
Long answer questions:

1. Describe the advantages and Limitations of Absorption costing.
2. Discuss the features, Advantages and disadvantages of Marginal costing.,
3. Write a note on CVP Analysis and Assumptions.
4. State the advantages of Break-even Charts.
I SHORT ANSWER PROBLEMS
1. Given the following, calculate P/V ratio and profit when sales are ₹20,000
i) Fixed cost ₹4,000 ii) BEP ₹10,000
2. Given the following, find the margin of safety sales: i) profit earned ₹24,000 ii) Selling
price per unit ₹10 iii) Marginal cost per unit ₹7.
3. From the following compute BEP:
Selling price per unit ₹20
Variable cost per unit ₹15
If sales are 20% above BEP, determine the net profit.
COMPREHENSIVE PROBLEMS
1. Assuming that the cost structure and selling prices remain the same in Periods I and II,
find out:
71
a) P/V ratio b) Fixed cost c) BEP for sales d) Profit when Sales are of ₹1,00,000 e)
Sales required to earn a profit of ₹ 20,000 and f) Margin of safety at a profit of
₹15,000 g) Variable cost in Period II
Period I - Sales ₹1, 20,000 - Profit ₹9,000
Period II - Sales ₹1, 40,000- Profit ₹13,000
2. P Ltd. has furnished the following data for the two years:
1997-98 1998-99
Sales ₹8,00,000 ?
P/V ratio 50% 37.5%
Margin of safety sales as % 40% 21.875%

of Total sales
There has been substantial savings in the fixed cost in the year 1998-99 due to the
restructuring process. The company could maintain its sales quantity level of 1997-98 in
1998-99 by reducing selling price. Calculate the following: i) Sales for 1998-99 in ₹ ii) Fixed
cost for 1998-99
iii) BEP sales for 1998-99 in ₹
II ANSWERS FOR COMPREHENSIVE PROBLEMS
1. a) P/V ratio = 20% b) Fixed cost = ₹9,000 c) BEP (₹) = ₹75,000 d) Profit = ₹5,000 e)
Sales = ₹1,75,000 f) Margin of safety = ₹75,000 g) ₹ 1,12,000
2.i) ₹6,40,000 ii) ₹1,87,500 iii) ₹ 5,00,000
72
PRACTICE PROBLEM 2
The following figures are extracted from the books of a manufacturing concern for the year
2001:
Direct materials - ₹2, 05,000
Direct labour - ₹75,000
Variable overheads - ₹1, 00,000
Sales - ₹5, 00,000
Represent each of the above figures graphically on a break-even chart and determine from
the chart BEP making necessary assumptions. Showon the graph the effects on BEP of an
increase of 10% in a) fixed expense and b) Variable expenses.
ANSWERS:
1. BEP = 8,000 units , Selling price = ₹18

2. BEP = ₹2,50,000 a) ₹2,75,000 b) ₹3,65,854
PRACTICE PROBLEM 1
Present the following information to show to the management a) the marginal

product cost and the contribution per unit b) the contribution and profit resulting
from each of the following sales mixtures:
Product Per unit
Direct materials A 10.00
73
B 9.00
Direct wages A 3.00
B 2.00
Fixed expenses ₹800
(Variable expenses are

allocated to products as
100% of direct wages)
Sale price A 20.00
B 15.00
Sales mix:
i) 1,000 units of product A and 2,000 units of B
ii) 1,500 units of A and 1,500 units of B
ii) 2,000 units if A and 1,000 units of B
Recommend which of the sales mix should be adopted?
PRACTICE PROBLEM 2
From the following data you are required to present to the management:
i) The marginal cost of product X and Y and the contribution per unit.
ii) The total contribution and profit resulting from each of the suggested sales mix:
74
Direct materials ₹ per unit Direct wages ₹ per unit
X 10.50 X 3.00
Y 8.50 Y 2.00
Fixed expenses ₹800 Selling price

(Total)
X 20.50
Y 14.50
Variable
expenses
100% of direct
wages per
product
Suggested sales mix:
i) No of units
X- 100 & Y 200
ii) X- 150 & Y 150
iii) X - 200 & Y 10
ANSWER:
1. Profit -i) ₹7,200 ii) ₹8,200 iii) ₹ 9,200Sales mix iii is recommended.
75
2. Profit i) Nil ii) ₹100 iii) ₹ 200 Option iii is recommended.
PRACTICE PROBLEM 1
X Ltd., having an installed capacity of 1, 00,000 units of a product is currently operating at

70% utilisation. At current levels of input prices, the FOB unit cots (after credit for
applicable export incentives) works out as follows:
Capacity utilisation % FOB unit cost ₹
70 97
80 92
90 87
100 82
The company received three foreign offers from different sources as under:
Source A - 5,000 units @₹55 per unit FOB
Source B -10,000 units @₹52 per unit FOB
Source C - 10,000 units @₹51 per unit FOB
Advise the company as to whether any or all the export orders should be accepted or not.
PRACTICE PROBLEM 2
Due to industrial depression, a plant is running at present, at 50% capacity. The following
details are available:
76
Cost of production per unit₹
Direct materials 2
Direct labour 1
Variable overheads 3
Fixed overheads 2
Production per month 20,000 units
Total cost of ₹1,60,000

production
Sale price ₹1,40,000
Loss 20,000
An exporter offers to buy 5,000 units p.m. at the rate of ₹6.50 per unit and the company
hesitates to accept the offer for fear of increasing its already large operating losses. Advisor
whether the company should accept or decline the offer.
PRACTICE PROBLEM 3
The X Company manufactures a product which costs:
Fixed (per month) ₹1,000
77
Variable (per unit) 10 paise
Sales are at present 10,000 units per month at 30 paise per unit.
a) A proposal to extend the sale to a foreign market has come where demand for an
additional 5,000 units per month is expected. However, in order to do this it will be
necessary to absorb additional shipping cost and duties amounting to 12 paise per
unit. Will the foreign business be profitable?
b) A domestic chain store has offered to take 5,000 units per month at 18 paise per
unit. Should this order be accepted in place of the foreign order?
c) The sales department proposes to reduce the selling price of the product to increase
sales. The following estimates of sales volume at various prices are made:
i) 30 paise per unit (present price) - 10,000 units p.m.
ii) 25 paise per unit - 14,000 units p.m.
iii) 20 paise per unit - 19,000 units p.m.
Assuming that the above estimates are correct, should you reduce the price? If so,
what level?
ANSWER
1. A- Loss ₹10,000 B - Nil C - ₹90,000. Should accept all the orders.

2. The company should accept the offer since the amount of loss will stand reduced
from ₹ 20,000 to ₹17,500.
3. a) Additional profit - ₹1,000 b) i) Total profit ₹1,000 ii) Total profit - ₹1,100 iii)
Total profit - ₹900
Thus ignoring the question of additional sale abroad or to domestic chain store. Sale
of 14,000 units gives the best results. It may be advisable to accept the order of
5,000 units from abroad, besides selling 14,000units @ ₹0.25 per unit, presuming
availability of capacity.
78
PRACTICE PROBLEM 1
As a prelude to finalizing the plans for the coming year, the executives thought it is
advisable to have a look at the product-wise performance during the current year. The
following information is furnished:
Particulars A₹ B₹ C₹
Unit selling price (i) 80 60 36
Direct material 28 24 16
Direct labour 20 12 12
Factory overhead
Variable 8 6 4
Fixed 8 6 1.28
Cost of production 64 48 33.28
Selling, distribution and

general administration
4 2 2
Expenses:
4 6 1.52
Variable
Fixed
Unit cost(ii) 72 56 36.80
79
Unit profit (Loss) 8 4 (0.80)
(i) - (ii)
Sales volume (units) 10,000 15,000 15,000
Profit (loss) 80,000 60,000 (12,000)
For the coming period, the selling prices and costs of the three products are
expected to remain unchanged. There will be an increase in the sales of Product A by 1,000
units and the increase in sales of Product C is expected to be 8,000 units. The sales of
product B will remain unchanged. Sufficient additional capacity exists to enable the
executives to contend that it will be unwise to go for additional production and sale of
product C since it is already losing ₹ 0.80 per unit. Their suggestion is that product C should
be eliminated altogether. Do you agree? Substantiate with necessary analysis and
determine the product-wise and overall profits for the coming year.
PRACTICE PROBLEM 2
A Company which sells four products, some of them unprofitable, proposes discontinuing
the sale of one of them. The following information is available regarding income, costs and
activity for the year ended 31.3.1999:
Products
A B C D
₹ ₹ ₹ ₹
80
Sales 3,00,000 5,00,000 2,50,000 4,50,000
Cost of sales at 2,00,000 4,50,000 2,10,000 2,25,000

purchase price
Area of storage ( sq. 60,000 40,000 80,000 30,000

ft)
No. of parcels sent 1,00,000 1,50,000 75,000 1,75,000
No. of invoices sent 80,000 1,40,000 60,000 1,20,000
Its overhead costs and basis of allocation are:
Fixed costs: ₹ Basis of allocation to products
Rent and insurance 30,000 Sq.ft. occupied
Depreciation 10,000 Parcels sent
Salesmen's salaries and 60,000 Sales volume

expenses
Administration wages 50,000 No. of invoices

and salaries
Variable costs:
81
Packing wages and 20 paise per parcel
materials
Commission 4% of sales
Stationery 10 paise per invoice
Prepare:
i) Profit and loss statement, showing the percentage of profit or loss to sales for each
product.
ii) Compare the profit if the company discontinues the sale of product B with the profit if it
discontinues C.
PRACTICE PROBLEM 3
A Limited manufactures three different products and the following information has been
collected from the books of account:
Products
S T Y
Sales mix 35% 35% 30%
Selling price ₹30 ₹40 ₹20
Variable cost ₹ 15 20 12
82
Total fixed costs ₹ 1,80,000
Total sales ₹ 6,00,000
The company has currently under discussion a proposal to discontinue the manufacture of
product Y and replace it with product M, when the following results are anticipated:
Products
S T M
Sales mix 50% 25% 25%
Selling price ₹ 30 40 30
Variable cost ₹ 15 20 15
Total fixed costs ₹ 1,80,000
Total sales ₹ 6,40,000
Will you advise the company to change over to production of M? Give reasons for your
answer.
ANSWER:
1. Total profit =₹1, 28,000
Performance for the coming year: Profit - A - ₹1, 00,000 B- ₹ 60,000 C- ₹ 4,000
83
Product c should not be discontinued since it also contributes towards meeting the fixed
costs of the company.
2. i)A- profit -9.5% B -Loss - 12.1% C- Loss - 8.8% D profit - 26.4%
ii) Total profit if B is discontinued ₹ 79,000, total profit if C is discontinued ₹ 56,000.
3. Present profit - ₹1, 02,000 Present BEP - ₹3, 83,000 Profit under proposed situation
₹1, 40,000. BEP - ₹3, 60,000. The proposal to replace product Y with product M is to be
accepted.
PRACTICE PROBLEM 1
A Company produces three products for which the following operating statement has been
presented:
Products A B C Total
₹ ₹ ₹ ₹
Sales 32,000 45,000 40,000 1,1,7000
Total costs 35,000 30,000 95,000
30,000
Net profit/loss -3,000 15,000 10,000 22,000
The total costs comprise variable costs 70% and fixed costs 30%. The Directors consider
that as product A shows a loss it should be discontinued. Based on the above data, should
the product A be dropped? What other factors should be considered?
84
PRACTICE PROBLEM 2
The Excel Ltd., has three divisions each of which makes a different product. The budgeted
data for the next year are as follows:
Divisions A B C
₹ ₹ ₹
Sales 1,12,000 56,000 84,000
Costs:
Direct materials 14,000 7,000 14,000
Direct labour 56,000 7,000 22,400
Variable 14,000 7,000 28,000

overheads
Fixed costs 28,000 14,000 28,000
The management is considering closing down division C. There is no possibility of reducing

fixed costs. Advise whether or not Division C should be closed down.
ANSWERS
1. Product A should not be dropped because it contributes ₹7,500.

2. Division C should not be closed because it contributed ₹19,600
85
UNIT V
Contents
LEARNING OBJECTIVES.................................................................................. 259
5.1 BUDGETARY CONTROL ................................................................ 259
5.2 PRODUCTION BUDGET ................................................................. 268
5.3 CASH BUDGET .................................................................................. 273
5.4 FIXED AND FLEXIBLE BUDGET ................................................. 280
5.5 STANDARD COSTING AND VARIANCE ANALYSIS.............. 287
5.6 DIRECT LABOUR VARIANCES .................................................... 293
5.7 ACCOUNTING STANDARDS ......................................................... 307
5.8 ACCOUNTING DISCLOSURE PRACTICES IN INDIA ............ 315
LEARNING OUTCOMES ................................................................................... 320
SHORT ANSWER QUESTIONS: ..................................................................... 320
LONG ANSWER QUESTIONS ......................................................................... 320
258
LEARNING OBJECTIVES
 To understand the Meaning , objectives and importance of Budget and Budgetary
control
 To explain the process of preparing Production Budget
 To estimate the amount of cash receipts and cash payments
 To identify the Fixed expenses which remain constant irrespective of the level of
activity
 To identify the variable costs that are to be incurred
 To learn about standard costing.
 To learn the various accounting standards and its applications
5.1 BUDGETARY CONTROL
Meaning of Budget, Budgeting and Budgetary Control
A Budget is a blue print of a plan expressed in quantitative terms. Budgeting is technique

for formulating budgets. Budgetary Control refers to the principles, procedures and practices of
achieving given objectives through budgets.
Definition of Budget, Budgeting and Budgetary Control
Rowland and William have differentiated the three terms as: “Budgets are the individual
objectives of a department, etc., whereas Budgeting may be said to the act of building budgets.
Budgetary control embraces all and in addition includes the science of planning the budgets to
effect an overall management tool for the business planning and control”
Objectives of Budgetary Control
 To ensure planning for future setting up various budgets.

 To co-ordinate the activities of different departments.
 To operate various cost centres and departments with efficiency and economy.
 Elimination of wastes and increase in profitability.
259
 To anticipate capital expenditures for future.
 To centralize the control system.
 Correction of deviations from the established standards.
 Fixation of responsibilities of various individuals in the organization.
Characteristics of Good Budgeting
 A good budgeting system should involve persons at different levels while

preparing the budgets.
 The delegation of authority should be done in a proper way.
 The targets of the budgets should be realistic and be able to follow.
 A good system of Accounting is also essential to make budgeting successful.
 The budgeting system should have a whole-hearted support of the top
management.
 The employees should be imparted budgeting education.
 The actual results should be promptly reported frequently so that performance
appraisal is undertaken.
Advantages of Budgetary Control
 Maximization of profit
 Proper Co-ordination
 Provides specific aims
 Tool for measuring performance
 Economy
 Corrective action
 Creates Budget consciousness
 Reduces Costs
 Determines weakness
 Introduction of incentive schemes
Limitations of Budgetary Control
260
 Uncertain future
 Revision required
 Discourages efficient persons
 Problem of Co-ordination
 Conflict among different departments
 Depends upon support of Top management
Types of Budget
The types of Budget are as follows:
Sales Budget:
Sales factor becomes a key factor in the majority cases, and therefore, it is the starting point.
Sales Budget is a financial plan on allocation of resources to achieve the forecasted sales.
It focuses on the number of products sold and at the price which they are sold. It estimates a
company’s total revenue in a specific time period. This is the most important budget as it is
usually difficult to forecast. It is prepared by the sales manager. In the preparation, the sales
manager should consider the following points:
1. Analysis of the sales of the previous year,

2. Salesman’s assessment,
3. General trade conditions,
4. Availability of raw materials,
5. Availability of funds,
6. Plant capacity,
7. Seasonal fluctuations,
8. Restrictions imposed by the Government,
9. Competition and Consumer’s preference,
10. Efficiency of advertising.
Sales budget must be shown in terms of finished products, quantities and price; and it is
prepared according to products, territories, periods, types of customer or salesman etc.
261
Production Budget:
It is a budget prepared by the production manager, showing the forecast of output. The
objective is to determine the quantity of production for a budgeted period. It is in quantity of
units to be produced during the budget period. It is based on the Sales Budget. It is in two parts –
one part contains the volume of production and the other part shows the cost of production. Cost
of production includes material, labour and overheads. Apart from the sales budget, optimum
utilization of plant, availability of raw materials, labour etc., are to be considered. It must avoid
overwork in rush seasons. It must contain a minimum stock of finished goods.
Cash Budget:
This budget represents the amount of cash receipts and payments and a balance during
the budgeted period. It is prepared after all the functional budgets are prepared by the Chief
Accountant either monthly or weekly giving the following hints-
I. It ensures sufficient cash for business requirements,

II. It proposes arrangements to be made overdraft to meet any shortage of cash,
III. It reveals the surplus amount, and the effect of the seasonal fluctuations on cash
position.
The objective of Cash Budget is the proper co-ordination of total working capital, sale,
investment and credit.
Fixed Budget:
This is a budget which is designed to remain unchanged irrespective of the level of

activity actually attained. This is prepared for definite production and capacity level. It is not
adjusted according to activity level attained. The fixed budgets are not effective tools of cost
control. These types of budgets have limited use. However, in practical life, conditions do not
remain static. The main reason is that actual output is often different from the budgeted output.
In such a case, the budget cannot be used for the purpose of cost control. There may be internal
or external factors which force the level of activity to change.
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Flexible Budget:
This is a dynamic budget. It is a budget which is designed to change in accordance with

the level of activity. Actual output may differ from the budgeted output; and as such, it is
necessary to modify the budget on the basis of changed output. The budget is prepared in such a
way to present the budgeted cost for different levels of activity, it is more realistic and practical,
because changes expected at different levels of activity are given due consideration. It is also
called variable budget or sliding scale budget. The expenses are divided into three categories –
fixed, variable and semi- variable. It is an important tool of cost control, as it facilitates
comparison of actual results with the budgeted figures.
Zero based Budgeting:
The purpose of Management control is to ensure better performance and better utilisation
of scarce resources. Traditional budgeting fails to achieve this objective of Management
effectively. “Zero based budgeting” provides a solution towards this end.
“Zero based budgeting” was originally developed by Peter A. Pyhrr at Texas

instruments. Peter A.Pyhrr has defined ZBB as “An operating, Planning and Budgeting
processes which requires each manager to justify his entire budget request in detail from
scratch and shifts the burden of proof to each manager to justify why we should spend any
money at all”
Zero based budgeting involves the following aspects
1. Concerned with all requisites of Budgets

2. Evaluation of existing and newly proposed activities
3. Planning the resources, Prioritization of different activities and redeployment of
resources accordingly
SALES BUDGET
Problems:
263
1. Shri Ram Company Ltd., manufactures two products X and Y. Its sales department has
three divisions: East, Westand North. Preliminary sales budgets for the year ending 31 st
December 1999 based on the assessments of the divisional managers were:
Product X: East – 3, 00,000 units; West – 6, 00,000 units and North – 1, 50,000 units
Product Y: East – 4, 00,000 units; West – 5, 00,000 units and North – Nil
Sales price = X: Rs.5 and Y: Rs.4 in all areas
Arrangements are made for the extensive advertising of products X and Y and it is
estimated that East division sales will increase by 1, 50,000 units. Arrangements are also
made to advertise and distribute product Y in the Northern area in the second half of 1999
when sales are expected to be 6,00,000 units.
Since the estimated sales of the West division represented an unsatisfactory target,
it is agreed to increase both the estimates by 20%.
Prepare a sales budget for the year to 31st December 1999.

Solution:
Shri Ram Co. Ltd.
Sales Budget for the year 1999
Divisions Product ‘X’ Product ‘Y’ Total
Rs.
Quantity Price Value Quantity Price Value
Rs. Rs. Rs. Rs.
East 4,50,000 5 22,50,000 5,50,000 4 22,00,000 44,50,000
West 7,20,000 5 36,00,000 6,00,000 4 24,00,000 60,00,000
North 1,50,000 5 7,50,000 6,00,000 4 24,00,000 31,50,000
13,20,000 66,00,000 17,50,000 70,00,000 136,00,000
1. An estimate shows that there is a market for 10, 00,000 units of divide 80% of the
market. Among other companies producing the bell, Ranjini Ltd., should get 15% of the
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total market. 60% of Ranjini’s Sales will probably be evenly divided between the first
and the last calendar quarters of the year, with twice as many sales being made in the
second quarter as in the third.
The bell sells for Rs. 60 a unit with manufacturing costs as follows:
The cost is worked out with reference to normal working capacity for the production
which is 1, 50,000 bells a year.
Direct Material Cost – Rs.30, Direct Labour Cost – Rs.15

Variable Overhead Cost – Rs.5, Fixed Overhead – Rs.2, 00,000
Prepare a Sales Budget for the year showing Cost of Production and Gross Profit by
calendar quarters. Assume no change in the inventory levels during the year.
Solution:
Working Note
Sales of Rajini Ltd., should be 15% of 10, 00,000 i.e. 1, 50,000 bells.60% of 1, 50,000
i.e. 90,000 bells evenly divided between first and last calendar quarter.
Rs.
1st Quarter = 45,000
Last Quarter = 45,000
2ndQuarter Balance 1, 50,000 – 90,000 = 60,000 x 2/3 = 40,000
3rd Quarter = 60,000 x 1/3 = 20,000

--------------
Total Sales = 1, 50,000
--------------
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Sales Budget (Rs. In lakhs)
Production and Sales I Quarter II Quarter III Quarter IV Quarter Total

(Units) 45,000 40,000 20,000 45,000 1,50,000
Direct material 13.50 12.00 6.00 13.5 45.00
Direct labour 6.75 6.00 3.00 6.75 22.50
Variable Overhead 2.25 2.00 1.00 2.25 7.50
Fixed Overhead 0.50 0.50 0.50 0.50 2.00
Cost of Production 23.00 20.50 10.50 23.00 77.00
(A)
Sales (B) 27.00 24.00 12.00 27.00 90.00
Gross Profit (B) - (A) 4.00 3.50 1.50 4.00 13.00
2. Quick products Ltd., sells two products X and Y in two divisions North and South. The
following were the budgeted and actual sales for the year 1999.
Budget Actual
North South North South

Units Rs.per Units Rs.per Units Rs.per Units Rs.per
unit unit unit unit
Product 500 180 300 180 600 180 400 180
X
Product 300 430 200 430 200 430 150 430
Y
For the year 2000, the board of directors has approved the proposal of sales department to
increase the price of ‘X’ to Rs.200 and decrease the price of ‘Y” to 400. The sales estimates from
the divisional managers were as follows:
North. X -800 units “Y” – 500 units

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South. X- 600 units ‘Y- 300 units.
An intensive advertising campaign proposed by advertising consultants is expected to

result in additional sales of 20% of each product in each division over the estimated sales.
Prepare the sales budget for the year 2000 and present it together with the budgeted and actual
sales for 1999.
Solution:
Quick products Ltd.,
Sales budget for the year 2000
Division Product Budget for 2000 Budget for 1999 Actual sales for 1999
Qty Price Amount Qty Price Amount Qty Price Amount

Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
North X 960 200 1,92,000 500 180 90,000 600 180 1,08,000
Y 600 400 2,40,000 300 430 1,29,000 200 430 86,000
Total 1560 4,32,000 800 2,19,000 800 1,94,000
South X 720 200 1,44,000 300 180 54,000 400 180 72,000
Y 360 400 1,44,000 200 430 86,000 150 430 64,500
Total 1080 2,88,000 500 1,40,000 550 1,36,500
Total X 1680 200 3,36,000 800 180 1,44,000 1000 180 1,80,000
Y 960 400 3,84,000 500 430 2,15,000 350 430 1,50,500

Total 2640 7,20,000 1300 3,59,000 1350 3,30,500
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5.2 PRODUCTION BUDGET
1. Prepare Production budget for the quarter ending 31st March 2004:
SOLUTION:
PRODUCTION BUDGET FOR MARCH 31, 2004
2. A firm produces two products called ‘A’ and ‘B’. The opening balance of the productsare
7,800 units and 8,400 units respectively. The estimated sales during a month are 14,700units and
15,300 units respectively. The required closing balances are 8,200 and 9,000 units.
SOLUTION:
PRODUCTION BUDGET
268
3.The following details apply to an annual budget for a manufacturing company:
Quantity of raw material per unit of production: 2 kgs
Budgeted opening stock of raw materials: 4,000 kg (cost Rs. 4,000)
Budgeted closing stock of raw materials: 2,000 kg.
Issues are priced on FIFO basis.
Calculate the following budgeted figures:
(i) Quarterly and annual purchases of raw material by weight and value.
(ii) Closing quarterly stock by weight and value.
SOLUTION:
PRODUCTION BUDGET – FIFO ISSUE
269
4. From the following particulars, prepare a production budget of Sales Corporation forthe year
ended on 30th June 2007.
SOLUTION:
PRODUCTION BUDGET FOR 2006 – 2007
5. Prepare a production budget for 3 months ending 31-3-1998 for a factory producing
5 products, on the basis of the following information.
270
SOLUTION:
PRODUCTION BUDGET FOR 31.03.1998
6. From the following particulars, prepare production budget for 3 months ending 30th June 1993.
It is the policy of the company to maintain 50% of the month’s sales as opening Stock
SOLUTION:
PRODUCTION BUDGET FOR 3 MONTHS FROM APRIL – JUNE
(In Units)
271
7. A manufacturing unit plans to sell 1, 10,000 units in the first week, 1, 20,000 units inthe
second week, 1, 30,000 units in the third week and 1, 40,000 units in the fourth week. At
thebeginning of the first week there are 14,000 units in the stock. At the end of each week
thecompany plans to have an inventory equal to one fifth of the sales for the next week.
How manyunits must be manufactured in each week?
SOLUTION:
PRODUCTION BUDGET FOR 3 MONTHS FROM APRIL – JUNE
(In units)
8. The following figures relating to product “Duper” for the quarter ending 31.03.2007 are
available:
Budgeted sales: January – 3, 00,000 units; February – 2, 40,000 units; March – 3, 60,000 units.
Stock position: 01.01.2007 – 50% of January’s budgeted sales; 31.03.2007 – 80,000 units;
31.01.2007 – 40% of February’s budgeted sales; 28.02.2007 – 60% of March’s budgeted sales.
You are required to prepare a production budget for the quarter ending 31.03.2007.
SOLUTION:
272
PRODUCTION BUDGET FOR 3 MONTHS FROM JAN - MARCH
(In Units)
5.3 CASH BUDGET
1. XYZ Company wishes to arrange O.D. facilities with its bankers during the period
April – June, when it will be manufacturing mostly for stock.
(i) Prepare cash budget for the above period from the following data
(ii) 50% of credit sales is realised in the month following the sale and the other 50%in the
second month following. Creditors are paid in the month following themonth of Purchase.
(iii) Wages are paid at the end of the respective month.
(iv) Cash at bank – 1st April – Rs. 25,000.
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Working Notes:
SOLUTION:
Cash budget for the month ending June of XYZ Company
2. Using the information given below prepare a cash budget showing expected cashreceipts and
disbursements for the month of May and balance expected at May 31, 2006.
Budgeted cash balance May 1, 2006 – Rs. 60,000.
Sales: March – Rs. 5, 00,000; April – Rs. 3, 00,000; May – Rs. 8, 00,000.
Half collected in the month of sales, 40% in the next month and 10% in the third month.
Purchases: April – Rs. 2, 50,000; May – Rs. 4, 00,000.
40% paid in the month of purchase, and 60% paid in next month.
Wages due in May for Rs. 88,000. 3 years insurance policy due in May for renewal Rs. 2,000to
be paid in cash. Other expenses for May, payable in May: Rs. 44,000. Depreciation for the
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month of May Rs. 2,000. Accrued taxes for May, payable in December Rs. 6,000. Fixed deposit
receipts due May 15th Rs. 1, 75,000 plus Rs. 10,000 interests.
Working Notes:
SOLUTION:
Cash budget for the month ended May
275
3. A firm expects to have Rs. 30,000 on 1st May 2006 and requires you to prepare anestimate of
the cash position during the 3 months May to July 2006. The following informationis supplied to
you.
Other information:
(i) 25% of the sale is for cash, remaining amount is collected in the month following that of sale.
(ii) Suppliers supply goods on two months credit.
(iii) Delay in payment of wages and all other expenses: one month.
(iv) Income tax of Rs. 10,000 is due to be paid in July.
(v) Preference share dividend of 10% on Rs. 1, 00,000 is to be paid in May.
Working Notes:
SOLUTION:
Cash budget for the period ending May – July 2006
276
4. Prepare a cash budget for the months of May, June and July 2006 on the basis of thefollowing
information:
(a) Income and expenditure forecasts:
(b) Cash balance on 1st May 2006 – Rs. 8,000.
(c) Plant costing Rs. 16,000 is due for delivery in July: Payable 10% on delivery and thebalance
after 3 months.
(d) Advance tax of Rs. 8,000 each is payable in March and June.
(e) Period of credit allowed: (i) by suppliers – 2 months and (ii) to customers – 1 month.
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(f) Lag in payment of manufacturing expenses – ½ month.
(g) Lag in payment of office and selling expenses – 1 month.
Working Notes:
SOLUTION:
Cash budget for the period ending May – July 2006
5. From the following budgeted figures prepare a cash budget in respect of three months to June
30.
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Expected cash balance on 1st April – Rs. 20,000.
Other information:
(a) Materials and overheads are to be paid during the month following the month ofsupply.
(b) Wages are to be paid during the month in which they are incurred.
(c) Terms of sales: The terms of credit sales are payment by the end of the month following the
month of sales; 1/2 of the sales are paid when due the other half to be paid during the next
month.5% sales commission is to be paid within the month following actual sales.
(d) Preference dividend of Rs. 30,000 is to be paid on 1st May.
(e) Share call money of Rs. 25,000 is du on 1st April and 1st June.
(f) Plant & Machinery worth Rs. 10,000 is to be installed in the month of January and the
payment is to be made in the month of June.
Working Notes:
SOLUTION:
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Cash budget for the period of April – June
Particulars April May June

Opening balance of cash 20,000 32,600 (5,600)
Add: cash receipts
Sales: 1st month 32,000 40,000 42,000
2nd month 28,000 32,000 40,000
Share call money 25,000 ------ 25,000
Total receipts(A) 1,05,000 1,04,600 1,01,400
Less: cash payments
Wages 12,400 13,000 14,000
Materials 50,000 56,000 62,000
Overheads 6,800 7,200 8,600
Preference dividend ----- 30,000 -------
Plant and Machinery ----- ----- 10,000
Sales Commission 5%(one 3,200 4,000 4,200
month delay)
Total payments(B) 72,400 1,10,200 98,800
Closing cash balance (A)-(B) 32,600 (5,600) 2,600
5.4 FIXED AND FLEXIBLE BUDGET
1. A company which supplies its output on contract basis as component to an assembling

firm has a contract to supply 10,000 units of its only product during 1999. The following
were the budgeted expenses and revenue
Material Rs.15 per unit
Wages Rs.10 per unit
Work expenses- Fixed Rs.40,000
280
Work expenses- Variable Rs. 4 per unit
General expenses(all fixed) Rs. 60,000
Profit is 20% on sale price. Prepare the Budget for 1999 showing the cost and Profit
Solution:
Fixed Budget (Output 10,000 units)
Particulars Total (Rs) Per unit
Variable Cost:
Materials 1,50,000 15.00
Wages 1,00,000 10.00
Prime cost 2,50,000 25.00
Add :Work expenses Fixed 40,000 4.00
Work expenses: Variable 40,000 4.00
Works cost 3,30,000 33.00
Add: General expenses 60,000 6.00
Total cost 3,90,000 39.00
Add: Profit 97,500 9.75
3,90,000 X 20/(100-20)
Sales 4,87,500 48.75
2. Prepare a flexible budget for production at 80% and 100% activity on the basis ofthe
following information:
SOLUTION:
281
FLEXIBLE BUDGET
3.With the following data for 60% activity, prepare a budget at 80% activity. Productionat 60%
capacity – 600 units; Materials – Rs. 100 per unit; Labour – Rs. 40 per unit; Directexpenses – Rs.
10 per unit; Factory expenses – Rs. 40,000 (40% fixed); Administrationexpenses –
Rs. 30,000 (60% fixed).
SOLUTION:
FLEXIBLE BUDGET
282
4. A company at present operating at 50% capacity produces and sells 10,000 units.The unit cost
is Rs. 180 and the selling price is Rs. 200. The expenses per unit are givenbelow:
Direct material – Rs. 100; Direct labour – Rs. 30; Factory expenses (60% variable) – Rs. 30;
Administrative expenses (40% fixed) – Rs. 20. Prepare a flexible budget at 80% capacity.
SOLUTION:
FLEXIBLE BUDGET
283
5. A company at present operating at 80% capacity produces and sells 40,000 units.
Given below are the expenses per unit.
Prepare a budget at 60% capacity and 90% capacity.
SOLUTION:
FLEXIBLE BUDGET
Particulars Per unit 60% Per 80% Per unit 90%

unit
(30,000 units) (40,000 units) (45,000 units)
Direct materials 15 4,50,000 15 6,00,000 15 6,75,000
Direct labour 10 3,00,000 10 4,00,000 10 4,50,000
Prime cost 7,50,000 10,00,000 11,25,000
Factory
Expenses
30% Fixed 12 60,000 1.50 60,000 1.33 60,000
70% variable 3.50 1,05,000 3.50 1,40,000 3.50 1,51,500
Office expenses
40%Fixed 1.60 48,000 1.20 48,000 1.07 48,000
60% variable 1.80 54,000 1.80 72,000 1.80 81,000
Selling expenses
50% Fixed 1.33 40,000 1 40,000 0.89 40,000
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50% variable 1 30,000 1 40,000 1 45,000
Total cost 10,87,000 14,00,000 15,56,500
6. Prepare a flexible budget on the basis of the data given below and ascertain the totalcost at
40% capacity and 80% capacity levels.
SOLUTION:
FLEXIBLE BUDGET
285
7.Following is the cost structure of Chandran Ltd
Particulars Level of activity

60% 70% 80%
Output (in units) 2,400 2,800 3,200
Costs Rs. Rs. Rs.
Materials 48,000 56,000 64,000
Wages 14,400 16,800 19,200
Factory overheads 25,600 27,200 28,800
Total cost 88,000 1,00,000 1,12,000
The factory is considering an increase of production to 90% level of activity. No increase

infixed overheads is expected at this level. The management requires a statement showing
alldetails of factory cost at 90% level of activity.
SOLUTION:
FLEXIBLE BUDGET
Particulars p/u 60% p/u 70% p/u 80% p/u 90%

Variable
Expenses
Materials 20 48,000 20 56,000 20 64,000 20 72,000
Wages 6 14,400 6 16,800 6 19,200 6 21,600
Semi-variable expenses
Factory overheads-Fixed 6.70 16,000 5.71 16,000 5 16,000 4.40 16,000
Variable 4 9,600 4 11,200 4 12,800 4 14,400
Total cost 36.70 88,000 35.71 1,00,000 35 1,12,000 34.40 1,24,000
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5.5 STANDARD COSTING AND VARIANCE ANALYSIS
Standard Cost: Standard Cost is “A predetermined cost which is calculated from

management’s standards of efficient operation and the relevant necessary expenditure. It
may be used as a basis for price fixing and for cost control through variance analysis”
ICMA England.
Standard Costing: As per the ICMA England Terminology of Cost Accounting.

“Standard costing is the preparation and use of standard costs, their comparison with
actual costs and the analysis of variances to their causes and points of incidence.”
Advantages of Standard Costing:
1. Controlling and reducing costs becomes a systematic practice under standard costing
2. Standard costing provides the norms and yardsticks with which the actual performance
can be measured and assessed
3. The whole firm is imbibed with a dynamic forward looking mentality
4. It helps to promote labour efficiency and productivity
5. It helps in valuing the closing stock
6. It helps in fixing the selling price in advance of production thus quotation can be sent and
orders secured
7. It simplifies the accounting procedure resulting in less clerical work and time
Limitations of Standard Costing
1. It is quite difficult to establish accurate standard costs, inaccurate and unreliable

standards do more harm than good
2. It is not suitable for job or contract type industries and also in organisations where work
is not repetitive in nature
3. Operation of the standard costing system is it costly affair and small firms cannot simply
afford it
4. The staff may not be capable of operating the system
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5. When standards are set at a high level , its non-achievement may have an adverse effect
on the morale and motivation of the employees
MEANING OF VARIANCE AND VARIANCE ANALYSIS
Variance:
According to ICMA, England a cost variance is “The difference between a standard cost and
the comparable actual cost incurred during a period “
Variance Analysis
According to ICMA England Variance analysis is “The resolution into constituent parts and
explanation of variances“
COMPUTATION OF VARIANCES
Variances can be broadly classified into two categories
1. Cost variance
2. Sales variance
Direct Material Cost Variance:
It is the difference between standard direct material cost for the actual output and the actual cost
of direct materials used.
DMCV= Standard cost for actual output –Actual cost of materials used
=(Standard price x standard quantity of material for actual output) - (Actual price x Actual
quantity of materials used)=(SP x SQ)-(AP x AQ)
288
DMPV= Standard cost of actual material used –Actual cost of materials used
=Actual Quantity x (standard price – Actual Price)=(AQ X SP-AP)
DMMV= Total actual Quantity in standard proportions at standard price- Actual Quantity of
each material at standard price
=standard price x (Revised standard quantity– Actual Quantity)=SP x (RSQ- AQ)
DMYV= Standard cost per unit of output x (Standard yield for actual material – Actual yield)
Problems:
1. Product “A’ requires 10kg of Material at the rate of ₹4 per kg. The actual consumption
of material for manufacturing of product “A” came to 12 kg of material at the rate of 4.50
per kg. Calculate (i) Material Cost Variance (ii) Material usage variance (iii) Material
Price Variance
Solution:
(i) DMCV= Standard cost for actual output –Actual cost of materials used
quantity of materials used)= (SP x SQ)-(AP x AQ)
= (4 x 10)- (4.50 X 12) = 40 - 54= ₹. 14 (Adverse)
(ii)DMUV = standard price x(standard quantity– Actual Quantity)
=SP x (SQ- AQ) =. 4 x (10-12) = ₹. 8 (Adverse)
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(iii)DMPV= Standard cost of actual material used –Actual cost of materials used
=Actual Quantity x (standard price – Actual Price)
= (AQ X SP-AP) = 12 x (4- 4.50) = ₹. 6 (Adverse)
2. Calculate Material variances from the following data:
Particulars Standard Actual
Quantity 400kgs 460kgs
Price ₹. 2 per kg ₹.1.5 per kg
Value ₹. 800 ₹. 690
Solution:
(i)DMCV= Standard cost for actual output –Actual cost of materials used
quantity of materials used)=(SP x SQ)-(AP x AQ)
= (2 x 400) -(1.5 x 460) = ₹.110 (Adverse)
(ii)DMUV = standard price x(standard quantity– Actual Quantity)
=SP x (SQ- AQ) = ₹. 2 x (400-460) = ₹.120 (Adverse)
(iii)DMPV= Standard cost of actual material used –Actual cost of materials used
=Actual Quantity x (standard price – Actual Price)= (AQ X SP-AP)
= 460 x (2-1.50) = ₹. 230 (Favourable)
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3. From the following information of a product calculate
(i) Material Cost Variance (ii) Material usage variance (iii) Material Price Variance
(iv) Material Mix Variance (ii) Material sub-usage variance
Material Standard Quantity(Kgs) Standard Price Actual Actual Price
(₹) Quantity(Kgs) (₹)
X 20 5 24 4.00
Y 16 4 14 4.50
Z 12 3 10 3.25
48 48
Solution:
(i) DMCV= Standard cost for actual output –Actual cost of materials used
=(Standard price x standard quantity of material for actual output)- (Actual
price x Actual quantity of materials used)=(SP x SQ)-(AP x AQ)
X =(5 x 20)- (4 x 24) = 100-96= ₹4 (Favourable)
Y =(4 x 16)- (4.5 x 14) = 64-63= ₹1 (Favourable)
Z =(3 x 12)- (3.25 x 10) = 36-32.5= ₹3.5 (Favourable)
Material Cost Variance = ₹8.5 (Favourable)
(ii) DMUV = standard price x ( standard quantity– Actual

Quantity) =SP x (SQ- AQ)
X= 5(20-24) = 5 x -4= ₹20 (Adverse)
Y= 4(16-14) = 4 x 2= ₹8(Favourable)
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Z= 3(12-10) = 3 x 2 = ₹6(Favourable)
Material usage variance =₹6 (Adverse)
(iii) DMPV= Standard cost of actual material used –Actual cost of materials used
=Actual Quantity x (standard price – Actual Price)
=(AQ X SP-AP)
X= 24(5-4) = 24 x 1 = ₹24 (Favourable)
Y=14(4-4.5) = 14 x -0.5= ₹ 7(Adverse)
Z= 10(3-3.25) = 10 x -0.25 = ₹2.5(Adverse)
Material Price variance = ₹14.5 (Favourable)
(iv)DMMV= Total actual Quantity in standard proportions at standard price- Actual Quantity of
each material at standard price
=standard price x (Revised standard quantity– Actual Quantity)
=SP x (RSQ- AQ)
X= 5(20-24)= 5 x -4= ₹20(Adverse)
Y= 4(16-14) = 4 x 2= ₹8(Favourable)
Z= 3(12-10) = 3 x 2 = ₹6(Favourable)
Material Mix variance =₹6 (Adverse)
(v) Material sub-usage variance = Standard price x (Std quantity- Revised standard
Quantity)Since standard quantity and revised standard quantity are one and the same material
sub-usage variance is NIL.Verification: MCV =MPV+MUV
8.5(F) =14.5(F) +6(A)
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5.6 DIRECT LABOUR VARIANCES
1. Direct Labour Cost Variance
It is the difference between direct labour cost allowed for the actual output and the actual
direct labor cost incurred.As per I.C.M.A. Terminology, direct wages variance is “the difference
between the standard direct wages specified for the activity achieved and the actual direct wages
paid”.
Formula:
Direct Labour Cost Variance (DLVC) = Standard labour cost for actual output – Actual
labour cost incurred
= (Standard rate x Standard time for actual output) – (Actual rate x Actual time)
= (S.R x S.T) – (A.R x A.T)
If actual labour cost is more the variance is negative and vice versa. The symbols ‘+’
and‘–‘indicate positive and negative variances.Labour cost can be further analysed as follows:
293
2. Direct Labour rate Variance
It is also called wages rate variance or Labor rate variance. It is “that proportion of the direct
wages variance which is due to the difference between the standard rate of pay specified and
actual rate paid”. I.C.M.A.
Formula:
Direct Labour Rate Variance (D.L.R.V) = Standard wages for actual time – Actual wages paid
= Actual time x (Standard Rate – Actual Rate)
= A.T. x (S.R. – A.R.)
Here the actual time refers to the time for which wages are paid. It includes the idle time
also for which workers are eligible for payment.
Reasons for Labour Rate variance
 More or less wages are due to more skilled workers with higher rate or new workers
with lower rate being used.

 Change in wage rate
 Change in grades of workers.
 Employment of casual workers.
 More overtime work than specified.
 Faulty recruitment.
 Changes in gang position.
 Wrong standards set.
 Higher rates due to pressure of work, etc.
Labor rates are generally uncontrollable, mainly because of Labour unions and agreements
relating to wage rates. However, it may be possible to control the overtime work, gang
composition, etc.
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3. Total Direct Labour Efficiency Variance
It is also called Labour time variance because it accounts for the difference between the
total time for which workers are paid and the time effectively used for production as per the
standards of efficiency.
It is “That portion of the direct wages variance which is due to the difference
between the standard labour hours specified for the activity achieved and the actual labour
hours expended”. I.C.M.A
The direct labour efficiency or time variance actually includes three components. It
includes that portion of abnormal idle time which is due to uncontrollable causes. It also
includes the time difference and cost due to change in the labour mix or composition of the labor
gangs (groups). Finally it contains the cost of difference in time due to efficiency or inefficiency
of the workers.
Formula:
Total Direct Labour Efficiency Variance (T.D.L.E.V.)
= Standard wages for actual output – Actual time at standard rate
= Standard rate x (Standard time for actual output – Actual time)
= S.R. (S.T. – A.T.)
Reasons for Labour efficiency variance:
Different factors affect labour efficiency, some favourable and others adversely.
 Supervision
 Quality of materials
 Tools and equipment
 Morale of workers
 Incentive systems
 Working conditions
 Coordination in workers gangs
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 Labour turnover
 Training to workers
 Rigidity of inspection
 Method of production
 Faulty standard setting, etc.
4. Direct Labor Efficiency Variance
This variance is that portion of the total direct labour efficiency variance which is the result of
causes other than idle time. Idle time variance is separately calculated.
Formula:
Direct Labor Efficiency Variance (D.L.E.V.)
= Standard wages for actual output – Standard wages for actual time worked
= Standard rate x (Standard time for actual output – Actual time worked)
= SR (ST – AT worked)
5. Direct Labor Idle Time Variance
Idle time variance is due to time lost abnormally on account of strikes, lockouts, power
failure, machine breakdown, etc. Time wasted due to such cases on which the individual workers
have no control should be separately accounted for and should be shown as a separate variance.
Formula:
Direct Labor Idle Time Variance (D.L.I.T.V.)
= Standard rate hour / Day x Idle time in house / day
= S.R. x I.T.
It should be noted that this variance is always adverse.
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6. Direct Labour Mix or Gang Composition Variance
Labour mix variance arises only when two or more kinds of Labor perform some work as a
group or gang. Mix variance reflects the cost of any change in the composition of labour
groups. It may be favorable if cheaper labour is used in place of costly labour and vice versa.
Formula:
Direct Labour Mix Variance (D.L.M.V.)
= Standard rate x (Revised standard time – Actual time worked)
= S.R. x [R.S.T. – A.T. (worked)]
Note: Idle time should be excluded from “Actual time”.
Revised Standard Time
Total Actual time
= ------------------------ x Standard time of each grade of workers
Total Standard time
7. Revised Labour Efficiency Variance
When labour mix variance is calculated, the balance of Labor efficiency variance must be
due to the actual efficiency or inefficiency of the workers. It may be called ‘Revised labour
efficiency variance’. This variance is calculated in the same way as material sub-usage
variance, when information about output is not given.
Formula:
Revised Labour Efficiency Variance
= Standard rate x (Standard time for actual output - Revised standard time)
= S.R. x (S.T. – R.S.T.)
The total of mix variance and revised labor efficiency variance will be equal to the ‘Labour
efficiency variance’.
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8. Labour Yield Variance
This variance is calculated on the same lines as material yield variance. It may be defined as “the
variation in labour cost on account of increase or decrease in yield or output as compared to the
relative standard”.
The variance is calculated when information about output is given.
(Otherwise, revised labour efficiency variance is calculated.)
Formula:
Direct Labour Yield Variance (D.L.Y.V.)
= Standard labour cost per unit of output x (Standard output for actual time – Actual output)
It should be noted that if actual output is more than the standard output for actual time, the
variance is favourable and vice versa. The symbols ‘+’ and ‘-’ indicate adverse and favourable
variances respectively. The logic is the same as in case of material yield variance. Other labour
variances are concerned with input i.e., time and rate whereas yield variance is concerned with
output.
9. Revision Variance
Sometimes, management may be forced to revise standards during a budget. Change in

wage rates is the major cause for such revision. In such cases, a revision variance is calculated
separately. All other variants will be computed, using the revised standards as though they are
the real standards.
Formula:
Revision Variance
= Original Standard cost of Actual output – Revised Standard cost of Actual output
It should be specifically noted that, after ascertaining revision variance, the revised
standard (or) standards will be used for computing all other labor variances.
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PROBLEMS
1. A. Calculate labour rate variance from the following:
Standard:
40 workers to work for 8 hours per day in a five day week and get paid at Rs. 10 per hour.
Actual:
43 workers worked on average 9 hours per day in the five day week and were paid at Rs. 11 per
hour on average.
B. In a factory, the standard rate for labour hours is fixed at Rs. 20. During the month of
March 1999,
80,000 hours of Labour were recorded and were paid as follows:
25,000 hours at rupees 20 per hour
Calculate labor rate variance.
C. Standard:
40 men at rupees 25 per hour
20 women at rupees 20perhour
Standard working week: 8 hours per day for five days.
Actual:
35 men at Rs.26 per hour.
28 women at Rs.19 per hour.
Compute labour rate variance.
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Solution:
A. Labour Rate Variance = Actual time x (Standard rate – Actual rate)

= 1935 x (10 – 11)
= 1935 x - 1 =Rs. 1935 (A)
Note: ‘A’ denotes adverse variance.
Working Note:
Computation of actual time
43 workers at 9 hours per day for 5 days
= 43 x 9 x 5 = 1935 labour hours.
B. Labour Rate Variance = Actual time x (Standard rate – Actual rate)

= 25,000 (20 – 20) = 25,000 x 0 = 0
= 30,000 (20 – 23) = 30,000 x -3 = 90,000 (A)
= 25,000 (20 – 25) = 25,000 x -5 = 1, 25,000 (A)
-------------------
Labour Rate Variance Rs. 2, 15,000 (A)
--------------------
Note: Because of the difference in rates, L.R.V. is shown separately for hours carrying different
rates.
1. Labour Rate Variance = Actual time x (Standard rate – Actual rate)
Men = 1,400 (25 – 26) = 1,400 x -1 = Rs.1, 400 (A)

Women = 1,120 (20 – 19) = 1,120 x 1 = Rs. 1,120 (F)
--------------
Rs. 280 (A)
---------------
Note: It is assumed that 5 days at 8 hours per day are actually worked.
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‘F’ denotes favourable variance.
2. A. Standard production for the week ending 31st December 1998: 5,000 Units, with a
Standard time of 1.5 hours each, at Rs. 10 per hour.
Actual results:
4800 units were produced, using 8000 hours at a cost of rupees 12,800.
Calculate labour time or efficiency variance.
B. 50 workers, working for 8 hours a day were asked to finish a job in 10 working days, as
a part of standard costing system, to be paid at Rs. 50 per labour hour.
40 workers finished the job in 15 days of 8 hours each, of which they were all idle for half a day
due to power failure.
Calculate efficiency variance and idle time variance.
C. The following is the standard gang of Labour.
Skilled: 10 workers at rupees 80 per hour.
Unskilled: 15 workers at rupees 50 per hour
Standard hours of the day: 8 hours.
Standard output by gang: 2000 units.
Actual output: 1200 units.
Idle time due to machine breakdown 2 hours
Actual gang:
Skilled: 12 workers
Unskilled: 10 workers
Calculate labour efficiency, mix and idle time variance.
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Solution:
A. Labour efficiency (or) Time variance

= 10 x (7,200-8,000)
=10 x -800 = Rs. 8,000(A)
W.N.
Standard time for Actual output = Actual output x standard time per unit
=4,800x1.5= 7,200 hours
(B)(1) Total labour Efficiency variance
= Standard rate x ( std time for actual output - Actual time)
= 50x (4,000-4,800)
= 50x- 800= Rs. 40,000(A)
W.N.1:
Standard time for actual output = 50 workers x 8 hours per day x 10 days
= 50x 8x 10 = 4,000 labours hours
W.N.2:
Actual time = 40 workers x 8 hours x 15 days
= 40x 8x 15= 4,800 labours hours
W.N.3:
Idle time = 40 workers x 8 hoursx1/2 day
= 40x8x1/2= 160 labour hours
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(2) Labour efficiency variance
= 50 x (4,000-4,640)
= 50x- 640 = Rs. 32,000(A)
W.N.4: Actual time worked = Actual time – Idle time

= 4,800 hours – 160 hours = 4,640 hours
(3) Labour Idle time variance = Std rate x Idle time hours
= 50x 160= Rs. 8,000(A)
NOTE: (1): Idle time variance is always adverse

(2): ‘A’ indicates adverse variance and ‘F’ indicates favourable variance
VERIFICATION:
Total labour efficiency variance = Labour efficiency variance+ Idle time variance
=Rs 40,000(A) =Rs 32,000(A) + Rs 8,000(A)
(C)(1) Total direct labour efficiency variance
Skilled = 80 x (48-96) = 80x-48= -3,840 (A)
Unskilled = 50 x (72-80) = 50x-8= -400 (A)
-----------
Total direct labour efficiency variance = Rs.4, 240 (A)
------------
W.N. 1 Actual time = Skilled 12 x 8 = 96 hours
= Unskilled 10 x 8 = 80 hours
-----------
176 hours
-------------
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W.N. 2
Standard time for actual output = Skilled 10 x 8 x 1200 / 2,000 = 48 hours
Unskilled 15 x 8 x 1200 / 2,000 = 72 hours
(2) Direct labour efficiency variance

Skilled = 80 x (48 – 72) = 80 x - 24 = Rs. 1,920 (A)
Unskilled = 50 x (72 – 60) = 50 x 12 = Rs. 600 (F)
Labour efficiency variance = Rs. 1,320 (A)
W.N. 3 Actual time worked = Actual time – Idle time

Skilled = (12 x 8) – (12 x 12) = 96 – 24 = 72 hours
Unskilled = (10 x 8) – (10 x 2) = 80 – 20 = 60 hours
(3) Labour Idle time Variance = Standard rate x Idle time hours
Skilled = 80 x 24 = Rs. 1,920 (A)

Unskilled = 50 x 20 = Rs. 1,000 (A)
Labour Idle time Variance = Rs. 2,920 (A)
Verification: T.D. L.E.V. = D.L.E.V. + L.I.T.V.

= 4,240 (A) = 1,320 (A) + 2,920 (A)
Note: Labour Idle time Variance is always negative

‘A’ indicates adverse variance and ‘F’ indicates positive variance.
(4) Labour mix variance = Standard rate x (Revised standard time – Actual time worked)
Skilled = 80 x (52.8 – 72) = 80 x -19.2 = Rs. 1,536 (A)
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Unskilled = 50 x (79.2 – 60) = 50 x 19.2 = Rs. 960 (F)
Labour mix variance = Rs. 576 (A)
W.N. 4
Total actual time worked

Revised standard time = -------------------------------- x Standard time of each grade of workers
Total Standard time
Skilled = 132 / 200 x 80 = 52.8 hours
Unskilled = 132 / 200 x 120 = 79.2 hours
Note: If labour yield variance is also calculated, the mix and yield variances together will be
equal to labour efficiency variance.
3. The following data is gathered from the records of Samuel and Company for the month
of January 1997:
Standards for labour:
Rate: Rs. 50 per labour hour
Hours set per unit: 10 hours
Actual data for the month:
Units produced: 1,000
Hours worked: 12,000
Actual labour cost: Rs. 7, 20,000
You are required to calculate labour variances.
Solution:
1. Labour cost variance
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= (Standard rate x Standard time for actual output) – (Actual rate x Actual time)
= (50 x 10,000) – (7, 20,000)
= 5, 00,000 – 7, 20,000 = Rs. 2, 20,000 (A)
Note: Actual rate x Actual time = Actual labour cost = 7, 20,000 (given)
W.N. 1
Standard time for actual output = Actual output x Standard time per unit of output
= 1,000 x 10 = 10,000 hours.
2. Labour rate variance = Actual time x (Standard rate – Actual rate)

= 12,000 (50) – (7, 20,000)
= 6, 00,000 – 7, 20,000 = Rs. 1, 20,000 (A)
Note: Actual rate x Actual time = Actual labour cost = 7, 20,000 (given)
3. Labour efficiency variance = Standard rate x (Standard time for actual output – Actual time)
= 50 (10,000 – 12,000)
= 50 x – 2,000 = Rs. 1, 00,000 (A)
Note: A’ denotes adverse variance and ‘F’ denotes favourable variance.
Verification:
Labour cost variance = Labour rate variance + Labour efficiency variance
= Rs. 2, 20,000 (A) =Rs. 1, 20,000 (A) + Rs. 1, 00,000 (A)
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5.7 ACCOUNTING STANDARDS
MEANING
Accounting Standards may be defined as policy documents issued by an expert

accounting body or Government or other regulatory body covering the aspects of recognition,
measurement, treatment, presentation and disclosure of accounting transactions in the financial
statement.
Who has set these Accounting Standards?
Accounting Standards in India are issued by the Institute of Chartered Accountants of

India (ICAI).
PURPOSE OF DEVELOPING ACCOUNTING STANDARDS
 Standardize the diverse accounting policies and practices,
 Ensure comparability of financial statements,
 Establish reliability to financial statements,
 Ensure confidence in the users of information,
 Ensure Universal acceptance of financial statements, and
 Ensure correct Accounting treatment.
SIGNIFICANCE
 Accounting Standards seek to describe accounting principles, the valuation techniques
and the method of applying accounting principles in the preparation and presentation of
financial statements.
 Accounting Standards are a regulatory framework within which financial statements are
prepared for universal acceptance.

 Institute of Chartered Accountant of India (ICAI), the apex body in India, is a member of
the International Accounting Standard Committee (IASC) – London.

 ICAI has issued 31 accounting standards.
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ROLE OF ACCOUNTING STANDARDS
 Recognition of events and transactions in the financial statements,
 Measurement of these transactions and events,
 Presentation of these transactions and events in the financial statements in a manner that
is meaningful and understandable to the reader, and

 The disclosure relating to these transactions and events to enable the public at large and
the stakeholders and the potential investors in particular, to get an insight into what these
financial statements are trying to reflect and thereby facilitating them to take prudent and
informed business decisions.
BENEFITS
Accounting Standards seek to describe the accounting principles, the valuation techniques
and the methods of applying the Accounting principles in the preparation and presentation of
financial statements so that they may give a true and fair view. By setting the Accounting
Standards, the Accountant has following benefits:
 Standards reduce to a reasonable extent or eliminate altogether confusing variations in the
accounting treatments used to prepare financial statements.

 There are certain cases where important information are not statutorily required to be
disclosed. Standards may call for disclosure beyond that required by law.
 The application of Accounting Standards would, to a limited extent, facilitate comparison
of financial statements of companies situated in different parts of the world and also of
different companies situated in the same country. However it should be noted in this
respect that differences in the institutions, traditions and legal systems from one country
to another give rise to differences in accounting standards adopted in different countries.
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LIST OF ACCOUNTING STANDARDS OF ICAI: AS-1 TO AS-32 (UPDATED
01.02.2022)
Total of 32 Accounting Standards (AS-1 to AS-32) have been issued by the ICAI, out of
which AS-1 to AS-29 are mandatory in nature whereas AS-6, AS-8, AS-30, AS-31 and AS-32
have been withdrawn by ICAI through different Announcements. Therefore now effectively
there are only 27 Accounting Standards of ICAI as of 01/02/2022. All these accounting standards
are mandatory in nature, as of 01/07/2017 and onwards:
1. ICAI’s AS-1: Disclosure of Accounting Policies

AS-1 deals with the disclosure of significant accounting policies followed in preparing
and presenting financial statements, by way of a separate statement/ notes forming part of
such financial statements, to facilitate meaningful comparison of financial statements of
different enterprises/ periods.
2. ICAI’s :AS-2 Valuation of Inventories
This Standard deals with the determination of value at which inventories are carried in
the financial statements, including the ascertainment of cost of inventories and any write-
down thereof to net realisable value.
3. ICAI’s AS-3: Cash Flow Statements

This Standard deals with the provision of information about the historical changes in cash
and cash equivalents of an enterprise by means of a Cash Flow Statement which classifies
cash flows during the period from operating, investing and financing activities.
4. ICAI’s AS-4: Contingencies and Events Occurring After Balance Sheet Date
This Standard deals with the treatment of contingencies and events occurring after the
balance sheet date.
5. ICAI’s AS-5: Net profit or Loss for the period, Prior Period Items and Changes in
Accounting Policies
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This Standard should be applied by an enterprise in presenting profit or loss from
ordinary activities, extraordinary items and prior period items in the Statement of Profit
and Loss, in accounting for changes in accounting estimates, and in disclosure of changes
in accounting policies.
6. ICAI’s AS-7: Construction Contracts

This Standard prescribes the accounting for construction contracts in the financial
statements of contractors.
7. ICAI’s AS-9: Revenue Recognition

This Standard deals with the bases for recognition of revenue in the Statement of Profit
and Loss of an enterprise. The Standard is concerned with the recognition of revenue
arising in the course of the ordinary activities of the enterprise from: a) Sale of goods; b)
Rendering of services; and c) Interest, royalties and dividends.
8. ICAI’s AS-10: Property, Plant and Equipment
The objective of this Standard is to prescribe the accounting treatment for property, plant
and equipment (PPE).
9. ICAI’s AS-11: The Effects of Changes in Foreign Exchange Rates

AS 11 lays down principles of accounting for foreign currency transactions and foreign
operations, i.e., which exchange rate to use and how to recognise in the financial
statements the financial effect of changes in exchange rates.
10. ICAI’s AS-12: Government Grants
This Standard deals with accounting for government grants. Government grants are
sometimes called by other names such as subsidies, cash incentives, duty drawbacks, etc.
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11. ICAI’s AS-13: Accounting for Investments
This Standard deals with accounting for investments in the financial statements of
enterprises and related disclosure requirements.
12. ICAI’s AS-14: Accounting for Amalgamations
This Standard deals with accounting for amalgamations and the treatment of any resultant
goodwill or reserves.
13. ICAI’s AS-15: Employee Benefits
The objective of this Standard is to prescribe the accounting treatment and disclosure for
employee benefits in the books of employer except employee share-based payments. It
does not deal with accounting and reporting by employee benefit plans.
14. ICAI’s AS-16: Borrowing Costs
This Standard should be applied in accounting for borrowing costs. This Standard does
not deal with the actual or imputed cost of owners’ equity, including preference share
capital not classified as a liability.
15. ICAI’s AS-17: Segment Reporting
The objective of this Standard is to establish principles for reporting financial

information, about the different types of segments/ products and services an enterprise
produces and the different geographical areas in which it operates.
16. ICAI’s AS-18: Related Party Disclosures
This Standard should be applied in reporting related party relationships and transactions
between a reporting enterprise and its related parties. The requirements of this Standard
apply to the financial statements of each reporting enterprise and also to consolidated
financial statements presented by a holding company.
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17. ICAI’s AS-19: Leases
The objective of this Standard is to prescribe, for lessees and lessors, the appropriate
accounting policies and disclosures in relation to finance leases and operating leases.
18. ICAI’s AS-20: Earnings Per Share
AS 20 prescribes principles for the determination and presentation of earnings per share
which will improve comparison of performance among different enterprises for the same
period and among different accounting periods for the same enterprise.
19. ICAI’s AS-21: Consolidated Financial Statements
The objective of this Standard is to lay down principles and procedures for preparation
and presentation of consolidated financial statements. These statements are intended to
present financial information about a parent and its subsidiary (ies) as a single economic
entity to show the economic resources controlled by the group, obligations of the group
and results the group achieves with its resources.
20. ICAI’s AS-22: Accounting for Taxes on Income
The objective of this Standard is to prescribe accounting treatment of taxes on income

since the taxable income may be significantly different from the accounting income due
to many reasons, posing problems in matching of taxes against revenue for a period.
21. ICAI’s AS-23: Accounting for Investments in Associates
This Standard should be applied in accounting for investments in associates in the

preparation and presentation of consolidated Financial Statements (CFS) by an investor.
22. ICAI’s AS-24: Discontinuing Operations
The objective of AS 24 is to establish principles for reporting information about

discontinuing operations, thereby enhancing the ability of users of financial statements to
make projections of an enterprise’s cash flows, earnings generating capacity, and
financial position by segregating information about discontinuing operations from
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information about continuing operations. AS 24 applies to all discontinuing operations of
an enterprise.
23. ICAI’s AS-25: Interim Financial Reporting
This Standard applies if an entity is required or elects to publish an interim financial

report. The objective of AS 25 is to prescribe the minimum content of an interim
financial report and to prescribe the principles for recognition and measurement in
complete or condensed financial statements for an interim period.
24. ICAI’s AS-26: Intangible Assets
AS 26 prescribes the accounting treatment for intangible assets (i.e. identifiable non-
monetary asset, without physical substance, held for use in the production or supply of
goods or services, for rental to others, or for administrative purposes).
25. ICAI’s AS-27: Financial Reporting of Interests in Joint Ventures
The objective of AS 27 is to set out principles and procedures for accounting for interests
in joint ventures and reporting of joint venture assets, liabilities, income and expenses in
the financial statements of venturers and investors.
26. ICAI’s AS-28: Impairment of Assets
The objective of AS 28 is to prescribe the procedures that an enterprise applies to ensure

that its assets are carried at no more than their recoverable amount. The asset is described
as impaired if its carrying amount exceeds the amount to be recovered through use or sale
of the asset and AS 28 requires the enterprise to recognise an impairment loss in such
cases. It should be noted that AS 28 deals with impairment of all assets unless
specifically excluded from the scope of the Standard.
27. ICAI’s AS-29: Provisions, Contingent Liabilities and Contingent Assets
The objective of AS 29 is to ensure that appropriate recognition criteria and measurement

bases are applied to provisions and contingent liabilities and that sufficient information is
disclosed in the notes to the financial statements to enable users to understand their
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nature, timing and amount. The objective of this Standard is also to lay down appropriate
accounting for contingent assets.
Note:
 ICAI has withdrawn the AS 8 on Accounting for Research and Development.
 ICAI Amends AS 2, AS 4, AS 10, AS 13, AS 14, AS 21, AS 29 and withdraws AS 6.

 ICAI withdraws its Announcement on Treatment of exchange differences under AS
11.
 Companies (Accounting Standards) Amendment Rules, 2018 notified by MCA: AS
11 amended.
List of ICAI’s Non-Mandatory Accounting Standards (AS 30~32)
ICAI has announced on 15 Nov. 2016 that ‘AS 30- Financial Instruments: Recognition
and Measurement’, ‘AS 31- Financial Instruments: Presentation’, ‘AS 32- Financial Instruments:
Disclosures’ stands withdrawn.
LIMITATIONS
 Alternative solutions to certain accounting problems may each have arguments to
recommend them. Therefore the choice between different alternative accounting

treatments may become difficult.
 There may be a trend towards rigidity and away from flexibility in applying the
accounting standards.
 Accounting Standards cannot override the statute. The standards are required to be
framed within the ambit of prevailing statutes.
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5.8 ACCOUNTING DISCLOSURE PRACTICES IN INDIA
The information presented in the financial statements of an organisation is of its financial

position. The profit or loss can be affected to a large degree by the accounting policies followed.
The accounting policies followed vary from organisation to organisation.
It is important to disclose significant accounting policies followed to make the financial
statements understandable. The disclosure is required by law in certain cases. In recent years,
organisations in India have adopted the practice of including a separate statement of accounting
policies followed in their annual reports to shareholders.
Many organisations list the accounting policies followed by them in the notes to their
financial statements, but there is no consistency in the disclosures among organisations.
In other words, the disclosure forms part of accounts in some cases, while in others it is given as
supplementary information. The purpose of this standard is to promote a better understanding of
financial statements by establishing the practice of disclosure of significant accounting policies
followed and the manner in which they are disclosed in the financial statements. Such disclosure
would also facilitate a more meaningful comparison between financial statements of different
organisations.
INTRODUCTION TO DISCLOSURE OF ACCOUNTING POLICIES (AS-1)
1. This Standard deals with the disclosure of significant accounting policies followed in
preparing and presenting financial statements.
2. The view presented in the financial statements of an enterprise of its state of affairs and of the
profit or loss can be significantly affected by the accounting policies followed in the preparation
and presentation of the financial statements. The accounting policies followed vary from
enterprise to enterprise. Disclosure of significant accounting policies followed is necessary if the
view presented is to be properly appreciated.
315
3. The disclosure of some of the accounting policies followed in the preparation and presentation
of the financial statements is required by law in some cases.
4. The Institute of Chartered Accountants of India has, in Standard issued by it, recommended
the disclosure of certain accounting policies, e.g., translation policies in respect of foreign
currency items.
5. In recent years, a few enterprises in India have adopted the practice of including in their
annual reports to shareholders a separate statement of accounting policies followed in preparing
and presenting the financial statements.
6. In general, however, accounting policies are not at present regularly and fully disclosed in all
financial statements. Many enterprises include in the Notes on the Accounts, descriptions of
some of the significant accounting policies. But the nature and degree of disclosure vary
considerably between Disclosure of Accounting Policies 3 the corporate and the non-corporate
sectors and between units in the same sector.
7.Even among the few enterprises that presently include in their annual reports a separate
statement of accounting policies, considerable variation exists. The statement of accounting
policies forms part of accounts in some cases while in others it is given as supplementary
information.
8.The purpose of this Standard is to promote better understanding of financial statements by
establishing through an accounting standard the disclosure of significant accounting policies and
the manner in which accounting policies are disclosed in the financial statements. Such
disclosure would also facilitate a more meaningful comparison between financial statements of
different enterprises.
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FUNDAMENTAL ACCOUNTING ASSUMPTIONS
Certain assumptions are used in the preparation of financial statements. They are usually
not specifically stated because they are assumed to be followed. Disclosure is necessary only if
they are not followed. The following have been generally accepted as fundamentalaccounting
assumptions:
 Going Concern: The organisation is normally viewed as a going concern, that is to say,
it will be in continuing operations for the foreseeable future. It is assumed that the
organisation has neither the intention nor the necessity of shutting down or reducing the
scale of operations.
 Consistency: It is assumed that accounting policies are consistently followed from one
period to another. No frequent changes are expected.\
 Accrual: Revenues and costs are recorded when they are earned or incurred (and not as
money is received or paid) in the periods to which they relate.
NATURE OF ACCOUNTING POLICIES
Accounting policies refer to accounting principles and the methods of applying these
principles adopted by the organisation in the preparation of their financial statements. There is no
single list of accounting policies that are applicable in all circumstances. The different
circumstances in which organisations operate make alternative accounting principles acceptable.
The choice of the appropriate accounting principles calls for a large degree of judgment by the
management of the organization.The various standards of the Institute of Chartered Accountants
of India, combined with the efforts of the Government and other regulatory agencies have
reduced the number of acceptable alternatives in recent years, particularly in the case of
corporations. While continuing efforts in this regard in the future are likely to reduce the number
still further, the availability of alternative accounting principles is not likely to be eliminated
altogether keeping in mind the different circumstances faced by the organisations.
Areas in which differing Accounting Policies are possible to be adopted. The following
are examples of areas in which different accounting policies may be adopted by organisations.
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1. Methods of depreciation, depletion and amortisation
2. Treatment of expenditure during construction
3. Conversion or translation of foreign currency items
4. Valuation of inventories
5. Treatment of goodwill
6. Valuation of investments
7. Treatment of retirement benefits
8. Recognition of profit on long-term contracts
9. Valuation of fixed assets
10. Treatment of contingent liabilities
The above list of examples is not exhaustive.
CONSIDERATIONS IN THE SELECTION OF ACCOUNTING POLICIES

The primary consideration in the selection of accounting policies by an organisation is that
the financial statements should represent a true and fair picture of the financial position for the
period. For this purpose, the major considerations governing the selection and application of
accounting policies are:
 Prudence: In view of the uncertainty of future events, profits are not anticipated but
recognised only when earned, though not necessarily in cash. However, provision is
made for all known liabilities and losses even though the amount cannot be
determined with certainty and represents only an estimate.
 Substance over Form: The accounting treatment and presentation of transactions and
events in financial statements should be governed by their substance and not merely
by the legal form.
 Materiality: Financial statements should disclose all “material” items, i.e. items, the
knowledge of which might influence the decisions of the user of the financial
statements.
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DISCLOSURE OF ACCOUNTING POLICIES
 To ensure proper understanding of financial statements, it is necessary that all significant
accounting policies adopted in the preparation and presentation of financial statements

must be disclosed.
 Such disclosure should form part of the financial statements.
 It would be helpful to the reader of financial statements if they are all disclosed in one
place instead of being scattered over several statements, schedules and notes.
 Any change in an accounting policy which has a significant effect should be disclosed.
 The amount by which any item in the financial statements is affected by such change
should also be disclosed to the extent it can be calculated.

 Where such amount is not ascertainable, wholly or in part, the fact should be disclosed.
 If a change is made in the accounting policies which has no material effect on the
financial statements for the current period but is expected to have a material effect in later
periods, the fact of such change should be appropriately disclosed in the period in which
the change is adopted.
 Disclosure of accounting policies or of the changes is not a remedy for any wrong or
inappropriate treatment of items in the accounts.
IMPORTANT PRINCIPLES TO FOLLOW

 All significant accounting policies used in the preparation and presentation of
financial statements should be disclosed.

 The disclosure should form part of the financial statements, normally in one place.
 Any change in the accounting policies which has a material effect in the current period
or is expected to have a material effect in later periods should be disclosed. In case of

a change in accounting policies which has a material effect in the current period, the
amount by which any item in the financial statements is affected should also be
disclosed to the extent it can be calculated. Where such amount is not ascertainable,
wholly or in part, the fact should be indicated.
 If the fundamental accounting assumptions of Going Concern, Consistency, and
Accrual are followed in financial statements, specific disclosure is not required. If a

fundamental accounting assumption is not followed, the fact should be disclosed.
319
LEARNING OUTCOMES
 Meaning , objectives and importance of Budget and Budgetary control

 Determination of targets of the quantity to be produced during a period
 Identifying the Fixed expenses which remain constant irrespective of the level of
activity
 To apply the standard costing technique.
 To learn the types of variances.
 To learn about standard costing.
 To know the meaning of accounting standards.
 To understand the disclosure of accounting policies in India
SHORT ANSWER QUESTIONS:
1. What do you mean by a Budget?

2. Explain Flexible budget.
3. What is “standard Cost”?
4. Write short notes on accounting standards.
5. Write short notes on AS 3
6. What are the fundamental accounting assumptions?
LONG ANSWER QUESTIONS
1. What do you understand by Budget? What are the characteristics of a good Budget?
2. Explain the Merits and Demerits of standard costing
3. Discuss the important principles to follow in adopting the accounting standards.
320
PRACTICE PROBLEM
1. X Ltd. Sells two products A and B which are produced in its special products division. Sales
for the year 2019 were planned as follows:
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Units Units Units Units
Product A 10,000 12,000 13,000 15,000
Product B 5,000 4,500 4,000 3,800
The selling prices were Rs.20 per unit and Rs.50 per unit respectively for A and B. Average sales
returns are 5% of sales and the discounts and bad debts amount to 4% of the total sales.Prepare
Sales Budget for the year 2019.
2. A Manufacturing company submits the following figures of Product X for the first Quarter
of 2003
Sales in units:
January 50000
February 40000
March 60000
Selling price per unit Rs.100
Target of First Quarter 2004:
Sales units increased by 20%
Selling price increased by 10%
Prepare the sales budget.
321
3. The Royal industries has prepared its Annual sales forecast by expecting to achieve sales of
Rs. 30, 00,000 next year. The controller is uncertain about the pattern of sales to be expected
month by month. The following sales data pertain to the year, which is considered to be
representative of a normal year.
Month Sales(Rs) Month Sales(Rs)
Jan 1,10,000 July 2,60,000
Feb 1,15,000 August 3,30,000
March 1,00,000 Sep 3,40,000
April 1,40,000 Oct 3,50,000
May 1,80,000 Nov 2,00,000
June 2,25,000 Dec 1,50,000
Prepare a monthly sales budget for the coming year on the basis of the above data.
PRACTICE PROBLEMS
1. You are required to prepare a Production Budget for the half year ending June 2000 from
the following information:
Product Budgeted sales Actual stock on Desired stock on
Quantity 31.12.99 30.06.2000
units units units
S 20,000 4,000 5,000
T 50,000 6,000 10,000
2. Prepare a Production Budget for three months ending 31st March 1989, for a factory
producing four products on the basis of the following information:
Type of Product Estimated stock on Estimated sales Desired closing
1.1.89(units) during Jan-Mar stock on 31.3.1989
1989(units) (units)
A 8,000 40,000 12,000
B 12,000 60,000 20,000
322
C 16,000 52,000 12,000
D 12,000 48,000 8,000
3. Prepare a production budget from the following information

4.
PRACTICE PROBLEMS
1. A company expects to have Rs. 37,500 cash in hand on 1st April 2006 and requiresyou to
prepare an estimate of cash position during the three months April to June 2006. Thefollowing
information is supplied to you:
Other information:
(a) Period of credit allowed by suppliers – 2 months.
(b) 20% of sales is for cash and period of credit allowed to customers for credit sales idone
month.
(c) Delay in payment of wages and all expenses – 1 month.
323
(d) Income tax of Rs. 57,000 is due to be paid on June 15, 2006.
(e) The company is to pay dividends to shareholders and bonus to workers of Rs. 15,000 andRs.
22,500 respectively in the month of April.
(f) Plant has been ordered and is expected to be received and paid in May. It will cost Rs.
1, 20,000.
2. From the following information prepare a cash budget for the 3 months commencing
1st June, when the bank balance was Rs. 1, 10,000.
A sales commission of 5% on sales due 2 months after sales, is payable in addition tothe above
selling overheads. Capital expenditure: Plant purchased, June Rs. 38,000, payableon delivery,
building purchased June for Rs. 80,000, payable in two half yearly instalments, 1stin July and 1st
January of next year.A dividend of Rs. 20,000 will be paid in October. Period of credit allowed
by suppliersand to customers – 8 weeks. Lag in payment as to the following are to be taken into
account:
Wages – 1/8th month; factory overheads – 4 weeks; administrative overheads – 4 weeks;research

expenditure – 4 weeks; selling overheads – 4 weeks.
3. From the following budget data, forecast the cash position at the end of April, Mayand June
2002.
324
Sales: 20% realised in the month of sales, discount allowed 2%. Balance realised equally in
two subsequent months; Purchases: These are paid in the month following the month of supply;
Wages: 25% paid in arrears following month; Miscellaneous expenses: Paid a month in arrears;
Rent: Rs. 1,000 per month paid quarterly in advance due in April; Income tax: First instalment
of advance tax Rs. 25,000 due on or before 15th June; Income from investments: Rs. 5,000
received quarterly, in April July, etc.; Cash in hand: Rs. 5,000 on 1st April, 2002.
PRACTICE PROBLEMS
1.The monthly budgets for manufacturing overhead of a concern for two levels of activity were
as follows:
You are required:
325
(i) Indicate which of the items are fixed, variable and semi – variable.
(ii) Prepare a budget for 80% capacity and
(iii) Find the total cost, both fixed and variable, per unit of output at 60%, 80% and
100%capacity.
2. The expenses budgeted for production of 10,000 units in a factory are furnished below
Prepare a flexible budget for the production of (a) 8,000 units and (b) 6,000 units.
3. A company which supplies its output on contract basis as component to an assembling firm
has a contract to supply 10,000 units of its only product during 2019. The following were the
budgeted expenses and revenue
Material Rs.30 per unit

Wages Rs.20 per unit
Work expenses- Fixed Rs.80,000
Work expenses- Variable Rs. 8 per unit
General expenses(all fixed) Rs.1,20,000
Profit is 20% on sale price. Prepare the Budget for 2019 showing the cost and Profit
326
PRACTICE PROBLEMS
1. Given that the cost standards for materials consumption are 40 kgs at ₹10 per kg. Compute
the variances when actuals are”
a. 48 kgs at ₹10 per kg
b. 40 kgs at ₹ 12 per kg
2. The standard material and standard cost per kg of material required for the production of one
unit of Product “A” is as follows:
Material – 5 kgs
Standard price – ₹5 per kg
The actual production and related material data are as follows:
400 units of product “A”
Material used 2,200 kgs
Price of material per kg .4.50
Calculate (a) Material cost variance
(b) Material usage variance
(c) Material price variance
3. From the following data for May 2002 of a factory calculate:

1. Material cost variance
2. Material price variance
3. Material usage variance
4. Material mix variance
Name of Material Standard Actual
327
Kg Rate ₹ Kg Rate ₹
X 8000 1.05 7500 1.20
Y 3000 2.15 3300 2.30
Z 2000 3.30 2400 3.50
4. From the following data for May 2002 of a factory calculate:
Material variances
Name of Material Standard Actual
Qty (units) Price per unit₹ Qty(units) Price per unit
A 80 8 90 7.50
B 70 3 80 4
ANSWERS:
1.i)MCV= ₹80(A) , MUV= ₹80(A) ii) MCV= ₹80(A) MPV=₹80(A)
2.a)MCV = ₹100(F) b) MUV= ₹1,000(A) c) MPV = ₹1,100(F) Std. Qty = 2,000 kgs.
3.i) ₹3,540 (A) ii) ₹2,100 (A) iii) ₹1,140 (A) iv) ₹1,110 (A)
4.1) MCV Total ₹145 (A) 2) MPV Total ₹110 (A) 3) MUV Total ₹110 (A) 4) MMV Total ₹3.33
(F)5) Material sunusage variance or Revised Material usage variance Total ₹113.33(A)
328
PRACTICE PROBLEMS:
1. Data relating to a job are as under:
Standard rate of wages per hour: Rs. 10
Standard hours: 300
Actual rate of wages per hour: Rs. 12
Actual hours - 200
You are required to calculate:
i. Labour cost variance

ii. Labour rate variance
iii. Labour efficiency variance
2. From the data given below
Calculate cost, rate and efficiency variances for the department A
Actual gross wages (direct): Rs. 2000
Standard hours for production: 8000
Standard rate per hour: Re.0.30
Actual hours worked: 8200
3. The standard cost card reveals the following information:
Labour rate - 50 paise per hour
Hours set per unit - 10 hours
Actual data are given below:
Units produced - 500
329
Hours worked - 6500
Actual labour cost – Rs. 2400. Calculate labour variances.
Answers
1. i. L.C.V.: Rs. 600(F); ii. L.R.V.: Rs. 400(A), iii. L.E.V.: Rs.1, 000(F)
2. L.C.V.: Rs. 400(F); L.R.V.: Rs. 460(F), iii. L.E.V.: Rs. 60(A)
3. L.C.V.: Rs. 100(F); L.R.V.: Rs. 850(F), iii. L.E.V.: Rs. 750(A)
330

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ACCOUNTING FOR DECISION MAKING

UNIT I FINANCIALACCOUNTING - Introduction to Financial, Cost and

UNIT II ANALYSIS OF FINANCIAL STATEMENTS - Financial ratio analysis,

UNIT III COST ACCOUNTING - Cost Accounts – Classification of costs –

UNIT IV MARGINAL COSTING - Marginal Costing and profit planning – Cost,

UNIT V BUDGETING AND VARIANCE ANALYSIS - Budgetary Control –

 To understand the meaning and Process of Accounting

1.1.1. Introduction to Accounting

In an organization, numerous transactions take place. It is not possible for the

1.1.2. Meaning of Accounting

Accounting is the process of recording, classifying, summarizing, analyzing and

1.1.3. Process of Accounting

1.1.4. Internal Users of Accounting Information

1.1.6. TYPES OF ACCOUNTING

Modern Accounting can be classified into three categories

Financial accounting is mainly concerned with the recording of all financial

Definition of Financial Accounting

Objectives of Financial Accounting

The main objectives of Financial Accounting are:

1. ecording the transactions occurring in the business.

Benefits of Financial Accounting

The benefits of Financial Accounting are as follows:

Definition of Cost Accounting

Objectives of Cost Accounting

The main objectives of Cost Accounting are:

Benefits of Cost Accounting

The benefits of Cost Accounting are as follows:

The term Management accounting is concerned with description of accounting

Definition of Management Accounting

“Management Accounting is the term used to describe accounting methods, systems

Objectives of Management Accounting

The main objectives of Management Accounting are:

(i) Presenting Accounting information in a form that enables the Management to

Benefits of Management Accounting

The benefits of Management Accounting are as follows:

 It helps in decision making in the areas of pricing, make or buy, acceptance of

Basis of Distinction Financial Accounting Cost Accounting

Purpose It provides information regarding It guides the Management for

Recording Records are kept in a subjective Records are kept in an objective

Control It concentrates only on recording It provides a detailed system of

Periodicity Accounts are prepared at the end It is a continuous system of

Nature It records all commercial It is concerned with internal

Inventory Valuation Inventory is valued at cost or Inventory is valued at cost

1.1.8. DIFFERENCES BETWEEN COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Basis of Distinction Cost Accounting Management Accounting

Nature It deals with ascertaining, It deals with the effect and

Information type It is Quantitative. It is both Quantitative and

Objective To ascertain the cost of To provide information to

Base It acts as a base for It is derived from both Cost

Role It is helpful in collecting It plays a role in Decision

Scope It does not include Financial It includes Financial and Cost

Interdependency It can be installed without It cannot be installed without

1.1.9. DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

Basis of Distinction Financial Accounting Management Accounting

Nature It is an accounting system It is an accounting system

Nature of data It is mainly based on actual It is based on actual data as

Nature of statements General purposes Financial Special purposes Financial

Reality It is mainly objective It is both objective and

Users Both internal and external Only internal users can

Periodicity Accounts are prepared at the Management reports are